Financial reporting developments A comprehensive guide

Lease accounting Accounting Standards Codification 840, Leases

Revised October 2017

To our clients and other friends

We are pleased to provide you with this updated edition of our Financial Reporting Developments (FRD)

publication, Lease accounting. This edition of our publication primarily has been updated from our prior

edition to reflect updates to relevant accounting standards and provide further clarifications and

enhancements to our interpretive guidance. Refert to Appendix D for further detail on the updates provided.

The classification of a lease for accounting purposes can have a significant impact on the financial

position and earnings reported by either party to a lease transaction. The accounting guidance discussed

in this publication affects entities engaged in leasing activities as either a lessee or lessor and requires

both lessees and lessors to classify leases based on specified criteria. There is a high degree of complexity

in accounting for lease transactions. The consequences of incorrectly assessing accounting requirements

can be severe if the goal was to obtain off-balance sheet financing. Accordingly, it is important to carefully

assess the propriety of a specific lease transaction prior to consummation.

For many companies, a lease transaction is an infrequent and significant event. This guide is designed to

provide a summary, in one location, of the lease accounting rules. Companies that are involved in lease

accounting transactions on a regular basis will be familiar with many of the issues described herein.

However, those companies as well as companies that only occasionally consider lease transactions often

need the advice and assistance of professional advisors to evaluate the facts and circumstances that may

be encountered in a particular transaction.

In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards

Update (ASU) 2016-02, Leases, which is codified in ASC 842. The new leases standard requires lessees

to recognize assets and liabilities for most leases but recognize expenses on their income statement in a

manner similar to todays accounting. ASC 842 will supersede ASC 840.

The FASB issued the new leases guidance after joint deliberations with the International Accounting

Standards Board (IASB), which issued IFRS 16 Leases. However, there are significant differences

between the FASBs and IASBs standards (e.g., lessees do not classify leases under IFRS). ASU 2016-02

is effective for annual periods beginning after 15 December 2018, and interim periods within those

years, for public business entities and certain not-for-profit entities and employee benefit plans. For all

other entities, it is effective for annual periods beginning after 15 December 2019, and interim periods

the following year. Early adoption is permitted for all entities. This publication does not address the

accounting for leases under the new standard.

Ernst & Young professionals are prepared to help you identify and understand the issues related to lease

accounting. In addition, our audit and tax professionals would be pleased to discuss with you any other

issues relating to your proposed transaction.

October 2017

Financial reporting developments Lease accounting | i

Contents

1 Scope ........................................................................................................................ 1

1.1 Determining whether an arrangement contains a lease ............................................................ 1

1.1.1 Property, plant or equipment ......................................................................................... 2

1.1.2 Specified assets ............................................................................................................ 2

1.1.3 Right-to-use property, plant or equipment ...................................................................... 4

1.1.4 Reassessment of the arrangement ................................................................................. 6

1.1.5 Multiple-element arrangements that contain a lease (prior to the adoption of ASC 606) ................................................................................................................ 10

1.1.5A Multiple-element arrangements that contain a lease (subsequent to the adoption of ASC 606) (updated October 2017)............................................................. 12

1.1.6 Transition provisions ................................................................................................... 16

1.1.7 Examples Determining whether an arrangement contains a lease (updated December 2016) .......................................................................................... 17

1.2 Take-or-pay contracts .......................................................................................................... 20

1.3 Throughput contracts .......................................................................................................... 20

1.4 Heat supply contracts .......................................................................................................... 21

1.5 Management agreements ..................................................................................................... 21

1.5.1 Real property management agreements....................................................................... 21

1.5.1.1 Right to operate ................................................................................................. 22

1.5.1.2 Control physical access ....................................................................................... 23

1.5.1.3 Facts and circumstances ..................................................................................... 24

1.5.1.4 Related party arrangements ............................................................................... 24

1.6 Software license arrangements (updated August 2015) ......................................................... 24

1.6.1 Licensee accounting (prior to the adoption of ASU 2015-05) ........................................ 25

1.6.1A Licensee accounting (subsequent to the adoption of ASU 2015-05) (added December 2016).............................................................................................. 25

1.6.2 Lessor accounting for leases of property, plant or equipment and software (prior to the adoption of ASC 606) ................................................................. 25

1.6.2A Lessor accounting for leases of property, plant or equipment and software (subsequent to the adoption of ASC 606) (added December 2016) ................................ 27

1.7 Applicability to state and local governmental units (updated October 2017) ........................... 27

1.8 Applicability to current value financial statements ................................................................. 28

1.9 Lease broker ....................................................................................................................... 28

1.10 Acquisition of lease residual values ....................................................................................... 29

1.11 Lease accounting for a group of assets ................................................................................. 30

1.12 Service concession arrangements (updated October 2017) ................................................... 31

1.12.1 Service concession arrangements in regulated operations ............................................. 35

2 Definitions ............................................................................................................... 37

2.1 Definitions used in this publication ........................................................................................ 37

2.2 Lease inception ................................................................................................................... 37

2.2.1 Lease inception date for equipment subject to a master lease agreement ...................... 37

Contents

Financial reporting developments Lease accounting | ii

2.3 Fair value ............................................................................................................................ 38

2.3.1 Determining fair value ................................................................................................. 39

2.3.2 Fair value used to perform 90% test ............................................................................. 40

2.3.3 Manufacturer or dealer lessors fair value ..................................................................... 40

2.3.4 Fair value when lessor is not a manufacturer or dealer .................................................. 41

2.3.5 Changes in fair value due to changes in construction or acquisition costs ....................... 41

2.3.6 Effect of removal costs on the determination of fair value ............................................. 41

2.4 Bargain purchase option ...................................................................................................... 42

2.4.1 Methods of estimating fair value at the end of the lease term ........................................ 42

2.4.1.1 Impact of inflation on estimated fair value of leased property ............................... 42

2.4.2