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Lease accounting reset - Embedded leases · PwC's accounting podcast

0:00
SPEAKER_02: Thought Leadership from PWC's National Office.
0:06
SPEAKER_00: Hello, and welcome to PWC's Accounting Podcast.
0:10
SPEAKER_00: I'm Heather Horn.
0:12
SPEAKER_00: Today we're wrapping up our lease accounting miniseries with an episode on embedded leases.
0:17
SPEAKER_00: Those arrangements that are tucked inside a service or supply contract that, while not labeled as leases, may meet the definition under the accounting standards.
0:26
SPEAKER_00: Identifying an embedded lease is more than a technical exercise.
0:30
SPEAKER_00: It can shift the entire accounting model for both customers and suppliers, affecting everything from revenue recognition to presentation on the balance sheet.
0:42
SPEAKER_00: Helping us break down this complex topic are Pat Gerbin, Deputy Chief Accountant, and Mark Jerusalem, Managing Director, both from PWC's national office.
0:51
SPEAKER_00: Also joining us again today, I'm happy to turn things over to guest host Diana Stoltzfis, frequent podcast guest and also a partner in our national office.
1:01
SPEAKER_00: With that, over to Diana.
1:03
SPEAKER_01: Today we're talking about leases embedded in a service or supply contract.
1:07
SPEAKER_01: Often, arrangements to provide services or purchase inventory rely on the use of a specific asset to fulfill the contract.
1:14
SPEAKER_01: Even if the word lease is not mentioned in the contract, there may be an embedded lease.
1:19
SPEAKER_01: When a contract contains an embedded lease, the customer is no longer simply purchasing services or products.
1:26
SPEAKER_01: Instead, they are leasing an asset and hiring the supplier to operate andor maintain the leased asset on the customer's behalf.
1:33
SPEAKER_01: It's important to identify an embedded lease because the accounting can look very different when a lease is involved for both the customer and the supplier.
1:40
SPEAKER_01: Before we get into the details, maybe Pat, can you start by telling us about some of the common arrangements where we might find embedded leases?
1:48
SPEAKER_04: Sure.
1:49
SPEAKER_04: I think there's uh I put them in a couple of buckets, sort of like maybe the classic sort of old economy version, and then some of what we're seeing in the new sort of as-a-service space.
1:59
SPEAKER_04: So contract manufacturing can certainly give rise to it.
2:03
SPEAKER_04: That'd be a situation where you've either hired someone to supply you a very specific product for an extended period of time, or maybe you're the contract manufacturer.
2:13
SPEAKER_04: This works both ways, right?
2:15
SPEAKER_04: You have to think of it from both the customer and supplier perspective.
2:19
SPEAKER_04: Umspation and logistics, so I've committed to use some transportation equipment for a period of time to largely be exclusive to my use, or I've decided to make that available.
2:34
SPEAKER_04: You could see an embedded lease in those arrangements.
2:37
SPEAKER_04: Um maybe it's a hybrid of old economy, new economy, but IT infrastructure, IT outsourcing, um, where you're basically dependent upon somebody else's um computer servers to provide your IT infrastructure, um, anything with as a service in it.
2:57
SPEAKER_04: So we sometimes hear about hardware as a service, energy as a service, those could all give rise to embedded leases.
3:04
SPEAKER_04: Um, so I think say just be on the lookout if it says as a service.
3:08
SPEAKER_01: Aaron Powell Okay, that's helpful.
3:09
SPEAKER_01: So now that we have an idea of the different types of arrangements that could uh lead to these embedded leases, maybe you can share with our listeners why it's important to identify the embedded leases and maybe some of the accounting implications if a supplier or a customer has failed to identify an embedded lease.
3:26
SPEAKER_04: Aaron Powell Yeah, well, I think as you highlighted in your intro, right?
3:29
SPEAKER_04: I mean, if you don't identify an embedded lease when one exists, um you're probably going to get the accounting wrong because the accounting can be pretty different if you do have an embedded lease in one of these arrangements.
3:40
SPEAKER_04: Um taking it in pieces, if we focus on the supplier or less or side, and you know, sometimes you can think of it like the accidental lessor or the accidental lesse.
3:50
SPEAKER_04: But for the supplier less or the way you determine the contract consideration is different between sort of a pure revenue arrangement or a lease arrangement.
4:00
SPEAKER_04: And when we we'll discuss later, but you know, if you have a lease involved, what tends to happen is the leasing framework, the leasing model sort of takes over and governs a lot of the accounting, even if there is a still a revenue arrangement or a revenue element to the arrangement.
4:17
SPEAKER_04: The pattern or the timing of income recognition can be different.
4:20
SPEAKER_04: Lease income generally is recognized over time, or lease expenses over time.
4:24
SPEAKER_04: Revenue obviously depends more on how you perform, which sometimes may be over time, so it may align, but it definitely can be different.
4:33
SPEAKER_04: From a presentation standpoint on the income statement, you can't combine revenue from a lease or lease revenue with revenue from contracts with customers under 606.
4:43
SPEAKER_04: So you'd have two separate lines on the financial statements.
4:47
SPEAKER_04: You have different frameworks under the leasing standard versus the revenue standard for evaluating contract modifications.
4:54
SPEAKER_04: And then uh disclosures are different, right?
4:57
SPEAKER_04: There's uh a lot of disclosures you have to make about leases if you're either a lessee or a less or, and similarly, if you're providing uh services or goods under the revenue standard, you have uh a package of disclosures there.
5:08
SPEAKER_04: So you're gonna have differences sort of across the board if you're a um from the supplier less or perspective.
5:16
SPEAKER_04: If we take it from the uh customer lessee perspective, um I'd say we have less prescriptive guidance when you're a purchaser of goods and services, right?
5:26
SPEAKER_04: Unlike the revenue standard, which governs all of that, um, we have less specific guidance.
5:31
SPEAKER_04: But if you have an embedded lease, obviously you'll then have to recognize a lease obligation and a right of use asset, which in a pure sort of service or supply contract, you put nothing on the balance sheet typically.
