Appendix A: Special Situations Not Yet Addressed by IAS 17 but Which Have been Interpreted Under US GAAP | WILEY IAS 2003: Interpretation and Application of International Accounting Standards

In the following section, a number of interesting and common problem areas that have not been addressed by the international standards are briefly considered. The guidance found in US GAAP is referenced, as this is likely to represent the most comprehensive source of insight into these matters. However, it should be understood that this constitutes only possible approaches and is not authoritative guidance.

Sale-Leaseback Transactions

The accounting treatment from the seller-lessee's perspective will depend on the degree of rights to use retained by the seller-lessee. The degree of rights to use retained may be categorized as follows:

Substantially all
Minor
More than minor but less than substantially all

The guideline for the determination substantially all is based on the classification criteria presented for the lease transaction. For example, a test based on the 90% recovery criterion seems appropriate. That is, if the present value of fair rental payments is equal to 90% or more of the fair value of the sold asset, the seller-lessee is presumed to have retained substantially all the rights to use the sold property. The test for retaining minor rights would be to substitute 10% or less for 90% or more in the preceding sentence.

If substantially all the rights to use the property are retained by the seller-lessee and the agreement meets at least one of the criteria for capital lease treatment, the seller-lessee should account for the leaseback as a capital lease, and any profit on the sale should be deferred and either amortized over the life of the property or treated as a reduction of depreciation expense. If the leaseback is classified as an operating lease, it should be accounted for as one, and any profit or loss on the sale should be deferred and amortized over the lease term. Any loss on the sale would also be deferred unless the loss were perceived to be a real economic loss, in which case the loss would be recognized immediately and not deferred.

If only a minor portion of the rights to use are retained by the seller-lessee, the sale and the leaseback should be accounted for separately. However, if the rental payments appear unreasonable based on the existing market conditions at the inception of the lease, the profit or loss should be adjusted so that the rentals are at a reasonable amount. The amount created by the adjustment should be deferred and amortized over the life of the property if a capital lease is involved or over the lease term if an operating lease is involved.

If the seller-lessee retains more than a minor portion but less than substantially all the rights to use the property, any excess profit on the sale should be recognized on the date of the sale. For purposes of this paragraph, excess profit is derived as follows:

If the leaseback is classified as an operating lease, the excess profit is the profit that exceeds the present value of the minimum lease payments over the lease term. The seller-lessee should use its incremental borrowing rate to compute the present value of the minimum lease payments. If the implicit rate of interest in the lease is known, it should be used to compute the present value of the minimum lease payments.
If the leaseback is classified as a capital (i.e., finance) lease, the excess profit is the amount greater than the recorded amount of the leased asset.

When the fair value of the property at the time of the leaseback is less than its undepreciated cost, the seller-lessee should immediately recognize a loss for the difference. In the example below, the sales price is less than the book value of the property. However, there is no economic loss because the FMV is greater than the book value.

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The artificial loss must be deferred and amortized as an addition to depreciation.

The following diagram summarizes the accounting for sale-leaseback transactions.

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In the foregoing circumstances, when the leased asset is land only, any amortization should be on a straight-line basis over the lease term, regardless of whether the lease is classified as a capital or an operating lease.

Executory costs are not to be included in the calculation of profit to be deferred in a sale-leaseback transaction. The buyer-lessor should account for the transaction as a purchase and a direct financing lease if the agreement meets the criteria of either a direct financing lease or a sales-type lease. Otherwise, the agreement should be accounted for as a purchase and an operating lease.

Sale-leaseback involving real estate.

Under US GAAP, three requirements are necessary for a sale-leaseback involving real estate (including real estate with equipment) to qualify for sale-leaseback accounting treatment. Those sale-leaseback transactions not meeting the three requirements should be accounted for as a deposit or as a financing. The three requirements are

The lease must be a normal leaseback.
Payment terms and provisions must adequately demonstrate the buyer-lessor's initial and continuing investment in the property.
Payment terms and provisions must transfer all the risks and rewards of ownership as demonstrated by a lack of continuing involvement by the seller-lessee.

A normal leaseback involves active use of the leased property in the seller-lessee's trade or business during the lease term.

