Leading the finance function
for a captive finance company is challenging. Captives exist to enable sales of equipment while providing creative financing solutions to the customer. Accounting for financing transactions arranged by a captive often needs to be viewed in the context of the affiliated vendor entity. Increasingly, customers are looking for risk-sharing solutions for equipment as well as contracts that encompass the use of equipment, service and other deliverables.
Common structures include pay-per-use leases, asset remarketing services and end-of-term activities (i.e., sharing of gains/losses, residual value guarantees and put/call options).
When accounting for transactions involving leases, the captive needs to consider the intersection of revenue recognition and lease accounting with respect to measurement for the sale of equipment, service and other deliverables. Accounting considerations include:
• Allocation of consideration to multiple components of the contract
• Lease classification and measurement
• Transfer of control
Pay-per-use, a common leasing structure with copiers, is increasingly popular in leases involving other types of equipment. Where a customer’s revenue is derived from the usage of leased equipment, it is helpful to have rentals aligned to the revenue and cash generated by the usage of the equipment. These structures can involve leases with nominal fixed rentals and variable rentals that are determined based on the usage of the equipment. The calculations of the variable consideration can vary and create all sorts of operational complexity, but ultimately both the lessee and lessor need to properly account for the arrangement.
Further, where the contract with the customer includes an embedded lease and service, captives and affiliated vendors need to consider the revenue recognition implications of the pay-per-use structure in relation to the multiple components in the arrangement.
Below, we’ll address (1) allocation of consideration in a multiple component arrangement between an equipment lease and service; and (2) lease accounting for fixed and variable rentals and a recently issued ASU.
For the allocation of consideration between equipment and service, ASC 842-10-15-38 states “a lessor shall allocate… the consideration in the contract to the separate lease and nonlease components using the requirements in 606-10-32-28 through 32-41…” This provides for obtaining the standalone transaction price for each component. The relative fair value of the components of the contract should be used to allocate the consideration paid by the customer to the sales of equipment and services. This example assumes the embedded lease is classified as a sales-type lease.
Increasingly, customers are looking for
risk-sharing solutions for equipment.
Another item to consider is the treatment of variable rentals in the context of lease classification. ASC 842 requires that a lessor determine whether a lease should be classified as a sales-type lease or a direct financing lease at lease commencement on the basis of specified classification criteria (842-10-25-2 through 25-3). A lessor is not permitted to estimate most variable payments and must exclude variable payments that are not estimated. Subsequently, those excluded variable payments are recognized entirely as lease income when the changes in facts and circumstances on which those variable payments are based occur. Consequently, the net investment in the lease with variable payments of a certain magnitude that do not depend on a reference index or a rate may be less than the carrying amount of the underlying asset derecognized at lease commencement. As a result, the lessor recognizes a selling loss at lease commencement (“Day 1 loss”) even if the lessor expects the arrangement to be profitable.
The concern raised to the FASB highlighted the issue that recognizing a Day 1 loss for a sales-type lease with variable payments results in reporting results that do not represent the underlying economics of the transaction.
The key update as a result of ASU 2021-05 is the amended paragraph 842-10-25-3A which requires the lessor to classify a lease as an operating lease if classifying as a sales-type or direct financing lease would result in a Day 1 loss.
This amendment essentially reinstates a longstanding practice based on interpretations of ASC 840. ASU 2021-05 is effective for fiscal years beginning after Dec. 15, 2021 for all entities that have adopted ASC 842 and may be applied retrospectively or prospectively.
In certain circumstances, captive finance entities may arrange lease financing by unaffiliated financial institutions in order to enable equipment sales of the affiliated vendor. Often, the third-party lessor may not be interested in or capable of managing the end-of-term scenarios in a lease, particularly when a lessee returns equipment at the end of the lease. Captive finance entities may provide certain remarketing services or have an agreement with the third party that results in the captive finance entity potentially repurchasing the equipment.
In these situations, captives and affiliated vendors need to be careful not to run afoul with these repurchase/remarketing arrangements, causing them to jeopardize recognition of the sale of the equipment under ASC 606 at the outset of the transaction.
Repurchases may result from call options held by the captive, put options for the third party to sell to the captive, or both. Further, the price for such options may be contractually agreed to be the fair value at the time of the transaction or a fixed price based on the estimated residual value that is determined at inception of the lease.
The overarching question to ask is what is the impact of any put or call option in determining whether the vendor has transferred control in accordance with the repurchase agreement literature in ASC 606-10-55-66-77. Careful consideration should also be given in analyzing whether other contractual rights or obligations exist that could effectively lead to implicit or in-substance options that prevent control transfer.
These are just a few examples of structures involving leases that are used by captive finance entities. As always, it’s very important to first understand what accounting model is applicable to the transaction. And, for captive finance entities, it’s usually a good idea to understand what implications, if any, the financing structure will have on the accounting for sales of equipment and service by their affiliated vendors.
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