Item 7. Management’s Discussion and Analysis
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
On February 3, 2022 (the “Closing Date”), SES consummated its previously disclosed business combination (the “Business Combination”). Prior to the closing of the Business Combination, Ivanhoe Capital Acquisition Corp. (“Ivanhoe”), a Cayman Islands exempted company, migrated out of the Cayman Islands and domesticated as a Delaware corporation (the “Domestication”) and changed its name to “SES AI Corporation.” On the Closing Date, SES AI Corporation and Wormhole Amalgamation Sub Pte. Ltd., a Singapore private company limited by shares and a direct, wholly-owned subsidiary of Ivanhoe (“Amalgamation Sub”), consummated the Business Combination, which was accounted for as a reverse recapitalization. Under this method of accounting, SES AI Corporation was treated as the “acquired” company for financial reporting purposes. Except as otherwise provided herein, our financial statement presentation includes (i) the historical operating results of Old SES prior to the Business Combination; (ii) the combined results of SES and Old SES following the Closing; (iii) the assets and liabilities of Old SES at their historical cost; and (iv) SES’s equity structure for all periods presented. See “Note 3 – Business Combination” set forth in Part II, Item 8 of this Annual Report on Form 10-K, for additional information.
The following discussion and analysis provides information which our management believes is relevant to an assessment and understanding of our consolidated results of operations and financial condition. The following discussion and analysis should be read in conjunction with our audited consolidated financial statements as of and for the years ended December 31, 2022 and 2021 and the accompanying notes included in this Annual Report on Form 10-K. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs, which are subject to risks, uncertainties and assumptions. Our actual results and the timing of events may differ materially from those expressed or implied as a result of various factors, including those set forth in the sections titled “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements.”
Overview
We are engaged in the development and production of high-performance, Lithium-Metal (“Li-Metal”) rechargeable battery technologies for electric vehicles (“EVs”), electric vehicle take-off and landing (“eVTOL”) and other applications. Our third-party tested, differentiated battery technology has been designed to combine the high energy density of Li-Metal with the cost-effective, large-scale manufacturability of conventional Lithium-ion (“Li-ion”) batteries and will help to promote the transition from the global dependence on fossil fuel-based automotive vehicles to clean and efficient EVs.
Our mission is to facilitate the widespread adoption of sustainable electric transportation, both on land and in air, by creating best-in-class, high energy density Li-Metal batteries centered around long-range performance and safety. To assist in achieving this mission, we have partnered with leading global original equipment manufacturers (“OEMs”), GM, Hyundai and Honda, among other strategic partners, under joint development agreements (“JDAs”) to jointly develop and produce our Li-Metal battery cells and technology. We are also conducting research and development activities to further improve the performance, quality and cost of our battery technologyby focusing on the following key areas, all of which we expect to help us achieve our commercialization goal, at our facilities in Woburn, Massachusetts in the United States, Shanghai, China, and Chungju, South Korea.
● Scale-up : Our design is further being customized with and validated by several OEMs. Based on our collaborations with OEMs, we believe that a roughly 100 Ah cell-size manufactured at GWh scale (five to seven cells-per-minute) is needed to achieve commercialization in EVs at a large, global scale. We are developing processes and equipment to scale up the manufacturing of our current cell design from three to nine Ah capacity to 50 Ah and 100 Ah.
● Module and Pack Design : Li-Metal cells must be integrated into modules and packs as part of their integration into vehicles. Our active development efforts are focused on the integration of our Li-Metal cells in modules to enable our Li-Metal cells to perform as intended once they are integrated into modules and vehicles.
● Advanced Artificial Intelligence (“AI”) Software and Battery Management Systems (“BMS”) : Software is critical to ongoing monitoring of battery health and safety. We continue to develop advanced AI algorithms to diagnose battery cell-related health issues, develop advanced control algorithms and charging methods to enhance cycle life and safety, and port such software on to a BMS that could be integrated into a battery pack.
● Advanced Materials and Coatings : We continue to research and develop advanced electrolyte and anodes to further improve cycle life and safety. In addition, we continue to develop novel methods of laminating or depositing lithium metal onto current collector that can be deployed at commercial GWh scale.
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● Cathode Materials and Design : We develop our Li-Metal cells for a variety of different cathode materials, cathode design and cathode processing methods that can provide ultra-high energy density and/or significant cost-reduction.
