4.4 Determining and Allocating Consideration in the Contract

At this point, entities have identified their separate lease and nonlease components to which consideration in the contract will be allocated. Noncomponents have also been identified to ensure that the consideration in the contract is not allocated to them.

Next, entities must:

Determine the consideration in the contract.
Allocate the consideration in the contract to the separate lease and nonlease components.

The remainder of this section will discuss the requirements related to measuring and allocating the consideration in the contract for lessees (Section 4.4.1) and lessors (Section 4.4.2). The following matrix summarizes those requirements.

	Lessee	Lessor
Determining the consideration in the contract	Includes: Lease payments (see Chapter 6). Any other fixed payments. Any other variable payments based on index or rate.	Includes: Lessee consideration in the contract (i.e., everything in the column at left). Estimate of variable consideration (determined under ASC 606) when it is related only to the nonlease component(s).
Allocating the consideration in the contract to lease and nonlease components	When practical expedient is elected, no allocation is performed (see Section 4.3.3.1).	When practical expedient is elected for eligible nonlease components, no allocation is performed (see Section 4.3.3.2).
	When practical expedient is not elected, allocate on the basis of: Observable stand-alone price, if readily available. Otherwise, estimated stand-alone price (maximizing use of observable inputs).	When practical expedient is not elected, allocate on the basis of stand-alone selling price in accordance with ASC 606 (see Chapter 7 of Deloitte’s Roadmap Revenue Recognition).

Connecting the Dots

Allocating Zero to a Component

In limited circumstances, it may be appropriate for a lessee or lessor to allocate none of the consideration in the contract to a component in a contract (i.e., on the basis of a stand-alone price of zero). As discussed in the Connecting the Dots in Section 4.3.1, nonlease components do not need to be “distinct” (i.e., in accordance with ASC 606) to be separated from the lease component. The first criterion in ASC 606 that a promised good or service must meet to be distinct is that it must be capable of being distinct — that is, it must have stand-alone value (see Chapter 5 of Deloitte’s Roadmap Revenue Recognition). Therefore, because a nonlease component is separated from a lease component if it transfers a good or service to the lessee (as opposed to a good or service that is distinct and thus must have stand-alone value), it could be reasonable to conclude that the lease component or nonlease component does not have value on its own and thus has a stand-alone price of zero. However, we think that these situations will be rare and that any such conclusions will be met with skepticism. We encourage entities that identify such situations to consult with their accounting advisers.

4.4.1 Lessee

ASC 842 contains all of the guidance for lessees on determining and allocating the consideration in the contract. That is, unlike the requirements for lessors, the guidance for lessees does not refer to ASC 606 or any other GAAP. Paragraph BC156 of ASU 2016-02 addresses the FASB’s reasoning behind its construction of the guidance with respect to allocation:

The allocation guidance for lessees in Topic 842 does not reference other Topics; the Board decided that it will be less complex and more intuitive for lessees to include the allocation guidance within the leases Topic. The Board also decided that having lessees apply the revenue recognition guidance in Topic 606 (as is the case for lessors) does not make conceptual sense because a lessee is the customer in a lease rather than the supplier.

The sections below further lay out the guidance for lessees on determining and allocating the consideration in the contract.

Connecting the Dots

Timing of Measurement and Allocation of the Consideration in the Contract

ASC 842 does not provide guidance for lessees on the timing of measurement of the consideration in the contract when a nonlease component begins before the commencement date of the lease.

For example, assume that a lessee enters into a contract commencing on December 1, 20X0, in which the lessor provides (1) the right to use a warehouse and land and (2) landscaping services to the property. The lease also contains a renewal option. The landscaping services are set to begin one month before the lease commencement date. Accordingly, the lessee should begin recognizing expense associated with the nonlease component for the landscaping services on November 1, 20X0.

However, under ASC 842, it is not clear what amount the lessee in this case should recognize as expense for the landscaping services. This is because payments under the contract begin on lease commencement, the lease component(s) is (are) not measured until the commencement date of the lease, and the determination of whether the lessee is reasonably certain to exercise the renewal option would not take place until the commencement date of the lease.

Generally, we think that the lessee in this case should make a preliminary estimate and allocation of the consideration in the contract at the time at which the entity should begin to recognize expense for the nonlease component (i.e., on November 1, 20X0). Accordingly, at that time, the lessee should also assess, on a preliminary basis, the likelihood of exercising the renewal option.

On the commencement date of the lease, the lessee’s initial estimate and allocation of the consideration in the contract as of November 1, 20X0, should be trued up to the actual measurement and allocation of the consideration in the contract as of December 1, 20X0.

4.4.1.1 Determining the Consideration in the Contract

ASC 842-10

15-35 The consideration in the contract for a lessee includes all of the payments described in paragraph 842-10-30-5, as well as all of the following payments that will be made during the lease term:

Any fixed payments (for example, monthly service charges) or in substance fixed payments, less any incentives paid or payable to the lessee, other than those included in paragraph 842-10-30-5
Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.

The consideration in the contract measured by a lessee will largely comprise the lease payments determined in accordance with ASC 842-10-30-5. (The determination of lease payments is discussed in detail in Chapter 6.) These are the payments made by the lessee for the right to use the underlying asset (i.e., for the lease component).

However, to reflect all fixed payments and ensure an appropriate allocation between the lease and nonlease components, a lessee must also do the following in measuring the consideration in the contract:

Add any fixed or in-substance fixed payments made during the lease term that are related to a nonlease component (in-substance fixed payments should be considered the same as when the lease payments are determined in accordance with ASC 842-10-30-5 — see Section 6.2.1).
Add any variable payments related to a nonlease component that are based on an index or rate by using the index or rate as of lease commencement.
Subtract any incentives paid or payable to the lessee that are related to a nonlease component (i.e., other than incentives reflected in the lease payments, in accordance with ASC 842-10-30-5).

The lessee does not include variable payments that are not based on an index or rate (i.e., that are based on performance or usage), regardless of whether they are related to the lease or nonlease component, in the measurement of the consideration in the contract. Paragraph BC162 of ASU 2016-02 explains that such variable payments are excluded from the consideration in the contract for the following reasons:

Doing so “aligns the accounting for variable payments for nonlease components with the Board’s decision on the accounting for variable lease payments.”
“[I]t would be costly and complex to require lessees to estimate variable payments for nonlease components included in a contract that contains a lease,” especially when customers “generally are not required to estimate variable payments for similar nonlease components that do not include a lease.”

The graphic below summarizes the guidance in ASC 842-10-15-35.

The example below illustrates how a lessee would apply the guidance in ASC 842-10-15-35. (Note that the lessor’s determination of the consideration in the contract for the example below is illustrated in Example 4-18.)

Example 4-13

Case A

Lessee and Lessor enter into a five-year vehicle lease of an open-wheel race car in which Lessor will also perform maintenance and repair services on the race car. Accordingly, Lessee concludes that there are two components in the contract:

A lease component for the right to use the underlying asset.
A nonlease component for the maintenance and repair services.

Lessee will pay a fixed monthly payment of $2,000 over the five-year lease. Lessee will pay an additional $500 for each month in which the vehicle is driven the minimum mileage.

Lessee determines that the consideration in the contract is $120,000 (i.e., $2,000 per month × 12 months per year × 5 years). The additional $500 monthly fee is variable: it does not depend on an index or rate and is based on usage or performance. Therefore, this fee is excluded from the consideration in the contract.

Lessee will allocate the $120,000 to the components in the contract.

Case B

Assume the same facts as in Case A, except that the additional fee is the greater of (1) $500 for each month in which the vehicle is driven the minimum mileage or (2) $15,000 total. Also, once Lessee has driven the minimum mileage for nine months within a single calendar year, Lessor agrees to pay Lessee $100 for each additional month of the year in which Lessee drives the minimum mileage (i.e., for a maximum possible incentive of $300 each year).

Lessee determines that the consideration in the contract is $135,000 (i.e., $120,000, determined in the same manner as in Case A, plus an in-substance fixed payment of $15,000). The incentive is variable: it does not depend on an index or rate and is based on usage or performance. Therefore, the incentive is excluded from the measurement of the consideration in the contract.

Lessee will allocate the $135,000 to the components in the contract.

Common arrangements for which lessees will need to determine (and allocate) the consideration in the contract include gross and triple net leases of real estate. In a typical gross lease, the lessee pays a single fixed payment that covers rent, property taxes, insurance, and CAM. Alternatively, in a typical triple net lease, the lessee pays a single fixed payment for rent but reimburses (or pays directly to a third party on behalf of) the lessor for the lessee’s share of property taxes, insurance, and CAM. That is, in a triple net lease, payments for property taxes, insurance, and CAM are generally variable.

The example below illustrates how a lessee would determine the consideration in the contract in both a gross and a triple net lease of real estate. (Note that the allocation of the consideration in the contract determined in the example below is illustrated in Example 4-15.)

Example 4-14

Case A — Gross Lease of Real Estate

Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:

Lease term: 5 years.
Fixed annual lease payment: $85,000.
Property taxes and insurance on Lessor’s interest in the building: included in the fixed annual lease payment.
CAM: included in the fixed annual lease payment.

Lessee determines that the contract contains the following components:

A lease component for the right to use the building.
A nonlease component for the CAM.

In addition, Lessee determines that the consideration in the contract is $425,000 ($85,000 annual lease payment × 5 years).

Case B — Triple Net Lease of Real Estate

Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:

Lease term: 5 years.
Fixed annual lease payment: $60,000.
Property taxes and insurance on Lessor’s interest in the building: reimbursed costs, estimated to be $5,000 annually.
CAM: estimated to be $20,000 annually.

Lessee agrees to reimburse Lessor for actual property taxes, insurance, and CAM and determines that the contract contains the following components:

A lease component for the right to use the building.
A nonlease component for the CAM.

In addition, Lessee determines that the consideration in the contract is $300,000 ($60,000 annual lease payment × 5 years).

Note that in both Case A and Case B in the example above and in a manner consistent with the guidance in Sections 4.3.2.1 and 4.3.2.2, the property taxes and the insurance that protects the lessor’s interest in the asset will be (1) noncomponents, (2) part of the consideration in the contract, and (3) allocated to the components in the contract.

4.4.1.2 Allocating the Consideration in the Contract

ASC 842-10

15-33 A lessee shall allocate (that is, unless the lessee makes the accounting policy election described in paragraph 842-10-15-37) the consideration in the contract to the separate lease components determined in accordance with paragraphs 842-10-15-28 through 15-31 and the nonlease components as follows:

The lessee shall determine the relative standalone price of the separate lease components and the nonlease components on the basis of their observable standalone prices. If observable standalone prices are not readily available, the lessee shall estimate the standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain.
The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the nonlease components of the contract.

Initial direct costs should be allocated to the separate lease components on the same basis as the lease payments.

15-34 A price is observable if it is the price that either the lessor or similar suppliers sell similar lease or nonlease components on a standalone basis.

ASC 842-10-15-33 requires lessees to allocate the consideration in the contract to the lease and nonlease components (and initial direct costs to the separate lease components) on the basis of the relative stand-alone price. The notion of the relative stand-alone price in ASC 842-10-15-33 thus creates a hierarchy for determining the basis of allocation:

If observable stand-alone prices are readily available for the lease and nonlease components, they must be used.
If observable stand-alone prices are not readily available for some or all of the lease and nonlease components, such prices may be estimated. However, estimates of the stand-alone prices must maximize the use of observable inputs.
If observable stand-alone prices are not readily available for some of the lease and nonlease components, those prices are highly variable or highly uncertain, and some lease and nonlease components have observable stand-alone prices, a residual estimation approach may be used. However, a residual estimation method should still maximize the use of observable inputs.