5:43
SPEAKER_04: Um, and that can also affect the timing of your expense or cost recognition, right?
5:48
SPEAKER_04: It'll be more time-based rather than when you're actually consuming the good.
5:52
SPEAKER_04: Um, and again, we have this very specific guidance in the leasing standard for contract modifications.
5:58
SPEAKER_04: We don't have that similar specific guidance if you're a purchaser of uh goods or services for a contract modification.
6:06
SPEAKER_04: And then you have some very specific disclosures about your lease obligations, future lease payments, et cetera, which you wouldn't typically have if you were just in a supply contract.
6:15
SPEAKER_01: So And Pat, I know we're gonna walk through the different types of things that we need to think about when we're identifying embedded leases, but maybe before we get into that, would it be the same kind of considerations that you'd think through, whether you're the supplier or the customer?
6:29
SPEAKER_04: Aaron Powell Some of them will overlap, but I think there are definitely different considerations, um, specifically because we have such specific guidance for the revenue side of the arrangement if you're the supplier and less specific as the purchaser, you know, outside of the lease.
6:45
SPEAKER_04: A lot of the leasing considerations I think do tend to overlap.
6:48
SPEAKER_01: Aaron Powell Okay.
6:49
SPEAKER_01: That's helpful.
6:50
SPEAKER_01: So maybe Mark, turning to you.
6:52
SPEAKER_01: So I know we before we were um talking about what we need to think about.
6:56
SPEAKER_01: And it sounds to me like there's kind of four questions or four main questions that we need to think about when we're determining if there's an embedded lease in arrangement.
7:04
SPEAKER_01: So maybe we can walk through each of those four considerations.
7:07
SPEAKER_01: So maybe Mark, can you start with the first question?
7:10
SPEAKER_03: Sure.
7:11
SPEAKER_03: I mean, the first question in determining whether an arrangement contains a lease embedded within it is in fulfilling this contract, is the supplier expected to use some identified equipment in order to do so, right?
7:26
SPEAKER_03: And, you know, one of the things, you know, I like that Pat used the term accidental supply or accidental lessor, which I think is just a great term because we're not talking about things here that are labeled as a lease on the top of the contract, right?
7:39
SPEAKER_03: Things that are labeled as a lease always have an identified asset.
7:42
SPEAKER_03: If you're leasing real estate, it has an address.
7:44
SPEAKER_03: You're leasing an automobile, it has a vehicle number, et cetera, et cetera.
7:48
SPEAKER_03: In many of these supply contracts, you have to go a little further to determine whether there is an identified asset.
7:54
SPEAKER_03: Sometimes there will be, right, in the arrangement.
7:56
SPEAKER_03: Sometimes the arrangement will be very specific and it'll give you serial numbers, et cetera.
8:01
SPEAKER_03: Oftentimes it won't specify whether there are specific assets.
8:06
SPEAKER_03: So we have to dig a little deeper to determine are there identified assets?
8:10
SPEAKER_03: If it's not explicitly identified, is the fact pattern such that at the beginning of the arrangement, at the time you sign the deal, if there's only one asset or one set of assets that it is economically feasible for the supplier to use in order to provide the services or the or provide the goods that he's obligated to do so.
8:28
SPEAKER_03: Think of a situation where the supplier had to go out and purchase the underlying equipment in order to provide the services.
8:35
SPEAKER_03: Well, it is possible that the reason they had to go purchase that is because they didn't have any other equipment in order to do so.
8:43
SPEAKER_03: And, you know, just Pat mentioned a few types of typical embedded lease arrangements.
8:50
SPEAKER_03: So if it's contract manufacturing, think of the facility that is producing the goods or services.
8:56
SPEAKER_03: Is there only one or are there many available facilities to do so?
9:01
SPEAKER_03: Think of the equipment line, think of the tooling.
9:03
SPEAKER_03: If the supplier is providing the tooling, that is generally going to be very specific to that customer's needs.
9:10
SPEAKER_03: Um, if we're talking about transportations or logistics contracts, think of the warehouse location or even the ships or the trucks or whatever or the trains that you may use.
9:22
SPEAKER_03: Um again, IT, IT services, think of the data servers or the building that's the data center itself.
9:31
SPEAKER_03: Um, energy as a service, I know Pat mentioned that as well.
9:35
SPEAKER_03: That is something that we've seen a lot in the past decade or so.
9:39
SPEAKER_03: Uh it is it's a frequent flyer, so to speak.
9:42
SPEAKER_03: And in those situations, frequently those are going to be things that may be installed at the customer site.
9:47
SPEAKER_03: So think of you know, upgrades to HVAC equipment, upgrades to lighting, solar panels, et cetera.
9:53
SPEAKER_03: So it would be difficult for the supplier to provide those services using equipment that is off-site.
9:59
SPEAKER_01: Right.
10:00
SPEAKER_03: Right.
10:00
SPEAKER_01: Right.
10:01
SPEAKER_03: So I think one of the main things here is that the answer to this question is not going to be found within the accounting department.
10:08
SPEAKER_03: You're going to have to talk to the people that are really involved with negotiating the contract or involved with actually providing the goods and services to be able to answer this question.
10:17
SPEAKER_01: Yeah, it seems like you're you really need to understand what the purpose is, like how the contract works, like what are the specific assets, their location.
10:24
SPEAKER_01: So to your point, things that may maybe not it directly in the contract either.
10:28
SPEAKER_01: So really understanding the business purpose.
10:31
SPEAKER_01: Okay, so now if we've identified that there is a specific asset, whether this is explicitly or implicitly, as we just talked through, uh what's the next step?
10:39
SPEAKER_03: So the next step, and it's it's really less of a step other than a consideration, but we we do spend a lot of time talking with our clients and our teams about substitution rights.
10:50
SPEAKER_03: Because sometimes what a supplier or a customer will assert is that yes, I'm provide I'm using a specific asset, maybe an implicitly identified asset, but I have the right to substitute that asset, which would essentially that would override whether there's an identified asset.
