2.3 Interaction With Other Accounting Standards

2.3.1 ASC 606 — Revenue From Contracts With Customers

ASC 842 has many areas of crossover between, or direct references to, ASC 606. For example, ASC 842 requires lessors to use the guidance in ASC 606-10-32-28 through 32-41 when separating, and allocating consideration to, the components in a contract (see Chapter 4 for a detailed discussion of those requirements).

In addition, the guidance in ASC 606 on sales with a repurchase agreement may require suppliers to account for certain contracts with a customer within the scope of ASC 842. The next section further discusses those requirements in ASC 606 and how they are related to ASC 842.

2.3.1.1 Repurchase Agreements

ASC 606-10

55-66 A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.

55-68 If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity should account for the contract as either of the following:

A lease in accordance with Topic 842 on leases, if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset unless the contract is part of a sale and leaseback transaction. If the contract is part of a sale and leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale and leaseback transaction in accordance with Subtopic 842-40.
A financing arrangement in accordance with paragraph 606-10-55-70, if the entity can or must repurchase the asset for an amount that is equal to or more than the original selling price of the asset.

55-72 If an entity has an obligation to repurchase the asset at the customer’s request (a put option) at a price that is lower than the original selling price of the asset, the entity should consider at contract inception whether the customer has a significant economic incentive to exercise that right. The customer’s exercising of that right results in the customer effectively paying the entity consideration for the right to use a specified asset for a period of time. Therefore, if the customer has a significant economic incentive to exercise that right, the entity should account for the agreement as a lease in accordance with Topic 842 on leases unless the contract is part of a sale and leaseback transaction. If the contract is part of a sale and leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale and leaseback transaction in accordance with Subtopic 842-40.

The guidance in ASC 606 on sales with a repurchase agreement (whether an obligation or an option) is intended to identify scenarios in which the supplier has not transferred control of the asset to the customer. That is, the economic substance of the sale, together with the repurchase obligation or right, is to convey to the customer control of the use of the asset for a certain period in exchange for consideration.

Example 62, Case B, in ASC 606 illustrates how a sale with a repurchase agreement that includes a put option would be accounted for as a lease. For this example and further discussion of the guidance in ASC 606 on sales with a repurchase agreement, see Section 8.7 of Deloitte’s Roadmap Revenue Recognition.

Changing Lanes

Lease Classification in a Sale With a Repurchase Agreement

In the sale of an asset, an entity may “fail” the transfer-of-control guidance in ASC 606 because of an obligation or right to repurchase the asset (e.g., through a call option) for an amount that is less than its original selling price. As a result, in accordance with ASC 606-10-55-68, the supplier would not record a sale and recognize revenue from a contract with a customer but would instead account for the arrangement as a lease under ASC 842.

Stakeholders have questioned whether it is possible for a supplier to fail sale accounting under ASC 606 but classify the arrangement under ASC 842 as a sales-type lease. We believe that an entity can classify the lease as a sales-type lease under ASC 842 provided that any of the criteria in ASC 842-10-25-2 are met and the conditions in ASC 842-10-25-3A are not met. In other words, a supplier could transfer control (and thus recognize a selling profit or loss at commencement) under ASC 842 but not under ASC 606. (See Chapter 9 for further discussion of a lessor’s accounting and classification.) This scenario is illustrated in Example 2-3.

However, we believe that, in certain circumstances, the application of the repurchase guidance in ASC 606 is not as straightforward. In such cases, we would expect the classification of the lease as a sales-type lease to be rare (see Example 2-4). Entities that enter into such transactions should consider consulting their accounting advisers.

Example 2-3

Supplier enters into an arrangement to sell a piece of equipment to Customer at its fair value, $10 million. The equipment has a 25-year economic and useful life with a residual value of $0. Included in the arrangement is a call option granted to Supplier through which Supplier may repurchase the asset. The repurchase option is exercisable after 20 years (on a specified date). The strike price of the repurchase option is $2 million. In this scenario, it may be appropriate for Supplier to classify its arrangement with Customer as a sales-type lease in accordance with ASC 842-10-25-2 and recognize selling profit or loss at commencement because, while the call option precludes the transfer of control of the asset to Customer under ASC 606, the resulting lease accounted for under ASC 842 is for a term that constitutes the major part of the remaining economic life of the underlying asset.

