Chapter 8 — Lessee Accounting
Chapter 8 — Lessee Accounting
8.1 Overview
ASC 842-20
05-1 This Subtopic addresses accounting by lessees for leases that have been classified as finance leases
or operating leases in accordance with the requirements in Subtopic 842-10. Lessees shall follow the
requirements in this Subtopic as well as those in Subtopic 842-10.
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic.
8.1.1 Setting the Stage
As discussed in Chapter 1, the primary objective of the FASB’s leasing project was to address the
off-balance-sheet treatment of leases from the lessee’s perspective. As a result, ASC 842 improves
financial statement transparency related to the rights and obligations arising from leases by requiring
the recognition, on the balance sheet, of the lessee’s right to use the asset subject to the lease (the ROU
asset) over the period of use and its corresponding commitment to the lessor (lease liabilities). ASC 842
also enhances transparency by introducing a number of new qualitative and quantitative disclosure
requirements for lease agreements.
Connecting the Dots
Impact of ASC 842 on Debt Covenants and Bank Capital
Requirements
Since ASC 842 requires a lessee to recognize a lease liability and corresponding
ROU asset for all of its leases (including
operating leases), financial statement preparers
and users raised questions about the impact of the
new requirements related to operating lease
liabilities and ROU assets on an entity’s metrics
(e.g., debt covenants and bank capital
requirements).
Impact on Debt Covenants
During its redeliberations, the Board considered concerns about the potential impact of
additional liabilities resulting from the application of ASC 842. Specifically, paragraph BC14 of
ASU 2016-02 states:
The Board further considered the concern that the additional lease liabilities recognized as a result
of adopting Topic 842 will cause some entities to violate debt covenants or may affect some entities’
access to credit because of the potential effect on the entity’s GAAP-reported assets and liabilities.
Regarding access to credit, outreach has demonstrated that the vast majority of users, including
private company users, presently adjust an entity’s financial statements for operating lease obligations
that are not recognized in the statement of financial position under previous GAAP and, in doing
so, often estimate amounts significantly in excess of what will be recognized under Topic 842. The
Board also considered potential issues related to debt covenants and noted that the following factors
significantly mitigate those potential issues:
- A significant portion of loan agreements contain “frozen GAAP” or “semifrozen GAAP” clauses such that a change in a lessee’s financial ratios resulting solely from a GAAP accounting change either:
- Will not constitute a default.
- Will require both parties to negotiate in good faith when a technical default (breach of loan covenant) occurs as a result of new GAAP.
- Banks with whom outreach has been conducted state that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change, even if the loan agreement did not have a frozen or semifrozen GAAP provision.
- Topic 842 characterizes operating lease liabilities as operating liabilities, rather than debt. Consequently, those amounts may not affect certain financial ratios that often are used in debt covenants.
- Topic 842 provides for an extended effective date that should permit many entities’ existing loan agreements to expire before reporting under Topic 842. For those loan agreements that will not expire, do not have frozen or semifrozen GAAP provisions, and have covenants that are affected by additional operating liabilities, the extended effective date provides significant time for entities to modify those agreements.
While the FASB has clearly articulated its view that lease liabilities resulting
from operating leases under ASC 842 are intended
to be characterized as operating liabilities
outside of debt, the Board could not dictate how
banks and other lenders viewed such amounts.
Banks and other lenders differ in their approaches to evaluating liabilities for
debt covenant purposes. Therefore, we encourage
preparers and other stakeholders to communicate
with these organizations to better understand
their views on the impact of debt covenants on
lease liabilities.
Impact on Bank Capital Requirements
Bank regulatory capital (expressed as a ratio of capital to risk-weighted assets or average assets) is the amount of capital that banking regulators (e.g., the FDIC, the Federal Reserve Board, and the OCC) require banks or bank holding companies to hold. Most intangible assets are deducted from regulatory capital, while tangible assets are not. Since ASC 842 does not provide definitive guidance on whether an ROU asset represents a tangible or an intangible asset, stakeholders have asked how bank regulators will treat ROU assets when establishing required capital.
On April 6, 2017, the Basel Committee on Banking Supervision (of which the United States is a member) issued FAQs on how an ROU asset would be treated for regulatory capital purposes. Specifically, the FAQs note that the ROU asset:
- “[S]hould not be deducted from regulatory capital [since] the underlying asset being leased is a tangible asset.”
- “[S]hould be included in the risk-based capital and leverage [ratio] denominators.”
- “[S]hould be risk-weighted at 100%, [which is] consistent with the risk weight applied historically to owned tangible assets and to a lessee’s leased assets under leases accounted for as [capital] leases” under ASC 840.
8.1.2 Navigating the Lessee Model
This chapter of the Roadmap highlights the guidance and interpretations that a lessee must apply when accounting for its leases, including guidance on classifying leases and recognizing and measuring the lease liability as well as the corresponding ROU asset. In addition, this chapter discusses the income statement expense recognition profile and related presentation for both operating and finance leases. Other aspects of lessee accounting addressed in this chapter include:
- Remeasurement of the lease liability (Section 8.5).
- Accounting for lease modifications (Section 8.6).
- Lease derecognition (Section 8.7).
- Master lease agreements, leases denominated in foreign currencies, accounting for leasehold improvements, and accounting for maintenance deposits (Section 8.8).
- Codification examples (Section 8.9).
The following chapters of this Roadmap also contain information relevant to the lessee model:
- Chapter 2 — Discusses how to identify whether an arrangement involving an underlying asset is within the scope of the leasing standard.
- Chapter 3 — Addresses factors related to evaluating whether a contract is or contains a lease.
- Chapter 4 — Explains how to identify the separate lease components and nonlease components within a contract and how the consideration is allocated to components.
- Chapter 5 — Discusses how the lessee should determine the lease term of its leases at lease commencement as well as when it should reassess the lease term.
- Chapter 6 — Covers the identification of lease payments as well as the initial and subsequent measurement of consideration that must be allocated to the components identified.
- Chapter 7 — Addresses how a lessee determines the appropriate discount rate as well as when it should reassess this rate.
- Chapter 14 — Discusses the balance sheet, income statement, and cash flow statement presentation requirements from the lessee’s perspective.
- Chapter 15 — Outlines the interim and annual lessee disclosure requirements.
8.2 Policy Decisions That Affect Lessee Accounting
Before applying the accounting requirements in ASC 842, a lessee will need to
make certain key accounting policy decisions.
These decisions could have a significant impact on
the amounts that are ultimately recognized,
presented, and disclosed in the lessee’s financial
statements. For discussion of a lessee’s decision
on the election of a practical expedient to
account for the nonlease components in a contract
as part of the single lease component to which
they are related, see Section
4.3.3.1.
This section discusses key policy decisions related to the following topics:
- The short-term lease recognition exemption (Section 8.2.1).
- Accounting for leases at a portfolio level (Section 8.2.2).
In addition, when making such key policy decisions, it would be reasonable for an entity to establish
a balance sheet recognition capitalization threshold for its leases. See Section 2.2.5.2 for additional
considerations.
8.2.1 Short-Term Lease Recognition Exemption
ASC 842-20
Short-Term Lease
A lease that, at the commencement date, has a lease term of 12 months or less
and does not include an option to purchase the
underlying asset that the lessee is reasonably
certain to exercise.
25-2 As an accounting policy, a lessee may elect not to apply the recognition requirements in this Subtopic to
short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis
over the lease term and variable lease payments in the period in which the obligation for those payments is
incurred (consistent with paragraphs 842-20-55-1 through 55-2). The accounting policy election for short-term
leases shall be made by class of underlying asset to which the right of use relates.
25-3 If the lease term or the assessment of a lessee option to purchase the underlying asset changes such that, after the change, the remaining lease term extends more than 12 months from the end of the previously determined lease term or the lessee is reasonably certain to exercise its option to purchase the underlying asset, the lease no longer meets the definition of a short-term lease and the lessee shall apply the remainder of the guidance in this Topic as if the date of the change in circumstances is the commencement date.
25-4 See Example 1 (paragraphs 842-20-55-13 through 55-16) for an illustration of the requirements on short-term leases.
Illustration of a Short-Term Lease
55-13 Example 1 illustrates the assessment of whether a lease is a short-term lease.
Example 1 — Short-Term Lease
55-14 Lessee has made an accounting policy election not to recognize right-of-use assets and lease liabilities that arise from short-term leases for any class of underlying asset.
55-15 Lessee enters into a 12-month lease of a vehicle, with an option to extend for another 12 months. Lessee has considered all relevant factors and determined that it is not reasonably certain to exercise the option to extend. Because at lease commencement Lessee is not reasonably certain to exercise the option to extend, the lease term is 12 months.
55-16 The lease meets the definition of a short-term lease because the lease term is 12 months or less. Consequently, consistent with Lessee’s accounting policy election, Lessee does not recognize the right-of-use asset and the lease liability arising from this lease.
ASC 842-20 defines a short-term lease as a lease whose lease term, at
commencement, is 12 months or less and that does
not include a purchase option whose exercise is
reasonably certain. ASC 842 permits a lessee, as
an accounting policy election, not to recognize on
its balance sheet assets and liabilities related
to short-term leases. This accounting policy, if
elected, would be applied by underlying asset
class and would result in a lessee’s recognition
of its lease payments on a straight-line basis
over the lease term in a manner similar to how
operating leases were accounted for under ASC 840
(see Section 4.3.3.1
for considerations related to determining an
underlying asset class). While this exemption will
result in off-balance-sheet accounting for
short-term leases, ASC 842 does include specific
presentation and disclosure requirements for these
leases. (See Sections 14.2
and 15.2.4.3,
respectively, for additional information.)
As with other leases, the option to extend or terminate the lease, or to
purchase the underlying asset that is subject to
the short-term lease exemption, needs to be
reassessed upon the occurrence of certain discrete
reassessment events. (See Section
8.5.1 for additional information.) A
lease will no longer meet the definition of a
short-term lease and thus no longer qualify for
the exemption if, as a result of a reassessment
event, (1) the lease term changes and the change
causes the remaining term to extend more than 12
months beyond the end of the previously determined
lease term or (2) the lessee now concludes that
the lessee’s exercise of a purchase option is
reasonably certain. When a lease no longer
qualifies for the short-term lease exemption, a
lessee will need to apply ASC 842’s guidance on
initial recognition and measurement; the
commencement date of the lease for this purpose is
the date of the change in circumstances.
A lessee, for tax or other
business purposes, may enter into a lease
agreement for a period approximating but exceeding
one year. For example, in certain jurisdictions, a
vehicle lease subject to a TRAC often has a
noncancelable period of 367 days. Such a lease
would not qualify for the short-term lease
exemption because the lease term in this example
is greater than a year (i.e., 367 days). In
addition, we believe that a lease that originally
had a term of less than 365 days, but that was
subsequently extended in such a way that the total
lease term is greater than 365 days but the
remaining lease term as of the lease extension
date is less than 365 days, would still qualify
for the short-term lease exemption if that
exemption was initially applied to that lease. The
short-term lease exemption only applies to leases
(1) with a term of 12 months or less and (2) that
do not include a purchase option whose exercise by
the lessee is reasonably certain.
Example 8-1
Scenario A
BuildCo enters into a lease for a crane. The lease is for a six-month noncancelable term, can be extended
on a month-to-month basis after the six months, and does not include a purchase option. On the lease
commencement date, BuildCo determines that (1) it will need the crane for a project that will take 18 months to
complete and (2) the monthly rental payments during the extension period are significantly below market rates.
On the basis of these factors, BuildCo concludes that it is reasonably certain that it will keep the lease for the
18-month period. BuildCo has an established accounting policy of using the short-term lease exemption for the
class of underlying asset subject to this lease.
In this scenario, because BuildCo needs the underlying asset for its project and the pricing of the extension
period is below the market rate, it is reasonably certain that BuildCo will extend the noncancelable period to 18
months. Therefore, the lease term is greater than 12 months (i.e., 18 months) and the lessee may not account
for the lease as a short-term lease.
Scenario B
SalesCo enters into a vehicle lease that is subject to a 12-month noncancelable
period, after which the lease will continue on a
month-to-month basis. At any point after the
noncancelable period, SalesCo can return the
vehicle to the lessor and will be responsible for
paying to the lessor any shortfall (or will
receive any surplus) in the selling price of the
vehicle compared with the remaining book value
(TRAC). SalesCo estimates that there will be a
shortfall at the end of the first year that will
be significant in such a way that SalesCo is
likely to renew the lease and avoid the shortfall
payment.
In this scenario, since SalesCo concludes that the estimated shortfall at the end of the first year is expected to
be significant, it would not be reasonable to conclude that the term is 12 months since returning the vehicle
after 12 months would generally result in an economic penalty to SalesCo. Therefore, it is reasonably certain
that SalesCo will extend the lease beyond the 12-month period. Because the lease term in this scenario is
greater than 12 months, the lessee may not account for the lease as a short-term lease.
Scenario C
Retailer enters into a lease of warehouse space. The lease is for a nine-month noncancelable term, can be
extended for four months, and does not include a purchase option. On the lease commencement date, Retailer
concludes that it is not reasonably certain that it will renew the lease beyond the nine-month noncancelable
period because (1) the noncancelable period coincides with the period in which Retailer expects to need the
additional storage and (2) the monthly lease payments during the optional extension period are expected to be
at market rates.
In this scenario, because Retailer only needs the warehouse space to support its operations for a nine-month
period and the pricing for the optional period is expected to be consistent with the expected market rates, it
would be reasonable to conclude that the lease term is limited to the nine-month cancelable period. Therefore,
the lease term is 12 months or less and Retailer applies the short-term lease exemption in accounting for the
lease (i.e., it recognizes lease payments as an expense on a straight-line basis over the lease term and does not
recognize a lease liability or ROU asset on its balance sheet).
Connecting the Dots
Applying the Short-Term Lease
Exemption
While deliberating the new lease accounting standard, the FASB and IASB concluded that the inclusion of a balance sheet recognition exemption for short-term leases could reduce the cost and complexity of applying the new requirements. However, while a lessee can elect an accounting policy of not recognizing, on its balance sheet, liabilities and assets related to leases with a term of 12 months or less, the lessee must disclose in the notes to the financial statements its short-term lease expense. See Section 15.2.4.3 for additional information.
Moreover, the recognition exemption for short-term leases is an accounting policy election that is applied at an asset class level. Once a lessee elects to apply (or not apply) the exemption for a particular asset class, any future leases with a term of 12 months or less within that asset class would have to be accounted for consistently. In addition, if a lessee would like to change its policy at a future date, it would need to evaluate the potential change in accordance with ASC 250.
Changing the Conclusion About the
Short-Term Lease Exemption Is a One-Way
Street
Irrespective of whether a
reassessment event causes the lease term to be
less than 12 months, because an entity assesses
its ability to apply the short-term lease
exemption at lease commencement, an arrangement
that previously did not qualify for the short-term
lease exemption never would subsequently qualify
for it. In other words, once a lease is recorded
on the balance sheet, it cannot be derecognized as
a result of a term reassessment, even if the
revised term is 12 months or less. This would be
the case irrespective of whether the lessee
extends the term of a lease by exercising a
renewal option whose exercise was not originally
deemed reasonably certain or by extending the
lease term by renegotiating an extension not
included in the original contract terms (i.e.,
lease modifications not considered to be separate
contracts).
Bridging the GAAP
Differences Between the Accounting for
Short-Term Leases Under U.S. GAAP and That Under
IFRS Accounting Standards
The definition of a short-term lease under IFRS 16 differs slightly from that
under ASC 842. Specifically, under IFRS 16, a
lease that includes a purchase option would never
qualify for the short-term lease exemption;
however, under ASC 842, the short-term lease
exemption would only be precluded if it is
reasonably certain that the lessee will exercise
the purchase option. As a result, more leases may
qualify for the short-term lease exemption under
U.S. GAAP than under IFRS Accounting
Standards.
8.2.2 Accounting for Leases at a Portfolio Level
ASC 842 permits a lessee to account for its leases at a portfolio level provided that the leases
commenced at or around the same time and the resulting accounting at this level would not differ
materially from the accounting at the individual lease level. We therefore believe that this approach
would be permitted when the portfolio includes leases that are (1) similar in nature (e.g., similar
underlying assets) and (2) have identical or nearly identical contract provisions.
Connecting the Dots
Applying the Portfolio
Approach
In applying the portfolio approach, a lessee will need to use judgment to conclude that
the accounting for a group of assets at the portfolio level would not materially differ from
the accounting for the leases in the portfolio on an individual lease basis. To reach such a
conclusion, the lessee will need to critically assess the size and composition of the portfolio.
While it may appear that an entity would be required to perform a quantitative
assessment to evaluate the appropriateness of applying the portfolio
approach, the Background Information and Basis for Conclusions of ASU
2016-02 notes that such an assessment may not be necessary and that a
more holistic evaluation could be appropriate. Specifically, paragraph
BC120 of ASU 2016-02 states, in part, that the “Board indicated that it
did not intend for an entity to quantitatively evaluate each outcome
but, instead, that the entity should be able to take a reasonable
approach to determine the portfolios that would be appropriate for its
types of leases.”
Further, paragraph BC121 of ASU 2016-02 notes, in part:
[T]he cost relief offered by applying the leases guidance at a portfolio level need not be limited to
simply grouping contracts together. The cost relief also could be particularly high for certain aspects
of the leases guidance for which entities need to make judgments and estimates, such as determining
the discount rate or determining and reassessing the lease term.
See Section 7.2.5
for additional considerations related to determining a discount rate for a
portfolio of leases and the next section for more information about applying the
lease classification criteria.
8.3 Lease Classification
ASC 842-10
25-1 An entity shall classify each separate lease component at the commencement date. An entity shall
not reassess the lease classification after the commencement date unless the contract is modified and the
modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. In addition,
a lessee also shall reassess the lease classification after the commencement date if there is a change in the
lease term or the assessment of whether the lessee is reasonably certain to exercise an option to purchase the
underlying asset. When an entity (that is, a lessee or lessor) is required to reassess lease classification, the entity shall reassess classification of the lease on the basis of the facts and circumstances (and the modified terms and conditions, if applicable) as of the date the reassessment is required (for example, on the basis of the fair value and the remaining economic life of the underlying asset as of the date there is a change in the lease term or in the assessment of a lessee option to purchase the underlying asset or as of the effective date of a modification not accounted for as a separate contract in accordance with paragraph 842-10-25-8).
8.3.1 Relevance of Classification Determination
From the lessee’s perspective, leases are classified as either finance or operating leases. While the determination of lease classification does not affect the initial measurement of the lease, it will have a direct impact on items such as subsequent measurement and financial statement presentation and disclosure.
8.3.2 Classification Date
Lease classification is assessed on the lease commencement date,
which is defined as the date on which the lessor makes the underlying asset
available for use by the lessee (see Section 8.4.1). After the lease
commencement date, a lessee would only be required to reassess lease
classification when there is a change in the lease term (see Section 8.5.2.1), a change in the conclusion
about the lessee’s assessment of whether it is reasonably certain to exercise an
option to purchase the underlying asset (see Section
8.3.5.1.2), or a lease modification that is not accounted for as
a separate contract (see Section 8.6.3).
Changing Lanes
Classification Date
Unlike ASC 842, ASC 840 required entities to classify leases on the basis of the
facts and circumstances present at lease inception (i.e., the date of
the lease agreement or commitment, if earlier) instead of at lease
commencement (the date on which the lessor makes an underlying asset
available to the lessee). For many entities, this is not a significant
change, since there typically is not a significant lag between lease
inception and lease commencement; however, in certain circumstances, the
two dates significantly differ. In such cases, a lessee could
theoretically arrive at different conclusions if facts and circumstances
change between the dates (e.g., the fair value of the underlying asset
or the discount rate). The diagram below illustrates the difference
between lease inception and lease commencement.
8.3.3 Lease Classification Criteria
ASC 842-10
25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at
lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
- The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.
- The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term.
25-3 When none of the criteria in paragraph 842-10-25-2 are met:
- A lessee shall classify the lease as an operating lease. . . .
25-3A
Notwithstanding the requirements in paragraphs
842-10-25-2 through 25-3, a lessor shall classify a
lease with variable lease payments that do not depend on
an index or a rate as an operating lease at lease
commencement if classifying the lease as a sales-type
lease or a direct financing lease would result in the
recognition of a selling loss.
25-7 See paragraphs 842-10-55-2 through 55-15 for implementation guidance on lease classification.
8.3.3.1 Overview of the Classification Criteria
A lessee’s lease classification has a direct impact on the subsequent accounting for a lease. From the
lessee’s perspective, a lease will be classified as a finance lease when it meets one or more of the
five criteria in ASC 842-10-25-2. When none of these criteria are met, the lease will be classified as an
operating lease. A lessee performs its lease classification assessment at lease commencement (i.e.,
when the lessee obtains the right to use the asset).
By establishing the same five basic lease classification criteria for both
lessors and lessees, the FASB attempted to achieve lease classification
symmetry to a certain extent (i.e., a lease recorded as a finance lease by
the lessee would generally be recorded as a sales-type lease by the lessor,
or both parties would record an operating lease). Correct application of the
lease classification criteria could result in asymmetrical classification of
the same lease by the lessor and the lessee, however.
Circumstances in which such asymmetrical accounting may occur include:
-
The lessee’s use of its incremental borrowing rate instead of the rate implicit in the lease.
-
The inclusion in lease payments of third-party guarantees to the lessor.
-
A penalty that, from the lessee’s perspective, makes renewal of the lease reasonably certain but that is not similarly perceived by the lessor.
-
Differing assessments regarding the economic life or fair value of the underlying asset or the determination if the underlying asset will have an alternative use to the lessor at the end of the lease term.
-
Differing determinations of lessee options to renew or terminate the lease or purchase the underlying asset.
-
After the adoption of ASU 2021-05, leases with variable lease payments that do not depend on an index or rate and give rise to a day 1 loss for a lessor would need to be classified as an operating lease, while a lessee may classify the lease as a finance lease. See Section 17.3.1.8.1 for further details.
Connecting the Dots
Application of the Lease Classification Guidance at a Portfolio
Level
It may be appropriate for a lessee to apply the lease classification
criteria to a portfolio of leases under ASC 842 as long as the
results do not materially differ from those achieved when the
individual leases are classified on a lease-by-lease basis. We
therefore believe that this approach would only be permitted when
the portfolio includes leases that (1) are similar in nature (have
similar underlying assets) and (2) have identical or nearly
identical lease terms. See Section 8.2.2 for
additional discussion of the application of the portfolio
approach.
Bridging the GAAP
Dual-Model Versus Single-Model Approach for Lessees
ASC 842 includes a dual-model approach for lessees under which a lease is accounted for as
either a finance lease or an operating lease in accordance with the lease classification criteria
in ASC 842. In contrast, IFRS 16 prescribes a single-model approach for lessees under which
all leases are accounted for in a manner similar to that under the U.S. GAAP accounting model
for finance leases. Therefore, from the lessee’s perspective, lease classification is eliminated
altogether under IFRS 16. See Appendix B for additional information about the differences
between ASC 842 and IFRS 16.
8.3.3.2 Decision Tree on Determining Classification
8.3.3.3 Transfer of Ownership at the End of the Lease Term
ASC 842-10
25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at
lease commencement:
- The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. . . .
55-4 The criterion in paragraph 842-10-25-2(a) is met in leases that provide, upon the lessee’s performance in accordance with the terms of the lease, that the lessor should execute and deliver to the lessee such documents (including, if applicable, a bill of sale) as may be required to release the underlying asset from the lease and to transfer ownership to the lessee.
55-5 The criterion in paragraph 842-10-25-2(a) also is met in situations in which the lease requires the payment by the lessee of a nominal amount (for example, the minimum fee required by the statutory regulation to transfer ownership) in connection with the transfer of ownership.
55-6 A provision in a lease that ownership of the underlying asset is not transferred to the lessee if the lessee elects not to pay the specified fee (whether nominal or otherwise) to complete the transfer is an option to purchase the underlying asset. Such a provision does not satisfy the transfer-of-ownership criterion in paragraph 842-10-25-2(a).
A lessee would “classify a lease as a finance lease” if ownership of the underlying asset is transferred to the lessee by the end of the lease term. For this criterion to be met, title must be transferred at little or no cost to the lessee shortly after the end of the lease term. In substance, such a transaction is akin to a financed purchase (i.e., the asset was purchased and financed through lease payments).
While the lessee accounting model has evolved since the issuance of FASB Statement 13 from a risks-and-rewards model (i.e., one based on benefits and risks) to a control-based model, certain of the underlying principles have not changed significantly. For example, when the lessee is required to pay only a nominal fee for title transfer, the lease would meet the criterion in ASC 842-10-25-2(a). If paying the fee (even when the fee is nominal) is optional, the lease would not explicitly meet this criterion but would still be evaluated under the criterion in ASC 842-10-25-2(b) — that is, the criterion indicating that the purchase option is reasonably certain to be exercised.
8.3.3.4 Purchase Option Reasonably Certain to Be Exercised
ASC 842-10
25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at lease commencement: . . .
b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. . . .
A lease would be classified as a finance lease if, at lease commencement, the lessee deems it to be reasonably certain that it will exercise a purchase option by the end of the lease term.
“Reasonably certain” is meant to be a high threshold. That is, it would be a higher threshold than “probable” under ASC 450. (See Section 5.2.2 for additional discussion of the application of the “reasonably certain” criteria.) ASC 842 includes certain factors that a lessee should evaluate when determining whether exercise of a purchase option is reasonably certain, including contract-based, asset-based, entity-based, and market-based factors. Generally speaking, after considering these factors, the lessee should evaluate whether it has an economic compulsion or incentive to exercise its purchase option, since this is a strong indicator that exercise of the option is reasonably certain.
ASC 842-10-55-26 includes a list of economic factors (not all-inclusive) for an entity to consider when
evaluating whether the exercise of an option is reasonably certain. Such an evaluation must include an
assessment of whether an economic compulsion exists.
The examples below demonstrate scenarios in which the lessee’s exercise of its purchase option
would be reasonably certain. In addition to the below discussion, Examples 23 and 24 in ASC 842-10
(reproduced in Section 8.9.2) illustrate the accounting for purchase options.
Example 8-2
Entity P leases a tractor that it may purchase for $10,000 at the end of the lease term. The fair value of the
tractor is expected to be $20,000 when the lease term ends. Further, P has provided the lessor with a residual
value guarantee of $25,000 in the event that P does not exercise the purchase option.
Example 8-3
Entity U leases an airplane in which it installs luxury seating and a gold-plated cocktail bar, both of which add
significant value to the airplane. At the end of the lease term in three years, U may purchase the airplane for
an amount that is commonly paid for an airplane that does not have luxury seating and a cocktail bar. The
remaining useful life of the seating and bar assets extends 20 years after the noncancelable lease term.
8.3.3.5 Major Part of the Remaining Economic Life
ASC 842-10
25-2 A lessee shall classify
a lease as a finance lease . . . when the lease
meets any of the following criteria at lease
commencement: . . .
c. The lease term is for the major part of
the remaining economic life of the underlying
asset. However, if the commencement date falls at
or near the end of the economic life of the
underlying asset, this criterion shall not be used
for purposes of classifying the lease. . . .
55-2 When determining lease
classification, one reasonable approach to assessing
the criteria in paragraphs 842-10-25-2(c) through
(d) and 842-10-25-3(b)(1) would be to conclude:
-
Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
-
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset. . . .
A lessee would “classify a lease as a finance lease [when
the] lease term is for the major part of the remaining economic life of the
underlying asset” (i.e., the economic life that remains on the commencement
date versus the economic life when the asset is new). The ASC master
glossary defines economic life as “[e]ither the period over which an asset
is expected to be economically usable by one or more users or the number of
production or similar units expected to be obtained from an asset by one or
more users.” Note that a lease would not be subject to the “major part of
the economic life” criterion if (1) the lease commences at or near the end
of the economic life of the underlying asset (see discussion below in
Section
8.3.3.5.1) or (2) the lease involves facilities owned by a
government unit or authority and the remaining economic life of the
underlying asset is indeterminate (see discussion in Section 8.3.5.3).
Connecting the Dots
Use of ASC 840’s Bright-Line Thresholds for Lease
Classification
The lease classification tests under the legacy leasing guidance in
ASC 840 involved “bright lines” (e.g., the 90 percent fair value
test). That is, under ASC 840, a lease was classified as a capital
lease if the lease term was 75 percent or more of the remaining
economic life of an underlying asset or if the sum of the present
value of the lease payments and the present value of any residual
value guarantees amounted to 90 percent or more of the fair value of
the underlying asset. However, under the lease classification
guidance in ASC 842-10-25-2, entities are no longer required to
assess certain quantitative bright-line thresholds when classifying
a lease. Nevertheless, they are still permitted to use quantitative
thresholds when classifying a lease under ASC 842.
In fact, the implementation guidance in ASC 842-10-55 states that a
reasonable approach to applying the lease classification criteria in
ASC 842 is to use the same bright-line thresholds as those in ASC
840. ASC 842-10-55-2 states the following:
When
determining lease classification, one reasonable approach to
assessing the criteria in paragraphs 842-10-25-2(c) through (d)
and 842-10-25-3(b)(1) would be to conclude:
-
Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset.
-
A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset.
-
Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset.
On the basis of this implementation guidance, we
would not object if an entity were to apply ASC 840’s bright-line
thresholds when classifying a lease under ASC 842. We would expect
that under such an approach, an entity would classify a lease in
accordance with the quantitative result. That is, if an entity
applies ASC 840’s bright-line thresholds and determines that a lease
term is equal to 76 percent of an asset’s useful life, the entity
should classify the lease as a finance lease. The entity should not
attempt to overcome the assessment with qualitative evidence to the
contrary. Likewise, if the same entity determines that a lease term
is equal to 74 percent of an asset’s useful life, the entity should
classify the lease as an operating lease. We would expect that if an
entity decides to apply the bright-line thresholds in ASC 840 when
classifying a lease, the entity would apply those thresholds
consistently to all of its leases.
8.3.3.5.1 Estimated Economic Life Versus Depreciable Life
Generally, we would expect the economic life of an asset
to correspond to its depreciable life used for financial reporting. In
accordance with ASC 360, depreciable life is calculated on the basis of
the asset’s useful life, which is similar but not identical to
the economic life an entity uses in performing the lease
classification test.
The ASC master glossary defines useful life as the
“period over which an asset is expected to contribute directly or
indirectly to future cash flows” and economic life as “[e]ither the
period over which an asset is expected to be economically usable by one
or more users or the number of production or similar units expected to
be obtained from an asset by one or more users.”
The objective of determining either the useful life or
economic life of an asset is to identify the period over which the asset
will provide benefit. The asset’s useful life represents the period over
which the reporting entity will benefit from use
of the asset. In contrast, the economic life represents the period over
which “one or more users” will benefit from use
of the asset. Therefore, the asset’s estimated depreciable life pertains
to the intended use by the current owner, whereas the estimated economic
life may encompass both the current and future owners of the asset.
This difference between the two definitions is not
relevant in many cases since a single entity (the current owner) is
often expected to use an asset for its entire life. However, depending
on the facts and circumstances, it may sometimes be appropriate for an
entity to use an estimated economic life for lease classification
purposes that is longer than the asset’s estimated depreciable life.
Example 8-4
Company X, an automobile lessor,
routinely purchases automobiles that are
economically usable for seven years. Company X
leases the automobiles to lessees for three years
and sells the automobiles after the end of the
three-year lease term. Company X may have a
supportable basis for using a three-year
depreciable life (with a correspondingly higher
salvage value) for financial reporting purposes
but a seven-year economic life for lease
classification purposes.
8.3.3.5.2 Economic Life Considerations for Land
Land has an infinite economic life and therefore could
never meet the criterion in ASC 842-10-25-2(c). Thus, the estimated
economic life test cannot be applied to a lease that only involves land
or when land is treated as a separate lease component.
8.3.3.5.3 At or Near the End of the Economic Life
When an underlying asset in a lease is at or near the
end of its economic life, it is not subject to the economic life test.
This is consistent with the guidance in ASC 842-10-25-2(c), which
states, in part:
However, if the commencement date
falls at or near the end of the economic life of the underlying
asset, this criterion shall not be used for purposes of classifying
the lease.
Further, ASC 842-10-55-2 indicates that a “reasonable
approach” to determining whether an underlying asset is at or near the
end of its economic life would be evaluating whether the “commencement
date . . . falls within the last 25 percent of the total economic life
of the underlying asset.”
8.3.3.5.4 Considerations Related to the Predominant Asset
ASC 842-10
25-5 If a single lease
component contains the right to use more than one
underlying asset (see paragraphs 842-10-15-28
through 15-29), an entity shall consider the
remaining economic life of the predominant asset
in the lease component for purposes of applying
the criterion in paragraph 842-10-25-2(c).
A lease contract may include a single lease component
that relies on the use of more than one underlying asset. For example,
pieces of equipment that have different remaining economic lives may be
leased in the aggregate, but a lessee may conclude that there is only a
single lease component on the basis of the criteria in ASC 842-10-15-28.
(See Chapter
4 for additional information on separate lease
components.) In such cases, an entity must consider the remaining
economic life of the predominant asset in the overall lease component
when applying the classification criterion in ASC 842-10-25-2(c).
Regarding the assessment of the predominant asset in a
lease component, paragraph BC74 of ASU 2016-02 states, in part:
The Board noted that assessing the predominant
asset in a lease component that includes multiple underlying assets
will be straightforward in most cases. That is, the assessment is a
qualitative one that requires entities to conclude on what is the
most important element of the lease, which should be relatively
clear in most cases. The Board also noted that if an entity is
unable to identify the predominant asset, it may indicate that there
is more than one separate lease component in the contract.
8.3.3.6 Substantially All of the Fair Value of the Underlying Asset
ASC 842-10
25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at
lease commencement:
d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee
that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals
or exceeds substantially all of the fair value of the underlying asset. . . .
55-2 When determining lease classification, one reasonable approach to assessing the criteria in paragraphs
842-10-25-2(c) through (d) and 842-10-25-3(b)(1) would be to conclude: . . .
c. Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value
of the underlying asset.
As noted above, a lessee would classify a lease as a finance lease if, at lease
commencement, the “present value of the sum of the lease payments and any
residual value guaranteed by the lessee that is not already reflected in the
lease payments . . . equals or exceeds substantially all of the fair value
of the underlying asset.” When performing this classification test, the
lessee should include any lease payments made to, or lease incentives
received from, the lessor before or on the commencement date of the
lease.
In the calculation of the present value of the lease payments and any residual value guaranteed by
the lessee, the discount rate used by the lessee is the rate implicit in the lease unless that rate cannot
be readily determined. In that case, the lessee is required to use its incremental borrowing rate (see
Chapter 7 for additional information on a lessee’s determination of its discount rate).
Connecting the Dots
Evaluating “Substantially All”
Under ASC 840, there were many opportunities to create highly
structured leases. Specifically, many leases were designed so that
the present value of lease payments would be 89.9 percent of the
fair value.
One of the most notable aspects of ASC 842 is the exclusion of “bright lines”
(e.g., the 90 percent fair value test) from the lease classification
tests. However, ASC 842-10-55-2 acknowledges that 90 percent may be
an appropriate threshold for the “substantially all” criterion.
Because the FASB takes a more principles-based approach to
classification in ASC 842, we do not believe that an 89.9 percent
present value would necessarily result in an operating lease
classification. This would, however, depend on the entity’s
accounting policies, which should be consistently applied. See
Section
8.3.3.5 for more information.
Considerations Related to Residual Value Guarantees
The ASC master glossary defines a residual value
guarantee as follows:
A guarantee made to a
lessor that the value of an underlying asset returned to the
lessor at the end of a lease will be at least a specified
amount.
Irrespective of what the fair value of the
underlying asset is expected to be at the end of the lease term, a
residual value guarantee should be included under this lease
classification criterion at the maximum required deficiency that a
lessee may be required to pay to the lessor at the end of the lease
term.
In addition, there is a significant difference
between residual guarantees related to determining lease payments
for lease measurement purposes and those related to evaluating lease
classification. For lease payments, a lessee would only include the
amount that it is probable it will owe at the end of the lease term
under a residual value guarantee. In contrast, for lease
classification purposes, a lessee would include the entire residual
value guarantee (i.e., both the portion of the residual value
guarantee that is considered a lease payment and any residual value
guaranteed by the lessee that is not already reflected in such
payments).
Example 8-5
Company A enters into a lease
agreement with Supplier for the use of a backhoe for
a five-year period. Supplier estimates that the
residual value of the backhoe at the end of the
lease term will be $150,000, which is based on an
expected 3,000 hours of use during the term. As part
of the lease contract, A provides a residual value
guarantee under which it is required to compensate
the lessor for any difference if the value of the
backhoe at the end of the lease is less than
$140,000 (i.e., the maximum A could be required to
pay under the residual value guarantee is $140,000).
At lease commencement, A concludes that it expects
to use the backhoe for an estimated 4,500 hours
during the lease term and therefore expects the
value of the backhoe at the end of the term, on the
basis of the excess wear and tear from additional
usage, to be $135,000. As a result, A determines
that the amount that it is probable it will owe to
Supplier at the end of the lease term is $5,000,
which reflects the $140,000 that the lessee
guaranteed less the expected value of $135,000 on
the basis of the expected usage of the backhoe over
the lease term.
