Chapter 2 — Scope and Scope Exceptions
Chapter 2 — Scope and Scope Exceptions
2.1 Property, Plant, and Equipment
ASC 842-10 — Glossary
Contract
An agreement between two or more parties that creates enforceable rights and obligations.
Lease
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.
As indicated above, ASC 842-10-20 defines a lease as a “contract . . . that
conveys the right to control the use of . . . property, plant, or equipment”
(PP&E). In paragraph BC110 of ASU 2016-02, the Board acknowledges that
only leases of “land and/or depreciable assets” are within the scope of ASC 842.
Therefore, because the FASB ultimately decided to include only leases of PP&E
within the scope of ASC 842, the scope of ASC 840 is effectively carried forward.
Accordingly, leases of nondepreciable assets (e.g., inventory) are outside the scope
of ASC 842, as detailed in ASC 842-10-15-1 (reproduced in Section 2.2).
In addition, an agreement involving PP&E must create enforceable rights and obligations to be within
the scope of ASC 842. That is, it must meet the definition of a “contract” in ASC 842, which is defined the
same way as it is in ASC 606.
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
1
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.
2
Assume that the land agreement in this arrangement meets
the definition of a lease in accordance with ASC 842.
3
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.
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 606-10-66-58, 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.
However, 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.
If so, it would be possible for a supplier to transfer control (and thus recognize 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.) In such cases, it appears that there would
be an accounting arbitrage opportunity to structure transactions that achieve a desired financial
reporting result.
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 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
and recognize selling profit or loss at
commencement.
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 are outside 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 815-10-15-96
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 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 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
(i.e., 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, 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 satisfies the criteria of a derivative
instrument on a freestanding basis.
The table below highlights some of the economic characteristics that are and are
not generally considered to indicate that an embedded derivative is 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 |
|
|
The examples below describe how payment features commonly
observed in lease contracts would be evaluated for potential bifurcation as
embedded derivatives.
Example 2-4
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 meet the definition of a
derivative on a freestanding basis and would not
need to be bifurcated in accordance with ASC
815-15-25-1(c).
Example 2-5
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, 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, 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 use 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.
Footnotes
4
Under ASC 830, a lessee with
an operating lease denominated in a nonfunctional
currency would not be required to bifurcate the
foreign currency embedded derivative.
2.4 Land Easements
The objectives of the land easement amendments in ASU 2018-01, which was issued in response to
feedback received by the FASB regarding implementation of ASU 2016-02, are to:
- Clarify that land easements entered into (or existing land easements modified) on or after the effective date of ASC 842 must be assessed under ASC 842.
- Provide a transition practical expedient for existing or expired land easements that were not previously accounted for in accordance with ASC 840. The practical expedient would allow entities to elect not to assess whether those land easements are, or contain, leases in accordance with ASC 842 when transitioning to ASC 842.
The amendments in ASU 2018-01 do not, and are not intended to:
- Provide illustrative or application guidance on whether land easements are, or contain, leases in accordance with the definition of a lease in ASC 842.
- Help entities identify the appropriate accounting framework for situations in which a land easement is not determined to be a lease under ASC 842.
See Section 16.5.3 for information about the effective date and transition provisions of ASU 2018-01.
2.4.1 Background
Generally, an easement is a right to access, cross, or otherwise use someone
else’s land for a specified purpose. Most easements provide limited rights to
the easement holder, such as the right to cross over land or the right to
construct and maintain specified equipment on the land. For example, an electric
utility will typically obtain a series of contiguous easements so that it can
construct and maintain its electric transmission system on land owned by third
parties. Easements can be perpetual or term-based, be paid in advance or over
time, and provide the customer with exclusive or shared use.
Historically, some companies have considered easements to be intangible assets under ASC 350. In fact, ASC 350 contains an example illustrating easements acquired to support the development of a natural gas pipeline. In contrast, some companies may have considered easements to be leases or executory contracts. When preparing their financial statements, many companies have presented prepaid amounts related to easements in the PP&E section of their balance sheets because easements are closely associated with the PP&E they support. We understand that reporting requirements of the Federal Energy Regulatory Commission may have also influenced the balance sheet geography for companies regulated by that agency.
