August 25, 2019

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CPI and other indices or rates in minimum lease payments

Should you include assumed future increases in rent due to CPI when determining minimum lease payments?

ASC 840-10-25-4 states (emphasis added),

This guidance addresses what constitutes minimum lease payments under the minimum-lease-payments criterion in paragraph 840-10-25-1(d) from the perspective of the lessee and the lessor. Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. (Example 6 [see paragraph 840-10-55-38] illustrates this guidance.) However, lease payments that depend on an existing index or rate, such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable. (Example 7 [see paragraph 840-10-55-39] illustrates this guidance.)

The sentence above is one that I’ve seen misunderstood countless times.  Specifically, around the consideration of an index, such as the Consumer Price Index, whether or not to include future rent increases in the definition of Minimum Lease Payments based on some historical rate of increase.  First, I should point out that the example provided for by the guidance (Example 7, 840-10-55-39) only provides an example with a prime rate, and therefore when it comes to leases with an increase provision based on CPI, it doesn’t appear to be extremely helpful.  So let’s go through an example with CPI.

Let’s assume the following facts:

Company ABC. Co enters into an agreement on 12/1/2010 to lease office space from Lessor Co. for 10 years beginning on 1/1/2011 through 12/31/2020.  On 12/1/2010, the Bureau of Labor Statistics publishes information showing that the CPI is increasing at an annual rate of 3% per year based on the last 12 months which is consistent with the last several years of growth.  Rents shall be a base of $10,000 per month.  Every January 1st of a new lease year, rents shall be adjusted to increase or decrease by a percentage equal to the percentage growth or decline of the CPI over the last 12 months.  e.g., If on 12/1/2011, the CPI rose an additional 3% as compared to the date 12 months prior, rents would increase to $10,300 (3% increase).  ABC’s Incremental Borrowing Rate is 5%.  The lessor’s implicit rate of borrowing is unknown.  Fair value of the space is concluded to be $1.1M.  The lease contains no transfer of title clauses nor contains any bargain purchase options.

So here we (ABC) are, on December 1st, 2010, required to put together a lease assessment to determine whether or not our lease constitutes a capital lease.  The question becomes how to interpret the sentence “Lease payments that depend on an existing index or rate, such as the consume price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception” when considering whether or not to include annual increases of 3% in your rents.  Clearly there are two schools of thought here (or maybe at this point you think the question is obvious and didn’t realize there was a different school of thought out there).  Under one method, you say, the annual rate of increase in the CPI has been and currently is 3%.  Therefore, this is the rate that is existing at lease inception and I must factor this into my minimum lease payments.  A different approach is to say the opposite.  That future changes in CPI is an increase or decrease in lease payments that result from subsequent changes in the index or rate, and therefore meet the definition of contingent rentals, and thus are expensed only when incurred and not included in minimum lease payments.  Before I get into the answer, let’s take a quick second to see why this matters.

90% Test with and without assumed CPI increases

90% Test with and without assumed CPI increases

As you can see above, the answer to this question, in this situation, would most likely change the determination of whether or not this lease is considered a capital lease (fail the 90% test).  In addition, even if the capital vs operating assessment is not impacted, this question will certainly impact ABC’s disclosures when it comes to disclosing contingent rents paid and future commitments under operating leases.

Now the fun part.  First thing I would point your attention to.  The Codification refers to index or rate.  The word “or” is important as these are patently different concepts.  The example provided for in the guidance (Example 7 aforementioned), is a rate.  The consumer price index is not a rate at all, it is an index.  When the Bureau of Labor Statistics publishes the CPI, they are nice enough to run comparisons of growth rates of the CPI vs other periods of time (e.g., month over month, year over year, quarter over quarter), however the CPI itself is a number that is not a rate.

CPI Table

Therefore, if we look at the guidance again, and compare to the above, we are required to include lease payments that depend on an existing index, such as the consume price index, based on the index existing at lease inception.  In this case, the index existing at lease inception (12/1/2010) is 218.803.  In our case, this will become the base year for future increases to be compared against (or perhaps the following month depending on the specific details of the lease).  Therefore, if we are confident that in 12 months, the CPI will increase to 225.367 (218.803 x 103%), do we still want to include this increase in our minimum lease payments?  From this perspective, it becomes much more evident that this subsequent change would clearly fall into the “any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable” category.  Therefore they should not be included.

