9.5 Leveraged Lease Accounting

9.5.1 History of and Accounting for Leveraged Leases

Under ASC 840, leveraged lease accounting was a special type of accounting that a lessor applied to certain direct financing leases because of its unique economic effect on the lessor. This unique economic effect stems from a combination of nonrecourse financing and a cash flow pattern that typically enables the lessor to recover its investment in the early years of the lease (as a result of tax benefits generated by depreciation, interest, and ITC deductions) and, thereafter, affords it the temporary use of funds from which additional income can be derived.

ASC 840-10-25-43(c) required that a lease be classified as a leveraged lease if it had all of the following characteristics:

It met the criteria in ASC 840-10-25-43(b) to be classified as a direct financing lease.
At least three parties were involved (i.e., a long-term creditor in addition to the lessee and lessor).
“The financing that the long-term creditor provided was “nonrecourse as to the general credit of the lessor.”
The lessor’s net investment in the lease declined in the lease’s early years and rose in its later years.

The accounting for leveraged leases under ASC 840 was very complex but followed two basic premises:

The lessor’s balance sheet reflected the lessor’s equity in the property on an after-tax basis, net of the related debt.
The lessor’s income statement reflected an after-tax constant rate of return on the lessor’s net investment. During those periods in which the net investment was zero or below zero, no income was recognized.

Bridging the GAAP

No Leveraged Lease Accounting Under IFRS Accounting Standards

IFRS Accounting Standards do not address leveraged leases. Therefore, the considerations in this section and the remainder of Section 9.5 do not apply to entities applying IFRS Accounting Standards. See Appendix B for a listing of the differences between ASC 842 and IFRS 16.

9.5.2 Impact of ASC 842 on Leveraged Lease Accounting

ASC 842-50 — Glossary

Leveraged Lease

From the perspective of a lessor, a lease that was classified as a leveraged lease in accordance with the leases guidance in effect before the effective date and for which the commencement date is before the effective date.

ASC 842-50

05-1 This Subtopic addresses accounting for leases that meet the definition of a leveraged lease.

ASC 842-10

65-1 . . .

z. For leases that were classified as leveraged leases in accordance with Topic 840, and for which the commencement date is before the effective date, a lessor shall apply the requirements in Subtopic 842-50. If a leveraged lease is modified on or after the effective date, it shall be accounted for as a new lease as of the effective date of the modification in accordance with the guidance in Subtopics 842-10 and 842-30. . . .

Leases previously classified as leveraged leases under ASC 840 will be subject to the guidance in ASC 842-50. The legacy accounting requirements are grandfathered in for leases that were entered into and accounted for as leveraged leases before the effective date of ASC 842. A leveraged lease modified on or after the effective date of ASC 842 would be accounted for as a new lease under the lessor model in ASC 842, which is discussed throughout this chapter. Entities are not permitted to account for any new or subsequently amended lease arrangements as leveraged leases after the effective date of ASC 842.

Paragraph BC397 of ASU 2016-02 summarizes the FASB’s reasoning for eliminating leveraged lease accounting for new leases under ASC 842 and grandfathering in the guidance for existing leveraged leases in ASC 842-50:

The Board decided that the existing accounting model for leveraged leases should not be retained. That is, all leases should be accounted for in a consistent manner and special rules should not exist for leases with certain characteristics. One reason is because leveraged lease accounting provides net presentation and some Board members do not agree with allowing a net presentation for only a subset of certain lease transactions. Another reason is to limit some of the complexity in the lease accounting guidance by eliminating the unique accounting for leveraged leases. As such, lessors should not distinguish leveraged leases from other leases in Topic 842. This is consistent with the proposed requirements in the 2010 and 2013 Exposure Drafts. However, the Board decided to grandfather existing leveraged leases during transition. Respondents to the 2013 Exposure Draft noted that the transition of existing leveraged leases to the current lessor model would require particular challenges when unwinding the income tax effects of the leveraged leases and income statement results on transition that would not properly depict the economics of the transaction. The Board recognized that there would be significant complexities relating to unwinding existing leveraged leases and that the outcome of doing so would not be beneficial to users. Therefore, the Board decided to grandfather the accounting under previous guidance for existing leveraged lease transactions.

ASC 842-50

Pending Content (Transition Guidance: ASC 805-60-65-1)

15-1 This Subtopic addresses accounting for leases that meet the criteria in transition paragraph 842-10-65-1(z). If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph 842-10-65-1(z) that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a lease modification as described in paragraph 842-10-65-1(z). A joint venture formation accounted for in accordance with Subtopic 805-60 shall apply the guidance in this Subtopic applicable to the acquiring entity in a business combination. The joint venture shall be viewed as analogous to the acquiring entity in a business combination, and any recognized businesses and/or assets shall be viewed as analogous to an acquiree.

9.5.3 Impact of Exercising Renewal Options on Leveraged Leases

ASC 842-10-65-1(z) states that if a leveraged lease is modified after the effective date of ASC 842, the lease would be accounted for as a new lease under ASC 842 and thus would no longer be classified as a leveraged lease. Questions have arisen about whether a lessee’s exercise of a renewal option would constitute a lease modification in accordance with the transition guidance related to leveraged leases in ASC 842-10-65-1(z). ASC 842-50-15-1 states, in part, “If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph 842-10-65-1(z) that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a lease modification as described in paragraph 842-10-65-1(z)” (emphasis added).

