Financial reporting developments A comprehensive guide

Lease accounting Revised August 2015

To our clients and other friends

We are pleased to provide you with this updated edition of our Financial Reporting Developments publication, Lease accounting. This edition of our publication primarily has been updated from our prior edition to reflect updates to relevant accounting standards.

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.

The August 2015 updates to this publication provide additional considerations for evaluating service concession arrangements in accordance with ASU 2014-05, Service Concession Arrangements, which was primarily codified in ASC 853, Service Concession Arrangements. Arrangements within the scope of ASC 853 are excluded from the scope of ASC 840, Leases. The updates also highlight new guidance issued by the FASB in ASU 2015-05, Intangibles Goodwill and Other Internal-Use Software, which eliminates the requirement in ASC 350-40 that customers analogize to ASC 840 to determine the asset acquired in a software licensing arrangement.

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.

August 2015

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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 ....................................................... 9 1.1.6 Transition provisions ................................................................................................... 11 1.1.7 Examples Determining whether an arrangement contains a lease ............................... 12

1.2 Take-or-pay contracts .......................................................................................................... 14 1.3 Throughput contracts .......................................................................................................... 14 1.4 Heat supply contracts .......................................................................................................... 15 1.5 Management agreements ..................................................................................................... 15

1.5.1 Real property management agreements....................................................................... 15 1.5.1.1 Right to operate ....................................................................................... 16 1.5.1.2 Control physical access ............................................................................. 17 1.5.1.3 Facts and circumstances ........................................................................... 18 1.5.1.4 Related party arrangements ...................................................................... 18

1.6 Software license arrangements ............................................................................................ 19 1.6.1 Licensee accounting .................................................................................................... 19 1.6.2 Lease of property, plant or equipment and software ..................................................... 19

1.7 Applicability to state and local governmental units ................................................................. 21 1.8 Applicability to current value financial statements ................................................................. 21 1.9 Lease broker ....................................................................................................................... 22 1.10 Acquisition of lease residual values ....................................................................................... 23 1.11 Lease accounting for a group of assets ................................................................................. 25 1.12 Service concession arrangements ......................................................................................... 25

1.12.1 Service concession arrangements in regulated operations ............................................. 29 1.12.2 Service concession arrangements transition provisions .............................................. 30

2 Definitions ............................................................................................................... 31 2.1 Definitions used in this publication ........................................................................................ 31 2.2 Lease inception ................................................................................................................... 31

2.2.1 Lease inception date for equipment subject to a master lease agreement ...................... 31 2.3 Fair value ............................................................................................................................ 32

2.3.1 Determining fair value ................................................................................................. 33 2.3.2 Fair value used to perform 90% test ............................................................................. 34 2.3.3 Manufacturer or dealer lessors fair value ..................................................................... 34 2.3.4 Fair value when lessor is not a manufacturer or dealer .................................................. 35 2.3.5 Changes in fair value due to changes in construction or acquisition costs ....................... 35 2.3.6 Effect of removal costs on the determination of fair value ............................................. 35

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2.4 Bargain purchase option ...................................................................................................... 36 2.4.1 Methods of estimating fair value at the end of the lease term ........................................ 36

2.4.1.1 Impact of inflation on estimated fair value of leased property ....................... 36 2.4.2 Economic penalty creates a bargain purchase option .................................................... 37 2.4.3 Favorable purchase option contingent on external factors ............................................. 37

2.5 Bargain renewal option ........................................................................................................ 38 2.6 Lease term .......................................................................................................................... 38

2.6.1 Renewal penalty ......................................................................................................... 40 2.6.2 Sublessee impact on lease term ................................................................................... 40 2.6.3 Guarantee of residual value at a point in time prior to expiration .................................... 41 2.6.4 Fiscal funding clause ................................................................................................... 41 2.6.5 Lessees guarantee of lessors debt or lessee loans to lessor .......................................... 42 2.6.6 Lessors option to renew lease ..................................................................................... 42 2.6.7 Lease term under a master lease agreement ................................................................ 42

2.7 Economic life ....................................................................................................................... 42 2.8 Residual value / unguaranteed residual value ........................................................................ 43 2.9 Minimum lease payments ..................................................................................................... 44

2.9.1 Minimum lease