4.2 Identify the Separate Lease Components

ASC 842-10

15-28 After determining that a contract contains a lease in accordance with paragraphs 842-10-15-2 through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met:

The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.

15-29 The guidance in paragraph 842-10-15-28 notwithstanding, to classify and account for a lease of land and other assets, an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land lease component would be insignificant).

Once an entity determines that a contract is, or contains, a lease (i.e., part or all of the contract is a lease — see Chapter 3), the entity (i.e., both the customer and the supplier) must assess whether the contract contains multiple lease components (i.e., when a contract conveys the rights to use multiple underlying assets). ASC 842-10-15-28(a) and (b) prescribe criteria (reproduced above) for identifying whether one lease component is considered separate from other lease components in the contract.

However, land is considered an exception to the guidance in ASC 842-10-15-28. In accordance with ASC 842-10-15-29, a right to use land must be separated from the rights to use other underlying assets (e.g., from the right to use a building that sits on top of the land), unless the effect of separating the land is insignificant to the resulting lease accounting.

Connecting the Dots

Importance of the Unit of Account

Paragraph BC145 of ASU 2016-02 stresses that it is important for an entity to identify the appropriate unit of account when applying the lessee or lessor accounting models in ASC 842 (see Chapters 8 and 9, respectively), since the unit of account can affect the allocation of consideration to the components in the contract. Specifically, paragraph BC145 of ASU 2016-02 states, in part:

By way of example, regarding allocation, the Board noted that the standalone price (observable or estimated) for a bundled offering (for example, the lease of a data center) may be substantially different from the sum of the standalone prices for separate leases of the items within a bundled offering (for example, the lease of each asset in the data center). Given the substantially different accounting for lease and nonlease components in Topic 842, the allocation of contract consideration carries additional importance as compared with previous GAAP. Consequently, the Board concluded that including separate lease components guidance in Topic 842 will result in more accurate accounting that also is more consistent among entities.

ASC 840 did not include guidance on how to identify the unit of account to which lease accounting should be applied. For example, ASC 840 did not specify whether to classify rights to use several underlying assets in a contract individually or as a single right of use. Rather, in practice, interpretive guidance arose that was effective but not necessarily based on GAAP. Accordingly, in the Board’s view, ASC 842 reflects an improvement over ASC 840 in this area.

The decision tree below illustrates how an entity might think about the guidance in ASC 842-10-15-28 and 15-29 for each contract containing a lease.

4.2.1 Separating Lease Components

Effectively, the guidance in ASC 842-10-15-28 is intended to help entities evaluate whether the parties are contracting to provide the customer with multiple, individual outputs (i.e., multiple rights of use) or a single output (i.e., a single right of use) that comprises multiple inputs. To accomplish this objective, the FASB uses two criteria:

The customer can economically benefit from the right of use (1) on its own or (2) together with other, readily available resources. “Readily available resources” could be those that the customer can obtain separately (whether from the supplier in the contract or others) or those that have already been transferred to the customer in the current contract or other, prior contracts. For example, the fact that a right of use is contracted on its own is an indicator that it meets this first criterion.
This criterion is intended to be effectively the same as the “capable of being distinct” criterion in ASC 606-10-25-19(a) and 25-20 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this first criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.1 of Deloitte’s Roadmap Revenue Recognition.
The right of use is “neither highly dependent on nor highly interrelated with” other rights of use in the same contract (i.e., the right of use is separately identifiable). The right of use may not be separately identifiable if (1) the supplier integrates it with other rights of use in the contract in such a way that it is only one input in an effort to deliver a combined right of use (i.e., a single output) to the customer or (2) it significantly modifies or affects — or is significantly modified or affected by — the other rights of use in the contract.
This criterion is intended to be effectively the same as the “distinct within the context of the contract” criterion in ASC 606-10-25-19(b) and ASC 606-10-25-21 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this second criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.2 of Deloitte’s Roadmap Revenue Recognition.

