3.2 Definition of a Lease

ASC 842-10

15-3 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. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).

Pending Content (Transition Guidance: ASC 842-10-65-7)

15-3A As a practical expedient, an entity that is not a public business entity; a not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market; or an employee benefit plan that files or furnishes financial statements with or to the U.S. Securities and Exchange Commission may use the written terms and conditions of a related party arrangement between entities under common control to determine whether that arrangement is or contains a lease. For purposes of determining whether a lease exists under this practical expedient, an entity shall determine whether written terms and conditions convey the practical (as opposed to enforceable) right to control the use of an identified asset for a period of time in exchange for consideration. If an entity determines that a lease exists, the entity shall classify and account for that lease on the basis of those written terms and conditions. An entity may elect the practical expedient on an arrangement-by-arrangement basis.

15-3B If no written terms or conditions exist, an entity shall not apply the practical expedient in paragraph 842-10-15-3A. Rather, the entity shall determine whether the related party arrangement between entities under common control is or contains a lease in accordance with paragraph 842-10-15-3 and, if so, classify and account for that lease on the basis of its legally enforceable terms and conditions in accordance with paragraph 842-10-55-12.

15-3C If after an entity has applied the practical expedient in paragraph 842-10-15-3A an arrangement is no longer between entities under common control, the entity shall determine whether a lease exists in accordance with paragraph 842-10-15-3.

If the arrangement was previously determined to be a lease and continues to be a lease, the entity shall classify and account for the lease on the basis of the enforceable terms and conditions. If the enforceable terms and conditions differ from the written terms and conditions previously used to apply paragraph 842-10-15-3A, the entity shall apply the modification requirements in paragraphs 842-10-25-9 through 25-17 using the enforceable terms and conditions. If the enforceable terms and conditions are the same as the written terms and conditions previously used to apply paragraph 842-10-15-3A, the modification requirements in those paragraphs are not applicable.
If the arrangement was previously not determined to be a lease and is determined to be a lease, the entity shall account for the arrangement as a new lease.
If the arrangement was previously determined to be a lease and the lease ceases to exist:
1. A lessee shall apply the derecognition requirements for fully terminated leases in paragraph 842-20-40-1.
2. A lessor with a lease previously classified as a sales-type lease or a direct financing lease shall apply the derecognition requirements for terminated leases in paragraph 842-30-40-2.
3. A lessor with a lease previously classified as an operating lease shall derecognize any amounts that would not exist if the arrangement was not accounted for as a lease and account for the arrangement in accordance with other generally accepted accounting principles (GAAP).

15-4 To determine whether a contract conveys the right to control the use of an identified asset (see paragraphs 842-10-15-17 through 15-26) for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs 842-10-15-17 through 15-19)
The right to direct the use of the identified asset (see paragraphs 842-10-15-20 through 15-26). . . .

15-5 If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term.

ASC 842-10-15-3 indicates that a lease is a contract — or part of a contract — in which a supplier conveys to a customer “the right to control the use of identified [PP&E] for a period of time in exchange for consideration.” The graphic below illustrates this relationship.

Although the definition of a lease in ASC 842-10-15-3 includes the phrase “in exchange for consideration,” the identification of a lease does not depend on whether the contract contains stated or cash consideration. See Chapter 6 for a detailed discussion of lease payments and what constitutes consideration.

3.2.1 Process for Identifying a Lease

To help entities determine whether a contract is or contains a lease in accordance with ASC 842-10-15-3 and 15-4, the FASB included a flowchart in its implementation guidance. Each piece of this flowchart will be further discussed throughout the remainder of this chapter.

ASC 842-10

15-8 Paragraph 842-10-55-1 includes a flowchart that depicts the decision process for evaluating whether a contract is or contains a lease.

Identifying a Lease

55-1 The following flowchart depicts the decision process to follow in identifying whether a contract is or contains a lease. The flowchart does not include all of the guidance on identifying a lease in this Subtopic and is not intended as a substitute for the guidance on identifying a lease in this Subtopic.

Connecting the Dots

Not a Step-by-Step Process

The FASB’s flowchart in ASC 842-10-55-1 appears to suggest that the lease identification assessment comprises a series of steps. For example, the flowchart seems to imply that, in determining whether it has the right to control the use of an asset, an entity must determine whether there is an identified asset in the contract before it can move on to assessing the right to control the use in the following sequential manner:

Whether there is an identified asset.
Whether the customer has the right to obtain substantially all of the economic benefits from use of the identified asset.
Whether the customer has the right to direct the use of the identified asset.

