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Leases: Brushing up on “day 2” accounting · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:07
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_02: I'm Heather Horn.
• 0:12
  SPEAKER_02: In today's episode, we're going to talk about day two of lease accounting as we continue our lease mini-series.
• 0:19
  SPEAKER_02: Lease accounting is not a set it and forget it model.
• 0:22
  SPEAKER_02: And events can happen during the lease term that require additional accounting.
• 0:27
  SPEAKER_02: So, questions: when do you revisit the accounting and when do you let it ride?
• 0:31
  SPEAKER_02: How is accounting impacted by remeasurement?
• 0:34
  SPEAKER_02: Today we'll talk about those questions and more.
• 0:37
  SPEAKER_03: Events can happen during the lease term that require the lessee to re-measure the lease.
• 0:42
  SPEAKER_03: And we're actually seeing some of these events more frequently lately where companies are making changes to their plans for leased assets.
• 0:49
  SPEAKER_03: A lot with real estate, too.
• 0:50
  SPEAKER_03: So, like modifications, changes in lease terms, things like that.
• 0:59
  SPEAKER_02: That was Suzanne Stefani, who's also joined by Mark Juslam, who are both in our national office and who specialize in lease transactions.
• 1:07
  SPEAKER_02: Having answered many questions on this topic over the years, there are plenty of great insights in this episode.
• 1:13
  SPEAKER_02: So let's get started.
• 1:15
  SPEAKER_02: Suzanne, Mark, welcome back for another leasing episode.
• 1:18
  SPEAKER_02: And on our last podcast, we talked about lease classification and covered some of the key points of what I'll say is day one lease accounting.
• 1:25
  SPEAKER_02: So classification, lease term, lease payments, and discount rate.
• 1:30
  SPEAKER_02: So hopefully, listeners realize that of course the next logical progression in this series would be to talk about day two accounting, which is what we're going to cover today.
• 1:40
  SPEAKER_02: So, Suzanne, can you just run us through what we're going to cover in today's episode?
• 1:45
  SPEAKER_03: Yeah, so we're doing a day two podcast because the leasing model is not set it and forget it anymore, right?
• 1:51
  SPEAKER_03: Events can happen during the lease term that require the lessee to re-measure the lease.
• 1:56
  SPEAKER_03: And we're actually seeing some of these events more frequently lately where companies are making changes to their plans for leased assets, a lot with real estate too.
• 2:05
  SPEAKER_03: So like modifications, changes in lease terms, things like that.
• 2:08
  SPEAKER_03: So with that in mind, we're going to go through the reassessment events today and the related accounting, as well as a few other things like impairment, subleases, things like that.
• 2:17
  SPEAKER_02: All right.
• 2:17
  SPEAKER_02: I feel like there's many, or if not most, of our accounting models are not set it and forget it.
• 2:23
  SPEAKER_02: But this is definitely one where it's very important to make sure you do have the right processes and controls to make sure that you know you're keeping track of any events that could lead to a change.
• 2:33
  SPEAKER_02: So with that in mind, then, Suzanne, what are some of the events that companies should be looking for?
• 2:38
  SPEAKER_03: Yeah.
• 2:38
  SPEAKER_03: So we're gonna talk about the remeasurement or reassessment events, I'll say.
• 2:42
  SPEAKER_03: There's five events that require a remeasurement of a lease.
• 2:45
  SPEAKER_03: So three are a full remeasurement and two are what I call like a partial remeasurement.
• 2:51
  SPEAKER_03: So the three full remeasurement events would be a contract modification, not accounted for as a separate new lease, and I think we're separate new contract, and we'll I think we're gonna get into that later.
• 3:02
  SPEAKER_03: Um changes in the assessment of lease term, and third, changes in the assessment of a purchase option.
• 3:08
  SPEAKER_03: Those are the three full remeasurement events.
• 3:10
  SPEAKER_03: The partial remeasurement events are contingency resolution, so that's where a contingency in which variable payments are based occurs such that the variable payment now becomes fixed.
• 3:22
  SPEAKER_03: And then the second is when there's a change in the amount of payment that's probable under a residual value guarantee.
• 3:29
  SPEAKER_03: So those are the two requiring partial remeasurements.
• 3:31
  SPEAKER_02: All right, well, why don't we start with uh full remeasurement first?
• 3:34
  SPEAKER_02: So what is involved in that?
• 3:36
  SPEAKER_03: Yeah, so in order to do a full remeasurement of a lease, you need to go through three things first.
• 3:42
  SPEAKER_03: I'll call them steps.
• 3:43
  SPEAKER_03: So step one, does the contract still contain a lease?
• 3:46
  SPEAKER_03: Now, this is only gonna apply when we have a lease that's embedded in another contract, and there's a modification to that contract.
• 3:53
  SPEAKER_03: Just as an aside, if you're wondering what an embedded lease is, we're gonna do another podcast on that.
• 3:59
  SPEAKER_03: The next step, and this is for all of the three full remeasurement events, you're gonna reallocate contract consideration between lease and non-lease components using updated consideration amounts.
• 4:10
  SPEAKER_03: Now, important here, you need to update standalone selling prices at the remeasurement date to do this allocation.
• 4:17
  SPEAKER_03: And that has to be done even when it's just a change like in lease term or purchase option assessment.
• 4:23
  SPEAKER_03: So, like even when the contract consideration doesn't change, you still have to reallocate based on that updated standalone selling price.