The buyer-lessor's initial investment is adequate if it demonstrates the buyer-lessor's commitment to pay for the property and indicates a reasonable likelihood that the seller-lessee will collect any receivable related to the leased property. The buyer-lessor's continuing investment is adequate if the buyer is contractually obligated to pay an annual amount at least equal to the level of annual payment needed to pay that debt and interest over no more than (1) twenty years for land and (2) the customary term of a first mortgage loan for other real estate.

Any continuing involvement by the seller-lessee other than normal leaseback disqualifies the lease from sale-leaseback accounting treatment. Some examples of continuing involvement other than normal leaseback include

The seller-lessee has an obligation or option (excluding the right of first refusal) to repurchase the property.
The seller-lessee (or party related to the seller-lessee) guarantees the buyer-lessor's investment or debt related to that investment or a return on that investment.
The seller-lessee is required to reimburse the buyer-lessor for a decline in the fair value of the property below estimated residual value at the end of the lease term based on other than excess wear and tear.
The seller-lessee remains liable for an existing debt related to the property.
The seller-lessee's rental payments are contingent on some predetermined level of future operations of the buyer-lessor.
The seller-lessee provides collateral on behalf of the buyer-lessor other than the property directly involved in the sale-leaseback.
The seller-lessee provides nonrecourse financing to the buyer-lessor for any portion of the sales proceeds or provides recourse financing in which the only recourse is the leased asset.
The seller-lessee enters into a sale-leaseback involving property improvements or integral equipment without leasing the underlying land to the buyer-lessor.
The buyer-lessor is obligated to share any portion of the appreciation of the property with the seller-lessee.
Any other provision or circumstance that allows the seller-lessee to participate in any future profits of the buyer-lessor or appreciation of the leased property.

Example of accounting for a sale-leaseback transaction

To illustrate the accounting treatment in a sale-leaseback transaction, suppose that Lessee Corporation sells equipment that has a book value of $80,000 and a fair value of $100,000 to Lessor Corporation, and then immediately leases it back under the following conditions:

The sale date is January 1, 2003, and the equipment has a fair value of $100,000 on that date and an estimated useful life of 15 years.
The lease term is 15 years, noncancelable, and requires equal rental payments of $13,109 at the beginning of each year.
Lessee Corp. has the option annually to renew the lease at the same rental payments on expiration of the original lease.
Lessee Corp. has the obligation to pay all executory costs.
The annual rental payments provide the lessor with a 12% return on investment.
The incremental borrowing rate of Lessee Corp. is 12%.
Lessee Corp. depreciates similar equipment on a straight-line basis.

Lessee Corp. should classify the agreement as a capital lease since the lease term exceeds 75% (which is deemed to be a major part) of the estimated economic life of the equipment, and because the present value of the lease payments is greater than 90% (deemed to be substantially all) of the fair value of the equipment. Assuming that collectibility of the lease payments is reasonably predictable and that no important uncertainties exist concerning the amount of nonreimbursable costs yet to be incurred by the lessor, Lessor Corp. should classify the transaction as a direct financing lease because the present value of the minimum lease payments is equal to the fair market value of $100,000 ($13,109 x 7.62817).

Lessee Corp. and Lessor Corp. would normally make the following journal entries during the first year:

Upon Sale of Equipment on January 1, 2003
Lessee Corp.			Lessor Corp.
Cash	100,000		Equipment	100,000
Equipment^[a]		80,000	Cash		100,000
Unearned profit on sale-leaseback		20,000
Leased equipment	100,000		Lease receivable ($13,109 x 15)	196,635
Lease obligations		100,000	Lease receivable ($13,109 x 15)
			Equipment		100,000
			Unearned interest		96,635
^[a]Assumes new equipment

To Record First Payment on January 1, 2003
Lessee Corp.			Lessor Corp.
Lease obligations	13,109		Cash	13,109
Cash		13,109	Lease receivable		13,109

To Record Incurrence and Payment of Executory Costs
Lessee Corp.			Lessor Corp.
Insurance, taxes, etc.	xxx		(No entry)
Cash (accounts payable)		xxx

To Record Depreciation Expense on the Equipment, December 31, 2003
Lessee Corp.			Lessor Corp.
Depreciation expense	6,667		(No entry)
Accum. depr.—capital leases ($100,000 15)		6,667

