Chapter 4 — Components of a Contract
Chapter 4 — Components of a Contract
4.1 Introduction
The phrase “whether a contract is or contains a lease” (emphasis added)
is consistently used throughout ASC 842-10-15 and
Chapter 3 of
this Roadmap. The reason behind this wording
choice is more fully explained in Section
3.2.2 — a lease may be embedded in a
larger service arrangement. When that is the case,
contracts contain both lease and nonlease
components. Generally, the nonlease components are
services that the supplier is also performing for
the customer. For example, in a single contract,
the supplier could be leasing equipment to a
customer while also agreeing to provide ongoing
maintenance services for the equipment throughout
the period of use.
Further, in paragraph BC143 of ASU
2016-02, the FASB acknowledges that contracts may contain
multiple lease components. Paragraph BC143 of ASU 2016-02 cites a contract
for the right to use a marine port as one example of a contract that may contain
several lease components (e.g., leases of land, buildings, and equipment).
Changing Lanes
More Guidance on How to Separate, and Allocate
Consideration to, Components of a Contract
ASC 840-10-15-16 through 15-19 (formerly EITF Issue 01-8) required separation
of, and allocation of consideration to, lease and nonlease components.
However, ASC 840 provides little guidance on how to perform such separation
and allocation. Accordingly, the FASB recognized the need for more
comprehensive guidance on accounting for contracts that contain multiple
components. Specifically, paragraph BC144 of ASU 2016-02 states:
Previous GAAP provided limited guidance on how to
separate lease components and nonlease components of a contract,
even though it required that separation. Because Topic 842 results
in lease components of a contract being accounted for differently
from nonlease components (for all leases except short-term leases
for which a lessee elects the recognition and measurement
exemption), the Board decided to provide expanded guidance on how
entities should account for contracts that contain both lease
components and nonlease components.
Paragraph BC144 of ASU 2016-02 explains that, because the customer’s accounting for a lease
results in balance sheet recognition (except for short-term leases — see Chapter 8 for detailed
discussion of lessee accounting) while its accounting for a service generally does not, ASC 842
places additional emphasis on the separation of lease and nonlease components. That is, the
Board is increasing the importance of appropriately identifying the components of — and
consideration in — a contract that is subject to balance sheet recognition. In addition, since
operating leases have different income statement effects than finance leases, separation of
multiple lease components remains relevant.
The guidance in ASC 842-10-15 effectively establishes the following process for identifying the contract
component(s) (i.e., the units of account) and consideration subject to lease accounting:
- Considering whether the contract involves the use of PP&E, as covered in ASC 842-10-15-1 (see Chapter 2).
- Assessing whether that contract is, or contains, a lease, as addressed in ASC 842-10-15-2 through 15-27 (see Chapter 3).
- Determining which lease component(s) in that contract is (are) subject to the recognition and measurement guidance in ASC 842, as covered in ASC 842-10-15-28 through 15-42 (discussed in the remainder of this chapter).
The third part of the process is expanded in the graphic below, which outlines steps related to considering how to separate, and allocate consideration to, components in a contract under ASC 842. Each of these steps is discussed in greater detail in the remainder of this chapter.
4.2 Identify the Separate Lease Components
ASC 842-10
15-28 After determining that a contract contains a lease in accordance with paragraphs 842-10-15-2 through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met:
- The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
- The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.
15-29 The guidance in paragraph 842-10-15-28 notwithstanding, to classify and account for a lease of land and other assets, an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land lease component would be insignificant).
Once an entity determines that a contract is, or contains, a lease (i.e., part or all of
the contract is a lease — see Chapter 3), the entity (i.e., both the customer and the
supplier) must assess whether the contract contains multiple lease components (i.e.,
when a contract conveys the rights to use multiple underlying assets). ASC 842-10-15-28(a) and (b) prescribe criteria (reproduced above) for identifying whether one
lease component is considered separate from other lease components in the
contract.
However, land is considered an exception to the guidance in ASC 842-10-15-28. In accordance with ASC
842-10-15-29, a right to use land must be separated from the rights to use other underlying assets (e.g.,
from the right to use a building that sits on top of the land), unless the effect of separating the land is
insignificant to the resulting lease accounting.
Connecting the Dots
Importance of the Unit of
Account
Paragraph BC145 of ASU 2016-02 stresses that it is important for an entity to identify the
appropriate unit of account when applying the lessee or lessor accounting models in ASC
842 (see Chapters 8 and 9, respectively), since the unit of account can affect the allocation of
consideration to the components in the contract. Specifically, paragraph BC145 of ASU 2016-02
states, in part:
By way of example, regarding allocation, the Board noted that the standalone price (observable
or estimated) for a bundled offering (for example, the lease of a data center) may be substantially
different from the sum of the standalone prices for separate leases of the items within a bundled
offering (for example, the lease of each asset in the data center). Given the substantially different
accounting for lease and nonlease components in Topic 842, the allocation of contract consideration
carries additional importance as compared with previous GAAP. Consequently, the Board concluded
that including separate lease components guidance in Topic 842 will result in more accurate
accounting that also is more consistent among entities.
ASC 840 did not include guidance on how to identify the unit of account to which
lease accounting should be applied. For example, ASC 840 did not
specify whether to classify rights to use several underlying
assets in a contract individually or as a single right of use.
Rather, in practice, interpretive guidance arose that was
effective but not necessarily based on GAAP. Accordingly, in the
Board’s view, ASC 842 reflects an improvement over ASC 840 in
this area.
The decision tree below illustrates how an entity might think about the guidance
in ASC 842-10-15-28 and 15-29 for each contract containing a lease.
4.2.1 Separating Lease Components
Effectively, the guidance in ASC 842-10-15-28 is intended to help entities evaluate whether the parties
are contracting to provide the customer with multiple, individual outputs (i.e., multiple rights of use) or a
single output (i.e., a single right of use) that comprises multiple inputs. To accomplish this objective, the
FASB uses two criteria:
- The customer can economically benefit from the right of use (1) on its own or (2) together with other, readily available resources. “Readily available resources” could be those that the customer can obtain separately (whether from the supplier in the contract or others) or those that have already been transferred to the customer in the current contract or other, prior contracts. For example, the fact that a right of use is contracted on its own is an indicator that it meets this first criterion.This criterion is intended to be effectively the same as the “capable of being distinct” criterion in ASC 606-10-25-19(a) and 25-20 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this first criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.1 of Deloitte’s Roadmap Revenue Recognition.
- The right of use is “neither highly dependent on nor highly interrelated with” other rights of use in the same contract (i.e., the right of use is separately identifiable). The right of use may not be separately identifiable if (1) the supplier integrates it with other rights of use in the contract in such a way that it is only one input in an effort to deliver a combined right of use (i.e., a single output) to the customer or (2) it significantly modifies or affects — or is significantly modified or affected by — the other rights of use in the contract.This criterion is intended to be effectively the same as the “distinct within the context of the contract” criterion in ASC 606-10-25-19(b) and ASC 606-10-25-21 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this second criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.2 of Deloitte’s Roadmap Revenue Recognition.
Connecting the Dots
Similarities Between
Identifying Separate Lease Components Under ASC
842 and Identifying Separate Performance
Obligations Under ASC 606
The concept of separating lease components under ASC 842 is similar to the notion of
identifying performance obligations under ASC 606. Specifically, paragraph BC146 of ASU
2016-02 states:
The separate lease components guidance in paragraph 842-10-15-28 is similar to the guidance on
identifying performance obligations in Topic 606, and, therefore, the Board expects that it will be
applied in a similar manner. . . . Accordingly, rather than developing entirely separate requirements
addressing how to identify separate lease components, the Board decided that it is logical to provide
requirements similar to those in Topic 606 on the identification of performance obligations to
determine whether a lessee is contracting for the right to use multiple underlying assets (for example,
five vehicles) or for the right to use a single solution that is comprised of multiple assets (for example,
many data centers or manufacturing facilities).
In other words, the Board’s intention was
not to create a different set of requirements for
separating lease components but to link the concepts from
the two standards so that they may be applied
consistently. Accordingly, we think that the guidance in
ASC 606 — as well as Deloitte’s related interpretive
guidance in Section 5.3.2 of
Deloitte’s Roadmap Revenue
Recognition — will be helpful to
entities applying the guidance in ASC 842-10-15-28.
Further, ASC 606’s guidance on identifying performance
obligations is more robust and descriptive than ASC 842’s
guidance on separating lease components. ASC 606 also
contains more examples that address the “distinct”
criteria.
The link between the revenue and leasing
standards will be a consistent theme throughout the
remainder of this chapter, since the two standards are
also similar regarding the allocation and reallocation of
the consideration to the components in the contract.
The example below illustrates the guidance in ASC 842-10-15-28 on separating
lease components. (See Section 4.2.3 for additional
examples, including an illustration of a situation in which the right
to use land is not separated from other rights of use in the
contract.)
Example 4-1
Garden Co., the lessee, leases a dump truck, riding lawn mower, and skid loader from Tools Inc., the lessor. Tools Inc. sells and leases each piece of machinery separately to other customers and lessees, respectively, during its normal course of business.
Although it leased all three pieces of machinery together for use in its landscaping business, Garden Co. determined that the rights to use the machinery represent three separate lease components. This conclusion is based on the following:
- Garden Co. can economically benefit from the use of each piece of machinery on its own or together with other, readily available resources. For example, Garden Co. can lease separately — either from Tools Inc. or from another supplier — an excavator that may be used in conjunction with the dump truck to perform the landscaping services that it provides to its customers.
- Each piece of machinery is neither highly dependent on, nor highly interrelated with, the others. Tools Inc. is not integrating the rights to use the machinery into a single, combined right of use. Further, no piece of machinery is significantly modified or affected by the others — they do not come together, for example, to form a larger, more efficient piece of machinery.
Accordingly, Garden Co. and Tools Inc. would account for each piece of machinery as a separate lease component in accordance with the lessee and lessor accounting models, respectively.
4.2.2 Land and Other Assets
ASC 842-10-15-29 requires that land be considered a
separate lease component in a contract involving land and other
assets, unless the effect of separately accounting for the land
portion of the contract is insignificant.
Connecting the Dots
The Nature of
Land
Paragraph BC147 of ASU 2016-02 states, in
part:
Topic 842 also requires an
entity to account for a right to use land as a
separate lease component, even if the separating
lease components criteria are not met, unless the
accounting effect of doing so would be
insignificant. The Board decided that land, by
virtue of its indefinite economic life and
nonpredictable nature, is different from other
assets, such that it should be assessed separately
from other assets regardless of whether the
separating lease components criteria are met.
Paragraph BC147 of ASU 2016-02 should be
interpreted as meaning that if an entire building were
leased, the lessee would implicitly also be leasing the
land on which the building sits. Because the underlying
land asset is subject to unique risks compared with those
of the building, the right to use the land should be
accounted for as a separate lease component (unless the
accounting effect of doing so would be insignificant).
However, the same may not be true if an
entity is leasing only part of a building (e.g., a
physically distinct portion of a larger building, such as
a single floor in an office building). Entities should
consider whether facts and circumstances indicate
otherwise, but in these situations, we do not expect that
a lessee will have an implicit lease of the underlying
land. (See Section 4.2.2.2 for
further discussion.)
ASC 842 does not explicitly define the term
“insignificant,” as used in ASC 842-10-15-29. Therefore, management
will need to use judgment in applying this term. In determining
significance, an entity should separately assess (1) whether
separating the land component affects the classification of any lease
component, (2) the value of the land component in the context of the
overall contract, and (3) whether the right to use the land is
coterminous with the rights to use the other assets.
For example, if a lease includes both land and a
building component and an entity concludes that both components would
be classified as an operating lease over the same lease term if they
are accounted for separately, it may be reasonable for the entity to
conclude that the difference between accounting for the two lease
components together and accounting for the land and building
separately would be insignificant.
ASC 842-10-15-29 gives two examples illustrating when
the accounting effect of separating the right to use land from other
rights of use would be insignificant, both of which are mentioned
above. The first of those examples (i.e., the effect on lease
classification) is discussed in the preceding paragraph. The Changing
Lanes discussion and Section 4.2.2.1 below address the second (i.e., the
value of the right to use the land). A third example (i.e., the terms
of the different rights of use), also mentioned above, is discussed in
Example 13 in ASC 842-10-55-146 through 55-149 (reproduced in
Section
4.2.3).
Changing Lanes
Bifurcation of the
Land Component May Be More Common
ASC 842’s approach to accounting for leases
of land and other assets is consistent with the historical
approach in IAS 17 under IFRS Accounting Standards but
represents a change from the U.S. GAAP guidance in ASC
840. The guidance in ASC 840 required a lessee to do the
following for land and other assets: (1) when the lease
meets either the transfer-of-ownership or
bargain-purchase-price classification criteria, account
for the land and other assets separately (see ASC
840-10-25-38(a)), or (2) when the fair value of the land
is 25 percent or more of the total fair value of the
leased property at lease inception, classify the land and
other assets separately (as discussed in Section
4.2.2.1). The new approach may result in
more bifurcation of real estate leases into separate lease
components.