• 4:30
  SPEAKER_03: So once you do that, then you're gonna re-evaluate lease classification.
• 4:34
  SPEAKER_03: And I'm not gonna go through all the five points of classification.
• 4:38
  SPEAKER_03: We did cover those in our last podcast, but I'm gonna highlight just a couple that likely will be the ones that are like most impacted here.
• 4:45
  SPEAKER_03: First one would be lease term test.
• 4:47
  SPEAKER_03: So for the lease term test, the lease term might change now, right?
• 4:50
  SPEAKER_03: You might have updated assumptions on extension or termination options, so it might be longer or shorter, or you might modify the lease term.
• 4:59
  SPEAKER_03: For example, so you might have an updated lease term there and you'd compare that to the economic life of the asset at the remeasurement date.
• 5:06
  SPEAKER_03: Now, when you go to the lease payments test, so you're gonna you're gonna have revised payments.
• 5:11
  SPEAKER_03: So some payments might change for a variety of reasons, right?
• 5:14
  SPEAKER_03: But you might have a modification that outright changes payments, might have a difference now because of how you reallocated lease and non-lease components, might have a change in lease term.
• 5:25
  SPEAKER_03: So that might mean more or less payments, even variable lease payments that depend on an index or a rate, like think about CPI-based payments, those need to be updated as well using the index or rate at the remeasurement date, even if that payment wasn't modified or changed.
• 5:40
  SPEAKER_03: Now, big one discount rate, that has to be updated at the remeasurement date using facts and circumstances at that date.
• 5:48
  SPEAKER_03: And then also fair value of the asset.
• 5:49
  SPEAKER_03: You got to get an updated fair value of the asset at the remeasurement date as well.
• 5:53
  SPEAKER_03: So just it requires a pretty, you know, big update of assumptions there to do that classification.
• 5:58
  SPEAKER_02: So uh Suzanne, let me ask you a question about step two.
• 6:01
  SPEAKER_02: We were talking about reallocating contract consideration.
• 6:04
  SPEAKER_02: Yeah.
• 6:04
  SPEAKER_02: So it you're reallocating between lease and non-lease elements.
• 6:08
  SPEAKER_02: Now, am I remembering correctly that there's a practical expedient that you don't have to separate them?
• 6:14
  SPEAKER_02: Yes.
• 6:14
  SPEAKER_03: Yeah, sorry, yeah, I should have said that.
• 6:16
  SPEAKER_03: If you're a lessee and you take the election to not separate lease and non-lease components, then you can skip over that.
• 6:23
  SPEAKER_02: Okay, and you wouldn't reconsider that as part of this?
• 6:26
  SPEAKER_03: No, I think you're making the election by asset class and you would stick with it.
• 6:30
  SPEAKER_02: Okay, perfect.
• 6:31
  SPEAKER_02: That's very helpful.
• 6:32
  SPEAKER_02: So now that we know that, so we know that if you have any one of these three full remeasurement events, then you would update the assumptions, reclassify the lease.
• 6:40
  SPEAKER_02: So now we're ready to re-measure the lease.
• 6:43
  SPEAKER_02: So, Mark, what would be involved in that?
• 6:45
  SPEAKER_01: Well, now that we have our changes in our payments and perhaps our changes in our allocation, we would remeasure the lease liability using all of these updated assumptions that we've just talked about as of the remeasurement date, the reassessment date.
• 6:59
  SPEAKER_01: And um, we would use the same assumptions that we just used to classify the lease.
• 7:04
  SPEAKER_01: The right of use asset would then be adjusted for the change in the lease liability.
• 7:08
  SPEAKER_01: Generally, there's no gain or loss.
• 7:10
  SPEAKER_01: However, if the right of use asset is being reduced and it's already reduced down to zero, then the remainder of the adjustment does go straight to the PL.
• 7:19
  SPEAKER_01: The only exception is when a lease modification that decreases the lessee's right to use the asset, and we'll get into the details of that later.
• 7:27
  SPEAKER_01: Then the lease expense would be recalculated, revised based on the updated lease payments and the lease classification.
• 7:34
  SPEAKER_02: All right.
• 7:34
  SPEAKER_02: So then that's full remeasurement.
• 7:36
  SPEAKER_02: So, Suzanne, going back to you for partial remeasurement, what does that entail?
• 7:40
  SPEAKER_03: Yeah, so just a reminder, it's those two events if a can you have a contingency resolution or a change in um the amount of payment that's probable under a residual value guarantee.
• 7:50
  SPEAKER_03: Um, I'm gonna start with, I guess, the good news.
• 7:52
  SPEAKER_03: What you don't have to do as compared to a full remeasurement, you don't have to reassess whether there's a lease, don't have to change the discount rate, don't have to reassess lease term, and don't have to reevaluate lease classification.
• 8:05
  SPEAKER_03: So it's much simpler, right?
• 8:06
  SPEAKER_03: It's really just focusing on the revised payments.
• 8:08
  SPEAKER_03: So you're gonna reallocate contract consideration between lease and non-lease components if you're doing that, right?
• 8:15
  SPEAKER_03: If you didn't take that expedient.
• 8:17
  SPEAKER_03: And there's a policy choice on how to do that.
• 8:19
  SPEAKER_03: One option is to just continue using the same basis of initial allocation that you did, you know, when the lease started, or you can update the relative standalone selling price, like update the allocation, sorry, based on the relative standalone selling price on the remeasurement date.
