4.3 Identify the Separate Nonlease Components

ASC 842-10

15-30 The consideration in the contract shall be allocated to each separate lease component and nonlease component of the contract (see paragraphs 842-10-15-33 through 15-37 for lessee allocation guidance and paragraphs 842-10-15-38 through 15-42C for lessor allocation guidance). Components of a contract include only those items or activities that transfer a good or service to the lessee. Consequently, the following are not components of a contract and do not receive an allocation of the consideration in the contract:

Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.

Once the separate lease components are identified (see Section 4.2), entities must determine whether there are any nonlease components to be separated. An allocation of the consideration in the contract is required for both lease and nonlease components, since they transfer a good or service to the customer. However, as indicated in ASC 842-10-15-30, such allocation does not extend to activities that do not transfer a good or service to the customer (e.g., administrative tasks and reimbursement or payment of the lessor’s costs).

ASC 842-10-15-30 notes that “[c]omponents of a contract include only those items or activities that transfer a good or service to the lessee.” For example, a contract may include a separate lease component (e.g., the right to use the underlying asset that is the subject of the agreement) as well as additional goods or services that are transferred to the lessee (e.g., maintenance services), which are nonlease components (see Section 4.3.1). Once the separate lease components are identified (see Section 4.2), entities must determine whether there are any nonlease components to be separated.

Contracts often include other costs or fees that do not provide a separate good or service to the lessee — for example, costs paid by the lessee, such as (1) the cost of administrative tasks performed to set up a contract or initiate the lease or (2) reimbursement or payment of the lessor’s costs (e.g., property taxes and insurance related to the leased asset). These types of costs do not transfer a good or service to the lessee and would therefore not be considered a component in the contract (see Section 4.3.2).

An entity is required to allocate the total consideration in a contract (including all amounts charged for administrative start-up, property taxes, and some insurance — see Section 4.4.1.1 for lessees and Section 4.4.2.1 for lessors) to its identified separate lease and nonlease component(s). The manner of allocating the consideration depends on whether the entity is the lessee (see Section 4.4.1.2) or lessor (see Section 4.4.2.2) in the arrangement. Practical expedients may be available that, upon election, would allow entities not to separate, and thus not allocate consideration in the contract between, lease and nonlease components (see Section 4.3.3 for further discussion).

The graphic below summarizes the concepts in ASC 842-10-15-30.

The accounting for lease components differs from that for nonlease components, as articulated in ASC 842-10-15-31:6

ASC 842-10

15-31 An entity shall account for each separate lease component separately from the nonlease components of the contract (that is, unless a lessee makes the accounting policy election described in paragraph 842-10-15-37 or unless a lessor makes the accounting policy election in accordance with paragraph 842-10-15-42A). Nonlease components are not within the scope of this Topic and shall be accounted for in accordance with other Topics.

Understanding the difference between lease components, nonlease components, and “noncomponents” (i.e., activities paid for by the customer that do not transfer a good or service to the customer) will be critical throughout the remainder of this chapter. The table below outlines these three types of components in greater detail.

Lease Component	The right to use an underlying asset is considered a separate lease component if (1) a lessee can benefit from the use of the underlying asset either on its own or with other resources that are readily available and (2) the underlying asset is not highly dependent on or highly interrelated with other assets in the arrangement. Separate lease components are discussed in detail in Section 4.2.
Nonlease Component	An activity that transfers a separate good or service to the customer is a nonlease component. For example, maintenance services consumed by the customer and bundled with the lease component in the contract would be a separate nonlease component because the performance of the maintenance transfers a service to the customer that is separate from the right to use the asset. As discussed further below, under ASC 842, services or other nonlease components may be accounted for separately from the lease component(s) even if they would not be accounted for separately from other promised goods or services in a revenue contract with a customer. This may be counterintuitive to some that find nonlease components in a contract not to be distinct from the lease component(s). See the Connecting the Dots in Section 4.3.1 for further discussion.
Noncomponent	Any activity in a contract that does not transfer a separate good or service to the lessee is neither a lease component nor a nonlease component; therefore, consideration in the contract would not be allocated to such an activity. For example, payments made by the customer for property taxes or insurance that covers the supplier’s interests would not represent a component in the contract.

Connecting the Dots

Determination of Whether a Lease Exists Precedes Component Identification and Separation

Before identifying and separating lease and nonlease components, an entity must determine whether a contract is or contains a lease (see Chapter 3). Once it has been determined that a lease exists, the identification of the components does not affect that conclusion. A contract can contain one or more lease and nonlease components or noncomponents without influencing the determination that a contract is or contains a lease.

Services Generally Should Be Accounted for in the Same Manner Regardless of Whether They Are Included in a Contract With a Lease Component

Paragraph BC148 of ASU 2016-02 states that the recognition and measurement guidance for leases in ASC 842 should only be applied to the lease components in a contract and that “a nonlease component should not, in general, be subject to different accounting requirements solely because it is included in a contract that contains a lease.” Further, Paragraph BC149 of ASU 2016-02 goes on to say:

The Board also decided that [entities] should account for lease and nonlease (typically, service) components separately . . . Board members observed that to do otherwise could result in different accounting for services solely depending on whether the service is included together with a lease. . . . [T]he accounting for services should be the same, regardless of whether the contract that includes the services also includes a lease.

Accordingly, both lessees and lessors are required to separate lease and nonlease components (unless they elect the practical expedients discussed in Section 4.3.3) so that (1) lease components may be appropriately reflected in accordance with ASC 842 (e.g., to ensure more precise measurement of the lessee’s lease assets and lease liabilities) and (2) nonlease components may be appropriately reflected in accordance with other applicable GAAP (e.g., to ensure an appropriate pattern of revenue recognition in accordance with ASC 606 when lessors also provide services to lessees).

Example 12 in ASC 842-10-55-141 through 55-145, reproduced below, constitutes a good introductory illustration of the guidance in ASC 842-10-15-30 and 15-31.

ASC 842-10

Example 12 — Activities or Costs That Are Not Components of a Contract

Case A — Payments for Taxes and Insurance are Variable

55-141 Lessor and Lessee enter into a five-year lease of a building. The contract designates that Lessee is required to pay for the costs relating to the asset, including the real estate taxes and the insurance on the building. The real estate taxes would be owed by Lessor regardless of whether it leased the building and who the lessee is. Lessor is the named insured on the building insurance policy (that is, the insurance protects Lessor’s investment in the building, and Lessor will receive the proceeds from any claim). The annual lease payments are fixed at $10,000 per year, while the annual real estate taxes and insurance premium will vary and be billed by Lessor to Lessee each year.

55-142 The real estate taxes and the building insurance are not components of the contract. The contract includes a single lease component — the right to use the building. Lessee’s payments of those amounts solely represent a reimbursement of Lessor’s costs and do not represent payments for goods or services in addition to the right to use the building. However, because the real estate taxes and insurance premiums during the lease term are variable, those payments are variable lease payments that do not depend on an index or a rate and are excluded from the measurement of the lease liability and recognized by Lessee in profit or loss in accordance with paragraph 842-20-25-5 or 842-20-25-6. Lessor also recognizes those payments as variable lease payments in accordance with paragraph 842-10-15-40A because the real estate taxes and insurance premiums are paid by Lessor to the taxing jurisdiction and insurance company and reimbursed by Lessee to Lessor. However, if Lessee paid the costs directly to the third parties, those lessor costs would not be recognized by Lessor as variable payments because of the requirement in paragraph 842-10-15-40A.

Case B — Payment for Taxes and Insurance Are Fixed

55-143 Assume the same facts and circumstances as in Case A (paragraphs 842-10-55-141 through 55-142), except that the fixed annual lease payment is $13,000. There are no additional payments for real estate taxes or building insurance; however, the fixed payment is itemized in the contract (that is, $10,000 for rent, $2,000 for real estate taxes, and $1,000 for building insurance). Consistent with Case A, the taxes and insurance are not components of the contract. The contract includes a single lease component, the right to use the building. The $65,000 in payments Lessee will make over the 5-year lease term are all lease payments for the single component of the contract and, therefore, are included in the measurement of the lease liability.