However, Example 10, Case A, in ASC 842-10-55-124 through 55-126 (reproduced in Section 3.7.10) states that when the customer in a contract does not have the right to control the use of PP&E, an entity does not need to assess whether the PP&E is an identified asset. Accordingly, we do not think that it is necessary for lease identification to be performed on a step-by-step basis. (However, a step-by-step assessment is required for the specific evaluation of whether the customer has the right to direct the use of the asset — see Section 3.4.2 for further discussion.)

One way to think about identifying a lease is that the definition of a lease sits on a three-legged stool. Each leg represents one of the three requirements in ASC 842-10-15-4: (1) the contract depends on an identified asset, (2) the customer has the right to obtain substantially all of the economic benefits from use of the PP&E, and (3) the customer has the right to direct the use of the PP&E. If you were to kick out any one of the three legs (i.e., if you were to determine that a contract does not meet any one of the requirements), the stool falls over and the definition of a lease is not met.

The flowchart below illustrates an entity’s determination of whether a contract is or contains a lease and ties into the discussion in the remainder of this chapter.

Connecting the Dots

It’s All About Control

The notion of control is critical in ASC 842. The concept is used to identify a lease as well as to classify one when it is identified (see Chapters 8 and 9 for a discussion of the lessee’s and lessor’s classification, respectively). Accordingly, there is effectively a two-step process related to the control concepts behind the FASB’s ROU model in ASC 842:

Step 1 — Determine whether the customer has the right to control the use of an identified asset. If so, the contract is or contains a lease. If not, the supplier has the right to control the use of the asset.
Step 2 — Determine the extent of the customer’s control over the use of the asset. There is a range of outcomes from this step. However, if enough control of the use rests with the customer, the customer effectively obtains control of the entire asset. The extent to which the customer has control of the use of the asset governs the classification of the lease and its accounting.

In paragraphs BC124 and BC125 of ASU 2016-02, the FASB notes that the control concept in the definition of a lease (i.e., step 1 as described above) should be compatible with the same concept articulated in the revenue standard (i.e., ASC 606) and the consolidation guidance (i.e., ASC 810). Further, paragraph BC134 of ASU 2016-02 indicates that, in the determination of whether a customer has the right to control the use of an asset under ASC 842, the concept of control should have “power” and “benefits” (or “economics”) elements, just as ASC 606 or ASC 810 do for control of a good (or service) or another entity, respectively.

The table below compares the control principles from the leasing, revenue, and consolidation standards.

	Consolidation	Revenue	Leasing
ASC Reference	810-10-25-38A	606-10-25-25	842-10-15-4
Control principle (power and economics elements)	“A reporting entity shall be deemed to have a controlling financial interest in a VIE if it has both of the following characteristics: The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance [power element] The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE [economics element].”	“Goods and services are assets, even if only momentarily, when they are received and used (as in the case of many services). Control of an asset refers to the ability to direct the use of [power element], and obtain substantially all of the remaining benefits from, the asset [economics element].”	“To determine whether a contract conveys the right to control the use of an identified asset . . . for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following: The right to obtain substantially all of the economic benefits from use of the identified asset [economics element] The right to direct the use of the identified asset [power element].”

3.2.2 Embedded Leases

Section 3.1 clarifies the balance sheet impact of properly differentiating between a lease and a service under ASC 842. Further, certain contracts may not be wholly a lease or wholly a service; in fact, it is not uncommon for some service arrangements to contain a right to control the use of an asset. An entity may enter into a service arrangement that involves PP&E necessary to deliver the contract’s promised services. The importance of the PP&E to the overall delivery of the service may vary depending on the type of arrangement. For example, a customer contracting for transportation services to ship a package from Munich to Milwaukee may care little about the PP&E used to perform the services. In contrast, a customer contracting a vessel and crew for a specified period to transport its goods where and when it chooses is likely to be more concerned with the PP&E used in the arrangement. Both arrangements, however, involve a significant service component provided by the supplier to operate the PP&E used to fulfill its transportation obligations.

