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Lease accounting reset – Variable rents · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PwC's National Office.
• 0:08
  SPEAKER_02: Hello, and welcome to PWC's Accounting Podcast.
• 0:11
  SPEAKER_02: I'm Heather Horn.
• 0:13
  SPEAKER_02: Today we're back with another episode in our lease accounting miniseries, diving into variable lease payments.
• 0:19
  SPEAKER_02: From determining whether a payment should be included in the initial measurement of lease liabilities to recognizing when a payment becomes fixed over the lease term, understanding the nuances of variable payments is critical to getting the accounting right.
• 0:33
  SPEAKER_02: To help us explore these complexities, I'm handing the mic over to our guest host, Diana Stoltzfist, a partner in our national office.
• 0:41
  SPEAKER_02: Diana is joined by our stars to this mini-series, Mark Jerusalem, a managing director, and Suzanne Stefani, a director, also in our national office, and who both bring deep expertise in lease accounting.
• 0:53
  SPEAKER_02: Let's tune in to the show.
• 0:56
  SPEAKER_04: Mark, Suzanne, thanks so much for joining me today.
• 0:59
  SPEAKER_04: Today we're diving into variable lease payments, a topic that often raises questions like why some payments are included in the initial lease measurement and others aren't, especially when we think about things that are tied to performance or inflation.
• 1:12
  SPEAKER_04: So maybe to start us off, Suzanne, can you give us a quick overview of some of the key categories of lease payments?
• 1:18
  SPEAKER_03: Yeah.
• 1:18
  SPEAKER_03: So we'll just start super basic.
• 1:21
  SPEAKER_03: There's two buckets of lease payments where you think about it.
• 1:24
  SPEAKER_03: There's fixed and there's variable.
• 1:26
  SPEAKER_03: So obviously we'll spend most of our time on variable today.
• 1:29
  SPEAKER_03: But fixed payments are payments that are known at least commencement.
• 1:32
  SPEAKER_03: You'll typically see that fixed dollar amount stated right in the contract.
• 1:37
  SPEAKER_03: They're basically unavoidable payments.
• 1:39
  SPEAKER_03: You're gonna make them.
• 1:40
  SPEAKER_03: As opposed to variable payments, those are payments that vary because of changes in circumstances.
• 1:46
  SPEAKER_03: Really, any change besides just simply the passage of time would be a variable payment.
• 1:51
  SPEAKER_03: And they can actually be positive or negative changes.
• 1:55
  SPEAKER_03: So there's two types of variable lease payments.
• 1:58
  SPEAKER_03: There's the usage performance-based type payments.
• 2:01
  SPEAKER_03: So that's like think about you're leasing a car and you pay some fee per mile or percent of sales where you're leasing real estate space and the lesie pays additional rent if sales maybe go over a certain threshold every month or quarter or something like that.
• 2:18
  SPEAKER_03: So those are the usage performance-based payments.
• 2:21
  SPEAKER_03: And then you have the indexed or rate-based payments.
• 2:24
  SPEAKER_03: These are payments that vary based on CPI or like changes in interest rates and things like that.
• 2:30
  SPEAKER_03: So, like for example, you have your lease payments and they're going to increase every year by an amount equal to the CPI increase.
• 2:38
  SPEAKER_03: That would be an indexed or rate-based payment.
• 2:40
  SPEAKER_04: Okay.
• 2:41
  SPEAKER_04: And we always like to do this CPI.
• 2:42
  SPEAKER_04: I'm sure most of our listeners know, but that's the consumer price index.
• 2:46
  SPEAKER_03: Sorry.
• 2:46
  SPEAKER_03: So well, great.
• 2:48
  SPEAKER_04: Well, now that we've covered, you know, fixed payments and then two types of variable payments, the usage-based and the index paced.
• 2:54
  SPEAKER_04: Maybe you can walk us through how the accounting differs for each of those.
• 2:58
  SPEAKER_03: Yeah, sure.
• 2:59
  SPEAKER_03: So for the fixed payments, if you have fixed payments, you allocate any payments in the contract to the lease component and you use those fixed payments to classify the lease.
• 3:09
  SPEAKER_03: So you include all fixed payments when doing the lease payments test, right?
• 3:13
  SPEAKER_03: To determine if the payments are substantially all the fair value of the leased asset.
• 3:18
  SPEAKER_03: And you're also going to use it when you measure the lease.
• 3:20
  SPEAKER_03: So the lease liability is the present value of all the fixed payments allocated to the lease.
• 3:25
  SPEAKER_03: And RU asset is basically based off the measurement of that lease liability.
• 3:30
  SPEAKER_03: And then also the lease expense is driven from the fixed payments.
• 3:34
  SPEAKER_03: Now, if you go to variable payments allocated to the lease component, generally those are not included in the payments used to classify or measure the lease.
• 3:43
  SPEAKER_03: They're just expensed as incurred.
• 3:45
  SPEAKER_03: So that's why it's super important to kind of distinguish between the two for the accounting and also even disclosure.
• 3:52
  SPEAKER_04: Okay.
• 3:52
  SPEAKER_04: So I know a couple of times you've mentioned this allocating payments to the lease a few times.
• 3:57
  SPEAKER_04: So maybe can you explain to us like what that means and why that's important?
• 4:02
  SPEAKER_03: Oh yeah.
• 4:02
  SPEAKER_03: So some leases have both lease and non-lease components to them.
• 4:06
  SPEAKER_03: Like think about your leasing a building and it has you're also getting services from the less or like maintenance or things like that.
• 4:13
  SPEAKER_03: That's a non-lease component.
• 4:15
  SPEAKER_03: So if an arrangement has both lease and non-lease components, the lessee has to first allocate all of the payments, fixed and variable, by the way, to both components.
• 4:25
  SPEAKER_03: But only those fixed payments that are allocated to the lease component, those are the ones like we'll include when we're measuring the lease and such.
