The new current expected credit loss (CECL) impairment model is applicable to lessors for certain types of leases. The CECL model applies to net investments in leases associated with sales-type leases and direct financing leases. The FASB recognized that these receivables include both financial and non-financial elements, but concluded that the application of a single impairment model to the recognized lease asset would be preferable to assessing different components of a single asset under different impairment models.
The FASB recently amended the CECL guidance to clarify that receivables arising from operating leases are not within the scope of CECL. The FASB noted that the new leases standard has a specific model to assess the collectability of operating lease payments and guidance on how to recognize lease income based on those payments that is operational and well understood.
The net investment in a lease has a number of components. Some of the components are financial elements that involve credit risk as that term is traditionally thought of, that is, the risk that a party may fail to perform on its obligation. Other components of the balance involve non-financial risks.
The financial components of the net investment in a lease include rental payments and any residual value guarantee where the lessee or guarantor could fail to perform on their obligations. The rental payments are an obligation of the lessee to make payments that are collateralized by the leased asset. In the event the lessee defaults on its obligation to make rental payments, the lessor generally has a right to the return of the leased asset, which mitigates any losses incurred as a result of a lessee default. This is similar to a collateralized loan in which a lender can foreclose or seize the collateral if a borrower defaults.
Some net investment in lease balances also include a non-financial component relating to an estimated unguaranteed residual value of the leased asset. This represents a contractual right that is not a stated contractual cash flow. The value of the right to the return of the asset at the end of the lease depends on the value of the asset at that time. In addition, unlike in most traditional loans, if the lessee defaults on its obligation and the lessor repossesses the leased asset, the lessor does not return any excess of the value of the leased asset over what the borrower owes. Thus, there is a potential for an economic gain upon obtaining the leased asset either through repossession or upon return of the leased asset at the maturity of the lease.
The lessee might also have an option embedded in the lease to purchase the leased asset at a stated price. This option may impact the cash flows that would be received as compared to a lease without a purchase option if, for example, the residual value of the asset is higher than the purchase price.
A net investment in a lease may have other components that impact its amortized cost balance, including deferred selling profit or deferred costs. While these amounts may not be a source of future cash flows, they impact the amortized cost basis of the net investment of the lease and therefore may impact the CECL estimate. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net amount expected to be collected on the financial asset.
The CECL model requires an allowance for credit losses to be recognized on the date that a sales-type lease or direct financing lease receivable is recognized, either through origination or acquisition. The guidance requires an entity’s estimate of expected credit losses to include a measure of the expected risk of credit loss even if that risk is remote. It also requires that the measurement of credit losses be on a collective (pool) basis when individual assets share similar risk characteristics.
For leases that are originated, the initial measurement of the allowance for credit losses will be recorded through earnings.
For leases that will be accounted for as sales-type or direct financing leases acquired either though a business combination or an asset purchase, we believe an entity should assess whether the acquired leases would be considered purchased credit deteriorated (PCD). To the extent a lease is not considered PCD, the initial measurement of the allowance for credit losses would be reported in current earnings (similar to an originated lease). If a lease is considered PCD, the initial measurement of the allowance for credit losses will create a basis adjustment to the amortized cost basis of the net investment in lease. This is commonly referred to as a “gross up” as the initial entry to establish the allowance adjusts the carrying value of the asset. See Chapter 9 in PwC’s Loans and investments guide for additional information on the purchased credit deteriorated model.
The PCD initial recognition model is an integral part of the new credit impairment guidance. Since the FASB concluded that the impairment of sales-type and direct financing leases should follow the CECL model (of which the PCD guidance is a component) we believe that the PCD guidance is applicable to these leases as well.
Since a net investment in a lease balance includes non-financial elements, these elements will impact the determination of whether the net investment is considered PCD. For example, the estimated residual value of the leased asset will impact the net investment in a lease. If there has been a decline in the estimated residual value, this decline in value is considered a credit loss and therefore could impact whether the net investment in the lease is considered PCD if acquired. In addition, declines in the estimated residual value of the leased asset since the lease’s origination could impact the amount of the “day one” allowance for a lease. To estimate the allowance upon acquisition of a lease, the purchaser will need to estimate what the residual value of the asset at the end of the lease was forecasted to be at the inception of the lease.
