Chapter 3 — Identifying a Lease

3.1 Introduction

As indicated in the decision tree in Section 2.2, whether a contract is within the scope of ASC 842 is only a gating question. Once an entity determines that the contract is within the scope, it must then proceed through the analysis in ASC 842-10-15 to determine whether the contract is or contains a lease.

ASC 842-10

15-2 At inception of a contract, an entity shall determine whether that contract is or contains a lease.

15-7 In making the determination about whether a contract is or contains a lease, an entity shall consider all relevant facts and circumstances.

Although a contract is not recognized and measured until commencement if it is a lease (see Chapters 8 and 9 for a detailed discussion of lessee and lessor accounting, respectively), the lease identification analysis must be performed at inception. If an arrangement is determined not to be, or not to contain, a lease, an entity must look to other U.S. GAAP (e.g., ASC 606) to determine the appropriate accounting and must apply the appropriate recognition and measurement guidance in such GAAP at whatever time is required, which could be at a contract’s inception.

Changing Lanes

Definition of a Lease Is the New Line Between On- and Off-Balance-Sheet Treatments

Under ASC 842, the determination of whether an arrangement is or contains a lease is critical. A lessee’s failure to identify leases, including those embedded in service arrangements, is likely to lead to a financial statement error given that ASC 842 requires lessees to reflect all leases, other than short-term leases, on the balance sheet (see Chapter 8 for further discussion of the lessee accounting model). On the other hand, if a customer concludes that a contract is a service arrangement and does not contain an embedded lease, the customer is not required to reflect the contract on its balance sheet (unless it is required to do so by other U.S. GAAP).

The assessment of the arrangement may be more critical under ASC 842 than under ASC 840 because, under ASC 840, the balance sheet and income statement treatment of operating leases was often the same as that of service arrangements. In other words, under ASC 840, the difference between on- and off-balance-sheet treatments often depended on whether the lease is classified as operating or capital. Under ASC 842, however, all leases (other than short-term leases) are on the balance sheet. Therefore, an off-balance-sheet treatment will often depend on whether an arrangement meets the definition of a lease.

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.

3.3 Identified Asset

In accordance with the definition of a lease in ASC 842, fulfillment of the contract must depend on the use of an identified asset. This is an important concept, as the Board notes in paragraph BC128 of ASU 2016-02, because the customer must know the asset over which it is agreeing to have a right to control the use. Similarly, paragraph BC105(a)(1) of the 2013 leasing exposure draft (ED) explained that in contracts that do not involve an identified asset (e.g., a service), the customer does not have the right to control the use of an asset.

Effectively, the FASB recognized that if an arrangement does not contain an identified asset, it is unlikely that the customer has the right to control the use of an asset. Accordingly, the Board decided against broadening the concept of identified assets to include, for example, assets of a particular specification. The Board stated as much in paragraph BC105(a)(2) of the 2013 leasing ED:

In most contracts for which there is no identified asset, the customer does not have the right to control the use of an asset. Consequently, widening the definition in that respect would possibly have forced some entities to go through the process of assessing whether the customer obtains the right to control the use of an asset, only to conclude that it does not. That would potentially have increased costs for little benefit.

Connecting the Dots

Explicit and Implicit Identification Are Consistent With ASC 840

Paragraph BC128 of ASU 2016-02 states, in part, that the “requirement that there be an identified asset is substantially the same as the requirement in previous GAAP that a lease depends on the use of a specified asset.” In addition, ASC 840-10-15-5 noted that a specified asset may be either explicitly or implicitly specified in the arrangement, which is consistent with ASC 842-10-15-9. Therefore, we do not expect ASC 842 to significantly differ from ASC 840 with respect to the explicit or implicit identification of an asset.

However, the identified-asset notion in ASC 842’s definition of a lease differs from ASC 840 regarding the assessment of substitution rights. See Section 3.3.3 for a detailed discussion of this issue.

In many cases, the PP&E being leased will be identified by an address, serial number, VIN, GPS coordinates, etc. However, the assessment sometimes may be more complex. The decision tree below illustrates the process an entity should consider when determining whether PP&E is identified in the contract:

The remainder of this section walks through this decision tree in greater detail.

3.3.1 Explicitly and Implicitly Specified Assets

ASC 842-10

15-9 An asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer.

The most observable forms of identified assets are those that are explicitly specified in the arrangement. Typically, an asset is explicitly specified through the inclusion of a serial number or part number in the contract. For example, if a customer enters into an arrangement to lease a computer server and the contract states that the customer has the right to use Server ABC123, the server is explicitly specified. Alternatively, if the contract states that the customer has a right to use any of the company’s servers that meet certain specification and functionality requirements, the server is not explicitly specified.

If an asset is not explicitly specified in the contract, an entity should consider whether an asset is implicitly specified in the arrangement. As stated in ASC 842-10-15-9, an asset that is implicitly specified can qualify as an identified asset. This concept is further expanded in paragraph BC128 of ASU 2016-02:

Nonetheless, when assessing whether there is an identified asset, an entity does not need to be able to identify the particular asset that will be used to fulfill the contract to conclude that there is an identified asset. Instead, the entity simply needs to know whether an asset is needed to fulfill the contract from commencement. If that is the case, an asset is implicitly specified.

The examples below illustrate cases in which assets are implicitly specified.

Example 3-4

Railcars

Customer JB enters into a contract with Supplier TK to use a railcar to transport hazardous liquids over a three-year period. The contract does not explicitly specify the railcar that will be used to transport JB’s products but does stipulate that the railcar used must be capable of transporting hazardous bulk commodities (e.g., hazardous liquids and gases). Supplier TK has a large fleet of railcars but only one railcar that is designed to transport hazardous bulk commodities. Therefore, although the railcar is not explicitly specified in the contract, it is implicitly specified because TK has only one railcar that can be used to fulfill the contract.

