Chapter 6 — Lease Payments
Chapter 6 — Lease Payments
6.11.1 Payment Made by a Lessor to a Lessee
to Induce Early Termination of a Lease
6.11.2 “Key Money” Payment Made to an
Existing Lessee to Assume a Lease
6.1 General
To determine the appropriate lease classification and measure a lessee’s ROU
asset and lease liability and a lessor’s net investment in the lease at lease
commencement, lessees and lessors, respectively, must determine the lease payments
related to the use of the underlying asset during the lease term. Lease payments are
determined after the lease term has been established (see Chapter 5). This determination will include an
assessment of any payments during renewal periods for which exercise is deemed
reasonably certain. The graphic below depicts the types of payments that are and are not
included in the calculation of the lease payments at lease commencement.
Connecting the Dots
Lease Payments May Be an Allocated
Amount
As discussed in Chapter 4, once an entity determines that a contract contains a lease, the entity must identify and separate the lease and nonlease components in the contract. While this process for lessees differs slightly from that for lessors, in both cases the total consideration in the contract must be measured and allocated to the lease and nonlease components by maximizing the use of observable inputs. ASC 842-10-30-5 indicates that lease payments are amounts related to the use of the underlying asset (i.e., the lease component(s) in the contract). Therefore, when nonlease components are present, the lease payments are the consideration in the contract that is allocated to the lease component(s) rather than the total consideration in the contract.
Example 6-1
Company L (the lessee) enters into an arrangement to lease a building for 10
years. As part of the arrangement, the lessor is
required to provide CAM services for the 10-year lease
term. In exchange for the right to use the building and
obtain the CAM services, L will make fixed monthly
payments of $5,000. Company L concludes that the right
to use the building and the CAM are separate lease and
nonlease components in the contract, respectively, for
which the consideration in the contract should be
allocated on a stand-alone price basis. The stand-alone
price of the monthly building lease and CAM is $4,750
and $500, respectively.
The following table illustrates the allocation of the monthly contractual consideration of $5,000 between the lease and nonlease components in the contract.
Company L’s monthly lease payments are equal to $4,525, which is the amount allocated to the lease component of the contract. The $475 monthly amount allocated to the nonlease component (i.e., the CAM service) is not included in L’s lease payments.
For additional information on separating lease and nonlease components and allocating the consideration in the contract to those components, see Chapter 4.
Changing Lanes
Treatment of Executory Costs
Under ASC 840, some lessees may have determined that the definition of minimum
lease payments included “executory costs such as insurance, maintenance, and
taxes to be paid by the lessor, including any profit thereon” (although
executory costs may have been excluded from classification, measurement, or
disclosure — for example, in accordance with ASC 840-10-25-1(d)). See Q&As 16-1 and 16-2A for additional discussion.
Under ASC 842, an entity needs to distinguish between lease and nonlease
components in accounting for payments made for insurance, maintenance, and taxes
as part of a lease contract. Components for separate services, such as CAM,
represent a nonlease component in the contract to which a portion of the
consideration is allocated. (See Section 4.3.1 for detailed
discussion of nonlease components.) However, in other cases, such as
reimbursements of lessor costs, no good or service is transferred to the
customer and, accordingly, such payments do not represent a lease or nonlease
component in the contract (e.g., insurance and taxes). (See Section 4.3.2
for detailed discussion of “noncomponents.”) In such cases, no portion of the
consideration is allocated to items that do not transfer a good or service to
the customer (i.e., to the noncomponents). See Chapter 4 for further discussion
of separating lease and nonlease components and allocating the consideration in
the contract.
Example 6-2
Company L (the lessee) enters into an arrangement to lease a
building for 10 years. As part of the arrangement, the lessor is
required to provide CAM services for the 10-year lease term. In
exchange for the right to use the building and obtain the CAM
services, L will make fixed monthly payments of $5,000. In
addition, L agrees to pay the lessor a fixed monthly payment of
$300, which is intended to reimburse the lessor for its property
taxes and insurance for the building. The stand-alone price of
the monthly building lease and CAM is $5,050 and $500,
respectively.
Under ASC 840, the fixed monthly payment of $300 to reimburse the
lessor for its property taxes and insurance would not be
included in the measurement of minimum lease payments.
Under ASC 842, the property taxes
and insurance on the building do not represent a lease or
nonlease component in the contract. Therefore, the related fixed
monthly payment of $5,300 should be allocated between the lease
(i.e., building) and nonlease (i.e., CAM) components in the
contract, as shown in the following table:
6.1.1 Including Noncash Consideration in Lease Payments
Some leases require the lessee to make some or all of the lease
payments with noncash consideration. For example, a lessee could be required to
provide value in the form of hard assets, stock of the lessee or others, or
guarantees of certain of the lessor’s obligations.
An entity generally should include noncash consideration in its
determination of lease payments and should measure such consideration at fair
value at lease commencement. That is, we believe that the fair value of the
noncash consideration would generally be akin to an index or rate, which is
included in lease payments at commencement.1 Any fluctuations in the fair value of noncash consideration to be provided
between the initial measurement of the ROU asset and liability, or the net
investment in the lease, and the final measurement determined in accordance with
other U.S. GAAP should be recognized as variable lease income or expense. For
noncash consideration in the form of a guarantee (other than a residual value
guarantee and a guarantee of the lessor’s debt, the latter of which is discussed
below), the amounts accrued and ultimately paid under the guarantee would not be
considered variable lease payments. Rather, the providing of
the guarantee is the lease payment because the lessee has delivered its
stand-ready obligation under the guarantee.
Note, however, that a guarantee of the lessor’s debt is outside
the scope of lease payments.2
Example 6-3
Company A provides Company B with
materials and labor needed to build a tavern, and A has
agreed to lease the tavern from B at the end of the
construction period. Company A does not control the
asset under construction.3 The fair value of the materials and labor
provided to B should be recognized by A as a prepaid
lease payment and should be included in the measurement
of the ROU asset at lease commencement.
Example 6-4
Company X (the lessee) enters into an
arrangement to lease an aerosol can factory from Company
Y (the lessor) for three years. As consideration for the
right to use the aerosol can factory, X agrees to
transfer to Y 50, 60, and 70 shares of stock in Company
Z, in arrears each year, respectively. As of lease
commencement, the fair value per share of Z’s stock is
$20. Company X uses its incremental borrowing rate of 9
percent when discounting the lease payments since the
rate implicit in the lease is not known.
In accordance with the lease
classification tests (for lessees and lessors) under ASC
842-10-25-2(d), the lease payments should include the
three payments made in shares of Z’s stock. Assume that
the lease is an operating lease. The lessee’s lease
obligation should be measured at $3,009.4 Further assume that the fair value of the stock at
the end of year 1 of the lease (transfer date of the 50
shares) is $25 per share. The lessee should recognize
the incremental fair value not included in the lease
liability as a variable lease cost (i.e., $250, which
represents 50 shares multiplied by the increase in the
value of the stock since lease commencement). However,
the shares to be delivered in years 2 and 3 should not
be adjusted to their fair value at the end of year 1
because the fair value of the stock is an index or rate
that is not adjusted after lease commencement unless the
lease is remeasured for other reasons.
6.1.2 Security Deposits
Certain leasing arrangements may include a security deposit that
must be paid to the owner of the leased asset at or before lease commencement.
The security deposit is generally provided to support the lessee’s intent and
commitment to lease the underlying asset (i.e., upon receipt of a security
deposit, the lessor typically stops marketing the asset for lease).
ASC 842-10 defines lease payments with respect to identifying the types of
payments that an entity should consider when determining the classification,
initial measurement, and subsequent measurement of a lease. Specifically, ASC
842-10-30-5 states, in part:
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).
Security deposits can be either nonrefundable or refundable depending on the
terms of the contract, which affects whether such deposits are considered lease
payments.
6.1.2.1 Nonrefundable Deposits
A nonrefundable deposit is an amount the lessee pays the
lessor to secure the terms of the contract for both parties. This payment
represents a portion of the consideration to be transferred during the
contract term and is not refunded by the lessor. Because the payment to the
lessor is nonrefundable, it is considered a fixed payment under ASC
842-10-30-5. See Section 6.2 for further discussion of fixed lease payments.
6.1.2.2 Refundable Deposits
A refundable security deposit is an amount that the lessee
is required to submit to the lessor to protect the lessor’s interest in the
contract and the property. The lessor holds this amount until the occurrence
of an event that would allow it to use some or all of the deposit to meet
the contract requirements (e.g., use the deposit to recover any shortfall in
the lessee’s payment or to repair any damages to the leased property). In
the absence of such a need, the lessor would generally be required under the
contract to return the remaining, unused security deposit to the lessee at
the end of the lease. Because the payment is refundable, it would not meet the definition of a lease payment.
Note that when the lessor recovers a portion of a refundable
security deposit to recover a shortfall in a lease payment, the lessor would
effectively be settling a portion of the lease liability associated with the
missed payment. In contrast, any portion of the refundable security deposit
retained by the lessor for other reasons (e.g., excess wear and tear on the
underlying asset) would generally be considered a variable lease payment.5 As with other variable payment requirements, lessees should consider
the implementation guidance in ASC 842-20-55-1 and 55-2 when evaluating
whether a lessee should recognize costs from variable payments before the
achievement of a specified target (see Section 8.4.3.3.1).
In addition, to the extent that the arrangement provides for
interest to be earned on the deposit, any interest earned on the refundable
security deposit that the lessee forgoes (i.e., that the lessor is entitled
to retain) should be considered a variable lease payment.
Footnotes
1
See ASC 842-10-30-5(b), reproduced in Section 6.3.
2
See ASC 842-10-30-6(b), reproduced in Section
6.9.2.
3See ASC 842-40-55-3 through
55-6.
4
Calculated as the sum of the
present value of the lease payments — $1,000 ($20
× 50 shares) paid at the end of year 1, $1,200
($20 × 60 shares) paid at the end of year 2, and
$1,400 ($20 × 70 shares) paid at the end of year 3
— discounted at 9 percent.