Easements generally convey to the customer some rights associated with the use of land (i.e., PP&E). Therefore, questions have arisen about whether easements are within the scope of ASC 842 and, if so, whether the benefit to financial statement users of entities assessing those arrangements in accordance with the definition of a lease would outweigh the cost to the entities of doing so (both upon transition and on an ongoing basis).
2.4.2 Scope
ASU 2018-01 only addresses land easements. Although the FASB does not define this term, ASC 842-10- 65-1(gg) and paragraph BC3 of ASU 2018-01 describe both a land easement and a right of way as a “right to use, access, or cross another entity’s land for a specified purpose.”
Further, ASU 2018-01 effectively breaks land easements into two groups on the basis of the effective date of ASU 2016-02: (1) land easements entered into (or existing easements modified) on or after the effective date (collectively, “new land easements”) and (2) land easements that existed as of, or expired before, the effective date (collectively, “existing land easements”).
For existing land easements that were not previously accounted for as a lease under ASC 840, ASU 2018-01 provides a practical expedient under which an entity may elect to “run off” all such easements by using its historical accounting approach for land easements. Importantly, an entity may elect this practical expedient even if it does not elect the package of practical expedients in ASC 842-10-65-1(f) that would allow the entity not to reevaluate whether any expired or existing contracts are or contain leases. See Section 16.5.2.1 for more information about this “package of three” practical expedients.
Connecting the Dots
No
Analogies
We think that the FASB’s use of the term “land easements” is intentional. Therefore, we do not believe that an entity should analogize to the ASU’s favorable transition practical expedient for existing land easements when considering other types of arrangements.
For new land easements, ASU 2018-01 amends the illustrative example (Example 10) in ASC 350-30- 55-30 as follows to clarify that ASC 350 may only be applied after a new land easement is determined not to be a lease in accordance with the definition of a lease in ASC 842:
Entity A is a distributor of natural gas. Entity A has two self-constructed pipelines, the Northern pipeline and the Southern pipeline. Each pipeline was constructed on land for which Entity A owns perpetual easements that Entity A evaluated under Topic 842 and determined do not meet the definition of a lease under that Topic (because those easements are perpetual and, therefore, do not convey the right to use the underlying land for a period of time). The Northern pipeline was constructed on 50 easements acquired in 50 separate transactions. The Southern pipeline was constructed on 100 separate easements that were acquired in a business combination and were recorded as a single asset. Although each pipeline functions independently of the other, they are contained in the same reporting unit. Operation of each pipeline is directed by a different manager. There are discrete, identifiable cash flows for each pipeline; thus, each pipeline and its related easements represent a separate asset group under the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10. While Entity A has no current plans to sell or otherwise dispose of any of its easements, Entity A believes that if either pipeline was sold, it would most likely convey all rights under the easements with the related pipeline.
In addition, paragraph BC11 of ASU 2018-01 states, in part:
The Board noted that a land easement conveys (in various forms) a right to use land and that a right to use land needs to be evaluated to determine whether it is within the scope of Topic 842. Accordingly, the
amendments in this Update provide clarity that an entity should apply Topic 842 to a land easement to determine whether that easement is or contains a lease. [Emphasis added]
Changing Lanes
New
Land Easements Must First Be Evaluated Under ASC
842
The FASB makes its objective for new land easements very clear in paragraph BC11 of ASU
2018-01, and the amendment to ASC 350-30-55-30 helps reinforce the scope hierarchy in GAAP with respect to such easements. That is, all new land easements must first be assessed under ASC 842 to determine whether the arrangement is, or contains, a lease.
If an arrangement is not a lease, other GAAP may be applicable (e.g., ASC 350, ASC 360). However, in paragraph BC11 of ASU 2018-01, the Board explains that it intentionally did not address the appropriate accounting guidance to apply in these situations:
While there may be diversity about which guidance an entity should apply when a land easement is not a lease, that diversity is outside the scope of the amendments in this Update and, accordingly, the amendments do not modify an entity’s accounting for land easements that are not leases.
2.4.3 Identifying a Lease
ASU 2018-01 is not intended to provide illustrative or application guidance
about whether new land easements6 meet the definition of a lease in ASC 842.
Therefore, stakeholders and respondents may
continue to raise questions about the application
of the definition of a lease to new land easement
arrangements, and it is possible that the FASB,
IASB, and SEC staffs will want to share their
perspectives as those questions are raised.
