ASC 842-50
Leveraged Lease Arrangements
842 Leases
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ASC 842-50 preserves the legacy leveraged lease accounting model, but only for leases that existed at the ASC 842 transition date and meet the criteria in 842-10-65-1(z) — no new leveraged leases may be created. A lessor records a single net investment consisting of rentals receivable (net of nonrecourse debt service), investment-tax-credit receivable, estimated residual value, and unearned/deferred income (842-50-25-1; 842-50-30-1), and recognizes income only in years when the net investment (less related deferred taxes) is positive, using the rate of return that distributes total net income to those years (842-50-35-2). Important assumptions, including residual value and the projected timing of income tax cash flows, must be reviewed at least annually, with any change triggering recalculation from lease inception and immediate gain or loss recognition (842-50-35-6 through 35-8).
Key points (7)
- The Subtopic applies only to leases meeting transition paragraph 842-10-65-1(z); exercise of a previously not-reasonably-assured extension option is treated as a lease modification under that paragraph (842-50-15-1).
- The lessor's net investment in a leveraged lease is the net of rentals receivable (net of the portion applicable to principal and interest on the nonrecourse debt), the investment-tax-credit receivable, the estimated residual value, and unearned and deferred income (842-50-25-1; 842-50-30-1).
- Periodic income is computed on the net investment less related deferred taxes, using a rate of return — distinct from the interest rate implicit in the lease — applied only in years in which the net investment is positive (842-50-35-2).
- Net income comprises pretax lease income (or loss), investment tax credit, and the tax effect of pretax lease income (or loss); any loss that the method would allocate to future years must be recognized immediately (842-50-35-3 through 35-5).
- Residual value and other important assumptions (including the projected timing of income tax cash flows) must be reviewed at least annually; a decline in residual value that is other than temporary, or a change in total estimated net income, requires recalculation from inception with a gain or loss recognized in the year of the change, and upward adjustments of estimated residual value are prohibited (842-50-35-6 through 35-9; 35-19).
- Recalculations reflect tax positions under 740-10-25-6, 740-10-30-7, and 740-10-40-2, exclude interest and penalties, and treat advance payments/deposits with a taxing authority as part of the projected settlement amount rather than actual cash flows (842-50-35-12 through 35-15).
- Presentation requires related deferred taxes to be shown separately from the net investment on the balance sheet, and pretax leveraged lease income, its tax effect, and investment tax credit recognized to be shown separately in the income statement or notes; components of the net investment are disclosed if leveraged leasing is a significant part of the lessor's business (842-50-45-1; 842-50-50-1).
For students. This is grandfathered legacy guidance: ASC 842 prohibits new leveraged leases, so 842-50 applies only to pre-transition arrangements that were not modified. The classic exam trap is the asymmetry in residual value — an other-than-temporary decline forces a recalculation from lease inception with immediate gain/loss, but upward revisions of estimated residual value are never permitted (842-50-35-8(c)).
leveraged leasenet investment in leveraged leasenonrecourse debtunearned and deferred incomeinvestment tax creditresidual value review and recalculationrate of return on positive net investment yearsdeferred taxes on leveraged leases
Machine-generated study aid for ASC 842-50. Check the source paragraphs below.
842-50-00Status
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842-50-00-1
The following table identifies the changes made to this Subtopic.
842-50-05Overview and Background
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842-50-05-1
This Subtopic addresses accounting for leases that meet the definition of a leveraged lease.
842-50-15Scope and Scope Exceptions
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842-50-15-1
This Subtopic addresses accounting for leases that meet the criteria in transition paragraph 842-10-65-1(z). If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph 842-10-65-1(z) that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a lease modification as described in paragraph 842-10-65-1(z). A joint venture formation accounted for in accordance with Subtopic 805-60 shall apply the guidance in this Subtopic applicable to the acquiring entity in a business combination. The joint venture shall be viewed as analogous to the acquiring entity in a business combination, and any recognized businesses and/or assets shall be viewed as analogous to an acquiree.
842-50-25Recognition
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842-50-25-1
A lessor shall record its investment in a leveraged lease. The net of the balances of the following accounts as measured in accordance with this Subtopic shall represent the lessor's initial and continuing investment in leveraged leases:
- a Rentals receivable
- b Investment-tax-credit receivable
- c Estimated residual value of the leased asset
- d Unearned and deferred income.
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
842-50-25-2
In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall retain the classification of the acquired entity's investment as a lessor in a leveraged lease at the date of the combination. The net investment of the acquired leveraged lease shall be disaggregated into its component parts, namely net rentals receivable, estimated residual value, and unearned income including discount to adjust other components to present value.
842-50-30Initial Measurement
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842-50-30-1
A lessor shall initially measure its investment in a leveraged lease net of the nonrecourse debt (as discussed in paragraph 842-50-25-1). The net of the balances of the following accounts shall represent the initial and continuing investment in leveraged leases:
- a Rentals receivable, net of that portion of the rental applicable to principal and interest on the nonrecourse debt.
- b A receivable for the amount of the investment tax credit to be realized on the transaction.
- c The estimated residual value of the leased asset. The estimated residual value shall not exceed the amount estimated at lease inception except if the lease agreement includes a provision to escalate minimum lease payments either for increases in construction or acquisition cost of the leased property or for increases in some other measure of cost or value (such as general price levels) during the construction or preacquisition period. In that case, the effect of any increases that have occurred shall be considered in the determination of the estimated residual value of the underlying asset at lease inception.
- d Unearned and deferred income consisting of both of the following:
- 1 The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income over the lease term.
- 2 The investment tax credit remaining to be allocated to income over the lease term.
- 1
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
842-50-30-2
In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall assign an amount to the acquired net investment in the leveraged lease in accordance with the general guidance in Topic 805 on business combinations, based on the remaining future cash flows and giving appropriate recognition to the estimated future tax effects of those cash flows.
842-50-35Subsequent Measurement
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Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
842-50-35-1
In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall subsequently account for its acquired investment as a lessor in a leveraged lease in accordance with the guidance in this Subtopic as it would for any other leveraged lease.