4.2.2.1 Use of a 25 Percent Threshold to Separate Land
To determine when the right to use land must be
accounted for separately under ASC 840-10-25-38(b), an entity
uses a 25 percent threshold to compare the fair value of the
land with the fair value of the entire leased property. That is,
under ASC 840, if the fair value of the underlying land was less
than 25 percent of the fair value of the entire leased property,
the land is combined with the other rights of use.
However, it is not appropriate to use a 25 percent
threshold to determine whether land should be separated in
accordance with ASC 842-10-15-29 because the concept behind the
guidance in ASC 842-10-15-29 (discussed in the Connecting the
Dots above) differs from that in ASC 840.
Under ASC 842, the value of the land component in
a contract containing the right to use land and other assets may
be considered in the determination of whether the accounting
effect of separating the land component is insignificant.
However, the sole reliance on any bright-line threshold based on
the land value, compared with the total property value, would
not be appropriate in this assessment.
For example, although the land component in a
contract containing the right to use land and a building may
represent a fair value that is lower than 25 percent of the
entire leased property, the lease classification for the right
to use the land could differ from that for the right to use the
building. In such situations, an entity should consider all
facts and circumstances to determine whether the accounting
effect of not separating the components is insignificant.
Entities should also consider arrangements in
which lessees are leasing a significant capacity portion of a
building (or another asset atop land). Such arrangements may
inherently convey a right to use the underlying land and would
need to be assessed in accordance with ASC 842-10-15-29.
4.2.2.2 Inherent Land Leases When a Portion of a Building Is Leased
Regardless of the portion (or capacity) of the
building it is leasing, a lessee in a multitenant building
inherently has some rights to use the underlying land. However,
the land may not represent an identified asset to the lessee in
such a way that the lessee would have the right to control the
use of an identified asset (i.e., in such a way that the lessee
would have a lease of the land, as defined in ASC
842-10-15-3 and 15-4 and further discussed in Chapter
3 of this Roadmap).
A lessee in a multitenant building will have the
right to control the use of a physically distinct portion of the
building, but its rights related to the underlying land are not
over a physically distinct portion of the land unless the lessee
is, in effect, leasing the entire building. In such
cases, the lessee is also effectively leasing the entire,
underlying plot of land. Therefore, we think that when the
lessee has the right to control the use of substantially all of
the capacity of the building, it also has the right to control
the use of substantially all of the capacity of the land. (See
Section
3.3.2 for further discussion of when a capacity
portion of a larger asset is an identified asset.)
In such arrangements, lessees and lessors should
consider whether the lessee’s rights to use the land represent a
separate lease component in accordance with ASC
842-10-15-29.
4.2.2.3 Allocation of the Fair Value of Land When a Portion of a Multitenant Building Is Leased
As discussed in Section 4.2.2.2, when a
lessee leases a portion of a multitenant building, the lessee
generally only has the ability to control the use of the
underlying land if it has the ability to control the use of
substantially all of the capacity of the building that rests on
that land. If the lessee is able to control the underlying land,
both the lessee and the lessor should account for the lessee’s
right to use the land as a separate lease component (unless the
accounting effect of doing so would be insignificant as stated
in ASC 842-10-15-29). When accounting for the right to use the
underlying land as a separate lease component, an entity would
allocate lease payments separately between the two lease
components (i.e., the lease of land and lease of the building).
Accordingly, an entity would separately compare the present
value of those allocated lease payments with the fair value of
the underlying land and the fair value of the building in
assessing the classification of each lease component in
accordance with ASC 842-10-25-2(d).
However, if the control assessment reveals that
the lessee does not control the land and no other tenant in the
building obtains substantially all the use of the land, the land
does not represent a separate lease component. In these cases,
the lease payments that would otherwise be allocated to the land
component instead would be entirely allocated to the lease of
the lessee’s portion of the building. We believe that the lessee
and the lessor should consider whether some of the lease
payments economically represent payments
to use a portion of the underlying land. If so, in the
assessment of the classification of the lease, the fair value of
the underlying asset should include both the fair value of the
lessee’s portion of the building and a proportional amount of
the fair value of the underlying land.
For more information about lease classification
and about evaluating whether the present value of lease payments
represents substantially all of the fair value of a lease
component, see Section 8.3.3.6 for
lessee considerations and Section 9.2.1.4 for
lessor considerations.
Example 4-2
Lessee and Lessor enter into a
lease agreement in which Lessee obtains the right
to use multiple floors of a building for a term of
10 years. Lessee is the most significant tenant
and occupies a majority of the floors in the
building, which represents approximately 95
percent of the building’s usable square footage.
The building takes up the entire underlying land
of the property. Accordingly, no other structures
can be built on the land and the tenants of the
building collectively are receiving the full
economic benefits from the use of the land during
the lease term. No individual tenant has the right
to use a physically distinguishable portion of the
underlying land.
The terms of the lease
agreement require that Lessee make lease payments
of $30 million annually at the end of each year
for the entire 10-year lease term. The fair value
of the entire property is $500 million, of which
$100 million is related to the land and $400
million is related to the building. The
stand-alone prices (lessees) and stand-alone
selling prices (lessors) of the right to use the
land and building components are $66 million and
$264 million, respectively. Lessee has an
incremental borrowing rate of 10 percent.
Both entities (Lessee and
Lessor) have concluded that the ability to control
90 percent or more of the building is indicative
of substantially all of the building’s capacity.
Because Lessee has the right to use 95 percent of
the building, both entities (Lessee and Lessor)
have determined that Lessee has the right to
control the use of substantially all of the
economic benefits of the building and therefore
also has the right to control the use of 100
percent of the underlying land. Lessee and Lessor
will account for the building and the land as two
separate lease components and will allocate the
consideration to be paid over the lease term on
the basis of each component’s relative stand-alone
price (lessees) and stand-alone selling price
(lessors).
As illustrated in the table
below, Lessee and Lessor will allocate $60
million, or 20 percent, of the total consideration
of $300 million to the land and the remaining $240
million to the building. Lessee1 will use its incremental borrowing rate of
10 percent to calculate the present value of these
payments, yielding approximately $37 million and
$147 million2 for the land and building lease components,
respectfully. Lessee will then compare the present
value of these payments with the fair value of
$100 million and approximately $380 million (95
percent of the total building fair value) for the
land and building lease components, respectively,
to determine whether these payments represent
substantially all of the fair value of the
underlying asset in accordance with ASC
842-10-25-2(d).
Example 4-3
Assume the same facts as in
the example above, except that the lessee only
controls 80 percent of the capacity of the
building. Because Lessee’s capacity is less than
90 percent of the building, Lessee does not have
the right to control the use of substantially all
of the economic benefits of the building and no
other tenant obtains substantially all of the
economic benefits (i.e., the other 20 percent,
regardless of whether it is used by one or more
tenants, is not substantially all). As a result,
the underlying land would not be accounted for as
a separate lease component.
In this example, both entities
(Lessee and Lessor) will allocate the entirety of
their future lease payments of $300 million to the
building, which is the only lease component.
Lessee3 will then compare the present value of these
lease payments of approximately $184 million4 with the fair value of its allocable portion
of the property. Because Lessee occupies 80
percent of the capacity of the building, it will
allocate approximately 80 percent of the total
property value (including land) to the building in
this calculation. Thus, Lessee will use a fair
value of $400 million (80% of $500 million) in its
lease classification test.
Changing Lanes
Classification
of the Land Component Under ASC 840
In addition to the lack of a 25
percent threshold under ASC 842 (discussed in
Section
4.2.2.1), the new guidance diverges
from ASC 840 in both how consideration is allocated
to the land and building elements of the lease
arrangement, as well as the classification of these
elements.
ASC 840-10-25-38(b)(2) prescribed how
consideration is allocated between the land and
building elements of a lease arrangement, stating,
in part:
The minimum lease
payments after deducting executory costs,
including any profit thereon, applicable to the
land and the building shall be separated by the
lessee by determining the fair value of the land
and applying the lessee’s incremental borrowing
rate to it to determine the annual minimum lease
payments applicable to the land element; the remaining minimum lease
payments shall be attributed to the building
element. [Emphasis added]
However, under ASC 842, the land
element of the lease arrangement is allocated
consideration in the same manner as the other
components in the contract (i.e., on the basis of
its relative stand-alone price or stand-alone
selling price). Further, depending on the entity’s
determination of whether to separate lease and
nonlease components in the contract for that asset
class, allocated consideration may or may not
include certain costs defined as executory costs
under ASC 840.
From a classification perspective, ASC
840-10-25-38(b)(2) stated the following, in part:
- If the building element of the lease meets the lease-term criterion in 840-10-25-1(c) or the minimum-lease-payments criterion in paragraph 840-10-25-1(d), the building element shall be accounted for by the lessee as a capital lease and amortized in accordance with the guidance in paragraph 840-30-35-1(b). The land element of the lease shall be accounted for separately by the lessee as an operating lease. [Emphasis added]
- If the building element of the lease meets neither the lease-term criterion in 840-10-25-1(c) nor the minimum-lease-payments criterion in paragraph 840-10-25-1(d), both the building element and the land element shall be accounted for by the lessee as a single operating lease.
ASC 842 diverges from this approach,
since both lease components would be subject to the
lease classification test in ASC 842-10-25-2. While
the land component of a lease would never meet the
economic-life criterion in ASC 842-10-25-2(c) as a
result of its indefinite life, lease payments
allocated to this component may represent
substantially all of the fair value of the
underlying land. Accordingly, scenarios may exist in
which the land component is classified as a finance
or sales-type lease by passing the fair value test
in ASC 842-10-25-2(d), whereas land was always
classified as an operating lease under ASC 840. For
more information about the lease classification
tests under ASC 842, see Section 8.3.
4.2.3 Applying the Guidance on Separate Lease Components
The examples below — the first of which is reproduced from ASC 842-10-55-146
through 55-149 — illustrate the process outlined in the decision tree
in Section
4.2 and the guidance in ASC 842-10-15-28 and 15-29
(further discussed in Section 4.2.2).
ASC 842-10
Example 13 — Lease of a Turbine Plant
55-146 Lessor leases a gas-fired turbine plant to Lessee for eight years so that Lessee can produce electricity
for its customers. The plant consists of the turbine housed within a building together with the land on which
the building sits. The building was designed specifically to house the turbine, has a similar economic life as the
turbine of approximately 15 years, and has no alternative use. The lease does not transfer ownership of any
of the underlying assets to Lessee or grant Lessee an option to purchase any of the underlying assets. Lessor
does not obtain a residual value guarantee from Lessee or any other unrelated third party. The present value
of the lease payments is not substantially all of the aggregate fair value of the three underlying assets.
55-147 While the lease of the plant includes the lease of multiple underlying assets, the leases of those
underlying assets do not meet the second criterion necessary to be separate lease components, which is that
the right to use the underlying asset is neither dependent on nor highly interrelated with the other rights of
use in the contract. Therefore, the contract contains only one lease component. The rights to use the turbine,
the building, and the land are highly interrelated because each is an input to the customized combined item for
which Lessee has contracted (that is, the right to use a gas-fired turbine plant that can produce electricity for
distribution to Lessee’s customers).
55-148 However, because the contract contains the lease of land, Lessee and Lessor also must consider the
guidance in paragraph 842-10-15-29. Lessee and Lessor each conclude that the effect of accounting for the
right to use the land as a separate lease component would be insignificant because Lessee’s right to use the
turbine, the building, and the land is coterminous and separating the right to use the land from the right to use
the turbine and the building would not affect the lease classification of the turbine/building lease component.
Lessee and Lessor each conclude that a single lease component comprising the turbine, the building, and the
land would be classified as an operating lease, as would two separate lease components comprising the land
and the turbine/building, respectively.
55-149 The predominant asset in the single lease component is the turbine. Lessee entered into the lease
primarily to obtain the power-generation capabilities of the turbine. The building and land enable Lessee to
obtain the benefits from use of the turbine. The land and building would have little, if any, use or value to
Lessee in this contract without the turbine. Therefore, the remaining economic life of the turbine is considered
in evaluating the classification of the single lease component.
Example 4-4
City Living Properties, the lessor, rents a fully furnished, newly renovated high-rise apartment building with an
elevator to Easy Rentals, the lessee, for a term of 20 years. Easy Rentals will eventually lease the building’s fully
furnished, individual apartment units to tenants. Easy Rentals pays one fixed monthly rental payment to City
Living Properties.
The apartment building, elevator, and apartment furnishings have a 40-, 20-, and 10-year useful life,
respectively. The land on which the building sits has an indefinite useful life. Easy Rentals determines that it
has the right to use four underlying assets: (1) the apartment building, (2) the elevator, (3) the land, and (4) the
apartment furnishings.
Further, Easy Rentals determines that the leases for both the land and the building are operating leases (see Chapter 8 for further discussion of the lessee classification guidance), primarily because the 20-year stated lease term, when compared with the useful life of each underlying asset, will not result in a finance lease classification conclusion for either. Therefore, Easy Rentals reasonably concludes that the accounting effect of separating the land from the building is insignificant.