11:07
SPEAKER_01: Okay.
11:08
SPEAKER_03: Don't look at the asset I'm using right now, because I could use a different asset tomorrow.
11:12
SPEAKER_03: Okay.
11:13
SPEAKER_03: So the standard contemplates that yes, if you could just use a different asset tomorrow, right, then in fact you wouldn't have an identified asset.
11:22
SPEAKER_03: And there wouldn't be a lease.
11:23
SPEAKER_03: So um, in order to establish that there's a substitution right, first of all, there has to be an actual right.
11:28
SPEAKER_03: So that you need a contract that doesn't say thou shalt not substitute without the customer's approval.
11:34
SPEAKER_03: If it says that, then you don't even have the right.
11:36
SPEAKER_03: But let's assume that there's nothing precluding the supplier from using a different asset.
11:40
SPEAKER_03: So the question is, well, how economically feasible again?
11:43
SPEAKER_03: Now same question, how economically feasible is it that there are other assets that you could use?
11:47
SPEAKER_03: Right.
11:47
SPEAKER_03: Right?
11:48
SPEAKER_03: If it isn't economically feasible, then it's not a substantive right.
11:53
SPEAKER_03: And the next question that we'd ask is, well, how would you make more money?
11:57
SPEAKER_03: I'm very plainly, how would you make more money by substituting the asset?
12:00
SPEAKER_03: How would you make more money by having the flexibility to substitute the asset?
12:05
SPEAKER_03: Because frequently, what people will tell us is that, Mark, we substitute assets all the time.
12:10
SPEAKER_03: And I say, well, why do you do that?
12:11
SPEAKER_03: And they say, well, in order to keep the service level at a certain level, we have to make sure that we have to perform the right maintenance, we have to take things offline to maintain them better.
12:20
SPEAKER_03: And the standard explicitly tells you that maintenance is not a substitution right.
12:25
SPEAKER_01: Okay.
12:25
SPEAKER_03: Okay.
12:26
SPEAKER_03: So it can't just be maintenance.
12:27
SPEAKER_03: You have to think about I can use that asset, the asset that you're using today, maybe tomorrow I'll use that asset to service another customer.
12:36
SPEAKER_01: Okay.
12:37
SPEAKER_03: That would be a good substitution right.
12:40
SPEAKER_03: The final consideration on substitution, two two more considerations.
12:43
SPEAKER_03: From the supplier's perspective, the final consideration is you have to consider also, and this is a killer for a lot of people, how likely is it that during that customer's period of use, whatever that is, that you're going to substitute that asset?
12:57
SPEAKER_03: Because if you're asserting that you can make more money by being flexible enough to use that asset for customer A and tomorrow for customer B, then presumably you're doing so.
13:07
SPEAKER_03: Right?
13:07
SPEAKER_03: Right.
13:08
SPEAKER_03: So a a simple example, you know, like if you think about a hotel room, hotels always have the right to substitute the room you're in.
13:16
SPEAKER_03: And they have an economic reason to do so.
13:17
SPEAKER_03: Maybe the room you're in is needed for another customer because their brother is sleeping in the room next door.
13:23
SPEAKER_03: They may want to move you to a different room.
13:25
SPEAKER_03: Great.
13:26
SPEAKER_03: But you're only in the room for four days.
13:28
SPEAKER_03: How likely is it that the hotel is going to substitute you during your four-day stay?
13:34
SPEAKER_03: You know, that's like saying every week somebody wins the lottery, but Mark has never won a lottery.
13:39
SPEAKER_03: So, you know, like how likely does it occur during that stay?
13:43
SPEAKER_03: So you ask that question and it it should be pretty evident, right?
13:48
SPEAKER_03: And if it isn't evident, that raises some questions.
13:50
SPEAKER_03: And then finally, because this is kind of a judgmental thing, the standard explicitly says this is something that is more geared toward the suppliers than to the customers.
14:00
SPEAKER_03: The customers should never assume that the supplier has a right to substitute unless it is something that is easy to determine.
14:07
SPEAKER_03: What that means, I don't know.
14:09
SPEAKER_03: But it should stare you in the face and you said, of course, I they can substitute that.
14:13
SPEAKER_01: Okay.
14:14
SPEAKER_01: So now we have an identified asset and the supplier does not have a substantive right to substitute the asset.
14:20
SPEAKER_01: So now my understanding is the third step is to determine if the customer controls that asset.
14:25
SPEAKER_01: So maybe, Pat, how do we think about that definition of the customer controlling the asset?
14:30
SPEAKER_04: Aaron Powell Right.
14:30
SPEAKER_04: So the the concept of control in the leasing guidance is um based on two criteria.
14:38
SPEAKER_04: Um whether the party has the right to substantially all of the economic benefits from the use of the asset and also the right to direct the use of the asset.
14:49
SPEAKER_04: So those are the two things we have to think about to figure out if we have control of that specified asset.
14:56
SPEAKER_04: Um when we think about economic benefits, um, that can include the primary outputs from the equipment as well as byproducts.
15:04
SPEAKER_04: For example, you know, a power plant may produce the power, which would be the primary output.
15:09
SPEAKER_04: They may also generate steam.
15:11
SPEAKER_04: Um sometimes they have um they come along with renewable energy credits that potentially um could be considered um an output, um, but you need to understand whether those types of things derive from the use of the asset, because sometimes some of those credits relate more to the construction of the facility and wouldn't relate to the use, and therefore so they'd be excluded from the economic benefits from the use of the asset.
15:41
SPEAKER_01: Okay.
15:41
SPEAKER_01: So if the customer has substantially all the economic benefits, so controls, then Mark, what what's the fourth step?
15:49
SPEAKER_03: The fourth step, or really the the second part of control, is which party has the right to direct how the asset's being used or to change how the asset's being used during the period of use.
16:03
SPEAKER_03: So this is sort of a more common notion of who's controlling how the asset's being used, right?