Income Recognition on a Leveraged Lease
842-50-35-2
The investment in leveraged leases minus deferred taxes arising from differences between pretax accounting income and taxable income shall represent the lessor's net investment in leveraged leases for purposes of computing periodic net income from the leveraged lease. Given the original investment and using the projected cash receipts and disbursements over the term of the lease, the rate of return on the net investment in the years in which it is positive shall be computed. The rate is that rate that, when applied to the net investment in the years in which the net investment is positive, will distribute the net income to those years and is distinct from the interest rate implicit in the lease. In each year, whether positive or not, the difference between the net cash flow and the amount of income recognized, if any, shall serve to increase or reduce the net investment balance. The use of the term years is not intended to preclude application of the accounting prescribed in this paragraph to shorter accounting periods.
842-50-35-3
The net income (or loss) that a lessor recognizes on a leveraged lease shall be composed of the following three elements:
- a Pretax lease income (or loss)
- b Investment tax credit
- c Tax effect of pretax lease income (or loss).
842-50-35-4
The pretax lease income (or loss) and investment tax credit elements shall be allocated in proportionate amounts from the unearned and deferred income included in the lessor's net investment (as described in paragraph 842-50-30-1(d)). The tax effect of the pretax lease income (or loss) recognized shall be reflected in tax expense for the year. The tax effect of the difference between pretax accounting income (or loss) and taxable income (or loss) for the year shall be charged or credited to deferred taxes.
842-50-35-5
If, at any time during the lease term the application of the method prescribed in this Subtopic would result in a loss being allocated to future years, that loss shall be recognized immediately. This situation might arise in circumstances in which one of the important assumptions affecting net income is revised (see paragraphs ).
842-50-35-6
Any estimated residual value and all other important assumptions affecting estimated total net income from the leveraged lease shall be reviewed at least annually. The rate of return and the allocation of income to positive investment years shall be recalculated from lease inception following the method described in paragraphs and using the revised assumption if, during the lease term, any of the following conditions occur:
- a The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
- b The revision of another important assumption changes the estimated total net income from the lease.
- c The projected timing of the income tax cash flows is revised.
842-50-35-7
The lessor shall update all assumptions used to calculate total and periodic income if the lessor is performing a recalculation of the leveraged lease. That recalculation shall include actual cash flows up to the date of the recalculation and projected cash flows following the date of recalculation.
842-50-35-8
The accounts constituting the net investment balance shall be adjusted to conform to the recalculated balances, and the change in the net investment shall be recognized as a gain or loss in the year in which the assumption is changed. The gain or loss shall be recognized as follows:
- a The pretax gain or loss shall be included in income from continuing operations before income taxes in the same line item in which leveraged lease income is recognized.
- b The tax effect of the gain or loss shall be included in the income tax line item.
- c An upward adjustment of the estimated residual value (including any guaranteed portion) shall not be made.
842-50-35-9
The projected timing of income tax cash flows generated by the leveraged lease is an important assumption and shall be reviewed annually, or more frequently, if events or changes in circumstances indicate that a change in timing has occurred or is projected to occur. The income effect of a change in the income tax rate shall be recognized in the first accounting period ending on or after the date on which the legislation effecting a rate change becomes law.
842-50-35-10
A revision of the projected timing of the income tax cash flows applies only to changes or projected changes in the timing of income taxes that are directly related to the leveraged lease transaction. For example, a change in timing or projected timing of the tax benefits generated by a leveraged lease as a result of any of the following circumstances would require a recalculation because that change in timing is directly related to that lease:
- a An interpretation of the tax law
- b A change in the lessor's assessment of the likelihood of prevailing in a challenge by the taxing authority
- c A change in the lessor's expectations about settlement with the taxing authority.
842-50-35-11
In contrast, as discussed in paragraph 842-50-35-20, a change in timing of income taxes solely as a result of an alternative minimum tax credit or insufficient taxable income of the lessor would not require a recalculation of a leveraged lease because that change in timing is not directly related to that lease. A recalculation would not be required unless there is an indication that the previous assumptions about total after-tax net income from the leveraged lease were no longer valid.
842-50-35-12
Tax positions shall be reflected in the lessor's initial calculation or subsequent recalculation on the recognition, measurement, and derecognition criteria in paragraphs 740-10-25-6, 740-10-30-7, and 740-10-40-2. The determination of when a tax position no longer meets those criteria is a matter of individual facts and circumstances evaluated in light of all available evidence.
842-50-35-13
If the lessor expects to enter into a settlement of a tax position relating to a leveraged lease with a taxing authority, the cash flows following the date of recalculation shall include projected cash flows between the date of the recalculation and the date of any projected settlement and a projected settlement amount at the date of the projected settlement.
842-50-35-14
The recalculation of income from the leveraged lease shall not include interest or penalties in the cash flows from the leveraged lease.
842-50-35-15
Advance payments and deposits made with a taxing authority shall not be considered an actual cash flow of the leveraged lease; rather, those payments and deposits shall be included in the projected settlement amount.
Effect of Alternative Minimum Tax
842-50-35-16
An entity shall include assumptions about the effect of the alternative minimum tax, considering its consolidated tax position, in leveraged lease computations.
842-50-35-17
Any difference between alternative minimum tax depreciation and the tax depreciation assumed in the leveraged lease or between income recognition for financial reporting purposes and alternative minimum tax income could, depending on the lessor's overall tax situation, result in alternative minimum tax or the utilization of alternative minimum tax credits.
842-50-35-18
If alternative minimum tax is paid or an alternative minimum tax credit is utilized, the total cash flows from the leveraged lease could be changed and the lessor's net investment in the leveraged lease and income recognition would be affected.
842-50-35-19
If a change to the tax assumptions changes total estimated after-tax net income, the rate of return on the leveraged lease shall be recalculated from inception, the accounts constituting the lessor's net investment shall be adjusted, and a gain or loss shall be recognized in the year in which the assumption is changed.
842-50-35-20
However, an entity whose tax position frequently varies between alternative minimum tax and regular tax shall not be required to recalculate the rate of return on the leveraged lease each year unless there is an indication that the original assumptions regarding total after-tax net income from the lease are no longer valid. In that circumstance, the entity shall be required to revise the leveraged lease computations in any period in which total net income from the leveraged lease changes because of the effect of the alternative minimum tax on cash flows for the lease.
