Leases – Part Five

Five Areas Where It’s Easy to Stump Your Toe

ASC 842 is in full swing now. Most private companies and CPA firms have been in the weeds for some time. It would be an understatement to say the standard is massive and not entirely transparent. Because ASC 842 is principle-based and yet very specific in certain areas, it’s far too easy to make implementation errors. In no particular order, here are my top five areas prone to mistakes.

  1. Misunderstanding the Effective Date for Interim Financial Statements. The effective date for private companies and private not-for-profit entities is fiscal years beginning after December 15, 2021. This includes all annual financial statements with dates that begin in 2022. However, it does not include interim periods that begin in 2022. For example, a company that prepares interim financial statements for May 1, 2022, through October 31, 2022, would account for leases under ASC 840 unless the company implements ASC 842 early. This is because the FASB set the effective date for interim financial statements for a year later, i.e., interim periods beginning after December 15, 2022.

  2. Not Giving Sufficient Thought to Elections. The standard is replete with various elections that can significantly affect the complexity and results of lease accounting. These elections include:
    • Short-term lease. This is a very beneficial election made at the class level to not apply the lease standard to leases of twelve months or less.
    • Nonlease components. This is an election, made at the class level, to combine lease and non-lease components as a single lease component. This election can significantly reduce the complexity of accounting but may increase the lease liability.
    • Discount rate. This is an election, made at the class level, to use the risk-free rate to measure the lease liability. This election reduces complexity but will generally increase the lease liability.
    • Classification Criteria. One classification criterion is determining if the lease term is a major part of the underlying asset’s economic life. A policy election may be made to define major part as 75%. Another classification criterion is determining if the lease payments’ present value is substantially all of the fair value of the underlying asset. An election can be made to define substantially all as 90%.

      These elections bring back the bright-line rules under ASC 840. The good thing about these elections is that they provide a bright line. But the bad thing about these elections is that the decision is made using bright lines instead of professional judgment.

    • Transition Package Election. Transition relief must be elected as a package that streamlines and simplifies the transition of leases under the old standard to ASC 842.

  3. Embedded Leases. Are you familiar with the Shakespearian expression “beware the Ides of March”? Well, beware of embedded leases. They can hide in service contracts, subcontracts, and who knows where? Even though not described as such, they are leases in sheep’s clothing that must be carved out and accounted for as leases under ASC 842. Think in terms of significant underlying assets, like cranes and scaffolding.

  4. Reasonably Certain. What is reasonably certain? This one is hard to tie up into a nice pretty bow. Even though the concept of reasonably certain is critical under the standard, it is not defined in ASC 842.

    In which areas does the concept of reasonably certain become important?

    • Options to extend the lease term
    • Options to purchase the underlying asset
    • Options to terminate the lease
    • Lease classification (finance or operating)
    • Short-term lease election
    • Lease liabilities measurement
    • Lease ROU asset measurement

    As can be seen, the concept impacts several essential areas. Even though important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

  5. ROU Asset Life. It’s far too easy to stump your toe in this area and, therefore, really mess up the ROU amortization. The ROU asset life is usually the same as the lease term. “ROU asset life equals the lease term” can become automatic to us. After all, this is lease accounting. However, suppose you have a finance lease that transfers ownership or is almost certain to transfer ownership of the underlying asset to the lessee. In that case, the ROU asset’s life is the useful life of the underlying asset (not the lease term.)

    ASC 842-20-35-8 states the following:

    A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset.

Leases – Part Four

Common Control Lease Arrangements – Give Me a Break?

On November 30, 2022, the FASB issued, for public comment, Exposure Draft 2022-ED500 Leases (Topic 842)-Common Control Arrangements (Update). The Update proposes significant changes to common control arrangements (leases between related party entities) in two areas:

Issue 1. Determining if a related party lease between entities under common control exists and, if so, the classification and accounting for that lease, and

Issue 2. Lessee accounting for leasehold improvements associated with leases between parties under common control.

