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Identifying embedded leases in your contracts · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:06
  SPEAKER_03: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_03: I'm Heather Horn.
• 0:11
  SPEAKER_03: Today we'll wrap up our April podcast series on lease accounting with a focus on embedded leases.
• 0:17
  SPEAKER_03: This can be one of the more complex areas to lease accounting, and it may not always be obvious when a lease is embedded within a larger contract.
• 0:26
  SPEAKER_03: So you definitely want to stay tuned.
• 0:28
  SPEAKER_02: If you have a service contract or a supply contract and you conclude that there is a lease involved, then you have to go through all the work to identify that lease, you know, measure that lease, and you likely do end up with something on your balance sheet.
• 0:42
  SPEAKER_02: So it's very important to figure this out.
• 0:49
  SPEAKER_03: That was Mark Jerusalem, a managing director in PWC's national office who has years of experience specializing in lease transactions.
• 0:57
  SPEAKER_03: In this episode, Mark helps us navigate the topic by breaking it down into simpler terms and sharing all of his experience.
• 1:05
  SPEAKER_03: You won't want to miss this episode, so let's get started.
• 1:08
  SPEAKER_03: Mark, welcome back to our monthly series talking all about leases.
• 1:14
  SPEAKER_03: And today's topic is one that I think uh hopefully will resonate with a lot of our listeners.
• 1:19
  SPEAKER_03: And it's a very important topic.
• 1:21
  SPEAKER_03: And that's dealing with leases that are in a contract and that are not called leases.
• 1:28
  SPEAKER_03: So so-called embedded leases, which I know often will trip people up because when they look at the contract and it's not called a lease, often they won't even think about that.
• 1:37
  SPEAKER_03: So, why, though, is this from your perspective such an important topic?
• 1:42
  SPEAKER_02: Right.
• 1:42
  SPEAKER_02: So, as we've talked about on some of these other podcasts, leasing is often attractive because it offers more flexibility than owning an asset outright, right?
• 1:52
  SPEAKER_02: However, nevertheless, leases are still on balance sheet, right?
• 1:56
  SPEAKER_02: They still have a balance sheet footprint for a lease liability and a right of use asset.
• 2:00
  SPEAKER_02: So someone might try to find ways to further reduce their lease exposure and try to package a lease as essentially an executory contract, specifically perhaps to avoid having to invest in assets and to have liabilities on their balance sheet.
• 2:17
  SPEAKER_02: Um, but nevertheless, if you have a service contract or a supply contract and you conclude that there is a lease involved, then you have to go through all the work to identify that lease, you know, measure that lease, and you likely do end up with something on your balance sheet.
• 2:32
  SPEAKER_02: So it's very important to figure this out.
• 2:34
  SPEAKER_03: All right.
• 2:34
  SPEAKER_03: And so, Mark, you mentioned there um service contracts, supply contracts.
• 2:39
  SPEAKER_03: I know those are frequent sources of these embedded leases.
• 2:42
  SPEAKER_03: There may be other types of transactions embedded in different types of contracts.
• 2:47
  SPEAKER_03: So what are some other examples you see where something may not be called a lease, but that actually you should be applying lease accounting?
• 2:55
  SPEAKER_02: That's right.
• 2:56
  SPEAKER_02: So there are a couple of other examples besides supply and service contracts.
• 3:00
  SPEAKER_02: The one that comes to mind immediately are things that are what I call a failed sale transaction.
• 3:07
  SPEAKER_02: So again, the top of the contract says that it's actually a sale to the customer.
• 3:11
  SPEAKER_02: But in fact, that sale doesn't give the customer permanent control.
• 3:15
  SPEAKER_02: It really only gives the customer temporary control of the asset.
• 3:19
  SPEAKER_02: The one that comes to mind is anytime a supplier or a seller sells something to a customer, but it has the right to call that asset back in the future, that is not a sale, right?
• 3:32
  SPEAKER_02: It is likely to be a lease because essentially the customer only has temporary use, not permanent use of that asset.
• 3:38
  SPEAKER_02: It's something we also see in sale and lease back transactions, which we're not going to talk about today, but that's a place where something, you know, is labeled a sale, but in fact it's not a sale.
• 3:50
  SPEAKER_02: Um, the other area that something could be a lease is where I sell something to a customer and the customer has the right to put the asset back to me.
• 4:00
  SPEAKER_02: And that could be a lease if they have an incentive to exercise, more than an insignificant incentive to exercise that put option.
• 4:08
  SPEAKER_02: Again, may not be the most common thing in the world, but the one thing I would just tell people to watch out for is trade-in rights.
• 4:16
  SPEAKER_02: Okay.
• 4:17
  SPEAKER_02: So if you have an arrangement that has a trade-in right where sometime down the line you can put that asset back to the seller, right?
• 4:25
  SPEAKER_02: And there's an incentive to do so, that's a very important part of it, right?
• 4:29
  SPEAKER_02: Then you'd really have to evaluate that and literally talk to your accountants and figure out if that is just a trade-in right, which could just be another component to the transaction, or if in fact you should account for that as a lease, because again, you you're only going to control that asset temporarily.
• 4:47
  SPEAKER_02: So that's an evaluation.
• 4:48
  SPEAKER_02: We're not going to get into that today.
• 4:50
  SPEAKER_02: Today, what we're going to talk about are leases embedded in a supply or service contract.
• 4:54
  SPEAKER_03: All right.