• 4:33
  SPEAKER_03: And I knew I went over the allocation a bit um quickly, and it comes up a lot and is super important usually when you have in leases that are embedded in like a service or a supply contract, because often the non-lease component's pretty big there.
• 4:47
  SPEAKER_03: We're actually gonna have a separate um whole podcast on impedant leases.
• 4:50
  SPEAKER_03: We'll we'll really get into it.
• 4:52
  SPEAKER_03: So I just wanted to touch on it here.
• 4:54
  SPEAKER_04: Okay.
• 4:54
  SPEAKER_04: Okay, so maybe we'll get back to variable payments since that's our focus today.
• 4:58
  SPEAKER_04: So I know you said that they're generally not included in classifying and measuring the lease.
• 5:04
  SPEAKER_04: So I assume that means maybe there's some exceptions.
• 5:07
  SPEAKER_04: Yep, yeah, there is.
• 5:08
  SPEAKER_03: So so all usage-based, performance-based type variable lease payments, like I was saying before, pay per to mile, uh, percentage of sales, things like that, those are totally excluded from consideration for classification and measurement.
• 5:21
  SPEAKER_03: But there are index, the index rate-based payments that I spoke about earlier, like CPI type payments.
• 5:27
  SPEAKER_03: Those are actually included when measuring and classifying the lease.
• 5:32
  SPEAKER_03: But the thing is you use the rate in effect at least commencement, right?
• 5:36
  SPEAKER_03: Like CPI at least commencement.
• 5:39
  SPEAKER_03: Any changes in that index or rate after commencement, it's not gonna impact measurement.
• 5:45
  SPEAKER_03: It's just gonna be, they're just gonna be expensed as incurred.
• 5:48
  SPEAKER_03: So, like say I'm leasing office space and maybe five years or something.
• 5:52
  SPEAKER_03: And the and the lease says that the lease payments going to increase each year by an amount equivalent to the increase in CPI from the previous year, which also could be a common feature we see.
• 6:04
  SPEAKER_03: So let's say lease payments during the first year are$10,000 a month.
• 6:09
  SPEAKER_03: That that was set at commencement based on CPI at the commencement date.
• 6:13
  SPEAKER_03: But that$10,000 will go up each year based on CPI increases.
• 6:18
  SPEAKER_03: So if CPI goes up by say 3% during the previous year, then the lease payments for year two of the lease would be$10,300, right?
• 6:29
  SPEAKER_03: It goes up by 3%.
• 6:31
  SPEAKER_03: So for but when I'm classifying and measuring that lease at commencement, I'm just gonna use 10,000 for all five years in the lease payment.
• 6:40
  SPEAKER_03: That's based on the CPI at commencement.
• 6:42
  SPEAKER_03: And when that lease payment, if it does go up to 10,300 in year two, that additional 300 is just gonna be variable rent expense.
• 6:50
  SPEAKER_03: I'm not gonna have to remeasure every time that index changes.
• 6:54
  SPEAKER_03: Okay, got it.
• 6:55
  SPEAKER_04: And then I would assume, like if you had a lease and then say it just said that the payment was going up by 2% every year, like it was a fixed amount in the contract, then that would be baked in.
• 7:04
  SPEAKER_04: Yeah, it's at the beginning of the lease.
• 7:06
  SPEAKER_04: It's just because we don't know what CPI is gonna be each year.
• 7:09
  SPEAKER_04: And so therefore you can't bake that in.
• 7:12
  SPEAKER_04: Is that right?
• 7:12
  SPEAKER_04: Okay.
• 7:13
  SPEAKER_04: Yeah.
• 7:13
  SPEAKER_04: Okay, Mark, maybe we can bring you into the conversation now.
• 7:17
  SPEAKER_04: And maybe, you know, another thing that we sometimes see in leases is fair market rent adjustments.
• 7:22
  SPEAKER_04: So some leases stipulate that the lease payments may be adjusted to a fair market value at some point during the lease.
• 7:29
  SPEAKER_04: So maybe for instance, you have a 10-year lease with fixed payments for the first five years, and then the rent may adjust in that year six to a market rent.
• 7:40
  SPEAKER_04: How would companies think about those types of adjustments?
• 7:44
  SPEAKER_01: Yeah, so that is actually a um it's more common than we'd think.
• 7:48
  SPEAKER_01: And where we see it happening a lot is in ground leases, longer dated leases, obviously, but we see it sometimes in ground leases, which are even longer leases, right?
• 7:56
  SPEAKER_01: Somebody's built a building on that.
• 7:58
  SPEAKER_01: And, you know, the proverbial farmer Jack who leased out his land to you 10 years ago, he put a provision in there that says every 10 years, we're gonna adjust the rents to whatever market rents are for a piece of land.
• 8:09
  SPEAKER_01: So we, and I say we, the whole profession that thinks of these fair market rent adjustments as being another form of an index or a rate.
• 8:18
  SPEAKER_01: Okay.
• 8:19
  SPEAKER_01: So following what Suzanne was saying, what we would tell you is no, you don't get to just measure the lease liability based on five years' worth of payments, because who knows the payments in year six could be zero, right?
• 8:30
  SPEAKER_01: That's not a variable rent.
• 8:31
  SPEAKER_01: We think that's a variable rent based on a rate or an index.
• 8:34
  SPEAKER_01: So we would use today's index, right?
• 8:36
  SPEAKER_01: Which is frequently the rents you're paying at the beginning of the lease, right?
• 8:39
  SPEAKER_01: Today's index, and we're going to use that to measure the liability for years six through ten.
• 8:43
  SPEAKER_01: What we don't do is just like on inflation, we don't project or guess or estimate what the fair market rents will be at that date.
• 8:51
  SPEAKER_01: So, you know, if if, for example, if the lease is in Silicon Valley and people assume that the market rents will be much higher, we don't change that.
• 9:00
  SPEAKER_01: Okay.