In accordance with ASC 842-10-15-2, entities must evaluate service arrangements that involve the use of PP&E to determine whether the arrangements contain a lease at contract inception. Often, the assessment of whether a contract is or contains a lease will be straightforward. However, the evaluation will be more complicated when a service arrangement involves a specified physical asset or when both the customer and the supplier make decisions about the use of the underlying asset. Examples of these more ambiguous and complex arrangements include those that involve cloud computing services (i.e., if there is a lease of the supporting equipment, such as mainframes and servers) and cable television services (i.e., if the cable box provided to the customer is a leased asset).

Further, not all leases will be labeled as such, and leases may be embedded in larger arrangements. For example, supply agreements, power purchase agreements (PPAs), and oil and gas drilling contracts may contain leases (i.e., there may be an embedded lease of a manufacturing facility, generating asset, or drill rig, respectively). If an entity identifies PP&E in an arrangement (either explicitly or implicitly), the customer and supplier must both determine whether the customer controls the use of the PP&E throughout the period of use.

3.2.2.1 Embedded Leases and Service Providers

In a manner consistent with the discussion in Section 3.2.2, it is important to review contracts (particularly service contracts) to determine whether they are or contain a lease. When the service provider also conveys control of PP&E to a customer, an embedded lease (to the customer) is likely to exist. On the other hand, when the customer conveys control of PP&E to the service provider to facilitate the delivery of the service, it is less likely that there is an embedded lease in the arrangement.

In certain industry sectors, it is common for a customer to provide a vendor with the use of an asset (e.g., a piece of customer-owned equipment) so that the vendor can provide goods or services to the customer (i.e., the “vendor’s revenue contract”). The vendor’s use of the equipment is typically limited to activities defined in the contract that by their nature only benefit the customer. Further, the vendor would not have the right to opt out of using the customer-owned equipment (i.e., the vendor could not choose to bring vendor-owned or vendor-leased equipment). In summary, the vendor typically must use the customer-furnished asset and the asset’s use is contractually limited to fulfilling the terms of the vendor’s revenue contract with the customer (i.e., the asset cannot be used to satisfy the terms of other contracts of the vendor and may not be assigned to third parties).

Arrangements in which customer-furnished assets are used exclusively to fulfill the vendor’s contract with the customer typically include either of the following:

One or more embedded leases that should be accounted for separately (i.e., a lease from the customer to the vendor and then a corresponding lease back from the vendor to the customer); some may describe such accounting as accounting for the arrangement on a gross basis.
No leases (such accounting is sometimes described as accounting on a net basis, suggesting an equal and offsetting exchange of rights because the substance of the transaction is that no leases exist).

We believe that, in accounting for such arrangements, an entity should carefully evaluate the facts and circumstances to determine whether control of an asset is transferred through the rights to use the asset as conveyed in the arrangement. In some cases, it will be appropriate to recognize a lease; however, we believe that when the three criteria outlined below are met, control of the asset is not conveyed to one party (vendor) and then transferred back to the owner (customer).

When the three criteria are met, the substance of the transaction is that there are no leases (i.e., neither inbound nor outbound) and the accounting should therefore be on a net basis (i.e., there are no separate accounting effects related to the customer-furnished assets). However, if these criteria are not met or are only met for a portion of the term of the use of the customer-furnished asset, the vendor and customer should further evaluate whether the customer has leased its asset to the vendor.

The vendor (potential lessee/sublessor) and customer (potential lessor/sublessee) should not treat customer-furnished assets as embedded leases (and recognize the gross effects of such leases) only if all of the following three criteria are met:

Linked contracts — The right to use the asset is directly linked to the revenue arrangement. That is, the arrangement is executed as part of one contract or each part of two or more contracts is deemed to be combined and accounted for as a single transaction since the contracts are interdependent.
Coterminous period — Some or all of the period of use of the asset is coterminous with the revenue arrangement. As discussed further below, if the period of use for the asset begins before or ends after the revenue arrangement, this condition would only be satisfied (and therefore net treatment would only be appropriate) for the overlapping period.
Restricted use — During the coterminous period identified in criterion 2, the vendor’s use of the asset is either restricted contractually or limited practically to solely transferring the goods or services promised in the revenue arrangement, including restricting the vendor from assigning or transferring the rights of the asset without the customer’s consent.

