9.4 Other Lessor Reporting Issues

9.4.1 Commitments to Guarantee Performance of Underlying Asset

ASC 842-10

55-33 A lessor should evaluate a commitment to guarantee performance of the underlying asset or to effectively protect the lessee from obsolescence of the underlying asset in accordance with paragraphs 606-10-55-30 through 55-35 on warranties. If the lessor’s commitment is more extensive than a typical product warranty, it might indicate that the commitment is providing a service to the lessee that should be accounted for as a nonlease component of the contract.

For more information about commitments to guarantee performance of underlying assets, see Deloitte’s Roadmap Revenue Recognition.

9.4.2 Sales of Equipment With Guaranteed Minimum Resale Amount

ASC 842-30

55-1 This implementation guidance addresses the application of the provisions of this Subtopic in the following circumstances. A manufacturer sells equipment with an expected useful life of several years to end users (purchasers) utilizing various sales incentive programs. Under one such sales incentive program, the manufacturer contractually guarantees that the purchaser will receive a minimum resale amount at the time the equipment is disposed of, contingent on certain requirements.

55-2 The manufacturer provides the guarantee by agreeing to do either of the following:

Reacquire the equipment at a guaranteed price at specified time periods as a means to facilitate its resale
Pay the purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the guaranteed minimum resale value.

There may be dealer involvement in these types of transactions, but the minimum resale guarantee is the responsibility of the manufacturer.

55-3 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees that it has either a right or an obligation to reacquire the equipment at a guaranteed price (or prices) at a specified time (or specified time periods) as a means to facilitate its resale should be evaluated in accordance with the guidance on satisfaction of performance obligations in paragraph 606-10-25-30 and the guidance on repurchase agreements in paragraphs 606-10-55-66 through 55-78. If that evaluation results in a lease, the manufacturer should account for the transaction as a lease using the principles of lease accounting in Subtopic 842-10 and in this Subtopic.

55-4 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees that it will pay a purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the guaranteed minimum resale value should be accounted for in accordance with Topic 460 on guarantees and Topic 606 on revenue from contracts with customers.

55-5 The lease payments used as part of the determination of whether the transaction should be classified as an operating lease, a direct financing lease, or a sales-type lease generally will be the difference between the proceeds upon the equipment’s initial transfer and the amount of the residual value guarantee to the purchaser as of the first exercise date of the guarantee.

55-6 If the transaction qualifies as an operating lease, the net proceeds upon the equipment’s initial transfer should be recorded as a liability in the manufacturer’s balance sheet.

55-7 The liability is then subsequently reduced on a pro rata basis over the period to the first exercise date of the guarantee to the amount of the guaranteed residual value at that date with corresponding credits to revenue in the manufacturer’s income statement. Any further reduction in the guaranteed residual value resulting from the purchaser’s decision to continue to use the equipment should be recognized in a similar manner.

55-8 The equipment should be included in the manufacturer’s balance sheet and depreciated following the manufacturer’s normal depreciation policy.

55-9 The Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10 on property, plant, and equipment provide guidance on the accounting for any potential impairment of the equipment.

55-10 At the time the purchaser elects to exercise the residual value guarantee by selling the equipment to another party, the liability should be reduced by the amount, if any, paid to the purchaser. The remaining undepreciated carrying amount of the equipment and any remaining liability should be removed from the balance sheet and included in the determination of income of the period of the equipment’s sale.

55-11 Alternatively, if the purchaser exercises the residual value guarantee by selling the equipment to the manufacturer at the guaranteed price, the liability should be reduced by the amount paid to the purchaser. Any remaining liability should be included in the determination of income of the period of the exercise of the guarantee.

55-12 The accounting for a guaranteed minimum resale value is not in the scope of Topic 815 on derivatives and hedging. In the transaction described, the embedded guarantee feature is not an embedded derivative instrument that must be accounted for separately from the lease because it does not meet the criterion in paragraph 815-15-25-1(c).

55-13 Specifically, if freestanding, the guarantee feature would be excluded from the scope of paragraph 815-10-15-59(b) because of both of the following conditions:

It is not exchange traded.
The underlying on which settlement is based is the price of a nonfinancial asset of one of the parties, and that asset is not readily convertible to cash. It is assumed that the equipment is not readily convertible to cash, as that phrase is used in Topic 815.

55-14 Paragraph 815-10-15-59(b)(2) states that the related exception applies only if the nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. (In some circumstances, the exclusion in paragraph 815-10-15-63 also would apply.)