Case C — Common Area Maintenance

55-144 Assume the same facts and circumstances as in Case B (paragraph 842-10-55-143), except that the lease is of space within the building, rather than for the entire building, and the fixed annual lease payment of $13,000 also covers Lessor’s performance of common area maintenance activities (for example, cleaning of common areas, parking lot maintenance, and providing utilities to the building). Consistent with Case B, the taxes and insurance are not components of the contract. However, the common area maintenance is a component because Lessor’s activities transfer services to Lessee. That is, Lessee receives a service from Lessor in the form of the common area maintenance activities it would otherwise have to undertake itself or pay another party to provide (for example, cleaning the lobby for its customers, removing snow from the parking lot for its employees and customers, and providing utilities). The common area maintenance is a single component in this contract rather than multiple components, because Lessor performs the activities as needed (for example, plows snow or undertakes minor repairs when and as necessary) over the same period of time.

55-145 Therefore, the contract in Case C includes two components — a lease component (that is, the right to use the building) and a nonlease component. The consideration in the contract of $65,000 is allocated between those 2 components (unless Lessee elects the practical expedient in paragraph 842-10-15-37 or Lessor elects the practical expedient in paragraph 842-10-15-42A when the conditions in that paragraph are met). The amount allocated to the lease component is the lease payments in accounting for the lease.

4.3.1 Nonlease Components

Nonlease components in a contract (i.e., any activity that transfers a good or service to the lessee) will generally represent some sort of service that the lessee is paying for in the contract and that the lessor is providing to the lessee in addition to the lease component. The following are examples of common nonlease components in a contract that contains both lease and nonlease components:

A contract for the right to use equipment, when the lessor also provides regular maintenance of the equipment throughout the contract.
A contract for the right to use a transportation vehicle (e.g., airplane, ship, or truck), when the lessor also provides operating personnel to operate the vehicle for the lessee throughout the contract.
A contract for the right to use an oil, gas, or mining drill rig, when the lessor also provides a crew to man and operate the rig throughout the contract.
A contract for the right to use a manufacturing facility, when the lessor also provides the materials and labor needed to produce a product for the lessee.
A contract for the right to use several floors of an office building, when the lessor also provides maintenance services to clean the building lobbies, maintain elevators, etc. (i.e., common-area maintenance [CAM]).

Because ASC 842-10-15-30 describes nonlease components as any “items or activities that transfer a good or service to the lessee,” such components may be something other than the typical services described above. For example, ASC 842-10-55-32 and 55-33 clarify that entities (particularly lessors) may need to consider whether guarantees and indemnifications are nonlease components, which must be accounted for in accordance with other applicable GAAP.

ASC 842-10

55-32 Paragraph 460-10-15-4(c) states that, except as provided in paragraph 460-10-15-7, the provisions of Subtopic 460-10 on guarantees apply to indemnification agreements (contracts) that contingently require an indemnifying party (guarantor) to make payments to an indemnified party (guaranteed party) based on changes in an underlying that is related to an asset, a liability, or an equity security of the indemnified party. Paragraph 460-10-55-23A provides related implementation guidance for a tax indemnification provided to a lessor.

55-33 A lessor should evaluate a commitment to guarantee performance of the underlying asset or to effectively protect the lessee from obsolescence of the underlying asset in accordance with paragraphs 606-10-55-30 through 55-35 on warranties. If the lessor’s commitment is more extensive than a typical product warranty, it might indicate that the commitment is providing a service to the lessee that should be accounted for as a nonlease component of the contract.

The concept of a nonlease component in ASC 842 is effectively the same as that for “promised goods or services” under ASC 606. Section 5.2 of Deloitte’s Roadmap Revenue Recognition contains detailed discussion of promises in a contract and may help entities understand whether an activity provided by the lessor (other than the right of use) transfers a good or service to the lessee.

Connecting the Dots

Nonlease Components Do Not Need to Be Distinct

Although the concept of nonlease components in ASC 842 is similar to that of promised goods or services in ASC 606, there is one significant difference: nonlease components do not need to be distinct from lease components to be accounted for separately.

Under ASC 606, for revenue recognition purposes, the transaction price is allocated only to distinct performance obligations. (See Section 5.3 of Deloitte’s Roadmap Revenue Recognition for detailed discussion of when a promised good or service is a distinct performance obligation.) Under ASC 842, the consideration in the contract is allocated to an item or activity when that item or activity transfers a good or service to the lessee.

When developing ASC 842, the FASB considered whether the “distinct” guidance in ASC 606 should apply to identifying and separating nonlease components. Paragraph BC151(a) of ASU 2016-02 explains that the 2010 leasing ED included guidance that required lessees and lessors to account for a service or other nonlease component separately only if it was distinct in accordance with the guidance that the Board was developing on revenue recognition. However, paragraph BC151(a) of ASU 2016-02 further notes that, in feedback on the 2010 ED, respondents indicated that they “found the proposals confusing, or they disagreed with some aspects of those proposals, in particular, the proposal to account for the entire contract as a lease if nonlease components were not distinct.”

Accordingly, under ASC 842, services or other nonlease components may be accounted for separately from the lease component(s) even if they would not be accounted for separately from other promised goods or services in a revenue contract with a customer. This may be counterintuitive to some lessees and lessors that find nonlease components in a contract not to be distinct from the lease component(s) (e.g., when the asset being leased cannot run or operate without the services provided by the lessor’s operating personnel). In addition, it may be challenging to develop an appropriate stand-alone price (for lessees) or stand-alone selling price (for lessors) — for both the lease component(s) and the nonlease components — with respect to allocating consideration in the contract. (The allocation methods for both lessees and lessors are further discussed in Section 4.4.)

Although nonlease components do not need to be distinct from lease components to be accounted for separately, ASC 842-10-15-31 states that nonlease components are not within the scope of ASC 842 (unless a lessor makes the accounting policy election in accordance with ASC 842-10-15-42A) and therefore must be accounted for in accordance with other applicable GAAP. For lessors, this means that nonlease components (e.g., maintenance services) generally should be accounted for in accordance with the guidance on revenue from contracts with customers in ASC 606.7 Accordingly, lessors will need to consider whether any of the promised goods or services in the separated nonlease component(s) represent distinct performance obligations. That is, although a bundle of promised goods or services may be separated from the lease component as nonlease components, the lessor will further need to identify distinct performance obligations within that bundle in accordance with step 2 of the revenue model in ASC 606. The guidance on identifying performance obligations in ASC 606 is discussed in detail in Chapter 5 of Deloitte’s Roadmap Revenue Recognition. Lessors should consider our interpretive guidance in assessing any nonlease components that are separated from the lease component(s) in a contract that contains a lease.

Maintenance services are likely to be some of the most commonly identified nonlease components in contracts that contain a lease. It is very common for leases of real estate (e.g., leases of an apartment, space in an office building, dwellings in a retirement home) to include some form of CAM. Lessors of such real estate may also procure and provide to lessees certain utilities (e.g., water, gas, and electricity).

4.3.1.1 Common-Area Maintenance and Utilities

Leases of office or commercial space often contain provisions that require the tenant to reimburse the landlord for amounts such as CAM costs or the cost of providing utilities (e.g., heat, water, gas, and electricity). Both CAM and utilities are considered nonlease components, as discussed in the following paragraphs.

CAM costs might include an allocated portion of costs for landscaping, janitorial services, repairs, snow removal, and other maintenance of common areas. CAM charges can be based on the actual costs incurred by the landlord. However, such charges also might be negotiated at the inception of the lease as fixed amounts, potentially with scheduled increases over the lease term.

CAM represents the transfer of a good or service to the lessee other than the right to use the underlying asset. Therefore, unless a practical expedient is available and elected (see Section 4.3.3), it is a nonlease component (1) that both the lessee and lessor must separate from the lease component(s) and (2) to which consideration in the contract must be allocated. Example 12, Case C, in ASC 842-10-55-144 and 55-145 (reproduced in Section 4.3), supports this conclusion and states, in part:

[T]he common area maintenance is a component because Lessor’s activities transfer services to Lessee. That is, Lessee receives a service from Lessor in the form of the common area maintenance activities it would otherwise have to undertake itself or pay another party to provide (for example, cleaning the lobby for its customers, removing snow from the parking lot for its employees and customers, and providing utilities).

As for utilities, they may be charged to the tenant at cost, allocated cost, or either cost or allocated cost plus a margin. The lessor transfers a good or service to the lessee that is separate from the right to use the underlying asset when it provides water, gas, electricity, or other utilities. Therefore, unless a practical expedient is available and elected (see Section 4.3.3), utilities reflect a nonlease component (1) that both the lessor and lessee must separate from the lease component(s) and (2) to which consideration in the contract must be allocated.