To Amortize Profit on Sale-Leaseback by Lessee Corp., December 31, 2003
Lessee Corp.			Lessor Corp.
Unearned profit on sale-leaseback	1,333		(No entry)
Depr. expense ($20,000 15)		1,333

To Record Interest for 2001, December 31, 2003
Lessee Corp.			Lessor Corp.
Interest expense	10,427		Unearned interest income	10,427
Accrued interest payable		10,427	Unearned interest income
Accrued interest payable			Interest income		10,427

Partial Lease Amortization Schedule
Date	Cash payment	Interest expense	Reduction of obligation	Lease obligation
Inception of lease				$100,000
1/1/03	$13,109	$--	$13,109	86,891
1/1/04	13,109	10,427	2,682	84,209

Leases Involving Land and Buildings—Guidance under IAS 17

IAS 17 stipulates rules relating to leases of land and building. In general, the treatment of such leases is to be the same as for leases of other assets. However, since land has an indefinite useful life, if title is not expected to pass to the lessee at the end of the lease term, such leases are to be classified as operating leases. Were the lessee to capitalize such a lease arrangement, the fact that no periodic depreciation would be reported would inevitably result in a write-off of the asset at the termination of the lease, which clearly would not contribute to meaningful financial reporting.

Similarly, IAS recognizes the fact that buildings have useful lives that extend well beyond the lease terms, and often, long-term leases for buildings contain provisions whereby rents are regularly adjusted upward to market rates. Thus, if title is not expected to pass to the lessee at the end of the lease term or if rents are adjusted upward regularly to reflect market rates, the lessor retains a significant part of the risks and rewards incidental to ownership, and hence, such leases should normally be classified as operating leases. However, whether or not to capitalize the building in the financial statements of the lessee is a question of facts and circumstances, and to do so is not absolutely prohibited by the standard.

Note that amendments to IAS 17 currently proposed would require that leases for land and buildings be analyzed into component parts, with each element separately accounted for as provided by IAS 17.

Leases Involving Real Estate—Guidance under US GAAP

Again, the guidance under IAS 17 is limited, and the practice under US GAAP is instructive. Under those standards, leases involving real estate can be divided into the following four categories:

Leases involving land only
Leases involving land and building(s)
Leases involving real estate and equipment
Leases involving only part of a building

Leases Involving Land Only

Lessee accounting.

If the lease agreement transfers ownership or contains a bargain purchase option, the lessee should account for the lease as a capital lease and record an asset and related liability in an amount equal to the present value of the minimum lease payments. If the lease agreement does not transfer ownership or contain a bargain purchase option, the lessee should account for the lease as an operating lease.

Lessor accounting.

If the lease gives rise to dealer's profit (or loss) and transfers ownership (i.e., title), the standards require that the lease shall be classified as a sales-type lease and accounted for under the provisions of the US standard dealing with sales of real estate, in the same manner as would a seller of the same property. If the lease transfers ownership, both the collectibility and the no material uncertainties criteria are met, but if it does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing or leveraged lease, as appropriate. If the lease contains a bargain purchase option and both the collectibility and no material uncertainties criteria are met, the lease should be accounted for as a direct financing, leveraged, or operating lease as appropriate. If the lease does not meet the collectibility and/or no material uncertainties criteria, the lease should be accounted for as an operating lease.

Leases Involving Land and Building

Lessee accounting.

Under US GAAP, if the agreement transfers title or contains a bargain purchase option, the lessee should account for the agreement by separating the land and building components and capitalize each separately. The land and building elements should be allocated on the basis of their relative fair market values measured at the inception of the lease. The land and building components are accounted for separately because the lessee is expected to own the real estate by the end of the lease term. The building should be depreciated over its estimated useful life without regard to the lease term.

When the lease agreement neither transfers title nor contains a bargain purchase option, the fair value of the land must be determined in relation to the fair value of the aggregate properties included in the lease agreement. If the fair value of the land is less than 25% of the fair value of the leased properties in aggregate, the land is considered immaterial. Conversely, if the fair value of the land is 25% or greater of the fair value of the leased properties in aggregate, the land is considered material.