• 9:00
  SPEAKER_01: But the other caveat is that, you know, just be careful.
• 9:03
  SPEAKER_01: It's what are market rents today, which I just said are frequently the beginning rents, right?
• 9:08
  SPEAKER_01: But if you had a situation where you got a six-month rent holiday, right, you don't look at just the contractual rents on day one.
• 9:15
  SPEAKER_01: You look at what are market rents today and plug in those numbers for years six through ten in your example.
• 9:20
  SPEAKER_04: Okay.
• 9:21
  SPEAKER_04: So maybe, maybe I think sometimes in contracts, right, we things see things that are like technically papered as maybe a variable payment, but that may not really be the substance of what those payments are.
• 9:33
  SPEAKER_04: So do we see that type of thing in leasing?
• 9:36
  SPEAKER_03: Maybe Suzanne, can you take this one?
• 9:38
  SPEAKER_03: Yeah, yeah, we definitely do.
• 9:39
  SPEAKER_03: So they're we call them, well, the guidance calls them insubstanced fixed lease payments.
• 9:45
  SPEAKER_03: So, like you said, they look like variable payments when you're reading the contract, but they're really not.
• 9:50
  SPEAKER_03: When you sit down and look at them, there's not real, like genuine variability, right?
• 9:56
  SPEAKER_03: Either because maybe they don't have any economic substance, that variability, or they're just providing different potential pricing options, but there's some sort of minimum that has to be paid.
• 10:08
  SPEAKER_03: So back to the beginning when I said fixed payments, they're unavoidable, right?
• 10:12
  SPEAKER_03: So these payments are also unavoidable.
• 10:15
  SPEAKER_03: Um, there's might be variability about when they'll be paid, but there's no question on if they'll be paid, right?
• 10:22
  SPEAKER_03: So I'll give you an example commonly called take or pay arrangements with an embedded lease.
• 10:28
  SPEAKER_03: So, say we had a company, maybe some sort of pharmaceutical company that has a contract with a supplier that contains a lease, an embedded lease, right?
• 10:37
  SPEAKER_03: Um, supplier is manufacturing, let's say, a drug, but also this contract has a lease of manufacturing equipment kind of embedded in that contract.
• 10:46
  SPEAKER_03: So if we look at the contract payments in this example, let's say the only payment in there is the company has to pay the supplier$2 for each unit purchased.
• 10:58
  SPEAKER_03: But also in that contract is there's a penalty payment.
• 11:01
  SPEAKER_03: So if the company doesn't buy 500,000 units per year, there's a penalty payment owed to the supplier to make up the shortfall.
• 11:11
  SPEAKER_03: So basically, what this penalty is doing is ensuring that the supplier will always get paid at least a million dollars per year, no matter how many units that you know company actually purchases.
• 11:22
  SPEAKER_03: So if the lessee only purchased, let's say 300,000 during the year for whatever reason, they only paid the supplier 600,000, right?
• 11:31
  SPEAKER_03: 300 times using$2 for the price.
• 11:34
  SPEAKER_03: Um, the penalty at the end of the year would be$400,000, right?
• 11:38
  SPEAKER_03: Because the lesser always wants to get that million dollars.
• 11:41
  SPEAKER_03: So you can see this one, right?
• 11:42
  SPEAKER_03: Like while you look at it on the surface, you're like, oh, it's$2 per unit.
• 11:47
  SPEAKER_03: That looks variable to me.
• 11:48
  SPEAKER_03: But if you really dig down, you're like, oh, wait, no, the lesser always gets a million dollars per year.
• 11:54
  SPEAKER_03: So that piece, that million dollars, it's in substance fixed payment, unavoidable.
• 12:00
  SPEAKER_03: It's just a question of when the lessor is going to get it, right?
• 12:03
  SPEAKER_03: Right.
• 12:03
  SPEAKER_03: So, so for classification and measurement, what you do with an in-substance fixed payment basically is that million dollars is treated just like any other fixed payment, right?
• 12:13
  SPEAKER_03: Because it's it's unavoidable.
• 12:15
  SPEAKER_03: So you include it in the consideration when you're classifying and measuring the lease.
• 12:19
  SPEAKER_03: That's what I'm saying.
• 12:20
  SPEAKER_03: Okay.
• 12:20
  SPEAKER_03: Yeah.
• 12:21
  SPEAKER_04: So even in these take or pay scenarios where you know you might think that it's not profitable, you're gonna pay the penalty because you think I'm definitely gonna purchase more than my 500,000 units, you would still factor that million dollar minimum payment in, kind of regardless of the fact that the lessee could say, well, that's under my control and and how much I'm purchasing.
• 12:42
  SPEAKER_04: So maybe then how would the lessee account for this in the lease then?
• 12:46
  SPEAKER_03: Yeah.
• 12:47
  SPEAKER_03: So, like I said, it's gonna be used to classify and measure the lease, but how?
• 12:52
  SPEAKER_03: Like, how does that work here, right?
• 12:54
  SPEAKER_03: Because the timing is different.
• 12:56
  SPEAKER_03: So we would likely have this look, we have this lease of equipment, but we're gonna have multiple probably non-lease components here too, like product, manufacturing services, things like that.
• 13:07
  SPEAKER_03: Um, so the lessees will assume there is a practical expedient to combine lease and non-lease components, get into that maybe better lease this podcast, but let's assume they're not doing that.
• 13:17
  SPEAKER_03: So the lessee would need to take the million dollars here of this fixed and substance fixed payment annually and allocate it to the components in the contract.
• 13:25
  SPEAKER_03: Then anything allocated to the leased component would be used to, you know, classify and and measure this lease.
• 13:32
  SPEAKER_03: Okay.
• 13:33
  SPEAKER_04: And then I one thing that that just wanted to pick up on is you said there could be variations in the timing as to this payment, right?