Example 2-4

Entity X sells enterprise customers a bundled cybersecurity solution to protect against advance cybersecurity threats. In its standard revenue contracts, X promises to provide customers with a smart device (i.e., hardware with embedded software) and annual subscription services that deliver timely notifications by combining the output from the hardware with proprietary know-how. Entity X performs an analysis under ASC 606 (see Chapter 5 of Deloitte’s Roadmap Revenue Recognition) and concludes, on the basis of the specific facts and circumstances, that its contracts include a single performance obligation and revenue is recognized ratably over the subscription term.

In the current year, X enters into a contract with Customer G, a governmental entity. The contract requires G to obtain title to the hardware but includes a term that gives X the right to repurchase the hardware for $1 at the end of the contract term. As a result of X’s right to purchase the hardware, in accordance with ASC 606-10-55-58, X should account for the arrangement as a lease under ASC 842. We believe that it may be acceptable for X to conclude that there is no lease because, in addition to the lease-out from the supplier (X) to the customer (G), there may be a corresponding lease-in from G back to X given X’s use of the hardware’s output under ASC 842. This may be because X uses the hardware to transfer the promised services to G and G does not obtain the right to direct the how and for what purpose (HAFWP) decisions related to the hardware throughout the period of use. Accordingly, X would not classify the arrangement as a sales-type lease.

When applying the repurchase guidance in ASC 606-10-55-68 in this scenario, X should carefully evaluate all the facts and circumstances and consider consulting its accounting advisers.

Connecting the Dots

Asymmetry Between Supplier and Customer in a Sale With a Repurchase Agreement

ASC 606 does not address the customer’s accounting for arrangements within its scope, so there is no requirement in ASC 606 for a customer in a sale with a repurchase agreement to account for that arrangement as a lease.

Therefore, a customer is likely to account for such an arrangement as a purchase of the asset (e.g., in accordance with ASC 360 for PP&E). In other words, while ASC 606 contains comprehensive guidance governing when a supplier transfers control of an asset, there is little guidance in U.S. GAAP governing when a customer obtains control.

Changing Lanes

Seller-Provided Residual Value Guarantees

Section 8.7 of Deloitte’s Roadmap Revenue Recognition notes that the FASB, in its deliberations with the IASB related to ASC 606 and IFRS 15, respectively, explicitly decided to view sales with a seller-provided residual value guarantee (e.g., when a seller provides its customer with a guaranteed amount to be paid on resale) differently from sales with a repurchase agreement. In paragraph BC431 of ASU 2014-09, the boards acknowledged that such arrangements are economically similar in terms of cash flows but differ with respect to the customer’s ability to control the asset. That is, the customer is “not constrained in its ability to direct the use of, and obtain substantially all of the benefits from, the asset” it purchased that is subject to a seller-provided residual value guarantee.

Further, the FASB recognized that its decisions on this topic would lead to a change in practice. Under ASC 605 and ASC 840, such arrangements were generally accounted for as leases. Accordingly, sales with a seller-provided residual value guarantee are subject to the five steps of the model in ASC 606 and are not accounted for as leases within the scope of ASC 842.

2.3.2 ASC 815 — Derivatives and Hedging

ASC 842-10

15-43 Paragraph 815-10-15-79 explains that leases that are within the scope of this Topic are not derivative instruments subject to Subtopic 815-10 on derivatives and hedging although a derivative instrument embedded in a lease may be subject to the requirements of Section 815-15-25. Paragraph 815-10-15-80 explains that residual value guarantees that are subject to the guidance in this Topic are not subject to the guidance in Subtopic 815-10. Paragraph 815-10-15-81 requires that a third-party residual value guarantor consider the guidance in Subtopic 815-10 for all residual value guarantees that it provides to determine whether they are derivative instruments and whether they qualify for any of the scope exceptions in that Subtopic.