Lease Payment
Used for Lease Measurement Purposes
In accordance with ASC
842-10-30-5(f), $5,000 would be considered a lease
payment for A, since this would be the amount that
it is probable A would owe under the residual value
guarantee.
Lease
Classification
In accordance with ASC 842-10-25-2,
A would include $140,000 in the “substantially all
of the fair value” classification test when
evaluating lease classification. The $140,000
represents the residual value of the backhoe that A
is guaranteeing at the end of the lease term (i.e.,
this amount would include both the $5,000 included
in the lease payments and the $135,000 of potential
additional deficiency not included in the lease
payments).
Changing Lanes
Consideration of Nonperformance-Related Default
Provisions
Some lease agreements contain nonperformance-related default
provisions that may require the lessee to purchase the leased asset
or make another payment if the lessee is in default under such
provisions. Common examples of these provisions include clauses
related to bankruptcy, changes in control, and material adverse
changes. Under ASC 840, these provisions needed to be carefully
considered and often directly affected the classification of the
lease. Specifically, ASC 840-10-25-14 listed four conditions that
needed to be satisfied for the default provisions not to
affect lease classification:
- The default covenant provision is customary in financing arrangements.
- The occurrence of the event of default is objectively determinable (for example, subjective acceleration clauses would not satisfy this condition).
- Predefined criteria, related solely to the lessee and its operations, have been established for the determination of the event of default.
- It is reasonable to assume, based on the facts and circumstances that exist at lease inception, that the event of default will not occur.
If any of the above conditions were not met under ASC 840, a lessee
determining the lease classification was required to include, in its
minimum lease payments, the maximum potential amount that it could
owe under the default provision. This requirement applied to both
the lessee’s and the lessor’s classification evaluation.
The guidance in ASC 840 on nonperformance-related default provisions
was not carried over to ASC 842. Thus, an entity no longer
has to include these amounts in its lease payments when determining
its lease classification from the perspective of either the lessee
or the lessor.
While these provisions are no longer expected to affect the
classification of the lease, it will nonetheless be important to
monitor compliance with the provisions since their occurrence can
trigger payment obligations for the lessee. We believe that these
payments will often represent variable lease payments given that
they arise on the basis of changes in facts and circumstances
occurring after the commencement date of the lease. See Section 6.9.1 for guidance on
variable lease payments that do not depend on an index or rate and
Section 6.10 for guidance
on subsequent measurement of lease payments. The guidance on
variable lease payments in that section is likely to apply when the
default remedy is a one-time payment incurred in the period in which
the default provision is violated. If, instead of a one-time
payment, the remedy calls for increased payments over some future
period (e.g., the remaining term of the lease), it will most likely
be necessary to remeasure the lease. See Section 8.5.3 for a discussion of the accounting
treatment when variable payments become lease payments on the basis
of the resolution of a contingency.
Classification of the Land Component Under ASC 840
ASC 842 diverges from ASC 840 in how both lessees and lessors
allocate consideration and classify the land component of a lease
arrangement when the entity accounts for the right to use land
separately from the other components in the contract. For more
information about how this guidance differs, see Section 4.2.2.
8.3.3.6.1 Impact of Portfolio Residual Value Guarantees on Lessee’s Lease Classification
Lessees often enter into lease agreements to lease
multiple similar assets from lessors. In these circumstances, lessees
will often guarantee the residual value for the group of assets being
leased (e.g., the portfolio of underlying assets) rather than that for
each individual underlying asset. ASC 842-10-55-10 states that a lessor should not2 consider residual value guarantees of a portfolio of underlying
assets when evaluating the lease classification criteria, since
“[r]esidual value guarantees of a portfolio of underlying assets
preclude a lessor from determining the amount of the guaranteed residual
value of any individual underlying asset within the portfolio.”
ASC 842 does not explicitly address whether a
lessee should consider a PRVG when classifying individual
leases within a portfolio. However, when performing the lease
classification test in ASC 842-10-25-2(d), the lessee should take into
account “any residual value guaranteed by the lessee that is not already
reflected in the lease payments.” This criterion reflects the maximum
amount that the lessee could be obligated to pay under the lease
arrangement, which should include residual value guarantees regardless
of whether they are based on a portfolio or on an individual asset. If
residual value guarantees were excluded, the lessee’s full potential
obligation under the lease arrangement would not be depicted.
We believe that there are two acceptable approaches
lessees can use to apportion a PRVG to the individual leases in a
portfolio: (1) the all-in approach and (2) the pro rata approach. The
all-in approach is appropriate in all circumstances, while the pro rata
approach is acceptable only if the leases are substantially similar in
such a way that they meet the following criteria (these criteria are
similar to those in Section 9.2.1.4.2, which addresses PRVGs from a lessor’s
perspective):
-
The individual leases in the portfolio commence and end at the same time.
-
The leased assets are physically similar to each other.
-
The variability associated with the expected residual values is expected to be highly correlated (i.e., one asset’s residual value is expected to be similar to that of the other assets’ residual values).
The following are some additional details about the
all-in and pro rata approaches:
-
All-in approach — This approach is predicated on the fact that the lessee has an unavoidable obligation to provide a residual value guarantee on the portfolio of leased assets. In addition, the lessee effectively has control of each individual asset through its unilateral right to choose which (or how much) of the underlying assets subject to the PRVG will be consumed in accordance with paragraph BC71(d) of ASU 2016-02. Under this approach, a lessee will allocate the full amount of the PRVG to each lease within the portfolio.
-
Pro rata approach — Under this approach, the PRVG amount will be spread among the individual leases within the portfolio. That is, the lessee will apply the PRVG on a pro rata basis in relation to the expected residual value of each underlying asset at the end of the lease term, which should be a similar amount for each underlying asset, provided that the criteria above are met.
Example 8-6
Lessee enters into a master
lease of four substantially similar pieces of
equipment. The following facts apply to each item
of equipment at lease commencement (which is the
same date for all equipment):
-
Noncancelable lease term of five years.
-
Fixed lease payments of $3,100 per year, payable in arrears.
-
No transfer of ownership.
-
No renewal, purchase, or termination options.
-
Fair value of $24,000 for each piece of equipment.
-
Total economic life of each piece of equipment is 10 years.
-
Remaining economic life of each piece of equipment is eight years.
-
There is an alternative use to Lessor at the end of the lease.
-
The estimated residual value at the end of the lease is $7,500 per piece of equipment.
-
Lessee’s incremental borrowing rate is 3.5 percent (the implicit rate cannot be readily determined).
-
The present value of lease payments for each lease, excluding allocated residual value guarantees, is $13,997.
-
There are no initial direct costs.
Lessee provides a guarantee that
the residual value of the four pieces of equipment
will be $30,000 in the aggregate at the end of the
lease and uses the bright-line threshold of 90
percent when performing the present value test.
The tables below illustrate the inclusion of the
PRVG for lease classification by using the present
value test under the (1) all-in approach and (2)
pro rata approach.
All-In Approach
Pro Rata Approach
8.3.3.6.2 First-Dollar-Loss Residual Value Guarantee
The guidance in ASC 840-10-55-9 was clear that a lessee
should include the maximum amount that it could be required to pay under
a residual value guarantee when determining the minimum lease payments
to be used in the assessment of lease classification in accordance with
ASC 840-10-25-1(d). Specifically, ASC 840-10-55-9 stated, in part:
If a lease limits the amount of the lessee’s
obligation to make up a residual value deficiency to an amount
less than the stipulated residual value of the leased property
at the end of the lease term, the amount of the lessee’s
guarantee to be included in minimum lease payments under
paragraph 840-10-25-6(b) shall be limited to the specified
maximum deficiency the lessee can be required to make up.
It is common for lease arrangements to limit (i.e., cap)
the amount of residual value guarantee that the lessee would be required
to pay. Such an arrangement, as described in the example below, is
commonly referred to as a “first-dollar-loss residual value guarantee,”
since any initial deficiency below the guaranteed residual value must
first be borne by the lessee.
Example 8-7
A lessee and lessor enter into a
lease arrangement for use of an office building.
The lessee agrees to a residual value guarantee of
$450,000, subject to a limit of $390,000
representing a first-dollar-loss residual value
guarantee. At the end of the lease term, the
lessee is only obligated to reimburse the lessor
on a dollar-for-dollar basis for any shortfall
below $450,000 in the amount received upon sale of
the property up to $390,000. In other words, if
the lessor cannot sell the property for $450,000
or more, the lessee would be required to
compensate the lessor for each dollar below
$450,000, up to a maximum of $390,000. The lessor
only has a remaining residual risk in the property
in the event that the sales price drops below
$60,000.
First-dollar-loss residual value guarantees should be
treated in the same manner in the assessment of lease classification
under ASC 842 as they were under ASC 840. This conclusion is supported
by the discussion in paragraph BC71(d) of ASU 2016-02. Therefore, the
lessee should include in the lease classification test the maximum
payment that it could be required to pay to the lessor under the leasing
arrangement at the end of the lease term. In the example above, because
the lessee will never be required to pay more than $390,000, only
$390,000 should be included in the lease payments for lease
classification purposes.
As discussed in Section 6.7, a lessee considers its
full exposure under a residual value guarantee when classifying its leases;
however, a lessee only considers the amount likely to be owed under the
residual value guarantee when measuring its lease payments. This measurement
approach represents a departure from ASC 840, which required the use of the
full exposure for both classification and measurement (to the extent that a
lease was classified as a capital lease).
8.3.3.6.3 Impracticable to Determine Fair Value
ASC 842-10
55-3 In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).
We believe it would be unlikely that a lessee would not be able to determine the
fair value of an underlying asset. Lessees that consider ASC 842-10-55-3
to be applicable to their facts and circumstances should consult their
accounting advisers.
8.3.3.6.4 Lessee’s Determination of the Fair Value of a Portion of a Larger Asset
In determining whether to classify a lease as a finance
lease, a lessee must determine whether “the present value of the sum of
the lease payments . . . equals or exceeds substantially all of the fair
value of the underlying asset” in accordance with ASC 842-10-25-2(d)
(see Section
8.3.3.6). Accordingly, when classifying the lease (i.e.,
as a finance or operating lease), the lessee must determine the fair
value of the underlying asset — for use in the fair value test — at the
level associated with the identified lease component. This level could
be a portion of a larger asset, such as a floor of an office building.
If it is impracticable for a lessee to determine the fair value of an
underlying asset in accordance with ASC 842-10-55-3, the lessee should
assess the lease classification without considering the criterion in ASC
842-10-25-2(d). In this context, “practicable” means that fair value can
be reasonably estimated without undue cost or effort.
Consider an example in which a lessee leases space on a
cell tower (e.g., a hanger) from an owner/lessor. The individual hanger
is the unit of account from a leasing perspective. A similar situation
may arise when a lessee leases an individual floor of a building from an
owner/lessor. As stated above, when classifying the lease, the lessee
must determine the fair value of the underlying asset for use in the
fair value test — which would be at the level of the individual hanger
or individual floor in these examples — unless it is impracticable to do
so.
While ASC 842 does not address the determination of the
fair value of a larger asset, we believe that a lessee can use various
methods to make this determination, depending on the facts and
circumstances. To the extent that the lessee is able to determine the
fair value of the entire larger asset (e.g., a cell tower or building,
as described in the examples above), it may be appropriate to use an
“allocation approach” to allocate the fair value of the larger asset to
the respective portions of the larger asset that are being leased.
For example, the fair value of the larger asset could be
proportionately allocated — on the basis of the perceived value of the
individual leasable spaces — to the individual portions of the larger
asset. When this method is used, other conditions that may be more
representative of the fair value of the leased asset should be
considered. In a building, for instance, higher floors are often more
desirable, have a higher stand-alone selling price, and are leased at a
higher cost to the lessee than lower floors. In such circumstances, use
of an appropriate allocation method would result in the allocation of a
greater fair value to the higher floors. Such an allocation would better
represent the economics of the individual lease arrangements and better
reflect the fair value of each respective portion.
Likewise, we believe that an entity that is estimating
the fair value of a portion of a larger asset should consider the
intended use of the asset. It is also important not to confuse relative
fair value with relative construction or replacement costs. In the cell
tower example described above, while the percentage of the costs for the
individual hangers may not be disproportionately high compared with the
cost of the overall structure, it is likely that the hangers in the
aggregate account for most of the fair value of the tower since they
represent its revenue-producing parts. In other words, we would
sometimes expect the fair value of discrete portions of a larger asset
to be disproportionate compared with that of the entire asset on a space
or square-footage basis when the relative revenue-producing potential of
the discrete portions is taken into account.
We believe that a lessee should generally be able to
determine the fair value of a portion of an underlying asset. Further,
we would expect that a lessee that can estimate the fair value of the
larger asset (which will often be the case) would typically be able to
reasonably allocate an appropriate percentage of that fair value to the
portion being leased without undue cost or effort.
8.3.3.6.5 Investment Tax Credits
ASC 842-10
55-8 When evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1), the
fair value of the underlying asset should be reduced by any related investment tax credit retained by the lessor and
expected to be realized by the lessor.
When an entity applies the “present value” test, the fair value of the
underlying asset would be reduced by any ITCs since these are linked to
the ownership of the asset and are retained by the lessor.
8.3.3.7 Underlying Asset Is Specialized and Has No Alternative Use to the Lessor at the End of the Lease Term
ASC 842-10
25-2 A lessee shall classify a lease as a finance lease . . . when the lease meets any of the following criteria at
lease commencement: . . .
e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the
lessor at the end of the lease term.
55-7 In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term
in accordance with paragraph 842-10-25-2(e), an entity should consider the effects of contractual restrictions
and practical limitations on the lessor’s ability to readily direct that asset for another use (for example, selling
it or leasing it to an entity other than the lessee). A contractual restriction on a lessor’s ability to direct an
underlying asset for another use must be substantive for the asset not to have an alternative use to the lessor.
A contractual restriction is substantive if it is enforceable. A practical limitation on a lessor’s ability to direct
an underlying asset for another use exists if the lessor would incur significant economic losses to direct the
underlying asset for another use. A significant economic loss could arise because the lessor either would incur
significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss. For
example, a lessor may be practically limited from redirecting assets that either have design specifications that
are unique to the lessee or that are located in remote areas. The possibility of the contract with the customer
being terminated is not a relevant consideration in assessing whether the lessor would be able to readily direct
the underlying asset for another use.
A lessee would “classify a lease as a finance lease” if, at lease commencement, the “underlying asset is
of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the
lease term.” The basis for this determination is that when an underlying asset has no alternative use to
the lessor at the end of a lease term, it is presumed that the lessee will consume all (or substantially all)
of the benefits of the asset.
Changing Lanes
New Lease Classification Criterion
The new lease classification criterion in ASC 842-10-25-2(e) has not been previously applied
in practice under U.S. GAAP and is not expected to frequently be met in isolation. We do not
believe that this criterion should be interpreted as applying to situations in which the underlying
asset is near the end of its economic life and the lessee, by virtue of the lease, therefore has
obtained all of the use of the asset so that it has “no alternative use.” Rather, the application
of this criterion is intended to identify situations in which the lessee uses all of the asset’s
economic benefits because the asset is so specialized for that particular lessee that the lessor
would not be expected to generate economic benefit from the asset’s use outside of the lease.
Connecting the Dots
Meeting the Criterion in ASC
842-10-25-2(e)
It is unlikely that the criterion in ASC
842-10-25-2(e) would be met in isolation because a lessor
economically would not enter into an arrangement in which it would
not be compensated to obtain a worthless asset at the end of a lease
term. However, if a lease is structured with entirely variable lease
payments (and the lease therefore does not meet the criterion in ASC
842-10- 25-2(d)), the lease may be more likely to meet the criterion
in ASC 842-10-25-2(e) in isolation.
8.3.4 Classification Reassessment Requirements
After the lease commencement date, if a lease is modified and
that modification is not accounted for as a separate contract, both the lessee
and the lessor must reassess lease classification as of the effective date of
the modification. Similarly, a lessee must also reassess lease classification
when there is a change in the lease term or in the lessee’s conclusion about
whether exercise of a purchase option is reasonably certain. When reassessing
lease classification, an entity should consider the facts and circumstances that
exist as of the reassessment date, as required by ASC 842-10-25-1 and ASC
842-10-25-9. For example, an entity would consider the fair value and the
remaining economic life of the underlying asset as of the effective date of a
modification not accounted for as a separate contract or (for a lessee) as of
the date on which there is a change in the lease term or in the lessee’s
conclusion regarding the exercise of a purchase option.
When performing the fair value classification test in
reassessing the classification of a lease, an entity should include all the
remaining lease payments (as defined by ASC 842-10-30-5), along with any
residual value guaranteed by the lessee that is not already reflected in the
remaining lease payments, in accordance with ASC 842-10-25-2(d). In addition,
ASC 842-10-25-1 states, in part, “When an entity (that is, a lessee or lessor)
is required to reassess lease classification, the entity shall reassess
classification of the lease on the basis of the facts and circumstances (and the
modified terms and conditions, if applicable) as of the date the reassessment is
required.” The facts and circumstances as of the date of the lease
classification reassessment include the unamortized balance of any prepaid or
accrued lease payments and the unamortized balance of any incentives paid by the
lessor to the lessee. That is, if the unamortized balances were not present
(e.g., a prepaid lease payment did not exist or was never required to be paid),
the modification would most likely have resulted in different negotiated terms.
Accordingly, an entity should consider the unamortized balance of any prepaid
items when performing the fair value classification test. As discussed in
Section
8.3.3.6, an entity also considers such prepaid items when classifying
a lease at commencement.
Example 8-8
Lessee enters into a 10-year lease of a
nonspecialized asset. Lease payments are $50,000 per
month, payable at the beginning of the month, plus a
one-time payment at lease commencement of $1,000,000.
The lease does not transfer ownership of the underlying
asset or grant Lessee an option to purchase the
underlying asset or renew the lease. At lease
commencement, the remaining economic life of the
underlying asset is 20 years, and the fair value of the
underlying asset is $6,500,000. Lessee’s incremental
borrowing rate is 3 percent. At lease commencement, the
sum of the present value of the lease payments
(including the one-time payment at lease commencement)
is $6,191,033, which is substantially all of the fair
value of the underlying asset (i.e., 95.2 percent).
Accordingly, the lease is classified as a finance lease.
At the beginning of year 2, the lease is
modified in such a way that the monthly lease payments
are reduced by 5 percent (i.e., remaining lease payments
are $47,500 per month). The fair value of the underlying
asset is $5,750,000. The unamortized balance of the
prepaid lease payment (included in the ROU asset) is
$900,000. Lessee’s incremental borrowing rate is 3.1
percent. As of the effective date of the modification,
the sum of the present value of the lease payments
(including the unamortized balance of the prepaid lease
payment) is $5,383,070, which is substantially all of
the fair value of the underlying asset (i.e., 93.6
percent). Accordingly, the lease continues to be
classified as a finance lease.
It would be inappropriate for Lessee to
disregard the unamortized balance of the prepaid lease
payment when determining the present value of the lease
payments, since this balance is part of the
consideration in the arrangement that is associated with
the ongoing lease as of the effective date of the
modification. The sum of the present value of the
remaining lease payments (without considering
the unamortized balance of the prepaid lease payment) is
$4,483,070, which is not substantially all of the fair
value of the underlying asset (i.e., 78 percent).
Accordingly, if Lessee would have disregarded the
unamortized balance of the prepaid lease payment, the
lease classification would have inappropriately changed
to an operating lease classification.
Connecting the Dots
Consideration of Facts and Circumstances Existing as of the
Reassessment Date
ASU 2016-02, as originally drafted, was not clear on
whether a lessee is required to reassess lease classification on the
basis of the facts and circumstances existing as of the reassessment
date. In response to stakeholder feedback on this matter, in July 2018,
the FASB issued ASU 2018-10, which, among other amendments, added
the following passage to ASC 842-10-25-1:
When an
entity (that is, a lessee or lessor) is required to reassess lease
classification, the entity shall reassess classification of the
lease on the basis of the facts and circumstances (and the modified
terms and conditions, if applicable) as of the date the reassessment
is required (for example, on the basis of the fair value and the
remaining economic life of the underlying asset as of the date there
is a change in the lease term or in the assessment of a lessee
option to purchase the underlying asset or as of the effective date
of a modification not accounted for as a separate contract in
accordance with paragraph 842-10-25-8).
See Section 17.3 for additional information on FASB
standard-setting activity related to ASC 842.
8.3.5 Other Considerations Related to Lease Classification
8.3.5.1 Lease of an Acquiree
ASC 842-10
55-11 In a business
combination or an acquisition by a not-for-profit
entity, the acquiring entity should retain the
previous lease classification in accordance with
this Subtopic unless there is a lease modification
and that modification is not accounted for as a
separate contract in accordance with paragraph
842-10-25-8.
Pending Content (Transition Guidance: ASC
805-60-65-1)
55-11 In a business
combination or an acquisition by a not-for-profit
entity, the acquiring entity should retain the
previous lease classification in accordance with
this Subtopic unless there is a lease modification
and that modification is not accounted for as a
separate contract in accordance with paragraph
842-10-25-8. A joint venture formation accounted
for in accordance with Subtopic 805-60 should
apply the guidance in this paragraph applicable to
the acquiring entity in a business combination.
The joint venture should be viewed as analogous to
the acquiring entity in a business combination,
and any recognized businesses and/or assets should
be viewed as analogous to an acquiree.
ASC 805-20
25-28A The acquirer shall
recognize assets and liabilities arising from leases
of an acquiree in accordance with Topic 842 on
leases (taking into account the requirements in
paragraph 805-20-25-8(a)).
25-28B For leases for which
the acquiree is a lessee, the acquirer may elect, as
an accounting policy election by class of underlying
asset and applicable to all of the entity’s
acquisitions, not to recognize assets or liabilities
at the acquisition date for leases that, at the
acquisition date, have a remaining lease term of 12
months or less. This includes not recognizing an
intangible asset if the terms of an operating lease
are favorable relative to market terms or a
liability if the terms are unfavorable relative to
market terms.
As noted above, for leases acquired as the result of “a
business combination or an acquisition by a not-for-profit entity,” lease
classification will not be revisited unless the lease contract is modified
“and that modification is not accounted for as a separate contract.” If
there is a modification as of or after the business combination, the
acquiree will need to reevaluate lease classification in accordance with the
lease modification guidance (see Section 8.6 for additional
considerations).
For more information about accounting for leases acquired in
a business combination, see Section 4.3.11 of Deloitte’s Roadmap
Business
Combinations.
8.3.5.1.1 Accounting for Leases Acquired in a Business Combination
8.3.5.1.1.1 Classification
An acquiree’s classification of its leases is not
reconsidered in a business combination unless the lease agreement is
modified as part of the business combination and that modification
is not accounted for as a separate contract. Therefore, the
acquiree’s classification of its lease agreements generally carries
over to the acquiring entity.
If the terms of a lease agreement are modified as
part of the business combination and the modification is not
accounted for as a separate contract in accordance with ASC
842-10-25-8, the lease is classified as of the acquisition date by
using the modified terms.
8.3.5.1.1.2 Recognition
In accordance with ASC 805-20-25-28A, the acquirer
should recognize assets and liabilities arising from leases (both
operating and financing type) of an acquiree in accordance with ASC
842. Notwithstanding the requirement in ASC 805-20-25-28A, an
acquirer may elect, as an accounting policy, not to recognize assets
and liabilities arising from leases of an acquiree if both of the
following conditions are met: (1) the acquiree is the lessee and (2)
the remaining term of the lease, as of the acquisition date, is one
year or less.
8.3.5.1.1.3 Measurement
The acquirer in a business combination should apply
the guidance in paragraph BC415 of ASU 2016-02 when measuring the assets and
liabilities resulting from leases (both operating and financing
type) in which the acquiree is a lessee. Paragraph BC415 of ASU
2016-02 states:
The Board decided that when the acquiree in
a business combination is a lessee, the acquirer should
measure the acquiree’s lease liability at the present value
of the remaining lease payments as if the acquired lease
were a new lease at the date of acquisition. Measuring the
acquired lease as if it were a new lease at the date of
acquisition includes undertaking a reassessment of all of
the following:
-
The lease term
-
Any lessee options to purchase the underlying asset
-
Lease payments (for example, amounts probable of being owed by the lessee under a residual value guarantee)
-
The discount rate for the lease.
The acquiree’s right-of-use asset should be
measured at the amount of the lease liability, adjusted for
any off-market terms (that is, favorable or unfavorable
terms) present in the lease. Prepaid or accrued rent should
not be recognized because such amounts do not meet the
definition of an asset or a liability in Concepts Statement
6 under the acquisition method of Topic 805, Business
Combinations. Instead, the remaining lease payments required
under the terms of the lease are considered in evaluating
whether the terms of the lease are favorable or unfavorable
at the acquisition date.
Further, as discussed in paragraph BC416 of ASU
2016-02, the Board had considered whether, when the acquiree is a
lessee, the acquirer should apply the general principle in ASC 805
and therefore measure the ROU assets and lease liabilities at fair
value. However, the Board believed that the costs of obtaining
information about fair value in such circumstances would outweigh
the benefits. Rather, the Board decided that the acquirer should
reassess the key inputs (i.e., lease term, purchase options, lease
payments, and discount rate) as of the acquisition date to measure
the ROU asset and lease liability.
For more information about accounting for leases
acquired in a business combination, see Section 4.3.11.1 of Deloitte’s
Roadmap Business Combinations.
8.3.5.1.2 Accounting for Leases Acquired in a Business Combination When It Is Reasonably Certain That the Acquirer Will Exercise a Purchase Option in an Acquired Operating Lease
The acquirer in a business combination retains the
original classification of an acquired lease if the lease is not
modified as a result of the acquisition. Upon acquisition, the acquirer
should measure the acquired lease as if it were a new lease and
recognize a lease liability and ROU asset in an amount determined, in
part, on the basis of the remaining lease term and remaining lease
payments.3 These payments include the lease payment associated with a
purchase option that the acquirer is deemed reasonably certain to
exercise, regardless of whether the acquiree concluded that such
exercise was reasonably certain to occur at lease commencement. Thus,
there may be circumstances in which exercise of a purchase option is
determined to be reasonably certain but the lease is classified as an
operating lease because it retains its legacy classification.4
Consider the following scenario:
- Company P obtains control of Company D in an acquisition that is accounted for as a business combination under ASC 805-10.
- Acquired assets include an existing lease for office space in which D is the lessee.
- The office space lease has a fixed-price purchase option; D determined that exercise of the option at lease commencement was not reasonably certain.
- The lease is classified as an operating lease and the lease is not modified as a result of the business combination. Accordingly, P retains the operating lease classification in accordance with ASC 842-10-55-11.
- As of the acquisition date, the lease has a remaining contractual lease term of four years, with no termination options. The remaining useful life of the asset as of the acquisition date is 10 years.
- The annual lease payments are $50,000 for the lease’s remaining contractual term. The lease payments are deemed consistent with current market rates.
- The lease has a purchase option at the end of the contractual term for an amount of $150,000. Company P has determined that it is reasonably certain that it will exercise this purchase option upon completion of the contractual term.
- Company P’s incremental borrowing rate is 5 percent as of the acquisition date.
Upon acquisition, P will record a lease liability and
ROU asset of $300,703 on the basis of the present value of the remaining
annual lease payments and the exercise price of the purchase option.
Because control of the leased asset will ultimately be transferred to P
upon exercise of the purchase option, this lease would have been
classified as a finance lease in the absence of the requirement to
retain lease classification in a business combination. However, because
the lease is not modified as a result of the acquisition, it retains its
operating lease designation.
When it is reasonably certain that a purchase option
will be exercised, a lessee will typically classify the lease as a
finance lease and would thus amortize the asset in accordance with the
framework for subsequent measurement of a finance lease. ASC 842-20-35-8
explains this subsequent measurement:
A lessee shall amortize the right-of-use asset
from the commencement date to the earlier of the end of the
useful life of the right-of-use asset or the end of the lease
term. However, if the lease transfers ownership of the
underlying asset to the lessee or the lessee is reasonably
certain to exercise an option to purchase the underlying asset,
the lessee shall amortize the right-of-use asset to the end of
the useful life of the underlying asset.
However, the concept of amortizing a ROU asset through
the end of the useful life of an underlying asset that extends beyond
the contractual term is not contemplated for operating leases under ASC
842, since a purchase option that the lessee is reasonably certain to
exercise would typically disqualify the lease for operating lease
treatment. Thus, questions have arisen regarding whether the ROU asset
should be amortized over the remaining contractual term of the lease or
over the remaining useful life of the underlying asset when an acquirer
in a business combination concludes that it is reasonably certain to
exercise a purchase option in an operating lease.
In such circumstances, the ROU asset should be amortized
over the remaining useful life of the underlying asset, which is 10
years in the scenario discussed above. While the remaining contractual
term of the lease in the above example is only four years, the economic
substance of the transaction is the acquisition of an asset with a
10-year useful life because it is reasonably certain that the purchase
option will be exercised.
Further, ASC 842-10-30-1 through 30-3 describe what
periods are considered to be within the lease term, stating that such
periods include the noncancelable period and periods covered by an
option to extend the lease when the exercise of such options is
reasonably certain. An entity should evaluate purchase options in the
same manner in which it considers options to extend or terminate the
lease. The FASB explained this in paragraph BC218 of ASU 2016-02, which
states:
On reconsideration, in issuing the 2013
Exposure Draft, the Board decided that purchase
options should be accounted for in the same way as options to
extend the term of a lease (that is, the exercise price of a
purchase option would be included in the measurement of lease assets
and lease liabilities if the lessee had a significant economic
incentive to exercise that option). Topic 842 affirms that decision
but, instead, consistent with the Board’s decision about options to
extend (or not to terminate) a lease, refers to whether the lessee
is reasonably certain to exercise the purchase option on the basis
of an evaluation of relevant economic factors. The Board concluded that a purchase option is the ultimate
option to extend the lease term. A lessee that has an option to
extend a lease for all of the remaining economic life of the
underlying asset is, economically, in a similar position to a
lessee that has an option to purchase the underlying asset.
Accordingly, the Board decided that those two options should be
accounted for in the same way. [Emphasis added]
Therefore, a lease that includes a purchase option that
is reasonably certain to be exercised is similar to a lease containing
optional renewal periods that are reasonably certain to be exercised and
that would extend the lease to cover the remaining economic life of the
asset. In other words, the economics of a lease with a four-year
contractual term and a 10-year useful life of the underlying asset are
the same regardless of whether the lessee has an option to purchase the
asset at the end of the lease term or an option to extend the lease term
for an additional six years. In both instances, the lessee is able to
direct the use of and obtain benefit from using the asset for a 10-year
period. Accordingly, the entity should amortize the ROU asset over 10
years when it is reasonably certain that it will exercise the purchase
option.
We believe that there are two acceptable approaches
(described below) for measuring the amortization of the ROU asset over
the useful life of the underlying asset when an acquirer in a business
combination concludes that it is reasonably certain to exercise a
purchase option in an operating lease. The election of either approach
is a policy choice that should be consistently applied. Given the
complexity of both approaches, entities are encouraged to consult with
their accounting advisers in such situations.
8.3.5.1.2.1 Approach 1: Amortize the ROU Asset by Calculating a Single Lease Expense for the Asset’s Entire Useful Life
A “straight-line approach” is one way to measure the
amortization of the ROU asset to record in each period. Under such
an approach, a single lease expense is calculated and the same total
expense (i.e., $35,000 in the example above)5 is recorded in each year of the underlying asset’s 10-year
useful life. The amortization of the ROU asset would be lessened by
interest expense throughout the contractual term in a manner
consistent with the bifurcation of a single lease expense between
its interest expense and amortization expense components under an
operating lease framework. The remaining ROU asset would be
reclassified to PP&E when the purchase option is exercised at
the end of year 4. Once the asset is purchased, P should apply the
guidance on depreciation in ASC 360-10. Under this approach, the ROU
asset at the end of year 4 would have a carrying value of $210,000,
which would be depreciated over the remaining six years of the
asset’s useful life (or $35,000 per year).
Approach 1 results in greater
amortization/depreciation of the asset in the years after the end of
the contractual term of the lease. As a result, the carrying value
of the asset upon execution of the purchase option may be higher
than the purchase option price. While the asset could therefore be
recorded at an amount higher than its actual cost (the carrying
value of the asset is $210,000 in the above example, while the
purchase price is $200,000), we believe that Approach 1 is
consistent with the overall straight-line expense approach generally
prescribed for operating leases and is acceptable as an application
of the single lease cost model throughout the useful life of the
asset.
The table below
illustrates the straight-line expense approach.
8.3.5.1.2.2 Approach 2: Amortize the ROU Asset by Reference to the Outcome That Would Have Resulted From a Finance Lease
A second approach to measuring the amortization of
the ROU asset would be to calculate the amortization in such a way
that the ending ROU asset at the end of the contractual lease term
(i.e., when the purchase option is exercised) would be the same
ending balance as if the lease had been classified as a finance
lease (in which case the ROU asset would be amortized on a
straight-line basis over the useful life of the underlying asset).
Once the purchase option is exercised, the carrying value would then
be transferred to PP&E and depreciated in accordance with ASC
360-10. Although this approach results in the same ROU asset balance
at the end of the lease term as if the lease were a finance lease,
because the lease must be accounted for as an operating lease, P
would need to adjust the relative amount of amortization taken
during each year of the lease term to maintain an overall
straight-line lease expense (including both interest and
amortization) over the lease term. As a result of this approach, the
entire financing component (i.e., interest) of the asset’s
acquisition would be accounted for during the lease term while the
single lease cost framework for the acquired operating lease would
be preserved but would feature different straight-line expense
amounts before and after the purchase of the underlying asset.
Under this approach, P will recognize a single lease
expense over the four-year lease term that will result in the ending
ROU asset balance of $180,422 at the end of year 4, which is
calculated as ($300,703 ÷ 10-year useful life) × 6-year life
remaining. This balance would correspond to the ending balance of a
ROU asset calculated under the finance lease expense methodology.
However, although the average amortization
of the ROU asset is $30,070 per year during the lease term, the
amortization in each year is adjusted to
maintain an overall straight-line lease expense during the lease
term. As with Approach 1, the ROU asset would be reclassified to
PP&E once the purchase option is exercised at the end of year 4
and would be depreciated over its remaining useful life in
accordance with ASC 360-10. Provided that a straight-line
depreciation method is selected, P would record depreciation expense
of $30,070 each year over the remaining useful life of the asset
(consistent with the average annual amortization during the lease
term).
This approach results in recognition during the
lease term of all of the interest expense, together with a
proportional amount of the asset amortization/depreciation, while
only the depreciation of the asset is recognized after the lease
term. Accordingly, this approach results in a higher cost recorded
during the contractual lease term than Approach 1. This second
approach is illustrated in the table below.
We believe that the approaches described and
illustrated above are acceptable in these circumstances and are in
keeping with the straight-line expense recognition guidance
applicable to operating leases. ASC 842 does not explicitly
acknowledge or address such a scenario; therefore, there may be
other acceptable approaches. Companies contemplating an approach
other than the two discussed above are encouraged to consult with
their auditors or accounting advisers.
8.3.5.1.3 Determining Lease Classification When a Lease Is Acquired in an Asset Acquisition
ASC 842 does not provide guidance on how an entity
should determine lease classification when a lease is acquired in an
asset acquisition. In the absence of guidance specific to asset
acquisitions, we believe that there are two acceptable alternatives: an
entity can either (1) retain the previous classification of the seller
or (2) reassess the lease classification. Application of more than one
alternative in the same asset acquisition transaction would not be
expected.
8.3.5.1.3.1 Retain Previous Lease Classification
We believe that it would be acceptable to analogize
to the business combination guidance in ASC 842-10-55-11, which
requires that the previous lease classification be retained unless
there is a lease modification and that modification is not accounted
for as a separate contract:
In a business combination or an acquisition
by a not-for-profit entity, the acquiring entity should
retain the previous lease classification in accordance with
this Subtopic unless there is a lease modification and that
modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8.
Under this alternative, an entity would not reassess
the lease classification when a lease is acquired in an asset
acquisition, provided that only the identity of the lessee or
lessor, but not any other provisions of the lease, is changed. In
these circumstances, an entity views the asset acquisition as a
continuation of the historical lease agreement.
ASC 842-20-20 defines a lease modification as a
“change to the terms and conditions of a contract that results in a
change in the scope of or the consideration for a lease.” We do not
believe that a change only in the parties to a lease is contemplated
in this definition, since such a change does not alter scope or
consideration.
8.3.5.1.3.2 Reassess Lease Classification
We also believe that it would be acceptable to
reassess lease classification by considering each lease acquired as
a new lease on the date of the asset acquisition. The fact that the
FASB provided specific guidance related to business combinations but
did not extend that guidance to asset acquisitions may indicate that
the Board did not intend for entities to use the same approach for
asset acquisitions. In addition, unlike an acquiring entity in a
business combination, an acquiring entity in an asset acquisition
may not have the information necessary to determine the original
classification of the lease. Under this alternative, an acquiring
entity in an asset acquisition would reassess lease classification
as of the acquisition date since that date marks the entity’s first
involvement with the lease (i.e., it is a new lease from the
acquiring entity’s perspective).