In addition, if the lessee uses an estimation method to establish the stand-alone price of a lease or nonlease component, it should use that approach consistently in similar circumstances (e.g., in all similar cases in which the lessee is determining the stand-alone price of CAM in a certain market).

Connecting the Dots

Lessee Allocation Guidance Is Similar to Step 4 of the Revenue Recognition Model

In developing the hierarchy in ASC 842-10-15-33(a) for determining the relative stand-alone price, the FASB created an allocation method for lessees that is broadly consistent with the concepts entities use to allocate the transaction price to performance obligations under ASC 606. The Board acknowledges this in paragraph BC156 of ASU 2016-02, which states, in part:

[T]he allocation guidance for lessees is similar to that for lessors and also is broadly consistent with that in previous GAAP, although some additional rigor has been added to the process for determining the standalone price of a lease or nonlease component. That is, the Board decided that in determining the standalone price of lease and nonlease components of the contract, a lessee is required to use observable standalone prices, if available, before using an estimated standalone price. [Emphasis added]

ASC 842-10-20 defines the stand-alone price as the “price at which a customer would purchase a component of a contract separately.” ASC 842-10-15-34 clarifies that a stand-alone price is observable if the lessor or similar suppliers would charge this price to sell the lease or nonlease component separately.

Connecting the Dots

Considerations Related to Estimating the Stand-Alone Price of the Lease Component and Inputs to Be Used

A lessee that cannot find an observable stand-alone price for a lease component will need to use judgment in estimating this price. Management should consider similar leased assets available in the marketplace and refer to the terms of similar lease contracts as well as the purchase price of comparable assets. Comparable assets do not need to be identical to the underlying asset in the lease component, provided that the lease component is not of a specialized nature. Products or services available from comparable suppliers with similar inputs into the lease contract, such as price, payment structure, lease term, renewal options, and purchase options, can be useful data points.

If no observable information is available for a leased asset (e.g., when an asset is unique to a supplier), a lessee may want to obtain information from the supplier on how prices are established in such arrangements.

The examples below illustrate the guidance in ASC 842-10-15-33 and 15-34 on the lessee’s allocation of the consideration in the contract.18 Note that, in these examples, it is assumed that the lessee has not elected the practical expedient in ASC 842-10-15-37 (see Section 4.3.3.1).

Example 4-15

Case A — Gross Lease of Real Estate

The facts below are consistent with Example 4-14, Case A.

Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:

Lease term: 5 years.
Fixed annual lease payment: $85,000.
Property taxes and insurance: included in the fixed annual lease payment.
CAM: included in the fixed annual lease payment.

Lessee determines that the contract contains the following components and consideration:

A lease component for the right to use the building.
A nonlease component for the CAM.
Consideration in the contract of $425,000 ($85,000 annual lease payment × 5 years).

The facts below are unique to Case A in this example.

Lessee determines that the stand-alone prices of the lease and nonlease components are as follows:

Lease component, in which the lessee includes an estimate of property taxes and insurance: $325,000 ($65,000 annual payment × 5 years).
Nonlease component: $100,000 ($20,000 annual payment × 5 years).

The lessee allocates the consideration in the contract ($425,000) to the lease and nonlease components as follows:

Case B — Triple Net Lease of Real Estate

The facts below are consistent with Example 4-14, Case B.

Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:

Lease term: 5 years.
Fixed annual lease payment: $60,000.
Property taxes and insurance: estimated to be $5,000 annually.
CAM: estimated to be $20,000 annually.

Lessee contractually agrees to reimburse Lessor for Lessee’s share of actual property taxes, insurance, and CAM.

Lessee determines that the contract contains the following components and consideration:

A lease component for the right to use the building.
A nonlease component for the CAM.
Consideration in the contract of $300,000 ($60,000 annual lease payment × 5 years).

The facts below are unique to Case B in this example.

Lessee determines that the stand-alone prices of the lease and nonlease components are as follows:

Lease component, in which the lessee includes an estimate of property taxes and insurance: $325,000 ($65,000 annual payment × 5 years).
Nonlease component: $100,000 ($20,000 annual payment × 5 years).

The lessee allocates the consideration in the contract ($300,000) to the lease and nonlease components as follows:

While the CAM is estimated to be $20,000 annually, payments for CAM are variable and are therefore not included in the consideration in the contract. The same can be said for the estimated property taxes and insurance of $5,000 annually.

A portion of the fixed consideration in the lease is allocated up front to the nonlease component on the basis of the stand-alone price of the CAM. Thereafter, as variable payments for CAM, property taxes, and insurance are incurred, they will be allocated to the lease and nonlease components on the same basis as the fixed consideration (i.e., 76.47 percent to the lease component as variable lease payments and 23.53 percent to the nonlease component as variable payments for CAM) when they are recognized in the income statement (see Chapter 8 for discussion of a lessee’s recognition of variable lease payments). If the lessee’s estimates of the stand-alone prices for the lease and nonlease components turn out to be accurate, then by the end of the lease, a total of $325,000 will be allocated to the lease component and a total of $100,000 will be allocated to the nonlease component. However, unlike ASC 606’s variable consideration allocation guidance in ASC 606-10-32-39 through 32-41 (which the lessor may consider — see Section 4.4.2.2), ASC 842 does not establish a basis for the lessee to allocate variable consideration entirely to one or more, but not all, components in a contract.

Note that in the example above, the lessee’s estimates of the stand-alone price are consistent with the pricing in the contract, most evidently in Case A. This indicates that the contracts in the example above are effectively priced at fair value, with no discount on either the lease or nonlease component. The example below illustrates a different scenario.

Example 4-16

Lessee enters into a five-year lease (a gross lease) of a building from Lessor under which Lessee must make a fixed annual lease payment of $35,000 (payments total $175,000 over the five-year term). In accordance with the terms of the contract, the $35,000 annual payment comprises $20,000 for building rent, $7,000 for CAM, $5,000 for property taxes, and $3,000 for insurance that protects Lessor’s interest in the building. From Lessee’s perspective, the estimated stand-alone price of the right to use the building (including an estimate for taxes and insurance) is $30,000 per year, and the estimated stand-alone price of the CAM is $8,000 per year.

In evaluating the separate components in the contract, Lessee would need to determine what goods and services are being provided in the contract, which may include both lease and nonlease components. In this contract, the primary good or service is the right to use the building and is considered a lease component. In addition, the contract requires Lessor to provide CAM, which represents a nonlease component.

As part of the $35,000 fixed annual lease payment, Lessee also pays Lessor consideration attributable to property taxes and insurance. However, in accordance with ASC 842-10-15-30, those payments would not be considered separate components (either lease components or nonlease components), since each fee is a reimbursement of Lessor’s costs. Therefore, despite requiring the payment of four separately described fees in the contract, the arrangement includes only two components. The total fees of $35,000 must be allocated between the two identified goods and services representing the lease component and the nonlease component.

As a result, Lessee allocates the consideration in the contract ($175,000) as follows:

On the basis of Lessee’s estimate of the stand-alone prices for the lease and nonlease components, the contract contains a discount of $15,000 ($190,000 total stand-alone price – $175,000 total consideration). The lessee allocation method in ASC 842-10-15-33 therefore results in the allocation of that discount between both the lease component, the building (i.e., $15,000 × 78.95% = $11,842), and the nonlease component, the CAM (i.e., $15,000 × 21.05% = $3,158). Unlike ASC 606’s discount allocation guidance in ASC 606-10-32-36 through 32-38 (which the lessor would consider when allocating a discount — see Section 4.4.2.2), ASC 842 does not establish a basis for the lessee to allocate a discount in a contract entirely to one or more, but not all, components in a contract.

4.4.1.3 Remeasure and Reallocate the Consideration in the Contract

ASC 842-10

15-36 A lessee shall remeasure and reallocate the consideration in the contract upon either of the following:

A remeasurement of the lease liability (for example, a remeasurement resulting from a change in the lease term or a change in the assessment of whether a lessee is or is not reasonably certain to exercise an option to purchase the underlying asset) (see paragraph 842-20-35-4)
The effective date of a contract modification that is not accounted for as a separate contract (see paragraph 842-10-25-8).

Certain events trigger the need for a lessee to remeasure and reallocate the consideration in a contract to the various lease and nonlease components:

Remeasurement of the lease liability — The lease liability must be remeasured when the lease payments change. This could be due to changes in (1) the lease term, (2) information about whether a lessee will exercise a purchase option, (3) amounts that it is probable the lessee will owe under a residual value guarantee, or (4) the resolution of a contingency in such a way that some (or all) of the variable lease payments that will be paid over the remainder of the lease term become fixed. Remeasurement of lease payments is discussed in detail in Section 6.10, while the lessee’s accounting for a remeasurement of its lease liability is addressed in Section 8.5.
Lease modifications not accounted for as a separate contract — For lease modifications that do not meet the criteria to be accounted for as a separate contract, the remaining consideration in the contract must be remeasured and reallocated upon the effective date of the modification. A modification that is not accounted for as a separate contract may (1) grant the lessee an additional right of use, (2) extend the term of the lease, (2) reduce the term of the lease, (3) fully or partially terminate the lease, or (4) change the consideration in the contract. A lessee’s accounting for lease modifications is discussed in detail in Section 8.6.

4.4.2 Lessor

The requirements under which a lessor determines and allocates the consideration in the contract are housed partially in ASC 842 and partially in ASC 606:

Determining the consideration in the contract — A lessor measures the consideration in the contract in the same manner as a lessee (i.e., in accordance with ASC 842-10-15-35 — see Section 4.4.1.1). A lessor must also measure certain variable consideration in accordance with the guidance in step 3 of the revenue recognition model in ASC 606. (See the next section.)
Allocating the consideration in the contract — A lessor allocates the consideration in the contract in accordance with the guidance in step 4 of the revenue recognition model in ASC 606. (See Section 4.4.2.2.)

The next sections further elaborate on these requirements.

4.4.2.1 Determining the Consideration in the Contract

ASC 842-10

15-39 The consideration in the contract for a lessor includes all of the amounts described in paragraph 842-10-15-35 and any other variable payment amounts that would be included in the transaction price in accordance with the guidance on variable consideration in Topic 606 on revenue from contracts with customers that specifically relates to either of the following:

The lessor’s efforts to transfer one or more goods or services that are not leases
An outcome from transferring one or more goods or services that are not leases. . . .

15-39A A lessor may make an accounting policy election to exclude from the consideration in the contract and from variable payments not included in the consideration in the contract all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific lease revenue-producing transaction and collected by the lessor from a lessee (for example, sales, use, value added, and some excise taxes). Taxes assessed on a lessor’s total gross receipts or on the lessor as owner of the underlying asset shall be excluded from the scope of this election. A lessor that makes this election shall exclude from the consideration in the contract and from variable payments not included in the consideration in the contract all taxes within the scope of the election and shall comply with the disclosure requirements in paragraph 842-30-50-14.