When the land component of the lease agreement is considered immaterial (FMV land < 25% total FMV), the lease should be accounted for as a single lease unit. The lessee should capitalize the lease if one of the following occurs:

The term of the lease is 75% or more of the economic useful life of the real estate
The present value of the minimum lease payments equals 90% or more of the fair market value of the leased real estate less any lessor tax credits

If neither of the two criteria above is met, the lessee should account for the lease agreement as a single operating lease.

When the land component of the lease agreement is considered material (FMV land ≥ 25% total FMV), the land and building components should be separated. By applying the lessee's incremental borrowing rate to the fair market value of the land, the annual minimum lease payment attributed to land is computed. The remaining payments are attributed to the building. The division of minimum lease payments between land and building is essential for both the lessee and lessor. The lease involving the land should always be accounted for as an operating lease. Under US GAAP, the lease involving the building(s) must meet either the 75% (of useful life) or 90% (of fair value) test to be treated as a capital lease. If neither of the two criteria is met, the building(s) will also be accounted for as an operating lease.

Lessor accounting.

The lessor's accounting depends on whether the lease transfers ownership, contains a bargain purchase option, or does neither of the two. If the lease transfers ownership and gives rise to dealer's profit (or loss), US GAAP requires that the lessor classify the lease as a sales-type lease and account for the lease as a single unit under the provisions of SFAS 66 in the same manner as a seller of the same property. If the lease transfers ownership, meets both the collectibility and no important uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing or leveraged lease as appropriate.

If the lease contains a bargain purchase option and gives rise to dealer's profit (or loss), the lease should be classified as an operating lease. If the lease contains a bargain purchase option, meets both the collectibility and no material uncertainties criteria, but does not give rise to dealer's profit (or loss), the lease should be accounted for as a direct financing lease or a leveraged lease, as appropriate.

If the lease agreement neither transfers ownership nor contains a bargain purchase option, the lessor should follow the same rules as the lessee in accounting for real estate leases involving land and building(s).

However, the collectibility and the no material uncertainties criteria must be met before the lessor can account for the agreement as a direct financing lease, and in no such case may the lease be classified as a sales-type lease (i.e., ownership must be transferred).

The treatment of a lease involving both land and building can be illustrated in the following examples.

Example of accounting for land and building lease containing transfer of title

Assume the following:

The lessee enters into a 10-year noncancelable lease for a parcel of land and a building for use in its operations. The building has an estimated useful life of 12 years.
The FMV of the land is $75,000, while the FMV of the building is $310,000.
A payment of $50,000 is due to the lessor at the beginning of each of the 10 years of the lease.
The lessee's incremental borrowing rate is 10%. (Lessor's implicit rate is unknown.)
Ownership will transfer to the lessee at the end of the lease.

The present value of the minimum lease payments is $337,951 ($50,000 x 6.75902^[1]). The portion of the present value of the minimum lease payments that should be capitalized for each of the two components of the lease is computed as follows:

FMV of land			$ 75,000
FMV of building			310,000
Total FMV of leased property			$385,000
Portion of PV allocated to land	$337,951	_x	75,000	=	$ 65,835
			385,000
Portion of PV allocated to building	$337,951	_x	310,000	=	272,116
			385,000
Total PV to be capitalized					$337,951

The entry made to record the lease initially is as follows:

Leased land	65,835
Leased building	272,116
Lease obligation		337,951

Subsequently, the obligation will be decreased in accordance with the effective interest method. The leased building will be amortized over its expected useful life.

Example of accounting for land and building lease without transfer of title or bargain purchase option

Assume the same facts as in the previous example except that title does not transfer at the end of the lease.

The lease is still a capital lease because the lease term is more than 75% of the useful life. Since the FMV of the land is less than 25% of the leased properties in aggregate, ($75,000/$385,000 = 19%), the land component is considered immaterial and the lease will be accounted for as a single lease. The entry to record the lease is as follows:

Leased property	337,951
Lease obligation		337,951

Assume the same facts as in the previous example except that the FMV of the land is $110,000 and the FMV of the building is $275,000. Once again, title does not transfer.

Because the FMV of the land exceeds 25% of the leased properties in aggregate ($110,000/$385,000 = 28%), the land component is considered material and the lease would be separated into two components. The annual minimum lease payment attributed to the land is computed as follows:

The remaining portion of the annual payment is attributed to the building.