8.3.5.2 Related-Party Leases
Before the adoption of ASU 2023-01, ASC 842-10-55-12
indicates that related-party leases (leases between parties under common
control) should be classified in the same manner as leases between unrelated
parties (i.e., on the basis of the legally enforceable terms and conditions
of the lease). Specifically, ASC 842-10-55-12 states:
Leases between related parties should be classified in accordance with
the lease classification criteria applicable to all other leases on the
basis of the legally enforceable terms and conditions of the lease. In
the separate financial statements of the related parties, the
classification and accounting for the leases should be the same as for
leases between unrelated parties.
After adopting ASU 2023-01,
private companies, as well as not-for-profit entities that are not conduit
bond obligors, can elect an optional practical expedient for related-party
arrangements between entities under common control. This practical expedient
allows for the evaluation of a common-control lease on the basis of the
written terms and conditions of such an arrangement.
See Section 13.2 for more information about related-party leases
and the next section for further details on leases between parties under
common control and the optional practical expedient.
8.3.5.2.1 Leases Between Parties Under Common Control
Parties under common control often enter into
intercompany agreements, some of which could meet the definition of a
lease under ASC 842 (regardless of whether they are formally
documented).
Before the adoption of ASU 2023-01, the guidance in ASC
842 on accounting for related-party leases is limited to that in ASC
842-10-55-12 (see above) and paragraph BC374 of ASU 2016-02, which
states:
The Board decided that the recognition
and measurement requirements for all leases should be applied by
lessees and lessors that are related parties on the basis of legally
enforceable terms and conditions of the arrangement, acknowledging
that some related party transactions are not documented and/or the
terms and conditions are not at arm’s length. In addition, lessees
and lessors are required to apply the disclosure requirements for
related party transactions in Topic 850. In previous GAAP, entities
were required to account for leases with related parties on the
basis of the economic substance of the arrangement, which may be
difficult when there are no legally enforceable terms and conditions
of the arrangement. Examples of difficulties include related party
leases that are month to month and related party leases that have
payment amounts dependent on cash availability. In these situations,
it is difficult and costly for preparers to apply the recognition
and measurement requirements. Even when applied, the resulting
information often is not useful to users of financial
statements.
While this guidance on accounting for related-party
leases may appear to be clear — that is, an entity would not impute
provisions that do not legally exist or cannot be enforced — questions
have arisen regarding whether terms that are outside the lease agreement
create legally enforceable terms and conditions that would be considered
part of the lease. Such questions, in part, led to the issuance of ASU
2023-01 (see further discussion below).
Unless an entity is eligible for and applies the
practical expedient described in ASU 2023-01, the accounting for a lease
depends on the enforceable rights and obligations of each party as a
result of the contract. This principle applies irrespective of whether
such rights or obligations are included in the contract or explicitly or
implicitly provided outside of the contract (i.e., there may be
enforceable rights or obligations that extend beyond the written lease
contract).
While it is clear that the FASB wanted to minimize the
cost and complexity of the accounting for leases between parties under
common control by limiting the application of the guidance in ASC 842 to
rights and obligations that are enforceable (i.e., the parties would not
impute any terms or otherwise be required to deviate from the
enforceable terms to reflect the substance of the arrangement), we do
not think that it would be appropriate to ignore any facts and
circumstances related to rights and obligations outside of a lease
contract. That is, terms and conditions not written in an agreement or
that are included in contracts separate and apart from the lease
contract may create enforceable rights and obligations for the parties
subject to the lease. For example, while the term of an arrangement may
be explicitly limited to six months, factors outside the contract may
indicate that the term is longer.
The determination of whether terms and conditions not
written in a lease agreement create enforceable rights and obligations
to the parties subject to the lease involves judgment and, in some
cases, may involve legal questions that should be evaluated with the
assistance of legal counsel.
For more information about the practical expedient in ASU 2023-01, see
Section 17.3.1.10.
Changing Lanes
Legally Enforceable Terms
Versus Arrangement Substance
As part of the FASB’s postimplementation review
of ASC 842, private companies asserted that the requirement to
assess a common-control lease on the basis of its legally
enforceable terms and conditions creates unnecessary cost and
complexity for financial statement preparers, since the terms
and conditions of such common-control lease arrangements may
lack sufficient details, may be uneconomic, or may be changed
without approval, given that one party in the common-control
group generally controls the arrangement.
In response to such feedback, ASU 2023-01
provides an optional practical expedient under which private
companies, as well as not-for-profit entities that are not
conduit bond obligors, can use the written terms and conditions
of an arrangement between entities under common control to
determine (1) whether a lease exists and (2) the subsequent
accounting for (and classification of) the lease.
8.3.5.3 Leases Involving Facilities Owned by a Governmental Unit or Authority
ASC 842-10
55-13 Because of special provisions normally present in leases involving terminal space and other airport
facilities owned by a governmental unit or authority, the economic life of such facilities for purposes of
classifying a lease is essentially indeterminate. Likewise, it may not be practicable to determine the fair value of
the underlying asset. If it is impracticable to determine the fair value of the underlying asset and such leases
also do not provide for a transfer of ownership or a purchase option that the lessee is reasonably certain to
exercise, they should be classified as operating leases. This guidance also applies to leases of other facilities
owned by a governmental unit or authority in which the rights of the parties are essentially the same as in a
lease of airport facilities. Examples of such leases may be those involving facilities at ports and bus terminals.
The guidance in this paragraph is intended to apply to leases only if all of the following conditions are met:
- The underlying asset is owned by a governmental unit or authority.
- The underlying asset is part of a larger facility, such as an airport, operated by or on behalf of the lessor.
- The underlying asset is a permanent structure or a part of a permanent structure, such as a building, that normally could not be moved to a new location.
- The lessor, or in some circumstances a higher governmental authority, has the explicit right under the lease agreement or existing statutes or regulations applicable to the underlying asset to terminate the lease at any time during the lease term, such as by closing the facility containing the underlying asset or by taking possession of the facility.
- The lease neither transfers ownership of the underlying asset to the lessee nor allows the lessee to purchase or otherwise acquire ownership of the underlying asset.
- The underlying asset or equivalent asset in the same service area cannot be purchased or leased from a nongovernmental unit or authority. An equivalent asset in the same service area is an asset that would allow continuation of essentially the same service or activity as afforded by the underlying asset without any appreciable difference in economic results to the lessee.
55-14 Leases of underlying assets not meeting all of the conditions in paragraph 842-10-55-13 are subject
to the same criteria for classifying leases under this Subtopic that are applicable to leases not involving
government-owned property.
Leases involving terminal space and certain other facilities owned by a governmental unit or authority
(e.g., those at airports, bus terminals, and ports) may be subject to special lease classification
considerations. For example, as discussed above, it may not be possible to identify the economic life of
the underlying asset or practical to determine the fair value of the underlying asset. In such cases, the
lease should be accounted for as an operating lease. As described above, the default to operating lease
treatment is limited to leases of underlying assets that meet the specific conditions in ASC 842-10-55-13;
otherwise, a lessee would apply the lease classification criteria that apply to leases of non-government-owned
property.
8.3.5.4 Lessee Indemnification for Environmental Contamination
ASC 842-10
55-15 A provision that requires lessee indemnification for environmental contamination, whether for environmental contamination caused by the lessee during its use of the underlying asset over the lease term or for preexisting environmental contamination, should not affect the classification of the lease.
Contracts that are or contain a lease may include a clause that will indemnify a lessor for any environmental contamination associated with the leased asset, irrespective of whether the contamination resulted from the lessee’s use of the underlying asset over the lease term or from a preexisting condition. This type of indemnification (1) would be considered variable and therefore has no impact on lease classification and (2) would signify that the lessee is retaining certain risks and rewards, which by themselves would not be indicative of control.
Footnotes
1
Although ASC 842-10-55-3 indicates that an entity need
not consider the fourth classification criterion if it is not
“practical” to determine the fair value of the underlying asset, we
believe that it would be unlikely for a lessee not to be able to
determine the fair value of an underlying asset.
2
See Section 9.2.1.4.2 for a
discussion of circumstances in which it would be acceptable for
a lessor to take a PRVG into account when assessing the
classification of leases in a portfolio.
3
The measurement of a ROU asset in a business
combination incorporates an adjustment for any favorable or
unfavorable terms of the lease in comparison to current market
terms. For more information about the initial measurement of a
ROU asset acquired in a business combination, see Section
4.3.11.1.3 of Deloitte’s Roadmap Business
Combinations.
4
While this section addresses purchase options
that an acquirer is reasonably certain to exercise, similar
circumstances may arise when renewal options exist that, if
exercised, would cause the lease to be classified as a finance
lease if it were not for the guidance in ASC 842-10-55-11. Under
ASC 805-20-30-24, such extension options constitute part of the
acquirer’s “new” lease term if the exercise of such options is
reasonably certain as of the acquisition date. Accordingly, both
elements of the single lease expense (interest and amortization
of the ROU asset) would be recognized over the extended term.
With respect to straight-line expense recognition over that
term, the lessee should apply one of the approaches described in
Example
8-13.
5
Calculated on the basis of the sum of the
total fixed payments of $200,000 (annual fixed payments of
$50,000 × 4-year lease term) and the purchase option of
$150,000, divided by the 10-year useful life of the
underlying asset.
8.4 Recognition and Measurement
ASC 842 introduces a lessee model under which all leases except those subject to the short-term lease exemption are recognized on the balance sheet.
This section addresses phases 1 through 4 of the lease “life cycle.” That is, it provides an overview of the guidance that a lessee would evaluate when determining (1) the lease inception and commencement dates, (2) how to initially recognize and measure a lease, (3) how to subsequently measure a lease, and (4) how to account for the impairment of an ROU asset (when applicable).
8.4.1 Lease Inception and Lease Commencement
8.4.1.1 Lease Inception
Lease inception is the date on which the terms of the contract are agreed to and the agreement creates enforceable rights and obligations. At lease inception, an entity must evaluate whether a contract is or contains a lease. See Chapter 3 for additional information on identifying a lease.
8.4.1.2 Lease Commencement Date
ASC 842-10
55-19 In some lease arrangements, the lessor may make the underlying asset available for use by the lessee (for example, the lessee may take possession of or be given control over the use of the underlying asset) before it begins operations or makes lease payments under the terms of the lease. During this period, the lessee has the right to use the underlying asset and does so for the purpose of constructing a lessee asset (for example, leasehold improvements).
55-20 The contract may require the lessee to make lease payments only after construction is completed and the lessee begins operations. Alternatively, some contracts require the lessee to make lease payments when it takes possession of or is given control over the use of the underlying asset. The timing of when lease payments begin under the contract does not affect the commencement date of the lease.
55-21 Lease costs (or income) associated with building and ground leases incurred (earned) during and after a
construction period are for the right to use the underlying asset during and after construction of a lessee asset.
There is no distinction between the right to use an underlying asset during a construction period and the right
to use that asset after the construction period. Therefore, lease costs (or income) associated with ground or
building leases that are incurred (earned) during a construction period should be recognized by the lessee (or
lessor) in accordance with the guidance in Subtopics 842-20 and 842-30, respectively. That guidance does not
address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should
capitalize rental costs associated with ground and building leases.
The ASC master glossary defines the commencement date of the lease as the “date on which a lessor
makes an underlying asset available for use by a lessee.” Although a contract may explicitly define a date
that meets the legal definition of the “lease commencement date” with respect to identifying when rent
will need to be paid, that date may not necessarily meet the accounting definition of the commencement
date of the lease. This is because, from an accounting perspective, the lease commencement date is
linked to when the underlying asset is made available for use by the lessee and this date may sometimes
differ from the explicit contract commencement date and is not always aligned with the date on which
payment commences.
Example 8-9
Determining the Lease Commencement Date
Retailer enters into an arrangement to lease retail space from Landlord for a period of 10 years. According to
the legal contract terms, the commencement date of the lease will be June 30, 20X2. At that point, Retailer is
expected to commence its retail operations and will begin making the contractually required lease payments.
Landlord has agreed to give Retailer access to the property starting on March 1, 20X2, so that Retailer can
make the necessary leasehold improvements to the space before commencing commercial operations.
In this scenario, although the contract explicitly defines the legal lease commencement as June 30, 20X2, the
lease commencement date for accounting purposes would be March 1, 20X2, since Landlord has made the
underlying asset available for Retailer’s use as of that date.
Connecting the Dots
Recognition and Disclosure Requirements Before Lease
Commencement
Although there is no recognition or measurement of leases before lease commencement,
ASC 842-20-50-3(b) requires the disclosure of “[i]nformation about leases that have not yet
commenced but that create significant rights and obligations for the lessee.” See Section 15.2.2
for more information.
In addition, as indicated in paragraph BC182 of ASU 2016-02, “if the costs of meeting an
obligation under the lease exceed the economic benefits expected from the lease, an entity
should consider the guidance in Topic 450 on contingencies.” As a result, the lessee may be
required to recognize a liability after lease inception but before the lease commencement date.
Changing Lanes
Initial Measurement of a Lease
A lease is initially recognized at lease commencement under ASC 840 and ASC 842.
However, the inputs used to initially measure the lease under ASC
840 and ASC 842 are determined at different times. For example,
under ASC 840, inputs such as discount rate and fair value, as well
as the lease classification itself, were determined at lease
inception; however, under ASC 842, the inputs and lease
classification are determined at lease commencement. As a result,
there could be differences between the initial recognition of a
lease under ASC 842 and that under ASC 840.
8.4.2 Initial Recognition and Measurement of the Lease
ASC 842-20
25-1 At the commencement date, a lessee shall recognize a right-of-use asset and a lease liability.
30-1 At the commencement date, a lessee shall measure both of the following:
- The lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (as described in paragraphs 842-20-30-2 through 30-4)
- The right-of-use asset as described in paragraph 842-20-30-5.
30-2 The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the commencement date.
30-3 A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate. A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases.
30-4 See Example 2 (paragraphs 842-20-55-17 through 55-20) for an illustration of the requirements on the discount rate.
30-5 At the commencement date, the cost of the right-of-use asset shall consist of all of the following:
- The amount of the initial measurement of the lease liability
- Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
- Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10).
30-6 See Example 3 (paragraphs 842-20-55-21 through 55-39) for an illustration of the requirements on lessee measurement of the lease term.
All leases (finance and operating leases), other than those that qualify for
(and for which an entity elected to apply) the short-term recognition exemption,
must be recognized as of the lease commencement date on the lessee’s balance
sheet. Accordingly, at this time, a lessee will recognize a liability for its
obligation related to the lease and a corresponding asset representing its right
to use the underlying asset over the period of use. In addition to the below
discussion of the initial determination of the lease liability and ROU asset,
Example 3 in ASC 842 (reproduced in Section
8.9.1.1) illustrates the initial measurement of the lease
liability and ROU asset for both finance and operating leases. Further, Example
4 in ASC 842 (reproduced in Section 8.9.1.2) comprehensively illustrates the initial
measurement and subsequent measurement of the lease liability and ROU asset for
an operating lease.
8.4.2.1 Initial Determination of the Lease Liability
Irrespective of whether a lease is classified as an operating lease or a finance lease, a lessee must
recognize a lease liability and measure this liability at the present value of lease payments not yet paid
(see Chapter 6 for additional discussion of lease payments). This value should be discounted by using an
appropriate discount rate. When calculating the discount rate used to initially measure the lease liability,
the lessee must use information that is available as of the lease commencement date (see Chapter 7 for
more information about the discount rate).
8.4.2.2 Initial Determination of the ROU Asset
In addition to recognizing the lease liability,
a lessee will recognize a corresponding asset representing its right to use
the underlying asset over the lease term. The ROU asset is initially
measured as follows:
ROU Asset Components | Description | Roadmap Section |
---|---|---|
Lease liability | Present value of lease payments not yet paid | |
Plus: Initial direct costs | Costs that are directly attributable to negotiating and
arranging the lease that would not have been incurred
had the lease not been executed (e.g., commissions paid,
payments made to an existing tenant to incentivize that
tenant to terminate its lease) | |
Plus: Prepaid lease payments | Any lease payments made to the lessor before or at the
commencement of the lease | N/A |
Less: Lease incentives received | Include both payments made by the lessor to or on behalf
of the lessee and any losses incurred by the lessor as a
result of assuming a lessee’s preexisting lease with a third
party |
Changing Lanes
Consideration of Asset’s Fair Value
ASC 840 explicitly prohibited the recognition of a capital lease asset in an
amount greater than the fair value of the underlying asset. By
contrast, lease measurement under ASC 842 may result in the
recognition of an ROU asset whose carrying amount is greater than
the fair value of the underlying asset. When the carrying amount of
the ROU asset is greater than the fair value of the asset, a lessee
should challenge the inputs and assumptions used to determine the
right of use, such as the discount rate used, the identification of
lease and nonlease components, and the associated allocation of
consideration to those components. When the carrying value of the
ROU asset exceeds the fair value of the underlying asset, insofar as
a triggering event occurs that would cause a lessee to test the
underlying asset for recoverability under ASC 360, the underlying
asset or related asset group could be impaired. See Section 8.4.4
for a discussion of the requirements related to testing the ROU
asset for impairment. Also see Q&A 16-4A in Section
16.3.1.1.2 for considerations related to the impact
of “hidden” impairments upon adoption of ASC 842.
Example 8-10
Initial Measurement of the Lease Liability and ROU Asset
Lessee enters into a five-year contract with Supplier for the right to use specified machinery over the lease term. The contract meets the definition of a lease and only includes a single lease component. As a result, Lessee needs to determine the lease liability and ROU asset resulting from the lease at lease commencement.
The facts relevant to determining the initial measurement of the lease liability and ROU asset are as follows:
Lease Liability Calculation
At commencement, the initial measurement of the lease liability (regardless of lease classification) is calculated as the present value of the lease payments not yet paid by using the lease term and discount rate determined at lease commencement. As illustrated below, the information relevant to determining the lease liability is the lease term of five years, lease payments that increase by 2.5 percent in each period, and the lessee’s incremental borrowing rate.
ROU Asset Calculation
At commencement, the initial measurement of the ROU asset (regardless of lease classification) is calculated
as the lease liability, increased by any initial direct costs and prepaid lease payments, reduced by any lease
incentives received before commencement.
The information relevant to determining the ROU asset includes the lease
liability of $65,328, increased by the initial
direct costs of $750 and lease payments made
before lease commencement (there are no
prepayments in this example), and reduced by lease
incentives received of $2,500.
Recognizing the Lease Liability and ROU Asset (Journal Entries)
As a result of the above calculations, at lease commencement the lessee would recognize the following
amounts in its general ledger:
8.4.2.3 Accounting for Lease Incentives When Lease Payments Are Highly or Totally Variable
A lessor sometimes provides a lessee with a lease incentive
to entice the lessee into leasing the underlying asset (e.g., the lessor may
provide the lessee with funding for the construction of certain
lessee-specific leasehold improvements). Lease incentives are a component of
lease payments, which, as described in ASC 842-10-30-5(a), include “[f]ixed
payments, including in substance fixed payments, less
any lease incentives paid or payable to the lessee” (emphasis
added). ASC 842 also explicitly indicates that lease incentives that the
lessee receives on or before the lease commencement date would be accounted
for as a reduction of the ROU asset in accordance with ASC 842-20-30-5,
which states:
At the commencement date, the cost of the
right-of-use asset shall consist of all of the following:
-
The amount of the initial measurement of the lease liability
-
Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
-
Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10). [Emphasis added]
In certain arrangements, when the payment structure of the
lease is such that the fixed lease payments are minimal or zero (e.g., a
retail store lease in which the lessee pays the lessor a percentage of the
gross sales as rent), the lease liability and ROU asset balance, as
calculated at lease commencement, may not be significant or may equal zero.
While ASC 842 clearly stipulates that lease incentives should be accounted
for as a reduction of the ROU asset when the ROU asset is initially measured
(either directly or through a reduction in the fixed lease payments), ASC
842 is silent on how an entity should account for lease incentives when the
lease payments are highly or totally variable in such a way that reducing
the ROU asset would result in a negative balance.6
To the extent that lease incentives received from the lessor
are greater than the ROU asset balance (before adjusting for
the lease incentives), a lessee should reduce the ROU asset down to zero and
recognize the difference as a liability, because it would be inappropriate
to recognize a negative ROU asset. This liability should be reversed on a
straight-line basis over the lease term and should be recognized as a
reduction of lease cost.
Example 8-11
Assume the following facts:
-
Lessee enters into a lease agreement with Lessor for the use of building space for a 10-year term.
-
According to the agreement, before the lease commencement date, Lessor will provide Lessee with a $1.25 million tenant incentive for Lessee to use in building out the space.
-
Over the lease term, Lessee is not required to pay any fixed lease payments for use of the property; however, Lessee is required to pay 2 percent of gross sales, which is recognized as variable lease cost in each period.
In this example, because the payment
structure is such that there are no fixed lease
payments to be paid by Lessee, Lessee would not
recognize a lease liability or ROU asset as of the
lease commencement date. Rather, Lessee would be
required to recognize a variable lease cost in the
form of 2 percent of gross sales in each period.
Because no ROU asset is recognized at lease
commencement, the $1.25 million tenant incentive
received would be recognized as a liability rather
than as a reduction of the ROU asset. After lease
commencement, the incentive liability would be
reversed and recognized as a reduction of lease cost
on a straight-line basis over the lease term. Lessee
would therefore record the following journal entry
for each year:
8.4.2.4 Lessee’s Accounting for Costs Related to Shipping, Installation, and Other Similar Items When the Lessor Does Not Provide Such Activities
After lease inception, a lessee may incur certain costs for
shipping, installing, and performing other services to ready the leased
asset for its intended use (e.g., site preparation). When the lessee pays
the lessor to perform activities necessary to ready the leased asset for its
intended use, such activities do not represent nonlease components in the
contract, because the lessee is not receiving a separate service from the
lessor in connection with these activities. Rather, these activities are
necessary to fulfill the lease. Because these activities do not represent a
nonlease component, any payments made by the lessee to the lessor should be
included in the lessee’s lease payments (unless there are nonlease
components in the contract to which a portion of the payments should be
allocated).
Although ASC 842 provides guidance on how a lessee should
account for payments made to a lessor to perform fulfillment activities
necessary to ready the leased asset for its intended use,7 ASC 842 is less clear on how a lessee should account for such costs
when it pays a third party8 (unrelated to the lessor) to perform these activities after lease
inception.
The definition of initial direct costs in ASC 842 focuses on
incremental costs that a lessee (or lessor) incurs to negotiate and obtain a
lease (this focus is similar to that in the definition of incremental costs
to obtain a contract with a customer in ASC 340-40). Because shipping and
installation represent activities performed to ready the leased asset for
its intended use and are incurred after the lease has been obtained, we
generally do not believe that it is appropriate to apply the guidance on
initial direct costs in ASC 842 to account for these costs.
On the basis of a technical inquiry with the FASB staff, we
understand that, in the absence of explicit cost guidance in U.S. GAAP,
including ASC 842, a lessee may elect to use either of the following
approaches to account for these costs:
-
Approach A — Analogize to the measurement guidance in ASC 360 and capitalize the costs as appropriate. ASC 360-10-30-1 states, in part:Paragraph 835-20-05-1 states that the historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. [Emphasis added]Because shipping, installation, and other similar activities are necessary to bring the leased asset to the condition and location necessary for its intended use, we believe that it is appropriate for a lessee to analogize to the guidance in ASC 360 when capitalizing costs incurred to compensate a third party for performing these services.
-
Approach B — Expense the costs as incurred.
In the technical inquiry, the FASB staff indicated that
lessees should apply the accounting policy election consistently on an
entity-wide basis to all leases and should disclose the accounting policy
elected, if material.
The above approaches are consistent with a speech given by
Andrew Pidgeon, a professional accounting fellow in the SEC’s Office of the
Chief Accountant, at the 2018 AICPA Conference on Current SEC and PCAOB
Developments. Mr. Pidgeon stated, in part:
For example, a lessee may pay a party other than the
lessor to ship a leased asset to the lessee’s premises. Topic 360
would require capitalization of those costs if the lessee purchased
the asset. Since the asset is leased, not purchased, the lessee
could determine that the costs are in the scope of other GAAP, or it
could determine recognition in current period earnings is
appropriate. In lieu of recognizing those costs in current period
earnings, the staff did not object to a lessee, as an accounting
policy election, analogizing to Topic 360 to capitalize costs
incurred to place a leased asset into its intended use. [Footnotes
omitted]
We further understand, on the basis of the aforementioned
technical inquiry with the FASB staff, that a lessee may elect, as an
accounting policy, to present the capitalized costs associated with
shipping, installing, and other similar services performed to ready a leased
asset for its intended use as either a separate asset within PP&E or as
part of the related ROU asset (thereby increasing the ROU asset).
Regardless of the presentation elected by the lessee, we
would not expect a difference in the total expense recognition pattern, and
the capitalized costs should be included in the same asset group as the ROU
asset when impairment testing is performed under ASC 360.
A lessee should also apply its accounting policy on this
presentation consistently on an entity-wide basis to all leases and should
disclose the accounting policy elected, if material.
8.4.2.5 Leases Entered Into for R&D Activities
ASC 730-10
25-2 Elements of costs
shall be identified with research and development
activities as follows (see Subtopic 350-50 for
guidance related to website development):
-
Materials, equipment, and facilities. The costs of materials (whether from the entity's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment, or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. See Topic 360 for guidance related to property, plant, and equipment; the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10 for guidance related to impairment and disposal; and paragraphs 360-10-35-2 through 35-6 for guidance related to depreciation. . . .
A lessee may lease an underlying asset (e.g., PP&E) for
use in research and development (R&D) activities. The initial accounting
for a lease used in R&D activities depends both on whether the leased
assets have an alternative future use and on the classification of the
lease. For ROU assets related to finance leases for R&D activities, an
entity should apply the guidance in ASC 730, which requires an entity to
expense PP&E acquired for use in R&D activities if such assets have
no alternative future use. Thus, the same accounting should be applied to
ROU assets associated with an R&D finance lease since a finance lease is
akin to an acquisition of the underlying asset.
We believe that there are two acceptable approaches to accounting for ROU
assets associated with R&D operating leases:
-
View 1 — Underlying assets that have no alternative future use are expensed as of the commencement date in a manner consistent with ASC 730. (This approach is similar to that discussed above for a finance lease.)
-
View 2 — The R&D operating leases should be accounted for in a manner consistent with the accounting for other non-R&D operating leases, as outlined in Section 8.4.
8.4.3 Subsequent Measurement
ASC 842-20
35-6 See Examples 3 and 4 (paragraphs 842-20-55-21 through 55-46) for an illustration of the requirements on
lessee subsequent measurement.
While the requirements for initial recognition and measurement of the lease
liability and ROU asset are the same for every lease regardless of whether it is
classified as a finance lease or an operating lease, the subsequent measurement
and related expense profile differ on the basis of the lease classification.
That is, finance leases generally have a front-loaded expense recognition
profile (see Section
8.4.3.1 for additional details) and operating leases have a
straight-line expense recognition profile (see Section 8.4.3.2 for additional details).
The graph below compares these two recognition profiles.
The discussion below describes the accounting requirements related to, and
includes examples illustrating, the subsequent measurement of both finance and
operating leases. Note that Section 8.9 also includes examples from ASC 842 that illustrate
the subsequent measurement of finance and operating leases. Specifically,
Example 3 (ASC 842-20-55-22 and ASC 842-20-55-30, reproduced in Section 8.9.1.1) and
Example 4 (ASC 842-20-55-41 through 55-46, reproduced in Section 8.9.1.2), depict the initial and
subsequent measurement of the lease liability and ROU asset.
8.4.3.1 Subsequent Measurement of a Finance Lease
ASC 842-20
25-5 After the commencement date, a lessee shall recognize in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics:
- Amortization of the right-of-use asset and interest on the lease liability
- Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs 842-20-55-1 through 55-2)
- Any impairment of the right-of-use asset determined in accordance with paragraph 842-20-35-9.
35-1 After the commencement date, for a finance lease, a lessee shall measure both of the following:
- The lease liability by increasing the carrying amount to reflect interest on the lease liability and reducing the carrying amount to reflect the lease payments made during the period. The lessee shall determine the interest on the lease liability in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability, taking into consideration the reassessment requirements in paragraphs 842-10-35-1 through 35-5.
- The right-of-use asset at cost less any accumulated amortization and any accumulated impairment losses, taking into consideration the reassessment requirements in paragraphs 842-10-35-1 through 35-5.
35-2 A lessee shall recognize amortization of the right-of-use asset and interest on the lease liability for a
finance lease in accordance with paragraph 842-20-25-5.
35-7 A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis
is more representative of the pattern in which the lessee expects to consume the right-of-use asset’s future
economic benefits. When the lease liability is remeasured and the right-of-use asset is adjusted in accordance
with paragraph 842-20-35-4, amortization of the right-of-use asset shall be adjusted prospectively from the
date of remeasurement.
35-8 A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of
the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership
of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the
underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying
asset.
After lease commencement, a lessee measures its lease liability by using the effective interest rate
method. That is, in each period, the liability will be increased to reflect the interest that is accrued on the
related liability by using the appropriate discount rate, offset by a decrease in the liability resulting from
the periodic lease payments.
The lessee’s recognition of the ROU asset after lease commencement will be similar to that for other
nonfinancial assets. That is, the lessee would generally recognize the ROU asset at cost, reduced by any
accumulated amortization and accumulated impairment losses.
The ROU asset itself is amortized on a straight-line basis unless another systematic method better reflects
how the underlying asset will be used by and benefit the lessee over the lease term. The period over
which the underlying asset will be amortized is the shorter of (1) the useful life of the underlying asset or
(2) the end of the lease term. Two exceptions to this principle are situations in which the lease agreement
includes a provision that either (1) results in the transfer of ownership of the underlying asset to the lessee
at the end of the lease term or (2) includes a purchase option whose exercise by the lessee is reasonably
certain. In either of these scenarios, the ROU asset should be amortized over the useful life of the
underlying asset.
Together, the interest and amortization expense components result in a front-loaded expense profile
similar to that of a capital lease arrangement under ASC 840. Lessees would separately present the
interest and amortization expenses in the income statement.
The example below illustrates the subsequent measurement of a finance lease. For
an additional illustration of such measurement, see Example 3 in ASC 842
(ASC 842-20-55-27 and 55-28, reproduced in Section 8.9.1.1).
Example 8-12
Subsequent Measurement of a Finance Lease
Assume the same facts as in Example 8-10. Further, assume that
after evaluating the lease classification on the
commencement date, Lessee concludes that the lease
should be classified as a finance lease. As a
result of this determination, Lessee would
subsequently account for the lease liability and ROU
asset in the following manner:
Subsequent Measurement of Lease Liability
The lease liability at any given time is accounted for by using the effective-interest method. Under this approach, the liability is adjusted to reflect an increase for the periodic interest expense (calculated by using the discount rate determined at lease commencement), reduced by the lease payment.
In this example, the discount rate used to determine the interest expense for each given period is the lessee’s incremental borrowing rate of 6.5 percent.
Subsequent Measurement of ROU Asset
The ROU asset at the end of any given period is calculated as the ROU asset at the beginning of the period, reduced by the periodic amortization of the ROU asset. In a manner consistent with the amortization approach for other nonfinancial assets, the ROU asset is amortized in each period on a straight-line basis unless another systematic basis is more representative of the pattern in which the lessee expects to consume the ROU asset’s future economic benefits.
Journal Entries
As a result of the above calculations, during the first year of the lease, Lessee would recognize the following amounts in its general ledger (note that only year 1 entries have been included):
8.4.3.2 Subsequent Measurement of an Operating Lease
ASC 842-20
25-6 After the commencement date, a lessee shall recognize all of the following in profit or loss, unless the
costs are included in the carrying amount of another asset in accordance with other Topics:
- A single lease cost, calculated so that the remaining cost of the lease (as described in paragraph 842-20- 25-8) 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 (see paragraph 842-20-55-3), unless the right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, in which case the single lease cost is calculated in accordance with paragraph 842-20-25-7
- Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs 842-20-55-1 through 55-2)
- Any impairment of the right-of-use asset determined in accordance with paragraph 842-20-35-9.
25-8 Throughout the lease term, the remaining cost of an operating lease for which the right-of-use asset has
not been impaired consists of the following:
- The total lease payments (including those paid and those not yet paid), reflecting any adjustment to that total amount resulting from either a remeasurement in accordance with paragraphs 842-10-35-4 through 35-5 or a lease modification; plus
- The total initial direct costs attributable to the lease; minus
- The periodic lease cost recognized in prior periods.
35-3 After the commencement date, for an operating lease, a lessee shall measure both of the following:
- The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date (unless the rate has been updated after the commencement date in accordance with paragraph 842-20-35-5, in which case that updated rate shall be used)
- The right-of-use asset at the amount of the lease liability, adjusted for the following, unless the right-of-use asset has been previously impaired, in which case the right-of-use asset is measured in accordance with paragraph 842-20-35-10 after the impairment:
- Prepaid or accrued lease payments
- The remaining balance of any lease incentives received, which is the amount of the gross lease incentives received net of amounts recognized previously as part of the single lease cost described in paragraph 842-20-25-6(a)
- Unamortized initial direct costs
- Impairment of the right-of-use asset.
55-3 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.
After lease commencement, a lessee is required to measure its lease liability for each period at the
present value of any remaining lease payments, discounted by using the rate determined at lease
commencement. Effectively, this approach is consistent with the model used to calculate the liability
related to the finance lease (i.e., lease liabilities are subsequently measured the same way regardless of
lease classification). That is, in each period, the liability will reflect an increase for interest that is accrued
on the related liability by using the appropriate discount rate, offset by a decrease resulting from the
periodic lease payments.
For an operating lease, the subsequent measurement of the ROU asset is linked to the amount recognized as the lease liability (unless the ROU asset is impaired). Accordingly, the ROU asset would be measured as the lease liability adjusted by (1) accrued or prepaid rents (i.e., the aggregate difference between the cash payment and straight-line lease cost), (2) remaining unamortized initial direct costs and lease incentives, and (3) impairments of the ROU asset.
After lease commencement and over the lease term, a lessee would recognize, in the income statement, (1) a single lease cost calculated in a manner that results in the allocation of the remaining lease costs over the remaining lease term, either on a straight-line basis or another systematic or rational basis that is more representative of the pattern in which the underlying asset is expected to be used; (2) variable lease payments not recognized in the measurement of the lease liability in the period in which the related obligation has been incurred; and (3) any impairment of the operating lease ROU asset.
Connecting the Dots
Overview of the “Plug” Approach
While the ASU discusses subsequent measurement of the ROU asset arising from an operating lease primarily from a balance sheet perspective, a simpler way to describe it would be from the standpoint of the income statement. Essentially, the goal of operating lease accounting is to achieve a straight-line expense pattern over the term of the lease (provided that there is not a more representative pattern of consumption of the benefit). Accordingly, an entity effectively takes into account the interest on the liability (i.e., the lease obligation consistently reflects the lessee’s obligation on a discounted basis) and adjusts the amortization of the ROU asset to arrive at a constant expense amount. To achieve this, the entity first determines the straight-line expense amount by taking total payments over the life of the lease, net of any lessor incentives, plus initial direct costs, divided by the lease term. Then, the entity calculates the interest on the liability by using the discount rate for the lease and deducts this amount from the required straight-line expense amount for the period. This difference is simply “plugged” as amortization of the ROU asset. By using this method, the entity recognizes a single operating lease expense rather than separate interest and amortization charges, although the effect on the lease liability and ROU asset on the balance sheet reflects a bifurcated view of the expense. Under this method, the amortization of the ROU asset generally increases each year as the liability accretion decreases as a result of a declining lease liability balance.
The example below illustrates the subsequent measurement of an operating lease.
For additional illustrations, see Example 3 (ASC 842-20-55-29 and 55-30,
reproduced in Section
8.9.1.1) and Example 4 (ASC 842-20-55-41 through 55-46,
reproduced in Section
8.9.1.2), which depict the subsequent (Example 3) and initial
and subsequent (Example 4) measurement of the lease liability and ROU asset
for an operating lease.
Example 8-13
Subsequent Measurement of an Operating Lease
Assume the same facts as in Example 8-10. Further, assume that
upon evaluating the lease classification on the
commencement date, Lessee concludes that the lease
should be classified as an operating lease.
As a result of this determination, Lessee would
subsequently account for the lease liability and ROU
asset by using one of two approaches, each of which
results in the same outcome:
Approach A: ROU Asset Balance Derived From Lease Liability
Approach B: Application of the “Plug” Approach
Lease Cost
After lease commencement, a lessee would recognize a single lease cost in the income statement, calculated
so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis unless
there is another systematic and rational basis that better reflects how the benefits of the underlying asset are
consumed over the lease term.
In this example, the total remaining lease cost on the commencement date would be $77,094, which is calculated as the total lease payments (including those that have been paid and those that have not yet been paid) increased by initial direct costs and reduced by any incentives paid or payable to the lessee (fixed payments of $78,844 plus the $750 in initial direct costs less the $2,500 incentive). Generally, the total lease payments would be adjusted by the prior-period lease costs (which are zero in this example).
The resulting remaining lease cost is recognized on a straight-line basis over
the remainder of the lease term (i.e., Lessee
would recognize $15,4199 in each period, which is calculated as
$77,094 ÷ 5).
Subsequent Measurement of Lease Liability
The lease liability for an operating lease at any given time is calculated as the present value of the lease payments not yet paid, discounted by using the rate that was established on the lease commencement date (unless the rate was adjusted as a result of a liability remeasurement event).
