Deloitte's Roadmap: Leases
Preface
Preface
We are pleased to present the 2023 edition of Leases (the
“Roadmap”). Since the issuance of ASU 2016-021 (codified in ASC 842) on February 25, 2016, the FASB has continued to discuss
and make updates to ASC 842 on the basis of implementation questions raised,
challenges identified by stakeholders, and the Board’s postimplementation review
process.2
The body of the Roadmap combines the requirements in ASC 842 with
Deloitte’s interpretations and examples in a comprehensive, reader-friendly format.
In addition, the Roadmap highlights (1) the requirements of ASC 842 that
significantly differ from those in ASC 840 and IFRS 16 and (2) recent
standard-setting developments (through September 15, 2023). In this Roadmap, it is
assumed that ASU 2018-20 has been adopted or is being adopted in connection with an
entity’s adoption of ASC 842.
We hope that this publication will enable entities to deal with some of the more
challenging aspects of ASC 842. This publication has been developed for readers who
have been following every development of the standard as well as for those who are
working through the new guidance for the first time. That is, it may function as a
quick resource guide for those who have a specific question and are looking for a
clear answer, or it may serve as an all-encompassing guide for those who are still
building up their knowledge base related to the new leasing standard.
Although the mandatory effective date for public companies has
passed, challenging questions remain, and we expect new implementation questions to
continue emerging. Accordingly, we will continue to develop guidance to help
stakeholders with implementation.
Note that in this year's update of the Roadmap, we have continued
our process of converting text that was previously in Q&A format into regular
text format. Although not all Q&As are being converted this year, we expect to
convert the remaining ones as part of subsequent updates. See Appendix H for a mapping of
the Q&As (and example renumbering as applicable) that have been converted thus
far to their respective new sections for 2023.
Further, the updated edition of this Roadmap includes some new
interpretations and certain modifications to previously expressed views to reflect
our latest thinking as well as input from standard setters and regulators. Appendix I highlights all new
content as well as any substantive revisions to previous content.
Be sure to check out On the
Radar (also available as a
stand-alone publication), which
briefly summarizes emerging issues and trends related to the
accounting and financial reporting topics addressed in the
Roadmap.
We encourage you to use this Roadmap as a guide throughout your
application of ASC 842 and to contact us with any questions or suggestions for
future improvements. However, the Roadmap is not a substitute for consulting with
Deloitte professionals on complex accounting questions and transactions.
We hope that you find this Roadmap helpful in achieving a successful
adoption of the new guidance as well as in navigating the ongoing accounting
requirements for leases after adoption.
Footnotes
1
For a list of the titles of standards and other literature
referred to in this publication, see Appendix F. For a list of
abbreviations used in this publication, see Appendix G.
2
For a complete list of proposed and final ASUs and more
information about how the ASUs issued amend certain aspects of ASC 842, see
Chapter
17.
Videos in This Roadmap
Process for Identifying a Lease
Periods Covered by Options
Lease Classification Criteria
Sections 8.3.3
and 9.2
Accounting for Modifications
Lessor’s Accounting for Certain Leases With
Variable Payments
On the Radar
On the Radar
The current macroeconomic environment has created ongoing challenges and uncertainty
in various areas of accounting, including the accounting for leases. For example,
the U.S. 30-year fixed mortgage rate has nearly doubled since 2016, the year in
which ASC 842 was issued.1
Many commercial real estate entities have encountered increased costs of capital and
tightening lending standards while also dealing with higher levels of maturing debt;
reductions in the volume of real estate transactions; and evolving real estate
demands and preferences related to the way people work, live, and shop. The actual
impact of the current macroeconomic environment on commercial real estate assets
will differ on the basis of various factors, including geographic location,
tenant-specific operations, and in-place lease terms. Commercial real estate
entities, including real estate owners, operators, and developers, should
continually monitor, evaluate, and update their lease-related accounting and
reporting.
Lease Accounting Hot Topics for Entities That Have Adopted ASC 842
Real Estate Rationalization
The COVID-19 pandemic ignited a shift in how entities in
almost every industry sector are doing business. Many entities are
reevaluating where their employees conduct their required business
activities and to what extent they will rely on the use of brick-and-mortar
real estate assets on a go-forward basis. Specifically, many entities have
initiated a real estate rationalization program to reevaluate their
organization-wide real estate footprint. The goal of initiating such
programs may be for entities to rightsize their real estate portfolios to
manage costs while adequately supporting their evolving business needs. In
addition to the macroeconomic challenges and uncertainty mentioned above,
expectations related to hybrid-work approaches have led to increased vacancy
rates for office properties in certain locales.
We have also observed an increase in entities abandoning
properties, subleasing space they are no longer using, or modifying existing
leases to change the amount of space or the lease term. Further, as a
financing method to improve their liquidity, entities are increasingly
entering into sale-and-leaseback transactions involving real estate. As a
result of these real estate rationalization efforts, companies are also more
frequently evaluating leases for impairment. Each of these topics is
addressed below and within this publication. Note that the accounting
considerations below apply to entities that have already adopted ASC
842.
See Deloitte’s March 30, 2021, Accounting
Spotlight and May 22, 2023,
Financial Reporting
Alert for further details on the
impact of real estate rationalization and commercial
real estate macroeconomic trends, respectively, on
an entity’s lease accounting.
Impairment and Abandonment
The right-of-use (ROU) assets recorded on a lessee’s
balance sheet under ASC 842 are subject to the ASC 360-10 impairment
guidance applicable to long-lived assets. When events or changes in
circumstances indicate that the carrying amount of the asset group may
not be recoverable (i.e., impairment indicators exist), the asset group
should be tested to determine whether an impairment exists. The decision
to change the use of a property subject to a lease could be an
impairment indicator. See Section 8.4.4 for more information
about the two-step impairment process.
Although the existence of an impairment indicator would
not itself be a reason for a lessee to reevaluate the lease term for
accounting purposes, an entity should consider whether any of the
reassessment events in ASC 842-10-35-1 have occurred simultaneously with
the impairment indicator. See Section 5.4.1.2 for
further discussion of the relationship between these concepts.
The guidance in ASC 360-10 on accounting for abandoned long-lived assets
also applies to ROU assets. 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 but still has a contractual obligation under the
underlying lease, the lessee needs to evaluate whether the ROU asset has
been or will be abandoned. Abandonment accounting only applies when the
underlying property subject to a lease is no longer used for any
business purposes, including storage. If the lessee intends to use the
space at a future time or retains the intent and ability
to sublease the property, abandonment accounting would be
inappropriate.
Common Pitfall
We have seen some companies
assert that they are abandoning the property, even
though it is only temporarily idled, or that they
may still be using it for minor operational needs
or may have the intent and ability to sublease it.
Under these circumstances, abandonment accounting
would not be appropriate. An entity may need to
use significant judgment in evaluating whether
abandonment has occurred, and a high bar has been
set for concluding that a property has been
abandoned.
In our experience, establishing management’s intent regarding subleasing
involves judgment and depends on various facts and circumstances, such
as the remaining lease term, the nature of the property, and the level
of demand in the rental market. For example, it may be reasonable to
conclude that an ROU asset is subject to abandonment accounting when the
remaining lease term is shorter and the rental market is, and is
expected to remain, weak. On the other hand, it may be more challenging
to conclude that management has forgone the opportunity to sublease the
property if the remaining lease term is longer, given the increased
uncertainty about the level of demand in the rental market over a longer
time horizon. It may be particularly difficult to reach such a
conclusion in the current environment given the uncertainties related to
the duration of the COVID-19 pandemic and its impact on the real estate
strategy of other market participants going forward. There are no bright
lines regarding the duration of the remaining lease term in this
analysis, and the exercise could differ from one rental market to the
next. We would also expect specialized properties to be more difficult
to sublease than more generic properties such as retail shopping units
and office space. Entities should carefully evaluate their specific
facts and circumstances when determining whether the ASC 360 abandonment
accounting applies to the ROU asset.
Subleases
A lessee may enter into a sublease if the lessee no
longer wants to use the underlying asset but has identified a third
party to which the asset will be leased. In a sublease, the original
lease between the lessor and the original lessee (i.e., the head lease)
typically remains in effect and the original lessee becomes the
intermediate lessor. Generally, the lessee/intermediate lessor should
account for the head lease and the sublease as separate contracts and
should consider whether the sublease changes the lease term of the head
lease or its classification. The head lessor’s accounting is unaffected
by the existence of the sublease. See Chapter 12 for additional guidance
on accounting for sublease arrangements.
Modification of Existing Lease Arrangements
In the current environment, tenants may negotiate with
lessors to exit early from a leased space, decrease the amount of leased
space, or terminate the lease in its entirety. Some lessees are
modifying existing lease agreements by (1) eliminating or scaling back
office space as a result of hybrid models in a post-pandemic working
environment and (2) reducing space because of changes in the current
environment to cut or maintain costs. The accounting for a lease
modification under ASC 842 depends on whether the modification is
accounted for as a separate contract as well as the nature of the
modification.
Common Pitfall
Many amended contracts describe
a lease amendment as an early termination. In
evaluating these types of amendments, a lessee
must determine whether the amendment is actually a
modification to reduce the lease term. If a
termination takes effect after a specified period
(even a relatively short period), the lessee still
has the right to use the leased asset for that
period. In such cases, the modification consists
of a reduction in the lease term rather than a
full or partial termination. The guidance on full
or partial terminations only applies when all or
part of the lessee’s right of use ceases
contemporaneously with the execution of the
modification (i.e., the space is immediately
vacated). As a reminder, an immediate charge to
the income statement is only appropriate when the
lease is fully or partially terminated.
Evaluation of Lease Options
When determining the lease term at lease commencement, an entity
should determine the noncancelable period of a lease, which includes
lessee renewal option periods whose exercise is believed to be
reasonably certain (and includes lessee termination option periods
when exercise is reasonably certain not to occur). The likelihood of
whether a lessee will be economically compelled to exercise or not
exercise an option to renew or terminate a lease is evaluated at
lease commencement. In performing this assessment, an entity would
consider contract-based, asset-based, entity-based, and market-based
factors (e.g., the market rental rates for comparable assets), which
may be affected by changes in the macroeconomic environment.
A lessor would not reassess the lease term unless the lease is
modified and the modification is not accounted for as a separate
contract.
See Sections 5.2 and 5.4 for
further discussion of the impact of options on lease term.
Sale-and-Leaseback Arrangements
A sale-and-leaseback transaction is a common and
important financing method for many entities and involves the transfer
of a property by the owner (“seller-lessee”) to an acquirer
(“buyer-lessor”) and a transfer of the right to control the use of that
same asset back to the seller-lessee for a certain period.
It is important for an entity to evaluate the provisions
of any sale-and-leaseback arrangement since the contract terms may
significantly affect the accounting. For example, the seller-lessee
would not be able to derecognize the underlying asset (i.e., a failed
sale) or recognize any associated gain or loss on the sale if (1) the
contract includes a provision that grants the original owner (future
tenant) an option to repurchase the property or (2) the leaseback would
be classified as a finance lease. Rather, both parties would account for
the transaction as a financing arrangement. The below graphic outlines
key considerations related to the accounting for a sale-and-leaseback
arrangement. See Chapter 10 for more information.
Lease Collectibility
In addition to the impairment considerations described above, lessors
should be aware that net investments in leases (arising from sales-type
and direct financing leases) are subject to the CECL impairment model,
which is based on expected losses rather than historical incurred
losses. See Section 5.3 of
Deloitte’s Roadmap Current Expected Credit
Losses for further discussion of the application
of the CECL model to lease receivables.
Lessors with outstanding operating lease receivables must apply the
collectibility model under ASC 842-30. Entities should apply this
collectibility model in a timely manner in the period in which amounts
under the lease agreement are due. Under the ASC 842-30 collectibility
model, an entity continually evaluates whether it is probable that
future operating lease payments will be collected on the basis of the
individual lessee’s credit risk. When collectibility of the lease
payments is probable, the lessor will apply an accrual method of
accounting. When collectibility is not probable, the lessor will limit
lease income to the cash received, as described in ASC 842-30-25-13.
Entities should continue to assess the impact of the current environment
when determining whether to move tenants either to or from this cash
basis of accounting as opposed to the accrual method of accounting.
Ongoing Accounting Standard-Setting Activities
Since the issuance of ASU 2016-02 several years ago, the
FASB has released various ASUs to provide additional transition relief and make
certain technical corrections and improvements to the standard. See Chapter 17 for details on
these ASUs and current FASB projects.
Most recently, in March 2023, the FASB issued ASU 2023-01, which amends certain provisions of ASC 842
that apply to arrangements between related parties under common control. ASU
2023-01 allows non-PBEs, as well as not-for-profit entities that are not conduit
bond obligors, to make an accounting policy election of using the written terms
and conditions of a common-control arrangement when determining whether a lease
exists, as well as the accounting for the lease (including lease
classification), on an arrangement-by-arrangement basis. Accordingly, a non-PBE,
as well as a not-for-profit entity that is not a conduit bond obligor, that
makes this election may not be required to consider the legal enforceability of
such written terms and conditions, as described above.
ASU 2023-01 also amends the accounting for leasehold improvements in
common-control arrangements for all entities.
See Section 17.3.1.10 for more
information.
The FASB continues
to evaluate stakeholder feedback on the adoption of
ASC 842. Chapter 17
discusses ongoing FASB activity, including the
current items on the FASB’s technical agenda. Stay
tuned for future refinements in accounting standard
setting as a result of these initiatives.
Footnotes
1
Source for graphic: Mortgage Rates —
Freddie Mac.
Contacts
Contacts
If you have questions about the information in this publication, please contact any
of the following Deloitte professionals:
|
Kristin Bauer
Audit &
Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 3877
|
|
James Barker
Audit &
Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3550
|
|
Chris Chiriatti
Audit &
Assurance
Managing Director
Deloitte & Touche
LLP
+1 203 761 3039
|
|
Jamie Davis
Audit &
Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 0303
|
|
Stephen McKinney
Audit & Assurance
Managing
Director
Deloitte & Touche
LLP
+1 203 761 3579
|
|
Shekhar Sanwaria
Audit &
Assurance
Managing Director
Deloitte & Touche
LLP
+1 215 405 7788
|
If you are interested in Deloitte’s lease accounting service
offerings, please contact any of the following Deloitte professionals:
|
Tim Kolber
Audit &
Assurance
Managing Director
Deloitte & Touche
LLP
+1 203 563 2693
|
|
Matt Hurley
Audit & Assurance
Advisory Partner
Deloitte & Touche
LLP
+1 615 313 4365
|
Chapter 1 — Overview
Chapter 1 — Overview
1.1 Background
Legacy lease accounting guidance under U.S. GAAP and IFRS® Accounting
Standards was often criticized as being too reliant on bright lines
and subjective judgments. Many believe that such reliance
historically led entities to account for economically similar
transactions differently and has presented opportunities for
entities to structure transactions to achieve a desired accounting
effect. Such criticism prompted the SEC — in its 2005 report on
off-balance-sheet arrangements — to recommend that the FASB
undertake a project on lease accounting. The FASB and International
Accounting Standards Board (IASB®) added lease accounting
to their agendas in 2006 as part of their Memorandum of
Understanding to work toward convergence.
The primary objective of the leases project was to address off-balance-sheet financing concerns related to lessees’ operating leases. However, it proved to be no small task to develop an approach under which all operating leases must be recorded on the balance sheet. During the process, the FASB and IASB had to grapple with questions such as (1) whether an arrangement is a service or a lease, (2) what amounts should be initially recorded on the lessee’s balance sheet for the arrangement, (3) how to reflect the effects of leases in the lessee’s statement of comprehensive income (a point on which the FASB and IASB were unable to converge), and (4) how to apply the resulting accounting in a cost-effective manner.
After working for more than a decade, in 2016, the FASB issued its standard on
accounting for leases, ASU 2016-02 (codified
as ASC 842) while the IASB issued its own leasing standard, IFRS 16.
The timeline below depicts the stages in the boards’ development of
their leasing guidance, beginning with the FASB’s issuance of
Statement 13 in 1976.
1.1.1 Lease Accounting Timeline
Although the project was initially a convergence effort
and the boards conducted joint deliberations, there are several
notable differences between ASC 842 and IFRS 16. We have highlighted
those differences throughout this publication.1
Footnotes
1
See Appendix B for a
summary of the differences between ASC 842 and IFRS
16.
1.2 Overview
ASC 842-10
05-1 The Leases Topic includes the following Subtopics:
- Overall
- Lessee
- Lessor
- Sale and Leaseback Transactions
- Leveraged Lease Arrangements
05-2 The Subtopics listed in paragraph 842-10-05-1 establish the requirements of financial accounting and
reporting for lessees and lessors.
10-1 This Topic specifies the
accounting for leases. An entity should consider the terms
and conditions of the contract and all relevant facts and
circumstances when applying this Topic. An entity should
apply this Topic consistently to leases with similar
characteristics and in similar circumstances.
10-2 The objective of this Topic is to establish the principles that lessees and lessors shall apply to report useful information to users of financial statements about the amount, timing, and uncertainty of cash flows arising from a lease.
The most significant change in ASU 2016-02 is its lessee model that brings most leases on the balance sheet. The ASU also addresses other concerns related to the lessee accounting model in ASC 840. For example, it eliminates the required use of bright-line tests for determining lease classification, thus eliminating a potential source of structuring. Furthermore, ASU 2016-02 aligns certain of the underlying principles of lessor accounting with those in ASC 606, the FASB’s revenue standard (e.g., up-front profit recognition through a sales-type lease is governed by whether control of the underlying asset is transferred to the lessee at lease commencement). The ASU also requires lessors to provide more transparent information about their exposure to the changes in the value of residual assets as well as how they manage that exposure.
The structure of the guidance in ASC 842 is depicted in the graphic below. This Roadmap is designed with this structure in mind.
ASU 2016-02 is effective for (1) public companies in periods beginning after
December 15, 2018; (2) certain public NFPs2 in periods beginning after December 15, 2019; and (3) all other
entities in periods beginning after December 15, 2021 (because of the
deferral in ASU 2020-05, which was issued in June 2020). It represents
a wholesale change to lease accounting; as a result, many entities
have faced significant implementation challenges during the periods
leading up to the effective date and beyond.
Footnotes
2
The deferral provided by ASU
2020-05 applies to public NFPs
that have not issued financial statements or made
financial statements available for issuance as of
June 3, 2020. Public NFPs that have issued
financial statements or have made financial
statements available for issuance before that date
must comply with the effective dates prescribed
for public companies above.
1.3 Key Provisions
The table below highlights some of the key provisions of ASU 2016-02 and
includes links to sections of this Roadmap that discuss these provisions in more
detail.
Key Provision
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ASU 2016-02
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---|---|
Scope
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The scope of ASC 842 includes leases of all
property, plant, and equipment (PP&E) and excludes:
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Identifying a lease
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A lease is defined as a “contract, or part
of a contract, that conveys the right to control the use of
identified property, plant, or equipment (an identified
asset) for a period of time in exchange for
consideration.“
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Components of a contract
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An entity is generally required to identify
the lease and nonlease components of a contract that
contains a lease. A contract may also contain multiple lease
components. The right to use an underlying asset is
considered a separate lease component if (1) a lessee can
benefit from the use of the underlying asset either on its
own or together with other resources that are readily
available and (2) the underlying asset is not highly
dependent on or highly interrelated with other assets in the
arrangement.
When a contract includes multiple
components, an entity is generally required to allocate the
consideration in the contract to the various components. The
guidance for lessors on allocating the consideration in the
contract is separate from that for lessees.
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Lease term
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The lease term is the noncancelable period
in which the lessee has the right to use an underlying asset
together with optional periods (1) for which it is
reasonably certain that the lessee will exercise the renewal
option or not exercise the termination option or (2) covered
by an option to extend (or not to terminate) the lease in
which the exercise of the option is controlled by the
lessor. Lessees will be required to reassess the lease term
after lease commencement in certain circumstances; however,
lessors are not required to reassess the lease term unless
the lease is modified and the modified lease is not a
separate contract.
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Lease payments
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Lease payments include:
Lease payments do not include variable lease
payments that are based on the usage or performance of the
underlying asset (e.g., a percentage of revenues).
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Discount rate
|
Lessees use the rate charged by the lessor
(i.e., the rate implicit in the lease) if that rate is
readily determinable. If that rate is not readily
determinable, lessees will use their incremental borrowing
rate as of the date of lease commencement.
Lessors use the rate they charge the
lessee.
Private-company lessees can elect to use a
risk-free rate.
|
Lessee accounting
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As of the lease commencement date, a lessee
recognizes:
The lessee will use the effective interest
rate method to subsequently account for the lease
liability.
Two approaches are used for subsequently
amortizing the ROU asset: (1) the finance lease approach and
(2) the operating lease approach. Under the finance lease
approach, the ROU asset is generally amortized on a
straight-line basis. This amortization, when combined with
the interest on the lease liability, results in a
front-loaded expense profile in which interest and
amortization are presented separately in the income
statement. By contrast, the operating lease approach
generally results in a straight-line expense profile that is
presented as a single line item in the income statement.
The determination of which approach to apply
is based on lease classification criteria that are similar
to the requirements in IAS 17.
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Lessor accounting
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The lessor accounting model retains the
approach for operating and capital/ finance (direct
financing and sales-type) leases.
However, the lease classification criteria
will change, and the treatment of selling profit, if any,
will be affected:
Leveraged lease accounting is eliminated
going forward (i.e., existing leveraged leases are
grandfathered).
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Lease modifications
(Chapters 8 and
9)
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A lease modification is any change to the
contractual terms and conditions of a lease that results in
a change in the scope of or the consideration for a
lease.
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Sale-and-leaseback transactions
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A transaction is accounted for as a
sale-and-leaseback transaction when control of the
underlying asset is transferred from the seller-lessee to
the buyer-lessor in accordance with ASC 606. In addition to
the control transfer principle in ASC 606, the transfer of
the underlying asset is not considered a sale if either of
the following conditions is met:
If control of the underlying asset is
transferred to the buyer-lessor, the transaction is
accounted for as a sale and leaseback and the entire gain on
the transaction would be immediately recognized.
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While the FASB published ASU 2016-02 in 2016, it has amended certain of the
ASU’s original requirements over time both in an attempt to provide relief from the
costs of implementing the standard and in response to stakeholder feedback. The FASB
also continues to monitor companies’ implementation of the leasing standard’s
requirements as part of its ongoing postimplementation review process.
See Chapter 17 for more information on recent FASB activities.
Chapter 2 — Scope and Scope Exceptions
Chapter 2 — Scope and Scope Exceptions
2.1 Property, Plant, and Equipment
ASC 842-10 — Glossary
Contract
An agreement between two or more parties that creates enforceable rights and obligations.
Lease
A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or
equipment (an identified asset) for a period of time in exchange for consideration.
As indicated above, ASC 842-10-20 defines a lease as a “contract . . . that
conveys the right to control the use of . . . property, plant, or equipment”
(PP&E). In paragraph BC110 of ASU 2016-02, the Board acknowledges that
only leases of “land and/or depreciable assets” are within the scope of ASC 842.
Therefore, because the FASB ultimately decided to include only leases of PP&E
within the scope of ASC 842, the scope of ASC 840 is effectively carried forward.
Accordingly, leases of nondepreciable assets (e.g., inventory) are outside the scope
of ASC 842, as detailed in ASC 842-10-15-1 (reproduced in Section 2.2).
In addition, an agreement involving PP&E must create enforceable rights and obligations to be within
the scope of ASC 842. That is, it must meet the definition of a “contract” in ASC 842, which is defined the
same way as it is in ASC 606.
2.2 Scope Exclusions
ASC 842-10
15-1 An entity shall apply this Topic to all leases, including subleases. Because a lease is defined as a contract,
or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an
identified asset) for a period of time in exchange for consideration, this Topic does not apply to any of the
following:
- Leases of intangible assets (see Topic 350, Intangibles — Goodwill and Other).
- Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources (see Topics 930, Extractive Activities — Mining, and 932, Extractive Activities — Oil and Gas). This includes the intangible right to explore for those natural resources and rights to use the land in which those natural resources are contained (that is, unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources.
- Leases of biological assets, including timber (see Topic 905, Agriculture).
- Leases of inventory (see Topic 330, Inventory).
- Leases of assets under construction (see Topic 360, Property, Plant, and Equipment).
Whether a contract is within the scope of ASC 842 is effectively a gating question; if a contract is within
the standard’s scope, an entity must apply the guidance in ASC 842 to determine whether the contract
is, or contains, a lease (as discussed in Chapter 3). In other words, if an arrangement includes a right
of use or a lease of a type of asset described in ASC 842-10-15-1, an entity does not need to further apply
the requirements of ASC 842 because the arrangement is explicitly outside its scope. Conversely, in
an arrangement that involves the use of any other PP&E to comply with the enforceable rights and
obligations of the contract, an entity must apply the requirements of ASC 842 to identify whether the
contract is, or contains, a lease.
The decision tree below further expands on this
gating question.
Changing Lanes
Heat Supply Contracts for Nuclear Fuel
While ASC 840 explicitly applied to heat supply contracts for nuclear fuel, ASC
842 does not specify whether such contracts are within its scope.
Accordingly, entities will have to assess such contracts to determine
whether they meet the new definition of a lease. (See Chapter 3 for more
information about how to identify whether a contract is, or contains, a
lease.)
2.2.1 Leases of Intangible Assets
Entities commonly enter into arrangements that convey rights to use intangible
assets (e.g., licensing arrangements, such as those involving software
licenses). Rights to use intangible assets are outside the scope of ASC 842. As
stated in ASC 842-10-15-1, entities should consider the guidance in ASC 350 when
accounting for such arrangements. In addition, the owner of the intellectual
property that is subject to the agreement should consider the implementation
guidance on licensing in ASC 606.
Bridging the GAAP
The FASB acknowledges in paragraph BC110(a) of ASU 2016-02 that there is “no conceptual basis
for excluding leases of intangible assets from the scope” of ASC 842. Indeed, the IASB allows
entities to apply IFRS 16 to leases of certain intangible assets (i.e., except for rights held under a
licensing arrangement for items such as films, video recordings, plays, patents, and copyrights).
The FASB decided that such arrangements should be subject to a larger, more comprehensive
review of the accounting for intangible assets at a future date before a customer is required (or
allowed) to account for rights to use intangible assets within the scope of ASC 842.
2.2.2 Leases to Explore for or Use Nonregenerative Resources and Leases of Biological Assets
Paragraph BC110(b) of ASU 2016-02 indicates that the scope exclusion in ASC 842-10-15-1(b) applies to both (1) the intangible right to explore for nonregenerative resources such as oil, natural gas, and minerals and (2) the right to use the land that contains those resources. Such rights are accounted for under the industry guidance in ASC 930 (minerals) and ASC 932 (oil and natural gas) and are outside the scope of ASC 840. The Board did not consider it necessary to change this scope exclusion.
However, the Board acknowledges in the Background Information and Basis for Conclusions of ASU 2016-02 that leases of PP&E used to explore for or produce such nonregenerative resources (e.g., drilling rigs) are not part of this scope exclusion. Accordingly, mining and oil and gas entities should identify whether contracts that involve PP&E used in the exploration or production of minerals, oil, and natural gas are, or contain, leases (see Chapter 3).
In a manner similar to its observations on rights to explore for or use nonregenerative resources, the FASB observed in paragraph BC110(c) of ASU 2016-02 that the accounting for biological assets, including plants and animals, is best contained within a single, industry-specific Codification topic, ASC 905. Accordingly, rights to use biological assets are outside the scope of ASC 842.
In certain instances, a lessee’s right to use land may not be
limited to the right to explore for or use nonregenerative resources or
biological assets. Although natural resource rights are outside the scope of ASC
842, the guidance in ASC 842-10-15-1(b) indicates that rights to use land are
not excluded from lease accounting solely because natural resource rights are
included in the arrangement. ASC 842-10-15-1(b) states, in part:
An entity shall apply this Topic to all leases, including
subleases. Because a lease is defined as a contract, or part of a contract,
that conveys the right to control the use of identified property, plant, or
equipment (an identified asset) for a period of time in exchange for
consideration, this Topic does not apply to any of the following: . . .
b. Leases to explore for or use minerals, oil, natural gas, and
similar nonregenerative resources (see Topics 930, Extractive
Activities — Mining, and 932, Extractive Activities — Oil and Gas).
This includes the intangible right to explore for those natural
resources and rights to use the land in which those natural
resources are contained (that is, unless those
rights of use include more than the right to explore for natural
resources), but not equipment used to explore for the
natural resources. [Emphasis added]
Therefore, if a lessee’s rights to use land contain both natural
resource rights as well as the right to use the land in other ways, the lessee
should consider whether the arrangement includes a lease of the land in addition
to the natural resource rights. If so, the natural resource rights would be a
nonlease component that should be separated from the lease component in the
contract.1 In reaching this conclusion, we also considered paragraph BC110(b) of ASU
2016-02, which states, in part:
The Board decided that,
consistent with previous GAAP, only leases of property, plant, and equipment
(that is, land and/or depreciable assets) are within the scope of Topic 842.
Consequently, none of the items in the list that follows, which is not
intended to be an all-inclusive list, are in the scope of Topic 842. In
addition to the fact that none of these assets are depreciable assets, the
Board observed the following with respect to each: . . .
b. Leases to explore for or use natural resources, such as
minerals, oil, and natural gas. That is because accounting practices
for assets relating to exploration and evaluation are diverse and
differ from the accounting for other types of assets. Furthermore,
the accounting for assets related to the exploration and use of
natural resources is specified in Topics 930, Extractive Activities
— Mining, and 932, Extractive Activities — Oil and Gas. Leases to
explore for or use natural resources also were excluded from
previous GAAP. However, the determination of whether certain
ancillary items were leases was less important in previous GAAP than
in Topic 842 because the operating leases and services were
accounted for similarly. Some stakeholders asked
whether this scope exception referred solely to the intangible
right to explore for these natural resources. The Board observed
that this scope exception refers to that as well as to the
rights to use the land in which those natural resources are
contained. However, leases of equipment used to explore for
natural resources (for example, drilling equipment) are not part of
this scope exception. [Emphasis added]
We believe that the reference to “land in which those natural
resources are contained” is meant to extend the scope exception to surrounding
land when the arrangement involves only the right to explore for natural
resources (i.e., there will naturally be some land formations — whether surface
or subsurface — that establish the parameters of the exploration rights). On the
other hand, when the land can be used for other purposes, we believe that an
entity should evaluate whether the arrangement contains a lease.
Consider an arrangement that includes both mineral rights and
the right to develop an apartment complex on land. In this arrangement, a lease
of land would not be precluded solely because the arrangement includes mineral
rights.2 Rather, the mineral rights (natural resource rights) should be treated as
a nonlease component in accordance with other GAAP.
2.2.3 Leases of Inventory
Like ASC 840, ASC 842 excludes rights to use inventory from its scope. In the
Background Information and Basis for Conclusions of ASU 2016-02, the Board
indicates that it decided to exclude rights to use inventory largely out of
cost-benefit considerations. Specifically, in paragraph BC110(d), the Board
observed that few arrangements could actually convey the right to control the
use of an asset that is held for sale by the customer — or that is consumed in
the customer’s production of goods or services to be available for sale — while
the supplier continues to own that asset. Accordingly, the FASB decided that the
costs of requiring entities to evaluate such arrangements under ASC 842’s
definition of a lease (see Chapter 3) outweighed the benefits.
The example below illustrates a simple arrangement involving the use of precious-metals inventory. Because the arrangement is for inventory (i.e., for an asset that is consumed in the customer’s production of goods or services to be available for sale), it is outside the scope of ASC 842 and the parties are not required to assess whether the contract is, or contains, a lease.
Example 2-1
TJ Inc., an auto manufacturer, enters into a contract with EC Supply Company for 1,000 pounds of palladium over the next five years. TJ uses palladium in catalytic converters that are installed in the automobiles that it sells to third-party customers. TJ pays EC a fixed, monthly payment over the contract term. At the end of year 5, TJ must return 1,000 pounds of palladium to EC.
2.2.4 Leases of Assets Under Construction
Like rights to use inventory, rights to use assets under construction (e.g., construction work-in-progress or CWIP) are outside the scope of ASC 842 for cost-benefit reasons. Shortly before issuing ASU 2016-02, the Board decided to include guidance in ASC 842-40 that requires lessees and lessors to determine whether a lessee controls an underlying asset before the commencement of a lease. (See Chapter 11 for a detailed discussion of this guidance.) If it is determined that a lessee does control an asset before the commencement date, the lessee must (1) recognize the entire asset as the deemed accounting owner and (2) apply ASC 842’s sale-and-leaseback guidance to assess whether it may derecognize the asset on the lease commencement date. The guidance in ASC 842-40 addresses arrangements in which a lessee is involved in the construction of an asset before a lease commences.
As the Board acknowledges in paragraph BC110(e) of ASU 2016-02, the FASB received stakeholder feedback indicating that the complexity of applying ASC 842 was likely to increase if an entity is required to assess whether a lessee (1) controls an underlying asset under construction or (2) controls the use of an underlying asset under construction (as would be the case if CWIP were within the scope of ASC 842). The Board decided that the benefits of performing this complex assessment would not outweigh the costs, given that such an evaluation would yield financial reporting results substantially similar to those under ASC 840. Accordingly, the FASB excluded rights to use assets under construction from the scope of ASC 842; however, lessees and lessors must still assess whether a lessee obtains control of an underlying asset under construction (i.e., the entire asset, and not just the right to use it) before lease commencement in accordance with ASC 842-40.
2.2.5 Other Scope Exclusions
2.2.5.1 Service Concession Arrangements
Service concession arrangements accounted for under ASC 853 are specifically
excluded from the scope of ASC 840 in ASC 840-10-15-9A. However, ASC 842
does not explicitly contain the same scope exception. Rather, ASC
853-10-25-2 (as amended by ASU 2016-02) indicates that
service concession arrangements that are subject to the scope provisions of
ASC 853-10-15 will continue to be outside the scope of lease accounting:
The infrastructure that is the subject of a service
concession arrangement within the scope of this Topic shall not be
recognized as property, plant, and equipment of the operating entity.
Service concession arrangements within the scope of this Topic are not
within the scope of Topic 842 on leases.
2.2.5.2 Noncore Assets and Capitalization Policy Considerations
Paragraph BC111 of ASU 2016-02 acknowledges that “assets that are not essential
to the operations of an entity” (hereafter referred to as “noncore assets”)
may be less important to financial statement users because they “often are
less material.” Accordingly, the benefits of recognizing leases of noncore
assets may not justify the costs of requiring lessees to do so. The Board
therefore considered excluding noncore assets from the scope of ASC 842 but
ultimately decided against a scope exclusion for noncore assets for the
following reasons:
-
It is difficult to define noncore assets and to differentiate leases of noncore assets from leases of other assets.
-
Entities’ interpretations of the definition of noncore assets are likely to differ, thereby reducing comparability for financial statement users.
-
There is no GAAP distinction between noncore purchased assets and core purchased assets for capitalization purposes. Accordingly, there is little justification for distinguishing between rights to use noncore assets and rights to use core assets.
Many entities have accounting policies that establish a
materiality threshold for capitalizing fixed assets (i.e., PP&E). Under
such policies, expenditures below the established threshold are expensed in
the period incurred rather than capitalized on the balance sheet and
depreciated over the life of the asset.
Because ASC 842 requires entities to recognize an ROU asset
and a lease liability for all leases (other than short-term leases) and does
not contain a “small-ticket item” exception similar to that in IFRS 16,3 many entities have asked whether a similar capitalization threshold
may be established for lease assets and lease liabilities under ASU 2016-02.
While there is no explicit scope exception for assets defined as, or
determined to be, “noncore,” paragraph BC122 of ASU 2016-02 indicates that a
lessee can use capitalization and materiality policies when evaluating the
requirement to recognize, on the balance sheet, leases that otherwise must
be recognized under ASC 842, thereby reducing the cost of applying the
standard. Specifically, paragraph BC122 states, in part:
[E]ntities will likely be able to adopt reasonable
capitalization thresholds below which lease assets and lease
liabilities are not recognized, which should reduce the costs of
applying the guidance. An entity’s practice in this regard may be
consistent with many entities’ accounting policies in other areas of
GAAP (for example, in capitalizing purchases of property, plant, and
equipment).
Therefore, an entity should not simply default to its
pre–ASC 842 capitalization threshold for PP&E for the following
reasons:
-
The pre–ASC 842 capitalization threshold for PP&E is unlikely to include the effect of the additional asset base introduced by the ASU. That is, the addition of another set of assets not recognized on an entity’s balance sheet may require a refreshed analysis of the entity’s capitalization thresholds to ensure that the aggregated amounts will not become material.
-
The pre–ASC 842 capitalization threshold for PP&E does not take into account the liability side of the balance sheet. Under ASC 842, if an entity wishes to establish a threshold that will be used to avoid accounting for both ROU assets and lease liabilities on the balance sheet, it must consider the materiality, in the aggregate, of all of its ROU assets and related lease liabilities that would be excluded when it adopts such a threshold.
One reasonable approach to developing a capitalization
threshold for leases is to use the lesser of the
following:
-
A capitalization threshold for PP&E, including ROU assets (i.e., the threshold takes into account the effect of leased assets determined in accordance with ASU 2016-02).
-
A recognition threshold for liabilities that takes into account the effect of lease liabilities determined in accordance with the ASU.
Another reasonable approach to developing a capitalization
threshold for leases is to record all lease liabilities but to subject the
related ROU assets to such a threshold. Under this approach, if an ROU asset
is below the established capitalization threshold, it would immediately be
recognized as an expense. In subsequent periods, entities would amortize the
lease liability by using the effective interest method, under which a
portion of the periodic lease payments would reduce the liability and the
remainder would be recognized as interest expense.
In addition, when evaluating and applying a capitalization
threshold for leases determined in accordance with the ASU, entities should
consider the following:
-
The gross balance of each side of the lease entry — It would be inappropriate for an entity to consider only the net balance sheet effect of the lease entry (which is often zero) when assessing materiality.
-
Disclosure requirements — We expect that entities will often want to omit disclosures about leases that they have determined, on the basis of their use of capitalization thresholds (as discussed above), do not need to be recognized on the balance sheet. We believe that while it may be appropriate to omit such disclosures, an entity will need to consider the impact of the omitted disclosures when performing a materiality assessment to establish the thresholds.
-
Implications related to internal control over financial reporting (ICFR) — As entities revisit and change (or create new) capitalization thresholds for financial reporting purposes, they should be cognizant of the related ICFR implications. In addition, entities should consider the Form 10-K and Form 10-Q disclosure requirements under SEC Regulation S-K, Item 308(c), with respect to material changes in ICFR.
-
SAB Topic 1.M (SAB 99) — Entities may find the guidance on materiality in SAB Topic 1.M helpful when identifying an appropriate capitalization threshold for leases.
Example 2-2
A lessee enters into a five-year
lease of a machine to use in its operations. The
lessee determines that its ROU asset and lease
liability are $3,260 at lease commencement.
To identify an appropriate
capitalization threshold for its ROU assets and
lease liabilities, the lessee considers the
following:
-
The gross balances (rather than the net balance) of its ROU assets and lease liabilities.
-
The disclosures that would be omitted if certain ROU assets and lease liabilities were not recognized.
-
The appropriate internal controls needed for the lessee to apply and monitor the capitalization threshold.
-
Overall materiality considerations in SAB Topic 1.M.
After considering these factors, the
lessee determines that (1) an appropriate
capitalization threshold for PP&E, including ROU
assets, is $3,500 and (2) an appropriate recognition
threshold for lease liabilities is $3,000. The
lessee should apply the lower of the two thresholds
when determining whether to record the lease on its
balance sheet. Given that the initial measurement of
the lessee’s ROU asset and lease liability exceeds
the $3,000 threshold established for lease
liabilities (i.e., the lower of the two thresholds),
the lessee should recognize the ROU asset and lease
liability on its balance sheet at lease
commencement.
Alternatively, the lessee may choose
to recognize the lease liability of $3,260 but not
the ROU asset on the basis of the established $3,500
threshold for PP&E, including ROU assets (i.e.,
the lessee may choose to expense the cost of the ROU
asset at lease commencement).
Footnotes
1
If the lessee elects the practical expedient to combine
lease and nonlease components (see Section 4.3.3.1), the natural
resource rights would instead be combined with the land lease.
2
Assume that the land agreement in this arrangement meets
the definition of a lease in accordance with ASC 842.
3
Under IFRS 16, an entity may exclude leases for
which the underlying asset is of low value from its ROU assets and
lease liabilities. See paragraphsB3–B8 of IFRS 16 for information
about how to assess whether an asset is of low value. Also, see
Appendix
B for a summary of the differences between ASC 842
and IFRS 16.
2.3 Interaction With Other Accounting Standards
2.3.1 ASC 606 — Revenue From Contracts With Customers
ASC 842 has many areas of crossover between, or direct references to, ASC 606. For example, ASC 842 requires lessors to use the guidance in ASC 606-10-32-28 through 32-41 when separating, and allocating consideration to, the components in a contract (see Chapter 4 for a detailed discussion of those requirements).
In addition, the guidance in ASC 606 on sales with a repurchase agreement may
require suppliers to account for certain contracts with a customer within the
scope of ASC 842. The next section further discusses those requirements in ASC
606 and how they are related to ASC 842.
2.3.1.1 Repurchase Agreements
ASC 606-10
55-66 A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.
55-68 If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity should account for the contract as either of the following:
- A lease in accordance with Topic 842 on leases, if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset unless the contract is part of a sale and leaseback transaction. If the contract is part of a sale and leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale and leaseback transaction in accordance with Subtopic 842-40.
- A financing arrangement in accordance with paragraph 606-10-55-70, if the entity can or must repurchase the asset for an amount that is equal to or more than the original selling price of the asset.
55-72 If an entity has an obligation to repurchase the asset at the customer’s request (a put option) at a price that is lower than the original selling price of the asset, the entity should consider at contract inception whether the customer has a significant economic incentive to exercise that right. The customer’s exercising of that right results in the customer effectively paying the entity consideration for the right to use a specified asset for a period of time. Therefore, if the customer has a significant economic incentive to exercise that right, the entity should account for the agreement as a lease in accordance with Topic 842 on leases unless the contract is part of a sale and leaseback transaction. If the contract is part of a sale and leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale and leaseback transaction in accordance with Subtopic 842-40.
The guidance in ASC 606 on sales with a repurchase agreement (whether an obligation or an option) is intended to identify scenarios in which the supplier has not transferred control of the asset to the customer. That is, the economic substance of the sale, together with the repurchase obligation or right, is to convey to the customer control of the use of the asset for a certain period in exchange for consideration.
Example 62, Case B, in ASC 606 illustrates how a sale with a repurchase
agreement that includes a put option would be accounted for as a lease. For
this example and further discussion of the guidance in ASC 606 on sales with
a repurchase agreement, see Section
8.7 of Deloitte’s Roadmap Revenue Recognition.
Changing Lanes
Lease Classification in a
Sale With a Repurchase Agreement
In the sale of an asset, an entity may “fail” the transfer-of-control guidance in ASC 606 because of
an obligation or right to repurchase the asset (e.g., through a call option) for an amount that is
less than its original selling price. As a result, in accordance with ASC 606-10-66-58, the supplier
would not record a sale and recognize revenue from a contract with a customer but would
instead account for the arrangement as a lease under ASC 842.
However, stakeholders have questioned whether it is possible for a supplier to fail sale
accounting under ASC 606 but classify the arrangement under ASC 842 as a sales-type lease.
If so, it would be possible for a supplier to transfer control (and thus recognize selling profit
or loss at commencement) under ASC 842 but not under ASC 606. (See Chapter 9 for further
discussion of a lessor’s accounting and classification.) In such cases, it appears that there would
be an accounting arbitrage opportunity to structure transactions that achieve a desired financial
reporting result.
Example 2-3
Supplier enters into an
arrangement to sell a piece of equipment to
Customer at its fair value, $10 million. The
equipment has a 25-year economic life with a
residual value of $0. Included in the arrangement
is a call option granted to Supplier through which
Supplier may repurchase the asset. The repurchase
option is exercisable after 20 years (on a
specified date). The strike price of the
repurchase option is $2 million. In this scenario,
it may be appropriate for Supplier to classify its
arrangement with Customer as a sales-type lease
and recognize selling profit or loss at
commencement.
Connecting the Dots
Asymmetry Between Supplier
and Customer in a Sale With a Repurchase
Agreement
ASC 606 does not address the customer’s accounting for arrangements within its scope, so
there is no requirement in ASC 606 for a customer in a sale with a repurchase agreement to
account for that arrangement as a lease.
Therefore, a customer is likely to account for such an arrangement as a purchase of the
asset (e.g., in accordance with ASC 360 for PP&E). In other words, while ASC 606 contains
comprehensive guidance governing when a supplier transfers control of an asset, there is little
guidance in U.S. GAAP governing when a customer obtains control.
Changing Lanes
Seller-Provided Residual
Value Guarantees
Section 8.7 of Deloitte’s Roadmap
Revenue
Recognition notes that the FASB, in its
deliberations with the IASB related to ASC 606 and IFRS 15,
respectively, explicitly decided to view sales with a
seller-provided residual value guarantee (e.g., when a seller
provides its customer with a guaranteed amount to be paid on resale)
differently from sales with a repurchase agreement. In paragraph
BC431 of ASU
2014-09, the boards acknowledged that such
arrangements are economically similar in terms of cash flows but
differ with respect to the customer’s ability to control the asset.
That is, the customer is “not constrained in its ability to direct
the use of, and obtain substantially all of the benefits from, the
asset” it purchased that is subject to a seller-provided residual
value guarantee.
Further, the FASB recognized that its decisions on this topic would lead to a
change in practice. Under ASC 605 and ASC 840, such arrangements
were generally accounted for as leases. Accordingly, sales with a
seller-provided residual value guarantee are subject to the five
steps of the model in ASC 606 and are not accounted for as leases
within the scope of ASC 842.
2.3.2 ASC 815 — Derivatives and Hedging
ASC 842-10
15-43 Paragraph 815-10-15-79 explains that leases that are within the scope of this Topic are not derivative instruments subject to Subtopic 815-10 on derivatives and hedging although a derivative instrument embedded in a lease may be subject to the requirements of Section 815-15-25. Paragraph 815-10-15-80 explains that residual value guarantees that are subject to the guidance in this Topic are not subject to the guidance in Subtopic 815-10. Paragraph 815-10-15-81 requires that a third-party residual value guarantor consider the guidance in Subtopic 815-10 for all residual value guarantees that it provides to determine whether they are derivative instruments and whether they qualify for any of the scope exceptions in that Subtopic.
Because leases are outside the scope of ASC 815-10, contracts within the scope
of ASC 842 that meet the definition of a lease (see Chapter 3) are not accounted for as
freestanding derivative instruments. However, this guidance may still be
relevant in the determination of whether a lease agreement contains an embedded
derivative that must be separated from the lease contract and accounted for
separately as a derivative instrument in accordance with ASC 815. Thus, when
analyzing a leasing transaction, an entity should consider the derivative and
hedging implications, including ASC 815 and the relevant implementation
guidance.
Components of a lease agreement that might be considered embedded derivatives
include, but are not limited to:
-
Option arrangements, such as purchase or renewal options.
-
Indexed rental payments.
-
Additional rental payments that are contingent on the occurrence of an outside event or achieving a certain threshold.
-
Rental payments denominated in a foreign currency.
The terms of any lease arrangement containing these or similar
provisions must be analyzed to determine whether the provision meets the
definition of a derivative described in ASC 815-10-15-83 and, if so, whether ASC
815 requires separate accounting for the embedded derivative. ASC 815-10-15-96
and other implementation guidance include extensive guidance on identifying and
accounting for embedded derivatives that must be separated from their host
contracts.
Lessors and lessees may also want to enter into hedging
transactions to reduce their potential cash flow variability. ASC 815 and
relevant implementation guidance address the requirements for achieving hedge
accounting and how to account for a hedging relationship.
See the next section for further discussion of derivatives
embedded in leases.
2.3.2.1 Derivatives Embedded in a Lease
Certain variable lease payments (e.g., those that depend on an index or rate) could meet the criteria
in ASC 815-15 to be bifurcated as an embedded derivative. Accordingly, the FASB acknowledged in
paragraph BC119 of ASU 2016-02 that because ASC 842 does not require entities to measure such
variable lease payments at fair value, “unrelated derivative contracts could be bundled with leases to
avoid measuring such embedded derivatives at fair value.” Accordingly, the Board decided to retain the
requirement to assess a lease contract to determine (1) whether any embedded derivatives exist and, if
so, (2) whether they should be bifurcated in accordance with the guidance in ASC 815-15.
The assessment of whether an embedded derivative is clearly and closely related to its host contract
(i.e., a lease within the scope of ASC 842) is based on the economic relationship between the embedded
derivative and the host contract. To be considered clearly and closely related to a lease host, economic
characteristics and risks of the lease contract should be similar to those of the embedded derivative.
If the two are not clearly and closely related, the embedded derivative should be bifurcated and
accounted for separately at fair value if the embedded feature satisfies the criteria of a derivative
instrument on a freestanding basis.
The table below highlights some of the economic characteristics that are and are
not generally considered to indicate that an embedded derivative is clearly
and closely related to a lease host contract. See Section 4.3.2.4.1 of Deloitte’s Roadmap Derivatives for further discussion of
common embedded features in lease host contracts.
Clearly and Closely Related | Not Clearly and Closely Related | |
---|---|---|
Lease host |
|
|
The examples below describe how payment features commonly
observed in lease contracts would be evaluated for potential bifurcation as
embedded derivatives.
Example 2-4
Rent Increases Based on Sales Volume
Company ABC leases property from Company XYZ in
Germany. The lease provides for annual rent
increases based on a percentage of ABC’s retail
sales in Germany during the calendar year. The
increase is an adjustment to the following year’s
rent payments.
The lease contains an embedded
contingent rent payment based on ABC’s retail sales
in Germany. The embedded derivative does not need to
be accounted for separately because ABC’s retail
sales would qualify for the exception in ASC
815-10-15-59(d), which excludes from its scope
non-exchange-traded contracts with underlyings that
are the sales or service revenues of one of the
parties to the contract. Therefore, this embedded
derivative on a percentage of ABC’s German retail
revenues would not meet the definition of a
derivative on a freestanding basis and would not
need to be bifurcated in accordance with ASC
815-15-25-1(c).
Example 2-5
Lease Contracts With Adjustments That Are Based on
Interest Rate Changes
Company D has 10-year operating
leases for retail stores and a distribution center.
The operating lease payments are part of a synthetic
lease transaction in which an off-balance-sheet
special-purpose entity (SPE) has obtained debt
financing and equity that it will use to construct
the retail stores and distribution center. The SPE
will lease these buildings to D. The leases require
D to make quarterly variable lease payments on the
basis of the SOFR interest rate applied to the SPE’s
total debt outstanding. For example, if the SPE has
drawn cash to begin construction on one of the new
retail stores, D must begin to make interest
payments to the SPE on that drawn amount.
The operating leases for the retail
stores and distribution center have embedded
derivatives that result in an adjustment to the
lease payment and are based on interest rates (i.e.,
SOFR). The embedded derivative does not need to be
bifurcated because the obligation to make future
payments for the use of the leased assets and the
adjustment of those payments for changes in a
variable interest rate index are considered clearly
and closely related under ASC 815-15-25-22.
Note that SPEs should be evaluated
to determine whether they are subject to ASC 810-10.
Some “synthetic lease” transactions may have to be
consolidated under ASC 810-10.
2.3.2.2 Residual Value Guarantees
As noted above in ASC 842-10-15-43, residual value guarantees that are accounted for under ASC 842, including any residual value guarantee between the lessee and the lessor, are not subject to the derivative accounting guidance in ASC 815-10. However, a third-party guarantor must assess whether any residual value guarantee that it writes on an underlying leased asset is subject to the guidance in ASC 815-10.
A leased asset subject to a third-party residual value guarantee will always be a nonfinancial asset (i.e., financial assets cannot be leased). Accordingly, a third-party guarantor may seek to avoid fair value measurement of the guarantee and instead use the scope exception in ASC 815-10-15-59(b) for contracts that are not traded on an exchange and that are settled on the basis of a price or value of a nonfinancial asset. Third-party guarantors will generally meet the second condition in ASC 815-10-15-59(b) because increases in the fair market value of the underlying nonfinancial asset reduce the third-party guarantor’s exposure and the asset’s owner therefore would not benefit from such an increase in value under the contract.
2.3.3 ASC 810 — Consolidation
ASC 810-10
55-39 Receivables under an operating lease are assets
of the lessor entity and provide returns to the lessor
entity with respect to the leased property during that
portion of the asset’s life that is covered by the lease.
Most operating leases do not absorb variability in the fair
value of a VIE’s net assets because they are a component of
that variability. Guarantees of the residual values of
leased assets (or similar arrangements related to leased
assets) and options to acquire leased assets at the end of
the lease terms at specified prices may be variable
interests in the lessor entity if they meet the conditions
described in paragraphs 810-10-25-55 through 25-56.
Alternatively, such arrangements may be variable interests
in portions of a VIE as described in paragraph 810-10-25-57.
The guidance in paragraphs 810-10-55-23 through 55-24
related to debt instruments applies to creditors of lessor
entities.
Once a lease has been identified under ASC 842, a reporting entity (lessee) should
evaluate whether a lease is a variable interest in the legal entity (lessor). The
assessment of whether a lease is a variable interest first depends on whether the
lease is classified as an operating lease or a finance lease. In a leasing
arrangement accounted for as an operating lease, all relationships and contractual
arrangements between the lessee, lessor, and variable interest holders of the lessor
should be evaluated to determine whether those relationships or arrangements result
in the lessee’s absorption of expected losses or the receipt of expected residual
returns of the legal entity, even if the lessee has not entered into an arrangement
that would be an explicit variable interest in the legal entity. In a leasing
arrangement accounted for as a finance lease, unless the fair value of the assets
subject to a lease represents less than half the fair value of the lessor’s assets
(see Chapter 6 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial
Interest), a finance lease represents a variable interest in
the legal entity. In addition, see Section
4.3.9 of Deloitte’s Roadmap Consolidation — Identifying a Controlling Financial
Interest for further details on other contractual features in a
lease that could represent a variable interest.
Footnotes
4
Under ASC 830, a lessee with
an operating lease denominated in a nonfunctional
currency would not be required to bifurcate the
foreign currency embedded derivative.
2.4 Land Easements
The objectives of the land easement amendments in ASU 2018-01, which was issued in response to
feedback received by the FASB regarding implementation of ASU 2016-02, are to:
- Clarify that land easements entered into (or existing land easements modified) on or after the effective date of ASC 842 must be assessed under ASC 842.
- Provide a transition practical expedient for existing or expired land easements that were not previously accounted for in accordance with ASC 840. The practical expedient would allow entities to elect not to assess whether those land easements are, or contain, leases in accordance with ASC 842 when transitioning to ASC 842.
The amendments in ASU 2018-01 do not, and are not intended to:
- Provide illustrative or application guidance on whether land easements are, or contain, leases in accordance with the definition of a lease in ASC 842.
- Help entities identify the appropriate accounting framework for situations in which a land easement is not determined to be a lease under ASC 842.
See Section 16.5.3 for information about the effective date and transition provisions of ASU 2018-01.
2.4.1 Background
Generally, an easement is a right to access, cross, or otherwise use someone
else’s land for a specified purpose. Most easements provide limited rights to
the easement holder, such as the right to cross over land or the right to
construct and maintain specified equipment on the land. For example, an electric
utility will typically obtain a series of contiguous easements so that it can
construct and maintain its electric transmission system on land owned by third
parties. Easements can be perpetual or term-based, be paid in advance or over
time, and provide the customer with exclusive or shared use.
Historically, some companies have considered easements to be intangible assets under ASC 350. In fact, ASC 350 contains an example illustrating easements acquired to support the development of a natural gas pipeline. In contrast, some companies may have considered easements to be leases or executory contracts. When preparing their financial statements, many companies have presented prepaid amounts related to easements in the PP&E section of their balance sheets because easements are closely associated with the PP&E they support. We understand that reporting requirements of the Federal Energy Regulatory Commission may have also influenced the balance sheet geography for companies regulated by that agency.
Easements generally convey to the customer some rights associated with the use of land (i.e., PP&E). Therefore, questions have arisen about whether easements are within the scope of ASC 842 and, if so, whether the benefit to financial statement users of entities assessing those arrangements in accordance with the definition of a lease would outweigh the cost to the entities of doing so (both upon transition and on an ongoing basis).
2.4.2 Scope
ASU 2018-01 only addresses land easements. Although the FASB does not define this term, ASC 842-10- 65-1(gg) and paragraph BC3 of ASU 2018-01 describe both a land easement and a right of way as a “right to use, access, or cross another entity’s land for a specified purpose.”
Further, ASU 2018-01 effectively breaks land easements into two groups on the basis of the effective date of ASU 2016-02: (1) land easements entered into (or existing easements modified) on or after the effective date (collectively, “new land easements”) and (2) land easements that existed as of, or expired before, the effective date (collectively, “existing land easements”).
For existing land easements that were not previously accounted for as a lease under ASC 840, ASU 2018-01 provides a practical expedient under which an entity may elect to “run off” all such easements by using its historical accounting approach for land easements. Importantly, an entity may elect this practical expedient even if it does not elect the package of practical expedients in ASC 842-10-65-1(f) that would allow the entity not to reevaluate whether any expired or existing contracts are or contain leases. See Section 16.5.2.1 for more information about this “package of three” practical expedients.
Connecting the Dots
No
Analogies
We think that the FASB’s use of the term “land easements” is intentional. Therefore, we do not believe that an entity should analogize to the ASU’s favorable transition practical expedient for existing land easements when considering other types of arrangements.
For new land easements, ASU 2018-01 amends the illustrative example (Example 10) in ASC 350-30- 55-30 as follows to clarify that ASC 350 may only be applied after a new land easement is determined not to be a lease in accordance with the definition of a lease in ASC 842:
Entity A is a distributor of natural gas. Entity A has two self-constructed pipelines, the Northern pipeline and the Southern pipeline. Each pipeline was constructed on land for which Entity A owns perpetual easements that Entity A evaluated under Topic 842 and determined do not meet the definition of a lease under that Topic (because those easements are perpetual and, therefore, do not convey the right to use the underlying land for a period of time). The Northern pipeline was constructed on 50 easements acquired in 50 separate transactions. The Southern pipeline was constructed on 100 separate easements that were acquired in a business combination and were recorded as a single asset. Although each pipeline functions independently of the other, they are contained in the same reporting unit. Operation of each pipeline is directed by a different manager. There are discrete, identifiable cash flows for each pipeline; thus, each pipeline and its related easements represent a separate asset group under the Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10. While Entity A has no current plans to sell or otherwise dispose of any of its easements, Entity A believes that if either pipeline was sold, it would most likely convey all rights under the easements with the related pipeline.
In addition, paragraph BC11 of ASU 2018-01 states, in part:
The Board noted that a land easement conveys (in various forms) a right to use land and that a right to use land needs to be evaluated to determine whether it is within the scope of Topic 842. Accordingly, the
amendments in this Update provide clarity that an entity should apply Topic 842 to a land easement to determine whether that easement is or contains a lease. [Emphasis added]
Changing Lanes
New
Land Easements Must First Be Evaluated Under ASC
842
The FASB makes its objective for new land easements very clear in paragraph BC11 of ASU
2018-01, and the amendment to ASC 350-30-55-30 helps reinforce the scope hierarchy in GAAP with respect to such easements. That is, all new land easements must first be assessed under ASC 842 to determine whether the arrangement is, or contains, a lease.
If an arrangement is not a lease, other GAAP may be applicable (e.g., ASC 350, ASC 360). However, in paragraph BC11 of ASU 2018-01, the Board explains that it intentionally did not address the appropriate accounting guidance to apply in these situations:
While there may be diversity about which guidance an entity should apply when a land easement is not a lease, that diversity is outside the scope of the amendments in this Update and, accordingly, the amendments do not modify an entity’s accounting for land easements that are not leases.
2.4.3 Identifying a Lease
ASU 2018-01 is not intended to provide illustrative or application guidance
about whether new land easements6 meet the definition of a lease in ASC 842.
Therefore, stakeholders and respondents may
continue to raise questions about the application
of the definition of a lease to new land easement
arrangements, and it is possible that the FASB,
IASB, and SEC staffs will want to share their
perspectives as those questions are raised.
Companies involved in land easement arrangements
should consult with their accounting advisers and
monitor developments on the topic.
The required accounting once ASC 842 is effective will ultimately depend on the facts and circumstances of each arrangement. However, to determine whether a new land easement contract is, or contains, a lease in accordance with ASC 842-10-15-2 through 15-27, entities may find it helpful to group the contracts into one of two categories, further discussed below: (1) perpetual easements and (2) term-based easements. In addition, we recommend that high-volume users of easements begin their analysis by (1) segregating term-based arrangements on the basis of similar contractual provisions and (2) investigating the rights retained by the landowner in those arrangements. This may streamline the process since many easements will have similar or identical provisions and therefore would be expected to result in similar accounting.