• 8:34
  SPEAKER_03: Um, and that's it.
• 8:35
  SPEAKER_03: Then you're gonna remeasure the lease liability simply using the updated consideration.
• 8:40
  SPEAKER_03: Again, not changing discount rate or anything.
• 8:43
  SPEAKER_03: And so whatever you update your lease liability to, the other side of the entry is gonna go to the right of use asset.
• 8:49
  SPEAKER_03: And then you're just gonna revise lease expense going forward based on the updated lease payments.
• 8:54
  SPEAKER_02: All right, so definitely a lot less change and a lot easier to deal with, but just definitely something you wouldn't want to miss if you did have that event.
• 9:01
  SPEAKER_02: Right.
• 9:01
  SPEAKER_02: But given that full remeasurement can result in much bigger changes, let's go back to that.
• 9:07
  SPEAKER_02: And Suzanne, you mentioned three events that would cause full remeasurement earlier at a very high level, but I think it might be helpful to go into more detail on those.
• 9:16
  SPEAKER_02: And so, Mark, maybe starting with you and the first one of lease term and purchase option uh reassessments.
• 9:23
  SPEAKER_01: Okay, so we'd have to reassess the lease term, meaning reassess the uh probability of us um extending a lease or terminating a lease or exercising a purchase option.
• 9:36
  SPEAKER_01: And there's a couple of different events that could cause us to do that.
• 9:39
  SPEAKER_01: The more obvious one are the contract-based events.
• 9:42
  SPEAKER_01: So a contract-based event is when an event happens that's already defined in the contract that now obligates the lessee to exercise something or to not exercise some optional payment.
• 9:54
  SPEAKER_01: So, for example, um allowing a required notification period to lapse would be just a contractual event, right?
• 10:01
  SPEAKER_01: Uh frequently, especially in real estate leases or really in any large ticket leases, the lessee must give notice by a certain date, often months in advance, that they will not be exercising the renewal option, or essentially they automatically exercise it.
• 10:16
  SPEAKER_01: So that would be just be a contractual event that occurs, that we'd have to reassess the lease term.
• 10:21
  SPEAKER_01: The even more obvious one is when we actually do elect to do something, right?
• 10:26
  SPEAKER_01: What I mean by that is sending a legally binding notice to the lessor that we're going to exercise an option that was initially not included in the lease term because it wasn't deemed to be reasonably certain, or the opposite, or notifying the lesor that it will not be exercising an option when it did include that option in the lease term initially because it thought it was reasonably certain to do so.
• 10:47
  SPEAKER_01: So those are the contractual-based ones, and I think people generally recognize when those things occur.
• 10:53
  SPEAKER_01: The second category, if you will, are significant events or changes and circumstances that is within the lessee's control that change whether the lessee is reasonably certain to exercise or not exercise an optional extension or termination provision or purchase option.
• 11:12
  SPEAKER_01: So this criteria is for lessees only.
• 11:18
  SPEAKER_01: For changes, at least term within the lessee's control.
• 11:20
  SPEAKER_02: All right, it's helpful.
• 11:21
  SPEAKER_02: So, Mark, just to be absolutely clear then, so if there's a contractual change, something is actually exercised or otherwise that impacts both.
• 11:29
  SPEAKER_02: But if the lessee is maybe thinking something different, or even if the lesseur thinks they may be thinking something different, only the lessee makes that assessment.
• 11:38
  SPEAKER_01: That's right.
• 11:39
  SPEAKER_02: All right, that's helpful.
• 11:40
  SPEAKER_02: So definitely more straightforward if something occurs from a contractual point of view.
• 11:44
  SPEAKER_02: Um, but I know we get a lot of questions around when a significant lessee-controlled event occurs that changes assumptions around an option.
• 11:54
  SPEAKER_02: And so I and obviously because it's assumptions, there's judgment involved.
• 11:59
  SPEAKER_02: So, Mark, what are some of the things that you would think about there?
• 12:02
  SPEAKER_01: Well, let's start off with something that may seem, you know, um that people may be inclined to think is a significant change, but is not a reassessment trigger, and that is changes in market-based factors.
• 12:14
  SPEAKER_01: So the lessee doesn't have to keep a lookout for how much would it cost me today to lease this asset or how much would it cost me today to buy a comparable asset, right?
• 12:23
  SPEAKER_01: So say that there's increases in market rents such that now your renewal rents that you had in your contract appear like a bargain, right?
• 12:32
  SPEAKER_01: You actually do not change the lease term when those events occur.
• 12:36
  SPEAKER_01: And like I said, similarly, you don't reassess the lease term just because it would be cheaper to buy as comparable asset.
• 12:43
  SPEAKER_01: And the reason that the FASB did that is because the FASB wanted to make the standard a little bit easier to implement.
• 12:48
  SPEAKER_01: And they didn't want to have to have companies like looking out every single quarter to see well, what has happened to the market rates in New York this quarter, right?
• 12:56
  SPEAKER_01: That would be like a little bit of a procedural nightmare, right?
• 13:00
  SPEAKER_01: So it's only for things that are within the lessee's control.
• 13:03
  SPEAKER_01: So let's talk about that.
• 13:05
  SPEAKER_01: I think when you talk about things within the lessee's control, you really have to take a look at the underlying reason.
• 13:11
  SPEAKER_01: And the thing, the question that I like to ask is has the lessee taken an action that commits them to a particular plan?