The combined land and building component and the elevator are not separately
identifiable because they are highly dependent and
highly interrelated. The rights to use the land,
building, and elevator are inputs into the
delivery of a single right to use a high-rise
apartment building. Therefore, these rights are
considered one lease component in the contract.
When classifying the lease, Easy Rentals would use
the useful life of the predominant asset within
the bundle to determine the useful life of the
entire lease component (i.e., 40 years, because
the apartment building is the predominant
asset).
The apartment furnishings are a separate lease component, since they can be used independently of the single lease component for the high-rise apartment building. Easy Rentals can use the apartment furnishings on their own or together with other readily available resources to economically benefit from the right of use. When making this determination, Easy Rentals considers the characteristics of the lease component itself, regardless of contractual limitations (i.e., it does not consider the way in which it may use or be allowed to use the lease component).
In addition, the apartment furnishings are not highly dependent on, or highly interrelated with, the single high-rise apartment building lease component. Rather, they are separately identifiable and are not combined with the high-rise apartment building to deliver a single right of use.
Easy Rentals would therefore allocate the consideration in the contract between
(1) the single high-rise apartment building lease
component and (2) the apartment furnishings.5 Allocation to components of a contract is
further discussed in Section 4.4.
4.2.3.1 Identifying Lease Components When the Underlying Asset Is Replaced During the Lease Term
Certain lease arrangements may either require or
allow for replacement of the underlying asset by the lessor
during the term of the arrangement. That is, in such
arrangements, it is expected (or required) at contract inception
that the underlying asset will be replaced. The purpose of such
replacement may be to ensure that the underlying asset continues
to meet agreed-upon performance standards for the lessee.
Example 4-5
A lessee enters into a
noncancelable contract with a lessor to obtain IT
processing services by using a dedicated server
for 10 years in exchange for 10 years of fixed
periodic payments. Assume that the contract
provides the lessee with a right to control HAFWP
an identified asset (the server) is used
throughout the 10-year contract term (i.e., the
contract contains a lease of the server). The
expected useful life of the server is five
years.
In this example, the contract
stipulates that the lessor must replace the server
once during the contract term. Since the original
server has a useful life of five years, it is
expected to be replaced at the end of year 5. The
purpose of the replacement is to maintain a
standard level of IT processing services provided
to the lessee. The contract pricing is established
up front and does not change as a result of the
server replacement. The replacement server
provides essentially the same benefit and
functionality as the original server; however, it
is unlikely that the original server would have
continued to provide the same level of benefit for
the entire 10-year contract term.
When determining the number of
lease components, evaluating lease classification
at lease commencement, and measuring its ROU asset
and lease liability, the lessee in this example
should consider each asset (i.e., the original
server and the replacement server) as a separate
lease component with separate lease terms — that
is, there are two separate lease components in
this example. The lease terms of the separate
lease components can be determined by considering
the expected replacement dates (five years in this
example), but we would not expect the lease term
to exceed the estimated useful life of the
underlying asset in a scenario in which an asset
must be replaced to maintain minimum performance
standards.
The lessee should allocate the
consideration (e.g., gross lease payments expected
to be paid over the course of the lease terms of
the lease components) between the two lease
components on a relative stand-alone price basis
and should record an ROU asset and lease liability
for the first asset (i.e., the server provided at
commencement) at lease commencement by using the
discounted lease payments over the lease term for
that asset (five years). (See Section
7.2 for more information about
determining the discount rate to be used by a
lessee.) The lessee should use the five-year lease
terms (and corresponding lease payments) in
determining the lease classification.
The example above is analogous to a master lease
agreement in which the lessee is committed to using a minimum
quantity of assets. A master lease agreement may specify that
the lessee will obtain control over the right to use multiple
underlying assets (e.g., servers) at various points during the
term of the master lease agreement. In these cases, the lessee’s
accounting depends on whether the master lease agreement commits
the lessee to obtaining control over the right to use a minimum
quantity (units or dollar value) of assets — see Section
13.4.1 for more information about such master
lease agreements.
In the above example, the lessee commits to
obtaining control over the right to use two servers (the
original server and the replacement server). In accordance with
ASC 842-10-55-17, because the lessee is obligated to use a
minimum quantity of equipment, the lessee must consider the
minimum quantity of equipment (i.e., two servers) when
identifying the separate lease components and allocating the
consideration in the contract. Further, the server to be
provided in year 5 does not qualify as an identified asset at
lease commencement of the original server under ASC 842-10-15-9,
which indicates that an asset can be identified “at the time
that the asset is made available for use by the customer.” In
other words, a lease does not commence until an identified asset
is made available for the customer’s use.
We would expect the lessee in such an arrangement
to disclose the “forward-starting” lease of the server provided
in year 5, if material, as required by ASC 842-20-50-3(b), which
states that a lessee should disclose “[i]nformation about leases
that have not yet commenced but that create significant rights
and obligations for the lessee.” The lessee would record an ROU
asset and lease liability for the remaining five-year lease term
once the lease of the replacement server commences.
4.2.3.1.1 Lessor Continually Provides a Server That Meets Certain Minimum Performance Standards
Assume that the contract differs from the one
described in Example 4-5 in such a way that the lessor is
required to continually provide a server that meets certain
minimum performance standards (e.g., processing speed and
capacity) but a replacement is not explicitly required during
the 10-year term (all other facts remain the same). In such
cases, the lessee should consider the specific facts and
circumstances of the arrangement, including the expected useful
life of the asset(s), when determining the lease component(s)
and lease term(s). If the lessee determines that the expected
useful life of the underlying asset is less than the overall
lease term (i.e., the underlying asset is not expected to be
able to meet certain minimum performance standards over the
course of the lease term), the lease arrangement may, in
substance, involve the use of two (or more) lease components to
fulfill the obligations under the arrangement. This is because
the lessor could not satisfy its obligation to the lessee to
maintain minimum performance standards without replacing the
assets during the lease term.
4.2.3.1.2 Lessee and Lessor in an Arrangement That Contains the Right or Obligation to Replace the Original Asset
The lessee and lessor in an arrangement that
contains the right or obligation (including implied rights or
obligations) to replace the original asset would have the same
contractual rights and obligations; therefore, the determination
of the lease components and lease term should generally be
aligned. In Example 4-5,
the lessor is delivering two lease components to the lessee
(i.e., the original server and the replacement server). The
lessor would evaluate lease classification separately for the
two identified lease components and account for the lease
agreements in accordance with ASC 842-30.
Footnotes
1
Lessor would calculate the
present value of the lease payments by using its
rate implicit in the lease; however, such a
calculation is not included in this example.
2
This balance reflects the
present value of the allocated portion of annual
lease payments paid over the lease term of 10
years. Thus, the land component represents the
present value of lease payments of $6 million (20%
× $30 million) per annum and the building
component represents the present value of lease
payments of $24 million (80% × $30 million) per
annum, both paid over the 10-year lease term and
discounted at Lessee’s 10 percent incremental
borrowing rate.
3
Lessor would use its rate
implicit in the lease to calculate the present
value of lease payments and compare that with the
fair value of the allocable portion of the total
property associated with the ROU asset ($400
million in this example). This example does not
illustrate that approach.
4
This balance reflects the
present value of the $30 million of annual lease
payments paid for the lease term of 10 years and
discounted at Lessee’s incremental borrowing rate
of 10 percent.
5
The apartment furnishings may
need to be separated further (e.g., a couch is
separable from a table); however, for illustration
purposes, such an evaluation is not performed.
4.3 Identify the Separate Nonlease Components
ASC 842-10
15-30 The consideration in the
contract shall be allocated to each separate lease component
and nonlease component of the contract (see paragraphs
842-10-15-33 through 15-37 for lessee allocation guidance
and paragraphs 842-10-15-38 through 15-42C for lessor
allocation guidance). Components of a contract include only
those items or activities that transfer a good or service to
the lessee. Consequently, the following are not components
of a contract and do not receive an allocation of the
consideration in the contract:
-
Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
-
Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.
Once the separate lease components are identified (see Section 4.2), entities
must determine whether there are any nonlease components to be separated.
An allocation of the consideration in the contract is required for both lease and
nonlease components, since they transfer a good or service to the customer.
However, as indicated in ASC 842-10-15-30, such allocation does not extend to
activities that do not transfer a good or service to the customer (e.g., administrative
tasks and reimbursement or payment of the lessor’s costs).
ASC 842-10-15-30 notes that “[c]omponents of a contract include only
those items or activities that transfer a good or service to the lessee.” For
example, a contract may include a separate lease component (e.g., the right to use
the underlying asset that is the subject of the agreement) as well as additional
goods or services that are transferred to the lessee (e.g., maintenance services),
which are nonlease components (see Section 4.3.1). Once the separate lease components are identified
(see Section 4.2), entities must determine whether there are
any nonlease components to be separated.
Contracts often include other costs or fees that do not provide a
separate good or service to the lessee — for example, costs paid by the lessee, such
as (1) the cost of administrative tasks performed to set up a contract or initiate
the lease or (2) reimbursement or payment of the lessor’s costs (e.g., property
taxes and insurance related to the leased asset). These types of costs do not
transfer a good or service to the lessee and would therefore not be considered a
component in the contract (see Section 4.3.2).
An entity is required to allocate the total consideration in a
contract (including all amounts charged for administrative start-up, property taxes,
and some insurance — see Section
4.4.1.1 for lessees and Section 4.4.2.1 for lessors) to its identified
separate lease and nonlease component(s). The manner of allocating the consideration
depends on whether the entity is the lessee (see Section 4.4.1.2) or lessor (see Section 4.4.2.2) in the
arrangement. Practical expedients may be available that, upon election, would allow
entities not to separate, and thus not allocate consideration in the contract
between, lease and nonlease components (see Section 4.3.3 for
further discussion).
The graphic below summarizes the concepts in ASC 842-10-15-30.
The accounting for lease components differs from that for nonlease
components, as articulated in ASC 842-10-15-31:6
ASC 842-10
15-31 An entity shall account for
each separate lease component separately from the nonlease
components of the contract (that is, unless a lessee makes
the accounting policy election described in paragraph
842-10-15-37 or unless a lessor makes the accounting policy
election in accordance with paragraph 842-10-15-42A).
Nonlease components are not within the scope of this Topic
and shall be accounted for in accordance with other
Topics.
Understanding the difference between lease components, nonlease
components, and “noncomponents” (i.e., activities paid for by the customer that do
not transfer a good or service to the customer) will be critical throughout the
remainder of this chapter. The table below outlines these three types of components
in greater detail.
|
Lease Component
|
The right to use an underlying asset is
considered a separate lease component if (1) a lessee can
benefit from the use of the underlying asset either on its
own or with other resources that are readily available and
(2) the underlying asset is not highly dependent on or
highly interrelated with other assets in the arrangement.
Separate lease components are discussed in detail in
Section 4.2.
|
|
Nonlease
Component
|
An activity that transfers a separate good
or service to the customer is a nonlease component. For
example, maintenance services consumed by the customer and
bundled with the lease component in the contract would be a
separate nonlease component because the performance of the
maintenance transfers a service to the customer that is
separate from the right to use the asset. As discussed
further below, under ASC 842, services or other nonlease
components may be accounted for separately from the lease
component(s) even if they would not be accounted for
separately from other promised goods or services in a
revenue contract with a customer. This may be
counterintuitive to some that find nonlease components in a
contract not to be distinct from the lease component(s). See
the Connecting the Dots in Section
4.3.1 for further discussion.
|
|
Noncomponent
|
Any activity in a contract that does not
transfer a separate good or service to the lessee is neither
a lease component nor a nonlease component; therefore,
consideration in the contract would not be allocated to such
an activity. For example, payments made by the customer for
property taxes or insurance that covers the supplier’s
interests would not represent a component in the
contract.
|
Connecting the Dots
Determination of Whether a Lease
Exists Precedes Component Identification and Separation
Before identifying and separating lease and nonlease
components, an entity must determine whether a contract is or contains a
lease (see Chapter
3). Once it has been determined that a lease exists, the
identification of the components does not affect that conclusion. A contract
can contain one or more lease and nonlease components or noncomponents
without influencing the determination that a contract is or contains a
lease.
Services Generally Should Be Accounted
for in the Same Manner Regardless of Whether They Are Included in a
Contract With a Lease Component
Paragraph BC148 of ASU 2016-02 states that the recognition
and measurement guidance for leases in ASC 842 should only be applied to the
lease components in a contract and that “a nonlease component should not, in
general, be subject to different accounting requirements solely because it
is included in a contract that contains a lease.” Further, Paragraph BC149
of ASU 2016-02 goes on to say:
The Board also decided that [entities] should
account for lease and nonlease (typically, service) components
separately . . . Board members observed that to do otherwise could
result in different accounting for services solely depending on
whether the service is included together with a lease. . . . [T]he
accounting for services should be the same, regardless of whether
the contract that includes the services also includes a lease.
