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ASC 840 deals with a very complex topic. Because there are many feasible interpretations of this standard, the Firm has developed interpretive responses to questions asked on this issue as follows:
Subject
Authoritative Pronouncement
Question No.
Lease Term
ASC 840-10-20 Glossary
1-2
Subject
Authoritative Pronouncement
Question No.
Changes, Extensions, Renewals and Terminations
3-5
Accounting and Reporting for Operating Leases by Lessees
6-8
Leases Involving Land and Buildings
9
Sale and Leaseback Transactions
10-12
Subleases and Similar Transactions
13
Accounting and Reporting for Leveraged Leases
14
Lease Term
Question 1: ASC 840-10-20 defines the lease term as also including all periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable. A lease for equipment may have an initial term of ten years with an option to renew for a second ten years at the same price, and an option to purchase the equipment for $1 at the end of the renewal period. There is a clear expectation that the value of the equipment 20 years hence will be significantly greater than $1. However, it is not at all clear that the utility of the equipment during the second ten-year period will be sufficient to warrant exercising the renewal option, notwithstanding the existence of the $1 purchase option. Does this situation indicate that the lease term is ten years or twenty years?
Interpretive Response: Based on the facts as stated and assuming the failure to renew would not result in a significant penalty, the lease term is probably ten years; the bargain purchase option should be disregarded. Exercise of the purchase option is reasonably assured, but only if the renewal option is first exercised. In the absence of utility of the equipment to the lessee during the second ten years, the renewal option would be exercised only in the event that the present value of the expected residual value of the equipment at the end of 20 years exceeds the present value of the lease payments during the renewal period.
Question 2: Company Y currently leases an entire fifteen-floor office building from Landlord (under a head lease). Company Y wants to sublease floors 1 and 2 to a sublessee for the remaining eight-year period under the head lease. Company X wants to lease floors 1 and 2 but wants to lock up the space for longer than eight years. Company X enters into a lease with Company Y pursuant to which Company X will sublease floors 1 and 2 for eight years (the "Sublease"). Company X simultaneously enters into a four-year lease (the "Sequential Lease") with Landlord to lease floors 1 and 2 for years nine through twelve -- that is, immediately after the expiration of the Sublease. Landlord agrees to assume Company Y's right, title and interest in the Sublease in the event of early termination of the head lease. A default by Company X under the Sublease will trigger a default under the Sequential Lease.
Rents under the Sublease are fixed and are subject to an escalation of 2 percent per year. Rents under the Sequential Lease are also fixed and are subject to an escalation of 3 percent per year. The initial rent under the lease is higher than the final rent under the Sublease.
Should Company X treat the Sublease and the Sequential Lease as a single twelve-year lease, that is, as a single lease or as two separate leases?
Interpretive Response: Company X should treat the Sublease and the Sequential Lease as a single twelve-year lease. If that lease is classified as an operating lease, Company X would recognize all of the rents payable over the twelve-year term on a straight-line basis.
The provisions under the Sublease and the Sequential Lease are such that Company X will have the right to uninterrupted use of the leased property for a continuous period of twelve years, absent a default by Company X. Furthermore, Company X negotiated and entered into the Sublease and the Sequential Lease simultaneously. Had Company X been able to negotiate a single lease with a single lessor, it would have done so.
Changes, Extensions, Renewals, and Termination
Question 3: A lessee and lessor agree to add a minor amount of computer equipment to a sales-type lease and remove certain other equipment. The minimum lease payments are adjusted to reflect this addition and removal of equipment, but the lease term is not extended and a new lease is not signed. Should the lessor and lessee consider the modified lease over its remaining term as a new agreement requiring new classification or simply a continuation of the original lease on the equipment remaining under lease combined with a new lease covering the additional equipment? Additionally, what accounting would the lessor and lessee apply to such a change?
Interpretive Response: This situation is not specifically addressed in ASC 840. Accordingly, the answer must be based on all relevant factors, which would include (1) whether a new lease is signed, (2) whether the old and new property are separable (e.g., computer hardware and related peripheral equipment) or inseparable (e.g., a building and an addition to it), and (3) the value of the property originally under lease compared with the value of the additional property.
In this case, because a new lease was not signed and because of the separable nature of the equipment and the minor value of the new equipment compared with the original property under lease, the situation should be viewed as a continuation of the original lease on the equipment remaining under lease combined with a new lease covering the additional equipment. Accordingly, the equipment added to the lease should be evaluated and classified by the lessor and lessee using the criteria in ASC 840-10-25, as appropriate. The removal of the equipment from the lease should be accounted for as the termination of a lease by the lessor (in accordance with ASC 840-30-40-7). The removal of the equipment should also be accounted for as the termination of a lease by the lessee (in accordance with ASC 840-30-40-1). The remaining investment should be accounted for as originally anticipated.
