6.2 Fixed Payments

ASC 842-10

30-5 At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term:

Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31). . . .

Lease payments, as defined in ASC 842-10, are the types of payments that an entity should consider when determining the classification, initial measurement, and subsequent measurement of a lease. Known cash flows in a lease contract are the simplest inputs to recognition and measurement. Fixed payments in the contract that are related to the right to use the underlying asset (including those that are “in-substance fixed”) are included in the lease payments, regardless of their timing. For example, fixed payments made by the lessee before lease commencement should be included in lease payments.

The next sections further discuss common ways in which payments may be fixed.

6.2.1 In-Substance Fixed Payments

ASC 842-10

55-31 Lease payments include in substance fixed lease payments. In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following:

Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance)
The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments.

Paragraph BC203 of ASU 2016-02 states, in part, that “[i]n substance fixed lease payments are payments that may, in form, appear to contain variability but are, in effect, fixed and unavoidable” and that the Board included these payments “in the measurement of lease assets and lease liabilities because those payments are unavoidable and, thus, are economically indistinguishable from fixed lease payments.”

ASC 842-10-30-5 and 30-6 indicate that lease payments include in-substance fixed lease payments but exclude variable lease payments that do not depend on an index or rate. Because the treatment of lease payments may differ depending on whether the payment is a variable or in-substance fixed payment, an entity will need to carefully evaluate such payments to determine whether a lease payment is truly variable or in-substance fixed. The example below illustrates the accounting for an in-substance fixed lease payment.

Example 6-5

Company P (the lessee) leases an automobile for a two-year lease term. In exchange for the right to use the automobile, P has the option to pay either (1) a fixed monthly payment of $250 or (2) $0.25 per mile driven with a minimum monthly payment of $100. Company P makes its election at the beginning of each month.

In accordance with ASC 842-10-55-31(b), because P must choose between the two sets of payments, both containing a fixed amount, its monthly payment is an in-substance fixed payment. The amount that should be included in lease payments is equal to the lesser of the two fixed amounts. Because the payment under the second option is, in part, variable and is not tied to an index or a rate, the in-substance fixed portion equals the minimum monthly amount of $100. Given that the unavoidable monthly amount of $100 in the second option is lower than the fixed monthly payment of $250 in the first option, the lease payments are $100 per month.

Connecting the Dots

Virtually Certain Variable Lease Payments Do Not Represent In-Substance Fixed Lease Payments

In some cases, a contract includes a variable lease payment that depends on the performance or usage of the underlying asset and a payment is virtually certain (e.g., a variable payment for highly predictable output from a solar farm or a variable payment for retail space that is based on a fixed percentage of a minimal retail sales volume). Although the probability of these payments may be virtually certain, we do not believe that the payments are in-substance fixed because they are contingent on the performance or usage of the underlying asset and thus are avoidable if the triggering event does not occur. However, we believe that, in accordance with ASC 842-10-55-31(a), an exception applies to situations in which contingent rental provisions are nonsubstantive and appear to be designed so that rental escalation is excluded from the lease payments.

Example 6-6 illustrates a scenario in which virtually certain lease payments depend on the performance or usage of the underlying asset, while Example 6-7 addresses a situation in which contingent rental provisions are designed to enable exclusion of rental escalation from lease payments.

Example 6-6

Company H (the lessee) enters into an arrangement to lease a space in a building for two years to use as a retail store. In exchange for the right to use the building space, H pays the lessor a fixed monthly fee of $1,500 and 5 percent of any sales exceeding $10,000 each month. Company H is virtually certain that its retail sales will be at least $12,000 each month.

Although H is virtually certain that it will exceed the $10,000 sales threshold each month, such amounts do not represent in-substance fixed payments and thus should not be included in H’s or the lessor’s lease payments. Company H’s lease payments and the lessor’s lease payments consist only of the $1,500 fixed monthly rental fee.