In this example, Lessee will measure the remaining lease payments at present value at the end of any given period by using the incremental borrowing rate of 6.5 percent, which was established at lease commencement.
Subsequent Measurement of ROU Asset (Approach A)
The ROU asset, at any given time, is measured as the amount of the lease liability, adjusted by (1) prepaid or accrued rents, (2) any unamortized initial direct costs, and (3) the remaining balance of any lease incentives received (gross amount received net of amount already recognized as part of the single lease costs).
In this example, Lessee will measure its ROU asset at the end of each period as the lease liability, adjusted by the prepaid/accrued rent, any unamortized initial direct costs, and any unamortized incentives received by the lessee.
Subsequent Measurement of ROU Asset (Approach B)
The ROU asset, at any given time, is measured as the ROU asset balance at the beginning of the period, adjusted by the current-period ROU asset amortization, which is calculated as the current-period lease cost adjusted by the lease liability accretion to the then outstanding lease balance (i.e., the increase in the liability as a result of applying the commencement-date discount rate).
In this example, which illustrates the accounting for period 1, Lessee will calculate the ROU balance of $52,405 at the end of period 1 in the following manner:
Journal Entries
As a result of the above calculations, during the first year of the lease, Lessee would recognize the following
amounts in its general ledger (note that only period 1 entries have been included):
8.4.3.2.1 Subsequent Measurement of an Operating Lease When the ROU Asset Would Be Reduced Below Zero Because of Accrued Rent10
At lease commencement, the ROU asset is measured as the
lease liability adjusted by (1) accrued or prepaid rents, (2) initial direct
costs, and (3) lease incentives received. In subsequently measuring an
operating lease, an entity must use an amortization method that achieves a
straight-line expense profile. An accrued rent balance is established when
escalating lease payments are present for a portion of the lease term (e.g.,
fixed lease payments in early years are lower than those in later years). In
a long-term lease with escalating lease payments (e.g., a 40-year ground
lease), the adjusting amount for accrued rent can be greater than the lease
liability balance. Accordingly, a question arises about how to subsequently
measure the ROU asset, since it would be reduced below zero. That is, the
cumulative lease payments less the cumulative straight-line expense
recognized (i.e., accrued rent) can be greater than the lease liability
balance; as a result, the ROU asset is reduced below zero.
We believe that, in the subsequent measurement of an
operating lease, when the ROU asset would be reduced below zero because the
cumulative lease payments less the cumulative straight-line expense
recognized (i.e., accrued rent) are greater than the lease liability, the
ROU asset should be reclassified and presented as a liability and the
straight-line expense should not be disrupted. Thereafter, when the balance
of the ROU asset returns to a positive amount, the balance should be
reverted to its original classification (i.e., should be presented again as
an ROU asset). We think that this approach is appropriate because we do not
believe that it is appropriate to present a negative ROU asset, thereby
offsetting other positive ROU assets. Similarly, we do not believe that it
would be appropriate to adjust the discount rate (i.e., impute a lower
discount rate) in these situations to “solve” for this problem (i.e.,
disallow the ROU asset from becoming negative).
Example 8-1411
Lessee’s
Accounting for an Operating Lease When the ROU
Asset Would Be Reduced Below Zero Because of
Accrued Rent
Retail Co. enters into a 20-year
agreement to lease land from Land Owner. According
to the terms of the agreement, Retail Co. will pay
$1,000 in year 1 and the lease payment will double
in each subsequent year (i.e., increase by 100
percent compared with the prior year’s lease
payment, so in year 2 a payment of $2,000 is due; in
year 3, $4,000; in year 4, $8,000; etc.). Retail
Co.’s incremental borrowing rate at lease
commencement is 8 percent. (Note that Retail Co.
cannot readily determine the rate implicit in the
lease.) Assume that none of the criteria in ASC
842-10-25-2 are met and that Retail Co. classifies
its lease as an operating lease.
At lease commencement, Retail Co.
will recognize a lease liability and an ROU asset of
$244,531,632, which is calculated as the present
value of the remaining lease payments by using the
incremental borrowing rate at commencement. In this
scenario, the total lease payments over the lease
term are $1,048,575,000 ($1,000 in year 1, with a
100 percent escalator each year). The recognition of
the total lease payments evenly over the 20 years
results in a straight-line rent expense of
$52,428,750 per year.
At the end of year 11, the lease
liability is equal to $567,935,936 while the
embedded accrued rent balance is $574,669,250
($2,047,000 cumulative lease payments less
$576,716,250 cumulative straight-line expense
recognized). As a result, at the end of year 11,
without adjustment, the ROU asset would be negative
$6,733,314 ($567,935,936 lease liability less
$574,669,250 of embedded accrued rent). Therefore,
in accordance with this section, we believe that at
the end of year 11, an adjustment to presentation is
necessary. Accordingly, the ROU asset is presented
as $0 and a liability of $6,733,314 is presented.
See the illustration in the table below.
In the above illustration, it can be observed that at the
end of year 13, the liability will reach its highest point of $17,250,114.
Thereafter, the balance of the liability will begin to deplete. At the end
of year 17, the lease liability will once again exceed the embedded accrued
rent, thereby reinstating a positive ROU asset. That is, the lease liability
is equal to $762,305,909, while the embedded accrued rent is $760,217,750.
At this point, the liability will have a zero balance and the ROU asset is
equal to $2,088,159. By the end of year 20 (i.e., the end of the lease
term), the lease liability and ROU asset will appropriately reduce to zero.
The total lease expense recognized over the lease term is $1,048,575,000,
which is equal to the total lease payments over the term; further, the
straight-line expense of $52,428,750 remained consistent each period.
8.4.3.3 Variable Payments Based on the Achievement of a Specified Target
ASC 842-20
55-1 A lessee should recognize costs from variable lease payments (in annual periods as well as in interim
periods) before the achievement of the specified target that triggers the variable lease payments, provided the
achievement of that target is considered probable.
55-2 Variable lease costs recognized in accordance with paragraph 842-20-55-1 should be reversed at such
time that it is probable that the specified target will not be met.
A lessee should recognize variable payments before achieving a specified target
when the achievement of the target is deemed probable. Variable payments
recognized in accordance with ASC 842-20-55-1 would be reversed when
achievement of the specified target is no longer deemed probable. As
illustrated in the next section, we believe that this guidance applies when
targets are based on cumulative performance during the lease term.
8.4.3.3.1 Lessee’s Timing of Variable Payments
Many lease arrangements contain variable payments based
on the use or performance of the underlying asset. Examples include (1)
a retail store lease that requires the lessee to pay a percentage of
store sales each month, (2) a car lease that requires the driver to pay
for each mile driven, and (3) a PPA that requires the lessee (the
off-taker) to buy all electricity produced by a weather-dependent
generating plant such as a wind farm.
Under ASC 842, variable payments that do not depend on
an index or rate are excluded from the initial measurement of the lease
liability and ROU asset.
ASC 842-20-25-5(b) (for finance leases) and ASC
842-20-25-6(b) (for operating leases) both state that variable lease
payments not included in the initial measurement of the lease should be
recognized in profit or loss “in the period in which the obligation for
those payments is incurred” (emphasis added). In
addition, the implementation guidance in ASC 842-20-55-1 states that a
“lessee should recognize costs from variable lease payments (in annual
periods as well as in interim periods) before the achievement of the
specified target that triggers the variable lease payments, provided the
achievement of that target is considered probable” (emphasis added).
In lease arrangements in which the lessee pays a
variable amount based on usage or performance, questions have arisen
about whether the lessee is required to assess the probability of future
performance throughout the lease term and record a charge (and a
corresponding liability) for the variable lease payment amount assessed
as probable.12
We believe that the guidance in ASC 842-20-55-1 on the
probable achievement of variable lease payment targets is meant to be
narrowly applied to scenarios involving discrete performance targets or
milestones that will be achieved over time (e.g., a specified level of
cumulative store sales) and, in those limited scenarios, is meant to
require recognition in each period over the lease term at an amount that
reflects an appropriate apportionment of the expected total lease cost.
This guidance ensures that the cost of the lease is appropriately
allocated to both the periods of use that contribute to the variable
payment requirement and the periods of use in which the variable payment
requirement has been met. Such allocation is necessary when performance
targets are cumulative and have the potential to cross reporting
periods.
We do not believe that the guidance on the probable
achievement of variable lease payment targets is meant to otherwise
require an assessment of a probable level of performance over the lease
term and require a charge in advance of actual performance when the
variability arises and is resolved within a reporting period. For
example, in a vehicle lease, a variable charge per mile driven that
starts with the first mile and continues throughout the lease term can
be discretely measured and expensed in the reporting period in which the
charge is incurred. That is, it is unnecessary to assess the probability
of future mileage to ensure proper period attribution of the variable
charges. Applying a probability model to this type of variable payment
structure could lead to an inappropriate acceleration of variable
expense attributable to future use.
The scenarios in the example below illustrate the
difference between the treatment of variability when discrete cumulative
targets exist and the treatment when the variability is resolved within
the reporting period.
Example 8-15
Scenario
A
Retailer X is a lessee in an
arrangement in which it is required to pay $500
plus 3 percent of store sales each month over a
five-year lease term. Retailer X is not required
to forecast its sales over the lease term and
accrue for a level of sales that is deemed
probable to occur. Rather, each month, X will
recognize variable lease expense equal to 3
percent of sales.
Scenario
B
Utility Y is a lessee in a PPA
in which it purchases all of the output from a
wind farm owned by an independent power producer
(IPP) at a fixed price per MWh. Since the wind
farm is 100 percent weather-dependent, Y’s lease
payments are 100 percent variable (Y pays only for
electricity produced). Studies performed before
the wind farm was constructed indicate that there
is a 95 percent likelihood that electrical output
will equal or exceed 25,000 MWh per month. Despite
the very high likelihood (95 percent is well above
the “probable” threshold) of a minimum performance
level, Y is not required to accrue for a
corresponding amount of lease payments (i.e., an
expectation of variable lease payments based on
future production). Rather, Y will recognize
variable lease expense each month as electricity
is delivered and billed by the IPP.
Scenario
C
Retailer Z is a lessee in a
five-year operating lease that requires it to pay
base rent of $500 per month plus an additional
$100 per month beginning when cumulative store
sales exceed $100,000. Retailer Z believes that it
is probable that this sales target will be
achieved by the end of year 2 (i.e., rent will
become $600 per month after the target is
met).
Retailer Z should quantify the
amount that it is probable for the entity to incur
on the basis of its achievement of the target
($3,600, or $100 per month for 36 months) and
should apportion that amount to each period
beginning at commencement. That is, since eventual
achievement of the cumulative sales target is
deemed probable at commencement, the $3,600 should
be recognized ratably over the five-year term
(i.e., $500 per month for 24 months plus $600 per
month for 36 months, resulting in an expense of
$560 per month) even though the target has not yet
been achieved. This is an appropriate accounting
outcome because sales in years 1 and 2 contribute
to the achievement of the target. Accordingly,
years 1 and 2 should be burdened by an appropriate
amount of the incremental lease expense.
On the basis of the above fact
pattern, Z would recognize an incremental lease
expense of $60 per month beginning at lease
commencement (i.e., $3,600 divided by the 60
months of the lease term) to reflect the expected
additional rent associated with the anticipated
achievement of the sales target.
In addition, once the target is
actually achieved, Z would remeasure the ROU asset
and corresponding liability in accordance with ASC
842-10-35-4(b), since it would conclude that a
“contingency upon which some or all of the
variable lease payments that will be paid over the
remainder of the lease term are based is resolved
such that those payments now meet the definition
of lease payments.”
Provided that Z achieves the
sales target as planned at the end of year 2
(assume a 0 percent discount rate for simplicity),
Z would recognize the following amounts in its
financial statements:
Bridging the GAAP
Target Achievement Under
U.S. GAAP Versus That Under IFRS Accounting
Standards
Under U.S. GAAP, a lessee is required to
recognize costs from variable lease payments in annual and
interim periods before the achievement of the specified target
if the target is considered probable; however, this guidance
does not exist under IFRS 16. Therefore, in such circumstances,
the accounting outcome under U.S. GAAP could differ from that
under IFRS Accounting Standards.
8.4.3.4 Subsequent Measurement for Leases That Include a Term Consisting of Nonconsecutive Periods of Use
The ASC master glossary defines “period of use” as “[t]he total period of time that an asset is used to
fulfill a contract with a customer (including the sum of any nonconsecutive periods of time).” Insofar as
the lessee concludes that the contract is or contains a lease over the “period of use,” the lease liability
and corresponding ROU asset initially would be measured on the basis of the present value of the
remaining lease payments that will be received over that nonconsecutive period, discounted by using
the appropriate rate at lease commencement (see Section 5.2.4.5 for additional information).
A lessee must also determine how it will subsequently measure the lease. ASC
842-20-25-6(a) states that after the commencement date, the lessee would
recognize in profit or loss “[a] single lease cost,
calculated so that the remaining cost of the lease (as described in
paragraph 842-20-25-8) 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).
If a lease grants a lessee the right to use an asset over
nonconsecutive periods and is determined to be an operating lease, the
lessee should limit the recognition of lease costs to the periods in which
it has the right to use the underlying asset.
The benefit that is expected to be derived from the lessee’s
use of the underlying asset is linked directly to the “period of use”
associated with the asset. When the period of use includes nonconsecutive
periods, the benefit expected to be derived from the lessee’s use of the
underlying asset would be recognized only in the periods in which it has the
right to use the underlying asset. Therefore, in a manner consistent with
the guidance in ASC 842-20-25-6(a), the lessee would recognize a single
lease cost in the income statement, calculated so that the remaining cost of
the lease is allocated on a straight-line basis over the lease term, which
would include the sum of the nonconsecutive periods.
Example 8-16
Lessee’s
Accounting for an Operating Lease With
Nonconsecutive Periods
Retail Co. enters into a two-year
lease agreement with Mall Owner under which Retail
Co. will lease a specific store front in the mall
from October through December for the holiday
seasons ending December 31, 2019, and December 31,
2020.
According to the terms of the
agreement, Retail Co. will pay $10,000 per month in
each of the three months during those periods.
Retail Co.’s incremental borrowing rate at lease
commencement is 6 percent. (Note that Retail Co.
cannot readily determine the rate implicit in the
lease.)
At lease commencement, Retail Co.
will recognize a lease liability and ROU asset of
$57,679, which is calculated as the present value of
the remaining lease payments by using the
incremental borrowing rate at commencement (i.e.,
the $10,000 payments made during the months of
October, November, and December for each of the two
years ending on December 31, 2019, and December 31,
2020).
Since the underlying asset only
benefits the lessee during the months of October,
November, and December, it would be appropriate to
only recognize a lease cost over these
nonconsecutive periods. In this scenario, the total
lease payments over the term of the lease term are
$60,000 ($10,000 per month × 6 months). The
recognition of the $60,000 evenly over the six,
nonconsecutive periods of use (i.e., a lease cost of
$10,000) results in a lease cost recognition pattern
that is representative of the pattern in which the
benefit is expected to be derived from the right to
use the underlying asset.
See Section 5.2.4.5
for additional information on accounting for an
operating lease with nonconsecutive periods and
evaluating whether such a lease qualifies as a
short-term lease.
Lease
Cost
In accordance with ASC 842, after
lease commencement, a lessee would recognize a
single lease cost in the income statement,
calculated so that the remaining cost of the lease
is allocated over the remaining lease term (but only
those periods for which the right to use the asset
exists) on a straight-line basis unless there is
another systematic and rational basis that better
reflects how the benefits of the underlying asset
are consumed over the lease term.
Retail Co. recognizes the remaining
lease cost equally over each of the six periods,
since the sum of the nonconsecutive periods of use
represents the lease term (i.e., Retail Co.
recognizes $10,000 in each period, which is
calculated as $60,000 ÷ 6).
Subsequent
Measurement of Lease Liability
The lease liability for an operating
lease in any given period is calculated as the
present value of the lease payments not yet paid,
discounted by using the rate that was established on
the lease commencement date (unless the rate was
adjusted as a result of a liability remeasurement
event).
In this example, Retail Co. measures
the six lease payments at present value by using the
commencement-date incremental borrowing rate of 6
percent on the basis of when the payments are paid.
For each period, the liability is adjusted to
reflect the effect of this discount rate on the
outstanding liability. (Note that the liability is
accreted each month.) Over the lease term, the lease
payments are only applied to the lease liability,
and this liability is only reduced, when payments
are made (October, November, and December of each
year).
Subsequent
Measurement of ROU Asset
The ROU asset for an operating lease
in any given period is calculated as the lease
liability, adjusted for certain discrete amounts,
when applicable. In this example, there are no
required adjustments; therefore, the ROU asset
balance will be exactly the same as the lease
liability balance at the end of any given period.
Because the payments and related lease costs are
limited to six discrete periods over the lease term,
the ROU asset will increase in the intervening
periods to reflect this fact.
8.4.4 Impairment of an ROU Asset
ASC 842-20
25-7 After a right-of-use asset has been impaired in accordance with paragraph 842-20-35-9, the single lease cost described in paragraph 842-20-25-6(a) shall be calculated as the sum of the following:
- Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset
- Accretion of the lease liability, determined for each remaining period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability.
35-9 A lessee shall determine whether a right-of-use asset is impaired and shall recognize any impairment loss in accordance with Section 360-10-35 on impairment or disposal of long-lived assets.
35-10 If a right-of-use asset is impaired in accordance with paragraph 842-20-35-9, after the impairment, it shall be measured at its carrying amount immediately after the impairment less any accumulated amortization. A lessee shall amortize, in accordance with paragraph 842-20-25-7 (for an operating lease) or paragraph 842-20-35-7 (for a finance lease), the right-of-use asset from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.
35-11 See Example 5 (paragraphs 842-20-55-47 through 55-51) for an illustration of the requirements for impairment of a right-of-use asset.
A lessee must test an ROU asset for impairment in a manner consistent with its
treatment of other long-lived assets (i.e., in accordance with ASC 360). The
impairment test is a two-step process as follows:
-
Step 1 — An entity compares the carrying value of the asset group with the undiscounted cash flows expected to be generated as a result of the asset group’s use and disposal to determine whether the asset group is recoverable (i.e., “the recoverability test”). If the recoverability test fails because the undiscounted cash flows are less than the carrying value of the asset group, the entity must perform step 2. Conversely, when the undiscounted cash flows exceed the carrying value of the asset group, the asset group is recoverable (i.e., there is no impairment) and therefore there is no need to determine whether the carrying value of the asset group exceeds its fair value.
-
Step 2 — An entity determines the fair value of the asset group and recognizes an impairment loss equal to the amount by which the carrying amount of an asset group exceeds its fair value (see ASC 360-10-35-17). However, the impairment loss recorded is limited to the carrying value of the long-lived assets in the asset group, and individual long-lived assets within the asset group cannot be written down below their individual fair values. An entity should determine the fair value in accordance with ASC 820-10 and use the perspective of a market participant.
See Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets and
Discontinued Operations for more information about the
ASC 360 impairment model.
If the ROU asset related to an operating lease is impaired, the
lessee would amortize the remaining ROU asset in accordance with the
subsequent-measurement guidance that applies to finance leases — typically, on a
straight-line basis over the remaining lease term (see Section 8.4.3.1). This
accounting continues to apply even if the ROU asset is remeasured after the
impairment. Thus, the operating lease would no longer qualify for the
straight-line treatment of total lease expense. However, in periods after the
impairment, a lessee would continue to present the ROU
asset reduction and interest accretion related to the lease liability as a
single line item in the income statement (see Section 14.2.2.2.1).
Connecting the Dots
Undiscounted Cash Flows
The determination of the undiscounted cash flows expected to be generated
by an asset group is based on guidance in ASC 360. That is, cash flows
included in the impairment test are not limited to cash flows that would
be included in the measurement of ROU assets and lease liabilities in
accordance with ASC 842. For example, although variable lease payments
that do not depend on an index or rate are not included in the
measurement of a lease liability and ROU asset, such amounts would be
included in cash flows for impairment test purposes.
8.4.4.1 Abandonment Accounting
ASC 360-10
Long-Lived
Assets to Be Abandoned
35-47 For purposes of this
Subtopic, a long-lived asset to be abandoned is
disposed of when it ceases to be used. If an entity
commits to a plan to abandon a long-lived asset
before the end of its previously estimated useful
life, depreciation estimates shall be revised in
accordance with paragraphs 250-10-45-17 through
45-20 and 250-10-50-4 to reflect the use of the
asset over its shortened useful life (see paragraph
360-10-35-22).
35-48 Because the continued
use of a long-lived asset demonstrates the presence
of service potential, only in unusual situations
would the fair value of a long-lived asset to be
abandoned be zero while it is being used. When a
long-lived asset ceases to be used, the carrying
amount of the asset should equal its salvage value,
if any. The salvage value of the asset shall not be
reduced to an amount less than zero.
In addition to being subject to the ASC 360 impairment
requirements, ROU assets are subject to its abandonment guidance as well.
Unlike the impairment requirements, which are applied at the asset group
level as discussed in Example 8-17, the abandonment
requirements are applied to individual lease components (regardless of
whether the lease components were accounted for separately at lease
commencement).
In the context of a real estate lease, when a lessee decides that it will no
longer need a property to support its business requirements (i.e., the
lessee will cease using the property immediately or at some designated
future date) but is still contractually obligated under the underlying
lease, it needs to evaluate whether the ROU asset has been or will be
abandoned, as a result of which such assets would be subject to abandonment
accounting. Abandonment accounting only applies when the underlying property
subject to a lease is no longer used for any business purposes,
including storage. By contrast, even if an entity has fully vacated the
space, the asset would not be considered abandoned if the lessee expects to
continue to obtain the economic benefits from using the underlying asset
(i.e., the underlying asset is viewed as temporarily idled, as contemplated
in ASC 360-10-35-49). This would be the case if the lessee intends to use
the space at a future time or when it has the intent and ability to sublease
the property. This guidance is consistent with ASC 842-10-15-17, which
states, in part:
A customer can obtain economic benefits from use of an asset
directly or indirectly in many ways, such as by using, holding,
or subleasing the asset. The economic benefits from use of
an asset include its primary output and by-products (including
potential cash flows derived from these items) and other economic
benefits from using the asset that could be realized from a
commercial transaction with a third party. [Emphasis added]
Accordingly, if a lessee can obtain economic benefit from using the asset, it
would continue to record lease expense for an operating lease and ROU
amortization for a finance lease.
In applying the abandonment model in ASC 360, a lessee would
shorten the remaining useful life of the ROU asset to equal the amount of
time remaining before the planned abandonment date. While the ROU asset is
affected by the entity’s decision to abandon an asset, the corresponding
lease liability is not affected because the lessee is not relieved of its
obligations under the lease. The example below illustrates a scenario in
which a lessee shortens the remaining useful life of an ROU asset.
Example 8-17
Impact of a Plan to Abandon the Underlying Leased
Asset Before the End of the Lease Term
On January 1, 2020, Company S, a
lessee, enters into a lease arrangement with a
noncancelable lease term of 10 years and no renewal
options. The lease is appropriately classified as an
operating lease and therefore will have an overall
straight-line expense profile (i.e., the
amortization of the ROU asset will be “plugged” in
each period to achieve an overall straight-line
expense pattern, when combined with interest expense
on the lease liability, over the 10-year term). At
the end of year 1 (i.e., on January 1, 2021), S
decides that it will abandon the leased asset on
January 1, 2027, before the end of the lease term.
Company S considers that the asset will be abandoned
since it will no longer use the asset and does not
have the intent and ability to sublease the leased
asset (see Q&A 16-5A). We
do not believe that it is appropriate to continue to
recognize an ROU asset after abandonment because S
is no longer obtaining economic benefits from the
use of the underlying asset through use or sublease.
However, S would still be required to recognize a
lease liability equal to the present value of the
remaining lease payments under the contract.
Further, the ROU asset is part of a larger asset
group that is not impaired.
In this scenario, at the beginning
of the second year, S should shorten the remaining
useful life of the ROU asset to equal the amount of
time remaining before the planned abandonment date.
The SEC staff has indicated that an entity should
revisit a long-lived asset’s useful life to
determine whether it should be adjusted (i.e.,
shortened to reflect the expected abandonment date).
Specifically, ASC 360-10-S99-2 states, in part:
If an entity commits to a plan
to abandon a long-lived asset before the end of
its previously estimated useful life, depreciation
estimates shall be revised in accordance with FASB
ASC Topic 250, Accounting Changes and Error
Corrections, to reflect the use of the asset over
its shortened useful life.
While ASC 360-10-S99-2 was issued in the context of owned
assets, we believe that it applies equally to ROU assets. In addition,
paragraph BC255 of ASU 2016-02 contains language indicating that the ROU
asset should be zero as of the abandonment date. Paragraph BC255 states, in
part:
In the Board’s view, it
would be inappropriate to continue to recognize a right-of-use asset
from which the lessee does not expect to derive future economic
benefits (for example, a right to use a building that the lessee has
abandoned) or to recognize that asset at an amount the lessee
does not expect to recover. [Emphasis added]
While the guidance is clear on the impact of impairments on
the prospective amortization of operating lease ROU assets (see above), we
do not believe that it is clear on how an entity should amortize the ROU
asset over the shortened remaining useful life in the event of an
abandonment plan. Some may view this scenario as akin to an impairment, in
which case the remaining balance of the ROU asset on January 1, 2021, would
be fully amortized on a straight-line basis over the remaining six years
(i.e., the shortened useful life). This amortization profile for the ROU
asset, when coupled with the interest expense on the liability (which, in
the absence of an early termination of the lease, continues to be recognized
by using an effective interest method throughout the entire remaining lease
term), will result in a front-loaded expense profile in a manner similar to
that for a finance lease. Others believe that, in the absence of an
impairment, S should be allowed to retain an overall straight-line expense
profile for the period between the (1) date on which a decision is made
regarding the abandonment and (2) actual abandonment date. This would be
accomplished by “plugging” the ROU asset amortization amount in each period
to achieve an overall straight-line expense recognition profile from January
1, 2021, through January 1, 2027, while ensuring that the ROU asset is fully
amortized by that date.
We generally believe that a lessee in an operating lease
should only be forced to lose overall straight-line expense recognition in
the case of an impairment based on ASC 842-20-25-6. While neither of the
approaches described above retains a straight-line expense profile over the
full remaining term of the lease, the second approach allows the
continuation of straight-line treatment (albeit at a higher amount than that
in year 1) through the remaining useful life of the ROU asset. However,
given the lack of explicit guidance addressing a planned abandonment
scenario, we would accept either of the amortization approaches described in
the preceding paragraph.
We are aware that, in practice, there are different views on
the accounting implications of a planned abandonment; we therefore encourage
affected entities to consult with their auditors and accounting advisers
regarding this matter. Geoff Griffin, then a professional accounting fellow
in the SEC’s Office of the Chief Accountant, addressed this topic in a speech at the 2020 AICPA
Conference on Current SEC and PCAOB Developments. Mr. Griffin stated, in
part:
Consider a fact pattern where the registrant
identified leases for abandonment, but expected there to be an
extended period of time between the identification of abandonment
and the actual abandonment date. The registrant noted that the
leases standard requires a lessee to recognize any impairment loss
for a right-of-use asset in accordance with existing guidance on
impairment or disposal of long-lived assets; however, upon
performing an impairment assessment of the asset group, the
registrant concluded there was no impairment. In this fact pattern,
the registrant’s identification of specific leases for abandonment
did not result in a change to the asset group (i.e., the lowest
level of identifiable cash flows) for which it assessed
impairment.
The registrant noted that the leases standard did
not provide explicit guidance to address its unique circumstances.
The registrant identified a number of alternatives that it believed
could be acceptable but ultimately concluded that it would be
appropriate to adjust the amortization period of the right of use
assets associated with the leases identified for abandonment. Given
its plans to abandon these leases, and in the absence of any
impairment, the registrant re-evaluated the economic life of the
associated right-of-use assets and determined that the remaining
right-of-use assets should be amortized ratably over the period
between identification of abandonment and the actual abandonment
date.
The staff did not object to the registrant’s
conclusion. [Footnote omitted]
We assume that in the consultation discussed above, it is appropriate for the
lessee to consider the lease abandoned. As discussed above, we generally
believe that a lessee can conclude that a lease will be abandoned when it
will no longer use the asset and does not have the intent and ability to
sublease it.
We believe that, as illustrated in Mr. Griffin’s speech and
Example
8-17, the remaining life of the ROU asset should be revised
(i.e., shortened) in such circumstances. We would accept different
approaches to amortizing the ROU asset over the shortened useful life,
including the ratable approach described in Mr. Griffin’s speech. Example 8-17 describes what we believe is
another acceptable approach that allows for retention of an overall
straight-line expense profile for the remaining life of the ROU asset.
8.4.4.2 Considerations Related to the Impairment of an ROU Asset
Under ASC 842, since operating and finance leases are both
recorded on a lessee’s balance sheet, the ROU assets associated with both
types of leases are subject to the impairment guidance in ASC 360-10-35.
That is, when events or changes in circumstances indicate that an ROU
asset’s carrying amount may not be recoverable (i.e., impairment indicators
exist), an ROU asset (or asset group that includes the ROU asset, referred
to interchangeably throughout as an “ROU asset”) should be tested to
determine whether there is an impairment.
As discussed above, the impairment test is a two-step
process. Because a lessee is required to (1) recognize lease liabilities and
ROU assets related to finance leases and operating leases under ASC 842 and
(2) subject ROU assets related to both finance leases and operating leases
to impairment testing under ASC 360-10, questions have arisen regarding how
a lessee should consider the respective lease liability in determining the
carrying value and undiscounted expected future cash flows of the asset
group when testing ROU assets for impairment.
8.4.4.2.1 Unit of Account for Impairment Testing — Asset Group/Lease Component Considerations Related to Subleasing a Portion of a Larger ROU Asset
As described above, an impairment loss is evaluated, recognized, and
measured at the asset group level. A lessee must reassess its identified
asset group when there are significant changes in the facts and
circumstances associated with how the asset or assets in the asset group
are used (as opposed to when management decides to change how they are
used). Changes in facts or circumstances that may result in the need to
reevaluate an asset group include:
-
The lessee changes how it is using the underlying asset within its business.
-
The lessee executes a sublease of the underlying asset.
In this respect, a lessee must carefully consider the impact of executing
a sublease of a property or a portion of a property in the context of
the asset group determination. Specifically, when a head
lessee/intermediate lessor subleases a property or a portion of a
property, the determination of the asset group for ROU asset impairment
testing could be affected (i.e., the sublease of the property or a
portion of the property may now meet the definition of an asset
group).
In addition to asset group considerations, a head lessee’s/intermediate
lessor’s sublease of a portion of a larger asset (e.g., one floor of a
10-floor office building) may indicate that the subleased portion of the
larger asset should be treated as a separate lease component in the head
lease. This would be the case irrespective of whether the various lease
components in the contract were formally identified and separated into
separate lease components at the inception of the lease. For example,
assume that the head lessee/intermediate lessor initially accounted for
the 10-floor building lease as a single lease component or unit of
account and, accordingly, recorded one ROU asset and lease liability for
the arrangement. We believe that the head lessee in a sublease
arrangement should generally reconsider whether the subleased asset
should be deemed a separate lease component under the head lease upon
the execution of the sublease. As a result, to apply the appropriate
accounting, an entity may need to allocate the ROU asset and lease
liability to two or more separate lease components (e.g., the ROU asset
and lease liability may need to be bifurcated between the subleased
asset and the remaining portion of the initial ROU asset).
If, after revisiting the asset group or reevaluating the
lease components in a contract, an entity determines that the property
(or a portion of the property subject to a sublease) represents a
separate asset group, it may then be subject to an ASC 360 impairment
assessment since, in accordance with ASC 360-10-35-21, such a change
could represent “[a] significant adverse change in the extent or manner
in which a long-lived asset (asset group) is being used.” In this
scenario, the impairment analysis may need to be performed at the level
of the individual ROU asset (if the underlying property is subleased or
ceases to be used).
When a lessee subleases a discrete portion of a larger
asset, the lessee’s reconsideration (as the head lessee/intermediate
lessor) of the following may be warranted under the head lease: (1) the
asset group for purposes of testing the ROU asset for impairment under
ASC 360 and (2) whether there should be a separate ROU asset for the
subleased portion of the larger asset (i.e., whether there is more than
one lease component in the head lease).
Example 8-18
A lessee has an existing lease
for 10 floors in an office building, which was
classified as an operating lease. The lessee
subsequently subleases one of the 10 floors to a
third party. The sublease is also classified as an
operating lease, and the head lessee/intermediate
lessor is not relieved of its primary obligation
under the head lease with respect to the subleased
floor. Upon entering into the head lease, the
lessee assumed that the unit of account for
recognition of the lease liability and ROU asset
was one asset encompassing all 10 floors in the
office building. That is, the lessee accounted for
the leased asset as one lease component but did
not specifically evaluate whether there were one
or more lease components, because accounting for
the lease would not have differed in this case if
multiple lease components had been identified.
(See Section 4.2 for
additional information related to the
identification of lease components.) Because the
unit of account is critical to determining an
impairment under ASC 360 and allocating
consideration under ASC 842, a head
lessee/intermediate lessor that subleases a
portion of a larger asset should consider whether
(1) the subleased asset (one floor) would qualify
as its own asset group for impairment testing and
(2) the subleased asset should be treated as a
separate lease component.
The criteria for assessing asset groups for the ASC 360
impairment test differ from those for identifying separate lease
components under ASC 842. The identification of an asset group focuses
on separately identifiable cash flows that are largely independent of
the cash flows of other groups of assets and liabilities. The
identification of separate lease components is based on whether an
entity meets the two criteria in ASC 842-10-15-28 related to (1)
economically benefitting from the right of use on its own or together
with other, readily available, resources and (2) whether the right of
use is separately identifiable (see Section 4.2.1).
Changing Lanes
Lease Impairment
Considerations
The requirements in ASC 842 for the impairment
assessment of finance lease ROU assets are consistent with those
for capital leases under ASC 840. However, the amounts that will
ultimately be factored into the determination of the ROU asset
may differ under ASC 842 since the guidance on this topic in ASC
842 differs from that in ASC 840 in certain respects (e.g., the
ROU asset may be greater under ASC 842 because of the allocation
between lease and nonlease components/executory costs). The
difference between the carrying amount of the ROU asset under
ASC 842 and that of the capital lease asset under ASC 840 may
therefore have an impact on the overall carrying amount of the
asset group as a whole and, in turn, may affect an impairment
analysis.
In addition, ASC 842 introduces the concept of
an operating lease ROU asset. Under ASC 840, operating leases
were accounted for off the balance sheet in a manner similar to
executory contracts and therefore were subject to the guidance
in ASC 420. Specifically, rather than applying an ASC 360
impairment model, an entity recognized any costs related to
terminating an operating lease, if certain criteria were met, in
accordance with ASC 420 (i.e., the costs and a related liability
were recognized as the difference between the remaining lease
costs to be paid by the lessee, offset by the anticipated
sublease income).
ASC 842 has eliminated the
operating-lease-related guidance in ASC 420, instead requiring
that a lessee use the ASC 360 impairment model to evaluate its
ROU assets for impairment. This is a notable difference from the
ASC 840 requirements in that rather than recognizing an
operating lease termination cost on a lease-by-lease basis (when
necessary), a lessee is required to apply the ASC 360 long-lived
asset impairment guidance at an asset group level. Therefore, an
impairment charge could potentially be recognized for an ROU
asset even if there are no impairment indicators at the ROU
asset level (as would be the case when an impairment is
allocated to all assets in the asset group).
Connecting the Dots
Applicability of ASC 420
to Nonlease Components
As discussed above, after the adoption of ASC
842, operating leases are no longer within the scope of ASC 420
on exit or disposal cost obligations; rather, lessees must use
the ASC 360 impairment model to evaluate their ROU assets for
impairment. ASC 420-10-15-3, as amended, states that the scope
of ASC 420 includes “[c]osts to terminate a contract that is not
a lease.” Therefore, questions have arisen regarding whether
nonlease components within a contract that also contains one or
more lease components should continue to be evaluated under ASC
420 after the adoption of ASC 842. Since ROU assets subject to
the guidance in ASC 360 are related only to the lease
component(s) in a contract, we believe that the amended scope of
ASC 420 is only intended to exclude the lease component(s) and
that lessees should therefore continue to evaluate any nonlease
components under ASC 420 if they have not elected the practical
expedient described in ASC 842-10-15-37. See Section 4.3.3.1 for a detailed
discussion of this practical expedient offered to lessees. For
entities that have elected this practical expedient not to
separate lease and nonlease components and instead account for
both lease and nonlease components as a single lease component,
all costs associated with the contract would be considered
outside the scope of ASC 420 as outlined in ASC 420-10-15-3.
The example below from ASC 842-20-55-48 through 55-51
illustrates the impairment of an ROU asset in an operating lease.
ASC 842-20
55-47 Example 5 illustrates
impairment of a right-of-use asset.
Example 5 — Impairment of a
Right-of-Use Asset in an Operating Lease
55-48 Lessee enters into a
10-year lease of a nonspecialized asset. Lease
payments are $10,000 per year, payable in arrears.
