NOTE 3. Adoption of Accounting Standards Codification Topic 842, Leases

In February 2016, the FASB issued ASU No. 2016‑02, Leases (Topic 842) (“ASU 2016‑02” or “ASC 842”). ASU 2016‑02 supersedes the current accounting for leases. The new standard, while retaining two distinct types of leases, finance and operating, (i) requires lessees to record a right of use asset and a related liability for the rights and obligations associated with a lease, regardless of lease classification, and recognize lease expense in a manner similar to current accounting, (ii) eliminates current real estate specific lease provisions, (iii) modifies the lease classification criteria and (iv) aligns many of the underlying lessor model principles with those in the new revenue standard (see Note 2). ASU 2016‑02 is effective for fiscal years beginning after December 15, 2018, and interim periods within. Early adoption is permitted. Entities are required to use a modified retrospective approach when transitioning to ASU 2016‑02 for leases that exist as of or are entered into after the beginning of the earliest comparative period presented in the financial statements.

The Company elected to early adopt ASU 2016‑02, effective as of April 1, 2016 (the “Adoption”), which was a change in accounting principle. Accordingly, the accompanying combined consolidated financial statements reflect the period‑specific effects of the Adoption. Upon the Adoption, the Company elected a permitted practical expedient to use hindsight in determining the lease term under the new standard. The Adoption results in a material change to the accounting for the Company’s Master Lease entered into by the Company and HCRMC in April 2011 upon the acquisition of the HCRMC Properties. Given the decline in HCRMC’s performance subsequent to the 2011 acquisition (see Notes 4 and 6), it was concluded that the lease term (as defined by ASC 842) was shorter than originally determined at (i) the lease commencement date in April 2011 and (ii) the lease classification reassessment date in March 2015 when the Company and HCRMC amended the Master Lease (the “HCRMC Lease Amendment”) (see Note 4). When applying hindsight, the lease classification reassessment in April 2011 resulted in the Master Lease being reclassified from a direct financing lease (“DFL”) to an operating lease. When applying hindsight, the lease classification reassessment in March 2015 resulted in the Master Lease continuing to be classified as an operating lease. Under the transition guidance required by ASU 2016‑02, the Master Lease, which was previously accounted for as a DFL, has been accounted for as an operating lease as of the earliest comparable period presented.

Reclassification of the Master Lease to an operating lease and application of the lessee transition provisions from the Adoption resulted in the following direct effects to the combined consolidated balance sheets: (i) recognition of real estate assets and intangible assets underlying the Master Lease, net of depreciation and amortization, (ii) derecognition of the net investment in the DFL, (iii) derecognition of the net acquired below market lease intangible assets associated with favorable terms of ground leases for which the Company is the lessee and the recognition of right of use assets and associated lease liabilities, net of amortization, (iv) recognition of a straight‑line rent receivable in accordance with the Company’s accounting policies and (v) recognition of the resulting difference being recorded as a cumulative impact to parent company equity. In accounting for the Master Lease as an operating lease, the Company has recorded the following adjustments to its combined consolidated statements of income and comprehensive income: (i) derecognition of income from the DFL, (ii) recognition of rental and related revenues consistent with the Company’s accounting policies and (iii) recognition of depreciation and amortization of the real estate assets and intangible assets over their estimated useful lives in accordance with the Company’s accounting policies. In addition, the Adoption resulted in the following indirect effects to the Company’s combined consolidated financial statements: (i) recognition of real estate and related assets held for sale and real estate impairments (ii) derecognition of previously recorded impairments of the DFL and recognition of an impairment charge of the straight‑line rent receivable related to the Master Lease, (iii) adjustments to previously recorded impairments of the equity method investment in HCRMC (iv) recognition of gain on sale of real estate and (v) rental and related revenues instead of income from the DFL being reclassified to equity income for the equity method investment in HCRMC. While the Company is primarily a lessor, it also considered the lessee transition and application requirements under ASU 2016‑02.

The effects of the change in accounting principle on periods prior to those presented are reflected in the carrying amount of assets and liabilities as of January 1, 2014. The cumulative effect of the change on prior periods was a reduction of $757.1 million in the opening balance of parent company equity as of January 1, 2014, which includes a reduction of parent company equity of $766.0 million from the direct effects of the Adoption and an increase to parent company equity of $8.9 million related to the indirect effects of the Adoption.

