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Lease accounting reset - Modifications and terminations · PwC's accounting podcast

0:00
SPEAKER_01: Thought leadership from PWC's National Office.
0:07
SPEAKER_04: Hello, and welcome to PWC's Accounting Podcast.
0:10
SPEAKER_04: I'm Heather Horn.
0:12
SPEAKER_04: Happy to be back today with another episode in our least accounting series.
0:16
SPEAKER_04: Today, focusing on a topic that generates a steady stream of questions.
0:21
SPEAKER_04: Accounting for lease modifications and terminations.
0:24
SPEAKER_04: From identifying whether a change creates a brand new lease or instead requires full remeasurement of an existing one, the implications of these types of transactions can be significant and the guidance isn't always intuitive.
0:40
SPEAKER_04: Here to help us with this discussion today are two of our regular guests from PwC's national office, Mark Jerusalem, a managing director, and Suzanne Stefani, a director, both who focus on leases and have deep expertise.
0:53
SPEAKER_04: With that, let's get started.
0:55
SPEAKER_04: All right.
0:56
SPEAKER_04: So Mark Suzanne, welcome back.
0:58
SPEAKER_04: Happy to have you on to talk about accounting for lease modifications.
1:02
SPEAKER_04: And this is a topic we've talked about on past podcasts, but I know we continue to get a lot of questions in this area.
1:09
SPEAKER_04: And so thought it would be nice to have another episode.
1:12
SPEAKER_04: So, Mark, perhaps you can kick things off.
1:14
SPEAKER_02: Sure.
1:15
SPEAKER_02: So whenever we think about modifications, I do want to say that overall there are some modifications that when you look through the contract and when you look at the guidance, in the end of all things, you're not even going to account for that as a modification at all.
1:31
SPEAKER_02: But rather, you would account for whatever was modified as if it's a separate new agreement and not adjust what's on your balance sheet already.
1:39
SPEAKER_02: Okay.
1:40
SPEAKER_02: So some modifications will be treated as new lease.
1:43
SPEAKER_02: We'll talk about that in a minute.
1:44
SPEAKER_02: But even before we talk about that, I do want to talk about just holistically, when we were talking about modifications, right?
1:51
SPEAKER_02: When I think of the word modification, I think modifications typically have two hallmark things to a lease mod.
1:57
SPEAKER_02: The first thing is that it is something that is newly negotiated.
2:02
SPEAKER_02: Okay.
2:02
SPEAKER_02: So if I didn't have to negotiate this change, but rather it was an option that was already enshrined in the original lease agreement, just because I exercise that option or choose not to exercise that option, we're not going to spend, I mean, yes, that's a change.
2:17
SPEAKER_02: Yes, we account for that as a modification, but that would of course never be like a separate new lease.
2:22
SPEAKER_02: So when we think of modifications, my first question is did it require new negotiation?
2:27
SPEAKER_02: Right.
2:27
SPEAKER_02: The second thing of a modification is that modifications change the scope or consideration in the lease.
2:36
SPEAKER_02: Okay.
2:36
SPEAKER_02: So when I say scope or consideration, well, consideration is easy.
2:39
SPEAKER_02: Is the payments changing, right?
2:42
SPEAKER_02: Scope, are we getting some incremental use of an asset?
2:45
SPEAKER_02: Are we reducing our use of an asset?
2:47
SPEAKER_02: Is it changing how much asset we get to use?
2:49
SPEAKER_02: And I just want to point out this is not a form-driven assessment, right?
2:55
SPEAKER_02: So it doesn't make a difference if the contract is labeled with the word modification or not, right?
3:00
SPEAKER_02: Um, and really, almost every change that you make to your leases is going to require some kind of a remeasurement.
3:08
SPEAKER_02: So just another thing to bear in mind.
3:10
SPEAKER_02: So let's get back to what we were talking about a moment ago, which is sometimes a lease modification just adds a new lease to your contract without affecting how much you've recorded on your other leases.
3:22
SPEAKER_02: And in order to just treat the modification as the acquisition of a new right of use asset, the change in the contract has to meet two conditions.
3:31
SPEAKER_02: One, you actually have to get a new right-of-use asset.
3:35
SPEAKER_02: That means an asset that you didn't have yesterday.
3:37
SPEAKER_02: So extending the use of a floor of a building for another year is not getting a new incremental right of use asset.
3:45
SPEAKER_02: That's just the same asset you're getting it for longer.
3:47
SPEAKER_02: So if you're getting a brand new asset and the amount you're paying for that brand new asset is the right price, it's the market price for what that asset ought to be.
3:56
SPEAKER_02: Then I would take that change to the contract, look at it separately, and say that's just the lease liability and right of use asset for my new floor of a building.