• 13:40
  SPEAKER_04: So you could have that maybe the lessee purchases all of the 500k in the first month of the year, or it could purchase them evenly throughout the year or not till the end of the year, or and you know, in the example, potentially not, you know, not purchase all of those 500,000 units.
• 13:55
  SPEAKER_04: So, how do you think about these different fluctuations in timing when you're classifying and measuring the lease?
• 14:01
  SPEAKER_03: Yeah, it's a good question because you don't know.
• 14:04
  SPEAKER_03: Um, so we think a reasonable approach is when you're doing the classification, just assume the latest date that you'd be required to make the payment.
• 14:13
  SPEAKER_03: So, in this case, like I said, this million dollar um penalty payment would have to be made at the end of each year of the shortfall.
• 14:20
  SPEAKER_03: So just assume, you know, you're not making any purchases and you're just gonna pay a million dollars at the end of each year to come up with, you know, the present value of lease payments to use for classification.
• 14:32
  SPEAKER_03: But when you're actually measuring it and you're setting up the lease liability, we look at it a little different because timing really does matter here because you have to get the lease liability to go out to zero at the end, right?
• 14:43
  SPEAKER_03: So we think the best approach here is to estimate when the lessee expects to make those payments based on their forecasts, right?
• 14:50
  SPEAKER_03: Like purchase forecast.
• 14:51
  SPEAKER_03: Right.
• 14:51
  SPEAKER_03: So let's say they expect to purchase these 500,000 units evenly throughout the year, then estimate that million dollars happening, you know, evenly throughout the year in your schedule to come up with your liability amount.
• 15:05
  SPEAKER_03: Now, inevitably you're not gonna be perfect, right?
• 15:09
  SPEAKER_03: The payment timing, it's gonna be off.
• 15:12
  SPEAKER_03: Right.
• 15:12
  SPEAKER_03: And if it's materially off, you have to true it up because you need that liability because it got to zero at the end.
• 15:19
  SPEAKER_03: So basically, we just continuously, as needed, right?
• 15:22
  SPEAKER_03: Yeah.
• 15:23
  SPEAKER_03: If it's material, right.
• 15:24
  SPEAKER_03: True true up the liability in your amortization schedule, true it up through the an adjustment to the R right of use asset.
• 15:31
  SPEAKER_03: Okay.
• 15:31
  SPEAKER_03: And this isn't like a full remeasurement type thing.
• 15:35
  SPEAKER_03: You're not gonna update the discount rate or anything.
• 15:37
  SPEAKER_03: You're just changing for the timing here.
• 15:39
  SPEAKER_03: Okay.
• 15:39
  SPEAKER_03: Yeah.
• 15:40
  SPEAKER_04: And you just do that in the period it occurs where if it's material.
• 15:43
  SPEAKER_04: Yeah.
• 15:44
  SPEAKER_04: Okay, great.
• 15:45
  SPEAKER_04: Well, maybe let's get into another scenario.
• 15:47
  SPEAKER_04: And and Mark, turning back to you.
• 15:49
  SPEAKER_04: I know that there are some leases where the lease payments change depending on how the equipment is used each day.
• 15:55
  SPEAKER_04: And there could even be situations where maybe some days you're not the lessee is not required to pay anything because the the equipment's not being operated at all.
• 16:05
  SPEAKER_04: Could you talk to us maybe about some of these different situations and how we think about that when we're thinking about variable and fixed payments?
• 16:13
  SPEAKER_01: Certainly.
• 16:14
  SPEAKER_01: Um, and we get a lot of questions on where exactly is where do variable payments kind of end and fixed payments begin.
• 16:22
  SPEAKER_01: So one of the principles, I guess, that the profession has kind of settled on a couple of years back is that when figuring out your fixed or variable payments, we would ignore a payment pattern that is merely protective in nature.
• 16:36
  SPEAKER_01: And I can give a good real life example that came from the, I'm gonna always mess this up, I apologize, the oil drilling rig lessors.
• 16:45
  SPEAKER_01: It's hard for me to say oil drilling rig, but I'll keep trying.
• 16:49
  SPEAKER_01: So oil drilling rigs, right?
• 16:51
  SPEAKER_01: So what was presented to you know the profession or the large accounting firms, and I think this was discussed back when with some of the standard setters, was we frequently have contracts where the lessee pays the highest rate when the oil drilling rig is drilling, where it's being used for drilling.
• 17:09
  SPEAKER_01: They pay a lesser rate when it's standby ready to drill, but the lessee, for whatever reason, doesn't want to drill today or they don't want to know where they want to drill yet.
• 17:18
  SPEAKER_05: Okay.
• 17:19
  SPEAKER_01: Right.
• 17:20
  SPEAKER_01: And then they could have a situation where they even pay zero.
• 17:24
  SPEAKER_01: Well, let me go back.
• 17:25
  SPEAKER_01: They could have another situation where you pay it even lower, let's say$1,000 is the highest rate,$750 was that second rate.
• 17:32
  SPEAKER_01: Yep.
• 17:32
  SPEAKER_01: They might pay$500 when the asset is not being used because it's because necessary repairs are being done.
• 17:40
  SPEAKER_05: Okay.
• 17:41
  SPEAKER_01: Okay.
• 17:41
  SPEAKER_01: And they'll often have a provision that says something like if the drilling rig is out of service for more than, let's say, 15 consecutive days, then following that you pay zero.
• 17:53
  SPEAKER_05: Okay.
• 17:53
  SPEAKER_01: But here's what they told us, which was very impactful, right?
• 17:56
  SPEAKER_01: They told us in virtually every contract there are periods of time that the lessee pay zero.
• 18:00
  SPEAKER_05: Oh, okay.
• 18:01
  SPEAKER_05: Right.
• 18:01
  SPEAKER_01: So we know that this happens.
• 18:02
  SPEAKER_01: This is not a probability assessment.
• 18:04
  SPEAKER_01: We know this happens in real life.