Changing Lanes

CAM and Utilities Are No Longer Just Executory Costs

ASC 840 required that “substantial services” be accounted for separately from the lease element in a contract that contains both a lease element and such substantial services. Although the phrase “substantial services” was not defined in ASC 840, we expect that any elements that are substantial services and that are thus currently separated from the lease element will also be nonlease components under ASC 842.

However, the treatment of maintenance and utilities under ASC 842 will generally differ from that under ASC 840. Specifically, under ASC 840-10-25-1(d), maintenance and utilities were generally considered executory costs and not substantial services. Therefore, under ASC 840-10-15-17 and ASC 840-10-15-19, maintenance and utilities were considered part of the lease element and are within the scope of ASC 840. Under ASC 842, on the other hand (and as explained above), maintenance (including CAM) and utilities are nonlease components. Accordingly, while the lease payments (i.e., the consideration in the contract) are not separately allocated to both CAM and utilities under ASC 840 for accounting purposes, the lease payments will be allocated in this way under ASC 842 (provided that a practical expedient is not available or is not elected — see Section 4.3.3). Further, under ASC 842, unless a practical expedient is available and elected, both CAM and utilities are accounted for in accordance with other applicable GAAP rather than being accounted for as part of the lease as they were under ASC 840.

Connecting the Dots

Real Estate Lessors’ Identification of Distinct Performance Obligations Within CAM

As discussed above, lessors will need to consider the guidance in ASC 606 to identify distinct performance obligations within the nonlease component(s) that are separated from the lease component(s).8 Similarly, to recognize revenue in accordance with ASC 606, real estate lessors will need to consider whether CAM is a single performance obligation or comprises multiple performance obligations.

We think that CAM will often represent a single performance obligation. Although CAM comprises multiple different activities that the lessor may perform on a day-to-day basis (e.g., cleaning the lobbies and bathrooms daily, buffing the lobby floors weekly), the nature of the lessor’s promise is to maintain the common areas of the real estate being leased. In promising to deliver CAM, the lessor agrees that it will undertake various activities to fulfill its overall promise to the lessee of providing a well-maintained building and common areas.

This view is consistent with that articulated by the FASB in ASC 606-10-55-157B through 55-157E (added to ASC 606 by ASU 2016-10), which illustrate an arrangement involving hotel management services. That is, in this example, the Board concludes that “[t]he service comprises various activities that may vary each day (for example, cleaning services, reservation services, and property maintenance) [but] those tasks are activities to fulfill the hotel management service and are not separate promises in the contract.” Accordingly, each increment (e.g., each day of the management services) of the promised service is distinct, but together the overall promise represents a series of distinct goods or services that are accounted for as a single performance obligation in accordance with ASC 606-10-25-14 and 25-15.

However, real estate lessors should carefully consider the promised goods or services within the overall CAM promise. For example, we do not think that it would be appropriate for utilities (discussed above) or major maintenance (discussed in Section 4.3.1.2) to be considered part of a single performance obligation with CAM just because those items may be billed together or expressed together in the contract with the lessee. That is, just because an activity is characterized as part of CAM does not mean that it should be bundled together as part of a single performance obligation with CAM.

Although an activity (e.g., a good or service) may be distinct from CAM, it may be reasonable to account for it together with the CAM if the pattern of transfer and the outcome of accounting for them together are the same, as indicated in paragraph BC116 of ASU 2014-09.

4.3.1.2 Major Maintenance

In leases of equipment and other large assets (e.g., airplanes, power plants), the lessor often provides nonroutine or “major” maintenance on the leased asset. Major maintenance differs from CAM or other routine maintenance in that, for major maintenance, the lessor (1) does not regularly provide the services and (2) may need to spend a certain amount of capital to keep the asset available for the lessee’s use. For example, a lessor may need to provide major maintenance for an airplane that it leases to a lessee — and remove the airplane from the lessee’s rotational use — at the earlier of (1) the time when a maximum number of miles is flown or (2) a federally regulated time since the last major maintenance was performed.

The performance of major maintenance represents the transfer of a good or service to the lessee other than the right to use the underlying asset. Therefore, unless a practical expedient is available and elected (see Section 4.3.3), it is a nonlease component (1) that both the lessor and lessee must separate from the lease component(s) and (2) to which consideration in the contract must be allocated.

Generally, major maintenance was considered a “substantial service” under ASC 840. Therefore, we would expect major maintenance to be separated from the lease component as a nonlease component in a manner consistent with that described in the Changing Lanes above. In addition, given the distinct characteristics and separable risks of major maintenance, compared with other services that the lessor may provide more regularly, such maintenance may represent a distinct performance obligation for the lessor in accordance with ASC 606.

4.3.2 Noncomponents

While lease components and nonlease components transfer a good or service to the lessee, noncomponents do not transfer anything to the lessee. Rather, they are incurred by the asset owner (i.e., the lessor) regardless of whether the asset is out on lease. As indicated in ASC 842-10-15-30, noncomponents are generally payments for either of the following:

Administrative tasks performed by the lessor that are necessary “to set up a contract or initiate the lease.”
Reimbursements (or direct payments) of the lessor’s costs that the lessor requires the lessee to pay as part of earning a return of (and on) the lessor’s costs to deliver the contract.

Payments made by the lessee for the following are considered noncomponents to which the consideration in the contract is not separately allocated:

Real estate or property taxes related to the leased asset (see Section 4.3.2.1).
Insurance that covers the lessor’s interest in the asset (see Section 4.3.2.2).
Commitment fees.
Other administrative charges.

In addition, payments for the items described above would be considered noncomponents regardless of whether the payments are fixed or variable.

In a manner similar to the guidance in ASC 606 on setup activities, the consideration in the contract is not allocated to noncomponents because they do not transfer a good or service to the lessee. Rather, fixed amounts paid for noncomponents are included in the consideration in the contract and allocated to the lease and nonlease components.9 (See Section 4.4 for detailed discussion of measuring and allocating consideration in the contract.) The Board explains this consistency in paragraph BC159 of ASU 2016-02:

The guidance in Topic 842 in this respect is consistent with the revenue recognition guidance in Topic 606, which states that promised goods or services do not include set up or other activities that an entity must undertake to fulfill a contract unless those activities transfer a good or service to the customer. Those activities, therefore, do not get an allocation of the transaction price.

However, these costs are also often variable and paid on the basis of the actual costs and are not considered part of the consideration in the contract. For lessees, the accounting and reporting requirements for these costs are the same regardless of whether the lessee is reimbursing the lessor or paying a third party directly on the lessor’s behalf (e.g., paying real estate taxes directly to the relevant tax authority). However, the accounting and reporting requirements for lessors differ when the noncomponent is a lessor cost. Specifically, lessor costs that a lessee pays directly to a third party on behalf of the lessor are excluded from variable payments, and thus from lease revenue, while lessor costs that the lessor pays directly to a third party, and that the lessee then reimburses, must be accounted for as variable payments and therefore as lease revenue. For detailed discussion of the measurement of the consideration in the contract (and whether or when variable payments are included in that measurement), see Section 4.4.1 (for lessees) and Section 4.4.2 (for lessors).

4.3.2.1 Property Taxes

Depending on the relevant tax authority, the asset owner (i.e., the lessor) generally owes property taxes on the asset regardless of whether or to whom the asset is out on lease. Accordingly, the relevant tax authority has recourse only to the lessor for property taxes owed. This is the case even when a lessor requires a lessee in the contract to pay property taxes directly to the tax authority — although the lessor may have recourse to the lessee, the tax authority ultimately holds the lessor responsible for such amounts.

The FASB discusses property taxes in paragraph BC157 of ASU 2016-02:

[I]t is common practice for one party to the contract to pay certain costs directly to a third party, although the counterparty to the contract is principally liable to make those payments (for example, a lessee may make property tax payments directly to the taxing authority although the lessor is principally liable for those payments).

The lessee receives no good or service in return for its payment of property taxes, regardless of whether it reimburses the lessor or pays the tax authority directly; as a result, the property taxes are not considered a component (lease or nonlease) in the contract. In many cases, the lessee is ultimately reimbursing the lessor for its costs, for which the lessor is the primary obligor to the tax authority. Therefore, both the lessee and lessor consider property taxes noncomponents in a contract and no consideration in the contract is allocated to the property taxes.

