In this article, we will look at the treatment of amounts paid with respect to leases from the lessee’s perspective. We will determine how these payments are treated in ASC 842 and determine the amount of lease payments.
Lease payments
The lease payment is an important concept in ASC 842, and the present value of the lease payments is used to determine the classification of the lease (financial lease or operating lease) (See Part 1.), and is the basis for calculating the amount of lease liabilities and ROU assets.
The composition of lease payments is discussed below. In a nutshell, “lease payments are the payments made by the lessee to the lessee to the lessee’s right to use the leased asset.”
In the previous ASC 840, one of the criteria for determining the classification of a lease was that the minimum lease payments must be at least 90% of the fair value of the leased asset (ASC 840-10-25-1 (d)). We mentioned in Part 1 that the new standard has a similar criterion (ASC 842-20-25-2 (d)), but it should be noted that the term “minimum lease payments” is not used in ASC 842-20-25-2 (d), but it’s simply lease payments mentioned above.
The new lease standard ASC 842-10-30-5 lists the following as components of lease payments
- fixed payment (842-10-30-5 (a)) This is simply the rental fee that is fixed in the contract. An example is monthly rent of $xxx.
- Lease incentive (842-10-30-5 (a)) This is often seen in real estate leasing, where the landlord bears the cost of tenant improvement. This is a so-called negative payment, and the amount received from or paid by the lessor is reduced from the lease payments.
- Variable lease payments (842-10-30-5 (b)) In addition to the fixed payments described in 1. above, variable payments may also be set forth in a lease contract.
ASC 842 defines variable payments as payments made by a lessee to a lessor for the right to use an underlying asset, which vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time. The treatment is divided into the following two categories
If the lease is based on an index or market rate (e.g., Consumer Price Index or market interest rate), the amount calculated based on the index or market rate at the beginning of the lease should be included in lease payments. For example, if the rent fluctuates annually based on a price index, the amount calculated based on the index or market rate at the inception of the lease should be included in lease payments.
Variable payments other than the above are not included in Lease Payment.
Therefore, for variable payments such as fixed rent + xx% of sales, which are often used in retail store rentals, the variable portion is not included in lease payments.
Purchase option (842-10-30-5 (c))
If it is reasonably certain that a lessee will exercise the purchase option at the end of the lease, the exercise price is included in lease payments. It could be argued that this is a purchase price and not a payment related to the lease, but the accounting standard seems to consider that there is no difference from the situation in which the lease term is extended to the useful life of the asset.
Also, ASC 842 does not clearly indicate how much certainty is required to be reasonably certain. In this regard, some commentaries define “reasonably certain” as about 75-80% certainty, which is the same concept as “reasonably assured” in ASC 840.
By the way, the phrase “reasonably certain” that the purchase option will be exercised is used in Part I. Types of Leases. The phrase “reasonably certain that the purchase option will be exercised” is also used in the following example. As you can see, in such a case, the lease is classified as a finance lease.
Termination penalties (842-10-30-5 (d))
A lease agreement may allow lessees to exercise an option to terminate the lease. If the lessee anticipates that it may exercise such an option to terminate the lease in determining the lease term for accounting purposes at the inception of the lease, the lessee should include in lease payments the penalty for exercising the option to terminate. For example, a lessee has a 10-year lease with an option to terminate the lease for a penalty of $10,000, and the lessee sets the lease term for accounting purposes based on the assumption that the lease will terminate in five years. ASC 842 is not very easy to understand at first glance, because it is structured from the other side of the coin, , and states if it is reasonably certain that the lessee will not exercise the option to terminate the lease, the termination is not considered in determining the lease term for accounting purposes.
Transaction structuring fees (842-10-30-5 (e))
In some large lease transactions, the property may be leased through a special-purpose entity. In such cases, if the lessee pays the lease structuring fees to the owner of the special-purpose entity, this is also included in lease payments.
Residual value guarantee (842-10-30-5 (f))
For residual value guarantees, the amount that is probable is included in lease payments.
It is important to note that the amount of lease payments is limited to the amount that is probable, not the entire amount that has been guaranteed. On the other hand, the criteria for determining whether a lease is a finance lease or an operating lease based on the amount of lease payments (ASC 842-10-25-2), which was simplified in Part 1, are as follows.
“The present value of the sum of lease payments and ANY RESIDUAL VALUE GUARANTEED BY THE LESSEE THAT IS NOT ALREADY REFLECTED IN LEASE PAYMENTS in accordance with paragraph 84210305(f) equals or exceeds substantially all of the fair value of the underlying asset.”
The probable residual value guarantee is part of lease payments as explained above. This provision indicates that when DETERMINING THE TYPE OF LEASE, the remaining residual value guarantee will be added to the determination. For example, if the residual value guarantee is $150,000 and the probable amount is $80,000, lease payments include $80,000, and the remaining $70,000 is treated separately from lease payments as any residual value guarantee. In determining the classification of the lease, the remaining $70,000 is added as any residual value guaranteed separately from lease payments, and the entire guaranteed amount of $150,000 is used. Thus, even if the probable amount of payment is zero, the residual value guaranteed is not zero when determining the classification of the lease.
ASC 842 states that provisions to compensate for shortfalls in residual value such as those caused by breakage, abnormal wear and tear, and excessive use do not constitute a residual value guarantee that is added to lease payments. This is because the residual value guarantee included in lease payments is structured to be calculated based on the expected fair value of the leased asset when it is returned to the lessee after being used as intended at the inception of the lease. Under ASC 842, an increase in the amount of the residual value guarantee compensation due to excessive use is similar to a variable lease payment.
In the next article, we will discuss the non-lease component, non-component, included in the lease agreement.
