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Navigating Lease Payments

With the impending effective date for private companies of Accounting Standards Update (ASU) 2016-02 Leases, a company will be required to evaluate its lease portfolio and record right-of-use assets (“ROU assets”) and lease liabilities on its balance sheet for its operating leases. There are numerous considerations that go into determining the amounts to be recorded related to the implementation of this standard, including the discount rate, remaining lease term, remaining lease payments, practical expedients, accounting policy elections, and many others that are beyond the scope of this article. This article will focus on lease payments and one accounting policy election which allows a company to combine lease and non-lease components. If elected, fixed lease and non-lease components would be included as lease payments in the calculation of the lease liability and ROU asset. In general, variable payments not depending on an index or rate are excluded from the lease payments utilized in this calculation. However, determining if a lease payment is fixed or variable is not always cut and dry. A company will have to carefully evaluate the contractual payments to determine if they should be included in the calculation.

Before we get into the nuances of that distinction, let’s first consider what types of payments are included in the lease liability calculation. The standard dictates that the lease liability be initially measured as the present value of the lease payments to be made over the lease term. Lease payments are comprised of the following:

  • Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee.
        • 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.
        • The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option.
        • Payments for penalties for terminating the lease if the lease term reflects the lessee exercising an option to terminate the lease.
        • Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction.
        • For a lessee only, amounts probable of being owed by the lessee under residual value guarantees.

        So, when it comes to evaluating payments, the calculation primarily focuses on fixed payments known at the time of lease commencement for new leases or adoption of ASC 842 for existing leases. Variable lease payments are defined by the standard as “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.” These variable payments that depend on usage or performance would generally be excluded from the calculation.

        Prior to determining what should be included in the calculation, a company must first determine if it will elect the practical expedient to combine lease and non-lease components. Components of a contract include only those items or activities that transfer a good or service to the lessee. Lease components are elements of the arrangement that provide the customer with the right to control the use of an identified asset (e.g., base rent payments for office space). Non-lease components are distinct elements of a contract not related to securing the use of the leased asset and are normally services ancillary to use of the leased asset. An example of a non-lease component would be common area maintenance or “CAM” charges such as cleaning a lobby of a building, snow removal from a parking lot, or utilities. The contract could also include non-components that do not transfer a good or service to a lessee, such as administrative tasks to set up a contract or reimbursement of the lessors’ executory costs (e.g., taxes and insurance).

        If the practical expedient were not elected to combine lease and non-lease components, then an allocation would have to be performed of the total consideration in the contract to the lease and non-lease components. The non-components are allocated pro-rata between the lease and non-lease components if fixed or expensed as incurred if variable. The lease component would then be recognized in accordance with ASC 842, while the non-lease component would be recognized in line with other relevant GAAP.

        However, if the election was made to combine, then the total fixed payment would be included in the lease liability calculation (including lease payments related to lease, non-lease and non-components).

        As indicated above, the only variable lease payments that are included in the lease payment calculation are variable lease payments that depend on an index or a rate (e.g., CPI, Libor, Prime interest rate, payments that depend on market rental rate). Only the lease payments as measured using the prevailing index or rate at the measurement date (i.e., lease commencement date for initial measurement) are included in the calculation because they were deemed by the FASB to be unavoidable. Lessees would then recognize any subsequent changes to that index or rate as a variable lease payment in profit or loss in the period of the change (i.e., similar to other variable lease payments).

        Variable lease payments that do not depend on an index or rate, such as those based on performance (e.g., a percentage of sales) or usage of the underlying asset (e.g., the number of hours flown, the number of units produced), are not included as lease payments. Entities should still carefully evaluate the provisions of variable lease payments to determine if the payments are in fact, in-substance fixed payments. In-substance fixed payments are payments that do not create genuine variability (such as those that result from clauses that do not have economic substance), an example being a situation whereby a lessee is required to make one of two payments. In that instance, the lease would include only the lower of the two payments as a fixed lease payment with any variations based on the actual result being reflected as a variable payment period cost. It is important to note variable payments based on performance or usage of the underlying asset that are highly certain should not be treated as in-substance fixed lease payments. Therefore, the ability to estimate variable costs should not be considered in the determination of whether it qualifies as a fixed payment for inclusion in the lease liability calculation. That being said, outside of the lease liability calculation, these variable expenses should be accrued over the period incurred.

        Consider an example: A common situation for office space leases is for the lease to include a fixed base rent payment plus a proportionate share of the total lessor costs for CAM. As the CAM is based on usage only, the fixed base rent payment would be included in the lease liability. Whereas the CAM would be treated as a variable payment period cost and excluded from contract consideration for the purposes of calculating the ROU asset and lease liability.

        Let’s take the same example and modify it such that for year one, the CAM is a fixed amount that is then trued up to actuals at the end of the year, with the tenant being responsible for the difference. Assume that the actual amount then becomes the amount charged in year two, with a reconciliation to actual occurring at the end of year two, and so on over the life of the lease. While the first year CAM payment may be stated in the agreement and appear fixed, the payment is not fixed over the entire lease term and therefore this situation would be considered variable, and the CAM payments excluded from contract consideration in the calculation of the ROU asset and lease liability.

        Taking this example one step further, let’s assume instead of resetting each year based on actual, the CAM amount is fixed over the entire term of the agreement with the same payments. Also assume that at the end of the year, the landlord provides the tenant with a reconciliation of actual costs and the tenant pays the difference either at the end of the year or monthly in the following year. While not explicitly covered in the accounting guidance, this could be considered analogous to a lease payment based on a rate or index (e.g., the CPI example), whereby the fixed amount determined at inception would be included as contract consideration. The total fixed consideration would then be allocated, based on stand-alone selling prices, between the lease and non-lease components and the portion of contract consideration relating to the lease components included in the calculation of the ROU asset and lease liability. The true-up would be considered a variable payment and excluded from contract consideration in the calculation of the ROU asset and lease liability. If the practical expedient were elected to combine lease and non-lease components, the fixed base rent and fixed CAM payments would be combined to calculate the ROU asset and lease liability.

        In adopting ASC 842, combining lease and non-lease components will generally result in higher assets and liabilities recorded. However, the combination will reduce the administrative burden of allocating contracts between lease and non-lease components. If elected, careful consideration of the lease payments for both lease and non-lease components should be assessed to ensure only the lease payments contemplated in the standard are included, as there is a specific exclusion of most variable payments.

        If you need further guidance or have any questions on this topic, we’re here to help. Bonadio professionals have posted a number of articles on the nuances of the new leasing standard - be on the lookout for more! Please also do not hesitate to reach out to our trusted experts to discuss your specific situation.

        This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.