Lease Payments: What’s Included Under ASC 842 Differs from ASC 840!
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Lease Payments: What’s Included Under ASC 842 Differs from ASC 840!

We’ve now spent several weeks discussing the top five biggest changes from the current leasing standard, ASC 840, to the new leasing standard, ASC 842. Why? Because the change is going to be huge and it is going to change life as we know it! So far, we’ve discussed how the new standard is going to “blow up the balance sheet” by requiring that all leases be presented on the balance sheet. We’ve also discussed the concept of identifying embedded leases. Now need to know what is included in the lease payments. Lucky for you, you’ll find out in this post!

Lease payments are the payments made by the lessee to the lessor for the right to use the underlying asset. As we’ll see, what is included in the calculation of the lease payments isn’t just the fixed lease payment per the lease agreement. But why does it matter? Because the lease payments are essential to determining the lease classification, as well as the measurement of lease assets and lease liabilities!

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The image above summarizes what is included in the lease payments. We’re going to discuss each item in more detail.

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Fixed lease payments are comprised of the lease payments per the lease agreement plus in-substance lease payments less lease incentives paid or payable to the lessee. Lease payments per the lease agreement are easy enough to figure out, but what are in-substance lease payments? What are lease incentives paid or payable to the lessee?

In-substance lease payments are payments that appear to contain variability but are unavoidable per the lease agreement. Lease incentives paid or payable to the lessee are those payments that are made to or on behalf of the lessee by the lessor. Confused? Let’s look at an example to hopefully provide clarity.

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Based on the above information, what amounts do you think should be included in Puppy Love’s fixed lease payment? We know that the fixed lease payments are at least equal to $5,000, but do the additional monthly lease payments or moving costs need to be included as well? The answer is yes!

The additional monthly lease payment is considered an in-substance lease payment. Although the amount appears to contain variability, the lease payment is unavoidable. Puppy Love knows it must pay at least an additional $500 each month! In this case, the additional $500 per month payment would be included in the fixed lease payment amount. If the payment becomes greater than $500, the difference between the payment and the $500 would be included in the income statement in the period when the increase occurs.

The $1,000 moving costs that Real Estate Guru Company paid to Puppy Love is considered a lease incentive and, therefore, would need to be deducted from the fixed lease payment amount.

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Variable lease payments that depend on an index or a rate (for example, CPI) are included in lease payments. This is because, even though there is uncertainty about a change in an index or rate, these payments are unavoidable. The additional amount to be included is based on the rate or index at lease inception. If there is a difference in payment as the result of a change in an index or rate subsequent to lease inception, the difference is recognized in the income statement in the period in which the change occurs.

Variable lease payments that depend on something other than an index or rate are excluded from lease payments and are recognized as an expense in the period when payment occurs.

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If a lessee is reasonably certain to exercise a purchase option, the exercise price is included in lease payments. Additionally, a lease termination penalty is excluded from lease payments if it is reasonably certain that a lessee will not terminate a lease.

Whether to include or exclude a purchase option or a termination penalty is dependent on whether it is reasonably certain to be exercised, focusing on whether the lessee has an economic incentive. All relevant facts and circumstances that create an economic incentive should be considered, such as:

  • Contractual terms and conditions for the optional periods compared with market rates;
  • Significant leasehold improvements undertaken over the term of the contract that are expected to have significant economic benefits for the lessee;
  • Costs relating to the termination of the lease; and
  • Importance of the underlying asset to the lessee’s operations

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Any fees paid by the lessee to the owners of a special purpose entity (SPE), usually the lessor or its affiliate, for structuring the transaction are included in lease payments.

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A residual value guarantee is a guarantee by the lessee to the lessor that the value of the underlying asset will be at least a specified amount at the end of the lease term. Any amounts probable of being owed to the lessor are included in lease payments.

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As you can see, the determination of what is included in lease payments isn’t always so simple! A lot more goes into lease payment than just the fixed lease payments per the lease agreement. Even though ASC 842 isn’t effective for a couple of years, it is important that all existing lease agreements are reviewed now to determine what is included in the lease payments, because this may affect the lease classification. If you need additional training on ASC 842, we can help! Give us a call or contact us today. Also, check out this post for a listing of links that will help you navigate the new standards (ASC 842 / IFRS 16).

Disclaimer
This post is published to spread the love of GAAP and provided for informational purposes only. Although we are CPAs and have made every effort to ensure the factual accuracy of the post as of the date it was published, we are not responsible for your ultimate compliance with accounting or auditing standards and you agree not to hold us responsible for such. In addition, we take no responsibility for updating old posts, but may do so from time to time.

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