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Lease classification

Question 3-14

When calculating the rate implicit in the lease, should the fair value of the residual asset be limited to
the lease commencement date fair value of the underlying asset?

PwC response
Yes. Under ASC 840, long standing practice has been that a lessor’s estimate of the residual value of
leased property should not exceed the fair value of the leased property at lease inception. However, a
literal read of the definitions of “lease receivable” and “unguaranteed residual asset” in ASC 842 may
suggest it is appropriate to not limit the estimated residual value to the underlying asset’s fair value at
lease commencement. This interpretation would result in a rate implicit in the lease that would
consider future inflation in the asset’s fair value. This would cause most leases to be classified as
operating, even those designed to be sales. It also, in the case of a sales-type lease, would result in the
recognition of estimated future increases in the value of the asset at the commencement date of the
lease. We do not believe these would be appropriate results. Consequently, we believe current practice
should continue and the estimated residual value of a leased asset should not exceed its fair value at
lease commencement.

Question 3-15

Would it be appropriate for a lessor to use a negative discount rate to avoid recording a day-1 loss in
arrangements where there are significant variable payments?

PwC response
No. The FASB confirmed that they did not intend for the rate implicit in the lease to be less than zero.

Incremental borrowing rate

The ASC 842 Glossary provides the following definition of incremental borrowing rate.

Definition from ASC 842 Glossary
Incremental Borrowing Rate: The rate of interest that a lessee would have to pay to borrow on a
collateralized basis over a similar term an amount equal to the lease payments in a similar economic
environment.

The definition of an incremental borrowing rate has changed from the definition in ASC 840.
Previously, the incremental borrowing rate was the rate that, at lease inception, a lessee would have
incurred to borrow over a similar term the funds necessary to purchase the leased asset. This
definition did not prohibit the lessee’s use of a secured borrowing rate as its incremental borrowing
rate if that rate was determinable, reasonable, and consistent with the financing that would have been
used in the particular circumstances. Accordingly, when a lessee was not reasonably able to borrow all
the funds necessary on a secured basis (e.g., when the loan-to-value was less than 100%), it may have
used a weighted-average rate that considered both secured and unsecured sources of funds.

ASC 842 requires a lessee to use a secured rate. Accordingly, the use of unsecured funding sources
may not be considered.

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