5
ASC 842 defines variable lease payments as
“[p]ayments made by a lessee to a lessor for the right to use an
underlying asset that vary because of changes in facts or
circumstances occurring after the commencement date, other than the
passage of time.” Therefore, any portion of a refundable security
deposit that is retained by a lessor because of changes in facts and
circumstances after the lease commencement date represents a
variable lease payment and should be recognized as an expense from
the lessee’s perspective and as income in profit or loss from the
lessor’s perspective in the period when incurred (lessee) or earned
(lessor).
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)
Connecting the Dots
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).
6.3 Variable Lease Payments That Depend on an Index or a Rate
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:
. . .
b. Variable lease payments that depend on an
index or a rate (such as the Consumer Price Index
or a market interest rate), initially measured
using the index or rate at the commencement date.
. . .
ASC 842-10 — Glossary
Variable
Lease Payments
Payments made by a lessee to a
lessor for the right to use an underlying asset
that vary because of changes in facts or
circumstances occurring after the commencement
date, other than the passage of time.
Leases frequently contain terms that revise or
reset the amounts payable to the lessor over the
lease term. Those adjustments to the amounts
payable to the lessor are described in ASC 842 as
variable lease payments. Generally, ASC 842
differentiates between two categories of
variability in lease payments:
-
Variability based on an index or rate (e.g., escalators based on the CPI, or rents that are referenced to or are increased on the basis of SOFR).6
-
Other variability, including variability that is typically described as based on performance or usage of the asset (e.g., rents based on the percentage of retail store sales or on mileage driven in a leased car).
ASC 842 requires only that limited types of
variable payments be included in the lease
payments that will affect the lease classification
and measurement. Specifically, ASC 842-10-30-5
states that “[a]t the commencement date, the lease
payments shall consist [in part] of the following
payments relating to the use of the underlying
asset during the lease term”:
b. Variable lease payments that depend on an
index or a rate (such as the Consumer Price Index
or a market interest rate), initially measured
using the index or rate at the commencement date.
In addition, ASC 842-10-30-6 explicitly states
that “[l]ease payments do not include [v]ariable
lease payments other than those in paragraph
842-10-30-5(b).”
Paragraph BC211 of ASU 2016-02
states the following regarding the FASB’s decision
to include variable lease payments that depend on
an index or a rate in the lease payments:
For reasons similar to those for
including in substance fixed payments in the
measurement of lease assets and lease liabilities,
the Board also decided to include variable lease
payments that depend on an index or a rate in the
measurement of lease assets and lease liabilities.
Those payments meet the definition of assets (for
the lessor) and liabilities (for the lessee)
because they are unavoidable (that is, a lessee
has a present obligation to make, and the lessor
has a present right to receive, those lease
payments). Any uncertainty, therefore, relates to
the measurement of the asset or liability that
arises from those payments and not to the
existence of the asset or liability.
See Section 6.2.1
for information about in-substance fixed payments.
An entity should include
variable lease payments that depend on an index or
a rate in its lease payments on the basis of the
spot index or rate at lease commencement.
In their initial proposals,
the boards suggested that a lessee should
remeasure variable lease payments that depend on
an index or a rate whenever there is a change in
contractual cash flows (e.g., a change in the
CPI). However, as explained in paragraph BC236 of
ASU 2016-02, some respondents “indicated concerns
about the cost of performing reassessments and
questioned whether the benefits for users of
financial statements would justify the costs for
preparers.” During redeliberations, the FASB
agreed that the benefits of requiring lessees to
remeasure variable lease payments upon changes in
contractual cash flows would not outweigh the cost
of performing the remeasurement. Consequently, as
stated in paragraph BC237 of ASU 2016-02, the FASB
decided that a lessee only “should
remeasure variable lease payments that depend on
an index or a rate when the lessee remeasures the
lease liability for another reason.”7 See Sections
6.3.2 and 6.10 for
additional guidance on the remeasurement of
variable lease payments that depend on an index or
a rate.
6.3.1 Initial Measurement of a Lease When There Are Variable Payments Based on an Index or Rate
The FASB included Example 25,
Case A, in ASC 842-10-55-226 through 55-231 to illustrate the requirements related to
measuring variable payments that depend on an index or a rate.
ASC 842-10
30-8 See
Example 25 (paragraphs 842-10-55-225 through
55-234) for an illustration of the requirements on
lessee accounting for variable lease payments . .
. .
55-225
Example 25 illustrates how a lessee accounts for
variable lease payments that depend on an index or
a rate . . . .
Example 25 — Variable Lease
Payments That Depend on an Index or a Rate . . .
Case A — Variable Lease
Payments That Depend on an Index or a Rate
55-226 Lessee
enters into a 10-year lease of a building with
annual lease payments of $100,000, payable at the
beginning of each year. The contract specifies
that lease payments for each year will increase on
the basis of the increase in the Consumer Price
Index for the preceding 12 months. The Consumer
Price Index at the commencement date is 125. This
Example ignores any initial direct costs. The
lease is classified as an operating lease.
55-227 The
rate implicit in the lease is not readily
determinable. Lessee’s incremental borrowing rate
is 8 percent, which reflects the rate at which
Lessee could borrow an amount equal to the lease
payment in the same currency, over a similar term,
and with similar collateral as in the lease.
55-228 At the
commencement date, Lessee makes the lease payment
for the first year and measures the lease
liability at $624,689 (the present value of 9
payments of $100,000 discounted at the rate of 8
percent). The right-of-use asset is equal to the
lease liability plus the prepaid rent
($724,689).
55-229 Lessee
prepares financial statements on an annual basis.
Lessee determines the cost of the lease to be $1
million (the total lease payments for the lease
term). The annual lease expense to be recognized
is $100,000 ($1 million ÷ 10 years).
55-230 At the
end of the first year of the lease, the Consumer
Price Index is 128. Lessee calculates the payment
for the second year, adjusted to the Consumer
Price Index, to be $102,400 ($100,000 × 128 ÷
125).
55-231
Because Lessee has not remeasured the lease
liability for another reason, Lessee does not make
an adjustment to the lease liability to reflect
the Consumer Price Index at the end of the
reporting period; that is, the lease liability
continues to reflect annual lease payments of
$100,000 (8 remaining annual payments of $100,000,
discounted at the rate of 8 percent is $574,664).
However, the Year 2 payment amount of $102,400
(the $100,000 annual fixed payment + $2,400
variable lease payment) will be recognized in
profit or loss for Year 2 of the lease and
classified as cash flow from operations in
Lessee’s statement of cash flows. In its
quantitative disclosures, Lessee will include
$100,000 of the $102,400 in its disclosure of
operating lease cost and $2,400 in its disclosure
of variable lease cost.
A lessee’s8 initial measurement of its lease liability and ROU asset should be determined on the
basis of the lease payments, which, as stated in ASC 842-10-30-5(b), include “[v]ariable
lease payments that depend on an index or a rate (such as the Consumer Price Index or a
market interest rate).” An entity initially measures variable payments based on an index
or rate by using the index or rate at lease commencement (i.e., the spot or gross index or
rate applied to the base rental amount). The use of the spot rate at lease commencement is
largely based on the FASB’s view that (1) the cost associated with forecasting future
rates would outweigh the benefits provided and (2) the use of forecasted rates or indexes
would be inconsistent among preparers and often imprecise.
In contrast, payments based on
a change in an index or a rate should
not be considered in the determination of
lease payments. Given the cost-benefit
considerations related to the use of forecasting
techniques, ASC 842 does not allow an entity to
forecast changes in an index or rate to determine
lease payments. Rather, adjustments to lease
payments that are based on a change in an index or
rate are treated as variable lease payments and
recognized in the period in which the obligation
for those payments was incurred (as illustrated in
Example 25, Case A, in ASC 842-10-55-226 through
55-231, reproduced above).
For example, assume that lease
payments are made in arrears and are based on a
fixed amount (e.g., a $100,000 base amount)
adjusted each year by SOFR at the end of the year.
If SOFR at lease commencement was 2.7 percent, the
total lease payments used to measure the lease
liability would be $102,700 per year of the lease,
which includes $2,700 in variable lease payments
based on an index or rate at lease commencement.
In contrast, if the payments were based on a fixed
amount ($100,000) that will subsequently be
adjusted in a manner corresponding to the
change in SOFR each year throughout the
lease term, the initial measurement of the lease
liability and ROU asset would not take into
account the future expected adjustments in SOFR.
Therefore, the initial measurement of the lease
liability and ROU asset would be based only on the
fixed payments through the lease term (see the
example below).
Example 6-12
A retailer enters into a lease
of a retail space for five years with the
following terms:
The first lease payment was
made on January 1. Each subsequent payment is made
on December 31. There were no initial direct costs
or lease incentives. The lessee recognizes total
lease expense and measures the lease liability and
ROU asset in the manner shown in the table below
(also see Chapter 8 for a
detailed discussion of the lessee accounting
requirements).
6.3.2 Subsequent-Measurement Implications of Index- or Rate-Based Payment Adjustments
The subsequent remeasurement
of a lease depends on whether the variability is
associated with an index or rate or arises for
other reasons. Specifically, ASC 842-10-35-4 and
35-5 require, in part, the following:
35-4 A
lessee shall remeasure the lease payments if any
of the following occur:
-
The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
-
A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term. However, a change in a reference index or a rate upon which some or all of the variable lease payments in the contract are based does not constitute the resolution of a contingency subject to (b) (see paragraph 842-10-35-5 for guidance on the remeasurement of variable lease payments that depend on an index or a rate).
-
There is a change in any of the following:
-
The lease term, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments on the basis of the revised lease term.
-
The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option.
-
Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees.