• 4:54
  SPEAKER_03: And Mark, one of the things that you know I know in dealing with these types of arrangements, in some cases, they actually can be, it's not just sometimes hard to identify them, but it can just be harder to or more complex to account for them than I'll call it so-called ordinary leases.
• 5:11
  SPEAKER_03: So what are some of the factors that go into that?
• 5:14
  SPEAKER_02: Exactly.
• 5:15
  SPEAKER_02: Once we find out that an arrangement, an arrangement may contain a lease, um, there's actually a lot involved with it.
• 5:22
  SPEAKER_02: I think one of the difficulties is that sometimes a customer may not be fully aware of what the specific assets are that are going to be used to provide the services or to sell or to purchase the supplies that it's looking for, right?
• 5:37
  SPEAKER_02: They they obviously have some idea because they've made the decision to buy these things rather than make them themselves, if you will.
• 5:43
  SPEAKER_02: But they may not have a good picture as to what exactly what all the assets are involved.
• 5:47
  SPEAKER_02: Okay.
• 5:48
  SPEAKER_02: Um, another thing is that when we're talking about supply and service arrangements that have an embedded lease, almost by definition, there's always both lease components and non-lease components.
• 6:00
  SPEAKER_02: The whole point of this is that you're either buying goods or you're buying services.
• 6:03
  SPEAKER_02: So there's definitely other components.
• 6:05
  SPEAKER_02: And once you have other components, you're going to have to allocate the consideration between the lease components and the non-lease components.
• 6:12
  SPEAKER_02: So, like I've said, companies really typically want to enter into these executory contracts to avoid having to go through this identification of assets and liabilities.
• 6:22
  SPEAKER_02: But once there's a lease involved, you know, there's going to be a lot of work and there may be something that you have to record on your balance sheet.
• 6:30
  SPEAKER_03: So then, Mark, can you give a few like all these sort of typical examples of either the types of arrangements where we may see these or where someone may be maybe more on alert that their supply agreement or service agreement is not just a supply or service agreement?
• 6:46
  SPEAKER_02: Well, certainly the one that comes to mind most frequently is simply contract manufacturing arrangements, right?
• 6:52
  SPEAKER_02: So you're not making the ass, you're not making the inventory yourself, you're hiring somebody else to do that for you.
• 6:58
  SPEAKER_02: Recently, we're seeing a lot more arrangements that are packaged as blank as a service, right?
• 7:04
  SPEAKER_02: And that could be power as a service, could be lighting as a service, could be IT as a service, anything really, right?
• 7:11
  SPEAKER_02: So whenever something is packaged as a service, the whole point of this is that you don't have to buy the assets yourself.
• 7:17
  SPEAKER_02: Somebody else can buy the assets and you're only going to use them perhaps sporadically or whatever.
• 7:22
  SPEAKER_02: So anything that is blank as a service is probably something to watch out for, along with the contract manufacturing.
• 7:28
  SPEAKER_02: Um, obviously, in this day and age, we're seeing more renewable energy type arrangements.
• 7:33
  SPEAKER_02: We're getting a lot of questions just recently about battery storage.
• 7:36
  SPEAKER_02: Um and so we could talk more about that, you know, in a couple of minutes, but that's something that we're seeing uh more now.
• 7:42
  SPEAKER_02: And again, we'll we'll get to some specific examples.
• 7:45
  SPEAKER_03: All right.
• 7:45
  SPEAKER_03: So before we get into uh some of the renewable energy battery storage types of examples, which can get very complicated, maybe we should run through overall just the model to figure out how to identify if you have a lease, and then we'll get into some of the challenges.
• 8:01
  SPEAKER_02: Right.
• 8:01
  SPEAKER_02: So the basic model, it sounds really simple when I say it out loud.
• 8:04
  SPEAKER_02: The basic model is you have a lease when there is an identified asset that is being used to fulfill the arrangement, right?
• 8:13
  SPEAKER_02: And the customer controls the use of that asset during the term of the arrangement.
• 8:17
  SPEAKER_02: Okay.
• 8:18
  SPEAKER_02: So that's you'd have a lease.
• 8:19
  SPEAKER_02: If you think about it, if it weren't an embedded lease, if it was just a plain old lease, right?
• 8:23
  SPEAKER_02: I lease a car, I know exactly what car it is, I have a registration number, and I get to do what I want with it for three years, right?
• 8:30
  SPEAKER_02: And give it back.
• 8:30
  SPEAKER_02: That's clearly a lease.
• 8:32
  SPEAKER_02: Um so anytime I have a, let's say, a contract manufacturing arrangement or other embedded lease, if I have both an identified asset and I have the right to use that identified asset or to direct the use of that identified asset, then I could have a lease.
• 8:47
  SPEAKER_02: Um determining each of those has its challenges.
• 8:50
  SPEAKER_02: And each one of those two things that I just said has two parts below it, and we will discuss each one of those in detail.
• 8:58
  SPEAKER_02: So let's start with the identified asset.
• 9:00
  SPEAKER_02: An asset could be identified either explicitly or it could be implicitly identified.
• 9:05
  SPEAKER_02: Obviously, the explicit ones are perhaps more common and they're certainly easier to determine, right?
• 9:11
  SPEAKER_02: So an example of an explicit, um explicitly identified asset is you literally could have a contract where the asset has a serial number, right?
• 9:23
  SPEAKER_02: But also, if there are supplies or services that are going to be located on your premises, then you know which assets are on your grounds, right?
• 9:33
  SPEAKER_02: Or if they're supplying assets from a nearby facility, again, you would typically know that that is the explicitly identified asset, right?
