6.1 General

To determine the appropriate lease classification and measure a lessee’s ROU asset and lease liability and a lessor’s net investment in the lease at lease commencement, lessees and lessors, respectively, must determine the lease payments related to the use of the underlying asset during the lease term. Lease payments are determined after the lease term has been established (see Chapter 5). This determination will include an assessment of any payments during renewal periods for which exercise is deemed reasonably certain. The graphic below depicts the types of payments that are and are not included in the calculation of the lease payments at lease commencement.

Connecting the Dots

Lease Payments May Be an Allocated Amount

As discussed in Chapter 4, once an entity determines that a contract contains a lease, the entity must identify and separate the lease and nonlease components in the contract. While this process for lessees differs slightly from that for lessors, in both cases the total consideration in the contract must be measured and allocated to the lease and nonlease components by maximizing the use of observable inputs. ASC 842-10-30-5 indicates that lease payments are amounts related to the use of the underlying asset (i.e., the lease component(s) in the contract). Therefore, when nonlease components are present, the lease payments are the consideration in the contract that is allocated to the lease component(s) rather than the total consideration in the contract.

Example 6-1

Company L (the lessee) enters into an arrangement to lease a building for 10 years. As part of the arrangement, the lessor is required to provide CAM services for the 10-year lease term. In exchange for the right to use the building and obtain the CAM services, L will make fixed monthly payments of $5,000. Company L concludes that the right to use the building and the CAM are separate lease and nonlease components in the contract, respectively, for which the consideration in the contract should be allocated on a stand-alone price basis. The stand-alone price of the monthly building lease and CAM is $4,750 and $500, respectively.

The following table illustrates the allocation of the monthly contractual consideration of $5,000 between the lease and nonlease components in the contract.

Company L’s monthly lease payments are equal to $4,525, which is the amount allocated to the lease component of the contract. The $475 monthly amount allocated to the nonlease component (i.e., the CAM service) is not included in L’s lease payments.

For additional information on separating lease and nonlease components and allocating the consideration in the contract to those components, see Chapter 4.

Changing Lanes

Treatment of Executory Costs

Under ASC 840, some lessees may have determined that the definition of minimum lease payments included “executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon” (although executory costs may have been excluded from classification, measurement, or disclosure — for example, in accordance with ASC 840-10-25-1(d)). See Q&As 16-1 and 16-2A for additional discussion.

Under ASC 842, an entity needs to distinguish between lease and nonlease components in accounting for payments made for insurance, maintenance, and taxes as part of a lease contract. Components for separate services, such as CAM, represent a nonlease component in the contract to which a portion of the consideration is allocated. (See Section 4.3.1 for detailed discussion of nonlease components.) However, in other cases, such as reimbursements of lessor costs, no good or service is transferred to the customer and, accordingly, such payments do not represent a lease or nonlease component in the contract (e.g., insurance and taxes). (See Section 4.3.2 for detailed discussion of “noncomponents.”) In such cases, no portion of the consideration is allocated to items that do not transfer a good or service to the customer (i.e., to the noncomponents). See Chapter 4 for further discussion of separating lease and nonlease components and allocating the consideration in the contract.

Example 6-2

Company L (the lessee) enters into an arrangement to lease a building for 10 years. As part of the arrangement, the lessor is required to provide CAM services for the 10-year lease term. In exchange for the right to use the building and obtain the CAM services, L will make fixed monthly payments of $5,000. In addition, L agrees to pay the lessor a fixed monthly payment of $300, which is intended to reimburse the lessor for its property taxes and insurance for the building. The stand-alone price of the monthly building lease and CAM is $5,050 and $500, respectively.

Under ASC 840, the fixed monthly payment of $300 to reimburse the lessor for its property taxes and insurance would not be included in the measurement of minimum lease payments.

Under ASC 842, the property taxes and insurance on the building do not represent a lease or nonlease component in the contract. Therefore, the related fixed monthly payment of $5,300 should be allocated between the lease (i.e., building) and nonlease (i.e., CAM) components in the contract, as shown in the following table:

6.1.1 Including Noncash Consideration in Lease Payments

Some leases require the lessee to make some or all of the lease payments with noncash consideration. For example, a lessee could be required to provide value in the form of hard assets, stock of the lessee or others, or guarantees of certain of the lessor’s obligations.

An entity generally should include noncash consideration in its determination of lease payments and should measure such consideration at fair value at lease commencement. That is, we believe that the fair value of the noncash consideration would generally be akin to an index or rate, which is included in lease payments at commencement.1 Any fluctuations in the fair value of noncash consideration to be provided between the initial measurement of the ROU asset and liability, or the net investment in the lease, and the final measurement determined in accordance with other U.S. GAAP should be recognized as variable lease income or expense. For noncash consideration in the form of a guarantee (other than a residual value guarantee and a guarantee of the lessor’s debt, the latter of which is discussed below), the amounts accrued and ultimately paid under the guarantee would not be considered variable lease payments. Rather, the providing of the guarantee is the lease payment because the lessee has delivered its stand-ready obligation under the guarantee.