-
35-5 When one or more of the events described
in paragraph 842-10-35-4(a) or (c) occur or when a
contingency unrelated to a change in a reference
index or rate under paragraph 842-10-35-4(b) is
resolved, variable lease payments that depend on
an index or a rate shall be remeasured using the
index or rate as of the date the remeasurement is
required. [Emphasis added]
A lessee would not be required
to remeasure a lease solely because of changes in
an index or rate. On the basis of discussions with
the FASB staff9 and of ASU 2018-10
on Codification improvements to ASC 842, we
understand that the guidance on remeasuring a
lease liability after the resolution of a
contingency is not meant to apply to index-based
escalators even when those escalators serve to
establish a new floor for the next lease payment.
Therefore, even when the index or rate establishes
a new floor (such as when the CPI increases and
establishes a new rate that will be used as a
benchmark for determining future lease payment
increases), that adjustment would not result in a
remeasurement of the lease liability as variable
lease expense and of the ROU asset. As a result,
the additional payments for increases in the CPI
will be recognized in the period in which they are
incurred.
However, as highlighted in ASC
842-10-35-5, if a lessee remeasures the lease
payments for any of the other reasons detailed in
ASC 842-10-35-4, the lessee is required to
remeasure variable lease payments that depend on
an index or rate by using the index or rate in
effect on the remeasurement date.
Bridging the GAAP
Lease
Payments Based on an Index or Rate
While ASC 842 and IFRS 16 are
generally converged with respect to the
recognition and measurement of variable lease
payments, there is a notable difference. Under
IFRS 16, for lease payments based on an index or
rate, the lease liability and ROU asset are
remeasured when there is a change in cash flows as
a result of a change in the index or rate.
Therefore, entities that are subject to dual
reporting under both U.S. GAAP and IFRS Accounting
Standards (e.g., a parent entity that applies U.S.
GAAP and has international subsidiaries applying
IFRS Accounting Standards for statutory reporting)
will be required to account for their leases under
two different remeasurement models.
CPI and market interest rates
are explicitly noted as examples of indexes and
rates that should be considered in accordance with
ASC 842-10-30-5(b). However, IFRS 16, which is
converged with ASC 842 with respect to the initial
measurement of variable lease payments that depend
on an index or rate, also includes “payments that
vary to reflect changes in market rental rates” as
an additional example of variable payments that
depend on an index or rate.
The next section discusses our
interpretation under ASC 842 of the applicability
of ASC 842-10-30-5(b) to variable payments based
on fair market rental rates.
6.3.3 Rents Based on Market Rates
Some lease agreements
(typically real estate leases) include variability
in the form of a rent reset provision that
requires the future lease payments after a
specified point in time to be reset to the fair
market rental rates at that time. For example, a
10-year lease of property in Chicago that requires
annual rental payments of $100,000 for years 1–5
may also include a provision to reset the rental
payments in years 6–10 of the lease to the updated
fair market rent as benchmarked to published rates
for Chicago.
Such a fair market rent reset
feature should be accounted for in accordance with
the guidance on variable payments that are based
on an index or rate.
Paragraph BC211 of ASU 2016-02
states the FASB’s rationale for including certain
variable lease payments that depend on an index or
rate in the measurement of the lease liability and
ROU asset:
For reasons similar
to those for including in substance fixed payments
in the measurement of lease assets and lease
liabilities, the Board also decided to include
variable lease payments that depend on an index or
a rate in the measurement of lease assets and
lease liabilities. Those payments meet the
definition of assets (for the lessor) and
liabilities (for the lessee) because they are
unavoidable (that is, a lessee has a present
obligation to make, and the lessor has a present
right to receive, those lease payments). Any
uncertainty, therefore, relates to the measurement
of the asset or liability that arises from those
payments and not to the existence of the asset or
liability.
While ASC 842 does not define
“index” or “rate,” we believe that an index or
rate is based on underlying economic performance
(e.g., the CPI measures the variation in prices
paid by a consumer household for certain retail
goods and services). Similarly, fair market rent
is indicative of the economic performance of a
specific geographic region and is analogous to a
formally published index or rate. Further, the
FASB and IASB converged certain aspects of their
guidance on leases, including the treatment of
payments subject to market rate resets as lease
payments that vary on the basis of an index or
rate. Paragraph 28 of IFRS 16 explicitly states
that a variable payment that is based on an index
or rate would include, among other things,
“payments that vary to reflect changes in fair
market rental rates.”
Since variable payments based
on fair market rental rates were determined to be
analogous to variable payments based on an index
or rate, we believe that the specific guidance on
variable payments based on an index or rate (see
Sections
6.3.1 and 6.3.2) should be applied to variable
payments based on fair market rental rates
(including those based on the fair market value of
the underlying asset). Accordingly, a lessee
should measure the lease liability and ROU asset
and a lessor should measure the net investment in
the lease on the basis of the fair market rental
rate in effect at lease commencement. The lessee’s
lease liability and ROU asset and the lessor’s net
investment in the lease would not be remeasured as
a result of any subsequent change in the fair
market rental rate (although remeasurement could
be required for another reason); such a change
would be recorded as variable lease expense or
income, respectively, in the appropriate period
depending on the change in the fair market rental
rate.
Footnotes
6
Note that an index or rate for these purposes
does not include tax rates such as sales tax or
VAT rates.
7
The IASB decided not to limit
the remeasurement of variable lease payments that
depend on an index or a rate to situations in
which the lessee remeasures the lease liability
for another reason. Rather, IFRS 16 requires
lessees to remeasure variable lease payments that
depend on an index or a rate whenever there is a
change in contractual cash flows (e.g., changes in
the CPI). See Appendix B for a
summary of differences between ASC 842 and IFRS
16.
8
While this discussion specifically focuses on the consideration of
variable payments based on an index or a rate when a lessee initially measures its
lease liability and ROU asset, the concept would similarly apply when a lessor
initially measures its net investment in a sales-type or direct financing lease.
9
In July 2018, the FASB issued
ASU
2018-10, which makes Codification
improvements to ASC 842 and amends ASC
842-10-35-4(b) and ASC 842-10-35-5 to clarify that
changes in an index or rate alone would not give
rise to a requirement to remeasure the lease. See
Section 17.3.1.3 for further
discussion of the ASU.
6.4 Exercise Price of a Purchase Option Reasonably Certain to Be Exercised
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: . . .
c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to
exercise that option (assessed considering the factors in paragraph 842-10-55-26). . . .
When calculating the lease payments, the lessee and the lessor should consider
whether the lessee has the option of purchasing the leased asset and, if so, the likelihood
that the lessee will exercise the purchase option. (See Section 5.3 for a discussion of the effect of this
assessment on the lease term.) If it is reasonably certain that the lessee will exercise its
option of purchasing the leased asset, the lease payments should include the exercise price
of the purchase option. This assessment is consistent with the evaluation of the lease
classification criterion in ASC 842-10-25-2(b)10 and is based on the economic factors in ASC 842-10-55-26 for determining whether a
lessee is reasonably certain to exercise an option. Such factors include:
-
Contract-based factors (e.g., the terms and conditions of a purchase option in the contract).
-
Asset-based factors (e.g., impact of significant leasehold improvements).
-
Market-based factors (e.g., costs associated with exercising the purchase option versus separately buying a similar asset or entering into a new lease for a similar asset).
-
Entity-based factors (e.g., the lessee’s intent and past experience with exercising purchase options).
A lessee should remeasure its lease payments when there is a change in the
assessment of whether the lessee is reasonably certain to exercise its purchase option in
accordance with ASC 842-10-35-1. However, the lessor would not remeasure its lease payments
in such circumstances. See Section
6.10 for more information about the requirements for lessees and lessors to
remeasure lease payments. The example below illustrates the effect of purchase options on
lease payments.
Example 6-13
Company S (lessee) enters into an arrangement to lease a building for 10 years
in exchange for fixed annual payments of $100,000. At the end of the 10-year
lease term, S has the option of purchasing the building for $326,000.
Case A — Company S Is Reasonably Certain to Exercise Its
Purchase Option
On the basis of the factors outlined in ASC 842-10-55-26, S has concluded that it is reasonably certain to exercise its purchase option. Therefore, the lease payments are equal to $1,326,000 ($100,000 per year multiplied by 10 years plus the $326,000 purchase price of the building).
Case B — Company S Is Not Reasonably Certain to Exercise
Its Purchase Option
If S determines that it is not reasonably certain to exercise its purchase option, it would not include the $326,000 purchase price in its lease payments. Rather, the lease payments would only consist of $1,000,000 ($100,000 per year multiplied by 10 years).
Footnotes
10
ASC 842-10-25-2(b) requires that a lease be classified as a finance
lease (lessee) or sales-type lease (lessor) if the lease grants the lessee an option of
purchasing the underlying asset and it is reasonably certain that the lessee will
exercise that option.
6.5 Penalties for Terminating a Lease
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: . . .
d. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease. . . .
As discussed in Chapter
5, the lease term includes any periods
covered by an option of terminating the lease if
it is reasonably certain that the lessee will
not exercise that option. In a manner
consistent with the determination of the lease
term, the lease payments would not include a
termination penalty if it is reasonably certain
that the lessee will not exercise that termination
option. However, if it is not reasonably certain
that the lessee will not terminate the lease, the
term would not include the
period past the termination date and the lease
payments would include any
related termination penalty.
The same treatment would apply to renewal options. That is, to the extent that a
lessee exercising a renewal option would be
required to pay a renewal fee, the lease payments
would include the renewal fee if it is reasonably
certain that the lessee will exercise the renewal
option. Conversely, the lease payments would not
include the renewal fee if it is not reasonably
certain that the lessee will exercise the renewal
option.
The FASB included Example 26 in ASC 842-10-55-235 through 55-238 to illustrate
the impact of termination penalties on lease payments.
ASC 842-10
30-8 . . . Example 26 (paragraphs 842-10-55-235 through 55-238) for an illustration of the requirements on
termination penalties.
55-235 Example 26 illustrates how a lessee accounts for termination penalties.
