Latest / PwC's accounting podcast / Lease classification – Finance or operating lease?

Transcript

Lease classification – Finance or operating lease? · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:06
  SPEAKER_05: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_05: I'm Heather Horn.
• 0:11
  SPEAKER_05: It's April, and for this month, we're focusing on lease accounting, which is always a popular topic and one that applies to almost all companies.
• 0:19
  SPEAKER_05: In this first episode, we'll cover one of the fundamentals to lease accounting, which is lease classification.
• 0:26
  SPEAKER_05: It's definitely important to get this right, that's where lease accounting starts.
• 0:30
  SPEAKER_03: So for a finance lease, you're gonna recognize interest expense and amortization expense related to that lease.
• 0:36
  SPEAKER_03: So it's like almost like a mortgaged asset, right?
• 0:39
  SPEAKER_03: Interest and sort of depreciation.
• 0:41
  SPEAKER_03: It's recognized separately on the PL, and you'll have that front-loaded expense recognition because you have the interest on the lease liability.
• 0:49
  SPEAKER_03: Now if we go to the operating lease, that's just straight line lease expense, single lease expense, one line item in the PL.
• 0:56
  SPEAKER_03: So totally different expense shown in the PL and the way you recognize it.
• 1:08
  SPEAKER_05: That was Suzanne Stefani, a director in PWC's National Office, and Mark Jerusalem, a managing director in PWC's National Office, who both specialize in lease transactions.
• 1:19
  SPEAKER_05: Having answered many, many, many questions on this topic over the years, they have a depth of knowledge and great insights to share.
• 1:27
  SPEAKER_05: So stay tuned as we kick off this month's series.
• 1:30
  SPEAKER_05: So, Suzanne, Mark, welcome to our month of leasing.
• 1:34
  SPEAKER_05: And it's so nice to have two of our firm specialists in this topic.
• 1:37
  SPEAKER_05: I know you've both spent a lot of time talking about this.
• 1:40
  SPEAKER_05: And I also know that this is an area where we got a lot of questions, and it's one of our most popular guides.
• 1:47
  SPEAKER_05: And this is our year, all about our most popular guide.
• 1:51
  SPEAKER_05: So Lisa is at the top of the list.
• 1:53
  SPEAKER_05: For today's podcast, though, I just want to make sure from a listener perspective, we're going to focus on lessees.
• 1:58
  SPEAKER_05: So make sure you kind of are using that lens when we get into it.
• 2:02
  SPEAKER_05: But maybe before we actually really jump into things, Mark, it would be helpful just to say from your perspective why you think we continue to get so many questions since the new standard has definitely been out there for a while.
• 2:15
  SPEAKER_02: Right.
• 2:15
  SPEAKER_02: The new standards, everybody should be using the new standard by this point, right?
• 2:19
  SPEAKER_02: The new standards have been out there for a while.
• 2:21
  SPEAKER_02: Um, I think that there's a couple of reasons that we continue to get a lot of leasing questions.
• 2:26
  SPEAKER_02: Um, first of all, is I'll just say the uncertainty in the economy.
• 2:31
  SPEAKER_02: Um, I think people are still evaluating their footprints, for example, for real estate leases.
• 2:36
  SPEAKER_02: Um, but just in general, I think companies really value being a lot more flexible with their plans.
• 2:41
  SPEAKER_02: And also with the movement in interest rates, I think companies are really just you know wanting to pivot quickly, and they'd rather have shorter term leases than sort of permanent ownership of an asset.
• 2:53
  SPEAKER_02: Um, the second thing I would say, just in terms of, you know, why do we get a lot of questions on leasing, is because we just have to realize that leasing is not what any lessee does for a living, if you will, right?
• 3:05
  SPEAKER_02: So I'm gonna have people on staff who really know the revenue standard and how to account for my revenues.
• 3:11
  SPEAKER_02: Typically, I'm just not gonna have the expertise in-house to be like the leasing expert.
• 3:15
  SPEAKER_02: And so we get a lot of questions.
• 3:16
  SPEAKER_05: Okay, well, it totally makes sense.
• 3:18
  SPEAKER_05: And obviously, lease classification is a good place to start since it is the starting point for accounting.
• 3:24
  SPEAKER_05: And if you don't get this right, then you don't have much chance of getting the rest of your accounting right.
• 3:30
  SPEAKER_05: Um, and so the lease classification, whether it's operating or financing, as I said, impacts many areas.
• 3:36
  SPEAKER_05: So, Suzanne, maybe before we get into the details of how you actually figure out which one you're in, you can remind us of those key differences.
• 3:43
  SPEAKER_05: So, sort of a refresher.
• 3:44
  SPEAKER_03: Yeah.
• 3:45
  SPEAKER_03: So there's there's a good amount of differences in accounting and presentation and disclosure.
• 3:50
  SPEAKER_03: Um, so I'll just give you the major ones that most people think about.
• 3:53
  SPEAKER_03: The first one, biggest one, I'd say, is expense recognition.
• 3:57
  SPEAKER_03: So for a finance lease, you're gonna recognize interest expense and amortization expense related to that lease.
• 4:04
  SPEAKER_03: So it's like almost like a mortgaged asset, right?
• 4:06
  SPEAKER_03: Interest and sort of depreciation.
• 4:09
  SPEAKER_03: It's recognized separately on the PL.
• 4:11
  SPEAKER_03: And you'll have that front-loaded expense recognition because you have the interest on the lease liability.
• 4:16
  SPEAKER_03: Now, if you go to the operating lease, that's just straight line lease expense, single lease expense, one line of in the PL.
• 4:23
  SPEAKER_03: So totally different expense shown in the PL and the way you recognize it.
• 4:29
  SPEAKER_03: Um, the next one I would say, I talk about the cash flow statement.
• 4:32
  SPEAKER_03: In there, if you have a finance lease, the payments are going to be just like I would say a mortgage, right?
• 4:37
  SPEAKER_03: The payments are broken down between principal and interest on the lease liability.
• 4:41
  SPEAKER_03: So the principal payments, of course, would be financing and the interest payments would go to operating.
• 4:46
  SPEAKER_03: Whereas if you have an operating lease, all payments are operating.
• 4:50
  SPEAKER_03: So there's those are the big ones.
• 4:51
  SPEAKER_03: There's also disclosures and things like that, but um, those are the ones that most people think about.
• 4:56
  SPEAKER_05: Well, and I think, Suzanne, notably there, you did not talk about the balance sheet because one of the big changes from the new lease standard was that under either model, now you are recording a right of use asset for your um for your lease interest.
• 5:10
  SPEAKER_03: Definitely, yeah.
• 5:10
  SPEAKER_05: All right.
• 5:11
  SPEAKER_05: So then if I'm a lessee, I think this is a great refresher.
• 5:14
  SPEAKER_05: How would I figure out then if I have an operating or a financing lease?
• 5:19
  SPEAKER_03: Yeah, so it's all about um transfer of control, right?
• 5:22
  SPEAKER_03: So if you have a finance lease, it's like the less or effectively transferred control of that asset that you're leasing to you as a lessee.
• 5:30
  SPEAKER_03: It's like an in-substance finance purchase of the asset almost.
• 5:34
  SPEAKER_03: Now, an operating lease obviously is the opposite, control doesn't transfer.
• 5:38
  SPEAKER_03: So, how do you figure that out?
• 5:39
  SPEAKER_03: How do you know if you've gotten control or not of the asset?
• 5:42
  SPEAKER_03: Um, the leases guidance gives five criteria for classification.