Initially, a lessor’s measurement of consideration in the contract is the same as a lessee’s. (See Section 4.4.1.1.) However, a lessor must perform a few additional steps related to variable consideration in the contract. A lessee only includes consideration in the contract if it is fixed (or in-substance fixed) or if there are variable payments that depend on an index or a rate. For a lessor, ASC 842-10-15-39 provides additional criteria for variable payments that must be included in the consideration in the contract. That is, a lessor will measure variable consideration in accordance with step 3 of the revenue recognition model in ASC 606, and include it in the consideration in the contract, if the variable payment is specifically related to either or both of the following:

The lessor’s efforts to transfer goods or services (i.e., nonlease components) other than the right to use the underlying asset (i.e., the lease component).
An outcome of the lessor’s performance in transferring goods or services (i.e., nonlease components) other than the right to use the underlying asset (i.e., the lease component).

If variable payments are fully, or even partially, related to the lease component, the lessor does not include such payments in the consideration in the contract. The following flowchart summarizes the variable consideration requirements in ASC 842-10-15-39:

As a result of this guidance, lessors will often measure more variable consideration as part of the consideration in the contract than lessees will. In addition, lessors will need to familiarize themselves with and use the guidance in ASC 606 on determining the transaction price. Section 6.3 of Deloitte’s Roadmap Revenue Recognition discusses the relevant guidance in ASC 606 in detail, and we encourage lessors to consider this guidance when determining their consideration in a contract that contains variable payments related to the nonlease component(s).

Connecting the Dots

Split Model for Variable Consideration

The flowchart above effectively depicts a split model for a lessor’s measurement of variable consideration. That is, if the variable consideration is entirely related to a nonlease item, it should be measured in a manner consistent with ASC 606. Otherwise, the variable consideration is in some way related to the lease component and therefore should be treated in a manner consistent with the guidance on variable lease payments in ASC 842.

The FASB further explains this split model in paragraph BC163 of ASU 2016-02:

The Board decided that providing guidance on consideration in the contract was necessary to ensure consistent application of the allocation guidance in Topic 842, particularly for lessors because of the differences between how the Board decided a lessor should account for variable lease payments and how an entity accounts for variable consideration in Topic 606. The Board concluded that accounting for a variable payment that relates partially to a lease component (for example, a performance bonus that relates to the leased asset and the lessor’s operation of that asset) in the same manner as a variable lease payment (that is, with respect to recognition and measurement) will be less costly and complex than accounting for that variable payment in accordance with the variable consideration guidance in Topic 606. In addition, the Board decided that a lessor should not account for a single variable payment in accordance with two accounting models (for example, partially as a variable lease payment and partially as variable consideration in the scope of Topic 606). [Emphasis added]

Ultimately, the split model for measuring variable consideration resulted from a desire to provide relief from the potential cost and complexity of applying the ASC 606 guidance on determining the transaction price (i.e., on estimating variable consideration) to variable payments that are related, even partially, to the lease component. However, we think that a split model introduces certain complexities of its own — namely, such a model could require lessors to use judgment in assessing whether a variable payment is related to a nonlease (i.e., revenue) or lease component in a contract.

The decision tree below summarizes the full requirements in ASC 842-10-15-39 with respect to a lessor’s determination of the consideration in the contract.

Connecting the Dots

Determining the Factors Governing Variable Payment Terms May Help Entities Determine the Lease or Nonlease Component to Which the Payments Are Related

Lessors should analyze variable payment terms in a contract to determine the lease or nonlease components to which those payments are related. Whether a variable payment is related to a lease or nonlease component will govern whether that payment is included in the lessor’s measurement of the consideration in the contract.

Determining the factors governing the variability in a payment will be helpful in the assessment of whether the payment is fully or partially related to a lease component. Payments in an arrangement that contains a lease may vary as a result of many different factors, including, but not limited to:

Usage of the underlying asset (e.g., machine hours, number of units produced).
Performance measures (e.g., revenues earned, profit margin achieved, costs incurred).
Occurrence or nonoccurrence of certain events (e.g., inclement weather).
Market conditions (e.g., market index price of electricity).

In addition, a factor governing variability can be within the control of:

The lessee (e.g., miles that an automobile is driven).
The lessor (e.g., costs incurred for delivering maintenance services).
Neither party (e.g., weather).

Once an entity determines the factors governing variability, they can be tagged to the lease or nonlease component. For example, if payments vary on the basis of the number of miles that the lessee drives a leased automobile, that factor (i.e., miles driven) is related to the lease component (i.e., the right to use the automobile). On the other hand, if payments vary on the basis of the costs the lessor incurs in delivering CAM to the lessee, that factor (i.e., costs incurred) is related to the nonlease component (i.e., CAM).

An entity will sometimes need to use judgment in performing this assessment, since it is not always clear whether the factor governing variability is related to a nonlease or lease component. In some cases, the variability may be related to both.

Example 14, Cases A and B, in ASC 842-10-55-150 through 55-156 (reproduced in Section 4.4.3), illustrates the guidance in ASC 842-10-15-39 on the lessor’s measurement of variable consideration in the contract. The examples below also illustrate the guidance in ASC 842-10-15-39.

Example 4-17

Customer X, which manufactures and sells complex battery systems to electric car manufacturers, enters into a contract with Lessor Y to lease a piece of machinery for use in creating the specialized batteries. According to the terms of the contract, Y will provide (1) the machinery at a fixed rate of $220,000 per year for a noncancelable period of five years and (2) marketing services over that same period to make electric car manufacturers more aware of X’s product. In consideration for the marketing services, X will pay an additional fixed fee of $30,000 per year.

Lessor Y determines that there are two components in the contract:

A lease component for the right to use the piece of machinery.
A nonlease component for the marketing services.

Lessor Y identifies fixed consideration in the contract of $250,000 per year ($220,000 for use of machinery + $30,000 for marketing services), or $1.25 million in total over the five-year contract term.

Lessor Y includes the $1.25 million of fixed consideration in its measurement of the consideration in the contract in accordance with ASC 842-10-15-35 and ASC 842-10-15-39.

Case A — Variable Consideration Is Partially Related to the Lease Component

Assume that the contract also stipulates that X will pay Y a commission of 2 percent of sales per year for each year for which sales have increased by 10 percent or more over the prior year. Therefore, Y also identifies variable consideration in the form of the 2 percent revenue-sharing commission. Lessor Y determines whether the consideration in the contract includes the variable consideration as follows:

Case B — Variable Consideration Is Related Specifically to the Nonlease Component

Assume instead that the contract also stipulates that X will pay Y a fee of $25 for every customer (or potential customer) of X that clicks on Internet advertisements that Y places on behalf of X as part of providing the marketing services in the contract. Therefore, Y also identifies variable consideration in the form of the $25 fee per click. Lessor Y determines whether the consideration in the contract includes the variable consideration as follows:

Example 4-18

This example represents a continuation of Example 4-13. Lessee and Lessor enter into a five-year vehicle lease of an open-wheel race car in which Lessor will also perform maintenance and repair services on the race car. Assume the following facts:

Lessee will pay a fixed monthly amount of $2,000.
Lessee will also make a variable payment in accordance with Cases A and B below.
There are two components in the contract:
- A lease component for the right to use the underlying asset.
- A nonlease component for the maintenance and repair services.

Case A

In Case A, Lessee will pay $500 for each month in which the vehicle is driven the minimum mileage (i.e., variable consideration).

Lessor concludes that the variable consideration should not be included in the consideration in the contract. That is because the variable payment each month is not solely related to performance of the nonlease maintenance and repair services; Lessee’s use of the race car (i.e., the lease component) substantively governs whether, and to what extent, Lessor will receive the additional fees. Therefore, Lessor’s initial measurement of the consideration in the contract is $120,000 (i.e., $2,000 per month in fixed consideration × 12 months per year × 5 years), which is the same as Lessee’s.

Case B

In Case B, the additional fee is the greater of (1) $500 for each month in which the vehicle is driven the minimum mileage or (2) $15,000 total. Lessor agrees that once Lessee has driven the minimum mileage for 9 months within a single calendar year, it will pay Lessee $100 for each additional month of the year in which the minimum mileage is driven (i.e., for a maximum possible incentive of $300 each year).

Lessor’s initial measurement of the consideration in the contract must include, at a minimum, $135,000 (i.e., $120,000 in fixed consideration, plus an in-substance fixed payment of $15,000). However, Lessor must also consider whether (1) any amounts above the in-substance fixed amount of $15,000 (i.e., a minimum) are entirely related to the nonlease component and (2) the incentive is entirely related to the nonlease component.

As in Case A, the variable payment each month is not solely related to performance of the nonlease maintenance and repair services; Lessee’s use of the race car (i.e., the lease component) substantively governs whether and to what extent Lessor will receive the additional fees (or be required to pay the incentive). Therefore, Lessor concludes that the variable consideration should not be included in the consideration in the contract. Lessor’s consideration in the contract is the same as Lessee’s — $135,000.

In Cases A and B, Lessor determines that its initial measurement of the consideration in the contract is the same as Lessee’s.

4.4.2.1.1 Variable Amounts for CAM

As discussed in Section 4.3.1, leases for office or commercial space often contain provisions that require the tenant to reimburse the landlord for CAM costs. Such costs might include an allocated portion of landscaping, janitorial services, repairs, snow removal, and other maintenance of common areas. CAM charges can be based on the actual costs (with or without margin) incurred by the landlord. That is, payments for CAM are often variable.

Variable payments for CAM are entirely related to a nonlease component.

CAM charges — whether they are direct reimbursements of actual costs or represent an allocated portion of total CAM performed for a property — are related to the lessor’s efforts to transfer, or an outcome from transferring, maintenance and other services that are not leases. Because they are related to a nonlease component (i.e., CAM is a nonlease component, as discussed in Section 4.3.1), variable payments for CAM should be included in the lessor’s initial measurement of the consideration in the contract in accordance with the guidance in ASC 606 on determining the transaction price (i.e., they should be estimated by using the “expected value” or “most likely amount” method and potentially constrained).

However, lessors that provide CAM should carefully consider whether there are any other variable amounts that are not related entirely to a nonlease component and, if so, ensure that their estimates for CAM do not incorporate those amounts. As discussed in the Connecting the Dots at the end of Section 4.3.1, other amounts (e.g., utilities, property taxes, and insurance) periodically may be billed together with CAM. Lessors should ensure that, although those amounts may be characterized together in the contract or on an invoice, their estimate of variable CAM charges does not include variable amounts for property taxes or insurance. Both property taxes and insurance are noncomponents (as discussed in Section 4.3.2) and are not entirely related to a nonlease component.

4.4.2.1.2 Certain Lessor Costs Paid Directly by Lessees

ASC 842-10

15-40A The guidance in paragraph 842-10-15-40 notwithstanding, a lessor shall exclude from variable payments lessor costs paid by a lessee directly to a third party. However, costs excluded from the consideration in the contract that are paid by a lessor directly to a third party and are reimbursed by a lessee are considered lessor costs that shall be accounted for by the lessor as variable payments (this requirement does not preclude a lessor from making the accounting policy election in paragraph 842-10-15-39A).

ASC 842-10-15-30(b) states that an entity “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 [on behalf of the lessor] 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.” A common example of such a cost is an insurance premium under which, according to the lease contract, the lessee must carry insurance to cover the underlying asset and the insurance policy names the lessor as the primary beneficiary of that policy. Before the guidance in ASC 842-10-15-40A, the new leasing standard required a lessor to report these amounts as revenue and expenses even though the lessee may not be required to provide payment amount information to the lessor. Further, the payment amount may be affected by a number of lessee-specific factors (e.g., discounts due to other policies the lessee has with the issuer that are unrelated to the leased asset). Accordingly, the lessor would not be able to present the lessee’s payments and the associated cost on a gross basis without either obtaining more information from the lessee or estimating the premium.