• 18:05
  SPEAKER_05: Okay.
• 18:06
  SPEAKER_01: Right?
• 18:06
  SPEAKER_01: So the question was well, maybe everything's a variable payment, right?
• 18:10
  SPEAKER_01: Because the minimum is zero.
• 18:12
  SPEAKER_01: Yeah, right.
• 18:13
  SPEAKER_01: Okay, well, so where this kind of landed is that we would ignore, we would ignore the provisions that are because the asset wasn't available to be used.
• 18:23
  SPEAKER_01: If you can't make if the lessor can't provide the asset for use to the lessee, then we wouldn't use that to set the accounting.
• 18:29
  SPEAKER_01: And where we landed on that particular fact pattern is that whatever decisions are within the control of the lessee, we would use that.
• 18:36
  SPEAKER_01: So in this case, in those funky numbers that I said, we would use the$750 payment while it's available to be used by the lessee, even though it's it's idle today.
• 18:45
  SPEAKER_01: Right.
• 18:46
  SPEAKER_01: We'd use that as the minimum rents.
• 18:47
  SPEAKER_01: And then the days where he's actually drilling, and it goes up to a thousand, the extra$250 would be variable rents.
• 18:54
  SPEAKER_04: Okay.
• 18:55
  SPEAKER_04: So then at the beginning of that contract, you would basically use that like ready-to-be-use number throughout the R.
• 19:00
  SPEAKER_01: $750 is my example.
• 19:02
  SPEAKER_01: It's it's standby, ready to be used.
• 19:04
  SPEAKER_01: Right.
• 19:04
  SPEAKER_01: We'd use that to establish and measure the lease liability.
• 19:07
  SPEAKER_04: Okay.
• 19:08
  SPEAKER_04: There's a lot more judgment in determining what's a variable during a fixed versus a fixed payment than maybe I appreciate it.
• 19:14
  SPEAKER_04: So one thing that you said, Mark, was you mentioned this concept of the minimum lease payment, which I, you know, under the old leasing standard, that that used to be the concept that was used.
• 19:24
  SPEAKER_04: But it seems like there's a little bit of a difference maybe between, you know, what is a minimum lease payment versus what we're seeing here, the fixed may not really be that minimum payment.
• 19:33
  SPEAKER_04: So maybe can you talk to us a little bit more about kind of the interaction between those concepts?
• 19:37
  SPEAKER_01: Yeah, and I I think I think that our appreciation for these nuances in the words of the standard has kind of evolved over time.
• 19:44
  SPEAKER_01: But this whole minimum lease payment, which is a uh you know, something that everyone who took the CPA exam remembers from back when, it doesn't really exist in 842 per se, right?
• 19:53
  SPEAKER_01: It was a common thing in 840, the old standard.
• 19:56
  SPEAKER_01: So the definition of a variable lease payment are payments that, other than time, that change in the future because of changes in circumstances.
• 20:06
  SPEAKER_05: Okay.
• 20:06
  SPEAKER_01: Okay.
• 20:06
  SPEAKER_01: So they could be up, they could be down, right?
• 20:09
  SPEAKER_01: Depending on changing the circumstances.
• 20:10
  SPEAKER_01: So it's not necessarily always the minimum payment that establishes your sort of floor for, you know, everything above that is variable.
• 20:18
  SPEAKER_01: And let me give you one real life example that we've seen uh seen recently.
• 20:22
  SPEAKER_01: So let's take a um I want to distinguish between payments based on the usage of an asset, which typically would be variable, as Suzanne talked about, versus payments based on the capacity of the asset and changes in the capacity, which may be variable rents.
• 20:37
  SPEAKER_01: Okay.
• 20:37
  SPEAKER_05: Okay.
• 20:38
  SPEAKER_01: So as an example, let's say that I'm leasing a battery or an array of batteries, right?
• 20:43
  SPEAKER_01: And um say that the payments are based on how many, and let me apologize in advance to people in the power and utilities industry.
• 20:50
  SPEAKER_01: I may get, like I may be saying you pay$100 for a nuclear power plant.
• 20:54
  SPEAKER_01: I I so let's say you pay one dollar per kilowatt hour of the battery usage, the battery power that you use.
• 21:00
  SPEAKER_01: Well, that would all be variable.
• 21:01
  SPEAKER_05: Right.
• 21:02
  SPEAKER_01: Because the change in circumstances is how much am I using today?
• 21:05
  SPEAKER_05: Right.
• 21:05
  SPEAKER_01: Right.
• 21:06
  SPEAKER_01: We've seen a number of contracts where you have a battery array and the batteries are expected to deliver a certain amount of power.
• 21:13
  SPEAKER_01: Let's just say 100 units, whatever that is.
• 21:16
  SPEAKER_01: And but we all know that batteries, unfortunately, still today, they do degrade over time, right?
• 21:22
  SPEAKER_01: And they they fade or lose some of their power capacity, which by the way is why I lease an entire array of batteries, because one of the things that LaSore does is they maintain it to keep that capacity up.
• 21:32
  SPEAKER_01: So say that my fixed payment today is based on 100% capacity.
• 21:36
  SPEAKER_01: But if capacity goes below 80%, I pay a lower rate.
• 21:40
  SPEAKER_05: Okay.
• 21:40
  SPEAKER_01: Right.
• 21:41
  SPEAKER_01: The fixed payment in that fact pattern would actually be 100, not the 80% minimum.
• 21:46
  SPEAKER_01: Right.
• 21:46
  SPEAKER_01: The fixed payment would be 100 because the change in capacity that goes down in the future from 100 to 80 is literally a change in circumstances, you know, based on something that happens in the future that is not simply based on time.
• 22:00
  SPEAKER_01: Right.
• 22:00
  SPEAKER_05: Right.
• 22:01
  SPEAKER_01: It's based on the physical capacity of the batteries.