Example 12, Case A, in ASC 842-10-55-141 and 55-142 (reproduced in Section 4.3), supports the conclusion that property taxes are noncomponents. In that example, the lessor and lessee conclude that property taxes are not a component in the contract because the “real estate taxes would be owed by Lessor regardless of whether it leased the building and who the lessee is.” Paragraph BC158 of ASU 2016-02 also addresses the Board’s conclusions regarding property taxes:

For example, an entity would not account for a portion of the consideration in the contract that is attributable to paying the lessor’s property taxes . . . as a component if the lessor is the primary obligor for those taxes . . . and the amounts paid are not for a service (for example, maintenance or operations services) provided by the lessor to the lessee.

For lessees and lessors, any amounts paid for property taxes that are included in the consideration in the contract (i.e., the costs are fixed in the contract) are allocated to the separate lease and nonlease components. However, the lessee and lessor requirements differ when the amounts paid for property taxes are excluded from the consideration in the contract (i.e., the costs are variable). For lessees, the variable payment is allocated on the same basis as the fixed consideration. For lessors, the requirements for lessee-paid costs differ from those for lessee-reimbursed costs. Any amounts that a lessee directly pays to a third party on behalf of the lessor for property taxes should be excluded from variable payments and thus from lease revenue. Any amounts that the lessee reimburses and the lessor pays to the third party should be included in variable payments and therefore in lease revenue. (See Section 4.4 for detailed discussion of measuring and allocating consideration in the contract.)

4.3.2.2 Insurance

In real estate and automobile leases, the lessor commonly requires the lessee to pay for insurance coverage to protect the lessor’s interest in the leased asset (e.g., insurance to cover the physical structure of an office building). Generally, the lessor would seek to obtain equivalent insurance coverage regardless of whether or to whom it was leasing the asset. The contract may require the lessee to pay the lessor (e.g., to reimburse the lessor’s premium) or to obtain the insurance coverage directly from, and pay the premium directly to, a third-party insurance provider.

It is also common for real estate and automobile leases to require — or for the lessee to decide on its own to obtain — insurance coverage to protect the lessee’s interests in the leased asset (e.g., to cover the contents of the physical structure that the lessee owns, such as with renter’s insurance). In such cases, the lessee would generally obtain the insurance directly from a third-party insurance provider.

4.3.2.2.1 Insurance Premiums Paid by Lessee to Protect Lessor’s Interest

With respect to insurance premiums that the lessee pays for insurance coverage to protect the lessor’s interest in the asset, the lessee receives no good or service in return for its payment of the insurance premium, regardless of whether the lessee reimburses the lessor or the lessee pays the insurance provider directly. The lessee is ultimately reimbursing the lessor for its costs, and when the policy covers the lessor’s interest in the asset as the named insured, the lessor is the primary beneficiary of the policy. Therefore, both the lessor and the lessee consider such insurance a noncomponent in the contract and no consideration in the contract is allocated to the insurance.

Example 12, Case A, in ASC 842-10-55-141 and 55-142 (reproduced in Section 4.3), supports the conclusion that payments for insurance coverage are noncomponents. In that example, the lessor and lessee conclude that insurance is not a component in the contract because “Lessor is the named insured on the building insurance policy (that is, the insurance protects Lessor’s investment in the building, and Lessor will receive the proceeds from any claim).”

For lessees and lessors, any amounts paid for such insurance coverage that are included in the consideration in the contract (i.e., the costs are fixed in the contract) are allocated to the separate lease and nonlease components. However, the lessee and lessor requirements differ when amounts paid for insurance coverage are excluded from the consideration in the contract (i.e., the costs are variable). For lessees, the variable payment is allocated on the same basis as the fixed consideration. For lessors, the requirements for lessee-paid costs differ from those for lessee-reimbursed costs. Any amounts that a lessee directly pays to a third party on behalf of the lessor for insurance coverage should be excluded from variable payments and thus from lease revenue. Any amounts that the lessee reimburses and the lessor pays to the third party should be included in variable payments and therefore in lease revenue. (See Section 4.4 for detailed discussion of measuring and allocating consideration in the contract.)

4.3.2.2.2 Insurance Premiums Paid by Lessee to Protect Lessee’s Interest

Insurance premiums that the lessee pays for insurance coverage to protect its own interest in the leased asset are also considered noncomponents in the contract.

The lessee receives a good or service in return for its payment of the insurance premium; however, that good or service does not result from the contract that contains the lease but from the contract between the lessee and the third-party insurance provider. The lessee is ultimately protecting its own interest in the leased asset by covering its own property within that leased asset; thus, the lessee is the named insured and primary beneficiary of the policy. In addition, the lessee is not reimbursing the lessor for any costs.

Therefore, both the lessee and the lessor consider such insurance separate from the contract that contains the lease. No consideration in the contract that contains the lease is allocated to the insurance. Rather, the lessee accounts for any amounts it paid for such insurance coverage in accordance with other applicable GAAP. The lessor would not account for the insurance coverage (i.e., the payments are not a lessor cost).

4.3.2.2.3 Insurance Premiums Paid by Lessee to Protect Both Lessee and Lessor Interests

In certain situations, the lessee may pay insurance premiums for an umbrella insurance policy that covers both the lessor’s and the lessee’s interest in the leased asset and the lessee and lessor may be required to allocate these premiums. This situation is common in automobile leases in which the lessor requires the lessee to purchase collision insurance (for which the lessor is the primary beneficiary) and the lessee also obtains liability (and potentially other) insurance under the same policy (for which the lessee is the primary beneficiary).

As explained in Section 4.3.2.2.1, and in accordance with ASC 842-10-15-30, an entity should consider whether any amounts paid for insurance that covers the lessor’s interest in the asset should be included in the consideration in the contract and allocated to the separate lease and nonlease components. (See Section 4.4 for detailed discussion of measuring and allocating consideration in the contract.)

Lessees should allocate the insurance premium amount between (1) the portion that is compensation for the insurance coverage over the lessor’s interest in the asset, when the lessor is the insured party, so that an appropriate amount of the premium can be considered for inclusion in the consideration in the contract (or for allocation of variable payments) and (2) the portion that is compensation for the insurance coverage over the lessee’s interest in the asset, when the lessee is the insured party, so that the lessee can account for an appropriate amount of the premium in accordance with other applicable GAAP.

In circumstances in which the lessee pays insurance premiums that cover both the lessor’s and lessee’s interest in the leased asset, lessors are most likely not aware of the actual amount of the policy premium since a lessee would typically pay a third party directly. Any amount that a lessee directly pays to a third party on behalf of the lessor for insurance coverage should be excluded from variable payments. Further, any amount that a lessee directly pays to a third party on behalf of itself for insurance coverage would not be a lessor cost; thus, lessors should never account for such an amount. Accordingly, lessors should exclude from variable payments, and thus from lease revenue, the entire insurance premium (provided that the lessee pays this premium directly to a third party).

Changing Lanes

Lessors Record Revenues and Expenses on a Gross Basis for Property Taxes and Insurance When Reimbursed by a Lessee

As discussed above, under ASC 842, property taxes and insurance (which covers the lessor’s interest in the asset) do not transfer a good or service to the lessee and are thus noncomponents of a contract. The consideration in the contract is not allocated to noncomponents; rather, both the lessee and the lessor allocate payments for noncomponents to the lease and nonlease components.

Under ASC 840, lessors often recorded payments for executory costs (including property taxes and insurance) net in the income statement, especially when the lessee makes these payments directly to a third party (e.g., the tax authority), such as in a triple net lease. That is, lessors do not record gross revenues for the amounts paid by the lessee and an expense for the amount of costs they incur. Often, the inflow (revenue) and outflow (expense) are equal and are thus “netted” down to zero for presentation in the income statement.

However, under ASC 842, to the extent that the lessee is reimbursing the lessor’s costs and the lessor is ultimately paying the third party (as discussed in Sections 4.3.2.1 and 4.3.2.2), the lessor should recognize its costs on a gross basis in the income statement as an expense, as it would for any other costs that it incurs. This is consistent with how an entity would recognize and present cost recovery amounts billed to customers in accordance with ASC 606. (See Sections 14.7.2.2 and C.5.1 of Deloitte’s Roadmap Revenue Recognition for detailed discussion of TRG Agenda Paper 2, which addresses the gross or net presentation of amounts billed to customers.)

This may result in a change from practice under ASC 840 for many lessors, especially real estate lessors. As a result, lessors may end up with higher revenues and expenses than were previously recorded.

That said, under ASC 842, if the lessee is paying a third party directly on behalf of the lessor, the lessor should recognize its costs on a net basis in the income statement (i.e., exclude lessee-paid costs from variable payments and therefore from lease revenue).

