THE ENVIRONMENTAL ASPECT OF ESG may cause a company to reexamine its leases and leasing strategy. In making a net-zero or other commitment to reduce its carbon footprint, a lessee could (1) decide to modify or terminate existing leases that are inconsistent with this commitment, such as those of carbon-heavy vehicles or facilities, or (2) undertake other actions that trigger a reassessment of one or more leases (e.g., change travel policies in a manner that triggers reassessing the company’s aircraft or corporate housing leases). Let’s look at the lease accounting issues at play in these situations.
Do the parties even have a lease?
If a contract is not, or does not contain, a lease, Topic 842 does not apply. A contract for the right to use even a specifically identified asset is not a lease when the supplier has the substantive right to substitute the leased asset for a different asset during the lease term.
For example, in the context of reducing its own carbon footprint, an energy management service provider may have the contractual right to substitute certain assets used in providing its services. Whether that substitution right is substantive is a factual question; it can be substantive only if the provider has the practical ability to substitute alternative assets throughout the period of use and it would benefit economically from doing so. Facts and circumstances can affect this evaluation. However, in general, reputational and other indirect benefits a supplier expects to realize from its “green” efforts are not considered in assessing whether the supplier would economically benefit from substitution. Instead, the supplier needs to demonstrate that the substitution would permit it to redeploy the substituted assets, after considering the costs of substitution (e.g., installation, removal, transport), in a more economically beneficial manner.
What happens if the parties modify a lease?
If contract changes result in a change to the scope of or consideration for a lease, then the parties apply the lease modification guidance in Topic 842. Examples include adding or eliminating the right to use one or more underlying assets and changing the contractual lease term.
Lessee accounting
There are two ways a lessee can account for a modification.
A modification is accounted for as a separate contract if it grants the lessee the right to use an additional asset and the corresponding increase in the lease payments is commensurate with the stand-alone price of that additional right of use. For example, to further its green initiatives, a lessee may add additional electric vehicles to its leased fleet under a master lease agreement at fair market rates. This lessee would likely account for the new vehicle leases as a separate contract.
By contrast, a lessee would not account for a modification where the lessor agrees to make energy efficiency upgrades to a leased building in return for increased lease payments as a separate contract. Similarly, if the lessee makes the upgrades itself, but those improvements are considered owned by the lessor for accounting purposes, a modification results that is not a separate contract. In that case, the lessee paying for lessor-owned property improvements changes the consideration for the lease without adding any new rights to use additional assets.
Lessor accounting
Like lessees, lessors account for modifications as separate contracts when the above criteria are met. If a modification is not a separate contract, a lessor reassesses its classification of the lease as of the effective date of the modification based on the underlying asset’s then fair value and remaining economic life, as well as other factors.
In addition to contractual changes, lessors apply modification accounting when lessees:
- exercise an option (e.g., renewal or purchase option) the lessor had previously determined the lessee was not reasonably certain to exercise; or
- do not exercise an option the lessor previously determined the lessee was reasonably certain to exercise.
What happens if the lessee’s plans change?
To action net-zero plans, a lessee may decide that it will exercise an early termination option it was previously reasonably certain not to exercise or not exercise a renewal option it was previously reasonably certain to exercise. For example, a lessee may decide it will exercise an option to early terminate certain gas-powered vehicle leases to enter into new leases for electric vehicles.
The immediate question is whether there has been a triggering event for the lessee to reassess its accounting lease term. If so, the lessee remeasures the lease as if it was effectively a new lease at the event date; this includes reassessing the lease classification, lease term and discount rate. If there has not been a triggering event, the lessee’s changed plans do not trigger a reassessment.
Identifying triggering events
A lease term triggering event is a significant event or change in circumstances that (1) is within the lessee’s control and (2) directly affects whether the lessee is reasonably certain to exercise the renewal or termination option. One or more actions a lessee takes to reduce its carbon footprint may constitute a triggering event.
Market-based or other events or changes in circumstances not in the lessee’s control (e.g., changes in laws, regulations, consumer preferences) are not, in isolation, triggering events.
A lessee’s change in plans will generally not give rise to a triggering event unless accompanied by an attendant action—e.g., a decision to vacate a facility or return a leased vehicle early accompanied by the lessee also entering into a new lease for a greener facility or vehicle, or legally notifying the lessor of early termination. Without the corresponding action, there is nothing to stop the lessee from simply reversing its decision.
Because they determine whether a lessee must reassess its lease accounting, mis-identifying triggering events can lead to material accounting issues.
Concluding thoughts
With the swift pace that ESG initiatives are moving, many companies have already reexamined, or will shortly reexamine, their leasing strategies. As they do so, they need to understand which actions they may take will trigger accounting consequences.
