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The Glossary in ASC 842-50 defines a leveraged lease.

Definition from ASC 842-50-20

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.

Prior to the adoption of ASC 842, a lease was considered a leveraged lease if the terms of the arrangement met specified criteria. It had to qualify as a direct financing lease under ASC 840-10-25-43(b) and meet the criteria specific for leveraged leases in ASC 840-10-25-43(c) (see LG 7.2.1).

Excerpt from ASC 840-10-25-43

If the lease at inception meets any of the four lease classification criteria in paragraph 840-10-25-1 and both of the criteria in the preceding paragraph, it shall be classified by the lessor as a sales-type lease, a direct financing lease, a leveraged lease, or an operating lease as follows:
a. Sales-type lease...
b. Direct financing lease. A lease is a direct financing lease if it meets all of the following conditions:
1. It meets any of the criteria in paragraph 840-10-25-1 and both of the criteria in the preceding paragraph.
2. It does not give rise to manufacturer's or dealer's profit (or loss) to the lessor.
3. It does not meet the criteria for a leveraged lease in (c).
c. Leveraged lease. Leases that meet the criteria of sales-type leases set forth in (a) shall not be accounted for as leveraged leases but shall be accounted for as prescribed in paragraph 840-30-25-6. A lease is a leveraged lease if it has all of the following characteristics:
1. It meets the criteria in (b)(1) and (b)(2) for a direct financing lease.
2. It involves at least three parties: a lessee, a long-term creditor, and a lessor (commonly called the equity participant).
3. The financing provided by the long-term creditor is nonrecourse as to the general credit of the lessor (although the creditor may have recourse to the specific property leased and the unremitted rentals relating to it). The amount of the financing is sufficient to provide the lessor with substantial leverage in the transaction.
4. The lessor's net investment (see paragraph 840-30-25-8) declines during the early years once the investment has been completed and rises during the later years of the lease before its final elimination. Such decreases and increases in the net investment balance may occur more than once.

Leveraged lease classification applies only to lessors. Lessees should account for leveraged leases in the same manner as nonleveraged leases and classify them as operating or finance leases, as appropriate. The grandfathering of leveraged leases, therefore, does not affect lessees; they should apply the applicable transition guidance to their leases upon adopting ASC 842.

7.2.1 Classification criteria for leveraged leases

Leveraged leases have the following characteristics:
  • The terms of the lease meet the criteria to be classified as a direct financing lease, as defined in ASC 840
  • The lease involves at least three parties: a lessee, a long-term creditor, and a lessor
  • The financing provided by the long-term creditor is nonrecourse to the general credit of the lessor and must provide the lessor (the equity investor) substantial leverage in the transaction
  • The lessor’s net investment in the leveraged lease declines during the early years of the lease term and subsequently rises

7.2.1.1 Classification as a direct financing lease under ASC 840

The definition of a direct financing lease under ASC 842 differs from its definition under ASC 840. Classification as a direct financing under ASC 840 was only possible when the lease did not give rise to profit or loss to the lessor at lease inception, i.e., the cost (or carrying value, if different) and fair value of the leased asset must be equal. If cost (or carrying value, if different) did not equal fair value at lease inception, the lessor could not classify the lease as a direct financing lease and it would be ineligible for leveraged lease accounting; rather, it would be classified as either a sales-type or operating lease, as appropriate. Unless the asset is acquired contemporaneously with the execution of the lease, the lessor’s cost (or carrying value, if different), and fair value of the underlying asset subject to a lease, are typically not the same at lease inception and, therefore, classification as a direct financing lease or leveraged lease under ASC 840 was rare. An example of a situation when a lease may have qualified as a direct financing lease is when a bank acquired a building from a third party and leased it under a capital lease (as defined by ASC 840) to the lessee. In this case, the cost and fair value of the real estate (land and building) would likely be the same given the purchase and concurrent sales-type lease.

7.2.1.2 “Down-and-up pattern” of a leveraged lease

To qualify as a leveraged lease, the lessor’s net investment in the leveraged lease must decline during the early years of the lease term and subsequently rise. Income from a leveraged lease is recognized by the lessor by applying a level rate of return to the net investment, but only in the periods that the net investment is positive. Because the calculated return is an after-tax amount, the cash flows from accelerated tax benefits are included in the overall leveraged lease cash flows. These cash flows occur in the early years of the lease and result in a rapid recovery of (i.e., decline in) the net investment, often causing the net investment to turn negative. The lessor will ultimately “reinvest” in the leveraged lease through the repayment of deferred tax liabilities, causing the net investment to increase in the later periods of the lease. This typical “down-and-up pattern” in the net investment causes a substantial portion of the income to be recognized in the early periods of the lease, which is a recognition pattern that is far more accelerated than a typical loan amortization (i.e., effective interest) pattern.
While the “down-and-up pattern” of a leveraged lease is typically created by the tax-related cash flows, ASC 840-10-25-43(c)(4) does not require that the pattern be created from the tax-related cash flows. Moreover, it does not require that the net investment in the leveraged lease go negative (in which case the balance of the deferred tax credit would exceed the pretax investment in the leveraged lease) at any point during the lease term. When the “down-and-up pattern” results from non tax-related cash flows, judgment may be required to determine whether the “down-an-up pattern” is sufficient to qualify for leveraged lease accounting.