If other, similar railcars are readily available to TK in the marketplace, substitution rights may need to be considered in the analysis as well. See Section 3.3.3 for further discussion of substitution rights.

Example 3-5

Servers

Customer TP, a health care provider, enters into a contract to store sensitive customer information subject to HIPAA regulations in a server farm. The contract does not explicitly specify the server farm that will be used by TP. However, because of the highly sensitive nature of the information that will be stored in the servers, the contract states that the server farm used must meet specific security and encryption requirements. Although the supplier has various server farms across the country, it only has one server farm with servers outfitted to match the security and encryption requirements outlined in the contract. Therefore, although that server farm is not explicitly specified in the contract, the server farm is implicitly specified as a result of the contractual provisions. To determine whether there is an identified asset, the parties must next assess whether the contract involves a capacity portion of the implicitly specified server farm that represents substantially all of the capacity of the server farm (see Section 3.3.2).

Example 3-6

Satellites

Supplier KB enters into a contract with Customer NL for satellite services so that the end users of NL’s services can communicate across the globe. Supplier KB operates and maintains several satellites in orbit. However, the services NL offers include global communication with specific compression and encryption. Accordingly, NL needs a satellite that can transmit a unique signal that is specifically compressed and encrypted. Supplier KB only has one satellite in orbit that can transmit this signal. Therefore, although this satellite is not explicitly specified in the contract, it is implicitly specified because of the terms of the contract with NL. To determine whether there is an identified asset, the parties must next assess whether the contract involves a capacity portion of the implicitly specified satellite that represents substantially all of the capacity of the satellite (see Section 3.3.2).

Connecting the Dots

Identified Assets When the Customer Has the Right to Select and Use Parcels of Land Within a Larger Plot

Certain contracts grant customers the right to select and use a parcel of land within a larger plot of land for a period of time. In these situations, the customer would need to assess whether it has exclusive use of the parcels selected and whether the landowner retains the right to use the remainder of the land that has not been selected by the customer. Questions have arisen regarding whether the specified asset in these arrangements is the specific parcel(s) of land selected by the customer or the larger plot of land. This determination is based on facts and circumstances, and reasonable judgment may need to be applied. The example below illustrates such scenarios. Also see Section 2.4 for a similar discussion related to land easements.

Although an asset may be explicitly or implicitly specified in the arrangement, an entity must also evaluate whether (1) the specified asset is a portion of a larger asset and whether that portion is physically distinct or substantially all of the larger asset’s capacity and (2) the supplier has the right to substitute the underlying asset throughout the period of use and, if so, whether the supplier’s substitution right is substantive. See the next section and Section 3.3.3 for further discussion of portions of assets and substantive substitution rights, respectively.

3.3.2 Portions of Assets (Capacity and Physical Distinctness)

ASC 842-10

15-16 A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fiber optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.

An entity will need to use judgment in distinguishing between a lease and a capacity contract. ASC 842-10- 15-16 clarifies that a “capacity portion of an asset is an identified asset if it is physically distinct” (e.g., a floor of a building).

Example 3-7

Use of a Portion of a Fiber-Optic Cable

Customer M, a telecommunications provider, enters into a 10-year contract with Supplier R for the right to use two fibers in a fiber-optic cable to transport data from New York City to London. Each fiber within the fiber-optic cable is physically distinct, and the contract explicitly specifies the two fibers that will be provided to M; therefore, the arrangement contains an identified asset.

On the other hand, a capacity portion of a larger asset that is not physically distinct (e.g., a percentage of the capacity of a pipeline) is not an identified asset unless the portion represents substantially all of the asset’s capacity.

Although ASC 842 does not define “substantially all,” it uses the term in the context of determining whether a capacity portion of an asset represents an identified asset as well as in discussion of the lease classification test (i.e., determining whether the present value of the lease payments represents substantially all of the fair value of the underlying asset). To help entities determine whether the “substantially all” criterion is met in the lease classification test, the FASB included implementation guidance that allows entities to use a 90 percent threshold. Specifically, paragraph BC73 of ASU 2016-02 states, in part:

Nevertheless, the Board understands that entities need to ensure the leases guidance is operational in a scalable manner, which often requires the establishment of internal accounting policies and controls. As a result, the Board included implementation guidance in Topic 842 that states that one reasonable application of the lease classification guidance in that Topic is to conclude, consistent with previous GAAP, that . . . 90 percent or greater is “substantially all” the fair value of the underlying asset.

Likewise, we believe that 90 percent should generally be used to determine whether a capacity portion of an asset meets the “substantially all” threshold. Therefore, under this guidance, if the capacity portion being used by the customer is 90 percent or more of the asset’s total capacity, the customer is using substantially all of the capacity of the asset. In such a scenario, the entire asset would represent an identified asset (subject to the guidance on substantive substitution rights, discussed in Section 3.3.3). Companies should consult with their auditors, accounting advisers, or both if they are considering the use of a different percentage threshold for this purpose.

Again, the FASB’s decisions regarding portions of larger assets reflect the importance of the control concept and establishing which party to the arrangement controls the right to use an asset. Paragraph BC133 of ASU 2016-02 states, in part, the following:

The Board concluded that a customer is unlikely to have the right to control the use of a capacity portion of a larger asset if that portion is not physically distinct (for example, if it is a 20 percent capacity portion of a pipeline). The customer is unlikely to have the right to control the use of its portion because decisions about the use of the asset are typically made at the larger asset level. [Emphasis added]

The examples below illustrate the application of the guidance in ASC 842-10-15-16.

Example 3-8

Use of a Portion of a Pipeline

Customer C enters into a five-year contract with Supplier S for the right to transport natural gas through S’s pipeline from the Marcellus shale supply region in Pennsylvania to the New York/New Jersey demand region. The contract specifies the amount of the pipeline’s capacity that C may use throughout the five-year period. In each case, S has the right to contract with other customers for the remaining capacity not being used by C.