That is, to determine whether the exercise of a renewal option represents a lease modification, a lessor should consider whether the exercised option was previously contemplated and whether its exercise was deemed reasonably assured. In such circumstances, the option period would have been included in the original lease classification test and would have been reflected in the lessor’s net investment in the lease. If the lessor previously determined that the lessee’s exercise of the renewal option was reasonably assured, the actual exercise of the renewal option would not represent a lease modification. Because the leveraged lease is not modified in this scenario, the lessor would continue to account for the leveraged lease in accordance with ASC 842-50 upon the lessee’s exercise of the renewal option.

If, on the other hand, the lessor did not previously consider the exercise of the renewal option to be reasonably assured, the lessee’s exercise of the renewal option would represent a lease modification in accordance with ASC 842-50-15-1. In this case, upon the lessee’s exercise of the renewal option, the lessor would account for the modification in accordance with ASC 842-10 and ASC 842-30 and would no longer apply the guidance in ASC 842-50 on leveraged lease accounting.

9.5.4 Accounting for Existing Leveraged Leases Upon Adoption of ASC 842

As noted in Section 9.5.2, existing leveraged leases previously accounted for under ASC 840 will be grandfathered in during the transition to ASC 842 and subsequently accounted for in accordance with ASC 842-50. The guidance quoted in this section is being carried forward from ASC 840.26

Recognition of Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
ASC 840-30-25-8	ASC 842-50-25-1
ASC 840-30-25-9	N/A — see explanation below
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
ASC 840-30-25-10	ASC 842-50-25-2

ASC 842-50

General

25-1 A lessor shall record its investment in a leveraged lease. The net of the balances of the following accounts as measured in accordance with this Subtopic shall represent the lessor’s initial and continuing investment in leveraged leases:

Rentals receivable
Investment-tax-credit receivable
Estimated residual value of the leased asset
Unearned and deferred income.

Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity

25-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall retain the classification of the acquired entity’s investment as a lessor in a leveraged lease at the date of the combination. The net investment of the acquired leveraged lease shall be disaggregated into its component parts, namely net rentals receivable, estimated residual value, and unearned income including discount to adjust other components to present value.

As noted in the table above, the existing leveraged lease guidance in ASC 840-30-25-9 was not carried forward under ASC 842. ASC 840-30-25-9 stated the following:

If the projected net cash receipts (that is, gross cash receipts minus gross cash disbursements exclusive of the lessor’s initial investment) over the term of the leveraged lease are less than the lessor’s initial investment, the deficiency shall be recognized by the lessor as a loss at lease inception.

The reason that this guidance was not carried forward under ASC 842 is because it addressed the recognition of a loss at lease inception for leases classified as leveraged leases. Upon adoption of ASC 842, new leases (and modified leases) will not be classified as leveraged leases. Therefore, this guidance is no longer relevant for lessors upon adoption of ASC 842.

Initial Measurement of Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
ASC 840-30-30-14	ASC 842-50-30-1
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
ASC 840-30-30-15	ASC 842-50-30-2

ASC 842-50

General

30-1 A lessor shall initially measure its investment in a leveraged lease net of the nonrecourse debt (as discussed in paragraph 842-50-25-1). The net of the balances of the following accounts shall represent the initial and continuing investment in leveraged leases:

Rentals receivable, net of that portion of the rental applicable to principal and interest on the nonrecourse debt.
A receivable for the amount of the investment tax credit to be realized on the transaction.
The estimated residual value of the leased asset. The estimated residual value shall not exceed the amount estimated at lease inception except if the lease agreement includes a provision to escalate minimum lease payments either for increases in construction or acquisition cost of the leased property or for increases in some other measure of cost or value (such as general price levels) during the construction or preacquisition period. In that case, the effect of any increases that have occurred shall be considered in the determination of the estimated residual value of the underlying asset at lease inception.
Unearned and deferred income consisting of both of the following:
1. The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income over the lease term.
2. The investment tax credit remaining to be allocated to income over the lease term.

Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity

30-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall assign an amount to the acquired net investment in the leveraged lease in accordance with the general guidance in Topic 805 on business combinations, based on the remaining future cash flows and giving appropriate recognition to the estimated future tax effects of those cash flows.

9.5.5 Tax Considerations Related to Leveraged Leases Acquired in a Business Combination

In a business combination, an acquired entity’s individual assets and liabilities are generally assigned fair values before taxes are considered. In accordance with ASC 842-50-30-2, in recording a leveraged lease acquired in a business combination, the acquiring entity should use the remaining future cash flows while “giving appropriate recognition to the estimated future tax effects of those cash flows.” Therefore, the fair value assigned to an acquired leveraged lease is determined on an after-tax basis (i.e., net of tax), and deferred taxes should not be established for temporary differences related to acquired leveraged leases as of the acquisition date.