● Li-Metal Recycling : Along with other battery components that are already being recycled today, Li-Metal foil will also need to be recycled in the future. We continue to explore methods of recycling that are productive and cost-effective.
During 2022, we continued to work towards developing and initially producing A-Sample batteries with specifications required by our OEM partners for their EVs. Our efforts resulted in 7 and 18 newly granted patents and trademarks and the construction of our pilot facilities in Shanghai, China and Chungju, South Korea. The Shanghai pilot facility was ready-to-use in March 2022 and fully operational in the third quarter of 2022, while the Chungju pilot facility ready-to-use in September 2022 and fully operational in the fourth quarter of 2022.
As we plan to transition the development and initial production of our Li-Metal batteries from A-sample to B-sample in 2023, we expect to significantly increase our headcount and the footprint of our research and pre-production pilot facilities by expanding our existing facilities and entering into new facilities. As a result, our materials consumption and the rate of cash utilization, as a function of time, will increase significantly.
After B-Sample, we plan to transition to C-Sample in 2024, which we then expect to enable us to commence commercial production of our technology in 2025. As the joint development of Li-Metal batteries with our OEM partners continues to progress, we also expect to launch future research facilities and, eventually, commercial production manufacturing facilities in the United States.
Finally, we expect to explore opportunities for partial vertical integration, both upstream and downstream, to ensure scalability of our battery and battery technology. Upstream, we intend to explore integrating vendors of key materials of our cells and providers of key equipment and engineering capabilities, such as cell assembly, anode processing, chemical processing and safety testing. Downstream, we plan to explore integrating providers of key engineering capabilities, such as battery state-of-health monitoring software, charging optimization software, battery module development and recycling.
Results of Operations
The discussion of our results of operations for the year ended December 31, 2021 can be found in Exhibit 99.2 Management’s Discussion and Analysis of Financial Condition and Results of Operations under our Amendment No. 1 Form 8-K (the “Super 8-K Amendment”) for the fiscal year ended December 31, 2021 filed with the Securities and Exchange Commission on March 31, 2022, which is incorporated herein by reference.
Factors Affecting Operating Results
We are an early-stage growth company in the pre-commercialization stage of development, and conduct our business through one operating segment. We have not generated any revenue from sales to customers to date, have spent $42.2 million, $31.5 million, and $9.4 million on research and development activities, which is prior to credits received by our OEM partners under the JDAs, and have incurred net losses of $51.0 million, $31.3 million, and $13.9 million for the years ended December 31, 2022, 2021 and 2020, respectively, and had an accumulated deficit of $145.3 million and $94.3 million from our inception through December 31, 2022 and 2021, respectively. Our historical results may not be indicative of our future results for reasons that may be difficult to anticipate and our ability to generate revenue in the future that is sufficient enough to achieve profitability will depend largely on the successful development of our products. Accordingly, the drivers of our future financial results, as well as the components of such results, may not be comparable to our historical results of operations.
During 2021 and 2022, we were subject to challenging conditions stemming from the COVID-19 pandemic. Previous spikes in COVID-19 cases in Shanghai resulted in government-mandated temporary shutdowns at our Shanghai facility in April 2022, causing a delay of over a month in our development, testing and manufacturing efforts and in our product schedule and our ability to obtain materials from our suppliers in the affected area. The government-mandated shutdown was lifted on June 1, 2022 and the Shanghai facility has re-opened. If our workforce is unable to work effectively, including due to illness, quarantines, government actions or other restrictions in connection with COVID-19, our operations will be adversely affected. See “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K for further discussion of the possible impact of the COVID-19 pandemic on our business.
The following table sets forth our historical operating results for the periods indicated:
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Operating Expenses
Years Ended December 31,
$
%
(in thousands)
2022
2021
Change
Change
Research and development
$
27,967
$
15,514
$
12,453
80
%
General and administrative
51,606
16,492
35,114
213
%
Total operating expenses
$
79,573
$
32,006
$
47,567
149
%
Research and Development
Research and development expenses consist primarily of costs incurred for salaries and personnel-related expenses, including stock-based compensation expense, for scientists, experienced engineers and technicians, expenses for materials and supplies used in product research and development, process engineering efforts and testing, as well as payments to consultants, patent related legal costs, depreciation, and allocated facilities and information technology costs.
