4.5 Contract Combinations

ASC 842-10

25-19 An entity shall combine two or more contracts, at least one of which is or contains a lease, entered into at or near the same time with the same counterparty (or related parties) and consider the contracts as a single transaction if any of the following criteria are met:

The contracts are negotiated as a package with the same commercial objective(s).
The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
The rights to use underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component in accordance with paragraph 842-10-15-28.

An entity is required to “combine two or more contracts . . . entered into at or near the same time with the same counterparty” if any of the criteria in ASC 842-10-25-19(a)–(c) above are met. The contract combination guidance should be assessed at contract inception. An entity will need to use judgment in determining whether multiple contracts are “entered into at or near the same time.” As a general rule, the longer the period between entering contracts with the same counterparty, the more likely those contracts are not economically linked.

Connecting the Dots

Contract Combination Guidance Is Consistent With That in ASC 606

The contract combination guidance in ASC 842 is generally consistent with that in ASC 606. In paragraph BC165 of ASU 2016-02, the FASB acknowledged that this consistency was intentional:

The Board included guidance in Topic 842 for when an entity should combine two or more contracts and account for them as a single contract. Although it is usually appropriate to account for a contract individually, an entity should assess the combined effect of contracts that are interdependent. An entity may enter into multiple contracts in contemplation of another such that the contracts, in substance, form a single arrangement that achieves an overall commercial effect. The financial reporting effect of recognizing those contracts separately may be different from the financial reporting effect of recognizing those contracts on a combined basis. In those situations, accounting for the contracts independently might not result in a faithful representation of the combined transaction. This accounting has been acknowledged throughout GAAP, and guidance similar to that in Topic 842 was included in Topic 606. [Emphasis added]

Although the contract combination guidance is generally consistent with that in ASC 606, the requirements in ASC 842-10-25-19 apply to both lessees and lessors. Therefore, an entity should establish policies and procedures to ensure that controls are in place to identify and consider arrangements entered into “at or near the same time.” Given that the guidance on this topic in ASC 842 is consistent with that in ASC 606, we would generally expect entities to adopt consistent policies related to what they consider “at or near the same time” when determining whether and, if so, when to combine contracts.

Generally, it will be appropriate for lessees and lessors to account for contracts individually. However, when certain contracts are interdependent, entities should assess their combined effect to determine whether the financial reporting outcome of accounting for those contracts on a combined basis is more representationally faithful than the outcome when those contracts are accounted for individually. This will generally be the case when the contracts are entered into to achieve a single, overall commercial objective. As a result, an entity must account for its arrangements on the basis of the substance (i.e., one commercial arrangement) rather than the form (e.g., three separate legal contracts).

The examples below illustrate the application of the guidance in ASC 842-10-15-19 on contract combinations.

Example 4-23

Company EC, the lessor, and LH Cruises, the lessee, enter into an initial agreement on January 1, 20X8, in which the lessor will provide a named sailboat to the lessee for a three-year period commencing on April 1, 20X8. One week after the initial agreement was executed, on January 8, 20X8, a separate contract was executed for the use of a specified dock to store the sailboat, also for a three-year period and commencing on April 1, 20X8.

The lessee will pay $25,000 per year for the right to use the sailboat. The dock space was leased at a rate of $5,000 per year. Under the contract to lease the dock space, the lessee also agrees to pay $500 for every hour that the sailboat is not docked. The standard rate at which the lessor rents sailboats is $40,000 annually, while the market rate for dock space is $5,000 per year.

Both the lessee and the lessor conclude that the contracts should be combined and accounted for as a single transaction because they are interdependent. The sailboat and dock are used in conjunction to achieve the single commercial objective of providing a sailboat and a dock to store the sailboat.

The contracts are combined in accordance with ASC 842-10-25-19 on the basis of the following:

The contracts are entered into at or near the same time (i.e., within one week of each other, between January 1, 20X8, and January 8, 20X8) with the same counterparty.
The annual lease payment for the sailboat is lower than the market rate because the lessor expects to recover the difference through the fixed and variable pricing (based on performance) of the dock rental. The criterion in ASC 842-10-25-19(b) is met.