See ASC 842-50-55-27 through 55-33 (reproduced later in this chapter) for an example illustrating the accounting for a leveraged lease acquired in a business combination.

Subsequent Measurement of Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
ASC 840-30-35-32	ASC 842-50-35-1
Income Recognition on a Leveraged Lease
ASC 840-30-35-33 through 35-36	ASC 842-50-35-2 through 35-5
Changes in Assumptions
ASC 840-30-35-38 through 35-47	ASC 842-50-35-6 through 35-15
Effect of Alternative Minimum Tax
ASC 840-30-35-48 through 35-52	ASC 842-50-35-16 through 35-20
Transfer of Minimum Rental Payments
ASC 840-30-35-53	ASC 842-50-35-21

ASC 842-50

General

Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity

35-1 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall subsequently account for its acquired investment as a lessor in a leveraged lease in accordance with the guidance in this Subtopic as it would for any other leveraged lease.

Income Recognition on a Leveraged Lease

35-2 The investment in leveraged leases minus deferred taxes arising from differences between pretax accounting income and taxable income shall represent the lessor’s net investment in leveraged leases for purposes of computing periodic net income from the leveraged lease. Given the original investment and using the projected cash receipts and disbursements over the term of the lease, the rate of return on the net investment in the years in which it is positive shall be computed. The rate is that rate that, when applied to the net investment in the years in which the net investment is positive, will distribute the net income to those years and is distinct from the interest rate implicit in the lease. In each year, whether positive or not, the difference between the net cash flow and the amount of income recognized, if any, shall serve to increase or reduce the net investment balance. The use of the term years is not intended to preclude application of the accounting prescribed in this paragraph to shorter accounting periods.

35-3 The net income (or loss) that a lessor recognizes on a leveraged lease shall be composed of the following three elements:

Pretax lease income (or loss)
Investment tax credit
Tax effect of pretax lease income (or loss).

35-4 The pretax lease income (or loss) and investment tax credit elements shall be allocated in proportionate amounts from the unearned and deferred income included in the lessor’s net investment (as described in paragraph 842-50-30-1(d)). The tax effect of the pretax lease income (or loss) recognized shall be reflected in tax expense for the year. The tax effect of the difference between pretax accounting income (or loss) and taxable income (or loss) for the year shall be charged or credited to deferred taxes.

35-5 If, at any time during the lease term the application of the method prescribed in this Subtopic would result in a loss being allocated to future years, that loss shall be recognized immediately. This situation might arise in circumstances in which one of the important assumptions affecting net income is revised (see paragraphs 842-50-35-6 through 35-15).

Changes in Assumptions

35-6 Any estimated residual value and all other important assumptions affecting estimated total net income from the leveraged lease shall be reviewed at least annually. The rate of return and the allocation of income to positive investment years shall be recalculated from lease inception following the method described in paragraphs 842-50-35-2 through 35-4 and using the revised assumption if, during the lease term, any of the following conditions occur:

The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
The revision of another important assumption changes the estimated total net income from the lease.
The projected timing of the income tax cash flows is revised.

35-7 The lessor shall update all assumptions used to calculate total and periodic income if the lessor is performing a recalculation of the leveraged lease. That recalculation shall include actual cash flows up to the date of the recalculation and projected cash flows following the date of recalculation.

35-8 The accounts constituting the net investment balance shall be adjusted to conform to the recalculated balances, and the change in the net investment shall be recognized as a gain or loss in the year in which the assumption is changed. The gain or loss shall be recognized as follows:

The pretax gain or loss shall be included in income from continuing operations before income taxes in the same line item in which leveraged lease income is recognized.
The tax effect of the gain or loss shall be included in the income tax line item.
An upward adjustment of the estimated residual value (including any guaranteed portion) shall not be made.

35-9 The projected timing of income tax cash flows generated by the leveraged lease is an important assumption and shall be reviewed annually, or more frequently, if events or changes in circumstances indicate that a change in timing has occurred or is projected to occur. The income effect of a change in the income tax rate shall be recognized in the first accounting period ending on or after the date on which the legislation effecting a rate change becomes law.

35-10 A revision of the projected timing of the income tax cash flows applies only to changes or projected changes in the timing of income taxes that are directly related to the leveraged lease transaction. For example, a change in timing or projected timing of the tax benefits generated by a leveraged lease as a result of any of the following circumstances would require a recalculation because that change in timing is directly related to that lease:

An interpretation of the tax law
A change in the lessor’s assessment of the likelihood of prevailing in a challenge by the taxing authority
A change in the lessor’s expectations about settlement with the taxing authority.

35-11 In contrast, as discussed in paragraph 842-50-35-20, a change in timing of income taxes solely as a result of an alternative minimum tax credit or insufficient taxable income of the lessor would not require a recalculation of a leveraged lease because that change in timing is not directly related to that lease. A recalculation would not be required unless there is an indication that the previous assumptions about total after-tax net income from the leveraged lease were no longer valid.

35-12 Tax positions shall be reflected in the lessor’s initial calculation or subsequent recalculation on the recognition, measurement, and derecognition criteria in paragraphs 740-10-25-6, 740-10-30-7, and 740-10-40-2. The determination of when a tax position no longer meets those criteria is a matter of individual facts and circumstances evaluated in light of all available evidence.