Example 6-7

Company M (the lessee) leases a piece of equipment for three years. Company M’s lease payments for the first year are $750 per month. After the first year, the lease payments are subject to the lesser of a 2 percent increase or 1 percent for every 0.1 percent increase in CPI from the previous year. On the basis of historical evidence, there is a remote likelihood that the CPI will increase by less than 0.3 percent each year. Because the likelihood of an increase less than 0.3 percent each year is remote, this represents a form of nongenuine variability (i.e., any variability below 0.3 percent is not a genuine form of variability) in accordance with ASC 842-10-55-31(a).

The SEC has indicated that under ASC 840 there did not appear to be any economic reason for the leverage factor described above and it appears that the CPI adjustment provision was put in place to avoid inclusion of the higher fixed rentals in the minimum lease payments. Our general view is that ASC 842 would not change this conclusion.

Because there is a remote likelihood that the CPI will increase by less than 0.3 percent each year, we believe that M should adjust its lease payments by 2 percent. Therefore, M calculates its lease payments as follows:

Year 1: $9,000 ($750/month multiplied by 12 months)
Year 2: $9,180 ($9,000 prior-year payment adjusted by 2 percent)
Year 3: $9,364 ($9,180 prior-year payment adjusted by 2 percent)

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Consistency With Other Topics in U.S. GAAP

The guidance on in-substance fixed lease payments is generally consistent with existing interpretive guidance on in-substance fixed payments in other areas of U.S. GAAP. Paragraph BC204 of ASU 2016-02 notes that although the FASB decided not to provide specific examples of what constitutes an in-substance fixed lease payment, “the examples that exist in practice and that are included in various pieces of interpretive guidance provide useful information on how the Board [FASB] intends this concept to apply in Topic 842.” One example that the FASB specifically points out in paragraph BC204 of ASU 2016-02 is the determination of whether a notional amount exists in the accounting for derivatives under ASC 815. On the basis of such comparisons, we do not expect the accounting for in-substance fixed lease payments under ASC 842 to differ from that under other literature.

6.2.2 Lease Incentives

ASC 842-10

55-30 Lease incentives include both of the following:

Payments made to or on behalf of the lessee
Losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease for use of the assumed underlying asset.

As indicated above, lease incentives include both (1) payments made by the lessor “to or on behalf of the lessee” and (2) any “losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party.” Lease incentives reduce the lease payments that are used to determine the appropriate lease classification and to measure the ROU asset (and the lease liability if not yet received) or the net investment in the lease at lease commencement.

Example 6-8

Company D (the lessee) is currently leasing a building from an unrelated third party and is obligated to continue leasing the building for six additional months in exchange for a fixed monthly fee of $1,000 (i.e., D is obligated to pay an additional $6,000 under its current lease).

Although D’s current lease is still effective, D enters into a separate agreement with Company T (the lessor) to lease a different building for a five-year term in exchange for fixed monthly payments of $1,500. To incentivize D to enter into the new lease, T agrees to pay D a lump-sum amount of $5,000, which is intended to defray a portion of D’s remaining costs under its existing lease.

The lease payments under the new lease are equal to $85,000, which are calculated as follows:

Fixed lease payments: $90,000 ($1,500 monthly payment multiplied by the 60-month lease term)

Less: Lease incentives: $5,000 payment made by T to D.

Connecting the Dots

No Changes in the Definition of Lease Incentives

The description of lease incentives in ASC 842-10-55-30 is consistent with the definition of lease incentives under ASC 840-20-25-7. For information on accounting for lease incentives that reduce lease payments by lessees and lessors, see Chapters 8 and 9, respectively.

6.2.2.1 Treatment of Payments to a Lessee When a Lease Is Terminated and the Lessee Enters Into a New Lease for Similar Assets

In certain situations, a lessor may pay a lessee consideration to terminate a lease before its originally negotiated end date.