55-15 Lastly, Topic 460 on guarantees does not affect the guarantor’s accounting for the guarantee because that Topic does not apply to a guarantee for which the underlying is related to an asset of the guarantor. Because the manufacturer continues to recognize the residual value of the equipment guaranteed by the manufacturer as an asset (included in the seller-lessor’s net investment in the lease) if recording a sales-type lease, that guarantee does not meet the characteristics in paragraph 460-10-15-4 and is, therefore, not subject to the guidance in Topic 460. Additionally, if the lease is classified as an operating lease, the manufacturer does not remove the asset from its books, and its guarantee would be a market value guarantee of its own asset. A market value guarantee of the guarantor’s own asset is not within the scope of Topic 460, and the guidance in paragraphs 842-10-55-32 through 55-33 for an operating lease is not affected. As a result, the guarantor’s accounting for the guarantee is unaffected by Topic 460.

In certain arrangements, a supplier may provide a minimum resale value guarantee on equipment sold to a customer. The guarantee may be satisfied if the manufacturer either reacquires the equipment at a guaranteed price or pays the customer an amount representing the difference between the proceeds from selling the equipment and the amount of the guarantee. The supplier may need to consider the guidance in ASC 606 regarding whether the obligation to reacquire the equipment precludes sale accounting and whether, as a result of the guarantee, the arrangement would need to be accounted for as a lease.

For more information about whether a supplier may be required to account for the transaction as a lease because of a right or obligation (i.e., a call option or a forward) to reacquire an asset, see Section 2.3.1.1 or Deloitte’s Roadmap Revenue Recognition.

9.4.3 Accounting for Tenant Improvements and Lease Incentives

ASC 842-10

55-30 Lease incentives include both of the following:

Payments made to or on behalf of the lessee
Losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease for use of the assumed underlying asset.

ASC 842 largely does not change the accounting for tenant improvements and lease incentives. Lessor funding of lessee expenditures may be direct or indirect (e.g., cash paid directly to the lessee or cash paid to third parties on behalf of the lessee). The appropriate accounting for such lessor funding must be determined on the basis of the substance of the arrangement. The determination of whether amounts payable under the lease are a lease incentive should be made on the basis of the contractual rights of the lessee and lessor as well as considerations related to the specific asset.

Though superseded, the guidance in FASB Technical Bulletin 88-1 continues to be relevant to lease incentives by analogy. Paragraph 7 of Technical Bulletin 88-1 states, in part:

Payments made to or on behalf of the lessee represent incentives that should be considered reductions of rental expense by the lessee and reductions of rental revenue by the lessor over the term of the new lease. Similarly, losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party should be considered an incentive by both the lessor and the lessee. Incentives should be recognized on a straight-line basis over the term of the new lease.

Further, in a February 7, 2005, letter to the Center for Public Company Audit Firms, the SEC chief accountant discussed the accounting for lease incentives as follows:

Landlord/Tenant Incentives — The staff believes that: (a) leasehold improvements made by a lessee that are funded by landlord incentives or allowances under an operating lease should be recorded by the lessee as leasehold improvement assets and amortized over a term consistent with the guidance in item 1 above; (b) the incentives should be recorded as deferred rent and amortized as reductions to lease expense over the lease term in accordance with paragraph 15 of SFAS 13 and the response to Question 2 of FASB Technical Bulletin 88-1 (“FTB 88-1”), Issues Relating to Accounting for Leases, and therefore, the staff believes it is inappropriate to net the deferred rent against the leasehold improvements; and (c) a registrant’s statement of cash flows should reflect cash received from the lessor that is accounted for as a lease incentive within operating activities and the acquisition of leasehold improvements for cash within investing activities. The staff recognizes that evaluating when improvements should be recorded as assets of the lessor or assets of the lessee may require significant judgment and factors in making that evaluation are not the subject of this letter.

ASC 842-10-55-30(b) is clear on the accounting for payments made by a landlord to, or on behalf of, a tenant to fund items that would be an expense or obligation of the tenant, such as moving expenses or assumption of the tenant’s preexisting lease. However, when a landlord pays a tenant (or a third party) for improvements, the accounting is more complicated. In some situations, such payments may be lease incentives (e.g., leasehold improvements owned by the lessee), which the landlord would account for as such and amortize as a reduction of rental income over the lease term. In other situations, the landlord may be acquiring tangible assets (e.g., tenant improvements) to lease to the tenant, which the lessor would account for as its PP&E and depreciate over their useful life.