4:04
SPEAKER_04: So then, Mark, that makes sense because it's a whole new asset that you're getting access to.
4:10
SPEAKER_04: But what about a case where instead of adding a new asset, the lessee instead adds a new service, so a non-lease component to the contract?
4:18
SPEAKER_04: Would that also be considered a quote, new asset when thinking about these conditions?
4:23
SPEAKER_02: That is a great question.
4:24
SPEAKER_02: And we've got to that question a number of times.
4:27
SPEAKER_02: It is something that is not explicitly addressed in the literature, so I can't say there's uniformity in practice on this, right?
4:34
SPEAKER_02: Because what the standard literally says is I treat it as a new contract if I get a new right-of-use asset.
4:40
SPEAKER_02: Well, what if I don't, to your point, what if it's not a new asset?
4:43
SPEAKER_02: What if I leased some office space and I declined the lessor's office, the offer to provide um janitorial services?
4:53
SPEAKER_02: I cleaned the bathrooms myself.
4:54
SPEAKER_02: I wiped down the desks at the end of the day myself.
4:57
SPEAKER_02: And then a year into the lease, I say, Can you do the janitorial service?
5:01
SPEAKER_02: And it says, sure.
5:02
SPEAKER_02: I'll charge you the same amount that I charge every other tenant in the building to do that.
5:07
SPEAKER_02: So the price is at market.
5:08
SPEAKER_02: It's a new incremental service, right?
5:10
SPEAKER_02: We think that you want to apply the same thought process in the lease's guidance and account for that just as a separate contract.
5:18
SPEAKER_02: It's an incremental service and it's at the right price.
5:22
SPEAKER_04: So, Mark, I noticed you were very specific in your example to say that the uh new service was being provided at market.
5:31
SPEAKER_04: I know that may not always be the case, and that then could result in or would result in a lease modification to the existing contract.
5:38
SPEAKER_04: I think sometimes it's helpful to bring this to life by giving some examples.
5:42
SPEAKER_04: So can you run through a few?
5:44
SPEAKER_02: Yeah, I mean interestingly, the fact pattern where you get a new incremental asset, and the only change in your consideration is the fair market price for that new rent.
5:56
SPEAKER_02: Um, in practice, we don't see that very often, right?
6:01
SPEAKER_02: So, really everything else is just a modification.
6:03
SPEAKER_02: And the modification means I'm gonna have to do some kind of remeasurement of my lease liability, right?
6:08
SPEAKER_02: So any change to the lease term, again, that was not just an option embedded in the original lease.
6:14
SPEAKER_02: Any change to how long you want to use the property, any change into the in the payment structure or even the timing of payments, if you got like a lease deferral that you could not pay this year's rent, but pay it next year instead, that would be a modification.
6:29
SPEAKER_02: Um, obviously reductions in the amount of space you have.
6:33
SPEAKER_02: We're gonna talk more about that.
6:34
SPEAKER_02: Um, leasing additional assets, but the the change in the rents is not just commensurate with, you know, that new asset you're getting.
6:43
SPEAKER_02: Um a change in the structure of the rent payments, where they're part fixed or part variable, and you change the formulas.
6:49
SPEAKER_02: Um, all of those would be lease modifications.
6:52
SPEAKER_02: And the one thing I do want to say is that the standard is very deliberate.
6:56
SPEAKER_02: It uses the terminology or the phrasing, modification of a contract.
7:02
SPEAKER_02: So it's really anything in the contract that contains the lease is modified.
7:07
SPEAKER_02: And so let me give a real life example that happens all the time.
7:11
SPEAKER_02: I have a contract where I lease two floors in a building and I want to get rid of one of the floors of the building, right?
7:18
SPEAKER_02: Well, that's a modification to the contract.
7:20
SPEAKER_02: So it's also a modification to the floor you're retaining, right?
7:24
SPEAKER_02: We're gonna get into that more later, but we think of the entire, if I just change the pricing of a service that I'm getting from the lessor, right?
7:34
SPEAKER_02: Again, unless it meets the criteria that were talked about previously, that would be a change to the entire contract, not just a change to the service.
7:43
SPEAKER_02: So, so yeah, so modifications are at the contract level.
7:47
SPEAKER_02: It really makes sense now to mention a little about a little bit about, excuse me, combination of contracts.
7:53
SPEAKER_02: There's specific guidance in topic 842.
7:55
SPEAKER_02: It's very similar, by the way, to the specific guidance in topic 606 on revenue.
8:00
SPEAKER_02: Sometimes they'll paper some things as one or perhaps as two contracts at the same time.