Property Taxes and Insurance May Inflate the Measurement of the Lease Liability and ROU Asset

On the basis of the lease accounting guidance in ASC 840-10-25-1(d), both property taxes and insurance were considered executory costs. ASC 840-10-15-17 and ASC 840-10-15-19 stated that such costs are considered part of the lease element and are therefore within the scope of ASC 840. However, executory costs for property taxes and insurance, and profits thereon, are excluded from minimum lease payments for purposes of lease classification (i.e., excluded from the 90 percent test) and the measurement of capital lease obligations and capital lease assets.

As explained in Sections 4.3.2.1 and 4.3.2.2, property taxes and insurance, respectively, will be noncomponents under ASC 842. Although these costs are often variable, any fixed amounts paid by the lessee for property taxes and insurance will be included in the consideration in the contract and allocated to the lease and nonlease components (to the extent that there are nonlease components in the contract), whereas they are not under ASC 840 guidance. This could potentially result in the following:

Increased likelihood that an entity will classify the lease component in the contract as a finance lease when considering the criterion in ASC 842-10-25-2(d), since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance. (The lessee’s classification is discussed in detail in Chapter 8.)
Higher lease liabilities and ROU assets, regardless of whether the lease is classified as an operating or finance lease, since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance to be included in the initial measurement of the lease.

4.3.2.3 Sales Taxes

In certain tax jurisdictions, lessees are subject to sales, use, and value-added taxes, etc., in connection with the use of an asset in a contract that contains a lease. The lessee may pay the taxes directly to the tax authority, or the contract may state that the lessor will collect the taxes from the customer and remit the funds to the tax authority.

4.3.2.3.1 Determining Whether Sales Taxes Paid by Lessee Represent Lease Payments

To determine whether the sales taxes represent payments associated with the contract that contains a lease, a lessee should assess whether the legal obligation (rather than the stated contract terms indicating an obligation for the lessee to make a payment) to the tax authority for the sales taxes resides with the lessee or the lessor.

If the obligation resides with the lessee, the lessee and lessor should consider such sales tax payments to be separate and apart from the contract that contains a lease. In this case, sales tax payments would not represent lease payments to the lessor or a reimbursement of lessor costs. See Section 4.3.2.3.2 for considerations related to a lessee’s initial and subsequent accounting for sales tax payments that are a lessee obligation.

If the obligation10 for the sales taxes resides with the lessor, the sales taxes paid by the lessee as part of the contract are considered to be payments associated with the contract that contains a lease. In this case, the lessee is reimbursing a lessor cost since the tax obligation resides with the lessor. Like property taxes and insurance, the sales taxes represent noncomponents under ASC 842, as explained in Sections 4.3.2.1 and 4.3.2.2. Although these costs are often variable payments, any fixed amounts paid by the lessee for sales taxes will be included in the consideration in the contract and allocated to the lease and nonlease components (to the extent that there are nonlease components in the contract). Fixed sales tax payments may be less common since a lessee often will reimburse a lessor’s actual sales tax as incurred (e.g., a pass-through from the lessor to the lessee).

Sales tax determined by applying the sales tax rate to the gross lease payment (i.e., the rate does not depend on the lessee’s use of the leased asset)11 is not a variable payment akin to an index or rate.12 Rather, sales tax is akin to real estate or property tax and therefore is treated as a variable payment that does not depend on an index or rate (in a manner similar to sales tax imposed on the basis of a lessee’s usage of the leased asset). Property tax is not deemed to depend on an index or rate because the tax itself is based on a number of factors, some of which are not dictated by market conditions. Taxes generally are subject to governmental policy considerations, and the tax rate is ultimately a function of the tax base and the revenue needs of the governing body. Since the revenue needs may change over time (and can increase or decrease), the tax payments of the lessee do not represent a present obligation until they are calculated and assessed. Sales taxes are no different in this regard.

4.3.2.3.2 Accruing Sales Tax Liabilities

When the sales tax obligation resides with the lessee, as discussed earlier in this section, the lessee could be required to accrue a sales tax liability before payment. A lessee should accrue a sales tax liability (separate from the lease liability) if it has an unavoidable obligation to pay sales tax (whether the payment is currently due or is payable as of a future date). For example, if a lessee, upon signing a contract to lease a new vehicle for five years, is legally obligated to make a sales tax payment of $2,500 that is due at lease commencement, the lessee has incurred a liability (which must be recognized) as of the date of contract execution. However, to the extent that there is potential variability in the amount of sales tax owed, or if the lessee is not presently obligated to make a payment, the lessee would not have an unavoidable obligation and therefore would not recognize a liability.

We believe that, to the extent that a lessee is required to accrue a sales tax liability, the lessee may treat the sales tax payments as a capitalizable cost (separate from the ROU asset) in accordance with ASC 360. We would expect the costs to be capitalized and expensed over the term to which the sales taxes are related. In the example above, the $2,500 due to the tax authority would be capitalized as an asset and expensed on a straight-line basis over five years, beginning at lease commencement.

4.3.3 Practical Expedients

Although the default model in ASC 842 requires separation of lease and nonlease components, certain practical expedients may be available to entities. Entities electing the practical expedient(s) would not separate lease and nonlease components. Rather, they would account for each lease component and the related nonlease component(s) together as a single component.

4.3.3.1 Lessees

ASC 842-10

15-37 As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.

ASC 842 affords lessees a practical expedient related to separating (and allocating consideration to) lease and nonlease components. That is, lessees may elect to account for the nonlease components in a contract as part of the single lease component to which they are related. The practical expedient is an accounting policy election that must be made by class of underlying asset (e.g., vehicles, IT equipment — see the Connecting the Dots discussion below).

Accordingly, when a lessee elects the practical expedient, any portion of the consideration in the contract that would otherwise be allocated to the nonlease components will instead be accounted for as part of the related lease component for classification, recognition, and measurement purposes (lessee accounting is discussed in detail in Chapter 8). In addition, any payments related to noncomponents would be accounted for as part of the related lease component (i.e., the associated payments would not be allocated between the lease and nonlease components).

Connecting the Dots

Magnitude of the Nonlease Components Does Not Matter

The practical expedient in ASC 842-10-15-37 is available to lessees regardless of the extent or significance of the nonlease components in the contract. However, in paragraph BC150 of ASU 2016-02, the FASB acknowledges that it would not expect lessees (even though it is allowed) to elect the practical expedient when the nonlease components in the contract are significant:

The availability of the practical expedient to a lessee is not affected by the relative size of the lease and the nonlease components. However, given that the result of electing this practical expedient is to record additional lease liabilities, the Board concluded that lessees will, in general, only elect this expedient in arrangements with less significant service components.

Paragraph BC150 of ASU 2016-02 further cites the following basis for providing the expedient:

“[T]he costs and administrative burden of allocating consideration to separate lease and nonlease components may not be justified by the benefit of more precisely reflecting the right-of-use asset and the lease liability,” especially when nonlease components in contracts for which the expedient is elected are not expected to be significant.
Because nonlease components in contracts for which the expedient is elected are not expected to be significant, “comparability should not be significantly affected as a result of providing this practical expedient.”

When electing the practical expedient to combine lease and nonlease components, lessees may combine nonlease activities accounted for under other GAAP (e.g., maintenance) with their related lease components; as a result, the overall accounting for these activities may be in accordance with ASC 842. However, in such circumstances, a lessee should carefully consider whether the nonlease component is truly associated with the leased asset. Specifically, the lessee should consider whether its ability to use or derive benefit from the nonlease component is interrelated with that for the lease component and vice versa.

Example 11, Case B, in ASC 842-10-55-138 through 55-140 (reproduced in Section 4.4.3) illustrates an application of the practical expedient in ASC 842-10-15-37 to a contract that contains multiple lease components. Accordingly, Example 11, Case B, also emphasizes an important part of the expedient in ASC 842-10-15-37: lessees may “account for each separate lease component and the nonlease components associated with that lease component as a single lease component” (emphasis added). That is, the practical expedient does not allow lessees to not separate lease components from other lease components in the contract, and the guidance in ASC 842-10-15-28 and 15-29 (see Section 4.2) must still be applied when a lessee makes the accounting policy election in ASC 842-10-15-37.

Connecting the Dots

Meaning of “Class of Underlying Asset”

ASC 842 provides lessees with two practical expedients that may be elected as an accounting policy by “class of underlying asset”:

ASC 842-10-15-37 allows lessees not to separate lease and nonlease components.
ASC 842-20-25-2 allows lessees not to recognize lease liabilities and ROU assets for short-term leases. (The short-term lease recognition exemption is discussed in detail in Section 8.2.1.)