• 5:46
  SPEAKER_03: I'm gonna put them like kind of in the form of questions because I think it's easier to think about.
• 5:50
  SPEAKER_03: And if the answer is yes to any of these questions, then you have a finance lease.
• 5:54
  SPEAKER_03: So the first one, is ownership of the asset transferred to the lessee by the end of the lease term?
• 6:00
  SPEAKER_03: Obviously, yes, it's a finance lease.
• 6:02
  SPEAKER_03: Is there a purchase option that's reasonably certain to be exercised?
• 6:06
  SPEAKER_03: Is the lease term for a major part of the remaining economic life of the asset?
• 6:11
  SPEAKER_03: Is the present value of the lease payment substantially all of the fair value of that asset?
• 6:16
  SPEAKER_03: And then lastly, is the asset of such a specialized nature that it's expected to have no alternative use to less or at the end of the lease term?
• 6:23
  SPEAKER_03: So if the answer to those questions, any of them, is yes, you've got a finance lease.
• 6:28
  SPEAKER_03: And there's a lot to go through, which I think we'll go, we will go through, but just to give a you know highlight or overview.
• 6:34
  SPEAKER_05: Yes, very helpful.
• 6:35
  SPEAKER_05: And you're right.
• 6:36
  SPEAKER_05: I do want to delve more into those, but maybe a few level setting questions first.
• 6:40
  SPEAKER_05: Yeah.
• 6:40
  SPEAKER_05: Um, so starting off, I think one of the questions that come up is when we should be doing this assessment, like what's the date we should use.
• 6:49
  SPEAKER_05: So, Mark, I'll go to you for that.
• 6:51
  SPEAKER_02: Right.
• 6:51
  SPEAKER_02: So we start, we we do our lease classification at the least commencement date.
• 6:56
  SPEAKER_02: And that's also the day that we would start recording the lease, is at the lease commencement date.
• 7:01
  SPEAKER_02: So, what is the lease commencement date according to the standard?
• 7:04
  SPEAKER_02: It's the day that the lesseur makes the underlying asset available for use by the lessee.
• 7:10
  SPEAKER_02: And if you think about it, let's say this were a car lease as an example, it's the day you get the keys to the car.
• 7:16
  SPEAKER_02: If it's an office lease, it's the day you get the keys to the office.
• 7:19
  SPEAKER_02: It's basically the time that the lessor has to ask your permission if they want to go into the space and do some repairs, right?
• 7:25
  SPEAKER_02: Because you are now controlling the space.
• 7:28
  SPEAKER_02: Uh, one thing I want to mention is that frequently this is not the date that's written into the document itself, right?
• 7:35
  SPEAKER_02: So often a lease will say, you know, the rents begin on April 1st, right?
• 7:40
  SPEAKER_02: April 1st may be the commencement date or may not be the commencement date.
• 7:43
  SPEAKER_02: So we have to look beyond the commencement date to look to the proverbial date that we get the keys.
• 7:48
  SPEAKER_02: Um, and the reason this is important is because when we're going to talk about all these things, but all of the factors that you have to evaluate, you're evaluating the factors as of this date, this commencement date.
• 8:00
  SPEAKER_02: What is the fair value of the underlying asset, for example?
• 8:03
  SPEAKER_02: It's as of this date.
• 8:05
  SPEAKER_02: Um, what is your discount rate?
• 8:07
  SPEAKER_02: Again, it's it's as of this date.
• 8:08
  SPEAKER_02: We know that interest rates can change, you know, sometimes quickly.
• 8:12
  SPEAKER_02: Your assumptions over the lease term and whether or not you're reasonably certain to exercise either a renewal option or a purchase option, again, those assumptions are as of this date.
• 8:22
  SPEAKER_02: And with some larger assets, you may have actually signed the lease agreement maybe a year ago, you know, and things can change.
• 8:30
  SPEAKER_02: Your business model can change.
• 8:32
  SPEAKER_02: So um that that's the commencement date.
• 8:35
  SPEAKER_05: So before um we go on then question for you, because you made the point of sort of the day you get the keys, and I don't want to overly complicate things, but obviously sometimes you're leasing an asset that um is being built for you and that may not be you know completed.
• 8:51
  SPEAKER_05: And so is it the same, would you consider the uh lease commencement date the same way, or are there some other considerations?
• 8:59
  SPEAKER_05: And if so, we don't necessarily have to get into them here.
• 9:02
  SPEAKER_02: Well, you're raising I'd say two points to that response.
• 9:06
  SPEAKER_02: One is um if you're involved with an asset before the asset exists, before it's being built, and you have some involvement, there's a whole part of the standard that has you evaluate whether you're deemed to be the owner of the asset while it's being constructed.
• 9:19
  SPEAKER_02: So that's a part we don't want to get into now.
• 9:21
  SPEAKER_02: That would be a whole podcast unto itself.
• 9:23
  SPEAKER_02: Yes.
• 9:23
  SPEAKER_02: Right?
• 9:24
  SPEAKER_02: The other thing that sometimes happens is that sometimes there's space that's perfectly ready, right?
• 9:30
  SPEAKER_02: Maybe there was another tenant in there before you, so some work has to be done.
• 9:35
  SPEAKER_02: And the Lessor is working on making some of those improvements for you.
• 9:40
  SPEAKER_02: And at the same time, he says you can also go in and start building out leasehold improvements.
• 9:45
  SPEAKER_02: We'll work in the we'll work in the space at the same time.
• 9:48
  SPEAKER_02: Um, that probably happens in most real estate leases, right?
• 9:52
  SPEAKER_02: And so then you still have to figure out at some point, if you think about it, you're asking the lessor when can you go in the space and install your carpeting, install your leasehold improvements.
• 10:03
  SPEAKER_02: And sometimes they're asking you, hey, I just need to figure off, you know, to do these check check the box items in the bathroom.
• 10:11
  SPEAKER_02: When can I come in?
• 10:13
  SPEAKER_02: Whoever has to ask the other one permission doesn't have control, right?
• 10:16
  SPEAKER_05: Oh, yes.
• 10:17
  SPEAKER_05: Okay, that's very helpful.
• 10:19
  SPEAKER_05: I think really a good point there.
• 10:20
  SPEAKER_05: And then, Mark, the other question I know comes up often, um, and just in thinking about this, is sometimes you might have a lease and then it's let's say for two floors to a building or something else, and those have different dates that you're getting the keys.
• 10:34
  SPEAKER_05: So do you how do you think about that?
• 10:36
  SPEAKER_02: Right.
• 10:37
  SPEAKER_02: So that gets me into sort of my next point.
• 10:39
  SPEAKER_02: So that's a very common situation.
• 10:41
  SPEAKER_02: I might get the keys to the first floor, let's say on May 1st, and get the keys to the second floor on July 1st.
• 10:46
  SPEAKER_02: Well, in that case, by definition, I guess you've got two commencement dates, right?
• 10:51
  SPEAKER_02: One for the first floor and one for the second floor.
• 10:54
  SPEAKER_02: Yeah, so you'd have different commencement dates for each for each asset in the contract.
• 10:59
  SPEAKER_02: One of the important things to know is that we're really accounting for the lease at the asset level, not at the contract level, right?
• 11:06
  SPEAKER_02: As we just said, in that case, each floor would be considered like a separate asset in the lease, right?
• 11:12
  SPEAKER_02: So how do we determine whether a lease has multiple assets or just one asset?