• 22:04
  SPEAKER_01: So in that case, we'd say the fixed payments are indeed 100.
• 22:07
  SPEAKER_01: And if you pay less in the future, that would be a negative variable payment.
• 22:11
  unknown: Okay.
• 22:12
  SPEAKER_04: Okay.
• 22:12
  SPEAKER_04: And I think we're going to get into changes in in the future in a little bit.
• 22:16
  SPEAKER_04: So hold my questions for that.
• 22:18
  SPEAKER_04: So so maybe another thing that comes up is tenant improvement allowances.
• 22:24
  SPEAKER_04: And maybe first you could just give us an idea of like some examples of what tenant improvement allowances are.
• 22:31
  SPEAKER_04: And then do companies like are the what category are those falling into?
• 22:34
  SPEAKER_04: Are those variable payments or those fixed payments?
• 22:37
  SPEAKER_04: How should should companies be thinking about those?
• 22:40
  SPEAKER_01: So the the typical example of this is somebody's moving into new, let's say, new office space, right?
• 22:46
  SPEAKER_01: And they want to let me let me back up in just a second.
• 22:50
  SPEAKER_01: Okay.
• 22:51
  SPEAKER_01: I'm going to preface this.
• 22:52
  SPEAKER_01: Whenever I negotiate to get a lease incentive, right?
• 22:56
  SPEAKER_01: Sometimes I get that lease incentive even before the lease begins.
• 22:59
  SPEAKER_01: So that would be often the case like, oh, you have to move some employees from Philadelphia to New York.
• 23:04
  SPEAKER_01: I'll give you$100,000 to help with those moving costs.
• 23:07
  SPEAKER_01: If you get it before, the the accounting for that is actually pretty easy.
• 23:10
  SPEAKER_01: Because at that time, there's no lease liability on the books, there's no right of used asset on the books.
• 23:14
  SPEAKER_01: It's just a a deferred cost that you're going to, you know, requires a liability on your balance sheet when you get the cash.
• 23:19
  SPEAKER_05: Okay.
• 23:20
  SPEAKER_01: Okay.
• 23:20
  SPEAKER_01: But what we're talking about here is what commonly happens in real estate leases is that you negotiate to get a tenant, a lease incentive, so that you can afford to build out your improvements to the property.
• 23:32
  SPEAKER_01: Let's say a nice employee lounge area or a gym or a nice kitchen.
• 23:37
  SPEAKER_01: And there is some potential variability because what may happen, because typically the way these are worded is that you're entitled to up to a million dollar reimbursement, but you first have to spend the money.
• 23:49
  SPEAKER_01: So if you choose to spend less money, you're only going to get however much you spent.
• 23:53
  SPEAKER_05: Right.
• 23:54
  SPEAKER_01: Um, and however much you take, whether you take a million or only$800,000, the subsequent rents won't change because the when the Lasor negotiated this with you, he expects that you're paying 10 years worth of rents.
• 24:07
  SPEAKER_01: So the question has come up well, is that a variable payment that that million dollars you expect to get back that you wouldn't account for until later, right?
• 24:16
  SPEAKER_01: Right.
• 24:17
  SPEAKER_01: Because there is some variability.
• 24:18
  SPEAKER_01: We just talked about that.
• 24:18
  SPEAKER_01: Yeah.
• 24:19
  SPEAKER_01: Right.
• 24:19
  SPEAKER_01: Or should we view that as a fixed payment?
• 24:21
  SPEAKER_01: And I think once again, where the profession has kind of landed on this, is that we think this is really another instance where it's an in-substance fixed payment, because you, the lessee, are the one that negotiated that.
• 24:32
  SPEAKER_01: Of course, it is rare that the lessee is going to leave$200,000, let's say, sitting on the table and not take that, especially when his rents won't be reduced for it.
• 24:40
  SPEAKER_01: Right.
• 24:41
  SPEAKER_01: By the way, just a caveat: if you did negotiate something where your rents change based on how much money you actually drew down on that incentive, the accounting, I think, would be different then.
• 24:50
  SPEAKER_05: Right, right.
• 24:50
  SPEAKER_01: Okay.
• 24:51
  SPEAKER_01: But in this case, which is common, you're entitled to up to a million dollars.
• 24:54
  SPEAKER_01: It's baked into what you're going to pay in the future.
• 24:57
  SPEAKER_01: But for the moment you get a million dollars back, we think that's an in-substance fix payment.
• 25:00
  SPEAKER_05: Okay.
• 25:01
  SPEAKER_01: So how do you account for that?
• 25:02
  SPEAKER_01: Again, there is some diversity in practice on this.
• 25:05
  SPEAKER_01: We've seen some people record that million dollars that they expect to get back from the lessor as a receivable other as receivable as they make the improvements for which they're entitled to reimbursement.
• 25:18
  SPEAKER_01: Um, we think another approach is better.
• 25:20
  SPEAKER_01: We we do recognize our people that do that out there.
• 25:23
  SPEAKER_01: Um, we think it should be actually that million dollar reimbursement.
• 25:27
  SPEAKER_01: You expect to get less to say it within a year.
• 25:30
  SPEAKER_01: We think that should be part of your lease liability.
• 25:33
  SPEAKER_01: So your lease liability should be all your cash outflows you're going to make over the entire lease term, less than million dollars you expect to get, again, estimated to be, you know, nine months from now, or whatever it is.
• 25:43
  SPEAKER_01: And the reason we think that is because the very definition of lease liability is the present value of lease payments.
• 25:50
  SPEAKER_01: The very definition of lease payments, if you read the standard, it literally says less incentives you're going to receive.
• 25:56
  SPEAKER_01: So we think, you know, just include it in there.
• 25:59
  SPEAKER_01: And then when you actually receive the cash, you would give it cash, of course, and then credit your lease liability such that now it only reflects your remaining cash outflows.
• 26:09
  SPEAKER_04: Right.