• 9:42
  SPEAKER_02: So that's generally easy to figure out.
• 9:44
  SPEAKER_02: The implicitly identified assets may be more difficult to figure out because that's a situation where essentially the supplier really only has one facility or one asset that he can fulfill this arrangement with, with you.
• 10:00
  SPEAKER_02: So again, if I have contract manufacturing arrangement in the United States, let's say, and the supplier only has one factory in the United States, then that would be perhaps implicitly identified.
• 10:11
  SPEAKER_03: So, Mark, I think this question of whether or not there's an asset can be very complicated.
• 10:17
  SPEAKER_03: And in particular, to your point, sometimes it's specified in lease, sometimes otherwise.
• 10:22
  SPEAKER_03: So I think you gave a good example of an implicitly identified one, but any other common examples that you see that could be helpful?
• 10:30
  SPEAKER_02: So in the pharma industry, if you think about it, if a drug manufacturer is outsourcing the production of a particular drug, right?
• 10:39
  SPEAKER_02: They're going to have to be very certain of the technical capabilities and the purity of that particular manufacturing line.
• 10:48
  SPEAKER_02: That is almost always going to be an explicitly or perhaps an implicitly identified asset in an arrangement because there's just no other asset that is approved to produce those pharmaceuticals on your behalf.
• 11:00
  SPEAKER_03: So, Mark, I think a related question that comes up is sometimes it becomes apparent what asset is being used, or maybe you will know before lease commencement, but you don't know when your lease is signed.
• 11:12
  SPEAKER_03: So when do you need to know whether or not there is an explicitly or implicitly identified asset?
• 11:19
  SPEAKER_02: Right.
• 11:20
  SPEAKER_02: So sometimes you'll know right away, right?
• 11:23
  SPEAKER_02: But sometimes the exact asset that you're going to be using literally won't be identified until a later date.
• 11:30
  SPEAKER_02: And essentially, you don't have to have the asset identified at least inception at the date you sign the contract.
• 11:36
  SPEAKER_02: It could be identified later.
• 11:38
  SPEAKER_02: Let me give both a simple example and perhaps a more real-world example, right?
• 11:43
  SPEAKER_02: In a simple example, I may make a reservation to rent a car from a car rental agency next week.
• 11:50
  SPEAKER_02: I may sign the agreement proverbally online, right?
• 11:53
  SPEAKER_02: At that point in time, I don't have an identified asset simply because I haven't gotten the keys yet.
• 11:58
  SPEAKER_02: A week later, I travel to that airport, I pick up the keys.
• 12:01
  SPEAKER_02: Obviously, at that point in time, I have an identified asset because that's the car that I'm using.
• 12:07
  SPEAKER_02: So now let's go to a real world example, right?
• 12:10
  SPEAKER_02: Sometimes in these service arrangements, you'll have an arrangement.
• 12:14
  SPEAKER_02: Let me give an example.
• 12:15
  SPEAKER_02: He'll have an arrangement where a supplier comes and says, We are going to evaluate your energy needs, right?
• 12:22
  SPEAKER_02: And we're going to find ways for you to save energy.
• 12:25
  SPEAKER_02: And we will share in your savings.
• 12:26
  SPEAKER_02: So we're going to charge you based on how much energy we save you.
• 12:29
  SPEAKER_02: At the date that we sign the contract, they may not know what types of assets they're going to use to fulfill that contract.
• 12:37
  SPEAKER_02: But as they come in and they do their research and they get the engineers out there, they may determine, okay, we're going to upgrade your HVAC and they're going to install new HVAC on site.
• 12:47
  SPEAKER_02: In that case, when you signed the arrangement, you might not have had a specified asset or identified asset.
• 12:53
  SPEAKER_02: But certainly when they install the asset on site, at that point, you do have an identified asset and you'd have to evaluate it to see whether or not there's a lease of that asset.
• 13:02
  SPEAKER_03: And then, Mark, how about other considerations?
• 13:04
  SPEAKER_03: Like, for example, what if they could change the asset during the lease?
• 13:09
  SPEAKER_03: Or maybe if there's I'm expecting a better asset to become available later.
• 13:14
  SPEAKER_03: Like, how do you think about those types of things when you're making this evaluation?
• 13:17
  SPEAKER_03: It's like maybe I have an asset, but I might get a different one.
• 13:22
  SPEAKER_02: Right.
• 13:22
  SPEAKER_02: So that's the second part of this identified asset criteria.
• 13:26
  SPEAKER_02: So the standard says that there would not be an identified asset.
• 13:29
  SPEAKER_02: And when I say not be an identified asset, therefore there would not be a lease, right?
• 13:33
  SPEAKER_02: When the supplier is both permitted to substitute the asset and they would economically benefit from doing so.
• 13:40
  SPEAKER_02: Okay.
• 13:41
  SPEAKER_02: So this you would address only at the inception of the contract based on the facts or circumstances that are available to you at that date.
• 13:49
  SPEAKER_02: And you would exclude consideration of future events that are not considered likely to occur.
• 13:56
  SPEAKER_03: So then, Mark, I mean, we often see this that the supplier will swap out equipment for maintenance or for efficiency or for other reasons.
• 14:05
  SPEAKER_03: So how do we consider that then?
• 14:08
  SPEAKER_03: Wouldn't this be likely to occur?
• 14:10
  SPEAKER_02: Right.
• 14:10
  SPEAKER_02: So the standard explicitly excludes substituting the asset for repairs, maintenance, or technical upgrades.