Accordingly, when all of the above criteria are met, there are no leases of the asset and there would be no gross-up of revenue and related expense (i.e., both the customer and the vendor would account for the arrangement as a typical service contract) for the period in which the vendor’s use of the identified asset coincides with the related revenue contract (including renewal/extension options). If the vendor can use the identified asset for a period longer than the related revenue contract, there may be a lease for the excess period (i.e., use of the asset before or after the related revenue contract begins or ends, respectively, provided that control is conveyed to the vendor before or after the revenue contract begins or ends, respectively). Therefore, the counterparties would need to determine whether a lease commences when the related revenue contract expires (or before it starts) because the output from the use of the identified asset is no longer limited to satisfying the related revenue contract.

The examples below illustrate situations in which the three criteria are met and the arrangements would be accounted for on a net basis.

Example 3-1

Customer-Furnished Equipment

Contractor C enters into a three-year arrangement with Governmental Agency G, the customer. Under the arrangement, C provides G with military base operations related to mail and food services while G owns and will provide C with exclusive use of its mail sorting and delivery equipment and food service equipment over the three-year term to execute the services. That is, G owns and will provide the use of all equipment that C would need to deliver its services to G. The terms of the contract explicitly limit C’s use of the equipment to activities defined in the contract as “contract activities,” and such contract activities directly benefit G through the services provided by C under the arrangement. Further, C cannot assign or transfer its rights under the contract or further sublease the equipment.

In this example, the three criteria are met as follows:

Linked contracts — The right to use the equipment is directly linked to the revenue arrangement. That is, the military base operations arrangement is executed as a single contract that includes C’s use of G’s equipment to execute the contract activities that directly benefit G.
Coterminous period — The period of use of the equipment is coterminous with the three-year arrangement for military base mail and food services.
Restricted use — The right to use the equipment is contractually restricted to solely transferring the services promised in the military base operations arrangement. That is, C cannot use the equipment to derive other economic benefits (through offering services to other customers or for C’s internal use). In addition, the contract explicitly restricts C from assigning or transferring its rights under the contract or further subleasing the equipment.

Accordingly, there is no lease of the mail sorting and delivery equipment or the food service equipment. Therefore, G will not recognize lease income as a lessor for C’s right to use its assets and a separate lease expense associated with the embedded lease in the services it receives from C. Similarly, C will not recognize lease expense as a lessee for its right to use G’s assets and separate lease income for its provision of an embedded lease within its service revenue agreement.

Example 3-2

Customer-Furnished Property

Vendor V enters into a five-year arrangement with a customer, Freight Carrier F, to provide the maintenance services on F’s railcars. The maintenance facility that V will use to execute its services is owned by F. That is, F owns and will provide exclusive use of its maintenance facility to V to perform all the maintenance work over the five-year term. The terms of the contract explicitly limit V’s use of the maintenance facility to activities defined in the contract as “contract activities.” Accordingly, V cannot use the maintenance facility (1) to service any customer other than F or (2) for its internal use. Vendor V cannot assign or transfer its rights under the contract or further sublease the maintenance facility.

In this example, the three criteria are met as follows:

Linked contracts — The right to use the maintenance facility is directly linked to the revenue arrangement. That is, the maintenance services arrangement is executed as a single contract that includes V’s use of F’s maintenance facility to execute the contract activities that directly benefit F.
Coterminous period — The period of use of the maintenance facility is coterminous with the five-year arrangement for maintenance services.
Restricted use — The right to use the maintenance facility is contractually restricted to solely transferring the services promised in the maintenance services arrangement. That is, V cannot use the maintenance facility to derive other economic benefits (through offering services to other customers or for V’s internal use). In addition, the contract explicitly restricts V from assigning or transferring its rights under the contract or further subleasing the maintenance facility.

Accordingly, there is no lease of the maintenance facility.1 Therefore, F will not recognize lease income as a lessor for V’s right to use its maintenance facility and a separate lease expense associated with the embedded lease in the maintenance services it receives from V. Similarly, V will not recognize lease expense as a lessee for its right to use F’s maintenance facility and separate lease income for its provision of an embedded lease within its service revenue agreement.

3.2.3 Joint Operations or Joint Arrangements

ASC 842-10

15-4 . . . If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.