Example 26 — Termination Penalties
55-236 Lessee enters into a
10-year lease of an asset, which it can terminate
at the end of each year beginning at the end of
Year 6. Lease payments are $50,000 per year during
the 10-year term, payable at the beginning of each
year. If Lessee terminates the lease at the end of
Year 6, Lessee must pay a penalty to Lessor of
$20,000. The termination penalty decreases by
$5,000 in each successive year.
55-237 At the commencement date, Lessee concludes that it is not reasonably certain it will continue to
use the underlying asset after Year 6, having considered both the significance of the termination penalty (in
absolute terms and in relation to the remaining lease payments after the date the termination option becomes
exercisable) and the other factors in paragraph 842-10-55-26.
55-238 Accordingly, Lessee determines that the lease term is six years. At the commencement date, Lessee
measures the lease liability on the basis of lease payments of $50,000 for 6 years plus the penalty of $20,000
payable at the end of Year 6.
6.6 Fees Paid by the Lessee to Owners of Special-Purpose Entities
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: . . .
e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d). . . .
In the case of SPEs, lease payments should include any amounts paid by the
lessee to the owners of the SPE for structuring
the transaction. Although these fees are included
in the lease payments, the fees should be excluded
from the calculation of the fair value of the
underlying asset in the determination of the
appropriate lease classification under ASC
842-10-25-2(d).
Example 6-14
Lessor LLC (a VIE) holds a single real estate asset that it leases to Lessee.
The lease contains a residual value guarantee (see the next
section). Lessee accounts for the lease as an operating
lease. Further, Lessee has a variable interest in Lessor LLC
through the residual value guarantee.
Although Lessee has a variable interest, Lessor LLC is consolidated by REIT, which is the primary beneficiary of Lessor LLC. REIT is in the business of owning real estate and leasing it to tenants as a source of financing. Lessor LLC was created by REIT to own the specific underlying real estate. REIT charges Lessee certain fees as compensation for the initial setup costs of Lessor LLC.
The lease payments should include the fees charged to Lessee by REIT for structuring the transaction.
6.7 Amounts That It Is Probable That the Lessee Will Owe Under a Residual Value Guarantee
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: . . .
f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).
ASC 842-10 — Glossary
Residual Value Guarantee
A guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount.
ASC 842-10
55-34 A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is similar to variable lease payments in that the amount is not determinable at the commencement date. Such a provision does not constitute a lessee guarantee of the residual value.
55-35 If the lessor has the right to require the lessee to purchase the underlying asset by the end of the lease term, the stated purchase price is included in lease payments. That amount is, in effect, a guaranteed residual value that the lessee is obligated to pay on the basis of circumstances outside its control.
If a lease contract contains a provision under which the lessee guarantees to the lessor the residual value of the leased asset at the end of the lease term, the lessee should include in its lease payments the amount that it is probable that the lessee will owe at the end of the lease term. Paragraph BC214 of ASU 2016-02 explains the FASB’s rationale for requiring lessees to include in their lease payments amounts that it is probable that the lessee will owe under residual value guarantees:
In the Board’s view, payments probable of being owed under residual value guarantees meet the definition of a liability and are part of the cost of the right-of-use asset and, thus, should be recognized and measured as part of the lease liability and the right-of-use asset. That is because those payments cannot be avoided by the lessee — the lessee has an unconditional obligation to pay the lessor if the market price of the underlying asset moves in a particular way. Accordingly, any uncertainty does not relate to whether the lessee has an obligation. Instead, it relates to the amount that the lessee may have to pay, which can vary on the basis of movements in the market price for the underlying asset. In that respect, residual value guarantees are similar to variable lease payments that depend on an index or a rate for the lessee.
A lessee should remeasure its lease payments when there is a change in the
amount that it is probable that the lessee will owe under a residual value
guarantee. However, a lessor would not remeasure its lease payments in such
circumstances. See Section
6.10 for more information about the requirements for lessees and
lessors to remeasure lease payments.
Connecting the Dots
Requirements Related to Residual Value Guarantees for Lessees Differ
From Those for Lessors
The requirement to include a portion of any residual value guarantee in the
lease payments applies only to lessees. Although the guidance states that a
lessor should not include any residual value guarantee amounts in its lease
payments, the lessor would initially measure residual value guarantee
amounts because, in accordance with ASC 842-30-30-1(a), a lessor would
include in its lease receivable the full amount at which the residual asset
is guaranteed by the lessee (or a third party). (See Chapter 9 for more
information about how to calculate a lessor’s lease receivable.) In
addition, a lessor would consider the full amount at which the residual
asset is guaranteed when classifying a lease in accordance with ASC
842-10-25-2(d) and ASC 842-10-25-3(b). The example below illustrates how the
accounting for a residual value guarantee for lessees differs from that for
lessors.
Example 6-15
A lessor leases equipment to a lessee for five years at $10,000 per year. The lessee guarantees that the equipment will have a residual value of at least $9,000 at the end of the lease. The expected residual value at the end of the lease term is $20,000.
Lessee Accounting
In its lease payment calculation, the lessee would only include the amount that it is probable that the lessee will owe under the residual value guarantee at the end of the lease term. Accordingly, the lessee would not include any amount in the initial measurement of the lease liability and ROU asset, because the expected residual value ($20,000) is greater than the guaranteed amount ($9,000). If the expected residual value was $8,000 instead of $20,000, the lessee would include the $1,000 difference between the expected residual value and the guaranteed residual value in its lease payments.
Lessor Accounting
The lessor would not include any amount of the residual value guarantee in its lease payment calculation. However, if the lease were classified as a sales-type lease or a direct financing lease in measuring its lease receivable, the lessor would include the entire portion of the residual asset guaranteed by the lessee (or any other party). Accordingly, in addition to the present value of the five annual lease payments of $10,000, the lessor would include the present value of the $9,000 guaranteed amount in its calculation of the lease receivable. The lessor’s net investment in the lease would consist of the total receivable (including the residual value guarantee) and the present value of the unguaranteed residual asset of $11,000.
Changing Lanes
Full Amount of Residual Value Guarantee Versus Amount That It Is
Probable That the Lessee Will Owe in Lease Payments
Under ASC 840, a lessee included in its minimum lease payments the entire amount
of the residual value guarantee; however, under ASC 842, a lessee only
includes in its lease payments those amounts that it is probable that the
lessee will owe under the residual value guarantee at the end of the lease
term. As a result, a lower ROU asset and lease liability will generally be
recognized on the lessee’s balance sheet for new leases under ASC 842
compared with situations in which that lease was classified as a capital
lease under ASC 840.
However, with respect to performing the lease classification test in ASC 842-10-25-2(d), we do not expect a difference between ASC 840 and ASC 842 because ASC 842-10-25-2(d) requires a lessee to include the full amount of any residual value guarantee, regardless of whether it is probable that the amount will be owed. (See Section 8.3.3.6 for a detailed discussion of a lessee’s application of the classification criterion in ASC 842-10-25-2(d).) This is consistent with the requirement under ASC 840 for the lessee to include the full amount of any residual value guarantee in its minimum lease payments when performing the lease classification test.
Entities should also consider whether the lessee has guaranteed the residual
value for a group of leased assets when performing the lease classification test in
ASC 842-10-25-2(d). Lessees often enter into lease agreements to lease multiple
similar assets from a lessor. In these circumstances, lessees will often guarantee
the residual value for the group of assets being leased rather than that for each
individual underlying asset. Lessees should take into account the impact of the
portfolio residual value guarantee (PRVG) when classifying the individual leases
within a portfolio. Depending on the facts and circumstances, lessees should use
either an “all-in approach” or a “pro-rata approach” to allocate the PRVG when
classifying a lease. See Section
8.3.3.6.1 for further discussion of the impact of PRVGs on lessees
and an example illustrating application of the all-in approach and pro rata
approach. In addition, we believe that, in certain circumstances, lessors may take
into account the impact of PRVGs when classifying the individual leases within a
portfolio. See Section
9.2.1.4.4 for further discussion of the impact of PRVGs on
lessors.
Connecting the Dots
Synthetic Lease Arrangements
As discussed above, under ASC 842, a lessee would include in its lease payments
only those amounts related to a residual value guarantee that it is probable
that the lessee will owe at the end of the lease term. Lease arrangements (e.g.,
synthetic lease arrangements) in which a significant portion of the lease
payments is structured as a residual value guarantee could therefore result in
ROU assets and lease liabilities that are significantly lower than those in
arrangements in which more of the lessee’s obligation takes the form of fixed
rental payments. For example, since many real estate assets are expected to hold
their value over the lease term, amounts that it is probable the lessee will owe
under residual value guarantees may be nominal. Accordingly, while these
arrangements will be brought onto the balance sheet, synthetic leases and other
lease arrangements in which a significant portion of the economics of the lease
are structured as a residual value guarantee may continue to yield favorable
accounting results (e.g., reduced leverage) under the new leasing guidance.
6.7.1 Sales Proceeds in Excess of Residual Value Guarantee
Some lease contracts may include a provision under which the
lessee is entitled to receive any proceeds in excess of the residual amount
guaranteed by the lessee upon the sale of the underlying asset at the end of the
lease term. Sales proceeds in excess of the residual value guaranteed by the
lessee represent a contingent gain for the lessee. Therefore, the lessee should
apply the guidance in ASC 450-30 on gain contingencies in accounting for such
proceeds. ASC 450-30-25-1 precludes an entity from recognizing a gain
contingency in its financial statements until the underlying contingency is
resolved. Accordingly, a lessee should not recognize anticipated excess sales
proceeds as a reduction in lease payments, or as a gain in its income statement,
until the underlying asset is sold and the contingency is resolved.
6.7.2 Residual Value Guarantee Obtained From Unrelated Third Party
ASC 842-10
55-36 A residual value guarantee obtained by the lessee from an unrelated third party for the benefit of the lessor should not be used to reduce the amount of the lessee’s lease payments under paragraph 842-10-30-5(f) except to the extent that the lessor explicitly releases the lessee from obligation, including the secondary obligation, which is if the guarantor defaults, a residual value deficiency must be made up. Amounts paid in consideration for a guarantee by an unrelated third party are executory costs and are not included in the lessee’s lease payments.