8:07
SPEAKER_02: And what the guidance tells you is that you have to combine any contracts with the same counterparty that are entered into at the same time, you know, and we have to think about whether they negotiated as a single package with a single commercial objective, right?
8:22
SPEAKER_02: Does the consideration in one contract depend on the consideration in the other contract, or are the goods and services part of the same performance obligation?
8:32
SPEAKER_02: But let me just say a bias here.
8:34
SPEAKER_02: If I negotiate with a single lasso or a single counterparty two things at the same time, right, I most likely have to think of those as a single contract because I could have just papered them as one contract, but I papered them as two contracts.
8:47
SPEAKER_02: So if I modify one of the components, right, I also have to bear in mind, hey, you remember three years ago when we entered into this lease, this was a combined contract with that other contract.
8:58
SPEAKER_02: And I have modified both of them.
9:01
SPEAKER_04: All right.
9:01
SPEAKER_04: And then, Mark, when we're thinking about modifications, what types of changes may trigger any modifications, or does it really need to be more substantive?
9:11
SPEAKER_02: So recently we got an interesting question, and this is because of the significant change in interest rates, right?
9:18
SPEAKER_02: So interest rates used to be pretty low, which meant that when people measured a liability, it would be a higher amount.
9:25
SPEAKER_02: Now interest rates are higher.
9:26
SPEAKER_02: So if I could remeasure that liability, it would be a lower amount.
9:30
SPEAKER_02: So a question has come up, you know, can can any modification trigger the remeasurement?
9:38
SPEAKER_02: Um, now, interestingly, in the standard itself, I would tell you that even the smallest modification should trigger a remeasurement.
9:44
SPEAKER_02: But I would caveat that to say, but it has to be a substantive modification.
9:49
SPEAKER_02: If the only reason I'm doing the modification, let me give you a stupid example.
9:52
SPEAKER_02: Say that I have a 20-year lease and I want to trigger a modification, so I add a renewal option to the lease to lease the asset for one more year at the end of 20 years.
10:04
SPEAKER_02: And it's not certain to begin with that I'm going to keep the asset for 20 years, right?
10:09
SPEAKER_02: Well, in that case, I would ask the question, you know, why did we negotiate that that extension?
10:15
SPEAKER_02: Or even it was an extension for a day.
10:17
SPEAKER_02: Why did we negotiate that extension for one day?
10:19
SPEAKER_02: And if there isn't a business purpose behind it, I would question whether we should really trigger modification accounting for a non-substantive change to the contract.
10:28
SPEAKER_04: Okay, so that definitely makes sense.
10:30
SPEAKER_04: So, Suzanne, then if I turn to you, and now that we've said, okay, is this modification a separate new lease or remeasurement of an existing lease?
10:40
SPEAKER_04: Now let's talk about what this actually means from an accounting perspective.
10:44
SPEAKER_00: Okay, sure.
10:44
SPEAKER_00: Yeah.
10:45
SPEAKER_00: So we'll start with if you have a you, you know, you think about all the conditions Mark spoke about, and you determine you have a separate new lease for this modification, that means the accounting for the existing lease that you have on your books already, not getting impacted at all.
10:59
SPEAKER_00: Just keep going like always, right?
11:01
SPEAKER_00: For this new um lease, we're gonna just set up an entirely new lease liability and right-of-use asset, just like you would for any lease.
11:10
SPEAKER_00: So there's that.
11:11
SPEAKER_00: Now, if you don't have a separate new lease, but rather you're basically being treated like you're modifying the whole contract, then that's gonna be a full remeasurement of everything on your balance sheet for that contract.
11:26
SPEAKER_00: So, in order to do a full remeasurement, you have some more work to do on this one.
11:30
SPEAKER_00: So there's a couple of steps.
11:32
SPEAKER_00: Um, the first one you have to think about when you open up this contract for a modification.
11:38
SPEAKER_00: Does the contract still contain a lease?
11:40
SPEAKER_00: Um, lots of times it's obvious because it's just a lease, but you know, sometimes you'll get these leases that are embedded in supply or service contracts and things like that.
11:50
SPEAKER_00: And if you make a modification to those, you have to look at a look at them again to figure out if there is still a lease embedded in that contract.
11:57
SPEAKER_00: Step two, you're gonna reallocate contract consideration between leased and non-lease components using updated consideration amounts at the modification date.
12:07
SPEAKER_00: So you'll need to update your standalone selling prices at the remeasurement date to do that allocation.
12:13
SPEAKER_00: Um, so you do that.
12:15
SPEAKER_00: Next, you're gonna re-evaluate lease classification.
12:17
SPEAKER_00: So that's step three.
12:19
SPEAKER_00: Um, I won't go through everything, you know, the five points of classification, but maybe I'll just focus on a couple that more likely would be impacted from a modification.