• 14:17
  SPEAKER_02: Those would not be considered substitution rights.
• 14:20
  SPEAKER_02: Those are just the operating parameters of what the contract requires.
• 14:25
  SPEAKER_02: And they don't inform us as to whether the customer really can direct the use of an identified asset.
• 14:30
  SPEAKER_03: So then what are some of the events that are not deemed, quote, likely to occur?
• 14:36
  SPEAKER_02: Right.
• 14:37
  SPEAKER_02: So there's a whole laundry list of things that you would probably have to ignore for purposes of determining whether there's a substitution right.
• 14:44
  SPEAKER_02: So for example, the supplier might say, well, when a new technology becomes available, I'll replace the asset.
• 14:52
  SPEAKER_02: We would ignore that, unless it's substantially developed already, right?
• 14:57
  SPEAKER_02: A supplier might substitute an asset if the customer's use of the asset is not what they expected at the beginning of the arrangement.
• 15:04
  SPEAKER_02: And this is something that we also see with battery storage, right?
• 15:08
  SPEAKER_02: Because sometimes customers need batteries with higher capabilities, or sometimes they don't need those higher capacities, if you will.
• 15:15
  SPEAKER_02: So you can't take into account, cannot take into account future changes in what the customer may or may not use.
• 15:22
  SPEAKER_02: Okay.
• 15:23
  SPEAKER_02: You don't take into account whether more efficient assets will become available in the future.
• 15:28
  SPEAKER_02: And the the last thing I would say is sometimes you have a service contract that is longer than the expected usage period of the underlying assets.
• 15:38
  SPEAKER_02: So say I've got a five-year IT contract, and the contract requires the supplier to swap out the IT equipment at the end of year three.
• 15:48
  SPEAKER_02: Well, that's not a substitution right.
• 15:50
  SPEAKER_02: In that case, you probably just have two leases, right?
• 15:53
  SPEAKER_02: You have a lease of the first set of equipment for three years and a forward starting lease three years down the road for the second set of equipment.
• 16:01
  SPEAKER_02: So those are some of the examples.
• 16:03
  SPEAKER_03: And as we're thinking about this then, I also understand the supplier has to actually be able to benefit or profit from swapping out the equipment.
• 16:12
  SPEAKER_03: And so how would I necessarily know that?
• 16:15
  SPEAKER_02: Well, as a customer, it's going to be really difficult for you to know this.
• 16:19
  SPEAKER_02: And the standard actually addresses this.
• 16:21
  SPEAKER_02: And again, if if I can, I'm going to read a sentence from the standard because it's just so clear.
• 16:26
  SPEAKER_02: 842 says, if the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.
• 16:37
  SPEAKER_02: So the bottom line is that if you're the customer in one of these outsourcing arrangements, it may be very unlikely that you'll be able to say, oh, I don't have a lease because this supplier can substitute the asset whenever he wants.
• 16:48
  SPEAKER_02: If you don't know whether he can economically benefit from it, then you are not allowed to assume it.
• 16:54
  SPEAKER_03: So step one, I need to figure out if I have an identified asset.
• 16:58
  SPEAKER_03: And then if I do, then I get into this question of whether or not I control the use of the asset.
• 17:05
  SPEAKER_03: And I think often, Mark, people kind of try to commingle both of these or they kind of skip straight to the second part and say, oh, it doesn't matter, I don't control it anyway.
• 17:13
  SPEAKER_03: But I do think it's very important to do this step process.
• 17:16
  SPEAKER_03: First, figure out if you have an identified asset.
• 17:18
  SPEAKER_03: And now let's move to this question of whether or not the customer controls it.
• 17:23
  SPEAKER_03: So now that we're ready for that part of the conversation, how do I think about that?
• 17:28
  SPEAKER_02: So, like the first one, this is also kind of a two-part evaluation, right?
• 17:32
  SPEAKER_02: The first thing you have to determine is whether the customer is entitled to substantially all of the economic benefit from that asset during the term of the arrangement.
• 17:41
  SPEAKER_02: And then, second, and it's not an or, and does the customer have the right to direct the use of the identified asset?
• 17:49
  SPEAKER_02: Okay.
• 17:49
  SPEAKER_02: And if you think about it, that's the very principle behind a lease, right?
• 17:52
  SPEAKER_02: Somebody else owns the asset, I don't own it, but I'm entitled to control its use for some period of time.
• 17:59
  SPEAKER_02: I'm entitled to the benefits of it, and I get to direct how it's being used.
• 18:03
  SPEAKER_02: So let's start with the first of those two parts, right?
• 18:06
  SPEAKER_02: How I how do I determine whether I get substantially all the benefits of the asset?
• 18:11
  SPEAKER_02: Well, sometimes that's not that hard to figure out.
• 18:14
  SPEAKER_02: And a simple case would be where the asset is physically within my premises.
• 18:19
  SPEAKER_02: If it's physically within my premises, who else is getting any of the economic benefits but me, right?
• 18:25
  SPEAKER_02: You might also have assets that are sort of built and designed to only serve one customer.
• 18:30
  SPEAKER_02: If you know that there's no other customers, then essentially you're getting all the economic benefit.
• 18:35
  SPEAKER_02: Um, another case would be where you're entitled to all the output.
• 18:40
  SPEAKER_02: What I mean by that is a fact pattern where the supplier is not allowed to use those assets to serve another customer unless he gets your permission first.
• 18:49
  SPEAKER_02: That's actually pretty common.