To reduce its exposure associated with a residual value guarantee, a lessee may obtain a guarantee from an unrelated third party, such as an insurance company, for part or all of the value of the lessee’s residual value guarantee owed to the lessor.
The residual value guarantee obtained from an unrelated third
party reduces the lessee’s lease payments only if the lessor explicitly releases
the lessee from its obligation under the residual value guarantee provision in
the lease contract between the lessee and lessor. The lessor must release the
lessee not only from its primary obligation but also from any secondary
obligation (i.e., the lessee’s obligation to pay the lessor if the insurance
company defaults on its obligation).
Example 6-16
Lessee K leases equipment from Lessor W
for five years in exchange for a fixed payment of
$10,000 per year. Lessee K guarantees that the equipment
will have a residual value of at least $5,000 at the end
of the lease. To reduce its exposure associated with the
$5,000 residual value guarantee, K obtains a matching
guarantee from an insurance company. Therefore, in the
event that the residual value of the equipment is less
than $5,000 at the end of the lease term, the insurance
company has agreed to pay the lessor the difference. The
expected residual value at the end of the lease term is
$1,000.
Case A — Lessor Does
Not Release the Lessee From Its Obligation
In this case, W does not explicitly
release K from its obligation to pay the residual value
guarantee if the insurance company defaults on its
obligation. Therefore, even though K may not be
primarily obligated to pay the residual value guarantee,
it still has a secondary obligation to W. Lessee K
should not reduce its lease payments for the guarantee
provided by the insurance company because W has not
explicitly released K from its obligations related to
the residual value guarantee. Therefore, K should
include $4,000 in its lease payments, which represents
the amount that it is probable W will be owed at the end
of the lease term ($5,000 guaranteed amount less $1,000
expected residual value).
Case B — Lessor
Fully Releases the Lessee From Its Obligation
In this case, because W has fully
released K from any primary or secondary obligation
related to the residual value guarantee, K should not
include any amounts related to the residual value
guarantee in its lease payments.
In certain situations, a lessee may be obligated by the lessor
or the lease agreement to obtain residual value insurance for the benefit of the
lessor. In such cases, the lessee should include the costs incurred to secure
the third-party guarantee of residual value in its lease payments (e.g., the
amount of the insurance premium needed to obtain the residual value insurance).
These types of costs are similar to payments made to an insurance company in
which the payor does not benefit (i.e., the lessee pays the insurance company
but the lessor is the beneficiary of the policy).
6.8 Costs Imposed to Dismantle and Remove an Underlying Asset at End of Lease Term
ASC 842-10
55-37 . . . In contrast, costs to dismantle and remove an underlying asset at the end of the lease term that are imposed by the lease agreement generally would be considered lease payments or variable lease payments.
A lessee may need to incur certain costs at the end of the lease term so that the lessee may return the asset to the lessor in accordance with the lease agreement. Those costs are generally considered to be either of the following:
- Lease payments, because the costs, which benefit the lessor and not the lessee, are imposed by the lease agreement and incurred to restore functionality of the leased asset or to dismantle or remove the actual underlying asset for return to the lessor (further discussed below).
- Asset retirement obligations in accordance with ASC 410-20, because the costs are incurred to remove lessee installations (e.g., leasehold improvements) so that the lessee may restore the underlying asset to its original condition (see Section 6.9.4).
In certain situations, a lessee may agree to pay for the costs of
removing and returning leased equipment to the lessor at the end of the lease. In
such circumstances, the lessee would be required to include its best estimate of
those costs in the lease payments at lease commencement. For example, for an asset
being leased, such as manufacturing equipment that must be returned to the lessor at
the end of the lease, the amount that the lessee expects to incur to ship or
otherwise return the manufacturing equipment to the lessor would be included in the
lease payments.
Connecting the Dots
Costs of Dismantling and Removing an Underlying Asset
Although costs imposed to dismantle and remove an underlying asset at the end
of the lease term should generally be included in lease payments,
obligations to return an underlying asset to its original condition would
not qualify as lease payments. See Section
6.9.4 for further discussion.
In addition, if the costs will vary on the basis of how much the lessee uses
the asset during the lease term, such costs are considered to be variable
lease payments and therefore are not estimated at lease commencement.
6.9 Amounts Not Considered a Lease Payment
6.9.1 Variable Lease Payments That Do Not Depend on an Index or Rate
ASC 842-10
30-6 Lease payments do not include any of the following:
- Variable lease payments other than those in paragraph 842-10-30-5(b) . . . .
Lease payments should exclude variable lease payments that do not depend on an index or a rate. Common examples of such variable lease payments include payments that depend on the lessee’s performance or use of the underlying asset (i.e., whether a payment will be required is contingent on a future event). Paragraph BC210 of ASU 2016-02 explains that the Board decided to exclude such amounts from the lease payments because “variable [lease] payments contingent on future events (for example, performance or use) do not represent a present obligation of the lessee or a right of the lessor and, therefore, do not meet the definition of an asset or a liability.”
A lessee should remeasure its lease payments when the contingency underlying such variable payments is resolved and, as a result, some (or all) of the remaining payments become fixed for some (or all) of the remaining lease term (e.g., when the underlying asset is used and the payment becomes required and fixed). However, a lessor would not remeasure its lease payments in such circumstances. See Section 6.10 for more information about the requirements for when lessees and lessors remeasure lease payments.
Connecting the Dots
Lessee Financial Statement Impact of Excluding Variable Lease
Payments That Do Not Depend on an Index or a Rate
The Board’s decision to exclude variable lease payments
that do not depend on an index or a rate from lease payments will result
in different accounting outcomes for lessees that have economically
similar transactions with different payment structures (i.e., fixed
lease payments versus variable lease payments that depend on performance
or usage of the underlying asset).
Balance Sheet Impact
As discussed in Chapter 8, the initial measurement
of a lessee’s ROU asset and lease liability includes the present value
of the lease payments. There is a direct correlation between the amount
of the lease payments and the amount that is recorded as the ROU asset
and lease liability on the lessee’s balance sheet. Because a lessee
includes fixed amounts in its lease payments but not variable payments
that depend on something other than an index or a rate, lease contracts
that are structured with fixed lease payments will result in a higher
ROU asset and lease liability than those structured with contingent
rentals.
Income Statement Impact
Under ASC 842, a lessee’s expense recognition pattern
depends on whether the lease is classified as a finance lease or an
operating lease. Lease classification is governed, in part, by the value
of the lease payments compared with the fair value of the underlying
asset (i.e., the higher the lease payments, the more likely that a lease
will be classified by the lessee as a finance lease rather than as an
operating lease). Therefore, lease contracts that are structured with
fixed lease payments may result in a different expense recognition
pattern than lease contracts structured with contingent rentals.
ASC 842-10
55-225 Example 25 illustrates how a lessee accounts for . . . variable lease payments that are linked to performance.
Example 25 — . . . Variable Lease Payments Linked to Performance . . .
Case B — Variable Lease Payments Linked to Performance
55-232 Lessee enters into a 10-year lease of a building with annual lease payments of $100,000, payable at the beginning of each year. The contract specifies that Lessee also is required to make variable lease payments each year of the lease, which are determined as 2 percent of Lessee’s sales generated from the building.
55-233 At the commencement date, Lessee measures the lease liability and right-of-use asset at the same amounts as in Case A (paragraphs 842-10-55-226 through 55-231) because the 2 percent royalty that will be paid each year to Lessor under the lease is a variable lease payment, which means that payment is not included in the measurement of the lease liability (or the right-of-use asset) at any point during the lease.
55-234 During the first year of the lease, Lessee generates sales of $1.2 million from the building and, therefore, recognizes total lease cost of $124,000 ($100,000 + [2% × $1.2 million]). In its quantitative disclosures, Lessee will include $100,000 of the $124,000 in its disclosure of operating lease cost and $24,000 in its disclosure of variable lease cost.
The example below illustrates the accounting for a lease liability and a
corresponding ROU asset in a contract manufacturing arrangement.
Example 6-17
A customer (lessee) enters into a
contract manufacturing arrangement with a supplier
(lessor). The customer has appropriately determined that
the contract manufacturing arrangement meets the
definition of a lease under ASC 842 (see Section
3.2). In this example, assume the
following:
-
The customer has contracted with a supplier for exclusive use of a manufacturing line over a four-year period.
-
The contract establishes a price per unit of product purchased and, periodically throughout the arrangement, the customer issues noncancelable purchase orders to the supplier when the customer wishes to procure manufactured products from the supplier.
-
The purchase order establishes a time frame (e.g., one month, two months) over which the related products will be produced as well as an unconditional obligation for the customer to purchase the products from the supplier.
-
The customer is not required to order a minimum volume of products over the four-year period. However, on the basis of its anticipated orders, the customer expects to use substantially all of the capacity of the supplier’s manufacturing line during the four-year term.
-
The supplier ships manufactured products free on board to the customer’s facility, and the customer is contractually obligated to pay the supplier upon the delivery of products to the customer’s facility.
-
The customer has identified a separate lease component (i.e., the right to use the supplier’s manufacturing line) and nonlease components associated with the arrangement.
In this example, when submitting a noncancelable purchase
order, the customer should establish a lease liability
and ROU asset related to the lease component associated
with the committed purchases (i.e., the committed use of
the manufacturing line during the time frame established
by the purchase order).11
Although, at commencement, all payments in the
arrangement are variable (given the lack of a minimum
purchase quantity in the arrangement), at the time when
the purchase order is issued, the payments related to
the lease component associated with the committed
purchases meet the definition of lease payments since
the contingency upon which the variable lease payments
are based is resolved. At that point, the customer has
an unconditional obligation to purchase products from
the supplier and therefore also has payments that meet
the definition of lease payments in accordance with ASC
842-10-35-4(b), which states, in part:
A contingency
upon which some or all of the variable lease
payments that will be paid over the remainder of the
lease term are based is resolved such that those
payments now meet the definition of lease payments.