Research and development expenses for the year ended December 31, 2022 increased $12.5 million, or 80%, to $28.0 million, compared with $15.5 million for the year ended December 31, 2021. The increase primarily resulted from a $8.2 million increase in personnel costs mainly attributable to our growth in headcount in support of our ongoing research and development efforts for battery cell development, which included $6.3 million of stock-based compensation expense that primarily relates to restricted earnout shares issued as part of the Business Combination in February 2022 and restricted and performance stock units issued in April 2022. Further, there was a $4.5 million increase in software development costs related to our advanced AI software and BMS, a $1.8 million increase in facility costs due to rent, utilities and depreciation expenses, and a $1.4 million increase in expenses for lab consumables and material supplies. These increases were partly offset by a $3.2 million increase in credits to research and development expense, which are amounts invoiced pursuant to the JDAs, and a $0.3 million decrease in fees associated with external consulting. We expect research and development expenses to significantly increase in 2023 compared with 2022 as we attempt to develop a battery cell with acceptable performance, yields and costs due to expansion of our science, engingeering, and technician personnel and investments in additional plant and equipment for product development, building prototypes and testing of battery cells.
General and Administrative
General and administrative expenses consist primarily of costs incurred for salaries and personnel-related expenses, including stock-based compensation expense, for our finance, legal and human resource functions, expenses for director and officer insurance, outside contractor and professional service fees, audit and compliance expenses, legal, accounting and other advisory services, as well as allocated facilities and information technology costs including depreciation. Upon commencement of commercial operations, we also expect to incur customer and sales support and advertising costs.
General and administrative expenses for the year ended December 31, 2022 increased $35.1 million, or 213%, to $51.6 million, compared with $16.5 million for the year ended December 31, 2021. This increase primarily resulted from a $17.5 million increase in personnel costs mainly attributable to our growth in headcount to support our operations as a public company, which included $11.9 million of stock-based compensation expense that primarily relates to restricted earnout shares issued as part of the Business Combination in February 2022 and restricted and performance stock units issued in April 2022. Further, there was a $7.5 million increase in insurance expense to cover potential liabilities under our indemnification obligations to our directors and certain officers of the Company, a $4.6 million increase in fees associated with external consulting, legal, marketing, public relations, audit and accounting services, a $3.4 million increase due to deferred offering costs associated with the Business Combination, a $1.1 million increase in facility costs due to rent, utilities and depreciation, a $0.6 million increase in travel costs primarily related to the opening of the South Korea facility, and a $0.4M increase in computer and software related costs. We expect general and administrative expenses to increase in 2023 compared with 2022 due to expansion of our personnel headcount to support our growth and operations as a public company.
Non-Operating Items
Interest Income, Net
Interest income primarily consists of interest earned on our cash and cash equivalents, which are primarily invested in money market funds, and short-term investments in marketable securities, which are invested in U.S. treasury securities, and accretion income from the marketable securities.
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During the year ended December 31, 2022, we had interest income of $6.2 million compared with $0.2 million for the year ended December 31, 2021. This $6.0 million increase was primarily due an increased investment in money market funds, a shift of a portion of our investment portfolio in the current year from cash and cash equivalents to higher yielding investments in U.S. treasury securities, and a general increase in interest rates during 2022.
Change of Fair Value of Earn-Out Liability, Net
During the year ended December 31, 2022, we incurred a $25.4 million gain associated with the change in fair value of the Sponsor Earn-Out liability. With the fair value of the Sponsor Earn-Out liability tied to the Company’s stock price, continued volatility in the stock price could result in further gains or losses resulting from the change in fair value. See “Note 11 – Sponsor Earn-Out Liability” to the consolidated financial statements for additional information.
Other (Expense) Income, Net
During the year ended December 31, 2022, we had other expense of $1.8 million, compared with other expense of $0.3 million for the year ended December 31, 2021. This $1.5 million increase in other expense was primarily the result of the accounting for certain postemployment benefits and a gain recorded in the prior year from the forgiveness of the PPP note received in 2020, partially offset by unrealized and realized foreign currency gains primarily due to the strengthening of the U.S. dollar compared with the Chinese renminbi and South Korean won.
Provision for Income Taxes
Income tax expense was $1.3 million on pre-tax loss of $49.7 million for the year ended December 31, 2022 compared with an immaterial income tax expense on pre-tax loss of $31.2 million for the year ended December 31, 2021. Our effective tax rate was (2.5)% and (0.1%) for the years ended December 31, 2022 and 2021, respectively. The difference between our effective tax rate and the U.S. federal statutory rate of 21% was primarily driven by non-recognized deferred tax benefits due to a full valuation allowance. See to “Note 18 – Income Taxes” to the consolidated financial statements for additional information on our income tax expense.
