Financial Watch
When Deals Change
Accounting for changes to lease transactions.
L
essors typically enter into leases with the expectation that the lease will run its full term, if not longer.
However, with leases constantly modified by events such
as changing lessee business requirements, mergers and
acquisitions, or declining credit strength, experience indicates otherwise. In what way does the lessor reflect these
changes in the accounting records?
This article addresses the accounting for some of the
more typical lease changes and modifications—those that
do not involve changes in the underlying continued use of
the same asset. Beginning with a short review of the underlying rules, it will then illustrate the application of those
rules to several different lease modifications. Modifications
considered as troubled debt restructurings or those that involve a refunding of tax-exempt debt will not be addressed
in this article, however.
Basic Accounting Framework
A lease, once classified, retains that original classification throughout its term. Even if there is a change in the
circumstances surrounding the lease—a lessee default, sale
of the lease, or a decline in residual value—this is true.
The only time the classification may change is if there is a
“new agreement” for accounting purposes, and sometimes
not even then. So when is a new agreement created? Does a
change in the provisions of the lease (not just the circumstances surrounding it) create a new agreement under the
lease accounting rules of FAS 13? Is an extension considered a new agreement?
When leases are modified,
in what way does the lessor
reflect these changes in the
accounting records?
Answers to these questions pivot around the nature of
the changes to the original lease and are set out, at least
for lessors, in paragraphs 9, 17, 18, and 19 of FAS 13.
These paragraphs assert that we must first identify whether
changes to the lease are due to an extension or a renewal,
or if they represent a change in the provisions of the lease.
Let’s begin by looking first at renewal/extension scenarios.
Renewal or Extension
The language of FAS 13 explicitly provides that a renewal
or extension of the lease always represents a new, separate
agreement from the original. As a new agreement, the lessor must retest any extended or renewed lease by applying
the four basic classification criteria (plus the additional
“collectibility” and “no important uncertainties” tests), as of
the date of the renewal or extension. Based on the classification of the original lease, accounting for the renewal/extension will differ.
Case One: Renewal or extension of an existing
operating lease.
If the original lease is operating, and the renewal or
extension is:
n An operating lease, the agreement continues to be
accounted for as an operating lease. Any accrued but
unpaid rent should be assessed and, if realizable,
recognized over the new lease term. This accounting
requirement raises an interesting question regarding the
treatment of any remaining deferred rent on the balance
sheet in an uneven rent structure.
June 2007 •
LT 15
Financial Watch
For example, assume a renewal at the end of year two of
the following high-low structure:
Term
3 years
Payments
Year 1
150
Year 2
100
Year 3
50
Deferred rent balance
50
In this case, the 50 of deferred rent at the time of the
renewal should be recognized over the renewal period, not
at the time of the renewal.
n A direct financing lease, the asset is removed from
the accounts and the net investment in the new lease
is booked. The term of the new lease includes the
remaining term of the lease plus any extension. It should
be noted that the likelihood of a renewal or extension
16
LT • June 2007
Once a lease is classified, the only
time the classification may change
is if there is a “new agreement”
for accounting purposes, and
sometimes not even then.
being classified as a direct financing lease (rather than
as a sales-type lease) is very low in this case, as the fair
value of the operating leased asset will rarely be the
same as its carrying value.
Case Two: Renewal or extension of an existing direct
financing lease.
If the original lease is a direct financing lease, and the
Financial Watch
renewal or extension is:
n An operating lease, the existing lease continues to be
accounted for as a direct financing lease over the original
term. The renewal or extension then is accounted for as
an operating lease.
n A direct financing lease, the balance of the minimum
lease payments and estimated residual, if affected as a
result of the renewal or extension, should be adjusted
and the adjustment charged or credited to unearned
income. There should not be any upward adjustment to
the residual and any decline in residual not based on the
change in the term due to the renewal/extension should
be recognized currently, not spread over the term of the
new agreement.
Other Modifications
The key to accounting for a change in the provisions of
a lease—other than through an extension or renewal, is
determining whether a new agreement is created as a result
of those changes. This determination is made by applying the criteria of FAS 13 to the original assumptions (fair
value, residual, etc.) and the revised terms of the lease as
if they all had been in place at inception. If retesting the
lease in this manner results in a change to the original classification of the lease, a new agreement has been created.
Should a new agreement exist, a second step must occur in
the form of a classification test to be preformed only on the
new lease as of the modification date.
For example, consider a lease with the following characteristics:
36-month lease at $1,417 per month, payments in advance
$5,700 unguaranteed residual
$50,000 fair market value (equipment cost)
8% implicit rate
Classification: direct financing lease
Six months into the lease, it is modified such that the
remaining 30 payments are set at $1,200 per month (assume there is no change to the residual). Because this
change represents a modification to the provisions of the
lease, and not a renewal or extension, the lease must be
re-evaluated against the classification criteria of FAS 13,
using the original assumptions and revised terms. The
components of the lease used for this new classification
test are as follows:
36-month lease, payments in advance
– 6 months of payments at $1,417 per month
– 30 months of payments at $1,200 per month
$5,700 unguaranteed residual
$50,000 fair market value (equipment cost)
Based on this retest, the lease would have been classified as an operating lease, which means the modification
has resulted in a new agreement for accounting purposes.
Because the modification has resulted in a new agreement,
that new agreement then must be classified in a separate
classification test as of the modification date using the criteria of FAS 13. Keep in mind that the classification of the
June 2007 •
LT 17
Financial Watch
new lease may result in a different lease classification than
the retest of the original lease.
Case Three: Modification of an existing direct
financing lease.
If the original lease is a direct financing lease, the modification creates a new agreement, and the new agreement is
classified as:
n An operating lease, the remaining net investment in
the original lease should be removed and the operating
lease asset recorded at the lower of original cost, current
carrying cost, or fair value, with any adjustment charged
to income of the period. The modification is then
accounted for as an operating lease.
n A direct financing lease, the balance of the minimum
lease payments and estimated residual, if affected by the
change in terms, should be adjusted and the adjustment
charged or credited to unearned income. There should
not be any upward adjustment to the residual and any
decline in residual not based on the change in terms
should be recognized currently, not spread over the
remaining term.
Case Four: Modification of an existing operating lease.
Assuming the original lease is an operating lease, much
the same process is followed. For example, after classifying the modified lease using the original assumptions and
revised terms, it is determined that the modified lease is a
new agreement, classifying this new agreement as:
n An operating lease, the agreement continuing to be
accounted for as an operating lease.
18
LT • June 2007
The key to accounting for
lease changes is determining
whether or not those changes
create a new agreement for
accounting purposes.
n A direct financing lease, the asset is removed from the
accounts and the net investment in the new lease is
booked. As previously discussed, the likelihood of a
modification being classified as a direct financing lease
is very low in this case, as the fair value of the operating
leased asset will rarely be the same as its carrying value.
The key to accounting for lease changes is determining whether or not those changes create a new agreement
for accounting purposes. If they have, the new agreement
must be classified using the criteria of FAS 13. Of course,
this discussion, barely begins scratching the surface of the
issues encountered in practices related to modifications
and changes to lease agreements. It does, however, provide
a framework for assessing other events such as upgrades
and changes to residual values. Future articles in this series
will address these types of changes plus those related to
changes regarding term, structure, the impact of IAS 17,
and as well as the new approach on all these factors.
ELT thanks Shawn D. Halladay of The Alta Group for this month’s column.