Case A — Capacity Is Substantially All

The contract gives C the right to use 93 percent of the capacity of S’s pipeline. In this case, because 93 percent represents substantially all of the pipeline’s capacity, the arrangement contains an identified asset (i.e., S’s pipeline).

Case B — Capacity Is Not Substantially All

The contract gives C the right to use 26 percent of the capacity of S’s pipeline. In this case, C does not have the right to use substantially all of the pipeline’s capacity; therefore, the arrangement does not contain an identified asset.

Example 3-9

Use of a Portion of a Warehouse

Case A — Contract Does Not Contain an Identified Asset

Customer LH enters into a contract with a warehouse operator to store up to 1,000 pallets of spare-parts inventory at one of the operator’s warehouse locations for a three-year period. The operator’s warehouse can store up to 10,000 pallets of inventory. During the contract period, the warehouse operator can use the remaining space in its warehouse for other storage needs. In addition, the warehouse operator can relocate LH’s pallets within the warehouse at any time without incurring significant costs.

Because LH does not have exclusive use of a specified portion of the warehouse and the portion being used is not substantially all of the warehouse capacity, there is no identified asset. Although the contract specifies the amount of spare-parts inventory that will be held, the warehouse operator can change the inventory’s location within its warehouse at any time.

Case B — Contract Contains an Identified Asset

Assume the same facts as in Case A, except that the operator’s warehouse can only store up to 1,100 pallets, rather than 10,000. In addition, assume that the operator cannot relocate the inventory to a different facility.

Since Customer LH’s storage requirement accounts for substantially all of the capacity of the operator’s warehouse (more than 90 percent), the arrangement contains an identified asset (i.e., the operator’s warehouse).

Connecting the Dots

Arrangements Involving Rights to Use Portions of Larger Assets

We have received questions about so-called secondary-use arrangements in which a customer shares the use of part of a larger asset for a defined period. Examples of such arrangements include advertising placed on the side of a fixed asset and nonutility customers’ attachment of distribution wires (e.g., cable wires) to utility poles. Often, we have been asked (1) how to assess economic benefits when two parties contemporaneously use the same asset and (2) what unit of account to use for the evaluation of control (the larger asset or the portion being shared).

ASC 842-10-15-16 provides guidance on evaluating whether a portion of an asset would be considered an “identified asset” and could be subject to ASC 842. Under this guidance, a “capacity or other portion of an asset that is not physically distinct . . . is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset” (emphasis added).

Questions sometimes arise regarding physical distinction, particularly in scenarios involving a larger asset, a specific portion of which is shared by one or more parties over a defined period for use in different ways. An example would be a building’s exterior wall to which one party is granted the exclusive right for advertising while the occupants of the building continue to use the wall for support of their residence, protection from the elements, and so forth. Unlike situations involving the lease of one floor of a multistory building, which is functionally independent and unique, these scenarios involve simultaneous but different uses of a portion of a larger asset. Other examples include the placement of solar panels on a specific section of rooftop and the attachment of cable wires to a specific spot on a utility pole (in both cases, the owner continues to use the entire asset while allowing another party to use a portion of the asset for a different purpose over a defined period). To the extent that there are substantive substitution rights in these arrangements, a lease will generally not be present. However, we understand that many of the scenarios found in practice do not allow for substitution. (See Section 3.3.3 for a detailed discussion of substitution rights.)

Some considerations that may ultimately be relevant to the determination of whether a lease exists include whether:

The arrangement involves a shared use of the larger asset, including the portion specified in the arrangement.
The portion being used by the customer is functionally independent and therefore separable from the larger asset.
The portion being used by the customer is commercially significant to the asset owner by design.

Shared Use

Shared-use arrangements will typically involve the contemporaneous use of the same asset (or the same portion of a larger asset) for different purposes. For example, many advertising scenarios feature shared use (e.g., an ad displayed on top of a baseball dugout, on the side of a bus, or on the floor of a grocery store). On the other hand, if the owner of the asset is not contemporaneously using the asset (or is not contractually allowed to use the asset), shared use may not exist (e.g., a cell tower operator that allows a customer to use a specific hosting site on the tower for a defined period or a satellite owner that allows a customer to use a specific transponder on the satellite for a period of time). Shared-use arrangements are less likely to contain leases, while exclusive-use arrangements (i.e., arrangements in which a customer has exclusive use of a portion of a larger asset) are more likely to contain leases. An entity may need to use judgment in determining whether a particular arrangement features shared or exclusive use of the portion of the larger asset.

Functional Independence

It may be useful to evaluate the functional independence of the portion being used by the customer, including the functional use and design of the asset that is subject to the arrangement. To the extent that the portion being used by the customer has a discrete functional use (e.g., a specific floor of a building), it could be more likely that the portion being used is physically distinct and an identified asset. On the other hand, if the portion being used is not functionally distinguishable from the larger asset (e.g., a spot on a utility pole), there may be a reasonable basis for viewing the larger asset as the identified asset in the arrangement.

Commercial Significance by Design

It may also be useful to consider commercial significance by design — that is, the commercial objectives of the asset owner when it built or purchased the asset. To the extent that the asset was built or purchased with the commercial objective of leasing a specific portion or portions to others (e.g., specific hosting locations on a cell tower), it could be more likely that the portion being used for these purposes is physically distinct and therefore an identified asset. On the other hand, if the asset was built or purchased without such a commercial objective (e.g., a utility pole), there may be a reasonable basis to view the larger asset as the identified asset in the arrangement.