Transfer of Minimum Rental Payments
842-50-35-21
If a lessor sells substantially all of the minimum rental payments associated with a leveraged lease and retains an interest in the residual value of the leased asset, the lessor shall not recognize increases in the value of the lease residual to its estimated value over the remaining lease term. The lessor shall report any remaining interest thereafter at its carrying amount at the date of the sale of the lease payments. If it is determined subsequently that the fair value of the residual value of the leased asset has declined below the carrying amount of the interest retained and that decline is other than temporary, the asset shall be written down to fair value, and the amount of the write-down shall be recognized as a loss. That fair value becomes the asset's new carrying amount, and the asset shall not be increased for any subsequent increase in its fair value before its sale or disposition.
842-50-45Other Presentation Matters
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842-50-45-1
For purposes of presenting the investment in a leveraged lease in the lessor's balance sheet, the amount of related deferred taxes shall be presented separately (from the remainder of the net investment). In the income statement or the notes to that statement, separate presentation (from each other) shall be made of pretax income from the leveraged lease, the tax effect of pretax income, and the amount of investment tax credit recognized as income during the period.
Income Taxes and Leveraged Leases
842-50-45-2
Integration of the results of income tax accounting for leveraged leases with the other results of accounting for income taxes under Topic 740 on income taxes is required if deferred tax credits related to leveraged leases are the only source (see paragraph 740-10-30-18) for recognition of a tax benefit for deductible temporary differences and carryforwards not related to leveraged leases. A valuation allowance is not necessary if deductible temporary differences and carryforwards will offset taxable amounts from future recovery of the net investment in the leveraged lease. However, to the extent that the amount of deferred tax credits for a leveraged lease as determined in accordance with this Subtopic differs from the amount of the deferred tax liability related to the leveraged lease that would otherwise result from applying the guidance in Topic 740, that difference is preserved and is not a source of taxable income for recognition of the tax benefit of deductible temporary differences and operating loss or tax credit carryforwards.
842-50-45-3
This Subtopic requires that the tax effect of any difference between the assigned value and the tax basis of a leveraged lease at the date of a business combination, an acquisition by a not-for-profit entity, or a joint venture formation shall not be accounted for as a deferred tax credit. Any tax effects included in unearned and deferred income as required by this Subtopic shall not be offset by the deferred tax consequences of other temporary differences or by the tax benefit of operating loss or tax credit carryforwards. However, deferred tax credits that arise after the date of a combination shall be accounted for in the same manner as for leveraged leases that were not acquired in a combination.
842-50-50Disclosure
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842-50-50-1
If leveraged leasing is a significant part of the lessor's business activities in terms of revenue, net income, or assets, the components of the net investment balance in leveraged leases as set forth in paragraph 842-50-25-1 shall be disclosed in the notes to financial statements.
842-50-50-2
For guidance on disclosures about financing receivables, which include receivables relating to a lessor's rights to payments from leveraged leases, see the guidance in Subtopic 326-20 on financial instruments measured at amortized cost.
842-50-50-3
If accounting for the effect on leveraged leases of the change in tax rates results in a significant variation from the customary relationship between income tax expense and pretax accounting income and the reason for that variation is not otherwise apparent, the lessor shall disclose the reason for that variation.
842-50-55Implementation Guidance and Illustrations
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Implementation Guidance
842-50-55-1
Although the carrying amount of an asset acquired previously may not differ significantly from its fair value, it is unlikely that the two will be the same. However, regulated utilities have argued that the carrying amounts of certain of their assets always equal the fair value based on the utility's ability to recover that cost in conjunction with a franchise to sell a related service in a specified area. That argument is not valid when considering the value of the asset to a third-party purchaser that does not own that franchise.
842-50-55-2
A delayed equity investment frequently obligates the lessor to make up the shortfall between rent and debt service in the first several years of the transaction. The type of recourse debt resulting from the delayed equity investment does not contradict the notion of nonrecourse and, therefore, does not preclude leveraged lease accounting as long as other requirements of leveraged lease accounting are met. The lessor's related obligation should be recorded as a liability at present value at lease inception.
842-50-55-3
Recognition of the liability would increase the lessor's net investment on which the lessor bases its pattern of income recognition. While the increase to the net investment results in an increase in income, it may be offset by the accrual of interest on the liability.
842-50-55-4
The accounting for income taxes related to leveraged leases set forth in this Subtopic is not consistent with the guidance in Topic 740 on income taxes.
842-50-55-5
The integration of the results of accounting for income taxes related to leveraged leases with the other results of accounting for income taxes as required by Topic 740 is an issue if all of the following exist:
- a The accounting for a leveraged lease requires recognition of deferred tax credits.
- b The guidance in Topic 740 limits the recognition of a tax benefit for deductible temporary differences and carryforwards not related to the leveraged lease.
- c Unrecognized tax benefits in this paragraph could offset taxable amounts that result from future recovery of the net investment in the leveraged lease.
Illustrations
842-50-55-6
This Example illustrates a lessor's accounting for a leveraged lease in accordance with the guidance in this Subtopic. It also illustrates one way of meeting the disclosure requirements in paragraphs 842-50-45-1 and 842-50-50-1 as applied to a leveraged lease. The Example does not encompass all circumstances that may arise about leveraged leases; rather, the Example is based on a single instance of a leveraged lease. The elements of accounting and reporting illustrated for this Example of a leveraged lease are as follows:
- a Cash flow analysis by years (see paragraph 842-50-55-8)
- b Allocation of annual cash flow to investment and income (see paragraph 842-50-55-9)
- c Journal entries for lessor's initial investment and first year of operation (see paragraph 842-50-55-10)
- d Financial statements including notes at end of second year (see paragraph 842-50-55-11)
- e Accounting for a revision in the estimated residual value of the leased asset assumed to occur in the eleventh year of the lease (from $200,000 to $120,000):
- 1 Revised allocation of annual cash flow to investment and income (see paragraph 842-50-55-12)
- 2 Balances in investment accounts at beginning of the eleventh year before revised estimate (see paragraph 842-50-55-13)
- 3 Journal entries (see paragraph 842-50-55-14)
- 4 Adjustment of investment accounts (see paragraph 842-50-55-15).
- 1
842-50-55-7
This Example has the following terms and assumptions.