2.4.3.1 Perpetual Easements
ASC 842-10-15-3 states, in part, “A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration” (emphasis added). When a land easement is perpetual, we would not
expect the arrangement to meet the definition of a lease given the lack of a stated term. As indicated by the amendments to ASC 350-30-55-30, rights conveyed in a land easement into perpetuity (i.e., for an unlimited time) are not conveyed “for a period of time” in accordance with ASC 842-10-15-3.
Arrangements with stated terms are not considered perpetual even if the terms
are very long (e.g., 100 years). On the other
hand, a use condition contained in a perpetual
easement (e.g., when an easement conveys rights to
the customer into perpetuity, as long as those
rights are used only to run fiber-optic cable)
would not affect the conclusion that a land
easement is perpetual.
2.4.3.2 Term-Based Easements
For term-based easements, the analysis will most likely be more extensive and involve a consideration of the right to control the use of the underlying land. That is, in accordance with ASC 842-10-15-4, entities will need to assess whether the customer in the arrangement has the right to (1) obtain substantially
all of the economic benefits from using the land throughout the period of use and (2) direct the use of the land throughout the period of use. Accordingly, many easement arrangements may not convey the right to control the use of the land to the customer given that the supplier continues to enjoy economic benefits derived from the use of the land and that the rights to direct the use of the land that are conveyed to the customer are limited (i.e., generally only for a specified purpose).
For example, in an arrangement in which a utility (as the easement holder) is
allowed to run electric transmission assets
through a farmer’s fields (i.e., transmission
lines that run over or under7 the farmer’s fields), it will be important
to understand whether the farmer can still use the
acreage subject to the easement (i.e., the acreage
under or over which the lines run). If so, the
utility may conclude that it does not have the
right to control the use of the land because the
farmer retains (1) rights to direct the use of the
land (e.g., rights to farm the land), (2) economic
benefits associated with the land that are not
insignificant (e.g., the crops yielded from
farming), or (3) both (1) and (2). On the other
hand, there may be easement arrangements that
effectively convey the right to control the use of
the land to the easement holder through the rights
conveyed or through use restrictions imposed on
the landowner.
In addition, to appropriately identify the unit of account, an entity sometimes may need to more carefully consider the identified asset in an easement arrangement, as illustrated in the common scenarios below.
Example 2-67
A customer enters into a land easement arrangement with a farmer for the right to pass a natural gas pipeline under the farmer’s land. At issue is whether the identified asset includes the entire plot of land or whether the land should be broken down into surface and subsurface rights, the latter of which the parties would evaluate to determine whether the customer has the right to control the use of the land.
If the identified asset is the entire plot of land, the parties are less likely
to conclude that the customer has the right to
obtain substantially all the economic benefits
from use of the land because the farmer retains
the surface rights (e.g., to farm the land).
However, if the identified asset is only the
subsurface rights, the customer might have the
right to obtain substantially all the economic
benefits from using the area below the surface of
the land. Further, subsurface rights for the same
plot of land may also be stacked in such a way
that one customer has an easement for the depth of
5 to 10 feet below the surface while another
customer has an easement for the depth of 10 to 20
feet below the surface.
Example 2-7
A customer enters into a land easement arrangement with a farmer for the right to construct and maintain 25 wind turbines on the farmer’s 500-acre plot of land. Each wind turbine will be constructed on individual acre plots. At issue is whether the identified asset is the entire 500-acre plot of land or whether there are 25 identified assets, each one acre of land.
As in the previous example, if the identified asset is the entire 500-acre plot of land, the parties are less likely to conclude that the customer has the right to obtain substantially all the economic benefits from use of the land because the farmer retains all of the rights to the economic benefits of the remaining 475 acres. However, if the identified assets are 25 individual acre plots of land, the customer may have the right to obtain substantially all the economic benefits from using each individual acre plot.
Connecting the Dots
An
Entity Will Need to Use Judgment to Determine the
Unit of Account
At its November 29, 2017, meeting, the FASB indicated that it would not provide additional, formal guidance on determining the unit of account with respect to performing the lease assessment for an easement. However, several Board members pointed out that an entity will need to use judgment in determining the unit of account and that diversity in practice could arise in this area. Board members have publicly expressed this view at previous meetings, including a July 2017 roundtable and an August 2017 meeting. Further, it was noted that the need to use judgment is not limited to scenarios involving subsurface rights (e.g., rights to run gas pipelines underground). Board members specifically discussed easements that convey only surface rights, including rights to construct renewable energy assets (e.g., wind or solar), noting that an entity will also be required to employ judgment in considering these arrangements and that there could be more than one approach to determining the unit of account.
On the basis of these views, we believe that, in practice, some will conclude that the unit of account is the entire land area defined by the easement contract (i.e., a larger area) while others will decide that a new unit of account should be established and assessed each time the easement holder occupies a portion of the land (i.e., a smaller area, such as the area taken up by a concrete pad used to serve as the foundation for a windmill or a transmission tower). We believe that either of these approaches is acceptable.
2.4.3.3 Treatment of Subsurface Rights as an Intangible Asset
As indicated in Example
2-6, certain easements may give an
entity the right to use area beneath the surface
of the land (i.e., the subsurface). Questions have
arisen about whether land below the surface should
be considered a unit of account that is separate
from the land’s surface in the identification of
whether a lease exists. Alternatively, others have
questioned whether the right to use the subsurface
is akin to an intangible asset (e.g., air rights)
that is outside the scope of ASC 842.
We believe that it may be
appropriate for an entity to analogize to air
rights (and thus treat subsurface rights as an
intangible asset) in certain circumstances, such
as those involving the use of subsurface space to
facilitate the build-out of a gas or electric
distribution system. We generally support an
analogy to air rights given the fact that
above-ground (air) and below-ground (subsurface)
uses are often commercially interchangeable. For
example, an electric utility can run its electric
wires 35 feet above the ground or 2 feet below the
ground, either of which will accomplish the same
commercial objective. Note that this analogy does
not apply to all underground scenarios (e.g.,
those involving the basement of a building or an
underground parking garage).
We believe that when a
subsurface easement conveys rights akin to air
rights, an entity is permitted, but not required,
to consider an arrangement that provides a right
to access the subsurface as an intangible asset by
analogy to air rights. Air rights are intangible
assets under ASC 805-20-55-37, which states:
Use rights such as drilling,
water, air, timber
cutting, and route authorities are contract-based intangible
assets to be accounted for separately from
goodwill. Particular use rights may have
characteristics of tangible, rather than
intangible, assets. For example, mineral rights
are tangible assets. An acquirer should account
for use rights based on their nature. [Emphasis
added]
Under this approach,
subsurface rights are outside the scope of ASC
842. The right to use the land’s surface would be
considered a unit of account that is separate from
subsurface rights.
We generally believe that if a
company does not analogize to air rights and
instead evaluates its subsurface easements under
ASC 842, the land below the surface should be
considered a unit of account that is separate from
the land’s surface in the identification of
whether a lease exists. Some have advocated a
“vertical slice” approach (i.e., evaluating the
right to use the surface and subsurface as a
single unit of account); however, we believe that
such an approach can lead to inappropriate
conclusions (e.g., a conclusion that an entity is
not leasing the land because it is not also
receiving the subsurface rights).
Companies should apply a
consistent approach to assessing their subsurface
easements and should consider disclosing this
approach, if such disclosure would be
material.
Footnotes
6
Although this section focuses
on land easements, we believe that the concepts
discussed herein can also be applied to other
types of land-use rights, including those provided
by the government in certain jurisdictions (e.g.,
countries that prohibit land ownership by foreign
investors). We think that entities should
generally assess whether such land-use rights are
leases before considering other applicable
GAAP.
7
See Section 2.4.3.3
for additional considerations related to
subsurface easements.
7
See footnote 6.
Chapter 3 — Identifying a Lease
Chapter 3 — Identifying a Lease
3.1 Introduction
As indicated in the decision tree in Section 2.2, whether a contract is within the
scope of ASC 842 is only a gating question. Once an entity determines that the
contract is within the scope, it must then proceed through the analysis in ASC
842-10-15 to determine whether the contract is or contains a lease.
Although a contract is not recognized and measured until commencement if it is a lease (see Chapters 8 and 9 for a detailed discussion of lessee and lessor accounting, respectively), the lease identification analysis must be performed at inception. If an arrangement is determined not to be, or not to contain, a lease, an entity must look to other U.S. GAAP (e.g., ASC 606) to determine the appropriate accounting and must apply the appropriate recognition and measurement guidance in such GAAP at whatever time is required, which could be at a contract’s inception.
Changing Lanes
Definition of a Lease Is the New Line
Between On- and Off-Balance-Sheet Treatments
Under ASC 842, the determination of whether an
arrangement is or contains a lease is critical. A lessee’s failure to
identify leases, including those embedded in service arrangements, is likely
to lead to a financial statement error given that ASC 842 requires lessees
to reflect all leases, other than short-term leases, on the balance sheet
(see Chapter 8
for further discussion of the lessee accounting model). On the other hand,
if a customer concludes that a contract is a service arrangement and does
not contain an embedded lease, the customer is not required to reflect the
contract on its balance sheet (unless it is required to do so by other U.S.
GAAP).
The assessment of the arrangement may be more critical under
ASC 842 than under ASC 840 because, under ASC 840, the balance sheet and
income statement treatment of operating leases was often the same as that of
service arrangements. In other words, under ASC 840, the difference between
on- and off-balance-sheet treatments often depended on whether the lease is
classified as operating or capital. Under ASC 842, however, all leases
(other than short-term leases) are on the balance sheet. Therefore, an
off-balance-sheet treatment will often depend on whether an arrangement
meets the definition of a lease.
3.2 Definition of a Lease
ASC 842-10
15-3 A contract is or contains a lease if the contract conveys the right to control the use of identified property,
plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time
may be described in terms of the amount of use of an identified asset (for example, the number of production
units that an item of equipment will be used to produce).
Pending Content (Transition
Guidance: ASC 842-10-65-7)
15-3A As a practical
expedient, an entity that is not a public business
entity; a not-for-profit entity that has issued or
is a conduit bond obligor for securities that are
traded, listed, or quoted on an exchange or an
over-the-counter market; or an employee benefit
plan that files or furnishes financial statements
with or to the U.S. Securities and Exchange
Commission may use the written terms and
conditions of a related party arrangement between
entities under common control to determine whether
that arrangement is or contains a lease. For
purposes of determining whether a lease exists
under this practical expedient, an entity shall
determine whether written terms and conditions
convey the practical (as opposed to enforceable)
right to control the use of an identified asset
for a period of time in exchange for
consideration. If an entity determines that a
lease exists, the entity shall classify and
account for that lease on the basis of those
written terms and conditions. An entity may elect
the practical expedient on an
arrangement-by-arrangement basis.
15-3B If no written terms or
conditions exist, an entity shall not apply the
practical expedient in paragraph 842-10-15-3A.
Rather, the entity shall determine whether the
related party arrangement between entities under
common control is or contains a lease in
accordance with paragraph 842-10-15-3 and, if so,
classify and account for that lease on the basis
of its legally enforceable terms and conditions in
accordance with paragraph 842-10-55-12.
15-3C If after an entity has
applied the practical expedient in paragraph
842-10-15-3A an arrangement is no longer between
entities under common control, the entity shall
determine whether a lease exists in accordance
with paragraph 842-10-15-3.
-
If the arrangement was previously determined to be a lease and continues to be a lease, the entity shall classify and account for the lease on the basis of the enforceable terms and conditions. If the enforceable terms and conditions differ from the written terms and conditions previously used to apply paragraph 842-10-15-3A, the entity shall apply the modification requirements in paragraphs 842-10-25-9 through 25-17 using the enforceable terms and conditions. If the enforceable terms and conditions are the same as the written terms and conditions previously used to apply paragraph 842-10-15-3A, the modification requirements in those paragraphs are not applicable.
-
If the arrangement was previously not determined to be a lease and is determined to be a lease, the entity shall account for the arrangement as a new lease.
-
If the arrangement was previously determined to be a lease and the lease ceases to exist:
-
A lessee shall apply the derecognition requirements for fully terminated leases in paragraph 842-20-40-1.
-
A lessor with a lease previously classified as a sales-type lease or a direct financing lease shall apply the derecognition requirements for terminated leases in paragraph 842-30-40-2.
-
A lessor with a lease previously classified as an operating lease shall derecognize any amounts that would not exist if the arrangement was not accounted for as a lease and account for the arrangement in accordance with other generally accepted accounting principles (GAAP).
-
15-4 To determine whether a contract conveys the right to control the use of an identified asset (see
paragraphs 842-10-15-17 through 15-26) for a period of time, an entity shall assess whether, throughout the
period of use, the customer has both of the following:
- The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs 842-10-15-17 through 15-19)
- The right to direct the use of the identified asset (see paragraphs 842-10-15-20 through 15-26). . . .
15-5 If the customer has the right to control the use of an identified asset for only a portion of the term of the
contract, the contract contains a lease for that portion of the term.
ASC 842-10-15-3 indicates that a lease is a contract — or part of a contract —
in which a supplier conveys to a customer “the right to control the use of
identified [PP&E] for a period of time in exchange for consideration.” The
graphic below illustrates this relationship.
Although the definition of a lease in ASC 842-10-15-3 includes the phrase “in exchange for
consideration,” the identification of a lease does not depend on whether the contract contains stated
or cash consideration. See Chapter 6 for a detailed discussion of lease payments and what constitutes
consideration.
3.2.1 Process for Identifying a Lease
To help entities determine whether a
contract is or contains a lease in accordance with ASC
842-10-15-3 and 15-4, the FASB included a flowchart in
its implementation guidance. Each piece of this
flowchart will be further discussed throughout the
remainder of this chapter.
|
ASC 842-10
15-8 Paragraph 842-10-55-1 includes a flowchart that depicts the decision process for evaluating whether a
contract is or contains a lease.
Identifying a Lease
55-1 The following flowchart depicts the decision process to follow in identifying whether a contract is or contains a lease. The flowchart does not include all of the guidance on identifying a lease in this Subtopic and is not intended as a substitute for the guidance on identifying a lease in this Subtopic.
Connecting the Dots
Not a Step-by-Step
Process
The FASB’s flowchart in ASC 842-10-55-1 appears to suggest that the lease identification
assessment comprises a series of steps. For example, the flowchart seems to imply that, in
determining whether it has the right to control the use of an asset, an entity must determine
whether there is an identified asset in the contract before it can move on to assessing the right
to control the use in the following sequential manner:
- Whether there is an identified asset.
- Whether the customer has the right to obtain substantially all of the economic benefits from use of the identified asset.
- Whether the customer has the right to direct the use of the identified asset.
However, Example 10, Case A, in ASC 842-10-55-124 through 55-126 (reproduced in Section
3.7.10) states that when the customer in a contract does not have the right to control the use
of PP&E, an entity does not need to assess whether the PP&E is an identified asset. Accordingly,
we do not think that it is necessary for lease identification to be performed on a step-by-step
basis. (However, a step-by-step assessment is required for the specific evaluation of whether the
customer has the right to direct the use of the asset — see Section 3.4.2 for further discussion.)
One way to think about identifying a lease is that the definition of a lease
sits on a three-legged stool. Each leg represents one of the three
requirements in ASC 842-10-15-4: (1) the contract depends on an
identified asset, (2) the customer has the right to obtain substantially
all of the economic benefits from use of the PP&E, and (3) the
customer has the right to direct the use of the PP&E. If you were to
kick out any one of the three legs (i.e., if you were to determine that
a contract does not meet any one of the requirements), the stool falls
over and the definition of a lease is not met.
The flowchart below illustrates an entity’s determination of whether a contract
is or contains a lease and ties into the discussion in the remainder of this
chapter.
Connecting the Dots
It’s All About
Control
The notion of control is critical in ASC 842. The concept is used to identify a lease as well as to classify one when it is identified (see Chapters 8 and 9 for a discussion of the lessee’s and lessor’s classification, respectively). Accordingly, there is effectively a two-step process related to the control concepts behind the FASB’s ROU model in ASC 842:
- Step 1 — Determine whether the customer has the right to control the use of an identified asset. If so, the contract is or contains a lease. If not, the supplier has the right to control the use of the asset.
- Step 2 — Determine the extent of the customer’s control over the use of the asset. There is a range of outcomes from this step. However, if enough control of the use rests with the customer, the customer effectively obtains control of the entire asset. The extent to which the customer has control of the use of the asset governs the classification of the lease and its accounting.
In paragraphs BC124 and BC125 of ASU 2016-02, the FASB notes that the control concept in the
definition of a lease (i.e., step 1 as described above) should be compatible with the same concept
articulated in the revenue standard (i.e., ASC 606) and the consolidation guidance (i.e., ASC 810). Further,
paragraph BC134 of ASU 2016-02 indicates that, in the determination of whether a customer has the
right to control the use of an asset under ASC 842, the concept of control should have “power” and
“benefits” (or “economics”) elements, just as ASC 606 or ASC 810 do for control of a good (or service) or
another entity, respectively.
The table below compares the control principles from the leasing, revenue, and
consolidation standards.
|
Consolidation
|
Revenue
|
Leasing
|
---|---|---|---|
ASC Reference
|
810-10-25-38A
|
606-10-25-25
|
842-10-15-4
|
Control principle (power and economics
elements)
|
“A reporting entity shall be deemed to
have a controlling financial interest in a VIE if it has
both of the following characteristics:
|
“Goods and services are assets, even if
only momentarily, when they are received and used (as in
the case of many services). Control of an asset refers
to the ability to direct the use of [power element], and
obtain substantially all of the remaining benefits from,
the asset [economics element].”
|
“To determine whether a contract conveys
the right to control the use of an identified asset . .
. for a period of time, an entity shall assess whether,
throughout the period of use, the customer has both of
the following:
|
3.2.2 Embedded Leases
Section
3.1 clarifies the balance sheet impact of properly
differentiating between a lease and a service under ASC 842. Further, certain
contracts may not be wholly a lease or wholly a service; in fact, it is not
uncommon for some service arrangements to contain a right to control the use of
an asset. An entity may enter into a service arrangement that involves PP&E
necessary to deliver the contract’s promised services. The importance of the
PP&E to the overall delivery of the service may vary depending on the type
of arrangement. For example, a customer contracting for transportation services
to ship a package from Munich to Milwaukee may care little about the PP&E
used to perform the services. In contrast, a customer contracting a vessel and
crew for a specified period to transport its goods where and when it chooses is
likely to be more concerned with the PP&E used in the arrangement. Both
arrangements, however, involve a significant service component provided by the
supplier to operate the PP&E used to fulfill its transportation
obligations.
In accordance with ASC 842-10-15-2, entities must evaluate
service arrangements that involve the use of PP&E to determine whether the
arrangements contain a lease at contract inception. Often, the assessment of
whether a contract is or contains a lease will be straightforward. However, the
evaluation will be more complicated when a service arrangement involves a
specified physical asset or when both the customer and the supplier make
decisions about the use of the underlying asset. Examples of these more
ambiguous and complex arrangements include those that involve cloud computing
services (i.e., if there is a lease of the supporting equipment, such as
mainframes and servers) and cable television services (i.e., if the cable box
provided to the customer is a leased asset).
Further, not all leases will be labeled as such, and leases may
be embedded in larger arrangements. For example, supply agreements, power
purchase agreements (PPAs), and oil and gas drilling contracts may contain
leases (i.e., there may be an embedded lease of a manufacturing facility,
generating asset, or drill rig, respectively). If an entity identifies PP&E
in an arrangement (either explicitly or implicitly), the customer and supplier
must both determine whether the customer controls the use of the PP&E
throughout the period of use.
3.2.2.1 Embedded Leases and Service Providers
In a manner consistent with the discussion in Section
3.2.2, it is important to review contracts (particularly
service contracts) to determine whether they are or contain a lease. When
the service provider also conveys control of PP&E to a customer, an
embedded lease (to the customer) is likely to exist. On the other hand, when
the customer conveys control of PP&E to the service provider to
facilitate the delivery of the service, it is less likely that there is an
embedded lease in the arrangement.
In certain industry sectors, it is common for a customer to
provide a vendor with the use of an asset (e.g., a piece of customer-owned
equipment) so that the vendor can provide goods or services to the customer
(i.e., the “vendor’s revenue contract”). The vendor’s use of the equipment
is typically limited to activities defined in the contract that by their
nature only benefit the customer. Further, the vendor would not have the
right to opt out of using the customer-owned equipment (i.e., the vendor
could not choose to bring vendor-owned or vendor-leased equipment). In
summary, the vendor typically must use the customer-furnished asset and the
asset’s use is contractually limited to fulfilling the terms of the vendor’s
revenue contract with the customer (i.e., the asset cannot be used to
satisfy the terms of other contracts of the vendor and may not be assigned
to third parties).
Arrangements in which customer-furnished assets are used
exclusively to fulfill the vendor’s contract with the customer typically
include either of the following:
-
One or more embedded leases that should be accounted for separately (i.e., a lease from the customer to the vendor and then a corresponding lease back from the vendor to the customer); some may describe such accounting as accounting for the arrangement on a gross basis.
-
No leases (such accounting is sometimes described as accounting on a net basis, suggesting an equal and offsetting exchange of rights because the substance of the transaction is that no leases exist).
We believe that, in accounting for such arrangements, an
entity should carefully evaluate the facts and circumstances to determine
whether control of an asset is transferred through the rights to use the
asset as conveyed in the arrangement. In some cases, it will be appropriate
to recognize a lease; however, we believe that when the three criteria
outlined below are met, control of the asset is not conveyed to one party
(vendor) and then transferred back to the owner (customer).
When the three criteria are met, the substance of the
transaction is that there are no leases (i.e., neither inbound nor outbound)
and the accounting should therefore be on a net basis (i.e., there are no
separate accounting effects related to the customer-furnished assets).
However, if these criteria are not met or are only met for a portion of the
term of the use of the customer-furnished asset, the vendor and customer
should further evaluate whether the customer has leased its asset to the
vendor.
The vendor (potential lessee/sublessor) and customer
(potential lessor/sublessee) should not treat customer-furnished assets as
embedded leases (and recognize the gross effects of such leases) only if all
of the following three criteria are met:
-
Linked contracts — The right to use the asset is directly linked to the revenue arrangement. That is, the arrangement is executed as part of one contract or each part of two or more contracts is deemed to be combined and accounted for as a single transaction since the contracts are interdependent.
-
Coterminous period — Some or all of the period of use of the asset is coterminous with the revenue arrangement. As discussed further below, if the period of use for the asset begins before or ends after the revenue arrangement, this condition would only be satisfied (and therefore net treatment would only be appropriate) for the overlapping period.
-
Restricted use — During the coterminous period identified in criterion 2, the vendor’s use of the asset is either restricted contractually or limited practically to solely transferring the goods or services promised in the revenue arrangement, including restricting the vendor from assigning or transferring the rights of the asset without the customer’s consent.
Accordingly, when all of the above criteria are met, there
are no leases of the asset and there would be no gross-up of revenue and
related expense (i.e., both the customer and the vendor would account for
the arrangement as a typical service contract) for the period in which the
vendor’s use of the identified asset coincides with the related revenue
contract (including renewal/extension options). If the vendor can use the
identified asset for a period longer than the related revenue contract,
there may be a lease for the excess period (i.e., use of the asset before or
after the related revenue contract begins or ends, respectively, provided
that control is conveyed to the vendor before or after the revenue contract
begins or ends, respectively). Therefore, the counterparties would need to
determine whether a lease commences when the related revenue contract
expires (or before it starts) because the output from the use of the
identified asset is no longer limited to satisfying the related revenue
contract.
The examples below illustrate situations in which the three
criteria are met and the arrangements would be accounted for on a net
basis.
Example 3-1
Customer-Furnished Equipment
Contractor C enters into a
three-year arrangement with Governmental Agency G,
the customer. Under the arrangement, C provides G
with military base operations related to mail and
food services while G owns and will provide C with
exclusive use of its mail sorting and delivery
equipment and food service equipment over the
three-year term to execute the services. That is, G
owns and will provide the use of all equipment that
C would need to deliver its services to G. The terms
of the contract explicitly limit C’s use of the
equipment to activities defined in the contract as
“contract activities,” and such contract activities
directly benefit G through the services provided by
C under the arrangement. Further, C cannot assign or
transfer its rights under the contract or further
sublease the equipment.
In this example, the three criteria
are met as follows:
-
Linked contracts — The right to use the equipment is directly linked to the revenue arrangement. That is, the military base operations arrangement is executed as a single contract that includes C’s use of G’s equipment to execute the contract activities that directly benefit G.
-
Coterminous period — The period of use of the equipment is coterminous with the three-year arrangement for military base mail and food services.
-
Restricted use — The right to use the equipment is contractually restricted to solely transferring the services promised in the military base operations arrangement. That is, C cannot use the equipment to derive other economic benefits (through offering services to other customers or for C’s internal use). In addition, the contract explicitly restricts C from assigning or transferring its rights under the contract or further subleasing the equipment.
Accordingly, there is no lease of
the mail sorting and delivery equipment or the food
service equipment. Therefore, G will not recognize
lease income as a lessor for C’s right to use its
assets and a separate lease expense associated with
the embedded lease in the services it receives from
C. Similarly, C will not recognize lease expense as
a lessee for its right to use G’s assets and
separate lease income for its provision of an
embedded lease within its service revenue
agreement.
Example 3-2
Customer-Furnished Property
Vendor V enters into a five-year
arrangement with a customer, Freight Carrier F, to
provide the maintenance services on F’s railcars.
The maintenance facility that V will use to execute
its services is owned by F. That is, F owns and will
provide exclusive use of its maintenance facility to
V to perform all the maintenance work over the
five-year term. The terms of the contract explicitly
limit V’s use of the maintenance facility to
activities defined in the contract as “contract
activities.” Accordingly, V cannot use the
maintenance facility (1) to service any customer
other than F or (2) for its internal use. Vendor V
cannot assign or transfer its rights under the
contract or further sublease the maintenance
facility.
In this example, the three criteria
are met as follows:
-
Linked contracts — The right to use the maintenance facility is directly linked to the revenue arrangement. That is, the maintenance services arrangement is executed as a single contract that includes V’s use of F’s maintenance facility to execute the contract activities that directly benefit F.
-
Coterminous period — The period of use of the maintenance facility is coterminous with the five-year arrangement for maintenance services.
-
Restricted use — The right to use the maintenance facility is contractually restricted to solely transferring the services promised in the maintenance services arrangement. That is, V cannot use the maintenance facility to derive other economic benefits (through offering services to other customers or for V’s internal use). In addition, the contract explicitly restricts V from assigning or transferring its rights under the contract or further subleasing the maintenance facility.
Accordingly, there is no lease of
the maintenance facility.1 Therefore, F will not recognize lease income
as a lessor for V’s right to use its maintenance
facility and a separate lease expense associated
with the embedded lease in the maintenance services
it receives from V. Similarly, V will not recognize
lease expense as a lessee for its right to use F’s
maintenance facility and separate lease income for
its provision of an embedded lease within its
service revenue agreement.
3.2.3 Joint Operations or Joint Arrangements
ASC 842-10
15-4 . . . If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.
Companies in a number of industries enter into joint arrangements to achieve a common commercial objective. These arrangements may include the use of specified PP&E for a stated time frame. Accordingly, under ASC 842-10-15-4, entities should evaluate such arrangements to determine whether they have the right to control the use of an asset.
Bridging the GAAP
No Joint Definitions
The terms “joint arrangement” and “joint operation” are defined in IFRS
Accounting Standards but not in U.S. GAAP. Under IFRS 11, a joint
arrangement is “an arrangement of which two or more parties have joint
control” and a joint operation is a type of joint arrangement
“whereby the parties that have joint control of the arrangement have
rights to the assets, and obligations for the liabilities, relating to
the arrangement.”
Although ASC 842 does not define these two terms, their use in U.S. GAAP is
aligned with that in IFRS Accounting Standards. The terms appear in ASC
842-10-15-4 for two reasons:
-
The FASB and IASB decided that the definition of a lease in ASC 842 would be converged with that in IFRS 16.
-
The FASB wanted to close a structuring opportunity so that entities cannot come together in a joint arrangement or joint operation structure to avoid identifying a lease and recognizing lease assets and lease liabilities.
Connecting the Dots
Joint Operating Agreements in the
Oil and Gas Industry
Entities in the oil and gas industry often enter into joint operating agreements (JOAs) in which
two or more parties (i.e., operators and nonoperators), without setting up a separate or new
legal entity, collaboratively explore for and develop oil or natural gas properties by using the
experience and resources of each party. These agreements often require the use of leased
equipment. Questions have arisen regarding ASC 842’s lease assessment requirements for
parties to JOAs. While we expect that the analysis of JOAs will be largely based on facts and
circumstances, the example and analysis below should be helpful to companies as they consider
these arrangements.
Example 3-3
Three companies — A, B, and C — form a JOA to execute an offshore drilling program. For the companies
to fulfill the JOA’s objective, a specific asset (e.g., a drill rig) will be necessary. Company A will act as the
counterparty to major contracts of the JOA, including a five-year contract to lease a specific drill rig from its
owner (Lessor X).
Question 1: Which Party, if Any, Is Leasing the Rig?
Given A’s role as primary obligor in the drill rig lease (the rig’s owner may
not be aware of the JOA and the parties that constitute
it), A will generally be deemed the lessee in the
arrangement. Accordingly, A will record the entire lease
on its balance sheet. Even though other parties will
receive economic benefits from the rig, those benefits
arise from the JOA and do not affect the
economic-benefits analysis of the contract between A and
the rig’s owner, X.
Question 2: What Is the Effect of the JOA?
The JOA’s terms may represent a sublease of the rig from A to the JOA. That is, ASC 842 requires the parties
to the JOA to consider the terms and determine whether the JOA is, or includes, a “virtual” lessee of the rig.
Although the JOA is typically not a legal entity that prepares financial statements, a conclusion that the JOA is a
lessee of the rig would have the following implications:
- Company A, as sublessor, would separately account for its sublease to the JOA (apart from its head lease with X, the rig’s owner).
- Each party to the JOA would need to consider other GAAP (e.g., proportionate consolidation guidance) that may require it to record its pro rata portion of lease assets and lease liabilities.
Note that the “other GAAP” mentioned in Question 2 of the example above may vary by industry (e.g.,
proportionate consolidation guidance is not applicable in many industries). Also note that the analysis
should be performed at the appropriate level, which may not always be the JOA. The “joint operation” or
“joint arrangement” mentioned in ASC 842-10-15-4 could be a subset of a JOA to the extent that multiple
parties have agreed to jointly use an identified asset for a defined time frame. For example, in a five-year
JOA involving five parties, if three of the parties agree to jointly develop a property by using a specified
drill rig for the first two years, it may be necessary to evaluate that two-year agreement to determine
whether it contains a lease.
The above example is not meant to suggest that most JOAs will contain leases but to highlight and explain the analysis that ASC 842-10-15-4 requires for joint arrangements involving the use of specified PP&E. We encourage entities affected by this issue to check with their auditors and accounting advisers for input on the accounting for specific arrangements.
Footnotes
1
While this example focuses on
the maintenance facility itself, a similar
analysis would apply to the land on which the
maintenance facility resides. Furthermore, we
believe that there are scenarios involving
vendor-owned assets attached to customer-owned
land (e.g., vendor-owned solar panels attached to
customer-owned land) whereby the land use rights
would be subject to the interpretive guidance in
this section.
3.3 Identified Asset
In accordance with the definition of a lease in
ASC 842, fulfillment of the contract must depend
on the use of an identified asset. This is an
important concept, as the Board notes in paragraph
BC128 of ASU 2016-02, because the customer must
know the asset over which it is agreeing to have a
right to control the use. Similarly, paragraph
BC105(a)(1) of the 2013 leasing exposure draft
(ED) explained that in contracts that do not
involve an identified asset (e.g., a service), the
customer does not have the right to control the
use of an asset.
Effectively, the FASB recognized that if an arrangement does not contain an identified asset, it is unlikely that the customer has the right to control the use of an asset. Accordingly, the Board decided against broadening the concept of identified assets to include, for example, assets of a particular specification. The Board stated as much in paragraph BC105(a)(2) of the 2013 leasing ED:
In most contracts for which there is no identified asset, the customer does not have the right to control the use of an asset. Consequently, widening the definition in that respect would possibly have forced some entities to go through the process of assessing whether the customer obtains the right to control the use of an asset, only to conclude that it does not. That would potentially have increased costs for little benefit.
Connecting the Dots
Explicit and Implicit Identification Are
Consistent With ASC 840
Paragraph BC128 of ASU 2016-02 states, in part, that the “requirement that there
be an identified asset is substantially the same as the requirement in previous GAAP
that a lease depends on the use of a specified asset.” In addition, ASC 840-10-15-5
noted that a specified asset may be either explicitly or implicitly specified in the
arrangement, which is consistent with ASC 842-10-15-9. Therefore, we do not expect ASC
842 to significantly differ from ASC 840 with respect to the explicit or implicit
identification of an asset.
However, the identified-asset notion in ASC 842’s definition of a lease differs
from ASC 840 regarding the assessment of substitution rights. See Section 3.3.3 for a detailed
discussion of this issue.
In many cases, the PP&E being leased will be
identified by an address, serial number, VIN, GPS
coordinates, etc. However, the assessment
sometimes may be more complex. The decision tree
below illustrates the process an entity should
consider when determining whether PP&E is
identified in the contract:
The remainder of this section walks through this decision tree in greater
detail.
3.3.1 Explicitly and Implicitly Specified Assets
ASC 842-10
15-9 An asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer.
The most observable forms of identified assets are those that are explicitly specified in the arrangement. Typically, an asset is explicitly specified through the inclusion of a serial number or part number in the contract. For example, if a customer enters into an arrangement to lease a computer server and the contract states that the customer has the right to use Server ABC123, the server is explicitly specified. Alternatively, if the contract states that the customer has a right to use any of the company’s servers that meet certain specification and functionality requirements, the server is not explicitly specified.
If an asset is not explicitly specified in the contract, an entity should consider whether an asset is implicitly specified in the arrangement. As stated in ASC 842-10-15-9, an asset that is implicitly specified can qualify as an identified asset. This concept is further expanded in paragraph BC128 of ASU 2016-02:
Nonetheless, when assessing whether there is an identified asset, an entity does not need to be able to identify the particular asset that will be used to fulfill the contract to conclude that there is an identified asset. Instead, the entity simply needs to know whether an asset is needed to fulfill the contract from commencement. If that is the case, an asset is implicitly specified.
The examples below illustrate cases in which assets are implicitly
specified.
Example 3-4
Railcars
Customer JB enters into a contract with Supplier TK to use a railcar to transport hazardous liquids over a three-year period. The contract does not explicitly specify the railcar that will be used to transport JB’s products but does stipulate that the railcar used must be capable of transporting hazardous bulk commodities (e.g., hazardous liquids and gases). Supplier TK has a large fleet of railcars but only one railcar that is designed to transport hazardous bulk commodities. Therefore, although the railcar is not explicitly specified in the contract, it is implicitly specified because TK has only one railcar that can be used to fulfill the contract.
If other, similar railcars are readily available to TK in the marketplace, substitution rights may need to be considered in the analysis as well. See Section 3.3.3 for further discussion of substitution rights.
Example 3-5
Servers
Customer TP, a health care provider, enters into a contract to store sensitive customer information subject to HIPAA regulations in a server farm. The contract does not explicitly specify the server farm that will be used by TP. However, because of the highly sensitive nature of the information that will be stored in the servers, the contract states that the server farm used must meet specific security and encryption requirements. Although the supplier has various server farms across the country, it only has one server farm with servers outfitted to match the security and encryption requirements outlined in the contract. Therefore, although that server farm is not explicitly specified in the contract, the server farm is implicitly specified as a result of the contractual provisions. To determine whether there is an identified asset, the parties must next assess whether the contract involves a capacity portion of the implicitly specified server farm that represents substantially all of the capacity of the server farm (see Section 3.3.2).
Example 3-6
Satellites
Supplier KB enters into a contract with Customer NL for satellite services so that the end users of NL’s services
can communicate across the globe. Supplier KB operates and maintains several satellites in orbit. However,
the services NL offers include global communication with specific compression and encryption. Accordingly,
NL needs a satellite that can transmit a unique signal that is specifically compressed and encrypted. Supplier
KB only has one satellite in orbit that can transmit this signal. Therefore, although this satellite is not explicitly
specified in the contract, it is implicitly specified because of the terms of the contract with NL. To determine
whether there is an identified asset, the parties must next assess whether the contract involves a capacity
portion of the implicitly specified satellite that represents substantially all of the capacity of the satellite (see
Section 3.3.2).
Connecting the Dots
Identified Assets When the Customer Has the
Right to Select and Use Parcels of Land Within a Larger Plot
Certain contracts grant customers the right to select and use a parcel of land within a larger plot
of land for a period of time. In these situations, the customer would need to assess whether it
has exclusive use of the parcels selected and whether the landowner retains the right to use
the remainder of the land that has not been selected by the customer. Questions have arisen
regarding whether the specified asset in these arrangements is the specific parcel(s) of land
selected by the customer or the larger plot of land. This determination is based on facts and
circumstances, and reasonable judgment may need to be applied. The example below illustrates
such scenarios. Also see Section 2.4 for a similar discussion related to land easements.
Although an asset may be explicitly or implicitly specified in the arrangement,
an entity must also evaluate whether (1) the
specified asset is a portion of a larger asset and
whether that portion is physically distinct or
substantially all of the larger asset’s capacity
and (2) the supplier has the right to substitute
the underlying asset throughout the period of use
and, if so, whether the supplier’s substitution
right is substantive. See the next section and
Section 3.3.3 for further discussion
of portions of assets and substantive substitution
rights, respectively.
3.3.2 Portions of Assets (Capacity and Physical Distinctness)
ASC 842-10
15-16 A capacity portion of
an asset is an identified asset if it is
physically distinct (for example, a floor of a
building or a segment of a pipeline that connects
a single customer to the larger pipeline). A
capacity or other portion of an asset that is not
physically distinct (for example, a capacity
portion of a fiber optic cable) is not an
identified asset, unless it represents
substantially all of the capacity of the asset and
thereby provides the customer with the right to
obtain substantially all of the economic benefits
from use of the asset.
An entity will need to use judgment in distinguishing between a lease and a capacity contract. ASC 842-10-
15-16 clarifies that a “capacity portion of an asset is an identified asset if it is physically distinct” (e.g., a
floor of a building).
Example 3-7
Use of a Portion of a Fiber-Optic Cable
Customer M, a telecommunications provider, enters into a 10-year contract with Supplier R for the right to use two fibers in a fiber-optic cable to transport data from New York City to London. Each fiber within the fiber-optic cable is physically distinct, and the contract explicitly specifies the two fibers that will be provided to M; therefore, the arrangement contains an identified asset.
On the other hand, a capacity portion of a larger asset that is not physically
distinct (e.g., a percentage of the capacity of a
pipeline) is not an identified asset unless the
portion represents substantially all of the
asset’s capacity.
Although ASC 842 does not
define “substantially all,” it uses the term in
the context of determining whether a capacity
portion of an asset represents an identified asset
as well as in discussion of the lease
classification test (i.e., determining whether the
present value of the lease payments represents
substantially all of the fair value of the
underlying asset). To help entities determine
whether the “substantially all” criterion is met
in the lease classification test, the FASB
included implementation guidance that allows
entities to use a 90 percent threshold.
Specifically, paragraph BC73 of ASU 2016-02
states, in part:
Nevertheless, the Board
understands that entities need to ensure the
leases guidance is operational in a scalable
manner, which often requires the establishment of
internal accounting policies and controls. As a
result, the Board included implementation guidance
in Topic 842 that states that one reasonable
application of the lease classification guidance
in that Topic is to conclude, consistent with
previous GAAP, that . . . 90 percent or greater is
“substantially all” the fair value of the
underlying asset.
Likewise, we believe that 90
percent should generally be used to determine
whether a capacity portion of an asset meets the
“substantially all” threshold. Therefore, under
this guidance, if the capacity portion being used
by the customer is 90 percent or more of the
asset’s total capacity, the customer is using
substantially all of the capacity of the asset. In
such a scenario, the entire asset would represent
an identified asset (subject to the guidance on
substantive substitution rights, discussed in
Section 3.3.3). Companies should
consult with their auditors, accounting advisers,
or both if they are considering the use of a
different percentage threshold for this
purpose.
Again, the FASB’s decisions
regarding portions of larger assets reflect the
importance of the control concept and establishing
which party to the arrangement controls the right
to use an asset. Paragraph BC133 of ASU 2016-02
states, in part, the following:
The Board concluded that a
customer is unlikely to have the right to control the use of a capacity portion of a
larger asset if that portion is not physically distinct (for example, if it is a 20
percent capacity portion of a pipeline). The customer is unlikely to
have the right to control the use of its portion because decisions about the use of
the asset are typically made at the larger asset level. [Emphasis added]
The examples below illustrate
the application of the guidance in ASC
842-10-15-16.
Example 3-8
Use of a
Portion of a Pipeline
Customer C enters into a
five-year contract with Supplier S for the right
to transport natural gas through S’s pipeline from
the Marcellus shale supply region in Pennsylvania
to the New York/New Jersey demand region. The
contract specifies the amount of the pipeline’s
capacity that C may use throughout the five-year
period. In each case, S has the right to contract
with other customers for the remaining capacity
not being used by C.
Case A
— Capacity Is Substantially All
The contract gives C the right
to use 93 percent of the capacity of S’s pipeline. In this case, because 93
percent represents substantially all of the pipeline’s capacity, the arrangement
contains an identified asset (i.e., S’s pipeline).
Case B
— Capacity Is Not Substantially All
The contract gives C the right
to use 26 percent of the capacity of S’s pipeline.
In this case, C does not have the right to use
substantially all of the pipeline’s capacity;
therefore, the arrangement does not contain an
identified asset.
Example 3-9
Use of a
Portion of a Warehouse
Case A
— Contract Does Not Contain an Identified
Asset
Customer LH enters into a
contract with a warehouse operator to store up to
1,000 pallets of spare-parts inventory at one of
the operator’s warehouse locations for a
three-year period. The operator’s warehouse can
store up to 10,000 pallets of inventory. During
the contract period, the warehouse operator can
use the remaining space in its warehouse for other
storage needs. In addition, the warehouse operator
can relocate LH’s pallets within the warehouse at
any time without incurring significant costs.
Because LH does not have
exclusive use of a specified portion of the
warehouse and the portion being used is not
substantially all of the warehouse capacity, there
is no identified asset. Although the contract
specifies the amount of spare-parts inventory that
will be held, the warehouse operator can change
the inventory’s location within its warehouse at
any time.
Case B
— Contract Contains an Identified
Asset
Assume the same facts as in
Case A, except that the operator’s warehouse can
only store up to 1,100 pallets, rather than
10,000. In addition, assume that the operator
cannot relocate the inventory to a different
facility.
Since Customer LH’s storage
requirement accounts for substantially all of the
capacity of the operator’s warehouse (more than 90
percent), the arrangement contains an identified
asset (i.e., the operator’s warehouse).
Connecting the Dots
Arrangements Involving Rights to Use Portions
of Larger Assets
We have received questions
about so-called secondary-use arrangements in
which a customer shares the use of part of a
larger asset for a defined period. Examples of
such arrangements include advertising placed on
the side of a fixed asset and nonutility
customers’ attachment of distribution wires (e.g.,
cable wires) to utility poles. Often, we have been
asked (1) how to assess economic benefits when two
parties contemporaneously use the same asset and
(2) what unit of account to use for the evaluation
of control (the larger asset or the portion being
shared).
ASC 842-10-15-16 provides
guidance on evaluating whether a portion of an
asset would be considered an “identified asset”
and could be subject to ASC 842. Under this
guidance, a “capacity or other
portion of an asset that is not physically
distinct . . . is not an identified asset, unless
it represents substantially all of the capacity of
the asset and thereby provides the customer with
the right to obtain substantially all of the
economic benefits from use of the asset” (emphasis
added).
Questions sometimes arise
regarding physical distinction, particularly in
scenarios involving a larger asset, a specific
portion of which is shared by one or more parties
over a defined period for use in different ways.
An example would be a building’s exterior wall to
which one party is granted the exclusive right for
advertising while the occupants of the building
continue to use the wall for support of their
residence, protection from the elements, and so
forth. Unlike situations involving the lease of
one floor of a multistory building, which is
functionally independent and unique, these
scenarios involve simultaneous but different uses
of a portion of a larger asset. Other examples
include the placement of solar panels on a
specific section of rooftop and the attachment of
cable wires to a specific spot on a utility pole
(in both cases, the owner continues to use the
entire asset while allowing another party to use a
portion of the asset for a different purpose over
a defined period). To the extent that there are
substantive substitution rights in these
arrangements, a lease will generally not be
present. However, we understand that many of the
scenarios found in practice do not allow for
substitution. (See Section 3.3.3
for a detailed discussion of substitution
rights.)
Some considerations that may
ultimately be relevant to the determination of
whether a lease exists include whether:
-
The arrangement involves a shared use of the larger asset, including the portion specified in the arrangement.
-
The portion being used by the customer is functionally independent and therefore separable from the larger asset.
-
The portion being used by the customer is commercially significant to the asset owner by design.
Shared
Use
Shared-use arrangements will
typically involve the contemporaneous use of the
same asset (or the same portion of a larger asset)
for different purposes. For example, many
advertising scenarios feature shared use (e.g., an
ad displayed on top of a baseball dugout, on the
side of a bus, or on the floor of a grocery
store). On the other hand, if the owner of the
asset is not contemporaneously using the asset (or
is not contractually allowed to use the asset),
shared use may not exist (e.g., a cell tower
operator that allows a customer to use a specific
hosting site on the tower for a defined period or
a satellite owner that allows a customer to use a
specific transponder on the satellite for a period
of time). Shared-use arrangements are less likely
to contain leases, while exclusive-use
arrangements (i.e., arrangements in which a
customer has exclusive use of a portion of a
larger asset) are more likely to contain leases.
An entity may need to use judgment in determining
whether a particular arrangement features shared
or exclusive use of the portion of the larger
asset.
Functional Independence
It may be useful to evaluate
the functional independence of the portion being
used by the customer, including the functional use
and design of the asset that is subject to the
arrangement. To the extent that the portion being
used by the customer has a discrete functional use
(e.g., a specific floor of a building), it could
be more likely that the portion being used is
physically distinct and an identified asset. On
the other hand, if the portion being used is not
functionally distinguishable from the larger asset
(e.g., a spot on a utility pole), there may be a
reasonable basis for viewing the larger asset as
the identified asset in the arrangement.
Commercial Significance by Design
It may also be useful to
consider commercial significance by design — that
is, the commercial objectives of the asset owner
when it built or purchased the asset. To the
extent that the asset was built or purchased with
the commercial objective of leasing a specific
portion or portions to others (e.g., specific
hosting locations on a cell tower), it could be
more likely that the portion being used for these
purposes is physically distinct and therefore an
identified asset. On the other hand, if the asset
was built or purchased without such a commercial
objective (e.g., a utility pole), there may be a
reasonable basis to view the larger asset as the
identified asset in the arrangement.
Determining Whether a Lease Exists
The above indicators may help
entities assess circumstances in which the use of
a portion of an asset might reasonably be viewed
as a secondary, or incidental, use of that portion
of the asset such that the owner retains
substantive economic benefits from the use of the
portion. Sometimes, it may be reasonable to view
the larger asset as the identified asset in the
arrangement and to assess control (including
economic benefits) on that basis. Such an approach
would generally make it more likely that the
arrangement does not contain a lease since the
customer may not obtain substantially all of the
economic benefits from the use of the larger asset
(the customer’s economic benefits are limited to
the portion it uses). The right to control the use
of an identified asset is discussed in detail in
Section 3.4, while the
economic-benefits element of control is discussed
in Section
3.4.1.
Our current views on this
topic are expressed in the examples and table
below. The SEC staff has indicated that it would
respect an entity’s conclusion regarding such
arrangements provided that it was based on
reasonable judgment. Therefore, arrangements
involving rights to use portions of larger assets
should be based on a careful assessment that takes
into account all relevant facts and
circumstances.
Example 3-10
Contract
for the Use of Space on a Cell Tower
Customer A enters into a
five-year contract with Supplier B to use space on
a cell tower. Customer A is assigned a
specifically identified hanger (hosting spot) on
the cell tower on the basis of its needs to
install its antennae and other telecommunications
equipment. Each hosting spot is commercially
designed to be leased by B’s customers, and each
comprises its own functionally independent
infrastructure that allows B’s customers to
install their equipment at the hosting spots.
Accordingly, A is not the only party with
equipment installed on the overall tower; rather,
A shares the use of the tower with third
parties.
Supplier B is not permitted to
move A’s equipment to a different hosting spot or
cell tower. In addition, A is the only party that
may install equipment on its identified hosting
spot. Customer A may install whatever antennae or
equipment it wants, subject to certain maximum
weight and height restrictions.
The arrangement contains an
identified asset because (1) the hosting spot is
explicitly identified in the contract and is
physically distinct from the larger asset (i.e.,
from the cell tower) and (2) B may not substitute
the asset (i.e., it may not move A’s equipment to
a different hosting spot or tower). Alternatively,
if B had the right to substitute hosting spots or
towers, the parties must assess whether that right
is a substantive substitution right (see Section
3.3.3).
Example 3-11
Contract
for the Use of a Portion of a Satellite
Customer A enters into a
five-year contract with Supplier B to use space on
a satellite. In a manner similar to the assigning
of the hanger on the cell tower in the example
above, A is assigned a specifically identified
transponder on the satellite. Each transponder is
commercially designed to be leased to B’s
customers, and each comprises its own functionally
independent infrastructure that allows B’s
customers to transmit data signals to and from the
transponder. Accordingly, A shares the use of the
overall satellite with third parties.
Supplier B is not permitted to
transfer A to a different transponder or satellite
for reasons other than warranty-related
considerations. In addition, A is the only party
that may transmit data signals to and from its
identified transponder. Customer A may transmit
whatever data it wants, subject to certain
frequency limitations that stem from the nature of
the transponder and satellite.
The arrangement contains an
identified asset because (1) the transponder is
explicitly identified in the contract and is
physically distinct from the larger asset (i.e.,
from the satellite) and (2) B does not have a
substantive substitution right (i.e., it may not
transfer A to a different transponder or
satellite, except for warranty-related
considerations).
Asset (Use)
|
Identified Asset?
|
Basis
|
---|---|---|
Wall space (e.g., painting an advertisement on the side of
a building)
|
No
|
The advertising is a secondary use of the wall. That is,
the wall’s primary purpose — the reason it was commercially designed — is to
hold up the building structure and protect the building’s occupants from the
elements. In addition, the advertiser is unlikely to obtain substantially
all of the capacity (or economic benefits from use) from the wall by using
its portion, which indicates that there is not an identified asset with
respect to the portion.
|
Retail floor advertising space (e.g., painting an
advertisement on the floor of a grocery store)
|
No
|
Similar to the basis articulated for wall space.
|
Side of a bus shelter or commuter train shelter (e.g.,
placing an advertisement on one wall of the shelter)
|
No
|
Similar to the basis articulated for wall space.
|
Billboard (e.g., placing an advertisement on a stand-alone
billboard or a billboard attached to another structure)
|
Yes
|
A billboard is commercially designed to be contracted to
customers for displaying advertisements. In addition, billboards attached to
other, larger structures (e.g., when hung on the side of a building) are
physically distinct from the larger structure.
|
Taxi tent (e.g., placing an advertisement on the sides of
a removable, magnetic tent on top of a taxi)
|
Yes
|
Similar to the basis articulated for a billboard (i.e., a
taxi tent is effectively a mobile billboard).
|
Pole attachments (e.g., either (1) a utility attaching its
lines to a pole owned by a phone company, or (2) a phone company attaching
its wires to a pole owned by a utility)
|
No
|
All spots on the pole where a customer would hang its
wires are functionally dependent on the rest of the structure, and none are
physically distinct.
|
Space on a rooftop to construct a bar or restaurant
|
Yes
|
In this case, the rooftop functions independently as a
floor in a building would. In accordance with ASC 842-10-15-16, the floor of
a building is a physically distinct portion of a larger asset.
|
Space on a rooftop for an advertisement (e.g., for when
commercial airplanes fly overhead)
|
No
|
Similar to the basis articulated for wall space, retail
floor advertising space, and the side of a bus shelter or commuter train
shelter.
|
Space on a rooftop to install solar panels (e.g., that
serve tenants of the building or a utility’s larger customer base)
|
It depends
|
Judgment is required. Space on a rooftop to install solar
panels may be similar to (1) space on a rooftop to construct a bar or
restaurant, (2) space on a rooftop for an advertisement, or (3) both of
these.
|
Kiosk in a mall (e.g., used by a customer for retail
purposes)
|
Yes
|
As long as there are no substitution rights akin to those
in Example 2 in ASC 842-10-55-52 through 55-54 (reproduced in Section 3.7.2), the
kiosk is physically distinct, functionally independent, and commercially
designed to be contracted to customers as retail space.
|
3.3.2.1 Pipeline Laterals and First-Mile/Last-Mile Connections (Identified Asset)
Pipelines are generally
constructed and operated in sprawling and integrated networks that transport natural
gas, oil, and refined products from supply regions to demand regions. Some customers are
connected to, and receive deliveries of transported commodities through, the larger
pipeline system via dedicated laterals. In addition, a pipeline system must, by its
nature, have starting and ending points. Therefore, these customers are connected to the
pipeline system through laterals, because they are connected to the first mile or last
mile of the larger pipeline system.
Customers connected to a
lateral or first mile/last mile of a pipeline system enter into contracts with the
pipeline system owner for transportation services through the network to their
connection point. Those contracts should be assessed to determine whether they are or
contain leases of the lateral or first mile/last mile.
ASC 842-10-15-16 (reproduced in Section 3.3.2) states
that a “capacity portion of an asset is an
identified asset if it is physically distinct (for
example, a floor of a building or a segment of
a pipeline that connects a single customer to the
larger pipeline)” (emphasis added). Pipeline
laterals and first-mile/last-mile connections
therefore are physically distinct from the larger
asset (i.e., the integrated pipeline system) and
are identified assets.
The FASB addressed this topic
at its May 10, 2017, Board meeting on implementation issues related to ASC 842. The
Board agreed that under ASC 842-10-15-16, a pipeline lateral is an identified asset and
that the assessment of whether it is a lease must focus on whether the customer has the
right to control the use of the identified asset in accordance with ASC 842-10-15-4
(reproduced in Section
3.2). See Section
3.4.2.1.2.2 for further discussion of the analysis related to whether the
customer has the right to control the use of the identified asset (i.e., the pipeline
lateral).
First-mile/last-mile
connections to other types of assets and infrastructural systems are generally
identified assets. In accordance with ASC 842-10-15-16, a portion of a larger asset is
physically distinct, and thus an identified asset, if it connects a single customer to
the larger asset or system. Even when the portion is part of a contiguous asset and is
not separable from the larger system, that portion may only serve a single customer and
thus is physically distinct.
Portions of assets to which
the guidance in ASC 842-10-15-16 may apply include, but are not limited to:
- Train tracks that connect a customer’s facility to the larger rail network.
-
Electric distribution lines that run (either overhead or underground) from the street, transformer, etc., to a customer’s home or facility.
-
Telephone wires that run (either overhead or underground) from the street to a customer’s home.
-
Coaxial and fiber-optic cables (i.e., for cable television and Internet) that run (either overhead or underground) from the street to a customer’s office building.
In line with the above
discussion, even if the arrangement depends on an identified asset because the first
mile/last mile is considered physically distinct, the customer may not have the right to
direct the use of the first mile/last mile (see Section 3.4.2.1.2.2 for detailed discussion).
3.3.3 Substantive Substitution Rights
ASC 842-10
15-10 Even if an asset is
specified, a customer does not have the right to
use an identified asset if the supplier has the
substantive right to substitute the asset
throughout the period of use. A supplier’s right
to substitute an asset is substantive only if both
of the following conditions exist:
-
The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).
-
The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).
15-11 An entity’s evaluation of whether a supplier’s substitution right is substantive is based on facts and
circumstances at inception of the contract and shall exclude consideration of future events that, at inception,
are not considered likely to occur. Examples of future events that, at inception of the contract, would not be
considered likely to occur and, thus, should be excluded from the evaluation include, but are not limited to, the
following:
- An agreement by a future customer to pay an above-market rate for use of the asset
- The introduction of new technology that is not substantially developed at inception of the contract
- A substantial difference between the customer’s use of the asset, or the performance of the asset and the use or performance considered likely at inception of the contract
- A substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract.
Once an entity has determined that PP&E is specified in a contract, it must also evaluate whether
the supplier has the right to substitute the underlying asset throughout the period of use and, if so,
whether the supplier’s substitution right is substantive. If the supplier has a substantive substitution
right, the underlying asset does not represent an identified asset and the contract does not contain a
lease. Paragraph BC128 of ASU 2016-02 notes that the FASB’s reason for establishing this requirement
was that if a supplier has a substantive right to substitute the asset throughout the period of use, “the
supplier (and not the customer) controls the use of the asset . . . , thereby deciding for what purpose the
asset is used.”
Accordingly, the FASB developed guidance in ASC 842-10-15-10 through 15-15 to help entities determine whether a substitution right is substantive. The Board explains in paragraph BC129 of ASU 2016-02 that its purpose in establishing this guidance was to differentiate between the following:
- Substitution rights that result in there being no identified asset because the supplier, rather than the customer, controls the use of an asset
- Substitution rights that do not change the substance or character of the contract because it is either not practically or economically feasible for the supplier to exercise those rights or not likely the supplier will be able to exercise those rights.
When developing the framework for the identified-asset notion in the 2013 leasing ED, the Board received significant feedback from stakeholders indicating that substitution rights and clauses in contracts could be used to structure arrangements so that they did not meet the definition of a lease (and, thus, so that lessees could avoid recognizing lease assets and lease liabilities on the balance sheet). The Board acknowledged this in paragraph BC105(b) of the 2013 leasing ED, which stated, in part:
The [Board has] included additional language to help determine when substitution rights are substantive. [Its] intention in doing so is to discourage the insertion of a substitution clause in a contract, which does not change the substance or character of the contract, solely to achieve a particular accounting outcome.
For a substitution right to be considered substantive, the following two conditions must be met:
- The supplier must have the “practical ability” to substitute the identified asset (see Section 3.3.3.1).
- The supplier must economically benefit from the substitution (see Section 3.3.3.2).
Connecting the Dots
Economically Beneficial Substitution Is a
Higher Hurdle Than Under ASC 840
ASC 840-10-15-10 through 15-14 addressed substitution rights. Generally, if an
arrangement gives the supplier a substitution right and the supplier has the practical
ability to exercise that right, the fulfillment of the arrangement does not depend on
the specified PP&E. Under ASC 840, “practical ability” took into account
contractual, legal, and economic constraints but does not require that a supplier
economically benefit from a substitution.
Accordingly, ASC 842’s requirement that a substitution right be economically beneficial to a supplier is a higher threshold than the requirements in ASC 840. We therefore expect that fewer entities will be able to avoid lease identification as a result of substitution rights in their arrangements. In other words, we expect that more arrangements will be subject to lease accounting under ASC 842.
The next section and Section
3.3.3.2 address how an entity would
assess the two conditions in ASC 842-10-15-10 to
conclude that a substitution right is substantive.
See also Example 2 in ASC 842-10-55-52 through
55-54 (reproduced in Section 3.7.2),
which illustrates the assessment of these
conditions in the context of concession space in
an airport.
3.3.3.1 Practical Ability to Substitute Alternative Assets
ASC 842-10
15-13 If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier does not have the practical ability to substitute alternative assets throughout the period of use.
Common indicators that the supplier has the practical ability to substitute alternative assets throughout
the period of use include the following:
- The customer cannot prevent the supplier from substituting an asset (i.e., the customer cannot block the substitution). See further discussion below.
- Alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period. However, in accordance with ASC 842-10-15-11, the supplier may not consider future events that, at inception, are considered unlikely to occur. If such events are considered unlikely to occur, the supplier may not assume in its assessment that alternative assets will be readily available to the supplier because of circumstances such as future manufacturing economies of scale, future technological developments, or assets otherwise becoming available in the future that are not available at inception.
- There are no contractual restrictions on when a supplier may substitute the asset. ASC 842-10-15-13 states that the supplier does not have the practical ability to substitute the asset when substitution rights are only exercisable on, or after, a particular date or are only exercisable upon the occurrence of a certain event or the resolution of a contingency.
These common indicators are further considered below.
