Impact of ASC Topic 842 Lease Standards on Lease Passthrough Structures
Question: How does the new lease standard under ASC 842 impact financial reporting for lease passthrough structures?
Answer: Historic tax credit (HTC) transactions that use the lease passthrough structure are structured in a manner in which two legal entities are created: one legal entity to own and hold legal title to the real estate (landlord) and another to lease the real estate and make rent payments under a master lease agreement, while simultaneously subleasing the space to the tenants of the building(s) (master tenant). One benefit of this structure is that the Internal Revenue Code (IRC) allows the landlord to “pass through” all or a portion of the HTCs to the master tenant by making an election pursuant to Treasury Regulation (Treas. Reg.) Section 1.48-4(a)(1). For purposes of this article, the landlord will be referred to as the lessor, and the master tenant will be referred to as the lessee.
The Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02, Leases (Topic 842) Feb. 25, 2016, to increase transparency and comparability among organizations by disclosing key information about leasing transactions, with the primary objective of recognizing all leases as assets and liabilities on the balance sheet. For those who have not already early adopted, the implementation of the new lease standard is required for fiscal years beginning after Dec. 15, 2021. It is important to understand how the guidance will impact financial statements prepared under generally accepted accounting principles (GAAP). One item to note is that the new leasing standard has no impact on financial statements prepared on other bases of accounting, such as the federal income tax basis of accounting. The discussion below is meant to be a high-level overview of the accounting changes and there are many other steps involved in evaluating the impact of adopting the standard.
ASC 842–Impact on Lessor Reporting
First, let us look at how ASC 842 impacts the landlord entity, or the lessor. Fortunately, the new standard generally remains consistent with existing GAAP under ASC 840. As a result, a master lease agreement will generally continue to be classified as an operating lease under ASC 842. The other two categories under ASC 842 which could be applicable for master leases are a direct financing lease or a sales type lease which are dependent on the criteria discussed in the lessee section below.
ASC 842–Impact on Lessee Reporting
Next, we will look at how ASC 842 impacts the master tenant entity, or the lessee. Under ASC 842-10-25-2, the lessee will determine its lease classification as either a financing lease or operating lease using the following five criteria:
- The lease transfers ownership of the underlying asset(s) to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset(s) that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset(s). However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset(s).
- The underlying asset(s) are of such a specialized nature that it is expected to have nonalternative use to the lessor at the end of the lease term.
If the lease qualifies as a sales-type lease for the lessor, the lessee shall classify its lease as a financing lease for financial statement reporting purposes. All other leases shall be classified as an operating lease. As discussed above, master lease agreements will generally be categorized as operating leases.
ASC 842 introduces the requirement for the lessee to report a “right-of-use” asset and a lease liability on its balance sheet, which is not required under ASC 840. The right-of-use asset is initially measured by calculating the present value of the lease payments, adjusted for lease prepayments, incentives and other direct costs. If the lease agreement does not disclose an interest rate to be used, the lessee shall use its incremental borrowing rate when performing the present value calculation.
In a financing lease, the lessee will recognize interest expense on the lease liability separately from amortization of the right-of-use asset in the statement of operations. The lessee will also classify principal repayments of the lease liability within financing activities and payments of interest within operating activities in the statement of cash flows. Accounting for a financing lease results in the following components: a right-of-use asset, a corresponding lease liability, amortization expense based on a straight-lining of the right-of-use asset, and interest expense incurred using the incremental borrowing rate.
In an operating lease, the lessee shall recognize a single lease expense, calculated such that the cost of the lease is allocated over the lease term on a straight-line basis. The lessee will classify all cash payments within operating activities in the statement of cash flows. Accounting for an operating lease results in the following components: a right-of-use asset, a corresponding lease liability and annual lease expense.
To compare financing lease vs. operating lease accounting treatment for the right-of-use asset and impact on operations, assume a lessee enters a 10-year lease with lease payments of $10,000 per year, and the lessee’s incremental borrowing rate is 7% per annum. Below is a table illustrating the accounting of a financing lease under these terms:
Below is a table illustrating the accounting of an operating lease from the lessee’s perspective using the same facts as above.
As reflected on the previous page, the accounting of the financing lease front-loads the expense recognition when compared to an operating lease. In either scenario, the right-of-use asset is required to be recorded on the balance sheet which was contrary to ASC 840.
While this article outlines an example of the basics of the accounting for the new lease standard, it is important to remember that each project is unique and presents its own set of fact patterns, which may have different results. For professional assistance on your historic rehabilitation development, be sure to consult with a Novogradac professional.
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