If, after considering the contractual terms of the arrangement and determining its substance, the landlord concludes that it is acquiring PP&E (e.g., tenant improvements) that is subject to a lease, it would be appropriate to account for such payments to the tenant as the acquisition of PP&E. However, notwithstanding the designation of the payment as a “tenant improvement allowance” in the lease agreement, if it is determined that, in substance, the landlord is not acquiring property, the landlord should account for such payments as lease incentives. Many lease agreements contain general provisions related to payments to fund such improvements. Such provisions may include those:

Stating that the intent of the payment is to fund “tenant improvements.”
Indicating that title to all “tenant improvements” is transferred to the landlord as soon as the improvements are installed.
Requiring the tenant to provide proof of the release of mechanics liens before the payment is made.
Requiring the tenant to submit architectural drawings and construction plans to the landlord for approval before construction.

By themselves, these provisions are not necessarily indicative of the arrangement’s substance and are not sufficient evidence that the landlord is acquiring property from the tenant. For example, an agreement may specify that the tenant intends to use the allowance to fund “tenant improvements” but (1) may not require that the tenant provide the landlord with proof of spending for such improvements or (2) may not otherwise provide for a mechanism under which the landlord can monitor the tenant’s usage of the allowance. In such instances, in the absence of other factors strongly indicating that landlord is acquiring PP&E (see factors listed below), it generally should be presumed that the payment to the tenant represents a lease incentive and not the acquisition of PP&E.

In other instances, the lease arrangement may require proof of expenditures related to improvements but give the tenant the right to retain or receive any allowance amounts that are greater than actual improvement costs. In such instances, in the absence of other factors strongly indicating that the landlord is acquiring PP&E (see factors listed below), it generally should be presumed that if a lease arrangement permits the tenant to retain this excess allowance as either cash or as a reduction of rent, the substance of the arrangement is that all or a portion of the allowance is a lease incentive and not the acquisition of property. Similarly, if the tenant has discretion regarding use of the funds received by the landlord (even if it is probable that such funds will be used to construct tenant improvements), the arrangement may, in substance, be the landlord’s provision of a lease incentive; in such an arrangement, any improvements may be considered assets of the tenant for accounting purposes.

If it is determined that, in substance, the improvements are assets of the tenant, the landlord should treat the funding provided to the tenant as a lease incentive in accordance with Technical Bulletin 88-1.

It is more difficult and subjective to determine the substance of a lease arrangement that does not (1) allow the tenant to retain the excess of landlord funding over actual improvement costs, (2) give the tenant discretion in how the allowance is spent, or (3) specifically identify the leased property as not including the leasehold improvements.

Generally, the terms of a lease arrangement obligate the landlord to deliver the property subject to the lease. However, the terms associated with the construction of related leasehold improvements typically vary from arrangement to arrangement. In some circumstances, a landlord may appropriately be considered owner of the leasehold improvements and therefore should not account for tenant allowances as a lease incentive. Factors to consider include, but are not limited to, whether the:

Lease agreement’s terms obligate the tenant to construct or install specifically identified assets (i.e., the leasehold improvements).
Tenant’s failure to make specified improvements is an event of default under which the landlord can require the lessee to make those improvements or otherwise enforce the landlord’s rights to those assets (or a monetary equivalent).
Tenant is permitted to alter or remove the leasehold improvements without the landlord’s consent or without compensating the landlord for any lost utility or diminution in fair value.
Tenant is required to provide the landlord with evidence supporting the cost of tenant improvements before the landlord pays the tenant for the tenant improvements.
Landlord is obligated to fund cost overruns for the construction of leasehold improvements.
Leasehold improvements are unique to the tenant or could reasonably be used by the lessor to lease to other parties.
Economic life of the leasehold improvements is such that a significant residual value of the assets is expected to accrue to the benefit of the landlord at the end of the lease term.

9.4.4 Accounting for Reimbursements of Repairs and Capital Improvements

Leases sometimes include provisions that require the lessor to perform routine repairs and maintenance for the underlying asset or that permit the lessor to make capital improvements to this asset (e.g., to replace the roof on a leased building). The contract may also allow the lessor to collect reimbursements of its costs for these activities from the lessee.