However, if the original lease contained a residual value guarantee from the lessee and the amount payable under the guarantee would be determined based on the aggregate value of the equipment at the end of the lease term, then the modification would trigger a new agreement requiring new classification with respect to all of the equipment.
Question 4: A lessee has a 20-year lease on a building, with a fixed price purchase option at the end of 20 years and two 10-year renewal options. During the lease term the lease is modified and, in exchange for a cash payment, the lessee relinquishes its purchase option and agrees to pay higher rents. Can the lessee recognize income equal to the excess of the cash payment received over the present value of the increase in the rental payments?
Interpretive Response: In a case involving this situation, the SEC staff concluded that the fixed price purchase option put the lessee in essentially the same position as an owner and that sale-leaseback accounting was therefore applicable. It also concluded that the amount of the cash payment was affected by the increased rent to be paid by the lessee in the revised lease and that, in accordance with the sale-leaseback rules, the profit should not be recognized by the lessee at the time of sale but should be deferred and amortized over the lease term. The SEC stated that it would insist on this accounting for similar future transactions.
Question 5: A lessee's office space lease has expired and the lessor grants a short extension. In consideration for the extension, the lessee agrees to pay a termination fee if the lease is not ultimately renewed. If the lease is not renewed, can the lessee amortize the termination fee over the term of a new lease with a different lessor?
Interpretive Response: A lease termination payment to a former landlord is not a cost incurred in connection with obtaining a new lease and should be expensed by the lessee in the current period.
Accounting and Reporting for Operating Leases by Lessees
Question 6: A company is the lessee of property under a three-year operating lease. According to the agreement, annual rental payments are equal to the greater of 5 percent of the company's gross revenue or $50,000, $60,000, and $70,000 in years one, two and three, respectively. If the company has gross revenue in years one, two, and three of $1,500,000, $1,000,000, and $1,500,000, respectively, how much rental expense should it record during the term of the lease?
Interpretive Response: The company should record the minimum rentals on a straight-line basis over the life of the lease, i.e., $60,000 per year for 3 years. Also, the company should record contingent rental expense in the period accruable. The following table illustrates the computation of annual rental expense for each of the three years during the lease term:
Minimum Payment
(1)
Expense on S/L Basis
(2)
Deferral
(1−2=3)
Gross Revenue
(4)
Contingent Rentals
(5)
Cash Paid
(6)
Annual Expense
(2+5=7) or (6-3=7)
Year 1
$50,000
$60,000
$(10,000)
$1,500,000
$25,000
$75,000
$85,000
Year 2
60,000
60,000
--
1,000,000
0
60,000
60,000
Year 3
70,000
60,000
10,000
1,500,000
5,000
75,000
65,000
$210,000
$210,000
Computation of Contingent Rentals
Year 1
($1,500,000 × .05) − $50,000 = $25,000
Year 2
($1,000,000 × .05) = $50,000 since
$50,000 < $60,000, contingent rental = 0
Year 3
($1,500,000 × .05) − $70,000 = $5,000
Question 7: A lease requires monthly rental payments, but rebates up to a specific amount are due to the lessee if the lessee's monthly sales do not meet certain defined levels. Similarly, if the lessee's sales exceed certain defined levels, additional payments are due to the lessor. What is the effect of the rental arrangement on lease classification and recognition of rent expense?
Interpretive Response: The lessee should classify the lease based upon the minimum rentals due under the lease agreement. The minimum rentals would be computed net of rebates, since contingent reductions in rent are viewed the same as contingent additional rents. For instance, an agreement to pay rent of $100 subject to a $20 rebate based on low sales volume is in substance equivalent to an agreement to pay rent of $80 subject to a $20 contingent rent based on high sales volume. In each case, minimum rentals due under the lease are $80.
For an operating lease, the minimum rentals should be recognized on a straight-line basis over the life of the lease. Any payments in excess of the minimum rentals should be expensed as incurred.
Question 8: Lessee enters into an operating lease with Lessor for an entire building. The lease term is 60 months. The rent is fixed with specified annual rent increases. The lease contains no renewal options. As an incentive to enter into the lease, Lessor will reimburse the cost of Lessee's leasehold improvements up to a maximum of $2 million (Lessee estimates that the leasehold improvements will cost $4 million). Lessee has already concluded it will not be considered the owner of the asset during the period of construction of the improvements.
Should Lessee recognize the expected lease incentive amount of $2 million as a reduction of rental expense on a straight-line basis?
Interpretive Response: Yes. ASC 840-20-25-6 requires lease incentives to be recognized as reductions of rental expense by a lessee on a straight-line basis over the term of the lease. As discussed in ASC 840-20-25-7, lease incentives include "payments made to or on behalf of the lessee." Lessee has every expectation of receiving payments of $2 million from Lessor because the construction project budget is substantially in excess of that amount. Accordingly, Lessee should consider the expected $2 million payment a lease incentive and recognize it as a reduction of rental expense on a straight-line basis.