Companies involved in land easement arrangements
should consult with their accounting advisers and
monitor developments on the topic.
The required accounting once ASC 842 is effective will ultimately depend on the facts and circumstances of each arrangement. However, to determine whether a new land easement contract is, or contains, a lease in accordance with ASC 842-10-15-2 through 15-27, entities may find it helpful to group the contracts into one of two categories, further discussed below: (1) perpetual easements and (2) term-based easements. In addition, we recommend that high-volume users of easements begin their analysis by (1) segregating term-based arrangements on the basis of similar contractual provisions and (2) investigating the rights retained by the landowner in those arrangements. This may streamline the process since many easements will have similar or identical provisions and therefore would be expected to result in similar accounting.
2.4.3.1 Perpetual Easements
ASC 842-10-15-3 states, in part, “A contract is or contains a lease if the contract 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” (emphasis added). When a land easement is perpetual, we would not
expect the arrangement to meet the definition of a lease given the lack of a stated term. As indicated by the amendments to ASC 350-30-55-30, rights conveyed in a land easement into perpetuity (i.e., for an unlimited time) are not conveyed “for a period of time” in accordance with ASC 842-10-15-3.
Arrangements with stated terms are not considered perpetual even if the terms
are very long (e.g., 100 years). On the other
hand, a use condition contained in a perpetual
easement (e.g., when an easement conveys rights to
the customer into perpetuity, as long as those
rights are used only to run fiber-optic cable)
would not affect the conclusion that a land
easement is perpetual.
2.4.3.2 Term-Based Easements
For term-based easements, the analysis will most likely be more extensive and involve a consideration of the right to control the use of the underlying land. That is, in accordance with ASC 842-10-15-4, entities will need to assess whether the customer in the arrangement has the right to (1) obtain substantially
all of the economic benefits from using the land throughout the period of use and (2) direct the use of the land throughout the period of use. Accordingly, many easement arrangements may not convey the right to control the use of the land to the customer given that the supplier continues to enjoy economic benefits derived from the use of the land and that the rights to direct the use of the land that are conveyed to the customer are limited (i.e., generally only for a specified purpose).
For example, in an arrangement in which a utility (as the easement holder) is
allowed to run electric transmission assets
through a farmer’s fields (i.e., transmission
lines that run over or under7 the farmer’s fields), it will be important
to understand whether the farmer can still use the
acreage subject to the easement (i.e., the acreage
under or over which the lines run). If so, the
utility may conclude that it does not have the
right to control the use of the land because the
farmer retains (1) rights to direct the use of the
land (e.g., rights to farm the land), (2) economic
benefits associated with the land that are not
insignificant (e.g., the crops yielded from
farming), or (3) both (1) and (2). On the other
hand, there may be easement arrangements that
effectively convey the right to control the use of
the land to the easement holder through the rights
conveyed or through use restrictions imposed on
the landowner.
In addition, to appropriately identify the unit of account, an entity sometimes may need to more carefully consider the identified asset in an easement arrangement, as illustrated in the common scenarios below.
Example 2-67
A customer enters into a land easement arrangement with a farmer for the right to pass a natural gas pipeline under the farmer’s land. At issue is whether the identified asset includes the entire plot of land or whether the land should be broken down into surface and subsurface rights, the latter of which the parties would evaluate to determine whether the customer has the right to control the use of the land.
If the identified asset is the entire plot of land, the parties are less likely
to conclude that the customer has the right to
obtain substantially all the economic benefits
from use of the land because the farmer retains
the surface rights (e.g., to farm the land).
However, if the identified asset is only the
subsurface rights, the customer might have the
right to obtain substantially all the economic
benefits from using the area below the surface of
the land. Further, subsurface rights for the same
plot of land may also be stacked in such a way
that one customer has an easement for the depth of
5 to 10 feet below the surface while another
customer has an easement for the depth of 10 to 20
feet below the surface.
Example 2-7
A customer enters into a land easement arrangement with a farmer for the right to construct and maintain 25 wind turbines on the farmer’s 500-acre plot of land. Each wind turbine will be constructed on individual acre plots. At issue is whether the identified asset is the entire 500-acre plot of land or whether there are 25 identified assets, each one acre of land.