In determining how to account for lessee reimbursements of lessor repairs and capital improvements, the lessor should first consider whether its activities constitute a nonlease component of the contract. For example, lessee reimbursements to the lessor for routine repairs to the roof of the leased building may be part of a CAM nonlease component. See Section 4.3.1 for detailed discussion of identifying nonlease components in a contract, including CAMs. If the activity for which the lessor is being reimbursed represents a nonlease component of the contract, the lessor should follow the steps outlined in Section 4.4.2.2 by allocating the consideration in the contract to this nonlease component and recognizing revenue in accordance with ASC 606 (or other applicable GAAP).

In other circumstances, a lessor is reimbursed for a capital improvement that is not a nonlease component of the contract but part of the existing lease component. For example, lessors may have lease contracts that include provisions permitting them to charge their tenants for capital improvements to the leased property. In these types of contracts, the capital improvements are only made at the discretion of the lessor and the contract does not require that the lessor make any such improvements. In many circumstances, if the improvements are made by the lessor, the contract requires the lessee to reimburse the lessor for these capital improvements on a straight-line basis over the useful lives of such improvements; such reimbursements are made proportionately with respect to the lessee’s remaining lease term. If the lessee were to terminate the lease before the lease term expires, the lessor would have the right to recover all rents under the lease, including any remaining reimbursements. However, if the lessor terminates the lease early or the lease term expires, the lessee would not have any obligation to continue reimbursing the lessor.

Example 9-17

Lessee C enters into a 15-year lease of a building from Lessor B. The contract gives B the right to make capital improvements to the building and be reimbursed by C in the manner described above. Accordingly, at the end of year 5 of the lease, B spends $200,000 to replace the roof of the building. Lessor B concludes that the roof has a 20-year useful life, so it bills C $10,000 ($200,000 cost ÷ 20-year useful life) for reimbursement in each of the 10 years remaining in the lease. Therefore, B will recover half of the total cost of the roof from C by the end of the lease term. Lessor B concludes that the roof replacement does not constitute a nonlease component of the contract, since B is not providing a separate good or service to C by replacing the roof.

In the example above, provided that the lease is not modified as a result of the capital improvement,25 B should recognize variable lease revenue for the improvement-related reimbursements in the periods after the improvement is performed and as it continues to provide C with the right to use the leased asset (including the new roof), upon which reimbursement in future periods is contingent. Accordingly, B should recognize $10,000 of variable lease revenue per year over the remaining 10 years of the lease.

Since B knows that it will have the right to recover a total of $100,000 from C over the remaining lease term, some may argue that the condition in ASC 842-30-25-11(b) to recognize variable lease income is met as soon as the capital improvement is completed. However, we believe that it would be inappropriate for B to recognize the full $100,000 of future reimbursements as revenue when the improvement is completed because the amount is not earned at that point in time. Rather, the reimbursements depend not only on the completion of the new roof but also on the stipulation that B will continue to make the underlying leased asset available for C’s use for the remaining lease term (i.e., will continue to allow C to use the leased asset).

9.4.5 Accounting for Short Payments by Lessee

In some situations, a lessee may decide to make rent payments that are less than the amount contractually owed under the lease contract (i.e., short payments). In such cases, the lessee would be required to evaluate whether the terms and conditions of the lease contract provide the lessee with an enforceable right to make a payment less than the contractually stated amount (for example, force majeure or other similar clauses that apply upon the occurrence of unforeseen events or circumstances may allow the lessee to make short payments while the situation persists). If so, the lessor would treat such short payments from the lessee as variable lease payments (albeit negative variable lease payments). As a result, the lessor would recognize the difference between the periodic lease income determined at lease commencement and the revised payments from the lessee due to short payments as variable lease revenue (albeit negative variable rent) in the applicable period.

On the other hand, if the terms and conditions of the lease contract do not provide the lessee with an enforceable right to make short payments, the lessor should continue to account for the lease in accordance with its original terms, unless the contract is modified to incorporate changes to lease payments (see Section 9.3.4 for discussion of the lessor’s lease modification accounting, and see Section 17.3.4 for more information about short payments related to rent concessions resulting from COVID-19). However, short payments by the lessee may be indicative of a change in the lessee’s credit risk, which makes it no longer probable that the lessor will collect substantially all of the lease payments to which it is entitled under the lease contract. (For a detailed discussion of accounting implications associated with changes in a lessee’s credit risk after lease commencement, see Section 9.3.7.4 for sales-type and direct financing leases and Section 9.3.9.2.1 for operating leases.)

Footnotes

See the Connecting the Dots in Section 9.3.4.1 for additional discussion of when a significant asset improvement may qualify as a lease modification. If the lease is modified as a result of the capital improvement, the reimbursements would similarly be accounted for prospectively.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.