Connecting the Dots

Similarities Between Identifying Separate Lease Components Under ASC 842 and Identifying Separate Performance Obligations Under ASC 606

The concept of separating lease components under ASC 842 is similar to the notion of identifying performance obligations under ASC 606. Specifically, paragraph BC146 of ASU 2016-02 states:

The separate lease components guidance in paragraph 842-10-15-28 is similar to the guidance on identifying performance obligations in Topic 606, and, therefore, the Board expects that it will be applied in a similar manner. . . . Accordingly, rather than developing entirely separate requirements addressing how to identify separate lease components, the Board decided that it is logical to provide requirements similar to those in Topic 606 on the identification of performance obligations to determine whether a lessee is contracting for the right to use multiple underlying assets (for example, five vehicles) or for the right to use a single solution that is comprised of multiple assets (for example, many data centers or manufacturing facilities).

In other words, the Board’s intention was not to create a different set of requirements for separating lease components but to link the concepts from the two standards so that they may be applied consistently. Accordingly, we think that the guidance in ASC 606 — as well as Deloitte’s related interpretive guidance in Section 5.3.2 of Deloitte’s Roadmap Revenue Recognition — will be helpful to entities applying the guidance in ASC 842-10-15-28. Further, ASC 606’s guidance on identifying performance obligations is more robust and descriptive than ASC 842’s guidance on separating lease components. ASC 606 also contains more examples that address the “distinct” criteria.

The link between the revenue and leasing standards will be a consistent theme throughout the remainder of this chapter, since the two standards are also similar regarding the allocation and reallocation of the consideration to the components in the contract.

The example below illustrates the guidance in ASC 842-10-15-28 on separating lease components. (See Section 4.2.3 for additional examples, including an illustration of a situation in which the right to use land is not separated from other rights of use in the contract.)

Example 4-1

Garden Co., the lessee, leases a dump truck, riding lawn mower, and skid loader from Tools Inc., the lessor. Tools Inc. sells and leases each piece of machinery separately to other customers and lessees, respectively, during its normal course of business.

Although it leased all three pieces of machinery together for use in its landscaping business, Garden Co. determined that the rights to use the machinery represent three separate lease components. This conclusion is based on the following:

Garden Co. can economically benefit from the use of each piece of machinery on its own or together with other, readily available resources. For example, Garden Co. can lease separately — either from Tools Inc. or from another supplier — an excavator that may be used in conjunction with the dump truck to perform the landscaping services that it provides to its customers.
Each piece of machinery is neither highly dependent on, nor highly interrelated with, the others. Tools Inc. is not integrating the rights to use the machinery into a single, combined right of use. Further, no piece of machinery is significantly modified or affected by the others — they do not come together, for example, to form a larger, more efficient piece of machinery.

Accordingly, Garden Co. and Tools Inc. would account for each piece of machinery as a separate lease component in accordance with the lessee and lessor accounting models, respectively.

4.2.2 Land and Other Assets

ASC 842-10-15-29 requires that land be considered a separate lease component in a contract involving land and other assets, unless the effect of separately accounting for the land portion of the contract is insignificant.

Connecting the Dots

The Nature of Land

Paragraph BC147 of ASU 2016-02 states, in part:

Topic 842 also requires an entity to account for a right to use land as a separate lease component, even if the separating lease components criteria are not met, unless the accounting effect of doing so would be insignificant. The Board decided that land, by virtue of its indefinite economic life and nonpredictable nature, is different from other assets, such that it should be assessed separately from other assets regardless of whether the separating lease components criteria are met.

Paragraph BC147 of ASU 2016-02 should be interpreted as meaning that if an entire building were leased, the lessee would implicitly also be leasing the land on which the building sits. Because the underlying land asset is subject to unique risks compared with those of the building, the right to use the land should be accounted for as a separate lease component (unless the accounting effect of doing so would be insignificant).

However, the same may not be true if an entity is leasing only part of a building (e.g., a physically distinct portion of a larger building, such as a single floor in an office building). Entities should consider whether facts and circumstances indicate otherwise, but in these situations, we do not expect that a lessee will have an implicit lease of the underlying land. (See Section 4.2.2.2 for further discussion.)

ASC 842 does not explicitly define the term “insignificant,” as used in ASC 842-10-15-29. Therefore, management will need to use judgment in applying this term. In determining significance, an entity should separately assess (1) whether separating the land component affects the classification of any lease component, (2) the value of the land component in the context of the overall contract, and (3) whether the right to use the land is coterminous with the rights to use the other assets.