7.2.1.3 Applying leveraged lease classification to partnerships

The classification criteria in ASC 840-10-25-43(c), which requires that the lessor's net investment, as defined, decline during the early years and rise during the later years of the lease, was generally not met in a partnership because the income tax benefits of the transaction are not realized by the partnership entity.
Generally, partnerships as lessors in an otherwise leveraged lease-type transaction did not account for the lease as a leveraged lease in situations when income tax benefits resulting from the transaction (e.g., investment tax credits (ITCs) and the use of accelerated depreciation) were not available to the entity, but, instead, were realized directly by the partners.
ASC 740-10-25-46 describes two methods to account for ITCs: the “flow-through method” and the “deferral method.” The deferral method, under which the tax credit is reflected in net income over the life of the acquired property, besides being described in ASC 740-10-25-46 as “considered preferable,” is more consistent with the income recognition model for a leveraged lease. Refer to TX 3.3.5.2 for more information about these two methods. If a partner's investment in the lease, as defined, would have met the requirements of ASC 840-10-25-43(c) because of the partner's ability to reflect the related income tax benefits, and the partner accounts for the ITC under the “deferral method,” (as opposed to the “flow-through method”), the partner may have used leveraged-lease accounting to record its share of partnership income.

7.2.2 Economic rationale for leveraged leases

Historically, leveraged leases were attractive to lessees that were unable to take advantage of the tax benefits typically associated with owning property, such as accelerated depreciation and investment tax credits. Lessors would typically obtain nonrecourse financing for 65% to 80% of the cost of the leased asset (tax regulations required the lessor to have a minimum of 20% of the cost of the leased asset “at-risk”). This typically enabled lessors to claim all the tax benefits of owning the asset, including deductions for interest expense on the nonrecourse financing, despite a relatively small investment.
The tax benefits associated with investing in the asset are typically realized relatively early in the lease term. Given the early return of investment, a lessor in a leveraged lease was able to offer a lessee a lower cost of borrowing than the lessee might have been able to obtain in a financed purchase transaction.
Changes in tax regulations related to depreciation and investment tax credits, as well as the reduction in corporate tax rates during the 1980’s reduced the tax benefits of leveraged leases to lessors, as well as their attractiveness to investors. Accordingly, many existing leveraged leases are in the later part of their lease terms.

7.2.3 Presentation and income recognition of leveraged leases

The balance sheet presentation (as described in ASC 840-30-30-14) and income recognition pattern for a leveraged lease (as described in ASC 840-30-35-33 through ASC 840-30-35-36) are both unique models.
Leveraged leases are presented as a net asset on the lessor’s balance sheet. The net asset equals the sum of the total rents receivable from the lessee and the estimated residual value of the asset at the expiration of the lease less the debt service associated with the nonrecourse debt, all reduced by unearned income. This net presentation is attractive to lessors as it enhances its investment return on assets.
The accounting treatment prescribed for leveraged leases requires one overall method of income recognition (level rate of return for those years when net investment in the lease is positive, based upon the after-tax cash flows projected at the inception of the leveraged lease) for all components of income to be realized, including investment tax credit.
Although the accounting for leveraged leases is inherently inconsistent with accounting for other collateralized financings, the FASB decided to allow lessors to continue to apply the leveraged lease model because of the relatively small population of leveraged leases, the relative age of the lease arrangements, and the fact that this accounting model is only applicable to lessors. A leveraged lease may no longer be grandfathered if the lessor modifies or changes the characteristics of the lease, as described in LG 7.3.1.

7.2.3.1 Leveraged lease: presentation of investment tax credit

The examples included in ASC 842-50-55-6 through ASC 842-50-55-15 indicate the inclusion of ITC amortization with income tax expense. There is, however, a large body of practice that reflects ITC amortization as part of pretax revenue. Disclosure of the method applied is recommended.
The examples in ASC 842-50-55-6 through ASC 842-50-55-15 indicate that the unamortized balance of deferred ITC would be presented in the lessor's balance sheet as a component of "unearned and deferred income" deducted in arriving at the net investment in the leveraged lease included among assets. This presentation is consistent with the discussion in ASC 255-10-55-8.
The treatment of deferred investment tax credits as a temporary difference is discussed in TX 3.3.5.
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