One of the objectives of the PCD model is that after initial recognition, the originated assets and purchased assets that have experienced credit deterioration will apply the same credit loss and interest recognition models. The “gross up” that is recorded as an adjustment to the amortized cost basis of the net investment in the lease will impact the calculation of lease income over the life of the lease. The allowance would be released with an offset to earnings if estimated collections improve, similar to the treatment for originated assets.
In developing the CECL model, the FASB consciously allowed for a variety of acceptable techniques to estimate credit losses. Entities can utilize discounted cash flow models, undiscounted approaches, such as loss rate or probability of default/loss given default models, or other models.
With respect to sales-type and direct financing leases that have financial and non-financial components, entities should consider a number of factors in their analysis.
The rental payments component of the net investment in leases could be thought of similar to a collateralized loan with an amortizing principal balance. This component consists of contractually specified payments on specified dates and if the lessee defaults, the lessor has the ability to repossess the leased asset similar to a lender’s ability to foreclose on collateral for a loan. In this context, consideration should be given to the probability that the lessee will default and the loss given default considering amounts that may be collected from the lessee as well as the ability to obtain the leased asset.
Obtaining the asset at the maturity of the lease is dependent on the lease reaching its maturity. To the extent the lessee defaults, the loss incurred by the lessor is dependent on the fair value of the leased asset when repossessed as opposed to at maturity.
In some instances, the fair value of the leased asset may be forecasted to decline at a different pace than the amortized cost basis of the net investment in the lease. This could impact credit modeling at inception if it is forecasted that at different points in the life of the lease, the degree to which the rental payments are collateralized changes. For example, if the fair value of the leased asset declines in the early years of a lease faster than the amortized cost basis of the net investment, different losses may be realized depending on when a default is estimated to occur. This should be considered in an entity’s estimate of credit losses, and may be captured in an entity’s historic loss information, which may serve as a starting point for estimating credit losses.
The leasing guidance requires certain residual value guarantees to be considered in determining the lease classification and the measurement of the initial recognition of the net investment in the lease. As such, we believe that it should be considered in the assessment of credit losses.
This may result in considering the impact of residual value guarantees when seemingly similar credit insurance arrangements would not be considered. ASC 326 indicates that credit insurance arrangements that are considered freestanding contracts would not be considered in determining the allowance for credit losses. However, we believe that guidance was written in the context of loan accounting, in which freestanding credit insurance agreements are not considered in the determination of the initial carrying value of the loan as they are not part of the same unit of account. If under the leasing guidance, the unit of account of the lease includes the residual value guarantee, we believe the unit of account for the purposes of determining credit losses should include the residual value guarantee as well.
In considering the impact of any residual value guarantee, the degree to which the estimated fair value of the residual asset is below the guaranteed amount, as well as the credit risk of the guarantee provider, will be key inputs into modelling the impact of such guarantees.
The CECL model requires the measurement of credit losses to be on a collective (pool) basis when individual assets share similar risk characteristics. The implementation guidance provides some examples of factors that could be used to identify assets that share similar risk characteristics. Many of these factors (e.g., credit rating of the lessee, remaining term of the lease) will be relevant when considering if leases share similar characteristics.
The nature of the leased asset will likely be a key consideration in determining whether leases share similar characteristics. The value of the leased asset can impact the estimate of expected credit losses both with respect to serving as collateral against rental payments and based on its residual value. The volatility of the value of a leased asset, whether the value of the assets is correlated amongst the leases, and other similar considerations will also be relevant. For example, it may not be appropriate to create a single portfolio of auto leases that includes some leases of small cars and others for large pickups and SUVs as those assets would not be expected to have similar risks with respect to their residual values.
At the June 11, 2018 Transition Resource Group for Credit Losses (TRG) meeting, the FASB staff shared their perspectives that expected gains on the disposal of leased assets should be included in an estimate of expected credit losses for a pool of lease receivables. Including expected gains serves to reduce credit losses within the pool (“offsetting” losses such as lessee default or declines in the residual value of other assets).