The proposed amendment to Issue 1 above would be available as a practical expedient for private companies and most not-for-profit entities. The proposed changes to Issue 2 above would be open to all entities (public, private, and not-for-profit.)

Comments are due January 16, 2023. Based on the AICPA’s discussions with the FASB staff, the Board will attempt to promptly issue a final ASU after considering public comment.

Will it be effective for private companies implementing ASC 842 in 2022? Maybe. However, in the exposure draft, the Board decided it would establish the effective date of the final amendment after receiving comments. If the exposure draft is issued as written, it will provide improved clarity and simplification to the determination, classification, and accounting for related party entity leases. Additionally, it will more faithfully represent the economic realities of leasehold improvement for related party leases between entities under common control.

Related Party Arrangements. Under ASC 842, companies are to determine if a related party arrangement is a lease and, if so, classify and account for the lease based on legally enforceable terms and conditions. However, what is legally enforceable between related parties under common control can be complex. Often, related party entities are owned by the same individual or group of individuals; thus, determining legally enforceable terms is ambiguous at best. In addition, there are often roadblocks in obtaining a meaningful legal opinion on a hypothetical with such a potentially fluid fact pattern.

This determination is often complicated by the existence of substantial leasehold improvements to the underlying lease asset made and owned by the related party lessee. ASC 842 generally requires leasehold improvements to be amortized over the shorter of the remaining lease term or the useful life of the leasehold improvements. This approach often does not recognize the economic realities between related parties under common control and may distort the presentation of operations.

But the Update appears to provide some much-needed relief. Here’s what it proposes.

Issue 1: Terms and Conditions to be Considered. A practical expedient is provided whereby the written terms and conditions of a common control arrangement (in contrast to the legally enforceable terms and conditions provision found in ASC 842) are used to determine the following:

  1. Whether a lease exists and, if so,
  2. The classification of and accounting for that lease.

Under the practical expediency, the Company would not be required to determine if the written terms are legally enforceable. Additionally, the practical expediency may be applied on an arrangement-by-arrangement basis. However, the practical expedient is not available if there are no written terms and conditions (i.e., no written contract). In such a case, the Company must continue using legally enforceable terms and conditions to apply the provisions in ASC 842.

Importantly, the Update permits the Company to document any existing unwritten terms and conditions of an arrangement between entities under common control before the date on which the Company’s first interim or annual financial statements are available to be issued in accordance with the amendments of the proposed Update.

Issue 2: Accounting for Leasehold Improvements. The Update would require the following for leasehold improvements associated with related party leases between entities under common control:

  1. Leasehold improvements should be amortized by the lessee over the economic life of the leasehold improvements (regardless of the lease term) as long as the lessee controls the underlying asset under a lease agreement.

    However, if the lessor obtained the right to control the underlying asset through a lease with an entity not part of the same controlled group, the amortization period may not exceed the lease term of the lessor’s unrelated party lease.

  2. Leasehold improvements should be accounted for as a transfer between related parties via an adjustment to equity when the lessee no longer controls the use of the underlying asset.

This is a significant change. As stated above, ASC 842 generally requires that leasehold improvements be amortized over the shorter of the remaining lease term or the useful life of the improvements. If the related party lease is classified as a short-term lease, the lessee’s operations could be punished because of misleading rapid amortization. Under the Update, generally, the amortization period would be the economic life of the leasehold improvements with respect to the related party group. This would be a significant and much-needed amendment to ASC 842.

Stay tuned. We’ll see what the FASB decides to do. And if the Board acts quickly enough, whether it will be applicable to unissued 2022 financial statements.

Leases – Part Three

Lease Accounting is No Cake-Walk

I remember when the Financial Accounting Standards Board issued FAS No. 13, Accounting for Leases, in November 1976. I was tasked with outlining the standard for the firm where I worked. Now, here it is in November, some 46 years later, and I’m looking at the latest rendition of the lease standard—ASC 842. When comparing the two, FAS 13 was much kinder and gentler than ASC 842, even though FAS 13 did not seem that way at the time. Under FAS 13, there were bright lines, and the accounting was more straightforward. For example, operating leases were not capitalized nor depreciated. On the other hand, capital leases, as the name implies, were capitalized and depreciated; thus, you could account for them in much the same way as you did with property, plant, and equipment.

