Lease Inception – What is it?

I am constantly surprised by the fact that this phrase, “lease inception” is so misunderstood.  I mean first of all, we should all agree that the definition matters.

Why it matters:

I probably don’t have enough time to enumerate all the reasons and intricacies of why this definition matters, but just know there are many tests and considerations that depend on the facts and circumstances AS OF lease inception.  Hence, it matters… a lot.  Here are some of them, just to jog your memory.

1. Inception of the lease is when you perform your lease assessments (lessee – capital vs operating, lessor – direct financing, leveraged, sales-type, etc.)  Probably the most important reason, but people tend to get this correct in my experience, and therefore this rarely leads to errors, in my jumble opinion, in any mid-sized to large company.
2. Along the same lines as #1 above, but many of the inputs into the lease tests only consider known items as of lease inception.  (For example separating residual value guarantees and unguaranteed residual values between ASC 840 and ASC 860 for lessors).
3. Bargain purchase options need to be assessed AS OF lease inception (especially important when you are assessing lease classification in a business acquisition as the time between the date with which you are performing your assessment, and the lease inception are often very different)
4. Determining lease term.  Specifically, lease renewal options which need to be assessed as whether or not they meet the definition of “reasonably assured”, again, as of LEASE INCEPTION.
5. Economic useful life is a judgmental assessment that is made based upon the purpose that a leased asset was intended for AT LEASE INCEPTION.

 
Ok, I could give many more examples, but of all the items listed above, none of them tend to result in errors.  Or if there theoretically should have been errors, it is some technicality such as “technically at lease inception we thought we would use the building for x, but we soon thereafter circumstances changed and the best use was y” and because of the very technical (and in this case if we assume there was an error meaning that the persons did not consider the originally intended use at lease inception, but some additional info from some later date, such as the beginning of the lease term, we may actually get to an answer that uses less information than was available at the actual time of the assessment) it is either never a big concern for auditors or management, and/or no one cares enough to even bring it up.

However, the one area that I see the MOST often where the definition of lease inception matters is during lease modifications.  Although topic for another post all together, it is well established amongst the Big 4 accounting firms that any extension or renewals of a lease are automatically considered to be new leases and therefore need to be reassessed as such.  Whereas during a new lease, lessees tend to be pretty good at realizing when the lease begins (typically when the landlord actually provides access to the building is what triggers this for companies), they tend to overlook the fact that lease inception may not, and often IS NOT, the discrete “extended period” per the new lease agreement.  (i.e., the lease inception date is not the day after the original lease ends, necessarily).

Lease Inception:

Here is the definition directly from the codification.

Lease Inception
The date of the lease agreement or commitment, if earlier. For purposes of this definition, a commitment shall be in writing, signed by the parties in interest to the transaction, and shall specifically set forth the principal provisions of the transaction. If any of the principal provisions are yet to be negotiated, such a preliminary agreement or commitment does not qualify for purposes of this definition.

Obviously, lease inception centers around an agreement of the terms and conditions around a lease transaction.  This is not by accident.  Most lease accounting (see my series on build-to-suit accounting whereby I think what I’m about to say could be refuted pretty easily) follows the general concept that the goal is that the accounting should follow the economics contemplated AT THE TIME THE DECISIONS WERE MADE (i.e., the facts were all known).  Therefore, if you enter into an agreement whereby you essentially agree to pay 100% fair value over time (after compensating for the time value of money) of an asset, then you are essentially financing the purchase of this asset (or why not just go and buy it today from a vendor?).  Does it matter if in between the time that you actually are scheduled to begin using said asset, and the time you negotiated it, that the value of the asset has significantly changed (gone up for example)?  No it doesn’t.  Because that wasn’t contemplated when you entered into the arrangement, and therefore, just as if you HAD actually gone out and purchased the same asset for the PV of your purchase price (future minimum lease payments) your accounting will follow capital lease accounting whereby you will pay off your “loan” and depreciate your capital lease asset.  This is the same pretty much across the board with lease accounting, and something to always consider.  Hence, this is how “lease inception” is defined.