16:11
SPEAKER_03: Um I would say out of all the four conditions, I told you before, we spend a lot of time talking about substitution rights, right?
16:17
SPEAKER_03: We do spend time talking about credits and and other byproducts, et cetera.
16:22
SPEAKER_03: Probably the number one question we get, especially from suppliers, is which party is directing how and for what purpose the asset's being used while it's being used.
16:32
SPEAKER_03: And like Pat said a moment ago on credits, we're talking about credits from using the equipment.
16:37
SPEAKER_03: Here too, we're not talking about who designed the equipment typically.
16:41
SPEAKER_01: Okay.
16:41
SPEAKER_03: Right.
16:42
SPEAKER_03: We're talking about who can decide today I want to produce red t-shirts on this line of equipment, and tomorrow I want to produce, you know, blue dress shirts on that line of equipment.
16:52
SPEAKER_03: And when we say who decides, you know, we have to look at the entire governance.
16:56
SPEAKER_03: So sometimes those decisions are right there in the contract.
16:59
SPEAKER_03: Right.
17:00
SPEAKER_03: Sometimes the decisions sound like one of the parties can make it, but there's actually some governing um requirements in the arrangement.
17:09
SPEAKER_03: Like, for example, especially in higher tech um production like uh pharmaceutical productions, there'll be an operating committee that that governs the entire manufacturing process.
17:21
SPEAKER_03: Who's on that committee?
17:22
SPEAKER_03: Is it more people from the customer's perspective or more people from the supplier side?
17:27
SPEAKER_03: Right?
17:27
SPEAKER_03: Right.
17:28
SPEAKER_03: And can they does does the customer have veto power?
17:31
SPEAKER_03: So always think of the highest level of governance.
17:33
SPEAKER_03: It's not the person who's operating, it's it's the boss who's telling him how to operate.
17:36
SPEAKER_01: Okay.
17:37
SPEAKER_03: Right.
17:38
SPEAKER_03: And then the questions that we ask are basically the same questions that you'd ask in your high school journalism class, right?
17:45
SPEAKER_03: What, when, whether, how, you know, these are the questions.
17:50
SPEAKER_03: Who which party is determining, kind of on a day-to-day basis, um when the asset's going to be used, or what the asset's going to be used for, or whether to use asset A or B.
18:03
SPEAKER_03: So some of the big questions that we that we get there is sort of the when the asset is used, right?
18:12
SPEAKER_03: Because service or supply contracts can kind of run the gamut from on-demand type services, a lot of things that are labeled as a service.
18:21
SPEAKER_03: If I'm getting power as a service, I'm going to get the power when I want the power.
18:25
SPEAKER_03: When I turn the lights on, I want the lights to go on.
18:27
SPEAKER_01: Right.
18:27
SPEAKER_03: Right.
18:28
SPEAKER_03: Um and then in manufacturing, sometimes manufacturing, frequently today, we have a lot of just-in-time manufacturing, we have manufacturing, the cadence of orders is relatively short, such that it doesn't really offer the supplier flexibility in when they can do things, right?
18:46
SPEAKER_03: Um, on the other hand, if I had a contract where let's say the customer has to uh put in a purchase order, you know, with 60 days notice, and every 60 days they put in their purchase order.
18:57
SPEAKER_03: If that actually gives the supplier the flexibility to run more shifts so that they can redeploy that workforce, for example, on other customers' orders on different equipment, you know, then the supplier may be deciding when the asset's being used, right?
19:13
SPEAKER_03: Um, this is very judgmental, right?
19:16
SPEAKER_03: And once again, you're not going to find the answers in the accounting department.
19:19
SPEAKER_03: You're going to have to talk to the people that actually do this for a living.
19:23
SPEAKER_03: Then so if the customer can turn the equipment on or off, then it's likely that they have the most impactful decisions.
19:30
SPEAKER_03: If we have, let's say, high-tech surgical equipment that we uh lease out to a hospital, under perhaps sometimes we see these contracts where the fees are really in the disposables or the consumables that are being used.
19:44
SPEAKER_03: Can the customer decide when he's scheduling the surgeries or which floor, which surgical suite he wants to move the equipment to, right?
19:51
SPEAKER_03: So frequently these decisions, some will be with a customer, some will be with a supplier.
19:57
SPEAKER_03: And in those cases, you really have to determine, you have to kind of like list them out and see on on an overall basis holistically, which party is making the more economically impactful decisions.
20:09
SPEAKER_01: Right.
20:09
SPEAKER_01: Sounds like there's a lot that needs to go into making these decisions and a lot of information that you need, then to your point, Mark, that that may or may not be in the contract that you really need to understand like how these different things are being used.
20:21
SPEAKER_01: Or may not be explicitly in the contract to the point earlier.
20:25
SPEAKER_04: That's right.
20:26
SPEAKER_04: I think the one thing to maybe highlight is just it's sort of some of these big, big decisions, like the turn-on, turn off, as opposed to like a lot of times it's not who's controlling the knobs and the dials, you know, day to day.
20:39
SPEAKER_04: It's the really the decision we're using this, we must use it now or not use it.
20:44
SPEAKER_04: And if that's sort of governed to Mark's point by the customer, like then they might have control of the asset, even if they're not the ones physically, as they typically would not be actually controlling the machine, say in a contract manufacturing environment.
20:59
SPEAKER_01: Right.
21:00
SPEAKER_03: So I just want to add one more thing, and and I don't mean to go back a little bit, but while we're still talking about these sort of four questions that you ask, and we've talked about the fact that we spend a lot of time talking with suppliers about whether there are substitution rights and then and then which party directs the use of the asset.
21:17
SPEAKER_03: I want to go back just for a moment to substitution rights and just overarching all these things that we're talking about now, these these um evaluations that we have to make, they all have to be made at the inception of the contract.
21:32
SPEAKER_03: And they have to be made using the facts and circumstances that exist at the inception of the contract.