12:29
SPEAKER_00: First one would be the lease term test.
12:31
SPEAKER_00: So that's, you know, is the term, the lease term for a major part of the assets remaining economically.
12:36
SPEAKER_00: Right.
12:36
SPEAKER_00: So the lease term, it could change just as a result of the modification itself.
12:40
SPEAKER_00: Maybe you negotiated a shorter term or longer.
12:44
SPEAKER_00: But even if you didn't, you know, contractually modify that lease term, the lease term could still change because now you have to use your assumptions, facts, and circumstances at this date to determine if the lessee is reasonably certain to exercise like an existing option, extension termination.
13:01
SPEAKER_00: And that could be different from what you thought at least um months been.
13:05
SPEAKER_00: And then obviously you'll compare that to the um economic life at the remeasurement date.
13:09
SPEAKER_00: And then the second test I'll highlight is the lease payments test.
13:12
SPEAKER_00: So do the lease payments exceed substantially all of the fair value of the asset?
13:17
SPEAKER_00: So for that, you're gonna have your revised payments, right?
13:20
SPEAKER_00: The payments might just be different because you modified them, um, might be different because there's a change in how you allocate things between lease and non-lease components.
13:28
SPEAKER_00: Like I said, using the standalone updated standalone selling prices, changes in lease term, changes in assessment of you know purchase options and things like that.
13:37
SPEAKER_00: Also, variable lease payments that depend on an index or rate.
13:41
SPEAKER_00: So that's like um CPI-based payments.
13:44
SPEAKER_00: Those need to be updated using the index and rate at the lease remeasurement date as well.
13:50
SPEAKER_00: So just we we have a whole podcast on variable lease payments, but but basically for those kind of payments, usually you don't update, you know, your your lease liability when there's a change in that index, but with a modification, given you're having a full remeasurement, you're gonna do it on the mod date.
14:04
SPEAKER_00: So it's just something else to think about.
14:06
SPEAKER_00: And then lastly, the discount rate.
14:08
SPEAKER_00: You're gonna have to update the discount rate at the remeasurement date, like Mark mentioned a little bit before.
14:12
SPEAKER_00: So that could be vastly different from when you entered into the lease initially.
14:17
SPEAKER_00: So basically you do all that, and then you got to fair value the at that asset again at the remeasurement date.
14:23
SPEAKER_00: So that might require a little work.
14:25
SPEAKER_04: So, Mark, maybe looping back to what you were saying at the very beginning of the podcast, where you were talking about we added an asset or we added a non-lease component, like a service or otherwise that was not at market rate, then either whether it was a service or an asset, you would have to go through these steps that Suzanne just summarized.
14:45
SPEAKER_02: That's right.
14:46
SPEAKER_02: Essentially, what Suzanne just summarized is you almost treat the situation as if you're entering into the lease anew and just starting from the top and going through all the steps I would do if I had a brand new lease.
14:59
SPEAKER_04: Yeah, and it's interesting if I go back to your example about janitorial services, I can see many cases where the company would want to say, oh, I just added the service, it's it's small, it's not this, you know, that that significant of a thing.
15:12
SPEAKER_04: Why do I have to go through all these steps?
15:14
SPEAKER_04: But you're saying nope, unless it's very clear it's market rate, you would have to go through all of this process for both services and assets.
15:23
SPEAKER_02: That's right, because all you've done is modified the contract, which means I have to modify how I account for or look at all the things in the contract.
15:32
SPEAKER_04: Yep.
15:32
SPEAKER_04: Okay, very helpful.
15:33
SPEAKER_04: And again, just wanted to tie those pieces together.
15:35
SPEAKER_04: So, Suzanne, then sticking with you.
15:37
SPEAKER_04: Now I've gone through everything, I've re- all the assumptions, I've reclassified my lease.
15:43
SPEAKER_04: So now can we remeasure the lease?
15:45
SPEAKER_04: What are the key components?
15:46
SPEAKER_00: Yeah, so now we're ready to re-measure the lease.
15:48
SPEAKER_00: So I think we've we've talked about all the things that have to update, right?
15:51
SPEAKER_00: When thinking about classification, those same things are what you would think about when you're updating your lease payments, right?
15:58
SPEAKER_00: You're gonna basically re-measure, sorry, your lease liability.
16:00
SPEAKER_00: So you take the fixed and indexed rate-based variable payments that were allocated to the lease based on all the updated assumptions we talked about, and just present value them using the updated discount rate.
16:11
SPEAKER_00: So just putting that lease liability like it's a new lease, basically.
16:15
SPEAKER_00: But you already had like an existing liability there.