• 11:19
  SPEAKER_02: And what the guidance says is that you have to separate the lease component into separate lease components based on sort of two criteria.
• 11:27
  SPEAKER_02: One, can you use the assets separately from one another?
• 11:31
  SPEAKER_02: And is the right to use one asset not so interrelated or so affected by the right to use another asset?
• 11:39
  SPEAKER_02: Right.
• 11:40
  SPEAKER_02: So going back to our example, what you've just described is really common.
• 11:44
  SPEAKER_02: I make a, you know, so it's kind of self-evident in that case that even though you people don't think about it that way, right?
• 11:51
  SPEAKER_02: Obviously, you really do have two assets because obviously you're already using the first floor before you could even use the second floor, right?
• 11:57
  SPEAKER_02: So frequently it's not that hard to figure out.
• 11:59
  SPEAKER_02: It's just that most people don't really think about it that way.
• 12:02
  SPEAKER_02: So you really have to think about it at the asset level.
• 12:04
  SPEAKER_05: All right, but then you're saying you could have other examples where you're leasing two items that you really need access to both them in order for it to operate the way that it would, and then in which case you wouldn't necessarily think about that as two separate leases.
• 12:18
  SPEAKER_02: That's right.
• 12:19
  SPEAKER_02: So if two assets had to work hand in hand, um there's one example in the standard where there's a building that simply houses um an electricity generating unit, right?
• 12:33
  SPEAKER_02: And you can't use the building to do anything else.
• 12:36
  SPEAKER_02: You can't use the generator without the building.
• 12:38
  SPEAKER_02: So the standard concludes that that may just be one asset.
• 12:41
  SPEAKER_05: Yes.
• 12:41
  SPEAKER_05: And I I think that was on my mind because as you know, anything electricity related, I always have an extra interest.
• 12:46
  SPEAKER_05: So then uh, Mark, the other thing that popped into my head when you were describing those is when we talk about the level of the assets, sometimes we get, you know, that you're leasing a group of assets, right?
• 12:58
  SPEAKER_05: Like the one that came into my head is like maybe I'm leasing like a portfolio of cars or something else.
• 13:02
  SPEAKER_05: And so then in that case, where it's a bunch of individual assets under the same lease, could I look at them all together or do I have to do each one separately?
• 13:11
  SPEAKER_02: Well, I guess the bottom line is that you could look at them together when that doesn't create any materially different results than if you would have looked at them separately, right?
• 13:22
  SPEAKER_02: So it's really permitted in situations where you sort of have typically a homogenous group of assets, and they the leases all start and stop on the same day.
• 13:32
  SPEAKER_02: Because again, if we go back to the example that you and I just talked about, two floors of a building, well, guess what?
• 13:37
  SPEAKER_02: That second floor that you're getting a few months later has a shorter lease term.
• 13:41
  SPEAKER_02: So the expense pattern could be different, right?
• 13:44
  SPEAKER_02: So it's really not so much an expedient as much as it is a recognition from a bookkeeping perspective that there may very well be master leases or other situations where you're leasing a bunch of assets, they're gonna be delivered to you all on the same day, right?
• 13:59
  SPEAKER_02: Or around the same time, you you give them back after three years, then certainly, again, if it doesn't make a difference from the accounting perspective, you're not gonna have a different classification as an example or a different lease term, then yes, you could, from a bookkeeping perspective, treat them as if it's just one lease.
• 14:16
  SPEAKER_05: All right.
• 14:17
  SPEAKER_05: So then, Mark, if one contract gives me the right to use multiple assets, as we talked about, then I still need to go through and identify each of the individual components.
• 14:26
  SPEAKER_05: And then I have to identify and classify each of those separately based on its own lease commencement date.
• 14:32
  SPEAKER_05: So my idea of my fleet of cars could work out, but maybe not so much if I'm getting different cars uh delivered to me at all different times.
• 14:39
  SPEAKER_04: Right.
• 14:40
  SPEAKER_05: All right.
• 14:40
  SPEAKER_05: So, Suzanne, let's go into then the questions that you raised earlier so people um can kind of think them through.
• 14:46
  SPEAKER_05: And we'll think uh we'll talk here a little bit about the ones where we get more questions.
• 14:50
  SPEAKER_05: I think starting with one that's probably the most common or among the most common is whether or not the lease term is for a major part of the remaining economic life of the asset, or also known as the least term test.
• 15:02
  SPEAKER_05: So, Suzanne, how do people think about this?
• 15:04
  SPEAKER_03: Yeah, definitely got a lot of questions on the least term test.
• 15:07
  SPEAKER_03: And I the first thing is if we say the lease term needs to be for a major part of the remaining life, economic life of the asset.
• 15:15
  SPEAKER_03: So, what does major part mean?
• 15:17
  SPEAKER_03: So just want to clarify that first, although we get most of the questions on lease term.
• 15:21
  SPEAKER_03: Um, the guidance doesn't have any specific bright lines here.
• 15:25
  SPEAKER_03: But when drafting this new lease's guidance, not totally new anymore, but you know what I mean.
• 15:31
  SPEAKER_03: ASC 842.
• 15:32
  SPEAKER_03: Um, the FASB observed one reasonable approach would be to conclude that 75% or greater is a major part of an asset's economic life.
• 15:42
  SPEAKER_03: And that is what's commonly used in practice today.
• 15:45
  SPEAKER_03: But before we get into what goes into the lease term, because that is definitely where we get most of the questions, I just want to point out there's two situations where a lesie wouldn't have to do that test.
• 15:56
  SPEAKER_03: One, of course, is land, because land doesn't, it's indefinite life.
• 15:59
  SPEAKER_03: So how could you do it?
• 16:00
  SPEAKER_03: So you can't do it if you have um if you're leasing land, instead you look at all the other tests.
• 16:06
  SPEAKER_03: The other one is where you're leasing an asset and it's at or near the end of its economic life.
• 16:12
  SPEAKER_03: That's another time where you wouldn't need to do this test, but you draw all the other.
• 16:16
  SPEAKER_03: So the question is what what is that?
• 16:18
  SPEAKER_03: What's at or near the end?
• 16:20
  SPEAKER_03: Again, no bright lines, but um, Fazby indicated a reasonable, one reasonable approach to use is if the lease is starting in the last 25% of the asset's economic life, then in those cases you wouldn't have to do this particular test.
• 16:35
  SPEAKER_05: All right.
• 16:36
  SPEAKER_05: So then, Suzanne, I think that's helpful.
• 16:38
  SPEAKER_05: And obviously, then there's a few cases that you don't have to do this test.
• 16:42
  SPEAKER_05: But otherwise, you mentioned that you get the most questions around what is the lease term.
• 16:47
  SPEAKER_05: Right.
• 16:48
  SPEAKER_05: And so if we're thinking about lease term, what are we thinking about?
• 16:51
  SPEAKER_03: Yeah, sure.
• 16:52
  SPEAKER_03: So it's the non-cancelable period of the lease together with extension options that are reasonably certain of exercise, which we'll talk about that, and less or options.
• 17:01
  SPEAKER_03: So options that are controlled by the lessor.
• 17:04
  SPEAKER_03: If those are, if there are less or options, they have to be included in the lease term because the lessee has no uh discretion over whether they're exercised or not.
• 17:14
  SPEAKER_05: All right.
• 17:14
  SPEAKER_05: The thing that jumped out at me when you mentioned that is reasonably certain.
• 17:18
  SPEAKER_05: Yeah.
• 17:18
  SPEAKER_05: And how would we know if something is reasonably certain of exercise?