The combined consolidated balance sheet as of December 31, 2016 was affected by the Adoption as follows (in thousands):


						As Reported
	If Classified					as Operating
	as DFL		Adjustment		Notes	Lease
ASSETS
Real estate:
Building and improvements	$	191,633	$	4,700,363		$	4,891,996
Land		14,147		623,454			637,601
Accumulated depreciation		(70,369)		(1,041,399)			(1,111,768)
Net real estate		135,411		4,282,418	(a)		4,417,829
Real estate and related assets held for sale, net		—		16,019	(b)		16,019
Net investment in direct financing lease		5,054,805		(5,054,805)	(c)		—
Cash and cash equivalents		126,185		—			126,185
Restricted cash		17		—			17
Intangible assets, net		16,032		183,713	(a)(d)		199,745
Straight-line rent receivables, net		—		3,296	(e)		3,296
Other assets, net		16,117		10,167	(d)(e)		26,284
Total assets	$	5,348,567	$	(559,192)		$	4,789,375
LIABILITIES AND EQUITY
Bank line of credit	$	25,000	$	—		$	25,000
Term loan		957,465		—			957,465
Senior secured notes		730,604		—			730,604
Tenant security deposits and deferred revenue		5,587		—			5,587
Accrued interest		12,526		—			12,526
Accounts payable and accrued liabilities		3,824		602	(f)		4,426
Income taxes payable		16,544					16,544
Total liabilities		1,751,550		602			1,752,152
Redeemable preferred stock		1,930		—			1,930
Equity:
Common stock		936		—			936
Additional paid-in capital		3,560,886		(396,932)	(g)		3,163,954
Retained earnings (accumulated deficit)		32,768		(162,862)	(g)		(130,094)
Total stockholders' equity		3,594,590		(559,794)			3,034,796
Noncontrolling interests		497		—			497
Total equity		3,595,087		(559,794)			3,035,293
Total liabilities and equity	$	5,348,567	$	(559,192)		$	4,789,375

(a)

Reflects the recognition of real estate and intangible assets underlying the Master Lease, net of depreciation, amortization and impairments (see Note 5).

(b)

Reflects the impact of classifying real estate and related assets as assets held for sale, net (see Note 5).

(c)

Reflects the derecognition of the net investment in the DFL.

(d)

Reflects the derecognition of intangible assets, net of $13.5 million associated with favorable terms of leases acquired for which the Company is a lessee and recognition of right of use assets, net of $13.5 million (see Note 8).

(e)

Reflects the adjustment to record a straight‑line rent receivable, net of impairment and reclassification of the historical straight‑line rent receivable balance related to the 28 non‑HCRMC Properties from other assets, net to straight‑line rent receivables, net (see Note 4).

(f)

Reflects the recognition of leasing liabilities for which the Company is a lessee.

(g)

Reflects the cumulative direct and indirect effects from the Adoption.

The combined consolidated balance sheet as of December 31, 2015 was affected by the Adoption as follows (in thousands):


						As Reported
	If Classified					as Operating
	as DFL		Adjustment		Notes	Lease
ASSETS
Real estate:
Building and improvements	$	191,633	$	4,800,128		$	4,991,761
Land		14,147		632,175			646,322
Accumulated depreciation		(65,319)		(954,502)			(1,019,821)
Net real estate		140,461		4,477,801	(a)		4,618,262
Real estate and related assets held for sale, net		—		117,949	(b)		117,949
Net investment in direct financing lease		5,154,316		(5,154,316)	(c)		—
Equity method investment		—		—			—
Cash and cash equivalents		6,058		—			6,058
Restricted cash		14,526		—			14,526
Intangible assets, net		17,049		207,359	(a)(d)		224,408
Straight-line rent receivables, net		—		95,259	(e)		95,259
Other assets, net		7,790		9,382	(d)(e)		17,172
Total assets	$	5,340,200	$	(246,566)		$	5,093,634
LIABILITIES AND EQUITY
Tenant security deposits and deferred revenue	$	4,424	$	—		$	4,424
Accounts payable and accrued liabilities		1,716		—			1,716
Total liabilities		6,140		—			6,140
Equity:
Net parent investment		5,334,060		(246,566)	(f)		5,087,494
Total liabilities and equity	$	5,340,200	$	(246,566)		$	5,093,634

(a)

Reflects the recognition of real estate and intangible assets underlying the Master Lease, net of depreciation, amortization and impairments (see Note 5).

(b)

Reflects the impact of classifying real estate and related assets as assets held for sale, net (see Note 5).

(c)

Reflects the derecognition of the net investment in the DFL.

(d)

Reflects the derecognition of intangible assets, net of $13.0 mllion associated with favorable terms of leases acquired for which the Company is a lessee and recognition of right of use assets, net of $13.0 million (see Note 8).

(e)

(f)

Reflects the cumulative direct and indirect effects from the Adoption.

The combined consolidated statement of operations and comprehensive income for the year ended December 31, 2016 was affected by the Adoption as follows (in thousands):


						As Reported
	If Classified					as Operating
	As DFL		Adjustment		Notes	Lease
Revenues:
Income from direct financing lease	$	442,278	$	(442,278)	(a)	$	—
Rental and related revenues		27,531		442,167	(b)(e)		469,698
Tenant recoveries		1,473		—			1,473
Total revenues		471,282		(111)			471,171
Costs and expenses:
Depreciation and amortization		5,862		159,693	(c)		165,555
Operating		4,077		(357)			3,720
General and administrative		21,701		357			22,058
Interest		25,019		—			25,019
Impairments		—		167,057	(d)		167,057
Total costs and expenses		56,659		326,750			383,409
Other income:
Gain on sales of real estate		—		10,583	(f)		10,583
Other income, net		282		—			282
Total other income, net		282		10,583			10,865
Income before income taxes		414,905		(316,278)			98,627
Income tax expense		(17,482)		—			(17,482)
Net income and comprehensive income	$	397,423	$	(316,278)		$	81,145

(a)

Reflects the derecognition of income from the DFL.

