6.9 Amounts Not Considered a Lease Payment

A customer (lessee) enters into a contract manufacturing arrangement with a supplier (lessor). The customer has appropriately determined that the contract manufacturing arrangement meets the definition of a lease under ASC 842 (see Section 3.2). In this example, assume the following:

• The customer has contracted with a supplier for exclusive use of a manufacturing line over a four-year period.
• The contract establishes a price per unit of product purchased and, periodically throughout the arrangement, the customer issues noncancelable purchase orders to the supplier when the customer wishes to procure manufactured products from the supplier.
• The purchase order establishes a time frame (e.g., one month, two months) over which the related products will be produced as well as an unconditional obligation for the customer to purchase the products from the supplier.
• The customer is not required to order a minimum volume of products over the four-year period. However, on the basis of its anticipated orders, the customer expects to use substantially all of the capacity of the supplier’s manufacturing line during the four-year term.
• The supplier ships manufactured products free on board to the customer’s facility, and the customer is contractually obligated to pay the supplier upon the delivery of products to the customer’s facility.
• The customer has identified a separate lease component (i.e., the right to use the supplier’s manufacturing line) and nonlease components associated with the arrangement.

In this example, when submitting a noncancelable purchase order, the customer should establish a lease liability and ROU asset related to the lease component associated with the committed purchases (i.e., the committed use of the manufacturing line during the time frame established by the purchase order).11

Although, at commencement, all payments in the arrangement are variable (given the lack of a minimum purchase quantity in the arrangement), at the time when the purchase order is issued, the payments related to the lease component associated with the committed purchases meet the definition of lease payments since the contingency upon which the variable lease payments are based is resolved. At that point, the customer has an unconditional obligation to purchase products from the supplier and therefore also has payments that meet the definition of lease payments in accordance with ASC 842-10-35-4(b), which states, in part:

The lessee would then recognize a lease liability and a corresponding ROU asset. We believe that each individual purchase order effectively creates fixed payments in the arrangement, in which the amount of the purchase order associated with the lease component is the minimum fixed amount that is owed to the supplier upon delivery of the manufactured products. Each subsequent purchase order would trigger another resolution of a contingency in accordance with ASC 842-10-35-4(b) and, as a result, the payments associated with the lease component of the purchase order become lease payments. The lessee thus recognizes a separate lease liability and a corresponding ROU asset for the amount allocated to the lease component for each individual purchase order.

ASC 842 does not provide any clear guidance on the period over which such an ROU asset should be amortized. Therefore, various approaches may be acceptable.

The following are two such approaches:

• Approach 1 — Because the purchase order has a specific production and payment schedule, the lease costs12 should be recognized over the purchase order term. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:

  After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]
  We believe that recognition of the costs over the purchase order term is a systematic and rational approach given that the consumption of the benefit associated with the ROU asset (manufacturing line) is directly aligned with the purchase order term. Under this approach, the ROU asset will be fully amortized over the period of the purchase order. This accounting will continue for the remainder of the lease term as each discrete ROU asset is amortized over the production period to which it is related. This approach may be less complex to apply than Approach 2 below and may better reflect the economics of a leasing structure that is based on purchase orders submitted.
• Approach 2 — Recognize the lease costs over the full remaining lease term. This approach is also consistent with the guidance in ASC 842-20-25-6(a), which states, in part:

  After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]
  Likewise, an entity should recognize lease costs on the basis of whether it has the right to use an asset, not the pattern of use, in accordance with ASC 842-20-55-3, which states:

  This Subtopic considers the right to control the use of the underlying asset as the equivalent of physical use. If the lessee controls the use of the underlying asset, recognition of lease cost in accordance with paragraph 842-20-25-6(a) or amortization of the right-of-use asset in accordance with paragraph 842-20-35-7 should not be affected by the extent to which the lessee uses the underlying asset.
  This approach would result in the layering on of each additional ROU asset once a purchase order is issued. For example, on the basis of the facts in the example above, the total lease cost for the initial purchase order (provided that it is issued on the first day of the arrangement) would be recognized over the entire four-year lease term. The total lease cost incurred in connection with the second purchase order would be recognized over the remaining lease term at that time. The subsequent impact on the ROU asset each year would reflect all purchase orders previously submitted. This accounting would continue for the remainder of the lease arrangement. This approach will generally result in a more back-loaded lease cost recognition pattern than Approach 1.

Note that depending on the time frame established by the purchase order and the frequency of purchase order submission by the customer, there may be scenarios in which the accounting in this example is not material to the financial statements. For example, under Approach 1 above, if purchase orders are submitted every month and establish a one-month production time frame, the customer’s lease costs would be appropriately apportioned to the production month and the impact on the balance sheet on a particular reporting cut-off date may be immaterial. On the other hand, if the customer in the example above submitted a two-year purchase order, the accounting described above would most likely be necessary so that lease costs can be appropriately apportioned and the lessee’s lease obligation can be properly reflected as of the intervening balance sheet dates.

Entity B (the lessee) leases an aircraft under a 10-year lease. The terms of the lease require B to perform an overhaul of the aircraft (a C-check) every three years to comply with regulations. The cost of each C-check is $10,000. In addition, at the end of the lease term, B must perform a C-check when returning the plane to the lessor regardless of whether it recently performed one. This final C-check does not benefit the lessee since it is returning the aircraft; however, it does benefit the lessor, which will not need to perform another C-check on the aircraft for three years.

The determination of whether the overhaul costs should be included in the lease payments depends on whether the lessee has a present obligation to perform the overhauls, and therefore to incur the expenditure, at lease commencement for the benefit of the lessor.

In this scenario, the cost of the final C-check (i.e., the C-check that the lessee must perform immediately before returning the plane to the lessor) should be included in the lease payments because it represents a present obligation of the lessee and does not benefit the lessee. Because there is no present obligation for the lessee to perform any other C-checks throughout the lease term for the benefit of the lessor, the cost of those C-checks should not be included in the lease payments at lease commencement.