Liquidity and Capital Resources
On February 3, 2022, as a result of the aforementioned Business Combination and PIPE Financing, we raised $282.9 million in net proceeds. Prior to that, since our inception we raised approximately $269.9 million of funding through the sales of our redeemable convertible preferred stock. As of December 31, 2022, we had total cash and cash equivalents of $106.6 million, short-term investments in marketable securities of $283.5 million, and an accumulated deficit of $145.5 million. As an early-stage growth company in the pre-commercialization stage of development, the net operating losses we have incurred since inception are consistent with our strategy and budget.
As a result of the capital-intensive nature of our business, we expect to sustain substantial operating expenses, without generating sufficient revenues to cover expenditures, for a number of years. To date, we have funded our operations through a combination of proceeds from the Business Combination and PIPE Financing and funding received through the sales of our redeemable convertible preferred stock. These funds are expected to finance our principal sources of liquidity and ongoing costs, such as research and development relating to our Li-Metal batteries and the construction of additional manufacturing facilities. In the future, if we are not able to fund our operations from cash flows generated from anticipated product sales, we expect that we will need to raise additional funds through a variety of possible methods, including, but not limited to, entry into joint ventures or other strategic arrangements, issuance of equity, equity-related or debt securities or through obtaining credit from financial institutions, as well as anticipated future revenue from product sales.
We believe that our cash on hand and marketable securities will be sufficient to meet our working capital and capital expenditure requirements for a period of at least 12 months from the date of this Report, and also sufficient to fund us to commercialization. However, additional funding may be required for a variety of reasons, including opportunities to build an integrated supply chain in the United States and delays in expected development of our Li-Metal battery cells. Our ability to successfully develop our products, commence commercial operations and expand our business will depend on many factors, including our working capital needs, the availability of equity and/or debt financing and, over time, our ability to generate positive cash flows from operations.
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Summary of Cash Flows
The following table provides a summary of our cash flow data for the periods indicated:
Years Ended December 31,
(in thousands)
2022
2021
Cash (used in) provided by:
Operating activities
$
(46,500)
$
(29,991)
Investing activities
(296,009)
3,314
Financing activities
289,927
184,760
Effect of exchange rate changes on cash
(526)
233
Net (decrease) increase in cash, cash equivalents and restricted cash
$
(53,108)
$
158,316
Operating Activities
Our cash flows used in operating activities to date have been primarily comprised of payroll, consumables and supplies related to research and development, expenditures and reimbursements related to our JDAs, and facilities expense and professional services for general and administrative activities. As we continue to ramp up hiring for research and development headcount to accelerate our engineering efforts, we expect our cash used in operating activities to increase significantly before we start to generate any material cash inflows from our operations.
Net cash used in operating activities of $46.5 million for the year ended December 31, 2022 was primarily attributable to net loss of $51.0 million, as adjusted for a gain on change in fair value of Sponsor Earn-Out liability of $25.4 million, stock-based compensation expense of $22.8 million, depreciation and amortization expense of $2.6 million and accretion income from available-for-sale short-term investments of $2.4 million, partially offset by a $6.4 million working capital inflow. The working capital inflow was driven by a $6.8 million increase in accrued expenses and other liabilities and a $5.5 million decrease in receivable from related party, partially offset by a $4.0 million decrease in accounts payable and a $1.6 million increase in prepaids and other assets. The increase in accrued expenses and other liabilities was primarily due to advanced payments received under the JDAs, accrued income taxes payable, payroll related accruals and the accounting of certain postemployment benefits. The decrease in receivable from related party was driven by activity from a JDA. The decrease in accounts payable was primarily due to the payment of transaction costs related to the Business Combination and PIPE Financing partially offset by an increase in accounts payable related to the purchase of property and equipment for the South Korea facility. The increase in prepaids and other assets was primarily due to insurance costs to cover potential liabilities under our indemnification obligations to our directors and certain officers.
