2.2 Scope Exclusions

ASC 842-10

15-1 An entity shall apply this Topic to all leases, including subleases. Because a lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration, this Topic does not apply to any of the following:

Leases of intangible assets (see Topic 350, Intangibles — Goodwill and Other).
Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources (see Topics 930, Extractive Activities — Mining, and 932, Extractive Activities — Oil and Gas). This includes the intangible right to explore for those natural resources and rights to use the land in which those natural resources are contained (that is, unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources.
Leases of biological assets, including timber (see Topic 905, Agriculture).
Leases of inventory (see Topic 330, Inventory).
Leases of assets under construction (see Topic 360, Property, Plant, and Equipment).

Whether a contract is within the scope of ASC 842 is effectively a gating question; if a contract is within the standard’s scope, an entity must apply the guidance in ASC 842 to determine whether the contract is, or contains, a lease (as discussed in Chapter 3). In other words, if an arrangement includes a right of use or a lease of a type of asset described in ASC 842-10-15-1, an entity does not need to further apply the requirements of ASC 842 because the arrangement is explicitly outside its scope. Conversely, in an arrangement that involves the use of any other PP&E to comply with the enforceable rights and obligations of the contract, an entity must apply the requirements of ASC 842 to identify whether the contract is, or contains, a lease.

The decision tree below further expands on this gating question.

Changing Lanes

Heat Supply Contracts for Nuclear Fuel

While ASC 840 explicitly applied to heat supply contracts for nuclear fuel, ASC 842 does not specify whether such contracts are within its scope. Accordingly, entities will have to assess such contracts to determine whether they meet the new definition of a lease. (See Chapter 3 for more information about how to identify whether a contract is, or contains, a lease.)

2.2.1 Leases of Intangible Assets

Entities commonly enter into arrangements that convey rights to use intangible assets (e.g., licensing arrangements, such as those involving software licenses). Rights to use intangible assets are outside the scope of ASC 842. As stated in ASC 842-10-15-1, entities should consider the guidance in ASC 350 when accounting for such arrangements. In addition, the owner of the intellectual property that is subject to the agreement should consider the implementation guidance on licensing in ASC 606.

Bridging the GAAP

The FASB acknowledges in paragraph BC110(a) of ASU 2016-02 that there is “no conceptual basis for excluding leases of intangible assets from the scope” of ASC 842. Indeed, the IASB allows entities to apply IFRS 16 to leases of certain intangible assets (i.e., except for rights held under a licensing arrangement for items such as films, video recordings, plays, patents, and copyrights). The FASB decided that such arrangements should be subject to a larger, more comprehensive review of the accounting for intangible assets at a future date before a customer is required (or allowed) to account for rights to use intangible assets within the scope of ASC 842.

2.2.2 Leases to Explore for or Use Nonregenerative Resources and Leases of Biological Assets

Paragraph BC110(b) of ASU 2016-02 indicates that the scope exclusion in ASC 842-10-15-1(b) applies to both (1) the intangible right to explore for nonregenerative resources such as oil, natural gas, and minerals and (2) the right to use the land that contains those resources. Such rights are accounted for under the industry guidance in ASC 930 (minerals) and ASC 932 (oil and natural gas) and are outside the scope of ASC 840. The Board did not consider it necessary to change this scope exclusion.

However, the Board acknowledges in the Background Information and Basis for Conclusions of ASU 2016-02 that leases of PP&E used to explore for or produce such nonregenerative resources (e.g., drilling rigs) are not part of this scope exclusion. Accordingly, mining and oil and gas entities should identify whether contracts that involve PP&E used in the exploration or production of minerals, oil, and natural gas are, or contain, leases (see Chapter 3).

In a manner similar to its observations on rights to explore for or use nonregenerative resources, the FASB observed in paragraph BC110(c) of ASU 2016-02 that the accounting for biological assets, including plants and animals, is best contained within a single, industry-specific Codification topic, ASC 905. Accordingly, rights to use biological assets are outside the scope of ASC 842.