However, ASC 842 does not address what is meant by the phrase “class of underlying asset.” We have received a number of questions about this topic from various stakeholders, and two views have emerged:

View 1 — The class of underlying asset is determined on the basis of the physical nature and characteristics of the asset. For example, real estate, manufacturing equipment, and vehicles would all be reasonable classes of underlying assets given their differences in physical nature. Therefore, irrespective of whether there are different types of similar assets (e.g., within the real estate class, there may be retail stores, warehouses, and distribution centers), the class of underlying asset would be limited to the physical nature as described above.
View 2 — The class of underlying asset is determined on the basis of the risks associated with the asset. While an asset’s physical nature may be similar to that of other assets (e.g., retail stores, warehouses, and distribution centers are all real estate, as discussed above), each has a different purpose and use to the lessee and would therefore have a separate risk profile. Therefore, for example, it could be appropriate for the lessee to disaggregate real estate assets into separate asset classes by “type” of real estate — to the extent that the different types are subject to different risks — when applying the practical expedients in ASC 842-10-15-37 and ASC 842-20-25-2.

To support their position, proponents of View 2 refer to paragraph BC341 of ASU 2016-02, which states:

The Board decided that a lessor should treat assets subject to operating leases as a major class of depreciable assets, further distinguished by significant class of underlying asset. Accordingly, a lessor should provide the required property, plant, and equipment disclosures for assets subject to operating leases separately from owned assets held and used by the lessor. In the Board’s view, leased assets often are subject to different risks than owned assets that are held and used (for example, the decrease in the value of the underlying asset in a lease could be due to several factors that are not within the control of the lessor), and, therefore, users will benefit from lessors segregating their disclosures related to assets subject to operating leases from disclosures related to other owned property, plant, and equipment. The Board further considered that to provide useful information to users, the lessor should disaggregate its disclosures in this regard by significant class of underlying asset subject to lease because the risk related to one class of underlying asset (for example, airplanes) may be very different from another (for example, land or buildings). [Emphasis added]

Irrespective of the views noted above, we do not think that it would be appropriate to determine the “class of underlying asset” on the basis of the lease contract with which it is associated. For example, we believe that it would be inappropriate to break real estate assets into different classes on the basis of whether they are related to gross leases or triple net leases. In that situation, the asset underlying the contract could be exactly the same while the contract differs. We do not think that approach is consistent with the intent of the guidance in ASC 842-10-15-37 or ASC 842-20-25-2.

4.3.3.2 Lessors

ASC 842-10

15-42A As a practical expedient, a lessor may, as an accounting policy election, by class of underlying asset, choose to not separate nonlease components from lease components and, instead, to account for each separate lease component and the nonlease components associated with that lease component as a single component if the nonlease components otherwise would be accounted for under Topic 606 on revenue from contracts with customers and both of the following are met:

The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.

15-42B A lessor that elects the practical expedient in paragraph 842-10-15-42A shall account for the combined component:

As a single performance obligation entirely in accordance with Topic 606 if the nonlease component or components are the predominant component(s) of the combined component. In applying Topic 606, the entity shall do both of the following:
1. Use the same measure of progress as used for applying paragraph 842-10-15-42A(a)
2. Account for all variable payments related to any good or service, including the lease, that is part of the combined component in accordance with the guidance on variable consideration in Topic 606.
Otherwise, as an operating lease entirely in accordance with this Topic. In applying this Topic, the entity shall account for all variable payments related to any good or service that is part of the combined component as variable lease payments.

In determining whether a nonlease component or components are the predominant component(s) of a combined component, a lessor shall consider whether the lessee would be reasonably expected to ascribe more value to the nonlease component(s) than to the lease component.

15-42C A lessor that elects the practical expedient in paragraph 842-10-15-42A shall combine all nonlease components that qualify for the practical expedient with the associated lease component and shall account for the combined component in accordance with paragraph 842-10-15-42B. A lessor shall separately account for nonlease components that do not qualify for the practical expedient. Accordingly, a lessor shall apply paragraphs 842-10-15-38 through 15-42 to account for nonlease components that do not qualify for the practical expedient.

The practical expedient in ASC 842-10-15-37, under which lessees can elect not to separate lease and nonlease components (see Section 4.3.3.1), was not initially available to lessors. ASC 842, as initially issued by way of ASU 2016-02, required lessors to separate lease and nonlease components in all circumstances. Accordingly, lessors were required to look to the guidance in step 4 of the revenue model in ASC 606 to allocate the consideration in the contract to the separated components. After the consideration is allocated, ASC 842 (including its presentation and disclosure guidance) applies to the lease component and ASC 606 (including its presentation and disclosure guidance) generally applies to the nonlease component. See Section 4.4.2 for further discussion of the guidance on allocating consideration in the contract to lease and nonlease components.

Such separation was required regardless of whether the pattern of transfer to the customer would be the same (i.e., a straight-line pattern of transfer to the customer over the same period) when the lease and nonlease components are separated (see Section 4.4.2.2.2). Accordingly, if the patterns of transfer are the same, separation and allocation may only affect presentation and disclosure. For example, this often may be the case when real estate lessors enter into operating leases of real estate and provide CAM services to the customer. However, the FASB received stakeholder feedback indicating that the costs of complying with ASC 842’s separation and allocation requirements for arrangements in which the pattern of transfer is the same outweigh the benefits (i.e., when the separation and allocation guidance only affects presentation and disclosure).

As a result, in July 2018, the FASB issued ASU 2018-11, which provides a practical expedient under which lessors can elect, by class of underlying asset, not to separate lease and nonlease components when certain criteria are met. Therefore, this practical expedient only affects lessors whose lease contracts also include nonlease components that are within the scope of ASC 606 and meet certain criteria (discussed below). If a lessor elects the practical expedient to combine lease and eligible nonlease components, it must evaluate whether the nonlease components in the combined component are predominant to determine whether the combined component should be accounted for under ASC 606 or ASC 842.

Connecting the Dots

Practical Expedient Results in Greater Alignment Between Lessee and Lessor Accounting

Unlike lessors, lessees have always been able, under ASC 842, to elect a practical expedient under which they can choose not to separate (and allocate consideration to) lease and nonlease components (see ASC 842-10-15-37). ASU 2018-11 aligns the lessor’s accounting for the separation of lease and nonlease components with that for lessees. Both lessors (when certain conditions are met) and lessees may now elect to account for each lease component and the associated nonlease components in a contract as part of a single component. Note that this election is an accounting policy election that must be made by class of underlying asset. (For more information, see the Connecting the Dots discussion in Section 4.3.3.1.) However, lessees do not have the option of accounting for the combined component under other U.S. GAAP. Instead, a lessee’s combined component must always be accounted for under ASC 842.

4.3.3.2.1 Criteria for Combining Lease and Nonlease Components

A lessor that elects the practical expedient would not be required to separate lease and nonlease components (i.e., it would account for the lease and nonlease components as a combined, single unit of account), provided that the nonlease component(s) otherwise would be accounted for under the revenue guidance in ASC 606 and both of the following conditions are met:

Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.13
Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.

ASC 842-10-15-42C also clarifies that the presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the expedient for the lease component and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease components that do not qualify for the practical expedient separately from the combined lease and nonlease components that do qualify.

Connecting the Dots

Assessing Timing and Pattern of Transfer

In ASU 2018-11, the Board amended Criterion A to focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer . . . to the customer over the same time period”) rather than on the timing and pattern of revenue recognition (as was originally proposed). The purpose of this amendment was to address concerns that the originally proposed practical expedient was unnecessarily restrictive and excluded contracts with variable consideration from its scope, since variable payments are accounted for differently under ASC 606 than they are under ASC 842. That is, the pattern of revenue recognition under ASC 606 could differ because estimates of variable consideration are recognized as revenue under ASC 606 while recognition of revenue for variable consideration under ASC 842 is restricted until the variability or contingency is resolved.

4.3.3.2.1.1 Noncoterminous Lease and Nonlease Components

As noted above, ASC 842-10-15-42A allows lessors to elect, as a practical expedient by class of underlying asset, an accounting policy of not separating nonlease components from lease components if (1) the timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component and (2) “the lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3.”14

In some arrangements, a lessee may commit to purchasing a service (that would be considered a nonlease component) for only part of the lease term. The lessee may have the option of renewing the service for an incremental fee over the lease term but is not contractually committed to do so. Therefore, the period over which a lessor is contractually required to provide services to a lessee (that would be a nonlease component) may not span the entire lease term. That is, in such circumstances, the lease term and the contractual service period would not be coterminous.

