Latest / PwC's accounting podcast / Leasing toolkit: Spotting embedded leases

Transcript

Leasing toolkit: Spotting embedded leases · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC.
• 0:06
  SPEAKER_02: Welcome to PWC's Accounting Podcast.
• 0:09
  SPEAKER_02: I'm Heather Horn.
• 0:11
  SPEAKER_02: Thanks for tuning in to another episode in our Toolkit series, where we're taking a deep dive each month into a single topic, recapping the basics, but also focusing in on frequently asked questions and judgmental areas.
• 0:26
  SPEAKER_02: For the month of June, it's all about leasing.
• 0:30
  SPEAKER_03: I think one of the key things is, you know, really going below the surface of what may appear in a contract.
• 0:37
  SPEAKER_03: And I think particularly in sort of the realm of embedded leases.
• 0:41
  SPEAKER_01: I think the area that has generated the most questions is trying to determine, again, whether the customer has the right to direct how the asset's being used, in particular, if the asset is not on site, if the asset is at the supplier's location.
• 1:06
  SPEAKER_02: They're continuing the leasing series with a focus on an area within the leasing guidance that presents numerous challenges and can be difficult to identify.
• 1:16
  SPEAKER_02: That would be embedded lease arrangements.
• 1:19
  SPEAKER_02: Now on to leasing.
• 1:28
  SPEAKER_02: Welcome, Jillian and Mark, for actually what's going to be our final episode in our leasing series.
• 1:34
  SPEAKER_02: And I think this is a topic that's important and can be very difficult.
• 1:38
  SPEAKER_02: It's one of the things that we often get questions about because sometimes it's kind of hard to tell if a service or supply contract includes a lease.
• 1:47
  SPEAKER_02: And Jillian, in particular, I know it's something we talk about a lot in our industry, so we'll get to that later.
• 1:53
  SPEAKER_02: But why don't before we get into uh the identification, let's just start with the definition of a lease.
• 2:01
  SPEAKER_02: So, Jillian, can you remind us to that definition?
• 2:04
  SPEAKER_03: Sure.
• 2:05
  SPEAKER_03: And I'm actually going to quote directly from the standard since there's a lot contained in it.
• 2:09
  SPEAKER_03: So the definition of a lease, a contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment, an identified asset, for a period of time in exchange for consideration.
• 2:23
  SPEAKER_03: So obviously, there's a lot that I think we'll unpack there within the definition.
• 2:28
  SPEAKER_03: But even before you get into some of the underlying criteria within that definition, we've we've had questions even around the last pieces of it.
• 2:38
  SPEAKER_03: So, you know, period of time and in exchange for consideration.
• 2:42
  SPEAKER_03: So I think that just goes to show that just like you said, Heather, it is a complex area and there's really a lot, a lot to understand.
• 2:48
  SPEAKER_02: Right.
• 2:49
  SPEAKER_02: And I think in particular, you know, I referenced um Jillian and I are both from the power and utilities industry, which frequent listeners would know that about me.
• 2:57
  SPEAKER_02: And I know what some of the questions we addressed early on are whether or not perpetual rights uh could be leases.
• 3:04
  SPEAKER_02: And in particular, in dealing with easement arrangements, and I know utilities are not the only ones that have easements.
• 3:11
  SPEAKER_02: So some of these easements may appear to be perpetual in nature, in some cases, maybe even had no end date.
• 3:17
  SPEAKER_02: And often in those cases, they would have a relatively large upfront payment and then basically little or no ongoing payment.
• 3:25
  SPEAKER_02: So, Jillian, how would you think about an arrangement like that?
• 3:30
  SPEAKER_03: So, generally speaking, if a customer has the right to use an asset in perpetuity or in an arrangement that doesn't have a specific end date, the transaction would likely be accounted for simply as a sale or purchase of that asset rather than as an actual lease, because again, there is no defined period of use within the contract.
• 3:53
  SPEAKER_03: But like you mentioned, Heather, some arrangements may appear on the surface as if they're perpetual, but really sometimes the devil's in the details.
• 4:03
  SPEAKER_03: And particularly with things like a pay as you go type of arrangement, where the customer actually is required to make payments throughout the term of the arrangement, those actually may not be perpetual.
• 4:17
  SPEAKER_03: And in those cases, what a company would want to think about is what actually happens if if or when the customer stops paying?
• 4:25
  SPEAKER_03: If the arrangement actually ends in that case, then that's a good sign that the contract actually isn't perpetual and instead maybe really is simply renewable.
• 4:35
  SPEAKER_03: And we know in looking at the guidance in 842 that a contract with renewal options could be a lease subject to the accounting model in 842 instead of the sale or purchase of that asset.
• 4:47
  SPEAKER_02: All right.
• 4:47
  SPEAKER_02: So definitely a point important point there on uh the period of time.
• 4:53
  SPEAKER_02: Mark, drawing you in now, how about Jillian mentioned we also get questions on the word consideration?
• 5:00
  SPEAKER_02: And so how do we think about that?
• 5:02
  SPEAKER_01: You're correct, Heather.
• 5:04
  SPEAKER_01: We do get questions on consideration, and the questions typically have come from arrangements where people, you know, just refer to it using lay terms as a free lease, right?
• 5:14
  SPEAKER_01: And by a free lease, we mean that people would acknowledge that it's probably a lease embedded in a service or supply contract, but there are no fixed or no minimum payments.
• 5:25
  SPEAKER_01: Uh customer would only pay for something when and if they order some supplies.
• 5:30
  SPEAKER_01: And the question that comes up is since this arrangement only contains variable payments, and variable payments are not included in the 842 definition of quote unquote consideration in the contract, and this the definition literally says it has to have an exchange for consideration.
• 5:46
  SPEAKER_01: So people ask, well, in that case, if there's no quote unquote consideration of the contract, maybe I don't have to account for this as lease at all, which would mean that as let's say the supplier or the customer would not have to separate that arrangement and account for the lease component under 842 and the non-lease component under 606 or whatever.