For example, if a lease includes both land and a building component and an entity concludes that both components would be classified as an operating lease over the same lease term if they are accounted for separately, it may be reasonable for the entity to conclude that the difference between accounting for the two lease components together and accounting for the land and building separately would be insignificant.

ASC 842-10-15-29 gives two examples illustrating when the accounting effect of separating the right to use land from other rights of use would be insignificant, both of which are mentioned above. The first of those examples (i.e., the effect on lease classification) is discussed in the preceding paragraph. The Changing Lanes discussion and Section 4.2.2.1 below address the second (i.e., the value of the right to use the land). A third example (i.e., the terms of the different rights of use), also mentioned above, is discussed in Example 13 in ASC 842-10-55-146 through 55-149 (reproduced in Section 4.2.3).

Changing Lanes

Bifurcation of the Land Component May Be More Common

ASC 842’s approach to accounting for leases of land and other assets is consistent with the historical approach in IAS 17 under IFRS Accounting Standards but represents a change from the U.S. GAAP guidance in ASC 840. The guidance in ASC 840 required a lessee to do the following for land and other assets: (1) when the lease meets either the transfer-of-ownership or bargain-purchase-price classification criteria, account for the land and other assets separately (see ASC 840-10-25-38(a)), or (2) when the fair value of the land is 25 percent or more of the total fair value of the leased property at lease inception, classify the land and other assets separately (as discussed in Section 4.2.2.1). The new approach may result in more bifurcation of real estate leases into separate lease components.

4.2.2.1 Use of a 25 Percent Threshold to Separate Land

To determine when the right to use land must be accounted for separately under ASC 840-10-25-38(b), an entity uses a 25 percent threshold to compare the fair value of the land with the fair value of the entire leased property. That is, under ASC 840, if the fair value of the underlying land was less than 25 percent of the fair value of the entire leased property, the land is combined with the other rights of use.

However, it is not appropriate to use a 25 percent threshold to determine whether land should be separated in accordance with ASC 842-10-15-29 because the concept behind the guidance in ASC 842-10-15-29 (discussed in the Connecting the Dots above) differs from that in ASC 840.

Under ASC 842, the value of the land component in a contract containing the right to use land and other assets may be considered in the determination of whether the accounting effect of separating the land component is insignificant. However, the sole reliance on any bright-line threshold based on the land value, compared with the total property value, would not be appropriate in this assessment.

For example, although the land component in a contract containing the right to use land and a building may represent a fair value that is lower than 25 percent of the entire leased property, the lease classification for the right to use the land could differ from that for the right to use the building. In such situations, an entity should consider all facts and circumstances to determine whether the accounting effect of not separating the components is insignificant.

Entities should also consider arrangements in which lessees are leasing a significant capacity portion of a building (or another asset atop land). Such arrangements may inherently convey a right to use the underlying land and would need to be assessed in accordance with ASC 842-10-15-29.

4.2.2.2 Inherent Land Leases When a Portion of a Building Is Leased

Regardless of the portion (or capacity) of the building it is leasing, a lessee in a multitenant building inherently has some rights to use the underlying land. However, the land may not represent an identified asset to the lessee in such a way that the lessee would have the right to control the use of an identified asset (i.e., in such a way that the lessee would have a lease of the land, as defined in ASC 842-10-15-3 and 15-4 and further discussed in Chapter 3 of this Roadmap).

A lessee in a multitenant building will have the right to control the use of a physically distinct portion of the building, but its rights related to the underlying land are not over a physically distinct portion of the land unless the lessee is, in effect, leasing the entire building. In such cases, the lessee is also effectively leasing the entire, underlying plot of land. Therefore, we think that when the lessee has the right to control the use of substantially all of the capacity of the building, it also has the right to control the use of substantially all of the capacity of the land. (See Section 3.3.2 for further discussion of when a capacity portion of a larger asset is an identified asset.)

In such arrangements, lessees and lessors should consider whether the lessee’s rights to use the land represent a separate lease component in accordance with ASC 842-10-15-29.