We believe that, in some cases, a lessor can elect the practical expedient in ASC 842-10-15-42A (i.e., to combine the nonlease component with the associated lease component) even if the nonlease component is not coterminous with the lease component. Specifically, we think that if the separation of the lease component from the nonlease component would only affect presentation and disclosure (i.e., the pattern and timing of revenue recognition would not differ if the nonlease component were accounted for separately), the lessor can elect the practical expedient to combine the lease and nonlease component even if the timing of transfer of the nonlease component is not coterminous with the lease component. This would generally be the case when the lease and optional nonlease component(s) are each priced at their stand-alone selling price and an allocation between components would therefore not be necessary (i.e., they are not priced at a significant discount in such a way that a material right within the scope of ASC 606 might need to be identified) and the timing and pattern of transfer of the nonlease component are the same as those for the lease component for the period over which the nonlease component will be transferred to the lessee.

This view is supported by paragraph BC31 of ASU 2018-11, which states, in part, that “[t]he Board noted that its objective in providing the practical expedient was to align the accounting by lessors under the new leases standard more closely with the revenue guidance.” Further, paragraph BC116 of ASU 2014-09 notes that “Topic 606 would not need to specify the accounting for concurrently delivered distinct goods or services that have the same pattern of transfer. This is because, in those cases, an entity is not precluded from accounting for the goods or services as if they were a single performance obligation, if the outcome is the same as accounting for the goods and services as individual performance obligations.”

On the basis of the Board’s stated objective, we believe that the practical expedient in ASC 842-10-15-42A can be applied when the only impact is on presentation and disclosure of amounts recognized as part of the arrangement (i.e., the pattern and timing of recognition are the same), provided that the lease component, if accounted for separately, would be classified as an operating lease.

Example 4-6

Lessor X enters into a lease arrangement with Lessee Y for the use of kitchen space (which is identified as a lease component) for a noncancelable one-year term. The lease component, if accounted for separately, would be classified as an operating lease. The lease arrangement also includes optional cleaning and inventory receiving services (nonlease components) that the lessee can elect to receive from the lessor on a month-by-month basis. When elected, the optional services provide the same benefit to Y each day and will be transferred to the lessee by using a time-based measure of progress (i.e., ratably) over the period in which the services are made available. Both the lease component and the optional services (the nonlease component) are priced at their stand-alone selling price. Therefore, there is no requirement to reallocate contractually stated consideration from the lease component to the nonlease component or vice versa and the right to purchase the optional services does not give rise to a material right, as discussed in ASC 606-10-55-42, that would require allocation of consideration separately between the lease and optional nonlease components under ASC 606-10-55-44 and 55-45.

If and when these optional services are purchased, X would use a time-based measure of progress to determine the amount of revenue to recognize from the cleaning and inventory receiving services because the services are transferred to the customer ratably over the elected service term(s). Accordingly, the pattern and timing of transfer of the optional services for the monthly period elected are the same as those for the kitchen space (the lease component).

Although the lessor is not contractually required to provide optional services over the entire lease term (i.e., the noncancelable one-year term of the lease arrangement), the pattern of transfer for the services will be the same as that for the lease component for the periods in which they are provided. Also, as mentioned above, the optional services are priced at their stand-alone selling prices and do not give rise to a material right that would require separate allocation of consideration to the lease and nonlease components. Consequently, X concludes that the separation of the nonlease component from the lease component would only affect presentation of revenue recorded and disclosure (i.e., the timing and pattern of revenue recognized would not differ if the nonlease component were accounted for separately). Therefore, X can apply the practical expedient in ASC 842-10-15-42A to combine the lease component and nonlease component for the periods in which Y exercises its right to receive the optional cleaning and inventory receiving services.

Once an entity has determined whether an arrangement would qualify for the lessor practical expedient, the entity must assess whether the lease component or nonlease component is the predominant element in the arrangement (see Section 4.3.3.2.2 for more information).

4.3.3.2.1.2 Effects of the Practical Expedient on Supplier (Lessor) Accounting

The practical expedient will most likely provide significant relief to certain lessors that are implementing ASC 842. When discussing the expedient at the FASB’s November 29, 2017, meeting, several Board members pointed out that certain real estate lessors would be allowed to apply ASC 842 in a manner consistent with how entities are permitted to apply ASC 606 when distinct goods or services are delivered concurrently and have the same pattern of transfer to the customer. Paragraph BC116 of ASU 2014-09 clarifies that, in such cases, entities are not precluded from accounting for, and recognizing revenue from, the goods and services as if they were a single performance obligation.

The examples below illustrate situations in which the practical expedient may provide relief to certain lessors implementing ASC 842. In these examples, assume that the nonlease component would otherwise be accounted for in accordance with ASC 606 and that the lease component, if accounted for separately, would be an operating lease.

Example 4-7

In a common real estate lease arrangement (e.g., a lease of floors in an office building), a lessor may also provide CAM services to the lessee. That is, in such an arrangement, the contract between the seller-lessor and the customer-lessee may include two separate components: (1) the right to use space (the lease component) and (2) maintenance services (the nonlease component). The lessor may perform the CAM services on an as-needed basis (e.g., cleaning the building lobbies, performing minor repairs, maintaining elevators); therefore, the maintenance services would be recognized as revenue ratably over the same period as that in which the leased floors are used. When elected, the practical expedient would allow the lessor to account for such a contract — which provides a lease and related CAM services — as containing a single component, as would be permitted for any other revenue-generating activity (e.g., two concurrently delivered services, each of which a purchaser could elect to buy, with or without the other). This alignment with ASC 606 is consistent with how the Board describes the leasing activities of lessors (i.e., as revenue-generating activities) in paragraphs BC92 and BC153 of ASU 2016-02.

Example 4-8

In a common vehicle lease arrangement, a lessor may agree to offer the customer, in addition to the lease, roadside assistance services on a stand-ready basis as well as participation in a loyalty program. As members of the loyalty program, customers earn points for each purchase and can thereby obtain future discounts or free car rentals. In such an arrangement, the seller-lessor is providing the customer-lessee with three things: (1) the right to use the car (the lease component), (2) roadside assistance as a stand-ready service (a nonlease component), and (3) a material right representing the future discounts offered as part of the loyalty program (a nonlease component). In this scenario, it may be reasonable to conclude that the timing and pattern of transfer for the vehicle lease are the same as those for the roadside assistance services; however, the timing and pattern of transfer associated with the loyalty program are unlikely to be the same as those for the others. Under ASU 2018-11, the lessor would be allowed to apply the practical expedient to combine the lease component and nonlease component for the roadside assistance (i.e., the eligible nonlease component) while separating the nonlease component for the loyalty program that is ineligible for the practical expedient and accounting for it in accordance with ASC 606.

Example 4-9

In certain arrangements, customers are provided with a monitoring service (i.e., a nonlease component) and a connected monitoring device (i.e., a lease component) for delivering the service. The lease and nonlease component may have the same timing and patterns of transfer (e.g., when the lease component is an operating lease and the nonlease component represents a continuous monitoring service). A lessor may apply the practical expedient to combine the components into a single component accounted for under ASC 842 or ASC 606, depending on whether the lease or nonlease component is predominant (see Section 4.3.3.2.2).

Note that unlike the lessee practical expedient, which is available for all contracts, the lessor practical expedient related to combining lease and nonlease components can only be elected when certain conditions are met. For example, the practical expedient cannot be applied to arrangements in which the patterns of transfer for the lease and nonlease components would not be the same. Therefore, lessors that enter into lease arrangements with revenue components that are transferred at a point in time (e.g., sales of equipment or other goods) will not be eligible for the relief from allocation between the lease and revenue component(s). Although constituents raised some concerns about allocation in these ineligible contracts, the Board did not address allocation by lessors that may be struggling to determine the appropriate stand-alone selling prices for the lease and nonlease components in such arrangements. Therefore, such entities will need to continue developing processes for estimating stand-alone selling prices in accordance with ASC 606 so that the consideration in the contract can be allocated to lease and nonlease components.

4.3.3.2.2 Determining Which Component Is Predominant

As with the lessee practical expedient, the FASB originally proposed that a lessor should always be required to account for the combined component as a lease under ASC 842. However, on the basis of feedback it received, the Board revised the final ASU to require an entity to perform another evaluation to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as a revenue component under ASC 606. Specifically, an entity should determine whether the nonlease component (or components) associated with the lease component is the predominant component of the combined component. If so, the entity is required to account for the single, combined component in accordance with ASC 606. Otherwise, the entity must account for the single, combined component as an operating lease in accordance with ASC 842.