21:37
SPEAKER_03: And just to illustrate that a little bit, we've talked about substitution rights.
21:41
SPEAKER_03: You know, when we say you have the right to substitute something, you'd have to have that right that that economic feasibility to do so at all times during the period of use.
21:52
SPEAKER_03: So you can't say on day one, well, look, this is a long contract.
21:56
SPEAKER_03: I'm sure that midway through the contract, I'm going to have a contract.
22:00
SPEAKER_03: Have better mouse traps to be able to provide those services, right?
22:03
SPEAKER_01: Right.
22:03
SPEAKER_03: You can't anticipate like improvements in technology.
22:06
SPEAKER_03: Improvements in technology or things that are not readily available today.
22:09
SPEAKER_01: Okay.
22:10
SPEAKER_03: Essentially.
22:11
SPEAKER_03: We've gotten questions.
22:12
SPEAKER_03: I say we, the standard setters, have gotten questions about a contract where you anticipate that midway through the contract, I think the specific example was batteries for buses.
22:23
SPEAKER_03: And they anticipated, in a 10-year contract, that about midway through the batteries would have degraded a little bit, perhaps not best suited for the buses, but there's plenty of other uses.
22:35
SPEAKER_03: So they anticipate swapping them out, right?
22:37
SPEAKER_03: For fresher batteries in the middle of the contract.
22:40
SPEAKER_03: Well, what the standard centers came back and said, I say standard centers, it was the um the IFRS standard centers.
22:46
SPEAKER_03: Okay.
22:47
SPEAKER_03: But they came back and said, then you don't have the right to substitute.
22:50
SPEAKER_03: It's not economically feasible for you to do so throughout the term of the contract.
22:54
SPEAKER_03: It's only after a specific date.
22:56
SPEAKER_03: And certainly if the contract says I can substitute after two years, you know, then you just don't have one.
23:02
SPEAKER_03: You don't have a substitution right.
23:04
SPEAKER_03: So this is just a small point in the broader concept that all these things we're thinking about, right?
23:09
SPEAKER_03: Are thinking about it based on the facts and circumstances that are in place at contract inception.
23:16
SPEAKER_03: And then one last thing I'll say is that we're not going to talk about modifications that much today, but these service and supply contracts tend to be modified more often than traditional leases.
23:28
SPEAKER_01: Okay.
23:28
SPEAKER_03: Okay.
23:29
SPEAKER_03: So unfortunately, when you modify a contract, it's kind of like pressing the reset button.
23:34
SPEAKER_03: So I just wanted to put that out there before we move on to, you know, accounting stuff now.
23:38
SPEAKER_01: Aaron Powell Yeah.
23:39
SPEAKER_01: Maybe one follow-up question.
23:40
SPEAKER_01: So if you said like there's like a substitution rate after a specific date, so it's like locked in for two years you can't substitute, then do you kind of treat that like a modification?
23:48
SPEAKER_01: Like for those first two years, you think about like they're not being uh or I guess they're I think you would think of it initially as let's say my example is a 10-year contract.
23:59
SPEAKER_01: Yes.
23:59
SPEAKER_03: Right?
24:00
SPEAKER_03: And then if in fact circumstances do change, right, then we evaluate it when the circumstances change.
24:07
SPEAKER_01: So maybe going back, so we've identified an asset, there's no substantive substitution rights, the customer takes substantially all the economic benefits, and the customer is able to direct how and for what purpose the assets are used.
24:21
SPEAKER_01: So we've determined now that we have an embedded lease in our arrangement.
24:25
SPEAKER_01: So once we've made this determination, um, then we need to think about what's the next step then, Mark?
24:31
SPEAKER_03: Well, the next step, because remember, you know, per the piece of paper, we have a supply contract or we're selling widgets, right, or or providing services.
24:39
SPEAKER_03: Now that we know that there's a lease component in there, we have to separate the lease component from the non-lease components.
24:44
SPEAKER_01: Okay.
24:44
SPEAKER_03: Okay.
24:45
SPEAKER_03: And frequently once we conclude that there's a lease component, there may be more than one lease component.
24:51
SPEAKER_03: It the accounting may be the same, like it may not make a difference, but we should at least be cognizant of the fact that it, you know, if you think about a data center, it may be the servers and the building.
25:02
SPEAKER_01: Right.
25:02
SPEAKER_03: Right.
25:03
SPEAKER_03: So uh that could have some ramifications because the economic life of the computer equipment is likely a lot shorter than the economic life of the building, which once you have a lease, then you know you have to classify that lease.
25:18
SPEAKER_03: We're not going to talk too much about that today.
25:20
SPEAKER_03: But do I have more than one right-of-use asset?
25:24
SPEAKER_03: Okay.
25:24
SPEAKER_03: And similarly, you know, you have to identify what exactly are the non-lease components.
25:29
SPEAKER_03: They're just a little bit different than they would have been had there not been a lease.
25:33
SPEAKER_03: And one of the things I that I tell people is to kind of rethink how you describe your business.
25:39
SPEAKER_03: You know, before I identifying whether there's an embedded lease, I thought I was selling widgets.
25:44
SPEAKER_03: Yeah.
25:45
SPEAKER_03: Right.
25:45
SPEAKER_03: Now you're no longer necessarily selling widgets.
25:48
SPEAKER_03: What you're doing is you are leasing out a fixed asset to a customer, and you're providing contract labor to that customer to operate his leased equipment.
25:58
SPEAKER_01: Okay.
25:58
SPEAKER_03: Okay.
25:59
SPEAKER_03: And you may be doing other services.
26:01
SPEAKER_03: You may be doing management services, you may be procuring raw materials, right?
26:06
SPEAKER_03: So there could be a number of services, but the main thing is to just change your mindset a little bit.
26:11
SPEAKER_03: Think about the lease components, the non-lease components.
26:14
SPEAKER_03: Um, again, in an IT contract, it may be data monitoring, right?
26:18
SPEAKER_03: Uh in a logistics contract, it's going to be, you know, you're providing truck drivers, you're providing a um a source of labor to do the warehousing, etc.