In certain instances, a lessee’s right to use land may not be limited to the right to explore for or use nonregenerative resources or biological assets. Although natural resource rights are outside the scope of ASC 842, the guidance in ASC 842-10-15-1(b) indicates that rights to use land are not excluded from lease accounting solely because natural resource rights are included in the arrangement. ASC 842-10-15-1(b) states, in part:

An entity shall apply this Topic to all leases, including subleases. Because a lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration, this Topic does not apply to any of the following: . . .

b. Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources (see Topics 930, Extractive Activities — Mining, and 932, Extractive Activities — Oil and Gas). This includes the intangible right to explore for those natural resources and rights to use the land in which those natural resources are contained (that is, unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources. [Emphasis added]

Therefore, if a lessee’s rights to use land contain both natural resource rights as well as the right to use the land in other ways, the lessee should consider whether the arrangement includes a lease of the land in addition to the natural resource rights. If so, the natural resource rights would be a nonlease component that should be separated from the lease component in the contract.1 In reaching this conclusion, we also considered paragraph BC110(b) of ASU 2016-02, which states, in part:

The Board decided that, consistent with previous GAAP, only leases of property, plant, and equipment (that is, land and/or depreciable assets) are within the scope of Topic 842. Consequently, none of the items in the list that follows, which is not intended to be an all-inclusive list, are in the scope of Topic 842. In addition to the fact that none of these assets are depreciable assets, the Board observed the following with respect to each: . . .

b. Leases to explore for or use natural resources, such as minerals, oil, and natural gas. That is because accounting practices for assets relating to exploration and evaluation are diverse and differ from the accounting for other types of assets. Furthermore, the accounting for assets related to the exploration and use of natural resources is specified in Topics 930, Extractive Activities — Mining, and 932, Extractive Activities — Oil and Gas. Leases to explore for or use natural resources also were excluded from previous GAAP. However, the determination of whether certain ancillary items were leases was less important in previous GAAP than in Topic 842 because the operating leases and services were accounted for similarly. Some stakeholders asked whether this scope exception referred solely to the intangible right to explore for these natural resources. The Board observed that this scope exception refers to that as well as to the rights to use the land in which those natural resources are contained. However, leases of equipment used to explore for natural resources (for example, drilling equipment) are not part of this scope exception. [Emphasis added]

We believe that the reference to “land in which those natural resources are contained” is meant to extend the scope exception to surrounding land when the arrangement involves only the right to explore for natural resources (i.e., there will naturally be some land formations — whether surface or subsurface — that establish the parameters of the exploration rights). On the other hand, when the land can be used for other purposes, we believe that an entity should evaluate whether the arrangement contains a lease.

Consider an arrangement that includes both mineral rights and the right to develop an apartment complex on land. In this arrangement, a lease of land would not be precluded solely because the arrangement includes mineral rights.2 Rather, the mineral rights (natural resource rights) should be treated as a nonlease component in accordance with other GAAP.

2.2.3 Leases of Inventory

Like ASC 840, ASC 842 excludes rights to use inventory from its scope. In the Background Information and Basis for Conclusions of ASU 2016-02, the Board indicates that it decided to exclude rights to use inventory largely out of cost-benefit considerations. Specifically, in paragraph BC110(d), the Board observed that few arrangements could actually convey the right to control the use of an asset that is held for sale by the customer — or that is consumed in the customer’s production of goods or services to be available for sale — while the supplier continues to own that asset. Accordingly, the FASB decided that the costs of requiring entities to evaluate such arrangements under ASC 842’s definition of a lease (see Chapter 3) outweighed the benefits.

The example below illustrates a simple arrangement involving the use of precious-metals inventory. Because the arrangement is for inventory (i.e., for an asset that is consumed in the customer’s production of goods or services to be available for sale), it is outside the scope of ASC 842 and the parties are not required to assess whether the contract is, or contains, a lease.

Example 2-1

TJ Inc., an auto manufacturer, enters into a contract with EC Supply Company for 1,000 pounds of palladium over the next five years. TJ uses palladium in catalytic converters that are installed in the automobiles that it sells to third-party customers. TJ pays EC a fixed, monthly payment over the contract term. At the end of year 5, TJ must return 1,000 pounds of palladium to EC.