35-13 If the lessor expects to enter into a settlement of a tax position relating to a leveraged lease with a taxing authority, the cash flows following the date of recalculation shall include projected cash flows between the date of the recalculation and the date of any projected settlement and a projected settlement amount at the date of the projected settlement.

35-14 The recalculation of income from the leveraged lease shall not include interest or penalties in the cash flows from the leveraged lease.

35-15 Advance payments and deposits made with a taxing authority shall not be considered an actual cash flow of the leveraged lease; rather, those payments and deposits shall be included in the projected settlement amount.

Effect of Alternative Minimum Tax

35-16 An entity shall include assumptions about the effect of the alternative minimum tax, considering its consolidated tax position, in leveraged lease computations.

35-17 Any difference between alternative minimum tax depreciation and the tax depreciation assumed in the leveraged lease or between income recognition for financial reporting purposes and alternative minimum tax income could, depending on the lessor’s overall tax situation, result in alternative minimum tax or the utilization of alternative minimum tax credits.

35-18 If alternative minimum tax is paid or an alternative minimum tax credit is utilized, the total cash flows from the leveraged lease could be changed and the lessor’s net investment in the leveraged lease and income recognition would be affected.

35-19 If a change to the tax assumptions changes total estimated after-tax net income, the rate of return on the leveraged lease shall be recalculated from inception, the accounts constituting the lessor’s net investment shall be adjusted, and a gain or loss shall be recognized in the year in which the assumption is changed.

35-20 However, an entity whose tax position frequently varies between alternative minimum tax and regular tax shall not be required to recalculate the rate of return on the leveraged lease each year unless there is an indication that the original assumptions regarding total after-tax net income from the lease are no longer valid. In that circumstance, the entity shall be required to revise the leveraged lease computations in any period in which total net income from the leveraged lease changes because of the effect of the alternative minimum tax on cash flows for the lease.

Transfer of Minimum Rental Payments

35-21 If a lessor sells substantially all of the minimum rental payments associated with a leveraged lease and retains an interest in the residual value of the leased asset, the lessor shall not recognize increases in the value of the lease residual to its estimated value over the remaining lease term. The lessor shall report any remaining interest thereafter at its carrying amount at the date of the sale of the lease payments. If it is determined subsequently that the fair value of the residual value of the leased asset has declined below the carrying amount of the interest retained and that decline is other than temporary, the asset shall be written down to fair value, and the amount of the write-down shall be recognized as a loss. That fair value becomes the asset’s new carrying amount, and the asset shall not be increased for any subsequent increase in its fair value before its sale or disposition.

9.5.6 Accounting for the Sale of a Leveraged Lease

ASC 842 does not specifically address the accounting for sales of leveraged leases. ASC 842-50-35-6 states that if revisions to the significant cash flow assumptions change the estimated total net income for the lease, the “rate of return and the allocation of income to positive investment years shall be recalculated from lease inception.”

The sale of a leveraged lease should not be treated as a change to the projected cash flows of the lease and should not be accounted for in accordance with ASC 842-50-35-6. Such a sale should not be considered a revision of an important assumption that would result in a recalculation of the estimated total net income for the lease and affect the rate of return and the allocation of income to the positive investment years of the lease.

9.5.7 Impact of Altering Significant Assumptions

9.5.7.1 Revised Assumptions Existing at the Inception of the Lease

Questions have arisen regarding situations in which an assumption in a leveraged lease is altered in such a way that the lease would not have qualified as a leveraged lease if the revised assumptions had existed at the inception of the lease.

The appropriate accounting in such situation would depend on the change in assumptions. First, the lessor would need to consider whether the leveraged lease has been modified in accordance with the lease modification guidance in ASC 842 (if the lease is considered modified, leveraged lease accounting would no longer be appropriate — see Section 9.3.4). If it is determined that the leveraged lease has not been modified, the lease must be reviewed in accordance with ASC 842-50-35-6, which states:

Any estimated residual value and all other important assumptions affecting estimated total net income from the leveraged lease shall be reviewed at least annually. The rate of return and the allocation of income to positive investment years shall be recalculated from lease inception following the method described in paragraphs 842-50-35-2 through 35-4 and using the revised assumption if, during the lease term, any of the following conditions occur:

The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
The revision of another important assumption changes the estimated total net income from the lease.
The projected timing of the income tax cash flows is revised.

Example 9-18

Assume that a lessor is in current negotiations with a lessee regarding its leveraged lease investments. The lessor is proposing to alter the residual value of the leased properties. The change in residual values would be considered a change in estimate and thus would not represent a lease modification for accounting purposes. However, the leveraged lease would have to be reviewed in accordance with ASC 842-50-35-6 because this might be considered an event that would affect the estimated total income from the leveraged lease. If the estimated total income were changed, the lessor would record the adjustment in accordance with ASC 842-50-35-6.