Accordingly, both lessees and lessors are required to
separate lease and nonlease components (unless they elect the practical
expedients discussed in Section 4.3.3) so that (1) lease components may be
appropriately reflected in accordance with ASC 842 (e.g., to ensure more
precise measurement of the lessee’s lease assets and lease liabilities) and
(2) nonlease components may be appropriately reflected in accordance with
other applicable GAAP (e.g., to ensure an appropriate pattern of revenue
recognition in accordance with ASC 606 when lessors also provide services to
lessees).
Example 12 in ASC 842-10-55-141 through 55-145, reproduced below,
constitutes a good introductory illustration of the guidance in ASC 842-10-15-30 and
15-31.
ASC 842-10
Example 12 — Activities or Costs That Are
Not Components of a Contract
Case A — Payments for Taxes and Insurance
are Variable
55-141 Lessor and Lessee enter into
a five-year lease of a building. The contract designates
that Lessee is required to pay for the costs relating to the
asset, including the real estate taxes and the insurance on
the building. The real estate taxes would be owed by Lessor
regardless of whether it leased the building and who the
lessee is. Lessor is the named insured on the building
insurance policy (that is, the insurance protects Lessor’s
investment in the building, and Lessor will receive the
proceeds from any claim). The annual lease payments are
fixed at $10,000 per year, while the annual real estate
taxes and insurance premium will vary and be billed by
Lessor to Lessee each year.
55-142 The real estate taxes and
the building insurance are not components of the contract.
The contract includes a single lease component — the right
to use the building. Lessee’s payments of those amounts
solely represent a reimbursement of Lessor’s costs and do
not represent payments for goods or services in addition to
the right to use the building. However, because the real
estate taxes and insurance premiums during the lease term
are variable, those payments are variable lease payments
that do not depend on an index or a rate and are excluded
from the measurement of the lease liability and recognized
by Lessee in profit or loss in accordance with paragraph
842-20-25-5 or 842-20-25-6. Lessor also recognizes those
payments as variable lease payments in accordance with
paragraph 842-10-15-40A because the real estate taxes and
insurance premiums are paid by Lessor to the taxing
jurisdiction and insurance company and reimbursed by Lessee
to Lessor. However, if Lessee paid the costs directly to the
third parties, those lessor costs would not be recognized by
Lessor as variable payments because of the requirement in
paragraph 842-10-15-40A.
Case B — Payment for Taxes and Insurance
Are Fixed
55-143 Assume the same facts and
circumstances as in Case A (paragraphs 842-10-55-141 through
55-142), except that the fixed annual lease payment is
$13,000. There are no additional payments for real estate
taxes or building insurance; however, the fixed payment is
itemized in the contract (that is, $10,000 for rent, $2,000
for real estate taxes, and $1,000 for building insurance).
Consistent with Case A, the taxes and insurance are not
components of the contract. The contract includes a single
lease component, the right to use the building. The $65,000
in payments Lessee will make over the 5-year lease term are
all lease payments for the single component of the contract
and, therefore, are included in the measurement of the lease
liability.
Case C — Common Area Maintenance
55-144 Assume the same facts and
circumstances as in Case B (paragraph 842-10-55-143), except
that the lease is of space within the building, rather than
for the entire building, and the fixed annual lease payment
of $13,000 also covers Lessor’s performance of common area
maintenance activities (for example, cleaning of common
areas, parking lot maintenance, and providing utilities to
the building). Consistent with Case B, the taxes and
insurance are not components of the contract. However, the
common area maintenance is a component because Lessor’s
activities transfer services to Lessee. That is, Lessee
receives a service from Lessor in the form of the common
area maintenance activities it would otherwise have to
undertake itself or pay another party to provide (for
example, cleaning the lobby for its customers, removing snow
from the parking lot for its employees and customers, and
providing utilities). The common area maintenance is a
single component in this contract rather than multiple
components, because Lessor performs the activities as needed
(for example, plows snow or undertakes minor repairs when
and as necessary) over the same period of time.
55-145 Therefore, the contract in
Case C includes two components — a lease component (that is,
the right to use the building) and a nonlease component. The
consideration in the contract of $65,000 is allocated
between those 2 components (unless Lessee elects the
practical expedient in paragraph 842-10-15-37 or Lessor
elects the practical expedient in paragraph 842-10-15-42A
when the conditions in that paragraph are met). The amount
allocated to the lease component is the lease payments in
accounting for the lease.
4.3.1 Nonlease Components
Nonlease components in a contract (i.e., any activity that
transfers a good or service to the lessee) will generally represent some sort of
service that the lessee is paying for in the contract and that the lessor is
providing to the lessee in addition to the lease component. The following are
examples of common nonlease components in a contract that contains both lease
and nonlease components:
-
A contract for the right to use equipment, when the lessor also provides regular maintenance of the equipment throughout the contract.
-
A contract for the right to use a transportation vehicle (e.g., airplane, ship, or truck), when the lessor also provides operating personnel to operate the vehicle for the lessee throughout the contract.
-
A contract for the right to use an oil, gas, or mining drill rig, when the lessor also provides a crew to man and operate the rig throughout the contract.
-
A contract for the right to use a manufacturing facility, when the lessor also provides the materials and labor needed to produce a product for the lessee.
-
A contract for the right to use several floors of an office building, when the lessor also provides maintenance services to clean the building lobbies, maintain elevators, etc. (i.e., common-area maintenance [CAM]).
Because ASC 842-10-15-30 describes nonlease components as any
“items or activities that transfer a good or service to the lessee,” such
components may be something other than the typical services described above. For
example, ASC 842-10-55-32 and 55-33 clarify that entities (particularly lessors)
may need to consider whether guarantees and indemnifications are nonlease
components, which must be accounted for in accordance with other applicable
GAAP.
ASC 842-10
55-32 Paragraph 460-10-15-4(c)
states that, except as provided in paragraph
460-10-15-7, the provisions of Subtopic 460-10 on
guarantees apply to indemnification agreements
(contracts) that contingently require an indemnifying
party (guarantor) to make payments to an indemnified
party (guaranteed party) based on changes in an
underlying that is related to an asset, a liability, or
an equity security of the indemnified party. Paragraph
460-10-55-23A provides related implementation guidance
for a tax indemnification provided to a lessor.
55-33 A lessor should evaluate
a commitment to guarantee performance of the underlying
asset or to effectively protect the lessee from
obsolescence of the underlying asset in accordance with
paragraphs 606-10-55-30 through 55-35 on warranties. If
the lessor’s commitment is more extensive than a typical
product warranty, it might indicate that the commitment
is providing a service to the lessee that should be
accounted for as a nonlease component of the
contract.
The concept of a nonlease component in ASC 842 is effectively
the same as that for “promised goods or services” under ASC 606. Section 5.2 of Deloitte’s
Roadmap Revenue
Recognition contains detailed discussion of promises in a
contract and may help entities understand whether an activity provided by the
lessor (other than the right of use) transfers a good or service to the
lessee.
Connecting the Dots
Nonlease Components Do Not Need
to Be Distinct
Although the concept of nonlease components in ASC 842
is similar to that of promised goods or services in ASC 606, there is
one significant difference: nonlease components do not need to be
distinct from lease components to be accounted for separately.
Under ASC 606, for revenue recognition purposes, the
transaction price is allocated only to distinct performance obligations.
(See Section
5.3 of Deloitte’s Roadmap Revenue Recognition for
detailed discussion of when a promised good or service is a distinct
performance obligation.) Under ASC 842, the consideration in the
contract is allocated to an item or activity when that item or activity
transfers a good or service to the lessee.
When developing ASC 842, the FASB considered whether the
“distinct” guidance in ASC 606 should apply to identifying and
separating nonlease components. Paragraph BC151(a) of ASU 2016-02
explains that the 2010 leasing ED included guidance that required
lessees and lessors to account for a service or other nonlease component
separately only if it was distinct in accordance with the guidance that
the Board was developing on revenue recognition. However, paragraph
BC151(a) of ASU 2016-02 further notes that, in feedback on the 2010 ED,
respondents indicated that they “found the proposals confusing, or they
disagreed with some aspects of those proposals, in particular, the
proposal to account for the entire contract as a lease if nonlease
components were not distinct.”
Accordingly, under ASC 842, services or other nonlease
components may be accounted for separately from the lease component(s)
even if they would not be accounted for separately from other promised
goods or services in a revenue contract with a customer. This may be
counterintuitive to some lessees and lessors that find nonlease
components in a contract not to be distinct from the lease component(s)
(e.g., when the asset being leased cannot run or operate without the
services provided by the lessor’s operating personnel). In addition, it
may be challenging to develop an appropriate stand-alone price (for
lessees) or stand-alone selling price (for lessors) — for both the lease
component(s) and the nonlease components — with respect to allocating
consideration in the contract. (The allocation methods for both lessees
and lessors are further discussed in Section 4.4.)
Although nonlease components do not need to be distinct from
lease components to be accounted for separately, ASC 842-10-15-31 states that
nonlease components are not within the scope of ASC 842 (unless a lessor makes
the accounting policy election in accordance with ASC 842-10-15-42A) and
therefore must be accounted for in accordance with other applicable GAAP. For
lessors, this means that nonlease components (e.g., maintenance services)
generally should be accounted for in accordance with the guidance on revenue
from contracts with customers in ASC 606.7 Accordingly, lessors will need to consider whether any of the promised
goods or services in the separated nonlease component(s) represent distinct
performance obligations. That is, although a bundle of promised goods or
services may be separated from the lease component as nonlease components, the
lessor will further need to identify distinct performance obligations within
that bundle in accordance with step 2 of the revenue model in ASC 606. The
guidance on identifying performance obligations in ASC 606 is discussed in
detail in Chapter 5 of Deloitte’s Roadmap
Revenue
Recognition. Lessors should consider our interpretive
guidance in assessing any nonlease components that are separated from the lease
component(s) in a contract that contains a lease.
Maintenance services are likely to be some of the most commonly
identified nonlease components in contracts that contain a lease. It is very
common for leases of real estate (e.g., leases of an apartment, space in an
office building, dwellings in a retirement home) to include some form of CAM.
Lessors of such real estate may also procure and provide to lessees certain
utilities (e.g., water, gas, and electricity).
4.3.1.1 Common-Area Maintenance and Utilities
Leases of office or commercial space often contain
provisions that require the tenant to reimburse the landlord for amounts
such as CAM costs or the cost of providing utilities (e.g., heat, water,
gas, and electricity). Both CAM and utilities are considered nonlease
components, as discussed in the following paragraphs.
CAM costs might include an allocated portion of costs for landscaping,
janitorial services, repairs, snow removal, and other maintenance of common
areas. CAM charges can be based on the actual costs incurred by the
landlord. However, such charges also might be negotiated at the inception of
the lease as fixed amounts, potentially with scheduled increases over the
lease term.
CAM represents the transfer of a good or service to the
lessee other than the right to use the underlying asset. Therefore, unless a
practical expedient is available and elected (see Section 4.3.3), it is a nonlease
component (1) that both the lessee and lessor must separate from the lease
component(s) and (2) to which consideration in the contract must be
allocated. Example 12, Case C, in ASC 842-10-55-144 and 55-145 (reproduced
in Section
4.3), supports this conclusion and states, in part:
[T]he common area maintenance is a component because
Lessor’s activities transfer services to Lessee. That is, Lessee
receives a service from Lessor in the form of the common area
maintenance activities it would otherwise have to undertake itself
or pay another party to provide (for example, cleaning the lobby for
its customers, removing snow from the parking lot for its employees
and customers, and providing utilities).
As for utilities, they may be charged to the tenant at cost,
allocated cost, or either cost or allocated cost plus a margin. The lessor
transfers a good or service to the lessee that is separate from the right to
use the underlying asset when it provides water, gas, electricity, or other
utilities. Therefore, unless a practical expedient is available and elected
(see Section
4.3.3), utilities reflect a nonlease component (1) that both
the lessor and lessee must separate from the lease component(s) and (2) to
which consideration in the contract must be allocated.
Changing Lanes
CAM and Utilities Are No
Longer Just Executory Costs
ASC 840 required that “substantial services” be
accounted for separately from the lease element in a contract that
contains both a lease element and such substantial services.
Although the phrase “substantial services” was not defined in ASC
840, we expect that any elements that are substantial services and
that are thus currently separated from the lease element will also
be nonlease components under ASC 842.
However, the treatment of maintenance and utilities
under ASC 842 will generally differ from that under ASC 840.
Specifically, under ASC 840-10-25-1(d), maintenance and utilities
were generally considered executory costs and not substantial
services. Therefore, under ASC 840-10-15-17 and ASC 840-10-15-19,
maintenance and utilities were considered part of the lease element
and are within the scope of ASC 840. Under ASC 842, on the other
hand (and as explained above), maintenance (including CAM) and
utilities are nonlease components. Accordingly, while the lease
payments (i.e., the consideration in the contract) are not
separately allocated to both CAM and utilities under ASC 840 for
accounting purposes, the lease payments will be allocated in this
way under ASC 842 (provided that a practical expedient is not
available or is not elected — see Section 4.3.3). Further, under
ASC 842, unless a practical expedient is available and elected, both
CAM and utilities are accounted for in accordance with other
applicable GAAP rather than being accounted for as part of the lease
as they were under ASC 840.
