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The CECL impairment model is applicable to lessors for certain types of leases. ASC 326-20 applies to net investments in leases associated with sales-type leases and direct financing leases. The FASB recognized that these receivables include both financial and non-financial elements, but concluded that the application of a single impairment model to the recognized lease asset would be preferable to assessing different components of a single asset under different impairment models.
ASC 326-20 requires an allowance for credit losses to be recognized on the date that a sales-type lease or direct financing lease receivable is recognized, either through origination or acquisition. The guidance requires an entity’s estimate of expected credit losses to include a measure of the expected risk of credit loss even if that risk is remote. It also requires that the measurement of credit losses be on a collective (pool) basis when individual assets share similar risk characteristics.
For leases that are originated, the initial measurement of the allowance for credit losses will be recorded through earnings. For leases that will be accounted for as sales-type or direct financing leases acquired either though a business combination or an asset purchase, we believe an entity should assess whether the acquired leases would be considered purchased credit deteriorated (PCD) assets. To the extent a lease is not considered to be a PCD asset, the initial measurement of the allowance for credit losses would be reported in current earnings (similar to an originated lease). If a lease is considered a PCD asset, the initial measurement of the allowance for credit losses will create a basis adjustment to the amortized cost basis of the net investment in the lease. This is commonly referred to as a “gross up” as the initial entry to establish the allowance adjusts the carrying value of the asset. Refer to LI 9 for further information on PCD assets.

7.6.1 Unit of measurement for leases under CECL

As discussed in LI 7.3.2, the CECL model requires the measurement of credit losses to be on a collective (pool) basis when individual assets share similar risk characteristics. The implementation guidance provides some examples of factors that could be used to identify assets that share similar risk characteristics. Many of these factors (e.g., credit rating of the lessee, remaining term of the lease) will be relevant when considering if leases share similar characteristics.
The nature of the leased asset will likely be a key consideration in determining whether leases share similar characteristics. The value of the leased asset can impact the estimate of expected credit losses in two ways; (1) with respect to serving as collateral against rental payments and (2) based on its residual value. The volatility of the value of a leased asset, whether the value of the assets is correlated amongst the leases, and other similar considerations will also be relevant. For example, it may not be appropriate to create a single portfolio of auto leases that includes some leases of small cars and others for large pickups and SUVs as those assets would not be expected to have similar risks with respect to their residual values.
At the June 11, 2018 TRG meeting, the FASB staff shared their perspectives that all cash flows from expected disposals of leased assets, including those that result in a gain, should be included in an estimate of expected credit losses for a pool of lease receivables (see TRG Memo 7: Cover Memo and TRG Memo 13: Summary of Issues Discussed and Next Steps) to the extent they reduce losses. Including expected gains serves to reduce credit losses within the pool (“offsetting” losses such as lessee default or declines in the residual value of other assets).
Some noted that using expected gains on the disposition of leased assets to offset credit losses effectively includes that gain in earnings (by reducing credit losses) before it is realized. In their conclusion, the FASB staff noted that the guidance requires the net investment in lease (including the residual value of the asset) to be evaluated as a single unit and that a pool-level assessment does not preclude including cash flows associated with the disposition of the asset.
To the extent that a pool includes leases with substantial expected gains on the disposal of the leased assets and substantial losses on the disposition of other leased assets, this may indicate that the leases do not share similar risk characteristics. As a result, the leases may need to be assessed as part of other pools of leases or be assessed individually for credit losses if they no longer share common risk characteristics with other leases.
The existence of a residual value guarantee (that is considered part of the unit of the account of the lease) and the credit risk of the provider of that guarantee (whether it is the lessee or a third party) may also be key factors in evaluating whether leases share similar risks characteristics.

7.6.2 Determining life of the lease when estimating credit losses

As stated in ASC 326-20-30-6A, when determining the life over which to estimate expected credit losses on a net investment in a lease subject to CECL, entities should determine lease term solely based upon the guidance in ASC 842. For example, if the lease term is determined to be 10 years under ASC 842, then 10 years should be used as the life under the CECL guidance.

