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7.4 Leveraged leases acquired in a business combination
Publication date: 31 May 2023
us Leases guide
A leveraged lease acquired in a business combination should retain its original lease classification provided it is not modified and it was eligible for grandfathering under ASC 842. The net investment in the leveraged lease is recorded at its fair value on the acquisition date, which normally approximates the present value of expected cash flows. Upon acquisition, the acquirer should measure the net investment in the leveraged lease at its fair value and separately recognize its component parts (i.e., the net rentals receivables, estimated residual value, and unearned income) on a gross basis.
A separate liability would be recorded in purchase accounting for pre-acquisition interest and penalties determined in accordance with ASC 740. The effects of any subsequent adjustment of the pre-acquisition liability would be determined in accordance with ASC 740.
The post-acquisition leveraged lease accounting would be based on income tax cash flows that are determined in accordance with ASC 740. If the acquirer expects to enter into a settlement with the taxing authorities relating to payment of back taxes for deductions taken earlier than may be appropriate under the tax laws, the leveraged lease cash flows typically include the following components:
- The benefit of tax deductions that the lessor anticipates taking on its tax return up to the date of a projected settlement with the taxing authorities;
- A projected settlement amount on the date of the projected settlement; and
- Projected cash flows following the date of the projected settlement.
Since the tax-related cash flows required by ASC 740 may be different from the cash flows that a market participant would use to determine the fair value of a leveraged lease, the rate that is used in the leveraged lease accounting would not necessarily be the same as the rate that was used to determine the fair value of the leveraged lease on the acquisition date.
Interest and penalties that accrue on an acquired leveraged lease after its acquisition should be recognized in expense, outside the leveraged lease model. If, after the acquisition, circumstances change the timing of the estimated income tax-related cash flows, the lessor should recalculate the leveraged lease and reflect the cumulative catch-up adjustment in net income. The lessor should also adjust the liability for post-acquisition interest and penalties, as appropriate, and record the effects of the adjustment in expense.
See ASC 842-50-55-27 through ASC 842-50-55-33 for an illustration. See BCG 4.3.3.7 for additional information on the accounting for leases acquired in a business combination.
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