Connecting the Dots
Real Estate Lessors’
Identification of Distinct Performance Obligations Within
CAM
As discussed above, lessors will need to consider
the guidance in ASC 606 to identify distinct performance obligations
within the nonlease component(s) that are separated from the lease
component(s).8 Similarly, to recognize revenue in accordance with ASC 606,
real estate lessors will need to consider whether CAM is a single
performance obligation or comprises multiple performance
obligations.
We think that CAM will often represent a single
performance obligation. Although CAM comprises multiple different
activities that the lessor may perform on a day-to-day basis (e.g.,
cleaning the lobbies and bathrooms daily, buffing the lobby floors
weekly), the nature of the lessor’s promise is to maintain the
common areas of the real estate being leased. In promising to
deliver CAM, the lessor agrees that it will undertake various
activities to fulfill its overall promise to the lessee of providing
a well-maintained building and common areas.
This view is consistent with that articulated by the
FASB in ASC 606-10-55-157B through 55-157E (added to ASC 606 by
ASU 2016-10),
which illustrate an arrangement involving hotel management services.
That is, in this example, the Board concludes that “[t]he service
comprises various activities that may vary each day (for example,
cleaning services, reservation services, and property maintenance)
[but] those tasks are activities to fulfill the hotel management
service and are not separate promises in the contract.” Accordingly,
each increment (e.g., each day of the management services) of the
promised service is distinct, but together the overall promise
represents a series of distinct goods or services that are accounted
for as a single performance obligation in accordance with ASC
606-10-25-14 and 25-15.
However, real estate lessors should carefully
consider the promised goods or services within the overall CAM
promise. For example, we do not think that it would be appropriate
for utilities (discussed above) or major maintenance (discussed in
Section 4.3.1.2) to be considered part of a
single performance obligation with CAM just because those items may
be billed together or expressed together in the contract with the
lessee. That is, just because an activity is characterized as part
of CAM does not mean that it should be bundled together as part of a
single performance obligation with CAM.
Although an activity (e.g., a good or service) may
be distinct from CAM, it may be reasonable to account for it
together with the CAM if the pattern of transfer and the outcome of
accounting for them together are the same, as indicated in paragraph
BC116 of ASU
2014-09.
4.3.1.2 Major Maintenance
In leases of equipment and other large assets (e.g.,
airplanes, power plants), the lessor often provides nonroutine or “major”
maintenance on the leased asset. Major maintenance differs from CAM or other
routine maintenance in that, for major maintenance, the lessor (1) does not
regularly provide the services and (2) may need to spend a certain amount of
capital to keep the asset available for the lessee’s use. For example, a
lessor may need to provide major maintenance for an airplane that it leases
to a lessee — and remove the airplane from the lessee’s rotational use — at
the earlier of (1) the time when a maximum number of miles is flown or (2) a
federally regulated time since the last major maintenance was performed.
The performance of major maintenance represents the transfer
of a good or service to the lessee other than the right to use the
underlying asset. Therefore, unless a practical expedient is available and
elected (see Section
4.3.3), it is a nonlease component (1) that both the lessor
and lessee must separate from the lease component(s) and (2) to which
consideration in the contract must be allocated.
Generally, major maintenance was considered a “substantial
service” under ASC 840. Therefore, we would expect major maintenance to be
separated from the lease component as a nonlease component in a manner
consistent with that described in the Changing Lanes above. In addition,
given the distinct characteristics and separable risks of major maintenance,
compared with other services that the lessor may provide more regularly,
such maintenance may represent a distinct performance obligation for the
lessor in accordance with ASC 606.
4.3.2 Noncomponents
While lease components and nonlease components transfer a good
or service to the lessee, noncomponents do not transfer anything to the lessee.
Rather, they are incurred by the asset owner (i.e., the lessor) regardless of
whether the asset is out on lease. As indicated in ASC 842-10-15-30,
noncomponents are generally payments for either of the following:
-
Administrative tasks performed by the lessor that are necessary “to set up a contract or initiate the lease.”
-
Reimbursements (or direct payments) of the lessor’s costs that the lessor requires the lessee to pay as part of earning a return of (and on) the lessor’s costs to deliver the contract.
Payments made by the lessee for the following are considered
noncomponents to which the consideration in the contract is not separately
allocated:
-
Real estate or property taxes related to the leased asset (see Section 4.3.2.1).
-
Insurance that covers the lessor’s interest in the asset (see Section 4.3.2.2).
-
Commitment fees.
-
Other administrative charges.
In addition, payments for the items described above would be
considered noncomponents regardless of whether the payments are fixed or
variable.
In a manner similar to the guidance in ASC 606 on setup
activities, the consideration in the contract is not allocated to noncomponents
because they do not transfer a good or service to the lessee. Rather, fixed
amounts paid for noncomponents are included in the consideration in the contract
and allocated to the lease and nonlease components.9 (See Section
4.4 for detailed discussion of measuring and allocating
consideration in the contract.) The Board explains this consistency in paragraph
BC159 of ASU 2016-02:
The guidance in Topic 842 in this respect is consistent
with the revenue recognition guidance in Topic 606, which states that
promised goods or services do not include set up or other activities
that an entity must undertake to fulfill a contract unless those
activities transfer a good or service to the customer. Those activities,
therefore, do not get an allocation of the transaction price.
However, these costs are also often variable and paid on the
basis of the actual costs and are not considered part of the consideration in
the contract. For lessees, the accounting and reporting requirements for these
costs are the same regardless of whether the lessee is reimbursing the lessor or
paying a third party directly on the lessor’s behalf (e.g., paying real estate
taxes directly to the relevant tax authority). However, the accounting and
reporting requirements for lessors differ when the noncomponent is a lessor
cost. Specifically, lessor costs that a lessee pays directly to a third party on
behalf of the lessor are excluded from variable payments, and thus from lease
revenue, while lessor costs that the lessor pays directly to a third party, and
that the lessee then reimburses, must be accounted for as variable payments and
therefore as lease revenue. For detailed discussion of the measurement of the
consideration in the contract (and whether or when variable payments are
included in that measurement), see Section 4.4.1 (for lessees) and Section 4.4.2 (for
lessors).
4.3.2.1 Property Taxes
Depending on the relevant tax authority, the asset owner
(i.e., the lessor) generally owes property taxes on the asset regardless of
whether or to whom the asset is out on lease. Accordingly, the relevant tax
authority has recourse only to the lessor for property taxes owed. This is
the case even when a lessor requires a lessee in the contract to pay
property taxes directly to the tax authority — although the lessor may have
recourse to the lessee, the tax authority ultimately holds the lessor
responsible for such amounts.
The FASB discusses property taxes in paragraph BC157 of ASU
2016-02:
[I]t is common practice for one party to the
contract to pay certain costs directly to a third party, although
the counterparty to the contract is principally liable to make those
payments (for example, a lessee may make property tax payments
directly to the taxing authority although the lessor is principally
liable for those payments).
The lessee receives no good or service in return for its
payment of property taxes, regardless of whether it reimburses the lessor or
pays the tax authority directly; as a result, the property taxes are not
considered a component (lease or nonlease) in the contract. In many cases,
the lessee is ultimately reimbursing the lessor for its costs, for which the
lessor is the primary obligor to the tax authority. Therefore, both the
lessee and lessor consider property taxes noncomponents in a contract and no
consideration in the contract is allocated to the property taxes.
Example 12, Case A, in ASC 842-10-55-141 and 55-142
(reproduced in Section
4.3), supports the conclusion that property taxes are
noncomponents. In that example, the lessor and lessee conclude that property
taxes are not a component in the contract because the “real estate taxes
would be owed by Lessor regardless of whether it leased the building and who
the lessee is.” Paragraph BC158 of ASU 2016-02 also addresses the Board’s
conclusions regarding property taxes:
For example, an entity would not account for a
portion of the consideration in the contract that is attributable to
paying the lessor’s property taxes . . . as a component if the
lessor is the primary obligor for those taxes . . . and the amounts
paid are not for a service (for example, maintenance or operations
services) provided by the lessor to the lessee.
For lessees and lessors, any amounts paid for property taxes
that are included in the consideration in the contract (i.e., the costs are
fixed in the contract) are allocated to the separate lease and nonlease
components. However, the lessee and lessor requirements differ when the
amounts paid for property taxes are excluded from the consideration in the
contract (i.e., the costs are variable). For lessees, the variable payment
is allocated on the same basis as the fixed consideration. For lessors, the
requirements for lessee-paid costs differ from those for lessee-reimbursed
costs. Any amounts that a lessee directly pays to a third party on behalf of
the lessor for property taxes should be excluded from variable payments and
thus from lease revenue. Any amounts that the lessee reimburses and the
lessor pays to the third party should be included in variable payments and
therefore in lease revenue. (See Section 4.4 for detailed discussion of
measuring and allocating consideration in the contract.)
4.3.2.2 Insurance
In real estate and automobile leases, the lessor commonly
requires the lessee to pay for insurance coverage to protect the lessor’s
interest in the leased asset (e.g., insurance to cover the physical
structure of an office building). Generally, the lessor would seek to obtain
equivalent insurance coverage regardless of whether or to whom it was
leasing the asset. The contract may require the lessee to pay the lessor
(e.g., to reimburse the lessor’s premium) or to obtain the insurance
coverage directly from, and pay the premium directly to, a third-party
insurance provider.
It is also common for real estate and automobile leases to
require — or for the lessee to decide on its own to obtain — insurance
coverage to protect the lessee’s interests in the leased asset (e.g., to
cover the contents of the physical structure that the lessee owns, such as
with renter’s insurance). In such cases, the lessee would generally obtain
the insurance directly from a third-party insurance provider.
4.3.2.2.1 Insurance Premiums Paid by Lessee to Protect Lessor’s Interest
With respect to insurance premiums that the lessee pays
for insurance coverage to protect the lessor’s interest in the asset,
the lessee receives no good or service in return for its payment of the
insurance premium, regardless of whether the lessee reimburses the
lessor or the lessee pays the insurance provider directly. The lessee is
ultimately reimbursing the lessor for its costs, and when the policy
covers the lessor’s interest in the asset as the named insured, the
lessor is the primary beneficiary of the policy. Therefore, both the
lessor and the lessee consider such insurance a noncomponent in the
contract and no consideration in the contract is allocated to the
insurance.
Example 12, Case A, in ASC 842-10-55-141 and 55-142
(reproduced in Section
4.3), supports the conclusion that payments for insurance
coverage are noncomponents. In that example, the lessor and lessee
conclude that insurance is not a component in the contract because
“Lessor is the named insured on the building insurance policy (that is,
the insurance protects Lessor’s investment in the building, and Lessor
will receive the proceeds from any claim).”
For lessees and lessors, any amounts paid for such
insurance coverage that are included in the consideration in the
contract (i.e., the costs are fixed in the contract) are allocated to
the separate lease and nonlease components. However, the lessee and
lessor requirements differ when amounts paid for insurance coverage are
excluded from the consideration in the contract (i.e., the costs are
variable). For lessees, the variable payment is allocated on the same
basis as the fixed consideration. For lessors, the requirements for
lessee-paid costs differ from those for lessee-reimbursed costs. Any
amounts that a lessee directly pays to a third party on behalf of the
lessor for insurance coverage should be excluded from variable payments
and thus from lease revenue. Any amounts that the lessee reimburses and
the lessor pays to the third party should be included in variable
payments and therefore in lease revenue. (See Section 4.4 for detailed
discussion of measuring and allocating consideration in the
contract.)
4.3.2.2.2 Insurance Premiums Paid by Lessee to Protect Lessee’s Interest
Insurance premiums that the lessee pays for insurance
coverage to protect its own interest in the leased asset are also
considered noncomponents in the contract.
The lessee receives a good or service in return for its
payment of the insurance premium; however, that good or service does not
result from the contract that contains the lease but from the contract
between the lessee and the third-party insurance provider. The lessee is
ultimately protecting its own interest in the leased asset by covering
its own property within that leased asset; thus, the lessee is the named
insured and primary beneficiary of the policy. In addition, the lessee
is not reimbursing the lessor for any costs.
Therefore, both the lessee and the lessor consider such
insurance separate from the contract that contains the lease. No
consideration in the contract that contains the lease is allocated to
the insurance. Rather, the lessee accounts for any amounts it paid for
such insurance coverage in accordance with other applicable GAAP. The
lessor would not account for the insurance coverage (i.e., the payments
are not a lessor cost).
4.3.2.2.3 Insurance Premiums Paid by Lessee to Protect Both Lessee and Lessor Interests
In certain situations, the lessee may pay insurance
premiums for an umbrella insurance policy that covers both the lessor’s
and the lessee’s interest in the leased asset and the lessee and lessor
may be required to allocate these premiums. This situation is common in
automobile leases in which the lessor requires the lessee to purchase
collision insurance (for which the lessor is the primary beneficiary)
and the lessee also obtains liability (and potentially other) insurance
under the same policy (for which the lessee is the primary
beneficiary).