16:18
SPEAKER_00: So any adjustment that you're doing to that liability, the other side, it's generally gonna go right to the right-of-use asset.
16:24
SPEAKER_00: Not gonna generally not gonna see a gain or loss or anything going to the PL.
16:29
SPEAKER_00: Just it happens sometimes.
16:31
SPEAKER_00: If you're going to adjust the ROU asset for your change and that ROU asset gets reduced to zero, well, obviously you can have a negative right of use asset.
16:40
SPEAKER_00: So that the differential will go to the PL.
16:43
SPEAKER_00: And then also it's not just that simple or straightforward when the lessee modifies to decrease their right of use of a distinct asset.
16:53
SPEAKER_00: So they're modifying to reduce capacity or something like that.
16:59
SPEAKER_00: Um, there's a little bit of a different way to look at it.
17:02
SPEAKER_00: There's there's two ways when you're adjusting the ROU asset.
17:04
SPEAKER_00: So if a lessee is in a warehouse and they reduce the space, let's say from 10,000 square feet to 6,000 square feet, to determine how to reduce the ROU asset, you can do it one of two ways.
17:16
SPEAKER_00: One, reduce the ROU asset by the percentage of space that was reduced.
17:22
SPEAKER_00: So if I'm leasing that warehouse space and I reduce it by 45%, I'm gonna write down the ROU asset by 45%.
17:30
SPEAKER_00: That's one option.
17:31
SPEAKER_00: Second option, reduce it by the percentage that the lease liability decreases.
17:37
SPEAKER_00: So if when I remeasured my liability, the liability decreases by 50%, I'm gonna write off just 50% of the right of use asset.
17:45
SPEAKER_00: So that's an accounting policy election.
17:47
SPEAKER_04: All right.
17:48
SPEAKER_04: And then, Mark, if I kind of look at these scenarios that Suzanne just gave, this downsizing of real estate, something you know that we're seeing quite frequently.
17:58
SPEAKER_04: Often these are written as termination.
18:00
SPEAKER_04: So I'm terminating part of my lease, but obviously we were just talking about this in the context of modification.
18:06
SPEAKER_04: So how do we think about that termination versus modification, particularly if I have an agreement that says, you know, terminated?
18:14
SPEAKER_02: Right.
18:14
SPEAKER_02: It's it's a great question.
18:15
SPEAKER_02: One thing I do want to point out about the example Suzanne just gave.
18:19
SPEAKER_02: And that example, by the way, is right in the standard, like no one's making this stuff up, right?
18:23
SPEAKER_02: But I do want to point out that in in real life, it's actually pretty rare that I have a single right of use asset that I can simply walk away from 40% of it.
18:34
SPEAKER_02: Okay.
18:35
SPEAKER_02: She gave the example of a warehouse.
18:36
SPEAKER_02: That's a good example.
18:37
SPEAKER_02: I can easily take a warehouse and divide it, right?
18:40
SPEAKER_02: But if I had two floors of a building and I walked away from one floor of the building, well, those are two separate components to begin with.
18:47
SPEAKER_02: So I'm just gonna say it's it's it's a rare bird, okay, if you have that.
18:52
SPEAKER_02: But let's think about terminations.
18:53
SPEAKER_02: And yeah, we get unfortunately, a well, or fortunately, a lot of questions about terminations.
18:59
SPEAKER_02: And I do want to point out that terminations, when we think about terminations, and and this is the thing that's kind of surprising to a lot of people, remember modifications are assessed at the contract level.
19:11
SPEAKER_02: Terminations are assessed at the contract level.
19:15
SPEAKER_02: So when we think about terminations, it means that everything the lessor has is providing for me under that contract has ended.
19:22
SPEAKER_02: That's a termination, right?
19:25
SPEAKER_02: If I can continue to get that same space from the lesseur, albeit for a shorter amount of time, well, that's not a termination.
19:31
SPEAKER_02: I'm still using his asset.
19:33
SPEAKER_02: It hasn't, it literally has not terminated.
19:35
SPEAKER_02: And frequently we'll see agreements that say at the top of it, whereas the parties wish to terminate the lease of 1, 2, 3, Main Street, right?
19:43
SPEAKER_02: And they'll say at the end that the lesseur has the lessee has 60 days to vacate the property.
19:49
SPEAKER_02: Well, that's not a termination, right?
19:51
SPEAKER_02: I now get to use this property.
19:53
SPEAKER_02: I get to continue to use this property for 60 days.
19:57
SPEAKER_02: So that's a shortening of the lease.
19:58
SPEAKER_02: That's not a termination.
20:00
SPEAKER_02: So a termination is only when everything has ended immediately.
20:05
SPEAKER_02: In real life, we don't find this frequently happens in real estate leases.