The lease does not transfer ownership of the
underlying asset or grant Lessee an option to
purchase the underlying asset. At lease
commencement, the remaining economic life of the
underlying asset is 50 years, and the fair value
of the underlying asset is $600,000. Lessee does
not incur any initial direct costs as a result of
the lease. Lessee’s incremental borrowing rate is
7 percent, which reflects the fixed rate at which
Lessee could borrow the amount of the lease
payments in the same currency, for the same term,
and with similar collateral as in the lease at
commencement. The lease is classified as an
operating lease.
55-49 At the commencement
date, Lessee recognizes the lease liability of
$70,236 (the present value of the 10 lease
payments of $10,000, discounted at the rate of 7
percent). Lessee also recognizes a right-of-use
asset of $70,236 (the initial measurement of the
lease liability). Lessee determines the cost of
the lease to be $100,000 (the total lease payments
for the lease term). The annual lease expense to
be recognized is therefore $10,000 ($100,000 ÷ 10
years).
55-50 At the end of Year 3,
when the carrying amount of the lease liability
and the right-of-use asset are both $53,893,
Lessee determines that the right-of-use asset is
impaired in accordance with Section 360-10-35 and
recognizes an impairment loss of $35,000. The
right-of-use asset is part of an asset group that
Lessee tested for recoverability because of a
significant adverse change in the business climate
that affects Lessee’s ability to derive benefit
from the assets within the asset group. The
portion of the total impairment loss for the asset
group allocated to the right-of-use asset in
accordance with paragraph 360-10-35-28 is $35,000.
After the impairment charge, the carrying amount
of the right-of-use asset at the end of Year 3 is
$18,893 ($53,893 – $35,000). Because of the
impairment, the total expense recognized in Year 3
is $45,000 ($10,000 in lease expense + the $35,000
impairment charge). Beginning in Year 4, and for
the remainder of the lease term, the single lease
cost recognized by Lessee in accordance with
paragraphs 842-20-25-6(a) and 842-20-25-7 will
equal the sum of the following:
-
Amortization of the right-of-use asset remaining after the impairment ($18,893 ÷ 7 years = $2,699 per year)
-
Accretion of the lease liability. For example, in Year 4, the accretion is $3,773 ($53,893 × 7%) and, in Year 5, the accretion is $3,337 ($47,665 × 7%).
55-51 Consequently, at the
end of Year 4, the carrying amount of the lease
liability is $47,665 (that is, calculated as
either the present value of the remaining lease
payments, discounted at 7 percent, or the previous
balance of $53,893 – $10,000 Year 4 lease payment
+ the $3,773 accretion of the lease liability).
The carrying amount of the right-of-use asset is
$16,194 (the previous balance of $18,893 – $2,699
amortization). Lessee measures the lease liability
and the right-of-use asset in this manner
throughout the remainder of the lease term.
The amortization schedule and related journal entries
below have been calculated on the basis of the facts in the example
above.
8.4.4.2.1.1 Asset Group Considerations
When a head lessee/intermediate lessor subleases a
portion of a larger asset, the determination of the asset group for
ROU asset impairment testing could be affected. If events or changes
in circumstances indicate that the carrying amount of an ROU asset
may not be recoverable (see ASC 360-10-35-21), a head
lessee/intermediate lessor will assess the head lease ROU asset for
impairment. A lessee is required to apply the guidance in ASC 360 on
impairment of long-lived assets at an asset group level. The ASC
master glossary defines an “asset group” as follows:
[T]he unit of accounting for a long-lived
asset or assets to be held and used, which represents the
lowest level for which identifiable cash flows are largely
independent of the cash flows of other groups of assets and
liabilities.
The guidance in ASC 360 on impairment focuses on
“identifiable cash flows” that are “largely independent,” including
both cash inflows and cash outflows. Since a head lessee (lessor
under the sublease) will receive separate cash flows under the
sublease, the head lessee should consider whether the subleased
portion of the larger asset represents its own asset group for
impairment testing purposes. In doing so the head lessee will also
need to consider whether the cash outflows due under the head lease
(e.g., rent, CAM, taxes) are separately identifiable for the
subleased portion of the larger asset. Therefore, when the sublease
is executed, the determination of the original asset group should be
revisited. In determining whether cash outflows are separately
identifiable, an entity should use judgment and consult with its
accounting advisers.
The assessment of whether the asset group is the
subleased portion of the leased asset or the larger asset is
important because a conclusion that the asset group is the subleased
portion may be more likely to result in an impairment. Further, once
an ROU asset related to an operating lease is impaired, a lessee can
no longer recognize lease expense on a straight-line basis in its
income statement in accordance with ASC 842-20-25-7. Rather, the
single lease expense profile for the impaired ROU asset will become
“front-loaded” in a manner similar to the treatment of a finance
lease. For further discussion of ROU asset impairment, see
Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets and
Discontinued Operations.
8.4.4.2.1.2 Considerations Related to the Lease Component
A head lessee’s/intermediate lessor’s sublease of a
portion of a larger asset (e.g., one floor of a 10-floor office
building from the example above) may indicate that the subleased
portion of the larger asset should be treated as a separate lease
component in the head lease. Assume that the head
lessee/intermediate lessor in the above example initially accounted
for the 10-floor building lease as a single lease component or unit
of account and, accordingly, recorded one ROU asset and lease
liability for the arrangement. We believe that the head lessee in a
sublease arrangement should generally reconsider whether the
subleased asset should be deemed a separate lease component under
the head lease. As a result, there could be two separate lease
components and corresponding ROU assets and liabilities (i.e., for
both the subleased asset and the remaining portion of the initial
ROU asset). It is important for an entity to determine the
appropriate unit of account when applying the lessee or lessor
accounting model in ASC 842, since implications include, but are not
limited to, the allocation of consideration to the components in the
contract. See Chapter 4 for additional information on components
of a contract.
8.4.4.3 ROU Assets That Are Held for Sale
A disposal group includes all long-lived assets, including
ROU assets, expected to be disposed of as a group through a sale. An ROU
asset would be considered held for sale when the disposal group meets the
held-for-sale criteria in ASC 360-10-45-9. That is, an ROU asset can be
considered “held for sale” if (1) the lease is part of a disposal group for
which it is expected that the purchaser will assume the lease as part of the
purchase of the group or (2) the entity has initiated a “plan” under which
it is identifying a third party to assume (acquire) the related lease so
that the entity can be relieved of being the primary obligor under the
lease. An ROU asset is not considered held for sale when the entity intends
to sublease the underlying property.
8.4.4.3.1 Amortization Considerations
A lessee should not continue to amortize an ROU asset
that is characterized as “held for sale.” ASC 842 amended ASC
360-10-15-4 to clarify that ROU assets of lessees are within the scope
of the guidance pertaining to the impairment or disposal of long-lived
assets, including the accounting for assets held for sale. Therefore,
when a long-lived asset (or disposal group) is characterized as held for
sale, the amortization of the ROU asset should cease in accordance with
ASC 360-10-35-43, which states:
A long-lived asset
(disposal group) classified as held for sale shall be measured at
the lower of its carrying amount or fair value less cost to sell. If
the asset (disposal group) is newly acquired, the carrying amount of
the asset (disposal group) shall be established based on its fair
value less cost to sell at the acquisition date. A long-lived asset shall not be depreciated (amortized) while
it is classified as held for sale. Interest and other
expenses attributable to the liabilities of a disposal group
classified as held for sale shall continue to be accrued. [Emphasis
added]
Further, this conclusion is not affected by the lease’s
classification as either operating or finance. That is, for both types
of leases, a lessee should stop amortizing the ROU asset at the point
when the ROU asset is classified as held for sale. With respect to
operating leases, this conclusion applies even though the lessee
recognizes a single lease cost within operating expenses, since ROU
asset amortization is a component of the single lease cost.
The resulting accounting impact on finance and operating
lease ROU assets, respectively, would be that (1) the amortization of
the finance lease ROU asset would cease and only the interest cost would
be recognized going forward and (2) the amortization of the operating
lease ROU asset would cease and only the liability accretion (interest
cost) would be recognized as the single lease cost. For operating
leases, the straight-line lease expense profile is no longer applicable;
rather, the expense profile related to the interest cost while the ROU
asset is held for sale would be similar to that of an impaired ROU asset
as discussed above.
ASC 360-10-45-6 indicates that if circumstances change
and an entity no longer plans to dispose of a long-lived asset (or
disposal group), the asset would be reclassified from “held for sale”
back to “held and used.” Further, ASC 360-10-35-44 states:
If circumstances arise that previously were
considered unlikely and, as a result, an entity decides not to sell
a long-lived asset (disposal group) previously classified as held
for sale, the asset (disposal group) shall be reclassified as held
and used. A long-lived asset that is reclassified shall be measured
individually at the lower of the following:
-
Its carrying amount before the asset (disposal group) was classified as held for sale, adjusted for any depreciation (amortization) expense that would have been recognized had the asset (disposal group) been continuously classified as held and used
-
Its fair value at the date of the subsequent decision not to sell.
Accordingly, ASC 360-10-35-44 requires the entity to
adjust the carrying amount of the long-lived asset that is reclassified
as “held and used” to the lower of (1) the asset’s fair value or (2) the
asset’s carrying amount before it was classified as held for sale,
adjusted for any depreciation that would have been recorded while the
asset was classified as held for sale. For this adjustment to be made,
there must be a catch-up of the depreciation that would have been
recognized had the asset remained classified as held and used.
For both finance and operating lease ROU assets, the
depreciation referred to above would equate to the ROU asset
amortization not recorded while the asset was held for sale. The
catch-up entry to record forgone amortization would align the ROU asset
balance with what would have been recorded had the ROU asset remained
classified as held and used. A normal amortization profile would then be
reestablished for the ROU asset (e.g., for operating leases, a
straight-line, single lease cost for the remaining lease term, provided
that the ROU asset continues to be classified as held and used and has
not been impaired, as discussed above).
Footnotes
6
The guidance in ASC 842-20-30-5(b) is applicable
regardless of whether the lease incentive is paid or payable at
commencement or is contingent on a future event. See
Section 8.5.4.3 for our views on acceptable
approaches to estimating and accounting for contingent lease
incentives. To the extent that the initial recognition of a
contingent lease incentive would result in a negative ROU asset, the
guidance in this section would be applicable.
7
See ASC 842-10-15-30(b).
8
Although this section focuses on the accounting for
a lessee’s costs incurred to compensate a third party to perform
these services, we believe that the same considerations would apply
to internal costs incurred by a lessee to perform these activities
on its own.
9
Answer is rounded.
10
See Q&A 16-3A for a discussion
of operating leases that would result in a negative ROU asset as of
the date of initial application because of a large accrued rent
balance.
11
This example contains an
extreme rent escalation to highlight the issue.
While we would not expect such extreme rent
escalations to be common in practice, this issue
does arise with certain leases, particularly
leases of land with long durations (e.g., 100
years).
12
“Probable” is defined as the “future event or
events are likely to occur,” in a manner consistent with the
term’s meaning in ASC 450 on contingencies.
8.5 Remeasurement of the Lease Liability
ASC 842-20
35-4 After the commencement date, a lessee shall remeasure the lease liability to reflect changes to the lease payments as described in paragraphs 842-10-35-4 through 35-5. A lessee shall recognize the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero, a lessee shall recognize any remaining amount of the remeasurement in profit or loss.
35-5 If there is a remeasurement of the lease liability in accordance with paragraph 842-20-35-4, the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following:
- A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset.
- A change in amounts probable of being owed by the lessee under a residual value guarantee (see paragraph 842-10-35-4(c)(3)).
- A change in the lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based (see paragraph 842-10-35-4(b)).
This section addresses phase 5 of the lease “life cycle,” which discusses the guidance that a lessee would evaluate when accounting for the remeasurement of the lease liability.
After the commencement date of the lease, a lessee must remeasure the lease
liability if there has been a change to the amounts deemed to be lease payments as
described in ASC 842-10-35-4. (See Chapter 6 for additional information on amounts that meet the
definition of lease payments, and see Section 8.5.4.4 for
considerations related to changes in variable payments based on an index or a rate.)
Generally, there will be a change in lease payments when certain discrete
reassessment-related events occur or when a lease is modified and that modification
is not accounted for as a separate contract.
However, some but not all of these events will necessitate an update to the discount rate used to
measure the liability. When a modification is not accounted for as a separate contract, the discount rate
must be based on a rate as of the remeasurement date. In addition, if there is a change in the lease
term or in the assessment of whether the lessee will exercise a purchase option, the discount rate must
be updated (i.e., a rate on the remeasurement date) unless the discount rate already reflects the options
to extend or terminate the lease or purchase the underlying asset.
A remeasurement of the lease liability will result in an adjustment to the corresponding ROU asset.
In addition, a remeasurement of the lease liability triggers the remeasurement of the consideration
in a contract and reallocation of that consideration to the separate components (i.e., a lessee would
reallocate the consideration in the contract to all lease and nonlease components).
Certain events that trigger a remeasurement of the lease liability also trigger a reassessment of the
lease classification, as noted in Section 8.3.4 and discussed further in this section. Thus, in addition to a
change in the lease liability amount, the presentation of this obligation may change (e.g., operating lease
liability to finance lease liability or vice versa). In addition to the balance sheet implications, the income
statement treatment may also change.
The table below summarizes the topics covered in the remainder of this
section.
Changing Lanes
Liability Remeasurement Requirements
The requirement to remeasure the lease liability over the lease term upon the
occurrence of certain reassessment events represents a wholesale change to
the ASC 840 requirements. For example, under ASC 840, a capital lease
liability was only remeasured when the lease is modified. Under ASC 842, the
lease liability undoubtedly will be reassessed and remeasured more
frequently.
8.5.1 Circumstances in Which a Lessee Is Required to Update Stand-Alone Prices
ASC 842-10-15-33 requires that lessees allocate the
consideration in a 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, as discussed in Section 4.4.1.2.
In accordance with ASC 842-10-15-36, a lessee must remeasure and
reallocate the consideration in the contract when there is (1) a remeasurement
of the lease liability or (2) a contract modification that is not accounted for
as a separate contract (collectively, a “remeasurement event”). (See Section 4.4.1.3 for a
discussion of remeasurement and reallocation of consideration in the contract.)
Further, as discussed above, ASC 842-20-35-4 specifies criteria for when and how
to remeasure a lease liability and ASC 842-10-35-4 contains indicators of when a
remeasurement event has occurred (see Section 6.10).
We believe that some may interpret the requirement related to
reallocation of “the consideration in the contract” as indicating that the
reallocation should be made by using the original allocation percentages
identified when ASC 842-10-15-33 is initially applied. Others may interpret the
guidance as indicating that an entity should determine new relative stand-alone
prices. Accordingly, while the guidance explicitly specifies that the
consideration in the contract will be remeasured and reallocated as a result of
a remeasurement event, it is not clear on (1) whether, or in which cases, a
lessee would need to reevaluate the stand-alone prices of each contract
component as of the date of the remeasurement event or (2) whether it would be
appropriate to retain the original relative stand-alone prices and thus carry
forward the original allocation percentages.
We believe that the requirement for a lessee to revise the
relative stand-alone price and related allocation percentages depends on the
nature of the remeasurement event. That is, when the remeasurement event is
limited to a subsequent-measurement adjustment (e.g., an incremental change in
consideration) rather than an event in which the components in the contract are
changed (added or subtracted), the lessee would not be
required to revise the relative stand-alone price and the related
allocation percentages assigned to the components in the contract. In effect, an
entity would apply the guidance in ASC 842-10-15-42, which points to the
guidance in ASC 606 associated with changes in transaction prices and states
that “[i]f 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.”
ASC 606-10-32-42 through 32-45 indicate that after contract
inception, the transaction price can change for various reasons, such as
“resolution of uncertain events or other changes in circumstances that change
the amount of consideration to which an entity expects to be entitled” (see
Section 7.6 of
Deloitte’s Roadmap Revenue
Recognition). In these cases, the lessee would reallocate
the updated consideration in the contract by using the original relative
stand-alone price allocation percentages.
In addition, we believe that when a contract modification is
accounted for as a separate contract, the original contract remains in effect
and the original stand-alone prices and allocations would also be used.
Accordingly, a lessee should first determine whether the remeasurement event
results only in a subsequent-measurement adjustment (e.g., a contingency is
resolved in such a way that otherwise variable payments become fixed) or another
change (e.g., an increase in consideration because the lease was modified to add
an additional lease component and a related nonlease component).
Therefore, in an evaluation of the lessee remeasurement guidance
in ASC 842-10-35-4 (see Section 6.10), if the following events outlined in ASC
842-10-35-4(b) and ASC 842-10-35-4(c)(3) occur in isolation, the lessee would not update the stand-alone prices or relative
stand-alone price allocation and updates to the consideration in the contract
would be allocated on the original basis:
A lessee shall remeasure the lease payments if any of
the following occur: . . .
b. A contingency upon which some or all of the variable lease
payments that will be paid over the remainder of the lease term
are based is resolved such that those payments now meet the
definition of lease payments. For example, an event occurs that
results in variable lease payments that were linked to the
performance or use of the underlying asset becoming fixed
payments for the remainder of the lease term. . . .
c. There is a change in any of the following: . . .
3. Amounts probable of being owed by the
lessee under residual value guarantees. A lessee shall determine
the revised lease payments to reflect the change in amounts
probable of being owed by the lessee under residual value
guarantees.
However, when any other condition in ASC 842-10-35-4 is met in
isolation (e.g., a contract modification that is not accounted for as a separate
contract) or in any instance in which the above guidance is combined with
another condition in ASC 842-10-35-4, updated standalone prices should be
established and consideration should be reallocated to the updated components.
This stipulation generally is consistent with the view that when additional
components (including extending the term of the contract) are added to (or
subtracted from) the contract, new stand-alone prices should be established in
connection with the remeasurement event. As a result, new estimates of
stand-alone prices and reallocation would be required when the following
remeasurement events outlined in ASC 842-10-35-4(a) and ASC 842-10-35-4(c)(1)
and (c)(2) occur:
a. The lease is modified, and that modification is not accounted for as
a separate contract in accordance with paragraph 842-10-25-8. . .
.
c. There is a change in any of the following:
1. The lease term, as described in paragraph
842-10-35-1. A lessee shall determine the revised lease payments on the
basis of the revised lease term.
2. The assessment of whether the lessee is
reasonably certain to exercise or not to exercise an option to purchase
the underlying asset, as described in paragraph 842-10-35-1. A lessee
shall determine the revised lease payments to reflect the change in the
assessment of the purchase option.
When a contract modification is accounted for as a contract that
is separate from the original contract in accordance with ASC 842-10-25-8 (see
Section 8.6.2),
the stand-alone price of each contract component in the new contract would
always need to be assessed, since the new contract is disassociated with the
existing agreement at the time of the modification.
8.5.2 Change in the Lease Term or in the Conclusion About the Exercise of a Purchase Option
ASC 842-20
35-5 If there is a remeasurement of the lease liability [as a result of a change in lease payments], the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following:
- A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset. . . .
8.5.2.1 Timing of Reassessment Related to Lease Term and Purchase Option
ASC 842-10-35-1 indicates that, upon the occurrence of certain discrete events, a lessee is required to reassess its conclusion about the lease term and the likelihood that it will exercise an option to purchase the underlying asset. See Section 5.4 for additional information.
As described below, when a lessee changes its conclusion about whether it will exercise a renewal, termination, or purchase option, it would generally (1) reassess lease classification in considering the facts and circumstances that exist as of the reassessment date, (2) remeasure the lease liability by using revised inputs as of the reassessment date, and (3) adjust the ROU asset. However, in certain circumstances, a lessee would not update its discount rate, such as when the discount rate already reflects the option.
8.5.2.2 Accounting for the Reassessment of the Lease Term and Purchase Option
If, as a result of a reassessment event, a lessee determines that the lease term has changed or changes its conclusion regarding whether it is reasonably certain that it will be exercising a purchase option, the lessee would update its lease payments to reflect the change and remeasure its lease liability. In remeasuring the lease liability, the lessee should remeasure variable lease payments based on an index or a rate by using the index or rate on the remeasurement date.
As shown in the graphic above, the lessee is required to do the following on the remeasurement date in
the circumstances described above:
- Remeasure and reallocate the consideration in the contract to the remaining lease and nonlease components (see Chapter 4).
- Remeasure the lease liability on the basis of the revised lease payments and updated discount rate, if applicable (see Section 6.10). The discount rate is updated by using the assumptions on the remeasurement date unless the discount rate in use (i.e., the discount rate as of the last lease commencement date) already reflects the option to extend or terminate the lease or purchase the underlying asset, in which case the discount rate in use continues to be employed (see Section 7.2.2).
- Adjust the ROU asset by the amount of the remeasurement of the lease liability. When the lease liability is reduced as the result of the remeasurement, the ROU asset would similarly be reduced. Note that the carrying amount of the ROU asset cannot be reduced below zero and any amounts in excess of the ROU asset balance are recognized in net income.
- Reassess lease classification as of the reassessment date on the basis of the facts and circumstances on that date. For example, the lessee should reassess classification on the basis of the fair value and remaining economic life of the underlying asset on the remeasurement date (see Section 8.3.4).
- If the classification of the lease changes as a result of the reassessment event, a lessee will prospectively adjust the remaining lease cost recognition pattern and update the income statement and cash flow statement presentation.
See Example 3 (ASC 842-20-55-31 through 55-39, reproduced in Section 8.9.1.1) for
an illustration of the accounting for a change in the lease term caused by a
change in a lessee’s conclusion about whether it will exercise a renewal
option.
8.5.3 Change in the Amount That It Is Probable a Lessee Will Owe at the End of the Lease Term Under a Residual Value Guarantee
ASC 842-20
35-5 If there is a remeasurement of the lease liability [due to a change in lease payments], the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following: . . .
b. A change in amounts probable of being owed by the lessee under a residual value guarantee (see paragraph 842-10-35-4(c)(3)). . . .
8.5.3.1 Continual Reassessment of the Amount That It Is Probable a Lessee Will Owe Under a Residual Value Guarantee
A lessee must continually evaluate the amount that it is probable the lessee will owe at the end of the lease term under a residual value guarantee. Any change in this amount is a reassessment event that would result in the remeasurement of the lease liability. See Section 6.7 for additional information.
8.5.3.2 Accounting for Changes in the Amount That It Is Probable a Lessee Will Owe Under a Residual Value Guarantee
When there is a change in the amount that it is probable the lessee will owe under a residual value guarantee, the lessee must remeasure its lease liability to reflect the change. In remeasuring the lease liability, the lessee should remeasure variable lease payments based on an index or a rate by using the index or rate on the remeasurement date.
As shown in the graphic above, the lessee is required to do the following on the remeasurement date in the circumstances described above:
- Remeasure and reallocate the consideration in the contract to the remaining lease and nonlease components (see Chapter 4).
- Remeasure the lease liability on the basis of the revised lease payments (see Section 6.10) by using the original discount rate that was used on the lease commencement date (see Section 7.2.2).
- Adjust the ROU asset by the amount of the remeasurement of the lease liability. Note that the carrying amount of the ROU asset cannot be reduced below zero and any amounts in excess of the ROU asset balance are recognized in net income.
When the lease liability is remeasured to reflect the change in amounts that it is probable the lessee will owe under a residual value guarantee, the lessee does not reassess lease classification.
Changing Lanes
Residual Value Guarantees
Under ASC 840, the accounting for residual value guarantees from the lessee’s perspective
depended on the lease’s classification. For an operating lease, amounts expected to be payable
under a residual value guarantee were accrued for separately on the balance sheet. In contrast,
for a capital lease, the full amount of the residual value guarantee was used to determine, and
accounted for as part of, the capital lease obligation and related asset. Under ASC 842, the
amount that it is probable a lessee will owe at the end of the lease term under a residual value
guarantee is considered a lease payment and used to determine the lease liability for both
operating and finance leases. Depending on the type of asset and the circumstances of the
lease, the amount that it is probable the lessee will owe could be significantly less than the full
guaranteed amount.
8.5.4 Variable Payments Become Lease Payments Because of the Resolution of a Contingency
ASC 842-20
35-5 If there is a remeasurement of the lease liability [due to a change in lease payments], the lessee shall
update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term
and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the
following: . . .
c. A change in the lease payments resulting from the resolution of a contingency upon which some or all
of the variable lease payments that will be paid over the remainder of the lease term are based (see
paragraph 842-10-35-4(b)).
8.5.4.1 Continual Reassessment of Whether Lease Payments Change Because of a Contingency Resolution
A lessee must continually evaluate the nature of its variable lease payments to determine whether
the variable payments at some point become fixed and would therefore meet the definition of lease
payments. When a contingency by which some (e.g., payments pertaining to years 3–9 of a remaining
10-year lease term) or all (e.g., payments pertaining to all years remaining in the lease term) of the
variable payments that will be paid over the remainder of the lease term has been resolved in such a
way that the payments become fixed and now meet the definition of lease payments, a lessee must
remeasure its lease liability to reflect this change.
8.5.4.2 Accounting for a Change in Lease Payments Resulting From the Resolution of a Contingency
When there is a resolution of a contingency that causes some or all of the variable payments to now meet the definition of lease payments (e.g., to become fixed for the remainder of the lease term), a lessee must remeasure its lease liability to reflect the change. In remeasuring the lease liability, the lessee should remeasure other variable lease payments that are based on an index or a rate by using the index or rate on the remeasurement date.
As shown in the graphic above, the lessee would be required to do the following on the remeasurement date in the circumstances described above:
- Remeasure and reallocate the consideration in the contract to the remaining lease and nonlease components (see Chapter 4).
- Remeasure the lease liability on the basis of the revised lease payments (see Section 6.10) by using the original discount rate used at the lease commencement date (see Section 7.2.2).
- Adjust the ROU asset by the amount of the remeasurement of the lease liability. Note that the carrying amount of the ROU asset cannot be reduced below zero and any amounts in excess of the ROU asset balance are recognized in net income.
When the lease liability is remeasured to reflect a change in lease payments because of the resolution of a contingency, the lessee does not reassess lease classification.
8.5.4.3 Accounting for Lease Incentives Not Paid or Payable at Commencement
A lessor sometimes provides a lessee with a lease incentive
to entice the lessee into leasing the underlying asset (e.g., the lessor may
provide the lessee with funding for the construction of certain
lessee-specific leasehold improvements). Lease incentives are a component of
lease payments, which, as described in ASC 842-10-30-5(a), include “[f]ixed
payments, including in substance fixed payments, less
any lease incentives paid or payable to the lessee” (emphasis
added). ASC 842 is also explicit that lease incentives that are received by
the lessee on or before the lease commencement date would be accounted for
as a reduction of the ROU asset in accordance with ASC 842-20-30-5.
While the guidance is clear on the accounting for incentives
received on or before the lease commencement date, it is not clear on how a
lessee should account for incentives that are included in the original lease
contract but received after lease commencement (e.g., incentives paid to the
lessee upon the completion of a certain activity, such as completion of
construction of leasehold improvements after lease commencement). See
Section
6.2.2 for more information on the definition of a lease
incentive in ASC 842. In addition, see Section 6.2.2.2
for considerations related to incentive payments a lessor makes to a lessee
after lease commencement.
While ASC 842 is silent on how a lessee should account for
lease incentives that are only receivable after a future event (other than
the passage of time) expected to occur after the lease commencement date, we
believe that a lessee could use the following two-step approach:14
-
Step 1: Evaluate whether it is appropriate to estimate the incentive at lease commencement — We believe that it would be appropriate for the lessee, on the lease commencement date, to estimate and include in its lease payments any lease incentive amounts based on future events when (1) the events are within the lessee’s control (e.g., construction of the leasehold improvements) and (2) the event triggering the right to receive the incentive is deemed reasonably certain to occur.If some or all of a recognized incentive is not ultimately received (i.e., the lessee does not become entitled to the incentives) or the amounts received are greater than the amounts previously estimated (i.e., the lessee becomes entitled to additional incentives not previously estimated), the change would be accounted for as a change in lease payments in a manner similar to the accounting described in step 2 below.
-
Step 2: Account for the incentive amounts triggered after lease commencement and received that were not previously recognized (or that were different from the amount recognized at commencement) as a change in lease payments — Any lease incentives that are received or become receivable after lease commencement and were not recognized at lease commencement or that differ from the amount recognized at lease commencement (i.e., by applying step 1) would result in the remeasurement of the lease payments once the triggering event occurs that provides the lessee with the right to the incentive. This view is by analogy to ASC 842-10-35-4(b), in which lease payments must be remeasured when a “contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments.”If the lease incentive received is greater than the amount recognized at lease commencement (or if no amount was recognized at lease commencement), this difference should be recognized as an adjustment (reduction) to the ROU asset. If the lease incentive received is less than the amount recognized at lease commencement, the difference (amount by which the original lease liability was adjusted but that is no longer expected to be received) would result in an adjustment to the lease liability (an increase in the liability) and a corresponding adjustment to the ROU asset. Further, under ASC 842-20-35-5(c), when remeasuring its lease liability, the lessee would not reassess lease classification or use an updated discount rate (i.e., the lessee would continue to use the discount rate that was used at lease commencement).
8.5.4.4 Implications of Index- or Rate-Based Payment Adjustments
Index- or rate-based payment adjustments that establish a
new floor do not represent a resolution of a contingency that would result
in a change in lease payments and would therefore not result in a liability
remeasurement event.
This is consistent with the guidance in ASC 842-10-35-4(b),
which was added by the Codification improvements in ASU 2018-10 and
states, in part:
However, a change
in a reference index or a rate upon which some or all of the
variable lease payments in the contract are based does not
constitute the resolution of a contingency subject to (b) (see
paragraph 842-10-35-5 for guidance on the remeasurement of variable
lease payments that depend on an index or a rate). [Emphasis
added]
On the basis of this technical amendment, the guidance on
remeasuring a lease liability after the resolution of a contingency is not
meant to apply to index-based escalators even when those escalators serve to
establish a new floor for the next lease payment. Therefore, even when the
index or rate establishes a new floor (such as when the CPI increases and
establishes a new rate that will be used as a benchmark for determining
future lease payment increases), that adjustment would not result in a
remeasurement of the lease liability and ROU asset. As a result, the
additional payments for increases in the CPI will be recognized in the
period in which they are incurred.
See Section 17.3.1.3 for additional information on other updates
made by ASU 2018-10.
8.5.4.5 Impact of Cotenancy Clauses on Determining Lease Payments
Certain real estate leases may include a provision that
would result in a decrease in the specified lease payments when there are
specific changes to the occupancy structure in the broader real estate
interest. For example, retail leases often include a cotenancy clause under
which there will be a specified reduction in the required lease payments if
an anchor tenant vacates or if the overall occupancy of the mall drops below
a certain level.
At lease commencement, the lessee would recognize a lease
liability and ROU asset on the basis of amounts meeting the definition of
lease payments as of the commencement date. This would exclude any amount
associated with the variability that may result from
the triggering of a cotenancy clause, since this clause is designed to be
protective for the lessee and would not affect the payment terms until a
triggering event occurs.
When facts and circumstances change or an event occurs that
results in the triggering of a cotenancy clause in a real estate lease, we
believe that it would be appropriate to apply one of the two approaches
below to the subsequent accounting.
-
Approach 1: Cotenancy clause results in negative rent — Any change in facts and circumstances that results in the triggering of a cotenancy clause would not be considered a lease payment remeasurement event that would affect the lease liability and ROU asset. Therefore, rebates resulting from the triggering of a cotenancy clause would be treated as a variable lease payment (though a negative variable lease payment) not based on an index or rate. As a result, the lessee would recognize the difference between the periodic lease cost determined at lease commencement and the revised payments due to the cotenancy clause as variable rent (albeit negative rent) in the applicable period.
-
Approach 2: Cotenancy results in the resolution of a contingency and is a lease payment reassessment event — Any change in facts and circumstances that results in the triggering of the cotenancy clause would be considered a lease payment remeasurement event that would affect the lease liability and ROU asset. Thus, the lease liability and ROU asset would be remeasured to reflect the revised lease payment amounts through the end of the lease term. If the cotenancy issue is later resolved in such a way that the lease payments return to their original amounts, such resolution is another remeasurement event. Therefore, under this approach, the lease liability and ROU asset will continually be reassessed upon changes in facts and circumstances that result in the triggering of the cotenancy clause and the subsequent resolution of the condition that led to the triggering of the clause.Some view this approach as consistent with the guidance in ASC 842-10-35-4(b). That is, the triggering of the cotenancy clause would be a resolution of a contingency in such a way that there is a change in some or all of the lease payments for the remainder of the lease term. While ASC 842-10-35-4(b) focuses on variable payments that subsequently become fixed and does not specifically describe fixed payments in an arrangement that subsequently become variable (or a lower fixed amount), we believe that it would be appropriate to apply such guidance by analogy.
Footnotes
13
The discount rate would not be updated in a scenario in
which a change in lease term or the exercise of a purchase option was
already reflected in the discount rate determination but the exercise of the
option itself was not deemed reasonably certain at lease commencement.
14
In addition, we believe that there may be other
acceptable approaches, including an election to move directly to
step 2 rather than estimating the lease incentive as of the
commencement date.
8.6 Lease Modifications
8.6.1 Setting the Stage
ASC 842-10
15-6 An entity shall reassess whether a contract is or contains a lease only if the terms and conditions of the
contract are changed.
This section addresses phase 6 of the lease “life cycle,” which discusses guidance that a lessee would evaluate when determining how to account for a modified lease.
Connecting the Dots
Rent Concessions Provided as a Result of COVID-19
In response to the COVID-19 pandemic, the FASB provided
both lessees and lessors with relief related to accounting for rent
concessions resulting from COVID-19. An entity that elects to apply the
relief to qualifying concessions may choose to account for the
concessions by either (1) applying the modification framework for these
concessions in accordance with ASC 840 or ASC 842, as applicable, or (2)
accounting for the concessions as if they were made under the
enforceable rights included in the original agreement and are thus
outside of the modification framework. See Section 17.3.4 for more
information.
8.6.1.1 Definition and Overview
A modification is a change in any of the terms and conditions of a contract. In accordance with ASC 842-10-15-6, when a contract is modified, the entity would need to reevaluate the contract to determine whether the modification affects its conclusions under ASC 842.
ASC 842-10-15-6 states, “An entity shall reassess whether a
contract is or contains a lease only if the terms and
conditions of the contract are changed” (emphasis added). In
contrast, the ASC master glossary defines a lease modification as
follows:
A change to the terms and conditions of a
contract that results in a change in the scope of or
the consideration for a lease (for example, a change to the
terms and conditions of the contract that adds or terminates the right
to use one or more underlying assets or extends or shortens the
contractual lease term). [Emphasis added]
This difference in wording has led some to question what
types of changes trigger a requirement to reassess whether a contract is or
contains a lease.
This question is particularly significant for entities that,
in making the transition to the new leasing standard, elected the practical
expedient package in ASC 842-10-65-1(f) that allowed them to (among other
things) not revisit whether a contract is or contains a lease under the
definition in ASC 842. Therefore, if an entity that has adopted the new
leasing standard is required to reassess whether such a “grandfathered”
contract is or contains a lease under the definition in ASC 842, a change in
that conclusion may be more likely than it would be if the initial
assessment had taken place under ASC 842.
We believe that an entity should reassess whether a contract
is or contains a lease whenever a substantive15 change is made to the terms and conditions of the contract. Such
changes are not limited to those that meet the definition of a lease
modification, which is a specific type of modification characterized by a
change in the scope of or consideration for a lease. When a modification
does not meet the definition of a lease modification, an entity should
reassess whether the contract is or contains a lease but would not apply the
lease modification framework (as discussed in the remainder of Section 8.6 and in
Section
9.3.4) if the conclusion regarding whether the contract is or
contains a lease is unchanged.
If a contract formerly did not contain a lease but, after a
modification, is deemed to contain one, the contract should be accounted for
under ASC 842 as if it were a newly originated lease (see Sections 8.4.2 and
9.3.2). If,
after a modification, a contract that formerly contained a lease is deemed
to no longer contain one, the change should be accounted for as a lease
termination (see Sections
8.7.2 and 9.3.5).
Example 8-19
Lessor and Lessee enter into a
contract that conveys to Lessee the right to use an
identified piece of equipment for five years. Both
parties conclude that the contract contains a lease
of the equipment. At the end of the third year, the
parties agree to modify the terms and conditions of
the contract to give Lessor a substitution right (no
other changes are made). Provided that this
modification has economic substance, both parties
should evaluate whether the contract still contains
a lease. If it does, the lease modification
framework should not be
applied since the scope of or consideration for the
lease has not changed. However, if the contract no
longer contains a lease, the modification should be
accounted for as the termination of the lease and
the parties should account for the modified contract
in accordance with other applicable GAAP.
The decision tree below illustrates the concepts discussed
above.
8.6.1.2 Decision Tree on Accounting for Modifications
8.6.2 Modifications Accounted for as a Separate Contract
ASC 842-10
25-8 An entity shall account
for a modification to a contract as a separate contract
(that is, separate from the original contract) when both
of the following conditions are present:
-
The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset).
-
The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee.
When the modification is considered a separate contract on the
basis of the guidance in ASC 842-10-25-8, the lessee would account for the
modified lease as if it were a stand-alone lease and apply the new requirements
to the separate contract. Therefore, after the modification, the lessee would
account for the agreement as two separate contracts: (1) the original,
unmodified contract and (2) a separate contract for the additional right of use
that is accounted for in a manner similar to the accounting for a new lease.