9.5.7.2 Impact of Altering Significant Tax Assumptions

When there is a change in income tax rates in a leveraged lease, an entity should recalculate the lease from its inception and record any differences in current-period earnings. In accordance with ASC 842-50-35-9, the entity would record the effect of the tax rate change on a leveraged lease “in the first accounting period ending on or after the date on which the legislation effecting a rate change becomes law.” ASC 842-50-S99-1 further clarifies that the “difference between the amounts originally recorded and the recalculated amounts must be included in income of the year in which the tax law is enacted.”

If the timing of deductions is changed, the entity would perform a review in accordance with ASC 842-50-35-6. On the basis of that review, if the total estimated income is changed, the entity would recalculate (1) the estimated total net income from the lease, (2) the rate of return, and (3) the allocation of income to positive investment years. To recalculate these amounts, the entity would apply the method described in ASC 842-50-35-2 through 35-5 and use the revised assumption. The accounts constituting the net investment balance would be adjusted to conform to the recalculated balances, and the change in the net investment would be recognized as a gain or loss in the year in which the assumption is changed. The estimated residual value would not be adjusted upward.

9.5.7.3 Accounting for a Change or Projected Change in the Timing of Cash Flows Related to Income Taxes Generated by a Leveraged Lease Transaction

A change or projected change in the timing of cash flows related to income taxes generated by a leveraged lease should be accounted for in accordance with ASC 842-50-35-6 through 35-15. Tax cash flows should be reflected in the lessor’s initial calculation or subsequent recalculation on the basis of the recognition, derecognition, and measurement criteria in ASC 740. The example below illustrates the application when the only assumption that has changed is the timing of cash flows related to income taxes generated by a leveraged lease.

Example 9-19

Assumptions:

At the inception of the arrangement, the lessor is expected to deduct one-half of the cost of the asset in its tax returns for each of the first two years of the lease (i.e., accelerated tax depreciation). Accordingly, the lessor’s estimated cash flows from the leveraged lease are as follows:

To allocate the earnings of the leveraged lease, the lessor has to determine the rate of return necessary to distribute the net income from the lease to only those years in which the net investment is positive. From the following, the lessor would determine that the appropriate rate is approximately 15.4 percent:

Accordingly, at the inception of the leveraged lease, the lessor would record the following net accounting entries:

During the first year of the leveraged lease, the lessor would have recorded the following net accounting entries:

Note that pre-tax income is recognized in proportion to after-tax income. In year one, for example, $308 of $600 of after-tax income was allocated to year one. Accordingly, 308/600 of $1,000 of pre-tax income is recognized in year one. Also note that deferred income taxes are provided for the difference between book and taxable income at the applicable tax rate.

Similarly, in year two of the leveraged lease, the lessor would record the following net accounting entries:

For illustration purposes, assume that at the end of year two, the lessor concludes, in a manner consistent with ASC 740, that the taxing authority is more likely than not to deny the previously taken accelerated depreciation deduction and, rather, will require that it be recognized on a straight-line basis over the term of the lease. As a result, the lessor’s expected cash flows (recalculated from the inception of the lease in accordance with the method described in ASC 842-50-35-2 through 35-4) are as follows:27

To reallocate the earnings of the leveraged lease, the lessor has to determine the rate of return necessary to distribute the net income from the lease to only those years in which the net investment is positive. From the following, the lessor would determined that the appropriate rate is approximately 6.64 percent:

At the end of year two, the lessor’s net investment in the leveraged lease would be:

At the end of year two, after the lessor has revised its expected timing of income-tax-related cash flows, the lessor’s net investment in the lease should be $1,757 (not the negative $464 actually recognized). As a result, the lessor needs to recognize a (net) $2,221 adjustment to appropriately state its net investment after determining the effects of the revised cash flows. The accounting entries to record the net adjustment are as follows:28

These entries have the effect of (1) revising the amount of unearned income so that the current balance is equal to the amount that would exist if the revised cash flows had been known at the inception of the lease, (2) recognizing an income tax benefit attributable to the reversal of leveraged lease income, and (3) appropriately recognizing a liability for unrecognized tax benefits for income tax deductions taken that have not been determined to be more likely than not to be realized.

Note that the amount of the liability for unrecognized tax benefits to recognize should equal the tax-effected difference between the “unrecognized tax benefit liability” basis and the “as filed” tax basis of an asset or liability. In this example, at the end of year two, the lessor has an as-filed tax basis of the leased equipment of $0 ($10,000 original cost less accelerated depreciation of $10,000 over the first two years of the lease). However, at the end of year two, the lessor concludes, on a more-likely-than-not measurement basis, that the unrecognized tax benefit liability basis of the leased equipment is $6,000 ($10,000 original cost less two years of straight-line depreciation totaling $4,000). The tax-effected difference equals $2,400, or ($0 – $6,000) × 40%.

Note that it is inappropriate to reflect the liability for unrecognized tax benefits as a component of the lessor’s net investment in the leveraged lease.