• 17:22
  SPEAKER_03: Yeah, so it's a pretty high threshold.
• 17:24
  SPEAKER_03: There's no bright lines in the guidance, but generally when people think about it, it's like a probable concept, which typically is about 75%.
• 17:32
  SPEAKER_03: Um so how do you figure that out?
• 17:34
  SPEAKER_03: It's it's judgmental and it's an assessment that you're gonna do based on facts and circumstances at the least commencement date.
• 17:41
  SPEAKER_03: It's really like think about it like a wholesome look at the economics of the whole arrangement.
• 17:45
  SPEAKER_03: Think about all factors.
• 17:47
  SPEAKER_03: So not just entity-based, but broader, like the asset itself and market factors as well.
• 17:53
  SPEAKER_03: Um, so really you're looking for extension options.
• 17:56
  SPEAKER_03: The extension options you're gonna put in your lease term are options where the lessee economically has like little choice but to exercise that option.
• 18:04
  SPEAKER_03: So you're looking for economic incentives here.
• 18:07
  SPEAKER_03: Does the lessee have an economic incentive to exercise that option?
• 18:12
  SPEAKER_03: And one place I like to start is looking at the renewal period rents and compare the rent payments and the renewal period to the current market rents.
• 18:21
  SPEAKER_03: So if the renewal rents are lower than the current market rents, that's usually a pretty good sign, right?
• 18:26
  SPEAKER_03: That there's an incentive to exercise.
• 18:28
  SPEAKER_03: Um, on the other hand, if the renewal rents are equal to or greater than the rents in the current term, may not really be an incentive there.
• 18:37
  SPEAKER_05: All right.
• 18:38
  SPEAKER_05: And I think it's important to note there, Suzanne, those are not the only things you would think about, right?
• 18:43
  SPEAKER_05: There could be other factors that would come into play here.
• 18:46
  SPEAKER_03: Yeah.
• 18:46
  SPEAKER_03: So you're looking for first you're kind of looking for incentives.
• 18:49
  SPEAKER_03: You're seeing, you know, is there anything that's really gonna compel the lessee to exercise?
• 18:54
  SPEAKER_03: But then on the flip side, if you don't have incentives, you got to look for significant economic penalties.
• 19:00
  SPEAKER_03: Like there might be penalties to that the lessee would suffer if they didn't exercise, right?
• 19:05
  SPEAKER_03: So think about, I don't know, a couple of examples.
• 19:08
  SPEAKER_03: Like if you have real estate, someone's leasing maybe a building or a storefront or something, is that location so unique that the lessee has to stay in that spot and they would incur kind of not incur, but kind of feel a penalty, right?
• 19:22
  SPEAKER_03: If they leave.
• 19:23
  SPEAKER_03: Um, are there replacement assets available again for real estate?
• 19:27
  SPEAKER_03: Like if you're gonna have to move from one location to the other, is there's are the um moving costs so significant that would cause you to have a penalty?
• 19:36
  SPEAKER_03: Um importance of the leased asset to the lessee's operations, like is this your headquarters?
• 19:41
  SPEAKER_03: That might be a problem to move.
• 19:43
  SPEAKER_03: Another one is really thinking about your kind of, we call them your sunk cost.
• 19:48
  SPEAKER_03: Like in the beginning, as a lessee, you might move in there and put leasehold improvements, you might have a significant amount of prepaid rent.
• 19:55
  SPEAKER_03: And think about how much value would the lessee lose if the lease is not renewed.
• 20:01
  SPEAKER_03: Like if you think about leasehold improvements, if you put a bunch of leasehold improvements in there and only stayed for the base term, might that not, you know, those lease, that leasehold improvement investment not have been worth it, right?
• 20:16
  SPEAKER_03: You put so much that you need to stay for the extended term.
• 20:19
  SPEAKER_03: So it's just kind of those, there's there's all sorts of things to think about, but those are just a couple examples.
• 20:24
  SPEAKER_05: All right.
• 20:24
  SPEAKER_05: So definitely making sure then that you're looking at all of the Fox and circumstances and that you're doing truly like a fulsome evaluation to figure out if you would be, you know, in your economic interest to exercise the extension option.
• 20:38
  SPEAKER_05: And just then, so if I had a five-year base lease with a two-year extension, and I was reasonably certain that I would exercise it, then for this purpose of classification, my lease term is seven years.
• 20:51
  SPEAKER_05: Um we talked about extension options, but what about termination options?
• 20:56
  SPEAKER_05: How do we think about those?
• 20:58
  SPEAKER_03: Yeah, so it's a very similar concept with the extension option.
• 21:01
  SPEAKER_03: So we'll give an example.
• 21:02
  SPEAKER_03: So kind of flip your example a little bit.
• 21:04
  SPEAKER_03: So if you had a lease with a five-year term, but it had a termination option in it, a lessy termination option after two years, that's really the same thing as having a two-year non-cancilable lease with a three-year extension option.
• 21:20
  SPEAKER_03: You look at it the same way, you just have to frame it that way.
• 21:22
  SPEAKER_03: And then if you look at that, if that way you say, okay, I have a two-year base term, three-year extension option.
• 21:28
  SPEAKER_03: So just all the things I talked about earlier, am I reasonably certain to exercise that option?
• 21:32
  SPEAKER_03: So it's kind of the same concept.
• 21:34
  SPEAKER_03: You just have to frame it up that way.
• 21:36
  SPEAKER_05: All right.
• 21:36
  SPEAKER_05: And then, Suzanne, all of that then gets compared to the estimated remaining economic life of the asset.
• 21:42
  SPEAKER_05: And I know that's another area where this can get have a lot of questions.
• 21:47
  SPEAKER_05: So, how do you think about that?
• 21:48
  SPEAKER_03: Yeah, so the the economic life, the guidance defines it as the period over which an asset is expected to be economically usable by one or more users.
• 21:58
  SPEAKER_03: So you look at that economic life.
• 22:00
  SPEAKER_03: At least commencement and you consider the condition of the asset at the time.
• 22:04
  SPEAKER_03: Right.
• 22:04
  SPEAKER_03: So for example, we're in New York and we know I walked by the Empire State building today on my way here, and it's over something like 90 years old.
• 22:13
  SPEAKER_03: I think it was built in the 30s.
• 22:15
  SPEAKER_03: Um, so that's pretty old, but no one would say that didn't have a remaining useful life, because you could clearly go in there and probably lease it for a lot of money, actually.
• 22:25
  SPEAKER_03: So it's very valuable.
• 22:26
  SPEAKER_03: So it's just about thinking about the condition, right, when you get in there and how how long is it expected to be used, and not just by you, but as a lessee, but as few as uh people after the lease as well.
• 22:38
  SPEAKER_05: All right, that's helpful.
• 22:39
  SPEAKER_05: And so then if I put that all together, if I do my analysis and I conclude that the lease term is for a major part of the economic life, then I would have a finance lease.
• 22:49
  SPEAKER_03: Yeah.
• 22:49
  SPEAKER_03: Well, the good news is you won't have to do the rest of the tests, but exactly.
• 22:52
  SPEAKER_03: I don't know if you want a finance lease.
• 22:55
  SPEAKER_05: All right.
• 22:55
  SPEAKER_05: So then let's move on to the another question.
• 22:58
  SPEAKER_05: And this one is around the present value of the lease payments and whether or not they're equal to or exceed substantially all of the fair value of the underlying asset.
• 23:07
  SPEAKER_05: And so this one is the lease payments test.