Because leases that are within the scope of ASC 842 are exempt from the scope of ASC 815-10, contracts within the scope of ASC 842 that meet the definition of a lease (see Chapter 3) are not accounted for as freestanding derivative instruments. However, this guidance may still be relevant in the determination of whether a lease agreement contains an embedded derivative that must be separated from the lease contract and accounted for separately as a derivative instrument in accordance with ASC 815. Thus, when analyzing a leasing transaction, an entity should consider the derivative and hedging implications, including ASC 815 and the relevant implementation guidance.

Components of a lease agreement that might be considered embedded derivatives include, but are not limited to:

Option arrangements, such as purchase or renewal options.
Indexed rental payments.
Additional rental payments that are contingent on the occurrence of an outside event or achieving a certain threshold.
Rental payments denominated in a foreign currency.

The terms of any lease arrangement containing these or similar provisions must be analyzed to determine whether the provision meets the definition of a derivative described in ASC 815-10-15-83 and, if so, whether ASC 815 requires separate accounting for the embedded derivative. ASC 815-15-25 and other implementation guidance include extensive guidance on identifying and accounting for embedded derivatives that must be separated from their host contracts.

Lessors and lessees may also want to enter into hedging transactions to reduce their potential cash flow variability. ASC 815 and relevant implementation guidance address the requirements for achieving hedge accounting and how to account for a hedging relationship. See Deloitte’s Roadmap Hedge Accounting for further discussion.

See the next section for further discussion of derivatives embedded in leases.

2.3.2.1 Derivatives Embedded in a Lease

Certain variable lease payments (e.g., those that depend on an index or rate) could meet the criteria in ASC 815-15-25-1 to be bifurcated as an embedded derivative. Accordingly, the FASB acknowledged in paragraph BC119 of ASU 2016-02 that because ASC 842 does not require entities to measure such variable lease payments at fair value, “unrelated derivative contracts could be bundled with leases to avoid measuring such embedded derivatives at fair value.” Accordingly, the Board decided to retain the requirement to assess a lease contract to determine (1) whether any embedded derivatives exist and, if so, (2) whether they should be bifurcated in accordance with the guidance in ASC 815-15.

The assessment of whether an embedded derivative is clearly and closely related to its host contract (e.g., a lease within the scope of ASC 842) is based on the economic relationship between the embedded derivative and the host contract. To be considered clearly and closely related to a lease host, the economic characteristics and risks of the lease contract should be similar to those of the embedded derivative. If the two are not clearly and closely related, the embedded derivative should be bifurcated and accounted for separately at fair value if the embedded feature has the characteristics of a derivative instrument on a freestanding basis in ASC 815-10-15-83 and does not qualify for a scope exception from derivative accounting.

The table below highlights embedded features that would generally not be considered clearly and closely related to a lease host contract. See Section 4.3.2.4.1 of Deloitte’s Roadmap Derivatives for further discussion of common embedded features in lease host contracts.

	Clearly and Closely Related	Not Clearly and Closely Related
Lease host	Nonleveraged inflation indexes (see ASC 815-15-25-50). Contingent rentals based on related sales or variable interest rates (see Section 6.9 of Deloitte’s Roadmap Derivatives). Foreign currency payment features if payments are made in the functional currency of a substantial party to the lease (see ASC 815-15-15-10).	Leveraged inflation indexes (e.g., two times consumer price index [CPI]) (see ASC 815-15-25-50). Inflation index adjustments based on an economic environment that is different from that in which payments are made (e.g., Mexican peso–denominated lease payments that vary on the basis of inflation rates in the United States if none of the parties to the lease are U.S. dollar functional entities). Certain leases payable in a foreign currency (e.g., lease payments in U.S. dollars between two U.K. entities) (see ASC 815-15-15-10).

The examples below describe how payment features commonly observed in lease contracts would be evaluated for potential bifurcation as embedded derivatives.

Example 2-5

Rent Increases Based on Sales Volume

Company ABC leases property from Company XYZ in Germany. The lease provides for annual rent increases based on a percentage of ABC’s retail sales in Germany during the calendar year. The increase is an adjustment to the following year’s rent payments.