However, ASC 842 requires capitalization of all leases on the balance sheet, both operating and finance leases. That is, unless you choose to make the short-term lease election not to capitalize a lease with a term of twelve months or less. Additionally, after the initial recording of the right-to-use asset and lease liability, ASC 842 requires different accounting for operating and finance leases on the income statement. This is because the FASB conceptually views finance leases more akin to property, plant, and equipment. But it considers operating leases conceptually more like the old FAS 13 operating leases and, therefore, affords them treatment on the income statement similar to that found in FAS 13.

This article will describe a few complex areas of ASC 842 for the lessee as a heads-up to those who have not yet made the deep dive into the (semi) new accounting standard. And by the way, if you are not up to speed on ASC 842 yet, it might be wise to set aside some time over the holidays to become more familiar with its oddities. It isn’t easy to wrap your head around it because leases are structured in countless ways. While the standard is principle-based to accommodate the many variations in lease agreements, it is also very specific in numerous areas to facilitate consistency in practice. And some of it may seem counter-intuitive.

The Components of a Lease Contract. A lease contract may specify payments for more types of components than just a lease component. Identifying each component of a lease contract is essential because each component type is to receive an allocation of the contract consideration, which is accounted for under different sections of the ASC.

A lease contract can have three broad components:

  1. Lease component
  2. Non-lease component
  3. Non-components

A good or service must be transferred to the lessee or customer to be considered a contract component. This is important because consideration in the contract is only allocated to components that transfer a good or service. Contract components are the first two identified above (i.e., lease component and non-lease component).

If the transfer of goods or services relates to an asset used in a leasing arrangement, it is considered a lease component subject to the rules of ASC 842. This includes leases for:

  • Real property (building and land)
  • Vehicles
  • Construction equipment
  • Copiers, etc.

All other payments for goods and services transferred in the contract are non-lease components accounted for under other GAAP (e.g., ASC 606 Revenue Recognition). This would include payments for:

  • Common area maintenance services
  • Management fees
  • Security services
  • Repairs and maintenance of the leased asset

Payments in the contract that are not for the transfer of goods and services are considered non-components. This would include the following:

  • Reimbursements of insurance and property taxes to the lessor or third party for the benefit of the lessor.
  • Administrative tasks to initiate the lease.

As stated above, contract consideration (see ASC 842-10-30-5 and ASC 842-10-15-35) is only allocated to lease and non-lease components. Notice that contract consideration is not assigned to non-components of the contract. This allocation can be a difficult and time-consuming process. However, the standard provides a way to simplify the accounting via an election to combine lease and non-lease components and treat all payments as lease payments.

The Consideration in a Contract. So what is consideration in a lease contract? Under ASC 842-10-30-5 – Consideration in the contract at the commencement date includes:

  • Fixed payments, including in substance fixed payments, less any lease incentives paid or payable
  • Variable lease payments that depend on an index or rate, initially measured using the index or rate at the commencement date
  • The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise the option
  • Payments for penalties for terminating the lease
  • Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
  • Amounts probable of being owed by the lessee under residual value guarantees

Additionally, ASC 842-10-15-35 specifies that consideration in a contract includes all payments described above in paragraph 842-10-30-5 as well as the following payments made during the lease term:

  • Any fixed payments or in substance fixed payments, less any incentives paid or payable
  • Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.

Notice that consideration in a contract can include payments for lease components, non-lease components, and non-components if it meets the criteria stated above. For example, fixed payments for lease components, non-lease components, and non-components would all be included as consideration in a contract. However, the contract consideration would only be allocated to the lease and non-lease components unless the election not to allocate is made. In such a case, all the fixed payments mentioned would be considered lease component payments.