As explained in Section 4.3.2.2.1,
and in accordance with ASC 842-10-15-30, an entity should consider
whether any amounts paid for insurance that covers the lessor’s interest
in the asset should be included in the consideration in the contract and
allocated to the separate lease and nonlease components. (See Section 4.4 for
detailed discussion of measuring and allocating consideration in the
contract.)
Lessees should allocate the insurance premium amount
between (1) the portion that is compensation for the insurance coverage
over the lessor’s interest in the asset, when the lessor is the insured
party, so that an appropriate amount of the premium can be considered
for inclusion in the consideration in the contract (or for allocation of
variable payments) and (2) the portion that is compensation for the
insurance coverage over the lessee’s interest in the asset, when the
lessee is the insured party, so that the lessee can account for an
appropriate amount of the premium in accordance with other applicable
GAAP.
In circumstances in which the lessee pays insurance
premiums that cover both the lessor’s and lessee’s interest in the
leased asset, lessors are most likely not aware of the actual amount of
the policy premium since a lessee would typically pay a third party
directly. Any amount that a lessee directly pays to a third party on
behalf of the lessor for insurance coverage should be excluded from
variable payments. Further, any amount that a lessee directly pays to a
third party on behalf of itself for insurance coverage would not be a
lessor cost; thus, lessors should never account for such an amount.
Accordingly, lessors should exclude from variable payments, and thus
from lease revenue, the entire insurance premium (provided that the
lessee pays this premium directly to a third party).
Changing Lanes
Lessors Record Revenues
and Expenses on a Gross Basis for Property Taxes and
Insurance When Reimbursed by a Lessee
As discussed above, under ASC 842, property
taxes and insurance (which covers the lessor’s interest in the
asset) do not transfer a good or service to the lessee and are
thus noncomponents of a contract. The consideration in the
contract is not allocated to noncomponents; rather, both the
lessee and the lessor allocate payments for noncomponents to the
lease and nonlease components.
Under ASC 840, lessors often recorded payments
for executory costs (including property taxes and insurance) net
in the income statement, especially when the lessee makes these
payments directly to a third party (e.g., the tax authority),
such as in a triple net lease. That is, lessors do not record
gross revenues for the amounts paid by the lessee and an expense
for the amount of costs they incur. Often, the inflow (revenue)
and outflow (expense) are equal and are thus “netted” down to
zero for presentation in the income statement.
However, under ASC 842, to the extent that the
lessee is reimbursing the lessor’s costs and the lessor is
ultimately paying the third party (as discussed in
Sections 4.3.2.1 and
4.3.2.2), the lessor should recognize
its costs on a gross basis in the income statement as an
expense, as it would for any other costs that it incurs. This is
consistent with how an entity would recognize and present cost
recovery amounts billed to customers in accordance with ASC 606.
(See Sections
14.7.2.2 and C.5.1 of Deloitte’s
Roadmap Revenue Recognition for detailed
discussion of TRG Agenda Paper 2, which addresses the gross or
net presentation of amounts billed to customers.)
This may result in a change from practice under
ASC 840 for many lessors, especially real estate lessors. As a
result, lessors may end up with higher revenues and expenses
than were previously recorded.
That said, under ASC 842, if the lessee is
paying a third party directly on behalf of the lessor, the
lessor should recognize its costs on a net basis in the income
statement (i.e., exclude lessee-paid costs from variable
payments and therefore from lease revenue).
Property Taxes and
Insurance May Inflate the Measurement of the Lease
Liability and ROU Asset
On the basis of the lease accounting guidance in
ASC 840-10-25-1(d), both property taxes and insurance were
considered executory costs. ASC 840-10-15-17 and ASC
840-10-15-19 stated that such costs are considered part of the
lease element and are therefore within the scope of ASC 840.
However, executory costs for property taxes and insurance, and
profits thereon, are excluded from minimum lease payments for
purposes of lease classification (i.e., excluded from the 90
percent test) and the measurement of capital lease obligations
and capital lease assets.
As explained in Sections 4.3.2.1 and
4.3.2.2, property taxes and insurance,
respectively, will be noncomponents under ASC 842. Although
these costs are often variable, any fixed amounts paid by the
lessee for property taxes and insurance will be included in the
consideration in the contract and allocated to the lease and
nonlease components (to the extent that there are nonlease
components in the contract), whereas they are not under ASC 840
guidance. This could potentially result in the following:
-
Increased likelihood that an entity will classify the lease component in the contract as a finance lease when considering the criterion in ASC 842-10-25-2(d), since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance. (The lessee’s classification is discussed in detail in Chapter 8.)
-
Higher lease liabilities and ROU assets, regardless of whether the lease is classified as an operating or finance lease, since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance to be included in the initial measurement of the lease.
4.3.2.3 Sales Taxes
In certain tax jurisdictions, lessees are subject to sales,
use, and value-added taxes, etc., in connection with the use of an asset in
a contract that contains a lease. The lessee may pay the taxes directly to
the tax authority, or the contract may state that the lessor will collect
the taxes from the customer and remit the funds to the tax authority.
4.3.2.3.1 Determining Whether Sales Taxes Paid by Lessee Represent Lease Payments
To determine whether the sales taxes represent payments
associated with the contract that contains a lease, a lessee should assess
whether the legal obligation (rather than the stated contract terms
indicating an obligation for the lessee to make a payment) to the tax
authority for the sales taxes resides with the lessee or the lessor.
If the obligation resides with the lessee, the lessee and
lessor should consider such sales tax payments to be separate and apart from
the contract that contains a lease. In this case, sales tax payments would
not represent lease payments to the lessor or a reimbursement of lessor
costs. See Section 4.3.2.3.2 for
considerations related to a lessee’s initial and subsequent accounting for
sales tax payments that are a lessee obligation.
If the obligation10 for the sales taxes resides with the lessor, the sales taxes paid by
the lessee as part of the contract are considered to be payments associated
with the contract that contains a lease. In this case, the lessee is
reimbursing a lessor cost since the tax obligation resides with the lessor.
Like property taxes and insurance, the sales taxes represent noncomponents
under ASC 842, as explained in Sections 4.3.2.1 and 4.3.2.2. Although
these costs are often variable payments, any fixed amounts paid by the
lessee for sales taxes will be included in the consideration in the contract
and allocated to the lease and nonlease components (to the extent that there
are nonlease components in the contract). Fixed sales tax payments may be
less common since a lessee often will reimburse a lessor’s actual sales tax
as incurred (e.g., a pass-through from the lessor to the lessee).
Sales tax determined by applying the sales tax rate to the
gross lease payment (i.e., the rate does not depend on the lessee’s use of
the leased asset)11 is not a variable payment akin to an index or rate.12 Rather, sales tax is akin to real estate or property tax and therefore
is treated as a variable payment that does not depend on an index or rate
(in a manner similar to sales tax imposed on the basis of a lessee’s usage
of the leased asset). Property tax is not deemed to depend on an index or
rate because the tax itself is based on a number of factors, some of which
are not dictated by market conditions. Taxes generally are subject to
governmental policy considerations, and the tax rate is ultimately a
function of the tax base and the revenue needs of the governing body. Since
the revenue needs may change over time (and can increase or
decrease), the tax payments of the lessee do not represent a present
obligation until they are calculated and assessed. Sales taxes are no
different in this regard.
4.3.2.3.2 Accruing Sales Tax Liabilities
When the sales tax obligation resides with the lessee,
as discussed earlier in this section, the lessee could be required to
accrue a sales tax liability before payment. A lessee should accrue a
sales tax liability (separate from the lease liability) if it has an
unavoidable obligation to pay sales tax (whether the payment is
currently due or is payable as of a future date). For example, if a
lessee, upon signing a contract to lease a new vehicle for five years,
is legally obligated to make a sales tax payment of $2,500 that is due
at lease commencement, the lessee has incurred a liability (which must
be recognized) as of the date of contract execution. However, to the
extent that there is potential variability in the amount of sales tax
owed, or if the lessee is not presently obligated to make a payment, the
lessee would not have an unavoidable obligation and therefore would not
recognize a liability.
We believe that, to the extent that a lessee is required
to accrue a sales tax liability, the lessee may treat the sales tax
payments as a capitalizable cost (separate from the ROU asset) in
accordance with ASC 360. We would expect the costs to be capitalized and
expensed over the term to which the sales taxes are related. In the
example above, the $2,500 due to the tax authority would be capitalized
as an asset and expensed on a straight-line basis over five years,
beginning at lease commencement.
4.3.3 Practical Expedients
Although the default model in ASC 842 requires separation of lease and nonlease components, certain practical expedients may be available to entities. Entities electing the practical expedient(s) would not separate lease and nonlease components. Rather, they would account for each lease component and the related nonlease component(s) together as a single component.
4.3.3.1 Lessees
ASC 842-10
15-37 As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.
ASC 842 affords lessees a practical expedient related to separating (and
allocating consideration to) lease and nonlease components. That is, lessees
may elect to account for the nonlease components in a contract as part of
the single lease component to which they are related. The practical
expedient is an accounting policy election that must be made by class of
underlying asset (e.g., vehicles, IT equipment — see the Connecting the Dots
discussion below).
Accordingly, when a lessee elects the practical expedient, any portion of the consideration in the
contract that would otherwise be allocated to the nonlease components will instead be accounted for as
part of the related lease component for classification, recognition, and measurement purposes (lessee
accounting is discussed in detail in Chapter 8). In addition, any payments related to noncomponents
would be accounted for as part of the related lease component (i.e., the associated payments would not
be allocated between the lease and nonlease components).
Connecting the Dots
Magnitude of the Nonlease
Components Does Not Matter
The practical expedient in ASC 842-10-15-37 is available to lessees regardless of the extent or
significance of the nonlease components in the contract. However, in paragraph BC150 of ASU
2016-02, the FASB acknowledges that it would not expect lessees (even though it is allowed) to
elect the practical expedient when the nonlease components in the contract are significant:
The availability of the practical expedient to a lessee is not affected by the relative size of the lease
and the nonlease components. However, given that the result of electing this practical expedient is
to record additional lease liabilities, the Board concluded that lessees will, in general, only elect this
expedient in arrangements with less significant service components.
Paragraph BC150 of ASU 2016-02 further cites the following basis for providing the expedient:
- “[T]he costs and administrative burden of allocating consideration to separate lease and nonlease components may not be justified by the benefit of more precisely reflecting the right-of-use asset and the lease liability,” especially when nonlease components in contracts for which the expedient is elected are not expected to be significant.
- Because nonlease components in contracts for which the expedient is elected are not expected to be significant, “comparability should not be significantly affected as a result of providing this practical expedient.”
When electing the practical expedient to combine lease and nonlease
components, lessees may combine nonlease activities accounted for under
other GAAP (e.g., maintenance) with their related lease components; as a
result, the overall accounting for these activities may be in accordance
with ASC 842. However, in such circumstances, a lessee should carefully
consider whether the nonlease component is truly associated with the leased
asset. Specifically, the lessee should consider whether its ability to use
or derive benefit from the nonlease component is interrelated with that for
the lease component and vice versa.
Example 11, Case B, in ASC 842-10-55-138 through 55-140 (reproduced in Section 4.4.3) illustrates an
application of the practical expedient in ASC 842-10-15-37 to a contract that contains multiple lease
components. Accordingly, Example 11, Case B, also emphasizes an important part of the expedient in ASC 842-10-15-37: lessees may “account for each separate lease component and the nonlease
components associated with that lease component as a single lease component” (emphasis added). That
is, the practical expedient does not allow lessees to not separate lease components from other lease
components in the contract, and the guidance in ASC 842-10-15-28 and 15-29 (see Section 4.2) must
still be applied when a lessee makes the accounting policy election in ASC 842-10-15-37.
Connecting the Dots
Meaning of “Class of
Underlying Asset”
ASC 842 provides lessees with two practical expedients that may be elected as an accounting
policy by “class of underlying asset”:
- ASC 842-10-15-37 allows lessees not to separate lease and nonlease components.
- ASC 842-20-25-2 allows lessees not to recognize lease liabilities and ROU assets for short-term leases. (The short-term lease recognition exemption is discussed in detail in Section 8.2.1.)
However, ASC 842 does not address what is meant by the phrase “class of underlying asset.” We have received a number of questions about this topic from various stakeholders, and two views have emerged:
- View 1 — The class of underlying asset is determined on the basis of the physical nature and characteristics of the asset. For example, real estate, manufacturing equipment, and vehicles would all be reasonable classes of underlying assets given their differences in physical nature. Therefore, irrespective of whether there are different types of similar assets (e.g., within the real estate class, there may be retail stores, warehouses, and distribution centers), the class of underlying asset would be limited to the physical nature as described above.
- View 2 — The class of underlying asset is determined on the basis of the risks associated with the asset. While an asset’s physical nature may be similar to that of other assets (e.g., retail stores, warehouses, and distribution centers are all real estate, as discussed above), each has a different purpose and use to the lessee and would therefore have a separate risk profile. Therefore, for example, it could be appropriate for the lessee to disaggregate real estate assets into separate asset classes by “type” of real estate — to the extent that the different types are subject to different risks — when applying the practical expedients in ASC 842-10-15-37 and ASC 842-20-25-2.