• 6:07
  SPEAKER_02: All right, so Mark, I'm sure our listeners are wondering the answer to that question.
• 6:11
  SPEAKER_02: But before we get to that, are we really hearing this more from lessees in that arrangement or lesseurs in that arrangement?
• 6:20
  SPEAKER_01: We're getting the question more from lesseurs, and perhaps the reason that we're not getting them from the lessees is because when there's no minimum payments and there's no fixed payments, then the lessee might have a lease, but they you know there wouldn't be any payments to go into the measurement of a lease liability, so it effectively it's off balance sheet anyway, right?
• 6:40
  SPEAKER_01: So the people asking the question typically are the lesseurs because lessours are are often concerned about having to account for a single transaction, right, under both 606 and 842, under two different standards.
• 6:53
  SPEAKER_01: And um maybe I can give like a simple example of when this could occur, and perhaps this is a stupid example that won't resonate with everybody, but it's it's it's readily understandable.
• 7:04
  SPEAKER_01: Let's say that a distributor is going to um sell soda, right?
• 7:11
  SPEAKER_01: And they're going to put a soda dispensing machine, whether that's a vending machine or a soda dispensing machine, at a customer's location, but the customer has no minimum payments whatsoever and would only have to make pay would only have to make payments as it buys the soda supplies.
• 7:26
  SPEAKER_01: So the question there is well, am I leasing that soda machine, that dispensing machine to the customer or not?
• 7:33
  SPEAKER_01: Um you might say, well, lessours may not care because they in any case have a practical expedient that would allow them to, in under certain circumstances, not separate the um the lease component and the non-lease component.
• 7:49
  SPEAKER_01: But actually, in in areas where the supplier is supplying a good, right, um, they would not be allowed to take that practical expedient because in order to take that practical expedient, the revenue derived from both the non-lease component and the lease component would both have to be on a straight line basis.
• 8:08
  SPEAKER_02: All right.
• 8:09
  SPEAKER_02: So definitely understand the concern then.
• 8:11
  SPEAKER_02: Um, but let's go back.
• 8:13
  SPEAKER_02: So what's the answer to the question?
• 8:14
  SPEAKER_02: Did these so-called free leases have to be accounted for as leases?
• 8:20
  SPEAKER_01: So, like in in many things, the answer is maybe.
• 8:24
  SPEAKER_01: Right?
• 8:25
  SPEAKER_02: So we waited for nothing then, Mark.
• 8:28
  SPEAKER_01: Well, actually, so this was discussed amongst the large firms and was also discussed informally with the FASB and the SEC.
• 8:34
  SPEAKER_01: And obviously the answer I think is going to depend on facts and circumstances.
• 8:38
  SPEAKER_01: The punchline, I think, is that most free leases would probably need to be accounted for as something that does, in fact, have a lease.
• 8:47
  SPEAKER_01: Though I guess we all acknowledge that there were perhaps arrangements where the PPE that's being used to supply the contract may not have to be accounted for under the LISA standard.
• 8:59
  SPEAKER_01: And there may be some diversity in practice in how to make that determination.
• 9:04
  SPEAKER_01: What we think, and I think what everybody thinks, is that in order to ignore or not account for something as a lease, right, in these situations, would be a scenario where the PPE is insignificant.
• 9:18
  SPEAKER_01: And it's only the judgment about how you determine whether it's insignificant and where the diversity may occur, right?
• 9:24
  SPEAKER_01: And one of the things that I would point out, so obviously we'd have to look at facts and circumstances, but I I would say that in a situation where when the arrangement ends and the customer is required to return the piece of equipment to the um to the supplier or to the vendor, right off the bat, I'm gonna say that that tends to contradict an assertion that the asset is insignificant, right?
• 9:46
  SPEAKER_01: If an asset is insignificant, then typically I would expect at the end of the arrangement the the customer could actually keep it or throw it away.
• 9:54
  SPEAKER_01: Right, right.
• 9:55
  SPEAKER_01: Now, again, that's not a hundred percent.
• 9:56
  SPEAKER_01: There may be other reasons why they want it back, but in order for something to be insignificant, we think, first of all, probably quantitatively just has to be insignificant, and it has to be something that they don't care about if they get it back.
• 10:08
  SPEAKER_01: And maybe the pot machine qualifies as that.
• 10:11
  SPEAKER_01: I don't know.
• 10:12
  SPEAKER_01: Right.
• 10:13
  SPEAKER_02: So, Mark, I liked your example, and actually, I know you weren't talking about vending machines, but you made me think of vending machines.
• 10:19
  SPEAKER_02: And I did read a very fascinating article.
• 10:21
  SPEAKER_02: Vending machines have a much more complicated history than you may realize.
• 10:24
  SPEAKER_02: So if you have any interest in vending machines, I I encourage people to research that a bit.
• 10:30
  SPEAKER_02: So a lot more complicated than you think to get things to vend.
• 10:34
  SPEAKER_02: So, with that total aside, let's go back then to the definition of a lease.
• 10:39
  SPEAKER_02: And Jillian, uh, it's interesting because you know you read that definition and then we focused in on a few words there.
• 10:46
  SPEAKER_02: We actually haven't even talked about the criteria yet.
• 10:48
  SPEAKER_02: So let's rewind.
• 10:50
  SPEAKER_02: And can you remind us of the four criteria for a lease?
• 10:53
  SPEAKER_02: Sure.
• 10:54
  SPEAKER_03: So within the definition, the sort of the four pillars, first would be an identified asset.
• 11:00
  SPEAKER_03: So that's really the starting point.
• 11:02
  SPEAKER_03: And in evaluating whether or not there is an identified asset, you'd have to think about whether there are substitution rights.
• 11:09
  SPEAKER_03: So that's really the second criteria that the supplier does not have the ability to substitute that specific asset.
• 11:16
  SPEAKER_03: Third, then, is that the customer has the right to substantially all of the economic benefits from using that asset.