For example, an event occurs that results in
variable lease payments that were linked to the
performance or use of the underlying asset becoming
fixed payments for the remainder of the lease
term.
The lessee would then recognize a lease liability and a
corresponding ROU asset. We believe that each individual
purchase order effectively creates fixed payments in the
arrangement, in which the amount of the purchase order
associated with the lease component is the minimum fixed
amount that is owed to the supplier upon delivery of the
manufactured products. Each subsequent purchase order
would trigger another resolution of a contingency in
accordance with ASC 842-10-35-4(b) and, as a result, the
payments associated with the lease component of the
purchase order become lease payments. The lessee thus
recognizes a separate lease liability and a
corresponding ROU asset for the amount allocated to the
lease component for each individual purchase order.
ASC 842 does not provide any clear guidance on the period over which
such an ROU asset should be amortized. Therefore,
various approaches may be acceptable.
The following are two such approaches:
-
Approach 1 — Because the purchase order has a specific production and payment schedule, the lease costs12 should be recognized over the purchase order term. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]We believe that recognition of the costs over the purchase order term is a systematic and rational approach given that the consumption of the benefit associated with the ROU asset (manufacturing line) is directly aligned with the purchase order term. Under this approach, the ROU asset will be fully amortized over the period of the purchase order. This accounting will continue for the remainder of the lease term as each discrete ROU asset is amortized over the production period to which it is related. This approach may be less complex to apply than Approach 2 below and may better reflect the economics of a leasing structure that is based on purchase orders submitted.
-
Approach 2 — Recognize the lease costs over the full remaining lease term. This approach is also consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]Likewise, an entity should recognize lease costs on the basis of whether it has the right to use an asset, not the pattern of use, in accordance with ASC 842-20-55-3, which states:This Subtopic considers the right to control the use of the underlying asset as the equivalent of physical use. If the lessee controls the use of the underlying asset, recognition of lease cost in accordance with paragraph 842-20-25-6(a) or amortization of the right-of-use asset in accordance with paragraph 842-20-35-7 should not be affected by the extent to which the lessee uses the underlying asset.This approach would result in the layering on of each additional ROU asset once a purchase order is issued. For example, on the basis of the facts in the example above, the total lease cost for the initial purchase order (provided that it is issued on the first day of the arrangement) would be recognized over the entire four-year lease term. The total lease cost incurred in connection with the second purchase order would be recognized over the remaining lease term at that time. The subsequent impact on the ROU asset each year would reflect all purchase orders previously submitted. This accounting would continue for the remainder of the lease arrangement. This approach will generally result in a more back-loaded lease cost recognition pattern than Approach 1.
Note that depending on the time frame established by the
purchase order and the frequency of purchase order
submission by the customer, there may be scenarios in
which the accounting in this example is not material to
the financial statements. For example, under Approach 1
above, if purchase orders are submitted every month and
establish a one-month production time frame, the
customer’s lease costs would be appropriately
apportioned to the production month and the impact on
the balance sheet on a particular reporting cut-off date
may be immaterial. On the other hand, if the customer in
the example above submitted a two-year purchase order,
the accounting described above would most likely be
necessary so that lease costs can be appropriately
apportioned and the lessee’s lease obligation can be
properly reflected as of the intervening balance sheet
dates.
6.9.2 Lessee’s Guarantee of the Lessor’s Debt
ASC 842-10
30-6 Lease payments do not include any of the following: . . .
b. Any guarantee by the lessee of the lessor’s debt . . . .
ASC 842-10-30-6(b) states that a lessee’s guarantee of the
lessor’s debt should be excluded from the calculation of lease payments.
Instead, the lessee should consider the guarantee under ASC 460. If the
guarantee is recognized on the balance sheet and initially measured in
accordance with ASC 460, it may be reasonable to recognize the offset (i.e., the
debit) as part of the ROU asset.
However, a lessee’s guarantee of a lessor’s loan in effect at
the end of the lease term may, in substance, be a residual value guarantee that
should be considered part of the lease payments in accordance with ASC
842-10-30-5(f). For example, when the lessor owns no significant assets other
than the leased asset, a lessee’s guarantee of the debt is economically
equivalent to the lessee’s providing a residual value guarantee, since the value
of the property is the sole means of repaying the debt. Accordingly, a lessee’s
guarantee of debt issued by an entity that has no significant assets other than
the leased asset should be included in the lessee’s computation of lease
payments when the fair value test in ASC 842-10-25-2(d) is applied, as long as
the guarantee remains in effect at the end of the lease term.
For similar reasons, a lessee’s guarantee of a lessor’s loan
that is nonrecourse to the lessor should also be treated as a residual value
guarantee if the guarantee will remain in effect at the end of the lease term,
since the value of the property is the sole means of repaying the loan.
Treating these loan guarantees as residual value guarantees may
cause the lease to be classified as a finance lease. See Section 6.7 for further
discussion of how residual value guarantees affect lease payments.
Connecting the Dots
Consistency With ASC 840 With Respect to a Lessee’s Guarantee of
the Lessor’s Debt
The requirement in ASC 842-10-30-6(b) to exclude
guarantees by the lessee of the lessor’s debt is consistent with the
previous requirement in ASC 840-10-25-5(b). We therefore do not expect
the application of this guidance under ASC 842 to differ from that under
ASC 840.
6.9.3 Amounts Allocated to Nonlease Components
ASC 842-10
30-6 Lease payments do not include any of the following: . . .
c. Amounts allocated to nonlease components in accordance with paragraphs 842-10-15-33 through 15-42.
As discussed in Section 6.1, lease payments are based on the consideration in the contract that is allocated to the lease component(s) in the contract. Any amounts allocated to the nonlease components in the contract should not be included in the calculation of lease payments. See Chapter 4 for a discussion of separating and allocating consideration to the lease and nonlease components in a contract.
6.9.4 Obligations to Return an Underlying Asset to Its Original Condition
ASC 842-10
30-7 Paragraph 410-20-15-3(e) addresses the scope application of Subtopic 410-20 on asset retirement obligations to obligations of a lessee in connection with a lease (see paragraph 842-10-55-37).
55-37 Obligations imposed by a lease agreement to return an underlying asset to its original condition if it has been modified by the lessee (for example, a requirement to remove a lessee-installed leasehold improvement) generally would not meet the definition of lease payments or variable lease payments and would be accounted for in accordance with Subtopic 410-20 on asset retirement and environmental obligations. . . .
To the extent that a lessee has agreed to remove modifications it has made to a
leased asset so that it can return the asset to the lessor in its original
condition, estimated future payments for such work would not be considered a
future lease payment. For example, at the end of the lease term, a lessee may
incur costs to remove leasehold improvements from the leased asset. Under ASC
842-10-55-37, the removal of lessee-installed leasehold improvements is an
example of a cost of returning an underlying asset that has been modified by a
lessee to its original condition and such a cost should not be included in lease
payments. Such an obligation would instead be accounted for under ASC 410-20 on
asset retirement and environmental obligations.
However, as discussed in Section 6.8, a lessee may also be required to restore
functionality, at the end of the lease term, to a leased asset that benefits the
lessor but not the lessee. The obligation related to such restorations would be
considered a future lease payment.
Example 6-18
Entity B (the lessee) leases an aircraft under a 10-year lease. The
terms of the lease require B to perform an overhaul of
the aircraft (a C-check) every three years to comply
with regulations. The cost of each C-check is $10,000.
In addition, at the end of the lease term, B must
perform a C-check when returning the plane to the lessor
regardless of whether it recently performed one. This
final C-check does not benefit the lessee since it is
returning the aircraft; however, it does benefit the
lessor, which will not need to perform another C-check
on the aircraft for three years.
The determination of whether the overhaul costs should be
included in the lease payments depends on whether the
lessee has a present obligation to perform the
overhauls, and therefore to incur the expenditure, at
lease commencement for the benefit of the lessor.
In this scenario, the cost of the final C-check (i.e.,
the C-check that the lessee must perform immediately
before returning the plane to the lessor) should be
included in the lease payments because it represents a
present obligation of the lessee and does not benefit
the lessee. Because there is no present obligation for
the lessee to perform any other C-checks throughout the
lease term for the benefit of the lessor, the cost of
those C-checks should not be included in the lease
payments at lease commencement.
6.9.5 Indemnification Clauses for Certain Tax Benefits
ASC 842-10
55-38 Some leases contain indemnification clauses that indemnify lessors on an after-tax basis for certain tax benefits that the lessor may lose if a change in the tax law precludes realization of those tax benefits. Although the indemnification payments may appear to meet the definition of variable lease payments, those payments are not of the nature normally expected to arise under variable lease payment provisions.
55-39 Because of the close association of the indemnification payments to specific aspects of the tax law, any payments should be accounted for in a manner that recognizes the tax law association. The lease classification should not be changed.
ASC 842-30
55-16
Indemnification payments related to tax effects other
than the investment tax credit should be reflected by
the lessor in income consistent with the classification
of the lease. That is, the payments should be accounted
for as an adjustment of the lessor’s net investment in
the lease if the lease is a sales-type lease or a direct
financing lease or recognized ratably over the lease
term if the lease is an operating lease.
Some lease contracts include provisions under which the lessee commits to compensate the lessor for certain tax benefits that the lessor may lose if there is a change in the tax law. Although these indemnification payments vary because of changes in facts or circumstances occurring after the commencement date (i.e., a change in the tax law) and thus appear to meet the definition of a variable payment, the boards decided that these payments should not be accounted for as variable lease payments because of the strong correlation between the indemnification payment and the related tax law. Rather, such payments should be accounted for in accordance with ASC 460 in such a way that the tax law association is recognized.
Conversely, as discussed in Section 4.3.2, some lease contracts
include provisions under which the lessee commits to compensating the lessor for
sales taxes or other similar taxes. In such cases, these taxes may or may not
represent payments associated with the contract that contains a lease. See
Section 4.3.2.3 for further
details.