To support their position, proponents of View 2 refer to paragraph BC341 of ASU 2016-02, which states:
The Board decided that a lessor should treat assets subject to operating leases as a major class of depreciable assets, further distinguished by significant class of underlying asset. Accordingly, a lessor should provide the required property, plant, and equipment disclosures for assets subject to operating leases separately from owned assets held and used by the lessor. In the Board’s view, leased assets often are subject to different risks than owned assets that are held and used (for example, the decrease in the value of the underlying asset in a lease could be due to several factors that are not within the control of the lessor), and, therefore, users will benefit from lessors segregating their disclosures related to assets subject to operating leases from disclosures related to other owned property, plant, and equipment. The Board further considered that to provide useful information to users, the lessor should disaggregate its disclosures in this regard by significant class of underlying asset subject to lease because the risk related to one class of underlying asset (for example, airplanes) may be very different from another (for example, land or buildings). [Emphasis added]
Irrespective of the views noted above, we do not think that it would be appropriate to determine the “class of underlying asset” on the basis of the lease contract with which it is associated. For example, we believe that it would be inappropriate to break real estate assets into different classes on the basis of whether they are related to gross leases or triple net leases. In that situation, the asset underlying the contract could be exactly the same while the contract differs. We do not think that approach is consistent with the intent of the guidance in ASC 842-10-15-37 or ASC 842-20-25-2.
4.3.3.2 Lessors
ASC 842-10
15-42A As a practical
expedient, a lessor may, as an accounting policy
election, by class of underlying asset, choose to
not separate nonlease components from lease
components and, instead, to account for each
separate lease component and the nonlease components
associated with that lease component as a single
component if the nonlease components otherwise would
be accounted for under Topic 606 on revenue from
contracts with customers and both of the following
are met:
- The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
- The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.
15-42B A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall account for the combined component:
-
As a single performance obligation entirely in accordance with Topic 606 if the nonlease component or components are the predominant component(s) of the combined component. In applying Topic 606, the entity shall do both of the following:
-
Use the same measure of progress as used for applying paragraph 842-10-15-42A(a)
-
Account for all variable payments related to any good or service, including the lease, that is part of the combined component in accordance with the guidance on variable consideration in Topic 606.
-
-
Otherwise, as an operating lease entirely in accordance with this Topic. In applying this Topic, the entity shall account for all variable payments related to any good or service that is part of the combined component as variable lease payments.
In determining whether a nonlease
component or components are the predominant
component(s) of a combined component, a lessor shall
consider whether the lessee would be reasonably
expected to ascribe more value to the nonlease
component(s) than to the lease component.
15-42C A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall combine all nonlease components that qualify
for the practical expedient with the associated
lease component and shall account for the combined
component in accordance with paragraph
842-10-15-42B. A lessor shall separately account for
nonlease components that do not qualify for the
practical expedient. Accordingly, a lessor shall
apply paragraphs 842-10-15-38 through 15-42 to
account for nonlease components that do not qualify
for the practical expedient.
The practical expedient in ASC 842-10-15-37, under which lessees can elect not to separate lease and nonlease components (see Section 4.3.3.1), was not initially available to lessors. ASC 842, as initially issued by way of ASU 2016-02, required lessors to separate lease and nonlease components in all circumstances. Accordingly, lessors were required to look to the guidance in step 4 of the revenue model in ASC 606 to allocate the consideration in the contract to the separated components. After the consideration is allocated, ASC 842 (including its presentation and disclosure guidance) applies to the lease component and ASC 606 (including its presentation and disclosure guidance) generally applies to the nonlease component. See Section 4.4.2 for further discussion of the guidance on allocating consideration in the contract to lease and nonlease components.
Such separation was required regardless of whether the pattern of transfer to
the customer would be the same (i.e., a straight-line pattern of transfer to
the customer over the same period) when the lease and nonlease components
are separated (see Section 4.4.2.2.2). Accordingly, if
the patterns of transfer are the same, separation and allocation may only
affect presentation and disclosure. For example, this often may be the case
when real estate lessors enter into operating leases of real estate and
provide CAM services to the customer. However, the FASB received stakeholder
feedback indicating that the costs of complying with ASC 842’s separation
and allocation requirements for arrangements in which the pattern of
transfer is the same outweigh the benefits (i.e., when the separation and
allocation guidance only affects presentation and disclosure).
As a result, in July 2018, the FASB issued ASU 2018-11, which provides a practical expedient under which lessors can elect, by class of underlying asset, not to separate lease and nonlease components when certain criteria are met. Therefore, this practical expedient only affects lessors whose lease contracts also include nonlease components that are within the scope of ASC 606 and meet certain criteria (discussed below). If a lessor elects the practical expedient to combine lease and eligible nonlease components, it must evaluate whether the nonlease components in the combined component are predominant to determine whether the combined component should be accounted for under ASC 606 or ASC 842.
Connecting the Dots
Practical Expedient Results
in Greater Alignment Between Lessee and Lessor
Accounting
Unlike lessors, lessees have always been able, under ASC 842, to elect a
practical expedient under which they can choose not to separate (and
allocate consideration to) lease and nonlease components (see ASC
842-10-15-37). ASU 2018-11 aligns the lessor’s accounting for the
separation of lease and nonlease components with that for lessees.
Both lessors (when certain conditions are met) and lessees may now
elect to account for each lease component and the associated
nonlease components in a contract as part of a single component.
Note that this election is an accounting policy election that must
be made by class of underlying asset. (For more information, see the
Connecting the
Dots discussion in Section 4.3.3.1.) However,
lessees do not have the option of accounting for the combined
component under other U.S. GAAP. Instead, a lessee’s combined
component must always be accounted for under ASC 842.
4.3.3.2.1 Criteria for Combining Lease and Nonlease Components
A lessor that elects the practical expedient would not
be required to separate lease and nonlease components (i.e., it would
account for the lease and nonlease components as a combined, single unit
of account), provided that the nonlease component(s) otherwise would be
accounted for under the revenue guidance in ASC 606 and both of the
following conditions are met:
-
Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.13
-
Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
ASC 842-10-15-42C also clarifies that the presence of a
nonlease component that is ineligible for the practical expedient does
not preclude a lessor from electing the expedient for the lease
component and nonlease component(s) that meet the criteria. Rather, the
lessor would account for the nonlease components that do not qualify for
the practical expedient separately from the combined lease and nonlease
components that do qualify.
Connecting the Dots
Assessing Timing and
Pattern of Transfer
In ASU 2018-11, the Board amended Criterion A to
focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer .
. . to the customer over the same time period”) rather than on
the timing and pattern of revenue recognition (as was originally
proposed). The purpose of this amendment was to address concerns
that the originally proposed practical expedient was
unnecessarily restrictive and excluded contracts with variable
consideration from its scope, since variable payments are
accounted for differently under ASC 606 than they are under ASC
842. That is, the pattern of revenue recognition under ASC 606
could differ because estimates of variable consideration are
recognized as revenue under ASC 606 while recognition of revenue
for variable consideration under ASC 842 is restricted until the
variability or contingency is resolved.
4.3.3.2.1.1 Noncoterminous Lease and Nonlease Components
As noted above, ASC 842-10-15-42A allows lessors to
elect, as a practical expedient by class of underlying asset, an
accounting policy of not separating nonlease components from lease
components if (1) the timing and pattern of transfer
for the lease component are the same as those for the nonlease
components associated with that lease component and (2) “the lease
component, if accounted for separately, would be classified as an
operating lease in accordance with paragraphs 842-10-25-2 through
25-3.”14
In some arrangements, a lessee may commit to
purchasing a service (that would be considered a nonlease component)
for only part of the lease term. The lessee may have the option of
renewing the service for an incremental fee over the lease term but
is not contractually committed to do so. Therefore, the period over
which a lessor is contractually required to provide services to a
lessee (that would be a nonlease component) may not span the entire
lease term. That is, in such circumstances, the lease term and the
contractual service period would not be coterminous.
We believe that, in some cases, a lessor can elect
the practical expedient in ASC 842-10-15-42A (i.e., to combine the
nonlease component with the associated lease component) even if the
nonlease component is not coterminous with the lease component.
Specifically, we think that if the separation of the lease component
from the nonlease component would only affect presentation and
disclosure (i.e., the pattern and timing of revenue recognition
would not differ if the nonlease component were accounted for
separately), the lessor can elect the practical expedient to combine
the lease and nonlease component even if the timing of transfer of
the nonlease component is not coterminous with the lease component.
This would generally be the case when the lease and optional
nonlease component(s) are each priced at their stand-alone selling
price and an allocation between components would therefore not be
necessary (i.e., they are not priced at a significant discount in
such a way that a material right within the scope of ASC 606 might
need to be identified) and the timing and pattern of
transfer of the nonlease component are the same as those for the
lease component for the period over which the nonlease component
will be transferred to the lessee.
This view is supported by paragraph BC31 of ASU
2018-11, which states, in part, that “[t]he Board noted that its
objective in providing the practical expedient was to align the
accounting by lessors under the new leases standard more closely
with the revenue guidance.” Further, paragraph BC116 of ASU 2014-09
notes that “Topic 606 would not need to specify the accounting for
concurrently delivered distinct goods or services that have the same
pattern of transfer. This is because, in those cases, an entity is
not precluded from accounting for the goods or services as if they
were a single performance obligation, if the outcome is the same as
accounting for the goods and services as individual performance
obligations.”
On the basis of the Board’s stated objective, we
believe that the practical expedient in ASC 842-10-15-42A can be
applied when the only impact is on presentation and disclosure of
amounts recognized as part of the arrangement (i.e., the pattern and
timing of recognition are the same), provided that the lease
component, if accounted for separately, would be classified as an
operating lease.
Example 4-6
Lessor X enters into a lease
arrangement with Lessee Y for the use of kitchen
space (which is identified as a lease component)
for a noncancelable one-year term. The lease
component, if accounted for separately, would be
classified as an operating lease. The lease
arrangement also includes optional cleaning and
inventory receiving services (nonlease components)
that the lessee can elect to receive from the
lessor on a month-by-month basis. When elected,
the optional services provide the same benefit to
Y each day and will be transferred to the lessee
by using a time-based measure of progress (i.e.,
ratably) over the period in which the services are
made available. Both the lease component and the
optional services (the nonlease component) are
priced at their stand-alone selling price.
Therefore, there is no requirement to reallocate
contractually stated consideration from the lease
component to the nonlease component or vice versa
and the right to purchase the optional services
does not give rise to a material right, as
discussed in ASC 606-10-55-42, that would require
allocation of consideration separately between the
lease and optional nonlease components under ASC
606-10-55-44 and 55-45.
If and when these optional
services are purchased, X would use a time-based
measure of progress to determine the amount of
revenue to recognize from the cleaning and
inventory receiving services because the services
are transferred to the customer ratably over the
elected service term(s). Accordingly, the pattern
and timing of transfer of the optional services
for the monthly period elected are the same as
those for the kitchen space (the lease component).
Although the lessor is not
contractually required to provide optional
services over the entire lease term (i.e., the
noncancelable one-year term of the lease
arrangement), the pattern of transfer for the
services will be the same as that for the lease
component for the periods in which they are
provided. Also, as mentioned above, the optional
services are priced at their stand-alone selling
prices and do not give rise to a material right
that would require separate allocation of
consideration to the lease and nonlease
components. Consequently, X concludes that the
separation of the nonlease component from the
lease component would only affect presentation of
revenue recorded and disclosure (i.e., the timing
and pattern of revenue recognized would not differ
if the nonlease component were accounted for
separately). Therefore, X can apply the practical
expedient in ASC 842-10-15-42A to combine the
lease component and nonlease component for the
periods in which Y exercises its right to receive
the optional cleaning and inventory receiving
services.
Once an entity has determined whether an arrangement
would qualify for the lessor practical expedient, the entity must
assess whether the lease component or nonlease component is the
predominant element in the arrangement (see Section
4.3.3.2.2 for more information).
4.3.3.2.1.2 Effects of the Practical Expedient on Supplier (Lessor) Accounting
The practical expedient will most likely provide
significant relief to certain lessors that are implementing ASC 842.
When discussing the expedient at the FASB’s November 29, 2017,
meeting, several Board members pointed out that certain real estate
lessors would be allowed to apply ASC 842 in a manner consistent
with how entities are permitted to apply ASC 606 when distinct goods
or services are delivered concurrently and have the same pattern of
transfer to the customer. Paragraph BC116 of ASU
2014-09 clarifies that, in such cases, entities
are not precluded from accounting for, and recognizing revenue from,
the goods and services as if they were a single performance
obligation.
The examples below illustrate situations in which
the practical expedient may provide relief to certain lessors
implementing ASC 842. In these examples, assume that the nonlease
component would otherwise be accounted for in accordance with ASC
606 and that the lease component, if accounted for separately, would
be an operating lease.