• 13:18
  SPEAKER_01: And it's very facts and circumstances dependent.
• 13:21
  SPEAKER_01: So some of the more common examples that we see is that a lessee would begin to renovate the space or they begin to install new leasehold improvements such that it becomes obvious that the reason they're doing that is because they want to stay in the space longer.
• 13:36
  SPEAKER_01: That would certainly be a trigger to reassess the lease term if you start doing that.
• 13:41
  SPEAKER_02: For the lessee.
• 13:42
  SPEAKER_01: For the lessee, right?
• 13:44
  SPEAKER_01: Um perhaps not so obvious, but something also that would be a trigger is making a business decision that directly affects whether the lessee will exercise or not exercise an option in this lease.
• 13:56
  SPEAKER_01: So let me give you an example of that.
• 13:58
  SPEAKER_01: Say that the lessee extends the lease of a complementary asset, or they dispose of an alternate asset that they use in the same business as this asset.
• 14:08
  SPEAKER_01: So that may be a trigger that they have to reassess this lease as well.
• 14:12
  SPEAKER_01: Um another example, certainly, if I enter into a sublease, if I sublease the space and the term of the sublease goes into my optional renewal period, then obviously I have to, you know, exercise that option when it comes up.
• 14:25
  SPEAKER_01: Um and finally, it could be a change in business plans.
• 14:29
  SPEAKER_01: The only thing I would caution people about changes in business plans is that we really do like to see a situation where the lessee has made a decision that would cost them some money.
• 14:40
  SPEAKER_01: It would be expensive for them to change their minds.
• 14:43
  SPEAKER_01: Because the thing that we're concerned about is something like management in some division just makes a business decision and then a quarter later they decide, oh, let's not do that anymore, right?
• 14:51
  SPEAKER_01: And it doesn't cost them anything to change their mind, then maybe that's too early to have a reassessment.
• 14:55
  SPEAKER_02: All right.
• 14:56
  SPEAKER_02: That's definitely helpful and definitely lots of judgment.
• 14:59
  SPEAKER_02: So one of the other remeasurement events then that you mentioned, Suzanne, is lease modifications.
• 15:04
  SPEAKER_02: And in some ways, that sounds a little like it overlaps with the uh contractual changes Mark was talking about, but I know it's different.
• 15:12
  SPEAKER_02: So what can you share with this lease modifications?
• 15:15
  SPEAKER_03: Yep.
• 15:15
  SPEAKER_03: So yeah, so let me clarify what I mean by lease modification here to kind of differentiate from just like exercising an option, like Mark was talking about.
• 15:23
  SPEAKER_03: So lease modification would be a negotiated contractual change between a lessee and less or that either impacts the lease's scope, so like the amount of assets in the lease, or a consideration, like the payments, right?
• 15:37
  SPEAKER_03: So whether or not the modification is going to require a full remeasurement of the existing lease, like I was talking about earlier, depends on if the modification is considered a separate new lease or not.
• 15:48
  SPEAKER_03: So when is it considered a separate new lease?
• 15:51
  SPEAKER_03: Well, first of all, it's not form-driven.
• 15:53
  SPEAKER_03: It's not about like, oh, this modification's on a different piece of paper or a separate contract, it's a separate new lease.
• 15:58
  SPEAKER_03: It's not that.
• 15:59
  SPEAKER_03: And that's pretty common in accounting.
• 16:01
  SPEAKER_03: So the leases guidance gives two specific conditions to have that modification be considered a separate new lease.
• 16:08
  SPEAKER_03: One, the lessee has to get the right to use an additional asset that wasn't in the original lease.
• 16:13
  SPEAKER_03: So they might get a new floor of a building or an additional piece of equipment.
• 16:17
  SPEAKER_03: They have to get another asset.
• 16:19
  SPEAKER_03: And I just want to clarify because it comes up a lot.
• 16:21
  SPEAKER_03: Lease term increase is not an additional right of use asset since you just have more time with the same asset.
• 16:28
  SPEAKER_03: Now, second, so you need that additional asset, and then second, the lease payments have to increase commensurate with that the standalone price for that additional asset.
• 16:38
  SPEAKER_03: So the guidance is really trying to capture situations here where it appears that the change in the rents for that additional asset was not at all affected by what the lessor is getting already from the existing lease.
• 16:50
  SPEAKER_03: So that's the separate new lease.
• 16:52
  SPEAKER_03: So if you have those two conditions, separate new lease.
• 16:55
  SPEAKER_03: If not anything else, it's considered just kind of a continuation or modification of the existing lease.
• 17:02
  SPEAKER_03: So, like a couple examples would be any changes in lease term, increase, decrease, any changes in payment amount or timing, or even a reduction in the amount of assets you're leasing or leased space, those would all just be considered other changes, not a separate new lease.
• 17:18
  SPEAKER_02: And so, Suzanne, then if we're thinking of the difference in accounting between that separate new lease and the modification, what are the key differences there then?
• 17:27
  SPEAKER_03: Yeah.
• 17:27
  SPEAKER_03: So the key difference is if you have a separate new lease, um the accounting for the existing lease that's already on the balance sheet is not impacted at all, right?
• 17:36
  SPEAKER_03: We just put on a new lease liability and right of use asset completely separate from the one, the existing one we already have on the books.
• 17:44
  SPEAKER_03: But if you have any other modification, so not a separate new lease, it's really looked at as a continuation of the existing lease.