One important thing to remember is that the lease term (please note that I am not saying “lease inception” here) definition does not state that it begins at lease inception.  These are technically two different concepts.  This, in my opinion, is the #1 source of confusion on the topic… this is the smoking gun.  The codification does not specifically state the “start date” of lease term, but instead uses circular definitions which refer to and from “noncancellable lease term” and “lease term” definitions in the glossary.  I’m speculating a little here, but I assume that the FASB felt that it would be clear that the lease term is the term over which you can use the asset / obtain the benefits of the asset (part of the definition of a lease by the way) and therefore, the period over which you are economically compensating the lessor for said right to use.  However, the term “lease inception” I think confuses people because the inception of the lease can be very different, and earlier, than the beginning of the lease term.  Hence…. CONFUSION.  (Some people may have never been confused by this, but let me tell you, many are).   The correct way to interpret the FASB’s definition is that you have to remember it uses the word lease, which comes with a slew of assumed facts (see definition of lease) including right to control and physical access, ability to operate, remote chance that other parties will take more than a minor amount of the output, etc..  Therefore, lease term is assumed to commence on the first date in which the lease exists, and then the other parts of the “lease term” definition may extend this beyond what is explicitly stated in the lease.

However, lease inception is a different concept than “first day of lease term”, which is the main point I wanted to convey.  In one of PwC’s publications based on information from May 10, 2013, they provided an example which may illustrate the difference between lease inception and beginning of lease term.  I’m not going to directly quote them, as they haven’t provided me with permission to do that, but I will summarize their example and ask that you reach out to them to understand further.  You can reference 4650.59 of their ARM if you have a contact there.

There’s a lease signed on November 1st, 20XX.  The use of the property begins February 1st 20X1(also states this in the lease).  Possession of the property will be maintained through January 31st, 20×2.  In order to perform the lease assessment tests, one would need to perform the test AS OF November 1st, 20XX by discounting all of payments of the lease back to the beginning of the lease term (Feb 1, 20×1) [remember that the 90% test requires present valuing BACK to the beginning of the lease term, not lease inception] using the incremental borrowing rate as of (Nov 1, 20XX – Lease inception).   If it ends up being considered a capital lease, then the capital lease assets and liabilities should be recorded as of the beginning of the lease term (Feb 1, 20×1).

You can already see that dates matter in this example.  The trickier part, specifically when it comes to lease modifications, is that depending on whether or not you are moving to/from an operating/capital lease, the accounting can vary pretty significantly as a result.  I believe the issue is the definition of “beginning of lease term”.  If you have a “new agreement” automatically by a renewal/extension, for example, and you are already in the building and utilizing the space, then the lease inception AND beginning of lease term are typically the same.  If you think back to my earlier comment about guidance trying to follow the economics at hand when a lessee made the decision to enter/modify the lease (hence why lease inception is so important), then it would make sense that if you are already in the building, then the guidance is going to force you (if in an operating lease and this assessment doesn’t change) to revise your operating lease schedule on the date you revised the agreement to result in an even expense until the new end of the lease term (i.e., the lease inception and beginning of lease term will be the same.  Else, you could have a jump in rents once the “extended term” began if the expense during this period were calculated on it’s own straight line schedule).  I personally can see in the logic of this.  At the end of this negotiation, whether papered on two separate documents or one, you have the right to use a particular asset with varying rental payments through the end of the term, and therefore why should this be treated any differently than if this were a brand new lease with no history to speak of?  However oddly enough, probably due to volatility in balance sheet balances, if you are going from capital to operating lease (again this assessment is made as of the lease inception date of the modification in an extension or renewal), then you let the original capital lease schedule run its course and account for the extended period as if the first day of the new lease term is the first day of the extended term (not consistent with operating to operating).

I’ll save the intricacies of modification accounting of leases until another day (although, as always, please reach out to me with specific questions), but know that when you read “lease inception” it does not necessarily mean whatever date is explicitly stated in a lease document, nor even the first day with which you have possession.

In my experience, I do believe that the firms have reached on a consensus on this topic and we do have very popular accounting.  😀