If, as a result of the lease termination, the lessee enters into a new lease agreement for the same type of equipment with the same lessor, the lessee generally must account for the consideration received in connection with the termination of the first lease (i.e., as compensation for terminating the lease) as a lease incentive for its new lease. This treatment is consistent with the guidance in ASC 842-10-55-30(a), which indicates that “[p]ayments made to or on behalf of the lessee” are lease incentives.

Even though the payment made by the lessor in this case is explicitly related to terminating the first lease, it also incentivizes the lessee to enter into the new lease. Therefore, we believe that the substance of the payment is typically an incentive for the new lease, which the lessee should defer as part of the ROU asset related to the new lease.

When the lessee in the same scenario enters into a new lease agreement for the same type of equipment with a new lessor, the accounting for the consideration received will depend on the specific facts and circumstances.

If, as part of the termination of the existing lease, the lessee is contractually required to enter into the new lease, we believe that the payment typically represents an incentive that the lessee should defer as part of the ROU asset related to the new lease. However, if the lessee is not contractually required to enter into the new lease with a new lessor, we believe that the payment typically does not represent an incentive for the new lease and that the lessee should instead take into account the payment received in determining the gain or loss upon termination of the original lease, as discussed in Section 8.7.2.

Example 6-9

Lessee enters into a nonassignable agreement to lease a 3-D printer from Lessor A. During the current year, A decides to sell its entire portfolio of printers to Lessor B. To facilitate the sale, A agrees to pay Lessee $1,000 as consideration for the termination of the existing lease. In addition, A requires that Lessee enter into a new lease with B for a 3-D printer. Even if the specific model of 3-D printer is not specified, Lessee should account for the $1,000 payment from A as an incentive to enter into the new lease with B and should defer that incentive as part of the ROU asset related to the new lease. On the other hand, if Lessee had no contractual obligation to enter a new lease with B, Lessee would instead account for the $1,000 payment as part of its gain or loss upon termination of its original lease with A. This would be the case even if Lessee decides, or (because of its reliance on the leased asset) is economically compelled, to lease a replacement 3-D printer from another lessor.

6.2.2.2 Payments From a Lessor to a Lessee During the Lease Agreement

Lease incentives are not always paid by the lessor to the lessee before lease commencement. In some cases, a lessor may make a payment to the lessee during the lease term (i.e., after the lease commencement date). Payments made by a lessor to a lessee, regardless of the timing of the payment, should be accounted for as lease incentives that reduce the lessee’s and lessor’s lease payments.

Although payments from the lessor may be specifically identified for items such as “business interruption” or “lost revenues,” it is difficult to separate a transaction into components when a continuing lease arrangement exists. Applying, by analogy, the accounting guidance on business interruption insurance or litigation settlement to payments from a lessor to a lessee is generally inappropriate even when the payments may be related to certain costs or accounting periods.

Example 6-10

Entity A, a retailer, leases retail space in a building owned by Entity B, a real estate investment trust (REIT). The lease is an operating lease with a term of 20 years. Entity A leases a portion of the building, and the remaining portions of the building are vacant. In the lease contract, B agrees to make a payment to A at the end of each of the first five years of the lease in accordance with a fixed schedule.

The payment from B to A represents a lease incentive so that A would agree to lease a portion of the building while B attempts to fill the remaining portions with other tenants. Therefore, both A and B should include the annual payments as a reduction to the lease payments at commencement.

Example 6-11

Entity A, a retailer, leases retail space in a building owned by Entity B, a REIT. The lease is an operating lease with a term of 20 years. Entity A leases a portion of the building, and the remaining portions of the building are vacant. In year 5, A and B agree that A will vacate the premises for an indefinite period so that B can refurbish the building. In exchange for vacating the premises, B will make monthly payments to A during the renovation period to compensate A for business interruption, employee termination costs, and lost profits. Once the renovation is complete, A will return to the space and resume making lease payments under the preexisting lease agreements.

The payments from B to A represent a lease incentive. Therefore, both A and B should include the monthly payments as a reduction to the lease payments at the time the payment obligation arises (see Section 8.5.4.3 for a more detailed discussion of how a lessee should account for such incentives).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.