Determining Whether a Lease Exists

The above indicators may help entities assess circumstances in which the use of a portion of an asset might reasonably be viewed as a secondary, or incidental, use of that portion of the asset such that the owner retains substantive economic benefits from the use of the portion. Sometimes, it may be reasonable to view the larger asset as the identified asset in the arrangement and to assess control (including economic benefits) on that basis. Such an approach would generally make it more likely that the arrangement does not contain a lease since the customer may not obtain substantially all of the economic benefits from the use of the larger asset (the customer’s economic benefits are limited to the portion it uses). The right to control the use of an identified asset is discussed in detail in Section 3.4, while the economic-benefits element of control is discussed in Section 3.4.1.

Our current views on this topic are expressed in the examples and table below. The SEC staff has indicated that it would respect an entity’s conclusion regarding such arrangements provided that it was based on reasonable judgment. Therefore, arrangements involving rights to use portions of larger assets should be based on a careful assessment that takes into account all relevant facts and circumstances.

Example 3-10

Contract for the Use of Space on a Cell Tower

Customer A enters into a five-year contract with Supplier B to use space on a cell tower. Customer A is assigned a specifically identified hanger (hosting spot) on the cell tower on the basis of its needs to install its antennae and other telecommunications equipment. Each hosting spot is commercially designed to be leased by B’s customers, and each comprises its own functionally independent infrastructure that allows B’s customers to install their equipment at the hosting spots. Accordingly, A is not the only party with equipment installed on the overall tower; rather, A shares the use of the tower with third parties.

Supplier B is not permitted to move A’s equipment to a different hosting spot or cell tower. In addition, A is the only party that may install equipment on its identified hosting spot. Customer A may install whatever antennae or equipment it wants, subject to certain maximum weight and height restrictions.

The arrangement contains an identified asset because (1) the hosting spot is explicitly identified in the contract and is physically distinct from the larger asset (i.e., from the cell tower) and (2) B may not substitute the asset (i.e., it may not move A’s equipment to a different hosting spot or tower). Alternatively, if B had the right to substitute hosting spots or towers, the parties must assess whether that right is a substantive substitution right (see Section 3.3.3).

Example 3-11

Contract for the Use of a Portion of a Satellite

Customer A enters into a five-year contract with Supplier B to use space on a satellite. In a manner similar to the assigning of the hanger on the cell tower in the example above, A is assigned a specifically identified transponder on the satellite. Each transponder is commercially designed to be leased to B’s customers, and each comprises its own functionally independent infrastructure that allows B’s customers to transmit data signals to and from the transponder. Accordingly, A shares the use of the overall satellite with third parties.

Supplier B is not permitted to transfer A to a different transponder or satellite for reasons other than warranty-related considerations. In addition, A is the only party that may transmit data signals to and from its identified transponder. Customer A may transmit whatever data it wants, subject to certain frequency limitations that stem from the nature of the transponder and satellite.

The arrangement contains an identified asset because (1) the transponder is explicitly identified in the contract and is physically distinct from the larger asset (i.e., from the satellite) and (2) B does not have a substantive substitution right (i.e., it may not transfer A to a different transponder or satellite, except for warranty-related considerations).

Asset (Use)	Identified Asset?	Basis
Wall space (e.g., painting an advertisement on the side of a building)	No	The advertising is a secondary use of the wall. That is, the wall’s primary purpose — the reason it was commercially designed — is to hold up the building structure and protect the building’s occupants from the elements. In addition, the advertiser is unlikely to obtain substantially all of the capacity (or economic benefits from use) from the wall by using its portion, which indicates that there is not an identified asset with respect to the portion.
Retail floor advertising space (e.g., painting an advertisement on the floor of a grocery store)	No	Similar to the basis articulated for wall space.
Side of a bus shelter or commuter train shelter (e.g., placing an advertisement on one wall of the shelter)	No	Similar to the basis articulated for wall space.
Billboard (e.g., placing an advertisement on a stand-alone billboard or a billboard attached to another structure)	Yes	A billboard is commercially designed to be contracted to customers for displaying advertisements. In addition, billboards attached to other, larger structures (e.g., when hung on the side of a building) are physically distinct from the larger structure.
Taxi tent (e.g., placing an advertisement on the sides of a removable, magnetic tent on top of a taxi)	Yes	Similar to the basis articulated for a billboard (i.e., a taxi tent is effectively a mobile billboard).
Pole attachments (e.g., either (1) a utility attaching its lines to a pole owned by a phone company, or (2) a phone company attaching its wires to a pole owned by a utility)	No	All spots on the pole where a customer would hang its wires are functionally dependent on the rest of the structure, and none are physically distinct.
Space on a rooftop to construct a bar or restaurant	Yes	In this case, the rooftop functions independently as a floor in a building would. In accordance with ASC 842-10-15-16, the floor of a building is a physically distinct portion of a larger asset.
Space on a rooftop for an advertisement (e.g., for when commercial airplanes fly overhead)	No	Similar to the basis articulated for wall space, retail floor advertising space, and the side of a bus shelter or commuter train shelter.
Space on a rooftop to install solar panels (e.g., that serve tenants of the building or a utility’s larger customer base)	It depends	Judgment is required. Space on a rooftop to install solar panels may be similar to (1) space on a rooftop to construct a bar or restaurant, (2) space on a rooftop for an advertisement, or (3) both of these.
Kiosk in a mall (e.g., used by a customer for retail purposes)	Yes	As long as there are no substitution rights akin to those in Example 2 in ASC 842-10-55-52 through 55-54 (reproduced in Section 3.7.2), the kiosk is physically distinct, functionally independent, and commercially designed to be contracted to customers as retail space.

3.3.2.1 Pipeline Laterals and First-Mile/Last-Mile Connections (Identified Asset)

Pipelines are generally constructed and operated in sprawling and integrated networks that transport natural gas, oil, and refined products from supply regions to demand regions. Some customers are connected to, and receive deliveries of transported commodities through, the larger pipeline system via dedicated laterals. In addition, a pipeline system must, by its nature, have starting and ending points. Therefore, these customers are connected to the pipeline system through laterals, because they are connected to the first mile or last mile of the larger pipeline system.