• 11:24
  SPEAKER_03: And then lastly, that the customer has the right to direct the use of that asset.
• 11:30
  SPEAKER_02: All right.
• 11:30
  SPEAKER_02: So lots of pieces there, and definitely I think we should look at them one by one.
• 11:34
  SPEAKER_02: So, Gillian, maybe we could start with the first one: identified assets.
• 11:39
  SPEAKER_03: Sure.
• 11:39
  SPEAKER_03: So in order to have a lease, you have to have an identified asset.
• 11:42
  SPEAKER_03: Step number one, and that can be explicit within the contract or implicit.
• 11:48
  SPEAKER_03: So explicitly, if the contract states, you know, a specific piece of machinery, a specific manufacturing facility, that's usually straightforward.
• 11:58
  SPEAKER_03: But in some arrangements, the contract may not actually specify an asset that's going to be leased.
• 12:05
  SPEAKER_03: And in some cases, it may not even talk about whether or not there will be an asset that's being leased.
• 12:11
  SPEAKER_03: And so that's where, you know, again, it takes a little bit more judgment to think through whether or not the leasing model would apply.
• 12:18
  SPEAKER_03: So maybe a couple examples here.
• 12:20
  SPEAKER_03: You know, one Heather that you and I spent a lot of time thinking through, like you mentioned, our land easements or rights of way arrangements, where, you know, one party, typically a landowner, is providing access to another party, not only for you know a general piece of land, but also in a lot of cases, providing the right to construct some type of asset.
• 12:43
  SPEAKER_03: So it could be a cell phone tower, it could be utility poles, various types of infrastructure.
• 12:49
  SPEAKER_03: But in a lot of cases, the specific location where that asset will be constructed may not be known at the beginning of the arrangement.
• 12:57
  SPEAKER_03: So, you know, in a simple example, a landowner could provide a customer with access to, say, like 10 acres of land, and also give the ability for them to identify within those 10 acres some smaller portion where that asset will be constructed.
• 13:13
  SPEAKER_03: But in order to determine the best location for that asset, there's you know a number of things, engineering studies, surveying that needs to be done.
• 13:22
  SPEAKER_03: So in a lot of cases, that specific location won't be known up front.
• 13:28
  SPEAKER_03: Another area where we see a similar type of arrangement is energy management services, which have become, you know, I think more common recently.
• 13:37
  SPEAKER_03: And in those cases, you know, you have a supplier who agrees to provide a customer with certain assets all intended to improve the customer's energy efficiency usage.
• 13:49
  SPEAKER_03: So think things like HVAC equipment, heating and cooling, those types of assets or machinery.
• 13:56
  SPEAKER_03: And similarly, there, when the parties enter that type of contract, they don't exactly know the individual assets that the supplier is going to be providing or installing for the customer.
• 14:07
  SPEAKER_03: Typically at the beginning, the supplier is agreeing to develop a strategy to maximize the savings that the customer will ultimately realize.
• 14:16
  SPEAKER_03: But again, there's oftentimes some level of consulting, additional work that needs to go into developing that actual strategy and then ultimately identifying what the specific assets will be.
• 14:30
  SPEAKER_03: And so for both of those, some people may hear these types of arrangements referred to as floating leases.
• 14:35
  SPEAKER_03: But that's sort of the general idea is that you have an arrangement, but on day one, you may not know exactly what assets will be involved.
• 14:43
  SPEAKER_02: All right.
• 14:43
  SPEAKER_02: So I think that term floating leases gives a hint to where we're going to go with this.
• 14:49
  SPEAKER_02: But in a case like this where you really don't know the identified asset, how do you think about that?
• 14:55
  SPEAKER_03: Yeah, so it's interesting, and you know, it's it may be a bit of an evolution throughout some of these types of arrangements because, like I said, you know, on day one, you may not have an identified asset.
• 15:06
  SPEAKER_03: And so in that case, typically we'd agree that you don't have a lease because you can't have a lease if you don't have an identified asset.
• 15:13
  SPEAKER_03: But once the parties actually agree to a specific plan or do determine what assets will be used.
• 15:21
  SPEAKER_03: So again, going back to the land easement arrangement, you know, once the customer determines this is where I'm going to construct my asset, or in the energy services contract, once they determine these are the assets that I'm going to provide to this customer, at that point in time, you would have an identified asset.
• 15:40
  SPEAKER_03: And then you'd have to think about that throughout the rest of the model to determine if you actually have a lease then.
• 15:46
  SPEAKER_02: All right.
• 15:46
  SPEAKER_02: So then, Mark, I know another question that comes up with identified assets is often there are substitution rights.
• 15:53
  SPEAKER_02: So not in Jillian's field case, because clearly once you've built the cell tower, in most cases you wouldn't be substituting.
• 16:00
  SPEAKER_02: But let's say a smaller piece of equipment or otherwise, how do you think about substitution rights when you're trying to consider if there was an identified asset?
• 16:10
  SPEAKER_01: Yeah, so Heather, you're right.
• 16:12
  SPEAKER_01: We see a fair number of questions come in where the parties initially approach the situation and they believe that the PPE that is being used to support the contract can be substituted and perhaps often is substituted, and therefore there cannot be a lease.
• 16:29
  SPEAKER_01: So, you know, in order to think about this, one of the things I want to point out is that often an arrangement can rely on more than one type of asset.
• 16:37
  SPEAKER_01: There could be multiple assets, and lease accounting is very specific to the asset as opposed to the contract.
• 16:45
  SPEAKER_01: So you could have a contract that, you know, arrangements that rely on some assets that can be substituted, but other assets that cannot be substituted, and that's okay.
• 16:54
  SPEAKER_01: And I guess we'll talk about whether the assets that cannot be substituted could be subject to a lease.
• 16:59
  SPEAKER_01: So just the evaluations on an asset basis, not the whole, you know, arrangement.
• 17:05
  SPEAKER_01: Um so in order for a supplier to have a right, a substantive right, to substitute an asset, well, first of all, I guess first of all, there has to be a contractual right to substitute the asset.