• 23:09
  SPEAKER_05: And so, Mark, can you walk through this model?
• 23:12
  SPEAKER_02: Sure.
• 23:12
  SPEAKER_02: So whereas the last test is often very judgmental, and you're dealing with sort of more qualitative factors, right?
• 23:20
  SPEAKER_02: Here, this one gets very quantitative, right?
• 23:23
  SPEAKER_02: So the first thing we have to do is we have to define what is what do we mean by substantially all.
• 23:28
  SPEAKER_02: Once again, while there might not be any bright lines in the standard, the FASB did say at the time that 90% is a good way to think of substantially all.
• 23:39
  SPEAKER_02: And in practice, that's what people use, right?
• 23:41
  SPEAKER_02: So if the discounted lease payments are 90% or more of the fair value of the underlying asset, you would have a finance lease, right?
• 23:51
  SPEAKER_02: So the first thing you have to do is you have to figure out how many payments you're going to make, i.e., what is the lease term, which is the stuff that Suzanne was just talking about, right?
• 24:00
  SPEAKER_02: The next thing you have to figure out is what are the lease payments, okay?
• 24:06
  SPEAKER_02: And in order to do that, you also have to give some thought to whether there are any non-lease components in the contract.
• 24:14
  SPEAKER_02: Okay.
• 24:15
  SPEAKER_02: Because whatever you're paying for for the entire contract, if there are both lease components and non-lease components, you would have to allocate some of those dollars to the non-lease components.
• 24:25
  SPEAKER_02: Now, non-lease components are actually more common than we may think.
• 24:29
  SPEAKER_02: Um, sometimes, like in real estate leases, sometimes I might lease a standalone building.
• 24:35
  SPEAKER_02: I'll be the only lessee.
• 24:36
  SPEAKER_02: It'll be a triple net lease, which means that I pay myself for any of the maintenance or the property taxes or anything else.
• 24:42
  SPEAKER_02: In that case, perhaps the lesseur is not performing any other services for you.
• 24:47
  SPEAKER_02: But again, we're here in New York City.
• 24:49
  SPEAKER_02: Lots of people are leasing office space.
• 24:51
  SPEAKER_02: And if you're in a multi-tenant property, in almost all cases, the Lessor is also providing maintenance.
• 24:57
  SPEAKER_02: So right off the bat, I have a non-lease component.
• 24:59
  SPEAKER_02: Similarly, in equipment leases, I might have, for example, a copier or a piece of medical equipment.
• 25:06
  SPEAKER_02: And I might also have as part of that contract, I will buy the paper or the patient disposables that I have to use with that medical equipment.
• 25:14
  SPEAKER_02: So it's not uncommon to have both lease and non-lease components.
• 25:18
  SPEAKER_02: If we do, then we have to take the consideration in the contract and we have to allocate them between the two based on their relative standalone prices.
• 25:28
  SPEAKER_02: Okay.
• 25:29
  SPEAKER_02: The the upshot of all this is that not all of your lease payment is going to go into the classification of your lease because some of that lease payment will be going to the other non-lease component.
• 25:40
  SPEAKER_02: Okay.
• 25:41
  SPEAKER_02: There is a practical expedient available to lessees to combine the uh consideration between lease and non-lease to put that all to just the lease, right?
• 25:52
  SPEAKER_02: If you were to choose to do that, then essentially the good news is you won't have to do the allocation.
• 25:58
  SPEAKER_02: The bad news is you would treat all of the payments as just being lease payments, in which case you might have a higher lease liability and right-of-use asset than you would have had you not taken that expedient.
• 26:10
  SPEAKER_02: And and also there'd be a greater chance, therefore, that you can get a finance lease.
• 26:14
  SPEAKER_05: So, Mark, to that exact point before we go on with this, um, in terms of thinking about what are our lease payments when we do allocate, do most people choose to take this expedient, or do you see more often that companies will allocate between the lease and non-lease components, or does it just really depend on the facts of the particular lease?
• 26:36
  SPEAKER_02: I'd say it really just does depend.
• 26:39
  SPEAKER_02: We see frequently in real estate leases, people do take the practical expedient.
• 26:43
  SPEAKER_02: Um, we see it also with things that actually have a high amount of service, such as, let's say, rail car leases or airplane leases where the lessor does everything for you.
• 26:53
  SPEAKER_02: We have seen people do that.
• 26:55
  SPEAKER_02: On the other hand, um, if both the non-lease component, like i if I have a supply contract that has an embedded lease, we often see people not taking the practical expedient.
• 27:06
  SPEAKER_05: Oh, okay.
• 27:07
  SPEAKER_05: All right, very helpful.
• 27:08
  SPEAKER_05: All right.
• 27:08
  SPEAKER_05: So then, Mark, now that we've talked about that allocation between lease and non-lease components, let's take another step down.
• 27:15
  SPEAKER_05: And which payments in the contract are considered lease payments?
• 27:19
  SPEAKER_02: Okay.
• 27:20
  SPEAKER_02: Well, obviously, the simplest thing is we have our fixed payments, the payments that are required under the lease.
• 27:26
  SPEAKER_02: And a fixed payment could also include, besides just your monthly rent check, right?
• 27:31
  SPEAKER_02: It could also include payments that you have to make on behalf of the lessor.
• 27:36
  SPEAKER_02: So, for example, at the beginning of the lease, you might cut a deal with a lessor where you have to say repair one of the lesseurs' assets or you know, fix the roof as an example.
• 27:47
  SPEAKER_02: That would be a fixed lease payment that you'd have to include in your classification evaluation.
• 27:53
  SPEAKER_02: Um, you might also have certain costs that you're gonna pay on the lesseurs' behalf.
• 28:00
  SPEAKER_02: For example, um the lessour may charge you for its loan commitment fee because it has to finance the assets.
• 28:06
  SPEAKER_02: They may have certain legal fees or other structuring fees to structure the entity that's gonna own the asset, right?
• 28:13
  SPEAKER_02: So anytime you're paying a cost that is really the lesores bill, then that is also essentially a fixed payment, right?
• 28:20
  SPEAKER_02: Um other fixed payments would include a negotiated lease incentive.
• 28:25
  SPEAKER_02: Now, lease incentives we don't often think about as lease payments because it's cash you receive rather than pay.
• 28:31
  SPEAKER_02: But actually, in the standard, it is part of the definition of lease payments.
• 28:35
  SPEAKER_02: So if you are going to collect lease incentives, perhaps immediately or shortly after you sign the lease, then you would actually reduce your lease payments by that amount.
• 28:45
  SPEAKER_02: And then finally, you know, we talked about renewal options, and in a few moments we're going to talk about purchase options.
• 28:51
  SPEAKER_02: But if you conclude that a purchase option is reasonably certain to be exercised, then you would also include that purchase option price as a fixed payment.
• 29:02
  SPEAKER_05: All right, that's helpful.
• 29:03
  SPEAKER_05: So then one of the payments I noticed you didn't mention, Mark, that many leases often have would be variable payments.
• 29:10
  SPEAKER_05: So how do we think about those when we're thinking about our total amount of lease payments for classification?
• 29:17
  SPEAKER_02: Right.
• 29:17
  SPEAKER_02: So variable payments, and again, just to define what variable payments are, um the standard says variable payments.
• 29:24
  SPEAKER_02: I'm reading here, payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.
• 29:39
  SPEAKER_02: The reason I wanted to read that is because when you read that, it seems like it's pretty broad, right?