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Cost of leased asset (equipment) "$1,000,000 " Lease term "15 years, dating from January 1, 1975" Lease rental payments "$90,000 per year (payable last day of each year)" Residual value "$200,000 estimated to be realized 1 year after lease termination; in the eleventh year of the lease the estimate is reduced to $120,000" Financing: Equity investment by lessor "$400,000 " Long-term nonrecourse debt "$600,000, bearing interest at 9% and repayable in annual installments (on last day of each year) of $74,435.30" Depreciation allowable to lessor for income tax purposes "7-year asset depreciation range life using double-declining-balance method for the first 2 years (with the half-year convention election applied in the first year) and sum-of-years digits method for remaining life, depreciated to $100,000 salvage value" "Lessor's income tax rate (federal and state)" 50.4% (assumed to continue in existence throughout the term of the lease) Investment tax credit "10% of equipment cost or $100,000 (realized by the lessor on last day of first year of lease)" Initial direct costs "For simplicity, initial direct costs have not been included in the illustration"
842-50-55-8
Cash flow analysis by years follows.
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1 2 3 4 5 6 7 8 9 Year Gross Lease Rentals and Residual Value Depreciation (for Income Tax Purposes) Loan Interest Payments Taxable Income (Loss) (Col. 1- 2- 3) Income Tax Credits (Charges) (Col. 4 × 50.4%) Loan Principal Payments Investment Tax Credit Realized Annual Cash Flow (Col. 1- 3 + 5 - 6 + 7) Cumulative Cash Flow Initial Investment - - - - - - - " $(400,000)" " $(400,000)" 1 " $90,000 " " $142,857 " " $54,000 " " $(106,857)" " $53,856 " " $20,435 " " $100,000 " " 169,421 " " (230,579)" 2 " 90,000 " " 244,898 " " 52,161 " " (207,059)" " 104,358 " " 22,274 " - " 119,923 " " (110,656)" 3 " 90,000 " " 187,075 " " 50,156 " " (147,231)" " 74,204 " " 24,279 " - " 89,769 " " (20,887)" 4 " 90,000 " " 153,061 " " 47,971 " " (111,032)" " 55,960 " " 26,464 " - " 71,525 " " 50,638 " 5 " 90,000 " " 119,048 " " 45,589 " " (74,637)" " 37,617 " " 28,846 " - " 53,182 " " 103,820 " 6 " 90,000 " " 53,061 " " 42,993 " " (6,054)" " 3,051 " " 31,442 " - " 18,616 " " 122,436 " 7 " 90,000 " - " 40,163 " " 49,837 " " (25,118)" " 34,272 " - " (9,553)" " 112,883 " 8 " 90,000 " - " 37,079 " " 52,921 " " (26,672)" " 37,357 " - " (11,108)" " 101,775 " 9 " 90,000 " - " 33,717 " " 56,283 " " (28,367)" " 40,719 " - " (12,803)" " 88,972 " 10 " 90,000 " - " 30,052 " " 59,948 " " (30,214)" " 44,383 " - " (14,649)" " 74,323 " 11 " 90,000 " - " 26,058 " " 63,942 " " (32,227)" " 48,378 " - " (16,663)" " 57,660 " 12 " 90,000 " - " 21,704 " " 68,296 " " (34,421)" " 52,732 " - " (18,857)" " 38,803 " 13 " 90,000 " - " 16,957 " " 73,043 " " (36,813)" " 57,478 " - " (21,248)" " 17,555 " 14 " 90,000 " - " 11,785 " " 78,215 " " (39,420)" " 62,651 " - " (23,856)" " (6,301)" 15 " 90,000 " - " 6,145 " " 83,855 " " (42,263)" " 68,290 " - " (26,698)" " (32,999)" 16 " 200,000 " " 100,000 " - " 100,000 " " (50,400)" - - " 149,600 " " 116,601 " Totals " $1,550,000 " " $1,000,000 " " $516,530 " " $33,470 " " $(16,869)" " $600,000 " " $100,000 " " $116,601 "
842-50-55-9
Allocation of annual cash flow to investment and income follows.
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1 2 3 4 5 6 7 Annual Cash Flow Components of Income (a) Year Lessor's Net Investment at Beginning of Year "Total (from Col. 8 of Paragraph 842-50-55-8)" Allocated to Investment Allocated to Income (b) Pretax Income Tax Effect of Pretax Income Investment Tax Credit 1 " $400,000 " " $169,421 " " $134,833 " " $34,588 " " $9,929 " " $(5,004)" " $29,663 " 2 " 265,167 " " 119,923 " " 96,994 " " 22,929 " " 6,582 " " (3,317)" " 19,664 " 3 " 168,173 " " 89,769 " " 75,227 " " 14,542 " " 4,174 " " (2,104)" " 12,472 " 4 " 92,946 " " 71,525 " " 63,488 " " 8,037 " " 2,307 " " (1,163)" " 6,893 " 5 " 29,458 " " 53,182 " " 50,635 " " 2,547 " 731 (368) " 2,184 " 6 " (21,177)" " 18,616 " " 18,616 " - - - - 7 " (39,793)" " (9,553)" " (9,553)" - - - - 8 " (30,240)" " (11,108)" " (11,108)" - - - - 9 " (19,132)" " (12,803)" " (12,803)" - - - - 10 " (6,329)" " (14,649)" " (14,649)" - - - - 11 " 8,320 " " (16,663)" " (17,382)" 719 206 (104) 617 12 " 25,702 " " (18,857)" " (21,079)" " 2,222 " 637 (321) " 1,906 " 13 " 46,781 " " (21,248)" " (25,293)" " 4,045 " " 1,161 " (585) " 3,469 " 14 " 72,074 " " (23,856)" " (30,088)" " 6,232 " " 1,789 " (902) " 5,345 " 15 " 102,162 " " (26,698)" " (35,532)" " 8,834 " " 2,536 " " (1,278)" " 7,576 " 16 " 137,694 " " 149,600 " " 137,694 " " 11,906 " " 3,418 " " (1,723)" " 10,211 " Totals " $516,601 " " $400,000 " " $116,601 " " $33,470 " " $(16,869)" " $100,000 " (a) "Lease income is recognized as 8.647% of the unrecovered investment at the beginning of each year in which the net investment is positive. The rate is that rate which, if applied to the net investment in the years in which the net investment is positive, will distribute the net income (net cash flow) to those years." (b) Each component is allocated among the years of positive net investment in proportion to the allocation of net income in column 4.
842-50-55-10
Illustrative journal entries for the year ending December 31, 1975, follow.