Presentation of Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
ASC 840-30-45-5	ASC 842-50-45-1
Income Taxes and Leveraged Leases
ASC 840-30-45-6 and 45-7	ASC 842-50-45-2 and 45-3

ASC 842-50

General

45-1 For purposes of presenting the investment in a leveraged lease in the lessor’s balance sheet, the amount of related deferred taxes shall be presented separately (from the remainder of the net investment). In the income statement or the notes to that statement, separate presentation (from each other) shall be made of pretax income from the leveraged lease, the tax effect of pretax income, and the amount of investment tax credit recognized as income during the period.

45-2 Integration of the results of income tax accounting for leveraged leases with the other results of accounting for income taxes under Topic 740 on income taxes is required if deferred tax credits related to leveraged leases are the only source (see paragraph 740-10-30-18) for recognition of a tax benefit for deductible temporary differences and carryforwards not related to leveraged leases. A valuation allowance is not necessary if deductible temporary differences and carryforwards will offset taxable amounts from future recovery of the net investment in the leveraged lease. However, to the extent that the amount of deferred tax credits for a leveraged lease as determined in accordance with this Subtopic differs from the amount of the deferred tax liability related to the leveraged lease that would otherwise result from applying the guidance in Topic 740, that difference is preserved and is not a source of taxable income for recognition of the tax benefit of deductible temporary differences and operating loss or tax credit carryforwards.

45-3 This Subtopic requires that the tax effect of any difference between the assigned value and the tax basis of a leveraged lease at the date of a business combination or an acquisition by a not-for-profit entity shall not be accounted for as a deferred tax credit. Any tax effects included in unearned and deferred income as required by this Subtopic shall not be offset by the deferred tax consequences of other temporary differences or by the tax benefit of operating loss or tax credit carryforwards. However, deferred tax credits that arise after the date of a combination shall be accounted for in the same manner as for leveraged leases that were not acquired in a combination.

Pending Content (Transition Guidance: ASC 805-10-65-1)
45-3 This Subtopic requires that the tax effect of any difference between the assigned value and the tax basis of a leveraged lease at the date of a business combination, an acquisition by a not-for-profit entity, or a joint venture formation shall not be accounted for as a deferred tax credit. Any tax effects included in unearned and deferred income as required by this Subtopic shall not be offset by the deferred tax consequences of other temporary differences or by the tax benefit of operating loss or tax credit carryforwards. However, deferred tax credits that arise after the date of a combination shall be accounted for in the same manner as for leveraged leases that were not acquired in a combination.

Pending Content (Transition Guidance: ASC 805-10-65-1)

45-3 This Subtopic requires that the tax effect of any difference between the assigned value and the tax basis of a leveraged lease at the date of a business combination, an acquisition by a not-for-profit entity, or a joint venture formation shall not be accounted for as a deferred tax credit. Any tax effects included in unearned and deferred income as required by this Subtopic shall not be offset by the deferred tax consequences of other temporary differences or by the tax benefit of operating loss or tax credit carryforwards. However, deferred tax credits that arise after the date of a combination shall be accounted for in the same manner as for leveraged leases that were not acquired in a combination.

Disclosure of Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
ASC 840-30-50-5 and 50-6	ASC 842-50-50-1 through 50-3

ASC 842-50

General

50-1 If leveraged leasing is a significant part of the lessor’s business activities in terms of revenue, net income, or assets, the components of the net investment balance in leveraged leases as set forth in paragraph 842-50-25-1 shall be disclosed in the notes to financial statements.

50-2 For guidance on disclosures about financing receivables, which include receivables relating to a lessor’s rights to payments from leveraged leases, see the guidance in Subtopic 326-20 on financial instruments measured at amortized cost and paragraph 310-10-50-31.

Pending Content (Transition Guidance: ASC 326-10-65-5)

50-2 For guidance on disclosures about financing receivables, which include receivables relating to a lessor's rights to payments from leveraged leases, see the guidance in Subtopic 326-20 on financial instruments measured at amortized cost.

50-3 If accounting for the effect on leveraged leases of the change in tax rates results in a significant variation from the customary relationship between income tax expense and pretax accounting income and the reason for that variation is not otherwise apparent, the lessor shall disclose the reason for that variation.

Implementation Guidance for Leveraged Leases
Location of Guidance in ASC 840	Location of Guidance in ASC 842
Leveraged Lease Involving an Existing Asset of a Regulated Entity
ASC 840-30-55-14	ASC 842-50-55-1
Delayed Equity Investment
ASC 840-30-55-15 and 55-16	ASC 842-50-55-2 and 55-3
Income Taxes Related to Leveraged Leases
ASC 840-30-55-17 and 55-18	ASC 842-50-55-4 and 55-5
Example: Lessor’s Accounting for a Leveraged Lease
ASC 840-30-55-29 through 55-38	ASC 842-50-55-6 through 55-15
Example: Income Taxes Related to a Leveraged Lease
ASC 840-30-55-39 through 55-46	ASC 842-50-55-16 through 55-23
Example: Effect of Advance Payments and Deposits on Recalculation of a Leveraged Lease
ASC 840-30-55-47 through 55-49	ASC 842-50-55-24 through 55-26
Example: Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
ASC 840-30-55-50 through 55-56	ASC 842-50-55-27 through 55-33

ASC 842-50

General

Implementation Guidance

Leveraged Lease Involving an Existing Asset of a Regulated Entity

55-1 Although the carrying amount of an asset acquired previously may not differ significantly from its fair value, it is unlikely that the two will be the same. However, regulated utilities have argued that the carrying amounts of certain of their assets always equal the fair value based on the utility’s ability to recover that cost in conjunction with a franchise to sell a related service in a specified area. That argument is not valid when considering the value of the asset to a third-party purchaser that does not own that franchise.