• 17:50
  SPEAKER_03: So it's gonna require a full remeasurement of the existing lease based on the modified terms, right?
• 17:56
  SPEAKER_03: Or, you know, whatever change there.
• 17:58
  SPEAKER_03: So, like I said earlier, full remeasurement, and I covered that before.
• 18:02
  SPEAKER_03: And it's remeasured on the effective date of the modification.
• 18:05
  SPEAKER_03: So that's gonna be the date that the modification is approved by both the lessee and less or all right.
• 18:10
  SPEAKER_02: And so then I know the one of the types of lease modifications that we're seeing a lot of is lease terminations, and that might be because people are downsizing or they're changing their business plan or lots of things related to the economy.
• 18:24
  SPEAKER_02: So they're negotiating with the lesseur to either reduce the amount of space they're leasing or to reduce the term.
• 18:31
  SPEAKER_02: So in that case, Mark, how would you think about that?
• 18:34
  SPEAKER_01: Well, once again, I guess the simpler example, though less common, is what I would refer to as a full termination, right?
• 18:41
  SPEAKER_01: So a full termination is a situation where the lessee is no longer controlling the leased asset or any other leases that were papered in the same agreement as the leased asset you're giving up, right?
• 18:53
  SPEAKER_01: In other words, a full termination is something that you surrender immediately.
• 18:57
  SPEAKER_01: And just practically speaking, that happens more commonly with equipment than it would with real estate.
• 19:03
  SPEAKER_01: But it could happen with either, potentially, okay.
• 19:05
  SPEAKER_01: And when you have a full termination, then you would de-recognize all the assets associated with the lease and all the liabilities associated with the lease.
• 19:13
  SPEAKER_01: And if there's any remaining amounts, you'd have a gain or loss.
• 19:16
  SPEAKER_02: All right.
• 19:17
  SPEAKER_02: But so obviously often, especially with real estate, it's not like you're just like, okay, today I'm giving this back.
• 19:23
  SPEAKER_02: There's normally some negotiation to shorten the term.
• 19:26
  SPEAKER_02: And so how would you think about that if let's say I agree now that I'm going to shorten, you know, the term and have the lease end early?
• 19:33
  SPEAKER_01: Right.
• 19:34
  SPEAKER_01: So any situation where the lessee doesn't give the asset back immediately is to your point, it's simply not a full termination.
• 19:42
  SPEAKER_01: I guess we could lump those all together and call them partial terminations, right?
• 19:46
  SPEAKER_01: Or shortening the lease.
• 19:48
  SPEAKER_01: Um when this occurs, there would be a full remeasurement event as we've described above, have to go through all the steps that Suzanne described.
• 19:55
  SPEAKER_01: And one thing I want to talk to people about is even if the parties negotiate to pay a one-time fee for this, you know, what they're calling a termination, that one-time fee would be expensed prospectively over the remainder of the shorter lease term.
• 20:12
  SPEAKER_01: So another example of a partial termination is when you're canceling only part of a lease.
• 20:17
  SPEAKER_01: And so, say the lessee was leasing five floors in an office building and it negotiated a modification to vacate two of the floors early.
• 20:26
  SPEAKER_01: So the lessee, you know, on the surface would seem to be terminating the lease of two floors.
• 20:31
  SPEAKER_01: But the lease of all five floors was initially in a single contract.
• 20:35
  SPEAKER_01: So, you know, what often happens is both lessees and lesseurs see this as a termination of two floors.
• 20:40
  SPEAKER_01: They think they should just reduce the lease liability by, you know, removing 40% of that example of the future payments for two out of five floors and taking the adjustment through the right-of-use asset.
• 20:51
  SPEAKER_01: And if there's a termination penalty for those floors, there's an inclination to expense it when it's signed, or perhaps to recognize it only over the shorter lease, but it's not so simple.
• 21:02
  SPEAKER_01: And I know we've talked about this a number of times, but we continue to get many questions on this.
• 21:07
  SPEAKER_01: And because the contract is still ongoing, it is simply not an immediate termination.
• 21:12
  SPEAKER_01: It's a modification of the contract, it's a full remeasurement event.
• 21:16
  SPEAKER_01: And since the lease is continuing, any fees to modify the contract would be recognized over the remaining leases.
• 21:23
  SPEAKER_01: So again, typically for real estate leases, as we've just talked about, the LESsee usually remains in the space for some time after the modification is negotiated.
• 21:32
  SPEAKER_01: And if that's the case, there are several leases here.
• 21:34
  SPEAKER_01: There's a lease of two floors for a shorter period, there's a lease of the other three floors for the original longer period, and the rents would have to be allocated and recognized over those respective periods.
• 21:46
  SPEAKER_01: So even though they may have negotiated a termination fee, a termination is just a form of consideration.
• 21:53
  SPEAKER_01: It is not either a lease component or a non lease component, and it's just part of the consideration, and it's not accounted for.
• 22:00
  SPEAKER_01: Immediately, but over the respective lease term.
• 22:02
  SPEAKER_01: And that's very surprising to a lot of people that a termination penalty isn't expensed as a result of the termination.
• 22:09
  SPEAKER_02: I know, sort of smiling here at Mark, because I feel like we say it's a surprise to many.
• 22:15
  SPEAKER_02: And I I think I can think of at least like five times on either this podcast or the webcast.