Connecting the Dots
Accounting for a Modification as a Separate Contract
One of the conditions in ASC 842-10-25-8 for accounting
for a modification as a separate contract is that “[t]he modification
grants the lessee an additional right of use not included in the
original lease (for example, the right to use an additional asset).” The
“additional right of use” needs to be an additional asset or lease
component that differs from that included in the original contract
(i.e., extension of the lease term for an asset already subject to the
lease would not be considered an additional
right of use).
This view is consistent with the discussion in paragraph
BC176(b) of ASU 2016-02, which states, in part:
A
modification of the type [that extends or reduces the term of an
existing lease] does not grant an additional right of use. Rather,
it merely changes an attribute of the lessee’s existing right to use
the underlying asset that it already controls. That is because the
duration of the lessee’s right of use (for example, 2, 5, or 10
years) is merely an attribute of that right of use in the same way
that the specifications of a piece of equipment (for example, its
color or functioning speed) are attributes of that tangible asset.
8.6.2.1 Lease Modification With Additional Right of Use and Changes to Existing Right of Use
A lessee and lessor may agree to modify a lease to both (1)
include an additional right of use at its stand-alone price and (2) change
the scope of or consideration for the existing right of use. In such cases,
the parties to the lease cannot account for the additional right of use as a
separate contract.
For an entity to be able to apply the guidance in ASC
842-10-25-8, the only change to the lease contract can be the addition of a
right of use not included in the original contract, with a corresponding
increase in the lease payments commensurate with the stand-alone price for
the additional right of use. If there are any changes to the scope of or
consideration for the existing right of use, the entity should apply the
modification guidance discussed in Section 8.6.3 (for lessees) or
Section
9.3.4 (for lessors). This view is consistent with the
discussion in paragraph BC172 of ASU 2016-02.
8.6.2.2 Forward-Starting Lease for an Asset Subject to an Existing Lease
A lessee may have an existing lease and sign a separate
lease contract for the same asset with the same lessor, which will commence
when the existing lease expires (i.e., a “forward-starting lease”). In such
cases, the lessee and lessor cannot account for the forward-starting lease
as a separate contract.
An extension of the duration of the right to use the same
asset by definition cannot be an “additional asset” as that phrase is used
in ASC 842-10-25-8. Therefore, any extension of the period of use of an
asset subject to an existing lease, even if written as a separate contract,
must be accounted for as a lease modification that extends the term of the
existing lease rather than as a separate contract. A lessee effectively
treats a modification that extends the term of an existing lease as a new
lease that commences on the date of the modification (see Section 8.6.3.4 for
additional information). See the Connecting the Dots in Section 9.3.4 for
considerations related to how a lessor evaluates the extension of the term
of an existing lease.
Example 8-20
Company Z signs a five-year lease
for the right to use office space, with a
commencement date of January 1, 2020. On January 1,
2024, Z signs a new three-year lease for the right
to use the same office space with different payment
terms and a commencement date of January 1, 2025
(i.e., the day after the expiration of the original
five-year contract). Company Z does not treat the
three-year forward-starting lease as a separate
contract in accordance with ASC 842-10-25-8
(irrespective of whether the payments are at
market). Rather, Z accounts for the forward-starting
lease as an extension of the term of the original
lease, which creates a “new” four-year lease that
includes the last year of the first contract plus
the additional three years in the extension.
Accordingly, Z should remeasure the lease liability
for the “new” four-year lease, as discussed in
Section 8.6.3.4. Similarly, the lessor
in the arrangement would account for the
forward-starting lease as a modification of the
existing lease rather than as a separate
contract.
The example below from ASC 842-10-55-160 and 55-161
illustrates a scenario in which a modification is accounted for as a
separate contract.
ASC 842-10
55-160 Lessee enters into a
10-year lease for 10,000 square feet of office
space. At the beginning of Year 6, Lessee and Lessor
agree to modify the lease for the remaining 5 years
to include an additional 10,000 square feet of
office space in the same building. The increase in
the lease payments is commensurate with the market
rate at the date the modification is agreed for the
additional 10,000 square feet of office space.
55-161 Lessee accounts for
the modification as a new contract, separate from
the original contract. This is because the
modification grants Lessee an additional right of
use as compared with the original contract, and the
increase in the lease payments is commensurate with
the standalone price of the additional right of use.
Accordingly, from the effective date of the
modification, Lessee would have 2 separate
contracts, each of which contain a single lease
component — the original, unmodified contract for
10,000 square feet of office space and the new
contract for 10,000 additional square feet of office
space, respectively. Lessee would not make any
adjustments to the accounting for the original lease
as a result of this modification.
8.6.3 Modification Is Not Accounted for as a Separate Contract
ASC 842-10
25-9 If a lease is modified and
that modification is not accounted for as a separate
contract in accordance with paragraph 842-10-25-8, the
entity shall reassess the classification of the lease in
accordance with paragraph 842-10-25-1 as of the
effective date of the modification.
25-11 A lessee shall reallocate
the remaining consideration in the contract and
remeasure the lease liability using a discount rate for
the lease determined at the effective date of the
modification if a contract modification does any of the
following:
-
Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8)
-
Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph 842-20-35-5)
-
Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease)
-
Changes the consideration in the contract only.
8.6.3.1 Accounting by Modification Type
The table below summarizes
the accounting for modifications that are not accounted for as a separate
contract.
Modification Type
|
Roadmap Section
|
Lessee Accounting
|
---|---|---|
Modification that extends or reduces
the lease term of an existing lease (other than
through exercise of an option)
|
The three modification types to the
left will be accounted for in the following
manner:
| |
Modification that grants the lessee
an additional right of use not included in the
original contract and that is not accounted for as a
separate contract
| ||
Modification that only changes the
consideration in the contract
| ||
Modification that decreases the
scope of the lease through a full or partial
termination
|
The modification type to the left
will be accounted for in the following manner:
|
8.6.3.2 Accounting for Initial Direct Costs, Lease Incentives, and Other Payments Made in Connection With a Modification
ASC 842-10
25-10 An entity shall account
for initial direct costs, lease incentives, and any
other payments made to or by the entity in
connection with a modification to a lease in the
same manner as those items would be accounted for in
connection with a new lease.
In a modification, as in a newly executed lease, a lessee
may (1) incur initial direct costs, (2) be required to prepay a portion of
the rent, or (3) receive an incentive from the lessor. In each of these
cases, the lessee would account for these amounts in the same manner as it
would account for them under a new lease.
Connecting the Dots
Considerations Related to
Premodification Initial Direct Costs and Lease
Incentives
The lessee modification guidance in ASC 842 has no
impact on previously recognized initial direct costs and lease
incentives since the amounts associated with these items are already
reflected in the premodification ROU asset. Therefore, when a lease
is modified, only those new, additional initial direct costs,
prepaid rent, and lease incentives would result in an incremental
adjustment to the ROU asset.
8.6.3.3 Modification in Which Classification Changes From Finance Lease to Operating Lease
ASC 842-10
25-14 If a finance lease is
modified and the modified lease is classified as an
operating lease, any difference between the carrying
amount of the right-of-use asset after recording the
adjustment required by paragraph 842-10-25-12 or
842-10-25-13 and the carrying amount of the
right-of-use asset that would result from applying
the initial operating right-of-use asset measurement
guidance in paragraph 842-20-30-5 to the modified
lease shall be accounted for in the same manner as a
rent prepayment or a lease incentive.
While the interest expense and amortization expense
components of a lease’s total cost are measured and presented independently
of one another in a finance lease, expense in an operating lease is
recognized on a straight-line basis over the lease term. Because total lease
cost is recognized on a straight-line basis, the amortization component of
total lease cost is interdependent with the amount of interest expense
recorded in each period (see ASC 842-20-25-6 and Section 8.4.3.2 of this Roadmap for
more information about subsequent measurement of an operating lease and
determination of single lease cost). When an operating lease is initially
measured, any difference in the lease liability and ROU asset balance, such
as a prepaid lease or lease incentive, is accreted/amortized over the term
of the lease through this straight-line lease expense.
ASC 842-10-25-14 states that when a lease previously
classified as a finance lease becomes an operating lease as a result of a
lease modification, “any difference between the carrying amount of the [ROU]
asset after recording the adjustment required by paragraph 842-10-25-12 or
842-10-25-13 and the carrying amount of the [ROU] asset that would result
from applying the initial operating [ROU] asset measurement guidance in
paragraph 842-20-30-5” is treated similarly to a lease incentive or rent
prepayment. Differences between the lease liability and ROU asset as of the
effective date of the modification are likely to exist given expense
recognition patterns for a finance lease, since the ROU asset is generally
amortized on a straight-line basis whereas the lease liability is accreted
by using the effective interest rate method (see Section 8.4.3.1 for more information
about subsequent measurement of a finance lease). In effect, this guidance
dictates that the difference between the lease liability and ROU asset
immediately before the modification is accreted through the revised
straight-line lease expense in a manner similar to how the difference
between the ROU asset and lease liability as a result of lease incentives or
prepayments is treated in the subsequent measurement of a new operating
lease. This accretion serves to reduce the straight-line expense recognized
for the operating lease after the modification and reflects the fact that
the premodification classification led to a front-loaded expense pattern
(the front-loaded amount serves to reduce the operating lease expense and is
spread evenly over the remaining lease term to preserve a straight-line
pattern after the modification).
The example below illustrates the subsequent measurement of
a lease that is initially classified as a finance lease but subsequently
classified as an operating lease as a result of a lease modification.
Example 8-21
On January 1, 20X1, Company P (the
lessee) enters into an agreement with Company D (the
lessor) to lease office equipment for six years. In
addition, P has an option to renew the lease for one
additional year and determines that it is reasonably
certain to exercise this option. Lease payments are
made annually in arrears for fixed amounts of
$10,000, and P uses an incremental borrowing rate of
8 percent. The arrangement does not contain any
termination or purchase options, and there are no
residual value guarantees. Further, there are no
lease incentives, rent prepayments, or variable
lease payments. The economic life of the leased
asset is eight years, and the fair value of the
leased asset is $70,000 at commencement.
Given that the renewal option at
commencement is reasonably certain, P determines
that the lease term is seven years. In a manner
consistent with the approach outlined in ASC
842-10-55-2(a), P concludes that 75 percent or more
of the remaining economic life of the underlying
asset represents a major part of its remaining
economic life. Accordingly, P determines that the
criterion in ASC 842-10-25-2(c) is met and
classifies the lease as a finance lease, since the
lease represents 87.5 percent of the asset’s
remaining economic life (seven-year term divided by
eight-year economic life). Company P determines that
no other criteria in ASC 842-10-25-2 are met that
would result in a finance lease classification.
At lease commencement, P calculates
a lease liability and ROU asset of $52,064 on the
basis of the present value of the lease payments.
Company P records annual interest expense and
amortization in the following manner:
On January 1, 20X3, P and D agree to
reduce the term of the lease to five years (three
years remaining as of January 1, 20X3) and eliminate
the renewal option. No other terms of the original
lease agreement are amended by the modification, and
no additional payments are made. Because no
additional right of use is granted through the lease
modification, the modification is not accounted for
as a separate contract under ASC 842-10-25-8.
Company P’s incremental borrowing rate on the
effective date of the modification remains at 8
percent. The lease liability and ROU asset balance
immediately before the lease modification are
$39,927 and $37,188, respectively.
Company P remeasures the lease
liability on the basis of the remaining payments of
$10,000 per year for the revised lease term of three
years and determines that the modified lease
liability equals $25,771. Thus, P reduces its lease
liability by $14,156 and records an offsetting entry
to the ROU asset balance;16 accordingly, P’s ROU asset balance is reduced
to $23,032 as a result of the modification. The
related journal entry is as follows:
Company P performs a lease
classification test as of the modification date and
determines that the major part of the economic life
criterion is no longer met, since the revised lease
term of three years only represents 50 percent of
the remaining economic life (three-year term divided
by six-year remaining economic life). Because P
determines that no other criteria in ASC 842-10-25-2
that would result in finance lease classification
are met, P classifies the modified lease as an
operating lease.
Company P measures its revised lease
cost in a manner commensurate with the straight-line
recognition expense profile for operating leases.
This amount is calculated on the basis of the total
remaining lease payments of $30,000, adjusted for
the difference between the carrying amount of the
ROU asset balance after the adjustment for ASC
842-10-25-12 is recorded (i.e., the $14,156
reduction as a result of the remeasured lease
liability from the reduction in the lease term) and
what the carrying amount of the ROU asset would have
been after the guidance on initial measurement is
applied in accordance with ASC 842-20-30-5 (i.e.,
the initial measurement of a new ROU asset).17 As shown below, this amount reduces the
remaining cost in the lease by $2,739 for a total
straight-line lease expense of $9,087 per year.
As a result, P will account for the
lease liability and ROU asset balances after the
effective date of the modification as follows:18
8.6.3.4 Modification That Extends or Reduces the Lease Term of an Existing Lease (Other Than Through Exercise of an Option)
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
b. Extends or reduces the term of an existing
lease (for example, changes the lease term from
five to eight years or vice versa), other than
through the exercise of a contractual option to
extend or terminate the lease (as described in
paragraph 842-20-35-5) . . .
25-12 In the case of [(b)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification extends or reduces the lease term
(other than through the exercise of options included in the lease), a lessee
must remeasure and reallocate the consideration of the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
Scenarios in which a lessee extends or reduces the lease
term through the exercise of a renewal or termination option already
included in the lease are not considered lease modifications (see Section 8.5.1 for
additional discussion).
8.6.3.4.1 Illustrative Example — Modification Extends Lease Term but No Change in Lease Classification
ASC 842-10
Example 16 — Modification
That Increases the Lease Term
Case A — No Change in Lease
Classification
55-162 Lessee and Lessor
enter into a 10-year lease for 10,000 square feet
of office space in a building with a remaining
economic life of 50 years. Annual payments are
$100,000, paid in arrears. Lessee’s incremental
borrowing rate at the commencement date is 6
percent. The lease is classified as an operating
lease. At the beginning of Year 6, Lessee and
Lessor agree to modify the lease such that the
total lease term increases from 10 years to 15
years. The annual lease payments increase to
$110,000 per year for the remaining 10 years after
the modification. Lessee’s incremental borrowing
rate is 7 percent at the date the modification is
agreed to by the parties.
55-163 At the beginning of
Year 6, Lessee’s lease liability and its
right-of-use asset both equal $421,236 (that is,
because the lease payments are made annually in
arrears and because the lease payments are even
throughout the lease term, the lease liability and
right-of-use asset will be equal).
55-164 The modification does
not grant an additional right of use to the
lessee; rather, it changes (modifies) an attribute
of the right to use the 10,000 square feet of
office space Lessee already controls. That is,
after the modification, Lessee still controls only
a single right of use transferred to Lessee at the
original lease commencement date.
55-165 Because the
modification does not grant Lessee an additional
right of use, the modification cannot be a
separate contract. Therefore, at the effective
date of the modification, Lessee reassesses
classification of the lease (which does not change
in this Example — see Case B [paragraphs
842-10-55-166 through 55-167] for a change in
lease classification) and remeasures the lease
liability on the basis of the 10-year remaining
lease term, 10 remaining payments of $110,000, and
its incremental borrowing rate at the effective
date of the modification of 7 percent.
Consequently, the modified lease liability equals
$772,594. The increase to the lease liability of
$351,358 is recorded as an adjustment to the
right-of-use asset (that is, there is no income or
loss effect from the modification).
Below is an additional analysis of certain aspects of
the FASB’s example above.
Remeasurement of the Lease Liability
The new lease liability
is calculated as the present value of the revised lease payments for the
extended 10-year term. The calculation results in a lease liability of
$772,594; therefore, a $351,358 adjustment is recorded as an increase to
the premodification liability balance of $421,236 at the beginning of
year 6. In addition, in a manner consistent with the guidance in ASC
842-10-25-12, the lessee would similarly recognize an increase to the
ROU asset. The resulting entry is as follows:
Determining the Revised Lease Cost
In a manner consistent
with ASC 842-20-25-8, the lessee calculates the remaining lease cost of
the operating lease as of the modification date as the total lease
payments (both paid and not yet paid), adjusted by the periodic lease
cost recognized in prior periods. The resulting revised lease cost is
recognized on a straight-line basis over the remaining lease term. The
table below illustrates these calculations.
8.6.3.4.2 Illustrative Example — Modification Extends Lease Term and Lease Classification Changes
ASC 842-10
Example 16 — Modification That
Increases the Lease Term
Case B — Change in Lease
Classification
55-166 Assume the same facts
as in Case A (paragraphs 842-10-55-162 through
55-165), except that the underlying asset is a piece
of equipment with a 12-year remaining economic life
at the effective date of the modification.
Consequently, when the lessee reassesses
classification of the lease in accordance with
paragraph 842-10-25-1 as of the effective date of
the modification based on the modified rights and
obligations of the parties, the lessee classifies
the modified lease as a finance lease (that is,
because the remaining lease term of 10 years is for
a major part of the 12-year remaining economic life
of the equipment).
55-167 Consistent with Case
A, at the effective date of the modification, the
lessee remeasures its lease liability based on the
10-year remaining lease term, 10 remaining payments
of $110,000, and its incremental borrowing rate of 7
percent. Consequently, the modified lease liability
equals $772,594. The increase to the lease liability
of $351,358 is recorded as an adjustment to the
right-of-use asset (that is, there is no income or
loss effect from the modification). However,
different from Case A, beginning on the effective
date of the modification, Lessee accounts for the
10-year modified lease as a finance lease.
Below is an additional analysis of certain aspects of the
FASB’s example above.
8.6.3.4.2.1 Remeasurement of the Lease Liability
The new lease liability
is calculated as the present value of the revised lease payments for the
extended 10-year term. The calculation results in a lease liability of
$772,594, resulting in the need for a $351,358 adjustment to the
premodification liability balance of $421,236 at the beginning of year
6. In addition, in a manner consistent with the guidance in ASC
842-10-25-12, the lessee would similarly recognize an adjustment to the
premodification ROU asset balance of $421,236 at the beginning of year
6. The resulting entry is as follows:
8.6.3.4.2.2 Revised Expense Recognition Pattern
As a result of the modification, the lease
classification changed from an operating lease to a finance lease.
Therefore, as opposed to the recognition of lease expense (presented as
a single line item) on a straight-line basis, the subsequent measurement
as a finance lease results in the separate recognition of interest
expense and amortization expense. These two amounts would be presented
in a manner consistent with interest from debt and amortization or
depreciation of other nonfinancial assets.
In this example, the
lessee would recognize the following interest and amortization expense
each period:
8.6.3.5 Modification Granting the Lessee an Additional Right of Use Not Included in the Original Contract or Accounted for as a Separate Contract
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following:
-
Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8) . . . .
25-12 In the case of [(a)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification grants the lessee an additional
right of use that is not included in the original contract and that does not
meet both of the criteria to be accounted for as a separate contract, a
lessee must remeasure and reallocate the consideration in the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
The example below from ASC 842-10-55-168 through 55-176
illustrates a modification in which an additional right of use is
granted.
ASC 842-10
Example 17 — Modification That
Grants an Additional Right of Use
55-168 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The lease payments are $100,000 per year,
paid in arrears. Lessee’s incremental borrowing rate
at lease commencement is 6 percent. At the beginning
of Year 6, Lessee and Lessor agree to modify the
contract to include an additional 10,000 square feet
of office space on a different floor of the building
for the final 4 years of the original 10-year lease
term for a total annual fixed payment of $150,000
for the 20,000 square feet.
55-169 The increase in the
lease payments (of $50,000 per year) is at a
substantial discount to the market rate at the date
the modification is agreed to for leases
substantially similar to that for the new 10,000
square feet of office space that cannot be
attributed solely to the circumstances of the
contract. Consequently, Lessee does not account for
the modification as a separate contract.
55-170 Instead, Lessee
accounts for the modified contract, which contains 2
separate lease components — first, the original
10,000 square feet of office space and, second, the
right to use the additional 10,000 square feet of
office space for 4 years that commences 1 year after
the effective date of the modification. There are no
nonlease components of the modified contract. The
total lease payments, after the modification, are
$700,000 (1 payment of $100,000 + 4 payments of
$150,000).
55-171 Lessee allocates the
lease payments in the modified contract to the 2
separate lease components on a relative standalone
price basis, which, in this Example, results in the
allocation of $388,889 to the original space lease
and $311,111 to the additional space lease. The
allocation is based on the remaining lease terms of
each separate lease component (that is, 5 years for
the original 10,000-square-foot lease and 4 years
for the additional 10,000-square-foot lease). The
remaining lease cost for each separate lease
component is equal to the total payments, as
allocated, which will be recognized on a
straight-line basis over their respective lease
terms. Lessee remeasures the lease liability for the
original space lease as of the effective date of the
modification — the lease classification of which
does not change as a result of the modification — on
the basis of all of the following:
-
A remaining lease term of 5 years
-
Annual allocated lease payments of $77,778 in Years 6 through 10 (see paragraph 842-10-55-173)
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-172 The remeasured lease
liability for the original space lease equals
$318,904. Lessee recognizes the difference between
the carrying amount of the modified lease liability
and the carrying amount of the lease liability
immediately before the modification of $102,332
($421,236 – $318,904) as an adjustment to the
right-of-use asset.
55-173 During Year 6, Lessee
recognizes lease cost of $77,778. At the end of Year
6, Lessee makes its lease payment of $100,000, of
which $77,778 is allocated to the lease of the
original office space and $22,222 is allocated to
the lease of the additional office space as a
prepayment of rent. Lessee allocates the lease
payment in this manner to reflect even payments for
the even use of the separate lease components over
their respective lease terms.
55-174 At the commencement
date of the separate lease component for the
additional office space, which is 1 year after the
effective date of the modification, Lessee measures
and recognizes the lease liability at $241,896 on
the basis of all of the following:
-
A lease term of 4 years
-
Four allocated annual payments of $72,222 ([allocated lease payments of $311,111 − $22,222 rent prepayment] ÷ 4 years)
-
Lessee’s incremental borrowing rate at the commencement date of the separate lease component for the additional office space of 7.5 percent.
55-175 At the commencement
date, the right-of-use asset for the additional
office space lease component is recognized and
measured at $264,118 (the sum of the lease liability
of $241,896 and the prepaid rent asset of
$22,222).
55-176 During Years 7–10,
Lessee recognizes lease cost of $77,778 each year
for each separate lease component and allocates each
$150,000 annual lease payment of $77,778 to the
original office space lease and $72,222 to the
additional office space lease.
Below is an additional analysis related to the FASB’s
example above, including the key calculations, amortization schedule, and
journal entries. Assume that the space per square foot is economically
similar in nature such that each square foot should receive an equal
allocation of the revised contract consideration.
8.6.3.5.1 Evaluating Contract Components
As noted in ASC 842-10-55-170, Lessee accounts for the
modified contract as two separate lease components:
-
Component 1 — “[T]he original 10,000 square feet of office space.”
-
Component 2 — “[T]he right to use the additional 10,000 square feet of office space for 4 years that commences 1 year after the effective date of the modification.”
The modified contract does not include any nonlease
components. The total lease payments, after the modification, are $700,000
(1 payment of $100,000 + 4 payments of $150,000).
8.6.3.5.2 Allocating Consideration in the Contract
8.6.3.5.2.1 Determining Relative Stand-Alone Price
In accordance with ASC
842, Lessee would allocate the consideration to the separate lease
components in the contract on a relative stand-alone price basis. The
table below illustrates how to determine the allocation percentages that
will be used to allocate the consideration in the contract in the
example above for each of the two components in the contract (see
details in ASC 842-10-55-171).
8.6.3.5.2.2 Determining the Remaining Lease Cost for Each Component
ASC 842-10-55-171 notes
that, in this scenario, the “remaining lease cost for each separate
lease component is equal to the total payments, as allocated, which will
be recognized on a straight-line basis over their respective lease
terms.” The graphic below shows the related calculations.
8.6.3.5.3 Accounting for Component 1
For this component, lease classification did not change as a
result of the lease modification. As noted in ASC 842-10-55-171, “Lessee
remeasures the lease liability for the original space lease as of the
effective date of the modification.” This remeasurement is based on the
following facts:
-
“A remaining lease term of 5 years.”
-
“Annual allocated lease payments of $77,778 in Years 6 through 10” (calculated as the total consideration allocated of $388,889 divided by the five-year term), which are recognized on a straight-line basis over the remaining five years.
-
“Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.”
As indicated in ASC 842-10-55-172, “[t]he remeasured lease
liability for the original space lease equals $318,904,” which is calculated
as the present value of the lease payments allocated to Component 1,
discounted by using the 7 percent discount rate as of the effective date of
the modification. Further, “Lessee recognizes the difference between the
carrying amount of the modified lease liability and the carrying amount of
the lease liability immediately before the modification of $102,332
($421,236 – $318,904) as an adjustment to the right-of-use asset.”
The resulting calculations
for Component 1 are as follows:
8.6.3.5.3.1 Lease Liability and ROU Asset Remeasurement
The resulting journal
entry to reflect the change in the lease liability and ROU asset is as
follows:
The liability is reduced in this example because the
additional right of use is priced at a discount and this discount is
effectively split between the two postmodification lease components.
8.6.3.5.3.2 Lease Cost Recognition and Year 6 Payment Allocation
For the remainder of the
lease term (i.e., years 6–10), Lessee recognizes a lease cost of $77,778
for Component 1. As discussed in ASC 842-10-55-173, in year 6, Lessee is
required to make a lease payment of $100,000, which represents $77,778
of lease cost related to Component 1 for year 6 and $22,222 related to a
prepayment of Component 2. That is, Lessee records the following journal
entry:
8.6.3.5.4 Accounting for Component 2
Lessee determined that this lease component is classified as
an operating lease. As noted in ASC 842-10-55-174, “[a]t the commencement
date of the separate lease component for the additional office space, which
is 1 year after the effective date of the modification, Lessee measures and
recognizes the lease liability at $241,896.” This measurement and
recognition are based on the following facts listed in ASC 842-10-55-174:
-
“A lease term of 4 years.”
-
“Four allocated annual payments of $72,222 ([allocated lease payments of $311,111 − $22,222 rent prepayment] ÷ 4 years).” Note that in year 6, before the commencement of the lease for Component 2, the lessee made a payment of $100,000, of which $77,778 was allocated to Component 1 and $22,222 was allocated to Component 2.
-
“Lessee’s incremental borrowing rate at the commencement date of the separate lease component for the additional office space of 7.5 percent.”
As indicated in ASC 842-10-55-175, the ROU asset equals
$264,118, which is calculated as the lease liability of $241,896 plus the
prepaid rent asset of $22,222.
The resulting calculations
for Component 2 are as follows:
8.6.3.5.4.1 Lease Liability and ROU Asset Recognition
The resulting journal
entry is recorded at the beginning of period 7 to reflect the
recognition of the lease liability and ROU asset related to Component
2:
8.6.3.5.4.2 Lease Cost Recognition
For the remainder of the lease term (i.e., years 7–10),
Lessee recognizes a lease cost of $77,778 for Component 2.
8.6.3.5.4.2.1 Lease Payment Allocation (Years 7–10)
As discussed in ASC 842-10-55-176, Lessee allocates
$77,778 of the $150,000 annual lease payment to Component 1 and
$72,222 to Component 2.
8.6.3.6 Modification That Changes Only the Consideration in the Contract
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
d. Changes the consideration in the contract
only.
25-12 In the case of [(d)] in
paragraph 842-10-25-11, the lessee shall recognize
the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to
the corresponding right-of-use asset.
When a lease modification changes only the consideration in
the contract, a lessee must remeasure and reallocate the consideration in
the contract (see Chapter
4). In addition, the lessee would reassess lease
classification on the basis of the relevant assumptions that exist as of the
effective date of the modification (see Section 8.3.4).
As a result of the modification, the lessee would remeasure
its lease liability and recognize the amount resulting from the
remeasurement of the lease liability as an adjustment to the corresponding
ROU asset. That is, the lessee would recognize the difference between the
remeasured lease liability and the premodification lease liability as an
adjustment to the ROU asset.
Since the remeasurement amount is directly recognized as an
adjustment to the ROU asset, no income statement impact is associated with
this type of modification.
The example below from ASC 842-10-55-186 through 55-189
illustrates a modification in which only the lease payments are changed.
ASC 842-10
Example 19 — Modification That
Changes the Lease Payments Only
55-186 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The lease payments are $95,000 in Year 1,
paid in arrears, and increase by $1,000 every year
thereafter. The original discount rate for the lease
is 6 percent. The lease is an operating lease. At
the beginning of Year 6, Lessee and Lessor agree to
modify the original lease for the remaining 5 years
to reduce the lease payments by $7,000 each year
(that is, the lease payments will be $93,000 in Year
6 and will continue to increase by $1,000 every year
thereafter). The modification only changes the lease
payments and, therefore, cannot be accounted for as
a separate contract. The classification of the lease
does not change as a result of the modification.
55-187 Lessee remeasures the
lease liability for the modified lease on the basis
of all of the following:
-
Remaining lease term of 5 years
-
Payments of $93,000 in Year 6, increasing by $1,000 each year for the remainder of the lease term
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-188 The remeasured lease
liability equals $388,965. Lessee recognizes the
difference between the carrying amount of the
modified lease liability and the lease liability
immediately before the effective date of the
modification of $40,206 ($429,171 premodification
lease liability – $388,965 modified lease liability)
as a corresponding reduction to the right-of-use
asset. Therefore, the adjusted right-of-use asset
equals $376,465 as of the effective date of the
modification. Lessee calculates its remaining lease
cost as $462,500 (the sum of the total lease
payments, as adjusted for the effects of the lease
modification, of $960,000 reduced by the total lease
cost recognized in prior periods of $497,500), which
it will recognize on a straight-line basis over the
remaining lease term.
55-189 During Year 6, Lessee
recognizes lease cost of $92,500 ($462,500 remaining
lease cost ÷ 5 years). As of the end of Year 6,
Lessee’s lease liability equals $323,193 (present
value of the remaining lease payments, discounted at
7 percent), and its right-of-use asset equals
$311,193 (the balance of the lease liability – the
remaining accrued rent balance of $12,000). Lessee
recognizes additional lease cost of $92,500 each
year of the remaining lease term and measures its
lease liability and right-of-use asset in the same
manner as at the end of Year 6 each remaining year
of the lease term. The following are the balances of
the lease liability and the right-of-use asset at
the end of Years 7 through 10 of the lease.
The table below summarizes
the calculations related to the lease liability and ROU asset in the example
above.
Before the modification, the annual lease cost is the sum of
all lease payments ($995,000) allocated on a straight-line basis over the
10-year lease term.
8.6.3.6.1 Remeasurement of the Lease Liability and ROU Asset
The new lease liability on
the effective date of the modification is calculated as the present value of
the revised lease payments for the remaining lease term. The calculation
results in a lease liability of $388,965; therefore, a $40,206 adjustment is
needed at the beginning of year 6. In addition, in a manner consistent with
the guidance in ASC 842-10-25-12, the lessee would recognize an offsetting
entry in the amount of the remeasurement of the lease liability for the
modified lease as an adjustment to the corresponding ROU asset. The lessee
records the following journal entry:
8.6.3.6.2 Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
would calculate the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet paid),
adjusted by the periodic lease cost recognized in prior periods. The
resulting revised lease cost would be recognized on a straight-line basis
over the remaining lease term.
In this example, the
calculation of the remaining lease cost would be as follows:
8.6.3.7 Modification Decreases the Scope of the Lease (a Full or Partial Termination)
ASC 842-10
25-11 A lessee shall
reallocate the remaining consideration in the
contract and remeasure the lease liability using a
discount rate for the lease determined at the
effective date of the modification if a contract
modification does any of the following: . . .
c. Fully or partially terminates an existing
lease (for example, reduces the assets subject to
the lease) . . . .
25-13 In the case of (c) in
paragraph 842-10-25-11, the lessee shall decrease
the carrying amount of the right-of-use asset on a
basis proportionate to the full or partial
termination of the existing lease. Any difference
between the reduction in the lease liability and the
proportionate reduction in the right-of-use asset
shall be recognized as a gain or a loss at the
effective date of the modification.
When a lease modification reduces the scope of a lease
through a full or partial termination of the lease (i.e., reduces the
underlying asset that is available for use by the lessee — for example, by
reducing the square footage leased in a building or by removing a lease
component from an arrangement containing multiple lease components), a
lessee must remeasure and reallocate the consideration in the contract (see
Chapter 4).
In addition, the lessee would reassess lease classification on the basis of
the relevant assumptions that exist as of the effective date of the
modification (see Section
8.3.4). The resulting accounting for a lease modification
that reduces the scope of a lease depends on whether it is a full or partial
termination:
-
Accounting for a full termination — In the case of a full termination, the lessee would derecognize the lease liability and ROU asset. The difference would be recognized in the income statement as a gain or loss.
-
Accounting for a partial termination — In the case of a partial termination, the lessee would first remeasure its lease liability and reflect the change as an adjustment to the premodification lease liability. The lessee would then reduce the ROU asset on a proportionate basis. Any difference between the proportionate reduction in the ROU asset and corresponding lease liability is recognized in the income statement as a gain or a loss on the effective date of the modification.
Connecting the Dots
Full or Partial Termination
of One or More (but Not All) Lease Components19
Entities often enter into lease contracts that
include multiple underlying assets accounted for as separate lease
components in accordance with ASC 842-10-15-28. As discussed in
Section
8.6.3.5, when a lease modification grants a lessee an
additional right of use that is not included in the original
contract (provided that the lease payments do not increase in a
manner commensurate with the stand-alone price), the lessee must
apply modification accounting to all the
lease components in the contract. Similarly, a change in the terms
or conditions of a contract with several lease components that
results in a full or partial termination of one or more (but not
all) of the lease components constitutes a modification of the
entire contract. Therefore, the lessee would reallocate the
consideration in the contract on the basis of modification-date
stand-alone prices and would reassess lease classification and
remeasure the lease liability for all the
remaining lease components.
According to the implementation guidance in ASC 842, there
are two alternative approaches for reducing the ROU asset when a
modification results in the reduction of the scope of the lease.
-
Approach 1: Remeasure the ROU asset on the basis of the liability change — Under this approach, the lessee would first remeasure its lease liability on the basis of the revised lease payments. The lessee would then determine the percentage reduction in the lease liability by comparing the remeasured liability with the premodification liability. The resulting percentage would be applied to the premodification ROU asset, and any difference between the lease liability adjustment and the resulting ROU asset adjustment amount would be recognized in the income statement as a gain or loss.
-
Approach 2: Remeasure the ROU asset on the basis of the ROU asset reduction — Under this approach, the lessee would first remeasure its lease liability on the basis of the revised lease payments. The lessee would then determine the percentage reduction in the physical space or productive capacity that resulted from the lease modification. In the determination of the postmodification carrying amount, the resulting percentage would be applied to the premodification liability and premodification ROU asset, resulting in both of the following:
-
Any difference between the change in the premodification liability and postmodification liability and the change in the premodification ROU asset and postmodification ROU asset would be recognized in the income statement as a gain or loss.
-
Any difference between the remaining lease liability and the remeasured lease liability, calculated by using the proportionate change resulting from the reduction of the physical right of use and the present value of the postmodification lease payments, would be recognized as an adjustment to the ROU asset, reflecting the change in the consideration paid for the lease and the revised discount rate.
-
Connecting the Dots
Modifications That Decrease
the ROU Asset
The implementation guidance in ASC 842 provides two
viable approaches for remeasuring a ROU asset as a result of a lease
modification that decreases the scope of the lease. We believe that
the approach for remeasuring the ROU asset as a result of a
modification that decreases the scope of a lessee’s right of use is
an accounting policy election and, therefore, should be applied
consistently to all similar types of modifications. In addition, we
believe that a lessee should disclose its elected accounting policy
if the impact of this policy is material to its financial
statements.
8.6.3.7.1 Penalty for a Partial Termination
The parties in an existing lease may agree to terminate
the lessee’s right to use (1) some of the assets under the lease (e.g.,
discrete pieces of equipment) or (2) a portion of an asset (e.g., one of
several leased floors in an office building). In some cases, the lessee
might agree to increase the lease payments for the remaining portion of
the lease. Previously, under ASC 840, lessees were required to evaluate
whether such an increase in lease payments was, in substance, a
termination penalty (which would be recognized as an expense
immediately) or only a modification of future lease payments (which
would be accounted for prospectively over the remaining lease term).20 However, ASC 842 does not contain similar guidance and instead
requires both parties to apply the new modification framework.
In such circumstances, the lessee should treat the
increased lease payments as part of the revised consideration in the
modified contract and should allocate the payments to the remaining
lease and nonlease components. Specifically, ASC 842-10-35-4 and ASC
842-10-25-11 state that upon a modification that is not accounted for as
a separate contract, including a partial termination, a lessee must
“remeasure the lease payments” and “reallocate the remaining
consideration in the contract and remeasure the lease liability.”
Importantly, ASC 842-10-25-11 neither requires nor permits entities to
allocate a portion of the remaining consideration to the terminated
component(s) of the contract. Instead, the remaining consideration is
entirely allocated to the remaining components in the contract.
We believe that the Board intended this outcome, since
it would often be highly complex and costly to determine what portion of
the revised lease payments is related to the terminated components of a
contract rather than to the remaining components. Similarly, this
complexity was part of the Board’s basis for its prospective approach to
modifications in ASC 606, as described in paragraph BC78 of ASU 2014-09:
The Boards also decided that a contract
modification should be accounted for prospectively when the goods or
services to be provided after the modification are distinct from the
goods or services already provided (see paragraph 606-10-25-13(a)).