(b)

Reflects the recognition of rental and related revenues (see Note 4).

(c)

Reflects depreciation and amortization of real estate and intangible assets over their estimated useful lives (see Note 7).

(d)

Reflects the recognition of an impairment charge of $145.7 million on real estate assets and $21.4 million on real estate assets held for sale (see Note 4).

(e)

Reflects the impact of rental and related revenues recharacterized (eliminated) related to the Company’s proportional ownership share in HCRMC (see Note 4).

(f)

Reflects recognition of gain on sale of real estate (see Note 5).

The combined consolidated statement of operations and comprehensive income for the year ended December 31, 2015 was affected by the Adoption as follows (in thousands):


						As Reported
	If Classified					as Operating
	As DFL		Adjustment		Notes	Lease
Revenues:
Income from direct financing lease	$	572,835	$	(572,835)	(a)	$	—
Rental and related revenues		27,651		546,681	(b)(e)		574,332
Tenant recoveries		1,464		—			1,464
Total revenues		601,950		(26,154)			575,796
Costs and expenses:
Depreciation and amortization		5,880		238,744	(c)		244,624
Operating		3,729		—			3,729
General and administrative		19,907		4,000	(d)		23,907
Impairments		1,295,504		(1,068,121)	(d)		227,383
Total costs and expenses		1,325,020		(825,377)			499,643
Other income:
Gain on sales of real estate		—		39,140	(g)		39,140
Other income, net		70		—			70
Total other income, net		70		39,140			39,210
(Loss) income before income taxes and income from and impairments of equity method investment		(723,000)		838,363			115,363
Income tax expense		(798)		—			(798)
Income from equity method investment		50,723		(16,213)	(e)		34,510
Impairments of equity method investment		(45,895)		10,013	(f)		(35,882)
Net (loss) income and comprehensive (loss) income	$	(718,970)	$	832,163		$	113,193

(a)

Reflects the derecognition of income from the DFL.

(b)

Reflects the recognition of rental and related revenues (see Note 4).

(c)

Reflects depreciation and amortization of real estate and intangible assets over their estimated useful lives (see Note 7).

(d)

Reflects adjustment to eliminate previously recorded impairments of the DFL, including a $4.0 million reclassification to general and administrative expense related to lease modification costs, offset by the recognition of (i) an impairment charge of $47.1 million on real estate assets and (ii) an impairment charge of $180.3 million on straight‑line rent receivables, net of $17.2 million recharacterized to equity income (see Notes 4 and 5).

(e)

Reflects the derecognition of DFL income previously recharacterized (eliminated) offset by rental and related revenues recharacterized (eliminated), related to the Company’s proportional ownership share in HCRMC (see Note 4).

(f)

Reflects adjustment to previously recorded impairments related to the Company’s equity method investment in HCRMC (see Note 6).

(g)

Reflects recognition of gain on sale of real estate (see Note 5).

The combined consolidated statement of operations and comprehensive income for the year ended December 31, 2014 was affected by the Adoption as follows (in thousands):


						As Reported
	If Classified					as Operating
	as DFL		Adjustment		Notes	Lease
Revenues:
Income from direct financing lease	$	598,629	$	(598,629)	(a)	$	—
Rental and related revenues		27,111		541,269	(b)(d)		568,380
Tenant recoveries		1,029		—			1,029
Total revenues		626,769		(57,360)			569,409
Costs and expenses:
Depreciation and amortization		4,979		242,935	(c)		247,914
Operating		3,247		—			3,247
General and administrative		20,690		—			20,690
Total costs and expenses		28,916		242,935			271,851
Other income:
Loss on sales of real estate		—		(1,917)	(f)		(1,917)
Other income, net		953		—			953
Total other income (loss), net		953		(1,917)			(964)
Income before income taxes and income from and impairment of equity method investment		598,806		(302,212)			296,594
Income tax expense		(765)		—			(765)
Income from equity method investment		53,175		7,294	(d)		60,469
Impairment of equity method investment		(35,913)		(27,342)	(e)		(63,255)
Net income and comprehensive income	$	615,303	$	(322,260)		$	293,043

(a)

Reflects the derecognition of income from the DFL.

(b)

Reflects the recognition of rental and related revenues (see Note 4).

(c)

Reflects depreciation and amortization of real estate and intangible assets over their estimated useful lives (see Note 7).

(d)

(e)

Reflects adjustment to previously recorded impairments related to the Company’s equity method investment in HCRMC (see Note 6).

(f)

Reflects recognition of loss on sale of real estate (see Note 5).