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Advanced Lease Accounting Topics
$ Master Lease Arrangements
$ Effect of Default Provisions on Lease Classification
$ Residual Value Guarantees & Expected Deficiencies
$ Refinancing Synthetic Leases
$ FAS 143, “Accounting for Asset Retirement Obligations”
$ FAS 146, “Accounting for Costs Associated with Exit or Disposal
Activities”
$ Subsequent Changes in Lease Provisions (time permitting)
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Master Lease Arrangements
$ Classification issue
• One lease or multiple leases for classification purposes?
$ Considerations
• Nature of leased assets (similar or dissimilar)
• Functional interdependence of leased assets
• Start and end dates (multiple draws occurring over a period of time)
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Master Lease Arrangements
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$ Potential pitfalls when more than one lease exists for classification purposes
• Allocation of rental payments
• Allocation of residual value guarantee
• “Payment waterfall” at lease expiry
$ How to address pitfalls
• Separate lease schedules
• Separate residual value guarantees
• Separate “payment waterfalls”
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Effect of Default Provisions on Lease
Classification
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$ Criteria set forth in EITF 97-1, Question 2
• Establishes framework to evaluate effect on lease classification of default provisions unrelated to lessee’s use of the property
– “Non-performance” related default provisions
• Does not address default provisions related to the lessee’s use of the leased asset
– “Performance related” default provisions, for example:
• Failure to pay rent
• Misuse of the asset,
• Failure to maintain the asset, or
• Failure to return the asset at lease expiry
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Effect of Default Provisions on Lease
Classification
$ Non-performance related defaults include a broad range of typical default provisions in leases, for example:
• Financial covenants,
• Lessee representations,
• Cross-default or acceleration provisions,
• Change in control provisions,
• Defaults based upon a change in credit rating,
• Bankruptcy,
• Material adverse change provisions,
• All others not considered “performance-related”
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Effect of Default Provisions on Lease
Classification
$ Applies to all leases, not just synthetic leases or leases that include
SPEs, for example:
• Leveraged leases, sale-leasebacks,equipment leases, true leases, etc.
$ Result of analysis will be:
• Minimum lease payment, or
• Contingent rent
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Effect of Default Provisions on Lease
Classification
$ Non-performance default provisions do not effect lease classification if all of the following conditions are met:
• Customary in financing arrangements
• Occurrence is objectively determinable
• Predefined criteria established, relating solely to lessee and its operations
• Reasonable to assume event of default will not occur
$ If any of the above 4 conditions are not met, the potential remedy available to the lessor is included as a minimum lease payment in the FAS 13 par. 7d (90%) test
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Effect of Default Provisions on Lease
Classification
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$ Common examples of pitfalls
• Material adverse change provisions
• Cross default and cross acceleration provisions
• Subjective default language
• Evergreen clauses
$ How to address pitfalls
• Restructure default to comply with EITF 97-1 Q2,
• Remove provision as an event of default, or
• Limit remedy available to lessor to an amount that will not cause the lessee to have a capital lease based upon the FAS
13, par. 7d (90%) test.
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Residual Value Guarantee & Expected
Deficiencies
$ Residual value guarantees
• Key terms
– “Residual value guaranteed by the lessee” (EITF 96-21,
Question 12)
• Also referred to as “stipulated residual value at the end of the lease term” (FIN 19).
– Maximum deficiency under the residual value guarantee.
– Expected deficiency under the residual value guarantee.
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Residual Value Guarantee & Expected
Deficiencies
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$ Maximum deficiency must be included as minimum lease payment in FAS 13 par. 7d (90%) test
$ Under EITF 96-21, Question 12, the effects of the guarantee for an operating lease are excluded from rent expense unless it becomes probable that the value of the property will be less than the
“residual value guaranteed by the lessee”.
$ Loss accrual required once it becomes probable that the lessee would be required to make a payment under the residual value guarantee
• Expected deficiency recognized on a straight-line basis over remaining lease term
• Accrual required regardless of whether lessee expects to exercise a purchase or renewal option.
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Residual Value Guarantee & Expected
Deficiencies
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Example under EITF 96-21, Question 12
Assumptions:
Lease Term
Residual value guaranteed by lessee
(stipulated residual value)
Maximum deficiency payable under guarantee
The end-of-lease expected value, estimated as of the end of year 3
5 years
$100
$ 85
$ 90
The lessee is required to bear any loss in residual value from $100 down to $15.