2.2.4 Leases of Assets Under Construction

Like rights to use inventory, rights to use assets under construction (e.g., construction work-in-progress or CWIP) are outside the scope of ASC 842 for cost-benefit reasons. Shortly before issuing ASU 2016-02, the Board decided to include guidance in ASC 842-40 that requires lessees and lessors to determine whether a lessee controls an underlying asset before the commencement of a lease. (See Chapter 11 for a detailed discussion of this guidance.) If it is determined that a lessee does control an asset before the commencement date, the lessee must (1) recognize the entire asset as the deemed accounting owner and (2) apply ASC 842’s sale-and-leaseback guidance to assess whether it may derecognize the asset on the lease commencement date. The guidance in ASC 842-40 addresses arrangements in which a lessee is involved in the construction of an asset before a lease commences.

As the Board acknowledges in paragraph BC110(e) of ASU 2016-02, the FASB received stakeholder feedback indicating that the complexity of applying ASC 842 was likely to increase if an entity is required to assess whether a lessee (1) controls an underlying asset under construction or (2) controls the use of an underlying asset under construction (as would be the case if CWIP were within the scope of ASC 842). The Board decided that the benefits of performing this complex assessment would not outweigh the costs, given that such an evaluation would yield financial reporting results substantially similar to those under ASC 840. Accordingly, the FASB excluded rights to use assets under construction from the scope of ASC 842; however, lessees and lessors must still assess whether a lessee obtains control of an underlying asset under construction (i.e., the entire asset, and not just the right to use it) before lease commencement in accordance with ASC 842-40.

2.2.5 Other Scope Exclusions

2.2.5.1 Service Concession Arrangements

Service concession arrangements accounted for under ASC 853 are specifically excluded from the scope of ASC 840 in ASC 840-10-15-9A. However, ASC 842 does not explicitly contain the same scope exception. Rather, ASC 853-10-25-2 (as amended by ASU 2016-02) indicates that service concession arrangements that are subject to the scope provisions of ASC 853-10-15 will continue to be outside the scope of lease accounting:

The infrastructure that is the subject of a service concession arrangement within the scope of this Topic shall not be recognized as property, plant, and equipment of the operating entity. Service concession arrangements within the scope of this Topic are not within the scope of Topic 842 on leases.

2.2.5.2 Noncore Assets and Capitalization Policy Considerations

Paragraph BC111 of ASU 2016-02 acknowledges that “assets that are not essential to the operations of an entity” (hereafter referred to as “noncore assets”) may be less important to financial statement users because they “often are less material.” Accordingly, the benefits of recognizing leases of noncore assets may not justify the costs of requiring lessees to do so. The Board therefore considered excluding noncore assets from the scope of ASC 842 but ultimately decided against a scope exclusion for noncore assets for the following reasons:

It is difficult to define noncore assets and to differentiate leases of noncore assets from leases of other assets.
Entities’ interpretations of the definition of noncore assets are likely to differ, thereby reducing comparability for financial statement users.
There is no GAAP distinction between noncore purchased assets and core purchased assets for capitalization purposes. Accordingly, there is little justification for distinguishing between rights to use noncore assets and rights to use core assets.

Many entities have accounting policies that establish a materiality threshold for capitalizing fixed assets (i.e., PP&E). Under such policies, expenditures below the established threshold are expensed in the period incurred rather than capitalized on the balance sheet and depreciated over the life of the asset.

Because ASC 842 requires entities to recognize an ROU asset and a lease liability for all leases (other than short-term leases) and does not contain a “small-ticket item” exception similar to that in IFRS 16,3 many entities have asked whether a similar capitalization threshold may be established for lease assets and lease liabilities under ASU 2016-02. While there is no explicit scope exception for assets defined as, or determined to be, “noncore,” paragraph BC122 of ASU 2016-02 indicates that a lessee can use capitalization and materiality policies when evaluating the requirement to recognize, on the balance sheet, leases that otherwise must be recognized under ASC 842, thereby reducing the cost of applying the standard. Specifically, paragraph BC122 states, in part:

[E]ntities will likely be able to adopt reasonable capitalization thresholds below which lease assets and lease liabilities are not recognized, which should reduce the costs of applying the guidance. An entity’s practice in this regard may be consistent with many entities’ accounting policies in other areas of GAAP (for example, in capitalizing purchases of property, plant, and equipment).