• 18:51
  SPEAKER_02: And once again, if you think about it, you're in control.
• 18:53
  SPEAKER_02: The customer's in control.
• 18:54
  SPEAKER_02: The customer is the one making that determination of whether you're going to use all the output yourself or allow him to sell some things to other people.
• 19:01
  SPEAKER_03: All right.
• 19:02
  SPEAKER_03: And then how that do we think about economic benefits?
• 19:05
  SPEAKER_02: So, economic benefits, we think of those items that are produced by the equipment, produced by the PPE, right?
• 19:13
  SPEAKER_02: Including any byproducts, right?
• 19:15
  SPEAKER_02: It would also include credits that are generated from using the asset, as long as those credits arise only from using the asset and not from owning the asset.
• 19:25
  SPEAKER_02: And those credits could be monetized with third parties.
• 19:29
  SPEAKER_02: So an example of this that's written right into the standard are renewable energy credits, right?
• 19:34
  SPEAKER_02: They're a form of economic benefit.
• 19:36
  SPEAKER_02: Um, they arise from the usage of the asset and they could be marketed or could be monetized with third parties.
• 19:44
  SPEAKER_02: Um, however, you know, sharing the proceeds from a single output doesn't necessarily mean that you're not getting all the benefits.
• 19:52
  SPEAKER_02: So, for example, if a supplier is entitled, let's say that a supplier is making widgets on your behalf, right?
• 19:58
  SPEAKER_02: And he's entitled to 20% of the actual widgets that come off the machine and he sells them himself, then you're not entitled to all of the economic benefits of the equipment, right?
• 20:11
  SPEAKER_02: If I contrast that with a similar but different fact pattern, say that you get 100% of the widgets that come off this machine, and you're the only one that's allowed to get the widgets that come off this machine.
• 20:22
  SPEAKER_02: But as part of your payment to the supplier, you give him 20% of the sales.
• 20:27
  SPEAKER_02: That is not the same fact pattern.
• 20:29
  SPEAKER_02: In that fact pattern, you control all the economic benefits, and the 20% is just how you're paying for it.
• 20:36
  SPEAKER_03: All right.
• 20:36
  SPEAKER_03: There's definitely a clear difference there.
• 20:38
  SPEAKER_03: And then when we talk about substantially all of the economic benefit, are we using that as sort of like a 90% rule of thumb?
• 20:46
  SPEAKER_02: We are once again using the 90% rule of thumb.
• 20:48
  SPEAKER_02: And when we think of substantially all.
• 20:50
  SPEAKER_03: All right.
• 20:51
  SPEAKER_03: And so when you think about that, you have the 90%, and it on the surface could seem like it would be rather obvious whether or not the customer is entitled to substantially all of the economic benefit.
• 21:03
  SPEAKER_03: But I know in practice it actually can be a lot more complicated.
• 21:06
  SPEAKER_03: So, what are some of the questions that we get there?
• 21:09
  SPEAKER_02: So the latest thing, if you will, we're getting a lot of new questions on some of the government tax credits that are available now and whether they would be considered economic benefits.
• 21:21
  SPEAKER_02: So these are very, very new and they're constantly evolving.
• 21:25
  SPEAKER_02: If I can just say a couple of things about this, investment tax credits, that's not an economic benefit from using the asset.
• 21:32
  SPEAKER_02: That's an economic benefit from having invested in creating the asset.
• 21:37
  SPEAKER_02: We're getting questions on production tax credits.
• 21:40
  SPEAKER_02: Is that an economic benefit?
• 21:41
  SPEAKER_02: And the answer to that one is maybe, right?
• 21:45
  SPEAKER_02: If I can take those production tax credits and sell them to a third party, you know, does a market exist for me to do so?
• 21:52
  SPEAKER_02: Then that might be an economic benefit.
• 21:55
  SPEAKER_02: Um there may be other credits because credits are constantly evolving.
• 21:59
  SPEAKER_02: I guess the one Layman's rule of thumb that I would tell you is that the standard explicitly tells us that renewable energy credits are considered an economic benefit.
• 22:09
  SPEAKER_02: And we know that those credits are generated from the use of the asset and they can be monetized with third parties.
• 22:15
  SPEAKER_02: So if you're looking at a particular credit, the more similar it is to a renewable energy credit, the more likely it would be considered an economic benefit.
• 22:24
  SPEAKER_02: And the more differences it has from a renewable energy credit, perhaps not then.
• 22:29
  SPEAKER_03: All right.
• 22:30
  SPEAKER_03: So, Mark, then when we talked about this question of whether or not the customer controls the use, we said there was an end.
• 22:38
  SPEAKER_03: So we said, is the customer entitled to substantially all of the economic benefit?
• 22:43
  SPEAKER_03: And does the customer have the right to direct the use of the identified basset?
• 22:47
  SPEAKER_03: So taking that second part of the valuation, then how what are some of the considerations?
• 22:53
  SPEAKER_02: So this is clearly the most judgmental area of the model.
• 22:57
  SPEAKER_02: And this is the one that we probably spend the most time on.
• 23:00
  SPEAKER_02: Okay.
• 23:00
  SPEAKER_02: When we think about whether the customer can direct the use of the asset, we consider the what, when, where, whether, and how decisions about using that asset that are permitted within the scope of the contract.
• 23:16
  SPEAKER_02: So let's consider sort of like a normal lease of a machine or a normal lease of office space, right?
• 23:23
  SPEAKER_02: If you think about it, the lessee operates that asset, right?