However, with the amendment in ASC 842-10-15-40A, the FASB achieved both of the following:

Addressed stakeholders’ concerns about the challenges related to determining costs paid by the lessee directly to a third party on behalf of the lessor by requiring lessors to exclude such costs from variable payments and thus from revenue and expenses.19
Clarified that costs excluded from the consideration in a contract that are paid directly to a third party by the lessor and then reimbursed by the lessee must be accounted for as variable payments and therefore as revenue and expenses.

Connecting the Dots

Background on Lessor Costs as Addressed Under ASU 2018-20

In December 2018, the FASB issued ASU 2018-20, which addresses certain requests made by stakeholders regarding lessor implementation issues associated with ASU 2016-02, including an issue related to certain lessor costs paid directly by lessees to an unrelated third party (e.g., a governmental agency for property taxes or an insurance provider for insurance coverage). ASU 2016-02, as initially issued, required a lessor to report those amounts as revenue and expenses. ASU 2018-20 requires lessors to “exclude from variable payments lessor costs paid by a lessee directly to a third party.” Lessor costs are considered costs that are not a component in the contract. That is, lessor costs (e.g., property taxes and insurance) are neither lease components nor nonlease components.

Importantly, under ASU 2018-20, a lessor must exclude from variable payments all lessee payments made directly to a third party for lessor costs, even if the lessor knows the exact dollar amount of those payments. However, at the February 13, 2019, Board meeting, the FASB staff clarified that payments a lessee makes directly to third parties for other lease-related payments (i.e., other than for lessor costs) are not within the scope of this amendment. For example, lease payments made by a sublessee directly to a head lessor typically do not represent lessee payments for sublessor costs, since those payments are generally for a lease component rather than for lessor costs.

This amendment made by ASU 2018-20 did not necessitate any updated disclosure requirements. See Section 17.3.1.5 for a detailed discussion of ASU 2018-20, including the transition requirements.

4.4.2.1.3 Practical Expedient Related to Sales Taxes and Other Similar Taxes Collected From Lessees

ASC 842-10

Under ASU 2018-20, lessors can elect, as an accounting policy, to exclude from revenue and expenses sales taxes and other similar taxes assessed by a governmental authority and collected by the lessor from a lessee.20 This is an entity-wide accounting policy election.

This accounting policy election was requested by lessors and offered by the FASB in an effort to align the leasing guidance with ASC 606, as amended by ASU 2016-12, which allows entities to elect an accounting policy of presenting sales taxes collected from customers on a net basis. Specifically, ASC 606-10-32-2A states, in part:

An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customer (for example, sales, use, value added, and some excise taxes).

Although lessors are not within the scope of ASC 606, they are performing a revenue-generating activity in a manner similar to a service accounted for under ASC 606. Accordingly, the FASB provides a similar practical expedient under which lessors can present sales taxes collected from lessees on a net basis.

Connecting the Dots

Background on Sales Taxes Practical Expedient as Addressed Under ASU 2018-20

In December 2018, the FASB issued ASU 2018-20, which addresses certain requests made by stakeholders regarding implementation issues associated with ASU 2016-02, including an issue related to sales taxes and other similar taxes collected from lessees.

The EITF addressed a similar topic in Issue 06-3, which formed the basis of the guidance on the topic in ASC 606. Therefore, we believe that this guidance is important to understanding the basis for the scope of the accounting policy election under ASC 842-10-15-39A. Issue 06-3 indicates that its scope includes all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction between a seller and a customer. However, the scope does not include taxes assessed on an entity’s total gross receipts or imposed during the inventory procurement process. Similarly, taxes assessed on a lessor’s total gross receipts or on the lessor as owner of the underlying asset are outside the scope of the accounting policy election under ASC 842-10-15-39A. The Board clarified the reason for this exclusion in paragraph BC12 of ASU 2018-20, which states, in part, that such taxes “are levied on a lessor’s gross revenue and not a specific lease-producing revenue transaction, [so] the Board concluded that a lessor likely would not be acting as an agent for a lessee with respect to those taxes.”

Moreover, during the deliberation of ASU 2018-20, stakeholders requested that the scope of this election be expanded to include property taxes but the FASB did not grant this request. That is, property taxes should not be considered to be within the narrow scope of this election; rather, an entity should consider property taxes when applying the guidance in ASC 842-10-15-40A, as discussed in Section 4.4.2.1.1.

We expect that entities will often align their accounting policy elections under ASC 606-10-32-2A with those under ASC 842-10-15-39A; however, we note that such consistency is not required.

See Section 17.3.1.5 for a detailed discussion of ASU 2018-20, including the transition and disclosure requirements.

4.4.2.2 Allocating the Consideration in the Contract

ASC 842-10

15-38 A lessor shall allocate (unless the lessor makes the accounting policy election in accordance with paragraph 842-10-15-42A) the consideration in the contract to the separate lease components and the nonlease components using the requirements in paragraphs 606-10-32-28 through 32-41. A lessor also shall allocate (unless the lessor makes the accounting policy election in accordance with paragraph 842-10-15-42A) any capitalized costs (for example, initial direct costs or contract costs capitalized in accordance with Subtopic 340-40 on other assets and deferred costs — contracts with customers) to the separate lease components or nonlease components to which those costs relate.

15-39 . . . Any variable payment amounts accounted for as consideration in the contract shall be allocated entirely to the nonlease component(s) to which the variable payment specifically relates if doing so would be consistent with the transaction price allocation objective in paragraph 606-10-32-28.

15-40 If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall not recognize those payments before the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee’s sales on which the amount of the variable payment depends occur). When the changes in facts and circumstances on which the variable payment is based occur, the lessor shall allocate those payments to the lease and nonlease components of the contract. The allocation shall be on the same basis as the initial allocation of the consideration in the contract or the most recent modification not accounted for as a separate contract unless the variable payment meets the criteria in paragraph 606-10-32-40 to be allocated only to the lease component(s). Variable payment amounts allocated to the lease component(s) shall be recognized as income in profit or loss in accordance with this Topic, while variable payment amounts allocated to nonlease component(s) shall be recognized in accordance with other Topics (for example, Topic 606 on revenue from contracts with customers).

15-42 If the consideration in the contract changes, a lessor shall allocate those changes in accordance with the requirements in paragraphs 606-10-32-42 through 32-45.

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.

Lessors are required (unless the lessor makes the accounting policy election in ASC 842-10-15-42A — see Section 4.3.3.2) to allocate the consideration in the contract to separate lease and nonlease components in accordance with step 4 of the revenue recognition model in ASC 606-10-32-28 through 32-41. That is, they will generally allocate the consideration in the contract on the basis of the relative stand-alone selling price. Accordingly, when allocating the consideration in the contract, lessors should consider the guidance in Chapter 7 of Deloitte’s Roadmap Revenue Recognition.

The allocation guidance in ASC 606 can be summarized as follows:

The objective for lessors that are allocating the consideration in the contract to lease and nonlease components is the same as that for entities allocating the transaction price to distinct performance obligations in a contract with a customer. That is, in accordance with ASC 606-10-32-28, the objective is for a lessor to allocate the consideration in the contract to each separate lease and nonlease component “in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services” to the lessee.
Generally, to meet the allocation objective, lessors will allocate the consideration in the contract to each component proportionately on the basis of the relative stand-alone selling price. (See Section 7.2 of Deloitte’s Roadmap Revenue Recognition.)
The stand-alone selling price, in accordance with ASC 606-10-32-32, is “the price at which an entity would sell a promised good or service separately to a customer.” The best evidence of a stand-alone selling price for a good or service is the observable price of that good or service when the entity sells it separately to similar customers and in similar circumstances. (See Section 7.3.1 of Deloitte’s Roadmap Revenue Recognition.)
When the stand-alone selling price is not observable, it should be estimated in a manner that (1) results in an allocation of the consideration in the contract that meets the allocation objective discussed above and (2) maximizes the use of observable inputs. (See Section 7.3.2 of Deloitte’s Roadmap Revenue Recognition.) In accordance with ASC 606-10-32-34, the following are acceptable methods of estimating the stand-alone selling price: (1) an adjusted market assessment approach; (2) an expected-cost-plus-a-margin approach; and (3) a residual approach, but only when certain criteria are met.
Proportionate allocation does not affect how profit margins are allocated between the lease and nonlease components. Accordingly, margins for the lease and nonlease components may not be the same when the consideration in the contract is allocated on a relative stand-alone selling price basis. In fact, there may be situations in which the allocation objective is not met by allocating the consideration in the contract proportionately across all components in a contract — for example, when the consideration in the contract includes (1) a discount or (2) variable consideration.
- In accordance with ASC 606-10-32-37, a discount should be allocated entirely to one or more, but not all, components in a contract if certain criteria are met. (See Section 7.4 of Deloitte’s Roadmap Revenue Recognition.)
- In accordance with ASC 606-10-32-40, variable consideration should be allocated entirely to one or more, but not all, components in a contract if certain criteria are met. (See Section 7.5 of Deloitte’s Roadmap Revenue Recognition.) ASC 842-10-25-39 emphasizes this notion as well.
The stand-alone selling prices of the components in the contract are determined at inception. In accordance with ASC 606-10-32-43, “an entity shall not reallocate . . . to reflect changes in standalone selling prices after contract inception.” Accordingly, subsequent changes in the consideration in the contract that are not due to a modification (e.g., when a contingency upon which some or all of the variable payments are based is resolved in such a way that those payments become fixed over the remainder of the contract term) are allocated between the lease and nonlease components in the same proportion as the initial allocation. (See Section 7.6 of Deloitte’s Roadmap Revenue Recognition.)

The guidance in ASC 842-10-15-40 addresses payments that are not included in the lessor’s initial determination of the consideration in the contract — variable payments, other than those that depend on an index or rate, that are fully or partially related to the lease component. Because those payments are not measured at inception and are not allocated to the lease and nonlease components as part of the consideration in the contract, they should be allocated between the lease and nonlease components in the same proportion as the initial allocation when the changes in facts and circumstances on which the variable payment is based occur. For example, if the lessor’s initial allocation of the consideration in the contract results in the allocation of 80 percent to the lease component and 20 percent to the nonlease component, a variable payment that is partially related to the lease component should also be allocated in those same percentages in the period in which the changes in facts and circumstances on which the variable payment is based occur. The portion of the payment allocated to the lease component should be recognized in profit or loss at that time, and the portion allocated to the nonlease component should be recognized in profit or loss in accordance with ASC 606 (or other applicable GAAP). Example 14, Case A, in ASC 842-10-55-152 (reproduced in Section 4.4.3) further illustrates this guidance.

Connecting the Dots

Background on Recognition of Variable Payments for Contracts With Lease and Nonlease Components as Addressed Under ASU 2018-20

ASU 2016-02 initially required lessors to recognize variable payments “in profit or loss in the period when the changes in facts and circumstances on which the variable payment is based occur,” regardless of whether the variable payment is related to the lease or nonlease component in the contract.

Stakeholders observed that the guidance, as issued, may lead a lessor to recognize as revenue a variable payment related to a nonlease component before control of the nonlease component is transferred to the customer. That is, as issued, ASC 842-10-15-40, read literally, implied that as soon as an uncertainty that created variability in the consideration is resolved, that amount should be recognized as revenue regardless of whether the item to which it is related has been delivered to the customer/lessee.