• 26:09
  SPEAKER_04: Okay.
• 26:10
  SPEAKER_04: Well, maybe now let's turn to, you know, the subsequent accounting.
• 26:14
  SPEAKER_04: So we have our lease on our books, we have the initial measurement, and and so now thinking about what are some types of events that could affect um, we've talked about things that have happened with these variable payments.
• 26:24
  SPEAKER_04: Maybe, Suzanne, you could walk us through some of these key triggers for remeasuring leases.
• 26:30
  SPEAKER_03: Yeah.
• 26:30
  SPEAKER_03: So there's five events that require some sort of remeasurement of the lease.
• 26:36
  SPEAKER_03: Um, I'll group them into two buckets.
• 26:38
  SPEAKER_03: I guess there's there's three events that require the lessee to basically remeasure the whole lease as if it's a new lease, updated assumptions and everything.
• 26:47
  SPEAKER_03: And then there's two events that are just a recalculation of the lease liability and right of use asset without going through all these updated assumptions.
• 26:56
  SPEAKER_03: So I'll start with the first bucket.
• 26:58
  SPEAKER_03: So we're remeasuring as if it's like a totally new lease.
• 27:02
  SPEAKER_03: Those three events would be a contract modification.
• 27:05
  SPEAKER_03: We have a whole nother podcast on that.
• 27:07
  SPEAKER_03: Um, changes in assessment of lease term, whether you think it's reasonably certain or not to exercise or not exercise an extension or termination option, for example.
• 27:18
  SPEAKER_03: And then changes in assessment of whether you're going to exercise or not exercise a purchase option.
• 27:23
  SPEAKER_03: So if you have those three events, it's going to be this full remeasurement of the lease liability, right of use asset.
• 27:30
  SPEAKER_03: And we did go into a lot of detail on this in our um modifications podcast, but basically you're going to reassess whether you have a lease in the contract, if it's like an embedded lease, um reallocate contract consideration, um, reassess lease classification, and then update all your assumptions to measure the lease liability, including an updated discount rate.
• 27:52
  SPEAKER_03: So that everything's updated like it's a new lease.
• 27:54
  SPEAKER_03: Now, so now what does that mean for variable payments?
• 27:57
  SPEAKER_03: Well, what it means is just focusing on those payments that I talked about earlier, the payments that are based on rater index, remember like a CPI brand, right?
• 28:06
  SPEAKER_03: So I said at um lease commencement, when you're measuring the lease liability, you're using the rater index at least commencement and you're not touching it, right?
• 28:15
  SPEAKER_03: If it changes, it's just yeah, it like goes through lease expense.
• 28:18
  SPEAKER_03: But if you're doing one of these full remeasurements, you would have to update all the um lease payments going forward from the remeasurement date using the new index, right?
• 28:28
  SPEAKER_03: So if you had like a CPI-based payment and you had it in that lease liability at CPI at commencement, at remeasurement date, you're gonna have to update all those payments for the CPI.
• 28:38
  SPEAKER_03: Okay.
• 28:39
  SPEAKER_04: So, like in the example, if we go back to the beginning where you said, okay, it goes up by 3% and your new payment is 10,300, if that's like at this remeasurement date, do you use then that 10,300 for the remaining life of the lease?
• 28:52
  SPEAKER_04: Right.
• 28:53
  SPEAKER_03: Yep.
• 28:53
  SPEAKER_03: Okay.
• 28:53
  SPEAKER_03: Yep.
• 28:54
  SPEAKER_03: And then anything that goes off from the 10,300 is a variable expense if it was like over time, if like the next year it goes up or down directly.
• 29:04
  SPEAKER_04: Okay, so I think I got it for the index rate-based payments that those get updated at this remeasurement event.
• 29:11
  SPEAKER_04: What about other remeasurement events?
• 29:13
  SPEAKER_03: Yeah, like so there's two events that I I'm saying are not like a full remeasurement, right?
• 29:20
  SPEAKER_03: Um, that is contingency resolution.
• 29:23
  SPEAKER_03: So this is right on to variable payments.
• 29:25
  SPEAKER_03: So it's when a contingency occurs on which the variable payment is based, such that the variable payments are now fixed, like you know what they are.
• 29:34
  SPEAKER_03: Okay.
• 29:35
  SPEAKER_03: That's one remeasurement event.
• 29:36
  SPEAKER_03: And the second is when there's a change in the amount of payment that's probable to be owed under residual value guarantee.
• 29:44
  SPEAKER_03: So when you have those two things, it's not a full remeasurement.
• 29:47
  SPEAKER_03: What you're gonna do is simply update the lease liability for these updated payment amounts and don't update the discount rate, don't reassess classification and all that.
• 29:58
  SPEAKER_03: It's just changing the payments and adjusting um through the right of use asset.
• 30:03
  SPEAKER_04: Okay.
• 30:04
  SPEAKER_04: Maybe, maybe Mark, can you?
• 30:06
  SPEAKER_04: So we talked about this like when a contingency is resolved and a variable payment becomes fixed.
• 30:13
  SPEAKER_04: Can you give us some examples of when this happens and talk a little bit about the remeasurement?
• 30:20
  SPEAKER_01: Sure.
• 30:21
  SPEAKER_01: So um, you know, what one of the more common examples that we've seen is often retail stores in a new location, especially a brand new mall.
• 30:31
  SPEAKER_01: So no one really knows how successful the mall is going to be.
• 30:34
  SPEAKER_01: So sometimes what the lessees and lessors will negotiate is that the rents will be based on the revenue activity of that store in the first year.
• 30:43
  SPEAKER_05: Okay.
• 30:44
  SPEAKER_01: Okay.
• 30:45
  SPEAKER_01: So say that I have a provision that says we don't know what the rents are on day one.
• 30:48
  SPEAKER_01: Okay.
• 30:49
  SPEAKER_01: They're gonna be based on the usage during the first year.
