The lease of a combustion turbine by Big Bear Power from Goliath Co includes three provisions that we must examine to determine whether they should be included in the “minimum lease payment” as defined in ASC 840.
This provision involves Big Bear paying $500,000 to its external counsel, and $1 million of legal fees to Goliath Co. The $1 million fee to Goliath Co. should be included in the minimum lease payment. This is supported by 840-10-25-6 which states: Fees that are paid by the lessee to the owners of the special-purpose entity for structuring the lease transaction…shall be included as part of minimum lease payments. The $500,000 to its external counsel should not be included because it was not an obligatory cost for the lease.
To determine if the penalty payment from a default would be included in the minimum lease payment, we look at ASC 840-10-25-14: [Default covenants related to nonperformance do not affect lease classification if all of the following conditions exist: a. The default covenant provision is customary in financing arrangements. b. The occurrence of the event of default is objectively determinable (for example, subjective acceleration clauses would not satisfy this condition). c. Predefined criteria, related solely to the lessee and its operations, have been established for the determination of the event of default. d. It is reasonable to assume, based on the facts and circumstances that exist at lease inception, that the event of default will not occur. In applying this condition, it is expected that entities would consider recent trends in the lessee’s operations.
If any of those conditions do not exist, then the maximum amount that the lessee could be required to pay under the default covenant shall be included in minimum lease payments for purposes of applying paragraph 840-10-25-1] The first condition about the default covenant provision being customary does exist due to the note stating that “this is a customary provision in leasing arrangements”. The company has positive cash flow and is in compliance with all its debt covenants, which supports Big Bear’s belief that the chance of default is low. Thus conditions 2 and 4 are met. Condition 3, which involves predetermined criteria in case of a default, does not seem to have been met. Since not all the conditions have been met, the default payment covenant shall be included in the minimum lease payment.
This provision states that Big Bear’s rent of $1 million will increase by the same percentage increase in the CPI. The most recent annual increase in CPI was 4%. 840-10-25-4 states that “lease payments that depend on an existing index or sate, such as the CPI or prime interest rate, shall be included in minimum lease payments based on the index”. Therefore after the first year, the minimum lease payment will rise by $40,000 per year or $3,333.33 per month.