Chapter 16 — Effective Date and Transition

16.7 Separation and Allocation of Consideration to Components in a Contract in Transition

16.7.1 Separation of Lease and Nonlease Components for Lessors Upon Adoption of ASC 606

As stated in ASC 606-10-15-2, the revenue standard does not apply to lease contracts within the scope of ASC 840 (or ASC 842, upon adoption of the new leasing standard). Although lease contracts are generally outside the scope of the revenue standard, ASC 606-10-15-4 states that a “contract with a customer may be partially within the scope of this Topic [ASC 606] and partially within the scope of other Topics listed in paragraph 606-10-15-2.” An example of a contract that may be partially within the scope of ASC 606 and partially within the scope of another ASC topic is a lease contract entered into by a lessor that contains both lease and service elements.26

Under ASC 840, the scope guidance in ASC 840-10-15-19 states the following:

For purposes of applying this Topic, payments and other consideration called for by the arrangement shall be separated at the inception of the arrangement or upon a reassessment of the arrangement into:

Those for the lease, including the related executory costs and profits thereon
Those for other services on a relative standalone selling price basis, consistent with the guidance in paragraph 606-10-15-4 and paragraphs 606-10-32-28 through 32-41. [Emphasis added]

ASC 840 further states that executory costs (such as a lessor’s property taxes, insurance, and maintenance) are excluded from the lessor’s minimum lease payments for purposes of lease classification and measurement. Although these costs are excluded from the lessor’s minimum lease payments, the costs are generally still considered part of the lease contract in accordance with ASC 840-10-15-19(a) rather than “other services” or substantial services27 that are separated and excluded from the scope of ASC 840 and therefore typically within the scope of revenue recognition guidance (historically, under ASC 605 or industry guidance). That is, executory costs are generally not separately accounted for under the legacy revenue recognition guidance in ASC 605.

In addition, before the effective date of ASU 2014-09, ASC 605-25-55-3 contained the following example clarifying when to apply the allocation guidance in ASC 605 and that in ASC 840:

For example, leased assets are required to be accounted for separately under the guidance in Subtopics 840-20 and 840-30. Consider an arrangement that includes the lease of equipment under an operating lease, the maintenance of the leased equipment throughout the lease term (executory cost), and the sale of additional equipment unrelated to the leased equipment. The arrangement consideration should be allocated between the deliverables subject to the guidance in Subtopic 840-20 and the other deliverables using the relative selling price method. (Although Topic 840 does not provide guidance regarding the accounting for executory costs, it does provide guidance regarding the allocation of arrangement consideration between the lease and the executory cost elements of an arrangement. Therefore, this example refers to the leased equipment and the related maintenance as deliverables subject to the guidance in that Topic.) The guidance in Topic 840 would then be applied to separate the maintenance from the leased equipment and to allocate the related arrangement consideration to those two deliverables. This Subtopic would be applied to further separate any deliverables not subject to the guidance in Topic 840 and to allocate the related arrangement consideration.

In accordance with this illustrative example in ASC 605, deliverables within the scope of the leasing guidance (including both the leased asset and executory costs) would be within the scope of ASC 840 and subject to the allocation guidance in ASC 840. However, the separate deliverable of the sale of additional equipment would not be covered by ASC 840 and would instead be subject to the accounting and allocation guidance in ASC 605.

In contrast to this approach under ASC 840, upon adoption of the new leasing standard, a lessor will be required to separate lease and nonlease components in a contract (unless the scope criteria in ASC 842-10-15-42A are met and the lessor elects to use the practical expedient of combining lease and nonlease components, as discussed in Section 16.7.2). As illustrated above, a common example of a nonlease component under ASC 842 is maintenance services (commonly referred to as CAM services) performed by the lessor, which may be currently accounted for as an executory cost under ASC 840. That is, upon a lessor’s adoption of ASC 842, maintenance services will be considered a service within the scope of ASC 606 rather than an executory cost accounted for under lease accounting guidance.