The lessee would include only the maximum deficiency, $85, in minimum lease payments in the FAS 13 par. 7d (90%) test (FIN 19).
In our fact pattern, beginning in year 4, the lessee would be required to accrue the expected deficiency of $10 ($100-$90) over the remaining two years of the lease term.
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Residual Value Guarantee & Expected
Deficiencies
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$ FASB Exposure Draft, Guarantor’s Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others
• Would nullify EITF 96-21, Question 12 (partially?)
• Would require initial recognition of liability corresponding to the fair of the guarantee.
• Timing of recognition: “at the inception of the guarantee”
• ED does not address:
– Accounting for the debit
– Subsequent (post inception) accounting for the liability
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Refinancing Synthetic Leases
$ There may be significant activity following the issuance of the
FASB’s new guidance regarding consolidation of SPEs
$ Changes in lease provisions (with same lessor) could trigger requirement for new lease classification
• Factors that could significantly impact new lease classification include:
– Fair value of the property
– Discount rate
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Refinancing Synthetic Leases
$ Refinancing a synthetic lease at lease expiry with a new lessor typically involves the sale of property to the new lessor
• Question exists as to whether a new lease should be evaluated under FAS 98, following an imputed purchase-sale-leaseback
• Implications of TRAC provisions in performing FAS 13 par. 7d
(90%) test
– Inclusion of appreciation in numerator and denominator.
• Any gain on transaction deferred in accordance with FAS 28 and EITF 86-17.
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Accounting for Asset Retirement Obligations
$ Overview
• Recognition of ARO liabilities when incurred
• Initial measurement of ARO at fair value
• Recognition of subsequent changes due to passage of time and due to changes in amount and timing of estimated cash flows
• Asset retirement cost capitalized as part of related asset cost, then allocated to expense systematically and rationally
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Accounting for Asset Retirement Obligations
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$ Scope
• Applies to unavoidable existing legal obligations associated with retirement
• Does not apply to obligations that result from ongoing, or improper, operation of an asset
• Does not apply to minimum lease payments or contingent rental payments under FAS 13
$ The key challenge is to determine whether possible obligations at end of lease term are:
• Minimum lease payments;
• Contingent rents; or
• Are subject to FAS 146
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SFAS 146
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$ Objective is to address significant issues relating to the recognition, measurement, and reporting of costs associated with exit and disposal activities including restructuring activities
$ Prohibits recognition of liability based solely on an entity’s commitment to a plan, which in turns nullifies EITF 94-3
$ Requires that the initial liability for costs associated with exit and disposal activities be measured at fair value
$ Requires that the liability for costs associated with exit and disposal activities be evaluated each reporting period and subsequent changes in the fair value of the liability be measured using an interest allocation approach
$ Effective for all exit or disposal activities initiated after 12/31/02
(prospective application only)
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SFAS 146
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$ Applies to costs associated with an exit activity including but not limited to, the following:
• One-time termination benefits for involuntary terminated employees
• Costs to consolidate facilities or relocate employees
• Cost to terminate a contract that is not a capital lease
$ Contract termination costs are costs that represent, the following:
• Cost to terminate the contract before the end of its term
• Costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity
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Lease Termination Costs
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$ For costs to terminate a contract before the end of its term
• Recognize and measure liability at fair value when the entity terminates the contract in accordance with its terms
$ For costs that continue to be incurred without economic benefit
• Recognize and measure liability at fair value when the entity ceases using the rights conveyed by the contract in its operations
– Liability based on remaining lease rentals should be measured at its fair value at the initial recognition date
– Reduced by estimated sublease rentals (reasonably obtainable), regardless as to whether entity intends to enter into a sublease
• Effectively nullifies EITF 88-10
• We understand that the FASB staff did not intend to nullify TB 79-15.
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Subsequent Changes in Lease Provisions
$ Determination of whether the changes constitute a “new agreement”
$ Classifying the new agreement
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Subsequent Changes in Lease Provisions
$ Is lease term extended? Generally new lease.
$ Change in MLP? Two-step process.
• Step 1: Retest as of inception.
• Step 2: If step 1 results in different classification from original classification, classify new lease as of change date.
$ New classification used only if steps 1 and 2 both result in classification different from original.
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