• 23:26
  SPEAKER_02: They determine when they're going to use that asset.
• 23:29
  SPEAKER_02: They determine how much they're going to use that asset, right?
• 23:33
  SPEAKER_02: If they're leasing a storefront, they determine what they're going to sell from that storefront.
• 23:37
  SPEAKER_02: If they're leasing equipment, they determine where they're going to use that equipment, right?
• 23:41
  SPEAKER_02: So if those the same kinds of decisions you can make in an embedded lease arrangement, then you would in fact have the ability to direct, you know, how and for what purpose an asset is being used during the term of this arrangement.
• 23:55
  SPEAKER_03: So, Mark, before you go on, can I ask a question?
• 23:58
  SPEAKER_03: Because when you gave your example of the storefront, often there could still be some parameters for when you can use the asset.
• 24:06
  SPEAKER_03: So, for example, you can't be open in the middle of the night or you have to be open in the middle of the night or otherwise.
• 24:12
  SPEAKER_03: How did those types of parameters go into this evaluation of whether or not I have the right to control the use or direct the use?
• 24:21
  SPEAKER_02: Well, so what the model has us do, it has us only look at those decisions that could be made during the term of the arrangement, right?
• 24:30
  SPEAKER_02: So anything that is sort of predetermined per the terms of the contract, I would actually ignore.
• 24:36
  SPEAKER_02: So one of the things that is surprising to people is sometimes those are the most important decisions, but they're already predetermined, right?
• 24:45
  SPEAKER_02: But the way the standard works is as long as there are still decisions you could make about using the asset during the term of the arrangement, you look to just those in a vacuum, so to speak, and determine whether the customer is controlling more of those decisions or if the supplier is determining more of those decisions.
• 25:05
  SPEAKER_03: So, Mark, I know in some cases, though, there might actually really be no decisions that need to be made once you start the period of use.
• 25:12
  SPEAKER_03: How do you think about that?
• 25:13
  SPEAKER_02: Right.
• 25:14
  SPEAKER_02: So as I've just said a moment ago, if there are any decisions, however relatively small those decisions are, if there's any decisions to be made during the course of the contract, then you only look to those decisions and you ignore the predetermined decisions, right?
• 25:29
  SPEAKER_02: But you're right.
• 25:30
  SPEAKER_02: Sometimes the standard contemplates, well, what if there's no decisions?
• 25:33
  SPEAKER_02: What if these assets are just basically in place and they're kind of working automatically?
• 25:37
  SPEAKER_02: In that case, we would look to one of two things or both of two things.
• 25:42
  SPEAKER_02: We would look to can the customer operate those assets?
• 25:46
  SPEAKER_02: Is it something that has an on-off switch, right?
• 25:48
  SPEAKER_02: And can the customer operate those?
• 25:50
  SPEAKER_02: In that case, the customer, you know, would have a lease, so to speak.
• 25:54
  SPEAKER_02: And the other one is whether the customer was involved in the um designing of the asset.
• 26:00
  SPEAKER_02: Right.
• 26:01
  SPEAKER_02: So if there's no decisions to be made, but the customer designed the asset, then they would also meet this criteria of being able to control the asset.
• 26:10
  SPEAKER_02: And not to complicate this, but any arrangement, as we've talked about in previous podcasts, any arrangement could have more than one asset.
• 26:20
  SPEAKER_02: Right.
• 26:20
  SPEAKER_02: And you might have to go through this analysis on each of the assets that are in that contract.
• 26:26
  SPEAKER_03: All right.
• 26:26
  SPEAKER_03: So then, Mark, can you give an example of where we need to consider whether everything is predetermined or not?
• 26:33
  SPEAKER_02: Um sure.
• 26:34
  SPEAKER_02: Let's consider a renewable power purchase arrangement.
• 26:38
  SPEAKER_02: Okay.
• 26:39
  SPEAKER_02: And in this hypothetical fact pattern, a supplier designs and installs solar panels on a customer's property.
• 26:47
  SPEAKER_02: Okay?
• 26:48
  SPEAKER_02: Let's further assume that there's only one customer, and the customer was not involved in the design of the solar panels at all.
• 26:55
  SPEAKER_02: Uh, they just provided the requirements for how much power they need, and they approved where the panels are being placed.
• 27:01
  SPEAKER_02: Let's further assume that the supplier provides battery backup power in order to provide energy at night, for example.
• 27:08
  SPEAKER_02: Right?
• 27:10
  SPEAKER_02: So if I think about this whole notion of whether things are predetermined or not predetermined, if all I had were the solar panels, I might conclude that the use of the solar panels is completely predetermined.
• 27:23
  SPEAKER_02: Right?
• 27:24
  SPEAKER_02: Once they're installed, those solar panels work automatically.
• 27:28
  SPEAKER_02: They always convert light into energy.
• 27:30
  SPEAKER_02: No one decides, sort of within the term of that arrangement, what do the panels do?
• 27:35
  SPEAKER_02: We know what they do, they convert light into energy.
• 27:37
  SPEAKER_02: Whether they do it, it's basically automatic.
• 27:40
  SPEAKER_02: Where do they do it?
• 27:41
  SPEAKER_02: Well, they're installed on site.
• 27:42
  SPEAKER_02: Once they're installed, we know where they're staying in place.
• 27:45
  SPEAKER_02: How much do they do, right?
• 27:47
  SPEAKER_02: Again, it's kind of automatic.
• 27:48
  SPEAKER_02: When do they operate?
• 27:50
  SPEAKER_02: Whenever the light shines.