Customers connected to a lateral or first mile/last mile of a pipeline system enter into contracts with the pipeline system owner for transportation services through the network to their connection point. Those contracts should be assessed to determine whether they are or contain leases of the lateral or first mile/last mile.

ASC 842-10-15-16 (reproduced in Section 3.3.2) states that a “capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline)” (emphasis added). Pipeline laterals and first-mile/last-mile connections therefore are physically distinct from the larger asset (i.e., the integrated pipeline system) and are identified assets.

The FASB addressed this topic at its May 10, 2017, Board meeting on implementation issues related to ASC 842. The Board agreed that under ASC 842-10-15-16, a pipeline lateral is an identified asset and that the assessment of whether it is a lease must focus on whether the customer has the right to control the use of the identified asset in accordance with ASC 842-10-15-4 (reproduced in Section 3.2). See Section 3.4.2.1.2.2 for further discussion of the analysis related to whether the customer has the right to control the use of the identified asset (i.e., the pipeline lateral).

First-mile/last-mile connections to other types of assets and infrastructural systems are generally identified assets. In accordance with ASC 842-10-15-16, a portion of a larger asset is physically distinct, and thus an identified asset, if it connects a single customer to the larger asset or system. Even when the portion is part of a contiguous asset and is not separable from the larger system, that portion may only serve a single customer and thus is physically distinct.

Portions of assets to which the guidance in ASC 842-10-15-16 may apply include, but are not limited to:

Train tracks that connect a customer’s facility to the larger rail network.
Electric distribution lines that run (either overhead or underground) from the street, transformer, etc., to a customer’s home or facility.
Telephone wires that run (either overhead or underground) from the street to a customer’s home.
Coaxial and fiber-optic cables (i.e., for cable television and Internet) that run (either overhead or underground) from the street to a customer’s office building.

In line with the above discussion, even if the arrangement depends on an identified asset because the first mile/last mile is considered physically distinct, the customer may not have the right to direct the use of the first mile/last mile (see Section 3.4.2.1.2.2 for detailed discussion).

3.3.3 Substantive Substitution Rights

ASC 842-10

15-10 Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:

The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).
The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

15-11 An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and circumstances at inception of the contract and shall exclude consideration of future events that, at inception, are not considered likely to occur. Examples of future events that, at inception of the contract, would not be considered likely to occur and, thus, should be excluded from the evaluation include, but are not limited to, the following:

An agreement by a future customer to pay an above-market rate for use of the asset
The introduction of new technology that is not substantially developed at inception of the contract
A substantial difference between the customer’s use of the asset, or the performance of the asset and the use or performance considered likely at inception of the contract
A substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract.

Once an entity has determined that PP&E is specified in a contract, it must also evaluate whether the supplier has the right to substitute the underlying asset throughout the period of use and, if so, whether the supplier’s substitution right is substantive. If the supplier has a substantive substitution right, the underlying asset does not represent an identified asset and the contract does not contain a lease. Paragraph BC128 of ASU 2016-02 notes that the FASB’s reason for establishing this requirement was that if a supplier has a substantive right to substitute the asset throughout the period of use, “the supplier (and not the customer) controls the use of the asset . . . , thereby deciding for what purpose the asset is used.”

Accordingly, the FASB developed guidance in ASC 842-10-15-10 through 15-15 to help entities determine whether a substitution right is substantive. The Board explains in paragraph BC129 of ASU 2016-02 that its purpose in establishing this guidance was to differentiate between the following:

Substitution rights that result in there being no identified asset because the supplier, rather than the customer, controls the use of an asset
Substitution rights that do not change the substance or character of the contract because it is either not practically or economically feasible for the supplier to exercise those rights or not likely the supplier will be able to exercise those rights.

When developing the framework for the identified-asset notion in the 2013 leasing ED, the Board received significant feedback from stakeholders indicating that substitution rights and clauses in contracts could be used to structure arrangements so that they did not meet the definition of a lease (and, thus, so that lessees could avoid recognizing lease assets and lease liabilities on the balance sheet). The Board acknowledged this in paragraph BC105(b) of the 2013 leasing ED, which stated, in part:

The [Board has] included additional language to help determine when substitution rights are substantive. [Its] intention in doing so is to discourage the insertion of a substitution clause in a contract, which does not change the substance or character of the contract, solely to achieve a particular accounting outcome.

For a substitution right to be considered substantive, the following two conditions must be met:

The supplier must have the “practical ability” to substitute the identified asset (see Section 3.3.3.1).
The supplier must economically benefit from the substitution (see Section 3.3.3.2).

Connecting the Dots

Economically Beneficial Substitution Is a Higher Hurdle Than Under ASC 840

ASC 840-10-15-10 through 15-14 addressed substitution rights. Generally, if an arrangement gives the supplier a substitution right and the supplier has the practical ability to exercise that right, the fulfillment of the arrangement does not depend on the specified PP&E. Under ASC 840, “practical ability” took into account contractual, legal, and economic constraints but does not require that a supplier economically benefit from a substitution.

Accordingly, ASC 842’s requirement that a substitution right be economically beneficial to a supplier is a higher threshold than the requirements in ASC 840. We therefore expect that fewer entities will be able to avoid lease identification as a result of substitution rights in their arrangements. In other words, we expect that more arrangements will be subject to lease accounting under ASC 842.

The next section and Section 3.3.3.2 address how an entity would assess the two conditions in ASC 842-10-15-10 to conclude that a substitution right is substantive. See also Example 2 in ASC 842-10-55-52 through 55-54 (reproduced in Section 3.7.2), which illustrates the assessment of these conditions in the context of concession space in an airport.