Footnotes
11
Depending on materiality, the accounting
described in this example (recognition of a lease
liability and ROU asset for each discrete purchase
order) may not be required in all circumstances.
For example, there may be short-duration or
low-dollar purchase orders for which the
application of ASC 842 would not have a material
impact on the financial statements.
12
The reference to “lease costs” can include
amounts that are recognized in other line items in
the income statement besides line items in which
lease expenses are recorded. For example, it may
be common in a contract manufacturing arrangement
for an entity to record costs associated with the
use of a manufacturing line as capitalizable
inventory costs. Those costs would ultimately be
reflected within cost of goods sold in the income
statement rather than in lease expense.
6.10 Subsequent Measurement of Lease Payments
ASC 842-10
35-4 A lessee shall remeasure the lease payments if any of the following occur:
- The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
- A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term. However, a change in a reference index or a rate upon which some or all of the variable lease payments in the contract are based does not constitute the resolution of a contingency subject to (b) (see paragraph 842-10-35-5 for guidance on the remeasurement of variable lease payments that depend on an index or a rate).
- There is a change in any of the following:
- The lease term, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments on the basis of the revised lease term.
- The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option.
- Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees.
35-5 When one or more of the events described in paragraph 842-10-35-4(a) or (c) occur or when a contingency unrelated to a change in a reference index or rate under paragraph 842-10-35-4(b) is resolved, variable lease payments that depend on an index or a rate shall be remeasured using the index or rate as of the date the remeasurement is required.
35-6 A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
The table below summarizes the guidance in ASC 842-10-35-4 through 35-6 for both
lessees and lessors.
|
|
Lessee Remeasures Lease
Payments Under ASC 842?
|
Lessor Remeasures Lease
Payments Under ASC 842?
|
|---|---|---|
|
The lease is modified, and
that modification is not accounted for as a
separate contract (Chapters 8 and
9)
|
X
|
X
|
|
Contingency underlying
variable lease payments that do not depend on an
index or a rate is resolved and, as a result, some
(or all) of the remaining payments become fixed
for some (or all) of the remaining lease term
(Section 6.9.1)
|
X
|
|
|
Change in the lease term
(Section 5.4)
|
X
|
|
|
Change in whether the lessee
is reasonably certain to exercise a purchase
option (Section 6.4)
|
X
|
|
|
Change in the amount that it
is probable the lessee will owe under a residual
value guarantee (Section 6.7)
|
X
|
|
Bridging the GAAP
Remeasurement of Lease Payments
Under ASC 842, when a lessee remeasures its lease payments for any of the
reasons illustrated in the table above, the lessee
should remeasure variable lease payments that
depend on an index or a rate by using the index or
rate as of the remeasurement date. As noted in
Section 6.3, this requirement differs
from the requirement under IFRS 16 to remeasure
variable lease payments that depend on an index or
a rate whenever there is a change in contractual
cash flows (e.g., changes in the CPI).
6.10.1 Accounting for a Lease Liability and Corresponding ROU Asset in an Arrangement Involving a “Minimum Annual Guarantee” Payment Structure in Which a New Lease Payment Floor Is Established Each Year
Leasing arrangements may have
a “minimum annual guarantee” (MAG) payment
structure in which a lessee guarantees a minimum
annual payment and only the minimum amount for the
first year is known upon lease commencement. After
year 1, the MAG will reset on the basis of the
revenue, usage, consumption, or another similar
factor for year 1. The reset mechanism can result
in an increase or decrease compared with the
amount of the year 1 MAG, indicating that, at
lease commencement, there is no established floor
for any year after year 1.
Example 6-19
Company B enters into a
three-year real estate lease. The arrangement
includes a rent payment structure in which the
annual rent is an amount equal to 5 percent of
annual revenue, with a MAG in year 1 of $210,000
(i.e., a fixed payment). For each subsequent year,
the MAG is an amount equal to 5 percent of the
prior year’s revenue, which establishes a payment
floor for that year (e.g., the rent in year 2 will
be the greater of 5 percent of year 2 revenue or 5
percent of year 1 revenue). Importantly, as of
lease commencement, there are no fixed or
in-substance fixed payments other than the MAG in
year 1 of $210,000, since the sales each year,
which are unknown, could result in a MAG that is
higher or lower (or potentially zero) for
subsequent years. The lease is classified as an
operating lease.14 The table below illustrates the MAG for each
year, which is based on the assumed annual revenue
over the lease term.
When analyzing arrangements
such as the one in the example above, it is critical for an entity to determine the
substance of the pricing mechanism. We believe that these mechanisms are designed to
establish minimum payments for future use rather than to impose incremental payments for
past use. The discussion below reflects our views on the accounting related to these
arrangements; these views are based on our view of the substance of the MAG payment
structure.
6.10.1.1 Measuring and Accounting for the Lease Liability
The MAG in year 1 of the real
estate lease represents an in-substance fixed
payment for year 1 only, because a floor is being
set by the MAG (see Section 6.2.1
for additional discussion of in-substance fixed
payments). In the example above, B would calculate
the lease liability at lease commencement on the
basis of the present value of the MAG for the
first year. We believe that the in-substance fixed
payment is limited to the MAG in year 1 because
the MAG amounts after year 1 (the MAG amounts
applicable to years 2 and 3) could increase or
decrease. Since the subsequent-year MAG amounts
can decrease, as of the commencement date of the
lease, a payment floor does not exist beyond year
1.
At the end of each year,15 B would calculate a new MAG for the
following year (e.g., a MAG calculated on the
basis of year 1 revenue establishes a rent floor
for year 2), which constitutes a remeasurement
event in accordance with ASC 842-20-35-5(c), since
the resolved uncertainty associated with year 1
revenue represents the resolution of a contingency
affecting B’s future lease payments. When a
contingency is resolved, a lessee must remeasure
the lease liability to reflect changes to the
lease payments, as described in ASC
842-10-35-4(b), which states, in part:
A contingency upon which some
or all of the variable lease payments that will be
paid over the remainder of the lease term are
based is resolved such that those payments now
meet the definition of lease payments.
See Section 8.5.4.2 for more information about
accounting for a change in lease payments resulting from the resolution of a
contingency. Through the effective interest method, the year 1 lease liability will be
reduced to zero by the time the MAG is reset at the end of year 1 (once the total sales
for year 1 are known), at which point the new MAG will be used to determine the year 2
liability (the new MAG represents an in-substance fixed payment for year 2 since it
establishes a payment floor for that year). Similarly, the year 2 liability will
subsequently be amortized as B makes the year 2 payments. This accounting will continue
over the remainder of the lease term. The expense recognition profile of the
corresponding lease cost is discussed in the section below.
6.10.1.2 Subsequent Measurement and Recognition of the Lease Cost
As discussed above, when the
MAG is reset each year, Company B must consider the guidance in ASC 842-10-35-4(b) and
remeasure the lease liability and ROU asset as of each reset date.
We believe that there may be
more than one acceptable approach to recognizing
the lease cost. We have outlined two acceptable
alternative approaches below that we believe an
entity can use to recognize the in-substance fixed
payment (i.e., lease cost) on a straight-line
basis over (1) the remaining lease term or (2) the
year to which the MAG is related:16
-
Recognize the lease cost for each MAG over the remaining lease term — The in-substance fixed payment in the form of a MAG represents payment for the right to use the underlying asset over the remaining lease term. This approach is supported by the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]Under this approach, each additional ROU asset would be layered on once the MAG is reset in each annual period. That is, in the example above, the MAG lease cost of $210,000 in year 1 would be recognized over the entire three-year lease term (i.e., $70,000 of lease cost in all three periods). The lease cost of $230,000 related to the reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would be recognized over the remaining two-year lease term (i.e., an additional $115,000 of lease cost in the two remaining periods). Accordingly, the balance of the ROU asset at the end of year 2 would include the remaining unamortized balance from both the year 1 MAG and the year 2 MAG. This accounting would continue for the remainder of the lease arrangement. This approach will result in higher expense recognition in the latter years of the contract (i.e., back-loaded lease cost), as illustrated in the table below.
-
Recognize the lease cost for each MAG in the year to which the MAG is related — Under this approach, the lease cost would be reflected for each MAG on the basis of the use of the underlying asset for one year only. Such cost recognition is aligned with the frequency at which lease payments are reset and in turn would be aligned with the physical-use pattern of the space. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]The lease cost resulting from the year 1 MAG would be recognized on a straight-line basis over year 1, and the corresponding ROU asset would thus be fully amortized by the end of year 1. The reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would trigger a resolution of a contingency in accordance with ASC 842-20-35-5(c) (see Section 6.10.1.1), in which the payments associated with the MAG for year 2 become an in-substance fixed payment. Accordingly, the lessee would recognize a separate lease liability and a corresponding ROU asset for the year 2 MAG only, which would be completely amortized in year 2. This accounting would continue for the remainder of the lease term. The table below illustrates the total lease cost recognized in each year (and is based on the same facts as those in the example above). Overall, this approach may be easier to apply than the previous approach since an entity will not have to track separate layers of an ROU asset as a MAG is reset over time. Rather, the entity will record a new ROU asset and lease liability each time a reset occurs, both of which will be exhausted during the year to which they are related. This approach may also better reflect the economics of a variable payment leasing structure with a floor mechanism that fluctuates over time.Note that we are aware of different views in practice regarding the substance of, and appropriate accounting for, leases that contain pricing reset mechanisms similar to the MAG structure discussed above. According to one such view, the MAG reset is considered to be a variable lease expense associated with the period that establishes the new MAG. For example, the year 2 MAG of $230,000 in the example above would be treated as variable lease cost for year 1. This view therefore has a front-loading effect on recognition of lease costs. Given the diversity of views on the substance of these reset mechanisms and the related accounting requirements, we encourage entities affected by this issue to discuss their proposed accounting treatment with their auditors or accounting advisers.
