The “Bear Minimum” case that was presented by Deloitte and Touche is one that deals with a
lease of equipment from Goliath Co. to Big Bear Power, a utility company who has had a history
of good financial standing. The lease agreement included three provisions, which have been the
subject of widespread debate. The question that these provisions give rise to is whether or not
they should be incorporated into the calculation of the minimum lease payments.
Provision one brings up the question of whether or not the costs associated with legal fees
should be included in the minimum lease payments. This would depend on whether or not these
fees are executory cost or initial direct costs.
ASC 840-10-25-5 (b) basically states that the minimum lease payments will not include
executory costs. ASC 840-10-25-5 says, “For a lessee, minimum lease payments comprise the
payments that the lessee is obligated to make or can be required to make in connection with the
leased property, excluding both of the following:
a. Contingent rentals
b. Any guarantee by the lessee of the lessor's debt and the lessee's obligation to pay
(apart from the rental payments) executory costs such as insurance, maintenance, and
taxes in connection with the leased property.”
I believe that this applies more to the $500,000 that was incurred by Big Bear and not by Goliath.
“Intermediate accounting, 15th edition” (Page 1277), which is the book that we use for this
course, states that executory costs are things that tangible assets incur, like insurance,
maintenance, and tax expenses. These are executory costs. The book also goes on to say, on page
1277, that they should be excluded in the calculation of the minimum lease payments, expensed,
and, in most cases, should be paid directly to the appropriate third party.
On the other hand, when you look at ASC 840-10-25-6 (e), it is worded “Fees that are
paid by the lessee to the owners of the special-purpose entity for structuring the lease transaction.
Such fees shall be included as part of minimum lease payments.” I believe that this applies more
to the $1,000,000 that Goliath incurred and required Big Bear to pay. These costs were necessary
to structure the lease transaction. I believe that these costs are initial direct costs. There is a
section in ASC 840 on initial direct costs in the operating lease section. ASC 840-20-25-17 says,
“Initial direct costs include only those costs incurred by the lessor that have both of the following
characteristics:
a. They are costs to originate a lease incurred in transactions with independent third
parties that meet both of the following conditions:
1. The costs result directly from and are essential to acquire that lease.
2. The costs would not have been incurred had that leasing transaction not occurred.
b. They are costs directly related to only the following activities performed by the lessor
for that lease:
1. Evaluating the prospective lessee's financial condition.
2. Evaluating and recording guarantees, collateral, and other security arrangements.
3. Negotiating lease terms.
4. Preparing and processing lease documents.
5. Closing the transaction.”
I believe that the $1,000,000 satisfies most of these characteristics. Therefore, this fee should be
classified as an initial direct cost.
Everywhere that I have read on the FASB ASC has stated that calculation of the
minimum lease payments must exclude executory costs. However, the section that I found on
initial direct costs is different from the sections on executory costs. The $500,000 should not be
included in the minimum lease payments since it was not obligatory to the leased asset. That
$500,000 should be expensed as an executory cost. The $1,000,000 should be included in the
minimum lease payments as it is necessary to structure the lease and is required.
The second provision of the lease agreement states that Big Bear must purchase the
combustion turbine from Goliath in less than 30 days if a change in control occurs as well as
requiring a penalty payment of $500,000. Under the lease agreement, a change in control is
defined as “ (1) a situation in which a person or entity becomes the beneficial owner, directly or
indirectly, of 50 percent of more of the outstanding votes shares of Big Bear or a (2) situation in
which Big Bear merges with another entity.”
ASC 840-10-25-14 states “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(d).”
From the proceeding paragraph and specifically in the final sentence, we can see that Big
Bear must not include the penalty payment of $500,000, considering that all of the above
conditions exists in the lease agreement. We are given no information that states that the default
covenant provision is out of the ordinary, therefore we can reasonable assume that it is
customary for Big Bear in financial arrangements. This satisfies condition A. We can see that it
passes condition B and C since the lease specifically states that occurrence of the lease is
determinable as well as predefining criteria for defaulting. We see this from the writing in the
lease stating “(1) a situation in which a person or entity becomes the beneficial owner, directly or
indirectly, of 50 percent of more of the outstanding votes shares of Big Bear or a (2) situation in
which Big Bear merges with another entity.” We know that Big Bear is in good financial
standing and believes that the likelihood of defaulting is remote which satisfies condition D.
Based upon the writing of the lease agreement we can see that provision 2 satisfies all of the
conditions of ASC 840-10-25-14, therefore the $500,000 penalty payment must not be included
in the minimum lease payment.
The third provision of the lease agreement involves an addition to the yearly rent payment if
there is an increase in consumer price index for that particular year. This provision of the lease
begins in January 2011 and is effective each year until the lease is over. CPI is a factor that can
fluctuate on a yearly basis, and therefore, cannot result in a scheduled and equal increase in the
rental payments for each year of the lease unless there is an existing CPI of a base year provided
in the agreement.
ASC 840-10-25-4 states that “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.)”
Although this provision may seem to constitute a typical contingent rental and, thus, be excluded
from the calculation of the minimum lease payments, the reliance upon a factor such as the CPI
in the amount of the yearly lease payments is accounted for differently. Because the most recent
measure of the CPI since the inception of the lease of 4% is provided in the provision, it is this
rate that the yearly rental payments will increase by to account for inflation. As a result of the
dependency of the lease payments on the CPI, this provision should be included when
calculating the minimum lease payments.