3.3.3.1 Practical Ability to Substitute Alternative Assets

ASC 842-10

15-13 If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier does not have the practical ability to substitute alternative assets throughout the period of use.

Common indicators that the supplier has the practical ability to substitute alternative assets throughout the period of use include the following:

The customer cannot prevent the supplier from substituting an asset (i.e., the customer cannot block the substitution). See further discussion below.
Alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period. However, in accordance with ASC 842-10-15-11, the supplier may not consider future events that, at inception, are considered unlikely to occur. If such events are considered unlikely to occur, the supplier may not assume in its assessment that alternative assets will be readily available to the supplier because of circumstances such as future manufacturing economies of scale, future technological developments, or assets otherwise becoming available in the future that are not available at inception.
There are no contractual restrictions on when a supplier may substitute the asset. ASC 842-10-15-13 states that the supplier does not have the practical ability to substitute the asset when substitution rights are only exercisable on, or after, a particular date or are only exercisable upon the occurrence of a certain event or the resolution of a contingency.

These common indicators are further considered below.

Connecting the Dots

When Contractual Provisions Specify That Customer Approval Is Needed Before Substitution

Certain contracts may specify that the supplier must obtain approval from the customer before substituting the underlying asset. In such circumstances, because the customer can block the supplier from substituting the underlying asset, the supplier does not have the practical ability to substitute the asset. Therefore, the supplier’s substitution right is not substantive.

To have the practical ability to substitute the asset in accordance with ASC 842-10-15-10(a), the supplier must be able to substitute the asset without the customer’s approval. Customer consent or approval rights may come in different forms. For example, the customer may be contractually granted a right that allows it to block the substitution itself or may be able to prevent the supplier from accessing the customer’s premises to substitute the asset when the underlying asset is located there. An entity should consider the substance and nature of any rights granted in the contract that may give the customer the right to prevent substitution.

Substantive Substitution Rights Less Relevant for Implicitly Specified Assets

We think that the assessment of whether a supplier has a substantive substitution right in contracts that explicitly specify the asset to be used to fulfill the contract is generally more relevant than that in arrangements for which fulfillment depends on the use of an implicitly specified asset. As discussed in Section 3.3.1, an implicitly specified asset typically exists when the supplier has only one asset (or very few assets) that may be used to fulfill the supplier’s obligation under the contract (e.g., a railcar that can carry hazardous commodities, a server farm with specific security features, or a satellite that can transmit a unique signal). If a supplier only has one asset that can be used to fulfill its obligations under the contract, the supplier most likely does not have the practical ability to substitute the underlying asset. For that reason, a supplier generally does not have a substantive substitution right for implicitly identified assets.

Example 3-12

Supplier Does Not Have the Practical Ability to Substitute

Company BC enters into an arrangement with Supplier LP under which LP will provide a customized Model 5000 copier to BC for two years. Supplier LP only has one customized Model 5000 copier. The arrangement allows LP to replace the copier at will. However, LP would need several months to manufacture such a replacement. Accordingly, no alternative assets are available for substitution. Because LP only has one asset that can be used to honor the agreement with BC and does not have the practical ability to substitute it, LP’s substitution right is not substantive.

Evaluating the Period of Use When a Substitution Right Exists

ASC 842-10-15-13 states that when a “supplier has a right or an obligation to substitute [PP&E] only on or after either a particular date or the occurrence of a specified event, the supplier does not have the practical ability to substitute alternative assets throughout the period of use” (emphasis added). (See Section 3.5 for further discussion of determining the period of use.) Accordingly, in such cases, the substitution right is not substantive because the contract restricts when the supplier can substitute the asset. Therefore, the supplier may not use the substitution right to conclude that the contract is not, or does not contain, a lease because there is no identified asset.

However, questions have arisen regarding the effect of timed substitution rights. The next sections address front-loaded and back-loaded substitution rights.

Front-Loaded Substitution Rights

Assume that a customer enters into a contract with a supplier for the right to use an asset for 10 years. The supplier has a front-loaded substitution right to substitute the asset in years 1 and 2. Although that right expires at the end of year 2, the right is substantive within years 1 and 2. The contract otherwise meets the definition of a lease, and no other contractual terms would prevent a conclusion that there is an identified asset in the contract.

View A — One view is that a contract that would otherwise meet the definition of a lease in ASC 842, but that contains a front-loaded substitution right, is a forward-starting lease. According to this view, both the customer and the supplier have a forward-starting lease that commences at the beginning of year 3 when there is an identified asset.

In performing a lease assessment, an entity must identify whether a contract is, or contains, a lease. In addition, ASC 842-10-15-9 indicates that an asset can be identified once it is made available for the customer’s use. Effectively, in a manner consistent with the definition of “commencement date of the lease” in ASC 842 (see Section 5.1), a lease does not commence until an identified asset is made available for the customer’s use. Therefore, a contract may contain a lease for the period after the expiration of the substitution right.

View A is consistent with ASC 842-10-15-5, which indicates that a contract that gives the customer the right to control the use of an identified asset for only a portion of a contract term contains a lease for that portion of the contract term.
View B — Another view is that there is an identified asset, and thus a lease, at the beginning of year 1.

Proponents of this view subscribe to a literal reading of ASC 842-10-15-13, which requires that, for a supplier to “have the practical ability to substitute alternative assets,” the substitution right must exist throughout the period of use. In a manner consistent with the definition of “period of use” in ASC 842 (see Section 3.5), an asset is used to fulfill the contract — in this case for 10 years. The substitution right does not exist for all 10 years and is therefore not substantive.

Back-Loaded Substitution Rights

Assume that a customer enters into a contract with a supplier for the right to use an asset for 10 years. The supplier has a back-loaded substitution right under which it can substitute the asset in years 9 and 10. Although that right does not exist until the beginning of year 9, the right is substantive during years 9 and 10. The contract otherwise meets the definition of a lease, and no other contractual terms would prevent a conclusion that there is an identified asset in the contract.