Connecting the Dots

An Entity Will Need to Use Judgment to Determine the Predominant Component

As indicated in the Background Information and Basis for Conclusions of ASU 2018-11, the FASB decided not to include a separate definition or threshold for determining whether “the nonlease component is the predominant component in the combined component.” Rather, the Board noted that an entity should consider whether the lessee would “ascribe more value to the nonlease component(s) than to the lease component.” Further, the Board acknowledged that the term “predominant” is used elsewhere in U.S. GAAP, including ASC 84215 and ASC 606.16

The Board also explained that it does not expect that an entity will need to perform a quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine, on a qualitative basis, whether to apply ASC 842 or ASC 606. Therefore, we expect that entities will need to use judgment in making this determination.

At its March 28, 2018, meeting, the Board discussed a scenario in which the components were evenly split (e.g., a 50/50 split of value) and suggested that, in such circumstances, the combined component should be accounted for under ASC 842 because the nonlease component is not predominant. That is, the entity would need to demonstrate that the predominant element is the nonlease component; otherwise, the combined unit of account would be accounted for as a lease under ASC 842.

We believe that the final language in the ASU is intended to indicate that an entity would need to determine whether the lease or nonlease component (or components) is larger (i.e., has more value); only when the nonlease component is larger should the combined component be accounted for under ASC 606.

In discussions with the FASB staff, we confirmed that an entity needs to look at which component has more value, not significantly more value. In a quantitative analysis, “more value” would constitute more than 50 percent. For example, when the value of the nonlease component is 51 percent and the value of the lease component is 49 percent, the nonlease component would be the predominant component. However, the FASB staff indicated that it generally expects that entities will be able to make this determination qualitatively. We also confirmed that the language “ascribe more value to the nonlease component(s) than to the lease component” intentionally excludes the wording “ascribe significantly more value to the license” from ASC 606-10-55-65. Accordingly, we believe that, to be predominant, the nonlease component only needs to be larger (not significantly larger) than the lease component.

The examples below illustrate the determination of the predominant component in a contract. In these examples, assume that the arrangement would qualify for the lessor practical expedient on the basis of the criteria in ASC 842-10-15-42A (outlined above).

Example 4-10

A lessor leases three floors of an office building to a lessee for a fixed annual lease payment that includes payment for CAM activities performed by the lessor (e.g., cleaning the building lobbies, maintaining elevators). The three floors represent a lease component (see Section 4.2), and the CAM is a nonlease component (see Section 4.3.1). The CAM (nonlease component) represents approximately 10 percent, and the lease component approximately 90 percent, of the contract value. In addition, the maintenance services are not specialized or customized and the lessee entered into the lease primarily because of the location of the office space. Therefore, the lease component would be considered the predominant component, since the lessee would be expected to ascribe more value to the lease component. As a result, if the practical expedient is elected for this class of underlying asset, the entire arrangement would be accounted for as an operating lease in accordance with ASC 842.

Example 4-11

An entity enters into an arrangement to provide a monitoring service that requires the use of a monitoring device (hardware) that tracks data and remits the data back to the service provider. In this example, assume that the arrangement for the monitoring service has been identified as containing a lease. The connected device provided to the customer is considered a lease component, and the monitoring service is a nonlease component. The connected device (hardware) represents 2 percent of the contract value, and the service (nonlease component) represents 98 percent of the contract value. Further, the outputs of the service (i.e., security alerts and monitoring reports obtained from the data provided by the monitoring device) were what the customer intended to obtain by entering into the arrangement. Therefore, the nonlease component would be considered the predominant component, since a lessee (customer) would be expected to ascribe more value to the nonlease component. In this case, if the seller (lessor) elects the practical expedient, the entire arrangement would be accounted for as a revenue arrangement in accordance with ASC 606.

Example 4-12

An entity may enter into an arrangement to provide tenants with accommodations (i.e., the lease component) in a health care or retirement community as well as health care services (i.e., the nonlease component). These arrangements vary (e.g., skilled nursing facilities), and the service component in certain arrangements may provide more value to the customer-lessee than it does in other arrangements (e.g., independent living facilities that may function more as apartment complexes). Therefore, it may not be clear whether the lessee would ascribe more value to the lease or nonlease component(s). An entity would be required to use judgment in making this determination. If the entity determines that the nonlease component represents a larger portion of the value of the contract (i.e., more than 50 percent), the nonlease component (i.e., the health care services) would be considered the predominant component and, if the practical expedient is elected, the entire arrangement would be accounted for in accordance with ASC 606. Alternatively, if the lessor determines that a lessee would ascribe more value to the lease component (i.e., the accommodations), the lease component would be the predominant component and, if the practical expedient is elected, the entire arrangement would be accounted for as an operating lease in accordance with ASC 842.

Connecting the Dots

Accounting for Variable Payments Should Be Consistent With That for the Combined Component

ASU 2018-11 includes language related to the interaction between the practical expedient and the guidance in (1) ASC 842-10-15-39 on consideration in the contract and (2) ASC 842-10- 15-40 on the recognition of variable payments. Specifically, ASC 842-10-15-42B(a)(2) clarifies the Board’s intent that the accounting for variable payments should be consistent with that for the combined component. That is, when the combined component is accounted for as a lease under ASC 842, there are no longer any nonlease (revenue) variable payments; rather, there are only variable payments related to the combined lease component, and that variability should be accounted for in accordance with ASC 842. Conversely, if the combined component is accounted for as a service under ASC 606, all variable payments related to the combined component should be accounted for in accordance with the guidance in ASC 606 on variable consideration. That is, an entity would be required to estimate the variable consideration and constrain such estimates in accordance with the guidance in ASC 606-10-32-11.

The flowchart below summarizes when a lessor may apply the practical expedient related to not separating lease and nonlease components in a contract as well as the required accounting for the combined component when the election is made.

See Sections 15.3.2.4 and 16.4.6 for further discussion of the disclosure and transition requirements, respectively, related to the lessor practical expedient.

Footnotes

In July 2018, the FASB issued ASU 2018-11, which includes a practical expedient that allows lessors, when certain conditions are met, not to separate lease and nonlease components. Lessors availing themselves of this practical expedient would not account for affected nonlease components separately. See Sections 4.3.3.2 and 17.3.1.4.2 for further discussion.

See footnote 6.

As discussed in Section 4.3.3.1, lessees can elect a practical expedient by asset class to combine lease and nonlease components into a single component. A similar practical expedient is available to lessors by asset class as long as certain criteria are met (see Section 4.3.3.2). When this practical expedient is elected, any consideration that would otherwise be allocated to the nonlease components, such as payments for noncomponents described in this section, will instead be accounted for as part of the related lease component or the predominant revenue component for lessors. In other words, if the practical expedient is elected, no allocation between lease and nonlease components is necessary.

While this discussion focuses on lessees, in December 2018, the FASB issued ASU 2018-20, which makes narrow-scope improvements to the accounting for lessors. Under the ASU’s amendments, lessors are allowed to elect, as an accounting policy, to analogize to the guidance in ASC 606 on presenting sales taxes collected from lessees on a net basis. See Section 4.4.2.1.2 for more information about the ASU.

Note that sales tax imposed on the basis of a lessee’s usage of a leased asset would also be deemed a variable lease payment that does not depend on an index or rate.

The guidance in Section 4.3.2.3.1 is only applicable if sales tax is determined to be an obligation of the lessor.

Importantly, not all over-time performance obligations will qualify for the practical expedient. Lessors should consider the measure of progress used to recognize revenue related to the nonlease component when assessing the condition in ASC 842-10-15-42A(a).

Upon adoption of ASU 2021-05, an entity should apply the guidance in ASC 842-10-25-2 through 25-3A to evaluate the lease classification.

ASC 842-10-25-5 states that “an entity shall consider the remaining economic life of the predominant asset in the lease component” to determine the classification when multiple underlying assets comprise a single lease component.

ASC 606-10-55-65A allows entities to use the sales-based and usage-based royalty exception to estimating variable consideration when “a license of intellectual property is the predominant item to which the royalty relates (for example, the license of intellectual property may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).”

Although an entity must apply the practical expedient to all eligible nonlease components, the presence of a nonlease component (or components) that is ineligible for the practical expedient does not preclude a lessor from applying the practical expedient to the eligible components.

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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.