• 22:20
  SPEAKER_02: We've talked about this, and yet people are still not remembering.
• 22:23
  SPEAKER_02: So maybe it's like all bold letters that it is not.
• 22:27
  SPEAKER_01: And if I may, I think that one of the reasons it's such a surprise is because economically it really is a termination.
• 22:33
  SPEAKER_01: And we all recognize that.
• 22:34
  SPEAKER_01: You know, that this doesn't really reflect the economics, it's just what the rules say.
• 22:38
  SPEAKER_02: Yeah, I think that's a good point, Mark.
• 22:40
  SPEAKER_02: And I do think it's probably intended to make sure, in some ways, to make things easier for people.
• 22:45
  SPEAKER_02: But in any event, it's definitely something people just need to know and understand.
• 22:49
  SPEAKER_02: But Suzanne, let me go back to something else you referenced, which would be subleasing the space.
• 22:54
  SPEAKER_02: So what's the model if you do decide instead of terminating um or shortening the term that you instead sublease?
• 23:01
  SPEAKER_03: Yeah.
• 23:02
  SPEAKER_03: So the first thing if you're, you know, you've got lease space and you're going to sublease it out, the first thing is to determine the lessee would determine if they're relieved of their primary obligation under the original lease.
• 23:13
  SPEAKER_03: So that's called the head lease, like when you're not talking about a sublease.
• 23:16
  SPEAKER_03: Now, this is usually not the case.
• 23:18
  SPEAKER_03: This usually doesn't happen, right?
• 23:20
  SPEAKER_03: It would only happen if the lessee's name in the lease is contractually replaced with someone else's name.
• 23:26
  SPEAKER_03: And if you had that, that would be a lease termination.
• 23:28
  SPEAKER_03: But again, like not the norm there.
• 23:30
  SPEAKER_03: Um what normally happens is the lessee is not relieved of its primary obligation under the head lease.
• 23:36
  SPEAKER_03: So if the lessee is not relieved of their primary obligation under the head lease, the lessee will just continue to account for their original lease.
• 23:43
  SPEAKER_03: And then they're gonna separately account for the sublease.
• 23:46
  SPEAKER_03: So let's talk about the sublease now.
• 23:48
  SPEAKER_03: So if you enter into a sublease as a lessee, you're gonna be actually applying the lesseur guidance and you're gonna classify and account for that sublease like you're the lesseur.
• 23:58
  SPEAKER_03: Um classification considerations to think about here.
• 24:01
  SPEAKER_03: Um, you're gonna use all the classification points that we talked about in our earlier leases podcasts.
• 24:06
  SPEAKER_03: So I'm not gonna go through all of them again, but we'll talk about a few areas where we kind of get questions on subleases.
• 24:12
  SPEAKER_03: One is the lease payments test.
• 24:14
  SPEAKER_03: For the lease payments test, um, that's again if the present value of the lease payments equals or exceeds substantially all of the fair value of the asset.
• 24:22
  SPEAKER_03: So what asset do you use, right?
• 24:25
  SPEAKER_03: When you're lit thinking about the fair value of the asset, you might think you compare the sublease rents to the fair value of the right of use asset, you know, for that space, but you don't.
• 24:34
  SPEAKER_03: It's you actually compare the sublease rents or the present value of the sublease rents to the fair value of that underlying asset.
• 24:40
  SPEAKER_03: So if the sublease is for a building, you use the full fair value of that building.
• 24:45
  SPEAKER_03: Now, on the discount rate, um, it's basically the same model you'd use for any lease.
• 24:51
  SPEAKER_03: So you'd use the rate implicit in the lease, if known, and this might be the case when the terms of the head lease and sublease are for the same term.
• 24:59
  SPEAKER_03: But if not, you would use the discount rate that was originally used to account for the head lease.
• 25:04
  SPEAKER_02: All right.
• 25:04
  SPEAKER_02: And I know that the um chapter three of the lease guide has some more detail on how, as a lessor, which again you said uh would be the case here for the original lessee, should classify an account for their leases, whether it's operating, sales type, or direct finance.
• 25:20
  SPEAKER_02: Um, but I think the more common example we see is where these subleases are operating.
• 25:25
  SPEAKER_02: So in that case, Suzanne, what is the accounting?
• 25:27
  SPEAKER_03: Yeah, so for an operating sublease, again, you're the lessor here, the sublease income would simply be recognized straight line over the sublease term.
• 25:36
  SPEAKER_03: The head lease accounting is generally gonna remain unchanged, but there are some reassessment and compairment considerations to think about here.
• 25:44
  SPEAKER_03: So Mark mentioned the reassessment one.
• 25:46
  SPEAKER_03: You know, if you enter into a sublease and it's longer than the lease term that you're using for your head lease, because you maybe you weren't gonna, you said you weren't reasonably certain to exercise an extension option, this would be one of those situations where you'd have to reassess.
• 26:02
  SPEAKER_02: All right.
• 26:02
  SPEAKER_02: So, Suzanne, let's hold off for a moment on impairment.
• 26:04
  SPEAKER_02: Um, but I know one of the main questions that you get on subleases is around the PL presentation and specifically if that income should be net against the head lease expense.
• 26:14
  SPEAKER_02: So, how do you think about that?
• 26:15
  SPEAKER_03: Yeah, I think this is probably the number one question we get on subleases.
• 26:19
  SPEAKER_03: So if you look at the leases guidance, it requires disclosure of gross sublease income separate from the head lease expense.