As in the previous example, if the identified asset is the entire 500-acre plot of land, the parties are less likely to conclude that the customer has the right to obtain substantially all the economic benefits from use of the land because the farmer retains all of the rights to the economic benefits of the remaining 475 acres. However, if the identified assets are 25 individual acre plots of land, the customer may have the right to obtain substantially all the economic benefits from using each individual acre plot.
Connecting the Dots
An
Entity Will Need to Use Judgment to Determine the
Unit of Account
At its November 29, 2017, meeting, the FASB indicated that it would not provide additional, formal guidance on determining the unit of account with respect to performing the lease assessment for an easement. However, several Board members pointed out that an entity will need to use judgment in determining the unit of account and that diversity in practice could arise in this area. Board members have publicly expressed this view at previous meetings, including a July 2017 roundtable and an August 2017 meeting. Further, it was noted that the need to use judgment is not limited to scenarios involving subsurface rights (e.g., rights to run gas pipelines underground). Board members specifically discussed easements that convey only surface rights, including rights to construct renewable energy assets (e.g., wind or solar), noting that an entity will also be required to employ judgment in considering these arrangements and that there could be more than one approach to determining the unit of account.
On the basis of these views, we believe that, in practice, some will conclude that the unit of account is the entire land area defined by the easement contract (i.e., a larger area) while others will decide that a new unit of account should be established and assessed each time the easement holder occupies a portion of the land (i.e., a smaller area, such as the area taken up by a concrete pad used to serve as the foundation for a windmill or a transmission tower). We believe that either of these approaches is acceptable.
2.4.3.3 Treatment of Subsurface Rights as an Intangible Asset
As indicated in Example
2-6, certain easements may give an
entity the right to use area beneath the surface
of the land (i.e., the subsurface). Questions have
arisen about whether land below the surface should
be considered a unit of account that is separate
from the land’s surface in the identification of
whether a lease exists. Alternatively, others have
questioned whether the right to use the subsurface
is akin to an intangible asset (e.g., air rights)
that is outside the scope of ASC 842.
We believe that it may be
appropriate for an entity to analogize to air
rights (and thus treat subsurface rights as an
intangible asset) in certain circumstances, such
as those involving the use of subsurface space to
facilitate the build-out of a gas or electric
distribution system. We generally support an
analogy to air rights given the fact that
above-ground (air) and below-ground (subsurface)
uses are often commercially interchangeable. For
example, an electric utility can run its electric
wires 35 feet above the ground or 2 feet below the
ground, either of which will accomplish the same
commercial objective. Note that this analogy does
not apply to all underground scenarios (e.g.,
those involving the basement of a building or an
underground parking garage).
We believe that when a
subsurface easement conveys rights akin to air
rights, an entity is permitted, but not required,
to consider an arrangement that provides a right
to access the subsurface as an intangible asset by
analogy to air rights. Air rights are intangible
assets under ASC 805-20-55-37, which states:
Use rights such as drilling,
water, air, timber
cutting, and route authorities are contract-based intangible
assets to be accounted for separately from
goodwill. Particular use rights may have
characteristics of tangible, rather than
intangible, assets. For example, mineral rights
are tangible assets. An acquirer should account
for use rights based on their nature. [Emphasis
added]
Under this approach,
subsurface rights are outside the scope of ASC
842. The right to use the land’s surface would be
considered a unit of account that is separate from
subsurface rights.
We generally believe that if a
company does not analogize to air rights and
instead evaluates its subsurface easements under
ASC 842, the land below the surface should be
considered a unit of account that is separate from
the land’s surface in the identification of
whether a lease exists. Some have advocated a
“vertical slice” approach (i.e., evaluating the
right to use the surface and subsurface as a
single unit of account); however, we believe that
such an approach can lead to inappropriate
conclusions (e.g., a conclusion that an entity is
not leasing the land because it is not also
receiving the subsurface rights).
Companies should apply a
consistent approach to assessing their subsurface
easements and should consider disclosing this
approach, if such disclosure would be
material.
Footnotes
6
Although this section focuses
on land easements, we believe that the concepts
discussed herein can also be applied to other
types of land-use rights, including those provided
by the government in certain jurisdictions (e.g.,
countries that prohibit land ownership by foreign
investors). We think that entities should
generally assess whether such land-use rights are
leases before considering other applicable
GAAP.
7
See Section 2.4.3.3
for additional considerations related to
subsurface easements.
7
See footnote 6.