The Boards decided that this should be the case regardless of
whether the pricing of the additional promised goods or services
reflected their standalone selling prices. This
is because accounting for those types of modifications on a
cumulative catch-up basis could be complex and may not
necessarily faithfully depict the economics of the modification
because the modification is negotiated after the original
contract and is based on new facts and circumstances.
Therefore, this approach avoids opening up the accounting for
previously satisfied performance obligations and, thus, avoids any
adjustments to revenue for satisfied performance obligations.
[Emphasis added]
The Board intentionally aligned many of the principles
in the ASC 842 modification framework with those in ASC 606. Paragraph
BC169 of ASU 2016-02 explains this alignment:
The
guidance on lease modifications in Topic 842 was developed
principally with the following in mind:
- The accounting for lease modifications in previous GAAP was generally considered to be very complex (often explained only by flowchart). In the Board’s view, the lease modifications guidance in Topic 842 is less complex and more intuitive to apply than the previous guidance.
- Contracts that contain leases frequently contain nonlease components (that is, other goods or services). This was particularly important to the Board’s considerations about lease modification accounting for lessors because Topic 606 contains a robust framework for accounting for modifications of contracts with customers to provide nonlease goods and services (for example, supplies for use with leased equipment or services such as maintenance or operation of the underlying asset).
Therefore, we believe that allocating the revised
consideration in the contract prospectively only to the remaining
components, even if such allocation does not reflect the economic
substance of the revised payments, is consistent with the Board’s intent
in (1) aligning the modification framework in ASC 842 with that in ASC
606 and (2) reducing the complexity of accounting for lease
modifications.
Further, ASC 842 does not contain explicit guidance on
how a lessee should account for a termination penalty paid to a lessor
upon a partial termination of a lease; however, ASC 842-10-30-5(d) does
include guidance on how to include termination payments and penalties21 within the scope of lease payments more generally:
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: . . .
d. Payments for penalties for terminating the lease if the
lease term (as determined in accordance with paragraph
842-10-30-1) reflects the lessee exercising an option to
terminate the lease.
Therefore, such a penalty should be included in the
consideration allocated to the components in the contract upon a partial
termination. As discussed above, the revised consideration in the
contract should be allocated only to the remaining components, rather
than in part to the terminated component(s). As a result, the full
amount of the termination penalty is recognized prospectively.
We believe that the basis for this outcome is
appropriately consistent with the one discussed above. Frequently, a
lessee and lessor may negotiate a termination payment in conjunction
with a renegotiation of the ongoing lease payments or in contemplation
of the existing ongoing lease payments, and the lessor may be
economically satisfied with a lower termination payment than it would
otherwise accept (or may require a higher termination payment than it
would otherwise accept) because of the ongoing lease payments.
Therefore, it would be highly complex and costly to differentiate
between, for example, a termination penalty related to a terminated
lease component and a prepayment for the remaining lease components. In
other cases, the parties may simply choose to finance the termination
penalty over the remaining lease term by adjusting the remaining lease
payments. As discussed above, the modification treatment appears clear
when future lease payments are adjusted and we do not believe that the
timing of the payment should dictate the accounting outcome.
In contrast to a partial termination, a termination
penalty paid as part of a full termination of a lease (i.e., when there
are no remaining components in the contract) should be included in the
determination of the gain or loss upon termination in accordance with
ASC 842-20-40-1 and ASC 842-20-40-3. However, as discussed in
Section 8.6.3.7.2, the guidance on full
terminations only applies when the lessee’s right of use ceases
contemporaneously with the execution of the modification (e.g., assets
are immediately returned to the lessor or space is immediately vacated),
which we believe will occur infrequently for leases of certain types of
assets (e.g., real estate) because of the time and administrative burden
that typically accompany relocating.
Example 8-22
On September 15, 2019, Lessee
enters into a 15-year lease for six floors of an
office building for a total of $6 million per
year, with no termination or renewal options. On
September 15, 2024, Lessee and Lessor agree to
immediately terminate the lease of two of those
six floors while retaining the lease of the other
four floors for the remaining 10-year lease term.
Lessee also agrees to pay Lessor a $4 million
termination penalty, which is determined by
comparing the remaining lease payments related to
the two floors being terminated with current
market rates. That is, the $4 million represents
the “in-the-money” portion of the terminated lease
components.
In accordance with ASC
842-10-35-4 and ASC 842-10-25-11, Lessee should
remeasure the lease liability for the remaining
lease components (i.e., the four remaining floors)
by remeasuring the lease payments and allocating
those lease payments to the remaining components
in the contract. Although $4 million is
contractually specifically related to the
terminated space, the $4 million termination
penalty should be included in those revised lease
payments — and thus deferred as part of the ROU
asset for the remaining floors — rather than being
recorded as part of any gain or loss upon
termination. Lessee should then apply the guidance
in ASC 842-10-25-13 (by using one of the
approaches discussed above) to determine the gain
or loss to be recognized as a result of the
partial termination.
8.6.3.7.2 Reduction in Lease Term Versus Lease Termination
The guidance in ASC 842-10-25-11(c) applies to full or
partial terminations and results in potential gains or losses when the
lease is remeasured. On the other hand, ASC 842-10-25-11(b) applies to
lease term extensions or reductions and requires
the lessee to recognize the amount of the remeasurement of the lease
liability for the modified lease as an adjustment to the corresponding
ROU asset, which generally does not result in a gain or a loss.
If a modification results in a reduced lease term for part of the leased asset (e.g., a reduced term
for a percentage of the leased space), the guidance in ASC
842-10-25-11(c) does not apply. Although the guidance in ASC
842-10-25-11(b) does not explicitly address this issue, we believe that
this guidance applies to reductions in the lease term of either the
entire leased asset or part of the leased asset. That is, regardless of
whether the term is reduced for the entire lease or for only a part or a
percentage of the lease (e.g., 20 percent of the leased space), the
lessee would apply the guidance in ASC 842-10-25-11(b). In addition, the
guidance in ASC 842-10-25-11(c) does not apply to a modification that
results in the termination of all or part of a lessee’s right of use
after a specified period (rather than immediate termination).
In such cases, the lessee still has the right to use the
leased asset for that period; therefore, the modification consists of a
reduction in the lease term rather than a full or partial termination
and the lessee would apply the guidance in ASC 842-10-25-11(b). The only
time that the guidance on full or partial terminations applies is when
all or part of the lessee’s right of use ceases contemporaneously with
the execution of the modification (e.g., assets are immediately returned
to the lessor or space is immediately vacated).
The example below from ASC 842-10-55-177 through 55-185
illustrates two approaches to measuring an ROU asset in a scenario in
which a modification decreases the scope of a lease.
ASC 842-10
Example 18 — Modification
That Decreases the Scope of a Lease
55-177 Lessee enters into a
10-year lease for 10,000 square feet of office
space. The annual lease payment is initially
$100,000, paid in arrears, and increases 5 percent
each year during the lease term. Lessee’s
incremental borrowing rate at lease commencement
is 6 percent. Lessee does not provide a residual
value guarantee. The lease does not transfer
ownership of the office space to Lessee or grant
Lessee an option to purchase the space. The lease
is an operating lease for all of the following
reasons:
-
The lease term is 10 years, while the office building has a remaining economic life of 40 years.
-
The fair value of the office space is estimated to be significantly in excess of the present value of the lease payments.
-
The office space is expected to have an alternative use to Lessor at the end of the lease term.
55-178 At the beginning of
Year 6, Lessee and Lessor agree to modify the
original lease for the remaining 5 years to reduce
the lease to only 5,000 square feet of the
original space and to reduce the annual lease
payment to $68,000. That amount will increase 5
percent each year thereafter of the remaining
lease term.
55-179 The classification of
the lease does not change as a result of the
modification. It is clear based on the terms of
the modified lease that it is not a finance lease
because the modification reduces both the lease
term and the lease payments. Lessee remeasures the
lease liability for the modified lease at the
effective date of the modification on the basis of
all of the following:
-
A remaining lease term of 5 years
-
Lease payments of $68,000 in the year of modification (Year 6), increasing by 5 percent each year thereafter
-
Lessee’s incremental borrowing rate at the effective date of the modification of 7 percent.
55-180 The remeasured lease
liability equals $306,098.
> Case A — Remeasuring the
Right-of-Use Asset Based on Change in Lease
Liability
55-181 The difference between
the premodification liability and the modified
lease liability is $284,669 ($590,767 – $306,098).
That difference is 48.2 percent ($284,669 ÷
$590,767) of the premodification lease liability.
The decrease in the lease liability reflects the
early termination of the right to use 5,000 square
feet of space (50 percent of the original leased
space), the change in the lease payments, and the
change in the discount rate.
55-182 Lessee decreases the
carrying amount of the right-of-use asset to
reflect the partial termination of the lease based
on the adjustment to the carrying amount of the
lease liability, with any difference recognized in
profit or loss. The premodification right-of-use
asset is $514,436. Therefore, at the effective
date of the modification, Lessee reduces the
carrying amount of the right-of-use asset by
$247,888 (48.2% × $514,436). Lessee recognizes the
difference between the adjustment to the lease
liability and the adjustment to the right-of-use
asset ($284,669 – $247,888 = $36,781) as a
gain.
> Case B — Remeasuring the
Right-of-Use Asset Based on the Remaining Right of
Use
55-183 Lessee determines the
proportionate decrease in the carrying amount of
the right-of-use asset based on the remaining
right-of-use asset (that is, 5,000 square feet
corresponding to 50 percent of the original
right-of-use asset).
55-184 Fifty percent of the
premodification right-of-use asset is $257,218
(50% × $514,436). Fifty percent of the
premodification lease liability is $295,384 (50% ×
$590,767). Consequently, Lessee decreases the
carrying amount of the right-of-use asset by
$257,218 and the carrying amount of the lease
liability by $295,384. At the effective date of
the modification, Lessee recognizes the difference
between the decrease in the lease liability and
the decrease in the right-of-use asset of $38,166
($295,384 − $257,218) as a gain.
55-185 Lessee recognizes the
difference between the remaining lease liability
of $295,384 and the modified lease liability of
$306,098 (which equals $10,714) as an adjustment
to the right-of-use asset reflecting the change in
the consideration paid for the lease and the
revised discount rate.
Below is a summary of the two different approaches to
remeasuring the ROU asset in this example.
Approach 1 — Remeasuring the ROU Asset on the
Basis of the Percentage Change in Lease Liability
Under this approach, the lessee calculates the
percentage decrease in the lease liability as a result of the
modification. This percentage is applied to the premodification ROU
asset to determine the postmodification ROU asset balance. The
difference between the change in the postmodification ROU asset and the
postmodification lease liability represents a gain or loss that is
recognized in the income statement as of the date of the modification.
See ASC 842-10-55-181 and 55-182 above for details related to the
calculation of the gain and the adjustments to the ROU asset under
Approach 1.
Journal Entries
As a result of the
calculations detailed in ASC 842-10-55-181 and 55-182, the lessee
records the following journal entry to account for the remeasurement of
the lease liability, ROU asset, and gain related to the
modification.
Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
calculates the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet
paid) and any adjustments resulting from a lease modification (including
amounts attributable to a gain or loss from the modification), less the
periodic lease cost recognized in prior periods. In other words, the
remaining lease cost is calculated as the sum of (1) the
postmodification balance for the ROU asset and (2) the expected future
accretion of the liability (i.e., the difference between the total
future lease payments and the postmodification lease liability balance).
The resulting revised lease cost is then recognized on a straight-line
basis over the remaining lease term.
The table below
illustrates the calculations related to the remaining lease cost.
Approach 2 — Remeasuring the ROU Asset on the
Basis of the Percentage Change in the Right of Use
Under this approach, the lessee calculates the
percentage decrease in the physical space subject to the right of use as
a result of the modification. This percentage is applied to the
premodification ROU asset to determine the postmodification ROU asset
balance. The difference between the change in the premodification
balance and postmodification balance and the lease liability adjustment
represents a gain or loss that is recognized in the income statement as
of the date of the modification.
See ASC 842-10-55-183 through 55-185 above for details
related to the calculation of the gain and the adjustments to the ROU
asset under Approach 2.
Journal Entries
As a result of the
calculations detailed in ASC 842-10-55-183 through 55-185, the lessee
records the following journal entries to account for the partial
derecognition of the lease liability, ROU asset, and gain related to the
modification. In addition, the lessee records, as an adjustment to the
ROU asset, the difference between the premodification lease liability of
$295,384 (50 percent of $590,767) and the modified lease liability of
$306,098.
Determining the Revised Lease Cost
In a manner consistent with ASC 842-20-25-8, the lessee
will calculate the remaining lease cost of the operating lease as of the
modification date as the total lease payments (both paid and not yet
paid) and any adjustments resulting from a lease modification (including
amounts attributable to a gain or loss from the modification), less the
periodic lease cost recognized in prior periods. In other words, the
remaining lease cost is calculated as the sum of (1) the
postmodification balance for the ROU asset and (2) the expected future
accretion of the liability (i.e., the difference between the total
future lease payments and the postmodification lease liability balance).
The resulting revised lease cost is then recognized on a straight-line
basis over the remaining lease term.
The calculation of the
remaining lease cost would be as follows:
Connecting the Dots
Modifications That
Decrease the ROU Asset and Increase the Lease
Liability
In certain interest rate environments, a lease
modification that decreases the scope of the lease may result in
an increase in the lease liability associated with a lower IBR
assumption. A partial termination, as opposed to a lease
modification, is characterized by the recognition of a profit
and loss (P&L) impact. The guidance on partial terminations
in ASC 842-10-25-13 refers to the requirement for the lessee to
“decrease the carrying amount of the ROU asset” as well as “the
reduction in the lease liability.” The implementation guidance
in ASC 842-10-55-177 through 55-185 outlines two alternative
approaches for adjusting the ROU asset when a modification
results in the reduction of the scope of the lease (Example 18).
However, this guidance does not explicitly contemplate a partial
termination in which the lease liability would
increase.
We believe that, in such circumstances, it would
be acceptable to apply an approach aligned with that in Example
18, Case B. That is, the determination of the decrease in the
modified ROU asset would be based on the decrease in the
remaining right of use of the leased space after the partial
termination. In applying this approach upon the partial
termination, the percentage decrease of the leased asset (e.g.,
square footage) would be applied to the premodification ROU
asset and premodification lease liability to decrease the
carrying amount of the ROU asset and the lease liability. For
example, if the square footage were to decrease by 8 percent,
there would be an 8 percent decrease in the ROU asset and lease
liability. The subsequent P&L impact would be recorded for
the difference in the reduced premodification lease liability
and ROU asset.
Subsequently (in a second step in Case B), the
lease liability is calculated by using the revised lease
payments and an updated discount rate. Therefore, an additional
adjustment to the ROU asset and lease liability is recorded as
the difference between the (1) reduced premodification lease
liability (calculated above) and (2) the modified lease
liability reflecting the change in the consideration paid for
the lease and the revised discount rate. According to View 1,
the P&L is only affected through the first step, detailed
above, for any difference in the reduced ROU and lease
liability. There is no incremental impact on the P&L in the
second step.
We believe that other views may also be
acceptable depending on an entity’s specific facts and
circumstances. Entities should consider consulting with their
accounting advisers when contemplating an approach other than
the one outlined above.
8.6.4 Other Scenarios Related to Lease Modifications
8.6.4.1 Lease Modifications in Connection With the Refunding of Tax-Exempt Debt
ASC 842-10
55-16 In some situations, tax-exempt debt is issued to finance construction of a facility, such as a plant or
hospital, that is transferred to a user of the facility by lease. A lease may serve as collateral for the guarantee
of payments equivalent to those required to service the tax-exempt debt. Payments required by the terms of
the lease are essentially the same, as to both amount and timing, as those required by the tax-exempt debt. A
lease modification resulting from a refunding by the lessor of tax-exempt debt (including an advance refunding)
should be accounted for in the same manner (that is, in accordance with paragraphs 842-10-25-8 through
25-18) as any other lease modification. For example, if the perceived economic advantages of the refunding
are passed through to the lessee in the form of reduced lease payments, the lessee should account for the
modification in accordance with paragraph 842-10-25-12, while the lessor should account for the modification
in accordance with the applicable guidance in paragraphs 842-10-25-15 through 25-17.
Governmental authorities often use tax-exempt debt to finance the construction of a facility (e.g., a
plant or a hospital) that they will lease to another entity. As noted above, the payment terms of the lease
generally mirror, with respect to both amount and timing, “those required by the tax-exempt debt.” Such
a lease “may serve as collateral for the guarantee of payments equivalent to those required to service
the tax-exempt debt.”
If the governmental authority enters into a refunding arrangement that replaces the existing tax-exempt
debt with new debt (as would be the case if the authority wanted to take advantage of lower interest
rates), the resulting change in the debt service payments may result in a reduction of the corresponding
lease payments. This reduction of lease payments would be accounted for as a modification. See
Section 8.6.3.6 for additional discussion of modifications that result only in a change to consideration in
the contract.
8.6.4.2 Applying the Modification Guidance to a Master Lease Agreement
As described in Section
13.4, a master lease agreement may specify that the lessee
will obtain control of multiple underlying assets (e.g., equipment) at
various times during the term of the agreement. In accordance with ASC
842-10-55-17, the lessee’s accounting in such cases depends on whether it is
obligated or committed to use, and therefore obtain control of, “a minimum
number of units or dollar value of equipment.” If so, the lessee should take
into account this minimum quantity when separating lease components and
allocating the consideration in the contract to the separate lease
components. Because the minimum quantity is factored into the initial
separation of and allocation to the lease components, the lessee’s
attainment of control of the underlying assets throughout the term of the
master lease agreement does not result in a lease modification. However,
because the lessee may obtain control of the underlying assets at different
times during the master lease agreement, the separate lease components may
have different lease commencement dates, as explained in ASC 842-10-55-22.
Note that if a lessee obtains control of underlying assets in addition to
the minimum quantity or value specified in the master lease agreement, there
would be a lease modification.
In addition, ASC 842-10-55-18 stipulates that if the lessee is not obligated or committed to use a minimum quantity of equipment, the attainment of control over each underlying asset must be accounted for as a lease modification in accordance with ASC 842-10-25-8 through 25-18. Depending on the terms of the arrangement, the resulting modification may result in accounting for each new asset as a separate lease or in a remeasurement of the existing lease. Because the equipment is not subject to a minimum commitment, the entity would not include the equipment in the initial separation of and allocation to the lease components in the contract. See Section 13.4 for additional information on accounting for master lease agreements.
8.6.4.3 Lease Modifications That Involve More Than One Change
ASC 842-10
25-11 A lessee shall reallocate the remaining consideration in the contract and remeasure the lease liability using a discount rate for the lease determined at the effective date of the modification if a contract modification does any of the following:
- Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8)
- Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph 842-20-35-5)
- Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease)
- Changes the consideration in the contract only.
25-12 In the case of (a), (b), or (d) in paragraph 842-10-25-11, the lessee shall recognize the amount of the remeasurement of the lease liability for the modified lease as an adjustment to the corresponding right-of-use asset.
25-13 In the case of (c) in paragraph 842-10-25-11, the lessee shall decrease the carrying amount of the right-of-use asset on a basis proportionate to the full or partial termination of the existing lease. Any difference between the reduction in the lease liability and the proportionate reduction in the right-of-use asset shall be recognized as a gain or a loss at the effective date of the modification.
When a lease modification is not accounted for as a separate contract, a lessee must reallocate the remaining consideration in the contract and remeasure its lease liability. If the modification extends or reduces the lease term of an existing lease (see Section 8.6.3.4), provides the lessee with an additional right of use not accounted for as a separate contract (see Section 8.6.3.5), or changes the consideration in the contract (see Section 8.6.3.6), the lessee should recognize the amount resulting from the remeasurement of the lease liability as an adjustment to the corresponding ROU asset. If the modification reduces the scope of a lease through a full or partial termination of the lease, the lessee should instead record a proportionate reduction in the ROU asset as well as a gain or loss for any difference between the decrease in the lease liability and the decrease in the ROU asset (see Section 8.6.3.7).
While the guidance in ASC 842 is clear on the accounting for a lease
modification that results in a single change, some lease modifications may
include multiple changes that need to be accounted for in different ways on
the basis of the nature of the change. ASC 842 does not clearly address how
to account for these types of lease modifications.
A lessee’s approach to modifications involving more than one
change will typically depend on the nature of the changes and whether they
would individually lead to different accounting treatments upon
remeasurement of the lease liability (i.e., all adjustments recognized on
the balance sheet versus potential for gain or loss in the income
statement). We generally believe that the lessee should account for each
change included in the modification in accordance with the guidance
applicable to that change rather than view one change as predominant. That
is, the lessee should generally not simply adjust the ROU asset for the
total remeasurement in the lease liability by using the modification
guidance applicable to the most significant change.
To properly account for each change, it may be helpful for a
lessee to bifurcate the original lease into the portions that are subject to
the different remeasurement rules in ASC 842-10-25-12 and 25-13. For
example, we believe that in dealing with a modification involving an
immediate termination of part of a lessee’s right of use coupled with a
lease term extension for the remaining right of use, it would be reasonable
for the lessee to first bifurcate the existing lease liability and ROU asset
on the basis of the portion of the lease affected by each change. The
bifurcation between the two portions should be on the basis of the relative
stand-alone prices.
Once the lease liability and ROU asset have been allocated
between the two portions, the lessee would apply the modification guidance
in ASC 842-10-25-11 through 25-13 to the balances allocated to each portion.
The lessee would thus derecognize the balances allocated to the terminated
portion of the lease (with a corresponding gain or loss) and would remeasure
the lease liability allocated to the retained portion of the lease (with a
corresponding adjustment to the ROU asset) by using the remaining lease term
and incremental borrowing rate determined as of the effective date of the
modification. The lessee would also reassess the classification of the lease
as of the effective date of the modification.
Example 8-23
Lessee has an existing lease for
5,000 square feet of office space with a remaining
lease term of three years. Lessee and Lessor agree
to modify the lease to (1) immediately terminate the
lease of 1,000 square feet of the office space and
(2) extend the lease term for the remaining 4,000
square feet to five years. On the basis of the
relative stand-alone prices, Lessee bifurcates the
ROU asset and lease liability into the portion
subject to the immediate termination (1,000 square
feet) and the portion subject to the lease term
extension (4,000 square feet). Lessee then (1)
applies the guidance in ASC 842-10-25-13 to the
portion of the ROU asset and lease liability
associated with the immediate termination (i.e.,
derecognizes those balances and records a gain or
loss for the difference) and (2) applies the
guidance in ASC 842-10-25-12 to the portion of the
ROU asset and lease liability associated with the
lease term extension (i.e., remeasures the lease
liability and makes a corresponding adjustment to
the ROU asset).
8.6.4.4 Lease Modifications in Connection With Reference Rate Reform
ASC 848-20
15-2 The guidance in this
Subtopic, if elected, shall apply to contracts that
meet the scope of paragraph 848-10-15-3 if either or
both of the following occur:
-
The terms that are modified directly replace, or have the potential to replace, a reference rate within the scope of paragraph 848-10-15-3 with another interest rate index. If other terms are contemporaneously modified in a manner that changes, or has the potential to change, the amount or timing of contractual cash flows, the guidance in this Subtopic shall apply only if those modifications are related to the replacement of a reference rate. For example, the addition of contractual fallback terms or the amendment of existing contractual fallback terms related to the replacement of a reference rate that are contingent on one or more events occurring has the potential to change the amount or timing of contractual cash flows and the entity potentially would be eligible to apply the guidance in this Subtopic.
-
The interest rate used for margining, discounting, or contract price alignment is modified as a result of reference rate reform.
15-3 Other than a
modification of the interest rate used for
margining, discounting, or contract price alignment
in accordance with paragraph 848-20-15-2(b), for
contracts that meet the scope of paragraph
848-10-15-3, the guidance in this Subtopic shall not
apply if a contract modification is made to a term
that changes, or has the potential to change, the
amount or timing of contractual cash flows and is
unrelated to the replacement of a reference rate.
That is, this Subtopic shall not apply if contract
modifications are made contemporaneously to terms
that are unrelated to the replacement of a reference
rate.
35-11 If an entity elects
the optional expedient in this paragraph for a
modification of a contract within the scope of Topic
840 or 842 that meets the scope of paragraphs
848-20-15-2 through 15-3, the entity shall not do
any of the following:
-
Reassess lease classification and the discount rate (for example, the incremental borrowing rate for a lessee)
-
Remeasure lease payments
-
Perform other reassessments or remeasurements that would otherwise be required under Topic 840 or 842 when a modification of a lease contract is not accounted for as a separate contract.
In March 2020, the FASB issued ASU 2020-04,
which established a new FASB Codification topic, ASC 848, on reference rate
reform. Specifically, the new guidance addresses constituents’ concerns
about some of the potential accounting consequences of the global markets’
anticipated transition away from LIBOR and other interbank offered rates to
alternative reference rates. The FASB also issued ASU
2021-01 in January 2021 to clarify the scope of ASC
848.
Entities whose lease contracts refer to LIBOR or another
interbank offered rate may seek to modify their arrangements to designate a
replacement reference rate. In the absence of the optional relief provided
by ASC 848, entities would be required to apply ASC 842’s normal lease
modification framework to account for such changes. (See Section 8.6 for a
discussion of the lessee’s lease modification accounting and Section 9.3.4 for a
discussion of the lessor’s lease modification accounting.)
When applying the lease modification relief in ASC 848 to eligible leases, an
entity would not (1) reassess the lease classification or the discount rate
or (2) remeasure lease payments or perform the other reassessments or
remeasurements that would otherwise be triggered by a modification under ASC
842 when that modification is not accounted for as a separate contract. The
modification of terms on which variable lease payments depend will not cause
the lessee to remeasure the lease liability. The effects of such changes
will instead be recognized in profit or loss in the period in which the
obligation for those payments is incurred.
Under ASU 2020-04, an entity that elects to apply an
expedient under a particular Codification topic, subtopic, or industry
subtopic must apply that expedient to all contract modifications that are
within the scope of the ASU and are accounted for under that topic,
subtopic, or industry subtopic.
Footnotes
15
In this section, we are assuming that the change is
substantive and has economic substance. We would not require or
accept a reassessment based on changes that lack economic substance
(e.g., insignificant changes designed to trigger a reassessment to
achieve a desired accounting outcome). Consultation with auditors
and accounting advisers is recommended in circumstances in which a
modification appears to lack substance.
16
Lessee records the difference
between the premodification lease liability and
postmodification lease liability as an adjustment
to the ROU asset in accordance with ASC
842-10-25-12, since the modification is a
reduction of lease term in accordance with ASC
842-10-25-11(b).
17
In our example, the
measurement of the ROU asset under ASC 842-20-30-5
would equal the initial measurement of the
modified lease liability of $25,771 described
above, since there are no prepaid lease payments,
lease incentives, or initial direct costs.
18
A company may apply one of two
approaches to subsequently account for an
operating lease, each of which results in the same
outcome. The table below illustrates the
subsequent measurement of an operating lease by
using the “plug” approach described in Example
8-13 in Section 8.4.3.2
(Approach B), which presents amortization activity
net for the adjustment to the ROU asset. See
Approach A in the aforementioned example for an
illustration of how a company would amortize this
adjustment when the adjustment is tracked
separately from the ROU asset balance.
19
Although written from the perspective of a
lessee, the concepts described in this Connecting the Dots
also apply to lessors.
20
See ASC 840-20-55-4 through 55-6.
21
Although this discussion focuses on termination
penalties paid to the lessor, we believe that the conclusion
reached would also apply to any consideration received by the
lessee from the lessor upon a partial termination of a
lease.
8.7 Derecognizing a Lease
8.7.1 Setting the Stage
This section addresses phase 7 of the lease
“life cycle,” which discusses the guidance that a lessee would evaluate when
determining how it will derecognize a lease.
8.7.2 Lease Termination
ASC 842-20
40-1 A termination of a lease before the expiration of the lease term shall be accounted for by the lessee by removing the right-of-use asset and the lease liability, with profit or loss recognized for the difference.
When a lease is fully terminated before the expiration of the lease term,
irrespective of whether the lease is classified as a finance lease or an
operating lease, the lessee would derecognize the ROU asset and corresponding
lease liability. Any difference would be recognized as a gain or loss related to
the termination of the lease. Similarly, if a lessee is required to make any
payments or receives any consideration when terminating the lease, it would
include such amounts in the determination of the gain or loss upon
termination.
When a lease is partially22 terminated before the expiration of the lease term, the lessee would
account for the partial termination as a lease modification (see Section 8.6.3.7 for more
information). If a lessee is required to make any payments or receives any
consideration when terminating the lease, it would include such amounts in the
determination of the revised consideration in the modified contract (see
Section 8.6.3.7.1 for more information).
8.7.3 Purchase of the Underlying Asset
ASC 842-20
40-2 The termination of a lease that results from the purchase of an underlying asset by the lessee is not the type of termination of a lease contemplated by paragraph 842-20-40-1 but, rather, is an integral part of the purchase of the underlying asset. If the lessee purchases the underlying asset, any difference between the purchase price and the carrying amount of the lease liability immediately before the purchase shall be recorded by the lessee as an adjustment of the carrying amount of the asset. However, this paragraph does not apply to underlying assets acquired in a business combination, which are initially measured at fair value in accordance with paragraph 805-20-30-1.
The lessee’s purchase of the underlying asset is not a lease termination under ASC 842-20-40-1. Rather, when a lessee purchases the underlying asset, it would reclassify the ROU asset balance and adjust the carrying value of the purchased asset by the difference between the purchase price of the asset and the lease liability immediately before the purchase.
Underlying assets that are acquired as part of a business combination are not subject to the accounting
guidance in ASC 842-20-40-2. Rather, these assets would be initially measured at fair value in
accordance with ASC 805.
8.7.4 Subleasing When Original Lessee Is Relieved of Primary Obligation
ASC 842-20
40-3 If the nature of a sublease is such that the original lessee is relieved of the primary obligation under
the original lease, the transaction shall be considered a termination of the original lease. Paragraph 842-20-
35-14 addresses subleases in which the original lessee is not relieved of the primary obligation under the
original lease. Any consideration paid or received upon termination that was not already included in the lease
payments (for example, a termination payment that was not included in the lease payments based on the lease
term) shall be included in the determination of profit or loss to be recognized in accordance with paragraph
842-20-40-1. If a sublease is a termination of the original lease and the original lessee is secondarily liable, the
guarantee obligation shall be recognized by the lessee in accordance with paragraph 405-20-40-2.
Under ASC 842, a head lessee that enters into a sublease with another party must consider whether
(1) it has subleased the asset to the other party or (2) it has extinguished its head lease as a result of its
arrangement with the other party. This determination is governed by whether the lessee is relieved of
its primary obligation under the head lease, as described in ASC 842-20-40-3. Scenarios in which a head
lessee subleases the asset to another party are addressed in Section 12.3.
In a sublease scenario, when the intermediate lessor is relieved of its obligations under the head lease
(i.e., the original lease that a lessee has with a third-party lessor), the transaction would be considered a
termination of the head lease. In a manner consistent with the discussion in Section 12.3.2, the lessee/
intermediate lessor would derecognize the ROU asset and lease liability arising from the head lease
and would recognize any difference in profit or loss. Any additional consideration received or paid on
termination that was not already included in the lease payments would generally be included in the
calculation of the gain or loss resulting from the termination (e.g., a termination penalty not included in
the determination of the original lease liability).
When a sublease results in the termination of the original head lease and the original lessee remains
secondarily liable in the lease agreement, the lessee would recognize a guarantee obligation in
accordance with ASC 405. Specifically, ASC 405-20-40-2 states that “in those circumstances, whether or
not explicit consideration was paid for that guarantee, the original debtor becomes a guarantor.” As a
result, the guarantee obligation would be measured at fair value, with an offsetting adjustment to the
gain or loss recognized on terminating the lease.
In each scenario in which an intermediate lessor is relieved of its primary obligation under the original
head lease, the intermediate lessor would not be subject to sublease accounting. See Chapter 12 for
additional information about subleases.
Footnotes
22
A partial termination occurs when the parties in an
existing lease agree to terminate the lessee’s right to use (1) some of
the assets under the lease (e.g., discrete pieces of equipment) or (2) a
portion of an asset (e.g., one of several leased floors in an office
building).
8.8 Other Lessee-Related Matters
8.8.1 Master Lease Agreements
A master lease agreement may specify that the lessee will obtain control over multiple underlying
assets (e.g., equipment) at various points during the term of the agreement. In these cases, the lessee’s
accounting will depend on whether the master lease agreement obligates or commits the lessee to
use, and therefore obtain control of, a minimum quantity (units or dollars) of equipment. (See Sections
13.4.1 and 13.4.2, respectively, for additional information about situations in which a lessee is or is not
obligated or committed to use a minimum quantity of equipment.)
When a lessee obtains control of the use of additional underlying assets that
are subject to a master lease agreement and that agreement specifies a minimum
quantity or dollar amount, the lessee’s taking of control over the additional
assets would not be accounted for as a modification
unless the minimum quantity has already been achieved. In contrast, if the
agreement does not specify a minimum quantity or dollar value, the lessee’s
taking of control over the additional assets would always be accounted for as a
lease modification. See Section 8.6.4.2 for more information on the modification of
master lease agreements.
8.8.2 Leases Denominated in a Foreign Currency
ASC 842-20
55-10 The right-of-use asset is
a nonmonetary asset while the lease liability is a
monetary liability. Therefore, in accordance with
Subtopic 830-10 on foreign currency matters, when
accounting for a lease that is denominated in a foreign
currency, if remeasurement into the lessee’s functional
currency is required, the lease liability is remeasured
using the current exchange rate, while the right-of-use
asset is remeasured using the exchange rate as of the
commencement date.
Irrespective of lease classification, a lease liability
represents a monetary liability and an ROU asset represents a nonmonetary asset.
Therefore, in accordance with ASC 830-10, a lease liability and ROU asset
denominated in a foreign currency that are remeasured into an entity’s
functional currency would be accounted for in the following manner:
-
Lease liability — Remeasured by using the current-period exchange rate, with changes recognized in net income in a manner consistent with other foreign-currency-denominated liabilities (see guidance in ASC 830-20-35 for additional considerations).
-
ROU asset — Remeasured by using the historical exchange rate as of the commencement date, provided that the lease has not been modified. Questions have arisen regarding the exchange rate to be applied when a lease has been modified and the modification was not accounted for as a separate contract. See Section 8.8.2.2 for further details.
8.8.2.1 Foreign Exchange Rate Considerations Related to the Single Lease Cost in an Operating Lease
A lessee’s lease may be denominated in a foreign currency
(rather than in its functional currency). In such scenarios, the single
lease cost associated with an operating lease consists of two components:
(1) the expense associated with the accretion of the lease liability and (2)
the amount associated with the reduction of the ROU asset. Therefore, a
reasonable approach to recognizing the single lease cost would be to
bifurcate the cost into its two separate components (monetary and
nonmonetary) and account for the resulting amounts in accordance with ASC
830.
8.8.2.1.1 Lease Liability Accretion — Monetary Liability
In a manner consistent with the accounting for other
foreign-currency-denominated monetary liabilities, when remeasuring the
time-value-of-money component of the lease cost related to the lease
liability accretion, it would be appropriate for the lessee to use the
average exchange rate for the period.
8.8.2.1.2 ROU Asset Reduction — Nonmonetary Asset
In a manner consistent with the accounting for other
nonmonetary assets, when measuring the component of the lease cost
representing the change in the ROU asset in each period, it would be
appropriate for the lessee to use the historical exchange rate that was
used when the ROU asset was initially recognized. That is, the ROU asset
functional currency amount would be determined by using the foreign
currency rate that was in effect as of the date on which the ROU asset
was initially recognized (i.e., the latter of the date of initial
application of ASC 842 or the lease commencement date). Therefore, in
each period, the component of the lease cost representing the change in
the ROU asset balance is no longer considered a
foreign-currency-denominated amount; therefore, in each subsequent
period, this amount would be calculated by using the exchange rate
employed to initially determine the ROU asset and would not change
unless an impairment is recognized or the ROU asset is updated as a
result of a liability remeasurement event (e.g., a lease
modification).
8.8.2.2 Foreign Exchange Rate Considerations Related to Lease Modifications and Remeasurements
When an entity applies modification accounting under ASC
842, the modification can be accounted for either as the addition of a
separate contract (see Section 8.6.2) or as a change to the original lease (see
Section
8.6.3). As discussed further in Section 8.6.2, when a modification is
considered a separate contract, the lessee accounts for the separate
contract as if it were a stand-alone lease and applies the requirements of
ASC 842 to that discrete unit of account. Accordingly, in such
circumstances, a new lease liability and ROU asset are established for the
new separate contract and the exchange rate on the date of modification
would be applied to the new separate ROU asset resulting from the
modification.
On the other hand, if the modification is not accounted for
as a separate contract, the lessee would effectively account for the
modified arrangement as a new lease. That is, the lessee would reassess the
classification of the lease as of the effective date of the modification by
using the modified terms and conditions and would remeasure the lease
liability and, in most cases (excluding partial terminations of a lease),
recognize any difference between the new lease liability and the old lease
liability as an adjustment to the ROU asset (see Section 8.6.3.1). As stated in ASC
842-20-55-10, a lease liability represents a monetary liability and is
remeasured by using the current-period exchange rate. Therefore, when a
modification is not accounted for as a separate contract, the lessee would
continue remeasuring the lease liability by using the current-period
exchange rate.
