Can a loan guarantees create liabilities that go on the balance sheet of the guarantor?
Yes.
Recording Loan Guarantees
FASB 5 (now ASC 450) has been with us for some time. It states that a company should record a contingent liability if two things occur:
The liability is subject to estimation (you can calculate it)
It is probable that the liability will be paid
ASC 450 addresses these contingent liabilities.
FIN 45 (now ASC 460) was issued in the early 2000s to clarify that some loan guarantees create liabilities–even when there is no loan default. ASC 460 deals with noncontingent liabilities. And it’s the noncontingent piece that confuses everyone (including me). So let’s first take a look at noncontingent liabilities.
Noncontingent Liability
ABC Co. guarantees a $2,000,000 loan of XYZ Co. (an unrelated entity); in exchange, XYZ agrees to pay a fee of $50,000.
Should ABC Co. record a liability for the guarantee? Yes.
What’s the entry?
Dr. Cr.
Accounts Receivable $50,000
Guarantee Liability $50,000
The standard allows the guarantor to use the guarantee fee as a practical expedient to valuing the loan guarantee.
What if there is no guarantee fee? For instance, let’s say ABC Co. guarantees a loan for Sidewalk Safety Nonprofit, Inc. This guarantee is provided to the nonprofit free of charge. How would ABC Co. record this guarantee?
First ABC Co. would need to determine the value of the guarantee. If Sidewalk Safety’s interest rate is 8% without the guarantee, but now it’s 4%, then you can compute the differential using present value calculations. Let’s say the result is $40,000, what is the entry?
Dr. Cr.
Guarantee Expense (Contribution) $40,000
Guarantee Liability $40,000
Guarantee of Related Party Debt
What if the loan guarantee is for an entity owned by the same parties? If the guarantee is on the debt of a related entity under common control, ASC 460-10-25-1 exempts the guarantor from the requirement to record the guarantee liability.
Next, we’ll see how to relieve the guarantee liability.
Guarantee Liability – In Subsequent Periods
After inception, the fair value liability (for both examples above) is taken to income as the guarantor is released from risk; the liability is to be adjusted to fair value at the period end.
ASC 460 does not provide detailed guidance as to how the guarantor’s initial liability should be measured after its initial recognition. Depending on the nature of the guarantee, the guarantor’s release from risk is recognized with an increase to earnings using one of three methods:
Systematic and rational
Deferring until expiration or settlement of the guarantee
Remeasurement at fair value (for guarantees accounted for as derivatives)
You now know how to account for the noncontingent liability, but what if the guaranteed party defaults on the loan. Now the guarantor needs to record the loan as a liability.
Contingent Liability
For example, what if Sidewalk Safety defaults on the loan? Then ABC Co. needs to book a liability for the remaining debt. Sidewalk Safety’s default triggers ASC 450.
This is the contingent piece of the equation (for which no amount is typically recorded at the inception of the guarantee). Upon Sidewalk Safety’s default, the debt amount is subject to estimation and payment is probable. ABC Co. is on the hook for the remaining debt.
Debt issuance costs have a new parking place. For some time now, such costs were booked as a deferred charge (an asset). Now, these cost will be netted with the related debt.
This change is required by Accounting Standards Update No. 2015-03, Interest – Imputation of Interest, Simplifying the Presentation of Debt Issuance Costs (Subtopic 835-30).
If you have not already done so, you need to adopt this standard for years ending December 31, 2016. This is a change in accounting principle.
Accounting for Debt Issuance Costs
ASU 2015-03 (ASC 835-30) states the following (bold emphasis mine):
To simplify the presentation of debt issuance costs, the amendments in this Update require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.
Do you ever need to solve accounting problems quickly?
I often hear the words, “Hey Charles, I’ve got a quick question,” and they launch into their issue, hopeful I can look into my crystal ball and give them an answer. As it turns out, I do have one. I keep it on my desktop. You probably have one too.
Most CPAs, when confronted with an accounting Gordian Knot, begin their quest to cut through the problem with their mighty sword–the GAAP Guide. Ah, an excellent choice for sure, but is it the best place to start? Or how about the granddaddy of them all? The FASB Codification. Another fine choice, but it’s an 800-pound gorilla. So where’s the best place to start? Thecrystal ball.
And what is the crystal ball? It’s your disclosure checklist.