• 27:51
  SPEAKER_02: So this is a really good example of something that would otherwise be completely predetermined.
• 27:56
  SPEAKER_02: But now I've also, in my hypothetical fact pattern, said, but I also have batteries, right?
• 28:02
  SPEAKER_02: Well, once I have batteries, presumably somebody is deciding, perhaps me, perhaps the supplier, somebody's deciding when those batteries should be charged and when those batteries should be discharged.
• 28:14
  SPEAKER_02: So if I just took a take a look at the first half of this arrangement, I might conclude that that arrangement, everything's predetermined, right?
• 28:21
  SPEAKER_02: And I wasn't involved in the um in the design of it and I don't operate it.
• 28:26
  SPEAKER_02: But now that I've combined it with the batteries, obviously there are some decisions to be made.
• 28:32
  SPEAKER_02: And that's when we kind of have to figure out what are the units of count.
• 28:36
  SPEAKER_02: No, uh, do I control them?
• 28:38
  SPEAKER_02: Does the supplier control them, et cetera?
• 28:40
  SPEAKER_02: That's why this can get very judgmental and could get complicated.
• 28:43
  SPEAKER_03: Well, also, Mark, to that point, if you change just one of those facts, it also could potentially change the conclusion.
• 28:50
  SPEAKER_02: That's right.
• 28:50
  SPEAKER_02: I mean, just consider if there's another customer on site, right?
• 28:54
  SPEAKER_02: Or you're not the only person using that property and they negotiate that the panels provide, you know, to you and your neighbor.
• 29:01
  SPEAKER_03: Right.
• 29:01
  SPEAKER_02: Right.
• 29:02
  SPEAKER_02: Um, once again, we talked about the renewable energy credits, right?
• 29:06
  SPEAKER_02: If those were involved, I could come up with a different thing.
• 29:09
  SPEAKER_02: Um, also, the actual use of the batteries may also be predetermined.
• 29:13
  SPEAKER_02: Uh again, this is very facts and circumstances.
• 29:16
  SPEAKER_02: There's no one size fits all answer, even for similar arrangements.
• 29:20
  SPEAKER_03: All right.
• 29:20
  SPEAKER_03: So, Mark, I think that's helpful.
• 29:22
  SPEAKER_03: And again, to our listeners, remember, we're talking here about directing the use of an asset.
• 29:27
  SPEAKER_03: And the example Mark just ran through, you know, is very clear that asset is on the customer's site, and you know, you they have good visibility into the asset itself.
• 29:39
  SPEAKER_03: But I know in some arrangements, Mark, the asset may not be on site.
• 29:43
  SPEAKER_03: So could the customer still conclude that they are directing it or not?
• 29:47
  SPEAKER_02: Well, you're right.
• 29:48
  SPEAKER_02: I guess it's easier to think about these things when the assets are on your site, and more difficult to think about these things when the assets are not on your site, right?
• 29:57
  SPEAKER_02: But just bear in mind that even though the assets are not on site, the customer may still be the one that is directing when and whether the assets are operated or how much the assets make.
• 30:09
  SPEAKER_02: So whenever the customer makes or controls those decisions, or controls more of those decisions than the supplier does, then the customer may be directing the use of the asset.
• 30:19
  SPEAKER_03: All right.
• 30:19
  SPEAKER_03: So then, Mark, let's presume you've gone through all of this analysis and you have the identified asset and you conclude that you have the right to control the use of the asset, then what comes next?
• 30:31
  SPEAKER_02: Well, what comes next then is that you have to identify both the lease component and the non-lease component in the contract and allocate the consideration between the two of those things.
• 30:42
  SPEAKER_02: And this is where it gets a little bit tricky because once you conclude then that it's a lease, you're kind of changing how you characterize the entire arrangement.
• 30:51
  SPEAKER_02: It's going to be different than what's written in the contract.
• 30:54
  SPEAKER_02: Remember, you may have had a contract, for example, to purchase parts, but if there's a lease involved, then it's not just purchasing those parts.
• 31:03
  SPEAKER_02: You're actually renting a machine.
• 31:05
  SPEAKER_02: And, well, who's operating the machine?
• 31:07
  SPEAKER_02: The suppliers operating the machine.
• 31:08
  SPEAKER_02: So instead of buying a widget, you're actually renting the machine that makes the widgets and you're hiring an outside labor force, right, to operate the machinery for you.
• 31:18
  SPEAKER_02: By the way, they're also going to be doing the maintenance of those machines for you.
• 31:22
  SPEAKER_02: And they're probably going to be purchasing your raw materials and they'll be, you know, inventorying and helping you with the logistics.
• 31:28
  SPEAKER_02: So I think the really the thing that's very difficult here for customers is that once they conclude that there's a lease, the way they think about the whole arrangement is different from the way it's written in the contract.
• 31:39
  SPEAKER_02: It's not just buying widgets.
• 31:41
  SPEAKER_03: Well, and Mark, I think even if we go back to your uh solar panel example or other renewable energy examples, often the customer just thinks, I'm buying power.
• 31:50
  SPEAKER_03: And yet, you know, to your same point, you give you are actually buying the use of the panels and the maintenance and everything else associated with them.
• 31:58
  SPEAKER_03: So definitely can get a lot more complicated than just, oh, I bought 10 megawatts of power today or 10 widgets today.
• 32:05
  SPEAKER_03: All right.
• 32:05
  SPEAKER_03: So, Mark, now we've identified the lease and non-lease components.