4.2.2.3 Allocation of the Fair Value of Land When a Portion of a Multitenant Building Is Leased

As discussed in Section 4.2.2.2, when a lessee leases a portion of a multitenant building, the lessee generally only has the ability to control the use of the underlying land if it has the ability to control the use of substantially all of the capacity of the building that rests on that land. If the lessee is able to control the underlying land, both the lessee and the lessor should account for the lessee’s right to use the land as a separate lease component (unless the accounting effect of doing so would be insignificant as stated in ASC 842-10-15-29). When accounting for the right to use the underlying land as a separate lease component, an entity would allocate lease payments separately between the two lease components (i.e., the lease of land and lease of the building). Accordingly, an entity would separately compare the present value of those allocated lease payments with the fair value of the underlying land and the fair value of the building in assessing the classification of each lease component in accordance with ASC 842-10-25-2(d).

However, if the control assessment reveals that the lessee does not control the land and no other tenant in the building obtains substantially all the use of the land, the land does not represent a separate lease component. In these cases, the lease payments that would otherwise be allocated to the land component instead would be entirely allocated to the lease of the lessee’s portion of the building. We believe that the lessee and the lessor should consider whether some of the lease payments economically represent payments to use a portion of the underlying land. If so, in the assessment of the classification of the lease, the fair value of the underlying asset should include both the fair value of the lessee’s portion of the building and a proportional amount of the fair value of the underlying land.

For more information about lease classification and about evaluating whether the present value of lease payments represents substantially all of the fair value of a lease component, see Section 8.3.3.6 for lessee considerations and Section 9.2.1.4 for lessor considerations.

Example 4-2

Lessee and Lessor enter into a lease agreement in which Lessee obtains the right to use multiple floors of a building for a term of 10 years. Lessee is the most significant tenant and occupies a majority of the floors in the building, which represents approximately 95 percent of the building’s usable square footage. The building takes up the entire underlying land of the property. Accordingly, no other structures can be built on the land and the tenants of the building collectively are receiving the full economic benefits from the use of the land during the lease term. No individual tenant has the right to use a physically distinguishable portion of the underlying land.

The terms of the lease agreement require that Lessee make lease payments of $30 million annually at the end of each year for the entire 10-year lease term. The fair value of the entire property is $500 million, of which $100 million is related to the land and $400 million is related to the building. The stand-alone prices (lessees) and stand-alone selling prices (lessors) of the right to use the land and building components are $66 million and $264 million, respectively. Lessee has an incremental borrowing rate of 10 percent.

Both entities (Lessee and Lessor) have concluded that the ability to control 90 percent or more of the building is indicative of substantially all of the building’s capacity. Because Lessee has the right to use 95 percent of the building, both entities (Lessee and Lessor) have determined that Lessee has the right to control the use of substantially all of the economic benefits of the building and therefore also has the right to control the use of 100 percent of the underlying land. Lessee and Lessor will account for the building and the land as two separate lease components and will allocate the consideration to be paid over the lease term on the basis of each component’s relative stand-alone price (lessees) and stand-alone selling price (lessors).

As illustrated in the table below, Lessee and Lessor will allocate $60 million, or 20 percent, of the total consideration of $300 million to the land and the remaining $240 million to the building. Lessee1 will use its incremental borrowing rate of 10 percent to calculate the present value of these payments, yielding approximately $37 million and $147 million2 for the land and building lease components, respectfully. Lessee will then compare the present value of these payments with the fair value of $100 million and approximately $380 million (95 percent of the total building fair value) for the land and building lease components, respectively, to determine whether these payments represent substantially all of the fair value of the underlying asset in accordance with ASC 842-10-25-2(d).

Example 4-3

Assume the same facts as in the example above, except that the lessee only controls 80 percent of the capacity of the building. Because Lessee’s capacity is less than 90 percent of the building, Lessee does not have the right to control the use of substantially all of the economic benefits of the building and no other tenant obtains substantially all of the economic benefits (i.e., the other 20 percent, regardless of whether it is used by one or more tenants, is not substantially all). As a result, the underlying land would not be accounted for as a separate lease component.

In this example, both entities (Lessee and Lessor) will allocate the entirety of their future lease payments of $300 million to the building, which is the only lease component. Lessee3 will then compare the present value of these lease payments of approximately $184 million4 with the fair value of its allocable portion of the property. Because Lessee occupies 80 percent of the capacity of the building, it will allocate approximately 80 percent of the total property value (including land) to the building in this calculation. Thus, Lessee will use a fair value of $400 million (80% of $500 million) in its lease classification test.