• 26:27
  SPEAKER_03: But there's actually no explicit guidance that addresses where it goes in the income statement.
• 26:32
  SPEAKER_03: So, of course, gross presentation always acceptable.
• 26:35
  SPEAKER_03: So that means you'd have sublease income on one line and then head lease expense would be on a you know on a separate line wherever you put that.
• 26:42
  SPEAKER_03: Always acceptable.
• 26:43
  SPEAKER_03: Um now net presentation, because that's what what a lot of um companies want to do.
• 26:48
  SPEAKER_03: So that's when you would have your head lease expense line, but it would be reduced for the sublease income.
• 26:54
  SPEAKER_03: So we wouldn't object to that for companies where subleasing is not their significant business activity, right?
• 27:01
  SPEAKER_03: If you have a company that's subleasing, they're really just doing it to kind of recoup some cash for space they're not using and it's not really part of their ongoing business, then that sh would be fine to net.
• 27:12
  SPEAKER_02: All right.
• 27:13
  SPEAKER_02: So definitely depends then on the facts and circumstances, which I feel like is uh fairly safe answer for almost everything in a county.
• 27:20
  SPEAKER_02: Uh but then also, Suzanne, you mentioned impairment of the ROU asset and a sublease could impact that.
• 27:27
  SPEAKER_02: So how does that work?
• 27:28
  SPEAKER_03: Yeah.
• 27:29
  SPEAKER_03: So just to kind of level stuff, so the right of use to asset impairment, and we've talked about this before, but it's just like any other fixed asset, like PPE, it's subject to the impairment guidance in 360.
• 27:40
  SPEAKER_03: And it's usually um part of a broader asset group, the ROU asset.
• 27:45
  SPEAKER_03: So if you're looking at the 360 guidance, any significant or adverse changes in the extent or manner in which an asset group is being used is an impairment indicator.
• 27:55
  SPEAKER_03: So why I bring this up for subleasing, when unless he contemplates subleasing an asset, that could be an indicator that the asset group is impaired.
• 28:03
  SPEAKER_03: You know, it really depends on the nature and magnitude of the lease to that overall asset group, if it if it's, you know, a large portion of it or not.
• 28:10
  SPEAKER_02: All right.
• 28:11
  SPEAKER_02: So definitely again, you have to look at the nature and magnitude.
• 28:14
  SPEAKER_02: And normally it's part of this broader asset group rather than on a standalone basis.
• 28:19
  SPEAKER_02: So then if you have an impairment just related to that lease, it seems like then it could actually wound up being shielded from actually uh recording something by the other assets in the group.
• 28:30
  SPEAKER_02: But so how do you think about just the change in the lease in the context of a broader asset group?
• 28:36
  SPEAKER_03: Yeah, so sometimes asset groups are reassessed, right?
• 28:40
  SPEAKER_03: Um so it's something to think about when you have a sublease, because asset groups are reassessed when there's a change in facts and circumstances and the interdependence of cash flows in the asset group.
• 28:51
  SPEAKER_03: So this might be necessary if the lessee subleases all are part of an underlying asset.
• 28:57
  SPEAKER_03: So if I could just give a quick example.
• 28:59
  SPEAKER_03: So if a lessee has, let's say, three manufacturing facilities and they all make widgets, right?
• 29:05
  SPEAKER_03: The manufacturing facilities, they're all in the same asset group because they all do the same thing.
• 29:10
  SPEAKER_03: If a company decides it no longer needs one of the facilities for production, so they decide to sublease it, they actually go ahead and sublease it.
• 29:17
  SPEAKER_03: Since the cash flows from the sublease are now, you know, they're no longer dependent on the widget manufacturing, the lessee might determine that the facility should no longer be in that widget asset group, but should be in its own, you know, separate asset group.
• 29:31
  SPEAKER_03: Now, I just want to clarify, in that example, the LESI, I'm saying they actually sublease the space.
• 29:36
  SPEAKER_03: If we just have a decision to sublease or even a plan to abandon, that might not in isolation cause reassessment of the asset group.
• 29:44
  SPEAKER_03: Um, particularly if the lessee is continuing to use that asset in substantially the same manner for some period after it makes that decision because the level of identifiable cash flows haven't materially changed yet.
• 29:57
  SPEAKER_03: So it's just something to keep an eye on.
• 29:58
  SPEAKER_02: All right.
• 29:59
  SPEAKER_02: And obviously, ROU potential asset impairment, broader asset impairment is much more complicated than just that little snippet that's all I'm qualified to say.
• 30:09
  SPEAKER_02: All right.
• 30:09
  SPEAKER_02: Well, we have some other episodes where we talk about impairment more, or definitely for our listeners, um, check out chapter five of the PPE guide.
• 30:16
  SPEAKER_02: But let's assume fast forward, fast forward, we just got through and there is an impairment of the asset group, and they, you know, that the ROU asset is impaired.
• 30:26
  SPEAKER_02: How does that impact then mark the lease accounting?
• 30:29
  SPEAKER_01: So the impairment charge would only impact the right of use asset.
• 30:33
  SPEAKER_01: It would not impact the value of the recorded lease liability absent actually modifying your lease, what, or having new terms or reassessment of uh an option to renew.
• 30:42
  SPEAKER_01: So again, you know, there could be operating leases or could be finance leases.
• 30:45
  SPEAKER_01: Let's talk about the more common case with operating leases.