26:29
SPEAKER_03: So inventory all your lease and non-lease components and think about the business a little bit differently.
26:35
SPEAKER_01: Okay.
26:36
SPEAKER_01: So then, Pat, maybe turning to you.
26:38
SPEAKER_01: So we've identified our lease components, the non-lease components, and then we allocate the consideration between these different components.
26:45
SPEAKER_01: Like how do we how do we think about that?
26:48
SPEAKER_04: Yeah, and again, um, because we're thinking about this from both the customer less E or the supplier less or side, um, we're gonna have different considerations depending on which perspective we're we're looking at.
26:58
SPEAKER_04: And maybe just to highlight a point I made earlier, because we're in an arrangement that we've determined contains a lease, this consideration question or the transaction price or whatever we want to call it, is governed by the lease standard.
27:13
SPEAKER_04: So some people might have come at this thinking, hey, I'm a supplier, I know 606 governs how we think about transaction price.
27:22
SPEAKER_04: You got to forget about that because we're now stuck in the lease standard, and the lease standard is gonna tell us what to do.
27:27
SPEAKER_04: So leasing generally is based on a concept of I've agreed to pay some amount of money to use an asset over a period of time.
27:34
SPEAKER_04: So start with fixed payments.
27:36
SPEAKER_04: Any fixed payments in the contract, those go in.
27:39
SPEAKER_04: Variable payments are included in the consideration, at least for the customer lessee, only to the extent that they depend on a rate or an index.
27:49
SPEAKER_04: So, for example, if there's an inflation factor in the contract, those would be included.
27:55
SPEAKER_04: Any other variable payments, if you're looking at this from the customer lessee perspective, that depend on usage over time, but vary depending on the extent of usage, those are not included in your lease consideration at inception.
28:10
SPEAKER_04: They only get included at the point they become determined.
28:14
SPEAKER_04: So you're not making any estimate of those.
28:18
SPEAKER_01: Okay.
28:18
SPEAKER_01: And we did recently have a podcast that we did, Mark and Suzanne and I did recently on variable lease payments.
28:25
SPEAKER_01: So if people want to understand more of the differences between variable and fixed payments and some of the considerations, I would definitely encourage our listeners to check out that podcast.
28:34
SPEAKER_04: And so that if we talk about from the supplier less or perspective, similar concept, but a little bit different.
28:41
SPEAKER_04: So we're going to include all the fixed payments, um, all the variable payments based on a rate or an index, just like we did for the lessees.
28:49
SPEAKER_04: Um for those payments, though, that are variable for some other reason, we have to take, you know, we have to sort of dig down one more layer and figure out if they relate um even partially to the lease component.
29:04
SPEAKER_04: Um, because if they do, i.e.
29:06
SPEAKER_04: like they relate to the usage of the asset, then these are considered variable lease payments.
29:12
SPEAKER_04: They're lease payments, but they're variable, and therefore they're excluded from contract consideration because we don't generally include variable lease payments again until they become determined.
29:24
SPEAKER_04: Um I think that the headline point here is that the model for variable consideration as a lessor is very different than the model for very variable consideration as a sort of pure supplier in a revenue contract.
29:38
SPEAKER_04: We don't account for those variable payments until they're determined under the leasing model, whereas if we were in the revenue model, right, we we have to estimate variable consideration.
29:48
SPEAKER_04: So that's a really important distinction.
29:51
SPEAKER_04: Um if these payments don't relate even in part to the leased asset, then um we have to figure out if they really just relate purely to the service arrangement, meaning the less or or the supplier's efforts to transfer one of the one or more of the goods or services that aren't the lease, or they're related to the outcome of transferring one of those services.
30:17
SPEAKER_04: In that case, we might get into a situation where we would include that in contract consideration if we were going to think of that purely through a 606 lens.
30:27
SPEAKER_04: Now, the one thing I will say is that question of does it relate even in part to the leased asset?
30:33
SPEAKER_04: Generally speaking, if it's a payment that arises from the use, there's probably going to be some tentacle to the leased asset.
30:41
SPEAKER_04: So in many cases, you sort of do get, I'll say, trapped in this is a variable lease payment, and therefore it's not going to be included in contract consideration until the point that it becomes known.
30:52
SPEAKER_04: So you could end up with some lumpiness potentially in your revenue.
30:57
SPEAKER_01: Maybe Pat, like when we were talking in our uh in our variable lease podcast, one of the things we talked about was sometimes that there are payments that are made based on sales or like the quantity, it seems like that would probably have tentacles to the equipment because you're gonna be manufacturing you know so much.
31:14
SPEAKER_01: So it seems like those payments probably would would then in your in this circumstance be tied.
31:19
SPEAKER_04: Yes, because they're, you know, that is the use of the asset, the the assets being used to produce that good.
31:25
SPEAKER_04: It relates, you know, at least partially, presumably, to the use of the asset.
31:29
SPEAKER_01: Aaron Powell Right.
31:30
SPEAKER_01: Okay.
31:31
SPEAKER_01: So now that we've identified our lease and our non-lease components and the contract consideration for both lessees and lessors, um, how do we go about allocating the consideration to the various components, Pat?
31:44
SPEAKER_04: Aaron Powell So this is interesting.
31:45
SPEAKER_04: This is an area where there actually is some similarity between the leasing model and the revenue model.
31:51
SPEAKER_04: Um we allocate the consideration on a relative standalone selling price basis, or sometimes we abbreviate that to SSP.
31:59
SPEAKER_04: But what we have to do then is figure out what are the standalone selling prices of the lease components and the non-lease components.
32:06
SPEAKER_04: And the important point here is the standalone selling price of the lease component is not the price of the asset itself.
32:14
SPEAKER_04: It's the price for the right to use that asset over the contract term.
32:18
SPEAKER_04: So think about the the net present value of the right to use over the lease term, not necessarily the full cost of the asset.