Footnotes
14
This section is written with
an operating lease in mind, but similar considerations would apply to a
finance lease. However, one notable difference between the two
classifications pertains to the expense recognition pattern of the lease
cost and the corresponding amortization of the ROU asset. Operating lease
cost is recognized on a straight-line basis, while the expense recognition
pattern for finance lease cost is front-loaded. The corresponding ROU
asset amortization also depends on the classification. See Section 6.10.1.2 for more information about
the expense recognition pattern for the lease cost and ROU asset
amortization.
15
For simplicity, we have
assumed that the metric that establishes the MAG for each year can increase or
decrease over the course of the entire year and therefore does not establish an
in-substance fixed payment for the following year until the measurement period ends.
This could be the case with revenues, for example, which can decrease on the basis
of customer returns. Depending on materiality to interim reporting, to the extent
that the metric that establishes the MAG cannot decrease over time (i.e., in future
interim periods), the accounting described in Section
6.10.1.1 may be accelerated and may involve multiple
remeasurements.
16
The amortization of the ROU
asset will be consistent with the method outlined
in ASC 842-20-35-3(b) for an operating lease in
which the amortization of the ROU asset generally
increases in each period as the liability
accretion decreases as a result of a declining
lease liability balance. In contrast, the
amortization of an ROU asset for a finance lease
will generally be on a straight-line basis in
accordance with ASC 842-20-35-7. Only the
operating lease cost is illustrated in this
example.
6.11 Initial Direct Costs
ASC 842-10 — Glossary
Initial Direct Costs
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
ASC 842-10
30-9 Initial direct costs for a lessee or a lessor may include, for example, either of the following:
- Commissions
- Payments made to an existing tenant to incentivize that tenant to terminate its lease.
30-10 Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs:
- General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
- Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities
- Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.
Connecting the Dots
Definition of Initial Direct Costs
Consistent With ASC 606
In a manner consistent with ASC 606, initial direct costs for both lessees and lessors include only those costs that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained. Paragraph BC307 of ASU 2016-02 explains the FASB’s decision for aligning the definition of initial direct costs under ASC 842 with that in ASC 606:
The Board [FASB] concluded that a lessor and a seller of the same good, including an entity that both sells and leases assets, should account for similar costs in the same way. In addition, the Board noted that the guidance on initial direct costs in previous GAAP was aligned with one of the two acceptable methods for accounting for costs to obtain a contract in previous revenue recognition guidance, and, therefore, the Board’s decision on initial direct costs in Topic 842 maintains alignment between the leases and revenue recognition guidance for these types of costs.
Changing Lanes
Fewer Costs Qualify as Initial Direct
Costs Under ASC 842
The definition of initial direct costs under ASC 842 is considerably more restrictive than the definition under ASC 840. For example, under ASC 842, commissions paid and payments made to existing tenants to obtain the lease are considered initial direct costs, whereas allocated internal costs and costs to negotiate and arrange the lease agreement that would have been incurred regardless of lease execution (e.g., professional fees such as those paid for legal and tax advice) no longer qualify as initial direct costs.
The FASB included Example 27 in ASC 842 to illustrate the types of costs that
qualify as initial direct costs under ASC 842.
ASC 842-10
Illustration of Initial Direct Costs
55-239 Example 27 illustrates initial direct costs.
Example 27 — Initial Direct Costs
55-240 Lessee and Lessor enter into an operating lease. The following costs are incurred in connection with the lease:
55-241 Lessor capitalizes initial direct costs of
$10,000, which it recognizes ratably over the lease term, consistent with its
recognition of lease income. The $10,000 in broker commissions is an initial
direct cost because that cost was incurred only as a direct result of obtaining
the lease (that is, only as a direct result of the lease being executed). None
of the other costs incurred by Lessor meet the definition of initial direct
costs because they would have been incurred even if the lease had not been
executed. For example, the employee salaries are paid regardless of whether the
lease is obtained, and Lessor would be required to pay its attorneys for
negotiating and drafting the lease even if Lessee did not execute the lease.
55-242 Lessee includes $20,000 of initial direct costs
in the initial measurement of the right-of-use asset. Lessee amortizes those
costs ratably over the lease term as part of its total lease cost. Throughout
the lease term, any unamortized amounts from the original $20,000 are included
in the measurement of the right-of-use asset. The $20,000 payment to the
existing tenant is an initial direct cost because that cost is only incurred
upon obtaining the lease; it would not have been owed if the lease had not been
executed. None of the other costs incurred by Lessee meet the definition of
initial direct costs because they would have been incurred even if the lease had
not been executed (for example, the employee salaries are paid regardless of
whether the lease is obtained, and Lessee would be required to pay its attorneys
for negotiating and drafting the lease even if the lease was not executed).
Connecting the Dots
Initial
Direct Costs May Be an Allocated Amount
As discussed in Section
6.1, when nonlease components are
present in a contract, the consideration in the
contract must be allocated to the lease and
nonlease components. In a manner consistent with
this requirement, ASC 842-10-15-38 requires that
lessors allocate capitalized costs (including
initial direct costs) to the separate components
in the contract. As a general rule, we believe
that lessors should allocate these costs on the
same basis as the consideration in the contract
(i.e., on the basis of stand-alone selling price).
However, when the capitalized costs (e.g.,
commissions) are entirely related to the lease
component(s) in the contract rather than to the
overall contract (which contains both lease and
nonlease components), we believe that it is
acceptable to allocate these costs entirely to the
lease component(s) in the contract.
On the other hand, ASC
842-10-15-33 requires that lessees allocate
initial direct costs to the separate lease components in the
contract on the same basis as lease payments
(i.e., on the basis of stand-alone price).
Example 6-20
Company L (the lessee) enters into an arrangement to lease a
building for 10 years. As part of the arrangement, the lessor is required to
provide CAM services for the 10-year lease term. In exchange for the right to
use the building and obtain the CAM services, L will make fixed monthly payments
of $5,000. The stand-alone price of the monthly building lease and CAM is $4,750
and $500, respectively. As compensation for executing the contract, the lessor
pays a one-time commission of $1,000 to its employee.
The following table illustrates the allocation of the $1,000
commission between the lease and nonlease components in the contract:
The $905 commission allocated to the lease component in the
contract should be accounted for in accordance with the guidance on initial
direct costs in ASC 842. The $95 commission allocated to the nonlease component
in the contract should be accounted for in accordance with the guidance on
incremental costs to obtain a contract in ASC 606 (see Section 13.2 of Deloitte’s
Roadmap Revenue
Recognition). The accounting treatment of the $905 commission
under ASC 842 may not be aligned with that of the $95 commission under ASC
606.
See Chapters
8 and 9 for a discussion of the recognition
and subsequent measurement of initial direct costs
for lessees and lessors, respectively.
6.11.1 Payment Made by a Lessor to a Lessee to Induce Early Termination of a Lease
A lessor may make a payment
(or payments) to a lessee to induce the lessee to
terminate the lease before the end of the lease
term. Such a situation may arise, for instance,
when the rental rate is unfavorable from the
lessor’s perspective (i.e., below the prevailing
market rate) or the lessor has an opportunity to
lease the space to a more attractive tenant.
Generally, at the time the payment is made, the
lessor either will have secured a replacement
lessee for the space (perhaps with eviction of the
current tenant being the only unresolved matter)
or, at a minimum, will have identified a
replacement lessee and will be in the process of
negotiating the lease.
A payment made by a lessor to
a lessee to induce the lessee to terminate the lease before the end of the lease term
generally qualifies as an initial direct cost of the lessor in obtaining the new lease.
(Similarly, such a payment received by the lessee generally qualifies as a lease incentive
in the lessee’s accounting for its new lease, as discussed in Section 6.2.2.1.)
Provided that, at the time of
the payment, the lessor has identified a replacement lessee for the space and entering
into the new lease with that identified replacement lessee is reasonably certain, the
payment made to induce the current lessee to terminate the lease qualifies as an initial
direct cost of obtaining the new lease. The lessor should defer the payment as an initial
direct cost of obtaining the new lease and recognize it into income over the term of the
new lease.
However, deferral of the
payment would not be appropriate in situations in
which, at the time the payment is made, either (1)
a specific replacement lessee has not been
identified or (2) a replacement lessee has been
identified but entering into the new lease with
that replacement lessee is not reasonably certain.
In these situations, the payment would not
constitute an initial direct cost and instead
should be expensed as incurred.
6.11.2 “Key Money” Payment Made to an Existing Lessee to Assume a Lease
In certain jurisdictions,
lessees are able to renew leases at below-market
rates because of the regulatory restrictions
placed on lessors. Therefore, an entity is
economically incentivized to assume a below-market
lease from an existing lessee rather than
negotiate a new lease at market rates. The entity
will often pay the existing lessee to assume the
lease; this payment is commonly referred to as a
“key money” payment.
We believe that key money
payments typically should be accounted for as
initial direct costs. ASC 842-10-20 defines
initial direct costs as “[i]ncremental costs of a
lease that would not have been incurred if the
lease had not been obtained.” Further, ASC
842-10-30-9 gives examples of two types of initial
direct costs:
Initial direct
costs for a lessee or a lessor may include, for
example, either of the following:
-
Commissions
-
Payments made to an existing tenant to incentivize that tenant to terminate its lease. [Emphasis added]
Although key money payments
are made to assume an existing lease with
favorable market terms rather than simply to
induce an existing tenant to terminate its lease,
both represent costs incurred to obtain the right
to use the underlying asset over the lease term
and would not have been incurred if the lease had
not been obtained. We therefore believe that key
money payments typically meet the definition of
initial direct costs.
Likewise, under the new
leasing standard, lessees no longer record
separate intangible assets for below-market lease
payments upon acquiring an operating lease in a
business combination; rather, such amounts are
capitalized as part of the ROU asset in accordance
with ASC 805-20-25-12. Therefore, we believe that
entities should generally capitalize the entire
key money payment as an initial direct cost — and
thus as part of the ROU asset — and amortize this
cost over the life of the ROU asset (i.e., over
the lease term unless the lease transfers
ownership or contains a purchase option that the
lessee is reasonably certain to exercise).