Connecting the Dots
When Contractual Provisions Specify That
Customer Approval Is Needed Before Substitution
Certain contracts may specify that the supplier must obtain
approval from the customer before substituting the underlying asset. In such
circumstances, because the customer can block the supplier from substituting the
underlying asset, the supplier does not have the practical ability to substitute the
asset. Therefore, the supplier’s substitution right is not substantive.
To have the practical ability to substitute the asset in
accordance with ASC 842-10-15-10(a), the supplier must be able to substitute the
asset without the customer’s approval. Customer consent or approval rights may come
in different forms. For example, the customer may be contractually granted a right
that allows it to block the substitution itself or may be able to prevent the
supplier from accessing the customer’s premises to substitute the asset when the
underlying asset is located there. An entity should consider the substance and
nature of any rights granted in the contract that may give the customer the right to
prevent substitution.
Substantive Substitution Rights Less Relevant for Implicitly
Specified Assets
We think that the assessment of whether a supplier has a
substantive substitution right in contracts that explicitly specify the asset to be
used to fulfill the contract is generally more relevant than that in arrangements
for which fulfillment depends on the use of an implicitly specified asset. As
discussed in Section
3.3.1, an implicitly specified asset typically exists when the supplier
has only one asset (or very few assets) that may be used to fulfill the supplier’s
obligation under the contract (e.g., a railcar that can carry hazardous commodities,
a server farm with specific security features, or a satellite that can transmit a
unique signal). If a supplier only has one asset that can be used to fulfill its
obligations under the contract, the supplier most likely does not have the practical
ability to substitute the underlying asset. For that reason, a supplier generally
does not have a substantive substitution right for implicitly identified assets.
Example 3-12
Supplier Does Not Have the
Practical Ability to Substitute
Company BC enters into an arrangement with Supplier LP
under which LP will provide a customized Model 5000 copier to BC for two
years. Supplier LP only has one customized Model 5000 copier. The
arrangement allows LP to replace the copier at will. However, LP would
need several months to manufacture such a replacement. Accordingly, no
alternative assets are available for substitution. Because LP only has
one asset that can be used to honor the agreement with BC and does not
have the practical ability to substitute it, LP’s substitution right is
not substantive.
Evaluating the Period of Use When a Substitution Right
Exists
ASC 842-10-15-13 states that when a “supplier has a right or an
obligation to substitute [PP&E] only on or after either a particular date or the
occurrence of a specified event, the supplier does not have the practical ability to
substitute alternative assets throughout the period of use”
(emphasis added). (See Section
3.5 for further discussion of determining the period of use.)
Accordingly, in such cases, the substitution right is not substantive because the
contract restricts when the supplier can substitute the asset. Therefore, the
supplier may not use the substitution right to conclude that the contract is not, or
does not contain, a lease because there is no identified asset.
However, questions have arisen regarding the effect of timed
substitution rights. The next sections address front-loaded and back-loaded
substitution rights.
Front-Loaded Substitution Rights
Assume that a customer enters into a contract with a supplier for
the right to use an asset for 10 years. The supplier has a front-loaded substitution
right to substitute the asset in years 1 and 2. Although that right expires at the
end of year 2, the right is substantive within years 1 and 2. The contract otherwise
meets the definition of a lease, and no other contractual terms would prevent a
conclusion that there is an identified asset in the contract.
-
View A — One view is that a contract that would otherwise meet the definition of a lease in ASC 842, but that contains a front-loaded substitution right, is a forward-starting lease. According to this view, both the customer and the supplier have a forward-starting lease that commences at the beginning of year 3 when there is an identified asset.In performing a lease assessment, an entity must identify whether a contract is, or contains, a lease. In addition, ASC 842-10-15-9 indicates that an asset can be identified once it is made available for the customer’s use. Effectively, in a manner consistent with the definition of “commencement date of the lease” in ASC 842 (see Section 5.1), a lease does not commence until an identified asset is made available for the customer’s use. Therefore, a contract may contain a lease for the period after the expiration of the substitution right.View A is consistent with ASC 842-10-15-5, which indicates that a contract that gives the customer the right to control the use of an identified asset for only a portion of a contract term contains a lease for that portion of the contract term.
-
View B — Another view is that there is an identified asset, and thus a lease, at the beginning of year 1.Proponents of this view subscribe to a literal reading of ASC 842-10-15-13, which requires that, for a supplier to “have the practical ability to substitute alternative assets,” the substitution right must exist throughout the period of use. In a manner consistent with the definition of “period of use” in ASC 842 (see Section 3.5), an asset is used to fulfill the contract — in this case for 10 years. The substitution right does not exist for all 10 years and is therefore not substantive.
Back-Loaded Substitution Rights
Assume that a customer enters into a contract with a supplier for
the right to use an asset for 10 years. The supplier has a back-loaded substitution
right under which it can substitute the asset in years 9 and 10. Although that right
does not exist until the beginning of year 9, the right is substantive during years
9 and 10. The contract otherwise meets the definition of a lease, and no other
contractual terms would prevent a conclusion that there is an identified asset in
the contract.
-
View A — One view is that the contract contains an eight-year lease that commences at the beginning of year 1 and expires at the end of year 8.In a manner similar to the concepts articulated in ASC 842-10-15-23 (reproduced in Section 3.4.2.2), the substitution rights in years 9 and 10 define the scope of the customer’s right to control the use of an identified asset. Accordingly, within that scope, the contract contains an identified asset — and thus a lease — for the first eight years of the contract term.In addition, View A is consistent with ASC 842-10-15-5, which indicates that a contract that gives the customer the right to control the use of an identified asset for only a portion of a contract term contains a lease for that portion of the contract term.In this view, substitution rights are approached in a manner consistent with View A on front-loaded substitution rights (articulated above).
-
View B — Another view is that there is an identified asset, and thus a lease, for all 10 years of the contract.In this view, substitution rights are approached in a manner consistent with View B on front-loaded substitution rights (articulated above).
In both the front-loaded and back-loaded substitution right
scenarios described above, we believe that it would be acceptable for an entity to
apply either view. However, since ASC 842 does not provide clear guidance on this
topic and we are aware that views on the issue differ, we encourage affected
stakeholders to consult with their accounting advisers and auditors.
3.3.3.2 Economic Benefit From Exercise of Substitution Rights
ASC 842-10
15-12 If the asset is located at the customer’s premises or elsewhere, the costs associated with substitution
are generally higher than when located at the supplier’s premises and, therefore, are more likely to exceed the
benefits associated with substituting the asset.
In addition to having the practical ability to substitute the asset, a
supplier must benefit economically from the substitution for the substitution right to
be substantive. ASC 842-10-15-10(b) states that the “supplier would benefit economically
[if] the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset”
(emphasis added). As indicated in ASC 842-10-15-12, when the underlying PP&E is
located “at the customer’s premises or elsewhere,” it is more likely that the costs of
substituting the asset will exceed the benefits to the supplier of doing so. This, in
effect, creates a presumption that the costs of substitution will exceed the benefits
when the asset is not located at the supplier’s premises. Accordingly, an entity may
need to perform a quantitative analysis of the costs and benefits of substitution before
concluding that the supplier would benefit economically from the exercise of its right
to substitute the asset.
In evaluating whether a supplier would economically benefit from
substituting an asset, and thus whether the supplier’s substitution right is
substantive, an entity should consider all costs that would be associated with the
substitution. Such costs may include, but are not limited to, the following:
-
Costs of (1) removing the existing asset and transporting it to a new location or (2) disposing of the asset.
-
Costs of gaining access to the customer’s premises when the underlying asset is located there.
-
Costs of transporting, installing, and testing the alternative assets.
-
Additional costs of configuring and operating the alternative assets, as necessary.
-
Customer losses associated with reduced production and increased downtime during the substitution process.
Costs that would have been incurred regardless of the substitution
should not be considered in the evaluation of whether the supplier would benefit
economically from the substitution.
Connecting the Dots
Economic Benefit Depends on Future Events
That Are Not Likely to Occur
ASC 842-10-15-11 states, in part, that an entity’s assessment of
“whether a supplier’s substitution right is substantive is based on facts and
circumstances” that exist as of contract inception and should ignore the effects of
future events that “are not considered likely to occur.” Therefore, when evaluating
whether a supplier would benefit economically from substituting the asset, entities
should not take into account the effects of future events that are not likely
to occur. Typically, such future events are outside the supplier’s control or the
supplier does not have historical evidence to support that the events will occur.
ASC 842-10-15-11 gives the following examples of such future events:
-
A new customer agrees to “pay an above-market rate for use of the asset.”
-
New technology is introduced.
-
There is a “substantial difference between the customer’s use of the asset, or the performance of the asset,” compared with that at contract inception.
-
There is a substantial change in the market price of the asset from the market price considered likely at inception.
The examples below illustrate the evaluation of whether a supplier
would benefit economically from exercising its right to substitute the underlying asset.
In addition, Example 4 in ASC 842 (ASC 842-10-55-63 through 55-71, reproduced in
Section 3.7.4)
illustrates the evaluation of a substitution right for which the supplier has the
practical ability to exercise its right but would not economically benefit from doing
so.
Example 3-13
Storage Locker
Company SM owns a storage facility comprising individual
storage lockers that it rents to customers for an annual fee. Each storage
locker is identified with a unique locker number, and each contract
explicitly specifies the locker number that has been assigned to the
customer. The contract also states that SM has the right to relocate, at its
sole discretion at any point during the annual rental period, the customer’s
belongings to any other locker that is the same size in the storage
facility. Company SM has a large number of available storage lockers within
the storage facility to accommodate other customers. Company SM’s cost of
relocating a customer’s belongings are less than the benefits that SM
receives by accommodating new customers.
Company SM has a practical ability to relocate each
customer’s belongings because the customer cannot block the substitution and
other storage lockers with the same specifications are readily available.
Because the economic benefits of providing storage lockers to new customers
outweigh the costs of relocating an existing customer’s belongings to
another storage locker, SM would also benefit economically from the
substitution. Therefore, SM has a substantive substitution right and an
identified asset does not exist. Accordingly, the contract does not contain
a lease and should be accounted for in accordance with other applicable U.S.
GAAP.
Example 3-14
Copier/Printer
Company A enters into an arrangement with Supplier B under
which B will provide a Model 5000 copier to A for two years. Company A will
use the Model 5000 copier on its own premises throughout the two-year
contract term. The contract explicitly specifies the copier that will be
provided to A but stipulates that B may replace the copier at will. Supplier
B has multiple Model 5000 copiers similar to the copier provided to A.
However, if a replacement copier were needed, B would incur significant
installation and transportation costs to substitute the copier. In addition,
B would incur costs associated with gaining access to A’s premises and may
be responsible for recouping A’s losses associated with downtime. The costs
that would be incurred outweigh the related benefits of substitution.
Supplier B has the practical ability to substitute the
copier because the customer cannot block the substitution and replacement
copiers with similar specifications are readily available to B. Although B
has the practical ability to substitute the copier, B would not benefit
economically from the substitution because the costs of substitution
outweigh the related benefits. Therefore, B does not have a substantive
substitution right. Because the copier is explicitly specified in the
contract and B does not have a substantive substitution right, an identified
asset exists.
3.3.3.3 Warranty or Upgrade Considerations
ASC 842-10
15-14 The supplier’s right or obligation to substitute an asset for repairs or maintenance, if the asset is not
operating properly, or if a technical upgrade becomes available, does not preclude the customer from having
the right to use an identified asset.
Notwithstanding the requirements in ASC 842-10-15-10, certain substitution
rights do not preclude the underlying asset from
being an identified asset. Specifically, a
substitution right is not substantive if a
supplier’s right (or obligation) to substitute an
alternative asset is limited to either operational
failure (i.e., a replacement asset must be used
while the original asset is undergoing repairs or
maintenance) or technical upgrade (i.e., a newer
version of the same asset becomes available).
Further, paragraph BC131 of ASU 2016-02 states, in
part, that “if a supplier has the right or
obligation to substitute an asset for the purpose
of repair or maintenance, . . . those substitution
rights . . . are not substantive regardless of
whether those circumstances are specified in the
contract.” It is thus important for entities to
understand both whether the supplier has the right
to substitute the asset and the reason for the
substitution provision when evaluating whether an
identified asset exists.
Entities should also assess whether the supplier has agreed to transfer a good
or service (a nonlease component) for the warranty
or upgrade provisions. For a detailed discussion
of the separation of lease and nonlease
components, see Chapter 4 of
this Roadmap. Suppliers in such arrangements
should also consider Section 5.5 of
Deloitte’s Roadmap Revenue
Recognition.
3.3.3.4 Presumption That Substitution Right Is Not Substantive
ASC 842-10
15-15 If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive.
It may be difficult (or nearly impossible, in some circumstances) for the customer to determine whether the supplier’s substitution right is substantive. For example, the customer may not know whether the substitution right gives the supplier an economic benefit.
A customer should presume that a substitution right is not substantive if it is impractical to prove otherwise; this determination involves significant judgment. Paragraph BC132 of ASU 2016-02 explains that the FASB’s reasoning for including this provision was to provide customers with some practical relief:
[T]he Board decided to add guidance stating that if a customer cannot readily determine whether a supplier has a substantive substitution right, the customer should presume that any substitution right is not substantive. It is intended that a customer should assess whether substitution rights are substantive if it is reasonably able to do so; if substitution rights are substantive, the Board noted that this should be relatively clear from the facts and circumstances. However, the requirement also is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive.
Connecting the Dots
Guidance on Substantive Substitution Rights
Is Anti-Abusive and May Result in Accounting Asymmetry
We view the guidance in ASC 842-10-15-15 as anti-abusive. That is, a lessee must
clear a high hurdle to conclude that substitution rights in an arrangement are
substantive and may need to perform a quantitative analysis in doing so (as
discussed in Section
3.3.3.2).
However, ASC 842-10-15-15 is only anti-abusive from the perspective of the lessee since it is written with only the customer in mind (i.e., the party that would potentially be recognizing an ROU asset and a lease liability). The supplier, on the other hand, is expected to have enough information at its disposal to readily determine whether its substitution rights are substantive.
Therefore, ASC 842’s guidance on substitution rights may result in asymmetry between the supplier’s and customer’s assessments. That is, the supplier may be able to readily determine that its substitution rights are substantive, in which case the contract would (1) not depend on the use of an identified asset and (2) not be identified as a lease. The customer, on the other hand, may not be able to readily determine whether the supplier’s substitution rights are substantive, in which case the guidance in ASC 842-10-15-15 would apply and the contract (1) would depend on the use of an identified asset and (2) could be identified as a lease.
3.3.3.5 Exercise of Nonsubstantive Substitution Rights
When a supplier’s substitution right is not substantive, an entity
does not consider the substitution right in determining whether the contract contains an
identified asset. If the customer has a right to control the use of the identified asset
(see Section 3.4), the
contract contains a lease and is subject to the measurement and recognition guidance in
ASC 842. However, although a supplier’s substitution right may have been deemed
nonsubstantive, instances may still arise in which the supplier actually ends up
substituting the asset for various reasons.
We generally believe that either of the following two accounting
approaches can be applied when a supplier exercises a substitution right that was not
deemed substantive at inception (provided that no other rights in the contract are
changed as a result of the substitution):
-
Approach A — The parties to the arrangement should account for the substitution as a termination of the original lease. (Sections 8.6 and 9.3.4 discuss in detail the lessee’s and lessor’s accounting, respectively, for lease modifications and terminations.) For example, under this approach, the lessee would write off the existing lease liability and ROU asset, which may result in the recording of a gain or loss in the lessee’s income statement. Upon substitution of an alternative asset, the parties would evaluate the arrangement as a potentially new lease in accordance with ASC 842’s guidance on lease identification. If the new arrangement contains a lease, the appropriate classification and subsequent accounting for the lease should be considered.
-
Approach B — The parties to the arrangement should account for the substitution as a lease modification that does not change the lessee’s right of use. In applying Approach B, an entity effectively would treat the actual substitution as a “non-substantive lease modification” for which no gain or loss would be recognized in the lessee’s income statement (i.e., for which there is no accounting whatsoever).
Note that the modification guidance in ASC 842-10-25-11(c) applies to
a full termination. Therefore, both approaches technically result in the application of
ASC 842’s modification guidance. However, the outcome of applying that guidance under
Approach A will differ from that under Approach B.
Generally, we think that the determination of whether to apply
Approach A (lease termination) or Approach B (lease modification) to the actual
substitution will be based on facts and circumstances and should involve consideration
of various factors, including whether the original asset and alternative asset are the
same (or similar) and whether the parties modify other terms in the contract upon
substitution. However, we would expect that if the asset substituted is similar to the
previous asset and there are no other changes to the contract, the actual substitution
should be considered a “nonsubstantive lease modification” and accounted for under
Approach B.
3.4 Right to Control the Use of the Identified Asset
As discussed in Section 3.2.1, the FASB carried forward into ASC 842 the control concepts it had been developing in other areas of U.S. GAAP (e.g., ASC 810 and ASC 606). Accordingly, to have the right to control the use of PP&E in a contract in which the PP&E is an identified asset (see Section 3.3), the customer must have both of the following:
- The right to obtain substantially all of the economic benefits from the use of the PP&E (i.e., the benefits or economics element, discussed in detail in Section 3.4.1).
- The right to direct the use of the PP&E (i.e., the power element, discussed in detail in Section 3.4.2).
Connecting the Dots
Control in ASC 842 Versus That in ASC
606 and ASC 810
ASC 606-10-25-25 states, in part, that “[c]ontrol of an asset refers to the
ability to direct the use of, and obtain substantially all of the remaining
benefits from, the asset.” This guidance is consistent with ASC 842-10-15-4
on the right to control the use of an identified asset. That is, for a lease
to exist, the customer must have the right to direct the use of, and obtain
substantially all of the economic benefits from, the identified asset during
the period of use.
ASC 842 is also consistent with ASC 606 with respect to determining when an arrangement should be accounted for as a sale. When the amount of control that a lessee has over the right to use an asset is so significant that the lessee has, effectively and economically, obtained control of the entire asset (i.e., not just control during the period of use), the lessor would account for that arrangement as a sale (i.e., as a sales-type lease; see Chapter 9 for a detailed discussion of the lessor’s lease classification and accounting).
However, the economics element of control in ASC 842 differs from that under the VIE consolidation guidance (i.e., ASC 810). Specifically, under ASC 842, the customer must have the right to obtain substantially all of the economic benefits from the use of the asset. The threshold of “substantially all the economic benefits” is different from and higher than that in ASC 810, which only requires the primary beneficiary of a VIE to absorb losses or receive benefits, either of which must only potentially be significant. Accordingly, the primary beneficiary in ASC 810 may control a VIE even when it is not exposed to substantially all of the economics of that entity.
The power element in ASC 842 differs from that in the ASC 810 VIE consolidation
model as well. ASC 842 does not specifically address the concept of “shared
power”; that is, ASC 842 does not address situations in which the most
relevant decision-making rights related to how and for what purpose (HAFWP)
the asset is used throughout the period of use are shared (see Section 3.4.2.4 for further discussion of
shared power). Consolidation principles, on the other hand, do allow for the
concept of shared power. Under the ASC 810 VIE consolidation model, when
shared power exists, neither of the parties that share in directing the
activities that most significantly affect economic performance has control
(provided that they are not related parties). However, when multiple,
different activities affect the economics, the control concepts in ASC 842
align more closely with those in the consolidation guidance. Specifically,
in such circumstances, an entity would need to determine which of those
different activities most significantly affects the economics and thus would
generally conclude that one party has control under both ASC 842-10-15-20
and ASC 810-10-25-38E.
The effect of design on the control analysis under ASC 842 also differs from that under the ASC
810 VIE consolidation model. That is, under the ASC 810 VIE consolidation model, the design
of the entity must be considered to determine the significant activities of the entity and who
has the power to control them (and thus controls the entity). However, by itself, design does
not give one party control of a legal entity, provided that ongoing operations have an effect on
the economics of the legal entity. Under ASC 842, on the other hand, the customer may have
power over an identified asset if it was significantly involved in the design of the asset, even if the
supplier operates the asset. Design and its role in the lease identification assessment are further
discussed in Section 3.4.2.
Link Between Power and
Economics
The FASB makes an important point when describing the
concept of the right to control the use in paragraph BC134 of ASU
2016-02:
[A] customer must have decision-making rights over
the use of the asset that give it the ability to influence the
economic benefits derived from use of the asset throughout the
period of use. Without any such decision-making rights, the customer
would have no more control over the use of the asset than any
customer purchasing supplies or services. If that were the case, the
customer would not control the use of the asset.
That is, with respect to the power element, the customer is
making decisions about the use of the asset so that it may maximize (or
minimize) the economic benefits that it will receive. ASC 842-10-15-24 makes
this clear in stating that “[d]ecision-making rights are relevant when they
affect the economic benefits to be derived from use.” In other words, the
customer cannot just have substantially all of the economics and some rights
over the use of the asset — the customer’s decision-making rights must
influence the economic benefits it has the right to obtain.
Changing Lanes
Control Over the Output of PP&E
Is No Longer Solely Determinative
Under ASC 840-10-15-6(c) (formerly EITF Issue 01-8), an arrangement may qualify as a lease because (1) the customer takes all (or substantially all) of the output of the PP&E and (2) the
contract is priced like a lease. That is, ASC 840 differentiated between a lease contract and a
service (or supply) contract on the basis of whether the supplier was pricing the contract to
recover, and earn a return on, the cost of either (1) the PP&E (in which case the contract is a
lease) or (2) each unit of output (in which case the contract is a service).
However, the pricing of an arrangement is not indicative of whether the customer has “power” under ASC 842. Paragraph BC134 of ASU 2016-02 explains that the pricing condition in ASC 840, which defined control on the basis of only “economics” and who controlled the output of the asset, is no longer indicative of control since the Board decided to align the new control concept with that in the revenue and consolidation guidance:
In previous leases guidance, a customer could have the right to control the use of an asset solely on the basis of obtaining substantially all of the output from that asset, assuming that the contract is priced in a particular way. This defined control on the basis of only a “benefits” element. Topics 606 and 810, however, define control to require both a “power” element and a “benefits” element. The Board decided that, to control the use of an asset, a customer is required to have not only the right to obtain substantially all of the economic benefits from use of an asset throughout the period of use (a “benefits” element), but also the ability to direct the use of that asset (a “power” element). [Emphasis added]
Moreover, the Board noted in paragraph BC105(d) of the 2013 leasing ED that removing the effect of pricing from the control concept would be advantageous because this condition had proved difficult to apply in practice.
Therefore, contracts that were or contained leases under ASC 840 solely because
the customer controls the output of the underlying asset no longer meet the
definition of a lease under ASC 842. We expect that the contracts most
likely to be affected by this change will be off-take and purchase
arrangements, such as PPAs and manufacturing supply contracts. Unless those
arrangements somehow also grant the customer power through decision-making
rights over the use of the asset (e.g., through dispatch rights, under which
the customer determines whether, when, and how much the asset is producing),
they are unlikely to be leases going forward.
Example 3-15
Power Purchase
Agreement
Supplier X, a power generation
company, executed a five-year PPA with Customer Z, a
utility. Customer Z will purchase 100 percent of the
electricity produced at X’s natural gas–fired
generating facility, to be delivered on an
as-available basis, because 100 percent of the
facility’s production capacity is not expected to
exceed the demand of Z’s end-use customers.
Accordingly, Z agrees to accept whatever volume of
electricity is produced at the facility.
Pricing under the PPA is a fixed
capacity payment of $300,000 per month (which
compensates X for reserving the facility to provide
energy to Z), plus $25 per unit of electricity
produced.
Under ASC 840, the contract
contained a lease because (1) facts and
circumstances at contract inception indicate that it
is remote that parties other than Z will take more
than a minor amount of the output (i.e., the
electricity) produced by X’s facility during the
five-year contract term and (2) the price paid by Z
per unit of electricity varies with the volume of
production (rather than being contractually fixed or
equal to the current market price of the
electricity).
However, under ASC 842, the parties
will need to assess whether Z both has the power
over and benefits from the economics of (i.e.,
whether it has the right to control the use of) the
facility. Although Z obtains substantially all of
the economic benefits from the facility through its
purchase of 100 percent of the electricity, Z may
not have the right to direct the use of the facility
(i.e., it may not have power over the use of the
facility).
Changing Lanes
Physical Access Is No Longer Solely
Determinative
Under ASC 840-10-15-6(b) (formerly EITF Issue 01-8), an arrangement may qualify as a lease because the customer (1) takes more than a minor amount of the output of the PP&E and
(2) controls physical access to the PP&E. That is, under ASC 840, the right to control the use of
PP&E may be conveyed through the right to control physical access to the PP&E.
However, under ASC 842, control of physical access is not solely determinative
of whether the customer has power over (i.e., whether the customer has the
right to direct the use of) the PP&E. The party that controls physical
access to the PP&E in an arrangement will generally have at least some
(but maybe not all) decision-making rights related to when and how the
PP&E is used.
Accordingly, while some contracts that are or contain leases under ASC 840 on
the basis of the control over physical access may still meet the definition
of a lease under ASC 842, others may not. The example below addresses one
contract type that may no longer meet the definition of a lease under ASC
842.
Example 3-16
Rooftop Solar
Developer Y executes a 25-year PPA with Resident Z under which Y will install solar panels on the roof
of Z’s home. In exchange, Z will purchase 100 percent of the electricity produced by the solar panels at
a price that is fixed per unit of electricity. The rooftop solar panels are expected to meet 50 percent of
Z’s demand for electricity.
Developer Y retains ownership of the solar panels and is responsible for any operation and
maintenance that is needed throughout the contract term. However, because the panels are installed
on Z’s home, Z controls physical access to them.
Under ASC 840, the contract is a lease because Z (1) will take more than a minor amount of the output
(i.e., the electricity) produced by the solar panels during the 25-year contract term and (2) controls
physical access to the solar panels.
However, under ASC 842, the parties need to assess whether Z has both power and
economics (i.e., whether it has the right to control
the use of the solar panels). Although Z obtains
substantially all of the economic benefits from the
use of the solar panels through its purchase of 100
percent of the electricity, Z may not have the right
to direct the use of the panels (i.e., it may not
have power over the use of the panels). (See
Section 3.4.2.3 for additional
discussion that would generally be relevant to this
example.)
3.4.1 Right to Obtain Substantially All of the Economic Benefits
In accordance with the definition of a lease — and the concept of control —
in ASC 842, the customer must have the right to obtain substantially all of
the economic benefits from the use of the PP&E throughout the period of
use. This is the “economics” element of the control concept, as discussed
above. It is an important piece of the concept, because a customer would not agree to pay for a right to
use PP&E unless it received the benefits resulting from that use.
This analysis is not confined to assets that physically produce outputs, and it
will often be relatively simple to determine whether the customer has the right
to obtain substantially all of the economic benefits from use of PP&E. For
example, in a lease of an office building, it is likely to be clear whether the
customer has the right to obtain substantially all of the benefits from using
the office building. However, in other situations, the assessment may be more
complex. The decision tree below illustrates the process an entity should
consider when determining whether the customer has the right to obtain
substantially all of the economic benefits from use of the PP&E.
The remainder of this section walks through this decision tree in greater
detail.
3.4.1.1 Economic Benefits That Result From Use of the Asset
ASC 842-10
15-17 To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (for example, by having exclusive use of the asset throughout that period). 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.
The concept of “economic benefits” in ASC 842-10-15-4(a) is described very broadly in ASC 842-10-15-17.
That is, ASC 842-10-15-17 identifies all of the following as potential economic benefits that may be obtained from the use of PP&E:
- Primary outputs (e.g., physical receipt of the widgets produced by or at a widget factory).
- By-products (e.g., physical receipt of the steam produced as a by-product of the manufacturing process in the widget factory).
- Cash flows derived from primary outputs and by-products (e.g., cash flows derived from the supplier’s selling, on the customer’s behalf, of widgets produced by or at the widget factory).
- Other “economic benefits . . . that could be realized from a commercial transaction with a third party” (e.g., SO2 or other emissions credits granted by the government when the widget factory runs because it is an environmentally efficient factory, provided that those credits can be sold to others).
Economic benefits can also be obtained from nonproductive assets. For example, the economic benefits
derived from the use of a warehouse include its storage capacity.
Further, ASC 842-10-15-17 indicates that economic benefits may be obtained either directly or indirectly,
such as in the following ways:
- Exclusive use of the asset (e.g., direct operation by the customer of the widget factory).
- Holding the asset (e.g., preventing others from operating the widget factory).
- Subleasing the asset (e.g., the customer subcontracts its rights to the capacity at the widget factory to another counterparty).
Because the concept of economic benefits in ASC 842-10-15-17 is broad, parties to an arrangement
should first identify all economic benefits that result from use of the asset. In doing so, the parties are
not considering the effects of contract terms (e.g., limitations) but are focusing on the nature of the
asset. The parties can thus ensure that they are considering all of the economic benefits before they
narrow the analysis to those benefits that are within the scope of the customer’s right to use the asset in
the contract (see Section 3.4.1.2).
3.4.1.1.1 Tangible and Intangible Economic Benefits
The economic benefits of PP&E often may be physical,
tangible outputs. For example, a PPA may give the customer the right to
purchase electricity from a particular generating facility, or the
customer may have the right to purchase widgets produced at a
manufacturing facility.
In the context of determining whether the customer has
the right to obtain substantially all of the economic benefits from use
of the asset, economic benefits can be both intangible and tangible.
Benefits that result from the use of the asset and that
can be realized through a commercial transaction with a third party
should be considered economic benefits in the context of ASC
842-10-15-17, regardless of whether they are tangible or intangible.
One example of an intangible economic benefit is
renewable energy credits (RECs), which are addressed in two places in
ASC 842:
-
In Example 9, Case A, in ASC 842-10-55-111(a) (reproduced in Section 3.7.9), RECs are identified as a by-product of the production of electricity by a solar farm (i.e., of the use of a solar farm).
-
Paragraph BC135 of ASU 2016-02 states, in part, that “a customer should consider benefits relating to the use of the asset (for example, renewable energy credits received from the use of an asset or by-products resulting from the use of an asset)” (emphasis added).
RECs are used to comply with renewable portfolio
standards (RPSs) within a particular jurisdiction (generally, RPSs are
established by state). They serve as evidence of the use of “green”
electricity that is produced by a renewable generating facility. RECs
have no physical substance and are transacted only by electronic
transfer among tracking accounts that are specific to each party in the
RPS jurisdiction. Although they are therefore intangible, RECs have
clear economic value (and sometimes an observable fair market value,
depending on the jurisdiction). In addition, they are conveyed and
exchanged in commercial transactions on the open market (e.g., as
opposed to being claimed in an owner’s tax return).
We think that ASC 842’s discussion of RECs as intangible
economic benefits demonstrates that the FASB believes intangible
benefits (or outputs), which may be realized through a commercial
transaction with a third party, should be considered in the analysis of
whether a customer has the right to obtain substantially all of the
economic benefits from use of the asset. In other words, we do not view
RECs to be an “exception” or the only intangible form of economic
benefit that should be considered in the analysis.
3.4.1.1.2 Economic Benefits From the Use of the Asset Versus Ownership of the Asset (e.g., Tax Attributes)
Economic benefits may be obtained directly or indirectly
from the asset (e.g., by using, holding, or subleasing the asset) and
may include the asset’s primary output and by-products. They may be
tangible or intangible (e.g., RECs, as discussed in Section 3.4.1.1.1).
Certain types of underlying assets may provide unique
tax benefits or tax attributes to the owner. Often, such tax benefits or
tax attributes are provided because a government has decided to
incentivize investments in the development of the assets. These benefits
or attributes may be critical to a buyer’s investment decision and often
economically justify an investment in an otherwise uneconomic asset or
technology.
An entity should not consider any tax attributes
associated with the ownership of the underlying asset — regardless of
whether they arise from investment (e.g., investment tax credits [ITCs])
or the asset’s production (production tax credits [PTCs]) — when
evaluating whether a customer has the right to obtain substantially all
of the economic benefits from the use of the asset. Some have questioned
whether the newly created transferable PTCs could be treated as economic
benefits from use of the asset. While we continue to support excluding
all tax credits from the evaluation, we understand that diversity may
exist with respect to transferable PTCs. For further discussion, see the
Connecting the Dots below on
tax credit considerations after the transferability feature added by the
Inflation Reduction Act.
ASC 842-10-15-17 indicates that economic benefits can be
realized from a commercial transaction with a third party. Tax
attributes, by nature, cannot be sold separately in a commercial
transaction because they are related to the ownership of the asset.
Further, paragraph BC135 of ASU 2016-02 clearly
differentiates between economic benefits resulting from use and those
resulting from ownership:
[O]nly the economic benefits arising from use of
an asset rather than the economic benefits arising from
ownership of that asset should be considered when assessing
whether a customer has the right to obtain the benefits from use
of an asset. A lease does not convey ownership of an underlying
asset; it conveys only the right to use that underlying asset .
. . . Accordingly, the Board concluded that,
when considering whether a contract contains a lease, a
customer should not consider economic benefits relating to
ownership of an asset (for example, tax benefits as a result
of owning an asset). [Emphasis added]
This approach is consistent with how outputs are
determined under ASC 840-10-15-6 and therefore is not expected to change
practice upon the adoption of ASU 2016-02.
Connecting the Dots
Identifying Intangible
Economic Benefits From Use
Section 3.4.1.1.1
clarifies the view that intangible benefits (or outputs)
can be economic benefits from use of the asset as
long as the intangible benefits (or outputs) can be realized
from a commercial transaction with a third party. Further,
Section
3.4.1.1.2 clearly differentiates between economic
benefits from use of the asset and
economic benefits from ownership of the
asset. However, in practice, entities in various industries have
raised questions about which intangible benefits (outputs)
constitute “economic benefits from use of the asset.”
Specifically, in various scenarios, either the
supplier or the customer may assert that a contract is not, or
does not contain, a lease on the basis that the supplier is
obtaining more than an insignificant portion of the economic
benefits from use of the asset because it retains certain
intangible benefits. As noted in this section, ASC 842-10-15-17
appears to create a broad concept for what may be considered
economic benefits from use. Entities in these scenarios rely on
that broad concept to include intangible benefits in the
analysis and thus to conclude that the customer does not obtain
substantially all of the economic benefits from use.
Examples of intangible benefits (or outputs)
that we have seen characterized as economic benefits from use
include, but are not limited to, the following:
-
Advertising rights or benefits that are associated with the display of a brand or image on the asset or are based on the asset’s use (e.g., advertising space on a professional race car).
-
Data captured by the asset about how it is used. For instance, data may be sent back to an automaker by using certain smart technology installed in a new car model. Examples of such data may include information about customer demographics, GPS information showing where the customer drives, accident information, frequency of use, or time of use.
-
Data generated by the asset regarding the health and function of the larger network of PP&E to which the asset is connected (e.g., data sent back by a utility meter connected to a ratepayer’s home about the speed and quality of electricity moving from the distribution line).
-
Remote access capabilities of the supplier so that the supplier may minimize the deployment of field technicians to diagnose and repair the asset (e.g., the supplier can log into a printer remotely, through the Internet, to troubleshoot a printer at a customer site that is not functioning properly).
At this time, stakeholders continue to consider
whether certain intangible benefits (or outputs) — including
those above — represent economic benefits from use. The more
economic benefits from use there are for a particular underlying
asset, the greater the likelihood that a supplier or customer
may conclude that the customer does not obtain
substantially all of the economic benefits from use of that
asset. Entities that are involved in these types of arrangements
should consult with their accounting advisers and monitor
developments on the topic.
We think that it would be helpful for entities
to consider the following questions when evaluating whether such
intangible benefits (or outputs) are economic benefits from use
(i.e., in determining whether such benefits have substance):
-
Are the benefits (or outputs) created by — or do they result from — the use of the PP&E? That is, can it be confirmed that they are not benefits solely associated with ownership of the asset?
-
Can the benefits (or outputs) from use be realized in a commercial transaction with a third party?
-
Is the generation or creation of the benefits (or outputs) passive? That is, if the customer is not actively using the asset, is the benefit still created in such a way that the benefit may not depend on the use of the asset?
-
How may the benefit (or output) be realized? If the benefit can only be realized by the supplier in the form of cost savings, the benefit (or output) may not be an economic benefit from use.
If such intangible benefits (or outputs) are
determined to be economic benefits from use, an entity will also
need to (1) identify which parties obtain the benefit(s) and (2)
determine whether the amount of benefits obtained by parties
other than the customer is sufficient to conclude that the
customer does not obtain substantially all of the economic
benefits from use of the asset. In performing the latter
assessment, an entity may need to quantify the amount of
benefits received by the parties in cases in which intangible
benefits (or outputs) are identified. See Section
3.4.1.3 for detailed discussion.
Economic Benefits Under ASC 842 — Tax Credit Considerations
Based on Transferability Feature Introduced by the
Inflation Reduction Act of 2022
Tax benefits, including ITCs and PTCs, are
prevalent in various industries and are often critical to the
economics of the underlying project (e.g., a solar or wind
farm). An ITC is a percentage-based tax credit based on the
installed cost of a qualifying facility, while a PTC is based on
productive output, offering credit linked to measurable electric
output from a qualifying facility.
Historically, under both ASC 840 and ASC 842, tax credits
available to owners of PP&E have not been considered in the
evaluation of whether an arrangement contains a lease. Under ASC
840, an entity did not consider tax credits to be an “output”
when assessing whether a customer obtained or controlled
substantially all of the output or utility expected to be
produced or generated by the PP&E. The treatment under ASC
840 was based, in part, on legacy discussions with the FASB and
the SEC, which indicated that tax attributes are different from
other intangible by-products of production (e.g., renewable
energy credits or RECs) and should not affect the lease
evaluation. ASC 842-10-15-17 states that 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.” Upon
public-company adoption of ASC 842, this definition effectively
carried forward the legacy ASC 840 treatment of tax credits
since, at the time, all tax credits had to be claimed on the
owner’s tax return to be realized. That is, the tax credits were
not a benefit from using the asset that could be realized in a
commercial transaction with a third party.
In 2022, the Inflation Reduction Act introduced a transferability
feature that allows for the one-time sale of eligible tax
credits (including both ITCs and PTCs) to a third party that
then uses the credits in its federal tax return to reduce its
income tax liability. Because of this feature, questions have
arisen about whether transferable PTCs should be viewed as
economic benefits from using the asset under ASC 842. The focus
has been on transferable PTCs since those credits are linked
directly to production and therefore depend on asset usage. This
issue can have significant accounting implications given the
value of the tax credits in the context of overall project
value.
As of the date of this publication, we do not believe that
entities are required to view transferable tax credits as
economic benefits from using the asset, irrespective of whether
the credits are associated with developing and placing the asset
in service (ITCs) or are based on production (PTCs). This view
applies to both parties in an arrangement that involves
qualifying PP&E.
On the basis of our discussions with entities in the power and
utilities industry, we understand that a consensus on this issue
has not yet been reached and, accordingly, that diversity in
practice most likely already exists. Companies that believe
transferable tax credits should be identified as an economic
benefit from using the related asset are encouraged to consult
with their auditors or accounting advisers.
3.4.1.2 Identifying Which Economic Benefits From Use Are Within the Scope of the Customer’s Right to Use the Asset in the Contract
Once the parties to the arrangement identify, on the basis of the nature of the asset, all of the economic benefits from use of the asset, they must identify which of those benefits are within the scope of the customer’s right to use the asset in the contract. These economic benefits are subject to the “substantially all” criterion in ASC 842-10-15-4(a) (see Section 3.4.1.3 for detailed discussion).
ASC 842-10
15-18 When assessing the right to obtain substantially all of the economic benefits from use of an asset, an entity shall consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset in the contract (see paragraph 842-10-15-23). For example:
- If a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle within that territory and not beyond.
- If a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle for the permitted mileage and not beyond.
The graphic above illustrates the example in ASC 842-10-15-18(b).
In this example, the supplier’s and customer’s assessments take into
account the economic benefits related to only the mileage the contract
permits the customer to drive a motor vehicle “during the period of use”
(represented by the blue area of the circle to the left) and not the entire
mileage that the vehicle may be driven on the basis of the nature of the
asset (represented by the entire circle). This makes sense in light of the
first paragraph of ASC 842-10-15-18, which indicates that, of the universe
of economic benefits derived from the use of the underlying asset —
identified in accordance with ASC 842-10-15-17 (and Section 3.4.1.1) —
parties to the arrangement should only consider benefits that are within
the scope of the customer’s right to use the asset in the contract. ASC
842-10-15-18 points readers to ASC 842-10-15-23 (discussed in Section
3.4.2.2) for guidance on determining the scope of the customer’s right to
use the asset in the contract.
Generally, the scope of the customer’s right to use the asset will be limited by the supplier’s protective
rights. With respect to the example in ASC 842-10-15-18(b), the supplier may limit the number of miles
that the customer may drive the leased vehicle during the period of use so that the supplier may better
protect its interest in the residual asset. The supplier’s protective rights, in this case, help ensure that the
supplier can market the residual asset for a minimum value to third parties after the conclusion of the
customer’s lease.
The supplier’s protective rights do not prevent the customer from obtaining substantially all of the
economic benefits from use of the asset because the “substantially all” assessment is performed with
respect to the economic benefits that are within the scope that is bound by those protective rights. Any
economic benefits that can only be realized by going “beyond” the scope of the customer’s right to use
the asset in the contract are not obtained by any party to the arrangement during the period of use.
3.4.1.3 Obtaining Substantially All of the Economic Benefits From Use
Once an entity has identified the economic benefits from use that are within the
scope of the contract, the parties to the arrangement must determine whether
the customer obtains substantially all of them. ASC 842-10-15-4(a) states
that, to have “the right to control the use of an identified asset,” the
customer must have the “right to obtain substantially all of the economic
benefits from use.”
Although ASC 842 does not define “substantially all,” it
uses the term frequently. The term is used, for instance, in the context of
(1) whether a capacity portion of a larger asset is an identified asset (see
Section
3.3.2 for detailed discussion of portions of assets and
whether they are identified assets) and (2) the lease classification test
(i.e., determining whether the present value of the lease payments
represents substantially all of the fair value of the underlying asset).
Paragraph BC73 of ASU 2016-02 indicates that entities should
be allowed to use a 90 percent threshold in determining whether the
“substantially all” criterion is met in the lease classification test:
Nevertheless, the Board understands that entities
need to ensure the leases guidance is operational in a scalable
manner, which often requires the establishment of internal
accounting policies and controls. As a result, the Board included
implementation guidance in Topic 842 that states that one reasonable
application of the lease classification guidance in that Topic is to
conclude, consistent with previous GAAP, that . . . 90 percent or
greater is “substantially all” the fair value of the underlying
asset.
Likewise, we think that 90 percent should generally be used
to determine whether the customer has the right to obtain substantially all
of the economic benefits from use. Accordingly, if the customer has the
right to obtain 90 percent or more of the economic benefits from use of the
identified asset, it has met the “substantially all” criterion in ASC
842-10-15-4(a). Companies should consult with their auditors, accounting
advisers, or both if they are considering the use of a different percentage
threshold for this purpose.
This is consistent with interpretations of the condition in
ASC 840-10-15-6(c), under which control is defined on the basis of only
economics (see the Changing Lanes discussion in Section 3.4). That is, the language
“it is remote that one or more parties other than the purchaser will take
more than a minor amount” in ASC 840-10-15-6(c) is generally interpreted as
meaning that another party will not take more than 10 percent, which is
consistent with the customer’s taking 90 percent.
Example 3-17
Outsourcing
Arrangement for Basketballs
Customer X enters into a contract
with Supplier Y to purchase a particular size, type,
quality, and quantity of basketball over a four-year
period. Supplier Y has only one factory that can
meet X’s needs and is unable to supply the
basketballs from another factory or source them from
a third-party supplier. Because Y does not have the
practical ability to source the basketballs from
another facility, the facility is implicitly
identified in the contract.
Case A —
Capacity of the Factory Exceeds the Output for
Which the Customer Has Contracted
Assume that the capacity of the
factory exceeds the output for which X has
contracted in such a way that X only has rights to
75 percent of the capacity of the factory. In
addition, Y can use the factory to manufacture
basketballs for other customers. In this case, X
does not have the right to obtain substantially all
of the economic benefits from the use of the factory
because Y can use the factory to fulfill its
obligations under contracts with other customers
(i.e., thereby retaining 25 percent of the economic
benefits). Accordingly, X does not have the right to
control the use of the facility and the contract
does not contain a lease.
Case B —
Output for Which the Customer Has Contracted
Represents Substantially All of the Capacity of
the Factory
In this case, assume that the
factory was specifically designed to manufacture
basketballs for X and that Y is practically limited
from using the facility to manufacture any other
products for any other customers. Because the
factory can only be used to manufacture basketballs
for X, X has the right to obtain substantially all
of the economic benefits from the use of the
factory. To determine whether the contract contains
a lease, the parties should evaluate whether X has
the right to direct the use of the factory. See
Section 3.4.2 for additional
information on the right to direct the use of an
identified asset.
In accordance with ASC 842-10-15-4(a) and ASC 842-10-15-17
for a contract to be or contain a lease, the customer must have the right to
obtain substantially all of the economic benefits from use of the asset. As
discussed above, “substantially all” in this context is generally
interpreted as referring to 90 percent or more of the economic benefits from
use.
An entity does not necessarily have to perform a
quantitative analysis to conclude that the customer has the right to obtain
90 percent or more (i.e., substantially all) of the economic benefits from
use, since ASC 842 does not require such an analysis in all circumstances.
If the contractual terms and conditions, as well as the related facts and
circumstances, are clear on whether the customer has the right to obtain
substantially all of the economic benefits from use, a quantitative analysis
is not needed.
However, when it is not qualitatively clear whether the
customer has the right to obtain substantially all of the economic benefits
from use, a quantitative analysis may be required. We think that a
quantitative analysis of the economic benefits from use might be necessary
in the following situations (not all-inclusive):
-
The identified economic benefits from use include intangible benefits (or outputs), and those intangible benefits could be more than insignificant. (See Section 3.4.1 for more information about intangible economic benefits.) Because of the intangible nature of such benefits, a qualitative assessment alone may be insufficient for determining whether they are more than insignificant.
-
The economic benefits from use include by-products or co-products that may be transacted with third parties.
When economic benefits from use, including by-products or
co-products, can be transacted in a secondary market with third parties, a
quantitative analysis may be easier to perform. In such situations, market
pricing may be both (1) readily accessible and (2) used by the parties to
the arrangement in their negotiations and economic decision-making related
to entering into, or not entering into, the arrangement.
Example 3-18
Sale of Energy
and Renewable Energy Credits Produced by a Solar
Facility
Off-Taker U enters into a PPA with
Supplier G to purchase 100 percent of the
electricity produced by a solar facility for 20
years. Supplier G owns the solar facility. Off-Taker
U will pay $40 per unit of electricity produced.
Besides electricity, the solar
facility produces one REC for every unit of
electricity produced. Supplier G has separately
entered into two contracts to sell RECs produced by
the solar facility to third parties: 25 percent of
the RECs produced are sold to Polluter A for 20
years, and 50 percent of the RECs produced are sold
to Polluter B for 20 years. Supplier G retains 25
percent of the RECs produced, either for its own
account or to sell in the spot market to other
market participants.
Off-Taker U and G determine that if
the PPA had also included the purchase of 100
percent of the RECs, G would have charged a bundled
price of $50 per unit of electricity produced.
Although U has the right to obtain
100 percent of the electricity produced by the solar
facility, a minimum of three additional parties have
the right to obtain the RECs produced by the solar
facility. As discussed in Section 3.4.1.1.1, both the
electricity and the RECs are economic benefits from
use of the solar facility.
On the basis of the stand-alone
value of the RECs and the electricity, U and G
determine that the RECs represent more than an
insignificant portion of the economic benefits from
use of the solar facility. Accordingly, U does not
have the right to obtain substantially all of the
economic benefits from use. The PPA neither is, nor
does it contain, a lease for either party to the
arrangement.
Connecting the Dots
Contracts in Which the
Customer’s Rights to Economic Benefits Change
It is common in off-take or other supply
arrangements for the economic benefits obtained by the customer to
change or fluctuate, contractually, throughout the period of use.
For example, a customer may obtain 100 percent of the
widget-production capacity at a manufacturing facility for the first
five years and then 50 percent of the widget-production capacity at
that facility for the next five years. Alternatively, for an asset
with a primary output and a by-product (both of which are identified
as economic benefits from use), a customer may obtain 100 percent of
the primary output throughout the period of use but only 50 percent
of the by-product in the first five years. Questions have arisen
about the period over which economic benefits should be assessed in
such situations (e.g., over the full period of use, on a yearly
basis, on a monthly basis).
Example 3-19
Assume that W through Z below
are supply arrangements in which the contracts
provide for a mix of goods that change over time
and result in the customer’s obtaining the
following percentage of economic benefits by year
of the contract:2
Two views have emerged
regarding how to assess the economic benefits in W
through Z.
View
A
Description
According to this view, an
entity first assesses the period of use (see
Section 3.5) and then determines
whether the customer has substantially all of the
economic benefits from use of the asset on the
basis of that period. This view is based on a
literal reading of ASC 842-10-15-4, which states,
in part:
To determine whether a
contract conveys the right to control the use of
an identified asset . . . for a period of time, an
entity shall assess whether, throughout the period of use, the customer
has both of the following:
-
The right to obtain substantially all of the economic benefits from use of the identified asset . . . . [Emphasis added]
In other words, View A places
significant weight on the order in which the words
in ASC 842-10-15-4 are written and thus suggests
that an assessment of the period of use must come
first.
Outcomes
View A would result in a
conclusion that the customer, in each of W through
Z, does not obtain substantially all of the
economic benefits from use of the asset. This is
because, on an aggregate basis over all 10 years,
the customer does not obtain at least 90 percent
(i.e., substantially all) of the economic benefits
from use of the asset during the period of use.
The period of use is 10 years according to this
view because, as indicated in ASC 842-10-20, that
is the “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).”
View A is consistent with
application of the guidance in ASC
840-10-15-6(c).
Shortcomings
View A potentially opens up
structuring opportunities for parties to an
arrangement to avoid identifying a lease. That is,
in applying View A, the parties to an arrangement
could avoid lease accounting by tacking on
nonsubstantive periods at the end of the contract
term so that the customer obtains a low percentage
of the economic benefits from use.
However, some proponents of
View A acknowledge that the assessment would need
to contain an anti-abuse override under which, for
example, the parties to an arrangement have a
disincentive to structure contracts to look like X
in the example above. Depending on the facts and
circumstances, some proponents of View A may
conclude that if there is an anti-abuse override,
the period of use in X is eight years in the
assessment of the economic benefits from use.
View
B
Description
According to this view, an
entity looks to the assessment of whether the
customer has substantially all of the economic
benefits from use of the asset to determine what
the period of use is. This view is based on the
guidance in ASC 842-10-15-5, which states the
following:
If the customer has the right
to control the use of an identified asset for only a portion of the term of
the contract, the contract contains a lease for
that portion of the term. [Emphasis added]
View B is also an
interpretation of the order in which the
assessments should be performed that minimizes (as
compared with View A) opportunities for parties to
an arrangement to use structuring to avoid
identifying a lease (i.e., for lessees to avoid
recognizing lease assets and lease
liabilities).
Outcomes
With respect to identifying
the period of use, View B would result in
bifurcation of the contract term into the periods
during which the customer obtains at least 90
percent (i.e., substantially all) of the economic
benefits from use of the asset. Effectively,
according to View B, (1) the period of use is more
closely aligned with the period during which the
customer gets the benefits from use and (2) the
period of use, as defined above and in ASC
842-10-20, may include nonconsecutive periods.
On the basis of this view, the
customer obtains substantially all of the economic
benefits from use during the following periods:
-
W: Years 3–10.
-
X: Years 1–8.
-
Y: Years 2, 4, 6, 8, and 10.
-
Z: Years 1–2, 4–5, and 7–8.
Accordingly, for each of W
through Z, the parties to the arrangement would
incorporate the periods identified above into the
assessment to determine whether the customer has
the right to direct the use of the asset during
those periods.
Shortcomings
View B could create challenges
related to applying the lessee and lessor
accounting models (e.g., if Y is determined to be
an operating lease, it would be more complex to
determine how to recognize lease expense or lease
income on a straight-line basis over
nonconsecutive periods). See Section
8.4.3.4 and Chapter 9 for
detailed discussion of lessee and lessor
accounting, respectively.
In addition, the supply
arrangements W through Z above focus on
economic-benefit percentages determined annually.
However, proponents of View B acknowledge that
there is no basis in ASC 842 for saying that the
annual level is the correct and lowest level at
which the assessment should be performed. For
example, if the customer can further break down
the percentages of economic benefits on the basis
of months, days, or even hours, there could be
further bifurcation of the period of use into
nonconsecutive periods. Accordingly, if the
arrangement is determined to be a lease, the
assessment and subsequent accounting would become
more complex.
Next
Steps
The issue, as well as the
views, continue to evolve. Companies involved in
these types of arrangements should consult with
their accounting advisers and monitor developments
on the topic.
3.4.1.3.1 Portion of Cash Flows Derived From Use Paid to Supplier or Third Party
ASC 842-10
15-19 If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived
from use of an asset as consideration, those cash flows paid as consideration shall be considered to be part
of the economic benefits that the customer obtains from use of the asset. For example, if a customer is
required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that
requirement does not prevent the customer from having the right to obtain substantially all of the economic
benefits from use of the retail space. That is because the cash flows arising from those sales are considered to
be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to
the supplier as consideration for the right to use that space.
ASC 842-10-15-19 clarifies that cash flows derived from the use of the asset are economic benefits from
use, even if a portion of those cash flows is paid to the supplier in the form of (variable) lease payments.
That is, the cash flow structure in the contract should not dictate which cash flows derived from use are
considered economic benefits from use or which party obtains those benefits.
In other words, a supplier generally prices a contract — and charges the customer — to earn a return
of and on its investment in the underlying PP&E. It may structure the cash flows it must receive to earn
that return in a number of ways. In the example in ASC 842-10-15-19, the supplier structures the cash
flows to share in the customer’s benefits from using the PP&E (i.e., to share in the upside). Alternatively,
it could have forecasted the customer’s sales and derived a fixed payment to achieve what is effectively
the same result. In either case, the supplier would have designed the payment terms to achieve a
necessary return.
Accordingly, whether the consideration in the arrangement is based on the customer’s performance in
using the asset or on a fixed basis (or some other variable basis) should not affect the assessment of
whether the customer obtains substantially all of the economic benefits from use. Example 4 in ASC 842
(ASC 842-10-55-63 through 55-71, reproduced in Section 3.7.4) illustrates this notion.
3.4.2 Right to Direct the Use
In accordance with the definition of a lease — and the concept of control — in ASC 842, the customer must have the right to direct the use of the PP&E throughout the period of use. This is the “power” element of the control concept, as discussed in Section 3.4. It is an important piece of the concept because a customer would not agree to pay for a right to use PP&E unless it could actually exercise that right and direct how it uses the PP&E.
ASC 842-10
15-20 A customer has the right to direct the use of an identified asset throughout the period of use in either of the following situations:
- The customer has the right to direct how and for what purpose the asset is used throughout the period of use (as described in paragraphs 842-10-15-24 through 15-26).
- The relevant decisions about how and for what purpose the asset is used are predetermined (see paragraph 842-10-15-21) and at least one of the following conditions exists:
- The customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use without the supplier having the right to change those operating instructions.
- The customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
A customer has the right to direct the use of an asset if it can determine HAFWP
that asset is used throughout the period of use. The extent to which the
customer directs HAFWP the asset is used will depend on whether the contract
grants the customer decision-making rights over that asset. Therefore, a
customer should (1) identify the decision-making rights that most affect HAFWP
the asset is used during the period of use (i.e., which decision-making rights
most affect the economic benefits from use of the asset) and (2) determine which
party controls those rights.
In many cases, it is relatively simple to determine whether the customer has the right to direct the use of the PP&E. For example, in a lease of an office building, it is likely to be clear that the customer has the right to direct HAFWP the office building is used throughout the period of use.
However, in other situations, the assessment may be more complex. When neither party to the arrangement (i.e., neither the supplier nor the customer) controls the decision-making rights that most affect HAFWP the asset is used throughout the period of use, then HAFWP the asset is used throughout the period of use may be predetermined. In those situations, the customer only directs the use of the asset when it either (1) operates the asset throughout the period of use or (2) designed the asset so that HAFWP the asset is used throughout that period is predetermined. Alternatively, when neither party controls the decision-making rights that most affect HAFWP the asset is used throughout the period of use, then power over those rights may be shared between the supplier and the customer.
The decision tree below illustrates the process an entity should consider when
determining whether the customer has the right to direct the use of the
PP&E.
3
See Section 3.4.2.4 for further
discussion of when power over the decision-making rights related to
HAFWP PP&E is used throughout the period of use is shared.
As noted in Section 3.2.1, the determination of whether the customer has the right to direct the use of the asset is generally a two-step process:
- Evaluate whether the customer or the supplier has the right to direct HAFWP the asset is used throughout the period of use.
- If no party has the right to direct HAFWP the asset is used throughout the period of use, HAFWP the asset is used throughout that period may be predetermined. In such cases, an entity evaluates whether the customer (1) can operate the asset or (2) designed the asset in a manner that predetermined HAFWP the asset is used throughout the period of use. (However, if no party has the right to direct HAFWP the asset is used throughout the period of use, an entity may need to consider whether power over that right is shared.)
The remainder of this section addresses the above decision tree in greater
detail.
3.4.2.1 How and for What Purpose the Asset Is Used Throughout the Period of Use
ASC 842-10
15-24 A customer has the right to direct how and for what purpose an asset is used throughout the period of use if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout that period. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose an asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.
15-25 Examples of decision-making rights that, depending on the circumstances, grant the right to direct how and for what purpose an asset is used, within the defined scope of the customer’s right of use, include the following:
- The right to change the type of output that is produced by the asset (for example, deciding whether to use a shipping container to transport goods or for storage, or deciding on the mix of products sold from a retail unit)
- The right to change when the output is produced (for example, deciding when an item of machinery or a power plant will be used)
- The right to change where the output is produced (for example, deciding on the destination of a truck or a ship or deciding where a piece of equipment is used or deployed)
- The right to change whether the output is produced and the quantity of that output (for example, deciding whether to produce energy from a power plant and how much energy to produce from that power plant).
15-26 Examples of decision-making rights that do not grant the right to direct how and for what purpose an asset is used include rights that are limited to operating or maintaining the asset. Although rights such as those to operate or maintain an asset often are essential to the efficient use of an asset, they are not rights to direct how and for what purpose the asset is used and often are dependent on the decisions about how and for what purpose the asset is used. Such rights (that is, to operate or maintain the asset) can be held by the customer or the supplier. The supplier often holds those rights to protect its investment in the asset. However, rights to operate an asset may grant the customer the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined (see paragraph 842-10-15-20(b)(1)).
As noted above in ASC 842-10-15-24, a customer can direct HAFWP an asset is used
throughout the period of use (and thus meets the criterion in ASC
842-10-15-20(a)) when the customer has “decision-making rights that are most
relevant to changing [HAFWP] an asset is used” throughout that period. The
most relevant decision-making rights are those that can affect the economic
benefits that result from use of the asset (i.e., there is a direct link
between the “power” and “economics” elements of the right to control the use
of the asset, as discussed in Section 3.4). Paragraph BC137 of ASU
2016-02 clarifies that those are the decision-making rights that are most
important to determining whether the customer has the right to control the
use of the asset.
Paragraph BC137 of ASU 2016-02 also clarifies that HAFWP is a “single concept.” That is, parties to the
arrangement should not assess how an asset is used separately from the asset’s intended purpose in
the arrangement. Decision-making rights that affect the economic benefits derived from the use of an
asset will differ depending on the nature of the asset. However, ASC 842-10-15-25 gives the following
common examples of decision-making rights that affect the economic benefits derived from the use of
the asset and, therefore, that govern HAFWP an asset is used:
- The customer’s ability to change what type and amount of output the asset produces (e.g., the type of widget — widget X or widget Y — the PP&E produces and the volume of each).
- The customer’s right to change when the asset is used (e.g., when the PP&E produces widget X).
- The customer’s ability to change where the asset is used (e.g., where a truck delivers goods).
- The customer’s right to change whether the asset is used (e.g., whether PP&E is operating to produce widgets and how many widgets the PP&E produces when it does operate).
In paragraph BC137 of ASU 2016-02, the Board observes that “decisions about how and for what
purpose an asset is used can be viewed as similar to considering the decisions made by a board of
directors when assessing control of an entity.” Specifically, under the consolidation guidance, the
choices made in the execution of — or the actions taken to carry out — the decisions made by a
board of directors are subordinate to the decisions themselves. Therefore, the control analysis in the
consolidation guidance focuses on the power of the board to direct the most significant activities of the
entity, not on who may determine how to execute those significant activities.