Delayed Equity Investment

55-2 A delayed equity investment frequently obligates the lessor to make up the shortfall between rent and debt service in the first several years of the transaction. The type of recourse debt resulting from the delayed equity investment does not contradict the notion of nonrecourse and, therefore, does not preclude leveraged lease accounting as long as other requirements of leveraged lease accounting are met. The lessor’s related obligation should be recorded as a liability at present value at lease inception.

55-3 Recognition of the liability would increase the lessor’s net investment on which the lessor bases its pattern of income recognition. While the increase to the net investment results in an increase in income, it may be offset by the accrual of interest on the liability.

Income Taxes Related to Leveraged Leases

55-4 The accounting for income taxes related to leveraged leases set forth in this Subtopic is not consistent with the guidance in Topic 740 on income taxes.

55-5 The integration of the results of accounting for income taxes related to leveraged leases with the other results of accounting for income taxes as required by Topic 740 is an issue if all of the following exist:

The accounting for a leveraged lease requires recognition of deferred tax credits.
The guidance in Topic 740 limits the recognition of a tax benefit for deductible temporary differences and carryforwards not related to the leveraged lease.
Unrecognized tax benefits in this paragraph could offset taxable amounts that result from future recovery of the net investment in the leveraged lease.

Example 1: Lessor’s Accounting for a Leveraged Lease

55-6 This Example illustrates a lessor’s accounting for a leveraged lease in accordance with the guidance in this Subtopic. It also illustrates one way of meeting the disclosure requirements in paragraphs 842-50-45-1 and 842-50-50-1 as applied to a leveraged lease. The Example does not encompass all circumstances that may arise about leveraged leases; rather, the Example is based on a single instance of a leveraged lease. The elements of accounting and reporting illustrated for this Example of a leveraged lease are as follows:

Cash flow analysis by years (see paragraph 842-50-55-8)
Allocation of annual cash flow to investment and income (see paragraph 842-50-55-9)
Journal entries for lessor’s initial investment and first year of operation (see paragraph 842-50-55-10)
Financial statements including notes at end of second year (see paragraph 842-50-55-11)
Accounting for a revision in the estimated residual value of the leased asset assumed to occur in the eleventh year of the lease (from $200,000 to $120,000):
1. Revised allocation of annual cash flow to investment and income (see paragraph 842-50-55-12)
2. Balances in investment accounts at beginning of the eleventh year before revised estimate (see paragraph 842-50-55-13)
3. Journal entries (see paragraph 842-50-55-14)
4. Adjustment of investment accounts (see paragraph 842-50-55-15).

55-7 This Example has the following terms and assumptions.

55-8 Cash flow analysis by years follows.

55-9 Allocation of annual cash flow to investment and income follows.

55-10 Illustrative journal entries for the year ending December 31, 1975, follow.

Lessor’s Initial Investment

First Year of Operation

Journal Entry 1

Journal Entry 2

Journal Entry 3

Journal Entry 4

Journal Entry 5

55-11 The following are illustrative partial financial statements including notes.

The following are notes to the illustrative financial statements included in this Example.

Investment in Leveraged Leases

Entity is the lessor in a leveraged lease agreement entered into in 1975 under which mining equipment having an estimated economic life of 18 years was leased for a term of 15 years. Entity’s equity investment represented 40 percent of the purchase price; the remaining 60 percent was furnished by third-party financing in the form of long-term debt that provides for no recourse against Entity and is secured by a first lien on the property. At the end of the lease term, the equipment is turned back to Entity. The residual value at that time is estimated to be 20 percent of cost. For federal income tax purposes, Entity receives the investment tax credit and has the benefit of tax deductions for depreciation on the entire leased asset and for interest on the long-term debt. During the early years of the lease, those deductions exceed the lease rental income, and substantial excess deductions are available to be applied against Entity’s other income. In the later years of the lease, rental income will exceed the deductions and taxes will be payable. Deferred taxes are provided to reflect this reversal. Entity’s net investment in leveraged leases is composed of the following elements.

55-12 Allocation of annual cash flow to investment and income follows, revised to include new residual value estimate.

55-13 Balances in investment accounts before revised estimate of residual value follow.

55-14 Illustrative journal entries involving a reduction in residual value follow.

Journal Entry 1

Journal Entry 2

55-15 Adjustment of investment accounts for revised estimates of residual value follows.

Example 2: Income Taxes Related to a Leveraged Lease

55-16 This Example illustrates integration of the results of a lessor’s income tax accounting for leveraged leases (in accordance with the guidance in this Subtopic) with the other results of accounting for income taxes as required by Topic 740.

55-17 At the end of Year 1 (the current year), an entity has two temporary differences.