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Lessor's Initial Investment Debit Credit "Rentals receivable (table in paragraph 842-50-55-8, total of column 1 minus residual value, minus totals of columns 3 and 6)" " $233,470 " "Investment tax credit receivable (table in paragraph 842-50-55-8, column 7)" " 100,000 " Estimated residual value (paragraph 842-50-55-7) " 200,000 " "Unearned and deferred income (table in paragraph 842-50-55-9, totals of columns 5 and 7)" " $133,470 " Cash " 400,000 " Record lessor's initial investment First Year of Operation Journal Entry 1 Cash " 15,565 " "Rentals receivable (table in paragraph 842-50-55-8, column 1 minus columns 3 and 6)" " 15,565 " Collection of first year's net rental Journal Entry 2 Cash (a) " 100,000 " "Investment tax credit receivable (table in paragraph 842-50-55-8, column 7)" " 100,000 " Receipt of investment tax credit Journal Entry 3 Unearned and deferred income " 9,929 " "Income from leveraged leases (table in paragraph 842-50-55-9, column 5)" " 9,929 " Recognition of first year's portion of pretax income allocated in the same proportion as the allocation of total income "(34,588 ÷ 116,601) × 33,470 = 9,929 " Journal Entry 4 Unearned and deferred income " 29,663 " "Investment tax credit recognized (table in paragraph 842-50-55-9, column 7)" " 29,663 " Recognition of first year's portion of investment tax credit allocated in the same proportion as the allocation of total income "(34,588 ÷ 116,601) × 100,000 = 29,663" Journal Entry 5 "Cash (table in paragraph 842-50-55-8, column 5) (a)" " 53,856 " "Income tax expense (table in paragraph 842-50-55-9, column 6)" " 5,004 " Deferred taxes " 58,860 " "To record receipt of first year's tax credit from lease operation, to charge income tax expense for tax effect of pretax accounting income, and to recognize as deferred taxes the tax effect of the difference between pretax accounting income and the tax loss for the year, calculated as follows:" "Tax loss (table in paragraph 842-50-55-8, column 4)" " $(106,857)" Pretax accounting income " 9,929 " Difference " $(116,786)" "Deferred taxes ($116,786 × 50.4%)" " $58,860 " (a) "Receipts of the investment tax credit and other tax benefits are shown as cash receipts for simplicity only. Those receipts probably would not be in the form of immediate cash inflow. Instead, they likely would be in the form of reduced payments of taxes on other income of the lessor or on the combined income of the lessor and other entities whose operations are joined with the lessor's operations in a consolidated tax return."
842-50-55-11
The following are illustrative partial financial statements including notes.
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BALANCE SHEET ASSETS LIABILITIES "December 31," "December 31," 1976 1975 1976 1975 Investment in leveraged leases " $334,708 " " $324,027 " Deferred taxes arising from leveraged leases " $166,535 " " $58,860 "
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INCOME STATEMENT (Ignoring all income and expense items other than those relating to leveraged leasing) 1976 1975 Income from leveraged leases " $6,582 " " $9,929 " Income before taxes and investment tax credit " 6,582 " " 9,929 " Less: Income tax expense (a) " (3,317)" " (5,004)" " 3,265 " " 4,925 " Investment tax credit recognized (a) " 19,664 " " 29,663 " Net income " $22,929 " " $34,588 " (a) "These two items may be netted for purposes of presentation in the income statement, provided that the separate amounts are disclosed in a note to financial statements."
- Investment in Leveraged Leases
- Entity is the lessor in a leveraged lease agreement entered into in 1975 under which mining equipment having an estimated economic life of 18 years was leased for a term of 15 years. Entity's equity investment represented 40 percent of the purchase price; the remaining 60 percent was furnished by third-party financing in the form of long-term debt that provides for no recourse against Entity and is secured by a first lien on the property. At the end of the lease term, the equipment is turned back to Entity. The residual value at that time is estimated to be 20 percent of cost. For federal income tax purposes, Entity receives the investment tax credit and has the benefit of tax deductions for depreciation on the entire leased asset and for interest on the long-term debt. During the early years of the lease, those deductions exceed the lease rental income, and substantial excess deductions are available to be applied against Entity's other income. In the later years of the lease, rental income will exceed the deductions and taxes will be payable. Deferred taxes are provided to reflect this reversal. Entity's net investment in leveraged leases is composed of the following elements.
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"December 31," 1976 1975 Rentals receivable (net of principal and interest on the nonrecourse debt) " $202,340 " " $217,905 " Estimated residual value of leased assets " 200,000 " " 200,000 " Less: Unearned and deferred income " (67,632)" " (93,878)" Investment in leveraged leases " 334,708 " " 324,027 " Less: Deferred taxes arising from leveraged leases " (166,535)" " (58,860)" Net investment in leveraged leases " $168,173 " " $265,167 "
842-50-55-12
Allocation of annual cash flow to investment and income follows, revised to include new residual value estimate.
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Annual Cash Flow Components of Income Year Lessor's Net Investment at Beginning of Year Total Allocated to Investment Allocated to Income (a) Pretax Loss Tax Effect of Pretax Loss Investment Tax Credit 1 " $400,000 " " $169,421 " " $142,458 " " $26,963 " " $(16,309)" " $8,220 " " $35,052 " 2 " 257,542 " " 119,923 " " 102,563 " " 17,360 " " (10,501)" " 5,293 " " 22,568 " 3 " 154,979 " " 89,769 " " 79,323 " " 10,446 " " (6,319)" " 3,184 " " 13,581 " 4 " 75,656 " " 71,525 " " 66,425 " " 5,100 " " (3,085)" " 1,555 " " 6,630 " 5 " 9,231 " " 53,182 " " 52,560 " 622 (377) 190 809 6 " (43,329)" " 18,616 " " 18,616 " - - - - 7 " (61,945)" " (9,553)" " (9,553)" - - - - 8 " (52,392)" " (11,108)" " (11,108)" - - - - 9 " (41,284)" " (12,803)" " (12,803)" - - - - 10 " (28,481)" " (14,649)" " (14,649)" - - - - 11 " (13,832)" " (16,663)" " (16,663)" - - - - 12 " 2,831 " " (18,857)" " (19,048)" 191 (115) 58 248 13 " 21,879 " " (21,248)" " (22,723)" " 1,475 " (892) 450 " 1,917 " 14 " 44,602 " " (23,856)" " (26,862)" " 3,006 " " (1,819)" 916 " 3,909 " 15 " 71,464 " " (26,698)" " (31,515)" " 4,817 " " (2,914)" " 1,469 " " 6,262 " 16 " 102,979 " " 109,920 " " 102,979 " " 6,941 " " (4,199)" " 2,116 " " 9,024 " Totals " $476,921 " " $400,000 " " $76,921 " " $(46,530)" " $23,451 " " $100,000 " (a) The revised allocation rate is 6.741%.