• 32:09
  SPEAKER_03: How do you allocate consideration in the arrangement?
• 32:12
  SPEAKER_02: Right.
• 32:13
  SPEAKER_02: So now you have to get the standalone selling price of each of these identified components, right?
• 32:19
  SPEAKER_02: As they've been recharacterized, like we've just talked about, right?
• 32:22
  SPEAKER_02: So right off the bat, the contract is most likely going to say that you pay a fixed fee of X and a per part fee of Y.
• 32:29
  SPEAKER_02: You're going to have some typically some combination of fixed and variable fees in there, right?
• 32:33
  SPEAKER_02: But what you have to do is determine the standalone selling price of each of the components you've identified, right?
• 32:39
  SPEAKER_02: So in my simple example, what's the standalone selling price of renting the leased equipment for the term of the arrangement, not of buying the asset, but you know, if this is a three-year arrangement, what's the rental price for renting this equipment for three years?
• 32:53
  SPEAKER_02: What's the standalone selling price of the supplier's procurement services that he's giving you, or his maintenance services that he's giving you?
• 33:02
  SPEAKER_02: What's the standalone selling price of the hired labor force, right?
• 33:06
  SPEAKER_02: And you have to come up with, you have to allocate the consideration of the contract to each of those components based upon their relative standalone selling price.
• 33:16
  SPEAKER_02: Let me just say that there is a lot of judgment and information to gather here in order to account for this properly.
• 33:22
  SPEAKER_03: All right.
• 33:22
  SPEAKER_03: So, Mark, especially given all the amount of judgment and potential complexity involved, is there anything companies can do to help simplify some of this?
• 33:32
  SPEAKER_02: Well, this is very complex.
• 33:34
  SPEAKER_02: The standard does have some practical expedients.
• 33:37
  SPEAKER_02: Um, lessees have an option to combine their lease and non-lease components and account for the entire combination as just a lease.
• 33:46
  SPEAKER_02: This election has to be made by the class of underlying asset, which means you need to group your leases based on the underlying leased asset and apply the option to all to all leases in that group.
• 33:58
  SPEAKER_02: So, for example, if I have blank as a service and it's IT services that I'm using.
• 34:04
  SPEAKER_02: So if I apply this election to IT equipment and I subsequently enter into a significant networking servicing arrangement, right?
• 34:13
  SPEAKER_02: I have to consider, well, I already have IT that I rent from another supplier, for example.
• 34:18
  SPEAKER_02: Have I already made an election?
• 34:19
  SPEAKER_02: Am I already separating, already combining?
• 34:22
  SPEAKER_02: And it doesn't make a difference whether it's in a standalone lease or a lease embedded in a supplier service contract.
• 34:28
  SPEAKER_02: You have to apply the election the same way.
• 34:30
  SPEAKER_02: But you certainly can do that.
• 34:32
  SPEAKER_02: That's why it's always important to think about all of your leases before making these elections, right?
• 34:38
  SPEAKER_02: To see what works best for you.
• 34:40
  SPEAKER_03: All right.
• 34:41
  SPEAKER_03: So then, Mark, uh definitely a lot to think about there as well.
• 34:45
  SPEAKER_03: Now that I've gone through this process and I've either taken the expedience or not, but I've allocated my consideration, then what comes next?
• 34:53
  SPEAKER_02: So then we just go back to the beginning.
• 34:54
  SPEAKER_02: Now that we've figured out the amounts that we want to allocate to the lease components, we use those amounts and that term to classify the lease.
• 35:02
  SPEAKER_02: And the amounts that you've allocated to the non-lease components would be governed by other literature.
• 35:08
  SPEAKER_02: And they typically would be accounted for as supply and service arrangements.
• 35:12
  SPEAKER_03: All right.
• 35:12
  SPEAKER_03: So it sounds like people, after they've finished listening to this episode, should go back to the beginning of our month and listen to the episode that you and I did with Suzanne.
• 35:21
  SPEAKER_03: Uh Mark, then with all of that said, any final reminders you'd like to leave us with?
• 35:26
  SPEAKER_02: Well, I guess just to summarize here, we have a standing joke in the office that every contract is or contains a lease.
• 35:32
  SPEAKER_02: Obviously, that's an exaggeration, but there is a kernel of truth to that.
• 35:36
  SPEAKER_02: A lot of contracts that don't say the word lease at the top kind of fall within its guidance.
• 35:41
  SPEAKER_02: And hopefully with this podcast, you know, you'll be learning to sort of ask the right types of questions.
• 35:47
  SPEAKER_02: Um, and you should be aware of those types of arrangements that typically lend themselves to leases.
• 35:53
  SPEAKER_02: Again, contract manufacturing arrangements and blank as a service arrangement.
• 35:57
  SPEAKER_02: We should definitely pay attention to those.
• 35:59
  SPEAKER_03: All right.
• 35:59
  SPEAKER_03: Well, Mark, as always, very insightful.
• 36:02
  SPEAKER_03: And I definitely encourage our listeners to check out chapter two of the leasing guide, or if you are dealing with either those renewable contracts that Mark talked about, or I believe we mentioned a pharma uh example, you should also check out the utility guide and the pharma and life sciences guide.
• 36:18
  SPEAKER_03: Um, but as always, Mark, such a pleasure to talk to you.
• 36:21
  SPEAKER_03: Thanks so much for joining me today.
• 36:23
  SPEAKER_02: Thank you.
• 36:24
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• 36:47
  SPEAKER_03: From Thought Leadership at PWC, I'm Heather Horn.
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