Some of you at this point may be thinking to yourself, “This doesn’t make any sense.  We believe that it is highly probable we will have rental increases.  In fact, we’re almost certain of it.  Why would the guidance exclude such payments?  This doesn’t seem to be a conservative approach.  PopularAccounting, you’re just some stupid blog run out of some guy’s poorly lit basement, and I patently disagree with you.”  To which, I would respond with, “My basement has very good lighting, thank you.”  Oh, I’d also elaborate with the following.

  1. This isn’t different from other contingent rental guidance that is not highly contested.
  2. Think of what it would be like if we didn’t have these rules.

On point 1, let’s say that we have a retail store selling widgets and a lease requires that we pay 2% of our total gross sales on an annual basis to the landlord.  There is no limit to the payment (i.e., maximum), and there is no minimum.  Even if we have 10 year history of at least $1,000,000 in sales for the store, the guidance says that we include ZERO in our minimum lease payments.  The issue is that we don’t know where to draw the line.  We’re 99.9999999% sure we’ll have at least 10,000 in sales, and maybe we’re 99.99% sure we’ll have 100,000 in sales. But we’re probably only 99.9% sure we’ll have 500,000 in sales, and perhaps only 99% sure we’ll have 1,000,000 in sales, and as we go up, the percentage drops.  The guidance is very clear that these types of payments are considered “contingent rentals” and that “contingent rentals” are excluded from the definition of minimum lease payments.   PwC, in their ARM 4650.1242, mirrors my opinion above when they state:

Arguably, there always could be some portion of contingent rent that is virtually assured (e.g., in a lease that provides for additional rents equal to one percent of sales derived from the output of the leased property, there always could be some level of reasonably assured sales). Nonetheless, as long as the contingent rent provision provides for variability in the rents, we believe that all the rents should be considered contingent.

 

Further, I can tell you that Deloitte will agree with the above statement.  In Deloitte’s Q&A 22 under 840-10, they explain that even in situations where a lessor and lessee believe it is “virtually certain” that a specified level of usage will be exceeded and some rental payment may be due, an additional rental payment derived therefrom should NOT be included in minimum lease payments.

Therefore, although you may be thinking it doesn’t appear appropriate to exclude virtually assured rental payments in our disclosures and minimum lease payment calculations, there is a clear popular accounting stance to the contrary when it comes to contingent rents.  Note: There is a separate section of guidance that discusses and explores contingent rental provisions that are, in essence, fixed rents, and these may meet the definition of minimum lease payments.  EY describes these well in their financial and reporting developments – Leases, publication.  Search “de facto minimum lease payments”.

On point 2, I would propose we think about the reason for the rule as I’ve described above.  The point is not to assume probable future variable increases (as I clearly explain above the guidance does not attempt to do), but it is to disallow clever accountants from excluding clearly minimum rents from their capital lease tests and related disclosures.  Instead of the example I proposed with ABC Co above, let’s assume that it said, base rent of $4,565, adjusted for increases or decreases in the July 1983 published CPI.  Without a rule such as what I’ve described above (and what the codification clearly has), a company may say that the base rent adjustment past the $4,565 should all be considered to be contingent, as it is based on a rate or index.  Therefore, monthly payments of $4,565 will be included in the minimum lease payments, and the 90% test passes with flying colors, and the disclosures will only include this amount.  However, on the day the lease is entered into, the published CPI is 218.803 (as we described above) . Since the July 1983 CPI was 99.9, ABC Co has essentially negotiated a $10,000 per month lease (same as above, calculated by taking 4,565 x (218.803/99.9)).  The codification’s rule above merely states that you have to include the movement from 99.9 to 218.803 as the index in existence at lease inception was 218.803, even though the lease states that the increases are based on a base index of 99.9.  To state a different way, the purpose of the rule is to close a loophole that would essentially provide an avenue for every company to easily bypass ever having to record a capital lease.  The purpose is NOT to have minimum lease payments reflect more accurately the most probable future variable changes.

Please feel free to comment below if you have any questions on any of the above.

Disclosure: As always, the views of any person (or firm) can change.  Interpretations of guidance can change.  I provide my insights and thoughts free of charge, and use the published views of others only to help educate the masses under the fair use doctrine.  The guidance above should not be misconstrued to be official professional advice.  You should always consult your CPA or Audit firm.  Although I may not agree that you can copyright laws, as the Codification has been adopted to be law, I should point out that the FASB has copyrighted the laws we all have to abide by somehow.

FASB Accounting Standards Codification: Copyright © 2005 – 2016 by Financial Accounting Foundation, Norwalk, Connecticut.

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