Therefore, an entity should not simply default to its pre–ASC 842 capitalization threshold for PP&E for the following reasons:

The pre–ASC 842 capitalization threshold for PP&E is unlikely to include the effect of the additional asset base introduced by the ASU. That is, the addition of another set of assets not recognized on an entity’s balance sheet may require a refreshed analysis of the entity’s capitalization thresholds to ensure that the aggregated amounts will not become material.
The pre–ASC 842 capitalization threshold for PP&E does not take into account the liability side of the balance sheet. Under ASC 842, if an entity wishes to establish a threshold that will be used to avoid accounting for both ROU assets and lease liabilities on the balance sheet, it must consider the materiality, in the aggregate, of all of its ROU assets and related lease liabilities that would be excluded when it adopts such a threshold.

One reasonable approach to developing a capitalization threshold for leases is to use the lesser of the following:

A capitalization threshold for PP&E, including ROU assets (i.e., the threshold takes into account the effect of leased assets determined in accordance with ASU 2016-02).
A recognition threshold for liabilities that takes into account the effect of lease liabilities determined in accordance with the ASU.

Another reasonable approach to developing a capitalization threshold for leases is to record all lease liabilities but to subject the related ROU assets to such a threshold. Under this approach, if an ROU asset is below the established capitalization threshold, it would immediately be recognized as an expense. In subsequent periods, entities would amortize the lease liability by using the effective interest method, under which a portion of the periodic lease payments would reduce the liability and the remainder would be recognized as interest expense.

In addition, when evaluating and applying a capitalization threshold for leases determined in accordance with the ASU, entities should consider the following:

The gross balance of each side of the lease entry — It would be inappropriate for an entity to consider only the net balance sheet effect of the lease entry (which is often zero) when assessing materiality.
Disclosure requirements — We expect that entities will often want to omit disclosures about leases that they have determined, on the basis of their use of capitalization thresholds (as discussed above), do not need to be recognized on the balance sheet. We believe that while it may be appropriate to omit such disclosures, an entity will need to consider the impact of the omitted disclosures when performing a materiality assessment to establish the thresholds.
Implications related to internal control over financial reporting (ICFR) — As entities revisit and change (or create new) capitalization thresholds for financial reporting purposes, they should be cognizant of the related ICFR implications. In addition, entities should consider the Form 10-K and Form 10-Q disclosure requirements under SEC Regulation S-K, Item 308(c), with respect to material changes in ICFR.
SAB Topic 1.M (SAB 99) — Entities may find the guidance on materiality in SAB Topic 1.M helpful when identifying an appropriate capitalization threshold for leases.

Example 2-2

A lessee enters into a five-year lease of a machine to use in its operations. The lessee determines that its ROU asset and lease liability are $3,260 at lease commencement.

To identify an appropriate capitalization threshold for its ROU assets and lease liabilities, the lessee considers the following:

The gross balances (rather than the net balance) of its ROU assets and lease liabilities.
The disclosures that would be omitted if certain ROU assets and lease liabilities were not recognized.
The appropriate internal controls needed for the lessee to apply and monitor the capitalization threshold.
Overall materiality considerations in SAB Topic 1.M.

After considering these factors, the lessee determines that (1) an appropriate capitalization threshold for PP&E, including ROU assets, is $3,500 and (2) an appropriate recognition threshold for lease liabilities is $3,000. The lessee should apply the lower of the two thresholds when determining whether to record the lease on its balance sheet. Given that the initial measurement of the lessee’s ROU asset and lease liability exceeds the $3,000 threshold established for lease liabilities (i.e., the lower of the two thresholds), the lessee should recognize the ROU asset and lease liability on its balance sheet at lease commencement.

Alternatively, the lessee may choose to recognize the lease liability of $3,260 but not the ROU asset on the basis of the established $3,500 threshold for PP&E, including ROU assets (i.e., the lessee may choose to expense the cost of the ROU asset at lease commencement).

Footnotes

If the lessee elects the practical expedient to combine lease and nonlease components (see Section 4.3.3.1), the natural resource rights would instead be combined with the land lease.

Assume that the land agreement in this arrangement meets the definition of a lease in accordance with ASC 842.

Under IFRS 16, an entity may exclude leases for which the underlying asset is of low value from its ROU assets and lease liabilities. See paragraphsB3–B8 of IFRS 16 for information about how to assess whether an asset is of low value. Also, see Appendix B for a summary of the differences between ASC 842 and IFRS 16.

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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.