842-50-55-13
Balances in investment accounts before revised estimate of residual value follow.
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1 2 3 4 5 6 7 "Unearned and Deferred Income" Rentals Receivable (a) Estimated Residual Value Investment Tax Credit Receivable Pretax Income (Loss) (b) Investment Tax Credit (c) Deferred Taxes (d) Net Investment (Col. 1+2+3) less (Col. 4 + 5 + 6) Initial investment " $233,470 " " $200,000 " " $100,000 " " $33,470 " " $100,000 " $- " $400,000 " Changes in year of operation 1 " (15,565)" - " (100,000)" " (9,929)" " (29,663)" " 58,860 " " (134,833)" 2 " (15,565)" - - " (6,582)" " (19,664)" " 107,675 " " (96,994)" 3 " (15,565)" - - " (4,174)" " (12,472)" " 76,308 " " (75,227)" 4 " (15,565)" - - " (2,307)" " (6,893)" " 57,123 " " (63,488)" 5 " (15,565)" - - (731) " (2,184)" " 37,985 " " (50,635)" 6 " (15,565)" - - - - " 3,051 " " (18,616)" 7 " (15,565)" - - - - " (25,118)" " 9,553 " 8 " (15,564)" - - - - " (26,672)" " 11,108 " 9 " (15,564)" - - - - " (28,367)" " 12,803 " 10 " (15,565)" - - - - " (30,214)" " 14,649 " "Balances, beginning of eleventh year" " $77,822 " " $200,000 " $- " $9,747 " " $29,124 " " $230,631 " " $8,320 " (a) "Table in paragraph 842-50-55-8, column 1, excluding residual value, minus columns 3 and 6." (b) "Table in paragraph 842-50-55-9, column 5." (c) "Table in paragraph 842-50-55-9, column 7." (d) 50.4% of difference between taxable income (loss) in column 4 of the table in paragraph 842-50-55-8 and pretax accounting income (loss) in column 5 of the table in paragraph 842-50-55-9.
842-50-55-14
Illustrative journal entries involving a reduction in residual value follow.
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Debit Credit Journal Entry 1 Pretax income (or loss) " $60,314 " Unearned and deferred income " 27,450 " Pretax income (loss): Balance at end of tenth year " $9,747 " (a) Revised balance " (9,939)" (b) Adjustment " (19,686)" Deferred investment tax credit: Balance at end of tenth year " 29,124 " (c) Revised balance " 21,360 " (d) Adjustment " (7,764)" Investment tax credit recognized " $7,764 " Estimated residual value " 80,000 " To record: a. The cumulative effect on pretax income and the effect on future income resulting from the decrease in estimated residual value: Reduction in estimated residual value " $80,000 " Less portion attributable to future years (unearned and deferred income) " (19,686)" Cumulative effect (charged against current income) " $60,314 " b. The cumulative and future effect of the change in allocation of the investment tax credit resulting from the reduction in estimated residual value Journal Entry 2 Deferred taxes " 30,398 " Income tax expense " 30,398 " To recognize deferred taxes for the difference between pretax accounting income (or loss) and taxable income (or loss) for the effect of the reduction in estimated residual value: Pretax accounting loss per Journal Entry 1 " $(60,314)" Tax income (or loss) - Difference " $(60,314)" "Deferred taxes ($60,314 × 50.4%)" " $(30,398)" (a) "Table in paragraph 842-50-55-13, column 4." (b) "Table in paragraph 842-50-55-12, total of column 5 minus amounts applicable to the first 10 years." (c) "Table in paragraph 842-50-55-13, column 5." (d) "Table in paragraph 842-50-55-12, total of column 7 minus amounts applicable to the first 10 years."
842-50-55-15
Adjustment of investment accounts for revised estimates of residual value follows.
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"Unearned and Deferred Income" Net Investment Rentals Receivable Estimated Residual Value Pretax Income (Loss) Investment Tax Credit Deferred Taxes (Col. 1 + 2) less (Col. 3 + 4 + 5) "Balances, beginning of eleventh year (table in paragraph 842-50-55-13)" " $77,822 " " $200,000 " " $9,747 " " $29,124 " " $230,631 " " $8,320 " "Adjustment of estimated residual value and unearned and deferred income (table in paragraph 842-50-55-14, Journal Entry 1)" - " (80,000)" " (19,686)" " (7,764)" - " (52,550)" "Adjustment of deferred taxes for the cumulative effect on pretax accounting income (table in paragraph 842-50-55-14, Journal Entry 2)" - - - - " (30,398)" " 30,398 " "Adjusted balances, beginning of eleventh year" " $77,822 " " $120,000 " " $(9,939)" " $21,360 " " $200,233 " " $(13,832)" (a) (a) "Table in paragraph 842-50-55-12, column 1."
842-50-55-16
This Example illustrates integration of the results of a lessor's income tax accounting for leveraged leases (in accordance with the guidance in this Subtopic) with the other results of accounting for income taxes as required by Topic 740.
842-50-55-17
At the end of Year 1 (the current year), an entity has two temporary differences.
842-50-55-18
The first temporary difference is for a leveraged lease that was entered into in a prior year. During Year 1, the enacted tax rate for Year 2 and thereafter changes from 40 percent to 35 percent.
842-50-55-19
After adjusting for the change in estimated total net income from the lease as a result of the change in tax rates, the components of the investment in the leveraged lease at the end of Year 1 are as follows.
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Net rentals receivable plus residual value minus unearned pretax income " $150,000 " Reduced by: Deferred investment tax credit " $9,000 " Deferred tax credits " 39,000 " " 48,000 " Net investment in leveraged lease for financial reporting " $102,000 "
842-50-55-20
The second temporary difference is a $120,000 estimated liability for warranty expense that will result in a tax deduction in Year 5 when the liability is expected to be paid. Absent consideration of the deferred tax credits attributable to the leveraged lease, the weight of available evidence indicates that a valuation allowance is needed for the entire amount of the deferred tax asset related to that $120,000 deductible temporary difference.