20:10
SPEAKER_02: It is more common to happen in equipment leases because equipment's portable, right?
20:15
SPEAKER_02: I could fly my leased aircraft, my lease jet to an airfield and turn over the keys.
20:21
SPEAKER_02: I could drive a truck to a dealership and turn over the keys, right?
20:25
SPEAKER_02: Real estate, it's the only time we've actually seen true terminations in real estate are fact patterns where the lessee has already completely vacated the space, but they haven't been able to finalize the negotiations with the lesseur yet, such that by the time they sign the piece of paper, the lesour says, fine, you could leave the space, just give me the keys and a million dollars, right?
20:47
SPEAKER_02: I'm already gone.
20:48
SPEAKER_02: So that could be a termination.
20:50
SPEAKER_02: I'm not saying they don't happen.
20:51
SPEAKER_02: I'm just saying that in most cases, what we find is that terminations are actually accounted for as modifications, even though it says termination.
20:58
SPEAKER_04: All right.
20:59
SPEAKER_04: And then Suzanne, going back to the examples that you were talking about.
21:02
SPEAKER_04: So Mark was giving this example of a quote unquote termination that was changing the term.
21:07
SPEAKER_04: But how about the case where I'm reducing the amount of space?
21:10
SPEAKER_04: So it's sort of similar to what you were talking about, but maybe taking an example of like floors in a building.
21:16
SPEAKER_00: Yeah, and we do get this question a lot.
21:19
SPEAKER_00: So I'm happy to talk about it.
21:20
SPEAKER_00: So let's use an example.
21:22
SPEAKER_00: Like a lessee is leasing five floors in a building, and just say the remaining lease term is five years.
21:28
SPEAKER_00: And the lessee negotiates a modification to leave two of the five floors early.
21:34
SPEAKER_00: But like Mark said, we're not gonna leave right away because we have to pack up and everything.
21:37
SPEAKER_00: So they're gonna leave the two floors in six months.
21:40
SPEAKER_00: The remaining three floors will just stay as they are for five years.
21:45
SPEAKER_00: But since all these five floors are in one contract, this change, even though on the surface looks like it's just impacting two floors, is gonna impact the accounting for all of the floors.
21:56
SPEAKER_00: We're gonna have a full remeasurement, like I was talking about earlier.
22:00
SPEAKER_00: Earlier.
22:00
SPEAKER_00: Um, I want to bring this one up because usually when we're talking to people, their initial reaction is to say, hey, this is just a termination of two floors, and I should just reduce the lease liability, you know, for 40%.
22:14
SPEAKER_00: That's two out of the five floors.
22:16
SPEAKER_00: And uh any termination penalty would just be expensed when this change is agreed to.
22:21
SPEAKER_00: But um, unfortunately, it's not so simple because it's treated as a modification of the whole contract, like I said, full remeasurement.
22:29
SPEAKER_00: So after this modification, we now have two different periods of use.
22:33
SPEAKER_00: We have a lease of two floors for the shortened period of six months and a lease of the remaining floors, three floors, for the original longer period of five years.
22:43
SPEAKER_00: And all of the payments, including the termination penalty here, would be allocated based on standalone selling prices to those two different, you know, periods of use.
22:53
SPEAKER_00: Um and the expense would be recognized over their respective periods of use, the two floors for six months and the three floors for the longer period.
23:02
SPEAKER_00: And when you think about that, you know, most of the consideration, including that termination penalty, it's going to get allocated to those three floors because the value of the right to use an asset, those three floors for five years, is is going to be much more, much higher, right, than the right to use two floors for six months.
23:23
SPEAKER_00: So that does sometimes come as a surprise, the fact that that penalty is really going to be taken over the longer terms.
23:30
SPEAKER_04: Okay.
23:30
SPEAKER_04: So taking a step back, I think as Suzanne, as you said, a lot of people are going to look at this and say, well, I made a termination penalty.
23:39
SPEAKER_04: I'm out of those two floors.
23:41
SPEAKER_04: I I want to recognize that payment now.
23:44
SPEAKER_04: Are there ever circumstances where you could do that?
23:47
SPEAKER_00: That you could recognize the payment immediately for the termination.
23:50
SPEAKER_00: Only if you got out of all five floors in my example immediately, right?
23:56
SPEAKER_00: When you make the payment, you've already gotten kind of what Mark was talking about.
23:58
SPEAKER_00: That's a true termination and you could expense it then.
24:01
SPEAKER_00: But otherwise, you're out of luck.
24:03
SPEAKER_04: So if some component of the lease is continuing, then you cannot.
24:07
SPEAKER_04: All right.
24:07
SPEAKER_04: So then let's go into a few other fact patterns.