Net cash used in operating activities of $30.0 million for the year ended December 31, 2021 was primarily attributable to net loss of $31.3 million, as adjusted for stock-based compensation expense of $4.6 million, depreciation and amortization of $1.7 million and gain on the forgiveness of the PPP note payable of $0.8 million, partially offset by a $4.2 million working capital outflow. The working capital outflow was primarily driven by a $7.9 million increase in receivable from related party and a $1.7 million increase in prepaids and other assets, partially offset by a $4.1 million increase in accrued expenses and other liabilities and a $1.3 million increase in accounts payable. The increase in receivable from related party was driven by activity from a JDA. The increase in prepaids and other assets was primarily attributable to prepaid rent and deposits related to the Shanghai facitlity. The increase in accrued expenses and other liabilities was primarily attributable to increased marketing and public relations activity and a prepayment attributable to a JDA. The increase in accounts payable was primarily attributable to professional fees associated with external legal, consulting and accounting services.
Investing Activities
Net cash used in in investing activities was $296.0 million for the year ended December 31, 2022, compared with net cash provided by investing activities of $3.3 million for the year ended December 31, 2021.
Purchases and Maturities of Investments – Net purchases of short-term investments were $281.4 million for the year ended December 31, 2022, compared with net proceeds from maturities of short-term investments of $12.3 million for the year ended December 31, 2021. The $293.6 million decrease in net proceeds was driven by a shift of our investment portfolio to cash equivalents in the current year.
Capital Spending – Capital expenditures were $14.7 million and $9.0 million for the years ended December 31, 2022 and 2021, respectively, and primarily related to purchases of lab machinery and equipment, lab tools and instruments and leasehold improvements to our facilities
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in the United States, Shanghai and South Korea. We expect capital expenditures to significantly increase in 2023 compared with 2022 as we continue to invest in the build out of our manufacturing pre-production facilities and expand into new facilities.
Financing Activities
Net cash provided by financing activities of $289.9 million for the year ended December 31, 2022 was primarily attributable to proceeds received from the Business Combination and PIPE Financing, net of transaction costs and from a government grant.
Net cash provided by financing activities of $184.8 million for the year ended December 31, 2021 related to proceeds received from the issuance of Series D and D plus redeemable convertible preferred stock, net of issuance costs.
Debt
In April 2020, we applied for and received $0.8 million in the PPP note. We received full forgiveness of all our debt under the terms of the program in February 2021 and recorded a gain of $0.8 million in other income in our consolidated statement of operations and comprehensive loss for the year ended December 31, 2021. As of the date of this filing, we have no debt obligations outstanding.
Contractual Obligations and Commitments
The following table summarizes our material contractual obligations for cash expenditures as of December 31, 2022, and the periods in which these obligations are due:
Short Term
Long Term
Total
Purchase obligations (1)
$
37,204
$
26,215
$
63,419
Operating lease obligations (2)
2,892
14,415
17,307
Total contractual obligations
$
40,096
$
40,630
$
80,726
(1) Purchase obligations include commitments for the purchase of lab supplies and equipment as well as committed spend related to a JDA. These commitments are derived from purchase orders, supplier contracts and open orders based on projected demand information.
(2) Operating lease obligations represent the fixed lease payments for the noncancelable lease term, fixed lease payments for optional renewal periods where the Company is reasonably certain the renewal option will be exercised, and variable lease payments that depend on an underlying index or rate in effect at lease commencement.
Off-Balance Sheet Arrangements
As of December 31, 2022, we had a letter of credit issued by a financial institution totaling $0.6 million. The letter of credit relates to deposits the Company is required to maintain under one of its operating leases agreements. We have restricted cash that serves as collateral for this outstanding letter of credit that is included in other assets on our consolidated balance sheet. No amounts have been drawn under the letter of credit.
Recent Accounting Pronouncements
See “Note 2 – Summary of Significant Accounting Policies” of our accompanying consolidated financial statements included in this Annual Report on Form 10-K for more information about recent accounting pronouncements, the timing of their adoption, and their potential impact on our financial condition, results of operations and cash flows.
Critical Accounting Estimates and Judgments
Our consolidated financial statements have been prepared in accordance with U.S. GAAP which requires management to use judgment in making estimates and assumptions that affect the reported amounts of assets, liabilities and the disclosure of contingent assets and liabilities as of the date of the financial statements, as well as the reported expenses incurred during the reporting periods.
We consider an accounting estimate or assumption to be critical when (1) the estimate or assumption is complex in nature or requires a high degree of judgment and (2) the use of different judgments, estimates and assumptions could have a material impact on the financial statements. Our significant accounting policies are described in “Note 2 – Summary of Significant Accounting Policies” of our accompanying consolidated financial statements included in this Annual Report on Form 10-K. We consider the following to be our critical accounting estimates.