Similarly, ASC 842 focuses on which party may make decisions about HAFWP an asset is used
throughout the period of use. The execution of (i.e., the operation and maintenance activities related to)
a party’s decisions about HAFWP an asset is used is subordinate. Accordingly, ASC 842-10-15-26 clarifies
that any rights to determine how the asset will be operated or maintained during the period of use are
subordinate to decision-making rights about HAFWP an asset is used throughout the period of use.
Further, paragraph BC137 of ASU 2016-02 notes, for instance, that “a supplier’s operational decisions
would have no effect on the economic benefits derived from use of an asset if the customer decides
that the asset should not be used.” Therefore, while operation and maintenance decisions are essential
to ensuring the efficient use of the asset, they are subject to, and can be overridden by, the rights to
change HAFWP the asset is used.
The graphic below illustrates this notion.
Connecting the Dots
Differentiating Between
Rights Over Operation and Decisions About HAFWP an Asset Is
Used
Paragraph BC137 of ASU 2016-02 explains that rights related to the operation and maintenance of an asset are subordinate to decision-making rights associated with HAFWP that asset is used:
In the Board’s view, the decisions about how and for what purpose an asset is used are more important in determining control of the use of an asset than other decisions to be made about use, including decisions about operating and maintaining the asset. That is because decisions about how and for what purpose an asset is used determine how and what economic benefits are derived from use.
In addition, rights over operation and maintenance are rights that are both (1) essential to the efficient use of the asset and (2) potentially protective if they are held by the supplier (i.e., because they would allow the supplier to ensure operation and maintenance practices that would protect the supplier’s investment in the asset). Therefore, it may be helpful to view rights over operation and maintenance as those that are most likely to have smaller effects on the operating margins (or the net cash flows) derived from using the asset.
By holding operation rights, the supplier may be able to lower the costs of operating the asset on the basis of its experiences in operating that asset and similar types of assets. For example, assume that a supplier knows which route is quickest when driving a delivery truck from Minneapolis to Milwaukee and therefore is able to minimize fuel costs. If the customer in this example holds decision-making rights related to when the route from Minneapolis to Milwaukee will be driven but decides not to exercise that right, no economic benefits (i.e., cash flows) will be derived. That is, the supplier’s right to choose the quickest route and thus lower operating costs is contingent on (subordinate to) the customer’s decisions.
The above example illustrates the difference between (1) the rights to operate an asset and (2) decision-making rights related to HAFWP an asset is used. That is, the latter rights have significantly more influence over the economic benefits to be derived from using the asset and, therefore, the former rights are subordinate to the latter.
Also illustrated above is another way in which the power notion in ASC 842 differs from that in
the consolidation guidance in ASC 810. The party that controls operation and maintenance has
power under ASC 810 in circumstances in which (1) there are ongoing operation and maintenance decisions to
be made for a legal entity and (2) it is determined that those decisions reflect the activities that
most significantly affect the economic performance of the legal entity. However, under ASC 842,
the supplier’s control of operation and maintenance decisions may not prevent the customer
from having the right to direct the use of the underlying asset throughout the period of use.
Further, ASC 842 requires that when HAFWP the asset is used throughout the period of use is
predetermined and the supplier controls operation and maintenance decisions, the analysis
must take into account whether the customer designed the asset (see Section 3.4.2.3.2 for
further discussion of design).
3.4.2.1.1 Dispatch Rights
“Dispatch rights” are rights that may be granted to a
customer in an arrangement to direct the asset to be used for its
intended purpose. In the power and utilities industry, such rights are
common and may be granted to an off-taker (i.e., the customer) in a PPA
to allow the off-taker to tell a power plant owner and operator whether
to use the plant to produce electricity, when to use the plant to
produce electricity, and what amount of electricity to produce.
However, dispatch rights can refer to similar rights
associated with any type of asset. For example, an emergency services
operator that is outsourcing to a third party can dispatch an ambulance
or helicopter owned by the third party to provide the services. In
addition, a customer in a manufacturing supply arrangement may have
dispatch rights in connection with a widget factory (or a discrete
manufacturing line within that factory) such that it can tell the owner
and operator of the factory whether to produce widgets and how many
widgets to produce.
Dispatch rights, when granted to the customer in an
arrangement, generally convey the right to direct HAFWP an asset is
used. Such rights allow the customer in an arrangement to change
whether, when, and to what extent an asset is used, which generally are
the decision-making rights that most affect the economic benefits to be
derived from the asset’s use and thus represent the rights to determine
HAFWP the asset is used throughout the period of use. Therefore, in
accordance with ASC 842-10-15-24 through 15-26 and the Connecting the
Dots discussion above, dispatch rights would override any
rights of the asset’s owner to operate and maintain the asset. Example
9, Case C, in ASC 842-10-55-117 through 55-123 (reproduced in Section 3.7.9)
illustrates the use of dispatch rights in a PPA.
In some industries, dispatch rights may be conveyed
through another right (e.g., an effective dispatch right). For example,
in some markets in the power and utilities industry, dispatch decisions
are ultimately made by an independent system operator on the basis of a
consideration of bid prices and any transmission system constraints
(i.e., if there are no constraints, generating units will be dispatched
economically by accepting the lowest bids first); therefore, in such
cases, neither the owner nor the off-taker can mandate physical
production. While the bid-in process in the power and utilities industry
is not entirely the same as a dispatch right held by a customer as
described above, companies should consider whether control over the
bidding process in such scenarios conveys to the customer the right to
direct HAFWP the asset is used, since that is the right an owner would
normally exercise in these markets to influence whether, when, and to
what extent the owner’s asset is used.
In a tolling arrangement, the right to provide the
inputs the asset needs to produce outputs may also constitute an
effective dispatch right. When a customer obtains a tolling right in an
arrangement, the asset may generally only produce outputs when the
customer provides the inputs that the asset needs to convert those
inputs to a refined or finished product (i.e., the asset produces
outputs upon the receipt of the necessary inputs). Further, the asset
will generally only produce to the extent of the inputs provided; that
is, the amount of outputs the asset produces is a function of the amount
of inputs provided and the efficiency of the asset in converting those
inputs. Therefore, in tolling arrangements, the customer will generally
control the rights that most affect the economic benefits to be derived
from the asset’s use — and thus the right to direct HAFWP the asset is
used — by virtue of the customer’s right to provide the inputs and
request conversion to outputs. Tolling arrangements are found not only
in the power and utilities industry but also in basic manufacturing as
well as in the metal, agriculture, and oil and gas industries.
3.4.2.1.2 Applying the Guidance in ASC 842-10-15-24 Through 15-26
The three examples below illustrate the guidance in ASC 842-10-15-24 through
15-26 and the discussion above.
Example 3-20
Exclusive
Limousine Service
Customer D, a politician, enters
into a contract with Company R, a limousine
service provider, for transportation during the
four-year term of D’s political assignment. The
contract explicitly specifies the VIN of the
limousine that will be used to transport D, and R
is contractually restricted from substituting the
limousine for reasons other than repairs or
maintenance. Therefore, the parties have
determined that the fulfillment of the contract
depends on an identified asset.
The limousine in question is
stored on R’s premises when not in use, but R may
not use the limousine to transport any other
customers during the four-year contract term. In
addition, R provides a dedicated driver for the
entire four-year contract term. The limousine will
be used to transport D to various speaking and
charity events according to a schedule that D
provides to R on a biweekly basis. However, once
the schedule is provided, the dedicated driver —
an employee of R — plans the routes to and from
each scheduled event.
Customer D has the right to
obtain substantially all of the economic benefits
from the limousine throughout the four-year period
of use because it is the only customer that will
be transported in the limousine during that
period. In addition, although R is responsible for
operating the limousine and has some discretion in
route planning, D has the right to direct the use
of the limousine because it is responsible for
determining whether and,
if so, when the limousine
will operate and where it
will travel.
For these reasons, D has the
right to control the use of the limousine and the
contract contains a lease.
Example 3-21
Refrigerated Storage Unit
Customer A enters into a contract with Company B for the exclusive use of a refrigerated storage unit for a
15-month period. Company B constructed the storage unit and is responsible for operating and maintaining
it. The contract explicitly identifies the storage unit via its serial number, and B is contractually restricted from
substituting the refrigerated storage facility during the contract term. Therefore, the parties have determined
that the fulfillment of the contract depends on an identified asset.
Throughout the 15-month period of use, A has the right to take products out of, or put them into, the storage
unit at any time without B’s consent. However, B controls physical access to the storage unit and only B’s
employees are allowed inside; therefore, B is responsible for physically moving the products as A requests.
Customer A has the right to obtain substantially all of the economic benefits from the storage unit throughout
the 15-month period of use because of its exclusive use of the storage unit. Although B controls physical
access to the storage unit and is responsible for operating it, B does so according to A’s decisions about what
products will be stored in the storage unit as well as whether and, if so, when they will be stored. Customer A
therefore has the right to direct the use of the storage unit.
Because A obtains substantially all of the economic benefits from the storage unit (an identified asset) and has
the right to direct its use, the contract contains a lease.
Example 3-22
Natural Gas Processing Facility
Customer U enters into a three-year contract for the exclusive use of Supplier M’s processing plant. Supplier M
agrees to separate “wet” natural gas that U extracts from shale rock formations into its component products of
“dry” natural gas and natural gas liquids (e.g., ethane, butane, propane).
The contract explicitly names M’s plant by address. Although M has, at times, contracted to provide varying
amounts of capacity to multiple customers simultaneously, U has contracted for 100 percent of the capacity of
the plant. This is the only plant M owns that is connected via a pipeline to U’s natural gas wellhead gathering
system, so M does not have an alternative plant that it could substitute to fulfill its obligations under the
contract. Accordingly, the parties have determined that the fulfillment of the contract depends on an identified
asset.
During the three-year contract period, M’s own employees will operate and maintain the plant. Although U
never has physical access to the plant, it may provide the wet gas for processing whenever it chooses and will
receive 100 percent of all products yielded (i.e., 100 percent of the dry gas and natural gas liquids produced).
Customer U has the right to obtain substantially all of the economic benefits from the processing plant
throughout the three-year period of use because it will receive 100 percent of the outputs (i.e., dry gas and
natural gas liquids) produced by the plant. Although M is entirely responsible for operating and maintaining the
plant, this contract is, in effect, a tolling agreement. That is, U determines whether and, if so, when the plant
is used, as well as what amount of output it will produce, by virtue of its right to provide 100 percent of the
plant’s inputs. For example, if U does not provide any wet gas, the plant does not produce dry gas and natural
gas liquids. Customer U therefore has the right to direct the use of the processing plant.
Because U obtains substantially all of the economic benefits from the processing plant (an identified asset) and
has the right to direct its use, the contract contains a lease.
Note that in all three of the above examples, the PP&E is kept on the supplier’s premises but the
customer has the right to direct HAFWP the asset is used throughout the period of use. These three
examples illustrate that the analysis should focus on the parties’ decision-making rights rather than on
the location of the PP&E.
Importantly, while the customer may have the right to direct HAFWP the asset is used throughout the period of use when the asset is kept on the supplier’s premises, the inverse can also be true. That is, as the FASB staff has indicated to us, the supplier may have the right to direct HAFWP the asset is used throughout the period of use even when assets dedicated to the customer are kept on the customer’s premises.
Example 10, Case A, in ASC 842-10-55-124 through 55-126 (reproduced in Section 3.7.10)
illustrates this notion, and the Connecting the Dots below discusses it
in greater detail.
Connecting the Dots
Assessing Which Party Has
the Right to Direct the Use of Dedicated Assets on the
Customer’s Premises
We have received a number of questions regarding the outcome of Example 10, Case
A, in ASC 842-10-55-124 through 55-126 (reproduced in Section 3.7.10). That example
involves a contract for network services under which a
telecommunications company (the supplier) installs and
configures multiple servers at a customer site to support the
customer’s network needs (primarily the storage and
transportation of data). During the term of the arrangement, the
supplier makes decisions about how to deploy the fleet of
servers to satisfy customer requests. Although the arrangement
involves dedicated equipment, some of which is maintained on the
customer’s premises, the conclusion reached in the example is
that the arrangement does not contain a lease since the customer
does not (but the supplier does) have the right to direct HAFWP
the individual servers are used.
Some may find this outcome counterintuitive since the servers are dedicated
solely to the customer for the term of the arrangement. However,
the conclusion highlights an important change from ASC 840.
Specifically, for a lease to exist under ASC 842, the customer
must obtain the right to control the use of the asset(s) in the
arrangement and the right to control the use is not limited to
having the right to all of the asset’s productive output (one of
the circumstances in which an entity could conclude that an
arrangement is a lease under ASC 840, as discussed in the
Changing
Lanes discussion in Section 3.4). Rather, the right to control the
use under ASC 842 is determined in a two-part test that focuses
on (1) economic benefits and (2) the right to direct the use of
the identified asset(s). In the example, the second condition is
not met; therefore, the arrangement does not contain a
lease.
A number of stakeholders have asked about the key factors related to why the
customer in the example does not have the right to direct the
use of the servers. For instance, questions have been raised
regarding why, if the right to dispatch a power plant (i.e., to
tell the owner-operator when to produce electricity — see
Section 3.4.2.1.1)
conveys to the customer the right to direct the use of the plant
(as illustrated in Example 9, Case C, in ASC 842-10-55-117
through 55-123, reproduced in Section 3.7.9), the right
to determine when and which data to store or transport by using
the network would not likewise convey to the customer the right
to direct the use of the underlying servers.
We understand the following regarding the key
factors behind the conclusion in Example 10, Case A:
-
The analysis is focusing on whether each individual server, as opposed to the entire network, is a lease. In the example, the supplier is providing a service (a network of a certain capacity and quality) by using dedicated assets. Therefore, the analysis to determine which party has the right to direct the use of the asset(s) should be performed at the asset level (i.e., at the individual server level).
-
The consideration of HAFWP the asset is used, as described in ASC 842-10-15-25, likewise focuses on decisions related to each individual server — not the output produced by the overall network.
-
The scenario involves multiple assets (multiple individual servers), and the supplier retains the discretion to deploy each individual server in whatever manner the supplier decides will best fulfill the overall network service.
-
Since each server on its own can perform different functions (e.g., storing data, transporting data), the supplier has the right to make meaningful decisions about which server(s) should be used to satisfy a particular customer request.
-
The customer cannot decide HAFWP each individual server is used and cannot prevent the supplier from making those decisions. The customer’s decisions are limited to how the customer uses the network and do not extend to the individual servers.
We think that these key factors, though they are
not all-inclusive, help differentiate the conclusion in Example
10, Case A, from the conclusion in Example 10, Case B, in ASC
842-10-55-127 through 55-130 (reproduced in Section
3.7.10). In Case B, the arrangement involves a
single server, and the customer makes the critical decisions
about which data to store or transport by using that single
server as well as about how (or whether) to integrate that
single server into its broader operations. Therefore, we believe
that Case B is more analogous than Case A to Example 9, Case C,
which involves dispatch rights over a power plant (also a single
asset).
Understanding the key distinguishing factors in
the above examples should help preparers identify leases under
ASC 842. However, the illustrative examples represent an
application of the framework to certain stated facts and
circumstances. An entity must perform a detailed analysis of its
own specific facts and circumstances in such scenarios. We
recommend that entities that have questions about their
arrangements and whether they should be analyzed in a manner
similar to the analysis in Example 10, Case A, should discuss
those questions with their auditors or accounting advisers.
3.4.2.1.2.1 Assessing the Right to Direct the Use of Multiple Assets in a Single Arrangement
In an arrangement involving the use of multiple
assets, the parties to the arrangement should assess whether the
customer has the right to direct the use of those assets. This
assessment should be performed at the individual asset level rather
than at the asset group level.
As discussed in the Connecting the Dots above, this
analysis should focus on decision-making rights related to each of
those assets. Feedback received from the FASB and IASB staffs has
indicated that this is a key element of the analysis in Example 10,
Case A.
This may seem counterintuitive given the order of
operations indicated by ASC 842. That is, in accordance with ASC
842-10-15, an entity should first determine whether a contract is or
contains a lease before it breaks that contract into its units of
account consisting of separate lease (and nonlease) components. (For
additional information about separating components in a contract,
see Chapter
4.) However, the guidance in ASC 842-10-15-24 through
15-26 continually uses the singular, referring to the right to
direct the use of an asset or HAFWP the asset is
used.
In addition, the decisions that affect the economic
benefits to be derived from use of an asset are most easily
identifiable at the level of the individual asset. We think that
this will be especially true when each individual asset has multiple
functionalities, as in Example 10, Case A (e.g., the supplier, at
its discretion, may individually deploy each server for such tasks
as filing, e-mail, or printing to provide the customer with a
network of a certain capacity and quality). It would follow, then,
that the customer has the right to direct HAFWP an asset is used
when it has decision-making rights that affect the economic benefits
derived from the use of the individual asset.
Example 3-23
Contract
for Construction-Related Services
Homebuilder B enters into a
contract with Vendor GC to provide demolition and
construction services for two years. Under the
arrangement, GC will use three pieces of heavy
construction equipment — an excavator, a crane,
and a skid loader — in the razing of real estate
purchased by B and the construction of a new
suburban housing development at B’s direction.
Assume that it is clear from
the contract that the equipment represents
identified assets and that B obtains substantially
all of the economic benefits from use of each of
these assets.
Each piece of equipment has
multiple functionalities. For example, the crane
can be used to lift heavy materials when a hook is
attached or to raze existing structures when a
wrecking ball is attached. Vendor GC’s own
employees are deployed to operate the equipment,
and B is contractually precluded from operating
the equipment itself or from hiring a third party
to do so.
Homebuilder B issues
instructions to Vendor GC each week with a stated
project. For example, B may instruct GC in the
first week to raze an existing structure on a
northwest parcel of the purchased land and, in the
second week, it may instruct GC to lay the
foundation for a new home on the southwest parcel
of the purchased land.
Vendor GC retains the
discretion to deploy each individual piece of
equipment in whatever manner it decides will best
fulfill the demolition and construction services
it is providing to B. For example, to accomplish
the first week’s project, GC may choose not to use
the skid loader and instead save its fuel; GC may
be able to complete the first week’s project
solely by using the demolition-related functions
of the crane and the excavator. Because each piece
of equipment on its own can perform different
functions, GC has the right to make meaningful
decisions about which pieces of equipment should
be used to satisfy each week’s project. Therefore,
GC’s decision-making rights go beyond basic
decisions about operating and maintaining the
equipment.
Homebuilder B cannot decide
HAFWP each individual piece of equipment is used
to complete each week’s project, and B cannot
prevent GC from making those decisions.
Homebuilder B’s decisions are limited to how it
will use the services provided by GC and do not
extend to the individual pieces of equipment.
Accordingly, GC retains the
right to direct HAFWP each piece of equipment is
used. The contract does not contain a lease.
When an arrangement involves the use of a single
asset that is made up of individual component assets (e.g., a power
plant with two turbines that is constructed to function as a single
asset), the parties to the arrangement should not break the single
asset into its individual component assets to assess whether the
customer has the right to direct the use of those assets (e.g., the
individual turbines). Rather, such an analysis should be performed
with respect to the single asset. Because the asset is built or
constructed to function as a single asset, the most relevant
decision-making rights will be those that affect the economic
benefits to be derived from use of the single asset.
For example, it is common in the power and utilities
industry for a power plant to contain two or more turbines that
produce electricity (in the case of a wind facility, there may be
many turbines). Those turbines will generally perform the same
function (i.e., producing electricity), and the individual turbines
will benefit jointly from the installation of other individual
PP&E within the power plant for efficiency purposes (e.g., a
single transformer). Because the individual turbines are constructed
to be a part of a larger, single asset for the intended use of
generating electricity as a single asset, it would be inappropriate
to assess the right to direct the use of each individual
turbine.
However, if the power plant was constructed to
contain two or more turbines, each capable of generating electricity
separately, it would be appropriate to assess the right to direct
the use of each individual turbine.
These concepts would also apply to a manufacturing
facility with multiple manufacturing lines that are constructed to
function as a single asset. That is, it would generally be
inappropriate to assess the right to direct the use of each
manufacturing line separately.
As discussed above, the right to direct HAFWP an
asset is used can be complex when the use of the asset is heavily
influenced by activities the supplier performs (e.g., in Example 10,
Case A, reproduced in Section 3.7.10). The analysis
can be equally complex when the use of the asset is heavily
influenced by, or depends on, infrastructure that is owned,
operated, and controlled by the supplier. Section 3.4.2.1.2.2 and the Connecting the
Dots discussion below discuss this complexity with
respect to pipeline laterals and the first miles and last miles of
tangible, integrated infrastructure systems.
3.4.2.1.2.2 Pipeline Laterals (Right to Control the Use)
Pipelines are generally constructed and operated in
sprawling and integrated systems that transport natural gas, oil,
and refined products from supply regions to demand regions. Some
customers are connected to, and receive deliveries of transported
commodities through, the pipeline system via dedicated laterals. In
addition, a pipeline system must, by its nature, have starting and
ending points. Therefore, other customers may be connected to the
pipeline system through effective laterals, because they are
connected to the first mile or last mile of the larger pipeline
system.
Section
3.3.2.1 explains that laterals and
first-mile/last-mile connections are physically distinct portions of
the larger pipeline system. Therefore, in transportation agreements,
they are identified assets in accordance with ASC 842-10-15-16.
Certain of these agreements are firm; accordingly, the customer is
guaranteed a certain amount of transportation capacity on the
pipeline system and is given priority above other customers that do
not have firm rights. At the May 10, 2017, Board meeting, the FASB
and its staff discussed whether the customer in a firm
transportation agreement has the right to control the use of a
pipeline lateral or a first-mile/last-mile connection to the larger
pipeline system.
While highlighting that the specific facts and
circumstances of each arrangement must be considered, the FASB staff
discussed two types of pipeline laterals on the basis of information
it obtained via outreach to entities in the midstream oil and gas
industry sector:
-
Type 1 — These “typically are connected to an integrated pipeline system”4 and are the most common type of pipeline laterals. While they cannot operate on their own, they share “supply sources with the main line and other customers.” The pipeline owner retains the ability to change the compression in the lateral to manage pressure in the lateral and on the larger system. Pressure moves commodity within the system, so changing the pressure in the lateral can affect the pressure in the larger system, thus affecting the speed at which other customers’ inventory moves through the system (and the speed at which the pipeline owner is able to provide its transportation services to others). Further, the pipeline owner retains the ability to store its own commodity in the lateral (i.e., line pack). Doing so also manages the pressure in the lateral and on the larger system.Accordingly, the pipeline owner retains both (1) economic benefits from the asset’s use that are more than insignificant through its rights to store commodity in the lateral and to use the compression in the lateral to manage the pressure in the larger system, even though the customer decides when to receive service and at what volumes, and (2) the right to direct the use of the asset throughout the period of use because of its rights to change when, whether, and to what extent the lateral is used to manage the pipeline owner’s larger system. Depending on the significance of retained rights, the Board agreed with the staff’s analysis that Type 1 pipeline lateral contracts do not contain a lease. Type 1 pipeline laterals are expected to be the most common type.
-
Type 2 — These laterals “are fully capable of operating using their own dedicated assets,” and “the customer has the right to substantially all the pipeline lateral’s capacity.” The customer is able to close off this type of lateral from the remainder of the pipeline system (by closing a valve or a similar mechanism), thus preventing the pipeline owner from directing the use of the asset. In addition, closing the lateral off from the larger system allows the customer to use the lateral independently from the larger system.The Board agreed with the staff’s analysis that a lease exists in this case, since the customer has “the right to obtain substantially all the economic benefits . . . and the right to direct the use of the pipeline lateral throughout the period of use.”
The Board agreed with the staff’s analyses, as noted
above, and did not believe that any additional standard setting was
required at that time.
Connecting the Dots
Right to Direct the
Use of Other First-Mile/Last-Mile Assets
As indicated in Section 3.3.2.1, other first-mile/last-mile
connections are identified assets in accordance with ASC
842-10-15-16. Therefore, entities must assess whether the
customer has the right to control the use of such assets. We
think that the FASB’s May 10, 2017, meeting discussion
regarding pipeline laterals (see above) is helpful to this
assessment.
The above discussion describes two types of
pipeline laterals, one of which — Type 2 — can be
functionally and tangibly closed off (e.g., by closing a
valve or a similar mechanism) from the remainder of the
larger pipeline system even though the lateral is not
physically disconnected from the system. The Board generally
expects that, for Type 2 laterals, the customer therefore
will have the right to use the lateral independently from
the larger system. The customer will thus have the right to
control the use of the lateral, and the related arrangement
will contain a lease.
We think that the same analysis can be
applied to other types of first-mile/last-mile connections.
That is, unless the customer is able to functionally and
tangibly close off the first-mile/last-mile asset from the
larger system, the customer will be unable to control the
use of this asset. In other words, when there is no such
“cut-off point,” or when the cut-off point is so near to the
customer’s facility that no substantive first-mile/last-mile
asset remains after that point, the related arrangement will
not contain a lease.
Note that just because an asset is connected
to, and requires the use of, a distribution system
controlled by the owner of the system, an entity should not
automatically conclude that there cannot be a lease. The
first-mile/last-mile issues address specific sections or
parts of the physical distribution network itself, and we
generally do not expect that portions of the larger network
will contain leases on the basis of the guidance above.
However, arrangements related to assets that are attached to distribution networks
(e.g., storage tanks, power plants) may still be identified
as leases or as containing leases.
Section
3.3.2.1 includes a list (not all-inclusive)
of examples that would be identified assets under the
guidance in ASC 842-10-15-16. Our understanding of the most
common facts and circumstances, as well as how they are
related to the lateral framework discussed above, is as
follows:
-
Electric and telecommunications (i.e., wire and cable that deliver telephone, cable television, and Internet services) — Wires and cables of this nature less commonly function as Type 2 pipeline laterals because (1) they are less likely to have a cut-off point after which the customer has the right to use the wires and cables independently from the larger system and (2) a cut-off point, if one exists, is most likely to be very close to the customer’s facility. While they may not function as Type 1 laterals because the supplier generally cannot use the first-mile/last-mile connection to manage its larger network, the important point is that they rarely function alone, without the assistance of the larger system. Accordingly, we think that it will be rare for the customer to have the right to control the use of first-mile/last-mile connections of electric and telecommunications wires and cables.
-
Rail — Such first-mile/last-mile connections may more closely function as Type 1 pipeline laterals if the owner of the larger rail network is able to store cars on the first mile/last mile (or miles) that connects to the customer’s facility. However, a rail may also function as a Type 2 lateral if the customer is able to functionally and tangibly close off from the rest of the rail network the portion of track that connects to its facility. In such cases, an entity should carefully consider the relevant facts and circumstances as well as the customer’s and the supplier’s decision-making rights in related arrangements.
3.4.2.1.3 Excluding Predetermined Use
ASC 842-10
15-22 In assessing whether a customer has the right to direct the use of an asset, an entity shall consider only rights to make decisions about the use of the asset during the period of use unless the customer designed the asset (or specific aspects of the asset) in accordance with paragraph 842-10-15-20(b)(2). Consequently, unless that condition exists, an entity shall not consider decisions that are predetermined before the period of use. For example, if a customer is able only to specify the output of an asset before the period of use, the customer does not have the right to direct the use of that asset. The ability to specify the output in a contract before the period of use, without any other decision-making rights relating to the use of the asset, gives a customer the same rights as any customer that purchases goods or services.
An entity should consider only decisions made during the period of use — and not before — in determining whether the customer has the right to direct HAFWP the asset is used throughout the period of use. For example, if the customer’s only decision-making right related to the use of the asset was to specify the amount, type, and quality of output to be produced by the asset as part of negotiating the contract (i.e., before the period of use), the customer cannot direct HAFWP the asset is used throughout the period of use. Example 8 in ASC 842-10-55-100 through 55-107 (reproduced in Section 3.7.8) illustrates a scenario in which the customer’s only right is to specify the output of an identified manufacturing facility.
When considered in this context, the phrase “throughout the period of use” is meant to create a break in
the timeline of the use of the asset between (1) the time before the beginning of the period of use (i.e.,
predetermination) and (2) the time during the period of use (“period of use” is defined in Section 3.5).
That is, “throughout the period of use” is synonymous with “during the period of use” in this respect. The
FASB further articulated this notion in paragraph BC140 of ASU 2016-02:
Topic 842 clarifies that only decisions made during the period of use (and not before the period of
use) should be considered in the control assessment, unless the customer designed the asset in a way that
predetermines how and for what purpose the asset will be used. In the Board’s view, if a customer specifies
the output from an asset at or before the beginning of the period of use (for example, within the terms of the
contract) and cannot change those specifications during the period of use, it generally does not control the use
of an asset. In that case, it would have no more decision-making rights than any customer in a typical supply or
service contract. [Emphasis added]
Some decisions about HAFWP the asset will be used during the period of use may be predetermined
by the nature of the asset. For example, in a lease of real estate, the decisions about where the asset
may be used during the period of use are predetermined: real estate is affixed permanently to a unique
space on the earth and, thus, no party to the arrangement may make such decisions.
However, even when some decisions about HAFWP the asset will be used during the period of use are
predetermined, other significant decision-making rights related to HAFWP the asset will be used can
most likely still be made during the period of use (e.g., when the asset is used during the period of use
to produce an output that the customer specified before the period of use). Those are the decision-making
rights that an entity should consider when assessing which party determines HAFWP the asset is
used throughout the period of use.
The diagram below illustrates how significant decision-making rights could be
granted in an arrangement. According to the diagram, an entity
performing the analysis would focus on which party controls the
decision-making rights in the green portion of the circle to determine
whether the customer can direct HAFWP the asset is used throughout the
period of use.
However, if all decisions about HAFWP the asset will be used throughout the period of use are predetermined and, therefore, no other significant decision-making rights about HAFWP the asset is used can be made during the period of use, the parties to the arrangement would consider whether the customer operates the asset throughout the period of use or designed the asset in a manner that predetermined HAFWP the asset will be used throughout the period of use in accordance with ASC 842-10-15-20(b). See Section 3.4.2.3 for a detailed discussion of those circumstances.
3.4.2.2 Protective Rights Define the Scope of the Contract
ASC 842-10
15-23 A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may specify the maximum amount of use of an asset or limit where or when the customer can use the asset, may require a customer to follow particular operating practices, or may require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.
Once entities identify the decision-making rights that are most relevant to changing HAFWP the asset is used throughout the period of use (i.e., the decision-making rights that can affect the economic benefits that result from use of the asset), they must identify which of those decision-making rights are within the scope of the contract. The decision-making rights that are within the scope of the contract are the rights that an entity should consider when determining whether the customer or the supplier has the right to direct HAFWP the asset is used throughout the period of use.
This concept is similar to that discussed in Section 3.4.1.2 with respect to the economic benefits that result from use of the asset. In a manner similar to the discussion for economic benefits, the scope of the contract will generally be limited by protective rights, as indicated in ASC 842-10-15-23.
The diagram in Section 3.4.1.2, therefore,
is equally applicable to the determination of which party has the right to
direct HAFWP the asset is used throughout the period of use. In that
diagram, the economic benefits that are within the scope of the contract are
bound by the blue portion of the circle. It would follow, then, that only
the decision-making rights that affect those economic benefits should
be factored into the analysis of which party has the right to direct HAFWP
the asset is used.
Accordingly, in line with the example from ASC 842-10-15-18 and Section 3.4.1.2, it would be inappropriate
to conclude that the customer is prevented from directing HAFWP the asset is
used on the basis of the fact that the customer does not have all possible
rights to decide where and to what extent the vehicle is used (i.e., because
the customer does not have the rights to decide to drive the vehicle in all
territories and for unlimited miles, respectively). Rather, the analysis
would include decision-making rights related to when, whether, where, and to
what extent the vehicle is driven, as limited by the protective rights in
the contract.
The following examples from ASC 842 illustrate the effect of protective rights on the scope of the contract in the determination of whether the customer has the right to direct HAFWP the asset is used throughout the period of use:
- Example 4 in ASC 842-10-55-63 through 55-71 (see Section 3.7.4).
- Example 6, Case B, in ASC 842-10-55-85 through 55-91 (see Section 3.7.6).
- Example 7 in ASC 842-10-55-92 through 55-99 (see Section 3.7.7).
The example below further illustrates this notion.
Example 3-24
Truck Rental
Subject to Certain Restrictions
Customer Bucky enters into a
contract with Supplier Badger for the use of a
specific truck for a two-year period. Supplier
Badger is not permitted to substitute the truck
during the contract term. Because the truck is
explicitly specified in the contract and Badger does
not have a substantive substitution right, the truck
represents an identified asset in the contract.
The contract stipulates that Bucky
decides whether and, if so, what cargo will be
transported; when cargo will be transported; and
where (e.g., to which cities) the truck will deliver
throughout the period of use. Bucky is required to
provide a properly licensed driver and is
responsible for the safe delivery of the cargo that
is carried. Certain restrictions prohibit Bucky’s
driver from using the truck beyond the maximum hours
permitted by law or from carrying hazardous
materials as cargo. Moreover, the contract prohibits
Bucky from driving the truck out of the United
States. Therefore, although Bucky has significant
demand for its products in Alaska, it is restricted
from driving the truck through Canada to get
there.
Customer Bucky has the right to
control the use of the identified truck for the
following reasons:
-
Although contractual restrictions limit to what extent the truck may be driven (i.e., a maximum number of hours allowable by regulation), where the truck may be driven (i.e., only within the continental United States), and what types of cargo may be transported (i.e., no hazardous cargo), these restrictions represent protective rights that define the scope of the contract.
-
Because Bucky has exclusive use of the truck, Bucky has the right under the contract to obtain substantially all of the economic benefits from the use of the truck during the period of use.
-
Within the scope of the contract, Bucky has the right to direct HAFWP the truck is used because it decides whether the truck will be used to transport cargo, what cargo will be transported, when the truck will be driven, and where the truck will be driven.
Because Bucky has the right to
control the use of the identified truck throughout
the period of use, the contract contains a lease for
the truck despite the existence of certain use
restrictions to protect the owner’s investment in
the truck.
3.4.2.3 How and for What Purpose the Asset Is Used Throughout the Period of Use Is Predetermined
HAFWP the asset is used during the period of use is predetermined when there are no decisions that
are available to be made, by either the supplier or the customer, during the period of use about HAFWP
the asset is used. In these instances, a “tiebreaker” notion applies under ASC 842. That is, under ASC
842-10-15-20(b), the analysis is forced toward a conclusion that one of the parties to the arrangement
must have the right to direct the use of the asset.
When HAFWP the asset is used during the period of use is predetermined, the customer has the
right to direct the use of the asset when it either (1) has the right to operate (or to direct others to
operate) the asset throughout the period of use without the supplier having the right to change those
operating instructions or (2) designed the asset (or the relevant aspects of the asset) in a manner that
predetermined HAFWP the asset is used during the period of use.
In paragraph BC139 of ASU 2016-02, the FASB explains that the guidance in ASC 842-10-15-20(b) is intended to identify situations in which the customer, even when it does not have the right to direct HAFWP the asset is used, still has rights beyond those of a customer in a service arrangement:
The approach to determining whether a customer has the right to direct the use of an identified asset changes if the decisions about how and for what purpose an asset is used are predetermined. Topic 842 clarifies that if decisions about how and for what purpose an asset is used are predetermined, a customer can still direct the use of an asset if it has the right to operate the asset, or if it designed the asset in a way that predetermines how and for what purpose the asset will be used. In either of these cases, the customer controls rights of use that extend beyond the rights of a customer in a typical supply or service contract (that is, the customer has rights that extend beyond solely ordering and receiving output from the asset). In those cases, the customer has the right to make (or has made in the case of design) decisions that affect the economic benefits to be derived from use of the asset throughout the period of use.
Accordingly, even though the decisions that are most relevant to changing HAFWP the asset is used may be predetermined, the customer may still be able to make (or may have made) some decisions that affect the economic benefits to be derived from use of the asset. Therefore, it may still obtain control through both the “power” and the “economics” elements.
ASC 842-10
15-21 The relevant decisions about how and for what purpose an asset is used can be predetermined in a number of ways. For example, the relevant decisions can be predetermined by the design of the asset or by contractual restrictions on the use of the asset.
As explained in ASC 842-10-15-21, HAFWP an asset is used during the period of use may be predetermined through the following:
- Design — The design of the asset may predetermine where, when, whether, to what extent, and for what type of output the asset is used. In addition, the nature of the asset will often play a role. For example, the design of a wind farm predetermines where (wherever it is installed) and for what type of output (electricity) the asset is used. In addition, because of the nature of the asset (e.g., an electricity-generating asset that depends on the wind blowing), when, whether, and to what extent the asset is used are beyond the control of any party to the arrangement (e.g., they are subject to the weather).Example 9, Case A, in ASC 842-10-55-108 through 55-111 (reproduced in Section 3.7.9) illustrates this concept with respect to a contract to purchase electricity produced by a solar farm.
- Contractual restrictions — Restrictions in the contract may predetermine where, when, whether, to what extent, and for what type of output the asset is used. Such restrictions are most likely to exist when dedicated machinery is used in certain supply arrangements or in situations in which the protective rights enforced by the supplier in the contract (see Section 3.4.2.2) are so severe that no decisions about HAFWP the asset is used can be made during the period of use.Example 6, Case A, in ASC 842-10-55-79 through 55-84 (reproduced in Section 3.7.6) illustrates this concept with respect to a contract to transport goods via ship.
Further, the FASB discusses a manner of predetermination — predetermination through contractually
negotiated terms and conditions — in paragraph BC138 of ASU 2016-02:
Nonetheless, decisions about how and for what purpose an asset is used can be predetermined. In that
case, those decisions cannot be made by either the customer or the supplier during the period of use. This
could happen if, for example, in negotiating the contract, the customer and supplier agree on all the relevant
decisions about how and for what purpose an asset is used and those decisions cannot be changed after the
commencement date.
We think that this manner of predetermination differs from the predetermination by contractual
restrictions discussed in ASC 842-10-55-21. Predetermination by contractual restrictions implies that the
arrangement becomes more like a service arrangement as a result of the supplier’s efforts to protect its
investment in the asset. That is, the supplier is willing to provide services to the customer but unwilling
to give the customer any rights to direct the use of the asset.
On the other hand, predetermination by negotiation implies that both parties
agree to the terms and conditions of the arrangement in such a way that the
use of the asset is predetermined. In this case, neither party is deemed to
control the agreed-upon terms, since the arrangement represents an
arm’s-length exchange. The example below illustrates this concept.
Example 3-25
Refrigerated
Storage Unit
Assume the same facts as in
Example 3-21, except that Customer A
and Supplier B, when negotiating and writing the
contract, agree that A will only store a certain
type of carbonated beverage in the refrigerated
storage unit and a specific quantity (e.g., in
gallons) of the beverage. Customer A is not allowed
to change the type or quantity of beverage to be
stored in the storage unit during the 15-month
contract term. Further, A and B agree that A will
provide the beverages for storage on the
commencement date and retrieve them from storage at
the end of the contract term.
In this case, the contract
predetermines HAFWP the storage unit will be used
throughout the period of use. That is, A and B
contractually agreed to what
products will be stored in the storage unit, what amount will be stored,
when the products will be
stored, and whether anything
will be stored. No decisions about HAFWP the storage
unit is used during the period of use can be made by
A or B during this period.
Even though these stipulations meet
A’s business requirements, A is not deemed to
control these aspects during the period of use
because they were agreed to up front and cannot be
changed. Rather, these HAFWP decisions are deemed to
be contractually predetermined. Therefore, A must
determine whether it either (1) has the right to
operate the storage unit throughout the period of
use or (2) was involved in the design of the storage
unit. As stated in Example 3-21, B
operates the storage unit. In addition, B had
already constructed the storage unit when the
contract was executed and A was not involved in the
design of the storage unit. Because neither of the
“tiebreaker” conditions are met, A does not have the
right to direct the use of the storage unit.
Therefore, even though A obtains
substantially all of the economic benefits from its
exclusive use of the storage unit over the 15-month
contract term, A does not have the right to control
the use of the storage unit. Accordingly, B controls
the use of the storage unit and, as a result, the
contract does not contain a lease.
Connecting the Dots
Predetermination Is Expected
in “Relatively Few Cases”
In the Background Information and Basis for Conclusions of ASU 2016-02, the FASB is careful to explain that it expects the analysis in ASC 842-10-15-20(b) to apply to “relatively few” contracts. Specifically, the Board twice indicates that it expects, in most leases, that either the customer or the supplier will have decision-making rights over HAFWP the asset is used during the period of use:
BC138. . . . The Board noted that it would expect decisions about how and for what purpose an asset is used to be predetermined in relatively few cases.
BC139. [The Board] expects that, for most leases, the assessment of whether a
customer directs the use of an asset will be based on
identifying the party that decides how and for what purpose
an asset is used.
As a result, we expect that it will be uncommon for an entity to use the tiebreaker tests in ASC 842-10-15-20(b) to determine whether a contract is, or contains, a lease.
3.4.2.3.1 Customer Has the Right to Operate the Asset
Although rights of operation do not factor into the assessment of who directs
HAFWP the asset is used, those rights can vest control of the asset to
the customer in accordance with ASC 842-10-15-20(b)(1) when HAFWP the
asset is used during the period of use is predetermined. The examples
and discussion below provide additional insight into this condition.
Example 3-26
Shipping Charter
Customer Y enters into an arrangement with Supplier Z for the exclusive use of an explicitly identified ship.
Customer Y indirectly chooses the type of ship to be used by selecting a shipping service package. In this case, Y receives the ship at designated Port City A. The ship is predetermined to go from Port City A to Port City B during a specific time frame. Customer Y’s own crew will man, steer, and otherwise operate the ship. Customer Y and Supplier Z agree up front on the contents and amount of cargo to be shipped.
The parties conclude that the arrangement constitutes a lease of the ship for the following reasons:
- The ship is explicitly specified in the arrangement, and Z does not have a substantive substitution right.
- Because of its exclusive use of the ship, Y obtains all of the economic benefits from the ship during the period of use.
- Because the output of the ship (i.e., the cargo and transportation capacity) is specified in the contract, the relevant decisions about HAFWP the ship is used are predetermined. However, Y has the right to operate the ship during the period of use (e.g., Y’s own operating personnel will man, steer, and otherwise operate the ship) and thus has the right to direct the use.
With respect to the “tiebreaker” conditions, rights to
kick out the operator of an asset are sufficient to give the customer
the right to direct the use of the asset in accordance with ASC
842-10-15-20(b). If HAFWP the asset is used during the period of use is
predetermined and the supplier operates the asset, but the customer has
the right to remove the supplier and hire a new operator, the customer
has the right to direct others to operate the asset in accordance with
ASC 842-10-15-20(b)(1). When the kick-out right is substantive (i.e.,
when the customer can remove and replace the operator without cause at
any time), the customer — not the supplier — is the decision maker with
respect to the operation of the asset.
Example 3-27
Ship
Assume the same facts as in
Example 6, Case A, in ASC 842-10-55-79 through
55-84 (reproduced in Section 3.7.6).
Supplier operates and maintains the ship and is
responsible for the safe passage of the onboard
cargo. However, in this scenario, Customer may
remove Supplier at will and without cause so that
it can hire another operator for the ship, or
operate the ship itself, during the term of the
contract.
As in ASC 842-10-55-82 and
55-83, the contract depends on the use of an
identified asset and Customer has the right to
obtain substantially all of the economic benefits
from use of the ship, respectively. In addition,
HAFWP the ship will be used is predetermined in
the contract. However, in this case, Customer has
the right to operate the asset throughout
the period of use in accordance with ASC
842-10-15-20(b)(1).
Accordingly, the contract
contains a lease of the ship.
3.4.2.3.2 Customer Has Designed the Asset
HAFWP an asset is used during the period of use can be predetermined by the design of an asset.
If the customer is the party that designed the asset — or is the party that designed aspects with the
most influence on HAFWP the entire asset is used — the customer had decision-making rights that
extend beyond those of a typical customer in a supply or service arrangement. In those instances, in
accordance with ASC 842-10-15-20(b)(2), the customer has the right to direct the use of the asset.
Example 9, Case A, in ASC 842-10-55-108 through 55-111 (reproduced in Section 3.7.9) illustrates an
application of the guidance in ASC 842-10-15-20(b)(2). However, as is evident from the discussion and
examples below, the complexity of applying ASC 842-10-15-20(b)(2) will often be related to determining
how much involvement in the design of the asset is enough to give the customer the right to direct the
use of the asset.
Connecting the Dots
Entities Need to Use
Significant Judgment in Evaluating Design
We expect that entities in certain industries will need to use significant judgment in evaluating
who has the right to direct the use of an asset under ASC 842, especially when HAFWP the asset
is used throughout the period of use is predetermined. Although an entity may not have trouble
determining whether the customer or supplier has control over the operating decisions related
to the asset, the assessment of whether the customer designed the asset will often be more
difficult given the different levels of influence a customer may have over the design decisions
(e.g., where the asset will reside/operate, determining the technology to be used). Accordingly,
we expect that this assessment will be one of the aspects of ASC 842 that will require entities to
use the greatest judgment.
The example below illustrates the difficulty in applying judgment in such cases.
Example 3-28
Renewable Power Purchase Agreement
Customer X, a utility company, enters into a 20-year PPA with Supplier Y, a power generation company, to buy all of the electricity produced by a new wind farm that Supplier Y will own. Assume the following:
- The wind farm is explicitly specified in the contract, and Y has no substitution rights.
- The electricity cannot be provided by another asset.
- Customer X hired an expert engineer to help determine the location of the wind farm and its size (i.e., the maximum electricity production capacity).
- Supplier Y is responsible for constructing, operating, and maintaining the wind farm during the contract term.
- All the relevant decisions about where, whether, when, and what amount of electricity will be produced are predetermined as a result of the design decisions and the nature of the asset. That is, the customer cannot change these decisions and, once the asset is constructed, the outputs derived from its use depend largely on weather.
- The wind farm is in a state with an RPS, and X will receive all RECs that accrue from using the wind farm.
- Supplier Y will receive PTCs that result from the operation of the wind farm.
The agreement meets the following conditions to be considered a lease:
- The wind farm is an identified asset because it is explicitly identified and Y does not have substitution rights.
- Customer X has the right to obtain substantially all of the economic benefits from use of the wind farm because it receives 100 percent of the electricity and RECs produced by the wind farm. PTCs do not represent economic benefits because they are an ownership attribute and cannot be monetized by sale to a third party (see Section 3.4.1.1.2).
Neither X nor Y may decide HAFWP the wind farm is used during the period of use. All relevant decisions about HAFWP the wind farm is used are predetermined by the nature and design of the wind farm. Because Y operates and maintains the wind farm throughout the period of use, X does not meet the condition in ASC 842-10-15-20(b)(1). However, X was involved in the design of the wind farm, so X must also consider whether it has the right to direct the use of the wind farm under ASC 842-10-15-20(b)(2).
We think that more information is needed before the extent of X’s involvement in the design of the wind farm can be assessed. For example, the following questions may be considered:
- In determining the maximum capacity of the wind farm, did X also determine how many wind turbines would be installed, or did Y make that design decision?
- How did X select the location? Did X determine that the wind farm should be constructed in Logan County, Oklahoma, within 10 miles of X’s interconnection point, or did it determine that the wind farm should be constructed on a specific plot of land in Oklahoma? Who was responsible for ultimately selecting the exact acreage where the wind farm would be constructed?
- Is X’s “involvement” in the design only with respect to a competitive request for a proposal that it issued and that Y won?
- Does X decide what technology to use (i.e., manufacturer and model type of turbine blades or drivetrain), and does X configure the wind farm (e.g., determine the placement of the individual turbines within the wind farm)?
Connecting the Dots
Design of a Renewable
Generating Asset
As indicated in Example 9, Case A (reproduced in Section 3.7.9), as well as the examples in this
section, contracts related to renewable generating assets are expected to often be subject
to ASC 842-10-15-20(b)(2). That is, once a weather-dependent renewable generating asset is
constructed, generally no HAFWP decisions can be made by any party during the period of
use. Certain HAFWP decisions are subject to the weather and are thus outside the control
of any party; otherwise, maintenance is essential to the continued operating efficiency of the
generating assets once they are installed.
As illustrated in Example
3-28, the evaluation of whether a customer
predetermined HAFWP a renewable generating asset is used because
of the extent of its involvement in the design of the asset
involves significant judgment. A customer may often be involved
in some, but not all, design decisions. In such cases, the
evaluation should focus on whether the customer made the design
decisions that most significantly affect the economic benefits
to be derived from use of the asset.
The design decisions that most significantly affect the economic benefits from use will differ
depending on the nature of the asset (i.e., wind, solar) and may change as these technologies
continue to develop. However, we expect that the most significant design decisions will often
comprise some combination of the following:
- Selecting the specific generating equipment (e.g., the wind turbines or photovoltaic cells) to be installed.
- Determining the technical design and site layout (e.g., determining whether solar panels will be static or rotate with the sun).
- Determining the specific location of the facility.
We understand that the power and utilities industry is working with stakeholders to develop
an interpretive framework for how to assess ASC 842-10-15-20(b)(2) with respect to renewable
generating assets. We continue to monitor those developments. In the meantime, we
recommend that entities discuss these scenarios with their auditors or accounting advisers.
3.4.2.4 Power Over How and for What Purpose the Asset Is Used Throughout the Period of Use Is Shared
As discussed in Section 3.4, ASC 842 does not address the concept of “shared power.” That is, ASC
842 does not specifically address situations in which the power over decision-making rights related to
HAFWP the asset is used throughout the period of use is shared.
Power over HAFWP the asset is used during the period of use is only considered shared when both
parties to the arrangement are involved in the decision-making rights that most affect the economic
benefits derived from the use of the asset. When power is shared, no single party (i.e., neither the
customer nor the supplier) has the right to direct the use of the asset.
For example, assume that the ability to change when and whether an asset is used represents the
decision-making rights that most affect the economic benefits derived from the use of that asset. If both
the customer and the supplier must approve an order that would call that asset into use for a specific
time frame, neither party controls those decision-making rights.
Connecting the Dots
Concluding That Power Is Shared
We think that, in practice, there is a high threshold for concluding that power is shared. Such a conclusion can only be reached if the customer and the supplier consent to all the decisions that most affect the economic benefits derived from the use of the asset.
Therefore, in a manner similar to that under the ASC 810 VIE consolidation model
(see Section 7.2 of Deloitte’s
Roadmap Consolidation — Identifying a Controlling Financial
Interest), it is important to differentiate
situations in which power is shared from those in which the supplier
and the customer have power over multiple, different
activities. As noted in Section 3.4, we think that, in
such situations, the guidance in ASC 842 would be aligned with the
ASC 810 VIE consolidation model, specifically the provisions in ASC
810-10-25-38E. That is, we think that ASC 842 requires an entity to
determine which of the different decision-making rights most affects
the economic benefits derived from the use of the asset. The party
with the power over that decision-making right has the right to
direct HAFWP the asset is used throughout the period of use.
Shared Power Is a Blind Spot
ASC 842-10-15-20 through 15-26 do not specifically
address circumstances in which both the customer and supplier must
consent to direct HAFWP the asset is used during the period of use.
Rather, ASC 842-10-15-20 only focuses on whether the customer
has the right to direct the use of the asset. Accordingly, we think
it may be reasonable to conclude that, when power is truly shared
between the parties, the customer does not have the right to direct
the use of the asset and thus there is no lease.
However, we note that when neither the customer nor
the supplier has the right to direct HAFWP the asset is used during
the period of use, the decision tree in ASC 842-10-55-1 (reproduced
in Section
3.2.1) would indicate that HAFWP the asset is used
during the period of use is predetermined. That is, the decision
tree would point an entity toward applying the tiebreaker test in
ASC 842-10-15-20(b) in these situations (see Section
3.4.2.3 for detailed discussion of this
guidance).
We therefore think that, when an entity is
concluding that power is shared, the entity should consider this
path in the decision tree. In these situations, an entity that also
performs the analysis in ASC 842-10-15-20(b) can confirm that the
entity does not have rights beyond those of a customer in a service
arrangement.
Footnotes
2
Note that none of the examples
W through Z have a contract year in which 0
percent of the economic benefits are conveyed to
the customer. In such situations, we think that
the arrangement would be indicative of having
nonconsecutive periods of use, which are discussed
in detail in Section 3.5.
3
See Section 3.4.2.4 for further
discussion of when power over the decision-making rights related to
HAFWP PP&E is used throughout the period of use is shared.
4
Quoted material in this section
is from the Board’s May 10, 2017, meeting
handout.
3.5 Period of Use
ASC 842-10-20 (reproduced in Appendix A) defines the term “period of use” as the “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).”
The term is used throughout this chapter as well as in the Codification examples in Section 3.7. In several places in this chapter, we discuss interpretive issues related to the effect of the term “period of use” on the lease identification assessment, including the following:
- Evaluating the period of use when a substitution right exists in the assessment of whether the supplier has the practical ability to substitute alternative assets (see Section 3.3.3.1).
- Determining whether the customer has the right to obtain substantially all of the economic benefits from use of an asset in contracts in which the customer’s rights to economic benefits change (see Section 3.4.1.3).
“Period of use” is an added term in ASC 842-10-20 and clarifies an important
concept: a right to use an asset for nonconsecutive periods can be identified as a
lease. In these cases, the periods of nonuse should effectively be ignored in the
assessment of the right to direct the use and the right to obtain substantially all
of the economic benefits from use. The example below illustrates this point.
Example 3-29
Nonconsecutive
Periods
Two unrelated parties, Party X and Party Y,
enter into separate arrangements with the owner of an
explicitly identified parking garage. The first arrangement
gives X the right to use the parking garage from Monday
through Friday each week for 10 years. The second
arrangement gives Y the right to use the parking garage on
Saturday and Sunday each week for the same 10-year
period.
Assume that, during the periods stated in
the contract, X (for Monday through Friday each week) and Y
(for Saturday and Sunday each week) each (1) can obtain
substantially all of the economic benefits of the parking
garage through their exclusive use and (2) have the right to
direct the use of the parking garage. In addition, assume
that the owner of the parking garage does not have any
substitution rights, so the parking garage is an identified
asset.
Although nonconsecutive, the periods of use
are as follows:
-
Party X — 2,600 days in total, calculated as 5 days per week for 52 weeks each year for 10 years.
-
Party Y — 1,040 days in total, calculated as 2 days per week for 52 weeks each year for 10 years.
Party X would assess whether, throughout the
2,600 days, it has the right to control the use of an
identified asset. On the basis of the facts presented above,
X has a lease of the parking garage for nonconsecutive
periods.
Party Y would perform the same assessment
throughout its 1,040 days and, like X, would conclude that
it has a lease of the same parking garage for nonconsecutive
periods.
Party X and Y, as lessees, would account for
the lease in accordance with Section 8.4.3.4. The
owner of the parking garage would also account for two
leases as a lessor (see Chapter 9 for a
discussion of lessor accounting).
3.6 Reassessment of Whether a Contract Is or Contains a Lease
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.
Lease identification is performed at contract inception in accordance with ASC
842-10-15-2. However, in accordance with ASC 842-10-15-6, the reassessment of
“whether a contract is or contains a lease” is not revisited unless “the terms and
conditions of the contract are changed.” See Section
8.6.1.1 for additional information.
3.7 Codification Examples
The examples below from ASC 842-10-55-42 through 55-130, which have been
reproduced in their entirety, reflect
implementation considerations related to the
guidance in ASC 842-10-15-2 through 15-26 on
identifying a lease. Although some of these
examples may illustrate a specific point with
respect to the guidance in ASC 842-10-15-2 through
15-26, each example walks through, at a minimum,
the entirety of the analysis of either (1) whether
there is an identified asset or (2) whether the
customer has the right to control the use of
PP&E.
3.7.1 Example 1 — Rail Cars
ASC 842-10
Example 1 — Rail Cars
Case A — Contract Contains a Lease
55-42 A contract between Customer and a freight carrier (Supplier) provides Customer with the use of 10 rail cars of a particular type for 5 years. The contract specifies the rail cars; the cars are owned by Supplier. Customer determines when, where, and which goods are to be transported using the cars. When the cars are not in use, they are kept at Customer’s premises. Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that Customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, Supplier is required to substitute a car of the same type. Otherwise, and other than on default by Customer, Supplier cannot retrieve the cars during the five-year period.
55-43 The contract also requires Supplier to provide an engine and a driver when requested by Customer. Supplier keeps the engines at its premises and provides instructions to the driver detailing Customer’s requests to transport goods. Supplier can choose to use any one of a number of engines to fulfill each of Customer’s requests, and one engine could be used to transport not only Customer’s goods, but also the goods of other customers (for example, if other customers require the transport of goods to destinations close to the destination requested by Customer and within a similar timeframe, Supplier can choose to attach up to 100 rail cars to the engine).
55-44 The contract contains leases of rail cars. Customer has the right to use 10 rail cars for 5 years.
55-45 There are 10 identified cars. The cars are explicitly specified in the contract. Once delivered to Customer, the cars can be substituted only when they need to be serviced or repaired. The engine used to transport the rail cars is not an identified asset because it is neither explicitly specified nor implicitly specified in the contract.
55-46 Customer has the right to control the use of the 10 rail cars throughout the 5-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the cars over the five-year period of use. Customer has exclusive use of the cars throughout the period of use, including when they are not being used to transport Customer’s goods.
- Customer has the right to direct the use of the cars. The contractual restrictions on the cargo that can be transported by the cars are protective rights of Supplier and define the scope of Customer’s right to use the cars. Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose the cars are used by being able to decide when and where the rail cars will be used and which goods are transported using the cars. Customer also determines whether and how the cars will be used when not being used to transport its goods (for example, whether and when they will be used for storage). Customer has the right to change these decisions during the five-year period of use.
55-47 Although having an engine and driver (controlled by Supplier) to transport the rail cars is essential to the
efficient use of the cars, Supplier’s decisions in this regard do not give it the right to direct how and for what
purpose the rail cars are used. Consequently, Supplier does not control the use of the cars during the period of
use.
Case B — Contract Does Not Contain a Lease
55-48 The contract between Customer and Supplier requires Supplier to transport a specified quantity of
goods by using a specified type of rail car in accordance with a stated timetable for a period of five years. The
timetable and quantity of goods specified are equivalent to Customer having the use of 10 rail cars for 5 years.
Supplier provides the rail cars, driver, and engine as part of the contract. The contract states the nature and
quantity of the goods to be transported (and the type of rail car to be used to transport the goods). Supplier
has a large pool of similar cars that can be used to fulfill the requirements of the contract. Similarly, Supplier
can choose to use any one of a number of engines to fulfill each of Customer’s requests, and one engine could
be used to transport not only Customer’s goods, but also the goods of other customers. The cars and engines
are stored at Supplier’s premises when not being used to transport goods.
55-49 The contract does not contain a lease of rail cars or of an engine.
55-50 The rail cars and the engines used to transport Customer’s goods are not identified assets. Supplier has
the substantive right to substitute the rail cars and engine because:
- Supplier has the practical ability to substitute each car and the engine throughout the period of use. Alternative cars and engines are readily available to Supplier, and Supplier can substitute each car and the engine without Customer’s approval.
- Supplier would benefit economically from substituting each car and the engine. There would be minimal, if any, cost associated with substituting each car or the engine because the cars and engines are stored at Supplier’s premises and Supplier has a large pool of similar cars and engines. Supplier benefits from substituting each car or the engine in contracts of this nature because substitution allows Supplier to, for example, (1) use cars or an engine to fulfill a task for which the cars or engine are already positioned to perform (for example, a task at a rail yard close to the point of origin) or (2) use cars or an engine that would otherwise be sitting idle because they are not being used by a customer.
55-51 Accordingly, Customer does not direct the use and does not have the right to obtain substantially all of
the economic benefits from use of an identified car or an engine. Supplier directs the use of the rail cars and
engine by selecting which cars and engine are used for each particular delivery and obtains substantially all of
the economic benefits from use of the rail cars and engine. Supplier is only providing freight capacity.
3.7.2 Example 2 — Concession Space
ASC 842-10
Example 2 — Concession Space
55-52 A coffee company (Customer) enters into a contract with an airport operator (Supplier) to use a space in
the airport to sell its goods for a three-year period. The contract states the amount of space and that the space
may be located at any one of several boarding areas within the airport. Supplier has the right to change the
location of the space allocated to Customer at any time during the period of use. There are minimal costs to
Supplier associated with changing the space for the Customer: Customer uses a kiosk (that it owns) that can be
moved easily to sell its goods. There are many areas in the airport that are available and that would meet the
specifications for the space in the contract.
55-53 The contract does not contain a lease.
55-54 Although the amount of space Customer uses is specified in the contract, there is no identified asset. Customer controls its owned kiosk. However, the contract is for space in the airport, and this space can change at the discretion of Supplier. Supplier has the substantive right to substitute the space Customer uses because:
- Supplier has the practical ability to change the space used by Customer throughout the period of use. There are many areas in the airport that meet the specifications for the space in the contract, and Supplier has the right to change the location of the space to other space that meets the specifications at any time without Customer’s approval.