24:10
SPEAKER_04: So the one we just talked about, we're saying the contract is modified because the parties haven't terminated everything.
24:15
SPEAKER_04: Some components continue.
24:17
SPEAKER_04: So we also talked about a case where maybe I had to account for two contracts together or combine.
24:22
SPEAKER_04: And let's say in this circumstance, one of those contracts was for the three floors, one of those contracts was for the two floors that were terminated.
24:31
SPEAKER_04: So now can I say, well, okay, I'm going to keep the one and I terminated the other?
24:35
SPEAKER_00: And not if they were treated as a combined contract together, at least commencement, you'd still do the same thing that I was discussing.
24:43
SPEAKER_00: They're still treated as one.
24:45
SPEAKER_04: All right.
24:45
SPEAKER_04: And then what if, again, lots of what ifs here?
24:48
SPEAKER_04: What if those two contracts were treated separately?
24:51
SPEAKER_04: Maybe I entered into them at much different times, or you know, whatever reason they were treated separately.
24:57
SPEAKER_04: Then would you have to treat them together?
25:00
SPEAKER_02: So the question the answer to that question is often yes.
25:04
SPEAKER_02: Okay, but it depends on what you're doing.
25:06
SPEAKER_02: Okay.
25:07
SPEAKER_02: So there is a less common fact pattern where I might be able to treat them as two separate contracts.
25:13
SPEAKER_02: So let's assume for the moment that I want to get out of one space, okay, but at the same time, I want to extend my lease in another space.
25:23
SPEAKER_02: So if I use an example, let's say I've got office space in both New York and New Jersey, right?
25:28
SPEAKER_02: And I want to combine the workforces into only one of those two offices.
25:32
SPEAKER_02: They were not, they're with the same Les Or, but I did not negotiate them originally at the same time.
25:36
SPEAKER_02: So they were always been two separate contracts.
25:38
SPEAKER_02: But if all I'm doing now is saying, okay, let me at the same time get out of my New York space and I'm going to extend the lease on my New Jersey space, then I have to, once again, combine these contracts and all the economics would then be recognized prospectively over the remaining lease terms of either New York or New Jersey.
25:58
SPEAKER_02: And I wouldn't take anything to the PL immediately, even if there's something labeled to the contract, pay me a million dollars today upon signing this termination agreement, right?
26:07
SPEAKER_04: And Mark, that's because it was with the same lassour that you entered.
26:11
SPEAKER_02: With the same lessour, it's negotiated as a package.
26:14
SPEAKER_02: It's kind of for the same purpose, it's the same employees working, you know, in one to the other.
26:18
SPEAKER_02: We would definitely say in that fact pattern, right, the termination penalty or fee that you're paying would just be part of the consideration for whatever you're continuing to get from that lessour.
26:29
SPEAKER_04: And then not to state the obvious, but if it was two different les sources, even if you're negotiating at the same time, you would treat in your example, New York is termination, New Jersey then as a modification.
26:41
SPEAKER_02: If all I'm doing is saying I you know, I've got two different lesores, right?
26:45
SPEAKER_02: Two different spaces, and I'm going to negotiate at the same time, but two different parties, then you treat those separately.
26:51
SPEAKER_04: So then, Mark, let's go back though.
26:52
SPEAKER_04: So that was a very specific pattern with these two different lesores.
26:56
SPEAKER_04: But going back to your fact pattern where it's the same les or two separate contracts originally accounted for as two separate leases, but now I'm terminating one, extending the other, all as part of the same negotiation.
27:09
SPEAKER_04: Then I would have to treat those two contracts together.
27:12
SPEAKER_04: And I think that comes as a surprise to some people considering they were originally separated.
27:18
SPEAKER_02: That's right.
27:18
SPEAKER_02: And I think that's what you've described as the right accounting for that.
27:23
SPEAKER_02: Um, I think that there is, you know, perhaps one exception that we that we do sometimes see in practice, is why I bring this up.
27:30
SPEAKER_02: And that is again, let's start off by assuming that these two contracts were never combined until now.
27:37
SPEAKER_02: Okay.
27:37
SPEAKER_02: But I now have um two arrangements.
27:40
SPEAKER_02: I want to shut down my New York office, and I happen to have with the same lesour, because just like any other supplier, frequently lessees deal with the same les sources over and over again.
27:51
SPEAKER_02: So say that I've got office space in New York, and let's just say a warehouse in Philadelphia, okay?
27:56
SPEAKER_02: Um assessing my business needs, I'm assessing my logistics, and I believe that I like the warehouse in Philadelphia, but I'm gonna shut down the office in New York.
28:07
SPEAKER_02: And I negotiate those two things at the same time.