• 17:17
  SPEAKER_01: And I only point that out because we sort of have a higher level of um skepticism when somebody says that the asset can be substituted when the asset is physically on the customer's site.
• 17:28
  SPEAKER_01: Right?
• 17:29
  SPEAKER_01: And in those cases, there might be a contractual restriction.
• 17:31
  SPEAKER_01: I don't know.
• 17:32
  SPEAKER_01: But that certainly there has to be a contractual right to do so.
• 17:36
  SPEAKER_01: And then um the next thing is that the cust the supplier, excuse me, has to be able to economically benefit from the substitution.
• 17:46
  SPEAKER_01: Now, this is where we we sometimes get a lot of questions because what a supplier will sometimes say to us is well, look, in many contracts we end up substituting the asset.
• 17:55
  SPEAKER_01: And whenever we do so, it economically benefits us because we there's some reason that we wanted to do so and had to do so, so there is an obvious benefit to doing so.
• 18:06
  SPEAKER_01: And um I guess the key here is that what the standard tells us is that when considering whether a supplier can substitute that asset, we would exclude events that are not likely to occur during this customer's period of use.
• 18:21
  SPEAKER_01: So, an example I might give is consider a car rental company, right?
• 18:25
  SPEAKER_01: A car rental company will tell you that they often have reasons why they have to substitute an asset.
• 18:30
  SPEAKER_01: You're renting a car and they call you up and say, we're gonna come and swap out your car for a different one.
• 18:35
  SPEAKER_01: It happens all the time, right?
• 18:37
  SPEAKER_01: But seriously, what is the likelihood that when you rent a car for four days, that the car rental company is gonna come to you and tell you that you have to substitute that?
• 18:45
  SPEAKER_01: It is simply unlikely to occur during my period of use.
• 18:49
  SPEAKER_01: Or perhaps another way to think about this is that somebody wins the lottery every week, but it's never me, right?
• 18:56
  SPEAKER_01: Like there's always a lottery winner, but the likelihood that it's I'm gonna be the lottery winner is pretty small.
• 19:02
  SPEAKER_01: The other thing that people have to consider, and this is perhaps one of the bigger ones that we get, bigger questions that we get, is um you're only supposed to consider facts that are on hand at the at the date you entered into the contract and not assume that things are going to change in the future.
• 19:20
  SPEAKER_01: You're so you're going to ignore expectations of let's just say that I'm gonna substitute this because in the future there's gonna be a technical upgrade, or in the future there's gonna be a better technology, right?
• 19:31
  SPEAKER_01: Or I'm gonna have to substitute it in the future because it's gonna break and I'm going to maintain it.
• 19:36
  SPEAKER_01: Maintenance is definitely not something you'd consider at all in determining whether something can be substituted.
• 19:41
  SPEAKER_01: Sometimes he'll say, well, you know, I'm gonna assume that that market prices are changed, and that's gonna change how I'll use my assets in the future.
• 19:49
  SPEAKER_01: These are all valid considerations, but they don't really, they have to be ignored when considering whether I'm gonna economically benefit from substitution.
• 19:57
  SPEAKER_01: And that's an area that that people are often surprised by because, like I said, people do substitute assets, right?
• 20:04
  SPEAKER_01: The question is, is it likely to occur during the course of this contract without considering that things will change in the future?
• 20:12
  SPEAKER_01: Um so again, you know, because of all these things, it is a higher hurdle to assert that substitution can occur when the asset's located at the customer's premises.
• 20:23
  SPEAKER_01: And one final thing, the standard even talks about this, that unless a lessee, or excuse me, the customer, right, can readily determine that the asset can be substituted, right?
• 20:36
  SPEAKER_01: There's it's one of these things where the lessor has a better insight into what it's going to do with an asset than the customer does in these situations.
• 20:42
  SPEAKER_01: So the customer is not supposed to assume that there's a right to substitute unless it's readily determinable.
• 20:47
  SPEAKER_02: All right.
• 20:47
  SPEAKER_02: Those are all good reminders there and definitely a lot to think about.
• 20:51
  SPEAKER_02: So, Jillian, let's move on then to the next criteria, which is uh the right to substantially all of the economic benefits.
• 20:57
  SPEAKER_02: And I know this is another area where there can be sometimes judgment and lots of questions.
• 21:01
  SPEAKER_02: So, what are some of the more common questions that we're getting?
• 21:05
  SPEAKER_03: Yeah, so the first one with respect to this criteria is maybe somewhat basic, but really understanding what is an economic benefit, and from the standard perspective, what are the types of things that entities need to be thinking about in making the determination of whether the customer does in fact receive substantially all of those benefits.
• 21:27
  SPEAKER_03: And so while the standard doesn't actually define economic benefit, it does provide some examples of things that would be considered economic benefits for purposes of doing this evaluation.
• 21:40
  SPEAKER_03: And so I'm going to quote again from the standard where it says that economic benefits from use of an asset include its primary output and byproducts, including potential cash flows derived from those items, and other economic benefits from using the asset that could be realized from a Commercial transaction with a third party.
• 22:02
  SPEAKER_03: So again, lots of words there.
• 22:04
  SPEAKER_03: But if we break that down, you know, I think the first two primary output and brought byproducts are generally probably pretty easy to understand, you know, would vary depending on the type of specific asset, but those are usually somewhat straightforward.
• 22:18
  SPEAKER_03: It's really the third category, sort of the broad catch-all, other economic benefits, where there can be a lot of questions of what should be included in that, how should a company think about that.
• 22:31
  SPEAKER_03: And a couple of things to point out there, you know, the standard is very specific that economic benefits from a leasing perspective are all those that are related to using the asset.
• 22:42
  SPEAKER_03: So in some cases, certain assets may entitle the entities that own the assets to things like tax credits.
• 22:51
  SPEAKER_03: So you think about investment tax credits, you know, heather in the renewable energy space, that's often a can be a significant benefit for some companies, but those are derived simply from owning those types of assets.