Annual payment	$ 50,000
Less amount attributed to land	(16,275)
Annual payment attributed to building	$33,725

The present value of the minimum annual lease payments attributed to the building is then computed as follows:

Minimum annual lease payment attributed to building	$ 33,725
PV factor	x 6.75902^[a]
PV of minimum annual lease payments attributed to building	$227,948
^[a]6.75902 is the PV of an annuity due for 10 periods at 10%.

The entry to record the capital portion of the lease is as follows:

Leased building	227,948
Lease obligation		227,948

There would be no computation of the present value of the minimum annual lease payment attributed to the land since the land component of the lease will be treated as an operating lease. For this reason, each year, $16,275 of the $50,000 lease payment will be recorded as land rental expense. The remainder of the annual payment ($33,725) will be applied against the lease obligation using the effective interest method.

Leases involving real estate and equipment.

When real estate leases also involve equipment or machinery, the equipment component should be separated and accounted for as a separate lease agreement by both lessees and lessors. According to US GAAP, "the portion of the minimum lease payments applicable to the equipment element of the lease shall be estimated by whatever means are appropriate in the circumstances." The lessee and lessor should apply the capitalization requirements to the equipment lease independently of accounting for the real estate lease(s). The real estate leases should be handled as discussed in the preceding two sections. In a sale-leaseback transaction involving real estate with equipment, the equipment and land are not separated.

Leases involving only part of a building.

It is common to find lease agreements that involve only part of a building, as, for example, when a floor of an office building is leased or when a store in a shopping mall is leased. A difficulty that arises in this situation is that the cost and/or fair market value of the leased portion of the whole may not be determinable objectively.

For the lessee, if the fair value of the leased property is objectively determinable, the lessee should follow the rules and account for the lease as described in "leases involving land and building." If the fair value of the leased property cannot be determined objectively but the agreement satisfies the 75% test, the estimated economic life of the building in which the leased premises are located should be used. If this test is not met, the lessee should account for the agreement as an operating lease.

From the lessor's position, both the cost and fair value of the leased property must be objectively determinable before the procedures described under "leases involving land and building" will apply. If either the cost or the fair value cannot be determined objectively, the lessor should account for the agreement as an operating lease.

Termination of a Lease

The lessor shall remove the remaining net investment from his or her books and record the leased equipment as an asset at the lower of its original cost, present fair value, or current carrying value. The net adjustment is reflected in the income of the current period.

The lessee is also affected by the terminated agreement because he or she has been relieved of the obligation. If the lease is a capital lease, the lessee should remove both the obligation and the asset from his or her accounts and charge any adjustment to the current period income. If accounted for as an operating lease, no accounting adjustment is required.

Renewal or Extension of an Existing Lease

The renewal or extension of an existing lease agreement affects the accounting of both the lessee and the lessor. US GAAP specifies two basic situations in this regard: (1) the renewal occurs and makes a residual guarantee or penalty provision inoperative or (2) the renewal agreement does not do the foregoing and the renewal is to be treated as a new agreement. The accounting treatment prescribed under the latter situation for a lessee is as follows:

If the renewal or extension is classified as a capital lease, the (present) current balances of the asset and related obligation should be adjusted by an amount equal to the difference between the present value of the future minimum lease payments under the revised agreement and the (present) current balance of the obligation. The present value of the minimum lease payments under the revised agreement should be computed using the interest rate that was in effect at the inception of the original lease.