- Supplier would benefit economically from substituting the space. There would be minimal cost associated with changing the space used by Customer because the kiosk can be moved easily. Supplier benefits from substituting the space in the airport because substitution allows Supplier to make the most effective use of the space at boarding areas in the airport to meet changing circumstances.
3.7.3 Example 3 — Fiber-Optic Cable
ASC 842-10
Example 3 — Fiber-Optic Cable
Case A — Contract Contains a Lease
55-55 Customer enters into a 15-year contract with a utilities company (Supplier) for the right to use 3 specified, physically distinct dark fibers within a larger cable connecting Hong Kong to Tokyo. Customer makes the decisions about the use of the fibers by connecting each end of the fibers to its electronic equipment (for example, Customer “lights” the fibers and decides what data and how much data those fibers will transport). If the fibers are damaged, Supplier is responsible for the repairs and maintenance. Supplier owns extra fibers but can substitute those for Customer’s fibers only for reasons of repairs, maintenance, or malfunction (and is obliged to substitute the fibers in these cases).
55-56 The contract contains a lease of dark fibers. Customer has the right to use the 3 dark fibers for 15 years.
55-57 There are three identified fibers. The fibers are explicitly specified in the contract and are physically distinct from other fibers within the cable. Supplier cannot substitute the fibers other than for reasons of repairs, maintenance, or malfunction.
55-58 Customer has the right to control the use of the fibers throughout the 15-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the fibers over the 15-year period of use. Customer has exclusive use of the fibers throughout the period of use.
- Customer has the right to direct the use of the fibers. Customer makes the relevant decisions about how and for what purpose the fibers are used by deciding when and whether to light the fibers and when and how much output the fibers will produce (that is, what data and how much data those fibers will transport). Customer has the right to change these decisions during the 15-year period of use.
55-59 Although Supplier’s decisions about repairing and maintaining the fibers are essential to their efficient use, those decisions do not give Supplier the right to direct how and for what purpose the fibers are used. Consequently, Supplier does not control the use of the fibers during the period of use.
Case B — Contract Does Not Contain a Lease
55-60 Customer enters into a 15-year contract with Supplier for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. The specified amount is equivalent to Customer having the use of the full capacity of 3 strands within the cable (the cable contains 15 fibers with similar capacities). Supplier makes decisions about the transmission of data (that is, Supplier lights the fibers and makes decisions about which fibers are used to transmit Customer’s traffic and about the electronic equipment that Supplier owns and connects to the fibers).
55-61 The contract does not contain a lease.
55-62 Supplier makes all decisions about the transmission of its customers’ data, which requires the use of only
a portion of the capacity of the cable for each customer. The capacity portion that will be provided to Customer
is not physically distinct from the remaining capacity of the cable and does not represent substantially all of the
capacity of the cable. Consequently, Customer does not have the right to use an identified asset.
3.7.4 Example 4 — Retail Unit
ASC 842-10
Example 4 — Retail Unit
55-63 Customer enters into a contract with property owner (Supplier) to use Retail Unit A for a five-year period.
Retail Unit A is part of a larger retail space with many retail units.
55-64 Customer is granted the right to use Retail Unit A. Supplier can require Customer to relocate to another
retail unit. In that case, Supplier is required to provide Customer with a retail unit of similar quality and
specifications to Retail Unit A and to pay for Customer’s relocation costs. Supplier would benefit economically
from relocating Customer only if a major new tenant were to decide to occupy a large amount of retail space at
a rate sufficiently favorable to cover the costs of relocating Customer and other tenants in the retail space that
the new tenant will occupy. However, although it is possible that those circumstances will arise, at inception of
the contract, it is not likely that those circumstances will arise. For example, whether a major new tenant will
decide to lease a large amount of retail space at a rate that would be sufficiently favorable to cover the costs of
relocating Customer is highly susceptible to factors outside Supplier’s influence.
55-65 The contract requires Customer to use Retail Unit A to operate its well-known store brand to sell its
goods during the hours that the larger retail space is open. Customer makes all of the decisions about the use
of the retail unit during the period of use. For example, Customer decides on the mix of goods sold from the
unit, the pricing of the goods sold, and the quantities of inventory held. Customer also controls physical access
to the unit throughout the five-year period of use.
55-66 The contract requires Customer to make fixed payments to Supplier as well as variable payments that
are a percentage of sales from Retail Unit A.
55-67 Supplier provides cleaning and security services as well as advertising services as part of the contract.
55-68 The contract contains a lease of retail space. Customer has the right to use Retail Unit A for five years.
55-69 Retail Unit A is an identified asset. It is explicitly specified in the contract. Supplier has the practical ability
to substitute the retail unit, but could benefit economically from substitution only in specific circumstances.
Supplier’s substitution right is not substantive because, at inception of the contract, those circumstances are
not considered likely to arise.
55-70 Customer has the right to control the use of Retail Unit A throughout the five-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of Retail Unit A over the five-year period of use. Customer has exclusive use of Retail Unit A throughout the period of use. Although a portion of the cash flows derived from sales from Retail Unit A will flow from Customer to Supplier, this represents consideration that Customer pays Supplier for the right to use the retail unit. It does not prevent Customer from having the right to obtain substantially all of the economic benefits from use of Retail Unit A.
- Customer has the right to direct the use of Retail Unit A. The contractual restrictions on the goods that can be sold from Retail Unit A and when Retail Unit A is open define the scope of Customer’s right to use Retail Unit A. Within the scope of its right of use defined in the contract, Customer makes the relevant decisions about how and for what purpose Retail Unit A is used by being able to decide, for example, the mix of products that will be sold in the retail unit and the sale price for those products. Customer has the right to change these decisions during the five-year period of use.
55-71 Although cleaning, security, and advertising services are essential to the efficient use of Retail Unit A, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose Retail Unit A is used. Consequently, Supplier does not control the use of Retail Unit A during the period of use, and Supplier’s decisions do not affect Customer’s control of the use of Retail Unit A.
3.7.5 Example 5 — Truck Rental
ASC 842-10
Example 5 — Truck Rental
55-72 Customer enters into a contract with Supplier for the use of a truck for one week to transport cargo from New York to San Francisco. Supplier does not have substitution rights. Only cargo specified in the contract is permitted to be transported on this truck for the period of the contract. The contract specifies a maximum distance that the truck can be driven. Customer is able to choose the details of the journey (speed, route, rest stops, and so forth) within the parameters of the contract. Customer does not have the right to continue using the truck after the specified trip is complete.
55-73 The cargo to be transported and the timing and location of pickup in New York and delivery in San Francisco are specified in the contract.
55-74 Customer is responsible for driving the truck from New York to San Francisco.
55-75 The contract contains a lease of a truck. Customer has the right to use the truck for the duration of the specified trip.
55-76 There is an identified asset. The truck is explicitly specified in the contract, and Supplier does not have the right to substitute the truck.
55-77 Customer has the right to control the use of the truck throughout the period of use because:
- Customer has the right to obtain substantially all of the economic benefits from the use of the truck over the period of use. Customer has exclusive use of the truck throughout the period of use.
- Customer has the right to direct the use of the truck. How and for what purpose the truck will be used (that is, the transport of specified cargo from New York to San Francisco within a specified time frame) are predetermined in the contract. Customer directs the use of the truck because it has the right to operate the truck (for example, speed, route, and rest stops) throughout the period of use. Customer makes all of the decisions about the use of the truck that can be made during the period of use through its control of the operations of the truck.
55-78 Because the duration of the contract is one week, this lease meets the definition of a short-term lease.
3.7.6 Example 6 — Ship
ASC 842-10
Example 6 — Ship
Case A — Contract Does Not Contain a Lease
55-79 Customer enters into a contract with a ship owner (Supplier) for the transport of cargo from Rotterdam
to Sydney on a specified ship. The ship is explicitly specified in the contract, and Supplier does not have
substitution rights. The cargo will occupy substantially all of the capacity of the ship. The contract specifies the
cargo to be transported on the ship and the dates of pickup and delivery.
55-80 Supplier operates and maintains the ship and is responsible for the safe passage of the cargo onboard
the ship. Customer is prohibited from hiring another operator for the ship or operating the ship itself during
the term of the contract.
55-81 The contract does not contain a lease.
55-82 There is an identified asset. The ship is explicitly specified in the contract, and Supplier does not have the
right to substitute that specified ship.
55-83 Customer has the right to obtain substantially all of the economic benefits from use of the ship over the
period of use. Its cargo will occupy substantially all of the capacity of the ship, thereby preventing other parties
from obtaining economic benefits from use of the ship.
55-84 However, Customer does not have the right to control the use of the ship because it does not have the
right to direct its use. Customer does not have the right to direct how and for what purpose the ship is used.
How and for what purpose the ship will be used (that is, the transport of specified cargo from Rotterdam to
Sydney within a specified time frame) are predetermined in the contract. Customer has no right to change how
and for what purpose the ship is used during the period of use. Customer has no other decision-making rights
about the use of the ship during the period of use (for example, it does not have the right to operate the ship)
and did not design the ship. Customer has the same rights regarding the use of the ship as if it were one of
multiple customers transporting cargo on the ship.
Case B — Contract Contains a Lease
55-85 Customer enters into a contract with Supplier for the use of a specified ship for a five-year period. The
ship is explicitly specified in the contract, and Supplier does not have substitution rights.
55-86 Customer decides what cargo will be transported and whether, when, and to which ports the ship will
sail, throughout the five-year period of use, subject to restrictions specified in the contract. Those restrictions
prevent Customer from sailing the ship into waters at a high risk of piracy or carrying hazardous materials as
cargo.
55-87 Supplier operates and maintains the ship and is responsible for the safe passage of the cargo onboard
the ship. Customer is prohibited from hiring another operator for the ship or operating the ship itself during
the term of the contract.
55-88 The contract contains a lease. Customer has the right to use the ship for five years.
55-89 There is an identified asset. The ship is explicitly specified in the contract, and Supplier does not have the right to substitute that specified ship.
55-90 Customer has the right to control the use of the ship throughout the five-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the ship over the five-year period of use. Customer has exclusive use of the ship throughout the period of use.
- Customer has the right to direct the use of the ship. The contractual restrictions about where the ship can sail and the cargo to be transported by the ship define the scope of Customer’s right to use the ship. They are protective rights that protect Supplier’s investment in the ship and Supplier’s personnel. Within the scope of its right of use, Customer makes the relevant decisions about how and for what purpose the ship is used throughout the five-year period of use because it decides whether, where, and when the ship sails, as well as the cargo it will transport. Customer has the right to change these decisions throughout the five-year period of use.
55-91 Although the operation and maintenance of the ship are essential to its efficient use, Supplier’s decisions in this regard do not give it the right to direct how and for what purpose the ship is used. Instead, Supplier’s decisions are dependent on Customer’s decisions about how and for what purpose the ship is used.
3.7.7 Example 7 — Aircraft
ASC 842-10
Example 7 — Aircraft
55-92 Customer enters into a contract with an aircraft owner (Supplier) for the use of an explicitly specified aircraft for a two-year period. The contract details the interior and exterior specifications for the aircraft.
55-93 There are contractual and legal restrictions in the contract on where the aircraft can fly. Subject to those restrictions, Customer determines where and when the aircraft will fly and which passengers and cargo will be transported on the aircraft.
55-94 Supplier is responsible for operating the aircraft, using its own crew. Customer is prohibited from hiring another operator for the aircraft or operating the aircraft itself during the term of the contract.
55-95 Supplier is permitted to substitute the aircraft at any time during the two-year period and must substitute the aircraft if it is not working. Any substitute aircraft must meet the interior and exterior specifications in the contract. There are significant costs involved in outfitting an aircraft in Supplier’s fleet to meet Customer’s specifications.
55-96 The contract contains a lease. Customer has the right to use the aircraft for two years.
55-97 There is an identified asset. The aircraft is explicitly specified in the contract, and although Supplier can substitute the aircraft, its substitution right is not substantive. Supplier’s substitution right is not substantive because of the significant costs involved in outfitting another aircraft to meet the specifications required by the contract such that Supplier is not expected to benefit economically from substituting the aircraft.
55-98 Customer has the right to control the use of the aircraft throughout the two-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the aircraft over the two-year period of use. Customer has exclusive use of the aircraft throughout the period of use.
- Customer has the right to direct the use of the aircraft. The restrictions on where the aircraft can fly define the scope of Customer’s right to use the aircraft. Within the scope of its right of use, Customer makes the relevant decisions about how and for what purpose the aircraft is used throughout the two-year period of use because it decides whether, where, and when the aircraft travels as well as the passengers and cargo it will transport. Customer has the right to change these decisions throughout the two-year period of use.
55-99 Although the operation of the aircraft is essential to its efficient use, Supplier’s decisions in this regard
do not give it the right to direct how and for what purpose the aircraft is used. Consequently, Supplier does
not control the use of the aircraft during the period of use, and Supplier’s decisions do not affect Customer’s
control of the use of the aircraft.
3.7.8 Example 8 — Contract for Shirts
ASC 842-10
Example 8 — Contract for Shirts
55-100 Customer enters into a contract with a manufacturer (Supplier) to purchase a particular type, quality,
and quantity of shirts for a three-year period. The type, quality, and quantity of shirts are specified in the
contract.
55-101 Supplier has only one factory that can meet the needs of Customer. Supplier is unable to supply the
shirts from another factory or source the shirts from a third-party supplier. The capacity of the factory exceeds
the output for which Customer has contracted (that is, Customer has not contracted for substantially all of the
capacity of the factory).
55-102 Supplier makes all decisions about the operations of the factory, including the production level at which
to run the factory and which customer contracts to fulfill with the output of the factory that is not used to fulfill
Customer’s contract.
55-103 The contract does not contain a lease.
55-104 The factory is an identified asset. The factory is implicitly specified because Supplier can fulfill the
contract only through the use of this asset.
55-105 However, Customer does not control the use of the factory because it does not have the right to obtain
substantially all of the economic benefits from use of the factory. This is because Supplier could decide to use
the factory to fulfill other customer contracts during the period of use.
55-106 Customer also does not control the use of the factory because it does not have the right to direct the
use of the factory. Customer does not have the right to direct how and for what purpose the factory is used
during the three-year period of use. Customer’s rights are limited to specifying output from the factory in the
contract with Supplier. Customer has the same rights regarding the use of the factory as other customers
purchasing shirts from the factory. Supplier has the right to direct the use of the factory because Supplier can
decide how and for what purpose the factory is used (that is, Supplier has the right to decide the production
level at which to run the factory and which customer contracts to fulfill with the output produced).
55-107 Either the fact that Customer does not have the right to obtain substantially all of the economic benefits
from use of the factory or the fact that Customer does not have the right to direct the use of the factory would
be sufficient in isolation to conclude that Customer does not control the use of the factory.
3.7.9 Example 9 — Contract for Energy/Power
ASC 842-10
Example 9 — Contract for Energy/Power
Case A — Contract Contains a Lease
55-108 A utility company (Customer) enters into a contract with a power company (Supplier) to purchase all of the electricity produced by a new solar farm for 20 years. The solar farm is explicitly specified in the contract, and Supplier has no substitution rights. The solar farm is owned by Supplier, and the energy cannot be provided to Customer from another asset. Customer designed the solar farm before it was constructed — Customer hired experts in solar energy to assist in determining the location of the farm and the engineering of the equipment to be used. Supplier is responsible for building the solar farm to Customer’s specifications and then operating and maintaining it. There are no decisions to be made about whether, when, or how much electricity will be produced because the design of the asset has predetermined these decisions. Supplier will receive tax credits relating to the construction and ownership of the solar farm, while Customer receives renewable energy credits that accrue from use of the solar farm.
55-109 The contract contains a lease. Customer has the right to use the solar farm for 20 years.
55-110 There is an identified asset because the solar farm is explicitly specified in the contract, and Supplier does not have the right to substitute the specified solar farm.
55-111 Customer has the right to control the use of the solar farm throughout the 20-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the solar farm over the 20-year period of use. Customer has exclusive use of the solar farm; it takes all of the electricity produced by the farm over the 20-year period of use as well as the renewable energy credits that are a by-product from use of the solar farm. Although Supplier will be receiving economic benefits from the solar farm in the form of tax credits, those economic benefits relate to the ownership of the solar farm rather than the use of the solar farm and, thus, are not considered in this assessment.
- Customer has the right to direct the use of the solar farm. Neither Customer nor Supplier decides how and for what purpose the solar farm is used during the period of use because those decisions are predetermined by the design of the asset (that is, the design of the solar farm has, in effect, programmed into the asset any relevant decision-making rights about how and for what purpose the solar farm is used throughout the period of use). Customer does not operate the solar farm; Supplier makes the decisions about the operation of the solar farm. However, Customer’s design of the solar farm has given it the right to direct the use of the farm (as described in paragraph 842-10-15-20(b)(2)). Because the design of the solar farm has predetermined how and for what purpose the asset will be used throughout the period of use, Customer’s control over that design is substantively no different from Customer controlling those decisions.
Case B — Contract Does Not Contain a Lease
55-112 Customer enters into a contract with Supplier to purchase all of the power produced by an explicitly specified power plant for three years. The power plant is owned and operated by Supplier. Supplier is unable to provide power to Customer from another plant. The contract sets out the quantity and timing of power that the power plant will produce throughout the period of use, which cannot be changed in the absence of extraordinary circumstances (for example, emergency situations). Supplier operates and maintains the plant on a daily basis in accordance with industry-approved operating practices. Supplier designed the power plant when it was constructed some years before entering into the contract with Customer; Customer had no involvement in that design.
55-113 The contract does not contain a lease.
55-114 There is an identified asset because the power plant is explicitly specified in the contract, and Supplier does not have the right to substitute the specified plant.
55-115 Customer has the right to obtain substantially all of the economic benefits from use of the identified
power plant over the three-year period of use. Customer will take all of the power produced by the power plant
over the three-year term of the contract.
55-116 However, Customer does not have the right to control the use of the power plant because it does not
have the right to direct its use. Customer does not have the right to direct how and for what purpose the plant
is used. How and for what purpose the plant is used (that is, whether, when, and how much power the plant will
produce) are predetermined in the contract. Customer has no right to change how and for what purpose the
plant is used during the period of use, nor does it have any other decision-making rights about the use of the
power plant during the period of use (for example, it does not operate the power plant) and did not design the
plant. Supplier is the only party that can make decisions about the plant during the period of use by making the
decisions about how the plant is operated and maintained. Customer has the same rights regarding the use of
the plant as if it were one of many customers obtaining power from the plant.
Case C — Contract Contains a Lease
55-117 Customer enters into a contract with Supplier to purchase all of the power produced by an explicitly
specified power plant for 10 years. The contract states that Customer has rights to all of the power produced
by the plant (that is, Supplier cannot use the plant to fulfill other contracts).
55-118 Customer issues instructions to Supplier about the quantity and timing of the delivery of power. If the
plant is not producing power for Customer, it does not operate.
55-119 Supplier operates and maintains the plant on a daily basis in accordance with industry-approved
operating practices.
55-120 The contract contains a lease. Customer has the right to use the power plant for 10 years.
55-121 There is an identified asset. The power plant is explicitly specified in the contract, and Supplier does not
have the right to substitute the specified plant.
55-122 Customer has the right to control the use of the power plant throughout the 10-year period of use
because:
- Customer has the right to obtain substantially all of the economic benefits from use of the power plant over the 10-year period of use. Customer has exclusive use of the power plant; it has rights to all of the power produced by the power plant throughout the 10-year period of use.
- Customer has the right to direct the use of the power plant. Customer makes the relevant decisions about how and for what purpose the power plant is used because it has the right to determine whether, when, and how much power the plant will produce (that is, the timing and quantity, if any, of power produced) throughout the period of use. Because Supplier is prevented from using the power plant for another purpose, Customer’s decision making about the timing and quantity of power produced, in effect, determines when and whether the plant produces output.
55-123 Although the operation and maintenance of the power plant are essential to its efficient use, Supplier’s
decisions in this regard do not give it the right to direct how and for what purpose the power plant is used.
Consequently, Supplier does not control the use of the power plant during the period of use. Instead, Supplier’s
decisions are dependent on Customer’s decisions about how and for what purpose the power plant is used.
3.7.10 Example 10 — Contract for Network Services
ASC 842-10
Example 10 — Contract for Network Services
Case A — Contract Does Not Contain a Lease
55-124 Customer enters into a contract with a telecommunications company (Supplier) for network services for two years. The contract requires Supplier to supply network services that meet a specified quality level. To provide the services, Supplier installs and configures servers at Customer’s premises; Supplier determines the speed and quality of data transportation in the network using the servers. Supplier can reconfigure or replace the servers when needed to continuously provide the quality of network services defined in the contract. Customer does not operate the servers or make any significant decisions about their use.
55-125 The contract does not contain a lease. Instead, the contract is a service contract in which Supplier uses the equipment to meet the level of network services determined by Customer.
55-126 Customer does not control the use of the servers because Customer’s only decision-making rights relate to deciding on the level of network services (the output of the servers) before the period of use — the level of network services cannot be changed during the period of use without modifying the contract. For example, even though Customer produces the data to be transported, that activity does not directly affect the configuration of the network services and, thus, it does not affect how and for what purpose the servers are used. Supplier is the only party that can make decisions about the use of the servers during the period of use. Supplier has the right to decide how data are transported using the servers, whether to reconfigure the servers, and whether to use the servers for another purpose. Accordingly, Supplier controls the use of the servers in providing network services to Customer. There is no need to assess whether the servers are identified assets because Customer does not have the right to control the use of the servers.
Case B — Contract Contains a Lease
55-127 Customer enters into a contract with an information technology company (Supplier) for the use of an identified server for three years. Supplier delivers and installs the server at Customer’s premises in accordance with Customer’s instructions and provides repair and maintenance services for the server, as needed, throughout the period of use. Supplier substitutes the server only in the case of malfunction. Customer decides which data to store on the server and how to integrate the server within its operations. Customer can change its decisions in this regard throughout the period of use.
55-128 The contract contains a lease. Customer has the right to use the server for three years.
55-129 There is an identified asset. The server is explicitly specified in the contract. Supplier can substitute the server only if it is malfunctioning.
55-130 Customer has the right to control the use of the server throughout the three-year period of use because:
- Customer has the right to obtain substantially all of the economic benefits from use of the server over the three-year period of use. Customer has exclusive use of the server throughout the period of use.
- Customer has the right to direct the use of the server. Customer makes the relevant decisions about how and for what purpose the server is used because it has the right to decide which aspect of its operations the server is used to support and which data it stores on the server. Customer is the only party that can make decisions about the use of the server during the period of use.
3.8 Decision Tree Related to Identifying a Lease
The decision tree below, which combines the decision trees from Sections
3.3, 3.4.1, and
3.4.2, gives an overview of the
analysis related to identifying whether a contract
is or contains a lease.
Chapter 4 — Components of a Contract
Chapter 4 — Components of a Contract
4.1 Introduction
The phrase “whether a contract is or contains a lease” (emphasis added)
is consistently used throughout ASC 842-10-15 and
Chapter 3 of
this Roadmap. The reason behind this wording
choice is more fully explained in Section
3.2.2 — a lease may be embedded in a
larger service arrangement. When that is the case,
contracts contain both lease and nonlease
components. Generally, the nonlease components are
services that the supplier is also performing for
the customer. For example, in a single contract,
the supplier could be leasing equipment to a
customer while also agreeing to provide ongoing
maintenance services for the equipment throughout
the period of use.
Further, in paragraph BC143 of ASU
2016-02, the FASB acknowledges that contracts may contain
multiple lease components. Paragraph BC143 of ASU 2016-02 cites a contract
for the right to use a marine port as one example of a contract that may contain
several lease components (e.g., leases of land, buildings, and equipment).
Changing Lanes
More Guidance on How to Separate, and Allocate
Consideration to, Components of a Contract
ASC 840-10-15-16 through 15-19 (formerly EITF Issue 01-8) required separation
of, and allocation of consideration to, lease and nonlease components.
However, ASC 840 provides little guidance on how to perform such separation
and allocation. Accordingly, the FASB recognized the need for more
comprehensive guidance on accounting for contracts that contain multiple
components. Specifically, paragraph BC144 of ASU 2016-02 states:
Previous GAAP provided limited guidance on how to
separate lease components and nonlease components of a contract,
even though it required that separation. Because Topic 842 results
in lease components of a contract being accounted for differently
from nonlease components (for all leases except short-term leases
for which a lessee elects the recognition and measurement
exemption), the Board decided to provide expanded guidance on how
entities should account for contracts that contain both lease
components and nonlease components.
Paragraph BC144 of ASU 2016-02 explains that, because the customer’s accounting for a lease
results in balance sheet recognition (except for short-term leases — see Chapter 8 for detailed
discussion of lessee accounting) while its accounting for a service generally does not, ASC 842
places additional emphasis on the separation of lease and nonlease components. That is, the
Board is increasing the importance of appropriately identifying the components of — and
consideration in — a contract that is subject to balance sheet recognition. In addition, since
operating leases have different income statement effects than finance leases, separation of
multiple lease components remains relevant.
The guidance in ASC 842-10-15 effectively establishes the following process for identifying the contract
component(s) (i.e., the units of account) and consideration subject to lease accounting:
- Considering whether the contract involves the use of PP&E, as covered in ASC 842-10-15-1 (see Chapter 2).
- Assessing whether that contract is, or contains, a lease, as addressed in ASC 842-10-15-2 through 15-27 (see Chapter 3).
- Determining which lease component(s) in that contract is (are) subject to the recognition and measurement guidance in ASC 842, as covered in ASC 842-10-15-28 through 15-42 (discussed in the remainder of this chapter).
The third part of the process is expanded in the graphic below, which outlines steps related to considering how to separate, and allocate consideration to, components in a contract under ASC 842. Each of these steps is discussed in greater detail in the remainder of this chapter.
4.2 Identify the Separate Lease Components
ASC 842-10
15-28 After determining that a contract contains a lease in accordance with paragraphs 842-10-15-2 through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met:
- The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
- The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.
15-29 The guidance in paragraph 842-10-15-28 notwithstanding, to classify and account for a lease of land and other assets, an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land lease component would be insignificant).
Once an entity determines that a contract is, or contains, a lease (i.e., part or all of
the contract is a lease — see Chapter 3), the entity (i.e., both the customer and the
supplier) must assess whether the contract contains multiple lease components (i.e.,
when a contract conveys the rights to use multiple underlying assets). ASC 842-10-15-28(a) and (b) prescribe criteria (reproduced above) for identifying whether one
lease component is considered separate from other lease components in the
contract.
However, land is considered an exception to the guidance in ASC 842-10-15-28. In accordance with ASC
842-10-15-29, a right to use land must be separated from the rights to use other underlying assets (e.g.,
from the right to use a building that sits on top of the land), unless the effect of separating the land is
insignificant to the resulting lease accounting.
Connecting the Dots
Importance of the Unit of
Account
Paragraph BC145 of ASU 2016-02 stresses that it is important for an entity to identify the
appropriate unit of account when applying the lessee or lessor accounting models in ASC
842 (see Chapters 8 and 9, respectively), since the unit of account can affect the allocation of
consideration to the components in the contract. Specifically, paragraph BC145 of ASU 2016-02
states, in part:
By way of example, regarding allocation, the Board noted that the standalone price (observable
or estimated) for a bundled offering (for example, the lease of a data center) may be substantially
different from the sum of the standalone prices for separate leases of the items within a bundled
offering (for example, the lease of each asset in the data center). Given the substantially different
accounting for lease and nonlease components in Topic 842, the allocation of contract consideration
carries additional importance as compared with previous GAAP. Consequently, the Board concluded
that including separate lease components guidance in Topic 842 will result in more accurate
accounting that also is more consistent among entities.
ASC 840 did not include guidance on how to identify the unit of account to which
lease accounting should be applied. For example, ASC 840 did not
specify whether to classify rights to use several underlying
assets in a contract individually or as a single right of use.
Rather, in practice, interpretive guidance arose that was
effective but not necessarily based on GAAP. Accordingly, in the
Board’s view, ASC 842 reflects an improvement over ASC 840 in
this area.
The decision tree below illustrates how an entity might think about the guidance
in ASC 842-10-15-28 and 15-29 for each contract containing a lease.
4.2.1 Separating Lease Components
Effectively, the guidance in ASC 842-10-15-28 is intended to help entities evaluate whether the parties
are contracting to provide the customer with multiple, individual outputs (i.e., multiple rights of use) or a
single output (i.e., a single right of use) that comprises multiple inputs. To accomplish this objective, the
FASB uses two criteria:
- The customer can economically benefit from the right of use (1) on its own or (2) together with other, readily available resources. “Readily available resources” could be those that the customer can obtain separately (whether from the supplier in the contract or others) or those that have already been transferred to the customer in the current contract or other, prior contracts. For example, the fact that a right of use is contracted on its own is an indicator that it meets this first criterion.This criterion is intended to be effectively the same as the “capable of being distinct” criterion in ASC 606-10-25-19(a) and 25-20 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this first criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.1 of Deloitte’s Roadmap Revenue Recognition.
- The right of use is “neither highly dependent on nor highly interrelated with” other rights of use in the same contract (i.e., the right of use is separately identifiable). The right of use may not be separately identifiable if (1) the supplier integrates it with other rights of use in the contract in such a way that it is only one input in an effort to deliver a combined right of use (i.e., a single output) to the customer or (2) it significantly modifies or affects — or is significantly modified or affected by — the other rights of use in the contract.This criterion is intended to be effectively the same as the “distinct within the context of the contract” criterion in ASC 606-10-25-19(b) and ASC 606-10-25-21 with respect to determining whether a performance obligation is distinct. Accordingly, when evaluating this second criterion for a contract that is, or contains, a lease, an entity may find it helpful to consider the guidance in Section 5.3.2.2 of Deloitte’s Roadmap Revenue Recognition.
Connecting the Dots
Similarities Between
Identifying Separate Lease Components Under ASC
842 and Identifying Separate Performance
Obligations Under ASC 606
The concept of separating lease components under ASC 842 is similar to the notion of
identifying performance obligations under ASC 606. Specifically, paragraph BC146 of ASU
2016-02 states:
The separate lease components guidance in paragraph 842-10-15-28 is similar to the guidance on
identifying performance obligations in Topic 606, and, therefore, the Board expects that it will be
applied in a similar manner. . . . Accordingly, rather than developing entirely separate requirements
addressing how to identify separate lease components, the Board decided that it is logical to provide
requirements similar to those in Topic 606 on the identification of performance obligations to
determine whether a lessee is contracting for the right to use multiple underlying assets (for example,
five vehicles) or for the right to use a single solution that is comprised of multiple assets (for example,
many data centers or manufacturing facilities).
In other words, the Board’s intention was
not to create a different set of requirements for
separating lease components but to link the concepts from
the two standards so that they may be applied
consistently. Accordingly, we think that the guidance in
ASC 606 — as well as Deloitte’s related interpretive
guidance in Section 5.3.2 of
Deloitte’s Roadmap Revenue
Recognition — will be helpful to
entities applying the guidance in ASC 842-10-15-28.
Further, ASC 606’s guidance on identifying performance
obligations is more robust and descriptive than ASC 842’s
guidance on separating lease components. ASC 606 also
contains more examples that address the “distinct”
criteria.
The link between the revenue and leasing
standards will be a consistent theme throughout the
remainder of this chapter, since the two standards are
also similar regarding the allocation and reallocation of
the consideration to the components in the contract.
The example below illustrates the guidance in ASC 842-10-15-28 on separating
lease components. (See Section 4.2.3 for additional
examples, including an illustration of a situation in which the right
to use land is not separated from other rights of use in the
contract.)
Example 4-1
Garden Co., the lessee, leases a dump truck, riding lawn mower, and skid loader from Tools Inc., the lessor. Tools Inc. sells and leases each piece of machinery separately to other customers and lessees, respectively, during its normal course of business.
Although it leased all three pieces of machinery together for use in its landscaping business, Garden Co. determined that the rights to use the machinery represent three separate lease components. This conclusion is based on the following:
- Garden Co. can economically benefit from the use of each piece of machinery on its own or together with other, readily available resources. For example, Garden Co. can lease separately — either from Tools Inc. or from another supplier — an excavator that may be used in conjunction with the dump truck to perform the landscaping services that it provides to its customers.
- Each piece of machinery is neither highly dependent on, nor highly interrelated with, the others. Tools Inc. is not integrating the rights to use the machinery into a single, combined right of use. Further, no piece of machinery is significantly modified or affected by the others — they do not come together, for example, to form a larger, more efficient piece of machinery.
Accordingly, Garden Co. and Tools Inc. would account for each piece of machinery as a separate lease component in accordance with the lessee and lessor accounting models, respectively.
4.2.2 Land and Other Assets
ASC 842-10-15-29 requires that land be considered a
separate lease component in a contract involving land and other
assets, unless the effect of separately accounting for the land
portion of the contract is insignificant.
Connecting the Dots
The Nature of
Land
Paragraph BC147 of ASU 2016-02 states, in
part:
Topic 842 also requires an
entity to account for a right to use land as a
separate lease component, even if the separating
lease components criteria are not met, unless the
accounting effect of doing so would be
insignificant. The Board decided that land, by
virtue of its indefinite economic life and
nonpredictable nature, is different from other
assets, such that it should be assessed separately
from other assets regardless of whether the
separating lease components criteria are met.
Paragraph BC147 of ASU 2016-02 should be
interpreted as meaning that if an entire building were
leased, the lessee would implicitly also be leasing the
land on which the building sits. Because the underlying
land asset is subject to unique risks compared with those
of the building, the right to use the land should be
accounted for as a separate lease component (unless the
accounting effect of doing so would be insignificant).
However, the same may not be true if an
entity is leasing only part of a building (e.g., a
physically distinct portion of a larger building, such as
a single floor in an office building). Entities should
consider whether facts and circumstances indicate
otherwise, but in these situations, we do not expect that
a lessee will have an implicit lease of the underlying
land. (See Section 4.2.2.2 for
further discussion.)
ASC 842 does not explicitly define the term
“insignificant,” as used in ASC 842-10-15-29. Therefore, management
will need to use judgment in applying this term. In determining
significance, an entity should separately assess (1) whether
separating the land component affects the classification of any lease
component, (2) the value of the land component in the context of the
overall contract, and (3) whether the right to use the land is
coterminous with the rights to use the other assets.
For example, if a lease includes both land and a
building component and an entity concludes that both components would
be classified as an operating lease over the same lease term if they
are accounted for separately, it may be reasonable for the entity to
conclude that the difference between accounting for the two lease
components together and accounting for the land and building
separately would be insignificant.
ASC 842-10-15-29 gives two examples illustrating when
the accounting effect of separating the right to use land from other
rights of use would be insignificant, both of which are mentioned
above. The first of those examples (i.e., the effect on lease
classification) is discussed in the preceding paragraph. The Changing
Lanes discussion and Section 4.2.2.1 below address the second (i.e., the
value of the right to use the land). A third example (i.e., the terms
of the different rights of use), also mentioned above, is discussed in
Example 13 in ASC 842-10-55-146 through 55-149 (reproduced in
Section
4.2.3).
Changing Lanes
Bifurcation of the
Land Component May Be More Common
ASC 842’s approach to accounting for leases
of land and other assets is consistent with the historical
approach in IAS 17 under IFRS Accounting Standards but
represents a change from the U.S. GAAP guidance in ASC
840. The guidance in ASC 840 required a lessee to do the
following for land and other assets: (1) when the lease
meets either the transfer-of-ownership or
bargain-purchase-price classification criteria, account
for the land and other assets separately (see ASC
840-10-25-38(a)), or (2) when the fair value of the land
is 25 percent or more of the total fair value of the
leased property at lease inception, classify the land and
other assets separately (as discussed in Section
4.2.2.1). The new approach may result in
more bifurcation of real estate leases into separate lease
components.
4.2.2.1 Use of a 25 Percent Threshold to Separate Land
To determine when the right to use land must be
accounted for separately under ASC 840-10-25-38(b), an entity
uses a 25 percent threshold to compare the fair value of the
land with the fair value of the entire leased property. That is,
under ASC 840, if the fair value of the underlying land was less
than 25 percent of the fair value of the entire leased property,
the land is combined with the other rights of use.
However, it is not appropriate to use a 25 percent
threshold to determine whether land should be separated in
accordance with ASC 842-10-15-29 because the concept behind the
guidance in ASC 842-10-15-29 (discussed in the Connecting the
Dots above) differs from that in ASC 840.
Under ASC 842, the value of the land component in
a contract containing the right to use land and other assets may
be considered in the determination of whether the accounting
effect of separating the land component is insignificant.
However, the sole reliance on any bright-line threshold based on
the land value, compared with the total property value, would
not be appropriate in this assessment.
For example, although the land component in a
contract containing the right to use land and a building may
represent a fair value that is lower than 25 percent of the
entire leased property, the lease classification for the right
to use the land could differ from that for the right to use the
building. In such situations, an entity should consider all
facts and circumstances to determine whether the accounting
effect of not separating the components is insignificant.
Entities should also consider arrangements in
which lessees are leasing a significant capacity portion of a
building (or another asset atop land). Such arrangements may
inherently convey a right to use the underlying land and would
need to be assessed in accordance with ASC 842-10-15-29.
4.2.2.2 Inherent Land Leases When a Portion of a Building Is Leased
Regardless of the portion (or capacity) of the
building it is leasing, a lessee in a multitenant building
inherently has some rights to use the underlying land. However,
the land may not represent an identified asset to the lessee in
such a way that the lessee would have the right to control the
use of an identified asset (i.e., in such a way that the lessee
would have a lease of the land, as defined in ASC
842-10-15-3 and 15-4 and further discussed in Chapter
3 of this Roadmap).
A lessee in a multitenant building will have the
right to control the use of a physically distinct portion of the
building, but its rights related to the underlying land are not
over a physically distinct portion of the land unless the lessee
is, in effect, leasing the entire building. In such
cases, the lessee is also effectively leasing the entire,
underlying plot of land. Therefore, we think that when the
lessee has the right to control the use of substantially all of
the capacity of the building, it also has the right to control
the use of substantially all of the capacity of the land. (See
Section
3.3.2 for further discussion of when a capacity
portion of a larger asset is an identified asset.)
In such arrangements, lessees and lessors should
consider whether the lessee’s rights to use the land represent a
separate lease component in accordance with ASC
842-10-15-29.
4.2.2.3 Allocation of the Fair Value of Land When a Portion of a Multitenant Building Is Leased
As discussed in Section 4.2.2.2, when a
lessee leases a portion of a multitenant building, the lessee
generally only has the ability to control the use of the
underlying land if it has the ability to control the use of
substantially all of the capacity of the building that rests on
that land. If the lessee is able to control the underlying land,
both the lessee and the lessor should account for the lessee’s
right to use the land as a separate lease component (unless the
accounting effect of doing so would be insignificant as stated
in ASC 842-10-15-29). When accounting for the right to use the
underlying land as a separate lease component, an entity would
allocate lease payments separately between the two lease
components (i.e., the lease of land and lease of the building).
Accordingly, an entity would separately compare the present
value of those allocated lease payments with the fair value of
the underlying land and the fair value of the building in
assessing the classification of each lease component in
accordance with ASC 842-10-25-2(d).
However, if the control assessment reveals that
the lessee does not control the land and no other tenant in the
building obtains substantially all the use of the land, the land
does not represent a separate lease component. In these cases,
the lease payments that would otherwise be allocated to the land
component instead would be entirely allocated to the lease of
the lessee’s portion of the building. We believe that the lessee
and the lessor should consider whether some of the lease
payments economically represent payments
to use a portion of the underlying land. If so, in the
assessment of the classification of the lease, the fair value of
the underlying asset should include both the fair value of the
lessee’s portion of the building and a proportional amount of
the fair value of the underlying land.
For more information about lease classification
and about evaluating whether the present value of lease payments
represents substantially all of the fair value of a lease
component, see Section 8.3.3.6 for
lessee considerations and Section 9.2.1.4 for
lessor considerations.
Example 4-2
Lessee and Lessor enter into a
lease agreement in which Lessee obtains the right
to use multiple floors of a building for a term of
10 years. Lessee is the most significant tenant
and occupies a majority of the floors in the
building, which represents approximately 95
percent of the building’s usable square footage.
The building takes up the entire underlying land
of the property. Accordingly, no other structures
can be built on the land and the tenants of the
building collectively are receiving the full
economic benefits from the use of the land during
the lease term. No individual tenant has the right
to use a physically distinguishable portion of the
underlying land.
The terms of the lease
agreement require that Lessee make lease payments
of $30 million annually at the end of each year
for the entire 10-year lease term. The fair value
of the entire property is $500 million, of which
$100 million is related to the land and $400
million is related to the building. The
stand-alone prices (lessees) and stand-alone
selling prices (lessors) of the right to use the
land and building components are $66 million and
$264 million, respectively. Lessee has an
incremental borrowing rate of 10 percent.
Both entities (Lessee and
Lessor) have concluded that the ability to control
90 percent or more of the building is indicative
of substantially all of the building’s capacity.
Because Lessee has the right to use 95 percent of
the building, both entities (Lessee and Lessor)
have determined that Lessee has the right to
control the use of substantially all of the
economic benefits of the building and therefore
also has the right to control the use of 100
percent of the underlying land. Lessee and Lessor
will account for the building and the land as two
separate lease components and will allocate the
consideration to be paid over the lease term on
the basis of each component’s relative stand-alone
price (lessees) and stand-alone selling price
(lessors).
As illustrated in the table
below, Lessee and Lessor will allocate $60
million, or 20 percent, of the total consideration
of $300 million to the land and the remaining $240
million to the building. Lessee1 will use its incremental borrowing rate of
10 percent to calculate the present value of these
payments, yielding approximately $37 million and
$147 million2 for the land and building lease components,
respectfully. Lessee will then compare the present
value of these payments with the fair value of
$100 million and approximately $380 million (95
percent of the total building fair value) for the
land and building lease components, respectively,
to determine whether these payments represent
substantially all of the fair value of the
underlying asset in accordance with ASC
842-10-25-2(d).
Example 4-3
Assume the same facts as in
the example above, except that the lessee only
controls 80 percent of the capacity of the
building. Because Lessee’s capacity is less than
90 percent of the building, Lessee does not have
the right to control the use of substantially all
of the economic benefits of the building and no
other tenant obtains substantially all of the
economic benefits (i.e., the other 20 percent,
regardless of whether it is used by one or more
tenants, is not substantially all). As a result,
the underlying land would not be accounted for as
a separate lease component.
In this example, both entities
(Lessee and Lessor) will allocate the entirety of
their future lease payments of $300 million to the
building, which is the only lease component.
Lessee3 will then compare the present value of these
lease payments of approximately $184 million4 with the fair value of its allocable portion
of the property. Because Lessee occupies 80
percent of the capacity of the building, it will
allocate approximately 80 percent of the total
property value (including land) to the building in
this calculation. Thus, Lessee will use a fair
value of $400 million (80% of $500 million) in its
lease classification test.
Changing Lanes
Classification
of the Land Component Under ASC 840
In addition to the lack of a 25
percent threshold under ASC 842 (discussed in
Section
4.2.2.1), the new guidance diverges
from ASC 840 in both how consideration is allocated
to the land and building elements of the lease
arrangement, as well as the classification of these
elements.
ASC 840-10-25-38(b)(2) prescribed how
consideration is allocated between the land and
building elements of a lease arrangement, stating,
in part:
The minimum lease
payments after deducting executory costs,
including any profit thereon, applicable to the
land and the building shall be separated by the
lessee by determining the fair value of the land
and applying the lessee’s incremental borrowing
rate to it to determine the annual minimum lease
payments applicable to the land element; the remaining minimum lease
payments shall be attributed to the building
element. [Emphasis added]
However, under ASC 842, the land
element of the lease arrangement is allocated
consideration in the same manner as the other
components in the contract (i.e., on the basis of
its relative stand-alone price or stand-alone
selling price). Further, depending on the entity’s
determination of whether to separate lease and
nonlease components in the contract for that asset
class, allocated consideration may or may not
include certain costs defined as executory costs
under ASC 840.
From a classification perspective, ASC
840-10-25-38(b)(2) stated the following, in part:
- If the building element of the lease meets the lease-term criterion in 840-10-25-1(c) or the minimum-lease-payments criterion in paragraph 840-10-25-1(d), the building element shall be accounted for by the lessee as a capital lease and amortized in accordance with the guidance in paragraph 840-30-35-1(b). The land element of the lease shall be accounted for separately by the lessee as an operating lease. [Emphasis added]
- If the building element of the lease meets neither the lease-term criterion in 840-10-25-1(c) nor the minimum-lease-payments criterion in paragraph 840-10-25-1(d), both the building element and the land element shall be accounted for by the lessee as a single operating lease.
ASC 842 diverges from this approach,
since both lease components would be subject to the
lease classification test in ASC 842-10-25-2. While
the land component of a lease would never meet the
economic-life criterion in ASC 842-10-25-2(c) as a
result of its indefinite life, lease payments
allocated to this component may represent
substantially all of the fair value of the
underlying land. Accordingly, scenarios may exist in
which the land component is classified as a finance
or sales-type lease by passing the fair value test
in ASC 842-10-25-2(d), whereas land was always
classified as an operating lease under ASC 840. For
more information about the lease classification
tests under ASC 842, see Section 8.3.
4.2.3 Applying the Guidance on Separate Lease Components
The examples below — the first of which is reproduced from ASC 842-10-55-146
through 55-149 — illustrate the process outlined in the decision tree
in Section
4.2 and the guidance in ASC 842-10-15-28 and 15-29
(further discussed in Section 4.2.2).
ASC 842-10
Example 13 — Lease of a Turbine Plant
55-146 Lessor leases a gas-fired turbine plant to Lessee for eight years so that Lessee can produce electricity
for its customers. The plant consists of the turbine housed within a building together with the land on which
the building sits. The building was designed specifically to house the turbine, has a similar economic life as the
turbine of approximately 15 years, and has no alternative use. The lease does not transfer ownership of any
of the underlying assets to Lessee or grant Lessee an option to purchase any of the underlying assets. Lessor
does not obtain a residual value guarantee from Lessee or any other unrelated third party. The present value
of the lease payments is not substantially all of the aggregate fair value of the three underlying assets.
55-147 While the lease of the plant includes the lease of multiple underlying assets, the leases of those
underlying assets do not meet the second criterion necessary to be separate lease components, which is that
the right to use the underlying asset is neither dependent on nor highly interrelated with the other rights of
use in the contract. Therefore, the contract contains only one lease component. The rights to use the turbine,
the building, and the land are highly interrelated because each is an input to the customized combined item for
which Lessee has contracted (that is, the right to use a gas-fired turbine plant that can produce electricity for
distribution to Lessee’s customers).
55-148 However, because the contract contains the lease of land, Lessee and Lessor also must consider the
guidance in paragraph 842-10-15-29. Lessee and Lessor each conclude that the effect of accounting for the
right to use the land as a separate lease component would be insignificant because Lessee’s right to use the
turbine, the building, and the land is coterminous and separating the right to use the land from the right to use
the turbine and the building would not affect the lease classification of the turbine/building lease component.
Lessee and Lessor each conclude that a single lease component comprising the turbine, the building, and the
land would be classified as an operating lease, as would two separate lease components comprising the land
and the turbine/building, respectively.
55-149 The predominant asset in the single lease component is the turbine. Lessee entered into the lease
primarily to obtain the power-generation capabilities of the turbine. The building and land enable Lessee to
obtain the benefits from use of the turbine. The land and building would have little, if any, use or value to
Lessee in this contract without the turbine. Therefore, the remaining economic life of the turbine is considered
in evaluating the classification of the single lease component.
Example 4-4
City Living Properties, the lessor, rents a fully furnished, newly renovated high-rise apartment building with an
elevator to Easy Rentals, the lessee, for a term of 20 years. Easy Rentals will eventually lease the building’s fully
furnished, individual apartment units to tenants. Easy Rentals pays one fixed monthly rental payment to City
Living Properties.
The apartment building, elevator, and apartment furnishings have a 40-, 20-, and 10-year useful life,
respectively. The land on which the building sits has an indefinite useful life. Easy Rentals determines that it
has the right to use four underlying assets: (1) the apartment building, (2) the elevator, (3) the land, and (4) the
apartment furnishings.
Further, Easy Rentals determines that the leases for both the land and the building are operating leases (see Chapter 8 for further discussion of the lessee classification guidance), primarily because the 20-year stated lease term, when compared with the useful life of each underlying asset, will not result in a finance lease classification conclusion for either. Therefore, Easy Rentals reasonably concludes that the accounting effect of separating the land from the building is insignificant.
The combined land and building component and the elevator are not separately
identifiable because they are highly dependent and
highly interrelated. The rights to use the land,
building, and elevator are inputs into the
delivery of a single right to use a high-rise
apartment building. Therefore, these rights are
considered one lease component in the contract.
When classifying the lease, Easy Rentals would use
the useful life of the predominant asset within
the bundle to determine the useful life of the
entire lease component (i.e., 40 years, because
the apartment building is the predominant
asset).
The apartment furnishings are a separate lease component, since they can be used independently of the single lease component for the high-rise apartment building. Easy Rentals can use the apartment furnishings on their own or together with other readily available resources to economically benefit from the right of use. When making this determination, Easy Rentals considers the characteristics of the lease component itself, regardless of contractual limitations (i.e., it does not consider the way in which it may use or be allowed to use the lease component).
In addition, the apartment furnishings are not highly dependent on, or highly interrelated with, the single high-rise apartment building lease component. Rather, they are separately identifiable and are not combined with the high-rise apartment building to deliver a single right of use.
Easy Rentals would therefore allocate the consideration in the contract between
(1) the single high-rise apartment building lease
component and (2) the apartment furnishings.5 Allocation to components of a contract is
further discussed in Section 4.4.
4.2.3.1 Identifying Lease Components When the Underlying Asset Is Replaced During the Lease Term
Certain lease arrangements may either require or
allow for replacement of the underlying asset by the lessor
during the term of the arrangement. That is, in such
arrangements, it is expected (or required) at contract inception
that the underlying asset will be replaced. The purpose of such
replacement may be to ensure that the underlying asset continues
to meet agreed-upon performance standards for the lessee.
Example 4-5
A lessee enters into a
noncancelable contract with a lessor to obtain IT
processing services by using a dedicated server
for 10 years in exchange for 10 years of fixed
periodic payments. Assume that the contract
provides the lessee with a right to control HAFWP
an identified asset (the server) is used
throughout the 10-year contract term (i.e., the
contract contains a lease of the server). The
expected useful life of the server is five
years.
In this example, the contract
stipulates that the lessor must replace the server
once during the contract term. Since the original
server has a useful life of five years, it is
expected to be replaced at the end of year 5. The
purpose of the replacement is to maintain a
standard level of IT processing services provided
to the lessee. The contract pricing is established
up front and does not change as a result of the
server replacement. The replacement server
provides essentially the same benefit and
functionality as the original server; however, it
is unlikely that the original server would have
continued to provide the same level of benefit for
the entire 10-year contract term.
When determining the number of
lease components, evaluating lease classification
at lease commencement, and measuring its ROU asset
and lease liability, the lessee in this example
should consider each asset (i.e., the original
server and the replacement server) as a separate
lease component with separate lease terms — that
is, there are two separate lease components in
this example. The lease terms of the separate
lease components can be determined by considering
the expected replacement dates (five years in this
example), but we would not expect the lease term
to exceed the estimated useful life of the
underlying asset in a scenario in which an asset
must be replaced to maintain minimum performance
standards.
The lessee should allocate the
consideration (e.g., gross lease payments expected
to be paid over the course of the lease terms of
the lease components) between the two lease
components on a relative stand-alone price basis
and should record an ROU asset and lease liability
for the first asset (i.e., the server provided at
commencement) at lease commencement by using the
discounted lease payments over the lease term for
that asset (five years). (See Section
7.2 for more information about
determining the discount rate to be used by a
lessee.) The lessee should use the five-year lease
terms (and corresponding lease payments) in
determining the lease classification.
The example above is analogous to a master lease
agreement in which the lessee is committed to using a minimum
quantity of assets. A master lease agreement may specify that
the lessee will obtain control over the right to use multiple
underlying assets (e.g., servers) at various points during the
term of the master lease agreement. In these cases, the lessee’s
accounting depends on whether the master lease agreement commits
the lessee to obtaining control over the right to use a minimum
quantity (units or dollar value) of assets — see Section
13.4.1 for more information about such master
lease agreements.
In the above example, the lessee commits to
obtaining control over the right to use two servers (the
original server and the replacement server). In accordance with
ASC 842-10-55-17, because the lessee is obligated to use a
minimum quantity of equipment, the lessee must consider the
minimum quantity of equipment (i.e., two servers) when
identifying the separate lease components and allocating the
consideration in the contract. Further, the server to be
provided in year 5 does not qualify as an identified asset at
lease commencement of the original server under ASC 842-10-15-9,
which indicates that an asset can be identified “at the time
that the asset is made available for use by the customer.” In
other words, a lease does not commence until an identified asset
is made available for the customer’s use.
We would expect the lessee in such an arrangement
to disclose the “forward-starting” lease of the server provided
in year 5, if material, as required by ASC 842-20-50-3(b), which
states that a lessee should disclose “[i]nformation about leases
that have not yet commenced but that create significant rights
and obligations for the lessee.” The lessee would record an ROU
asset and lease liability for the remaining five-year lease term
once the lease of the replacement server commences.
4.2.3.1.1 Lessor Continually Provides a Server That Meets Certain Minimum Performance Standards
Assume that the contract differs from the one
described in Example 4-5 in such a way that the lessor is
required to continually provide a server that meets certain
minimum performance standards (e.g., processing speed and
capacity) but a replacement is not explicitly required during
the 10-year term (all other facts remain the same). In such
cases, the lessee should consider the specific facts and
circumstances of the arrangement, including the expected useful
life of the asset(s), when determining the lease component(s)
and lease term(s). If the lessee determines that the expected
useful life of the underlying asset is less than the overall
lease term (i.e., the underlying asset is not expected to be
able to meet certain minimum performance standards over the
course of the lease term), the lease arrangement may, in
substance, involve the use of two (or more) lease components to
fulfill the obligations under the arrangement. This is because
the lessor could not satisfy its obligation to the lessee to
maintain minimum performance standards without replacing the
assets during the lease term.
4.2.3.1.2 Lessee and Lessor in an Arrangement That Contains the Right or Obligation to Replace the Original Asset
The lessee and lessor in an arrangement that
contains the right or obligation (including implied rights or
obligations) to replace the original asset would have the same
contractual rights and obligations; therefore, the determination
of the lease components and lease term should generally be
aligned. In Example 4-5,
the lessor is delivering two lease components to the lessee
(i.e., the original server and the replacement server). The
lessor would evaluate lease classification separately for the
two identified lease components and account for the lease
agreements in accordance with ASC 842-30.
Footnotes
1
Lessor would calculate the
present value of the lease payments by using its
rate implicit in the lease; however, such a
calculation is not included in this example.
2
This balance reflects the
present value of the allocated portion of annual
lease payments paid over the lease term of 10
years. Thus, the land component represents the
present value of lease payments of $6 million (20%
× $30 million) per annum and the building
component represents the present value of lease
payments of $24 million (80% × $30 million) per
annum, both paid over the 10-year lease term and
discounted at Lessee’s 10 percent incremental
borrowing rate.
3
Lessor would use its rate
implicit in the lease to calculate the present
value of lease payments and compare that with the
fair value of the allocable portion of the total
property associated with the ROU asset ($400
million in this example). This example does not
illustrate that approach.
4
This balance reflects the
present value of the $30 million of annual lease
payments paid for the lease term of 10 years and
discounted at Lessee’s incremental borrowing rate
of 10 percent.
5
The apartment furnishings may
need to be separated further (e.g., a couch is
separable from a table); however, for illustration
purposes, such an evaluation is not performed.
4.3 Identify the Separate Nonlease Components
ASC 842-10
15-30 The consideration in the
contract shall be allocated to each separate lease component
and nonlease component of the contract (see paragraphs
842-10-15-33 through 15-37 for lessee allocation guidance
and paragraphs 842-10-15-38 through 15-42C for lessor
allocation guidance). Components of a contract include only
those items or activities that transfer a good or service to
the lessee. Consequently, the following are not components
of a contract and do not receive an allocation of the
consideration in the contract:
-
Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
-
Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.
Once the separate lease components are identified (see Section 4.2), entities
must determine whether there are any nonlease components to be separated.
An allocation of the consideration in the contract is required for both lease and
nonlease components, since they transfer a good or service to the customer.
However, as indicated in ASC 842-10-15-30, such allocation does not extend to
activities that do not transfer a good or service to the customer (e.g., administrative
tasks and reimbursement or payment of the lessor’s costs).
ASC 842-10-15-30 notes that “[c]omponents of a contract include only
those items or activities that transfer a good or service to the lessee.” For
example, a contract may include a separate lease component (e.g., the right to use
the underlying asset that is the subject of the agreement) as well as additional
goods or services that are transferred to the lessee (e.g., maintenance services),
which are nonlease components (see Section 4.3.1). Once the separate lease components are identified
(see Section 4.2), entities must determine whether there are
any nonlease components to be separated.
Contracts often include other costs or fees that do not provide a
separate good or service to the lessee — for example, costs paid by the lessee, such
as (1) the cost of administrative tasks performed to set up a contract or initiate
the lease or (2) reimbursement or payment of the lessor’s costs (e.g., property
taxes and insurance related to the leased asset). These types of costs do not
transfer a good or service to the lessee and would therefore not be considered a
component in the contract (see Section 4.3.2).
An entity is required to allocate the total consideration in a
contract (including all amounts charged for administrative start-up, property taxes,
and some insurance — see Section
4.4.1.1 for lessees and Section 4.4.2.1 for lessors) to its identified
separate lease and nonlease component(s). The manner of allocating the consideration
depends on whether the entity is the lessee (see Section 4.4.1.2) or lessor (see Section 4.4.2.2) in the
arrangement. Practical expedients may be available that, upon election, would allow
entities not to separate, and thus not allocate consideration in the contract
between, lease and nonlease components (see Section 4.3.3 for
further discussion).
The graphic below summarizes the concepts in ASC 842-10-15-30.
The accounting for lease components differs from that for nonlease
components, as articulated in ASC 842-10-15-31:6
ASC 842-10
15-31 An entity shall account for
each separate lease component separately from the nonlease
components of the contract (that is, unless a lessee makes
the accounting policy election described in paragraph
842-10-15-37 or unless a lessor makes the accounting policy
election in accordance with paragraph 842-10-15-42A).
Nonlease components are not within the scope of this Topic
and shall be accounted for in accordance with other
Topics.
Understanding the difference between lease components, nonlease
components, and “noncomponents” (i.e., activities paid for by the customer that do
not transfer a good or service to the customer) will be critical throughout the
remainder of this chapter. The table below outlines these three types of components
in greater detail.
Lease Component
|
The right to use an underlying asset is
considered a separate lease component if (1) a lessee can
benefit from the use of the underlying asset either on its
own or with other resources that are readily available and
(2) the underlying asset is not highly dependent on or
highly interrelated with other assets in the arrangement.
Separate lease components are discussed in detail in
Section 4.2.
|
Nonlease
Component
|
An activity that transfers a separate good
or service to the customer is a nonlease component. For
example, maintenance services consumed by the customer and
bundled with the lease component in the contract would be a
separate nonlease component because the performance of the
maintenance transfers a service to the customer that is
separate from the right to use the asset. As discussed
further below, under ASC 842, services or other nonlease
components may be accounted for separately from the lease
component(s) even if they would not be accounted for
separately from other promised goods or services in a
revenue contract with a customer. This may be
counterintuitive to some that find nonlease components in a
contract not to be distinct from the lease component(s). See
the Connecting the Dots in Section
4.3.1 for further discussion.
|
Noncomponent
|
Any activity in a contract that does not
transfer a separate good or service to the lessee is neither
a lease component nor a nonlease component; therefore,
consideration in the contract would not be allocated to such
an activity. For example, payments made by the customer for
property taxes or insurance that covers the supplier’s
interests would not represent a component in the
contract.
|
Connecting the Dots
Determination of Whether a Lease
Exists Precedes Component Identification and Separation
Before identifying and separating lease and nonlease
components, an entity must determine whether a contract is or contains a
lease (see Chapter
3). Once it has been determined that a lease exists, the
identification of the components does not affect that conclusion. A contract
can contain one or more lease and nonlease components or noncomponents
without influencing the determination that a contract is or contains a
lease.