• 23:03
  SPEAKER_03: And so from a leasing perspective, that would not be something that would be considered an economic benefit, again, at least as it relates to the leasing assessment.
• 23:12
  SPEAKER_03: In contrast to something like a renewable energy credit that actually is produced from the use of an asset, that is actually explicitly identified within 842 as an example of something that would be an other economic benefit.
• 23:30
  SPEAKER_03: So again, I think there the key distinction is it's a benefit from using the asset, not from simply owning the asset.
• 23:38
  SPEAKER_02: So, Julian, before we go on, let me ask a question because for those who work with those types of contracts, that renewable energy credits um example included in the standard was an important clarification from 840.
• 23:51
  SPEAKER_02: But I'll direct this to both of you.
• 23:54
  SPEAKER_02: What other examples of other benefits do we really see in practice?
• 24:00
  SPEAKER_02: Or other economic benefits do we see in practice?
• 24:03
  SPEAKER_02: Do are there many, or is it really around these renewable energy credits is the most common example?
• 24:08
  SPEAKER_03: Yeah, I think, you know, Rex, like you said, is one that was explicitly called out in the standard.
• 24:12
  SPEAKER_03: I think, you know, there could be others, again, depending on the specific types of an arrangement.
• 24:18
  SPEAKER_03: And, you know, I think some of the other key language from how it's described in 842 is around things that could be realized from a transaction with a third party.
• 24:27
  SPEAKER_03: And so again, I think there could be other things that potentially could be sold to another party.
• 24:32
  SPEAKER_03: Um, and to the extent that there's a history of an entity doing that, you know, those may also qualify sort of as other economic benefits.
• 24:41
  SPEAKER_03: And then the other thing I think to keep in mind when you're thinking about economic benefits is thinking about arrangements that may actually have more than one type of benefit that's produced from the asset.
• 24:52
  SPEAKER_03: And in those cases, then companies really should be thinking about the fair value of their total contractual rights from using the asset.
• 24:59
  SPEAKER_03: And similar to other pieces of the standard, that should be based on the asset in its condition at the beginning of the arrangement.
• 25:07
  SPEAKER_03: So thinking about the expected capacity, what typical routine maintenance might be, um, and the overall just nature of the asset.
• 25:17
  SPEAKER_03: And then the second area where we sometimes get questions around the substantially all the economic benefits is really about the rights versus how those rights are used.
• 25:30
  SPEAKER_03: And what I mean by that is the standard really focuses on the customer having the right to those benefits, irrespective of how the customer may choose or not choose to actually exercise those rights.
• 25:44
  SPEAKER_03: So, in some contracts, the customer could have the right to receive certain benefit or output from an asset, but it may make a decision not to actually take that output.
• 25:56
  SPEAKER_03: And you know, for one example, maybe instead it would allow the supplier to actually sell a portion or all of that output to a separate third party.
• 26:05
  SPEAKER_03: From the evaluation within the standard, the key piece is the customer has that right.
• 26:11
  SPEAKER_03: And then it's up to them how they actually use or exercise that right.
• 26:16
  SPEAKER_03: So, in cases where a company maybe has the right of first refusal, or the supplier may have to request approval from the customer in order to provide a benefit or an output to a different third party, in those cases, the customer is probably still the one that actually has the contractual right.
• 26:36
  SPEAKER_03: And so this is a key piece to highlight because it's another area where there is a difference between the old leasing model under 840 and the new guidance under 842.
• 26:46
  SPEAKER_03: So under 842, it's not really a probability assessment of if the customer or some other party is ultimately going to receive the benefit.
• 26:56
  SPEAKER_03: It's really focused on who actually has the contractual rights within the arrangement.
• 27:00
  SPEAKER_02: All right.
• 27:01
  SPEAKER_02: So then let's move on to our final criterion.
• 27:04
  SPEAKER_02: And I think, Mark, you may correct me, but to me, this is one of actually the biggest differences between 840 and 842, which is the right to direct the use of the identified asset.
• 27:15
  SPEAKER_02: Because under 840, you could have a lease if the customer either had the right to the output, what Jillian was just talking about, or the right to direct the use of the asset.
• 27:26
  SPEAKER_02: But now under 842, you need both.
• 27:29
  SPEAKER_02: So, Mark, first of all, you can you can agree or disagree with me that this is one of the biggest changes.
• 27:35
  SPEAKER_02: Uh, but then I know we get lots of questions in this area.
• 27:37
  SPEAKER_02: So, what are some of the key points?
• 27:40
  SPEAKER_01: Yes, Heather, it certainly is an area that we get a lot of questions on.
• 27:43
  SPEAKER_01: It's probably an area that we get calls on literally every week to to companies and engagement teams want help in figuring out this evaluation as to which of the parties um directs the use of the asset.
• 27:55
  SPEAKER_01: And I guess maybe the first thing I want to say is that the standard uses this term, you know, uh focusing on how and for what purpose the asset in question can be used during the term of the arrangement.
• 28:08
  SPEAKER_01: So maybe the first thing I want to acknowledge, and we'll talk about this more in a moment, is that look, in almost every arrangement, there are certain things that are predetermined by the contractual terms, right?
• 28:20
  SPEAKER_01: And then there are also decisions that can be made during the term of the arrangement where one of the two parties, or perhaps both parties, can change how, what, where, when, whether the asset is used.
• 28:32
  SPEAKER_01: And so I just want to delineate between these two time periods and point out that the standard really focuses on the how, what, whether, when and where decisions that can be made during the term of the arrangement.
• 28:46
  SPEAKER_01: And only when there are none of those do we then look to the rights that were in the contract itself, the predetermined rights.
• 28:56
  SPEAKER_01: Okay.
• 28:57
  SPEAKER_01: So um, and just to give an example of what I mean by these predetermined rights, right, is let's think of a lease of a coffee shop inside a mall, right?