View A — One view is that the contract contains an eight-year lease that commences at the beginning of year 1 and expires at the end of year 8.

In a manner similar to the concepts articulated in ASC 842-10-15-23 (reproduced in Section 3.4.2.2), the substitution rights in years 9 and 10 define the scope of the customer’s right to control the use of an identified asset. Accordingly, within that scope, the contract contains an identified asset — and thus a lease — for the first eight years of the contract term.

In addition, View A is consistent with ASC 842-10-15-5, which indicates that a contract that gives the customer the right to control the use of an identified asset for only a portion of a contract term contains a lease for that portion of the contract term.

In this view, substitution rights are approached in a manner consistent with View A on front-loaded substitution rights (articulated above).
View B — Another view is that there is an identified asset, and thus a lease, for all 10 years of the contract.

In this view, substitution rights are approached in a manner consistent with View B on front-loaded substitution rights (articulated above).

In both the front-loaded and back-loaded substitution right scenarios described above, we believe that it would be acceptable for an entity to apply either view. However, since ASC 842 does not provide clear guidance on this topic and we are aware that views on the issue differ, we encourage affected stakeholders to consult with their accounting advisers and auditors.

3.3.3.2 Economic Benefit From Exercise of Substitution Rights

ASC 842-10

15-12 If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset.

In addition to having the practical ability to substitute the asset, a supplier must benefit economically from the substitution for the substitution right to be substantive. ASC 842-10-15-10(b) states that the “supplier would benefit economically [if] the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset” (emphasis added). As indicated in ASC 842-10-15-12, when the underlying PP&E is located “at the customer’s premises or elsewhere,” it is more likely that the costs of substituting the asset will exceed the benefits to the supplier of doing so. This, in effect, creates a presumption that the costs of substitution will exceed the benefits when the asset is not located at the supplier’s premises. Accordingly, an entity may need to perform a quantitative analysis of the costs and benefits of substitution before concluding that the supplier would benefit economically from the exercise of its right to substitute the asset.

In evaluating whether a supplier would economically benefit from substituting an asset, and thus whether the supplier’s substitution right is substantive, an entity should consider all costs that would be associated with the substitution. Such costs may include, but are not limited to, the following:

Costs of (1) removing the existing asset and transporting it to a new location or (2) disposing of the asset.
Costs of gaining access to the customer’s premises when the underlying asset is located there.
Costs of transporting, installing, and testing the alternative assets.
Additional costs of configuring and operating the alternative assets, as necessary.
Customer losses associated with reduced production and increased downtime during the substitution process.

Costs that would have been incurred regardless of the substitution should not be considered in the evaluation of whether the supplier would benefit economically from the substitution.

Connecting the Dots

Economic Benefit Depends on Future Events That Are Not Likely to Occur

ASC 842-10-15-11 states, in part, that an entity’s assessment of “whether a supplier’s substitution right is substantive is based on facts and circumstances” that exist as of contract inception and should ignore the effects of future events that “are not considered likely to occur.” Therefore, when evaluating whether a supplier would benefit economically from substituting the asset, entities should not take into account the effects of future events that are not likely to occur. Typically, such future events are outside the supplier’s control or the supplier does not have historical evidence to support that the events will occur. ASC 842-10-15-11 gives the following examples of such future events:

A new customer agrees to “pay an above-market rate for use of the asset.”
New technology is introduced.
There is a “substantial difference between the customer’s use of the asset, or the performance of the asset,” compared with that at contract inception.
There is a substantial change in the market price of the asset from the market price considered likely at inception.

The examples below illustrate the evaluation of whether a supplier would benefit economically from exercising its right to substitute the underlying asset. In addition, Example 4 in ASC 842 (ASC 842-10-55-63 through 55-71, reproduced in Section 3.7.4) illustrates the evaluation of a substitution right for which the supplier has the practical ability to exercise its right but would not economically benefit from doing so.

Example 3-13

Storage Locker

Company SM owns a storage facility comprising individual storage lockers that it rents to customers for an annual fee. Each storage locker is identified with a unique locker number, and each contract explicitly specifies the locker number that has been assigned to the customer. The contract also states that SM has the right to relocate, at its sole discretion at any point during the annual rental period, the customer’s belongings to any other locker that is the same size in the storage facility. Company SM has a large number of available storage lockers within the storage facility to accommodate other customers. Company SM’s cost of relocating a customer’s belongings are less than the benefits that SM receives by accommodating new customers.

Company SM has a practical ability to relocate each customer’s belongings because the customer cannot block the substitution and other storage lockers with the same specifications are readily available. Because the economic benefits of providing storage lockers to new customers outweigh the costs of relocating an existing customer’s belongings to another storage locker, SM would also benefit economically from the substitution. Therefore, SM has a substantive substitution right and an identified asset does not exist. Accordingly, the contract does not contain a lease and should be accounted for in accordance with other applicable U.S. GAAP.

Example 3-14

Copier/Printer

Company A enters into an arrangement with Supplier B under which B will provide a Model 5000 copier to A for two years. Company A will use the Model 5000 copier on its own premises throughout the two-year contract term. The contract explicitly specifies the copier that will be provided to A but stipulates that B may replace the copier at will. Supplier B has multiple Model 5000 copiers similar to the copier provided to A. However, if a replacement copier were needed, B would incur significant installation and transportation costs to substitute the copier. In addition, B would incur costs associated with gaining access to A’s premises and may be responsible for recouping A’s losses associated with downtime. The costs that would be incurred outweigh the related benefits of substitution.

Supplier B has the practical ability to substitute the copier because the customer cannot block the substitution and replacement copiers with similar specifications are readily available to B. Although B has the practical ability to substitute the copier, B would not benefit economically from the substitution because the costs of substitution outweigh the related benefits. Therefore, B does not have a substantive substitution right. Because the copier is explicitly specified in the contract and B does not have a substantive substitution right, an identified asset exists.