TREATMENT OF SELECTED ITEMS IN ACCOUNTING FOR LEASES UNDER US GAAP
	Operating	Lessor Direct financing and sales-type	Operating	Lesse capital
Initial direct costs	Capitalize and amortize over lease term in proportion to rent revenue recognized (normally SL basis)	Direct financing: Record in separate account Add to net investment in lease Compute new effective rate that equates gross amt. of min. lease payments and unguar. residual value with net invest. Amortize so as to poduce constant rate of return over lease term Sales-type: Expense in period incurred	N/A	N/A
Investment tax credit retained by lessor	N/A	Reduces FMV of leased asset for 90% test	N/A	Reduces FMV of leased asset for 90% test
Bargain purchase option	N/A	Include in: Minimum lease payments 90% test	N/A	Include in: Minimum lease payments 90% test
Guaranteed residual value	N/A	Include in: Minimum lease payments 90% test Sales-type: Include PV in sales revenues	N/A	Include in: Minimum lease payments 90% test
Unguaranteed residual value	N/A	Include In: "Gross Investment in Lease" Not included in: 90% test Sales-type: Exclude from sales revenue Deduct PV from cost of sales	N/A	Include in: Minimum lease payments 90% test
Contingent rentals	Revenue in period earned	No part of minimum lease payments; revenue in period earned	Expense in period incurred	No part of minimum lease payments; expense in period incurred
Amortization period	Amortize down to estimated residual value over estimated economic life of asset	N/A	N/A	Amortize down to estimated residual value over lease term or estimated economic life ^[a]
Revenue (expense) ^[b]	Rent revenue (normally SL basis)	Direct financing: Interest revenue on net investment in lease (gross investment less unearned interest income)	Rent expense (normally SL basis) ^[c]	Interest expense and depreciation expense
	Amortization (depreciation expense)	Sales-type: Dealer profit in period of sale (sales revenue less cost of leased asset) Interest revenue on net investment in lease

^[a]If lease has automatic passage of title or bargain purchase option, use estimated economic life; otherwise use the lease team. ^[b]Elements of revenue (expense) listed for the items above are not repeated here (e.g., treatment of initial direct costs). ^[c]If payments are not on a SL basis, recognize rent expense on a SL basis unless another systematic and rational method is more representative of use benefit obtained from the property, in which case, the other method should be used.

If the renewal or extension is classified as an operating lease, the current balances in the asset and liability accounts are removed from the books and a gain (loss) recognized for the difference. The new lease agreement resulting from a renewal or extension is accounted for in the same manner as other operating leases.

Under the same circumstances, US GAAP prescribes the following treatment to be followed by the lessor:

If the renewal or extension is classified as a direct financing lease, then the existing balances of the lease receivable and the estimated residual value accounts should be adjusted for the changes resulting from the revised agreement.

Note
Remember that an upward adjustment of the estimated residual value is not allowed.

The net adjustment should be charged or credited to an unearned income account.
If the renewal or extension is classified as an operating lease, the remaining net investment under the existing sales-type lease or direct financing lease is removed from the books and the leased asset recorded as an asset at the lower of its original cost, present fair value, or current carrying amount. The difference between the net investment and the amount recorded for the leased asset is charged to income of the period. The renewal or extension is then accounted for as for any other operating lease.
If the renewal or extension is classified as a sales-type lease and it occurs at or near the end of the existing lease term, the renewal or extension should be accounted for as a sales-type lease.

Note
A renewal or extension that occurs in the last few months of an existing lease is considered to have occurred at or near the end of the existing lease term.

If the renewal or extension causes the guarantee or penalty provision to be inoperative, the lessee adjusts the current balance of the leased asset and the lease obligation to the present value of the future minimum lease payments (according to the relevant standard, "by an amount equal to the difference between the PV of future minimum lease payments under the revised agreement and the present balance of the obligation"). The PV of the future minimum lease payments is computed using the implicit rate used in the original lease agreement.

Given the same circumstances, the lessor adjusts the existing balance of the lease receivable and estimated residual value accounts to reflect the changes of the revised agreement (remember, no upward adjustments to the residual value). The net adjustment is charged (or credited) to unearned income.

Leases between Related Parties

Leases between related parties are classified and accounted for as though the parties are unrelated, except in cases where it is clear that the terms and conditions of the agreement have been influenced significantly by the fact of the relationship. When this is the case, the classification and/or accounting is modified to reflect the true economic substance of the transaction rather than the legal form.

If a subsidiary's principal business activity is leasing property to its parent or other affiliated companies, consolidated financial statements are presented. The US GAAP standard on related parties requires that the nature and extent of leasing activities between related parties be disclosed.

Accounting for Leases in a Business Combination

A business combination, in and of itself, has no effect on the classification of a lease. However, if, in connection with a business combination, the lease agreement is modified to change the original classification of the lease, it should be considered a new agreement and reclassified according to the revised provisions.