• 29:07
  SPEAKER_01: So the coffee shop inside the mall, now it's kind of obvious that there's going to be decisions as to how the people can operate that coffee shop, right?
• 29:15
  SPEAKER_01: So in this case, there's definitely going to be a lease.
• 29:17
  SPEAKER_01: But just to illustrate the contractual terms that are predetermined, that contract with the mall owner is going to dictate which hours the asset could be operated, right?
• 29:27
  SPEAKER_01: When it opens, when it closes.
• 29:30
  SPEAKER_01: The operator probably has no uh authority to change that because they have to be open whenever the mall is open.
• 29:37
  SPEAKER_01: Um, they're going to probably be restricted in what they can serve because there may be other restaurants in the mall, and the lessor has told the coffee shop you can only serve coffee because I'm not allowing you to compete with other restaurants.
• 29:48
  SPEAKER_01: So the point here is there are certainly situations where there is a lot of predetermined decisions that are in the contract, right?
• 29:56
  SPEAKER_01: But those are not necessarily the decisions that either party can make during the term of the contract as to how the asset can be used.
• 30:04
  SPEAKER_01: And those are typically ignored unless there are no decisions to be made during the term of the contract.
• 30:09
  SPEAKER_01: And we'll talk about more about that in a moment.
• 30:11
  SPEAKER_02: All right.
• 30:12
  SPEAKER_02: So then, Mark, your point would be in this case, like I may say, well, wait a minute, Mark, whether or not I'm serving coffee or something else might be one of the most important things that's going to govern it.
• 30:23
  SPEAKER_02: But that was already decided.
• 30:24
  SPEAKER_02: I'm selling coffee.
• 30:26
  SPEAKER_02: So now if I'm the coffee shop owner, I'm the one who's deciding what kind of coffee, how I'm going to set the shop up, you know, if I'm going to have chairs or only place to stand, all of those types of things that the mall owner has no influence over.
• 30:40
  SPEAKER_02: And because those are the decisions being made during the term, those are the ones that would then say, okay, well, so the I, the coffee shop owner, do have the right to direct the use of the asset.
• 30:51
  SPEAKER_01: That's right.
• 30:52
  SPEAKER_01: And I do want to point out that while you always have to do this evaluation, typically when an arrangement is actually um written as a lease agreement, right, typically the lessee is going to have those rights.
• 31:05
  SPEAKER_01: It we don't usually get the question about whether something that is in form a lease agreement is really not a lease because they typically do have all those rights.
• 31:14
  SPEAKER_01: This question comes up more often in this embedded lease area that we're talking about, where the customer is just buying supplies or services and there may be an asset dedicated to supplying that contract.
• 31:26
  SPEAKER_01: Um, the other thing I just want to say is that when we think about the decisions that can be made during the term of the contract, right, we typically look at decisions, you know, the the authority to make those decisions.
• 31:39
  SPEAKER_01: So just because one of the sentences that the standard in its basis for conclusions uses is that they were thinking about this in terms of the rights of a board of directors, right, rather than the people who are actually the employees are implementing the board of directors' rights.
• 31:54
  SPEAKER_01: So when you think of decision making, who has the right to make the decision as opposed to the person carrying out those decisions?
• 32:00
  SPEAKER_02: All right, so then Mark, that definitely seems like a key point.
• 32:03
  SPEAKER_02: Can you give an example of where that has come into play?
• 32:07
  SPEAKER_01: Um sure.
• 32:08
  SPEAKER_01: So I thought one of the good examples of this was a um a paper that was actually submitted to the IFRIC under IFRS 16, which in this regard is pretty much identical to you know Topic 842.
• 32:22
  SPEAKER_01: And they were trying to um illustrate this example, excuse me, they were trying to illustrate this example where there weren't many decisions that could be made during the course of the contract.
• 32:34
  SPEAKER_01: The more important decisions were contractually ordained, right?
• 32:38
  SPEAKER_01: But nevertheless, they concluded that there was a lease because there was some decision that was made during the course of the contract, and the customer got to make that decision.
• 32:47
  SPEAKER_01: So the example was a shipping example, and in their example, a customer hired a ship for a number of years to carry, let's just say coal, to carry a certain product across the Atlantic 15 times a year, right?
• 33:02
  SPEAKER_01: So 15 times a year, it was going to travel back and forth across the Atlantic, delivering coal, let's say, to the United States.
• 33:09
  SPEAKER_01: And the loading location and the unloading location were dictated to the contract, the fees were dictated in the contract, and in this arrangement, they were assuming that the ship would always be in use.
• 33:22
  SPEAKER_01: It would never be idle, it could never be used for any other customers.
• 33:25
  SPEAKER_01: Okay.
• 33:26
  SPEAKER_01: So what decisions in that case were left?
• 33:28
  SPEAKER_01: Well, in the contract that they evaluated, they said that the uh the destination port, right, could be either, let's just say, New York, Baltimore, or Houston.
• 33:40
  SPEAKER_01: Okay, one of these three destinations, and even the number of trips to New York and the number to Baltimore and the number to Houston were predetermined.
• 33:49
  SPEAKER_01: So there were five, let's say, to location A and ten to location B.
• 33:53
  SPEAKER_01: Right.
• 33:54
  SPEAKER_01: And the only decision that a customer was able to make is what's the next trip gonna be?
• 34:01
  SPEAKER_01: Where is the next trip gonna go?
• 34:03
  SPEAKER_01: So today we unloaded in New York, the next one I want to be in, fill in the blank, New York or Houston.
• 34:10
  SPEAKER_01: And what the IFRIC concluded is that, well, that is a decision that can be made during the course of the contract.
• 34:18
  SPEAKER_01: It's the only decision to their example, and therefore the customer has the right to direct the use of the contract.
• 34:25
  SPEAKER_01: What they did is they ignored the fact that, you know, that the they could only use the ship to to send coal and nothing else, right?
• 34:34
  SPEAKER_01: They ignored all these perhaps more important decisions that were in the contract because those were not during the term of the arrangement.