To clarify the Board’s intent, ASU 2018-20 amended ASC 842 to require a lessor to allocate (rather than recognize) certain variable payments to the lease and nonlease components when the changes in facts and circumstances on which the variable payment is based occur. After the allocation, the amount of variable payments allocated to the lease component would be “recognized as income in profit or loss in accordance with this Topic [ASC 842], while variable payment amounts allocated to nonlease component(s) [would] be recognized in accordance with other Topics (for example, Topic 606 . . . ).”

This amendment made by ASU 2018-20 did not necessitate any updated disclosure requirements. See Section 17.3.1.5 for a detailed discussion of ASU 2018-20, including transition requirements.

4.4.2.2.1 Recognizing Variable Payments When a Portion Is Attributable to a Nonlease Component

ASC 842-10-15-40 includes the following guidance, which was amended by ASU 2018-20, on accounting for certain variable payments that are not included in the lessor’s initial determination of the consideration in the contract:

If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall not recognize [the lease and nonlease components related to] those payments before the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee’s sales on which the amount of the variable payment depends occur). When the changes in facts and circumstances on which the variable payment is based occur, the lessor shall allocate those payments to the lease and nonlease components of the contract. The allocation shall be on the same basis as the initial allocation of the consideration in the contract or the most recent modification not accounted for as a separate contract unless the variable payment meets the criteria in paragraph 606-10-32-40 to be allocated only to the lease component(s). Variable payment amounts allocated to the lease component(s) shall be recognized as income in profit or loss in accordance with this Topic, while variable payment amounts allocated to nonlease component(s) shall be recognized in accordance with other Topics (for example, Topic 606 on revenue from contracts with customers). [Emphasis added]

Under ASC 842-10-15-40, the pattern of revenue recognition for the portion of the variable payments attributable to the nonlease component(s) is consistent with how those amounts would be recognized as revenue in accordance with ASC 606.

Before the issuance of ASU 2018-20, ASC 842-10-15-40 implied, when read literally, that as soon as an uncertainty that created variability in the consideration is resolved, that amount should be recognized as revenue regardless of whether the item to which it is related has been delivered to the customer/lessee. Accordingly, the FASB amended the guidance by requiring a lessor to allocate (rather than recognize) certain variable payments to the lease and nonlease components when the changes in facts and circumstances on which the variable payment is based occur. After the allocation, the amount of variable payments allocated to the lease component would be “recognized as income in profit or loss in accordance with [ASC 842], while variable payment amounts allocated to nonlease component(s) [would] be recognized in accordance with other Topics (for example, Topic 606 . . . ).”

Example 4-19

Landlord enters into a five-year arrangement with Retailer to lease a retail space in a mall. Monthly payments are based on a variable structure, with a guaranteed minimum, as follows:

Four percent of monthly retail sales from January through June of each year.
Two percent of monthly retail sales from July through December of each year.
Minimum amount due each month is $20,000.

Each monthly payment is compensation for the right to use the retail space (including reimbursement of associated property taxes and insurance), CAM, and an annual report. Landlord will provide the report on December 31 of each year. The report will include various statistical metrics and analyses (e.g., customer foot traffic, customer buying habits, video tracking data).

Landlord identifies three components:

A lease component for the right to use the retail space.
A nonlease component for the CAM.
A nonlease component for the annual report that is a performance obligation distinct from the CAM services.

Landlord determines that, in accordance with ASC 606, the annual report (a nonlease component) is a performance obligation satisfied at a point in time and that control is transferred to Retailer upon delivery of the report on December 31. Accordingly, any variable payments received during the year and attributable to the annual report for the nonlease component should be deferred and recognized as revenue when the report is delivered and control is transferred at a point in time (i.e., at the end of each year). This conclusion is true regardless of whether the lessor has elected the practical expedient related to combining lease and nonlease components. This is because the nonlease component for the annual report would not meet the scope criteria for combination since its pattern of transfer (at a point in time) is not the same as the pattern of transfer of the lease component (over time provided that the lease component is an operating lease).

Connecting the Dots

Differences Between Lessee and Lessor Allocation

As discussed in the Connecting the Dots in Section 4.4.1.2, the method under which a lessee allocates the consideration in the contract on a relative stand-alone price basis is similar to the framework in ASC 606 for allocating the transaction price. Because lessors use ASC 606 to allocate the consideration in the contract, the method that lessees use is therefore similar to that for lessors.

However, there are two primary differences between the requirements for lessees and those for lessors:

Lessees always allocate the consideration in the contract proportionally to the lease and nonlease components on a relative stand-alone price basis. That is, there are no special considerations for allocating discounts or variable consideration. Lessors, on the other hand, would apply the specific requirements in ASC 606 to allocate discounts and variable consideration. For example, a lessor could allocate a discount entirely to the nonlease component, whereas the lessee would be required to spread that discount proportionately over all the components in the contract.
Lessors must determine the stand-alone selling price of each component in the contract to allocate the consideration in the contract. Accordingly, lessors must determine the price at which the entity (i.e., the lessor) would sell that promised good or service separately to a customer. On the other hand, the observable stand-alone price that the lessee must use for allocation purposes is the price at which either the lessor or similar suppliers sell similar lease or nonlease components on a stand-alone basis. That is, the lessee may take into account observable evidence of pricing by other suppliers (i.e., not just the lessor) in the market when determining the stand-alone price.

Lessors may incorporate observable data related to the pricing of goods or services by their competitors when using an adjusted market assessment approach to estimate the stand-alone selling price. However, the intent of that approach is to adjust such data to reflect the lessor’s costs and margins so that it may identify the price at which the entity would sell that good or service separately.

Allocation Between Revenue-Generating Activities Under ASC 842 Is Consistent With ASC 606

In ASC 606, the FASB developed a comprehensive framework for allocating consideration between performance obligations. Because leasing represents a revenue-generating activity for lessors, the Board found it appropriate for lessors to deploy that same framework in contracts that contain a lease.

The Board explains its rationale for this decision in paragraph BC153 of ASU 2016-02:

In the Board’s view, leasing transactions are fundamentally a revenue-generating activity (even if the principal revenue stream is interest income) in which the item that a lessor transfers to the customer is the right to use the underlying asset. Accordingly, it is appropriate for a lessor to allocate consideration to the lease and nonlease components as a seller allocates the transaction price (and changes in the transaction price) to performance obligations in a revenue contract and does not allocate consideration to activities or costs that do not transfer a good or service to the lessee.

4.4.2.2.2 Concurrently Delivered Lease and Nonlease Components

If a lease component’s pattern of transfer to the lessee is the same as that for a nonlease component, the separation of (and allocation of consideration in the contract to) the lease and nonlease components could be required depending on whether an entity elects the practical expedient that allows lessors, when certain conditions are met, not to separate lease and nonlease components. If an entity elects the practical expedient, separation of (and allocation of consideration in the contract to) the lease and nonlease components is not required. However, if a lessor does not elect the practical expedient, the guidance below should be considered (see Section 4.3.3.2). Paragraph BC153 of ASU 2016-02 states, in part:

In reaching its decisions on lessor allocation, the Board noted that the basis for conclusions in Update 2014-09 states that an entity is not precluded from accounting for concurrently delivered goods or services that have the same pattern of transfer to the customer as if they were a single performance obligation, even if they are distinct from each other, because the outcome would be the same as accounting for the goods and services separately. Therefore, it similarly would be reasonable for lessors to account for multiple components of a contract as a single component if the outcome from doing so would be the same as accounting for the components separately (for example, a lessor may be able to conclude that accounting for an operating lease and a related service element as a single component results in the same accounting as treating those two elements as separate components). The previous sentence notwithstanding, a lessor may need to separately consider presentation and disclosure in accordance with other Topics. [Emphasis added]

The last sentence in paragraph BC153 of ASU 2016-02 (emphasized in bold above) is the most important point — although the accounting (and revenue recognition) for a lease component may be the same as that for a nonlease component, the presentation and disclosure requirements for lease components differ from those for nonlease components (i.e., the requirements in ASC 842 and those in ASC 606, respectively). Therefore, separation of (and allocation of consideration in the contract to) the components in a contract is still required for presentation and disclosure purposes, even when the pattern of transfer to the lessee for a lease component is the same as that for a nonlease component. (See Chapters 14 and 15 for detailed discussion of the presentation and disclosure requirements, respectively, in ASC 842.)

However, paragraph BC153 of ASU 2016-02 also notes that the transfer of a right to use an underlying asset (i.e., a lease component) and a service (i.e., a nonlease component) are both revenue-generating activities. Accordingly, even when ASC 842 (and interactions between ASC 842 and ASC 606) requires separation and allocation for presentation and disclosure purposes, it may be reasonable to account for (and recognize revenue from) the lease component and nonlease component together if they have the same pattern of transfer (e.g., when both an operating lease and a nonlease service component are transferred evenly over the contract term).

Paragraph BC116 of ASU 2014-09 (and paragraph BC153 of ASU 2016-02) mentions this concept with respect to accounting for distinct goods or services that have the same pattern of transfer as if they were a single performance obligation; paragraph BC116 of ASU 2014-09 states, in part:

The Boards noted 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. [Emphasis added]

Connecting the Dots

Practical Expedient for Concurrently Delivered Lease and Nonlease Components

As discussed in Section 4.3.3.2, 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. One of those conditions is that the lease component’s pattern of transfer to the lessee is the same as that for the nonlease component (i.e., the lease and nonlease components are concurrently delivered). Lessors availing themselves of this practical expedient would not need to separate the lease and nonlease components, even for presentation and disclosure purposes (as discussed in Section 4.4.2.2.2). Rather, lessors would account for the lease component and its related nonlease component(s) as a single component.

If the practical expedient is elected, separation of (and allocation of consideration in the contract to) the components is not required when the patterns of transfer are the same. However, if the practical expedient is not elected, such separation and allocation are required in these circumstances.

See Sections 4.3.3.2 and 17.3.1.4.2 for detailed discussions of the practical expedient and its effects on the accounting by lessors.

The split model for measuring variable consideration (discussed in the Connecting the Dots in Section 4.4.2.1), as well as the requirements in ASC 606, increases the complexity of allocating variable consideration to the lease and nonlease components. The decision tree below illustrates how variable consideration, other than consideration that depends on an index or rate, is allocated in accordance with ASC 842-10-15-38 through 15-40.

Example 14, Cases A–C, in ASC 842-10-55-150 through 55-158 (reproduced in Section 4.4.3) illustrates the guidance in ASC 842-10-15-38 through 15-40 for lessors on allocating the consideration in the contract. The examples below also illustrate the guidance in ASC 842-10-15-38 through 15-40 (note that, in these examples, it is assumed that the lessor has not elected the practical expedient discussed in Section 4.3.3.2).

Example 4-20

This example represents a continuation of Example 4-17. Customer X, which manufactures and sells complex battery systems to electric car manufacturers, enters into a contract with Lessor Y to lease a piece of machinery for use in creating the specialized batteries. According to the terms of the contract, Y will provide (1) the machinery at a fixed rate of $220,000 per year for a period of five years and (2) marketing services over that same period to make electric car manufacturers more aware of X’s product. In consideration for the marketing services, X will pay an additional fixed fee of $30,000 per year.

Lessor Y determines that there are two components in the contract:

A lease component for the right to use the piece of machinery.
A nonlease component for the marketing services.