Changing Lanes

Classification of the Land Component Under ASC 840

In addition to the lack of a 25 percent threshold under ASC 842 (discussed in Section 4.2.2.1), the new guidance diverges from ASC 840 in both how consideration is allocated to the land and building elements of the lease arrangement, as well as the classification of these elements.

ASC 840-10-25-38(b)(2) prescribed how consideration is allocated between the land and building elements of a lease arrangement, stating, in part:

The minimum lease payments after deducting executory costs, including any profit thereon, applicable to the land and the building shall be separated by the lessee by determining the fair value of the land and applying the lessee’s incremental borrowing rate to it to determine the annual minimum lease payments applicable to the land element; the remaining minimum lease payments shall be attributed to the building element. [Emphasis added]

However, under ASC 842, the land element of the lease arrangement is allocated consideration in the same manner as the other components in the contract (i.e., on the basis of its relative stand-alone price or stand-alone selling price). Further, depending on the entity’s determination of whether to separate lease and nonlease components in the contract for that asset class, allocated consideration may or may not include certain costs defined as executory costs under ASC 840.

From a classification perspective, ASC 840-10-25-38(b)(2) stated the following, in part:

If the building element of the lease meets the lease-term criterion in 840-10-25-1(c) or the minimum-lease-payments criterion in paragraph 840-10-25-1(d), the building element shall be accounted for by the lessee as a capital lease and amortized in accordance with the guidance in paragraph 840-30-35-1(b). The land element of the lease shall be accounted for separately by the lessee as an operating lease. [Emphasis added]
If the building element of the lease meets neither the lease-term criterion in 840-10-25-1(c) nor the minimum-lease-payments criterion in paragraph 840-10-25-1(d), both the building element and the land element shall be accounted for by the lessee as a single operating lease.

ASC 842 diverges from this approach, since both lease components would be subject to the lease classification test in ASC 842-10-25-2. While the land component of a lease would never meet the economic-life criterion in ASC 842-10-25-2(c) as a result of its indefinite life, lease payments allocated to this component may represent substantially all of the fair value of the underlying land. Accordingly, scenarios may exist in which the land component is classified as a finance or sales-type lease by passing the fair value test in ASC 842-10-25-2(d), whereas land was always classified as an operating lease under ASC 840. For more information about the lease classification tests under ASC 842, see Section 8.3.

4.2.3 Applying the Guidance on Separate Lease Components

The examples below — the first of which is reproduced from ASC 842-10-55-146 through 55-149 — illustrate the process outlined in the decision tree in Section 4.2 and the guidance in ASC 842-10-15-28 and 15-29 (further discussed in Section 4.2.2).

ASC 842-10

Example 13 — Lease of a Turbine Plant

55-146 Lessor leases a gas-fired turbine plant to Lessee for eight years so that Lessee can produce electricity for its customers. The plant consists of the turbine housed within a building together with the land on which the building sits. The building was designed specifically to house the turbine, has a similar economic life as the turbine of approximately 15 years, and has no alternative use. The lease does not transfer ownership of any of the underlying assets to Lessee or grant Lessee an option to purchase any of the underlying assets. Lessor does not obtain a residual value guarantee from Lessee or any other unrelated third party. The present value of the lease payments is not substantially all of the aggregate fair value of the three underlying assets.

55-147 While the lease of the plant includes the lease of multiple underlying assets, the leases of those underlying assets do not meet the second criterion necessary to be separate lease components, which is that the right to use the underlying asset is neither dependent on nor highly interrelated with the other rights of use in the contract. Therefore, the contract contains only one lease component. The rights to use the turbine, the building, and the land are highly interrelated because each is an input to the customized combined item for which Lessee has contracted (that is, the right to use a gas-fired turbine plant that can produce electricity for distribution to Lessee’s customers).

55-148 However, because the contract contains the lease of land, Lessee and Lessor also must consider the guidance in paragraph 842-10-15-29. Lessee and Lessor each conclude that the effect of accounting for the right to use the land as a separate lease component would be insignificant because Lessee’s right to use the turbine, the building, and the land is coterminous and separating the right to use the land from the right to use the turbine and the building would not affect the lease classification of the turbine/building lease component. Lessee and Lessor each conclude that a single lease component comprising the turbine, the building, and the land would be classified as an operating lease, as would two separate lease components comprising the land and the turbine/building, respectively.