55-18 The first temporary difference is for a leveraged lease that was entered into in a prior year. During Year 1, the enacted tax rate for Year 2 and thereafter changes from 40 percent to 35 percent.

55-19 After adjusting for the change in estimated total net income from the lease as a result of the change in tax rates, the components of the investment in the leveraged lease at the end of Year 1 are as follows.

55-20 The second temporary difference is a $120,000 estimated liability for warranty expense that will result in a tax deduction in Year 5 when the liability is expected to be paid. Absent consideration of the deferred tax credits attributable to the leveraged lease, the weight of available evidence indicates that a valuation allowance is needed for the entire amount of the deferred tax asset related to that $120,000 deductible temporary difference.

55-21 The tax basis of the investment in the leveraged lease at the end of Year 1 is $41,000. The amount of the deferred tax liability for that leveraged lease that would otherwise result from the application of guidance in Topic 740 on income taxes is determined as follows.

55-22 Loss carryback (to Year 2) and loss carryforward (to Year 20) of the $120,000 tax deduction for warranty expense in Year 5 would offset the $100,000 of taxable amounts resulting from future recovery of the net investment in the leveraged lease over the remainder of the lease term.

55-23 At the end of Year 1, the entity recognizes a $42,000 ($120,000 at 35 percent) deferred tax asset and a related $7,000 valuation allowance. The effect is to recognize a $35,000 net deferred tax benefit for the reduction in deferred tax credits attributable to the leveraged lease. Deferred tax credits attributable to the leveraged lease determined under the guidance in this Subtopic are $39,000. However, the deferred tax liability determined is only $35,000. The $4,000 difference is not available for offsetting.

Example 3: Effect of Advance Payments and Deposits on Recalculation of a Leveraged Lease

55-24 This Example illustrates how (in accordance with the guidance in paragraph 842-50-35-13 and other paragraphs) a lessor would include advance payments and deposits in a recalculation of a leveraged lease resulting from a determination by the lessor that it would enter into a settlement of a tax position arising from a leveraged lease.

55-25 This Example assumes that the lessor has concluded that the position originally taken on the tax return would meet the more-likely-than-not threshold in Subtopic 740-10 on income taxes. It also assumes that the lessor would conclude that the estimate of $50 for the projected lease-in, lease-out settlement is consistent with the measurement guidance in that Subtopic.

55-26 A lessor makes an advance payment of $25 on July 1, 2007, $10 of which is estimated to be associated with issues arising from a lease-in, lease-out transaction. On July 1, 2007, the lessor changes its assumption about the timing of the tax cash flows and projects a settlement with the Internal Revenue Service on September 1, 2009. The projected settlement would result in a payment to the taxing authority of $125 of which $50 is associated with the lease-in, lease-out transaction. On July 1, 2007, when the lessor recalculates the leveraged lease, the lessor would include a $50 cash flow on September 1, 2009, as a projected outflow in the leveraged lease recalculation.

Example 4: Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity

55-27 This Example illustrates one way that a lessor’s investment in a leveraged lease might be valued by the acquiring entity in a business combination or an acquisition by a not-for-profit entity and the subsequent accounting for the investment in accordance with the guidance in this Subtopic. The elements of accounting and reporting illustrated for this Example are as follows:

Acquiring entity’s cash flow analysis by years (see paragraph 842-50-55-29)
Acquiring entity’s valuation of investment in the leveraged lease (see paragraph 842-50-55-30)
Acquiring entity’s allocation of annual cash flow to investment and income (see paragraph 842-50-55-31)
Journal entry for recording allocation of purchase price to net investment in the leveraged lease (see paragraph 842-50-55-32)
Journal entries for the year ending December 31, 1984 (Year 10 of the lease) (see paragraph 842-50- 55-33).

55-28 This Example has the following terms and assumptions.

55-29 Acquiring entity’s cash flow analysis by years follows.

55-30 Acquiring entity’s valuation of investment in the leveraged lease follows.

55-31 Acquiring entity’s allocation of annual cash flow to investment and income follows (see footnote (a)).

55-32 Illustrative journal entry for recording allocation of purchase price to net investment in the leveraged lease follows.

55-33 Illustrative journal entries for year ending December 31, 19Y4, follows.

Third Year of Operation After the Business Combination (Year 10 of the Lease)

Journal Entry 1

Journal Entry 2

Journal Entry 3

Footnotes

There are minor grammatical differences between the leveraged lease guidance in ASC 840 and that in ASC 842; however, such differences are minor and not expected to result in a change in the interpretation or application of the guidance for lessors. Therefore, those differences are not highlighted in this chapter.

In this example, it is assumed that the lessor did not make any advance, deposit, or settlement payments to the tax authority up to the date of the recalculation and that a projected settlement amount was not included in the recalculation. ASC 842-50-35-13 provides guidance on how, when a lessor has entered into (or expects to enter into) a settlement with a tax authority, such payments, cash flow projections, or both should be included in a recalculation.

Note that if these journal entries were being made as of the lessor’s initial adoption of this guidance, the amounts affecting the statement of operations would be recorded as an adjustment to the beginning balance of retained earnings as of the beginning of the period in which the guidance is adopted.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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.