You say, “but it’s just a laundry list of accounting requirements.” Yes, but it’s a great pointer (to answers).
To solve accounting problems quickly, do a word search in your disclosure checklist. My checklist is in Word, so I use the find feature (click control, find) to locate a keyword. Try to use a unique word where possible–such as noninterest or contingent. You may have to click next a few times to locate the relevant text. Once you find the relevant text, the pathway to your solution lies before you: the checklist provides you with the applicable FASB Codification ASC section (e.g., 850-10-50-5).You can key the number in the FASB Codification or your research libraryto find your answer.
Now you can provide a quick answer to that difficult question (and look like a genius). When your peers ask, “How did you find the answer so quickly?” Tell them, “My crystal ball.”
Most CPAs grapple with leases from the lessee’s point of view, so in this post, we’ll take a look at leases from the lessee’s perspective. Under the new lease standard, what are the types of leases? Does the accounting vary based on the type of lease? Are lease expenses different?
First, let’s start by defining the types of leases and how to classify them.
The Types of Leases
Upon the commencement date of the lease, the company should classify the lease as either a finance or an operating lease. (Under present lease standards a finance lease is referred to as a capital lease.)
Finance Lease
So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:
The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
The lease grants the lessee an option to purchase the underlying asset 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 (today we use the 75% rule)
The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
While the bright-line criteria (e.g., the lease term of 75% or more of economic life) have been removed, the basis for conclusions in the new lease standard acknowledges some of the old rules of thumb. It says that one reasonable approach to determining whether the lease is for a major portion of the asset’s life is the 75% threshold. The conclusion goes on to say that “90 percent or greater is ‘substantially all’ the fair value of the underlying asset.” So, in effect, FASB removed the bright-lines as a rule but not in principle–the conclusion says FASB “does not mandate those bright lines.”
Operating Lease
And what is an operating lease? It’s any lease that is not a financing lease.
Accounting Similarities and Differences
Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases is quite different.
Finance Lease Accounting
The accounting for a finance lease is similar to capital lease accounting under present standards.
When a company enters into a finance lease, it will record the right-of-use asset and the lease liability. The amortization of the right-of-use asset will be straight-line and the amortization of the liability will be accounted for using the effective interest method. Consequently, lease expenses are front-loaded (i.e., expenses will decline throughout the lease term). The amortization expense and the interest expense will be presented separately on the income statement.
As we are about to see, operating lease accounting is significantly different, particularly with regard to accounting for the lease expense and the amortization of the right-of-use asset.
Operating Lease Accounting
The primary change in lease accounting lies in the operating lease area. Under ASC 842 a company will book a right-of-use asset and a lease liability for all operating leases greater than twelve months in length. (Under current lease standards, no asset or liability is recorded.) Will the operating lease expense be any different than it has been? No. But the recording and amortization of the right-of-use asset and the lease liability is new.
The Initial Operating Lease Entries
Let’s say a company has a five-year operating lease for $1,000 per month and will pay $60,000 over the life of the lease. How do we account for this lease? First, the company records the right-of-use asset and the lease liability by discounting the present value of the payments using the effective interest method. In this example, the present value might be $54,000. As the right-of-use asset and lease liability are amortized the company will (each month) debit rent expense for $1,000—the amount the company is paying. So the expense amount is still the same as it was under ASC 840.
Amortizing the Right-of-Use Asset and the Lease Liability
Well, how does the company amortize the right-of-use asset and the lease liability? The lease liability is amortized using the effective interest method, and the interest expense is a component of the rent expense. What’s the remainder of the $1,000? The amortization of the right-of-use asset. The $1,000 rent expense is made up of two components: (1) the interest expense for the month and (2) the right-of-use amortization amount which is a plug to make the entry balance. Even though the rent expense is made up of these two components, it appears on the income statement as one line: rent expense (unlike the finance lease which reflects interest expense and amortization expense separately).
Potential Impairments
Due to the mechanics of the straight-line lease expense calculation, the right-of-use asset amortization expense is back-loaded (i.e. the amortization expense component is less in the early part of the lease). One potential consequence of this slower amortization is the right-of-use asset may be subject to impairment, especially toward the end of the lease. The impairment rules do apply to the right-of-use asset.
Your Thoughts
So, what do you think of the new lease accounting? Is it better? Worse?