55-149 The predominant asset in the single lease component is the turbine. Lessee entered into the lease primarily to obtain the power-generation capabilities of the turbine. The building and land enable Lessee to obtain the benefits from use of the turbine. The land and building would have little, if any, use or value to Lessee in this contract without the turbine. Therefore, the remaining economic life of the turbine is considered in evaluating the classification of the single lease component.

Example 4-4

City Living Properties, the lessor, rents a fully furnished, newly renovated high-rise apartment building with an elevator to Easy Rentals, the lessee, for a term of 20 years. Easy Rentals will eventually lease the building’s fully furnished, individual apartment units to tenants. Easy Rentals pays one fixed monthly rental payment to City Living Properties.

The apartment building, elevator, and apartment furnishings have a 40-, 20-, and 10-year useful life, respectively. The land on which the building sits has an indefinite useful life. Easy Rentals determines that it has the right to use four underlying assets: (1) the apartment building, (2) the elevator, (3) the land, and (4) the apartment furnishings.

Further, Easy Rentals determines that the leases for both the land and the building are operating leases (see Chapter 8 for further discussion of the lessee classification guidance), primarily because the 20-year stated lease term, when compared with the useful life of each underlying asset, will not result in a finance lease classification conclusion for either. Therefore, Easy Rentals reasonably concludes that the accounting effect of separating the land from the building is insignificant.

The combined land and building component and the elevator are not separately identifiable because they are highly dependent and highly interrelated. The rights to use the land, building, and elevator are inputs into the delivery of a single right to use a high-rise apartment building. Therefore, these rights are considered one lease component in the contract. When classifying the lease, Easy Rentals would use the useful life of the predominant asset within the bundle to determine the useful life of the entire lease component (i.e., 40 years, because the apartment building is the predominant asset).

The apartment furnishings are a separate lease component, since they can be used independently of the single lease component for the high-rise apartment building. Easy Rentals can use the apartment furnishings on their own or together with other readily available resources to economically benefit from the right of use. When making this determination, Easy Rentals considers the characteristics of the lease component itself, regardless of contractual limitations (i.e., it does not consider the way in which it may use or be allowed to use the lease component).

In addition, the apartment furnishings are not highly dependent on, or highly interrelated with, the single high-rise apartment building lease component. Rather, they are separately identifiable and are not combined with the high-rise apartment building to deliver a single right of use.

Easy Rentals would therefore allocate the consideration in the contract between (1) the single high-rise apartment building lease component and (2) the apartment furnishings.5 Allocation to components of a contract is further discussed in Section 4.4.

4.2.3.1 Identifying Lease Components When the Underlying Asset Is Replaced During the Lease Term

Certain lease arrangements may either require or allow for replacement of the underlying asset by the lessor during the term of the arrangement. That is, in such arrangements, it is expected (or required) at contract inception that the underlying asset will be replaced. The purpose of such replacement may be to ensure that the underlying asset continues to meet agreed-upon performance standards for the lessee.

Example 4-5

A lessee enters into a noncancelable contract with a lessor to obtain IT processing services by using a dedicated server for 10 years in exchange for 10 years of fixed periodic payments. Assume that the contract provides the lessee with a right to control HAFWP an identified asset (the server) is used throughout the 10-year contract term (i.e., the contract contains a lease of the server). The expected useful life of the server is five years.

In this example, the contract stipulates that the lessor must replace the server once during the contract term. Since the original server has a useful life of five years, it is expected to be replaced at the end of year 5. The purpose of the replacement is to maintain a standard level of IT processing services provided to the lessee. The contract pricing is established up front and does not change as a result of the server replacement. The replacement server provides essentially the same benefit and functionality as the original server; however, it is unlikely that the original server would have continued to provide the same level of benefit for the entire 10-year contract term.

When determining the number of lease components, evaluating lease classification at lease commencement, and measuring its ROU asset and lease liability, the lessee in this example should consider each asset (i.e., the original server and the replacement server) as a separate lease component with separate lease terms — that is, there are two separate lease components in this example. The lease terms of the separate lease components can be determined by considering the expected replacement dates (five years in this example), but we would not expect the lease term to exceed the estimated useful life of the underlying asset in a scenario in which an asset must be replaced to maintain minimum performance standards.