The Underlying Land in a Building Lease. Building leases are somewhat problematic. Should the underlying land be considered a separate lease? The answer is “maybe yes and maybe no—it ain’t necessarily so.”

The initial question is whether the underlying land can even be considered a lease. ASC 842-10-15-3 defines a lease as follows:

A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

So the overriding question is whether the lessee has the right to control the use of the underlying land. A follow-up question is, does the lessee have the right to control all or a substantial portion of the use of the building? If so, it would seem that the lessee also has the right to control the use of the underlying land. This right to control the use of identified property (land) determines that the contract contains a land lease. So how much control is “substantial”? It’s a matter of judgment, but many commentators think the ability to control 90% or more of the economic benefits of the building is substantial control that enables the lessee to control 100% of the underlying land.

Once control of the underlying land is established and considered a separate lease component, should part of the consideration in the contract be allocated to the land lease? ASC 842-10-15-29 states that:

…an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land component would be insignificant.)

Therefore, land should be considered a separate component and be allocated a portion of the consideration in the contract unless doing so would be insignificant.

Leases – Part Two

Other Things That Make You Go Hmmm

Well, it’s here for private companies. Welcome to the universe of ASC 842. The lease standard is massive and, being a principle-based standard, leaves a lot of GAAP in gray areas. Yet, the standard is also specific, especially regarding disclosure. This blog, directed at the lessee’s accounting, is a follow-up to our May 2021 blog on leases and will focus on a few of the areas of ASC 842 that have given us some — shall we say, pause.

First Things First. Before we dive into the deep gray, let’s briefly review some of the core tenants of ASC 842 as it applies to the lessee.

  • To be a lease contract, it must have two elements:
    1. There must be an identified asset, and
    2. The lessee must have a right to control the use of the asset for a period of time.
  • All leases should be accounted for under the right-of-use (“ROU”) model. This model requires the recognition of lease right-of-use assets and lease liabilities.
  • Leases with a maximum possible lease term of twelve months or less may be exempted from the right-of-use model. This exemption is a policy election.
  • There are two types of leases:
    1. Finance lease and
    2. Operating lease.
  • Both types of leases are capitalized on the balance sheet. If a lease doesn’t meet the finance lease criteria, it is accounted for as an operating lease.
  • At the implementation date, there is no grandfathering of pre-existing active leases. Accordingly, the old capital or operating leases must be capitalized on the implementation date, under ASC 842, as finance or operating leases.

Materiality. Of course, the professional decision of what is not material to financial statement presentation is not a new concept under ASC 842. However, materiality is of utmost importance under the lease standard because the standard places a heavy burden on companies performing calculations to capitalize the leases, in addition to the future effort required to account for leases to completion. Because of this burden, care must be taken not to spend precious time capitalizing immaterial leases.

So what is immaterial? Initially, the company should have a reasonable lease capitalization policy stating a threshold under which all leases will automatically be considered immaterial and, therefore, not capitalize.

Beyond the company’s capitalization policy, the overall materiality of the potential ROU assets and lease liabilities to the financial statements should be considered. While materiality is both a quantitative and qualitative assessment, in the end, the qualitative evaluation carries the most weight. For example, if capitalizing a lease liability causes the company to violate a financial loan covenant, then that lease is material to the financial statements, notwithstanding the quantitative analysis.

Reasonably Certain. The term “reasonably certain” is not defined in ASC 842. However, even though not defined, it is a critical term. The reasonably certain threshold plays a sizable part in determining the:

  • Lease term;.
  • Lease classification (finance or operating lease);
  • Amount of lease payments;
  • Amount of ROU assets; and
  • Amount of lease liabilities.

Even though the concept of reasonably certain is important, there are no bright lines. Some commentators have suggested that reasonably certain is 75% or better certainty. Others have suggested that it is “almost certain.” One thing is certain, though. The certainty rests in the minds of the company’s decision-makers. It will take sound professional judgment to ascertain the degree of reasonableness.