• 29:44
  SPEAKER_02: It's any changes that could happen.
• 29:46
  SPEAKER_02: And Heather, like you said, indeed, we are seeing a lot of leases that have variable payments.
• 29:51
  SPEAKER_02: So the typical variable payments would be things like payments that are based on a percentage of sales, percentage of revenue, percentage of profits, even, payments that are based on how much you use the asset.
• 30:01
  SPEAKER_02: So a payment per click on the copy machine or per mile that you drive a car.
• 30:06
  SPEAKER_02: All of those things that I've just said are things that change after you get the asset, right?
• 30:12
  SPEAKER_02: And they are excluded from lease payments for purposes of figuring out the classification of the lease and later on for purposes of measuring the lease liability.
• 30:21
  SPEAKER_02: Okay.
• 30:22
  SPEAKER_02: Um, other types of variable payments include payments that are based on a rate or an index.
• 30:26
  SPEAKER_02: Okay.
• 30:26
  SPEAKER_02: And the two common examples are a payment that's based on a certain interest rate base, right?
• 30:33
  SPEAKER_02: Like SOFR plus X, or that are based on what the then CPI is at the time that you, you know, the lease commences.
• 30:41
  SPEAKER_02: In that case, you would actually include, because remember, you're doing this test as of the lease commencement.
• 30:47
  SPEAKER_02: So you have that data today, right?
• 30:49
  SPEAKER_02: What is today's interest rate?
• 30:50
  SPEAKER_02: What is today's CPI?
• 30:52
  SPEAKER_02: And then you that is how you figure out the payments, right?
• 30:55
  SPEAKER_02: So if it's based on a rate or an index, you actually include it based on the rate or index at the date of lease commencement.
• 31:01
  SPEAKER_02: Now, there's a question that we commonly get here, right?
• 31:04
  SPEAKER_02: Sometimes we'll see in lease agreements that at some point during the lease, the rents reset to market.
• 31:11
  SPEAKER_02: And people will often ask us, well, how do I include rents that reset?
• 31:15
  SPEAKER_02: Do I even have to include that?
• 31:17
  SPEAKER_02: Or is it just zero?
• 31:18
  SPEAKER_02: I don't know what the market's going to be.
• 31:19
  SPEAKER_02: Well, the profession really views the future market as if it were an index.
• 31:25
  SPEAKER_02: So basically, the question that we would ask is, well, what is market rents today?
• 31:30
  SPEAKER_02: And if your rents reset to market, that would be the number that you would include in figuring out what your lease payments are, both for purposes of classifying the lease and for measuring the lease liability.
• 31:42
  SPEAKER_02: So it's what is today's market, right?
• 31:44
  SPEAKER_02: If if the lease is going to revert to market at some point in the future, right?
• 31:49
  SPEAKER_02: And that's the number you'd use.
• 31:50
  SPEAKER_02: So just to give a simple example, say that your rents are 100 in year one, 101 in year two, 102 in year three, and so on and so forth, right?
• 32:00
  SPEAKER_02: You might conclude that market rents today are actually$102.
• 32:05
  SPEAKER_05: Right, because you're using your average um price over the life of the lease.
• 32:09
  SPEAKER_02: So if I had that and the lease and I have a market reset at the end of year five, I would today say that market reset will be today's market, which I just said is 102.
• 32:19
  SPEAKER_05: All right.
• 32:19
  SPEAKER_02: Okay.
• 32:20
  SPEAKER_05: So you you can't assume zero for those later years.
• 32:24
  SPEAKER_05: So and then Mark, I know another common one is even if it's not called a fixed payment, you might have a payment that's sort of in substance fixed, and maybe you can describe what that is and how we think about that.
• 32:37
  SPEAKER_02: Right.
• 32:38
  SPEAKER_02: So the standard explicitly tells us that if something appears to be variable, but in substance, whatever that means, it's fixed, then that's a fixed lease payment and you have to include that in your classification.
• 32:49
  SPEAKER_02: Unfortunately for us, the standard doesn't define what an in-substance fixed payment is.
• 32:53
  SPEAKER_02: So we do get a lot of questions on that, and that absolutely does require judgment.
• 32:58
  SPEAKER_02: Okay.
• 32:59
  SPEAKER_02: The thing that I would say is if there is genuine variability in the amount you can pay, then it is not in substance fixed.
• 33:09
  SPEAKER_02: Okay.
• 33:09
  SPEAKER_02: Another thing that we see a lot of is people ask the question, which is similar to this question, but not the same.
• 33:15
  SPEAKER_02: What if I have a payment that's really, really probable?
• 33:18
  SPEAKER_02: Is that in substance fixed?
• 33:19
  SPEAKER_02: And if you think of a simple example, let's say I have an arrangement where I'm leasing solar panels and I pay based on the amount of electricity it generates, and I'm in Arizona.
• 33:31
  SPEAKER_02: And I know there's never been a year that I haven't gotten X kilowatts of energy from solar panels.
• 33:37
  SPEAKER_02: Nevertheless, that's not in substance fixed.
• 33:39
  SPEAKER_02: That is genuinely variable.
• 33:41
  SPEAKER_02: So it's not a matter of how probable is it.
• 33:44
  SPEAKER_02: We don't include variable payments regardless of how probable they are, as long as there's genuine variability.
• 33:51
  SPEAKER_02: In substance fixed would have to be something where perhaps as an example, there's a choice of two payments, but you're always going to pay the lower of those two payments.
• 34:00
  SPEAKER_02: Or something silly like you can rent my car and you'll pay half a cent for every mile that you drive, but the third mile you're going to pay$300 rent, right?
• 34:12
  SPEAKER_02: That's in substance fixed.
• 34:14
  SPEAKER_02: That's not a probability thing anymore.
• 34:16
  SPEAKER_02: So it's kind of one of those things that you kind of know it when you see it, right?
• 34:20
  SPEAKER_05: Yeah.
• 34:20
  SPEAKER_05: So and I I mean, in your case with the solar and it'd be the same with wind and otherwise, I mean, you can't control the weather either.
• 34:28
  SPEAKER_05: So there is true variability if the sun didn't shine as much.
• 34:32
  SPEAKER_05: I mean, we've had a lot of rain in LA recently.
• 34:34
  SPEAKER_05: So there you go.
• 34:35
  SPEAKER_05: Yes.
• 34:36
  SPEAKER_05: And though, so but Mark, to your sort of point on these, I'm going to use the word silly examples since you said that.
• 34:42
  SPEAKER_05: Um, given the fact that variable payments are excluded from the lease payments and also excluded from the right-of-use asset, are we seeing a lot more arrangements with significant variable rents or that have these type of in substance fixed rents, but that are masquerading as variable?
• 35:01
  SPEAKER_02: Um we have seen some examples where lesseurs will try to structure a lease that I'll just say if the asset can't be used, right, for some reason, then the rents are zero.
• 35:13
  SPEAKER_02: And they've asked the question since that always happens, and I'll give an example.
• 35:17
  SPEAKER_02: Since that always happens, are all the rents variable?
• 35:20
  SPEAKER_02: Okay.
• 35:21
  SPEAKER_02: So for example, somebody might say, I have an arrangement, and if the asset is down for repairs and maintenance, or if I'm not allowed to use the asset because of government shutdown, as an example, this came up a lot during COVID.
• 35:35
  SPEAKER_02: You don't owe me any rents.
• 35:37
  SPEAKER_02: Okay.