Note, however, that a guarantee of the lessor’s debt is outside the scope of lease payments.2

Example 6-3

Company A provides Company B with materials and labor needed to build a tavern, and A has agreed to lease the tavern from B at the end of the construction period. Company A does not control the asset under construction.3 The fair value of the materials and labor provided to B should be recognized by A as a prepaid lease payment and should be included in the measurement of the ROU asset at lease commencement.

Example 6-4

Company X (the lessee) enters into an arrangement to lease an aerosol can factory from Company Y (the lessor) for three years. As consideration for the right to use the aerosol can factory, X agrees to transfer to Y 50, 60, and 70 shares of stock in Company Z, in arrears each year, respectively. As of lease commencement, the fair value per share of Z’s stock is $20. Company X uses its incremental borrowing rate of 9 percent when discounting the lease payments since the rate implicit in the lease is not known.

In accordance with the lease classification tests (for lessees and lessors) under ASC 842-10-25-2(d), the lease payments should include the three payments made in shares of Z’s stock. Assume that the lease is an operating lease. The lessee’s lease obligation should be measured at $3,009.4 Further assume that the fair value of the stock at the end of year 1 of the lease (transfer date of the 50 shares) is $25 per share. The lessee should recognize the incremental fair value not included in the lease liability as a variable lease cost (i.e., $250, which represents 50 shares multiplied by the increase in the value of the stock since lease commencement). However, the shares to be delivered in years 2 and 3 should not be adjusted to their fair value at the end of year 1 because the fair value of the stock is an index or rate that is not adjusted after lease commencement unless the lease is remeasured for other reasons.

6.1.2 Security Deposits

Certain leasing arrangements may include a security deposit that must be paid to the owner of the leased asset at or before lease commencement. The security deposit is generally provided to support the lessee’s intent and commitment to lease the underlying asset (i.e., upon receipt of a security deposit, the lessor typically stops marketing the asset for lease).

ASC 842-10 defines lease payments with respect to identifying the types of payments that an entity should consider when determining the classification, initial measurement, and subsequent measurement of a lease. Specifically, ASC 842-10-30-5 states, in part:

At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term:

Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).

Security deposits can be either nonrefundable or refundable depending on the terms of the contract, which affects whether such deposits are considered lease payments.

6.1.2.1 Nonrefundable Deposits

A nonrefundable deposit is an amount the lessee pays the lessor to secure the terms of the contract for both parties. This payment represents a portion of the consideration to be transferred during the contract term and is not refunded by the lessor. Because the payment to the lessor is nonrefundable, it is considered a fixed payment under ASC 842-10-30-5. See Section 6.2 for further discussion of fixed lease payments.

6.1.2.2 Refundable Deposits

A refundable security deposit is an amount that the lessee is required to submit to the lessor to protect the lessor’s interest in the contract and the property. The lessor holds this amount until the occurrence of an event that would allow it to use some or all of the deposit to meet the contract requirements (e.g., use the deposit to recover any shortfall in the lessee’s payment or to repair any damages to the leased property). In the absence of such a need, the lessor would generally be required under the contract to return the remaining, unused security deposit to the lessee at the end of the lease. Because the payment is refundable, it would not meet the definition of a lease payment.

Note that when the lessor recovers a portion of a refundable security deposit to recover a shortfall in a lease payment, the lessor would effectively be settling a portion of the lease liability associated with the missed payment. In contrast, any portion of the refundable security deposit retained by the lessor for other reasons (e.g., excess wear and tear on the underlying asset) would generally be considered a variable lease payment.5 As with other variable payment requirements, lessees should consider the implementation guidance in ASC 842-20-55-1 and 55-2 when evaluating whether a lessee should recognize costs from variable payments before the achievement of a specified target (see Section 8.4.3.3.1).

In addition, to the extent that the arrangement provides for interest to be earned on the deposit, any interest earned on the refundable security deposit that the lessee forgoes (i.e., that the lessor is entitled to retain) should be considered a variable lease payment.

Footnotes

See ASC 842-10-30-5(b), reproduced in Section 6.3.

See ASC 842-10-30-6(b), reproduced in Section 6.9.2.

3See ASC 842-40-55-3 through 55-6.

Calculated as the sum of the present value of the lease payments — $1,000 ($20 × 50 shares) paid at the end of year 1, $1,200 ($20 × 60 shares) paid at the end of year 2, and $1,400 ($20 × 70 shares) paid at the end of year 3 — discounted at 9 percent.

ASC 842 defines variable lease payments as “[p]ayments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.” Therefore, any portion of a refundable security deposit that is retained by a lessor because of changes in facts and circumstances after the lease commencement date represents a variable lease payment and should be recognized as an expense from the lessee’s perspective and as income in profit or loss from the lessor’s perspective in the period when incurred (lessee) or earned (lessor).

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