• 34:41
  SPEAKER_02: So then, Mark, I love that example, but it kind of raises another question for me because it seems like many, most, almost all, I'll I'll pick something there, arrangements would have at least some relevant decisions that are being made during the term.
• 34:58
  SPEAKER_02: What are some examples of situations that we see where there really aren't any decisions?
• 35:05
  SPEAKER_01: I agree, Heather.
• 35:06
  SPEAKER_01: As you look at an arrangement and you think about who can change again, what the asset does, how it does it, when it operates, whether it's on or off, where it operates, there's usually something that can be decided during the term of the contract.
• 35:20
  SPEAKER_01: Perhaps a good example of one where there might not be, and everything's predetermined, are in residential solar panels.
• 35:28
  SPEAKER_01: Okay, so I I'm not an engineer, but but I I acknowledge that once the parties agree to install a solar panel on the roof of a home, right, that if I just think about the questions that the standard says, consider these you know indicators, can I change what it does?
• 35:46
  SPEAKER_01: Well, it it it really can't do anything else.
• 35:48
  SPEAKER_01: Can I change how it operates?
• 35:50
  SPEAKER_01: It it can only operate in one manner.
• 35:52
  SPEAKER_01: Can I determine when it operates?
• 35:54
  SPEAKER_01: Typically, these residential solar panels they operate 24-7.
• 35:58
  SPEAKER_02: Anytime they're sun, yeah.
• 35:59
  SPEAKER_01: Anytime they're sun.
• 36:01
  SPEAKER_01: Maybe they're turned off just for maintenance reasons, but again, we always ignore kind of maintenance as being the cause of things, right?
• 36:07
  SPEAKER_01: Um are they ever turned on or turned off?
• 36:11
  SPEAKER_01: Whether they're on or off, typically not something that can change.
• 36:14
  SPEAKER_01: Where it operates is not something, it's not something that the homeowner can move around on its rooftop and you know take to its vacation condo in Florida.
• 36:21
  SPEAKER_01: You know, it so everything's been predetermined.
• 36:24
  SPEAKER_01: And then in those circumstances where everything's predetermined, then we look to those contractual rights that predetermined how the asset's going to be used, right?
• 36:34
  SPEAKER_01: Because in this case, there are no decisions that could be made during the term of the contract.
• 36:38
  SPEAKER_01: So now we look at those predetermined rights.
• 36:41
  SPEAKER_01: And so this is kind of like an alternate model, right?
• 36:44
  SPEAKER_01: And in these predetermined rights, there could be a lease, or there would be a lease, under either of two conditions.
• 36:50
  SPEAKER_01: The first one is, and I'm gonna apologize, I've been reading from the standard here, the customer has the right to operate the asset or to direct others to operate the asset in a manner that it determines throughout the term, excuse me, throughout the period of use, without the supplier having the right to change those operating instructions.
• 37:09
  SPEAKER_01: Okay.
• 37:10
  SPEAKER_01: So if I can, if there is an asset that I can unplug as an example, then there could be a lease just because I can unplug it.
• 37:18
  SPEAKER_01: Or the second criterion, again, this is an or, not an and the customer designed the asset or specific aspects of the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
• 37:32
  SPEAKER_01: So the example I gave is a solar panel on top of a house, right?
• 37:37
  SPEAKER_01: But what if I had a hospital campus and I worked with a solar panel provider to really determine the best sites, right, where these solar panels are going to operate, collect the most sun, uh, provide energy to the nearest buildings.
• 37:51
  SPEAKER_01: I may be heavily involved in how this solar farm, if you will, is being uh constructed.
• 37:58
  SPEAKER_01: And perhaps that that would be something that would say there's a lease of those.
• 38:03
  SPEAKER_01: Okay.
• 38:04
  SPEAKER_01: So those are just a couple of examples of whether there may be a lease or may not be a lease.
• 38:09
  SPEAKER_02: All right, very helpful.
• 38:11
  SPEAKER_02: And I know we can you can find out more about all of these in the leasing guide.
• 38:15
  SPEAKER_02: I guess Mark, maybe one final question for you, and then I have some wrap-up questions.
• 38:20
  SPEAKER_02: You know, you made the point as we were going along that it's if you have a legal form, you know, a contract that is set up as a lease, it's there's rarely questions that whether or not it's a lease.
• 38:32
  SPEAKER_02: But we kind of jumped into the fact that this podcast was really focused on these embedded types of leases.
• 38:39
  SPEAKER_02: And can you just give some typical examples of where we might find leases that maybe companies may not necessarily be looking for them?
• 38:50
  SPEAKER_01: Well, the most common area that we see leases embedded in a supplier service contract would be typically in supply arrangements where the customer thinks it's just buying an output.
• 39:05
  SPEAKER_01: So I'm just buying brake pads.
• 39:06
  SPEAKER_01: And they may not realize that the vendor only has a single facility, you know, from which to provide those brake pads, or perhaps had to buy dedicated equipment because of something unique about the widget that you're purchasing.
• 39:22
  SPEAKER_01: Um Certainly that that's the biggest area where we see embedded leases is probably contract manufacturing arrangements, right?
• 39:30
  SPEAKER_01: We also see it sometimes in um service arrangements.
• 39:34
  SPEAKER_02: Okay, that's very helpful.
• 39:35
  SPEAKER_02: And I think really the key takeaway here is that really any type of contract could have a lease if it if there's something in there that meets these criteria.
• 39:44
  SPEAKER_02: So that's what we're we're looking for.
• 39:46
  SPEAKER_02: But maybe it's a final question then, as you guys are dealing with this lease evaluation question or whether or not you have a lease, what would be one piece of advice that you would give to the person making this evaluation?
• 40:00
  SPEAKER_02: Anything in particular that you kind of think about or where you start as you're thinking about that?
• 40:05
  SPEAKER_02: And Mark, maybe I'll go to you first for that question.