ASC 326-20-30-6A

For net investment in leases recognized by a lessor in accordance with Topic 842, instead of applying the guidance in paragraph 326-20-30-6, an entity shall use the lease term as the contractual term.

This will result in a different conclusion for leases than for other financial assets subject to CECL. For example, if an entity is a lessor for a 10-year lease (sales type or direct financing) and the lessee has the right to extend the lease for another 2 years, ASC 842 would treat the lease as a 10-year lease unless it is reasonably certain the lessee would exercise their option. Assuming the lessor is not reasonably certain of the exercise of the extension option, it would be considered a 10-year lease under ASC 842. For the purposes of estimating credit losses, it should also be assumed to be a 10-year credit exposure. If this contract was a 10-year loan for which the borrower had the right to extend the maturity date for 2 years, the term used for modeling credit losses would be 12 years and consider the probability the borrower did not extend (alternatively it could be thought of as a 10-year loan with a chance that it could become a 12-year loan).

7.6.3 Estimating lifetime expected credit losses for a lease

In developing the CECL model, the FASB consciously allowed for a variety of acceptable techniques to estimate credit losses. Entities can utilize DCF models, undiscounted approaches, such as loss rate or probability of default/loss given default models, or other models. See LI 7.3.3 for further information on measurement methodologies. With respect to sales-type and direct financing leases that have financial and non-financial components, entities should consider a number of factors in their analysis when estimating lifetime expected credit losses in addition to those discussed in LI 7.3.5.

7.6.3.1 Rental payments when applying the CECL model

The rental payments component of the net investment in leases could be thought of similar to a collateralized loan with an amortizing principal balance. This component consists of contractually specified payments on specified dates and if the lessee defaults, the lessor has the ability to repossess the leased asset similar to a lender’s ability to foreclose on collateral for a loan. In this context, consideration should be given to the probability that the lessee will default and the loss given default considering amounts that may be collected from the lessee as well as the ability to obtain the leased asset.
In some instances, the fair value of the leased asset may be forecasted to decline at a different pace than the amortized cost basis of the net investment in the lease. This could impact credit modeling at inception if it is forecasted that at different points in the life of the lease, the degree to which the rental payments are collateralized changes. For example, if the fair value of the leased asset declines in the early years of a lease faster than the amortized cost basis of the net investment, different losses may be realized depending on when a default is estimated to occur. This should be considered in an entity’s estimate of credit losses, and may be captured in an entity’s historic loss information, which may serve as a starting point for estimating credit losses.

7.6.3.2 Considering residual value of leased assets in the CECL model

Obtaining the asset at the maturity of the lease is dependent on the lease reaching its maturity. To the extent the lessee defaults, the loss incurred by the lessor is dependent on the fair value of the leased asset when repossessed as opposed to at maturity. However, the residual value of the asset is a component of the net investment in lease balance. As a result, lessors will need to update their estimates of the residual value of the leased asset when applying ASC 326-20.
As discussed in LI 7.6.1, during the June 11, 2018 TRG meeting, the FASB staff shared their perspectives that all cash flows from expected disposals of leased assets, including those that result in a gain, should be included in an estimate of expected credit losses for a pool of lease receivables (see TRG Memo 7: Cover Memo and TRG Memo 13: Summary of Issues Discussed and Next Steps) to the extent that they reduce losses. Including expected gains serves to reduce credit losses within the pool (“offsetting” losses such as lessee default or declines in the residual value of other assets). In their conclusion, the FASB staff noted that the guidance requires the net investment in lease (including the residual value of the asset) to be evaluated as a single unit and that a pool-level assessment does not preclude including cash flows associated with the disposition of the asset.