842-50-55-21
The tax basis of the investment in the leveraged lease at the end of Year 1 is $41,000. The amount of the deferred tax liability for that leveraged lease that would otherwise result from the application of guidance in Topic 740 on income taxes is determined as follows.
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Net rentals receivable plus residual value minus unearned pretax income " $150,000 " Temporary difference for deferred investment tax credit " 9,000 " " 141,000 " Tax basis of leveraged lease " 41,000 " Temporary difference " $100,000 " Deferred tax liability (35 percent) " $35,000 "
842-50-55-22
Loss carryback (to Year 2) and loss carryforward (to Year 20) of the $120,000 tax deduction for warranty expense in Year 5 would offset the $100,000 of taxable amounts resulting from future recovery of the net investment in the leveraged lease over the remainder of the lease term.
842-50-55-23
At the end of Year 1, the entity recognizes a $42,000 ($120,000 at 35 percent) deferred tax asset and a related $7,000 valuation allowance. The effect is to recognize a $35,000 net deferred tax benefit for the reduction in deferred tax credits attributable to the leveraged lease. Deferred tax credits attributable to the leveraged lease determined under the guidance in this Subtopic are $39,000. However, the deferred tax liability determined is only $35,000. The $4,000 difference is not available for offsetting.
842-50-55-24
This Example illustrates how (in accordance with the guidance in paragraph 842-50-35-13 and other paragraphs) a lessor would include advance payments and deposits in a recalculation of a leveraged lease resulting from a determination by the lessor that it would enter into a settlement of a tax position arising from a leveraged lease.
842-50-55-25
This Example assumes that the lessor has concluded that the position originally taken on the tax return would meet the more-likely-than-not threshold in Subtopic 740-10 on income taxes. It also assumes that the lessor would conclude that the estimate of $50 for the projected lease-in, lease-out settlement is consistent with the measurement guidance in that Subtopic.
842-50-55-26
A lessor makes an advance payment of $25 on July 1, 2007, $10 of which is estimated to be associated with issues arising from a lease-in, lease-out transaction. On July 1, 2007, the lessor changes its assumption about the timing of the tax cash flows and projects a settlement with the Internal Revenue Service on September 1, 2009. The projected settlement would result in a payment to the taxing authority of $125 of which $50 is associated with the lease-in, lease-out transaction. On July 1, 2007, when the lessor recalculates the leveraged lease, the lessor would include a $50 cash flow on September 1, 2009, as a projected outflow in the leveraged lease recalculation.
842-50-55-27
This Example illustrates one way that a lessor's investment in a leveraged lease might be valued by the acquiring entity in a business combination or an acquisition by a not-for-profit entity and the subsequent accounting for the investment in accordance with the guidance in this Subtopic. The elements of accounting and reporting illustrated for this Example are as follows:
- a Acquiring entity's cash flow analysis by years (see paragraph 842-50-55-29)
- b Acquiring entity's valuation of investment in the leveraged lease (see paragraph 842-50-55-30)
- c Acquiring entity's allocation of annual cash flow to investment and income (see paragraph 842-50-55-31)
- d Journal entry for recording allocation of purchase price to net investment in the leveraged lease (see paragraph 842-50-55-32)
- e Journal entries for the year ending December 31, 1984 (Year 10 of the lease) (see paragraph 842-50-55-33).
842-50-55-28
This Example has the following terms and assumptions.
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Cost of leased asset (equipment) "$1,000,000" Lease term "15 years, dating from January 1, 1975" Lease rental payments "$90,000 per year (payable last day of each year)" Residual value "$200,000 estimated to be realized 1 year after lease termination" Financing: Equity investment by lessor "$400,000" Long-term nonrecourse debt "$600,000, bearing interest at 9% and repayable in annual installments (on last day of each year) of $74,435.30" Depreciation allowable to lessor for income tax purposes "7-year asset depreciation range life using double-declining-balance method for the first 2 years (with the half-year convention election applied in the first year) and sum-of-years digits method for remaining life, depreciated to $100,000 salvage value" Lessor's income tax rate (federal and state) 50.4% (assumed to continue in existence throughout the term of the lease) Investment tax credit "10% of equipment cost or $100,000 (realized by the lessor on last day of first year of lease)" Initial direct costs "For simplicity, initial direct costs have not been included in the illustration" Date of business combination "January 1, 1982" Nontaxable transaction Tax status of business combination Appropriate interest rate for valuing net-of-tax return on investment 4½%
842-50-55-29
Acquiring entity's cash flow analysis by years follows.
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1 2 3 4 5 6 7 Year Gross Lease Rentals and Residual Value Depreciation (for Income Tax Purposes) Loan Interest Payments "Taxable Income (Col. 1 - 2 - 3)" Income Tax (Charges) (Col. 4 × 50.4%) Loan Principal Payments Annual Cash Flow (Col. 1 - 3 + 5 - 6) 8 " $90,000 " - " $37,079 " " $52,921 " " $(26,672)" " $37,357 " " $(11,108)" 9 " 90,000 " - " 33,717 " " 56,283 " " (28,367)" " 40,719 " " (12,803)" 10 " 90,000 " - " 30,052 " " 59,948 " " (30,214)" " 44,383 " " (14,649)" 11 " 90,000 " - " 26,058 " " 63,942 " " (32,227)" " 48,378 " " (16,663)" 12 " 90,000 " - " 21,704 " " 68,296 " " (34,421)" " 52,732 " " (18,857)" 13 " 90,000 " - " 16,957 " " 73,043 " " (36,813)" " 57,478 " " (21,248)" 14 " 90,000 " - " 11,785 " " 78,215 " " (39,420)" " 62,651 " " (23,856)" 15 " 90,000 " - " 6,145 " " 83,855 " " (42,263)" " 68,290 " " (26,698)" 16 " 200,000 " " $100,000 " - " 100,000 " " (50,400)" - " 149,600 " Totals " $920,000 " " $100,000 " " $183,497 " " $636,503 " " $(320,797)" " $411,988 " " $3,718 "
842-50-55-30
Acquiring entity's valuation of investment in the leveraged lease follows.