Leases involving Land and Buildings
Question 9: ASC 840-10-25-25 stipulates that, because of the special provisions normally present in leases involving terminal space and other airport facilities owned by a governmental unit or authority, as well as leases of other facilities owned by a governmental unit or authority wherein the rights of the parties are essentially the same as in a lease of airport facilities, such leases should be classified as operating leases. Is this provision applicable to complete buildings, such as hangars or terminals, which are part of a larger facility, such as an airport?
Interpretive Response: Yes. ASC 840-10-25-25 is applicable to the lease of complete buildings as well as to the lease of part of a building. See ASC 840-10-25-25, which specifies the conditions that must be met in order for the lease to be classified as an operating lease.
As discussed in ASC 840-40-15-2, construction of government-owned properties subject to a future lease of the completed improvements should be included in the scope of ASC 840-40-55-2 through 55-16. Accordingly, if the lessee is involved with the construction, for example, by guaranteeing the construction financing, the lessee would have to apply the provisions of ASC 840-40-55-2 through 55-16. This would normally result in a conclusion that the lessee is considered the owner of the property during the construction period, with the subsequent sale-leaseback accounted for pursuant to ASC 840-40.
Sale and Leaseback Transactions
Question 10: ASC 840-40-25 states that in a non-real estate sale-leaseback transaction involving an operating lease, any profit or loss on the sale shall be deferred and amortized in proportion to rental payments over the lease term. Does this mean that the amortization might extend beyond the noncancelable term of the lease?
Interpretive Response: Yes. The lease term as defined in ASC 840-10-25 covers the fixed noncancelable term plus all periods covered by bargain renewal options and various other periods. See also ASC 840-40-25-9 through 25-18 for sale-leaseback transactions involving real estate or real estate with equipment.
Question 11: A company sells its corporate headquarters property to an unrelated third party, and enters into a noncontrolled joint venture for the purpose of leasing the property from the third-party buyer. The venture will demolish the existing structure and construct a larger office complex. The company would then lease a portion of the space from the venture. Would the sale-leaseback provisions of ASC 840-40-25-9 through 25-18 apply to these circumstances? Can the sale of the property and the subsequent lease from the venture be recorded as separate transactions?
Interpretive Response: We believe that the transaction is within the scope of ASC 840-40-25-9 through 25-18 since the sale, formation of the venture, and sublease are all planned transactions. Financing accounting would be required because the company will not occupy substantially all of the property leased back, and the company, as a joint venture partner, will benefit from the cash flows associated with the sublease to other tenants. The ASC 840-40-20 definition of a normal leaseback is not met, and the company's continuing involvement in the property prevents the sale and subsequent lease transactions from being recorded separately.
Question 12: A hospital enters into a transaction to sell and lease back a building that it uses for medical offices. A normal arrangement in the hospital’s business is to provide office space to non-employee physicians in order to attract additional patients. In the normal course of its business, the hospital provides the space at a rent that is not intended to make a profit. If the space provided to the physicians is significant, would this arrangement preclude sale-leaseback accounting?
Interpretive Response: Yes. ASC 840-40-25-9 prohibits sale-leaseback accounting if the leaseback is not a normal leaseback. The relationship between the hospital and physicians is one of owner and tenant. The fact that the hospital has a business purpose in leasing space to physicians is not relevant to the distinction made in ASC 840-40-25-9. Consequently, subleasing more than a minor portion of the building to physicians will preclude sale-leaseback accounting.
Subleases and Similar Transactions
Question 13: A company that is leasing office space under a long-term lease decides that it no longer needs the space. Rather than subleasing the space, the lessee and the lessor agree to cancel the lease. However, because the fair market rental of the office space has increased since the lease was originally executed, the lessor pays a premium to the lessee for canceling. Can this cancellation premium be recognized in income immediately?
Interpretive Response: Yes. The lessee has no remaining obligation to the lessor or the new lessee, so the premium should be recognized currently. However, if a company does have remaining obligations, refer to ASC 840-10-40-2 regarding sublease and similar transactions for the appropriate accounting. The premium to be recognized currently in income should be reduced by any nonrecourse loans made by the lessee to the lessor.
Accounting and Reporting for Leveraged Leases
Question 14: A company is a lessor (the equity participant) in a leveraged lease. At the inception of the lease, the estimated residual value was $10 million. Prior to expiration of the lease term, an investor pays $3 million for an option for any excess of the asset's residual value over $10 million. How should the company account for the receipt of the $3 million?
Interpretive Response: The company should not take the $3 million into income immediately, nor should it make an upward adjustment of residual value in a leveraged lease. Rational methods of accounting that defer at least the portion of the $3 million that relates to the unexpired lease term are acceptable. We believe that the best approach may be to recalculate the income and cash flows from the leveraged lease, showing the $3 million received in the current year, with the residual value remaining at $10 million. A cumulative gain would be recorded in the current year resulting from the difference in cumulative income as recorded under this new calculation.
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