32:27
SPEAKER_04: That would be your standalone selling price for the lease component.
32:31
SPEAKER_04: You'd do something similar for the other, you know, other lease components, any non-lease components, and then you would have your total of all of the standalone selling prices, and then we would allocate the contract consideration in relation to those, you know, relative or in relation to the standalone selling prices.
32:49
SPEAKER_04: So that sets our allocation framework for whatever consideration we have, which will be you know maybe the only the fixed consideration at inception, but then as we get variable consideration that we then are allowed to include in the lease consideration, we would continue to allocate it on that same basis later on in the contract.
33:09
SPEAKER_01: Okay.
33:10
SPEAKER_01: So, like for example, if you the very simplistic, like if you like 50% was related to lease and 50% was related to non-lease, then like whatever you get later.
33:20
SPEAKER_01: You just go 50-50.
33:22
SPEAKER_01: Yeah.
33:22
SPEAKER_01: Okay.
33:24
SPEAKER_01: Well, it's probably much more challenging than my simple example of of 50-50.
33:28
SPEAKER_01: It sounds like it can be um quite complicated.
33:30
SPEAKER_01: Are there any practical expedients that are available to lessees or lessors where they don't have to allocate between the separately between the lease and non-lease components, maybe Mark?
33:42
SPEAKER_03: Yes, the the standard provides for practical expedients, separate practical expedients for both lessees and lessors.
33:49
SPEAKER_03: Um I'll let Pat talk about the Lessor one for the lessee one.
33:54
SPEAKER_03: Um well, one thing that I want to point out is that they operate differently because the lessee's practical expedient is only to combine the non-lease components into the lease component.
34:07
SPEAKER_03: It's a one-way um practical expedient, whereas the lesor one could go either way depending on the facts and circumstances.
34:15
SPEAKER_03: So for the lessee, a lessee could elect by class of asset.
34:20
SPEAKER_03: Okay, and that's well, I'll get back to that in a second, by class of asset to sort of ignore all the non-lease components and combine them into the lease component, which all things being equal would have the effect of probably increasing the payments that are being like there's there would be nothing allocated to the non-lease.
34:38
SPEAKER_03: You would just say all the fixed payments are lease, and therefore they would all go into the measurement of your lease liability and perhaps more impactful, they would also determine or help or go into the determination of whether you have an operating lease or a finance lease, because now you have a lot more consideration to include in there.
34:57
SPEAKER_03: Okay.
34:58
SPEAKER_03: So um it's only a one-way ratchet.
35:01
SPEAKER_03: You you can and and I think this was really designed for like real estate leases with common area maintenance.
35:07
SPEAKER_03: Oh, okay.
35:07
SPEAKER_03: Right.
35:07
SPEAKER_03: So I think I think, I'm not just speculating here, that when the uh FASB board members were deliberating this, they thought that the people that would choose this would choose this for assets where the lease is big and the non-lease services are relatively smaller, right?
35:24
SPEAKER_03: In contract manufacturing arrangements, that's you know not necessarily the case.
35:29
SPEAKER_03: And I want to point out that the election is by asset class.
35:33
SPEAKER_03: So we don't get these questions that often, but it's not by the type of contract.
35:37
SPEAKER_03: So you can't say, well, I'm gonna take all IT arrangements and treat them one way, because if the if the thing that you're leasing are servers, then what if you're just leasing servers and you have a maintenance contract, you know, from the whoever provided you the servers, if that's your policy, then that's your policy.
35:55
SPEAKER_03: It applies to the server, because that's the asset class, it's not the transaction type, so to speak.
36:01
SPEAKER_03: Um the one caveat that we have is again the you know, when they when they released the leases standard back in 2016 or 17, um it was pretty clear that they thought people would be combining services into the lease and they wouldn't have to break those two things apart.
36:19
SPEAKER_03: Um a question has come up about whether you can apply that to anything that's in the same contract with the embedded lease.
36:28
SPEAKER_03: We don't think you should do it in a situation where the other thing that you're obtaining is inventory such that you would skew your you know your your revenues and costs of goods sold by not accounting for the inventory, but instead putting that as part of the lease.
36:47
SPEAKER_01: Right.
36:48
SPEAKER_01: Okay.
36:48
SPEAKER_01: Well then maybe Pat turning to you on the practical expedients for the supplier or less or yeah, and I think Mark alluded to it.
36:55
SPEAKER_04: It so this could go um either way, but the standard gives you the option in certain circumstances to essentially do the same thing, to combine the lease and the non-lease components.
37:09
SPEAKER_04: Um you can do that if two things are the case.
37:12
SPEAKER_04: Um, the timing and the pattern of the transfer for the non-lease components and the lease components are the same.
37:19
SPEAKER_04: So, I mean, leases are by definition sort of delivered or transferred over time.
37:24
SPEAKER_04: So you need then a presumably service that would also be delivered over time to qualify for this and to also be provided ratibly over time, which you know may not always be the case.
37:35
SPEAKER_04: Um the other important thing is you can only do this if the lease component, once you've defined that lease component, would be an operating lease rather than a finance lease, right?
37:44
SPEAKER_04: You can't combine it, so you're gonna be stuck if it's a if it's a finance lease.
37:48
SPEAKER_04: Um and obviously the timing and pattern of transfer wouldn't be the same because presumably under a finance lease, you're basically saying I've bought the asset at the outset, or I've sold the asset rather.
37:59
SPEAKER_04: Um so once you combine it, then you also have to decide, okay, am I gonna account for the whole thing like a lease, or am I gonna account for the whole thing like a service arrangement?
38:12
SPEAKER_04: And that's gonna depend on an assessment of whichever component is predominant, wherever the predominant value is in the contract.
38:19
SPEAKER_04: And that's largely a qualitative determination.
38:23
SPEAKER_04: Um, obviously, if the non-lease component is deemed to be predominant, then you would account for the entire contract under uh 606 and you'd follow the uh revenue model for contract consideration, et cetera.