• 40:09
  SPEAKER_01: The FASB board members made an observation as they were discussing this, that in most cases, they think the parties would have some knowledge as to whether there is an asset that is dedicated to a supplier service contract.
• 40:23
  SPEAKER_01: And in my experience, I think that's probably true.
• 40:26
  SPEAKER_01: I as I mentioned earlier, I think the area that has generated the most questions is trying to determine, again, whether the customer has the right to direct how the asset's being used, and in particular if the asset is not on site, if the asset is at the supplier's location.
• 40:45
  SPEAKER_01: Where the asset is at the customer's location, I think there's probably a bias that the the customer does have some rights to direct the use of the asset.
• 40:57
  SPEAKER_01: And again, I don't mean to harp on this, but this whole notion that when thinking about whether you have the right to direct the use of the asset, it really is a comparative analysis.
• 41:06
  SPEAKER_01: You have to look at what the supplier has the right to do and what I have the right to do, and um sort of which party based on an overall analysis has more of those rights.
• 41:16
  SPEAKER_02: All right, very helpful.
• 41:17
  SPEAKER_02: And then Jillian, I know you've dealt with lots of embedded leases, um, even you know, back to when we were first interpreting 842.
• 41:25
  SPEAKER_02: What are some thoughts from your perspective?
• 41:28
  SPEAKER_03: Yeah, I think one of the key things is you know, really going below the surface of what may appear in a contract.
• 41:36
  SPEAKER_03: And I think particularly in sort of the realm of embedded leases, you know, I think there's sort of the the clear form leases, those may be straightforward.
• 41:46
  SPEAKER_03: But I think like a lot of the things that we've talked about, you know, once you really dig in and start to understand, as Mark talked about, who has certain rights within the contract, how does this actually operate over the term, you know, and is there an asset or a piece of equipment that's being used to supply or support that contract?
• 42:08
  SPEAKER_03: I think a lot of companies will find that more things than might appear or they might think about initially actually do meet those criteria under the new standard.
• 42:19
  SPEAKER_03: And so, again, probably not unlike other evaluations.
• 42:23
  SPEAKER_03: I think the key here is, you know, really understanding what is the contract for, what rights are being conveyed, and really like how does it work throughout the period of time to understand, you know, again, how you may or may not meet some of those specific leasing criteria.
• 42:38
  SPEAKER_02: All right, definitely good advice.
• 42:40
  SPEAKER_02: And I think probably for any contract, not just when you're looking for leases when you're doing your accounting.
• 42:45
  SPEAKER_02: So, both, thank you so much for your insight.
• 42:46
  SPEAKER_02: I do have one final question.
• 42:48
  SPEAKER_02: I have only one stump the guest question for you today.
• 42:51
  SPEAKER_02: And I if you've been paying attention in past webcasts, you should know the answer to this because I think we asked this as a polling question.
• 43:00
  SPEAKER_02: Uh, but who said one of my great ambitions before I die is to fly in an aircraft that is on an airline's balance sheet?
• 43:09
  SPEAKER_02: Any guesses?
• 43:10
  SPEAKER_01: I was gonna defer to Gillian on this one because I I think I know the answer because I've used that quote before.
• 43:16
  SPEAKER_03: Oh my gosh, I have no idea.
• 43:17
  SPEAKER_03: Go for it, Mark.
• 43:18
  SPEAKER_02: It's a joint effort, so whoever gets it right, it's score one for the team.
• 43:22
  SPEAKER_02: So go ahead, Mark.
• 43:24
  SPEAKER_01: So it was the uh former chair of the IESB who set this at at a um Australian or New Zealand banking conference, like 15 years before the standard became effective, or something like that.
• 43:42
  SPEAKER_01: Because I think the way he said it is in the next five years, and he was like way off.
• 43:47
  SPEAKER_01: And um his name is escaping me.
• 43:50
  SPEAKER_02: It is Sir David Tweety, but you definitely gave more other information than I was expecting.
• 43:56
  SPEAKER_02: So I guessed that you would at least directly know the answer, and I was right.
• 44:00
  SPEAKER_02: So, anyway, good guessing.
• 44:02
  SPEAKER_02: Thank you, Score One for the team, and uh thanks again for joining me today.
• 44:07
  SPEAKER_01: Thank you.
• 44:10
  SPEAKER_02: That's our show for today.
• 44:12
  SPEAKER_02: Join me this Thursday when we'll have more EHT reporting content for you with a special episode where we'll discuss PWC's recent comment letter on the SEC's climate disclosure proposal.
• 44:24
  SPEAKER_02: You won't want to miss this one.
• 44:26
  SPEAKER_02: My guest, Wes Bricker, the co-chair of PWC's Trust League Practice and former SEC chief accountant.
• 44:33
  SPEAKER_02: Wes has had a multitude of conversations with investors, companies, regulators, standard setters, partners, and many other stakeholders in the capital market's financial reporting ecosystem, and he brings a ton of insight into this proposal.
• 44:48
  SPEAKER_02: So that you never miss any of our audio content.
• 44:51
  SPEAKER_02: Follow the PwC Accounting Podcast series for every listen to your podcast.
• 44:56
  SPEAKER_02: And to stay up to date on all our latest accounting and reporting news, sign up for our newsletter at viewpoint.pwc.com.
• 45:06
  SPEAKER_02: From Thought Leadership at PWC, I'm Heather Horn.
• 45:11
  SPEAKER_02: Thanks for tuning in.
• 45:16
  SPEAKER_00: This podcast is brought to you by PWC, All Rights Preserved.
• 45:20
  SPEAKER_00: PWC refers to the U.S.
• 45:22
  SPEAKER_00: member firm or one of its subsidiaries or affiliates, and they sometimes refer to the PWC network.
• 45:28
  SPEAKER_00: Each member firm is a separate legal entity.
• 45:31
  SPEAKER_00: Please see www.pwc.com slash structure for further details.
• 45:37
  SPEAKER_00: This podcast is for general information purposes only and should not be used as a substitute for consultation with professional advisors.