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Cash Flow Present Value at 4½% Net-of-Tax Rate "1. Rentals receivable (net of principal and interest on the nonrecourse debt) ($15,564.70 at the end of each year for 8 years)" " $102,663 " "2. Estimated residual value ($200,000 realizable at the end of 9 years)" " 134,581 " "3. Future tax payments (various amounts payable over 9 years—see the table in paragraph 842-50-55-29)" " (253,489)" Net present value " $(16,245)"
842-50-55-31
Acquiring entity's allocation of annual cash flow to investment and income follows (see footnote (a)).
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1 2 3 4 5 6 Annual Cash Flow Components of Income (b) Year Net Investment at Beginning of Year "Total from Col. 7 of the Table in Paragraph 842-50-55-29" Allocated to Investment Allocated to Income (a) Pretax Income Tax Effect of Pretax Income 8 " $(16,245)" " $(11,108)" " $(11,108)" - - - 9 " (5,137)" " (12,803)" " (12,803)" - - - 10 " 7,666 " " (14,649)" " (14,973)" $324 " $5,530 " " $(5,206)" 11 " 22,639 " " (16,663)" " (17,621)" 958 " 16,353 " " (15,395)" 12 " 40,260 " " (18,857)" " (20,561)" " 1,704 " " 29,087 " " (27,383)" 13 " 60,821 " " (21,248)" " (23,822)" " 2,574 " " 43,937 " " (41,363)" 14 " 84,643 " " (23,856)" " (27,439)" " 3,583 " " 61,160 " " (57,577)" 15 " 112,082 " " (26,698)" " (31,443)" " 4,745 " " 80,995 " " (76,250)" 16 " 143,525 " " 149,600 " " 143,525 " " 6,075 " " 103,698 " " (97,623)" Totals " $3,718 " " $(16,245)" " $19,963 " " $340,760 " " $(320,797)" (a) "Lease income is recognized as 4.233% of the unrecovered investment at the beginning of each year in which the net investment is positive. The rate is that rate which, if applied to the net investment in the years in which the net investment is positive, will distribute the net income (net cash flow) to those years. " (b) Each component is allocated among the years of positive net investment in proportion to the allocation of net income in column 4. Journal Entry 2 in the table in paragraph 842-50-55-33 includes an example of this computation.
842-50-55-32
Illustrative journal entry for recording allocation of purchase price to net investment in the leveraged lease follows.
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"Rentals receivable (table in paragraph 842-50-55-29, total of column 1 minus residual value, minus totals of columns 3 and 6)" " $124,515 " Estimated residual value (paragraph 842-50-55-28) " 200,000 " "Purchase price allocation clearing account (paragraph 842-50-55-30, present value)" " 16,245 " "Unearned and deferred income (paragraph 842-50-55-30, present value, minus total of rentals receivable and estimated residual value)" " $340,760 "
842-50-55-33
Illustrative journal entries for year ending December 31, 19Y4, follows.
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"Third Year of Operation after the Business Combination (Year 10 of the Lease)" Journal Entry 1 Cash " $15,565 " "Rentals receivable (table in paragraph 842-50-55-29, column 1 minus columns 3 and 6)" " $15,565 " Collection of year's net rental Journal Entry 2 Unearned and deferred income " $5,530 " "Income from leveraged leases (table in paragraph 842-50-55-31, column 5)" " $5,530 " Recognition of pretax income for the year allocated in the same proportion as the allocation of total income computed as follows: "([$324 ÷ $19,963] × $340,760 = $5,530)" Journal Entry 3 "Deferred taxes (table in paragraph 842-50-55-29, column 5, minus table in paragraph 842-50- 55-31, column 6)" " $25,008 " "Income tax expense (table in paragraph 842-50- 55-31, column 6)" " 5,206 " "Cash (table in paragraph 842-50-55-29, column 5)" " $30,214 " To record payment of tax for the year
842-50-S00StatusSEC
Source downloaded: .Record version 305fac1c53f6. Effective date must be checked in the source.
842-50-S00-1
The following table identifies the changes made to this Subtopic.
| Paragraph | Action | Accounting Standards Update | Date |
| 842-50-S35-1 | Added | Accounting Standards Update No. 2017-13 | 09/29/2017 |
| 842-50-S99-1 | Added | Accounting Standards Update No. 2017-13 | 09/29/2017 |
842-50-S35Subsequent MeasurementSEC
Source downloaded: .Record version 2e61f01ef564. Effective date must be checked in the source.
Effect of a Change in Tax Law or Rates on Leveraged Leases
842-50-S35-1
See paragraph 842-50-S99-1, SEC Observer Comment: Effect of a Change in Tax Law or Rates on Leverage Leases, for SEC Staff views on the effect of a change in tax law or rate on leveraged leases.
842-50-S99SEC MaterialsSEC
Source downloaded: .Record version d60fdb789b4a. Effective date must be checked in the source.
SEC Staff Guidance
842-50-S99-1
The following is the text of SEC Observer Comment: Effect of a Change in Tax Law or Rates on Leveraged Leases.
- Section 842-50-35 requires that all components of a leveraged lease be recalculated from inception of the lease based on the revised after-tax cash flows arising from the change in the tax law, including revised tax rates. The difference between the amounts originally recorded and the recalculated amounts must be included in income of the year in which the tax law is enacted.
- This accounting may have distortive effects on the ratio of earnings to fixed charges ("the ratio") as calculated. For example, a favorable after-tax effect might consist of an unfavorable adjustment to pretax income that is more than offset by a favorable adjustment to income tax expense. In those circumstances, despite the overall favorable effect, the ratio as calculated pursuant to the applicable instructions to Item 503(d) of Regulation S-K would be affected negatively because the "earnings" component of the ratio is based on pretax income.
- In filings with the Commission the SEC staff will expect the cumulative effect on pretax income and income tax expense, if material, to be reported as separate line items in the income statement. SEC staff will not object to exclusion of an unfavorable pretax adjustment from the "earnings" component of the ratio, in cases in which the after-tax effect is favorable, provided that (1) such exclusion is adequately identified and explained in connection with all disclosures and discussions relating to the ratio and (2) supplemental disclosure is made of the ratio as calculated in accordance with the applicable instructions.