In most cases, a business combination that is accounted for by the pooling-of-interest method or by the purchase method will not affect the previous classification of a lease unless the provisions have been modified as indicated in the preceding paragraph.

The acquiring company should apply the following procedures to account for a leveraged lease in a business combination accounted for by the purchase method:

The classification of leveraged lease should be kept.
The net investment in the leveraged lease should be given a fair market value (present value, net of tax) based on the remaining future cash flows. Also, the estimated tax effects of the cash flows should be given recognition.
The net investment should be broken down into three components: net rentals receivable, estimated residual value, and unearned income.
Thereafter, the leveraged lease should be accounted for as described above in the section on leveraged leases.

Accounting for Changes in Lease Agreements Resulting from Refunding of Tax-Exempt Debt

If, during the lease term, a change in the lease results from a refunding by the lessor of tax-exempt debt (including an advance refunding) and (1) the lessee receives the economic advantages of the refunding and (2) the revised agreement can be classified as a capital lease by the lessee and a direct financing lease by the lessor, the change should be accounted for as follows:

If the change is accounted for as an extinguishment of debt
1. Lessee accounting. The lessee should adjust the lease obligation to the present value of the future minimum lease payments under the revised agreement. The present value of the minimum lease payments should be computed by using the interest rate applicable to the revised agreement. Any gain or loss should be recognized currently as a gain or loss on the extinguishment of debt in accordance with the provisions of SFAS 4.
2. Lessor accounting. The lessor should adjust the balance of the lease receivable and the estimated residual value, if affected, for the difference in present values between the old and revised agreements. Any resulting gain or loss should be recognized currently.
If the change is not accounted for as an extinguishment of debt
1. Lessee accounting. The lessee should accrue any costs in connection with the debt refunding that is obligated to be refunded to the lessor. These costs should be amortized by the interest method over the period from the date of refunding to the call date of the debt to be refunded.
2. Lessor accounting. The lessor should recognize any reimbursements to be received from the lessee, for costs paid in relation to the debt refunding, as revenue. This revenue should be recognized in a systematic manner over the period from the date of refunding to the call date of the debt to be refunded.

Sale or Assignment to Third Parties—Nonrecourse Financing

The sale or assignment of a lease or of property subject to a lease that was originally accounted for as a sales-type lease or a direct financing lease will not affect the original accounting treatment of the lease. Any profit or loss on the sale or assignment should be recognized at the time of transaction except under the following two circumstances:

When the sale or assignment is between related parties, apply the provisions presented above under "Leases between Related Parties."
When the sale or assignment is with recourse, it should be accounted for using the provisions of the US standard on sale of receivables with recourse.

The sale of property subject to an operating lease should not be treated as a sale if the seller (or any related party to the seller) retains substantial risks of ownership in the leased property. A seller may retain substantial risks of ownership by various arrangements. For example, if the lessee defaults on the lease agreement or if the lease terminates, the seller may arrange to do one of the following:

Acquire the property or the lease
Substitute an existing lease
Secure a replacement lessee or a buyer for the property under a remarketing agreement

A seller will not retain substantial risks of ownership by arrangements where one of the following occurs:

A remarketing agreement includes a reasonable fee to be paid to the seller
The seller is not required to give priority to the releasing or disposition of the property owned by the third party over similar property owned by the seller

When the sale of property subject to an operating lease is not accounted for as a sale because the substantial risk factor is present, it should be accounted for as a borrowing. The proceeds from the sale should be recorded as an obligation on the seller's books. Rental payments made by the lessee under the operating lease should be recorded as revenue by the seller even if the payments are paid to the third-party purchaser. The seller shall account for each rental payment by allocating a portion to interest expense (to be imputed in accordance with the provisions of APB 21), and the remainder will reduce the existing obligation. Other normal accounting procedures for operating leases should be applied except that the depreciation term for the leased asset is limited to the amortization period of the obligation.

The sale or assignment of lease payments under an operating lease by the lessor should be accounted for as a borrowing as described above.

Nonrecourse financing is a common occurrence in the leasing industry whereby the stream of lease payments on a lease is discounted on a nonrecourse basis at a financial institution with the lease payments collateralizing the debt. The proceeds are then used to finance future leasing transactions. Even though the discounting is on a nonrecourse basis, US GAAP prohibits the offsetting of the debt against the related lease receivable unless a legal right of offset exists or the lease qualified as a leveraged lease at its inception.