Example 4-24

Company M, an automobile manufacturer, and Company D, an unrelated car dealer, both want to benefit from a car dealership in Fort Worth, Texas, that will exclusively sell M’s cars. Company D owns the land and building in Fort Worth, and M wants to ensure that D will only use that property for the intended purpose for at least 25 years. To ensure that the property is used as a car dealership selling vehicles produced by M, the parties structure the transaction as a “lease-in and lease-out” (LILO), in which M leases the property from D and simultaneously subleases the property back to D.

The following are relevant terms of the LILO arrangement:

The terms of the head lease (i.e., D, as a lessor, leases to M, as a head lessee) and sublease (i.e., M, as a head lessee and sublessor, leases to D, as a sublessee) mirror each other. The head lease and sublease have identical fixed rental payments and 25-year fixed lease terms.
The terms of the sublease limit D’s use of the property to activities defined in the contract as “dealership activities” (i.e., use of the property as a car dealership to sell vehicles produced by M).
As the sublessee, D cannot assign or transfer its rights under the sublease, or further sublease the property, without M’s consent.
If D, as the sublessee, defaults on the sublease agreement (e.g., D fails to pay rent, or D conducts activities other than dealership activities), M has the option to (1) sublease the property to another car dealer or (2) terminate the sublease and retain control of the property for the remainder of the term of the head lease.
Under the head lease and during its term, D has the right to sell the property to a third party, with the following stipulations: (1) M has a first right of refusal and may purchase the property and (2) upon a sale, the property continues to be subject to the head lease and sublease (which will be assigned to the new owner of the property).

Both M and D conclude that the head lease and the sublease should be combined and accounted for as a single transaction because the contracts are interdependent. The contracts are combined in accordance with ASC 842-10-25-19 because the head lease and sublease were negotiated as a package with the same commercial objective. That is, the contracts were executed to ensure that D would use the property for 25 years as a car dealership to sell vehicles manufactured by M.

ASC 842-10-25-19 does not require that the contracts under consideration be coterminous. Therefore, the fact that the two contracts may not always be coterminous (e.g., if M were to terminate the sublease upon a default by D as the sublessee) is not relevant to the above conclusion to combine the head lease and sublease.

As a result, neither M nor D accounts for the head lease or the sublease as leases within the scope of ASC 842. Companies M and D must look to other applicable GAAP to account for the substance of the transaction (i.e., to ensure that D uses the property as a dealership to sell M’s cars).

4.5.1 Combining Contracts With Unrelated Parties

Consider a scenario in which Entity L enters into a contract to lease an asset to Retailer K, which K intends to simultaneously sublease to End User B for five years. Entity L separately contracts with B to provide maintenance services related to the asset for the five-year lease term. In legal form, there are three separate contracts: (1) the lease contract between L and K, (2) the lease contract between K and B, and (3) the service contract between L and B.

The three contracts are negotiated as a package with the same commercial objective of allowing B to use the asset and receive maintenance services. In addition, the consideration paid by B in its lease and service contracts depends on the price paid by K in its lease contract.

In this example, L should not combine its contracts to lease the asset to K and provide maintenance services to B. Under ASC 842-10-25-19, the contracts must be with the same counterparty (or related parties) to be combined. Therefore, the contracts in the above example cannot be combined even though (1) they are entered into simultaneously and are negotiated as a package with a single commercial objective and (2) the amount of consideration in one contract depends on the price of the other contract.

Sylvia Alicea, then a professional accounting fellow in the SEC’s Office of the Chief Accountant, addressed this topic in a speech at the 2016 AICPA Conference on Current SEC and PCAOB Developments. Ms. Alicea stated, in part:

Next, I’ll share some observations related to the contract combination guidance. I observe that the guidance in Topic 606 explicitly limits which contracts should be combined. In the consultation that OCA evaluated, the registrant had two contracts that were entered into at the same time and met some of the criteria for contract combination because they were: (i) negotiated between all parties with a single commercial objective; and (ii) were priced interdependently such that consideration paid under one contract was dependent on the price in the other contract. However, the contracts did not meet the requirement in Topic 606 to be with the same customer or related parties of the customer. Therefore, OCA objected to the registrant’s extension of the contract combination guidance beyond those parties. [Footnotes omitted]

Although Ms. Alicea’s remarks were associated with ASC 606, we believe that the same conclusion would be reached under ASC 842 because of the similarities between the two standards’ contract combination guidance.

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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.