Related Party Transactions. Under prior GAAP (ASC 840), the economic substance of the lease agreement determined how related party leases were classified. This, in turn, determined lease accounting. New GAAP changed things. Under ASC 842, leases between related parties are classified and accounted for based on legally enforceable terms. In short, lease accounting for leases between related parties is the same as accounting for leases between unrelated parties.

It sounds straightforward. But it’s not. Consider the following example:

The company(lessee) has three unrelated stockholders. One stockholder holds 60% of the stock. The minority stockholders each hold 20%. The company leases its operating facilities from an LLC lessor that is owned 100% by the majority stockholder of the lessee company. The company made substantial leasehold improvements with a fifteen-year useful life. The lease is month-to-month (unwritten). Questions: What is the lease term? What would be legally enforceable?

This type of lease arrangement, or similar, may put accountants in a dilemma. The majority owner of the lessee company, because he understandably wants to keep the lease obligation off the company’s separate(unconsolidated) financial statements, tells you that it’s a month-to-month lease. No doubt about it. It is not a long-term lease. The unwritten monthly options to renew will not extend longer than one year. After all, “reasonably certain” is in the mind of management — right?. However, the short-term lease status doesn’t make sense for several reasons. But primarily, it does not make sense because the substantial leasehold improvements, with a fifteen-year life, reflect an obvious intent to lease the operating facilities long-term.

It may be necessary to remind the majority owner, in very carefully chosen non-technical words, of course, that GAAP generally requires the leasehold improvements to be amortized over the lease term. So in this example, the improvements would be written off over twelve months. Ouch!

ASC 842-20-35-12 states the following:

Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life.

In the above example, the underlying asset (building) will not be transferred to or purchased by the company. This would not be to the advantage of the majority stockholder. Accordingly, the leasehold improvements must be amortized over the shorter of the lease term (twelve months or less) or the useful life of the building. The lease term is obviously shorter. This may cause the majority owner of the company to reconsider the lease term.

Leases – 10 Takeaways

It’s Almost Time To Implement ASC 842

The implementation date for the new lease standard for private companies is just around the corner. As amended by ASU 2020-5, the extended effective date is fiscal years beginning after December 15, 2021 (i.e., January 1, 2022, for calendar year companies). It doesn’t apply to interim periods until 2023. That gives private companies a bit more breathing room, but not much. The new lease standards are codified in ASC 842.

I suspect that many are not quite up to speed yet on the tenants of ASC 842. That’s understandable, given the pandemic, PPP loans, stimulus payments, and the many other rapid-fire legislation that have monopolized our time. Everyone has had their hands full. This standard is enormous, both in terms of print and the impact of its changes. This piece will highlight a few of the many primary provisions.

Our focus in this article is on lessee accounting. This is because most of the significant changes under ASC 842 are directed at the lessee instead of the lessor.

Brief History. Over forty years ago, the Financial Standards Accounting Board (“FASB”) issued the original standard, FAS 13 – Accounting for Leases. It’s been amended several times through the years. FAS 13 was later codified as ASC 840. For lessee accounting, ASC 840 categorized leases as either capital leases or operating leases. Capital leases were capitalized as assets and liabilities on the balance sheet, and operating leases were not. Instead, operating leases were expensed in the period incurred. Footnote disclosure provided information about long-term commitments for operating leases.

The prior standards under ASC 840 provided four criteria for classifying a lease as a capital lease. If none of the following criteria were met, the lease would be classified and accounted for as an operating lease:

  1. The lease transferred ownership of the property to the lessee by the end of the lease term.
  2. The lease contained a bargain purchase option.
  3. The lease term was equal to 75 percent or more of the estimated economic life of the leased property.
  4. At the beginning of the lease term, the present value of the minimum lease payments equaled or exceeded 90 percent of the fair value of the leased property.