7.6.3.3 Residual value guarantees in the CECL model

The leasing guidance requires certain residual value guarantees to be considered in determining the lease classification and the measurement of the initial recognition of the net investment in the lease. In these cases, we believe that it should be considered in the assessment of credit losses.
This may result in considering the impact of residual value guarantees when seemingly similar credit insurance arrangements would not be considered. ASC 326-20 indicates that credit insurance arrangements that are considered freestanding contracts would not be considered in determining the allowance for credit losses. However, we believe that guidance was written in the context of loan accounting, in which freestanding credit insurance agreements are not considered in the determination of the initial carrying value of the loan as they are not part of the same unit of account. If under the leasing guidance, the unit of account of the lease includes the residual value guarantee, we believe the unit of account for the purposes of determining credit losses should include the residual value guarantee as well.
In considering the impact of any residual value guarantee, the degree to which the estimated fair value of the residual asset is below the guaranteed amount, as well as the credit risk of the guarantee provider, will be key inputs into modelling the impact of such guarantees.

7.6.3.4 Lease writeoffs and recoveries in the CECL model

Estimated credit losses on sales-type and direct financing lease receivables are reflected through an allowance for credit losses account, which is separately reported in the financial statements as a deduction from the amortized cost basis of the asset. The CECL model requires assessments of allowance amounts to determine whether they should be written off against the amortized cost basis of the receivables. Receivables (and allowance accounts) are written off either in full or in part when such amounts are deemed uncollectible.
For leases, each component of a lease receivable (financial or non-financial) could cause a writeoff. Companies may need to establish policies and procedures to determine when receivables (and allowance balances) should be written off.
Further, ASC 326-20 requires entities to consider recoveries when estimating the allowance for credit losses on an individual or pool of financial assets. The amount of expected recoveries on previously written off and expected to be written off financial assets considered in the allowance should not exceed the aggregate of amounts previously written off and expected to be written off by the entity. See LI 7.3.5.4 for further information.

7.6.4 Applying the CECL model to collateral-dependent leases

The credit loss guidance provides a practical expedient under which an allowance can be measured based upon the difference between the fair value of collateral and the amortized cost basis when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral (see LI 7.4.1). If collection would be achieved through the sale of the collateral, costs to sell must also be considered. This method of calculating an allowance is required when foreclosure is deemed probable. See LI 7.3.5.6 for further information.
The collateral-dependent practical expedient and the requirement to use collateral value when foreclosure is probable are elements that are integral to the CECL model. As a result, we believe that the collateral-dependent practical expedient could be used for leases and the requirement to use collateral value when “foreclosure” is probable should also be applied to leases.
We do not believe that this guidance should be applied in situations when the lessee has performed (and is expected to perform) on its obligations to make payments and the leased asset is returned to the lessor at the expiration of the lease in accordance with the lease’s contractual provisions. However, if the lessee is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the leased asset following repossession, we believe that the collateral-dependent practical expedient can be applied. In addition, if it is probable that the lessee will default and the lessor will repossess the leased asset, we believe that the fair value of the leased asset (less costs to sell, if applicable) must be used in the determination of the allowance.

7.6.5 Sale of lease receivables under the CECL model

In some cases, a lessor may sell the receivable associated with future rental payments but retain ownership of the leased asset. ASC 860 is the applicable guidance for determining whether that transfer would be accounted for as a sale resulting in derecognition of the receivable. In instances when the transfer of the receivable is accounted for as a sale, and the asset remaining relates to the unguaranteed residual value, the leasing guidance states that the lessor should begin applying ASC 360, Property, Plant and Equipment, to determine whether the unguaranteed residual asset is impaired. As a result, the CECL model would no longer be applicable.
We do not believe that this guidance should be extended to address situations when the lessor has not transferred receivables and simply as a result of a lessee making payments, the net investment of the lease consists principally of the estimated residual value of the leased asset. In these situations, we believe it is appropriate to continue applying the credit loss model in ASC 326 until the leased asset is obtained.
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