Services Generally Should Be Accounted
for in the Same Manner Regardless of Whether They Are Included in a
Contract With a Lease Component
Paragraph BC148 of ASU 2016-02 states that the recognition
and measurement guidance for leases in ASC 842 should only be applied to the
lease components in a contract and that “a nonlease component should not, in
general, be subject to different accounting requirements solely because it
is included in a contract that contains a lease.” Further, Paragraph BC149
of ASU 2016-02 goes on to say:
The Board also decided that [entities] should
account for lease and nonlease (typically, service) components
separately . . . Board members observed that to do otherwise could
result in different accounting for services solely depending on
whether the service is included together with a lease. . . . [T]he
accounting for services should be the same, regardless of whether
the contract that includes the services also includes a lease.
Accordingly, both lessees and lessors are required to
separate lease and nonlease components (unless they elect the practical
expedients discussed in Section 4.3.3) so that (1) lease components may be
appropriately reflected in accordance with ASC 842 (e.g., to ensure more
precise measurement of the lessee’s lease assets and lease liabilities) and
(2) nonlease components may be appropriately reflected in accordance with
other applicable GAAP (e.g., to ensure an appropriate pattern of revenue
recognition in accordance with ASC 606 when lessors also provide services to
lessees).
Example 12 in ASC 842-10-55-141 through 55-145, reproduced below,
constitutes a good introductory illustration of the guidance in ASC 842-10-15-30 and
15-31.
ASC 842-10
Example 12 — Activities or Costs That Are
Not Components of a Contract
Case A — Payments for Taxes and Insurance
are Variable
55-141 Lessor and Lessee enter into
a five-year lease of a building. The contract designates
that Lessee is required to pay for the costs relating to the
asset, including the real estate taxes and the insurance on
the building. The real estate taxes would be owed by Lessor
regardless of whether it leased the building and who the
lessee is. Lessor is the named insured on the building
insurance policy (that is, the insurance protects Lessor’s
investment in the building, and Lessor will receive the
proceeds from any claim). The annual lease payments are
fixed at $10,000 per year, while the annual real estate
taxes and insurance premium will vary and be billed by
Lessor to Lessee each year.
55-142 The real estate taxes and
the building insurance are not components of the contract.
The contract includes a single lease component — the right
to use the building. Lessee’s payments of those amounts
solely represent a reimbursement of Lessor’s costs and do
not represent payments for goods or services in addition to
the right to use the building. However, because the real
estate taxes and insurance premiums during the lease term
are variable, those payments are variable lease payments
that do not depend on an index or a rate and are excluded
from the measurement of the lease liability and recognized
by Lessee in profit or loss in accordance with paragraph
842-20-25-5 or 842-20-25-6. Lessor also recognizes those
payments as variable lease payments in accordance with
paragraph 842-10-15-40A because the real estate taxes and
insurance premiums are paid by Lessor to the taxing
jurisdiction and insurance company and reimbursed by Lessee
to Lessor. However, if Lessee paid the costs directly to the
third parties, those lessor costs would not be recognized by
Lessor as variable payments because of the requirement in
paragraph 842-10-15-40A.
Case B — Payment for Taxes and Insurance
Are Fixed
55-143 Assume the same facts and
circumstances as in Case A (paragraphs 842-10-55-141 through
55-142), except that the fixed annual lease payment is
$13,000. There are no additional payments for real estate
taxes or building insurance; however, the fixed payment is
itemized in the contract (that is, $10,000 for rent, $2,000
for real estate taxes, and $1,000 for building insurance).
Consistent with Case A, the taxes and insurance are not
components of the contract. The contract includes a single
lease component, the right to use the building. The $65,000
in payments Lessee will make over the 5-year lease term are
all lease payments for the single component of the contract
and, therefore, are included in the measurement of the lease
liability.
Case C — Common Area Maintenance
55-144 Assume the same facts and
circumstances as in Case B (paragraph 842-10-55-143), except
that the lease is of space within the building, rather than
for the entire building, and the fixed annual lease payment
of $13,000 also covers Lessor’s performance of common area
maintenance activities (for example, cleaning of common
areas, parking lot maintenance, and providing utilities to
the building). Consistent with Case B, the taxes and
insurance are not components of the contract. However, the
common area maintenance is a component because Lessor’s
activities transfer services to Lessee. That is, Lessee
receives a service from Lessor in the form of the common
area maintenance activities it would otherwise have to
undertake itself or pay another party to provide (for
example, cleaning the lobby for its customers, removing snow
from the parking lot for its employees and customers, and
providing utilities). The common area maintenance is a
single component in this contract rather than multiple
components, because Lessor performs the activities as needed
(for example, plows snow or undertakes minor repairs when
and as necessary) over the same period of time.
55-145 Therefore, the contract in
Case C includes two components — a lease component (that is,
the right to use the building) and a nonlease component. The
consideration in the contract of $65,000 is allocated
between those 2 components (unless Lessee elects the
practical expedient in paragraph 842-10-15-37 or Lessor
elects the practical expedient in paragraph 842-10-15-42A
when the conditions in that paragraph are met). The amount
allocated to the lease component is the lease payments in
accounting for the lease.
4.3.1 Nonlease Components
Nonlease components in a contract (i.e., any activity that
transfers a good or service to the lessee) will generally represent some sort of
service that the lessee is paying for in the contract and that the lessor is
providing to the lessee in addition to the lease component. The following are
examples of common nonlease components in a contract that contains both lease
and nonlease components:
-
A contract for the right to use equipment, when the lessor also provides regular maintenance of the equipment throughout the contract.
-
A contract for the right to use a transportation vehicle (e.g., airplane, ship, or truck), when the lessor also provides operating personnel to operate the vehicle for the lessee throughout the contract.
-
A contract for the right to use an oil, gas, or mining drill rig, when the lessor also provides a crew to man and operate the rig throughout the contract.
-
A contract for the right to use a manufacturing facility, when the lessor also provides the materials and labor needed to produce a product for the lessee.
-
A contract for the right to use several floors of an office building, when the lessor also provides maintenance services to clean the building lobbies, maintain elevators, etc. (i.e., common-area maintenance [CAM]).
Because ASC 842-10-15-30 describes nonlease components as any
“items or activities that transfer a good or service to the lessee,” such
components may be something other than the typical services described above. For
example, ASC 842-10-55-32 and 55-33 clarify that entities (particularly lessors)
may need to consider whether guarantees and indemnifications are nonlease
components, which must be accounted for in accordance with other applicable
GAAP.
ASC 842-10
55-32 Paragraph 460-10-15-4(c)
states that, except as provided in paragraph
460-10-15-7, the provisions of Subtopic 460-10 on
guarantees apply to indemnification agreements
(contracts) that contingently require an indemnifying
party (guarantor) to make payments to an indemnified
party (guaranteed party) based on changes in an
underlying that is related to an asset, a liability, or
an equity security of the indemnified party. Paragraph
460-10-55-23A provides related implementation guidance
for a tax indemnification provided to a lessor.
55-33 A lessor should evaluate
a commitment to guarantee performance of the underlying
asset or to effectively protect the lessee from
obsolescence of the underlying asset in accordance with
paragraphs 606-10-55-30 through 55-35 on warranties. If
the lessor’s commitment is more extensive than a typical
product warranty, it might indicate that the commitment
is providing a service to the lessee that should be
accounted for as a nonlease component of the
contract.
The concept of a nonlease component in ASC 842 is effectively
the same as that for “promised goods or services” under ASC 606. Section 5.2 of Deloitte’s
Roadmap Revenue
Recognition contains detailed discussion of promises in a
contract and may help entities understand whether an activity provided by the
lessor (other than the right of use) transfers a good or service to the
lessee.
Connecting the Dots
Nonlease Components Do Not Need
to Be Distinct
Although the concept of nonlease components in ASC 842
is similar to that of promised goods or services in ASC 606, there is
one significant difference: nonlease components do not need to be
distinct from lease components to be accounted for separately.
Under ASC 606, for revenue recognition purposes, the
transaction price is allocated only to distinct performance obligations.
(See Section
5.3 of Deloitte’s Roadmap Revenue Recognition for
detailed discussion of when a promised good or service is a distinct
performance obligation.) Under ASC 842, the consideration in the
contract is allocated to an item or activity when that item or activity
transfers a good or service to the lessee.
When developing ASC 842, the FASB considered whether the
“distinct” guidance in ASC 606 should apply to identifying and
separating nonlease components. Paragraph BC151(a) of ASU 2016-02
explains that the 2010 leasing ED included guidance that required
lessees and lessors to account for a service or other nonlease component
separately only if it was distinct in accordance with the guidance that
the Board was developing on revenue recognition. However, paragraph
BC151(a) of ASU 2016-02 further notes that, in feedback on the 2010 ED,
respondents indicated that they “found the proposals confusing, or they
disagreed with some aspects of those proposals, in particular, the
proposal to account for the entire contract as a lease if nonlease
components were not distinct.”
Accordingly, under ASC 842, services or other nonlease
components may be accounted for separately from the lease component(s)
even if they would not be accounted for separately from other promised
goods or services in a revenue contract with a customer. This may be
counterintuitive to some lessees and lessors that find nonlease
components in a contract not to be distinct from the lease component(s)
(e.g., when the asset being leased cannot run or operate without the
services provided by the lessor’s operating personnel). In addition, it
may be challenging to develop an appropriate stand-alone price (for
lessees) or stand-alone selling price (for lessors) — for both the lease
component(s) and the nonlease components — with respect to allocating
consideration in the contract. (The allocation methods for both lessees
and lessors are further discussed in Section 4.4.)
Although nonlease components do not need to be distinct from
lease components to be accounted for separately, ASC 842-10-15-31 states that
nonlease components are not within the scope of ASC 842 (unless a lessor makes
the accounting policy election in accordance with ASC 842-10-15-42A) and
therefore must be accounted for in accordance with other applicable GAAP. For
lessors, this means that nonlease components (e.g., maintenance services)
generally should be accounted for in accordance with the guidance on revenue
from contracts with customers in ASC 606.7 Accordingly, lessors will need to consider whether any of the promised
goods or services in the separated nonlease component(s) represent distinct
performance obligations. That is, although a bundle of promised goods or
services may be separated from the lease component as nonlease components, the
lessor will further need to identify distinct performance obligations within
that bundle in accordance with step 2 of the revenue model in ASC 606. The
guidance on identifying performance obligations in ASC 606 is discussed in
detail in Chapter 5 of Deloitte’s Roadmap
Revenue
Recognition. Lessors should consider our interpretive
guidance in assessing any nonlease components that are separated from the lease
component(s) in a contract that contains a lease.
Maintenance services are likely to be some of the most commonly
identified nonlease components in contracts that contain a lease. It is very
common for leases of real estate (e.g., leases of an apartment, space in an
office building, dwellings in a retirement home) to include some form of CAM.
Lessors of such real estate may also procure and provide to lessees certain
utilities (e.g., water, gas, and electricity).
4.3.1.1 Common-Area Maintenance and Utilities
Leases of office or commercial space often contain
provisions that require the tenant to reimburse the landlord for amounts
such as CAM costs or the cost of providing utilities (e.g., heat, water,
gas, and electricity). Both CAM and utilities are considered nonlease
components, as discussed in the following paragraphs.
CAM costs might include an allocated portion of costs for landscaping,
janitorial services, repairs, snow removal, and other maintenance of common
areas. CAM charges can be based on the actual costs incurred by the
landlord. However, such charges also might be negotiated at the inception of
the lease as fixed amounts, potentially with scheduled increases over the
lease term.
CAM represents the transfer of a good or service to the
lessee other than the right to use the underlying asset. Therefore, unless a
practical expedient is available and elected (see Section 4.3.3), it is a nonlease
component (1) that both the lessee and lessor must separate from the lease
component(s) and (2) to which consideration in the contract must be
allocated. Example 12, Case C, in ASC 842-10-55-144 and 55-145 (reproduced
in Section
4.3), supports this conclusion and states, in part:
[T]he common area maintenance is a component because
Lessor’s activities transfer services to Lessee. That is, Lessee
receives a service from Lessor in the form of the common area
maintenance activities it would otherwise have to undertake itself
or pay another party to provide (for example, cleaning the lobby for
its customers, removing snow from the parking lot for its employees
and customers, and providing utilities).
As for utilities, they may be charged to the tenant at cost,
allocated cost, or either cost or allocated cost plus a margin. The lessor
transfers a good or service to the lessee that is separate from the right to
use the underlying asset when it provides water, gas, electricity, or other
utilities. Therefore, unless a practical expedient is available and elected
(see Section
4.3.3), utilities reflect a nonlease component (1) that both
the lessor and lessee must separate from the lease component(s) and (2) to
which consideration in the contract must be allocated.
Changing Lanes
CAM and Utilities Are No
Longer Just Executory Costs
ASC 840 required that “substantial services” be
accounted for separately from the lease element in a contract that
contains both a lease element and such substantial services.
Although the phrase “substantial services” was not defined in ASC
840, we expect that any elements that are substantial services and
that are thus currently separated from the lease element will also
be nonlease components under ASC 842.
However, the treatment of maintenance and utilities
under ASC 842 will generally differ from that under ASC 840.
Specifically, under ASC 840-10-25-1(d), maintenance and utilities
were generally considered executory costs and not substantial
services. Therefore, under ASC 840-10-15-17 and ASC 840-10-15-19,
maintenance and utilities were considered part of the lease element
and are within the scope of ASC 840. Under ASC 842, on the other
hand (and as explained above), maintenance (including CAM) and
utilities are nonlease components. Accordingly, while the lease
payments (i.e., the consideration in the contract) are not
separately allocated to both CAM and utilities under ASC 840 for
accounting purposes, the lease payments will be allocated in this
way under ASC 842 (provided that a practical expedient is not
available or is not elected — see Section 4.3.3). Further, under
ASC 842, unless a practical expedient is available and elected, both
CAM and utilities are accounted for in accordance with other
applicable GAAP rather than being accounted for as part of the lease
as they were under ASC 840.
Connecting the Dots
Real Estate Lessors’
Identification of Distinct Performance Obligations Within
CAM
As discussed above, lessors will need to consider
the guidance in ASC 606 to identify distinct performance obligations
within the nonlease component(s) that are separated from the lease
component(s).8 Similarly, to recognize revenue in accordance with ASC 606,
real estate lessors will need to consider whether CAM is a single
performance obligation or comprises multiple performance
obligations.
We think that CAM will often represent a single
performance obligation. Although CAM comprises multiple different
activities that the lessor may perform on a day-to-day basis (e.g.,
cleaning the lobbies and bathrooms daily, buffing the lobby floors
weekly), the nature of the lessor’s promise is to maintain the
common areas of the real estate being leased. In promising to
deliver CAM, the lessor agrees that it will undertake various
activities to fulfill its overall promise to the lessee of providing
a well-maintained building and common areas.
This view is consistent with that articulated by the
FASB in ASC 606-10-55-157B through 55-157E (added to ASC 606 by
ASU 2016-10),
which illustrate an arrangement involving hotel management services.
That is, in this example, the Board concludes that “[t]he service
comprises various activities that may vary each day (for example,
cleaning services, reservation services, and property maintenance)
[but] those tasks are activities to fulfill the hotel management
service and are not separate promises in the contract.” Accordingly,
each increment (e.g., each day of the management services) of the
promised service is distinct, but together the overall promise
represents a series of distinct goods or services that are accounted
for as a single performance obligation in accordance with ASC
606-10-25-14 and 25-15.
However, real estate lessors should carefully
consider the promised goods or services within the overall CAM
promise. For example, we do not think that it would be appropriate
for utilities (discussed above) or major maintenance (discussed in
Section 4.3.1.2) to be considered part of a
single performance obligation with CAM just because those items may
be billed together or expressed together in the contract with the
lessee. That is, just because an activity is characterized as part
of CAM does not mean that it should be bundled together as part of a
single performance obligation with CAM.
Although an activity (e.g., a good or service) may
be distinct from CAM, it may be reasonable to account for it
together with the CAM if the pattern of transfer and the outcome of
accounting for them together are the same, as indicated in paragraph
BC116 of ASU
2014-09.
4.3.1.2 Major Maintenance
In leases of equipment and other large assets (e.g.,
airplanes, power plants), the lessor often provides nonroutine or “major”
maintenance on the leased asset. Major maintenance differs from CAM or other
routine maintenance in that, for major maintenance, the lessor (1) does not
regularly provide the services and (2) may need to spend a certain amount of
capital to keep the asset available for the lessee’s use. For example, a
lessor may need to provide major maintenance for an airplane that it leases
to a lessee — and remove the airplane from the lessee’s rotational use — at
the earlier of (1) the time when a maximum number of miles is flown or (2) a
federally regulated time since the last major maintenance was performed.
The performance of major maintenance represents the transfer
of a good or service to the lessee other than the right to use the
underlying asset. Therefore, unless a practical expedient is available and
elected (see Section
4.3.3), it is a nonlease component (1) that both the lessor
and lessee must separate from the lease component(s) and (2) to which
consideration in the contract must be allocated.
Generally, major maintenance was considered a “substantial
service” under ASC 840. Therefore, we would expect major maintenance to be
separated from the lease component as a nonlease component in a manner
consistent with that described in the Changing Lanes above. In addition,
given the distinct characteristics and separable risks of major maintenance,
compared with other services that the lessor may provide more regularly,
such maintenance may represent a distinct performance obligation for the
lessor in accordance with ASC 606.
4.3.2 Noncomponents
While lease components and nonlease components transfer a good
or service to the lessee, noncomponents do not transfer anything to the lessee.
Rather, they are incurred by the asset owner (i.e., the lessor) regardless of
whether the asset is out on lease. As indicated in ASC 842-10-15-30,
noncomponents are generally payments for either of the following:
-
Administrative tasks performed by the lessor that are necessary “to set up a contract or initiate the lease.”
-
Reimbursements (or direct payments) of the lessor’s costs that the lessor requires the lessee to pay as part of earning a return of (and on) the lessor’s costs to deliver the contract.
Payments made by the lessee for the following are considered
noncomponents to which the consideration in the contract is not separately
allocated:
-
Real estate or property taxes related to the leased asset (see Section 4.3.2.1).
-
Insurance that covers the lessor’s interest in the asset (see Section 4.3.2.2).
-
Commitment fees.
-
Other administrative charges.
In addition, payments for the items described above would be
considered noncomponents regardless of whether the payments are fixed or
variable.
In a manner similar to the guidance in ASC 606 on setup
activities, the consideration in the contract is not allocated to noncomponents
because they do not transfer a good or service to the lessee. Rather, fixed
amounts paid for noncomponents are included in the consideration in the contract
and allocated to the lease and nonlease components.9 (See Section
4.4 for detailed discussion of measuring and allocating
consideration in the contract.) The Board explains this consistency in paragraph
BC159 of ASU 2016-02:
The guidance in Topic 842 in this respect is consistent
with the revenue recognition guidance in Topic 606, which states that
promised goods or services do not include set up or other activities
that an entity must undertake to fulfill a contract unless those
activities transfer a good or service to the customer. Those activities,
therefore, do not get an allocation of the transaction price.
However, these costs are also often variable and paid on the
basis of the actual costs and are not considered part of the consideration in
the contract. For lessees, the accounting and reporting requirements for these
costs are the same regardless of whether the lessee is reimbursing the lessor or
paying a third party directly on the lessor’s behalf (e.g., paying real estate
taxes directly to the relevant tax authority). However, the accounting and
reporting requirements for lessors differ when the noncomponent is a lessor
cost. Specifically, lessor costs that a lessee pays directly to a third party on
behalf of the lessor are excluded from variable payments, and thus from lease
revenue, while lessor costs that the lessor pays directly to a third party, and
that the lessee then reimburses, must be accounted for as variable payments and
therefore as lease revenue. For detailed discussion of the measurement of the
consideration in the contract (and whether or when variable payments are
included in that measurement), see Section 4.4.1 (for lessees) and Section 4.4.2 (for
lessors).
4.3.2.1 Property Taxes
Depending on the relevant tax authority, the asset owner
(i.e., the lessor) generally owes property taxes on the asset regardless of
whether or to whom the asset is out on lease. Accordingly, the relevant tax
authority has recourse only to the lessor for property taxes owed. This is
the case even when a lessor requires a lessee in the contract to pay
property taxes directly to the tax authority — although the lessor may have
recourse to the lessee, the tax authority ultimately holds the lessor
responsible for such amounts.
The FASB discusses property taxes in paragraph BC157 of ASU
2016-02:
[I]t is common practice for one party to the
contract to pay certain costs directly to a third party, although
the counterparty to the contract is principally liable to make those
payments (for example, a lessee may make property tax payments
directly to the taxing authority although the lessor is principally
liable for those payments).
The lessee receives no good or service in return for its
payment of property taxes, regardless of whether it reimburses the lessor or
pays the tax authority directly; as a result, the property taxes are not
considered a component (lease or nonlease) in the contract. In many cases,
the lessee is ultimately reimbursing the lessor for its costs, for which the
lessor is the primary obligor to the tax authority. Therefore, both the
lessee and lessor consider property taxes noncomponents in a contract and no
consideration in the contract is allocated to the property taxes.
Example 12, Case A, in ASC 842-10-55-141 and 55-142
(reproduced in Section
4.3), supports the conclusion that property taxes are
noncomponents. In that example, the lessor and lessee conclude that property
taxes are not a component in the contract because the “real estate taxes
would be owed by Lessor regardless of whether it leased the building and who
the lessee is.” Paragraph BC158 of ASU 2016-02 also addresses the Board’s
conclusions regarding property taxes:
For example, an entity would not account for a
portion of the consideration in the contract that is attributable to
paying the lessor’s property taxes . . . as a component if the
lessor is the primary obligor for those taxes . . . and the amounts
paid are not for a service (for example, maintenance or operations
services) provided by the lessor to the lessee.
For lessees and lessors, any amounts paid for property taxes
that are included in the consideration in the contract (i.e., the costs are
fixed in the contract) are allocated to the separate lease and nonlease
components. However, the lessee and lessor requirements differ when the
amounts paid for property taxes are excluded from the consideration in the
contract (i.e., the costs are variable). For lessees, the variable payment
is allocated on the same basis as the fixed consideration. For lessors, the
requirements for lessee-paid costs differ from those for lessee-reimbursed
costs. Any amounts that a lessee directly pays to a third party on behalf of
the lessor for property taxes should be excluded from variable payments and
thus from lease revenue. Any amounts that the lessee reimburses and the
lessor pays to the third party should be included in variable payments and
therefore in lease revenue. (See Section 4.4 for detailed discussion of
measuring and allocating consideration in the contract.)
4.3.2.2 Insurance
In real estate and automobile leases, the lessor commonly
requires the lessee to pay for insurance coverage to protect the lessor’s
interest in the leased asset (e.g., insurance to cover the physical
structure of an office building). Generally, the lessor would seek to obtain
equivalent insurance coverage regardless of whether or to whom it was
leasing the asset. The contract may require the lessee to pay the lessor
(e.g., to reimburse the lessor’s premium) or to obtain the insurance
coverage directly from, and pay the premium directly to, a third-party
insurance provider.
It is also common for real estate and automobile leases to
require — or for the lessee to decide on its own to obtain — insurance
coverage to protect the lessee’s interests in the leased asset (e.g., to
cover the contents of the physical structure that the lessee owns, such as
with renter’s insurance). In such cases, the lessee would generally obtain
the insurance directly from a third-party insurance provider.
4.3.2.2.1 Insurance Premiums Paid by Lessee to Protect Lessor’s Interest
With respect to insurance premiums that the lessee pays
for insurance coverage to protect the lessor’s interest in the asset,
the lessee receives no good or service in return for its payment of the
insurance premium, regardless of whether the lessee reimburses the
lessor or the lessee pays the insurance provider directly. The lessee is
ultimately reimbursing the lessor for its costs, and when the policy
covers the lessor’s interest in the asset as the named insured, the
lessor is the primary beneficiary of the policy. Therefore, both the
lessor and the lessee consider such insurance a noncomponent in the
contract and no consideration in the contract is allocated to the
insurance.
Example 12, Case A, in ASC 842-10-55-141 and 55-142
(reproduced in Section
4.3), supports the conclusion that payments for insurance
coverage are noncomponents. In that example, the lessor and lessee
conclude that insurance is not a component in the contract because
“Lessor is the named insured on the building insurance policy (that is,
the insurance protects Lessor’s investment in the building, and Lessor
will receive the proceeds from any claim).”
For lessees and lessors, any amounts paid for such
insurance coverage that are included in the consideration in the
contract (i.e., the costs are fixed in the contract) are allocated to
the separate lease and nonlease components. However, the lessee and
lessor requirements differ when amounts paid for insurance coverage are
excluded from the consideration in the contract (i.e., the costs are
variable). For lessees, the variable payment is allocated on the same
basis as the fixed consideration. For lessors, the requirements for
lessee-paid costs differ from those for lessee-reimbursed costs. Any
amounts that a lessee directly pays to a third party on behalf of the
lessor for insurance coverage should be excluded from variable payments
and thus from lease revenue. Any amounts that the lessee reimburses and
the lessor pays to the third party should be included in variable
payments and therefore in lease revenue. (See Section 4.4 for detailed
discussion of measuring and allocating consideration in the
contract.)
4.3.2.2.2 Insurance Premiums Paid by Lessee to Protect Lessee’s Interest
Insurance premiums that the lessee pays for insurance
coverage to protect its own interest in the leased asset are also
considered noncomponents in the contract.
The lessee receives a good or service in return for its
payment of the insurance premium; however, that good or service does not
result from the contract that contains the lease but from the contract
between the lessee and the third-party insurance provider. The lessee is
ultimately protecting its own interest in the leased asset by covering
its own property within that leased asset; thus, the lessee is the named
insured and primary beneficiary of the policy. In addition, the lessee
is not reimbursing the lessor for any costs.
Therefore, both the lessee and the lessor consider such
insurance separate from the contract that contains the lease. No
consideration in the contract that contains the lease is allocated to
the insurance. Rather, the lessee accounts for any amounts it paid for
such insurance coverage in accordance with other applicable GAAP. The
lessor would not account for the insurance coverage (i.e., the payments
are not a lessor cost).
4.3.2.2.3 Insurance Premiums Paid by Lessee to Protect Both Lessee and Lessor Interests
In certain situations, the lessee may pay insurance
premiums for an umbrella insurance policy that covers both the lessor’s
and the lessee’s interest in the leased asset and the lessee and lessor
may be required to allocate these premiums. This situation is common in
automobile leases in which the lessor requires the lessee to purchase
collision insurance (for which the lessor is the primary beneficiary)
and the lessee also obtains liability (and potentially other) insurance
under the same policy (for which the lessee is the primary
beneficiary).
As explained in Section 4.3.2.2.1,
and in accordance with ASC 842-10-15-30, an entity should consider
whether any amounts paid for insurance that covers the lessor’s interest
in the asset should be included in the consideration in the contract and
allocated to the separate lease and nonlease components. (See Section 4.4 for
detailed discussion of measuring and allocating consideration in the
contract.)
Lessees should allocate the insurance premium amount
between (1) the portion that is compensation for the insurance coverage
over the lessor’s interest in the asset, when the lessor is the insured
party, so that an appropriate amount of the premium can be considered
for inclusion in the consideration in the contract (or for allocation of
variable payments) and (2) the portion that is compensation for the
insurance coverage over the lessee’s interest in the asset, when the
lessee is the insured party, so that the lessee can account for an
appropriate amount of the premium in accordance with other applicable
GAAP.
In circumstances in which the lessee pays insurance
premiums that cover both the lessor’s and lessee’s interest in the
leased asset, lessors are most likely not aware of the actual amount of
the policy premium since a lessee would typically pay a third party
directly. Any amount that a lessee directly pays to a third party on
behalf of the lessor for insurance coverage should be excluded from
variable payments. Further, any amount that a lessee directly pays to a
third party on behalf of itself for insurance coverage would not be a
lessor cost; thus, lessors should never account for such an amount.
Accordingly, lessors should exclude from variable payments, and thus
from lease revenue, the entire insurance premium (provided that the
lessee pays this premium directly to a third party).
Changing Lanes
Lessors Record Revenues
and Expenses on a Gross Basis for Property Taxes and
Insurance When Reimbursed by a Lessee
As discussed above, under ASC 842, property
taxes and insurance (which covers the lessor’s interest in the
asset) do not transfer a good or service to the lessee and are
thus noncomponents of a contract. The consideration in the
contract is not allocated to noncomponents; rather, both the
lessee and the lessor allocate payments for noncomponents to the
lease and nonlease components.
Under ASC 840, lessors often recorded payments
for executory costs (including property taxes and insurance) net
in the income statement, especially when the lessee makes these
payments directly to a third party (e.g., the tax authority),
such as in a triple net lease. That is, lessors do not record
gross revenues for the amounts paid by the lessee and an expense
for the amount of costs they incur. Often, the inflow (revenue)
and outflow (expense) are equal and are thus “netted” down to
zero for presentation in the income statement.
However, under ASC 842, to the extent that the
lessee is reimbursing the lessor’s costs and the lessor is
ultimately paying the third party (as discussed in
Sections 4.3.2.1 and
4.3.2.2), the lessor should recognize
its costs on a gross basis in the income statement as an
expense, as it would for any other costs that it incurs. This is
consistent with how an entity would recognize and present cost
recovery amounts billed to customers in accordance with ASC 606.
(See Sections
14.7.2.2 and C.5.1 of Deloitte’s
Roadmap Revenue Recognition for detailed
discussion of TRG Agenda Paper 2, which addresses the gross or
net presentation of amounts billed to customers.)
This may result in a change from practice under
ASC 840 for many lessors, especially real estate lessors. As a
result, lessors may end up with higher revenues and expenses
than were previously recorded.
That said, under ASC 842, if the lessee is
paying a third party directly on behalf of the lessor, the
lessor should recognize its costs on a net basis in the income
statement (i.e., exclude lessee-paid costs from variable
payments and therefore from lease revenue).
Property Taxes and
Insurance May Inflate the Measurement of the Lease
Liability and ROU Asset
On the basis of the lease accounting guidance in
ASC 840-10-25-1(d), both property taxes and insurance were
considered executory costs. ASC 840-10-15-17 and ASC
840-10-15-19 stated that such costs are considered part of the
lease element and are therefore within the scope of ASC 840.
However, executory costs for property taxes and insurance, and
profits thereon, are excluded from minimum lease payments for
purposes of lease classification (i.e., excluded from the 90
percent test) and the measurement of capital lease obligations
and capital lease assets.
As explained in Sections 4.3.2.1 and
4.3.2.2, property taxes and insurance,
respectively, will be noncomponents under ASC 842. Although
these costs are often variable, any fixed amounts paid by the
lessee for property taxes and insurance will be included in the
consideration in the contract and allocated to the lease and
nonlease components (to the extent that there are nonlease
components in the contract), whereas they are not under ASC 840
guidance. This could potentially result in the following:
-
Increased likelihood that an entity will classify the lease component in the contract as a finance lease when considering the criterion in ASC 842-10-25-2(d), since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance. (The lessee’s classification is discussed in detail in Chapter 8.)
-
Higher lease liabilities and ROU assets, regardless of whether the lease is classified as an operating or finance lease, since there would be at least some allocation, to the lease component, of fixed amounts paid for property taxes and insurance to be included in the initial measurement of the lease.
4.3.2.3 Sales Taxes
In certain tax jurisdictions, lessees are subject to sales,
use, and value-added taxes, etc., in connection with the use of an asset in
a contract that contains a lease. The lessee may pay the taxes directly to
the tax authority, or the contract may state that the lessor will collect
the taxes from the customer and remit the funds to the tax authority.
4.3.2.3.1 Determining Whether Sales Taxes Paid by Lessee Represent Lease Payments
To determine whether the sales taxes represent payments
associated with the contract that contains a lease, a lessee should assess
whether the legal obligation (rather than the stated contract terms
indicating an obligation for the lessee to make a payment) to the tax
authority for the sales taxes resides with the lessee or the lessor.
If the obligation resides with the lessee, the lessee and
lessor should consider such sales tax payments to be separate and apart from
the contract that contains a lease. In this case, sales tax payments would
not represent lease payments to the lessor or a reimbursement of lessor
costs. See Section 4.3.2.3.2 for
considerations related to a lessee’s initial and subsequent accounting for
sales tax payments that are a lessee obligation.
If the obligation10 for the sales taxes resides with the lessor, the sales taxes paid by
the lessee as part of the contract are considered to be payments associated
with the contract that contains a lease. In this case, the lessee is
reimbursing a lessor cost since the tax obligation resides with the lessor.
Like property taxes and insurance, the sales taxes represent noncomponents
under ASC 842, as explained in Sections 4.3.2.1 and 4.3.2.2. Although
these costs are often variable payments, any fixed amounts paid by the
lessee for sales taxes will be included in the consideration in the contract
and allocated to the lease and nonlease components (to the extent that there
are nonlease components in the contract). Fixed sales tax payments may be
less common since a lessee often will reimburse a lessor’s actual sales tax
as incurred (e.g., a pass-through from the lessor to the lessee).
Sales tax determined by applying the sales tax rate to the
gross lease payment (i.e., the rate does not depend on the lessee’s use of
the leased asset)11 is not a variable payment akin to an index or rate.12 Rather, sales tax is akin to real estate or property tax and therefore
is treated as a variable payment that does not depend on an index or rate
(in a manner similar to sales tax imposed on the basis of a lessee’s usage
of the leased asset). Property tax is not deemed to depend on an index or
rate because the tax itself is based on a number of factors, some of which
are not dictated by market conditions. Taxes generally are subject to
governmental policy considerations, and the tax rate is ultimately a
function of the tax base and the revenue needs of the governing body. Since
the revenue needs may change over time (and can increase or
decrease), the tax payments of the lessee do not represent a present
obligation until they are calculated and assessed. Sales taxes are no
different in this regard.
4.3.2.3.2 Accruing Sales Tax Liabilities
When the sales tax obligation resides with the lessee,
as discussed earlier in this section, the lessee could be required to
accrue a sales tax liability before payment. A lessee should accrue a
sales tax liability (separate from the lease liability) if it has an
unavoidable obligation to pay sales tax (whether the payment is
currently due or is payable as of a future date). For example, if a
lessee, upon signing a contract to lease a new vehicle for five years,
is legally obligated to make a sales tax payment of $2,500 that is due
at lease commencement, the lessee has incurred a liability (which must
be recognized) as of the date of contract execution. However, to the
extent that there is potential variability in the amount of sales tax
owed, or if the lessee is not presently obligated to make a payment, the
lessee would not have an unavoidable obligation and therefore would not
recognize a liability.
We believe that, to the extent that a lessee is required
to accrue a sales tax liability, the lessee may treat the sales tax
payments as a capitalizable cost (separate from the ROU asset) in
accordance with ASC 360. We would expect the costs to be capitalized and
expensed over the term to which the sales taxes are related. In the
example above, the $2,500 due to the tax authority would be capitalized
as an asset and expensed on a straight-line basis over five years,
beginning at lease commencement.
4.3.3 Practical Expedients
Although the default model in ASC 842 requires separation of lease and nonlease components, certain practical expedients may be available to entities. Entities electing the practical expedient(s) would not separate lease and nonlease components. Rather, they would account for each lease component and the related nonlease component(s) together as a single component.
4.3.3.1 Lessees
ASC 842-10
15-37 As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.
ASC 842 affords lessees a practical expedient related to separating (and
allocating consideration to) lease and nonlease components. That is, lessees
may elect to account for the nonlease components in a contract as part of
the single lease component to which they are related. The practical
expedient is an accounting policy election that must be made by class of
underlying asset (e.g., vehicles, IT equipment — see the Connecting the Dots
discussion below).
Accordingly, when a lessee elects the practical expedient, any portion of the consideration in the
contract that would otherwise be allocated to the nonlease components will instead be accounted for as
part of the related lease component for classification, recognition, and measurement purposes (lessee
accounting is discussed in detail in Chapter 8). In addition, any payments related to noncomponents
would be accounted for as part of the related lease component (i.e., the associated payments would not
be allocated between the lease and nonlease components).
Connecting the Dots
Magnitude of the Nonlease
Components Does Not Matter
The practical expedient in ASC 842-10-15-37 is available to lessees regardless of the extent or
significance of the nonlease components in the contract. However, in paragraph BC150 of ASU
2016-02, the FASB acknowledges that it would not expect lessees (even though it is allowed) to
elect the practical expedient when the nonlease components in the contract are significant:
The availability of the practical expedient to a lessee is not affected by the relative size of the lease
and the nonlease components. However, given that the result of electing this practical expedient is
to record additional lease liabilities, the Board concluded that lessees will, in general, only elect this
expedient in arrangements with less significant service components.
Paragraph BC150 of ASU 2016-02 further cites the following basis for providing the expedient:
- “[T]he costs and administrative burden of allocating consideration to separate lease and nonlease components may not be justified by the benefit of more precisely reflecting the right-of-use asset and the lease liability,” especially when nonlease components in contracts for which the expedient is elected are not expected to be significant.
- Because nonlease components in contracts for which the expedient is elected are not expected to be significant, “comparability should not be significantly affected as a result of providing this practical expedient.”
When electing the practical expedient to combine lease and nonlease
components, lessees may combine nonlease activities accounted for under
other GAAP (e.g., maintenance) with their related lease components; as a
result, the overall accounting for these activities may be in accordance
with ASC 842. However, in such circumstances, a lessee should carefully
consider whether the nonlease component is truly associated with the leased
asset. Specifically, the lessee should consider whether its ability to use
or derive benefit from the nonlease component is interrelated with that for
the lease component and vice versa.
Example 11, Case B, in ASC 842-10-55-138 through 55-140 (reproduced in Section 4.4.3) illustrates an
application of the practical expedient in ASC 842-10-15-37 to a contract that contains multiple lease
components. Accordingly, Example 11, Case B, also emphasizes an important part of the expedient in ASC 842-10-15-37: lessees may “account for each separate lease component and the nonlease
components associated with that lease component as a single lease component” (emphasis added). That
is, the practical expedient does not allow lessees to not separate lease components from other lease
components in the contract, and the guidance in ASC 842-10-15-28 and 15-29 (see Section 4.2) must
still be applied when a lessee makes the accounting policy election in ASC 842-10-15-37.
Connecting the Dots
Meaning of “Class of
Underlying Asset”
ASC 842 provides lessees with two practical expedients that may be elected as an accounting
policy by “class of underlying asset”:
- ASC 842-10-15-37 allows lessees not to separate lease and nonlease components.
- ASC 842-20-25-2 allows lessees not to recognize lease liabilities and ROU assets for short-term leases. (The short-term lease recognition exemption is discussed in detail in Section 8.2.1.)
However, ASC 842 does not address what is meant by the phrase “class of underlying asset.” We have received a number of questions about this topic from various stakeholders, and two views have emerged:
- View 1 — The class of underlying asset is determined on the basis of the physical nature and characteristics of the asset. For example, real estate, manufacturing equipment, and vehicles would all be reasonable classes of underlying assets given their differences in physical nature. Therefore, irrespective of whether there are different types of similar assets (e.g., within the real estate class, there may be retail stores, warehouses, and distribution centers), the class of underlying asset would be limited to the physical nature as described above.
- View 2 — The class of underlying asset is determined on the basis of the risks associated with the asset. While an asset’s physical nature may be similar to that of other assets (e.g., retail stores, warehouses, and distribution centers are all real estate, as discussed above), each has a different purpose and use to the lessee and would therefore have a separate risk profile. Therefore, for example, it could be appropriate for the lessee to disaggregate real estate assets into separate asset classes by “type” of real estate — to the extent that the different types are subject to different risks — when applying the practical expedients in ASC 842-10-15-37 and ASC 842-20-25-2.
To support their position, proponents of View 2 refer to paragraph BC341 of ASU 2016-02, which states:
The Board decided that a lessor should treat assets subject to operating leases as a major class of depreciable assets, further distinguished by significant class of underlying asset. Accordingly, a lessor should provide the required property, plant, and equipment disclosures for assets subject to operating leases separately from owned assets held and used by the lessor. In the Board’s view, leased assets often are subject to different risks than owned assets that are held and used (for example, the decrease in the value of the underlying asset in a lease could be due to several factors that are not within the control of the lessor), and, therefore, users will benefit from lessors segregating their disclosures related to assets subject to operating leases from disclosures related to other owned property, plant, and equipment. The Board further considered that to provide useful information to users, the lessor should disaggregate its disclosures in this regard by significant class of underlying asset subject to lease because the risk related to one class of underlying asset (for example, airplanes) may be very different from another (for example, land or buildings). [Emphasis added]
Irrespective of the views noted above, we do not think that it would be appropriate to determine the “class of underlying asset” on the basis of the lease contract with which it is associated. For example, we believe that it would be inappropriate to break real estate assets into different classes on the basis of whether they are related to gross leases or triple net leases. In that situation, the asset underlying the contract could be exactly the same while the contract differs. We do not think that approach is consistent with the intent of the guidance in ASC 842-10-15-37 or ASC 842-20-25-2.
4.3.3.2 Lessors
ASC 842-10
15-42A As a practical
expedient, a lessor may, as an accounting policy
election, by class of underlying asset, choose to
not separate nonlease components from lease
components and, instead, to account for each
separate lease component and the nonlease components
associated with that lease component as a single
component if the nonlease components otherwise would
be accounted for under Topic 606 on revenue from
contracts with customers and both of the following
are met:
- The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
- The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.
15-42B A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall account for the combined component:
-
As a single performance obligation entirely in accordance with Topic 606 if the nonlease component or components are the predominant component(s) of the combined component. In applying Topic 606, the entity shall do both of the following:
-
Use the same measure of progress as used for applying paragraph 842-10-15-42A(a)
-
Account for all variable payments related to any good or service, including the lease, that is part of the combined component in accordance with the guidance on variable consideration in Topic 606.
-
-
Otherwise, as an operating lease entirely in accordance with this Topic. In applying this Topic, the entity shall account for all variable payments related to any good or service that is part of the combined component as variable lease payments.
In determining whether a nonlease
component or components are the predominant
component(s) of a combined component, a lessor shall
consider whether the lessee would be reasonably
expected to ascribe more value to the nonlease
component(s) than to the lease component.
15-42C A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall combine all nonlease components that qualify
for the practical expedient with the associated
lease component and shall account for the combined
component in accordance with paragraph
842-10-15-42B. A lessor shall separately account for
nonlease components that do not qualify for the
practical expedient. Accordingly, a lessor shall
apply paragraphs 842-10-15-38 through 15-42 to
account for nonlease components that do not qualify
for the practical expedient.
The practical expedient in ASC 842-10-15-37, under which lessees can elect not to separate lease and nonlease components (see Section 4.3.3.1), was not initially available to lessors. ASC 842, as initially issued by way of ASU 2016-02, required lessors to separate lease and nonlease components in all circumstances. Accordingly, lessors were required to look to the guidance in step 4 of the revenue model in ASC 606 to allocate the consideration in the contract to the separated components. After the consideration is allocated, ASC 842 (including its presentation and disclosure guidance) applies to the lease component and ASC 606 (including its presentation and disclosure guidance) generally applies to the nonlease component. See Section 4.4.2 for further discussion of the guidance on allocating consideration in the contract to lease and nonlease components.
Such separation was required regardless of whether the pattern of transfer to
the customer would be the same (i.e., a straight-line pattern of transfer to
the customer over the same period) when the lease and nonlease components
are separated (see Section 4.4.2.2.2). Accordingly, if
the patterns of transfer are the same, separation and allocation may only
affect presentation and disclosure. For example, this often may be the case
when real estate lessors enter into operating leases of real estate and
provide CAM services to the customer. However, the FASB received stakeholder
feedback indicating that the costs of complying with ASC 842’s separation
and allocation requirements for arrangements in which the pattern of
transfer is the same outweigh the benefits (i.e., when the separation and
allocation guidance only affects presentation and disclosure).
As a result, in July 2018, the FASB issued ASU 2018-11, which provides a practical expedient under which lessors can elect, by class of underlying asset, not to separate lease and nonlease components when certain criteria are met. Therefore, this practical expedient only affects lessors whose lease contracts also include nonlease components that are within the scope of ASC 606 and meet certain criteria (discussed below). If a lessor elects the practical expedient to combine lease and eligible nonlease components, it must evaluate whether the nonlease components in the combined component are predominant to determine whether the combined component should be accounted for under ASC 606 or ASC 842.
Connecting the Dots
Practical Expedient Results
in Greater Alignment Between Lessee and Lessor
Accounting
Unlike lessors, lessees have always been able, under ASC 842, to elect a
practical expedient under which they can choose not to separate (and
allocate consideration to) lease and nonlease components (see ASC
842-10-15-37). ASU 2018-11 aligns the lessor’s accounting for the
separation of lease and nonlease components with that for lessees.
Both lessors (when certain conditions are met) and lessees may now
elect to account for each lease component and the associated
nonlease components in a contract as part of a single component.
Note that this election is an accounting policy election that must
be made by class of underlying asset. (For more information, see the
Connecting the
Dots discussion in Section 4.3.3.1.) However,
lessees do not have the option of accounting for the combined
component under other U.S. GAAP. Instead, a lessee’s combined
component must always be accounted for under ASC 842.
4.3.3.2.1 Criteria for Combining Lease and Nonlease Components
A lessor that elects the practical expedient would not
be required to separate lease and nonlease components (i.e., it would
account for the lease and nonlease components as a combined, single unit
of account), provided that the nonlease component(s) otherwise would be
accounted for under the revenue guidance in ASC 606 and both of the
following conditions are met:
-
Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.13
-
Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
ASC 842-10-15-42C also clarifies that the presence of a
nonlease component that is ineligible for the practical expedient does
not preclude a lessor from electing the expedient for the lease
component and nonlease component(s) that meet the criteria. Rather, the
lessor would account for the nonlease components that do not qualify for
the practical expedient separately from the combined lease and nonlease
components that do qualify.
Connecting the Dots
Assessing Timing and
Pattern of Transfer
In ASU 2018-11, the Board amended Criterion A to
focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer .
. . to the customer over the same time period”) rather than on
the timing and pattern of revenue recognition (as was originally
proposed). The purpose of this amendment was to address concerns
that the originally proposed practical expedient was
unnecessarily restrictive and excluded contracts with variable
consideration from its scope, since variable payments are
accounted for differently under ASC 606 than they are under ASC
842. That is, the pattern of revenue recognition under ASC 606
could differ because estimates of variable consideration are
recognized as revenue under ASC 606 while recognition of revenue
for variable consideration under ASC 842 is restricted until the
variability or contingency is resolved.
4.3.3.2.1.1 Noncoterminous Lease and Nonlease Components
As noted above, ASC 842-10-15-42A allows lessors to
elect, as a practical expedient by class of underlying asset, an
accounting policy of not separating nonlease components from lease
components if (1) the timing and pattern of transfer
for the lease component are the same as those for the nonlease
components associated with that lease component and (2) “the lease
component, if accounted for separately, would be classified as an
operating lease in accordance with paragraphs 842-10-25-2 through
25-3.”14
In some arrangements, a lessee may commit to
purchasing a service (that would be considered a nonlease component)
for only part of the lease term. The lessee may have the option of
renewing the service for an incremental fee over the lease term but
is not contractually committed to do so. Therefore, the period over
which a lessor is contractually required to provide services to a
lessee (that would be a nonlease component) may not span the entire
lease term. That is, in such circumstances, the lease term and the
contractual service period would not be coterminous.
We believe that, in some cases, a lessor can elect
the practical expedient in ASC 842-10-15-42A (i.e., to combine the
nonlease component with the associated lease component) even if the
nonlease component is not coterminous with the lease component.
Specifically, we think that if the separation of the lease component
from the nonlease component would only affect presentation and
disclosure (i.e., the pattern and timing of revenue recognition
would not differ if the nonlease component were accounted for
separately), the lessor can elect the practical expedient to combine
the lease and nonlease component even if the timing of transfer of
the nonlease component is not coterminous with the lease component.
This would generally be the case when the lease and optional
nonlease component(s) are each priced at their stand-alone selling
price and an allocation between components would therefore not be
necessary (i.e., they are not priced at a significant discount in
such a way that a material right within the scope of ASC 606 might
need to be identified) and the timing and pattern of
transfer of the nonlease component are the same as those for the
lease component for the period over which the nonlease component
will be transferred to the lessee.
This view is supported by paragraph BC31 of ASU
2018-11, which states, in part, that “[t]he Board noted that its
objective in providing the practical expedient was to align the
accounting by lessors under the new leases standard more closely
with the revenue guidance.” Further, paragraph BC116 of ASU 2014-09
notes that “Topic 606 would not need to specify the accounting for
concurrently delivered distinct goods or services that have the same
pattern of transfer. This is because, in those cases, an entity is
not precluded from accounting for the goods or services as if they
were a single performance obligation, if the outcome is the same as
accounting for the goods and services as individual performance
obligations.”
On the basis of the Board’s stated objective, we
believe that the practical expedient in ASC 842-10-15-42A can be
applied when the only impact is on presentation and disclosure of
amounts recognized as part of the arrangement (i.e., the pattern and
timing of recognition are the same), provided that the lease
component, if accounted for separately, would be classified as an
operating lease.
Example 4-6
Lessor X enters into a lease
arrangement with Lessee Y for the use of kitchen
space (which is identified as a lease component)
for a noncancelable one-year term. The lease
component, if accounted for separately, would be
classified as an operating lease. The lease
arrangement also includes optional cleaning and
inventory receiving services (nonlease components)
that the lessee can elect to receive from the
lessor on a month-by-month basis. When elected,
the optional services provide the same benefit to
Y each day and will be transferred to the lessee
by using a time-based measure of progress (i.e.,
ratably) over the period in which the services are
made available. Both the lease component and the
optional services (the nonlease component) are
priced at their stand-alone selling price.
Therefore, there is no requirement to reallocate
contractually stated consideration from the lease
component to the nonlease component or vice versa
and the right to purchase the optional services
does not give rise to a material right, as
discussed in ASC 606-10-55-42, that would require
allocation of consideration separately between the
lease and optional nonlease components under ASC
606-10-55-44 and 55-45.
If and when these optional
services are purchased, X would use a time-based
measure of progress to determine the amount of
revenue to recognize from the cleaning and
inventory receiving services because the services
are transferred to the customer ratably over the
elected service term(s). Accordingly, the pattern
and timing of transfer of the optional services
for the monthly period elected are the same as
those for the kitchen space (the lease component).
Although the lessor is not
contractually required to provide optional
services over the entire lease term (i.e., the
noncancelable one-year term of the lease
arrangement), the pattern of transfer for the
services will be the same as that for the lease
component for the periods in which they are
provided. Also, as mentioned above, the optional
services are priced at their stand-alone selling
prices and do not give rise to a material right
that would require separate allocation of
consideration to the lease and nonlease
components. Consequently, X concludes that the
separation of the nonlease component from the
lease component would only affect presentation of
revenue recorded and disclosure (i.e., the timing
and pattern of revenue recognized would not differ
if the nonlease component were accounted for
separately). Therefore, X can apply the practical
expedient in ASC 842-10-15-42A to combine the
lease component and nonlease component for the
periods in which Y exercises its right to receive
the optional cleaning and inventory receiving
services.
Once an entity has determined whether an arrangement
would qualify for the lessor practical expedient, the entity must
assess whether the lease component or nonlease component is the
predominant element in the arrangement (see Section
4.3.3.2.2 for more information).
4.3.3.2.1.2 Effects of the Practical Expedient on Supplier (Lessor) Accounting
The practical expedient will most likely provide
significant relief to certain lessors that are implementing ASC 842.
When discussing the expedient at the FASB’s November 29, 2017,
meeting, several Board members pointed out that certain real estate
lessors would be allowed to apply ASC 842 in a manner consistent
with how entities are permitted to apply ASC 606 when distinct goods
or services are delivered concurrently and have the same pattern of
transfer to the customer. Paragraph BC116 of ASU
2014-09 clarifies that, in such cases, entities
are not precluded from accounting for, and recognizing revenue from,
the goods and services as if they were a single performance
obligation.
The examples below illustrate situations in which
the practical expedient may provide relief to certain lessors
implementing ASC 842. In these examples, assume that the nonlease
component would otherwise be accounted for in accordance with ASC
606 and that the lease component, if accounted for separately, would
be an operating lease.
Example 4-7
In a common real estate lease
arrangement (e.g., a lease of floors in an office
building), a lessor may also provide CAM services
to the lessee. That is, in such an arrangement,
the contract between the seller-lessor and the
customer-lessee may include two separate
components: (1) the right to use space (the lease
component) and (2) maintenance services (the
nonlease component). The lessor may perform the
CAM services on an as-needed basis (e.g., cleaning
the building lobbies, performing minor repairs,
maintaining elevators); therefore, the maintenance
services would be recognized as revenue ratably
over the same period as that in which the leased
floors are used. When elected, the practical
expedient would allow the lessor to account for
such a contract — which provides a lease and
related CAM services — as containing a single
component, as would be permitted for any other
revenue-generating activity (e.g., two
concurrently delivered services, each of which a
purchaser could elect to buy, with or without the
other). This alignment with ASC 606 is consistent
with how the Board describes the leasing
activities of lessors (i.e., as revenue-generating
activities) in paragraphs BC92 and BC153 of ASU
2016-02.
Example 4-8
In a common vehicle lease
arrangement, a lessor may agree to offer the
customer, in addition to the lease, roadside
assistance services on a stand-ready basis as well
as participation in a loyalty program. As members
of the loyalty program, customers earn points for
each purchase and can thereby obtain future
discounts or free car rentals. In such an
arrangement, the seller-lessor is providing the
customer-lessee with three things: (1) the right
to use the car (the lease component), (2) roadside
assistance as a stand-ready service (a nonlease
component), and (3) a material right representing
the future discounts offered as part of the
loyalty program (a nonlease component). In this
scenario, it may be reasonable to conclude that
the timing and pattern of transfer for the vehicle
lease are the same as those for the roadside
assistance services; however, the timing and
pattern of transfer associated with the loyalty
program are unlikely to be the same as those for
the others. Under ASU 2018-11, the lessor would be
allowed to apply the practical expedient to
combine the lease component and nonlease component
for the roadside assistance (i.e., the eligible
nonlease component) while separating the nonlease
component for the loyalty program that is
ineligible for the practical expedient and
accounting for it in accordance with ASC 606.
Example 4-9
In certain arrangements,
customers are provided with a monitoring service
(i.e., a nonlease component) and a connected
monitoring device (i.e., a lease component) for
delivering the service. The lease and nonlease
component may have the same timing and patterns of
transfer (e.g., when the lease component is an
operating lease and the nonlease component
represents a continuous monitoring service). A
lessor may apply the practical expedient to
combine the components into a single component
accounted for under ASC 842 or ASC 606, depending
on whether the lease or nonlease component is
predominant (see Section
4.3.3.2.2).
Note that unlike the lessee practical expedient,
which is available for all contracts, the lessor practical expedient
related to combining lease and nonlease components can only be
elected when certain conditions are met. For example, the practical
expedient cannot be applied to arrangements in which the patterns of
transfer for the lease and nonlease components would not be the
same. Therefore, lessors that enter into lease arrangements with
revenue components that are transferred at a point in time (e.g.,
sales of equipment or other goods) will not be eligible for the
relief from allocation between the lease and revenue component(s).
Although constituents raised some concerns about allocation in these
ineligible contracts, the Board did not address allocation by
lessors that may be struggling to determine the appropriate
stand-alone selling prices for the lease and nonlease components in
such arrangements. Therefore, such entities will need to continue
developing processes for estimating stand-alone selling prices in
accordance with ASC 606 so that the consideration in the contract
can be allocated to lease and nonlease components.
4.3.3.2.2 Determining Which Component Is Predominant
As with the lessee practical expedient, the FASB originally proposed that a lessor should always be
required to account for the combined component as a lease under ASC 842. However, on the basis of
feedback it received, the Board revised the final ASU to require an entity to perform another evaluation
to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as
a revenue component under ASC 606. Specifically, an entity should determine whether the nonlease
component (or components) associated with the lease component is the predominant component of
the combined component. If so, the entity is required to account for the single, combined component in
accordance with ASC 606. Otherwise, the entity must account for the single, combined component as an
operating lease in accordance with ASC 842.
Connecting the Dots
An Entity Will Need to
Use Judgment to Determine the Predominant
Component
As indicated in the Background Information and Basis for Conclusions of ASU
2018-11, the FASB decided not to include a separate definition
or threshold for determining whether “the nonlease component is
the predominant component in the combined component.”
Rather, the Board noted that an entity should consider whether
the lessee would “ascribe more value to the nonlease
component(s) than to the lease component.” Further, the Board
acknowledged that the term “predominant” is used elsewhere in
U.S. GAAP, including ASC 84215 and ASC 606.16
The Board also explained that it does not expect that an entity will need to
perform a quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine, on a qualitative basis, whether to apply ASC 842 or ASC 606. Therefore, we expect that entities will need to use judgment in making this determination.
At its March 28, 2018, meeting, the Board discussed a scenario in which the
components were evenly split (e.g., a 50/50 split of value) and
suggested that, in such circumstances, the combined component
should be accounted for under ASC 842 because the nonlease
component is not predominant. That is, the entity would need to
demonstrate that the predominant element is the nonlease
component; otherwise, the combined unit of account would be
accounted for as a lease under ASC 842.
We believe that the final language in the ASU is intended to indicate that an entity would need to determine whether the lease or nonlease component (or components) is larger (i.e., has more value); only when the nonlease component is larger should the combined component be accounted for under ASC 606.
In discussions with the FASB staff, we confirmed that an entity needs to look at
which component has more value, not significantly more
value. In a quantitative analysis, “more value” would constitute
more than 50 percent. For example, when the value of the
nonlease component is 51 percent and the value of the lease
component is 49 percent, the nonlease component would be the
predominant component. However, the FASB staff indicated that it
generally expects that entities will be able to make this
determination qualitatively. We also confirmed that the language
“ascribe more value to the nonlease component(s) than to the
lease component” intentionally excludes the wording “ascribe
significantly more value to the license” from ASC 606-10-55-65.
Accordingly, we believe that, to be predominant, the nonlease
component only needs to be larger (not significantly
larger) than the lease component.
The examples below illustrate the determination of the predominant component in a contract. In these examples, assume that the arrangement would qualify for the lessor practical expedient on the basis of the criteria in ASC 842-10-15-42A (outlined above).
Example 4-10
A lessor leases three floors of an office building to a lessee for a fixed
annual lease payment that includes payment for CAM
activities performed by the lessor (e.g., cleaning
the building lobbies, maintaining elevators). The
three floors represent a lease component (see
Section 4.2), and the CAM is a
nonlease component (see Section
4.3.1). The CAM (nonlease component)
represents approximately 10 percent, and the lease
component approximately 90 percent, of the
contract value. In addition, the maintenance
services are not specialized or customized and the
lessee entered into the lease primarily because of
the location of the office space. Therefore, the
lease component would be considered the
predominant component, since the lessee would be
expected to ascribe more value to the lease
component. As a result, if the practical expedient
is elected for this class of underlying asset, the
entire arrangement would be accounted for as an
operating lease in accordance with ASC 842.
Example 4-11
An entity enters into an arrangement to provide a monitoring service that
requires the use of a monitoring device (hardware)
that tracks data and remits the data back to the
service provider. In this example, assume that the
arrangement for the monitoring service has been
identified as containing a lease. The connected
device provided to the customer is considered a
lease component, and the monitoring service is a
nonlease component. The connected device
(hardware) represents 2 percent of the contract
value, and the service (nonlease component)
represents 98 percent of the contract value.
Further, the outputs of the service (i.e.,
security alerts and monitoring reports obtained
from the data provided by the monitoring device)
were what the customer intended to obtain by
entering into the arrangement. Therefore, the
nonlease component would be considered the
predominant component, since a lessee (customer)
would be expected to ascribe more value to the
nonlease component. In this case, if the seller
(lessor) elects the practical expedient, the
entire arrangement would be accounted for as a
revenue arrangement in accordance with ASC
606.
Example 4-12
An entity may enter into an arrangement to provide tenants with accommodations (i.e., the lease component)
in a health care or retirement community as well as health care services (i.e., the nonlease component). These
arrangements vary (e.g., skilled nursing facilities), and the service component in certain arrangements may
provide more value to the customer-lessee than it does in other arrangements (e.g., independent living facilities
that may function more as apartment complexes). Therefore, it may not be clear whether the lessee would
ascribe more value to the lease or nonlease component(s). An entity would be required to use judgment in
making this determination. If the entity determines that the nonlease component represents a larger portion
of the value of the contract (i.e., more than 50 percent), the nonlease component (i.e., the health care services)
would be considered the predominant component and, if the practical expedient is elected, the entire arrangement would be accounted for in
accordance with ASC 606. Alternatively, if the lessor determines that a lessee would ascribe more value to the
lease component (i.e., the accommodations), the lease component would be the predominant component and, if the practical expedient is elected,
the entire arrangement would be accounted for as an operating lease in accordance with ASC 842.