Under the bright-line tests in nos. 3 and 4 above, many, if not most, leases were classified as operating leases and therefore not presented on the balance sheet under (soon to be) legacy ASC 840. Furthermore, numerous leases were strategically structured to avoid classification as a capital lease and balance sheet presentation. This prompted many end users of the financial statements, such as bonding sureties, to make proforma adjustments to the balance sheet for the unrecorded operating leases.

Ten Key Takeaways. So ASC 842 steps in to address some of the gaps caused by the application of ASC 840. Here are ten essential takeaways from ASC 842.

  1. Identifying Leases. Agreements must be carefully reviewed to identify clauses that contain leases.
    • To be considered a lease under ASC 842, the lessee must have control of or direct how the asset is used
    • This identification can be tricky because some contracts, not described as lease agreements, may, nevertheless, contain lease clauses. For example, a service agreement for a copier may have an equipment lease embedded in the contract.
    • For larger companies, the process of locating agreements, identifying the lease clauses, and extracting the data points should begin as soon as possible. It could be a big undertaking.

  2. Capitalization of All Leases. All leases will now be included on the balance sheet.
    • That is, all leases, except those with a lease term of 12 months or less (if you choose to elect that practical expediency), will be capitalized on the balance sheet. In addition, such short-term leases must not include a purchase option reasonably certain to be exercised.
    • ASC 842 does not provide a low-dollar amount to exclude a lease from balance sheet capitalization. However, the general principle of materiality is still applicable.

  3. Right-of-Use Asset and Liability. The new standard requires recognition of a right-of-use asset and a lease liability at the inception of the lease.

  4. Lease Classifications. Under ASC 842, there are still only two types of leases for lessee accounting:
    • Finance lease – This is the new name for the legacy ASC 840 capital lease. And the accounting is pretty much the same for a finance lease as it was for a capital lease.
    • Operating lease – The name is the same. However, even though the FASB retained the name, accounting for operating leases under ASC 842 is profoundly different from ASC 840. This is because, under ASC 842, operating leases are also capitalized on the balance sheet.

  5. Finance Lease Criteria. Per ASC 842, the lessee will classify a lease as a finance lease when any of the following criteria are met at lease commencement. (The first four will sound familiar).
    • 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.
    • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments equals or exceeds substantially all of the fair value of the underlying asset.
    • 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.

    Notice that the first four criteria above for classification as a finance lease closely track the requirements for classification as a capital lease under legacy ASC 840. However, the bright-line 75% and 90% tests are removed from c and d above. Accordingly, ASC 842’s approach is more principle-based than the approach under ASC 840. Companies will need to develop policies on what constitutes a “major part of the remaining economic life” and “substantially all of the fair value of the underlying asset.”

    Also, notice that ASC 842 added one new criterion, i.e., the underlying asset has no alternative use to the lessor at the end of the lease term.

  6. Operating Lease Criteria. If the above criteria are not met, then the lease is classified as an operating lease.

  7. Purpose of Two Lease Classifications. If both finance and operating leases are capitalized on the balance sheet under ASC 842, what is the purpose of the two classifications? The reason is that the subsequent accounting and disclosure for each category differs.

  8. Discount Rate. Leases are capitalized using one of the following rates:
    • The rate implicit in the agreement (challenging to obtain)
    • Lessee’s incremental borrowing rate (the rate the lessee would have incurred to borrow over a similar term the funds necessary to purchase the leased asset)
    • Or use the risk-free interest rate as an accounting policy election for all leases (i. e., U.S. Treasury bond rate over the loan term).

  9. Embedded Leases. Leases included in broader agreements are important under ASC 842 because such embedded leases must be identified and capitalized on the balance sheet. These leases are often concealed in other contracts that are not explicitly considered lease agreements.

  10. Related Party Leases. ASC 842-10-55-12 states that “Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties.”
    • ASC 842-10-55-12 appears to represents a change in GAAP from that under ASC 840. Legacy GAAP required entities to account for the economic substance over the legal form of related party leases.
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