Connecting the Dots

Questions About Effect of Interaction Between ASC 606 and ASC 842 on Accounting for Nonlease Components

Because the effective dates of ASC 60628 and ASC 84229 are not the same, questions have been raised about whether and, if so, when a lessor would be required to separate nonlease components currently accounted for as executory costs (e.g., CAM) and account for those activities as services within the scope of ASC 606. Specifically, stakeholders have questioned whether a lessor would be required to separately account for CAM under ASC 606 (1) upon the adoption of ASC 606, (2) upon the adoption of ASC 842, or (3) in some other manner.

After these questions were raised, we participated in informal meetings with both the FASB staff and the SEC staff to discuss the interaction between ASC 606 and ASC 842 and how adoption of the revenue and new leasing standards will affect the accounting for nonlease components (e.g., CAM). On the basis of our discussions with both parties, our understanding is that a lessor would not be required, upon adoption of the revenue standard, to separate existing executory costs accounted for under ASC 840 that will meet the definition of a nonlease component under ASC 842 (e.g., CAM) and account for those activities as services within the scope of ASC 606. However, we believe that while a lessor would not be required to separate nonlease components, it would be acceptable for a lessor to elect to separate nonlease components and account for them as revenue-generating activities upon adoption of ASC 606.

Upon adoption of ASC 842, a lessor’s accounting for executory costs in existing leases that historically have been accounted for under ASC 840 would depend on whether:

The lessor elects the practical expedient in ASC 842-10-65-1(f) of not reassessing lease classification for existing leases at transition.
The lessor does not elect the practical expedient in ASC 842-10-65-1(f), and the lessor’s lease classification changes.
The lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components.

Accordingly, a lessor should consider the following scenarios:

Scenario 1: The lessor does not elect the practical expedient in ASC 842-10-65-1(f), and the lessor’s lease classification changes upon adoption of ASC 842 (excluding a change from sales-type to direct financing) — If a lessor’s lease classification changes upon adoption of ASC 842, the lessor must apply the guidance in the new leasing standard on separating components of a contract as of the lessor’s date of initial application, which, depending on the transition method elected, could be either (1) the beginning of the earliest period presented under ASC 842 (e.g., January 1, 2017, for calendar-year-end public entities) or (2) the date of adoption (e.g., January 1, 2019, for calendar-year-end public entities) when the lessor uses the Comparatives Under 840 transition method. Accordingly, the lessor would be required to separate, and allocate consideration to, nonlease components (e.g., CAM services) unless the lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components. If the lessor either does not qualify for the practical expedient in ASC 842-10-15-42A or does not elect to use it, the nonlease components would be accounted for in accordance with the revenue recognition guidance in ASC 606.
Scenario 2: The lessor’s lease classification does not change upon adoption of ASC 842 because the lessor either (1) elects to apply the practical expedient in ASC 842-10-65-1(f) of not reassessing lease classification for existing leases at transition or (2) elects instead to reevaluate classification, but the lease classification does not change (or changes only from sales-type to direct financing) upon reassessment at transition — We believe that if a lessor’s lease classification does not change upon adoption of ASC 842 for either of the reasons stated above, the lessor’s accounting for executory costs in existing leases would depend on whether the lessor elects to use the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components:
- Scenario 2(a): The lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components — In this scenario, any executory costs historically accounted for under ASC 840 should be combined with the lease and nonlease components and accounted for under either ASC 606 (if the nonlease component is the predominant component in the contract) or ASC 842 (if the nonlease component is not the predominant component in the contract).
- Scenario 2(b): The lessor does not elect the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components — We believe that in this scenario, it is acceptable for a lessor to account for executory costs that transfer a good or service to the lessee, including CAM, either as (1) a nonlease component under ASC 606 (i.e., separately from the lease component) by aligning existing leases to the lessor’s policy election of separating nonlease components under ASC 842 or (2) part of the lease component under ASC 842 (i.e., as if the lessor were “running off” its existing leases in a manner consistent with its accounting treatment under ASC 840).

In contrast to the discussion above on executory costs (including maintenance services), an entity should account for “other services” or substantial services that are not within the scope of ASC 840 in accordance with the guidance in ASC 606 as of the effective date applicable to the entity.