Connecting the Dots
Accounting for Variable
Payments Should Be Consistent With That for the Combined
Component
ASU 2018-11 includes language related to the interaction between the practical expedient and
the guidance in (1) ASC 842-10-15-39 on consideration in the contract and (2) ASC 842-10-
15-40 on the recognition of variable payments. Specifically, ASC 842-10-15-42B(a)(2) clarifies
the Board’s intent that the accounting for variable payments should be consistent with that for
the combined component. That is, when the combined component is accounted for as a lease
under ASC 842, there are no longer any nonlease (revenue) variable payments; rather, there are
only variable payments related to the combined lease component, and that variability should be
accounted for in accordance with ASC 842. Conversely, if the combined component is accounted
for as a service under ASC 606, all variable payments related to the combined component
should be accounted for in accordance with the guidance in ASC 606 on variable consideration.
That is, an entity would be required to estimate the variable consideration and constrain such
estimates in accordance with the guidance in ASC 606-10-32-11.
The flowchart below summarizes when a lessor may apply the practical expedient related to not
separating lease and nonlease components in a contract as well as the required accounting for the
combined component when the election is made.
See Sections 15.3.2.4 and 16.4.6 for further discussion of the disclosure and transition requirements,
respectively, related to the lessor practical expedient.
Footnotes
6
In July 2018, the FASB issued ASU 2018-11,
which includes a practical expedient that allows lessors, when certain
conditions are met, not to separate lease and nonlease components. Lessors
availing themselves of this practical expedient would not account for
affected nonlease components separately. See Sections 4.3.3.2 and 17.3.1.4.2 for
further discussion.
7
See footnote 6.
8
See footnote 6.
9
As discussed in Section 4.3.3.1, lessees can elect
a practical expedient by asset class to combine lease and nonlease
components into a single component. A similar practical expedient is
available to lessors by asset class as long as certain criteria are met
(see Section
4.3.3.2). When this practical expedient is elected, any
consideration that would otherwise be allocated to the nonlease
components, such as payments for noncomponents described in this
section, will instead be accounted for as part of the related lease
component or the predominant revenue component for lessors. In other
words, if the practical expedient is elected, no allocation between
lease and nonlease components is necessary.
10
While this discussion focuses on lessees, in
December 2018, the FASB issued ASU 2018-20, which makes
narrow-scope improvements to the accounting for lessors. Under the
ASU’s amendments, lessors are allowed to elect, as an accounting
policy, to analogize to the guidance in ASC 606 on presenting sales
taxes collected from lessees on a net basis. See Section
4.4.2.1.2 for more information about the ASU.
11
Note that sales tax imposed on the basis of a
lessee’s usage of a leased asset would also be deemed a variable
lease payment that does not depend on an index or rate.
12
The guidance in Section 4.3.2.3.1 is only
applicable if sales tax is determined to be an obligation of the
lessor.
13
Importantly, not all over-time
performance obligations will qualify for the
practical expedient. Lessors should consider the
measure of progress used to recognize revenue
related to the nonlease component when assessing the
condition in ASC 842-10-15-42A(a).
14
Upon adoption of ASU 2021-05, an entity
should apply the guidance in ASC 842-10-25-2 through 25-3A
to evaluate the lease classification.
15
ASC 842-10-25-5 states that “an entity
shall consider the remaining economic life of the
predominant asset in the lease component” to determine
the classification when multiple underlying assets
comprise a single lease component.
16
ASC 606-10-55-65A allows entities to use
the sales-based and usage-based royalty exception to
estimating variable consideration when “a license of
intellectual property is the predominant item to which
the royalty relates (for example, the license of
intellectual property may be the predominant item to
which the royalty relates when the entity has a
reasonable expectation that the customer would ascribe
significantly more value to the license than to the
other goods or services to which the royalty
relates).”
17
Although an entity must apply the practical
expedient to all eligible nonlease components, the presence of a
nonlease component (or components) that is ineligible for the
practical expedient does not preclude a lessor from applying the
practical expedient to the eligible components.
4.4 Determining and Allocating Consideration in the Contract
At this point, entities have identified their separate lease and
nonlease components to which consideration in the contract
will be allocated. Noncomponents have also been identified to
ensure that the consideration in the contract is not allocated to
them.
Next, entities must:
- Determine the consideration in the contract.
- Allocate the consideration in the contract to the separate lease and nonlease components.
The remainder of this section will discuss the requirements related to measuring and allocating the
consideration in the contract for lessees (Section 4.4.1) and lessors (Section 4.4.2). The following matrix
summarizes those requirements.
Lessee | Lessor | |
---|---|---|
Determining the consideration in the contract | Includes:
| Includes:
|
Allocating the consideration in the contract to lease and nonlease components | When practical expedient is elected, no allocation is performed (see Section 4.3.3.1). | When practical expedient is elected for eligible nonlease components, no allocation is performed (see Section 4.3.3.2). |
When practical expedient is not elected, allocate on the basis of:
| When practical expedient is not elected, allocate on the basis of stand-alone
selling price in accordance with ASC 606 (see Chapter
7 of Deloitte’s Roadmap Revenue
Recognition). |
Connecting the Dots
Allocating Zero to a Component
In limited circumstances, it may be appropriate for a lessee
or lessor to allocate none of the consideration in the contract to a
component in a contract (i.e., on the basis of a stand-alone price of zero).
As discussed in the Connecting the Dots in Section 4.3.1, nonlease components
do not need to be “distinct” (i.e., in accordance with ASC 606) to be
separated from the lease component. The first criterion in ASC 606 that a
promised good or service must meet to be distinct is that it must be capable
of being distinct — that is, it must have stand-alone value (see Chapter 5 of
Deloitte’s Roadmap Revenue Recognition). Therefore, because a
nonlease component is separated from a lease component if it transfers a
good or service to the lessee (as opposed to a good or service that is
distinct and thus must have stand-alone value), it could be reasonable to
conclude that the lease component or nonlease component does not have value
on its own and thus has a stand-alone price of zero. However, we think that
these situations will be rare and that any such conclusions will be met with
skepticism. We encourage entities that identify such situations to consult
with their accounting advisers.
4.4.1 Lessee
ASC 842 contains all of the guidance for lessees on determining and allocating the consideration in the
contract. That is, unlike the requirements for lessors, the guidance for lessees does not refer to ASC
606 or any other GAAP. Paragraph BC156 of ASU 2016-02 addresses the FASB’s reasoning behind its
construction of the guidance with respect to allocation:
The allocation guidance for lessees in Topic 842 does not reference other Topics; the Board decided that it will
be less complex and more intuitive for lessees to include the allocation guidance within the leases Topic. The
Board also decided that having lessees apply the revenue recognition guidance in Topic 606 (as is the case for
lessors) does not make conceptual sense because a lessee is the customer in a lease rather than the supplier.
The sections below further lay out the guidance for lessees on determining and allocating the
consideration in the contract.
Connecting the Dots
Timing of Measurement and
Allocation of the Consideration in the Contract
ASC 842 does not provide guidance for lessees on the timing of measurement of the
consideration in the contract when a nonlease component begins before the commencement
date of the lease.
For example, assume that a lessee enters into a contract commencing on December
1, 20X0, in which the lessor provides (1) the right to use a warehouse
and land and (2) landscaping services to the property. The lease also
contains a renewal option. The landscaping services are set to begin one
month before the lease commencement date. Accordingly, the lessee should
begin recognizing expense associated with the nonlease component for the
landscaping services on November 1, 20X0.
However, under ASC 842, it is not clear what amount the lessee in this case should recognize
as expense for the landscaping services. This is because payments under the contract begin on
lease commencement, the lease component(s) is (are) not measured until the commencement
date of the lease, and the determination of whether the lessee is reasonably certain to exercise
the renewal option would not take place until the commencement date of the lease.
Generally, we think that the lessee in this case should make a preliminary
estimate and allocation of the consideration in the contract at the time
at which the entity should begin to recognize expense for the nonlease
component (i.e., on November 1, 20X0). Accordingly, at that time, the
lessee should also assess, on a preliminary basis, the likelihood of
exercising the renewal option.
On the commencement date of the lease, the lessee’s initial estimate and
allocation of the consideration in the contract as of November 1, 20X0,
should be trued up to the actual measurement and allocation of the
consideration in the contract as of December 1, 20X0.
4.4.1.1 Determining the Consideration in the Contract
ASC 842-10
15-35 The consideration in the contract for a lessee includes all of the payments described in paragraph 842-10-30-5, as well as all of the following payments that will be made during the lease term:
- Any fixed payments (for example, monthly service charges) or in substance fixed payments, less any incentives paid or payable to the lessee, other than those included in paragraph 842-10-30-5
- Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.
The consideration in the contract measured by a lessee will largely comprise the lease payments determined in accordance with ASC 842-10-30-5. (The determination of lease payments is discussed in detail in Chapter 6.) These are the payments made by the lessee for the right to use the underlying asset (i.e., for the lease component).
However, to reflect all fixed payments and ensure an appropriate allocation between the lease and nonlease components, a lessee must also do the following in measuring the consideration in the contract:
- Add any fixed or in-substance fixed payments made during the lease term that are related to a nonlease component (in-substance fixed payments should be considered the same as when the lease payments are determined in accordance with ASC 842-10-30-5 — see Section 6.2.1).
- Add any variable payments related to a nonlease component that are based on an index or rate by using the index or rate as of lease commencement.
- Subtract any incentives paid or payable to the lessee that are related to a nonlease component (i.e., other than incentives reflected in the lease payments, in accordance with ASC 842-10-30-5).
The lessee does not include variable payments that are not based on an index or rate (i.e., that are based on performance or usage), regardless of whether they are related to the lease or nonlease component, in the measurement of the consideration in the contract. Paragraph BC162 of ASU 2016-02 explains that such variable payments are excluded from the consideration in the contract for the following reasons:
- Doing so “aligns the accounting for variable payments for nonlease components with the Board’s decision on the accounting for variable lease payments.”
- “[I]t would be costly and complex to require lessees to estimate variable payments for nonlease components included in a contract that contains a lease,” especially when customers “generally are not required to estimate variable payments for similar nonlease components that do not include a lease.”
The graphic below summarizes the guidance in ASC 842-10-15-35.
The example below illustrates how a lessee would apply the guidance in ASC
842-10-15-35. (Note that the lessor’s determination of the consideration in
the contract for the example below is illustrated in Example 4-18.)
Example 4-13
Case A
Lessee and Lessor enter into a five-year vehicle lease of an open-wheel race car in which Lessor will also
perform maintenance and repair services on the race car. Accordingly, Lessee concludes that there are two
components in the contract:
- A lease component for the right to use the underlying asset.
- A nonlease component for the maintenance and repair services.
Lessee will pay a fixed monthly payment of $2,000 over the five-year lease. Lessee will pay an additional $500
for each month in which the vehicle is driven the minimum mileage.
Lessee determines that the consideration in the contract is $120,000 (i.e., $2,000 per month × 12 months
per year × 5 years). The additional $500 monthly fee is variable: it does not depend on an index or rate and is
based on usage or performance. Therefore, this fee is excluded from the consideration in the contract.
Lessee will allocate the $120,000 to the components in the contract.
Case B
Assume the same facts as in Case A, except that the additional fee is the greater of (1) $500 for each month
in which the vehicle is driven the minimum mileage or (2) $15,000 total. Also, once Lessee has driven the
minimum mileage for nine months within a single calendar year, Lessor agrees to pay Lessee $100 for each
additional month of the year in which Lessee drives the minimum mileage (i.e., for a maximum possible
incentive of $300 each year).
Lessee determines that the consideration in the contract is $135,000 (i.e., $120,000, determined in the same
manner as in Case A, plus an in-substance fixed payment of $15,000). The incentive is variable: it does not
depend on an index or rate and is based on usage or performance. Therefore, the incentive is excluded from
the measurement of the consideration in the contract.
Lessee will allocate the $135,000 to the components in the contract.
Common arrangements for which lessees will need to determine (and allocate) the consideration in
the contract include gross and triple net leases of real estate. In a typical gross lease, the lessee pays a
single fixed payment that covers rent, property taxes, insurance, and CAM. Alternatively, in a typical triple
net lease, the lessee pays a single fixed payment for rent but reimburses (or pays directly to a third party
on behalf of) the lessor for the lessee’s share of property taxes, insurance, and CAM. That is, in a triple
net lease, payments for property taxes, insurance, and CAM are generally variable.
The example below illustrates how a lessee would determine the consideration in
the contract in both a gross and a triple net lease of real estate. (Note
that the allocation of the consideration in the contract determined in the
example below is illustrated in Example 4-15.)
Example 4-14
Case A — Gross Lease of Real Estate
Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:
- Lease term: 5 years.
- Fixed annual lease payment: $85,000.
- Property taxes and insurance on Lessor’s interest in the building: included in the fixed annual lease payment.
- CAM: included in the fixed annual lease payment.
Lessee determines that the contract contains the following components:
- A lease component for the right to use the building.
- A nonlease component for the CAM.
In addition, Lessee determines that the consideration in the contract is $425,000 ($85,000 annual lease payment × 5 years).
Case B — Triple Net Lease of Real Estate
Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:
- Lease term: 5 years.
- Fixed annual lease payment: $60,000.
- Property taxes and insurance on Lessor’s interest in the building: reimbursed costs, estimated to be $5,000 annually.
- CAM: estimated to be $20,000 annually.
Lessee agrees to reimburse Lessor for actual property taxes, insurance, and CAM and determines that the contract contains the following components:
- A lease component for the right to use the building.
- A nonlease component for the CAM.
In addition, Lessee determines that the consideration in the contract is $300,000 ($60,000 annual lease payment × 5 years).
Note that in both Case A and Case B in the example above and in a manner
consistent with the guidance in Sections 4.3.2.1 and
4.3.2.2, the property taxes and the insurance that
protects the lessor’s interest in the asset will be (1) noncomponents, (2)
part of the consideration in the contract, and (3) allocated to the
components in the contract.
4.4.1.2 Allocating the Consideration in the Contract
ASC 842-10
15-33 A lessee shall allocate (that is, unless the lessee makes the accounting policy election described in
paragraph 842-10-15-37) the consideration in the contract to the separate lease components determined in
accordance with paragraphs 842-10-15-28 through 15-31 and the nonlease components as follows:
- The lessee shall determine the relative standalone price of the separate lease components and the nonlease components on the basis of their observable standalone prices. If observable standalone prices are not readily available, the lessee shall estimate the standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain.
- The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the nonlease components of the contract.
Initial direct costs should be allocated to the separate lease components on the same basis as the lease
payments.
15-34 A price is observable if it is the price that either the lessor or similar suppliers sell similar lease or
nonlease components on a standalone basis.
ASC 842-10-15-33 requires lessees to allocate the consideration in the contract to the lease and
nonlease components (and initial direct costs to the separate lease components) on the basis of the
relative stand-alone price. The notion of the relative stand-alone price in ASC 842-10-15-33 thus creates
a hierarchy for determining the basis of allocation:
- If observable stand-alone prices are readily available for the lease and nonlease components, they must be used.
- If observable stand-alone prices are not readily available for some or all of the lease and nonlease components, such prices may be estimated. However, estimates of the stand-alone prices must maximize the use of observable inputs.
- If observable stand-alone prices are not readily available for some of the lease and nonlease components, those prices are highly variable or highly uncertain, and some lease and nonlease components have observable stand-alone prices, a residual estimation approach may be used. However, a residual estimation method should still maximize the use of observable inputs.
In addition, if the lessee uses an estimation method to establish the stand-alone price of a lease or
nonlease component, it should use that approach consistently in similar circumstances (e.g., in all similar
cases in which the lessee is determining the stand-alone price of CAM in a certain market).
Connecting the Dots
Lessee Allocation Guidance Is
Similar to Step 4 of the Revenue Recognition
Model
In developing the hierarchy in ASC 842-10-15-33(a) for determining the relative stand-alone
price, the FASB created an allocation method for lessees that is broadly consistent with the
concepts entities use to allocate the transaction price to performance obligations under ASC
606. The Board acknowledges this in paragraph BC156 of ASU 2016-02, which states, in part:
[T]he allocation guidance for lessees is similar to that for lessors and also is broadly consistent
with that in previous GAAP, although some additional rigor has been added to the process for
determining the standalone price of a lease or nonlease component. That is, the Board decided that
in determining the standalone price of lease and nonlease components of the contract, a lessee is
required to use observable standalone prices, if available, before using an estimated standalone price.
[Emphasis added]
ASC 842-10-20 defines the stand-alone price as the “price at which a customer would purchase a component of a contract separately.” ASC 842-10-15-34 clarifies that a stand-alone price is observable if the lessor or similar suppliers would charge this price to sell the lease or nonlease component separately.
Connecting the Dots
Considerations Related to
Estimating the Stand-Alone Price of the Lease Component and
Inputs to Be Used
A lessee that cannot find an observable stand-alone price for a lease component will need to use judgment in estimating this price. Management should consider similar leased assets available in the marketplace and refer to the terms of similar lease contracts as well as the purchase price of comparable assets. Comparable assets do not need to be identical to the underlying asset in the lease component, provided that the lease component is not of a specialized nature. Products or services available from comparable suppliers with similar inputs into the lease contract, such as price, payment structure, lease term, renewal options, and purchase options, can be useful data points.
If no observable information is available for a leased asset (e.g., when an asset is unique to a supplier), a lessee may want to obtain information from the supplier on how prices are established in such arrangements.
The examples below illustrate the guidance in ASC 842-10-15-33 and 15-34 on the
lessee’s allocation of the consideration in the contract.18 Note that, in these examples, it is assumed that the lessee has not
elected the practical expedient in ASC 842-10-15-37 (see Section 4.3.3.1).
Example 4-15
Case A — Gross Lease of Real Estate
The facts below are consistent with Example 4-14,
Case A.
Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:
- Lease term: 5 years.
- Fixed annual lease payment: $85,000.
- Property taxes and insurance: included in the fixed annual lease payment.
- CAM: included in the fixed annual lease payment.
Lessee determines that the contract contains the following components and consideration:
- A lease component for the right to use the building.
- A nonlease component for the CAM.
- Consideration in the contract of $425,000 ($85,000 annual lease payment × 5 years).
The facts below are unique to Case A in this example.
Lessee determines that the stand-alone prices of the lease and nonlease components are as follows:
- Lease component, in which the lessee includes an estimate of property taxes and insurance: $325,000 ($65,000 annual payment × 5 years).
- Nonlease component: $100,000 ($20,000 annual payment × 5 years).
The lessee allocates the consideration in the contract ($425,000) to the lease and nonlease components as
follows:
Case B — Triple Net Lease of Real Estate
The facts below are consistent with Example 4-14,
Case B.
Lessee enters into a lease to rent a building from Lessor. The contract has the following terms:
- Lease term: 5 years.
- Fixed annual lease payment: $60,000.
- Property taxes and insurance: estimated to be $5,000 annually.
- CAM: estimated to be $20,000 annually.
Lessee contractually agrees to reimburse Lessor for Lessee’s share of actual property taxes, insurance, and
CAM.
Lessee determines that the contract contains the following components and consideration:
- A lease component for the right to use the building.
- A nonlease component for the CAM.
- Consideration in the contract of $300,000 ($60,000 annual lease payment × 5 years).
The facts below are unique to Case B in this example.
Lessee determines that the stand-alone prices of the lease and nonlease components are as follows:
- Lease component, in which the lessee includes an estimate of property taxes and insurance: $325,000 ($65,000 annual payment × 5 years).
- Nonlease component: $100,000 ($20,000 annual payment × 5 years).
The lessee allocates the consideration in the contract ($300,000) to the lease and nonlease components as
follows:
While the CAM is estimated to be $20,000 annually, payments for CAM are variable and are therefore not
included in the consideration in the contract. The same can be said for the estimated property taxes and
insurance of $5,000 annually.
A portion of the fixed consideration in the lease is allocated up front to the nonlease component on the basis of the stand-alone price of the CAM. Thereafter, as variable payments for CAM, property taxes, and insurance are incurred, they will be allocated to the lease and nonlease components on the same basis as the fixed consideration (i.e., 76.47 percent to the lease component as variable lease payments and 23.53 percent to the nonlease component as variable payments for CAM) when they are recognized in the income statement (see Chapter 8 for discussion of a lessee’s recognition of variable lease payments). If the lessee’s estimates of the stand-alone prices for the lease and nonlease components turn out to be accurate, then by the end of the lease, a total of $325,000 will be allocated to the lease component and a total of $100,000 will be allocated to the nonlease component. However, unlike ASC 606’s variable consideration allocation guidance in ASC 606-10-32-39 through 32-41 (which the lessor may consider — see Section 4.4.2.2), ASC 842 does not establish a basis for the lessee to allocate variable consideration entirely to one or more, but not all, components in a contract.
Note that in the example above, the lessee’s estimates of the stand-alone price
are consistent with the pricing in the contract, most evidently in Case A.
This indicates that the contracts in the example above are effectively
priced at fair value, with no discount on either the lease or nonlease
component. The example below illustrates a different scenario.
Example 4-16
Lessee enters into a five-year lease (a gross lease) of a building from Lessor under which Lessee must make a fixed annual lease payment of $35,000 (payments total $175,000 over the five-year term). In accordance with the terms of the contract, the $35,000 annual payment comprises $20,000 for building rent, $7,000 for CAM, $5,000 for property taxes, and $3,000 for insurance that protects Lessor’s interest in the building. From Lessee’s perspective, the estimated stand-alone price of the right to use the building (including an estimate for taxes and insurance) is $30,000 per year, and the estimated stand-alone price of the CAM is $8,000 per year.
In evaluating the separate components in the contract, Lessee would need to determine what goods and services are being provided in the contract, which may include both lease and nonlease components. In this contract, the primary good or service is the right to use the building and is considered a lease component. In addition, the contract requires Lessor to provide CAM, which represents a nonlease component.
As part of the $35,000 fixed annual lease payment, Lessee also pays Lessor consideration attributable to property taxes and insurance. However, in accordance with ASC 842-10-15-30, those payments would not be considered separate components (either lease components or nonlease components), since each fee is a reimbursement of Lessor’s costs. Therefore, despite requiring the payment of four separately described fees in the contract, the arrangement includes only two components. The total fees of $35,000 must be allocated between the two identified goods and services representing the lease component and the nonlease component.
As a result, Lessee allocates the consideration in the contract ($175,000) as follows:
On the basis of Lessee’s estimate of the stand-alone prices for the lease and nonlease components, the
contract contains a discount of $15,000 ($190,000 total stand-alone price – $175,000 total consideration). The
lessee allocation method in ASC 842-10-15-33 therefore results in the allocation of that discount between
both the lease component, the building (i.e., $15,000 × 78.95% = $11,842), and the nonlease component, the
CAM (i.e., $15,000 × 21.05% = $3,158). Unlike ASC 606’s discount allocation guidance in ASC 606-10-32-36
through 32-38 (which the lessor would consider when allocating a discount — see Section 4.4.2.2), ASC 842
does not establish a basis for the lessee to allocate a discount in a contract entirely to one or more, but not all,
components in a contract.
4.4.1.3 Remeasure and Reallocate the Consideration in the Contract
ASC 842-10
15-36 A lessee shall remeasure and reallocate the consideration in the contract upon either of the following:
- A remeasurement of the lease liability (for example, a remeasurement resulting from a change in the lease term or a change in the assessment of whether a lessee is or is not reasonably certain to exercise an option to purchase the underlying asset) (see paragraph 842-20-35-4)
- The effective date of a contract modification that is not accounted for as a separate contract (see paragraph 842-10-25-8).
Certain events trigger the need for a lessee to remeasure and reallocate the consideration in a contract
to the various lease and nonlease components:
- Remeasurement of the lease liability — The lease liability must be remeasured when the lease payments change. This could be due to changes in (1) the lease term, (2) information about whether a lessee will exercise a purchase option, (3) amounts that it is probable the lessee will owe under a residual value guarantee, or (4) the resolution of a contingency in such a way that some (or all) of the variable lease payments that will be paid over the remainder of the lease term become fixed. Remeasurement of lease payments is discussed in detail in Section 6.10, while the lessee’s accounting for a remeasurement of its lease liability is addressed in Section 8.5.
- Lease modifications not accounted for as a separate contract — For lease modifications that do not meet the criteria to be accounted for as a separate contract, the remaining consideration in the contract must be remeasured and reallocated upon the effective date of the modification. A modification that is not accounted for as a separate contract may (1) grant the lessee an additional right of use, (2) extend the term of the lease, (2) reduce the term of the lease, (3) fully or partially terminate the lease, or (4) change the consideration in the contract. A lessee’s accounting for lease modifications is discussed in detail in Section 8.6.
4.4.2 Lessor
The requirements under which a lessor determines and allocates the consideration in the contract are housed partially in ASC 842 and partially in ASC 606:
- Determining the consideration in the contract — A lessor measures the consideration in the contract in the same manner as a lessee (i.e., in accordance with ASC 842-10-15-35 — see Section 4.4.1.1). A lessor must also measure certain variable consideration in accordance with the guidance in step 3 of the revenue recognition model in ASC 606. (See the next section.)
- Allocating the consideration in the contract — A lessor allocates the consideration in the contract in accordance with the guidance in step 4 of the revenue recognition model in ASC 606. (See Section 4.4.2.2.)
The next sections further elaborate on these requirements.
4.4.2.1 Determining the Consideration in the Contract
ASC 842-10
15-39 The consideration in
the contract for a lessor includes all of the
amounts described in paragraph 842-10-15-35 and any
other variable payment amounts that would be
included in the transaction price in accordance with
the guidance on variable consideration in Topic 606
on revenue from contracts with customers that
specifically relates to either of the following:
-
The lessor’s efforts to transfer one or more goods or services that are not leases
-
An outcome from transferring one or more goods or services that are not leases. . . .
15-39A A lessor may make an
accounting policy election to exclude from the
consideration in the contract and from variable
payments not included in the consideration in the
contract all taxes assessed by a governmental
authority that are both imposed on and concurrent
with a specific lease revenue-producing transaction
and collected by the lessor from a lessee (for
example, sales, use, value added, and some excise
taxes). Taxes assessed on a lessor’s total gross
receipts or on the lessor as owner of the underlying
asset shall be excluded from the scope of this
election. A lessor that makes this election shall
exclude from the consideration in the contract and
from variable payments not included in the
consideration in the contract all taxes within the
scope of the election and shall comply with the
disclosure requirements in paragraph
842-30-50-14.
Initially, a lessor’s measurement of consideration in the
contract is the same as a lessee’s. (See Section 4.4.1.1.) However, a lessor
must perform a few additional steps related to variable consideration in the
contract. A lessee only includes consideration in the contract if it is
fixed (or in-substance fixed) or if there are variable payments that depend
on an index or a rate. For a lessor, ASC 842-10-15-39 provides additional
criteria for variable payments that must be included in the consideration in
the contract. That is, a lessor will measure variable consideration in
accordance with step 3 of the revenue recognition model in ASC 606, and
include it in the consideration in the contract, if the variable payment is
specifically related to either or both of the following:
-
The lessor’s efforts to transfer goods or services (i.e., nonlease components) other than the right to use the underlying asset (i.e., the lease component).
-
An outcome of the lessor’s performance in transferring goods or services (i.e., nonlease components) other than the right to use the underlying asset (i.e., the lease component).
If variable payments are fully,
or even partially, related to the lease component, the lessor does not include
such payments in the consideration in the contract. The following flowchart
summarizes the variable consideration requirements in ASC 842-10-15-39:
As a result of this guidance, lessors will often measure more
variable consideration as part of the consideration in the contract than lessees
will. In addition, lessors will need to familiarize themselves with and use the
guidance in ASC 606 on determining the transaction price. Section 6.3 of Deloitte’s
Roadmap Revenue
Recognition discusses the relevant guidance in ASC 606 in
detail, and we encourage lessors to consider this guidance when determining
their consideration in a contract that contains variable payments related to the
nonlease component(s).
Connecting the Dots
Split Model for Variable
Consideration
The flowchart above effectively depicts a split model
for a lessor’s measurement of variable consideration. That is, if the
variable consideration is entirely related to a nonlease item, it should
be measured in a manner consistent with ASC 606. Otherwise, the variable
consideration is in some way related to the lease component and
therefore should be treated in a manner consistent with the guidance on
variable lease payments in ASC 842.
The FASB further explains this split model in paragraph
BC163 of ASU 2016-02:
The Board decided that providing guidance on
consideration in the contract was necessary to ensure consistent
application of the allocation guidance in Topic 842, particularly for lessors because of the
differences between how the Board decided a lessor should
account for variable lease payments and how an entity
accounts for variable consideration in Topic 606. The
Board concluded that accounting for a variable payment that
relates partially to a lease component (for example, a
performance bonus that relates to the leased asset and the
lessor’s operation of that asset) in the same manner as a
variable lease payment (that is, with respect to recognition and
measurement) will be less costly and complex than accounting for
that variable payment in accordance with the variable
consideration guidance in Topic 606. In addition, the Board
decided that a lessor should not account for a single variable
payment in accordance with two accounting models (for example,
partially as a variable lease payment and partially as variable
consideration in the scope of Topic 606). [Emphasis added]
Ultimately, the split model for measuring variable
consideration resulted from a desire to provide relief from the
potential cost and complexity of applying the ASC 606 guidance on
determining the transaction price (i.e., on estimating variable
consideration) to variable payments that are related, even partially, to
the lease component. However, we think that a split model introduces
certain complexities of its own — namely, such a model could require
lessors to use judgment in assessing whether a variable payment is
related to a nonlease (i.e., revenue) or lease component in a
contract.
The decision tree below summarizes the full requirements in ASC
842-10-15-39 with respect to a lessor’s determination of the consideration in
the contract.
Connecting the Dots
Determining the Factors Governing
Variable Payment Terms May Help Entities Determine the Lease or
Nonlease Component to Which the Payments Are Related
Lessors should analyze variable payment terms in a
contract to determine the lease or nonlease components to which those
payments are related. Whether a variable payment is related to a lease
or nonlease component will govern whether that payment is included in
the lessor’s measurement of the consideration in the contract.
Determining the factors governing the variability in a
payment will be helpful in the assessment of whether the payment is
fully or partially related to a lease component. Payments in an
arrangement that contains a lease may vary as a result of many different
factors, including, but not limited to:
-
Usage of the underlying asset (e.g., machine hours, number of units produced).
-
Performance measures (e.g., revenues earned, profit margin achieved, costs incurred).
-
Occurrence or nonoccurrence of certain events (e.g., inclement weather).
-
Market conditions (e.g., market index price of electricity).
In addition, a factor governing variability can be
within the control of:
-
The lessee (e.g., miles that an automobile is driven).
-
The lessor (e.g., costs incurred for delivering maintenance services).
-
Neither party (e.g., weather).
Once an entity determines the factors governing
variability, they can be tagged to the lease or nonlease component. For
example, if payments vary on the basis of the number of miles that the
lessee drives a leased automobile, that factor (i.e., miles driven) is
related to the lease component (i.e., the right to use the automobile).
On the other hand, if payments vary on the basis of the costs the lessor
incurs in delivering CAM to the lessee, that factor (i.e., costs
incurred) is related to the nonlease component (i.e., CAM).
An entity will sometimes need to use judgment in
performing this assessment, since it is not always clear whether the
factor governing variability is related to a nonlease or lease
component. In some cases, the variability may be related to both.
Example 14, Cases A and B, in ASC 842-10-55-150 through 55-156
(reproduced in Section
4.4.3), illustrates the guidance in ASC 842-10-15-39 on the
lessor’s measurement of variable consideration in the contract. The examples
below also illustrate the guidance in ASC 842-10-15-39.
Example 4-17
Customer X, which manufactures and sells
complex battery systems to electric car manufacturers,
enters into a contract with Lessor Y to lease a piece of
machinery for use in creating the specialized batteries.
According to the terms of the contract, Y will provide
(1) the machinery at a fixed rate of $220,000 per year
for a noncancelable period of five years and (2)
marketing services over that same period to make
electric car manufacturers more aware of X’s product. In
consideration for the marketing services, X will pay an
additional fixed fee of $30,000 per year.
Lessor Y determines that there are two
components in the contract:
-
A lease component for the right to use the piece of machinery.
-
A nonlease component for the marketing services.
Lessor Y identifies fixed consideration
in the contract of $250,000 per year ($220,000 for use
of machinery + $30,000 for marketing services), or $1.25
million in total over the five-year contract term.
Lessor Y includes the $1.25 million of
fixed consideration in its measurement of the
consideration in the contract in accordance with ASC
842-10-15-35 and ASC 842-10-15-39.
Case A — Variable
Consideration Is Partially Related to the Lease
Component
Assume that the contract also stipulates
that X will pay Y a commission of 2 percent of sales per
year for each year for which sales have increased by 10
percent or more over the prior year. Therefore, Y also
identifies variable consideration in the form of the 2
percent revenue-sharing commission. Lessor Y determines
whether the consideration in the contract includes the
variable consideration as follows:
Case B — Variable
Consideration Is Related Specifically to the
Nonlease Component
Assume instead that the contract also
stipulates that X will pay Y a fee of $25 for every
customer (or potential customer) of X that clicks on
Internet advertisements that Y places on behalf of X as
part of providing the marketing services in the
contract. Therefore, Y also identifies variable
consideration in the form of the $25 fee per click.
Lessor Y determines whether the consideration in the
contract includes the variable consideration as
follows:
Example 4-18
This example represents a continuation
of Example 4-13. Lessee and Lessor enter
into a five-year vehicle lease of an open-wheel race car
in which Lessor will also perform maintenance and repair
services on the race car. Assume the following facts:
-
Lessee will pay a fixed monthly amount of $2,000.
-
Lessee will also make a variable payment in accordance with Cases A and B below.
-
There are two components in the contract:
-
A lease component for the right to use the underlying asset.
-
A nonlease component for the maintenance and repair services.
-
Case
A
In Case A, Lessee will pay $500 for each
month in which the vehicle is driven the minimum mileage
(i.e., variable consideration).
Lessor concludes that the variable
consideration should not be included in the
consideration in the contract. That is because the
variable payment each month is not solely related to
performance of the nonlease maintenance and repair
services; Lessee’s use of the race car (i.e., the lease
component) substantively governs whether, and to what
extent, Lessor will receive the additional fees.
Therefore, Lessor’s initial measurement of the
consideration in the contract is $120,000 (i.e., $2,000
per month in fixed consideration × 12 months per year ×
5 years), which is the same as Lessee’s.
Case
B
In Case B, the additional fee is the
greater of (1) $500 for each month in which the vehicle
is driven the minimum mileage or (2) $15,000 total.
Lessor agrees that once Lessee has driven the minimum
mileage for 9 months within a single calendar year, it
will pay Lessee $100 for each additional month of the
year in which the minimum mileage is driven (i.e., for a
maximum possible incentive of $300 each year).
Lessor’s initial measurement of the
consideration in the contract must include, at a
minimum, $135,000 (i.e., $120,000 in fixed
consideration, plus an in-substance fixed payment of
$15,000). However, Lessor must also consider whether (1)
any amounts above the in-substance fixed amount of
$15,000 (i.e., a minimum) are entirely related to the
nonlease component and (2) the incentive is entirely
related to the nonlease component.
As in Case A, the variable payment each
month is not solely related to performance of the
nonlease maintenance and repair services; Lessee’s use
of the race car (i.e., the lease component)
substantively governs whether and to what extent Lessor
will receive the additional fees (or be required to pay
the incentive). Therefore, Lessor concludes that the
variable consideration should not be included in the
consideration in the contract. Lessor’s consideration in
the contract is the same as Lessee’s — $135,000.
In Cases A and B, Lessor determines that
its initial measurement of the consideration in the
contract is the same as Lessee’s.
4.4.2.1.1 Variable Amounts for CAM
As discussed in Section 4.3.1,
leases for office or commercial space often contain provisions that
require the tenant to reimburse the landlord for CAM costs. Such costs
might include an allocated portion of landscaping, janitorial services,
repairs, snow removal, and other maintenance of common areas. CAM
charges can be based on the actual costs (with or without margin)
incurred by the landlord. That is, payments for CAM are often
variable.
Variable payments for CAM are entirely related to a
nonlease component.
CAM charges — whether they are direct reimbursements of
actual costs or represent an allocated portion of total CAM performed
for a property — are related to the lessor’s efforts to transfer, or an
outcome from transferring, maintenance and other services that are not
leases. Because they are related to a nonlease component (i.e., CAM is a
nonlease component, as discussed in Section 4.3.1),
variable payments for CAM should be included in the lessor’s initial
measurement of the consideration in the contract in accordance with the
guidance in ASC 606 on determining the transaction price (i.e., they
should be estimated by using the “expected value” or “most likely
amount” method and potentially constrained).
However, lessors that provide CAM should carefully
consider whether there are any other variable amounts that are not
related entirely to a nonlease component and, if so, ensure that their
estimates for CAM do not incorporate those amounts. As discussed in the
Connecting the Dots at the end
of Section
4.3.1, other amounts (e.g., utilities, property taxes,
and insurance) periodically may be billed together with CAM. Lessors
should ensure that, although those amounts may be characterized together
in the contract or on an invoice, their estimate of variable CAM charges
does not include variable amounts for property taxes or insurance. Both
property taxes and insurance are noncomponents (as discussed in
Section
4.3.2) and are not entirely related to a nonlease
component.
4.4.2.1.2 Certain Lessor Costs Paid Directly by Lessees
ASC 842-10
15-40A The guidance in
paragraph 842-10-15-40 notwithstanding, a lessor
shall exclude from variable payments lessor costs
paid by a lessee directly to a third party.
However, costs excluded from the consideration in
the contract that are paid by a lessor directly to
a third party and are reimbursed by a lessee are
considered lessor costs that shall be accounted
for by the lessor as variable payments (this
requirement does not preclude a lessor from making
the accounting policy election in paragraph
842-10-15-39A).
ASC 842-10-15-30(b) states that an entity “may incur
various costs in its role as a lessor or as owner of the underlying
asset. A requirement for the lessee to pay those costs, whether directly
to a third party [on behalf of the lessor] or as a reimbursement to the
lessor, does not transfer a good or service to the lessee separate from
the right to use the underlying asset.” A common example of such a cost
is an insurance premium under which, according to the lease contract,
the lessee must carry insurance to cover the underlying asset and the
insurance policy names the lessor as the primary beneficiary of that
policy. Before the guidance in ASC 842-10-15-40A, the new leasing
standard required a lessor to report these amounts as revenue and
expenses even though the lessee may not be required to provide payment
amount information to the lessor. Further, the payment amount may be
affected by a number of lessee-specific factors (e.g., discounts due to
other policies the lessee has with the issuer that are unrelated to the
leased asset). Accordingly, the lessor would not be able to present the
lessee’s payments and the associated cost on a gross basis without
either obtaining more information from the lessee or estimating the
premium.
However, with the amendment in ASC 842-10-15-40A, the
FASB achieved both of the following:
-
Addressed stakeholders’ concerns about the challenges related to determining costs paid by the lessee directly to a third party on behalf of the lessor by requiring lessors to exclude such costs from variable payments and thus from revenue and expenses.19
-
Clarified that costs excluded from the consideration in a contract that are paid directly to a third party by the lessor and then reimbursed by the lessee must be accounted for as variable payments and therefore as revenue and expenses.
Connecting the Dots
Background on Lessor
Costs as Addressed Under ASU 2018-20
In December 2018, the FASB issued ASU
2018-20, which addresses certain requests
made by stakeholders regarding lessor implementation issues
associated with ASU 2016-02, including an issue related to
certain lessor costs paid directly by lessees to an unrelated
third party (e.g., a governmental agency for property taxes or
an insurance provider for insurance coverage). ASU 2016-02, as
initially issued, required a lessor to report those amounts as
revenue and expenses. ASU 2018-20 requires lessors to “exclude
from variable payments lessor costs paid by a lessee directly to
a third party.” Lessor costs are considered costs that are not a
component in the contract. That is, lessor costs (e.g., property
taxes and insurance) are neither lease components nor nonlease
components.
Importantly, under ASU 2018-20, a lessor must
exclude from variable payments all
lessee payments made directly to a third party for lessor costs,
even if the lessor knows the exact dollar amount of those
payments. However, at the February 13, 2019, Board meeting, the
FASB staff clarified that payments a lessee makes directly to
third parties for other lease-related payments (i.e., other than
for lessor costs) are not within the scope of this amendment.
For example, lease payments made by a sublessee directly to a
head lessor typically do not represent lessee payments for
sublessor costs, since those payments are generally for a lease
component rather than for lessor costs.
This amendment made by ASU 2018-20 did not
necessitate any updated disclosure requirements. See Section
17.3.1.5 for a detailed discussion of ASU
2018-20, including the transition requirements.
4.4.2.1.3 Practical Expedient Related to Sales Taxes and Other Similar Taxes Collected From Lessees
ASC 842-10
15-39A A lessor may make an
accounting policy election to exclude from the
consideration in the contract and from variable
payments not included in the consideration in the
contract all taxes assessed by a governmental
authority that are both imposed on and concurrent
with a specific lease revenue-producing
transaction and collected by the lessor from a
lessee (for example, sales, use, value added, and
some excise taxes). Taxes assessed on a lessor’s
total gross receipts or on the lessor as owner of
the underlying asset shall be excluded from the
scope of this election. A lessor that makes this
election shall exclude from the consideration in
the contract and from variable payments not
included in the consideration in the contract all
taxes within the scope of the election and shall
comply with the disclosure requirements in
paragraph 842-30-50-14.
Under ASU 2018-20, lessors can elect, as an accounting
policy, to exclude from revenue and expenses sales taxes and other
similar taxes assessed by a governmental authority and collected by the
lessor from a lessee.20 This is an entity-wide accounting policy election.
This accounting policy election was requested by lessors
and offered by the FASB in an effort to align the leasing guidance with
ASC 606, as amended by ASU 2016-12, which allows
entities to elect an accounting policy of presenting sales taxes
collected from customers on a net basis. Specifically, ASC 606-10-32-2A
states, in part:
An entity may make an accounting policy election
to exclude from the measurement of the transaction price all
taxes assessed by a governmental authority that are both imposed
on and concurrent with a specific revenue-producing transaction
and collected by the entity from a customer (for example, sales,
use, value added, and some excise taxes).
Although lessors are not within the scope of ASC 606,
they are performing a revenue-generating activity in a manner similar to
a service accounted for under ASC 606. Accordingly, the FASB provides a
similar practical expedient under which lessors can present sales taxes
collected from lessees on a net basis.
Connecting the Dots
Background on Sales Taxes
Practical Expedient as Addressed Under ASU
2018-20
In December 2018, the FASB issued ASU 2018-20, which
addresses certain requests made by stakeholders regarding
implementation issues associated with ASU 2016-02, including an
issue related to sales taxes and other similar taxes collected
from lessees.
The EITF addressed a similar topic in Issue 06-3, which formed the basis of the guidance on the topic in ASC 606. Therefore, we believe that this guidance is important to understanding the basis for the scope of the accounting policy election under ASC 842-10-15-39A. Issue 06-3 indicates that its
scope includes all taxes assessed by a governmental authority
that are both imposed on and concurrent with a specific
revenue-producing transaction between a seller and a customer.
However, the scope does not include taxes assessed on an
entity’s total gross receipts or imposed during the inventory
procurement process. Similarly, taxes assessed on a lessor’s
total gross receipts or on the lessor as owner of the underlying
asset are outside the scope of the accounting policy election
under ASC 842-10-15-39A. The Board clarified the reason for this
exclusion in paragraph BC12 of ASU 2018-20, which states, in
part, that such taxes “are levied on a lessor’s gross revenue
and not a specific lease-producing revenue transaction, [so] the
Board concluded that a lessor likely would not be acting as an
agent for a lessee with respect to those taxes.”
Moreover, during the deliberation of ASU
2018-20, stakeholders requested that the scope of this election
be expanded to include property taxes but the FASB did not grant
this request. That is, property taxes should not be considered
to be within the narrow scope of this election; rather, an
entity should consider property taxes when applying the guidance
in ASC 842-10-15-40A, as discussed in Section 4.4.2.1.1.
We expect that entities will often align their
accounting policy elections under ASC 606-10-32-2A with those
under ASC 842-10-15-39A; however, we note that such consistency
is not required.
See Section 17.3.1.5 for a
detailed discussion of ASU 2018-20, including the transition and
disclosure requirements.
4.4.2.2 Allocating the Consideration in the Contract
ASC 842-10
15-38 A lessor shall allocate
(unless the lessor makes the accounting policy
election in accordance with paragraph 842-10-15-42A)
the consideration in the contract to the separate
lease components and the nonlease components using
the requirements in paragraphs 606-10-32-28 through
32-41. A lessor also shall allocate (unless the
lessor makes the accounting policy election in
accordance with paragraph 842-10-15-42A) any
capitalized costs (for example, initial direct costs
or contract costs capitalized in accordance with
Subtopic 340-40 on other assets and deferred costs —
contracts with customers) to the separate lease
components or nonlease components to which those
costs relate.
15-39 . . . Any variable
payment amounts accounted for as consideration in
the contract shall be allocated entirely to the
nonlease component(s) to which the variable payment
specifically relates if doing so would be consistent
with the transaction price allocation objective in
paragraph 606-10-32-28.
15-40 If the terms of a
variable payment amount other than those in
paragraph 842-10-15-35 relate to a lease component,
even partially, the lessor shall not recognize those
payments before the changes in facts and
circumstances on which the variable payment is based
occur (for example, when the lessee’s sales on which
the amount of the variable payment depends occur).
When the changes in facts and circumstances on which
the variable payment is based occur, the lessor
shall allocate those payments to the lease and
nonlease components of the contract. The allocation
shall be on the same basis as the initial allocation
of the consideration in the contract or the most
recent modification not accounted for as a separate
contract unless the variable payment meets the
criteria in paragraph 606-10-32-40 to be allocated
only to the lease component(s). Variable payment
amounts allocated to the lease component(s) shall be
recognized as income in profit or loss in accordance
with this Topic, while variable payment amounts
allocated to nonlease component(s) shall be
recognized in accordance with other Topics (for
example, Topic 606 on revenue from contracts with
customers).
15-40A The guidance in
paragraph 842-10-15-40 notwithstanding, a lessor
shall exclude from variable payments lessor costs
paid by a lessee directly to a third party. However,
costs excluded from the consideration in the
contract that are paid by a lessor directly to a
third party and are reimbursed by a lessee are
considered lessor costs that shall be accounted for
by the lessor as variable payments (this requirement
does not preclude a lessor from making the
accounting policy election in paragraph
842-10-15-39A).
15-42 If the consideration in
the contract changes, a lessor shall allocate those
changes in accordance with the requirements in
paragraphs 606-10-32-42 through 32-45.
15-42A As a practical
expedient, a lessor may, as an accounting policy
election, by class of underlying asset, choose to
not separate nonlease components from lease
components and, instead, to account for each
separate lease component and the nonlease components
associated with that lease component as a single
component if the nonlease components otherwise would
be accounted for under Topic 606 on revenue from
contracts with customers and both of the following
are met:
- The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
- The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.
15-42B A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall account for the combined component:
-
As a single performance obligation entirely in accordance with Topic 606 if the nonlease component or components are the predominant component(s) of the combined component. In applying Topic 606, the entity shall do both of the following:
-
Use the same measure of progress as used for applying paragraph 842-10-15-42A(a)
-
Account for all variable payments related to any good or service, including the lease, that is part of the combined component in accordance with the guidance on variable consideration in Topic 606.
-
-
Otherwise, as an operating lease entirely in accordance with this Topic. In applying this Topic, the entity shall account for all variable payments related to any good or service that is part of the combined component as variable lease payments.
In determining whether a nonlease
component or components are the predominant
component(s) of a combined component, a lessor shall
consider whether the lessee would be reasonably
expected to ascribe more value to the nonlease
component(s) than to the lease component.
15-42C A lessor that elects
the practical expedient in paragraph 842-10-15-42A
shall combine all nonlease components that qualify
for the practical expedient with the associated
lease component and shall account for the combined
component in accordance with paragraph
842-10-15-42B. A lessor shall separately account for
nonlease components that do not qualify for the
practical expedient. Accordingly, a lessor shall
apply paragraphs 842-10-15-38 through 15-42 to
account for nonlease components that do not qualify
for the practical expedient.
Lessors are required (unless the lessor makes the accounting
policy election in ASC 842-10-15-42A — see Section 4.3.3.2) to allocate the
consideration in the contract to separate lease and nonlease components in
accordance with step 4 of the revenue recognition model in ASC 606-10-32-28
through 32-41. That is, they will generally allocate the consideration in
the contract on the basis of the relative stand-alone selling price.
Accordingly, when allocating the consideration in the contract, lessors
should consider the guidance in Chapter 7 of Deloitte’s Roadmap
Revenue
Recognition.
The allocation guidance in ASC 606 can be summarized as
follows:
-
The objective for lessors that are allocating the consideration in the contract to lease and nonlease components is the same as that for entities allocating the transaction price to distinct performance obligations in a contract with a customer. That is, in accordance with ASC 606-10-32-28, the objective is for a lessor to allocate the consideration in the contract to each separate lease and nonlease component “in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services” to the lessee.
-
Generally, to meet the allocation objective, lessors will allocate the consideration in the contract to each component proportionately on the basis of the relative stand-alone selling price. (See Section 7.2 of Deloitte’s Roadmap Revenue Recognition.)
-
The stand-alone selling price, in accordance with ASC 606-10-32-32, is “the price at which an entity would sell a promised good or service separately to a customer.” The best evidence of a stand-alone selling price for a good or service is the observable price of that good or service when the entity sells it separately to similar customers and in similar circumstances. (See Section 7.3.1 of Deloitte’s Roadmap Revenue Recognition.)
-
When the stand-alone selling price is not observable, it should be estimated in a manner that (1) results in an allocation of the consideration in the contract that meets the allocation objective discussed above and (2) maximizes the use of observable inputs. (See Section 7.3.2 of Deloitte’s Roadmap Revenue Recognition.) In accordance with ASC 606-10-32-34, the following are acceptable methods of estimating the stand-alone selling price: (1) an adjusted market assessment approach; (2) an expected-cost-plus-a-margin approach; and (3) a residual approach, but only when certain criteria are met.
-
Proportionate allocation does not affect how profit margins are allocated between the lease and nonlease components. Accordingly, margins for the lease and nonlease components may not be the same when the consideration in the contract is allocated on a relative stand-alone selling price basis. In fact, there may be situations in which the allocation objective is not met by allocating the consideration in the contract proportionately across all components in a contract — for example, when the consideration in the contract includes (1) a discount or (2) variable consideration.
-
In accordance with ASC 606-10-32-37, a discount should be allocated entirely to one or more, but not all, components in a contract if certain criteria are met. (See Section 7.4 of Deloitte’s Roadmap Revenue Recognition.)
-
In accordance with ASC 606-10-32-40, variable consideration should be allocated entirely to one or more, but not all, components in a contract if certain criteria are met. (See Section 7.5 of Deloitte’s Roadmap Revenue Recognition.) ASC 842-10-25-39 emphasizes this notion as well.
-
-
The stand-alone selling prices of the components in the contract are determined at inception. In accordance with ASC 606-10-32-43, “an entity shall not reallocate . . . to reflect changes in standalone selling prices after contract inception.” Accordingly, subsequent changes in the consideration in the contract that are not due to a modification (e.g., when a contingency upon which some or all of the variable payments are based is resolved in such a way that those payments become fixed over the remainder of the contract term) are allocated between the lease and nonlease components in the same proportion as the initial allocation. (See Section 7.6 of Deloitte’s Roadmap Revenue Recognition.)
The guidance in ASC 842-10-15-40 addresses payments that are
not included in the lessor’s initial determination of the consideration in
the contract — variable payments, other than those that depend on an index
or rate, that are fully or partially related to the lease component. Because
those payments are not measured at inception and are not allocated to the
lease and nonlease components as part of the consideration in the contract,
they should be allocated between the lease and nonlease components in the
same proportion as the initial allocation when the changes in facts and
circumstances on which the variable payment is based occur. For example, if
the lessor’s initial allocation of the consideration in the contract results
in the allocation of 80 percent to the lease component and 20 percent to the
nonlease component, a variable payment that is partially related to the
lease component should also be allocated in those same percentages in the
period in which the changes in facts and circumstances on which the variable
payment is based occur. The portion of the payment allocated to the lease
component should be recognized in profit or loss at that time, and the
portion allocated to the nonlease component should be recognized in profit
or loss in accordance with ASC 606 (or other applicable GAAP). Example 14,
Case A, in ASC 842-10-55-152 (reproduced in Section 4.4.3) further illustrates
this guidance.
Connecting the Dots
Background on Recognition of
Variable Payments for Contracts With Lease and Nonlease
Components as Addressed Under ASU 2018-20
ASU 2016-02 initially required lessors to recognize
variable payments “in profit or loss in the period when the changes
in facts and circumstances on which the variable payment is based
occur,” regardless of whether the variable payment is related to the
lease or nonlease component in the contract.
Stakeholders observed that the guidance, as issued,
may lead a lessor to recognize as revenue a variable payment related
to a nonlease component before control of the nonlease component is
transferred to the customer. That is, as issued, ASC 842-10-15-40,
read literally, implied that as soon as an uncertainty that created
variability in the consideration is resolved, that amount should be
recognized as revenue regardless of whether the item to which it is
related has been delivered to the customer/lessee.
To clarify the Board’s intent, ASU 2018-20 amended
ASC 842 to require a lessor to allocate (rather than recognize)
certain variable payments to the lease and nonlease components when
the changes in facts and circumstances on which the variable payment
is based occur. After the allocation, the amount of variable
payments allocated to the lease component would be “recognized as
income in profit or loss in accordance with this Topic [ASC 842],
while variable payment amounts allocated to nonlease component(s)
[would] be recognized in accordance with other Topics (for example,
Topic 606 . . . ).”
This amendment made by ASU 2018-20 did not
necessitate any updated disclosure requirements. See Section
17.3.1.5 for a detailed discussion of ASU 2018-20,
including transition requirements.
4.4.2.2.1 Recognizing Variable Payments When a Portion Is Attributable to a Nonlease Component
ASC 842-10-15-40 includes the following guidance, which
was amended by ASU 2018-20, on accounting for certain variable payments
that are not included in the lessor’s initial determination of the
consideration in the contract:
If the terms of a variable payment amount other
than those in paragraph 842-10-15-35 relate to a lease
component, even partially, the lessor shall not recognize [the
lease and nonlease components related to] those payments before
the changes in facts and circumstances on which the variable
payment is based occur (for example, when the lessee’s sales on
which the amount of the variable payment depends occur). When the changes in facts and circumstances
on which the variable payment is based occur, the lessor
shall allocate those payments to the lease and nonlease
components of the contract. The allocation shall be on the
same basis as the initial allocation of the consideration in
the contract or the most recent modification not accounted
for as a separate contract unless the variable payment meets
the criteria in paragraph 606-10-32-40 to be allocated only
to the lease component(s). Variable payment amounts
allocated to the lease component(s) shall be recognized as
income in profit or loss in accordance with this Topic,
while variable payment amounts allocated to nonlease
component(s) shall be recognized in accordance with other
Topics (for example, Topic 606 on revenue from contracts
with customers). [Emphasis added]
Under ASC 842-10-15-40, the pattern of revenue
recognition for the portion of the variable payments attributable to the
nonlease component(s) is consistent with how those amounts would be
recognized as revenue in accordance with ASC 606.
Before the issuance of ASU 2018-20, ASC 842-10-15-40
implied, when read literally, that as soon as an uncertainty that
created variability in the consideration is resolved, that amount should
be recognized as revenue regardless of whether the item to which it is
related has been delivered to the customer/lessee. Accordingly, the FASB
amended the guidance by requiring a lessor to allocate (rather than
recognize) certain variable payments to the lease and nonlease
components when the changes in facts and circumstances on which the
variable payment is based occur. After the allocation, the amount of
variable payments allocated to the lease component would be “recognized
as income in profit or loss in accordance with [ASC 842], while variable
payment amounts allocated to nonlease component(s) [would] be recognized
in accordance with other Topics (for example, Topic 606 . . . ).”
Example 4-19
Landlord enters into a five-year
arrangement with Retailer to lease a retail space
in a mall. Monthly payments are based on a
variable structure, with a guaranteed minimum, as
follows:
-
Four percent of monthly retail sales from January through June of each year.
-
Two percent of monthly retail sales from July through December of each year.
-
Minimum amount due each month is $20,000.
Each monthly payment is
compensation for the right to use the retail space
(including reimbursement of associated property
taxes and insurance), CAM, and an annual report.
Landlord will provide the report on December 31 of
each year. The report will include various
statistical metrics and analyses (e.g., customer
foot traffic, customer buying habits, video
tracking data).
Landlord identifies three
components:
-
A lease component for the right to use the retail space.
-
A nonlease component for the CAM.
-
A nonlease component for the annual report that is a performance obligation distinct from the CAM services.
Landlord determines that, in
accordance with ASC 606, the annual report (a
nonlease component) is a performance obligation
satisfied at a point in time and that control is
transferred to Retailer upon delivery of the
report on December 31. Accordingly, any variable
payments received during the year and attributable
to the annual report for the nonlease component
should be deferred and recognized as revenue when
the report is delivered and control is transferred
at a point in time (i.e., at the end of each
year). This conclusion is true regardless of
whether the lessor has elected the practical
expedient related to combining lease and nonlease
components. This is because the nonlease component
for the annual report would not meet the scope
criteria for combination since its pattern of
transfer (at a point in time) is not the same as
the pattern of transfer of the lease component
(over time provided that the lease component is an
operating lease).
Connecting the Dots
Differences Between
Lessee and Lessor Allocation
As discussed in the Connecting the Dots in
Section
4.4.1.2, the method under which a lessee
allocates the consideration in the contract on a relative
stand-alone price basis is similar to the framework in ASC 606
for allocating the transaction price. Because lessors use ASC
606 to allocate the consideration in the contract, the method
that lessees use is therefore similar to that for lessors.
However, there are two primary differences
between the requirements for lessees and those for lessors:
-
Lessees always allocate the consideration in the contract proportionally to the lease and nonlease components on a relative stand-alone price basis. That is, there are no special considerations for allocating discounts or variable consideration. Lessors, on the other hand, would apply the specific requirements in ASC 606 to allocate discounts and variable consideration. For example, a lessor could allocate a discount entirely to the nonlease component, whereas the lessee would be required to spread that discount proportionately over all the components in the contract.
-
Lessors must determine the stand-alone selling price of each component in the contract to allocate the consideration in the contract. Accordingly, lessors must determine the price at which the entity (i.e., the lessor) would sell that promised good or service separately to a customer. On the other hand, the observable stand-alone price that the lessee must use for allocation purposes is the price at which either the lessor or similar suppliers sell similar lease or nonlease components on a stand-alone basis. That is, the lessee may take into account observable evidence of pricing by other suppliers (i.e., not just the lessor) in the market when determining the stand-alone price.Lessors may incorporate observable data related to the pricing of goods or services by their competitors when using an adjusted market assessment approach to estimate the stand-alone selling price. However, the intent of that approach is to adjust such data to reflect the lessor’s costs and margins so that it may identify the price at which the entity would sell that good or service separately.
Allocation Between
Revenue-Generating Activities Under ASC 842 Is
Consistent With ASC 606
In ASC 606, the FASB developed a comprehensive
framework for allocating consideration between performance
obligations. Because leasing represents a revenue-generating
activity for lessors, the Board found it appropriate for lessors
to deploy that same framework in contracts that contain a
lease.
The Board explains its rationale for this
decision in paragraph BC153 of ASU 2016-02:
In the Board’s view, leasing
transactions are fundamentally a revenue-generating
activity (even if the principal revenue stream is
interest income) in which the item that a lessor
transfers to the customer is the right to use the
underlying asset. Accordingly, it is appropriate for a
lessor to allocate consideration to the lease and
nonlease components as a seller allocates the
transaction price (and changes in the transaction price)
to performance obligations in a revenue contract and
does not allocate consideration to activities or costs
that do not transfer a good or service to the
lessee.
4.4.2.2.2 Concurrently Delivered Lease and Nonlease Components
If a lease component’s pattern of transfer to the lessee
is the same as that for a nonlease component, the separation of (and
allocation of consideration in the contract to) the lease and nonlease
components could be required depending on whether an entity elects the
practical expedient that allows lessors, when certain conditions are
met, not to separate lease and nonlease components. If an entity elects
the practical expedient, separation of (and allocation of consideration
in the contract to) the lease and nonlease components is not required.