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Description
Judgments and Uncertainties
Effect if Results Differ From Assumptions
Stock-Based Compensation
We record stock-based compensation expense according to the provisions of ASC Topic 718 – Stock Compensation. ASC Topic 718 requires all share-based awards to employees, including grants of Restricted Stock Units (RSUs), Performance Stock Units (PSUs), Restricted Stock Awards (RSAs), and employee stock options, to be recognized in the financial statements based on their fair values.
Prior to the Business Combination, the RSAs and stock option grant date fair value of Old SES common stock was historically determined by its board of directors with the assistance of management and an independent valuation.
Post Business Combination, as our common stock is publicly traded, the fair value of RSU grants is based on the closing market price on the date grants are made . The fair value of PSU grants is determined through and independent valuation of the likelihood of the performance metrics being met within the terms of the award.
Under the provisions of ASC Topic 718, we determine the appropriate fair value model to be used for valuing share-based issuances and the amortization method for recording compensation cost, which can be impacted by the following assumptions:
●
expected term
●
expected volatility
●
expected dividend yield
●
risk-free interest rate
If we were to change any of these judgments or estimates, it could cause a material increase or decrease in the amount of stock-based compensation expense reported.
Earn-Out Restricted Shares
The Earn-Out Restricted Shares are accounted for as a single tranche equity award issued to employees subject to time and share price vesting hurdle. These Earn-Out Restricted Shares have a share price vesting hurdle and are also subject to forfeiture if a recipient’s service terminates prior to the vesting. Pursuant to ASC 718 – Stock Compensation, we recognize stock-based compensation based on the fair value determined as of Closing with the assistance of management and an independent valuation.
Under the provisions of ASC Topic 718, we determine the appropriate fair value model to be used for valuing share-based issuances and the amortization method for recording compensation cost, which can be impacted by the following assumptions:
●
expected term
●
expected volatility
●
expected dividend yield
●
risk-free interest rate
●
probability of change of control
If we were to change any of these judgments or estimates, it could cause a material increase or decrease in the amount
of stock-based compensation expense reported.
Sponsor Earn-out Liability
Certain Sponsor Earn-Out Shares are accounted for as a derivative liability measured at fair value, with changes in fair value recorded in the consolidated statement of operations and comprehensive loss at each reporting period, because the earn-out events that determine the number of Sponsor Earn-Out Shares to be earned back by the Sponsor include events that are not solely indexed to the common stock of the Company.
The fair value of our common stock, which is publicly traded, is used in determining the fair value of the derivative liability at each valuation date with the assistance of management and an independent valuation.
We determine the appropriate fair value model to be used for valuing the derivative liability to record the change in fair value in our consolidated statement of operations and comprehensive loss, which may be impacted by the following assumptions:
●
expected volatility
●
risk free rate
●
expected term
●
probability of change of control
If we were to change any of these judgments or estimates, it could cause a material increase or decrease in the amount of earn out liability reported.
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Description
Judgments and Uncertainties
Effect if Results Differ From Assumptions
Leases
We adopted ASC 842, Leases, with an initial application date of January 1, 2022, using the modified retrospective method with certain optional transition relief.
At the lease commencement date, we recognized a right-of-use (“ROU”) asset and a lease liability for all leases, except short-term leases with an original term of 12 months or less. The ROU asset represents the right to use the leased asset for the lease term. The lease liability represents the present value of the lease payments under the lease.
The operating lease liability is equal to the present value of (1) fixed lease payments for the noncancelable lease term, (2) fixed lease payments for optional renewal periods where it is reasonably certain the renewal option will be exercised, and (3) variable lease payments that depend on an underlying index or rate in effect at lease commencement. Variable lease payments that do not depend on an underlying index or rate in effect at lease commencement, such as common area maintenance, insurance, and property tax, are recognized in operating expenses when incurred.
The measurement of the lease liability depends on the expected lease term with renewal options wherein it is reasonably certain that the renewal option will be exercised. Because the Company’s operating lease does not provide an implicit rate, the Company estimates its incremental borrowing rate at lease commencement date for borrowings on a collateralized basis over a similar term in a similar economic environment.
If we were to change any of these judgments or estimates, it could cause a material increase or decrease in the amount of ROU asset and lease liability reported.