Case A — Variable Consideration Is Partially Related to the Lease Component

The facts below are consistent with Example 4-17, Case A.

Lessor Y determines that the consideration in the contract is $250,000 per year ($220,000 for use of machinery + $30,000 for marketing services), or $1,250,000 in total over the five-year contract term. No variable consideration is included in Y’s measurement of the consideration in the contract because the variable consideration (i.e., the 2 percent of sales per year for each year in which sales have increased by 10 percent or more over the prior year) is partially related to the lease component.

The facts below are unique to Case A in this example.

Lessor Y determines that the stand-alone selling prices of the lease and nonlease component are as follows:

Lease component: $1.125 million ($225,000 per year × 5 years).
Nonlease component: $175,000 ($35,000 annual payment × 5 years).

Accordingly, the contract contains a discount of $50,000 ($1,300,000 total stand-alone selling price – $1,250,000 consideration in the contract). However, Y does not have observable evidence to support, in accordance with ASC 606-10-32-37, that the entire discount is related to only one of the components in the contract.

Lessor Y allocates the consideration in the contract to the lease and nonlease components as follows:

Case B, Scenario 1 — Variable Consideration Is Specifically Related, and Allocated Entirely, to the Nonlease Component

The facts below are consistent with Example 4-17, Case B.

Assume that the contract also stipulates that X will pay Y a fee of $25 for every customer (or potential customer) of X that clicks on Internet advertisements that Y places on behalf of X as part of providing the marketing services in the contract. Therefore, Y also identifies variable consideration in the form of the $25 fee per click.

Lessor Y determines that the consideration in the contract is $1.5 million in total over the five-year contract term ($1,250,000 fixed consideration over the five-year contract term + $250,000 total estimate of variable consideration).

The facts below are unique to Case B, Scenario 1, in this example.

Lessor Y determines that the stand-alone selling prices of the lease component and nonlease component are as follows:

Lease component: $1.1 million.
Nonlease component: $400,000.

Lessor Y concludes that (1) the variable consideration is specifically related to an outcome from transferring the marketing services and (2) allocating the variable consideration entirely to the marketing services is consistent with the allocation objective in ASC 606-10-32-28 (i.e., there is no discount in the arrangement — see Scenario 2 below, in which this outcome is inconsistent with the allocation objective as a result of a discount that is not clearly related to one or more components in the contract). In addition, to maintain consistency with the allocation objective, on the basis of the stand-alone selling prices noted above, the fixed consideration would need to be allocated to both the lease and nonlease components.

Lessor Y allocates the fixed consideration in the contract to the lease and nonlease components as follows:

Lessor Y’s resulting allocation of the consideration in the contract is as follows:

Case B, Scenario 2 — Variable Consideration Is Specifically Related to the Nonlease Component and Is Allocated on the Basis of Stand-Alone Selling Prices

The facts below are consistent with Example 4-17, Case B.

The facts below are unique to Case B, Scenario 2, in this example.

Lessor Y determines that the stand-alone selling prices of the lease component and nonlease component are as follows:

Lease component: $1.25 million.
Nonlease component: $300,000.

Accordingly, the contract contains a discount of $50,000 ($1,550,000 total stand-alone selling price – $1,500,000 consideration in the contract). However, Y does not have observable evidence to support, in accordance with ASC 606-10-32-37, that the entire discount is related to only one of the components in the contract. Lessor Y concludes that allocating the variable consideration entirely to the nonlease component is inconsistent with the allocation objective in ASC 606-10-32-28, because doing so would inappropriately skew allocation of the discount toward the nonlease component.

Lessor Y allocates the consideration in the contract to the lease and nonlease components as follows:

Example 4-21

Case A — Gross Lease of Real Estate

Lessee enters into a five-year lease (a gross lease) of a building from Lessor under which Lessee is required to make a fixed annual lease payment of $35,000 (payments total $175,000 over the five-year term). In accordance with the terms of the contract, the $35,000 annual payment comprises $20,000 for building rent, $7,000 for CAM, $5,000 for property taxes, and $3,000 for insurance that protects Lessor’s interest in the building. From Lessor’s perspective, the stand-alone selling price of the right to use the building (including an estimate of Lessor’s costs for taxes and insurance) is $29,500 per year and the stand-alone selling price of the maintenance services is $7,650 per year.

In evaluating the separate components in the contract, Lessor would need to determine what goods and services are being provided, which may include both lease and nonlease components. In this contract, the primary good or service is the right to use the building, which is considered a lease component. In addition, the contract requires Lessor to provide maintenance services, which represent a nonlease component (i.e., a service to be accounted for in accordance with ASC 606).

As a result, Lessor allocates the consideration in the contract ($175,000) as follows:

Note that the contract contains a discount of $10,750 ($185,750 total stand-alone selling price – $175,000 consideration in the contract). However, Lessor does not have observable evidence to support, in accordance with ASC 606-10-32-37, that the entire discount is related to only one of the components in the contract. Therefore, Lessor appropriately allocates the consideration in the contract proportionately to the lease and nonlease components on a relative stand-alone selling price basis.

Case B — Triple Net Lease of Real Estate

Assume the same facts as in Case A, except that Lessee is required to make fixed annual lease payments of only $20,000 for building rent. Lessor charges payments for property taxes, insurance, and CAM to Lessee on the basis of Lessee’s share of actual costs incurred. Thus, payments for property taxes, insurance, and CAM all represent variable consideration. Lessor estimates that Lessee’s share of CAM will be $7,000 annually and that Lessee’s share of property taxes and insurance will be a total of $8,000 annually.

In a manner consistent with that in Case A, Lessor concludes that there are two components in the contract:

A lease component for the right to use the underlying asset, with a stand-alone selling price of $29,500 annually (which includes an estimate of Lessee’s share of the variable charges for taxes and insurance).
A nonlease component for the CAM, with a stand-alone selling price of $7,650 annually.

In a manner consistent with that described in Section 4.4.2.1.1, Lessor concludes that the variable consideration for the CAM is entirely related to the CAM nonlease component. Using the expected value method in ASC 606, Lessor estimates that the amount of consideration to which it will be entitled in exchange for transferring the CAM to Lessee is $7,000 annually. Lessor determines that it is probable that there will not be a significant reversal in the amount of cumulative revenue recognized with respect to its estimate.

However, Lessor does not include an estimate of the variable consideration for the property taxes and insurance in the consideration in the contract. The variable charges for property taxes and insurance that Lessee will pay are entirely or partially related to the lease component and are therefore excluded from the consideration in the contract. In accordance with ASC 842-10-15-40, Lessor, will (1) when changes in facts and circumstances upon which the variable payments are based occur, allocate those payments for property taxes and insurance in accordance with the same initial relative stand-alone selling price basis as for the consideration in the contract and (2) recognize the payments in accordance with the applicable guidance.

Therefore, Lessor concludes that the consideration in the contract is $135,000 ($20,000 fixed consideration for rent × 5 years + $7,000 estimated variable consideration for CAM × 5 years).

When allocating the consideration in the contract, Lessor considers the guidance in ASC 842-10-15-39 and determines that allocating the variable consideration entirely to the nonlease component would be consistent with the allocation objective in ASC 606-10-32-28. This is because allocating the variable consideration for CAM to the CAM nonlease component and the fixed consideration for the building rent to the lease component is in line with the stand-alone selling prices of each component (i.e., when Lessee’s estimated share of property taxes and insurance are also considered in the determination of the stand-alone selling price of the lease component).

Accordingly, Lessor applies the lessor accounting guidance (see Chapter 9) to the fixed consideration of $100,000 and the revenue recognition guidance in ASC 606 to the $35,000 of the estimated variable consideration included in the consideration in the contract. When there are changes in facts and circumstances upon which the variable payments for property taxes and insurance are based, Lessor will allocate those payments to the lease component (i.e., because allocating any of the payments to the nonlease component would not meet the allocation objective with respect to either the lease component or the nonlease component, when the stand-alone selling price of each is taken into account).

4.4.2.2.3 Estimating the Stand-Alone Selling Price of the Lease Component by Reference to a Gross Real Estate Lease at Fair Value

Example 4-21, Case A, illustrates an allocation by which the real estate lessor is able to estimate the stand-alone selling price of the lease component in a gross lease. However, lessors of real estate under gross leases often do not lease real estate separately without CAM and other services (i.e., they do not also lease on a triple net basis); thus, it may be difficult to estimate the stand-alone selling price of the lease component. However, a lessor of real estate under gross leases may be able to estimate the stand-alone selling price of CAM by using the expected-cost-plus-a-margin approach in ASC 606-10-32-34(b).

If a real estate lessor under a gross lease can show that the contract is priced at fair market value and can estimate the stand-alone selling price of CAM, questions have arisen about whether the lessor can estimate the stand-alone selling price of the lease component by reference to the fair market value price of the entire contract and the nonlease component.

The allocation method described above in Example 4-21, Case A, effectively results in the following when there are only two components in the contract (i.e., a lease component and nonlease component for CAM): stand-alone selling price of lease component = fair market value price of entire contract – estimate of stand-alone selling price of CAM.21

This allocation method is similar mathematically to the residual approach in ASC 606-10-32-34(c), which states:

Residual approach — An entity may estimate the standalone selling price by reference to the total transaction price less the sum of the observable standalone selling prices of other goods or services promised in the contract. However, an entity may use a residual approach to estimate, in accordance with paragraph 606-10-32-33, the standalone selling price of a good or service only if one of the following criteria is met:

The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence).
The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain).

However, when a lessor of gross real estate can prove by reference to objective and observable market data that the entire contract is priced at fair market value, we think that the allocation method described above is an acceptable approach to estimating the stand-alone selling price of a lease component. ASC 606-10-32-34 states that the approaches listed in ASC 606-10-32-34(a)–(c) are “[s]uitable methods for estimating the standalone selling price of a good or service” but that methods of estimating a stand-alone selling price “are not limited to” those approaches.

In addition, we think that the following conditions should also be met before a lessor of gross real estate may use the allocation method described above:

The lessor can reasonably estimate the stand-alone selling price of the CAM by using a suitable method in ASC 606-10-32-34(a) or (b). For example, the lessor can show, by using objective and observable market data (e.g., quotes from asset managers), that its estimate for the stand-alone selling price of CAM is in line with market pricing for related services.
The objective and observable market data used to prove that the entire contract is priced at fair market value sufficiently indicate that there is no discount in the contract. (If there is a discount, it must be allocated in accordance with ASC 606-10-32-36 through 32-38 and such allocation may not be on a relative stand-alone selling price basis.)
The allocation method generally should not result in an estimate of zero for the stand-alone selling price of one of the components in the contract. (However, see Section 4.4 for further discussion.)

When the entire contract is priced at fair market value and the other three conditions above are met, we think that the allocation method described above is effectively an adjusted market assessment approach in accordance with ASC 606-10-32-34(a) and that use of such an approach would result in sufficient objective evidence that the contract does not contain a discount. On the other hand, if a lessor of real estate under a gross lease is unable to prove, using objective and observable market data, that the entire contract is priced at fair market value, the allocation method described above is effectively the residual approach. In such cases, we think that neither the contract nor the good or service (i.e., the lease component) would meet the criteria in ASC 606-10-32-34(c) for use of the residual approach.

Real estate lessors that are considering the allocation method described above should consult with their accounting advisers and monitor developments on the topic, since views on the applicability of this method may differ.