In my last lease post, we saw that bright-line criteria (e.g., lease terms of 75% or more of economic life and minimum lease payments of 90% or more of fair market value) are eliminated with ASU 2016-02. Consequently, almost all leases—including operating leases—will create lease liabilities. This accounting change will alter the leasing industry.
Picture from AdobeStock.com
Lessees are presently paying high lease interest rates to obtain operating lease treatment (no lease debt is recorded). Now—with the new lease standard—those same operating leases will generate lease liabilities. So why would the lessee pay the higher interest rate? There is nothing to be gained. Lessees will begin to borrow money from banks (at a lower rate). And they will buy the formerly leased asset, or they will demand lower interest rates from the lessor. Lessees, I think, will obtain better interest rates.
The Scope of the Lease Standard
To what does the lease standard apply? It applies to leases of property, plant, and equipment (identified asset) based on a contract that conveys control to the lessee for a period of time in exchange for consideration. The period may be described in relation to the amount of usage (e.g., units produced). Also, the identified asset must be physically distinct (e.g., a floor of a building).
Control over the use of the leased asset means the customer has both:
The right to obtain substantially all of the economic benefits from the use of the identified asset
The right to direct the use of the asset
To what does the standard not apply?
The lease standard does not apply to the following:
Leases of intangible assets, including licenses of internal-use software
Leases to explore for or use minerals, oil, natural gas, and similar resources
So what is a finance lease? A lease is considered a finance lease if it meets any of the following criteria:
The lease transfers ownership of the underlying asset to the lessee by the end of the lease term
The lease grants the lessee an option to purchase the underlying asset 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 (today we use the 75% rule)
The present value of the sum of the lease payments and residual value guarantee equals or exceeds substantially all of the fair value of the underlying asset (today we use the 90% rule)
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term
And what is an operating lease? It’s any lease that is not a financing lease.
Both operating and finance leases result in a right-of-use asset and a lease liability. The subsequent accounting for the two types of leases will be different (a topic we’ll cover in my next lease post).
Related Party Leases
Leases between related parties will be classified just as any other lease will be. Companies will look to the legally enforceable terms and conditions of the lease to determine whether a lease contract exists. If a lease contract exists, the agreement will be treated as a lease with the lessor reflecting a sale and the lessee capitalizing the related lease liability and right-of-use asset.
Are there any leases that will not result in a right-of-use asset and a lease liability? Yes, those with terms of twelve months or less.
Lease Terms of Less Than 12 Months
Companies do have the option to not capitalize a lease of 12 months or less. To do so, the company must make an accounting policy election (by class of the underlying leased asset). Companies that use the election will recognize lease expenses on a straight-line basis, and no right of use asset or lease liability will be recorded. If, however, the terms of the short-term lease change, the agreement could become one in which the lease is capitalized–for example, if the lease term changes to greater than twelve months. (Expect to see plenty of leases terms of twelve months or less.)
Month-to-month leases will usually not be capitalized if the accounting policy election is taken. Consider, however, any options to renew or if the leases contain “mutual” renewal options. Once the noncancelable period is over and the contract is no longer enforceable, the lease becomes an “at-will” arrangement.
ASC 842-10-30-1 defines the lease term as the noncancelable period of the lease together with all of the following:
Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor
Getting Ready for the New Lease Standard
Companies can ready themselves for implementation of the new lease standard by doing the following:
Take an educational class that explains the particulars of the lease standard
Create an inventory of all leases (I would use an Excel spreadsheet and create a worksheet summarizing financing leases and another worksheet for operating leases)
Obtain copies of all lease agreements to support the inventory of leases (note–some verbal lease contracts are enforceable)
Determine the terms of the leases (see ASC 842-10-30-1 above)
Segregate the lease and non-lease (e.g., maintenance, cleaning) components in the lease contracts (companies will usually capitalize just the lease portion, though ASC 842-10-15-37 allows a lessee to make an election to not separate the non-lease component)
Document judgments made such as whether the lessee is reasonably certain to exercise a renewal extension
Compute all lease liabilities and right-of-use asset amounts
Determine whether the implementation of the standard might adversely affect the company’s compliance with debt covenants (you may want to discuss the impact with your lenders)
While this list is not comprehensive, performing these actions will assist you in preparing for implementation of the lease standard.
For public entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years.
For all other entities, the standard is effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020.
Early implementation is permissible for all entities.
More Lease Information Coming
We’ll continue this series of lease posts next week. So stay tuned.