• 35:38
  SPEAKER_02: You only have to pay for the days that you're able to use the asset, not for the days that you're not able to use the asset.
• 35:44
  SPEAKER_02: In that case, those are that is not the floor, if you will.
• 35:48
  SPEAKER_02: The floor is not zero in that case, because those are really just protective provisions, right?
• 35:53
  SPEAKER_02: If the asset's unavailable.
• 35:54
  SPEAKER_02: So the way to think about it is if the asset is available to use, what is the lowest amount I have to pay?
• 36:00
  SPEAKER_02: That's probably your floor.
• 36:02
  SPEAKER_02: Okay.
• 36:02
  SPEAKER_02: Yeah.
• 36:03
  SPEAKER_02: So the question that I would typically ask is say I get the asset, and not because it's being repaired or because the government, you know, shut down the facility, but just based on my own decisions within my own control.
• 36:15
  SPEAKER_02: If I chose tomorrow not to use that asset at all, I'm going to lease a car from the Ford dealership or the Toyota dealership.
• 36:23
  SPEAKER_02: I'm just going to park it in my driveway and never drive it again.
• 36:26
  SPEAKER_02: How much rent would I owe?
• 36:27
  SPEAKER_02: And that's a fixed payment.
• 36:29
  SPEAKER_05: All right.
• 36:29
  SPEAKER_05: Well, although in your example of if I had to drive three miles and the payments all on the third mile, that's well, that would be an in-substance fixed payment.
• 36:37
  SPEAKER_02: Fair enough.
• 36:39
  SPEAKER_05: All right.
• 36:39
  SPEAKER_05: Um, and then Mark, another one I know that can come up is related to residual value guarantees, because how do we think about those in terms of if I'm thinking about payments?
• 36:49
  SPEAKER_02: So we're actually seeing um an uptick in arrangements that have residual value guarantees.
• 36:55
  SPEAKER_02: And when you think about residual value guarantees, right, you have to think about two possible payments.
• 37:02
  SPEAKER_02: What is the total possible payment you might have to make, however improbable it is, right?
• 37:08
  SPEAKER_02: So for example, if you guarantee the lessor that this property will be worth, you know, X dollars, and if it's worth zero at the end, you have to make up that entire payment.
• 37:18
  SPEAKER_02: However unlikely that is, that's what you put into your classification test.
• 37:22
  SPEAKER_02: Okay.
• 37:23
  SPEAKER_02: On the other hand, though we're talking about classification now, when you actually get to measure the lease liability, you're only going to include the likely payments.
• 37:32
  SPEAKER_02: Okay.
• 37:33
  SPEAKER_02: So the reason that we're seeing an uptick in this now is because if you have a lease anyway, and I can put some of the payments into the residual value guarantee, it has a kind of a gentler model because my liability is only going to include the payments I'm really likely to make.
• 37:48
  SPEAKER_02: But you can give a lessor 100% guarantee and have a relatively low lease liability.
• 37:54
  SPEAKER_02: But for classification purposes, whatever payment you could be made to make, you include in classification.
• 38:01
  SPEAKER_05: All right.
• 38:01
  SPEAKER_05: That's definitely a lot to think about.
• 38:03
  SPEAKER_05: And at the end, for our listeners' benefit, we will definitely talk about where you can go look for more resources because we're still only halfway through the question here.
• 38:11
  SPEAKER_05: Because now that we've figured out our lease payments, we still have to consider the present value or calculate the present value of those payments, which obviously to do that, we would use a discount rate.
• 38:22
  SPEAKER_05: Hopefully, all of us remember that from our college courses.
• 38:25
  SPEAKER_05: And Suzanne, this is another area where we get a lot of questions.
• 38:28
  SPEAKER_05: So, what are some of the things you should think about?
• 38:30
  SPEAKER_03: So you'd use the discount rate at least commencement, like Mark mentioned earlier, right?
• 38:34
  SPEAKER_03: It's always least commencement to present value the payments.
• 38:38
  SPEAKER_03: And that discount rate would either be the rate implicit in the lease if the lessee knew that.
• 38:43
  SPEAKER_03: And it's pretty uncommon for the lessee to know that because they'd have to know the less or's estimate of residual value and also the less or's initial direct cost.
• 38:52
  SPEAKER_03: So that can be hard to get.
• 38:53
  SPEAKER_03: Um, so when usually uh most people are in the situation where they don't have that, so they're gonna have to come up with an incremental borrowing rate.
• 39:01
  SPEAKER_03: Now, the incremental borrowing rate is a rate that the lessee would get if it had to take out a fully secured loan to make the lease payments over the lease term.
• 39:12
  SPEAKER_03: So let's kind of break it down.
• 39:13
  SPEAKER_03: So fully secured, well, that's pretty um obvious, 100% secured loan.
• 39:18
  SPEAKER_03: Um, but we do get questions on that.
• 39:20
  SPEAKER_03: So you can't use any unsecured funding to put into your rate.
• 39:24
  SPEAKER_03: It's got to be all fully secured.
• 39:27
  SPEAKER_03: And any form of collateral can be used when you're coming up with that rate.
• 39:31
  SPEAKER_03: So it doesn't have to be the same type of asset as what you're leasing, right?
• 39:35
  SPEAKER_03: If you're leasing a building, you don't have to use a building as collateral.
• 39:38
  SPEAKER_03: You can use really anything as collateral.
• 39:41
  SPEAKER_03: And I just want to clarify because this comes up, fully collateralized rate is not the same as the risk-free rate.
• 39:47
  SPEAKER_03: If you're a lessee other than a private company, and I'll get to that in a second, you have to consider your particular credit profile here when you're coming up with a rate.
• 39:55
  SPEAKER_03: So it's not just going to the risk-free rate.
• 39:57
  SPEAKER_03: Now, with that being said, private companies do actually have an expedient here, but they can use the risk-free rate.
• 40:03
  SPEAKER_03: So they can do that if they want.
• 40:04
  SPEAKER_03: But everybody else has to look to their credit profile.
• 40:07
  SPEAKER_03: So that's fully secured.
• 40:09
  SPEAKER_03: Now, when you talk about the lease payment timing, simple when you're coming up with this rate, you're going to use same similar payment terms as in the lease.
• 40:17
  SPEAKER_03: So if the lease requires monthly payments, the borrowing that you're looking at for the rate should also have monthly payment terms, ideally.
• 40:25
  SPEAKER_05: All right.
• 40:25
  SPEAKER_05: So then, Suzanne, um, given that most lessees are not going to have a fully secured loan with the exact same payment terms as the lease that was taken out near the lease commencement date.
• 40:37
  SPEAKER_05: Like it's just a lot of factors you probably don't have.
• 40:40
  SPEAKER_05: Yeah.
• 40:40
  SPEAKER_05: Then how do lessees typically come up with the borrowing rate?
• 40:44
  SPEAKER_03: Yeah, that's right.
• 40:45
  SPEAKER_03: So all the world's stars would have to align or whatever to have the same borrowing rate.
• 40:50
  SPEAKER_03: So usually what competitors will try to do is they'll start within an existing borrowing rate that they already have and make adjustments for the payment schedule of the lease, the lease commencement date and things like that.
• 41:01
  SPEAKER_03: So usually they'll try to start with a fully secured borrowing.
• 41:04
  SPEAKER_03: No, sometimes it's not possible actually in today's environment with rising rates and changes in the less or lesseees, sorry, credit worthiness.
• 41:13
  SPEAKER_03: It might be more challenging even for a lessee to use an existing borrowing.