Example 4-7
In a common real estate lease
arrangement (e.g., a lease of floors in an office
building), a lessor may also provide CAM services
to the lessee. That is, in such an arrangement,
the contract between the seller-lessor and the
customer-lessee may include two separate
components: (1) the right to use space (the lease
component) and (2) maintenance services (the
nonlease component). The lessor may perform the
CAM services on an as-needed basis (e.g., cleaning
the building lobbies, performing minor repairs,
maintaining elevators); therefore, the maintenance
services would be recognized as revenue ratably
over the same period as that in which the leased
floors are used. When elected, the practical
expedient would allow the lessor to account for
such a contract — which provides a lease and
related CAM services — as containing a single
component, as would be permitted for any other
revenue-generating activity (e.g., two
concurrently delivered services, each of which a
purchaser could elect to buy, with or without the
other). This alignment with ASC 606 is consistent
with how the Board describes the leasing
activities of lessors (i.e., as revenue-generating
activities) in paragraphs BC92 and BC153 of ASU
2016-02.
Example 4-8
In a common vehicle lease
arrangement, a lessor may agree to offer the
customer, in addition to the lease, roadside
assistance services on a stand-ready basis as well
as participation in a loyalty program. As members
of the loyalty program, customers earn points for
each purchase and can thereby obtain future
discounts or free car rentals. In such an
arrangement, the seller-lessor is providing the
customer-lessee with three things: (1) the right
to use the car (the lease component), (2) roadside
assistance as a stand-ready service (a nonlease
component), and (3) a material right representing
the future discounts offered as part of the
loyalty program (a nonlease component). In this
scenario, it may be reasonable to conclude that
the timing and pattern of transfer for the vehicle
lease are the same as those for the roadside
assistance services; however, the timing and
pattern of transfer associated with the loyalty
program are unlikely to be the same as those for
the others. Under ASU 2018-11, the lessor would be
allowed to apply the practical expedient to
combine the lease component and nonlease component
for the roadside assistance (i.e., the eligible
nonlease component) while separating the nonlease
component for the loyalty program that is
ineligible for the practical expedient and
accounting for it in accordance with ASC 606.
Example 4-9
In certain arrangements,
customers are provided with a monitoring service
(i.e., a nonlease component) and a connected
monitoring device (i.e., a lease component) for
delivering the service. The lease and nonlease
component may have the same timing and patterns of
transfer (e.g., when the lease component is an
operating lease and the nonlease component
represents a continuous monitoring service). A
lessor may apply the practical expedient to
combine the components into a single component
accounted for under ASC 842 or ASC 606, depending
on whether the lease or nonlease component is
predominant (see Section
4.3.3.2.2).
Note that unlike the lessee practical expedient,
which is available for all contracts, the lessor practical expedient
related to combining lease and nonlease components can only be
elected when certain conditions are met. For example, the practical
expedient cannot be applied to arrangements in which the patterns of
transfer for the lease and nonlease components would not be the
same. Therefore, lessors that enter into lease arrangements with
revenue components that are transferred at a point in time (e.g.,
sales of equipment or other goods) will not be eligible for the
relief from allocation between the lease and revenue component(s).
Although constituents raised some concerns about allocation in these
ineligible contracts, the Board did not address allocation by
lessors that may be struggling to determine the appropriate
stand-alone selling prices for the lease and nonlease components in
such arrangements. Therefore, such entities will need to continue
developing processes for estimating stand-alone selling prices in
accordance with ASC 606 so that the consideration in the contract
can be allocated to lease and nonlease components.
4.3.3.2.2 Determining Which Component Is Predominant
As with the lessee practical expedient, the FASB originally proposed that a lessor should always be
required to account for the combined component as a lease under ASC 842. However, on the basis of
feedback it received, the Board revised the final ASU to require an entity to perform another evaluation
to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as
a revenue component under ASC 606. Specifically, an entity should determine whether the nonlease
component (or components) associated with the lease component is the predominant component of
the combined component. If so, the entity is required to account for the single, combined component in
accordance with ASC 606. Otherwise, the entity must account for the single, combined component as an
operating lease in accordance with ASC 842.
Connecting the Dots
An Entity Will Need to
Use Judgment to Determine the Predominant
Component
As indicated in the Background Information and Basis for Conclusions of ASU
2018-11, the FASB decided not to include a separate definition
or threshold for determining whether “the nonlease component is
the predominant component in the combined component.”
Rather, the Board noted that an entity should consider whether
the lessee would “ascribe more value to the nonlease
component(s) than to the lease component.” Further, the Board
acknowledged that the term “predominant” is used elsewhere in
U.S. GAAP, including ASC 84215 and ASC 606.16
The Board also explained that it does not expect that an entity will need to
perform a quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine, on a qualitative basis, whether to apply ASC 842 or ASC 606. Therefore, we expect that entities will need to use judgment in making this determination.
At its March 28, 2018, meeting, the Board discussed a scenario in which the
components were evenly split (e.g., a 50/50 split of value) and
suggested that, in such circumstances, the combined component
should be accounted for under ASC 842 because the nonlease
component is not predominant. That is, the entity would need to
demonstrate that the predominant element is the nonlease
component; otherwise, the combined unit of account would be
accounted for as a lease under ASC 842.
We believe that the final language in the ASU is intended to indicate that an entity would need to determine whether the lease or nonlease component (or components) is larger (i.e., has more value); only when the nonlease component is larger should the combined component be accounted for under ASC 606.
In discussions with the FASB staff, we confirmed that an entity needs to look at
which component has more value, not significantly more
value. In a quantitative analysis, “more value” would constitute
more than 50 percent. For example, when the value of the
nonlease component is 51 percent and the value of the lease
component is 49 percent, the nonlease component would be the
predominant component. However, the FASB staff indicated that it
generally expects that entities will be able to make this
determination qualitatively. We also confirmed that the language
“ascribe more value to the nonlease component(s) than to the
lease component” intentionally excludes the wording “ascribe
significantly more value to the license” from ASC 606-10-55-65.
Accordingly, we believe that, to be predominant, the nonlease
component only needs to be larger (not significantly
larger) than the lease component.
The examples below illustrate the determination of the predominant component in a contract. In these examples, assume that the arrangement would qualify for the lessor practical expedient on the basis of the criteria in ASC 842-10-15-42A (outlined above).
Example 4-10
A lessor leases three floors of an office building to a lessee for a fixed
annual lease payment that includes payment for CAM
activities performed by the lessor (e.g., cleaning
the building lobbies, maintaining elevators). The
three floors represent a lease component (see
Section 4.2), and the CAM is a
nonlease component (see Section
4.3.1). The CAM (nonlease component)
represents approximately 10 percent, and the lease
component approximately 90 percent, of the
contract value. In addition, the maintenance
services are not specialized or customized and the
lessee entered into the lease primarily because of
the location of the office space. Therefore, the
lease component would be considered the
predominant component, since the lessee would be
expected to ascribe more value to the lease
component. As a result, if the practical expedient
is elected for this class of underlying asset, the
entire arrangement would be accounted for as an
operating lease in accordance with ASC 842.
Example 4-11
An entity enters into an arrangement to provide a monitoring service that
requires the use of a monitoring device (hardware)
that tracks data and remits the data back to the
service provider. In this example, assume that the
arrangement for the monitoring service has been
identified as containing a lease. The connected
device provided to the customer is considered a
lease component, and the monitoring service is a
nonlease component. The connected device
(hardware) represents 2 percent of the contract
value, and the service (nonlease component)
represents 98 percent of the contract value.
Further, the outputs of the service (i.e.,
security alerts and monitoring reports obtained
from the data provided by the monitoring device)
were what the customer intended to obtain by
entering into the arrangement. Therefore, the
nonlease component would be considered the
predominant component, since a lessee (customer)
would be expected to ascribe more value to the
nonlease component. In this case, if the seller
(lessor) elects the practical expedient, the
entire arrangement would be accounted for as a
revenue arrangement in accordance with ASC
606.
Example 4-12
An entity may enter into an arrangement to provide tenants with accommodations (i.e., the lease component)
in a health care or retirement community as well as health care services (i.e., the nonlease component). These
arrangements vary (e.g., skilled nursing facilities), and the service component in certain arrangements may
provide more value to the customer-lessee than it does in other arrangements (e.g., independent living facilities
that may function more as apartment complexes). Therefore, it may not be clear whether the lessee would
ascribe more value to the lease or nonlease component(s). An entity would be required to use judgment in
making this determination. If the entity determines that the nonlease component represents a larger portion
of the value of the contract (i.e., more than 50 percent), the nonlease component (i.e., the health care services)
would be considered the predominant component and, if the practical expedient is elected, the entire arrangement would be accounted for in
accordance with ASC 606. Alternatively, if the lessor determines that a lessee would ascribe more value to the
lease component (i.e., the accommodations), the lease component would be the predominant component and, if the practical expedient is elected,
the entire arrangement would be accounted for as an operating lease in accordance with ASC 842.
Connecting the Dots
Accounting for Variable
Payments Should Be Consistent With That for the Combined
Component
ASU 2018-11 includes language related to the interaction between the practical expedient and
the guidance in (1) ASC 842-10-15-39 on consideration in the contract and (2) ASC 842-10-
15-40 on the recognition of variable payments. Specifically, ASC 842-10-15-42B(a)(2) clarifies
the Board’s intent that the accounting for variable payments should be consistent with that for
the combined component. That is, when the combined component is accounted for as a lease
under ASC 842, there are no longer any nonlease (revenue) variable payments; rather, there are
only variable payments related to the combined lease component, and that variability should be
accounted for in accordance with ASC 842. Conversely, if the combined component is accounted
for as a service under ASC 606, all variable payments related to the combined component
should be accounted for in accordance with the guidance in ASC 606 on variable consideration.
That is, an entity would be required to estimate the variable consideration and constrain such
estimates in accordance with the guidance in ASC 606-10-32-11.
The flowchart below summarizes when a lessor may apply the practical expedient related to not
separating lease and nonlease components in a contract as well as the required accounting for the
combined component when the election is made.
See Sections 15.3.2.4 and 16.4.6 for further discussion of the disclosure and transition requirements,
respectively, related to the lessor practical expedient.
Footnotes
6
In July 2018, the FASB issued ASU 2018-11,
which includes a practical expedient that allows lessors, when certain
conditions are met, not to separate lease and nonlease components. Lessors
availing themselves of this practical expedient would not account for
affected nonlease components separately. See Sections 4.3.3.2 and 17.3.1.4.2 for
further discussion.
7
See footnote 6.
8
See footnote 6.
9
As discussed in Section 4.3.3.1, lessees can elect
a practical expedient by asset class to combine lease and nonlease
components into a single component. A similar practical expedient is
available to lessors by asset class as long as certain criteria are met
(see Section
4.3.3.2). When this practical expedient is elected, any
consideration that would otherwise be allocated to the nonlease
components, such as payments for noncomponents described in this
section, will instead be accounted for as part of the related lease
component or the predominant revenue component for lessors. In other
words, if the practical expedient is elected, no allocation between
lease and nonlease components is necessary.
10
While this discussion focuses on lessees, in
December 2018, the FASB issued ASU 2018-20, which makes
narrow-scope improvements to the accounting for lessors. Under the
ASU’s amendments, lessors are allowed to elect, as an accounting
policy, to analogize to the guidance in ASC 606 on presenting sales
taxes collected from lessees on a net basis. See Section
4.4.2.1.2 for more information about the ASU.
11
Note that sales tax imposed on the basis of a
lessee’s usage of a leased asset would also be deemed a variable
lease payment that does not depend on an index or rate.
12
The guidance in Section 4.3.2.3.1 is only
applicable if sales tax is determined to be an obligation of the
lessor.
13
Importantly, not all over-time
performance obligations will qualify for the
practical expedient. Lessors should consider the
measure of progress used to recognize revenue
related to the nonlease component when assessing the
condition in ASC 842-10-15-42A(a).
14
Upon adoption of ASU 2021-05, an entity
should apply the guidance in ASC 842-10-25-2 through 25-3A
to evaluate the lease classification.
15
ASC 842-10-25-5 states that “an entity
shall consider the remaining economic life of the
predominant asset in the lease component” to determine
the classification when multiple underlying assets
comprise a single lease component.
16
ASC 606-10-55-65A allows entities to use
the sales-based and usage-based royalty exception to
estimating variable consideration when “a license of
intellectual property is the predominant item to which
the royalty relates (for example, the license of
intellectual property may be the predominant item to
which the royalty relates when the entity has a
reasonable expectation that the customer would ascribe
significantly more value to the license than to the
other goods or services to which the royalty
relates).”
17
Although an entity must apply the practical
expedient to all eligible nonlease components, the presence of a
nonlease component (or components) that is ineligible for the
practical expedient does not preclude a lessor from applying the
practical expedient to the eligible components.
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:
| Includes:
|
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:
| 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
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.
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).
15-40A 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).
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:
-
Use the same measure of progress as used for applying paragraph 842-10-15-42A(a)
-
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.
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 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.
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 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 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 nonlease component.
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)
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 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.
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.
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
18
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.
19
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.
20
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.
21
For example, by using an
expected-cost-plus-a-margin approach.
22
Vendor L would derecognize the full carrying
value of the equipment and would record a
corresponding loss.
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.