4.4.2.2.4 Allocating Consideration in Arrangements Involving the Use of an Asset for “Free”

Vendors in certain industries often provide customers with the right to use, for a specified period, a piece of equipment for no charge (“free equipment”) in exchange for exclusive rights to supply related products (i.e., consumables). The equipment typically can be used only to dispense consumables that are sold by the vendor. In many cases, the customer has the right, but not the obligation, to purchase consumables from the vendor at a specified price. These arrangements may be referred to as “free lease” arrangements because they often contain no explicit consideration related to the use of the equipment; rather, the consideration in the contract consists of a charge per unit of consumable purchased by the customer. Examples of such arrangements may include a contract that conveys the use of an x-ray scanner to a hospital (the hospital may purchase contrast dyes only from the vendor) and a contract that conveys the use of a soft drink fountain dispenser to a restaurant (the restaurant may purchase soda syrup only from the vendor).

Questions have arisen about whether a vendor in a “free lease” arrangement should allocate the consideration in the contract between the use of the equipment (i.e., a lease component) and the purchase of the consumables (i.e., a nonlease component)?

In general, we would expect the consideration in the contract (even if the consideration is all variable) to be allocated among the contract components. We would not normally expect a vendor to provide equipment to a customer without expecting compensation. This would suggest that some of the per-unit price of the consumables should be allocated to the use of the equipment.

However, in some limited circumstances, we would not object to allocating 100 percent of the per-unit price to the consumable sales if the following criteria are met:

The contract only includes variable payments not based on an index or rate; that is, the contract does not contain any fixed or in-substance fixed payments.
The consumables are priced at (or below) their stand-alone selling price.
The equipment is insignificant in the context of the contract.

If the contract contains a fixed or in-substance fixed payment, as described in ASC 842-10-30-5 and ASC 842-10-15-35 (e.g., a minimum commitment to purchase consumables), such an amount must be allocated between the identified equipment in the arrangement and any nonlease components. In these situations, provided that the customer has the right to control the use of the identified equipment, we believe that such a contract contains a lease of the equipment. (A lease is defined as the “right to control the use of identified [PP&E] for a period of time in exchange for consideration” [emphasis added].)

The second criterion is designed to identify scenarios in which a vendor has not “marked up” the consumables to compensate itself for providing the customer with use of the equipment. To the extent that the per-unit price is at or below the vendor’s stand-alone selling price for the consumables (i.e., the per-unit price is the same as or lower than the per-unit price for a customer that purchases the equipment), this fact constitutes evidence that the vendor is not seeking or receiving incremental compensation for the equipment.

If the first two criteria are met, the vendor should evaluate the equipment’s value in relation to the overall combined value of the arrangement (including an estimate of the consumable value by using its best projection of consumables to be purchased over the contract term). The vendor should also consider other relevant factors (qualitative and quantitative) to determine whether the equipment is insignificant in the context of the contract.

The fact that an arrangement satisfies these three criteria may suggest that the vendor has provided the right to use its asset over the term of the contract for no compensation. While future consumable purchases are expected, there are no enforceable rights to require future purchases. Therefore, in a manner consistent with an optional purchase model for a revenue transaction (as described in TRG Paper 48), those future consumable purchases are not enforceable and do not create additional consideration in the arrangement, and the customer thus obtains use of the vendor’s asset without any obligation to make payments. This outcome is consistent with a revenue transaction in which a vendor provides its customer with an up-front deliverable (e.g., a razor) for no consideration and expects (but is not able to require) the customer to make subsequent purchases of consumables (razor blades). In this revenue transaction, the vendor would record no revenue for the up-front deliverable (razor) and would incur a day 1 loss upon the transfer of control of the deliverable (razor) to the customer.

Example 4-22

Assume the following facts:

Vendor L provides Customer H with “free” diagnostic equipment for a stated noncancelable term of five years.
The equipment has no use other than in combination with consumables sold by L to produce a testing result.
The equipment is explicitly specified in the contract, and H controls the use of the equipment during the five-year contract term through its exclusive use and ability to direct the use of the equipment.
Customer H is required to return the equipment to L at the end of the contract term.
The contract contains no explicit consideration for the use of the equipment; the consideration consists of a cost per unit of consumable purchased by H.
Throughout the five-year contract term, H has the right, but not the obligation, to purchase consumables from L to use in operating the equipment. The contract does not contain any minimum purchase commitments related to the consumables. Customer H may only use the consumables with the equipment provided by L and may not use a third-party vendor’s consumables with the equipment.
Vendor L has determined that the stand-alone selling price for the use of the equipment over a five-year term is $200,000.

The scenarios below illustrate potential alternatives related to L’s allocation of consideration in the contract described in this example.

Scenario 1A (Before the Adoption of ASU 2021-05)

At contract inception, L estimates that H will purchase 100,000 consumables during the five-year contract term. The stand-alone selling price of consumables is $6 per unit and the selling price within the contract is $7.50 per unit, yielding an estimated $750,000 of contract consideration.

On the basis of these additional facts, the contractual price of consumables (i.e., $7.50 per unit) is higher than the stand-alone selling price of the consumables (i.e., $6 per unit). The higher contractual price is most likely established to compensate L for the use of the equipment. Even though there are no fixed or in-substance fixed payments, since the price of the consumables is higher than the stand-alone selling price, L would conclude that this contract includes both a lease component and a nonlease component.

Vendor L would be required to allocate consideration between the use of the equipment (a lease) and the sale of consumables. Vendor L will allocate the consideration between the equipment and the estimated future consumable purchases on the basis of their respective stand-alone selling prices, as determined at lease inception. The consideration in the contract is allocated as follows:

Since consideration must be allocated to the use of the equipment, this component of the arrangement will generally meet the definition of a lease (i.e., the right to control the use of identified PP&E for a period of time in exchange for consideration). For each consumable purchased by H, L will recognize $1.88 as variable lease income and $5.63 as revenue.

This scenario resulted in a conclusion that a lease exists because the contractual price of consumables is higher than the stand-alone selling price. However, even if this were not the case, because the equipment value is quantitatively assessed as 25 percent of the total contract value, a lease component would most likely still be identified given the significance of the equipment to the overall contract.

Depending on the life of the equipment compared with the contract term (i.e., if the contract term is greater than 75 percent of the useful life of the equipment), these arrangements may qualify as sales-type leases and could lead to commencement losses because of their dependence on variable consideration. (See the first Connecting the Dots in Section 9.3.7.1.2 for more information about commencement losses related to sales-type leases.)

With respect to operating leases of equipment, we also note that vendors will generally not qualify to use the lessor practical expedient related to not separating the lease (i.e., equipment) and nonlease (i.e., consumables) components in the contract because the transfer of consumables occurs at a point in time whereas the transfer of the leased equipment is over time.

Scenario 1B (After the Adoption of ASU 2021-05)

Since consideration must be allocated to the use of the equipment, this component of the arrangement will generally meet the definition of a lese (i.e., the right to control the use of identified PP&E for a period of time in exchange for consideration). For each consumable purchased by H, L will recognize $1.88 as variable lease income and $5.63 as revenue.

Before the adoption of ASU 2021-05, the arrangement in the scenario described above may qualify as a sales-type lease depending on the life of the equipment compared with the contract term (i.e., if the contract term is greater than 75 percent of the useful life of the equipment). After the adoption of ASU 2021-05, however, if treating the lease as a sales-type lease would result in the recognition of a selling loss at lease commencement, the lease would be classified as an operating lease in accordance with ASC 842-10-25-3A because of the inclusion of variable consideration. (See the first Connecting the Dots in Section 9.3.7.1.2 for more information about commencement losses related to sales-type leases and Section 17.3.1.8 for further discussion of ASU 2021-05.)

Scenario 2

At contract inception, L estimates that H will purchase 450,000 consumables during the five-year contract term. The stand-alone selling price of consumables is $7.50 per unit, as evidenced by separate observable sales of consumables within contracts in which L sells the equipment to customers. Use of the contractual price of $7.50 per unit yields an estimated $3.375 million of contract consideration.

First, L observes that the contract does not include any fixed or in-substance fixed payments throughout the contract term. Then, L considers that its business model is to provide the equipment for free to drive consumable sales, which is corroborated by the fact that the contractual price of consumables is identical to the stand-alone selling price of the consumables (i.e., a customer that purchases the equipment would pay the same price as a customer that signs this contract); L’s primary objective is to sell consumables, not to sell the insignificant equipment.

The table below illustrates how L may assess the relative value within the contract and how it would allocate the consideration to the potential components.

On the basis of this calculation, L concludes that the equipment value is approximately 5.6 percent of the total contract value. Upon considering this quantitative factor as well as other qualitative factors, L determines that the equipment is insignificant to the overall contract.

Accordingly, in this scenario, it may be acceptable for L to conclude that this contract does not include a lease since L has determined that no consideration is provided for the use of the equipment. (The glossary in ASC 842-10-20 defines a lease as the “right to control the use of identified [PP&E] for a period of time in exchange for consideration” [emphasis added].) As a result, 100 percent of the consideration would be allocated to the sale of the consumables (i.e., revenue). Compared with the conclusion reached in Scenarios 1A and 1B, this conclusion does not result in a timing difference for revenue recognition purposes but could result in a different presentation and disclosure outcome: revenue from contracts with customers and variable lease income would be presented in Scenarios 1A and 1B, whereas only revenue from contracts with customers would be presented in Scenario 2.

In addition, L should assess whether H obtains control of the equipment (not just the right to use it for five years). If control has been transferred, L would incur a day 1 loss22 upon delivery of the equipment to H, in a manner similar to the above example involving razors and razor blades. Conversely, if L determines that H did not obtain control of the equipment, L would continue to recognize the equipment as PP&E subject to the guidance in ASC 360 on subsequent measurement (e.g., depreciation and impairment). We generally believe that control of the equipment is transferred to the customer when the term of the arrangement constitutes the major part of the remaining useful life of the equipment. However, if the vendor has a right to reclaim the equipment during the term of the arrangement without the customer’s permission (e.g., in cases in which the customer is not purchasing as many consumables as expected), this reclamation right may indicate that control of the equipment has not been transferred.

4.4.2.3 Remeasure and Reallocate Consideration

ASC 842-10

15-41 A lessor shall remeasure and reallocate the remaining consideration in the contract when there is a contract modification that is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.

A lessor is required to remeasure and reallocate (rather than only reallocate, as required by ASC 842-10-15-42 and discussed in Section 4.4.2.2) the consideration in the contract only when there is (1) a contract modification that is not accounted for as a separate contract, (2) an exercise of an option for the lessee to extend the lease or purchase the underlying asset that the lessee was not previously certain to exercise, or (3) a lessor’s exercise of an option to terminate the lease that the lessor was not previously reasonably certain to exercise. (See Section 9.3.4 for detailed discussion of the contract modification guidance for lessors.) Upon the occurrence of a contract modification that is not accounted for as a separate contract, the lessor would measure the remaining consideration in the contract in accordance with Section 4.4.2.1 and allocate it in accordance with Section 4.4.2.2.

If the consideration in the contract is remeasured and reallocated in accordance with ASC 842-10-15-41 as a result of a contract modification that is not accounted for as a separate contract, and there is a subsequent change in the consideration in the contract that must be allocated in accordance with ASC 842-10-15-42, the allocation of the changed consideration should be on the same basis as the most recent allocation (i.e., on the same basis as the allocation performed as a result of the contract modification).