Companies in a number of industries enter into joint arrangements to achieve a common commercial objective. These arrangements may include the use of specified PP&E for a stated time frame. Accordingly, under ASC 842-10-15-4, entities should evaluate such arrangements to determine whether they have the right to control the use of an asset.

Bridging the GAAP

No Joint Definitions

The terms “joint arrangement” and “joint operation” are defined in IFRS Accounting Standards but not in U.S. GAAP. Under IFRS 11, a joint arrangement is “an arrangement of which two or more parties have joint control” and a joint operation is a type of joint arrangement “whereby the parties that have joint control of the arrangement have rights to the assets, and obligations for the liabilities, relating to the arrangement.”

Although ASC 842 does not define these two terms, their use in U.S. GAAP is aligned with that in IFRS Accounting Standards. The terms appear in ASC 842-10-15-4 for two reasons:

The FASB and IASB decided that the definition of a lease in ASC 842 would be converged with that in IFRS 16.
The FASB wanted to close a structuring opportunity so that entities cannot come together in a joint arrangement or joint operation structure to avoid identifying a lease and recognizing lease assets and lease liabilities.

Connecting the Dots

Joint Operating Agreements in the Oil and Gas Industry

Entities in the oil and gas industry often enter into joint operating agreements (JOAs) in which two or more parties (i.e., operators and nonoperators), without setting up a separate or new legal entity, collaboratively explore for and develop oil or natural gas properties by using the experience and resources of each party. These agreements often require the use of leased equipment. Questions have arisen regarding ASC 842’s lease assessment requirements for parties to JOAs. While we expect that the analysis of JOAs will be largely based on facts and circumstances, the example and analysis below should be helpful to companies as they consider these arrangements.

Example 3-3

Three companies — A, B, and C — form a JOA to execute an offshore drilling program. For the companies to fulfill the JOA’s objective, a specific asset (e.g., a drill rig) will be necessary. Company A will act as the counterparty to major contracts of the JOA, including a five-year contract to lease a specific drill rig from its owner (Lessor X).

Question 1: Which Party, if Any, Is Leasing the Rig?

Given A’s role as primary obligor in the drill rig lease (the rig’s owner may not be aware of the JOA and the parties that constitute it), A will generally be deemed the lessee in the arrangement. Accordingly, A will record the entire lease on its balance sheet. Even though other parties will receive economic benefits from the rig, those benefits arise from the JOA and do not affect the economic-benefits analysis of the contract between A and the rig’s owner, X.

Question 2: What Is the Effect of the JOA?

The JOA’s terms may represent a sublease of the rig from A to the JOA. That is, ASC 842 requires the parties to the JOA to consider the terms and determine whether the JOA is, or includes, a “virtual” lessee of the rig. Although the JOA is typically not a legal entity that prepares financial statements, a conclusion that the JOA is a lessee of the rig would have the following implications:

Company A, as sublessor, would separately account for its sublease to the JOA (apart from its head lease with X, the rig’s owner).
Each party to the JOA would need to consider other GAAP (e.g., proportionate consolidation guidance) that may require it to record its pro rata portion of lease assets and lease liabilities.

Note that the “other GAAP” mentioned in Question 2 of the example above may vary by industry (e.g., proportionate consolidation guidance is not applicable in many industries). Also note that the analysis should be performed at the appropriate level, which may not always be the JOA. The “joint operation” or “joint arrangement” mentioned in ASC 842-10-15-4 could be a subset of a JOA to the extent that multiple parties have agreed to jointly use an identified asset for a defined time frame. For example, in a five-year JOA involving five parties, if three of the parties agree to jointly develop a property by using a specified drill rig for the first two years, it may be necessary to evaluate that two-year agreement to determine whether it contains a lease.

The above example is not meant to suggest that most JOAs will contain leases but to highlight and explain the analysis that ASC 842-10-15-4 requires for joint arrangements involving the use of specified PP&E. We encourage entities affected by this issue to check with their auditors and accounting advisers for input on the accounting for specific arrangements.

Footnotes

While this example focuses on the maintenance facility itself, a similar analysis would apply to the land on which the maintenance facility resides. Furthermore, we believe that there are scenarios involving vendor-owned assets attached to customer-owned land (e.g., vendor-owned solar panels attached to customer-owned land) whereby the land use rights would be subject to the interpretive guidance in this section.

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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.