• 41:17
  SPEAKER_03: So sometimes they'll have to go out and actually get a quote from a third-party lender to kind of get their rate to line up with these terms.
• 41:24
  SPEAKER_05: All right.
• 41:24
  SPEAKER_05: So definitely a lot to think about.
• 41:26
  SPEAKER_05: And then now that I've gotten through all of that, I've figured out my lease payments and my discount rate, then I would come up with the present value of payments and I would compare that to the fair value of the underlying asset at least commencement, which we probably have more questions about fair value, but we'll save those for another podcast.
• 41:44
  SPEAKER_05: Um, but assuming then that if the present value of the payments is substantially all, which rule of thumb would be this 90% of the fair value, then again, we'd have a finance case.
• 41:54
  SPEAKER_05: All right.
• 41:55
  SPEAKER_05: So then that is two of our five indicators.
• 41:58
  SPEAKER_05: I know we get less questions on the other ones, but maybe Mark, can you hit a few highlights from those other three?
• 42:05
  SPEAKER_02: Absolutely.
• 42:06
  SPEAKER_02: So the first one that Suzanne mentioned is when title to the asset automatically transfers to the lessee at the end of the arrangement.
• 42:15
  SPEAKER_02: And when I when we say automatic, we mean that there's no optionality there.
• 42:19
  SPEAKER_02: At the end of the arrangement, if the lessee has paid all the required payments.
• 42:23
  SPEAKER_02: And those required payments could include the title transfer fees, like the nominal fees at the end of a lease in order to transfer a title.
• 42:30
  SPEAKER_02: That would be an automatic transfer of title.
• 42:32
  SPEAKER_02: That would automatically be a finance lease.
• 42:36
  SPEAKER_02: Don't see that very often, but it's that that one's actually one of the easiest ones to evaluate.
• 42:41
  SPEAKER_02: The second one is where there's a purchase option and the lessee is reasonably certain to exercise the purchase option.
• 42:49
  SPEAKER_02: So the distinction here is that there is optionality.
• 42:52
  SPEAKER_02: It's not automatic.
• 42:53
  SPEAKER_02: So these two are kind of close to one another, because in both cases, you will get title at the end of the arrangement.
• 42:59
  SPEAKER_02: But in this case, you have to evaluate the reasonably certain criteria, which are the same criteria that Suzanne just talked about before that you would use to evaluate whether a renewal option is reasonably certain, right?
• 43:12
  SPEAKER_02: So using those same types of thought processes, am I reasonably certain to exercise an option to purchase the asset?
• 43:19
  SPEAKER_02: If so, then that balloon payment, if you will, at the end to purchase the asset is part of your lease payments and part of the classification and measurement of the lease.
• 43:29
  SPEAKER_05: All right.
• 43:29
  SPEAKER_05: So, Mark, then the and just a reminder again to listeners, since we talked about that a little bit ago in the episode, reasonably certain is generally thought about the same way we would think about probable, but obviously there's specific indicators as Suzanne talked about.
• 43:45
  SPEAKER_05: So then, Mark, you could hit two with that summary, but I know we have one more, which is whether or not the asset is of such a specialized nature that it's expected to have no alternative use to the lessor at the end of the lease term.
• 43:58
  SPEAKER_05: And then you would also have a finance.
• 44:00
  SPEAKER_05: So how do you think about that one?
• 44:02
  SPEAKER_02: So that one is also qualitative rather than quantitative.
• 44:05
  SPEAKER_02: But the thing that you're trying to figure out is is the only way that the Lessoeur can recover his investment in this lease and a profit thereon going to be from you, right?
• 44:15
  SPEAKER_02: Is it something that he just has no other way to monetize that residual value in the asset with a third party or use it himself?
• 44:22
  SPEAKER_02: If you're the only one that's going to be available for him to recoup his investment, then you've likely tripped this criteria.
• 44:30
  SPEAKER_02: Again, it's not the one that we see more frequently because if you think about it, if that were the case, then you're going to also trip up the other criteria at the same time.
• 44:38
  SPEAKER_02: So a lot of these actually kind of go together.
• 44:40
  SPEAKER_02: But obviously we look to see just holistically, are you the only customer that the LESIC, the Lassor, excuse me, can recover his investment from?
• 44:49
  SPEAKER_05: And so I just want to make sure I'm thinking about this the right way.
• 44:52
  SPEAKER_05: And you but if that was the case, then likely I would also have been over 75% or reasonably certain, you know, the most of the economic life.
• 45:02
  SPEAKER_02: Or you might just have very high variable payments that were that were pretty certain of no, again, getting back to the solar panel thing, right?
• 45:08
  SPEAKER_02: Right.
• 45:08
  SPEAKER_02: If you set those payments pretty high, the less or could could recover, in which case you still have to evaluate this one.
• 45:14
  SPEAKER_05: Yeah.
• 45:14
  SPEAKER_05: And then so sorry, the last question on this then.
• 45:16
  SPEAKER_05: And I know you said it was not often that we see it.
• 45:19
  SPEAKER_05: Is there any example that comes to mind where this would have I'll be honest, we see it very infrequently.
• 45:26
  SPEAKER_02: It could be something where the asset itself is located in a very remote area that there's just no other way for or something that's installed and there's no way to move it and no one else can use it.
• 45:37
  SPEAKER_05: Okay, that actually that's helpful because I kept thinking like a super customized building, but even that, then you can retrofit or something else.
• 45:44
  SPEAKER_05: But yes, location I hadn't thought about.
• 45:46
  SPEAKER_05: So that is a good example.
• 45:48
  SPEAKER_05: And I'm sure there's others if we probably really spent some time pondering this.
• 45:53
  SPEAKER_05: All right.
• 45:53
  SPEAKER_05: So definitely a lot to think about there.
• 45:55
  SPEAKER_05: And I know we only skim the surface on how to think about all those different indicators.
• 46:00
  SPEAKER_05: Um, so if you need more information, I definitely recommend you check out the lease guide and then to stay tuned for our next um podcast in the series, which will get into real estate leases and embedded leases.
• 46:13
  SPEAKER_05: Um, and so you'll have uh Suzanne and Mark talking about um leases all month this month.
• 46:19
  SPEAKER_05: So stay tuned.
• 46:20
  SPEAKER_05: And thanks both for joining me.
• 46:21
  SPEAKER_05: Such a pleasure to have you on.
• 46:23
  SPEAKER_02: Thank you.
• 46:25
  SPEAKER_04: That's our show for today.
• 46:27
  SPEAKER_04: Tune in next week for more fresh episodes so that you never miss any of our audio content.
• 46:32
  SPEAKER_04: Follow the PWC Accounting Podcast wherever you listen to your podcasts.
• 46:37
  SPEAKER_04: And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.
• 46:47
  SPEAKER_04: From Thought Leadership at PWC, I'm Heather Horn.
• 46:51
  SPEAKER_04: Thanks for tuning in.
• 46:58
  SPEAKER_00: This podcast is brought to you by PWC, all rights reserved.
• 47:02
  SPEAKER_00: PwC refers to the U.S.
• 47:04
  SPEAKER_00: member firm or one of its subsidiaries or affiliates, and they sometimes refer to the PWC network.
• 47:10
  SPEAKER_00: Each member firm is a separate legal entity.
• 47:13
  SPEAKER_00: Please see www.pwc.com slash structure for further details.
• 47:20
  SPEAKER_00: This podcast is for general information purposes only and should not be used as a substitute for consultation with professional advisors, including accountants and lawyers.