28:09
SPEAKER_02: So in that fact pattern, first of all, they weren't combined to begin with.
28:13
SPEAKER_02: If they were, it'd be in one contract.
28:16
SPEAKER_02: Okay, but they weren't.
28:17
SPEAKER_02: And now they're really not used for the same purpose.
28:20
SPEAKER_02: It's not as if I'm moving my office employees in New York to my warehouse employees in Philadelphia.
28:26
SPEAKER_02: So these two things, I'm just gonna say, like holistically, they seem like very different purposes.
28:31
SPEAKER_02: They seem like different things.
28:33
SPEAKER_02: If I negotiate for the immediate termination of New York and at the same time an extension of Philadelphia, again, there's some diversity in practice, but we think there's an avenue there to just treat the termination of New York as a separate standalone transaction and not have to uh blend and extend it into my ongoing rent payments in Philadelphia.
28:56
SPEAKER_02: The only caveat that we'd have there is we want to make sure that the rents you're paying in Philadelphia are the right number.
29:03
SPEAKER_02: Because anytime I do two things with the same counterparty, whether it's leases, whether it's revenue, frequently I can just push the dollars from one contract into the other.
29:11
SPEAKER_02: But if those two arrangements were not together to begin with and they have two different purposes today, there might be a mechanical exercise to make sure that I'm allocating the right rents to Philadelphia based on the standalone selling prices.
29:25
SPEAKER_02: But if I do that, I can take the amount remaining after I've done the allocation and say, well, that's just a termination of my New York space and recognize that immediately.
29:34
SPEAKER_04: All right.
29:34
SPEAKER_04: But key point there being the fact that you really have to make sure that Philadelphia is the right market rents effectively, and that you're not just rolling in some cost termination of your New York office space.
29:47
SPEAKER_02: Right.
29:48
SPEAKER_02: And let me just point out that even though we certainly accept that, that again, two different types of assets simply being negotiated at the same time, we'd accept taking a termination penalty.
29:59
SPEAKER_02: There is diversity in practice there because others could argue that, well, today I should combine these two contracts because you just told me that the economics were intertwined.
30:09
SPEAKER_04: Right.
30:09
SPEAKER_02: Right.
30:10
SPEAKER_02: So I I take that point.
30:11
SPEAKER_02: And if somebody said, I don't want to take a termination penalty in that fact pattern, I want to recognize everything prospectively.
30:18
SPEAKER_02: I think there's diversity in practice that they could, they may be able to rely on.
30:21
SPEAKER_04: All right.
30:22
SPEAKER_04: So definitely a lot to think about anytime you're terminating your leases.
30:27
SPEAKER_04: Terminating, I used an air quotes, which obviously our uh listeners cannot see, but terminating or modifying our leases.
30:35
SPEAKER_04: So, Mark Suzanne, that that was the totality of the fact patterns that we were going to walk through today.
30:40
SPEAKER_04: But just to wrap things up, any final words of wisdom as you're dealing with companies that or for companies as they're dealing with changes to their leases?
30:51
SPEAKER_02: Well, I I I guess that I would just say it is counterintuitive that things labeled as terminations are frequently not accounted for as terminations.
31:01
SPEAKER_02: We've talked about this solely from the perspective of the lessees.
31:04
SPEAKER_02: We get a lot of these questions as well as from lesseurs, and we tell lessours the same thing, you know.
31:11
SPEAKER_02: Um and I again this caveat, I would say, that the standard uses the terminology, modification of a contract.
31:18
SPEAKER_02: And we know that contrasts can be combined.
31:20
SPEAKER_02: So you really have to think of this holistically, right?
31:23
SPEAKER_02: And anytime you're continuing to provide services or obtain services from the same counterparty, it is likely that you're going to recognize the effects of these changes prospectively rather than immediately.
31:36
SPEAKER_02: All right.
31:36
SPEAKER_02: So just bear that in mind and talk to your auditors.
31:40
SPEAKER_04: Very good advice and good rule of thumb.
31:42
SPEAKER_00: Suzanne, any other thoughts?
31:43
SPEAKER_00: Yeah, just similar marks.
31:45
SPEAKER_00: Substance over form, always right.
31:47
SPEAKER_00: Don't just blindly read the contract and account for it from what you're seeing there.
31:51
SPEAKER_00: Really think about holistically what's going on.
31:54
SPEAKER_04: All right.
31:54
SPEAKER_04: Well, it's always such a pleasure to talk to the two of you.
31:57
SPEAKER_04: Thanks so much for joining me today.
31:59
SPEAKER_04: Thank you.
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32:23
SPEAKER_03: From Thought Leadership at PwC, I'm Heather Horn.
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