3.3.3.3 Warranty or Upgrade Considerations

ASC 842-10

15-14 The supplier’s right or obligation to substitute an asset for repairs or maintenance, if the asset is not operating properly, or if a technical upgrade becomes available, does not preclude the customer from having the right to use an identified asset.

Notwithstanding the requirements in ASC 842-10-15-10, certain substitution rights do not preclude the underlying asset from being an identified asset. Specifically, a substitution right is not substantive if a supplier’s right (or obligation) to substitute an alternative asset is limited to either operational failure (i.e., a replacement asset must be used while the original asset is undergoing repairs or maintenance) or technical upgrade (i.e., a newer version of the same asset becomes available). Further, paragraph BC131 of ASU 2016-02 states, in part, that “if a supplier has the right or obligation to substitute an asset for the purpose of repair or maintenance, . . . those substitution rights . . . are not substantive regardless of whether those circumstances are specified in the contract.” It is thus important for entities to understand both whether the supplier has the right to substitute the asset and the reason for the substitution provision when evaluating whether an identified asset exists.

Entities should also assess whether the supplier has agreed to transfer a good or service (a nonlease component) for the warranty or upgrade provisions. For a detailed discussion of the separation of lease and nonlease components, see Chapter 4 of this Roadmap. Suppliers in such arrangements should also consider Section 5.5 of Deloitte’s Roadmap Revenue Recognition.

3.3.3.4 Presumption That Substitution Right Is Not Substantive

ASC 842-10

15-15 If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.

It may be difficult (or nearly impossible, in some circumstances) for the customer to determine whether the supplier’s substitution right is substantive. For example, the customer may not know whether the substitution right gives the supplier an economic benefit.

A customer should presume that a substitution right is not substantive if it is impractical to prove otherwise; this determination involves significant judgment. Paragraph BC132 of ASU 2016-02 explains that the FASB’s reasoning for including this provision was to provide customers with some practical relief:

[T]he Board decided to add guidance stating that if a customer cannot readily determine whether a supplier has a substantive substitution right, the customer should presume that any substitution right is not substantive. It is intended that a customer should assess whether substitution rights are substantive if it is reasonably able to do so; if substitution rights are substantive, the Board noted that this should be relatively clear from the facts and circumstances. However, the requirement also is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive.

Connecting the Dots

Guidance on Substantive Substitution Rights Is Anti-Abusive and May Result in Accounting Asymmetry

We view the guidance in ASC 842-10-15-15 as anti-abusive. That is, a lessee must clear a high hurdle to conclude that substitution rights in an arrangement are substantive and may need to perform a quantitative analysis in doing so (as discussed in Section 3.3.3.2).

However, ASC 842-10-15-15 is only anti-abusive from the perspective of the lessee since it is written with only the customer in mind (i.e., the party that would potentially be recognizing an ROU asset and a lease liability). The supplier, on the other hand, is expected to have enough information at its disposal to readily determine whether its substitution rights are substantive.

Therefore, ASC 842’s guidance on substitution rights may result in asymmetry between the supplier’s and customer’s assessments. That is, the supplier may be able to readily determine that its substitution rights are substantive, in which case the contract would (1) not depend on the use of an identified asset and (2) not be identified as a lease. The customer, on the other hand, may not be able to readily determine whether the supplier’s substitution rights are substantive, in which case the guidance in ASC 842-10-15-15 would apply and the contract (1) would depend on the use of an identified asset and (2) could be identified as a lease.

3.3.3.5 Exercise of Nonsubstantive Substitution Rights

When a supplier’s substitution right is not substantive, an entity does not consider the substitution right in determining whether the contract contains an identified asset. If the customer has a right to control the use of the identified asset (see Section 3.4), the contract contains a lease and is subject to the measurement and recognition guidance in ASC 842. However, although a supplier’s substitution right may have been deemed nonsubstantive, instances may still arise in which the supplier actually ends up substituting the asset for various reasons.

We generally believe that either of the following two accounting approaches can be applied when a supplier exercises a substitution right that was not deemed substantive at inception (provided that no other rights in the contract are changed as a result of the substitution):

Approach A — The parties to the arrangement should account for the substitution as a termination of the original lease. (Sections 8.6 and 9.3.4 discuss in detail the lessee’s and lessor’s accounting, respectively, for lease modifications and terminations.) For example, under this approach, the lessee would write off the existing lease liability and ROU asset, which may result in the recording of a gain or loss in the lessee’s income statement. Upon substitution of an alternative asset, the parties would evaluate the arrangement as a potentially new lease in accordance with ASC 842’s guidance on lease identification. If the new arrangement contains a lease, the appropriate classification and subsequent accounting for the lease should be considered.
Approach B — The parties to the arrangement should account for the substitution as a lease modification that does not change the lessee’s right of use. In applying Approach B, an entity effectively would treat the actual substitution as a “non-substantive lease modification” for which no gain or loss would be recognized in the lessee’s income statement (i.e., for which there is no accounting whatsoever).

Note that the modification guidance in ASC 842-10-25-11(c) applies to a full termination. Therefore, both approaches technically result in the application of ASC 842’s modification guidance. However, the outcome of applying that guidance under Approach A will differ from that under Approach B.

Generally, we think that the determination of whether to apply Approach A (lease termination) or Approach B (lease modification) to the actual substitution will be based on facts and circumstances and should involve consideration of various factors, including whether the original asset and alternative asset are the same (or similar) and whether the parties modify other terms in the contract upon substitution. However, we would expect that if the asset substituted is similar to the previous asset and there are no other changes to the contract, the actual substitution should be considered a “nonsubstantive lease modification” and accounted for under Approach B.