The lessee should allocate the consideration (e.g., gross lease payments expected to be paid over the course of the lease terms of the lease components) between the two lease components on a relative stand-alone price basis and should record an ROU asset and lease liability for the first asset (i.e., the server provided at commencement) at lease commencement by using the discounted lease payments over the lease term for that asset (five years). (See Section 7.2 for more information about determining the discount rate to be used by a lessee.) The lessee should use the five-year lease terms (and corresponding lease payments) in determining the lease classification.

The example above is analogous to a master lease agreement in which the lessee is committed to using a minimum quantity of assets. A master lease agreement may specify that the lessee will obtain control over the right to use multiple underlying assets (e.g., servers) at various points during the term of the master lease agreement. In these cases, the lessee’s accounting depends on whether the master lease agreement commits the lessee to obtaining control over the right to use a minimum quantity (units or dollar value) of assets — see Section 13.4.1 for more information about such master lease agreements.

In the above example, the lessee commits to obtaining control over the right to use two servers (the original server and the replacement server). In accordance with ASC 842-10-55-17, because the lessee is obligated to use a minimum quantity of equipment, the lessee must consider the minimum quantity of equipment (i.e., two servers) when identifying the separate lease components and allocating the consideration in the contract. Further, the server to be provided in year 5 does not qualify as an identified asset at lease commencement of the original server under ASC 842-10-15-9, which indicates that an asset can be identified “at the time that the asset is made available for use by the customer.” In other words, a lease does not commence until an identified asset is made available for the customer’s use.

We would expect the lessee in such an arrangement to disclose the “forward-starting” lease of the server provided in year 5, if material, as required by ASC 842-20-50-3(b), which states that a lessee should disclose “[i]nformation about leases that have not yet commenced but that create significant rights and obligations for the lessee.” The lessee would record an ROU asset and lease liability for the remaining five-year lease term once the lease of the replacement server commences.

4.2.3.1.1 Lessor Continually Provides a Server That Meets Certain Minimum Performance Standards

Assume that the contract differs from the one described in Example 4-5 in such a way that the lessor is required to continually provide a server that meets certain minimum performance standards (e.g., processing speed and capacity) but a replacement is not explicitly required during the 10-year term (all other facts remain the same). In such cases, the lessee should consider the specific facts and circumstances of the arrangement, including the expected useful life of the asset(s), when determining the lease component(s) and lease term(s). If the lessee determines that the expected useful life of the underlying asset is less than the overall lease term (i.e., the underlying asset is not expected to be able to meet certain minimum performance standards over the course of the lease term), the lease arrangement may, in substance, involve the use of two (or more) lease components to fulfill the obligations under the arrangement. This is because the lessor could not satisfy its obligation to the lessee to maintain minimum performance standards without replacing the assets during the lease term.

4.2.3.1.2 Lessee and Lessor in an Arrangement That Contains the Right or Obligation to Replace the Original Asset

The lessee and lessor in an arrangement that contains the right or obligation (including implied rights or obligations) to replace the original asset would have the same contractual rights and obligations; therefore, the determination of the lease components and lease term should generally be aligned. In Example 4-5, the lessor is delivering two lease components to the lessee (i.e., the original server and the replacement server). The lessor would evaluate lease classification separately for the two identified lease components and account for the lease agreements in accordance with ASC 842-30.

Footnotes

Lessor would calculate the present value of the lease payments by using its rate implicit in the lease; however, such a calculation is not included in this example.

This balance reflects the present value of the allocated portion of annual lease payments paid over the lease term of 10 years. Thus, the land component represents the present value of lease payments of $6 million (20% × $30 million) per annum and the building component represents the present value of lease payments of $24 million (80% × $30 million) per annum, both paid over the 10-year lease term and discounted at Lessee’s 10 percent incremental borrowing rate.

Lessor would use its rate implicit in the lease to calculate the present value of lease payments and compare that with the fair value of the allocable portion of the total property associated with the ROU asset ($400 million in this example). This example does not illustrate that approach.

This balance reflects the present value of the $30 million of annual lease payments paid for the lease term of 10 years and discounted at Lessee’s incremental borrowing rate of 10 percent.

The apartment furnishings may need to be separated further (e.g., a couch is separable from a table); however, for illustration purposes, such an evaluation is not performed.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.