38:36
SPEAKER_04: If the lease is predominant, then you're gonna apply 842 or the leasing standard to account for all of that.
38:42
SPEAKER_01: Okay.
38:43
SPEAKER_01: So in this case, you make this determinate.
38:45
SPEAKER_01: Like if you decide to use this practical expedient, you make this determination before you have the SSP.
38:53
SPEAKER_04: You would um obviously not have to worry about the SSP allocation if you decided you're gonna account for it on a combined basis.
38:59
SPEAKER_04: Right.
39:00
SPEAKER_04: Yes.
39:00
SPEAKER_04: Right.
39:01
SPEAKER_01: Okay.
39:02
SPEAKER_01: So maybe moving on from accounting for the lease component.
39:06
SPEAKER_01: So both customer lessees and supplier lessors are required to determine the appropriate lease classification prior to recognizing or measuring the lease.
39:15
SPEAKER_01: And since most embedded leases in a supply or service contract are operating leases, maybe maybe we'll focus on that.
39:22
SPEAKER_01: So, Mark, can you take us through the lessee side of this?
39:26
SPEAKER_03: Yeah, I'm just very briefly, I I think most people know obviously that once we determine that something has a lease and there are fixed payments associated with that lease, meaning the fix the portion of the fixed payments that have been allocated to the lease components, um lessees have to record a lease liability for the discounted value of those lease payments over the lease term.
39:47
SPEAKER_03: Um and I guess the main difference is that if this were only a supply contract, you know, as Pat mentioned earlier, the there's less prescriptive guidance for supply contracts.
39:57
SPEAKER_03: And frequently a customer would not have to record a liability on day one for the supplies that it will receive over the term of the arrangement.
40:07
SPEAKER_03: So the fixed payments, if there is the portion allocated to the lease, would go into your measurement of lease liability and the corresponding right-of-use asset.
40:17
SPEAKER_03: And then the payments, the variable payments that would you know become part of the arrangement, they would only be recognized when that underlying variability is is resolved.
40:28
SPEAKER_03: So and that part's probably not that much different, you know, between a lease and a non-lease for the lessee.
40:34
SPEAKER_01: Okay.
40:35
SPEAKER_03: Um sorry, and on the income statement, can't can't ignore the income statement.
40:39
SPEAKER_03: Um obviously lease expense is if it's an operating lease, I'd have just a single lease expense, which again is just a little bit different in terms of how you think about it, because if you thought you were buying widgets, right?
40:52
SPEAKER_03: Yeah, you're not buying widgets.
40:53
SPEAKER_03: You you have lease expense, and then you would also have, again, contract labor expense or other types of expenses.
41:00
SPEAKER_03: You may have an inventory costing system that rolls all of this into inventory costs, but nevertheless, it's that's why it's so important to really think about what is the nature of this contract.
41:10
SPEAKER_03: Because it it it changes the paradigm under which you think about how it's presented in your financials and how you discuss it, for example, in your MDNA.
41:19
SPEAKER_01: Right, right.
41:20
SPEAKER_01: Right.
41:20
SPEAKER_04: Or maybe how we're gonna disclose it under the new disaggregated income statement too.
41:26
SPEAKER_01: Well, Pat, maybe can you take us through the supplier lessor side?
41:30
SPEAKER_04: Aaron Powell Yeah.
41:31
SPEAKER_04: So um I guess for the supplier lessor, uh if we start with the assumption that it's an operating lease, um nothing much really changes on the uh balance sheet.
41:40
SPEAKER_04: They're gonna continue to recognize the asset or assets as their PPE, uh, which would be the same as if they were just doing a supply contract.
41:49
SPEAKER_04: Obviously, different answer if it's a finance lease, then they would effectively reflect it as though they sold the asset and would replace that with a finance receivable.
41:58
SPEAKER_04: Um there'd be a little bit of a need to, in order to recognize the lease income on a straight line basis to the extent that they were getting cash payments in an other than straight line manner, there'd need to be some accrual or receivable um to even out the lease income for the lease component if they ended up in that situation.
42:17
SPEAKER_04: So that would be the balance sheet side of it.
42:20
SPEAKER_04: Um more significant uh impacts obviously on the income statement.
42:24
SPEAKER_04: Um we talked earlier about the difference between the revenue model and the lease model relative to variable considerations, so you're gonna get a different timing of recognition of those.
42:35
SPEAKER_04: Um you probably will also get a different pattern of recognition, um, typically services or supply.
42:41
SPEAKER_04: You might have you know recognition as deliverables happen or as the you know variability in the service level happens, anything that's a lease is gonna be recognized radably over time.
42:52
SPEAKER_04: Um, so those are a couple of pretty big differences in terms of timing.
42:57
SPEAKER_04: And then you know, the income from the lease, as I mentioned, will be recognized on a straight line basis.
43:03
SPEAKER_04: And then finally, um, we haven't really spent a lot of time on this.
43:06
SPEAKER_04: It's the subject of a whole separate conversation, probably, but anytime there's a change in the contract, we're gonna have differences in the models between leasing and revenue, and that will also produce some differences on the income statement in terms of how you handle the contract modifications.
43:23
SPEAKER_01: Okay, well, great.
43:24
SPEAKER_01: Well, thank you, Pat and Mark, so much for joining me today.
43:27
SPEAKER_01: This has been a great conversation.
43:28
SPEAKER_01: Maybe one last question, Mark, before we go is if our listeners want to get more information, guidance on this topic, uh, where should they go?
43:36
SPEAKER_03: Well, from the leases perspective, we have our leases guide, and chapter two is all about embedded leases and identifying when something has a lease and talking about the different allocation models that we've been discussing today.
43:48
SPEAKER_03: And we also have the podcasts that we also just released in the last few weeks, including specifically one on variable payments, the different types of payments, and and also the modifications.
43:59
SPEAKER_03: Podcast is probably one worth listening to.
44:01
SPEAKER_01: Okay, great.
44:02
SPEAKER_01: Thank you both so much for joining me today.
44:06
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