16.7.2 Lessor Practical Expedient

ASC 842-10

15-42A As a practical expedient, a lessor may, as an accounting policy election, by class of underlying asset, choose to not separate nonlease components from lease components and, instead, to account for each separate lease component and the nonlease components associated with that lease component as a single component if the nonlease components otherwise would be accounted for under Topic 606 on revenue from contracts with customers and both of the following are met:

The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.

In July 2018, the FASB issued ASU 2018-11, under which lessors could elect not to separate lease and nonlease components when certain conditions are met. A lessor could elect to combine lease and associated nonlease components provided that the nonlease component(s) would otherwise be accounted for under ASC 606 and both of the conditions in ASC 842-10-15-42A(a) and (b) (“Criterion A” and “Criterion B”) are met. For further considerations related to these two criteria, see Section 4.3.3.2.1.

The ASU also clarifies that the presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the expedient for the lease component and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease components that do not qualify for the practical expedient separately from the combined lease and nonlease components that do qualify.

Connecting the Dots

Assessing the Timing and Pattern of Transfer

In ASU 2018-11, the Board amended Criterion A to focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer . . . to the customer over the same time period”) rather than on the timing and pattern of revenue recognition (as was originally proposed). The purpose of this amendment was to address concerns that the originally proposed practical expedient was unnecessarily restrictive and excluded contracts with variable consideration from its scope, since variable payments are accounted for differently under ASC 606 than they are under ASC 842.

16.7.2.1 Determining Which Component Is Predominant

The FASB originally proposed that a lessor should always be required to account for the combined component as a lease under ASC 842 in a manner consistent with a similar practical expedient afforded to lessees. However, on the basis of feedback it received, the Board revised the final ASU to require an entity to perform another evaluation to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as a revenue contract under ASC 606. Specifically, an entity should determine whether the nonlease component (or components) associated with the lease component is the predominant component of the combined component. If so, the entity is required to account for the combined component in accordance with ASC 606. Otherwise, the entity must account for the combined component as an operating lease in accordance with ASC 842.

Connecting the Dots

An Entity Will Need to Use Judgment to Determine the Predominant Component

As indicated in ASU 2018-11’s Background Information and Basis for Conclusions, the FASB decided not to include a separate definition or threshold for determining whether “the nonlease component is the predominant component of the combined component.” Rather, the Board indicates that a lessor should consider whether the lessee would “ascribe more value to the nonlease component(s) than to the lease component.” Further, the Board acknowledged that the term “predominant” is used elsewhere in U.S. GAAP, including ASC 842 and ASC 606.

The Board also explains that it does not expect that an entity will need to perform a quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine whether to apply ASC 842 or ASC 606. Therefore, we expect that entities will need to use judgment in making this determination.

At its March 28, 2018, meeting, the Board discussed a scenario in which the components were evenly split (e.g., a 50/50 split of value) and suggested that, in such circumstances, the combined component should be accounted for under ASC 842 because the nonlease component is not predominant. That is, the entity would need to demonstrate that the predominant element is the nonlease component; otherwise, the combined unit of account would be accounted for as a lease under ASC 842.

We believe that the final language in ASU 2018-11 was intended to indicate that an entity would need to determine whether the lease or nonlease component (or components) is larger (i.e., has more value); only when the nonlease component is larger should the combined component be accounted for under ASC 606.

Footnotes

Note that this would not apply to lessees because a lessee does not perform services or generate revenue under a lease contract.

“Substantial services” is a term used in EITF Issue 01-8 to differentiate services not accounted for under lease accounting from executory costs accounted for under lease accounting. This distinction between maintenance services, which are executory costs that historically have been accounted for under ASC 840, and substantial services, which historically have been accounted for under ASC 605, was raised in EITF Issue 08-2 but was not further clarified.

For public companies, ASC 606 became effective for annual reporting periods beginning after December 15, 2017, and interim periods therein.

For public companies, ASC 842 became effective for annual reporting periods beginning after December 15, 2018, and interim periods therein (i.e., one year after the effective date of ASC 606).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.