• 30:48
  SPEAKER_01: So once the right of use asset in an operating lease has been impaired, the lease expense will no longer be recognized on a straight line basis.
• 30:57
  SPEAKER_01: So what the LESC would do is they would continue to amortize the lease liability using the same effective interest method that they did before the impairment charge.
• 31:05
  SPEAKER_01: But the right of use asset, if you recall in an ordinary operating lease, the right of use asset is an ever-change, the amortization of the right-of-use asset is an ever-changing amount, such that the total expense is always going to be on a straight-line basis.
• 31:19
  SPEAKER_01: But after the right of use asset has been impaired, you would no longer do that and you would amortize the right of use asset on a straight line basis.
• 31:29
  SPEAKER_01: So the impact of this is that your lease expense is actually going to be different each period because the asset amortization will be straight line, but the interest will be an ever-changing amount.
• 31:39
  SPEAKER_01: Okay.
• 31:40
  SPEAKER_01: Now, that is actually the accounting that you would normally have for a finance lease, but I just want to point out that this is still an operating lease, and all of the disclosure requirements and the presentation requirements associated with an operating lease would continue to would continue.
• 31:55
  SPEAKER_01: And so, for example, um after a right-of-fuse asset has been impaired, even though the expense recognition is a little bit different, it's still called a single lease expense in the PL and it's not broken down into its interest and amortization.
• 32:09
  SPEAKER_01: So that's an operating lease.
• 32:10
  SPEAKER_01: In the finance lease, all that's really happening is you're calculating a new amortization expense because the the amount of the asset has been reduced.
• 32:18
  SPEAKER_02: All right, so a little more straightforward.
• 32:20
  SPEAKER_02: But then, Mark, let me ask you a question because I think where we get a lot of questions and I think sort of almost troubles people sometimes is this idea that I stopped using my asset, but there isn't an impairment.
• 32:34
  SPEAKER_02: Maybe it's protected by other assets in the asset group.
• 32:37
  SPEAKER_02: So is there any changes that I need to make to my accounting, either the right-of-use asset or maybe the useful life?
• 32:43
  SPEAKER_01: So that's going to depend a little bit on whether the asset is truly abandoned, right?
• 32:48
  SPEAKER_01: And what we find is that a right of use asset is generally not abandoned.
• 32:53
  SPEAKER_01: So I just want to point out temporarily idling a facility or temporarily idling an asset is not an abandonment, right?
• 33:00
  SPEAKER_01: So an example is leaving leased space unoccupied, but you have plans to at least reassess or perhaps go back into the space at a later date, that's not an abandonment.
• 33:10
  SPEAKER_01: Um typically for a space to be abandoned, it must be fully vacated.
• 33:13
  SPEAKER_01: So even if you're using it suboptimally, let's say you're just using it for storage, that's also not abandonment, right?
• 33:20
  SPEAKER_01: Even if you're keeping all your old furniture in there, well, you gotta protect your furniture somewhere, right?
• 33:25
  SPEAKER_01: You're using it as a warehouse, but it's not abandoned.
• 33:27
  SPEAKER_01: Okay.
• 33:28
  SPEAKER_01: But if one truly decides to completely vacate a leased property in the future, they would need to reconsider or to consider whether to reduce the useful life of the right-of-use asset and the related leasehold improvements in that space and determine whether they need to accelerate their amortization.
• 33:44
  SPEAKER_02: All right.
• 33:44
  SPEAKER_02: So, Mark, that's helpful.
• 33:46
  SPEAKER_02: But then I know often we'll see a case where companies haven't really fully decided what they're going to do with that property.
• 33:53
  SPEAKER_02: So then what do you do in that circumstance?
• 33:56
  SPEAKER_01: Well, if the lessee knows that it will completely vacate a property, but they're not sure whether they will sublet it or not, right?
• 34:03
  SPEAKER_01: Then that may not be an abandonment.
• 34:06
  SPEAKER_01: And certainly there's some judgment required.
• 34:09
  SPEAKER_01: The couple of things I would tell people is that the longer the lease term, the more likely it is that the asset is not abandoned.
• 34:15
  SPEAKER_01: Right.
• 34:16
  SPEAKER_01: If you think about it, if you have a long lease term, then the most logical thing to try to do would be to try to sublet the space.
• 34:21
  SPEAKER_01: And if you're shopping around for a sublessee, then you haven't abandoned it yet, right?
• 34:26
  SPEAKER_01: On the other hand, and this is much more rare, but if you have a space that has a really short life left to the lease term, then those are situations where you could have an abandonment because it may not be practical for you to try to find a sublesse.
• 34:38
  SPEAKER_02: All right.
• 34:38
  SPEAKER_02: So once again, then really will depend on the facts and circumstances, as we talked about earlier.
• 34:44
  SPEAKER_02: And maybe with that, I'll bring us full circle back to where we started, which was we were talking about how important it was to make sure that we have good controls and processes for not just that day one accounting, but also day two.
• 34:56
  SPEAKER_02: And obviously, understanding these events and accounting for them timely is critical to making sure you get it right.
• 35:02
  SPEAKER_02: So, as always, Mark and Suzanne, uh such a pleasure to talk to you.
• 35:06
  SPEAKER_02: Thanks so much for joining me today.
• 35:08
  SPEAKER_03: Sure.
• 35:08
  SPEAKER_03: Thank you.
• 35:10
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• 35:32
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
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