Money-Over-Money Lease Transactions

In cases where a lessor obtains nonrecourse financing in excess of the leased asset's cost, a technical bulletin states that the borrowing and leasing are separate transactions and should not be offset against each other unless a right of offset exists. Only dealer profit in sales-type leases may be recognized at the beginning of the lease term.

Acquisition of Interest in Residual Value

Recently, there has been an increase in the acquisition of interests in residual values of leased assets by companies whose primary business is other than leasing or financing. This generally occurs through the outright purchase of the right to own the leased asset or the right to receive the proceeds from the sale of a leased asset at the end of its lease term.

In instances such as these, the rights should be recorded by the purchaser at the fair value of the assets surrendered. Recognition of increases in the value of the interest in the residual (i.e., residual value accretion) to the end of the lease term are prohibited. However, a nontemporary write-down of the residual value interest should be recognized as a loss. This guidance also applies to lessors who sell the related minimum lease payments but retain the interest in the residual value. Guaranteed residual values also have no effect on this guidance.

Leases Involving Government Units

Leases that involve government units (i.e., airport facilities, bus terminal space, etc.) usually contain special provisions that prevent the agreements from being classified as anything but operating leases. These special provisions include the governmental body's authority to abandon a facility at any time during lease term, thus making its economic life indeterminable. These leases also do not contain a BPO or transfer ownership. The fair market value is generally indeterminable because neither the leased property nor similar property is available for sale.

However, leases involving government units are subject to the same classification criteria as those of nongovernment units, except when the following six criteria are met.

Note

If all six conditions are met, the agreement should be classified as an operating lease by both lessee and lessor.

A government unit or authority owns the leased property
The leased property is part of a larger facility operated by or on behalf of the lessor
The leased property is a permanent structure or part of a permanent structure that normally cannot be moved to another location
The lessor, or a higher governmental authority, has the right to terminate the lease at any time under the lease agreement or existing statutes or regulations
The lease neither transfers ownership nor allows the lessee to purchase or acquire the leased property
The leased property or similar property in the same area cannot be purchased or leased from anyone else

Accounting for a Sublease

A sublease is used to describe the situation where the original lessee re-leases the leased property to a third party (the sublessee), and the original lessee acts as a sublessor. Normally, the nature of a sublease agreement does not affect the original lease agreement, and the original lessee/sublessor retains primary liability.

The original lease remains in effect, and the original lessor continues to account for the lease as before. The original lessee/sublessor accounts for the lease as follows:

If the original lease agreement transfers ownership or contains a bargain purchase option and if the new lease meets any one of the four criteria specified in US GAAP (i.e., transfers ownership, BPO, the 75% test, or the 90% test) and both the collectibility and uncertainties criteria, the sublessor should classify the new lease as a sales-type or direct financing lease; otherwise, as an operating lease. In either situation, the original lessee/sublessor should continue accounting for the original lease obligation as before.
If the original lease agreement does not transfer ownership or contain a bargain purchase option, but it still qualified as a capital lease, the original lessee/sublessor should (with one exception) apply the usual criteria set by US GAAP in classifying the new agreement as a capital or operating lease. If the new lease qualifies for capital treatment, the original lessee/sublessor should account for it as a direct financing lease, with the unamortized balance of the asset under the original lease being treated as the cost of the leased property. The one exception arises when the circumstances surrounding the sublease suggest that the sublease agreement was an important part of a predetermined plan in which the original lessee played only an intermediate role between the original lessor and the sublessee. In this situation, the sublease should be classified by the 75% and 90% criteria as well as collectibility and uncertainties criteria. In applying the 90% criterion, the fair value for the leased property will be the fair value to the original lessor at the inception of the original lease. Under all circumstances, the original lessee should continue accounting for the original lease obligation as before. If the new lease agreement (sublease) does not meet the capitalization requirements imposed for subleases, the new lease should be accounted for as an operating lease.
If the original lease is an operating lease, the original lessee/sublessor should account for the new lease as an operating lease and account for the original operating lease as before.

^[1]6.75902 is the PV of an annuity due for 10 periods at 10%.