However, an ROU asset represents a nonmonetary asset and
should therefore be remeasured by using the historical exchange rate as of
the commencement date. Questions have arisen regarding what rate should be
used — and how it should be used — to remeasure the postmodification ROU
asset and whether (1) the ROU asset, in its entirety, should be remeasured
by using the exchange rate as of the “new” lease commencement date (i.e.,
the date of the lease modification) or (2) the historical exchange rate as
of the original lease commencement date should be applied to the ROU asset
established before the modification and the exchange rate as of the date of
the lease modification should be applied to any increase in the ROU asset
resulting from the modification (i.e., a bifurcated approach to foreign
currency remeasurement).
Similarly, questions have arisen regarding what exchange
rate should be used upon the occurrence of any of the lease remeasurement
events described in ASC 842-10-35-4. As discussed in Section 8.5, some
lease remeasurement events are accounted for in a manner similar to lease
modifications (“Category A remeasurement events”), while others do not
result in a reassessment of lease classification, discount rate, or
stand-alone prices (“Category B remeasurement events”):
-
Category A remeasurement events — Change in the (1) lease term or (2) assessment of whether the lessee is reasonably certain to exercise a purchase option.
-
Category B remeasurement events — (1) Change in the amount that it is probable the lessee will owe under a residual value guarantee or (2) resolution of a contingency, as a result of which future variable lease payments become fixed.
8.8.2.2.1 View 1 — Exchange Rate as of “New” Lease Commencement Date Applied to Full ROU Asset for Modifications and Category A Remeasurement Events; Historical Exchange Rate Applied to ROU Asset for Category B Remeasurement Events
Proponents of View 1 observe that paragraph BC173 of ASU
2016-02 states, in part, that “[w]hen a modification does not meet the
criteria to be accounted for as a separate contract, the lessee
remeasures the lease liability for the modified, existing lease as of
the effective date of the modification as if the modified lease were a
new lease that commences on that date.” That is, paragraph BC173 of ASU
2016-02 indicates that a modification results in accounting in which the
modified lease is treated as the termination of the old lease and the
creation of a new lease. An entity could thus interpret this paragraph
as indicating that the effective date of the modification represents the
new lease commencement date. Therefore, the exchange rate as of the
effective date of the modification would represent the exchange rate in
effect as of the commencement date and should be used to remeasure the
ROU asset, in its entirety, on a go-forward basis. Application of the
updated rate to the entire ROU asset will most likely result in a
corresponding foreign exchange gain or loss as of the date of the
modification.
As discussed in Section 8.5, stand-alone prices,
discount rates, and lease classification are all reassessed upon the
occurrence of Category A remeasurement events, which are economically
similar to lease modifications and thus accounted for in a similar
manner under ASC 842. On the other hand, Category B remeasurement events
do not result in the reassessment of stand-alone prices, discount rates,
or lease classification. Proponents of View 1 argue that Category B
remeasurement events represent an updated measurement of an existing
lease rather than the creation of a new lease. Therefore, according to
this view, upon the occurrence of a Category A remeasurement event, an
updated exchange rate (as of the remeasurement date) should be applied
to the ROU asset in the same manner as a lease modification; however,
upon the occurrence of a Category B remeasurement event, the historical
exchange rate should continue to be applied to the entire ROU asset,
including to any increases or decreases in the ROU asset as a result of
the remeasurement event.
8.8.2.2.2 View 2 — Historical Exchange Rate Applied to ROU Asset Established Before Modification/Remeasurement and Updated Exchange Rate Applied to Increases Resulting From Modification/Remeasurement
Proponents of View 2 note that an entity that applies
View 1 will recognize a foreign exchange gain or loss to bring the ROU
asset to the new exchange rate. However, paragraph BC175 of ASU 2016-02
(shown below) indicates that a modification other than a full or partial
termination should not result in a gain or a loss because there has been
no actual “termination, fully or partially, of the original lease.”
Therefore, while paragraph BC173 of ASU 2016-02 indicates that an entity
should account for a modification as if the original lease were
terminated, paragraph BC175 of ASU 2016-02 indicates that a termination
has not truly occurred and that an entity therefore should not recognize
any gain or loss. Paragraph BC175 of ASU 2016-02 states:
The Board concluded that for the types of
modifications in paragraph BC174(a), a
lessee should not recognize a gain or loss from the
modification because there has been no termination, fully or
partially, of the original lease. Instead, the
modification solely changes the cost of the right-of-use asset
resulting from the original lease. Consequently, the amount of the remeasurement of the lease
liability for the modified lease is recorded as an
adjustment to the right-of-use asset and, no amount is
recognized in profit or loss. In deliberating this
guidance, the Board noted that a lease may be modified even if
the stated terms of the modification do not change the stated
terms of the lease. For example, a stated change in the
consideration to be paid for a nonlease component may change the
remaining lease payments because the lessee must allocate that
change in consideration on the same basis as the original
consideration in the contract was allocated. [Emphasis
added]
As a result, proponents of View 2 believe that it is
inappropriate to apply the exchange rate as of the lease modification
date to the full ROU asset, since doing so would result in recognition
of a gain or loss upon modification and paragraph BC175 of ASU 2016-02,
while not directly addressing foreign currency remeasurement, appears to
suggest that the FASB did not intend for this outcome to occur. Instead,
proponents of View 2 believe that the exchange rate as of the
modification date should only be applied to any increase in the ROU
asset resulting from the modification. In a manner consistent with
paragraph BC175 of ASU 2016-02, View 2 would not result in recognition
of a gain or loss upon modification. According to View 2, each
subsequent increase in the ROU asset as a result of a modification that
is not accounted for as a separate contract would be subject to the same
remeasurement model, and any subsequent decrease in the ROU asset as a
result of a modification would need to be evaluated to determine the
“layer(s)” to which the decrease is related.
The same approach would also be applied to both Category
A and Category B remeasurement events. For example, if the ROU asset
increases because variable payments become fixed, the increase would be
measured at the then-current exchange rate; however, the historical
exchange rate would continue to be applied to the previously recognized
ROU asset balance.
On the basis of formal discussions with the SEC staff,
we understand that either View 1 or View 2 is acceptable. Entities
should elect one of the two approaches as an accounting policy and apply
it consistently to all leases. In addition, entities should disclose the
accounting policy elected, if material. However, we understand that
these views should not be applied by analogy to revenue transactions
within the scope of ASC 606.
8.8.3 Accounting for Leasehold Improvements
8.8.3.1 Amortization of Leasehold Improvements
ASC 842-20
35-12 Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold
improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to
the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which
case the lessee shall amortize the leasehold improvements to the end of their useful life.
Pending Content (Transition Guidance: ASC 842-10-65-8)
35-12 Leasehold improvements, other than those accounted for in
accordance with paragraph 842-20-35-12A, shall be
amortized over the shorter of the useful life of
those leasehold improvements and the remaining
lease term, unless the lease transfers ownership
of the underlying asset to the lessee or the
lessee is reasonably certain to exercise an option
to purchase the underlying asset, in which case
the lessee shall amortize the leasehold
improvements to the end of their useful life.
35-12A Leasehold improvements
associated with a lease between entities under
common control shall be:
- Amortized over the useful life of those improvements to the common control group as long as the lessee controls the use of the underlying asset through a lease. If the lessor obtained the right to control the use of the underlying asset through a lease with another entity not within the same common control group, the amortization period shall not exceed the amortization period of the common control group determined in accordance with paragraph 842-20-35-12.
- Accounted for as a transfer between entities under common control through an adjustment to equity (net assets for a not-for-profit entity) when the lessee no longer controls the use of the underlying asset.
35-12B An
entity with leasehold improvements accounted for
in accordance with paragraph 842-20-35-12A shall
apply the impairment requirements in paragraph
360-10-40-4, considering the useful life to the
common control group.
35-12C If
after the commencement date the lessee and lessor
become within the same common control group or are
no longer within the same common control group,
any change in the required amortization period for
leasehold improvements shall be accounted for
prospectively as a change in accounting estimate
in accordance with paragraph 250-10-45-17.
Amounts attributable to leasehold improvements (i.e., improvements to leased
property, such as additions, alterations, remodeling, or renovations) are
recognized separately from the underlying ROU asset that is the subject of a
lease. A lessee is generally required to amortize leasehold improvements
over the shorter of their useful life or the lease term unless the
improvements are part of a common-control arrangement. (ASU 2023-01 amends
the guidance on how to amortize leasehold improvements in a common-control
arrangement. See Section 17.3.1.10.2 for further
discussion of these changes.) The useful life of an asset is the period over
which an asset is expected to contribute directly or indirectly to the
owner’s future cash flows. (Note that the lease term is the same term used
to determine lease classification.)
If the ownership of the underlying asset that is the subject of the lease agreement is transferred to the
lessee at the end of the lease term or if the lease agreement includes a purchase option whose exercise
by the lessee is reasonably certain, the leasehold improvements would be amortized over their useful
life. In this case, the lessee is not constrained by the lease term since it will be able to benefit from the
leasehold improvements beyond the lease term (provided that the useful life is greater than the lease
term).
If the lease arrangement automatically transfers title of
the leased asset to the lessee at the end of the lease term, or the lessee
has a purchase option such that purchase of the leased asset is reasonably
certain, an amortization period greater than the lease term, if shorter than
the economic life of the leasehold improvements, may be appropriate.
In addition, if the lessee determines that leasehold
improvements can be relocated or sold upon lease expiration without
significant diminution in fair value (including removal costs, such as
relocation costs), it may be appropriate to amortize the leasehold
improvements over the lease term to expected fair value. In such cases, all
facts and circumstances should be considered and companies should establish
an accounting policy that should be applied consistently to similar
transactions.
Connecting the Dots
Amortization of Leasehold Improvements Under ASC 842 Is
Consistent With That Under ASC 840
The amortization of leasehold improvements under ASC
842 is generally consistent with that under ASC 840. As a result,
entities may not be significantly affected by the guidance on
leasehold improvements in ASC 842. However, see Q&A
16-2C for considerations related to transition for
leasehold improvements with an amortization period greater than the
remaining lease term.
As noted above, ASU 2023-01 further amends the guidance on how to
amortize leasehold improvements in a common-control arrangement.
This ASU requires a lessee in a common-control lease arrangement to
amortize leasehold improvements that it owns over the improvements’
useful life to the common-control group, regardless of the lease
term, if the lessee continues to control the use of the underlying
asset through a lease.
As a reminder, leasehold improvements, as well as
other long-lived assets in an asset group (e.g., ROU assets arising
from a lease), are subject to impairment testing under ASC 360. See
Section
8.4.4 for additional information about the
application of the impairment guidance in ASC 360 to a lessee’s ROU
assets.
Importance of Determining Which Party Owns the
Property Improvements
Determining which party in the arrangement owns the
improvements that are made to a property subject to a lease is
important and affects the related accounting. For example, if a
lessee (or the lessor on behalf of the lessee) is making
improvements to a rented space for the purpose of building out the
space to be consistent with the lessee’s branding and owns such
improvements, any costs that are paid by the lessor with respect to
the buildout would generally be considered a lease incentive. In
contrast, if the overall lease agreement was for a fully built-out
space (e.g., a fully functioning office space with interior walls,
plumbing, and lighting) and the lessor owns the improvements, any
costs that are paid would generally be considered as part of the
overall asset subject to the lease.
Factors for an entity to consider when evaluating
whether the lessee or lessor owns the improvements include, but are
not limited to:
-
Whether the terms of the lease agreement obligate the tenant to construct or install specifically identified assets (i.e., the leasehold improvements) as a condition of the lease.
-
Whether the tenant’s failure to make specified improvements is an event of default under which the landlord can require the lessee to make those improvements or otherwise enforce the landlord’s rights to those assets (or a monetary equivalent).
-
Whether the tenant is permitted to alter or remove the leasehold improvements without the consent of the landlord or without compensating the landlord for any lost utility or diminution in fair value.
-
Whether the tenant is required to provide the landlord with evidence supporting the cost of tenant improvements before the landlord pays the tenant for the tenant improvements.
-
Whether the landlord is obligated to fund cost overruns for the construction of leasehold improvements.
-
Whether the leasehold improvements are unique to the tenant or could reasonably be used by the lessor to lease to other parties.
-
Whether the economic life of the leasehold improvements is such that a significant residual value of the assets is expected to accrue to the benefit of the landlord at the end of the lease term.
All factors for each lease must be carefully
evaluated; no one factor should be considered determinative.
8.8.3.2 Leasehold Improvements Acquired in a Business Combination
ASC 842-20
35-13 Leasehold improvements acquired in a business combination or an acquisition by a not-for-profit entity
shall be amortized over the shorter of the useful life of the assets and the remaining lease term at the date of
acquisition.
Pending Content (Transition Guidance: ASC 842-10-65-8)
35-13 Leasehold improvements acquired in a business combination,
acquired in an acquisition by a not-for-profit
entity, or recognized by a joint venture upon
formation shall be amortized over the shorter of
the useful life of the assets and the remaining
lease term at the date of acquisition.
ASC 805-20
35-6 Leasehold improvements acquired in a business combination shall be amortized over the shorter of the
useful life of the assets and the remaining lease term at the date of acquisition. However, if the lease transfers
ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to
purchase the underlying asset, the lessee shall amortize the leasehold improvements to the end of their useful
life.
In a manner similar to the guidance on a lessee’s accounting for leasehold improvements, an acquiree is
required to amortize any of the leasehold improvements acquired in a business combination “over the
shorter of the useful life” of those improvements or the lease term unless “the lease transfers ownership
of the underlying asset to the lessee” or it is reasonably certain that the lessee will exercise the “option
to purchase the underlying asset.” Therefore, when the lease transfers ownership of the underlying
asset to the lessee or if the lessee’s exercise of an option to purchase the underlying asset is reasonably
certain, it would be appropriate for the lessee to amortize the leasehold improvements over their
estimated useful life.
8.8.4 Lessee’s Accounting for Maintenance Deposits
ASC 842-20
55-4 Under certain leases (for example, certain equipment leases), a lessee is legally or contractually
responsible for repair and maintenance of the underlying asset throughout the lease term. Additionally,
certain lease agreements include provisions requiring the lessee to make deposits to the lessor to financially
protect the lessor in the event the lessee does not properly maintain the underlying asset. Lease agreements
often refer to these deposits as maintenance reserves or supplemental rent. However, the lessor is required
to reimburse the deposits to the lessee on the completion of maintenance activities that the lessee is
contractually required to perform under the lease agreement.
55-5 Under a typical arrangement, maintenance deposits are calculated on the basis of a performance measure, such as hours of use of the underlying asset, and are contractually required under the terms of the lease agreement to be used to reimburse the lessee for required maintenance of the underlying asset on the completion of that maintenance. The lessor is contractually required to reimburse the lessee for the maintenance costs paid by the lessee, to the extent of the amounts on deposit.
55-6 In some cases, the total cost of cumulative maintenance events over the term of the lease is less than the cumulative deposits, which results in excess amounts on deposit at the expiration of the lease. In those cases, some lease agreements provide that the lessor is entitled to retain such excess amounts, whereas other agreements specifically provide that, at the expiration of the lease agreement, such excess amounts are returned to the lessee (refundable maintenance deposit).
55-7 The guidance in paragraphs 842-20-55-8 through 55-9 does not apply to payments to a lessor that are not substantively and contractually related to maintenance of the leased asset. If at the commencement date a lessee determines that it is less than probable that the total amount of payments will be returned to the lessee as a reimbursement for maintenance activities, the lessee should consider that when determining the portion of each payment that is not addressed by the guidance in paragraphs 842-20-55-8 through 55-9.
55-8 Maintenance deposits paid by a lessee under an arrangement accounted for as a lease that are refunded only if the lessee performs specified maintenance activities should be accounted for as a deposit asset.
55-9 A lessee should evaluate whether it is probable that an amount on deposit recognized under paragraph 842-20-55-8 will be returned to reimburse the costs of the maintenance activities incurred by the lessee. When an amount on deposit is less than probable of being returned, it should be recognized in the same manner as variable lease expense. When the underlying maintenance is performed, the maintenance costs should be expensed or capitalized in accordance with the lessee’s maintenance accounting policy.
Leases of certain types of equipment (e.g., an aircraft lease) may dictate that the lessee is legally or contractually required to perform all of the repair and maintenance of the underlying asset throughout the lease term. These leases often include a requirement that a lessee make deposits to the lessor to financially protect the lessor in the event that the lessee does not perform the required repair and maintenance activities. In these cases, the lessor must refund the deposits (often referred to as maintenance reserves or supplemental rent) to the lessee upon the completion of the contractually required repairs and maintenance activities.
The maintenance deposits under these types of arrangements are generally determined on the basis of a usage performance measure (e.g., hours of flight in the case of an aircraft). In accordance with the contract terms and to the extent the amount is on deposit, the lessor must reimburse the lessee any amounts paid for the required repairs and maintenance of the underlying asset once the maintenance activities have been completed.
8.8.4.1 Accounting for Maintenance Deposits During the Lease Term
The accounting for maintenance deposits, from the lessee’s perspective, is directly linked to whether, at the end of the lease term, the lessor must refund any excess portion of the maintenance deposit not expended by the lessee for maintenance activities.
8.8.4.1.1 Refundable Maintenance Deposit
If a lessee is entitled to a
refund of any maintenance deposit excess at the end of the lease term (a
refundable maintenance deposit), all lease payment amounts attributable to
repair and maintenance activities will be recognized as a deposit asset by
the lessee. Therefore, as the lessee makes a payment that is attributable to
the refundable maintenance deposit, it will recognize the following journal
entries:
As the lessee performs the
required repair and maintenance activities, it will be reimbursed by the
lessor for these costs by using the amounts on deposit. At the end of the
lease term, any remaining amounts returned to the lessee will offset the
deposit asset. Therefore, the lessee would recognize the following entries
during the term of the agreement and at the end of the lease term (in this
example, we have assumed that the lessee’s policy is to expense the
maintenance costs as incurred):
Repair and maintenance
activities (during term)
Residual balance returned
(end of the lease term)
In addition, to the extent
that the arrangement provides for interest on the deposit, any interest
earned on the refundable maintenance deposit that the lessee forgoes (i.e.,
that the lessor is entitled to retain) should be considered a variable lease
payment and would be recognized in the following manner:
Nonrefundable maintenance deposit
If a lessee is not entitled to a refund of the maintenance
deposit excess at the end of the lease term, at lease commencement, the
lessee must evaluate whether it is less than probable that the total amount
of payments will ultimately be reimbursed over the lease term through the
repair and maintenance activity requests.
Any amounts paid to the
lessor for repair and maintenance activities whose return is not deemed
probable should be accounted for in a manner similar to variable lease
expense (i.e., recognized in profit and loss in the period in which the
obligation for those payments is incurred). Any amounts paid to the lessor
for repair and maintenance activities whose return is deemed probable should
be recognized as a deposit asset that will be used to reimburse the lessee
as such activities are performed. Therefore, as the lessee makes a payment
that is attributable to the nonrefundable maintenance deposit, it records
the following journal entries (in this example, we have assumed that the
lessee’s policy is to expense the maintenance costs as incurred):
Nonrefundable deposit
recognition
The concept of probability should continually be reassessed
over the lease term and if no longer deemed probable, the deposit asset
should be reduced by recognizing variable lease expense.
Irrespective of whether the maintenance deposit is
refundable or nonrefundable, as the actual repair and maintenance activities
are performed, the lessee would capitalize or expense these costs in
accordance with its maintenance capitalization policy.
Connecting the Dots
Maintenance Deposits Versus
Other Deposits
Considerations Related to Refundable
Deposits
Refundable maintenance deposits are deferred and
recognized as a deposit asset until the actual repairs and
maintenance activities are performed during the lease term. Other
refundable deposits retained by the lessor (e.g., for other reasons
such as excess wear and tear on the underlying asset) would
generally be considered a variable lease payment. 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 for further
details).
Considerations Related to Nonrefundable
Deposits
Nonrefundable maintenance deposits are accounted for
in the following manner: (1) amounts whose use is probable are
deferred and recognized as a deposit asset until the actual repairs
and maintenance activities are performed during the lease term and
(2) amounts whose return is less than probable are recognized as a
variable lease cost when return is no longer deemed probable. In
contrast, other types of nonrefundable deposits are considered lease
payments and included in the determination of the lease
liability.
See Section 6.1 for additional
discussion of other refundable and nonrefundable deposits.
8.9 Codification Examples
ASC 842-20
55-21 Example 3 illustrates how a lessee would initially and subsequently measure right-of-use assets and
lease liabilities and how a lessee would account for a change in the lease term.
55-40 Example 4 illustrates how a lessee would recognize lease cost in an operating lease and initially and
subsequently measure right-of-use assets and lease liabilities for that lease.
The examples below from ASC 842-20-55-21 through 55-46 and ASC 842-10-55-211 through 55-224
reflect various aspects of the lessee accounting model. 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.
8.9.1 Lease Recognition, Initial and Subsequent Measurement, and Reassessment of Lease Term
The examples below from ASC 842-20-55-21 through 55-46 reflect implementation considerations
related to the guidance in ASC 842-20-25-1 through 35-15 on a lessee’s recognition and initial and
subsequent measurement of its leases as well as the reassessment of the lease term under the new
lease accounting requirements.
Example 3 illustrates a lessee’s recognition and initial and subsequent measurement of its leases as
well as the reassessment of lease term in the context of both a finance lease and an operating lease.
Example 4 comprehensively illustrates the recognition and initial and subsequent measurement of an
operating lease by a lessee.
8.9.1.1 Example 3 — Initial and Subsequent Measurement by a Lessee and Accounting for a Change in the Lease Term
ASC 842-20
Example 3 — Initial and Subsequent Measurement by a Lessee and Accounting for a
Change in the Lease Term
Case A — Initial and Subsequent Measurement of the Right-of-Use Asset and the
Lease Liability
55-22 Lessee enters into a 10-year lease of an asset, with an option to extend for an additional 5 years. Lease
payments are $50,000 per year during the initial term and $55,000 per year during the optional period, all
payable at the beginning of each year. Lessee incurs initial direct costs of $15,000.
55-23 At the commencement date, Lessee concludes that it is not reasonably certain to exercise the option to
extend the lease and, therefore, determines the lease term to be 10 years.
55-24 The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5.87
percent, which reflects the fixed rate at which Lessee could borrow a similar amount in the same currency, for
the same term, and with similar collateral as in the lease at the commencement date.
55-25 At the commencement date, Lessee makes the lease payment for the first year, incurs initial direct costs,
and measures the lease liability at the present value of the remaining 9 payments of $50,000, discounted at
the rate of 5.87 percent, which is $342,017. Lessee also measures a right-of-use asset of $407,017 (the initial
measurement of the lease liability plus the initial direct costs and the lease payment for the first year).
55-26 During the first year of the lease, Lessee recognizes lease expense depending on how the lease is classified. Paragraphs 842-20-55-27 through 55-30 illustrate the lease expense depending on whether the lease is classified as a finance lease or as an operating lease.
If the Lease Is Classified as a Finance Lease
55-27 Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset would be amortized on a straight-line basis over the 10-year lease term. The lease liability is increased to reflect the Year 1 interest on the lease liability in accordance with the interest method. As such, in Year 1 of the lease, Lessee recognizes the amortization expense of $40,702 ($407,017 ÷ 10) and the interest expense of $20,076 (5.87% × $342,017).
55-28 At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076), and the carrying amount of the right-of-use asset is $366,315 ($407,017 – $40,702).
If the Lease Is Classified as an Operating Lease
55-29 Lessee determines the cost of the lease to be $515,000 (sum of the lease payments for the lease term and initial direct costs incurred by Lessee). The annual lease expense to be recognized is therefore $51,500 ($515,000 ÷ 10 years).
55-30 At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076), and the carrying amount of the right-of-use asset is $375,593 (the carrying amount of the lease liability plus the remaining initial direct costs, which equal $13,500).
Case B — Accounting for a Change in the Lease Term
55-31 At the end of Year 6 of the lease, Lessee makes significant leasehold improvements. Those improvements are expected to have significant economic value for Lessee at the end of the original lease term of 10 years. The improvements result in the underlying asset having greater utility to Lessee than alternative assets that could be leased for a similar amount and that are expected to have significant economic life beyond the original lease term. Consequently, construction of the leasehold improvements is deemed a significant event or significant change in circumstances that directly affects whether Lessee is reasonably certain to exercise the option to extend the lease and triggers a reassessment of the lease term. Upon reassessing the lease term, at the end of Year 6, Lessee concludes that it is reasonably certain to exercise the option to extend the lease for five years. Taking into consideration the extended remaining lease term, Lessee’s incremental borrowing rate at the end of Year 6 is 7.83 percent. As a result of Lessee’s remeasuring the remaining lease term to nine years, Lessee also would remeasure any variable lease payments that depend on an index or a rate; however, in this Example, there are no variable lease payments that depend on an index or a rate. In accordance with paragraph 842-10-25-1, Lessee reassesses the lease classification as a result of the change in the lease term. Assume for purposes of this Example that the reassessment does not change the classification of the lease from that determined at the commencement date.
55-32 At the end of Year 6, before accounting for the change in the lease term, the lease liability is $183,973 (present value of 4 remaining payments of $50,000, discounted at the rate of 5.87 percent). Lessee’s right-of-use asset is $162,807 if the lease is classified as a finance lease or $189,973 if the lease is classified as an operating lease (the balance of the remeasured lease liability at the end of Year 6 plus the remaining initial direct costs of $6,000).
55-33 Lessee remeasures the lease liability, which is now equal to the present value of 4 payments of $50,000 followed by 5 payments of $55,000, all discounted at the rate of 7.83 percent, which is $355,189. Lessee increases the lease liability by $171,216, representing the difference between the remeasured liability and its current carrying amount ($355,189 – $183,973). The corresponding adjustment is made to the right-of-use asset to reflect the cost of the additional rights.
55-34 Following the adjustment, the carrying amount of Lessee’s right-of-use asset is $334,023 if the lease is a
finance lease (that is, $162,807 + $171,216) or $361,189 if the lease is an operating lease (that is, $189,973 +
$171,216).
55-35 Lessee then makes the $50,000 lease payment for Year 7, reducing the lease liability to $305,189
($355,189 – $50,000), regardless of how the lease is classified.
55-36 Lessee recognizes lease expense in Year 7 as follows, depending on how the lease had been classified at
the commencement date.
If the Lease Is Classified as a Finance Lease at the Commencement Date
55-37 Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset will
be amortized on a straight-line basis over the lease term. The lease liability will be reduced in accordance
with the interest method. As such, in Year 7 (the first year following the remeasurement), Lessee recognizes
amortization expense of $37,114 ($334,023 ÷ 9) and interest expense of $23,896 (7.83% × $305,189).
If the Lease Is Classified as an Operating Lease at the Commencement Date
55-38 Lessee determines the remaining cost of the lease as the sum of the following:
- The total lease payments, as adjusted for the remeasurement, which is the sum of $500,000 (10 payments of $50,000 during the initial lease term) and $275,000 (5 payments of $55,000 during the term of the lease extension); plus
- The total initial direct costs attributable to the lease of $15,000; minus
- The periodic lease cost recognized in prior periods of $309,000.
55-39 The amount of the remaining cost of the lease is therefore $481,000 ($775,000 + $15,000 – $309,000).
Consequently, Lessee determines that the annual expense to be recognized throughout the remainder of the
lease term is $53,444 ($481,000 ÷ the remaining lease term of 9 years).
8.9.1.2 Example 4 — Recognition and Initial and Subsequent Measurement by a Lessee in an Operating Lease
ASC 842-20
Example 4 — Recognition and Initial and Subsequent Measurement by a Lessee in an
Operating Lease
55-41 Lessee enters into a 10-year lease for 5,000 square feet of office space. The annual lease payment
is $10,000, paid in arrears, and increases 5 percent each year during the lease term. Lessee’s incremental
borrowing rate at lease commencement is 6 percent. Lessee classifies the lease as an operating lease in
accordance with paragraphs 842-10-25-2 through 25-3. Lessee incurs initial direct costs of $5,000.
55-42 At the commencement date, Lessee receives a $10,000 cash payment from Lessor that Lessee accounts
for as a lease incentive. Lessee measures the lease liability at the present value of the 10 remaining lease
payments ($10,000 in Year 1, increasing by 5 percent each year thereafter), discounted at the rate of 6 percent,
which is $90,434. Lessee also measures a right-of-use asset of $85,434 (the initial measurement of the lease
liability + the initial direct costs of $5,000 – the lease incentive of $10,000).
55-43 During the first year of the lease, Lessee determines the remaining cost of the lease as the sum of the following:
- The total lease payments of $115,779 (the sum of the 10 escalating payments to Lessor during the lease term of $125,779 − the lease incentive paid to Lessee at the commencement date of $10,000)
- The total initial direct costs attributable to the lease of $5,000.
The amount of the remaining lease cost is therefore $120,779 ($115,779 + $5,000). Consequently, Lessee determines that the single lease cost to be recognized every year throughout the lease term is $12,078 ($120,779 ÷ 10 years). This assumes that there are no remeasurements of the lease liability or modifications to the lease throughout the lease term.
55-44 At the end of Year 1, the carrying amount of the lease liability is $85,860 (9 remaining lease payments, discounted at the rate of 6 percent), and the carrying amount of the right-of-use asset is the amount of the liability, adjusted for the following:
- Accrued lease payments of $2,578 (the amount of payments to Lessor to be recognized as part of the single lease cost each year during the lease of $12,578 [total payments to Lessor of $125,779 ÷ 10 years] − the first year’s lease payment of $10,000)
- Unamortized initial direct costs of $4,500 (gross initial direct costs of $5,000 – amounts recognized previously as part of the single lease cost of $500 [total initial direct costs of $5,000 ÷ 10 years])
- The remaining balance of the lease incentive of $9,000 (gross lease incentive of $10,000 – amounts recognized previously as part of the single lease cost of $1,000 [total lease incentives of $10,000 ÷ 10 years]).
Therefore, at the end of Year 1, Lessee measures the right-of-use asset at the amount of $78,782 ($85,860 – $2,578 + $4,500 – $9,000).
55-45 At the beginning of Year 2, Lessee determines the remaining cost of the lease to be $108,701 (the total lease payments of $115,779 + the total initial direct costs of $5,000 – the single lease cost recognized in Year 1 of $12,078). The single lease cost to be recognized in Year 2 is still $12,078 ($108,701 ÷ 9 years). For the purposes of the Example, only the first two years’ determination of the single lease cost are shown. However, the single lease cost will be determined in the same way as in Years 1 and 2 for the remainder of the lease and, in this Example, will continue to equal $12,078 every period for the remainder of the lease term assuming that there are no remeasurements of the lease liability or modifications to the lease.
55-46 At the end of Year 2, the carrying amount of the lease liability is $80,511, and the carrying amount of the right-of-use asset is $71,855 (the carrying amount of the lease liability of $80,511 – the accrued lease payments of $4,656 + the unamortized initial direct costs of $4,000 – the remaining balance of the lease incentive received of $8,000). For the purposes of the Example, the subsequent measurement of the lease liability and the subsequent measurement of the right-of-use asset are shown only for the first two years. However, Lessee will continue to measure the lease liability and the right-of-use asset for this lease in the same manner throughout the remainder of the lease term.
8.9.2 Accounting for Purchase Options
The examples below from ASC 842-10-55-211 through 55-224 reflect implementation considerations related to a lessee’s accounting for purchase options, as discussed in ASC 842-10-30-3 (see Section 5.3 for additional information).
Examples 23 and 24 illustrate a lessee’s initial and subsequent measurement of a
finance lease as a result of the determination, at lease commencement, that the
exercise of the purchase option in the contract was deemed reasonably certain.
The examples also illustrate the accounting impact of the lessee’s exercise of
the purchase option at the end of year 5 and the subsequent settlement of the
lease liability and reclassification of the ROU asset to PP&E on the date of
the option’s exercise.
8.9.2.1 Example 23 — Lessee Purchase Option
ASC 842-10
Example 23 — Lessee Purchase Option
55-211 Lessee enters into a 5-year lease of equipment with annual lease payments of $59,000, payable at the
end of each year. There are no initial direct costs incurred by Lessee or lease incentives. At the end of Year 5,
Lessee has an option to purchase the equipment for $5,000. The expected residual value of the equipment at
the end of the lease is $75,000. Because the exercise price of the purchase option is significantly discounted
from the expected fair value of the equipment at the time the purchase option becomes exercisable, Lessee
concludes that it is reasonably certain to exercise the purchase option. The fair value of the equipment at the
commencement date is $250,000, and its economic life is 7 years. The discount rate for the lease, which is
Lessee’s incremental borrowing rate because the rate implicit in the lease is not available, is 6.5 percent.
55-212 Because the lease grants Lessee an option to purchase the underlying asset that it is reasonably certain
to exercise, Lessee classifies the lease as a finance lease.
55-213 Lessee recognizes the lease liability at the commencement date at $248,834 (the present value of 5
payments of $59,000 + the present value of the $5,000 payment for the purchase option, discounted at 6.5%).
Because there are no initial direct costs, lease incentives, or other payments made to Lessor at or before the
commencement date, Lessee recognizes the right-of-use asset at the same amount as the lease liability.
55-214 Lessee amortizes the right-of-use asset over the seven-year expected useful life of the equipment,
rather than over the lease term of five years, because Lessee is reasonably certain to exercise the option to
purchase the equipment. Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset is amortized on a straight-line basis.
55-215 During the first year of the lease, Lessee recognizes interest expense on the lease liability of $16,174
(6.5% × $248,834) and amortization of the right-of-use asset of $35,548 ($248,834 ÷ 7).
55-216 At the end of Year 1, the right-of-use asset is $213,286 ($248,834 – $35,548), and the lease liability is
$206,008 ($248,834 + $16,174 – $59,000).
55-217 At the end of Year 5, the carrying amount of the right-of-use asset is $71,094 ($248,834 – [$35,548
× 5]), and the remaining lease liability is $5,000, which is the exercise price of the purchase option. Lessee
exercises the purchase option and settles the remaining lease liability. If the right-of-use asset was not
previously presented together with property, plant, and equipment, Lessee reclassifies the right-of-use asset to
property, plant, and equipment and applies Topic 360 to the asset beginning on the date the purchase option
is exercised.
8.9.2.2 Example 24 — Lessee Purchase Option
ASC 842-10
Example 24 — Lessee Purchase Option
55-218 Lessee enters into a 5-year lease of specialized equipment with annual lease payments of $65,000, payable in arrears. There are no initial direct costs or lease incentives. At the end of Year 5, Lessee has an option to purchase the equipment for $90,000, which is the expected fair value of the equipment at that date. Lessor constructed the equipment specifically for the needs of Lessee. Furthermore, the specialized equipment is vital to Lessee’s business; without this asset, Lessee would be required to halt operations while a new asset was built or customized. As such, Lessee concludes that it is reasonably certain to exercise the purchase option because the specialized nature, specifications of the asset, and its role in Lessee’s operations create a significant economic incentive for Lessee to do so. The fair value of the equipment at the commencement date is $440,000, and its economic life is 10 years. Lessee’s incremental borrowing rate is 6.5 percent, which reflects the fixed rate at which Lessee could borrow an amount similar to that of the lease payments ([$65,000 × 5 lease payments] + the $90,000 purchase option exercise price = $415,000) in the same currency, for the same term, and with similar collateral as in the lease at the commencement date.
55-219 The lease grants Lessee an option to purchase the underlying asset that it is reasonably certain to exercise. In addition, the underlying asset is of such a specialized nature that it is expected to have no alternative use to Lessor at the end of the lease term. As such, Lessee classifies the lease as a finance lease.
55-220 Lessee recognizes the lease liability at the commencement date at $335,808 (the present value of 5 payments of $65,000 + the present value of the $90,000 payment for the purchase option to be made at the end of Year 5, discounted at 6.5%). Because there are no initial direct costs, lease incentives, or other payments made to Lessor at or before the commencement date, Lessee recognizes the right-of-use asset at the same amount as the lease liability.
55-221 Lessee amortizes the right-of-use asset over the 10-year expected useful life of the equipment rather than over the lease term of 5 years, because Lessee is reasonably certain to exercise the option to purchase the equipment. Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset is amortized on a straight-line basis.
55-222 During the first year of the lease, Lessee recognizes interest expense on the lease liability of $21,828 (6.5% × $335,808) and amortization of the right-of-use asset of $33,581 ($335,808 ÷ 10).
55-223 At the end of Year 1, the right-of-use asset is $302,227 ($335,808 – $33,581), and the lease liability is $292,636 ($335,808 + $21,828 – $65,000).
55-224 At the end of Year 5, the carrying amount of the right-of-use asset is $167,903 ($335,808 – $33,581 × 5), and the remaining lease liability is $90,000, which is the amount of the purchase option. Lessee exercises the option to purchase the equipment and settles the remaining lease liability. If the right-of-use asset was not previously presented together with property, plant, and equipment, Lessee reclassifies the right-of-use asset to property, plant, and equipment and will apply Topic 360 to the equipment beginning on the date the purchase option is exercised.