Some noted that using expected gains on the disposition of leased assets to offset credit losses effectively includes that gain in earnings before it is realized. In their conclusion, the FASB staff noted that the guidance requires the net investment in lease (including the residual value of the asset) to be evaluated as a single unit and that a pool-level assessment does not preclude including cash flows associated with the disposition of the asset.
To the extent that a pool includes leases with substantial expected gains on the disposal of the leased assets and substantial losses on the disposition of other leased assets, this may indicate that the leases do not share similar risk characteristics. As a result, the leases may need to be assessed as part of other pools of leases or be assessed individually for credit losses if they no longer share common risk characteristics with other leases.
The existence of a residual value guarantee (that is considered part of the unit of the account of the lease) and the credit risk of the provider of that guarantee (whether it is the lessee or a third party) may also be key factors in evaluating whether leases share similar risks characteristics.
Estimated credit losses on sales-type and direct financing lease receivables are reflected through an allowance for credit losses account, which is separately reported in the financial statements as a deduction from the amortized cost basis of the asset. The CECL model requires assessments of allowance amounts to determine whether they should be written off against the amortized cost basis of the receivables. Receivables (and allowance accounts) are written off either in full or in part when such amounts are deemed uncollectible.
For leases, each component of a lease receivable (financial or non-financial) could cause a write-off.
Companies may need to establish policies and procedures to determine when receivables (and allowance balances) should be written off.
The credit loss guidance provides a practical expedient under which an allowance can be measured based upon the difference between the fair value of collateral and the amortized cost basis when the borrower is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the collateral. If collection would be achieved through the sale of the collateral, costs to sell must also be considered. This method of calculating an allowance is required when foreclosure is deemed probable.
The collateral dependent practical expedient and the requirement to use collateral value when foreclosure is probable are elements that are integral to the CECL model. As a result, similar to the PCD guidance, we believe that the collateral dependent practical expedient could be used for leases and the requirement to use collateral value when “foreclosure” is probable should be applied to leases.
We do not believe that this guidance should be applied in situations when the lessee has performed (and is expected to perform) on its obligations to make payments and the leased asset is returned to the lessor at the expiration of the lease in accordance with the lease’s contractual provisions. However, if the lessee is experiencing financial difficulty and repayment is expected to be provided substantially through the operation or sale of the leased asset following repossession, we believe that the collateral dependent practical expedient can be applied. In addition, if it is probable that the lessee will default and the lessor will repossess the leased asset, we believe that the fair value of the leased asset must be used in the determination of the allowance.
In some cases, a lessor may sell the receivable associated with future rental payments but retain ownership of the leased asset. ASC 860 is the applicable guidance for determining whether that transfer would be accounted for as a sale resulting in derecognition of the receivable. In instances when the transfer of the receivable is accounted for as a sale, and the asset remaining relates to the unguaranteed residual value, the leasing guidance states that the lessor should begin applying ASC 360, Property, Plant and Equipment, to determine whether the unguaranteed residual asset is impaired. As a result, the CECL model would no longer be applicable.
We do not believe that this guidance should be extended to address situations when the lessor has not transferred receivables and simply as a result of a lessor making payments, the net investment of the lease consists principally of the estimated residual value of the leased asset. In these situations, we believe it is appropriate to continue applying the credit loss model in ASC 326 until the leased asset is obtained.
The new leasing guidance is effective for calendar year public business entities, not-for-profit entities that have issued or are a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and employee benefit plans that file or furnish financial statements with or to the SEC. Other entities have an additional year to adopt.
CECL is effective for calendar year public business entities that meet the definition of an SEC filer on January 1, 2020. Public business entities that do not meet the definition of an SEC filer, have an additional year to adopt and other entities have an additional 2 years to adopt.
Companies should continue to build and test models to develop credit loss estimates for lease receivables. The FASB continues to discuss certain elements of the credit loss guidance, and recently issued codification improvements. Industry groups continue to discuss implementation questions, such as potential differences in the treatment of termination and extension options under the leasing and credit losses guidance. Companies should continue to monitor the activities of the FASB, TRG, and industry discussions.
For additional information on the credit loss impairment model, see our Loans and Investments guide.