The lease contains an embedded contingent rent payment based on ABC’s retail sales in Germany. The embedded derivative does not need to be accounted for separately because ABC’s retail sales would qualify for the exception in ASC 815-10-15-59(d), which excludes from its scope non-exchange-traded contracts with underlyings that are the sales or service revenues of one of the parties to the contract. Therefore, this embedded derivative on a percentage of ABC’s German retail revenues would not need to be bifurcated in accordance with ASC 815-15-25-1(c).

Example 2-6

Lease Contracts With Adjustments That Are Based on Interest Rate Changes

Company D has 10-year operating leases for retail stores and a distribution center. The operating lease payments are part of a synthetic lease transaction in which an off-balance-sheet special-purpose entity (SPE) has obtained debt financing and equity that it will use to construct the retail stores and distribution center. The SPE will lease these buildings to D. The leases require D to make quarterly variable lease payments on the basis of the SOFR interest rate applied to the SPE’s total debt outstanding. For example, if the SPE has drawn cash to begin construction on one of the new retail stores, D must begin to make interest payments to the SPE on that drawn amount.

The operating leases for the retail stores and distribution center have embedded derivatives that result in an adjustment to the lease payment and are based on interest rates (i.e., SOFR). The embedded derivative does not need to be bifurcated because the obligation to make future payments for the use of the leased assets and the adjustment of those payments for changes in a variable interest rate index are considered clearly and closely related under ASC 815-15-25-22.

Note that SPEs should be evaluated to determine whether they are subject to ASC 810-10. Some “synthetic lease” transactions may have to be consolidated under ASC 810-10.

2.3.2.2 Residual Value Guarantees

As noted above in ASC 842-10-15-43, and as described in ASC 815-10-15-80, residual value guarantees that are accounted for under ASC 842, including any residual value guarantee between the lessee and the lessor, are not subject to the derivative accounting guidance in ASC 815-10. However, ASC 815-10-15-81 notes that a third-party guarantor must assess whether any residual value guarantee that it writes on an underlying leased asset is subject to the guidance in ASC 815-10.

A leased asset subject to a third-party residual value guarantee will always be a nonfinancial asset (i.e., financial assets cannot be leased). Accordingly, a third-party guarantor may seek to avoid fair value measurement of the guarantee and instead qualify for the scope exception in ASC 815-10-15-59(b) for contracts that are not traded on an exchange and that are settled on the basis of a price or value of a nonfinancial asset. Third-party guarantors will generally meet the second condition in ASC 815-10-15-59(b) because increases in the fair market value of the underlying nonfinancial asset reduce the third-party guarantor’s exposure and the asset’s owner therefore would not benefit from such an increase in value under the contract.

2.3.3 ASC 810 — Consolidation

ASC 810-10

55-39 Receivables under an operating lease are assets of the lessor entity and provide returns to the lessor entity with respect to the leased property during that portion of the asset’s life that is covered by the lease. Most operating leases do not absorb variability in the fair value of a VIE’s net assets because they are a component of that variability. Guarantees of the residual values of leased assets (or similar arrangements related to leased assets) and options to acquire leased assets at the end of the lease terms at specified prices may be variable interests in the lessor entity if they meet the conditions described in paragraphs 810-10-25-55 through 25-56. Alternatively, such arrangements may be variable interests in portions of a VIE as described in paragraph 810-10-25-57. The guidance in paragraphs 810-10-55-23 through 55-24 related to debt instruments applies to creditors of lessor entities.

Once a lease has been identified under ASC 842, a reporting entity (lessee) should evaluate whether a lease is a variable interest in the legal entity (lessor). The assessment of whether a lease is a variable interest first depends on whether the lease is classified as an operating lease or a finance lease. In a leasing arrangement accounted for as an operating lease, all relationships and contractual arrangements between the lessee, lessor, and variable interest holders of the lessor should be evaluated to determine whether those relationships or arrangements result in the lessee’s absorption of expected losses or the receipt of expected residual returns of the legal entity, even if the lessee has not entered into an arrangement that would be an explicit variable interest in the legal entity. In a leasing arrangement accounted for as a finance lease, unless the fair value of the assets subject to a lease represents less than half the fair value of the lessor’s assets (see Chapter 6 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest), a finance lease represents a variable interest in the legal entity. In addition, see Section 4.3.9 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial Interest for further details on other contractual features in a lease that could represent a variable interest.

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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.