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Leveraged leases

leased asset (tax regulations required the lessor to have a minimum of 20% of the cost of the leased
asset “at-risk”). This typically enabled lessors to claim all the tax benefits of owning the asset,
including deductions for interest expense on the nonrecourse financing, despite a relatively small
investment.

The tax benefits associated with investing in the asset are typically realized relatively early in the lease
term. Given the early return of investment, a lessor in a leveraged lease was able to offer a lessee a
lower cost of borrowing than the lessee might have been able to obtain in a financed purchase
transaction.

Changes in tax regulations related to depreciation and investment tax credits, as well as the reduction
in corporate tax rates during the 1980’s reduced the tax benefits of leveraged leases to lessors, as well
as their attractiveness to investors. Accordingly, many existing leveraged leases are in the later part of
their lease terms.

7.2.3 Financial statement presentation of leveraged leases and income recognition

The balance sheet presentation (as described in ASC 840-30-30-14) and income recognition pattern
for a leveraged lease (as described in ASC 840-30-35-33 through 35-36) are both unique models.

Leveraged leases are presented as a net asset on the lessor’s balance sheet. The net asset equals the
sum of the total rents receivable from the lessee and the estimated residual value of the asset at the
expiration of the lease less the debt service associated with the nonrecourse debt, all reduced by
unearned income. This net presentation is attractive to lessors as it enhances its investment return on
assets.

Income from a leveraged lease is recognized by the lessor by applying a level rate of return to the net
investment, but only in the periods that the net investment is positive. Because the calculated return is
an after-tax amount, the cash flows from accelerated tax benefits are included in the overall leveraged
lease cash flows. These cash flows occur in the early years of the lease and result in a rapid recovery of
(i.e., decline in) the net investment, often causing the net investment to turn negative. The lessor will
ultimately “reinvest” in the leveraged lease through the repayment of deferred tax liabilities, causing
the net investment to increase in the later periods of the lease. This typical down and up pattern in the
net investment causes a substantial portion of the income to be recognized in the early periods of the
lease, which is a recognition pattern that is far more accelerated than a typical loan amortization (i.e.,
effective interest) pattern.

Although the accounting for leveraged leases is inherently inconsistent with accounting for other
collateralized financings, the FASB decided to allow lessors to continue to apply the leveraged lease
model because of the relatively small population of leveraged leases, the relative age of the lease
arrangements, and the fact that this accounting model is only applicable to lessors. A leveraged lease
may no longer be grandfathered if the lessor modifies or changes the characteristics of the lease.

7.3 Changes to a leveraged lease arrangement

Once a lessor adopts ASC 842, it may only continue to apply leveraged lease accounting to
grandfathered leveraged leases. A lessor should account for any leveraged lease that is modified on or
after the effective date of ASC 842 as a new lease as of the effective date of the modification in

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