4.4.3 Codification Examples

ASC 842-10

15-32 See Examples 11 through 14 (paragraphs 842-10-55-131 through 55-158) for illustrations of the requirements for allocating consideration to components of a contract.

Examples 11–14 in ASC 842-10-55 illustrate implementation of the guidance in ASC 842-10-15-28 through 15-40. Although Examples 12 and 13 in ASC 842-10-55 are reproduced in Sections 4.3 and 4.2.3 (since they are particularly related to identifying the nonlease components in a contract and separating lease components in a contract, respectively), Examples 11 and 14 in ASC 842-10-55 are reproduced below in this section, since they address the determination and allocation of the consideration in the contract by both lessees and lessors. Rather than carving up each example and reproducing different pieces throughout this chapter, we have decided to keep them intact in their entirety since we find that approach to be more useful.

ASC 842-10

Example 11 — Allocation of Consideration to Lease and Nonlease Components of a Contract

Case A — Allocation of Consideration in the Contract

55-132 Lessor leases a bulldozer, a truck, and a crane to Lessee to be used in Lessee’s construction operations for three years. Lessor also agrees to maintain each piece of equipment throughout the lease term. The total consideration in the contract is $600,000, payable in $200,000 annual installments.

55-133 Lessee and Lessor both conclude that the leases of the bulldozer, the truck, and the crane are each separate lease components because both of the criteria in paragraph 842-10-15-28 are met. That is:

The criterion in paragraph 842-10-15-28(a) is met because Lessee can benefit from each of the three pieces of equipment on its own or together with other readily available resources (for example, Lessee could readily lease or purchase an alternative truck or crane to use with the bulldozer).
The criterion in paragraph 842-10-15-28(b) is met because, despite the fact that Lessee is leasing all three machines for one purpose (that is, to engage in construction operations), the machines are not highly dependent on or highly interrelated with each other. The machines are not, in effect, inputs to a combined single item for which Lessee is contracting. Lessor can fulfill each of its obligations to lease one of the underlying assets independently of its fulfillment of the other lease obligations, and Lessee’s ability to derive benefit from the lease of each piece of equipment is not significantly affected by its decision to lease or not lease the other equipment from Lessor.

55-134 In accordance with paragraph 842-10-15-31, Lessee and Lessor will account for the nonlease maintenance services components separate from the three separate lease 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—see Case B [paragraphs 842-10-55-138 through 55-140] for an example in which Lessee elects the practical expedient). In accordance with the identifying performance obligations guidance in paragraphs 606-10-25-19 through 25-22, Lessor further concludes that its maintenance services for each piece of leased equipment are distinct and therefore separate performance obligations, resulting in the conclusion that there are three separate lease components and three separate nonlease components (that is, three maintenance service performance obligations).

55-135 Lessor allocates the consideration in the contract to the separate lease components and nonlease components by applying the guidance in paragraphs 606-10-32-28 through 32-41. The consideration allocated to each separate lease component constitutes the lease payments for purposes of Lessor’s accounting for those components.

55-136 Lessee allocates the consideration in the contract to the separate lease and nonlease components. Several suppliers provide maintenance services that relate to similar equipment such that there are observable standalone prices for the maintenance services for each piece of leased equipment. In addition, even though Lessor, who is the manufacturer of the equipment, requires that all leases of its equipment include maintenance services, Lessee is able to establish observable standalone prices for the three lease components on the basis of the price other lessors lease similar equipment on a standalone basis. The standalone prices for the separate lease and nonlease components are as follows.

55-137 Lessee first allocates the consideration in the contract ($600,000) to the lease and nonlease components on a relative basis, utilizing the observable standalone prices determined in paragraph 842-10-55-136. Lessee then accounts for each separate lease component in accordance with Subtopic 842-20, treating the allocated consideration as the lease payments for each lease component. The nonlease components are accounted for by Lessee in accordance with other Topics. The allocation of the consideration to the lease and nonlease components is as follows.

Case B — Lessee Elects Practical Expedient to Not Separate Lease From Nonlease Components

55-138 Assume the same facts and circumstances as in Case A (paragraphs 842-10-55-132 through 55-137), except that Lessee has made an accounting policy election to use the practical expedient to not separate nonlease from lease components for its leased construction equipment. Consequently, Lessee does not separate the maintenance services from the related lease components but, instead, accounts for the contract as containing only three lease components.

55-139 Because Lessor regularly leases each piece of equipment bundled together with maintenance services on a standalone basis, there are observable standalone prices for each of the three combined components, each of which includes the lease and the maintenance services. Because each of the three separate lease components includes the lease of the equipment and the related maintenance services, the observable standalone price for each component in this scenario is greater than the observable standalone price for each separate lease component that does not include the maintenance services in Case A.

55-140 Lessee allocates the consideration in the contract ($600,000) to the three separate lease components on a relative basis utilizing the observable standalone selling price of each separate lease component (inclusive of maintenance services) and then accounts for each separate lease component in accordance with the guidance in Subtopic 842-20, treating the allocated consideration as the lease payments for each separate lease component. The standalone prices for each of the three combined lease components is as follows.

Example 14 — Determining the Consideration in the Contract — Variable Payments

Case A — Variable Payments That Relate to the Lease Component and the Nonlease Component

55-150 Lessee and Lessor enter into a three-year lease of equipment that includes maintenance services on the equipment throughout the three-year lease term. Lessee will pay Lessor $100,000 per year plus an additional $7,000 each year that the equipment is operating a minimum number of hours at a specified level of productivity (that is, the equipment is not malfunctioning or inoperable). The potential $7,000 payment each year is variable because the payment depends on the equipment operating a minimum number of hours at a specified level of productivity. The lease is an operating lease.

55-151 In accordance with paragraph 842-10-15-35, variable payments other than those that depend on an index or a rate are not accounted for as consideration in the contract by Lessee. Therefore, the consideration in the contract to be allocated by Lessee to the equipment lease and the maintenance services at lease commencement includes only the fixed payments of $100,000 each year (or $300,000 in total). Lessee allocates the consideration in the contract to the equipment lease and the maintenance services on the basis of the standalone prices of each, which, for purposes of this example, are $285,000 and $45,000, respectively.

Each $100,000 annual fixed payment and each variable payment are allocated to the equipment lease and the maintenance services on the same basis as the initial allocation of the consideration in the contract (that is, 86.4 percent to the equipment lease and 13.6 percent to the maintenance services). Therefore, annual lease expense, excluding variable expense, is $86,364. Lessee recognizes the expense related to the variable payments in accordance with paragraphs 842-20-25-6 and 842-20-55-1 through 55-2.

55-152 In accordance with paragraphs 842-10-15-39 through 15-40, Lessor also concludes that the potential variable payments should not be accounted for as consideration in the contract. That is because the potential variable payment each year is not solely related to performance of the nonlease maintenance services; the quality and condition of the underlying asset also substantively affect whether Lessor will earn those amounts. Therefore, Lessor’s allocation of the consideration in the contract ($300,000) in this Example is the same as Lessee. Lessor will allocate, in accordance with paragraph 842-10-15-40, the variable payments between the lease and nonlease maintenance services (on the same basis as the initial allocation of the consideration in the contract), when and if the productivity targets are met. Lessor will recognize the portion allocated to the lease at that time and will recognize the portion allocated to the nonlease maintenance services in accordance with the guidance on satisfaction of performance obligations in Topic 606 on revenue from contracts with customers.

Case B — Variable Payments That Relate Specifically to a Nonlease Component

55-153 Assume the same facts and circumstances as in Case A (paragraphs 842-10-55-150 through 55-152), except in this scenario the maintenance services are highly specialized and no entity would expect the equipment to meet the performance metrics without the specialized maintenance services.

55-154 Lessee would account for the potential variable payments consistent with Case A. The rationale for this accounting also is consistent with that in Case A.

55-155 In contrast to Case A, Lessor concludes that the variable payments relate specifically to an outcome from Lessor’s performance of its maintenance services. Therefore, Lessor evaluates the variable payments in accordance with the variable consideration guidance in paragraphs 606-10-32-5 through 32-13. If Lessor estimates, using the most likely amount method, that it will be entitled to receive the $21,000 in variable payments and that it is probable that including that amount in the transaction price for the maintenance services would not result in a significant revenue reversal when the uncertainty of the performance bonus is resolved, the $21,000 would be included in the consideration in the contract. Because allocating the $21,000 entirely to the maintenance services would not result in an allocation that is consistent with the allocation objective in paragraph 606-10-32-28 (that is, it would result in allocating $61,909 to the maintenance services and the remainder to the equipment lease, which would not reasonably depict the consideration to which Lessor expects to be entitled for each component), the entire consideration in the contract of $321,000 is allocated on a relative standalone price basis as follows.

55-156 The $277,227 allocated to the equipment lease is the lease payment in accounting for the lease in accordance with Subtopic 842-30. Lessor will recognize the consideration in the contract allocated to the maintenance services in accordance with the guidance on the satisfaction of performance obligations in paragraphs 606-10-25-23 through 25-37. If the consideration in the contract changes (for example, because Lessor no longer estimates that it will receive the full $21,000 in potential variable payments), Lessor will allocate the change in the transaction price on the same basis as was initially done.

Case C — Allocating Variable Payments Entirely to a Nonlease Component

55-157 Assume the same facts and circumstances as in Case B (paragraphs 842-10-55-153 through 55-156), except that in this scenario all of the following apply:

The potential variable payments are $14,000 per year ($42,000 in total), and the annual fixed payments are $93,000 per year ($279,000 in total).
While Lessor’s estimate of the variable payments to which it will be entitled is $42,000, Lessor concludes that it is not probable that including the full $42,000 in potential variable payments in the consideration in the contract will not result in a significant revenue reversal (that is, the entity applies the constraint on variable consideration in paragraph 606-10-32-11). Lessor concludes that only $28,000 is probable of not resulting in a significant revenue reversal. Therefore, the consideration in the contract is initially $307,000 ($279,000 + $28,000).

55-158 In contrast to Case B, Lessor concludes that allocating the variable payments entirely to the maintenance services and the fixed payments entirely to the equipment lease is consistent with the allocation objective in paragraph 606-10-32-28. This is because $42,000 (Lessor considers its estimate of the variable payments to which it expects to be entitled exclusive of the constraint on variable consideration in Topic 606 on revenue recognition) and $279,000 approximate the standalone price of the maintenance services ($45,000) and the equipment lease ($285,000), respectively. Because the variable payments are allocated entirely to the maintenance services, if the consideration in the contract changes (for example, because Lessor concludes it is now probable that it will earn the full $42,000 in variable payments), that change is allocated entirely to the maintenance services component in the contract.

Footnotes

Examples 11 and 14 in ASC 842-10-55-132 through 55-140 and ASC 842-10-55-150 through 55-158, respectively, also illustrate such allocation. Both examples are reproduced in Section 4.4.3.

IFRS 16 does not contain a similar requirement that lessor costs paid directly to a third party by a lessee should be excluded from variable payments. See Appendix B for a summary of differences between ASC 842 and IFRS 16.

IFRS 16 does not contain a similar practical expedient allowing lessors to present sales taxes collected from lessees on a net basis. See Appendix B for a summary of differences between ASC 842 and IFRS 16.

For example, by using an expected-cost-plus-a-margin approach.

Vendor L would derecognize the full carrying value of the equipment and would record a corresponding loss.

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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.