• 30:53
  SPEAKER_01: But once we know the usage during the first year, that will not only become the rents for year one, but that will be the rents every year for the remainder of the lease.
• 31:00
  SPEAKER_01: Or perhaps for the remainder of the lease, I'll become fixed with, you know, with even greater variable rents on top of that.
• 31:07
  SPEAKER_05: Okay.
• 31:08
  SPEAKER_01: Right.
• 31:08
  SPEAKER_01: So if I had that fact pattern at the beginning, all the rents are variable.
• 31:13
  unknown: Yeah.
• 31:13
  SPEAKER_01: It's based on how much sales I have, right?
• 31:15
  SPEAKER_01: So I would record no lease liability and no right of use asset.
• 31:19
  SPEAKER_05: Okay.
• 31:19
  SPEAKER_01: Okay.
• 31:20
  SPEAKER_01: At the end of year one, I now know I have had revenues in year one and I have an amount, right?
• 31:25
  SPEAKER_01: And so that amount would actually be a variable payment because it's it's a variable payment.
• 31:30
  SPEAKER_01: Now the contingency has been resolved.
• 31:32
  SPEAKER_01: But not only is it a variable payment, but I now know what my minimum rents, I I use the term minimum, even though I'm cautious there.
• 31:37
  SPEAKER_01: I I unavoidable rents is perhaps the better term.
• 31:40
  SPEAKER_01: Yeah.
• 31:41
  SPEAKER_01: If years two through five of that same amount, now I would record a lease liability and a rent of use asset using that new amount.
• 31:49
  SPEAKER_01: And to the point that Suzanne said earlier, I would, because I'm not redoing my assumptions, I don't have to reclassify the lease.
• 31:56
  SPEAKER_01: And frankly, I use the interest rate from a year ago.
• 31:58
  SPEAKER_05: Oh, okay.
• 31:59
  SPEAKER_01: Right?
• 31:59
  SPEAKER_01: Because I'm not updating anything.
• 32:01
  SPEAKER_01: I'm just resolving a contingency.
• 32:03
  SPEAKER_01: So that contingency has been resolved, and and that becomes my new lease liability and right-of-use asset, which we recognized over the remainder of the lease term.
• 32:11
  SPEAKER_04: Okay, that makes sense.
• 32:12
  SPEAKER_04: So what about changes in CPI?
• 32:14
  SPEAKER_04: Since CPI-based adjustments are very common in lease contracts, what do these changes require?
• 32:20
  SPEAKER_01: Right.
• 32:21
  SPEAKER_01: So um CPI, uh we we hit on this a little bit previously.
• 32:25
  SPEAKER_01: So if I have a lease that goes up every year, let's assume it only goes up.
• 32:29
  SPEAKER_01: It can't go down.
• 32:29
  SPEAKER_01: Okay.
• 32:30
  SPEAKER_01: Which is at least in the United States, that is sort of a common provision.
• 32:34
  SPEAKER_01: So if my if my rents could only increase by CPI, and again, I have my rents in year one, we we calculate the CPI increase at the end of year one, beginning of year two.
• 32:44
  SPEAKER_01: We actually do not remeasure the lease liability or right of use asset.
• 32:47
  SPEAKER_01: And then, you know, if it can only increase, then essentially the CPI compounds every year.
• 32:51
  SPEAKER_01: I can have 2% inflation in the first year, I can have 3% inflation in the second year.
• 32:55
  SPEAKER_01: Now in year three, I'm paying 105 a month instead of 100 a month.
• 32:58
  SPEAKER_01: That extra$5 always drops down to variable rent.
• 33:02
  SPEAKER_01: It does not, uh we don't remeasure the lease liability or right of use asset.
• 33:06
  SPEAKER_05: Okay.
• 33:06
  SPEAKER_01: Um, I could have fact patterns, and we have seen this, where the CPI adjustments get capped.
• 33:13
  SPEAKER_01: So I could have a lease that says, oh, you know, we'll keep on increasing every year for the CPI, but the rents will never increase above a cumulative CPI increase of let's just say 7%.
• 33:24
  SPEAKER_05: Okay.
• 33:24
  SPEAKER_01: So in that fact pattern, once I've hit the 7%, and now there is no more adjustment for CPI, well, then that contingency has been resolved.
• 33:32
  SPEAKER_01: So whenever that happens, I would then remeasure the lease liability and write-of-use asset, again, using the interest rate from day one from the original lease commencement date.
• 33:42
  SPEAKER_01: And again, everything's recognized prospectively, but I would remeasure the lease liability and asset.
• 33:46
  SPEAKER_04: Okay, well, I think we'll close it out now.
• 33:49
  SPEAKER_04: The concept we've talked about today really highlight how important it is to understand the difference between variable and fixed payments, and that they can have such a big impact too on the timing and recognition and lease accounting.
• 34:01
  SPEAKER_04: So I know there's also probably a bunch of presentation and disclosure considerations that are important too when we're thinking about leases.
• 34:08
  SPEAKER_04: So make sure to tune in.
• 34:09
  SPEAKER_04: We have a separate podcast all about uh lease presentation and disclosure.
• 34:14
  SPEAKER_04: So maybe one last question to close out is maybe Mark, can you let us know, is there a good place for our listeners to find additional guidance in this area?
• 34:25
  SPEAKER_01: Um well, of course, we have our leases guide.
• 34:27
  SPEAKER_01: And in our lease's guide, we talk about the nature of payments, whether they're fixed or variable, in chapter three of our guide.
• 34:34
  SPEAKER_01: And then we talked about remeasurement events in chapter five of our guide.
• 34:37
  SPEAKER_04: Well, thank you, Mark and Suzanne, so much for joining me today.
• 34:40
  SPEAKER_04: It was it was great chatting with you.
• 34:42
  SPEAKER_04: Thanks.
• 34:42
  SPEAKER_01: Thanks.
• 34:43
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