However, if a lessor does not elect the practical expedient, the
guidance below should be considered (see Section 4.3.3.2). Paragraph BC153
of ASU 2016-02 states, in part:
In reaching its decisions on lessor allocation,
the Board noted that the basis for conclusions in Update 2014-09
states that an entity is not precluded from accounting for
concurrently delivered goods or services that have the same
pattern of transfer to the customer as if they were a single
performance obligation, even if they are distinct from each
other, because the outcome would be the same as accounting for
the goods and services separately. Therefore, it similarly would
be reasonable for lessors to account for multiple components of
a contract as a single component if the outcome from doing so
would be the same as accounting for the components separately
(for example, a lessor may be able to conclude that accounting
for an operating lease and a related service element as a single
component results in the same accounting as treating those two
elements as separate components). The
previous sentence notwithstanding, a lessor may need to
separately consider presentation and disclosure in
accordance with other Topics. [Emphasis added]
The last sentence in paragraph BC153 of ASU 2016-02
(emphasized in bold above) is the most important point — although the
accounting (and revenue recognition) for a lease component may be the
same as that for a nonlease component, the presentation and disclosure
requirements for lease components differ from those for nonlease
components (i.e., the requirements in ASC 842 and those in ASC 606,
respectively). Therefore, separation of (and allocation of consideration
in the contract to) the components in a contract is still required for
presentation and disclosure purposes, even when the pattern of transfer
to the lessee for a lease component is the same as that for a nonlease
component. (See Chapters 14 and 15 for detailed discussion of the
presentation and disclosure requirements, respectively, in ASC 842.)
However, paragraph BC153 of ASU 2016-02 also notes that
the transfer of a right to use an underlying asset (i.e., a lease
component) and a service (i.e., a nonlease component) are both
revenue-generating activities. Accordingly, even when ASC 842 (and
interactions between ASC 842 and ASC 606) requires separation and
allocation for presentation and disclosure purposes, it may be
reasonable to account for (and recognize revenue from) the lease
component and nonlease component together if they have the same pattern
of transfer (e.g., when both an operating lease and a nonlease service
component are transferred evenly over the contract term).
Paragraph BC116 of ASU 2014-09 (and paragraph BC153 of
ASU 2016-02) mentions this concept with respect to accounting for
distinct goods or services that have the same pattern of transfer as if
they were a single performance obligation; paragraph BC116 of ASU
2014-09 states, in part:
The Boards noted that Topic 606 would not need
to specify the accounting for concurrently delivered distinct
goods or services that have the same pattern of transfer. This
is because, in those cases, an entity is not
precluded from accounting for the goods or services as if
they were a single performance obligation, if the outcome is
the same as accounting for the goods and services as
individual performance obligations. [Emphasis added]
Connecting the Dots
Practical Expedient for
Concurrently Delivered Lease and Nonlease
Components
As discussed in Section 4.3.3.2, in July
2018, the FASB issued ASU 2018-11, which
includes a practical expedient that allows lessors, when certain
conditions are met, not to separate lease and nonlease
components. One of those conditions is that the lease
component’s pattern of transfer to the lessee is the same as
that for the nonlease component (i.e., the lease and nonlease
components are concurrently delivered). Lessors availing
themselves of this practical expedient would not need to
separate the lease and nonlease components, even for
presentation and disclosure purposes (as discussed in
Section 4.4.2.2.2). Rather, lessors
would account for the lease component and its related nonlease
component(s) as a single component.
If the practical expedient is elected,
separation of (and allocation of consideration in the contract
to) the components is not required when the patterns of transfer
are the same. However, if the practical expedient is not
elected, such separation and allocation are required in these
circumstances.
See Sections 4.3.3.2 and
17.3.1.4.2 for detailed discussions of the
practical expedient and its effects on the accounting by
lessors.
The split model for measuring variable consideration
(discussed in the Connecting the Dots in Section 4.4.2.1), as well as the
requirements in ASC 606, increases the complexity of allocating variable
consideration to the lease and nonlease components. The decision tree
below illustrates how variable consideration, other than consideration
that depends on an index or rate, is allocated in accordance with ASC
842-10-15-38 through 15-40.
Example 14, Cases A–C, in ASC 842-10-55-150 through
55-158 (reproduced in Section 4.4.3) illustrates the guidance in ASC
842-10-15-38 through 15-40 for lessors on allocating the consideration
in the contract. The examples below also illustrate the guidance in ASC
842-10-15-38 through 15-40 (note that, in these examples, it is assumed
that the lessor has not elected the practical expedient discussed in
Section
4.3.3.2).
Example 4-20
This example represents a
continuation of Example 4-17.
Customer X, which manufactures and sells complex
battery systems to electric car manufacturers,
enters into a contract with Lessor Y to lease a
piece of machinery for use in creating the
specialized batteries. According to the terms of
the contract, Y will provide (1) the machinery at
a fixed rate of $220,000 per year for a period of
five years and (2) marketing services over that
same period to make electric car manufacturers
more aware of X’s product. In consideration for
the marketing services, X will pay an additional
fixed fee of $30,000 per year.
Lessor Y determines that there
are two components in the contract:
-
A lease component for the right to use the piece of machinery.
-
A nonlease component for the marketing services.
Case A —
Variable Consideration Is Partially Related to the
Lease Component
The facts below are consistent
with Example 4-17,
Case A.
Assume that the contract also
stipulates that X will pay Y a commission of 2
percent of sales per year for each year for which
sales have increased by 10 percent or more over
the prior year. Therefore, Y also identifies
variable consideration in the form of the 2
percent revenue-sharing commission.
Lessor Y determines that the
consideration in the contract is $250,000 per year
($220,000 for use of machinery + $30,000 for
marketing services), or $1,250,000 in total over
the five-year contract term. No variable
consideration is included in Y’s measurement of
the consideration in the contract because the
variable consideration (i.e., the 2 percent of
sales per year for each year in which sales have
increased by 10 percent or more over the prior
year) is partially related to the lease
component.
The facts below are unique to
Case A in this example.
Lessor Y determines that the
stand-alone selling prices of the lease and
nonlease component are as follows:
-
Lease component: $1.125 million ($225,000 per year × 5 years).
-
Nonlease component: $175,000 ($35,000 annual payment × 5 years).
Accordingly, the contract
contains a discount of $50,000 ($1,300,000 total
stand-alone selling price – $1,250,000
consideration in the contract). However, Y does
not have observable evidence to support, in
accordance with ASC 606-10-32-37, that the entire
discount is related to only one of the components
in the contract.
Lessor Y allocates the
consideration in the contract to the lease and
nonlease components as follows:
Case B,
Scenario 1 — Variable Consideration Is
Specifically Related, and Allocated Entirely, to
the Nonlease Component
The facts below are consistent
with Example 4-17,
Case B.
Assume that the contract also
stipulates that X will pay Y a fee of $25 for
every customer (or potential customer) of X that
clicks on Internet advertisements that Y places on
behalf of X as part of providing the marketing
services in the contract. Therefore, Y also
identifies variable consideration in the form of
the $25 fee per click.
Lessor Y determines that the
consideration in the contract is $1.5 million in
total over the five-year contract term ($1,250,000
fixed consideration over the five-year contract
term + $250,000 total estimate of variable
consideration).
The facts below are unique to
Case B, Scenario 1, in this example.
Lessor Y determines that the
stand-alone selling prices of the lease component
and nonlease component are as follows:
-
Lease component: $1.1 million.
-
Nonlease component: $400,000.
Lessor Y concludes that (1) the
variable consideration is specifically related to
an outcome from transferring the marketing
services and (2) allocating the variable
consideration entirely to the marketing services
is consistent with the allocation objective in ASC
606-10-32-28 (i.e., there is no discount in the
arrangement — see Scenario 2 below, in which this
outcome is inconsistent with the allocation
objective as a result of a discount that is not
clearly related to one or more components in the
contract). In addition, to maintain consistency
with the allocation objective, on the basis of the
stand-alone selling prices noted above, the fixed
consideration would need to be allocated to both
the lease and nonlease components.
Lessor Y allocates the fixed consideration in the
contract to the lease and nonlease components as
follows:
Lessor Y’s resulting allocation
of the consideration in the contract is as
follows:
Case B,
Scenario 2 — Variable Consideration Is
Specifically Related to the Nonlease Component and
Is Allocated on the Basis of Stand-Alone Selling
Prices
The facts below are consistent
with Example 4-17,
Case B.
Assume that the contract also
stipulates that X will pay Y a fee of $25 for
every customer (or potential customer) of X that
clicks on Internet advertisements that Y places on
behalf of X as part of providing the marketing
services in the contract. Therefore, Y also
identifies variable consideration in the form of
the $25 fee per click.
Lessor Y determines that the
consideration in the contract is $1.5 million in
total over the five-year contract term ($1,250,000
fixed consideration over the five-year contract
term + $250,000 total estimate of variable
consideration).
The facts below are unique to
Case B, Scenario 2, in this example.
Lessor Y determines that the
stand-alone selling prices of the lease component
and nonlease component are as follows:
-
Lease component: $1.25 million.
-
Nonlease component: $300,000.
Accordingly, the contract
contains a discount of $50,000 ($1,550,000 total
stand-alone selling price – $1,500,000
consideration in the contract). However, Y does
not have observable evidence to support, in
accordance with ASC 606-10-32-37, that the entire
discount is related to only one of the components
in the contract. Lessor Y concludes that
allocating the variable consideration entirely to
the nonlease component is inconsistent with the
allocation objective in ASC 606-10-32-28, because
doing so would inappropriately skew allocation of
the discount toward the nonlease component.
Lessor Y allocates the
consideration in the contract to the lease and
nonlease components as follows:
Example 4-21
Case A —
Gross Lease of Real Estate
Lessee enters into a five-year
lease (a gross lease) of a building from Lessor
under which Lessee is required to make a fixed
annual lease payment of $35,000 (payments total
$175,000 over the five-year term). In accordance
with the terms of the contract, the $35,000 annual
payment comprises $20,000 for building rent,
$7,000 for CAM, $5,000 for property taxes, and
$3,000 for insurance that protects Lessor’s
interest in the building. From Lessor’s
perspective, the stand-alone selling price of the
right to use the building (including an estimate
of Lessor’s costs for taxes and insurance) is
$29,500 per year and the stand-alone selling price
of the maintenance services is $7,650 per
year.
In evaluating the separate
components in the contract, Lessor would need to
determine what goods and services are being
provided, which may include both lease and
nonlease components. In this contract, the primary
good or service is the right to use the building,
which is considered a lease component. In
addition, the contract requires Lessor to provide
maintenance services, which represent a nonlease
component (i.e., a service to be accounted for in
accordance with ASC 606).
As part of the $35,000 fixed
annual lease payment, Lessee also pays Lessor
consideration attributable to property taxes and
insurance. However, in accordance with ASC
842-10-15-30, those payments would not be
considered separate components (either lease
components or nonlease components), since each fee
is a reimbursement of Lessor’s costs. Therefore,
despite requiring the payment of four separately
described fees in the contract, the arrangement
includes only two components. The total fees of
$35,000 must be allocated between the two
identified goods and services representing the
lease component and nonlease component.
As a result, Lessor allocates
the consideration in the contract ($175,000) as
follows:
Note that the contract contains
a discount of $10,750 ($185,750 total stand-alone
selling price – $175,000 consideration in the
contract). However, Lessor does not have
observable evidence to support, in accordance with
ASC 606-10-32-37, that the entire discount is
related to only one of the components in the
contract. Therefore, Lessor appropriately
allocates the consideration in the contract
proportionately to the lease and nonlease
components on a relative stand-alone selling price
basis.
Case B —
Triple Net Lease of Real Estate
Assume the same facts as in Case
A, except that Lessee is required to make fixed
annual lease payments of only $20,000 for building
rent. Lessor charges payments for property taxes,
insurance, and CAM to Lessee on the basis of
Lessee’s share of actual costs incurred. Thus,
payments for property taxes, insurance, and CAM
all represent variable consideration. Lessor
estimates that Lessee’s share of CAM will be
$7,000 annually and that Lessee’s share of
property taxes and insurance will be a total of
$8,000 annually.
In a manner consistent with that
in Case A, Lessor concludes that there are two
components in the contract:
-
A lease component for the right to use the underlying asset, with a stand-alone selling price of $29,500 annually (which includes an estimate of Lessee’s share of the variable charges for taxes and insurance).
-
A nonlease component for the CAM, with a stand-alone selling price of $7,650 annually.
In a manner consistent with that
described in Section
4.4.2.1.1, Lessor concludes that the
variable consideration for the CAM is entirely
related to the CAM nonlease component. Using the
expected value method in ASC 606, Lessor estimates
that the amount of consideration to which it will
be entitled in exchange for transferring the CAM
to Lessee is $7,000 annually. Lessor determines
that it is probable that there will not be a
significant reversal in the amount of cumulative
revenue recognized with respect to its
estimate.
However, Lessor does not include
an estimate of the variable consideration for the
property taxes and insurance in the consideration
in the contract. The variable charges for property
taxes and insurance that Lessee will pay are
entirely or partially related to the lease
component and are therefore excluded from the
consideration in the contract. In accordance with
ASC 842-10-15-40, Lessor, will (1) when changes in
facts and circumstances upon which the variable
payments are based occur, allocate those payments
for property taxes and insurance in accordance
with the same initial relative stand-alone selling
price basis as for the consideration in the
contract and (2) recognize the payments in
accordance with the applicable guidance.
Therefore, Lessor concludes that
the consideration in the contract is $135,000
($20,000 fixed consideration for rent × 5 years +
$7,000 estimated variable consideration for CAM ×
5 years).
When allocating the
consideration in the contract, Lessor considers
the guidance in ASC 842-10-15-39 and determines
that allocating the variable consideration
entirely to the nonlease component would be
consistent with the allocation objective in ASC
606-10-32-28. This is because allocating the
variable consideration for CAM to the CAM nonlease
component and the fixed consideration for the
building rent to the lease component is in line
with the stand-alone selling prices of each
component (i.e., when Lessee’s estimated share of
property taxes and insurance are also considered
in the determination of the stand-alone selling
price of the lease component).
Accordingly, Lessor applies the
lessor accounting guidance (see Chapter
9) to the fixed consideration of
$100,000 and the revenue recognition guidance in
ASC 606 to the $35,000 of the estimated variable
consideration included in the consideration in the
contract. When there are changes in facts and
circumstances upon which the variable payments for
property taxes and insurance are based, Lessor
will allocate those payments to the lease
component (i.e., because allocating any of the
payments to the nonlease component would not meet
the allocation objective with respect to either
the lease component or the nonlease component,
when the stand-alone selling price of each is
taken into account).
4.4.2.2.3 Estimating the Stand-Alone Selling Price of the Lease Component by Reference to a Gross Real Estate Lease at Fair Value
Example 4-21, Case A, illustrates an allocation by
which the real estate lessor is able to estimate the stand-alone
selling price of the lease component in a gross lease. However,
lessors of real estate under gross leases often do not lease real
estate separately without CAM and other services (i.e., they do not
also lease on a triple net basis); thus, it may be difficult to
estimate the stand-alone selling price of the lease component.
However, a lessor of real estate under gross leases may be able to
estimate the stand-alone selling price of CAM by using the
expected-cost-plus-a-margin approach in ASC 606-10-32-34(b).
If a real estate lessor under a gross lease can show
that the contract is priced at fair market value and can estimate
the stand-alone selling price of CAM, questions have arisen about
whether the lessor can estimate the stand-alone selling price of the
lease component by reference to the fair market value price of the
entire contract and the nonlease component.
The allocation method described above in Example 4-21, Case A, effectively
results in the following when there are only two components in the
contract (i.e., a lease component and nonlease component for CAM):
stand-alone selling price of lease component = fair market value
price of entire contract – estimate of stand-alone selling price of
CAM.21
This allocation method is similar mathematically to
the residual approach in ASC 606-10-32-34(c), which states:
Residual approach — An entity may estimate
the standalone selling price by reference to the total
transaction price less the sum of the observable standalone
selling prices of other goods or services promised in the
contract. However, an entity may use a residual approach to
estimate, in accordance with paragraph 606-10-32-33, the
standalone selling price of a good or service only if one of
the following criteria is met:
-
The entity sells the same good or service to different customers (at or near the same time) for a broad range of amounts (that is, the selling price is highly variable because a representative standalone selling price is not discernible from past transactions or other observable evidence).
-
The entity has not yet established a price for that good or service, and the good or service has not previously been sold on a standalone basis (that is, the selling price is uncertain).
However, when a lessor of gross real estate can
prove by reference to objective and observable market data that
the entire contract is priced at fair market value, we think
that the allocation method described above is an acceptable approach
to estimating the stand-alone selling price of a lease component.
ASC 606-10-32-34 states that the approaches listed in ASC
606-10-32-34(a)–(c) are “[s]uitable methods for estimating the
standalone selling price of a good or service” but that methods of
estimating a stand-alone selling price “are not limited to” those
approaches.
In addition, we think that the following conditions
should also be met before a lessor of gross real estate may use the
allocation method described above:
-
The lessor can reasonably estimate the stand-alone selling price of the CAM by using a suitable method in ASC 606-10-32-34(a) or (b). For example, the lessor can show, by using objective and observable market data (e.g., quotes from asset managers), that its estimate for the stand-alone selling price of CAM is in line with market pricing for related services.
-
The objective and observable market data used to prove that the entire contract is priced at fair market value sufficiently indicate that there is no discount in the contract. (If there is a discount, it must be allocated in accordance with ASC 606-10-32-36 through 32-38 and such allocation may not be on a relative stand-alone selling price basis.)
-
The allocation method generally should not result in an estimate of zero for the stand-alone selling price of one of the components in the contract. (However, see Section 4.4 for further discussion.)
When the entire contract is priced at fair market
value and the other three conditions above are met, we think that
the allocation method described above is effectively an adjusted
market assessment approach in accordance with ASC 606-10-32-34(a)
and that use of such an approach would result in sufficient
objective evidence that the contract does not contain a discount. On
the other hand, if a lessor of real estate under a gross lease is
unable to prove, using objective and observable market data, that
the entire contract is priced at fair market value, the allocation
method described above is effectively the residual approach. In such
cases, we think that neither the contract nor the good or service
(i.e., the lease component) would meet the criteria in ASC
606-10-32-34(c) for use of the residual approach.
Real estate lessors that are considering the
allocation method described above should consult with their
accounting advisers and monitor developments on the topic, since
views on the applicability of this method may differ.
4.4.2.2.4 Allocating Consideration in Arrangements Involving the Use of an Asset for “Free”
Vendors in certain industries often provide
customers with the right to use, for a specified period, a piece of
equipment for no charge (“free equipment”) in exchange for exclusive
rights to supply related products (i.e., consumables). The equipment
typically can be used only to dispense consumables that are sold by
the vendor. In many cases, the customer has the right, but not the
obligation, to purchase consumables from the vendor at a specified
price. These arrangements may be referred to as “free lease”
arrangements because they often contain no explicit consideration
related to the use of the equipment; rather, the consideration in
the contract consists of a charge per unit of consumable purchased
by the customer. Examples of such arrangements may include a
contract that conveys the use of an x-ray scanner to a hospital (the
hospital may purchase contrast dyes only from the vendor) and a
contract that conveys the use of a soft drink fountain dispenser to
a restaurant (the restaurant may purchase soda syrup only from the
vendor).
Questions have arisen about whether a vendor in a
“free lease” arrangement should allocate the consideration in the
contract between the use of the equipment (i.e., a lease component)
and the purchase of the consumables (i.e., a nonlease component)?
In general, we would expect the consideration in the
contract (even if the consideration is all variable) to be allocated
among the contract components. We would not normally expect a vendor
to provide equipment to a customer without expecting compensation.
This would suggest that some of the per-unit price of the
consumables should be allocated to the use of the equipment.
However, in some limited circumstances, we would not
object to allocating 100 percent of the per-unit price to the
consumable sales if the following criteria are met:
-
The contract only includes variable payments not based on an index or rate; that is, the contract does not contain any fixed or in-substance fixed payments.
-
The consumables are priced at (or below) their stand-alone selling price.
-
The equipment is insignificant in the context of the contract.
If the contract contains a fixed or in-substance
fixed payment, as described in ASC 842-10-30-5 and ASC 842-10-15-35
(e.g., a minimum commitment to purchase consumables), such an amount
must be allocated between the identified equipment in the
arrangement and any nonlease components. In these situations,
provided that the customer has the right to control the use of the
identified equipment, we believe that such a contract contains a
lease of the equipment. (A lease is defined as the “right to control
the use of identified [PP&E] for a period of time in exchange for consideration” [emphasis
added].)
The second criterion is designed to identify
scenarios in which a vendor has not “marked up” the consumables to
compensate itself for providing the customer with use of the
equipment. To the extent that the per-unit price is at or below the
vendor’s stand-alone selling price for the consumables (i.e., the
per-unit price is the same as or lower than the per-unit price for a
customer that purchases the equipment), this fact constitutes
evidence that the vendor is not seeking or receiving incremental
compensation for the equipment.
If the first two criteria are met, the vendor should
evaluate the equipment’s value in relation to the overall combined
value of the arrangement (including an estimate of the consumable
value by using its best projection of consumables to be purchased
over the contract term). The vendor should also consider other
relevant factors (qualitative and quantitative) to determine whether
the equipment is insignificant in the context of the contract.
The fact that an arrangement satisfies these three
criteria may suggest that the vendor has provided the right to use
its asset over the term of the contract for no compensation. While
future consumable purchases are expected, there are no enforceable
rights to require future purchases. Therefore, in a manner
consistent with an optional purchase model for a revenue transaction
(as described in TRG Paper 48), those future
consumable purchases are not enforceable and do not create
additional consideration in the arrangement, and the customer thus
obtains use of the vendor’s asset without any obligation to make
payments. This outcome is consistent with a revenue transaction in
which a vendor provides its customer with an up-front deliverable
(e.g., a razor) for no consideration and expects (but is not able to
require) the customer to make subsequent purchases of consumables
(razor blades). In this revenue transaction, the vendor would record
no revenue for the up-front deliverable (razor) and would incur a
day 1 loss upon the transfer of control of the deliverable (razor)
to the customer.
Example 4-22
Assume the following facts:
-
Vendor L provides Customer H with “free” diagnostic equipment for a stated noncancelable term of five years.
-
The equipment has no use other than in combination with consumables sold by L to produce a testing result.
-
The equipment is explicitly specified in the contract, and H controls the use of the equipment during the five-year contract term through its exclusive use and ability to direct the use of the equipment.
-
Customer H is required to return the equipment to L at the end of the contract term.
-
The contract contains no explicit consideration for the use of the equipment; the consideration consists of a cost per unit of consumable purchased by H.
-
Throughout the five-year contract term, H has the right, but not the obligation, to purchase consumables from L to use in operating the equipment. The contract does not contain any minimum purchase commitments related to the consumables. Customer H may only use the consumables with the equipment provided by L and may not use a third-party vendor’s consumables with the equipment.
-
Vendor L has determined that the stand-alone selling price for the use of the equipment over a five-year term is $200,000.
The scenarios below illustrate potential
alternatives related to L’s allocation of
consideration in the contract described in this
example.
Scenario 1A (Before the Adoption of ASU
2021-05)
At contract inception, L estimates that H will
purchase 100,000 consumables during the five-year
contract term. The stand-alone selling price of
consumables is $6 per unit and the selling price
within the contract is $7.50 per unit, yielding an
estimated $750,000 of contract consideration.
On the basis of these additional facts, the
contractual price of consumables (i.e., $7.50 per
unit) is higher than the stand-alone selling price
of the consumables (i.e., $6 per unit). The higher
contractual price is most likely established to
compensate L for the use of the equipment. Even
though there are no fixed or in-substance fixed
payments, since the price of the consumables is
higher than the stand-alone selling price, L would
conclude that this contract includes both a lease
component and a nonlease component.
Vendor L would be required to allocate
consideration between the use of the equipment (a
lease) and the sale of consumables. Vendor L will
allocate the consideration between the equipment
and the estimated future consumable purchases on
the basis of their respective stand-alone selling
prices, as determined at lease inception. The
consideration in the contract is allocated as
follows:
Since consideration must be allocated to the
use of the equipment, this component of the
arrangement will generally meet the definition of
a lease (i.e., the right to control the use of
identified PP&E for a period of time in
exchange for consideration). For each consumable
purchased by H, L will recognize $1.88 as variable
lease income and $5.63 as revenue.
This scenario resulted in a conclusion that a
lease exists because the contractual price of
consumables is higher than the stand-alone selling
price. However, even if this were not the case,
because the equipment value is quantitatively
assessed as 25 percent of the total contract
value, a lease component would most likely still
be identified given the significance of the
equipment to the overall contract.
Depending on the life of the
equipment compared with the contract term (i.e.,
if the contract term is greater than 75 percent of
the useful life of the equipment), these
arrangements may qualify as sales-type leases and
could lead to commencement losses because of their
dependence on variable consideration. (See the
first Connecting the Dots in
Section 9.3.7.1.2 for more
information about commencement losses related to
sales-type leases.)
With respect to operating leases of equipment,
we also note that vendors will generally not
qualify to use the lessor practical expedient
related to not separating the lease (i.e.,
equipment) and nonlease (i.e., consumables)
components in the contract because the transfer of
consumables occurs at a point in time whereas the
transfer of the leased equipment is over time.
Scenario 1B (After the Adoption of ASU
2021-05)
At contract inception, L estimates that H will
purchase 100,000 consumables during the five-year
contract term. The stand-alone selling price of
consumables is $6 per unit and the selling price
within the contract is $7.50 per unit, yielding an
estimated $750,000 of contract consideration.
On the basis of these
additional facts, the contractual price of
consumables (i.e., $7.50 per unit) is higher than
the stand-alone selling price of the consumables
(i.e., $6 per unit). The higher contractual price
is most likely established to compensate L for the
use of the equipment. Even though there are no
fixed or in-substance fixed payments, since the
price of the consumables is higher than the
stand-alone selling price, L would conclude that
this contract includes both a lease component and
a nonlease component.
Vendor L would be required to allocate
consideration between the use of the equipment (a
lease) and the sale of consumables. Vendor L will
allocate the consideration between the equipment
and the estimated future consumable purchases on
the basis of their respective stand-alone selling
prices, as determined at lease inception. The
consideration in the contract is allocated as
follows:
Since consideration must be allocated to the
use of the equipment, this component of the
arrangement will generally meet the definition of
a lese (i.e., the right to control the use of
identified PP&E for a period of time in
exchange for consideration). For each consumable
purchased by H, L will recognize $1.88 as variable
lease income and $5.63 as revenue.
This scenario resulted in a conclusion that a
lease exists because the contractual price of
consumables is higher than the stand-alone selling
price. However, even if this were not the case,
because the equipment value is quantitatively
assessed as 25 percent of the total contract
value, a lease component would most likely still
be identified given the significance of the
equipment to the overall contract.
Before the adoption of ASU
2021-05, the arrangement in the scenario described
above may qualify as a sales-type lease depending
on the life of the equipment compared with the
contract term (i.e., if the contract term is
greater than 75 percent of the useful life of the
equipment). After the adoption of ASU 2021-05,
however, if treating the lease as a sales-type
lease would result in the recognition of a selling
loss at lease commencement, the lease would be
classified as an operating lease in accordance
with ASC 842-10-25-3A because of the inclusion of
variable consideration. (See the first
Connecting the Dots in
Section 9.3.7.1.2 for more
information about commencement losses related to
sales-type leases and Section 17.3.1.8
for further discussion of ASU 2021-05.)
Scenario 2
At contract inception, L estimates that H will
purchase 450,000 consumables during the five-year
contract term. The stand-alone selling price of
consumables is $7.50 per unit, as evidenced by
separate observable sales of consumables within
contracts in which L sells the equipment to
customers. Use of the contractual price of $7.50
per unit yields an estimated $3.375 million of
contract consideration.
First, L observes that the contract does not
include any fixed or in-substance fixed payments
throughout the contract term. Then, L considers
that its business model is to provide the
equipment for free to drive consumable sales,
which is corroborated by the fact that the
contractual price of consumables is identical to
the stand-alone selling price of the consumables
(i.e., a customer that purchases the equipment
would pay the same price as a customer that signs
this contract); L’s primary objective is to sell
consumables, not to sell the insignificant
equipment.
The table below illustrates how L may assess
the relative value within the contract and how it
would allocate the consideration to the potential
components.
On the basis of this calculation, L concludes
that the equipment value is approximately 5.6
percent of the total contract value. Upon
considering this quantitative factor as well as
other qualitative factors, L determines that the
equipment is insignificant to the overall
contract.
Accordingly, in this scenario,
it may be acceptable for L to conclude that this
contract does not include a lease since L has
determined that no
consideration is provided for the use of the
equipment. (The glossary in ASC 842-10-20 defines
a lease as the “right to control the use of
identified [PP&E] for a period of time in exchange for
consideration” [emphasis added].) As a result,
100 percent of the consideration would be
allocated to the sale of the consumables (i.e.,
revenue). Compared with the conclusion reached in
Scenarios 1A and 1B, this conclusion does not
result in a timing difference for revenue
recognition purposes but could result in a
different presentation and disclosure outcome:
revenue from contracts with customers and variable
lease income would be presented in Scenarios 1A
and 1B, whereas only revenue from contracts with
customers would be presented in Scenario 2.
In addition, L should assess whether H obtains
control of the equipment (not just the right to
use it for five years). If control has been
transferred, L would incur a day 1 loss22 upon delivery of the equipment to H, in a
manner similar to the above example involving
razors and razor blades. Conversely, if L
determines that H did not obtain control of the
equipment, L would continue to recognize the
equipment as PP&E subject to the guidance in
ASC 360 on subsequent measurement (e.g.,
depreciation and impairment). We generally believe
that control of the equipment is transferred to
the customer when the term of the arrangement
constitutes the major part of the remaining useful
life of the equipment. However, if the vendor has
a right to reclaim the equipment during the term
of the arrangement without the customer’s
permission (e.g., in cases in which the customer
is not purchasing as many consumables as
expected), this reclamation right may indicate
that control of the equipment has not been
transferred.
4.4.2.3 Remeasure and Reallocate Consideration
ASC 842-10
15-41 A lessor shall remeasure and reallocate the remaining consideration in the contract when there is a contract modification that is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
A lessor is required to remeasure and reallocate (rather than only
reallocate, as required by ASC 842-10-15-42 and discussed in Section 4.4.2.2) the
consideration in the contract only when there is (1) a contract modification
that is not accounted for as a separate contract, (2) an exercise of an
option for the lessee to extend the lease or purchase the underlying asset
that the lessee was not previously certain to exercise, or (3) a lessor’s
exercise of an option to terminate the lease that the lessor was not
previously reasonably certain to exercise. (See Section 9.3.4 for detailed discussion
of the contract modification guidance for lessors.) Upon the occurrence of a
contract modification that is not accounted for as a separate contract, the
lessor would measure the remaining consideration in the contract in
accordance with Section
4.4.2.1 and allocate it in accordance with Section 4.4.2.2.
If the consideration in the contract is remeasured and reallocated in accordance
with ASC 842-10-15-41 as a result of a contract modification that is not
accounted for as a separate contract, and there is a subsequent change in
the consideration in the contract that must be allocated in accordance with
ASC 842-10-15-42, the allocation of the changed consideration should be on
the same basis as the most recent allocation (i.e., on the same basis as the
allocation performed as a result of the contract modification).
4.4.3 Codification Examples
ASC 842-10
15-32 See Examples 11 through 14 (paragraphs 842-10-55-131 through 55-158) for illustrations of the requirements for allocating consideration to components of a contract.
Examples 11–14 in ASC 842-10-55 illustrate implementation of the guidance in ASC 842-10-15-28
through 15-40. Although Examples 12 and 13 in ASC 842-10-55 are reproduced in Sections 4.3 and
4.2.3 (since they are particularly related to identifying the nonlease components in a contract and
separating lease components in a contract, respectively), Examples 11 and 14 in ASC 842-10-55
are reproduced below in this section, since they address the determination and allocation of the
consideration in the contract by both lessees and lessors. Rather than carving up each example and
reproducing different pieces throughout this chapter, we have decided to keep them intact in their
entirety since we find that approach to be more useful.
ASC 842-10
Example 11 — Allocation of Consideration to Lease and Nonlease Components of a
Contract
Case A — Allocation of Consideration in the Contract
55-132 Lessor leases a bulldozer, a truck, and a crane to Lessee to be used in Lessee’s construction operations
for three years. Lessor also agrees to maintain each piece of equipment throughout the lease term. The total
consideration in the contract is $600,000, payable in $200,000 annual installments.
55-133 Lessee and Lessor both conclude that the leases of the bulldozer, the truck, and the crane are each
separate lease components because both of the criteria in paragraph 842-10-15-28 are met. That is:
- The criterion in paragraph 842-10-15-28(a) is met because Lessee can benefit from each of the three pieces of equipment on its own or together with other readily available resources (for example, Lessee could readily lease or purchase an alternative truck or crane to use with the bulldozer).
- The criterion in paragraph 842-10-15-28(b) is met because, despite the fact that Lessee is leasing all three machines for one purpose (that is, to engage in construction operations), the machines are not highly dependent on or highly interrelated with each other. The machines are not, in effect, inputs to a combined single item for which Lessee is contracting. Lessor can fulfill each of its obligations to lease one of the underlying assets independently of its fulfillment of the other lease obligations, and Lessee’s ability to derive benefit from the lease of each piece of equipment is not significantly affected by its decision to lease or not lease the other equipment from Lessor.
55-134 In accordance with paragraph 842-10-15-31, Lessee and Lessor will account for the nonlease maintenance services components separate from the three separate lease components (unless Lessee elects the practical expedient in paragraph 842-10-15-37 or Lessor elects the practical expedient in paragraph 842-10-15-42A when the conditions in that paragraph are met—see Case B [paragraphs 842-10-55-138 through 55-140] for an example in which Lessee elects the practical expedient). In accordance with the identifying performance obligations guidance in paragraphs 606-10-25-19 through 25-22, Lessor further concludes that its maintenance services for each piece of leased equipment are distinct and therefore separate performance obligations, resulting in the conclusion that there are three separate lease components and three separate nonlease components (that is, three maintenance service performance obligations).
55-135 Lessor allocates the consideration in the contract to the separate lease components and nonlease
components by applying the guidance in paragraphs 606-10-32-28 through 32-41. The consideration allocated
to each separate lease component constitutes the lease payments for purposes of Lessor’s accounting for
those components.
55-136 Lessee allocates the consideration in the contract to the separate lease and nonlease components. Several suppliers provide maintenance services that relate to similar equipment such that there are observable standalone prices for the maintenance services for each piece of leased equipment. In addition, even though Lessor, who is the manufacturer of the equipment, requires that all leases of its equipment include maintenance services, Lessee is able to establish observable standalone prices for the three lease components on the basis of the price other lessors lease similar equipment on a standalone basis. The standalone prices for the separate lease and nonlease components are as follows.
55-137 Lessee first allocates
the consideration in the contract ($600,000) to the
lease and nonlease components on a relative basis,
utilizing the observable standalone prices determined in
paragraph 842-10-55-136. Lessee then accounts for each
separate lease component in accordance with Subtopic
842-20, treating the allocated consideration as the
lease payments for each lease component. The nonlease
components are accounted for by Lessee in accordance
with other Topics. The allocation of the consideration
to the lease and nonlease components is as follows.
Case B — Lessee Elects Practical Expedient to Not Separate Lease From
Nonlease Components
55-138 Assume the same facts and circumstances as in Case A (paragraphs 842-10-55-132 through 55-137), except that Lessee has made an accounting policy election to use the practical expedient to not separate nonlease from lease components for its leased construction equipment. Consequently, Lessee does not separate the maintenance services from the related lease components but, instead, accounts for the contract as containing only three lease components.
55-139 Because Lessor regularly leases each piece of equipment bundled together with maintenance services on a standalone basis, there are observable standalone prices for each of the three combined components, each of which includes the lease and the maintenance services. Because each of the three separate lease components includes the lease of the equipment and the related maintenance services, the observable standalone price for each component in this scenario is greater than the observable standalone price for each separate lease component that does not include the maintenance services in Case A.
55-140 Lessee allocates the consideration in the contract ($600,000) to the three separate lease components
on a relative basis utilizing the observable standalone selling price of each separate lease component (inclusive
of maintenance services) and then accounts for each separate lease component in accordance with the
guidance in Subtopic 842-20, treating the allocated consideration as the lease payments for each separate
lease component. The standalone prices for each of the three combined lease components is as follows.
Example 14 — Determining the Consideration in the Contract — Variable
Payments
Case A — Variable Payments That Relate to the Lease Component and the
Nonlease Component
55-150 Lessee and Lessor enter into a three-year lease of equipment that includes maintenance services
on the equipment throughout the three-year lease term. Lessee will pay Lessor $100,000 per year plus an
additional $7,000 each year that the equipment is operating a minimum number of hours at a specified level
of productivity (that is, the equipment is not malfunctioning or inoperable). The potential $7,000 payment each
year is variable because the payment depends on the equipment operating a minimum number of hours at a
specified level of productivity. The lease is an operating lease.
55-151 In accordance with paragraph 842-10-15-35, variable payments other than those that depend on an
index or a rate are not accounted for as consideration in the contract by Lessee. Therefore, the consideration
in the contract to be allocated by Lessee to the equipment lease and the maintenance services at lease
commencement includes only the fixed payments of $100,000 each year (or $300,000 in total). Lessee allocates
the consideration in the contract to the equipment lease and the maintenance services on the basis of the
standalone prices of each, which, for purposes of this example, are $285,000 and $45,000, respectively.
Each $100,000 annual fixed payment and each variable payment are allocated to the equipment lease and
the maintenance services on the same basis as the initial allocation of the consideration in the contract (that
is, 86.4 percent to the equipment lease and 13.6 percent to the maintenance services). Therefore, annual
lease expense, excluding variable expense, is $86,364. Lessee recognizes the expense related to the variable
payments in accordance with paragraphs 842-20-25-6 and 842-20-55-1 through 55-2.
55-152 In accordance with paragraphs 842-10-15-39 through 15-40, Lessor also concludes that the potential variable payments should not be accounted for as consideration in the contract. That is because the potential variable payment each year is not solely related to performance of the nonlease maintenance services; the quality and condition of the underlying asset also substantively affect whether Lessor will earn those amounts. Therefore, Lessor’s allocation of the consideration in the contract ($300,000) in this Example is the same as Lessee. Lessor will allocate, in accordance with paragraph 842-10-15-40, the variable payments between the lease and nonlease maintenance services (on the same basis as the initial allocation of the consideration in the contract), when and if the productivity targets are met. Lessor will recognize the portion allocated to the lease at that time and will recognize the portion allocated to the nonlease maintenance services in accordance with the guidance on satisfaction of performance obligations in Topic 606 on revenue from contracts with customers.
Case B — Variable Payments That Relate Specifically to a Nonlease
Component
55-153 Assume the same facts and circumstances as in Case A (paragraphs 842-10-55-150 through 55-152), except in this scenario the maintenance services are highly specialized and no entity would expect the equipment to meet the performance metrics without the specialized maintenance services.
55-154 Lessee would account for the potential variable payments consistent with Case A. The rationale for this accounting also is consistent with that in Case A.
55-155 In contrast to Case A, Lessor concludes that the variable payments relate specifically to an outcome from Lessor’s performance of its maintenance services. Therefore, Lessor evaluates the variable payments in accordance with the variable consideration guidance in paragraphs 606-10-32-5 through 32-13. If Lessor estimates, using the most likely amount method, that it will be entitled to receive the $21,000 in variable payments and that it is probable that including that amount in the transaction price for the maintenance services would not result in a significant revenue reversal when the uncertainty of the performance bonus is resolved, the $21,000 would be included in the consideration in the contract. Because allocating the $21,000 entirely to the maintenance services would not result in an allocation that is consistent with the allocation objective in paragraph 606-10-32-28 (that is, it would result in allocating $61,909 to the maintenance services and the remainder to the equipment lease, which would not reasonably depict the consideration to which Lessor expects to be entitled for each component), the entire consideration in the contract of $321,000 is allocated on a relative standalone price basis as follows.
55-156 The $277,227 allocated to the equipment lease is the lease payment in accounting for the lease in accordance with Subtopic 842-30. Lessor will recognize the consideration in the contract allocated to the maintenance services in accordance with the guidance on the satisfaction of performance obligations in paragraphs 606-10-25-23 through 25-37. If the consideration in the contract changes (for example, because Lessor no longer estimates that it will receive the full $21,000 in potential variable payments), Lessor will allocate the change in the transaction price on the same basis as was initially done.
Case C — Allocating Variable Payments Entirely to a Nonlease
Component
55-157 Assume the same facts and circumstances as in Case B (paragraphs 842-10-55-153 through 55-156),
except that in this scenario all of the following apply:
- The potential variable payments are $14,000 per year ($42,000 in total), and the annual fixed payments are $93,000 per year ($279,000 in total).
- While Lessor’s estimate of the variable payments to which it will be entitled is $42,000, Lessor concludes that it is not probable that including the full $42,000 in potential variable payments in the consideration in the contract will not result in a significant revenue reversal (that is, the entity applies the constraint on variable consideration in paragraph 606-10-32-11). Lessor concludes that only $28,000 is probable of not resulting in a significant revenue reversal. Therefore, the consideration in the contract is initially $307,000 ($279,000 + $28,000).
55-158 In contrast to Case B, Lessor concludes that allocating the variable payments entirely to the
maintenance services and the fixed payments entirely to the equipment lease is consistent with the allocation
objective in paragraph 606-10-32-28. This is because $42,000 (Lessor considers its estimate of the variable
payments to which it expects to be entitled exclusive of the constraint on variable consideration in Topic 606
on revenue recognition) and $279,000 approximate the standalone price of the maintenance services ($45,000)
and the equipment lease ($285,000), respectively. Because the variable payments are allocated entirely to the
maintenance services, if the consideration in the contract changes (for example, because Lessor concludes it
is now probable that it will earn the full $42,000 in variable payments), that change is allocated entirely to the
maintenance services component in the contract.
Footnotes
18
Examples 11 and 14 in ASC 842-10-55-132 through
55-140 and ASC 842-10-55-150 through 55-158, respectively, also
illustrate such allocation. Both examples are reproduced in
Section
4.4.3.
19
IFRS 16 does not contain a similar
requirement that lessor costs paid directly to a
third party by a lessee should be excluded from
variable payments. See Appendix B for a
summary of differences between ASC 842 and IFRS
16.
20
IFRS 16 does not contain a similar practical
expedient allowing lessors to present sales taxes collected from
lessees on a net basis. See Appendix B for a summary
of differences between ASC 842 and IFRS 16.
21
For example, by using an
expected-cost-plus-a-margin approach.
22
Vendor L would derecognize the full carrying
value of the equipment and would record a
corresponding loss.
4.5 Contract Combinations
ASC 842-10
25-19 An entity shall combine two or more contracts, at least one of which is or contains a lease, entered into
at or near the same time with the same counterparty (or related parties) and consider the contracts as a single
transaction if any of the following criteria are met:
- The contracts are negotiated as a package with the same commercial objective(s).
- The amount of consideration to be paid in one contract depends on the price or performance of the other contract.
- The rights to use underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component in accordance with paragraph 842-10-15-28.
An entity is required to “combine two or more contracts . . . entered into at or near the same time with
the same counterparty” if any of the criteria in ASC 842-10-25-19(a)–(c) above are met. The contract
combination guidance should be assessed at contract inception. An entity will need to use judgment in
determining whether multiple contracts are “entered into at or near the same time.” As a general rule,
the longer the period between entering contracts with the same counterparty, the more likely those
contracts are not economically linked.
Connecting the Dots
Contract Combination Guidance Is
Consistent With That in ASC 606
The contract combination guidance in ASC 842 is generally consistent with that in ASC 606. In paragraph BC165 of ASU 2016-02, the FASB acknowledged that this consistency was intentional:
The Board included guidance in Topic 842 for when an entity should combine two
or more contracts and account for them as a single contract.
Although it is usually appropriate to account for a contract
individually, an entity should assess the combined effect of
contracts that are interdependent. An entity may enter into multiple
contracts in contemplation of another such that the contracts, in
substance, form a single arrangement that achieves an overall
commercial effect. The financial reporting effect of recognizing
those contracts separately may be different from the financial
reporting effect of recognizing those contracts on a combined basis.
In those situations, accounting for the contracts independently
might not result in a faithful representation of the combined
transaction. This accounting has been
acknowledged throughout GAAP, and guidance similar to that in
Topic 842 was included in Topic 606. [Emphasis added]
Although the contract combination guidance is generally consistent with that in ASC 606, the requirements in ASC 842-10-25-19 apply to both lessees and lessors. Therefore, an entity should establish policies and procedures to ensure that controls are in place to identify and consider arrangements entered into “at or near the same time.” Given that the guidance on this topic in ASC 842 is consistent with that in ASC 606, we would generally expect entities to adopt consistent policies related to what they consider “at or near the same time” when determining whether and, if so, when to combine contracts.
Generally, it will be appropriate for lessees and lessors to account for contracts individually. However, when certain contracts are interdependent, entities should assess their combined effect to determine whether the financial reporting outcome of accounting for those contracts on a combined basis is more representationally faithful than the outcome when those contracts are accounted for individually. This will generally be the case when the contracts are entered into to achieve a single, overall commercial objective. As a result, an entity must account for its arrangements on the basis of the substance (i.e., one commercial arrangement) rather than the form (e.g., three separate legal contracts).
The examples below illustrate the application of the guidance in ASC
842-10-15-19 on contract combinations.
Example 4-23
Company EC, the lessor, and LH Cruises, the
lessee, enter into an initial agreement on January 1, 20X8,
in which the lessor will provide a named sailboat to the
lessee for a three-year period commencing on April 1, 20X8.
One week after the initial agreement was executed, on
January 8, 20X8, a separate contract was executed for the
use of a specified dock to store the sailboat, also for a
three-year period and commencing on April 1, 20X8.
The lessee will pay $25,000 per year for the
right to use the sailboat. The dock space was leased at a
rate of $5,000 per year. Under the contract to lease the
dock space, the lessee also agrees to pay $500 for every
hour that the sailboat is not docked. The standard rate at
which the lessor rents sailboats is $40,000 annually, while
the market rate for dock space is $5,000 per year.
Both the lessee and the lessor conclude that
the contracts should be combined and accounted for as a
single transaction because they are interdependent. The
sailboat and dock are used in conjunction to achieve the
single commercial objective of providing a sailboat and a
dock to store the sailboat.
The contracts are combined in accordance
with ASC 842-10-25-19 on the basis of the following:
-
The contracts are entered into at or near the same time (i.e., within one week of each other, between January 1, 20X8, and January 8, 20X8) with the same counterparty.
-
The annual lease payment for the sailboat is lower than the market rate because the lessor expects to recover the difference through the fixed and variable pricing (based on performance) of the dock rental. The criterion in ASC 842-10-25-19(b) is met.
Example 4-24
Company M, an automobile manufacturer, and Company D, an unrelated car dealer, both want to benefit
from a car dealership in Fort Worth, Texas, that will exclusively sell M’s cars. Company D owns the land and
building in Fort Worth, and M wants to ensure that D will only use that property for the intended purpose for
at least 25 years. To ensure that the property is used as a car dealership selling vehicles produced by M, the
parties structure the transaction as a “lease-in and lease-out” (LILO), in which M leases the property from D and
simultaneously subleases the property back to D.
The following are relevant terms of the LILO arrangement:
- The terms of the head lease (i.e., D, as a lessor, leases to M, as a head lessee) and sublease (i.e., M, as a head lessee and sublessor, leases to D, as a sublessee) mirror each other. The head lease and sublease have identical fixed rental payments and 25-year fixed lease terms.
- The terms of the sublease limit D’s use of the property to activities defined in the contract as “dealership activities” (i.e., use of the property as a car dealership to sell vehicles produced by M).
- As the sublessee, D cannot assign or transfer its rights under the sublease, or further sublease the property, without M’s consent.
- If D, as the sublessee, defaults on the sublease agreement (e.g., D fails to pay rent, or D conducts activities other than dealership activities), M has the option to (1) sublease the property to another car dealer or (2) terminate the sublease and retain control of the property for the remainder of the term of the head lease.
- Under the head lease and during its term, D has the right to sell the property to a third party, with the following stipulations: (1) M has a first right of refusal and may purchase the property and (2) upon a sale, the property continues to be subject to the head lease and sublease (which will be assigned to the new owner of the property).
Both M and D conclude that the head lease and the sublease should be combined and accounted for as a
single transaction because the contracts are interdependent. The contracts are combined in accordance
with ASC 842-10-25-19 because the head lease and sublease were negotiated as a package with the same
commercial objective. That is, the contracts were executed to ensure that D would use the property for 25
years as a car dealership to sell vehicles manufactured by M.
ASC 842-10-25-19 does not require that the contracts under consideration be coterminous. Therefore, the fact
that the two contracts may not always be coterminous (e.g., if M were to terminate the sublease upon a default
by D as the sublessee) is not relevant to the above conclusion to combine the head lease and sublease.
As a result, neither M nor D accounts for the head lease or the sublease as leases within the scope of ASC 842.
Companies M and D must look to other applicable GAAP to account for the substance of the transaction (i.e., to
ensure that D uses the property as a dealership to sell M’s cars).
4.5.1 Combining Contracts With Unrelated Parties
Consider a scenario in which Entity L enters into a contract to
lease an asset to Retailer K, which K intends to simultaneously sublease to End
User B for five years. Entity L separately contracts with B to provide
maintenance services related to the asset for the five-year lease term. In legal
form, there are three separate contracts: (1) the lease contract between L and
K, (2) the lease contract between K and B, and (3) the service contract between
L and B.
The three contracts are negotiated as a package with the same
commercial objective of allowing B to use the asset and receive maintenance
services. In addition, the consideration paid by B in its lease and service
contracts depends on the price paid by K in its lease contract.
In this example, L should not combine its contracts to lease the
asset to K and provide maintenance services to B. Under ASC 842-10-25-19, the
contracts must be with the same counterparty (or related parties) to be
combined. Therefore, the contracts in the above example cannot be combined even
though (1) they are entered into simultaneously and are negotiated as a package
with a single commercial objective and (2) the amount of consideration in one
contract depends on the price of the other contract.
Sylvia Alicea, then a professional accounting fellow in the
SEC’s Office of the Chief Accountant, addressed this topic in a speech at the
2016 AICPA Conference on Current SEC and PCAOB Developments. Ms. Alicea stated,
in part:
Next, I’ll share some observations related to the
contract combination guidance. I observe that the guidance in Topic 606
explicitly limits which contracts should be combined. In the
consultation that OCA evaluated, the registrant had two contracts that
were entered into at the same time and met some of the criteria for
contract combination because they were: (i) negotiated between all
parties with a single commercial objective; and (ii) were priced
interdependently such that consideration paid under one contract was
dependent on the price in the other contract. However, the contracts did
not meet the requirement in Topic 606 to be with the same customer or
related parties of the customer. Therefore, OCA objected to the
registrant’s extension of the contract combination guidance beyond those
parties. [Footnotes omitted]
Although Ms. Alicea’s remarks were associated with ASC 606, we
believe that the same conclusion would be reached under ASC 842 because of the
similarities between the two standards’ contract combination guidance.
Chapter 5 — Commencement Date, Lease Term, and Purchase Options
Chapter 5 — Commencement Date, Lease Term, and Purchase Options
5.1 Commencement Date of a Lease
ASC 842-10 — Glossary
Commencement Date of the Lease (Commencement Date)
The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the 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.
The commencement date of the lease is important under ASC 842 because that date
is when (1) lease classification is determined (see Sections 8.3.2 and 9.2 for more information about lessee and lessor classification,
respectively) and (2) the lease is initially measured (see Sections 8.4.2 and 9.3.2 for discussion of
lessee and lessor initial measurement, respectively). As noted above, the
commencement date is the “date on which a lessor makes an underlying asset [i.e.,
the PP&E subject to the lease] available for use by a lessee.” The commencement
date may differ from the date stated in the contract and is not affected by when the
lessee (1) must make lease payments (e.g., if the lessor grants the lessee a rent
holiday) or (2) expects to use or actually uses the underlying asset. A lease
agreement may grant the lessee access to and control over the leased asset before
the beginning of the fixed noncancelable term stated in the lease agreement. This is
common, for example, when the lessee needs time to construct leasehold improvements
or otherwise prepare the leased space for its intended use. It is also common for
the lessee not to be required to begin making rental payments until the beginning of
the fixed noncancelable lease term.
However, a lease can commence, for accounting purposes, before the
beginning of the fixed noncancelable term stated in a lease agreement. ASC 842-10-20
defines the lease commencement date as the “date on which a lessor makes an
underlying asset available for use by a lessee.” Further, ASC 842-10-55-19 states
that “[i]n some lease arrangements, the lessor may make the underlying asset
available for use by the lessee . . . before it begins operations or makes lease
payments under the terms of the lease.” In such cases, the lease commences when the
lessee has access to and the right to control the use of the leased asset (see
Section 3.4 for a detailed discussion of
when a customer has the right to control the use of an identified asset), even if
that occurs before the beginning of the fixed noncancelable lease term stated in the
lease agreement.
Example 5-1
A lease agreement for office space is signed
on January 1, 20X9, and the fixed noncancelable term begins
on June 1, 20X9, at which time the lessee will begin making
rental payments. Under the terms of the lease agreement, the
lessee is granted access to the office space to make
improvements to the space beginning on January 1, 20X9. In
this situation, the lease term commences on January 1,
20X9.
There may also be instances in which a lessee controls an underlying
asset before the commencement date of the lease. For example, this may be the case
for transactions in which the lessee is involved with a construction project (i.e.,
the underlying asset that will be subject to the lease is in the process of being
constructed). In such cases, the lessee would be required to recognize the asset as
the “deemed owner” of the asset before lease commencement and must determine whether
derecognition is appropriate as a sale-and-leaseback transaction. (See Chapter 11 for a detailed
discussion of when the lessee controls an underlying asset before the commencement
date of the lease, and see Chapter 10 for more
information about the accounting for sale-and-leaseback transactions.)
Changing Lanes
Inception Date Versus Commencement 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, which may lead to different conclusions regarding
classification if facts and circumstances change between the dates (see the
Changing Lanes discussions in Sections 8.3.2 and 9.2).
In addition, while a lease was initially recognized at lease
commencement under ASC 840 as it is under ASC 842, the inputs used to
initially measure the lease under ASC 842 are determined at different times
than they were under ASC 840. 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.
5.1.1 Lease Commencement Date for Master Lease Agreements
ASC 842-10
55-17 Under a master lease agreement, the lessee may gain control over the use of additional underlying
assets during the term of the agreement. If the agreement specifies a minimum number of units or dollar value
of equipment, the lessee obtaining control over the use of those additional underlying assets is not a lease
modification. Rather, the entity (whether a lessee or a lessor) applies the guidance in paragraphs 842-10-15-28
through 15-42 when identifying the separate lease components and allocating the consideration in the contract
to those components. Paragraph 842-10-55-22 explains that a master lease agreement may, therefore, result
in multiple commencement dates.
55-22 There may be multiple commencement dates resulting from a master lease agreement. That is
because a master lease agreement may cover a significant number of underlying assets, each of which are
made available for use by the lessee on different dates. Although a master lease agreement may specify
that the lessee must take a minimum number of units or dollar value of equipment, there will be multiple
commencement dates unless all of the underlying assets subject to that minimum are made available for use
by the lessee on the same date.
In a manner consistent with how an entity determines the commencement date for a
single lease, an entity must determine the commencement date for each underlying
asset that is leased under a master lease agreement on the basis of the date on
which the underlying asset is made available for use by a lessee. Therefore,
under a master lease agreement, there may be different commencement dates
related to when the different underlying assets are made available for the
lessee’s use. See Section 13.4 for more
information about the accounting for master lease agreements.
5.2 Lease Term
ASC 842-10 — Glossary
Lease Term
The noncancellable period for which a lessee has the right to use an underlying asset, together with all of the
following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
ASC 842-10
30-1 An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
55-25 The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.
The lease term is an important input to lease classification and to the initial
and subsequent measurement of a lease. The lease term is determined in accordance
with ASC 842-10-30-1 (as illustrated below). The next sections further discuss the
composition of the lease term and related issues.
5.2.1 Noncancelable Period and Enforceable Period
ASC 842-10
55-23 An entity should
determine the noncancellable period of a lease when
determining the lease term. When assessing the length of
the noncancellable period of a lease, an entity should
apply the definition of a contract and determine the
period for which the contract is enforceable. A lease is
no longer enforceable when both the lessee and the
lessor each have the right to terminate the lease
without permission from the other party with no more
than an insignificant penalty.
A contract is an agreement between two or more parties that
creates enforceable rights and obligations. Any noncancelable period within a
lease contract would generally be considered enforceable and should be included
in the lease term. In addition, cancelable periods should also be evaluated for
enforceability in accordance with ASC 842-10-55-23. For a lease to no longer be
enforceable under ASC 842-10-55-23, both parties must
“have the right to terminate the lease . . . with no more than an insignificant
penalty.” Accordingly, a lease is considered enforceable over a cancelable
period if either (1) only one party has a termination right or (2) both parties
have a termination right but either party would incur a
more than insignificant penalty by terminating the lease. After determining the
enforceable period, the parties should consider the guidance in ASC 842-10-30-1
(as discussed in Sections
5.2.2 and 5.2.3)
to determine the lease term within the enforceable period (i.e., the lease term
will either be shorter than or equal to the enforceable period). When either the
lessee or lessor has the right to terminate a lease at any time upon giving
notice to the other party, the noncancelable period of the lease would include
this “notice” period.
Connecting the Dots
Enforceability Is a Broad
Concept
As noted above, “noncancelable” and “enforceable” have
different meanings under ASC 842, and entities are required to evaluate
whether a contract is enforceable over optional periods on the basis of
the economic consequences to the parties rather than solely on the basis
of contractual or legal enforceability. Periods in which one or both
parties have the contractual right, but not the obligation, to extend
the agreement are enforceable but not noncancelable periods. Periods in
which either party has — but both parties do not have — the right to
terminate the agreement are also enforceable but not noncancelable
periods. Periods in which both parties have the right to terminate the
agreement are not enforceable unless either party would incur a more
than insignificant penalty by exercising its right. For example, a lease
would be considered enforceable over the period in which the lessee
would incur a more than insignificant penalty by terminating the lease,
even when the lease is subject to a contractual cancellation right held
by the lessor.
Further, in determining the lease term, both the lessee
and the lessor should evaluate options to extend or terminate the lease
during the enforceable period. Enforceable periods covered by options
that provide the lessor with the right to extend or unilaterally
terminate the lease are included in the lease term (i.e., it is assumed
that the lessor will extend or not terminate the lease). For enforceable
periods in which the lessee has the right to extend or terminate the
lease, the probability of exercise needs to be assessed. The lease term
would include enforceable periods in which it is reasonably certain that
the lessee will extend or not terminate the lease (see the next
section). Importantly, “reasonably certain” (which is used in the
determination of the lease term) differs from “more than insignificant”
(which is used in the determination of the enforceable period). For
example, when both parties have the right to terminate the lease yet the
lessee would incur a more than insignificant penalty to do so, the
optional period is enforceable, but this does not mean that the lessee
is reasonably certain not to exercise its termination option. However,
any economic penalty (or incentive) that would cause a lessee to be
reasonably certain not to terminate a lease would also indicate that the
lessee would incur a more than insignificant penalty by terminating the
lease; the related period would thus be included in both the enforceable
period and the lease term.
5.2.2 Periods Covered by Options (Reasonably Certain)
ASC 842-10
30-2 At the commencement date, an entity shall include the periods described in paragraph 842-10-30-1 in the lease term having considered all relevant factors that create an economic incentive for the lessee (that is, contract-based, asset-based, entity-based, and market-based factors). Those factors shall be considered together, and the existence of any one factor does not necessarily signify that a lessee is reasonably certain to exercise or not to exercise an option.
55-26 At the commencement date, an entity assesses whether the lessee is reasonably certain to exercise
or not to exercise an option by considering all economic factors relevant to that assessment — contract-based,
asset-based, market-based, and entity-based factors. An entity’s assessment often will require the
consideration of a combination of those factors because they are interrelated. Examples of economic factors to
consider include, but are not limited to, any of the following:
- Contractual terms and conditions for the optional periods compared with current market rates, such as:
- The amount of lease payments in any optional period
- The amount of any variable lease payments or other contingent payments, such as payments under termination penalties and residual value guarantees
- The terms and conditions of any options that are exercisable after initial optional periods (for example, the terms and conditions of a purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates).
- Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or to purchase the underlying asset becomes exercisable.
- Costs relating to the termination of the lease and the signing of a new lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee’s operations, or costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location.
- The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset and the location of the underlying asset.
Entities must assess whether it is
reasonably certain that a lease will continue into
periods covered by renewal or termination options. When
assessing the likelihood of whether a lessee will be
economically compelled to (i.e., when assessing whether
it is reasonably certain that a lessee will) exercise or
not exercise an option to renew or terminate a lease,
respectively, the lessee and lessor should consider
various economic factors (e.g., contract-based,
asset-based, entity-based, and market-based factors).
Because the assessment of “reasonably certain” is based
on judgments and estimates, lessees and lessors may
reach different conclusions about whether it is
reasonably certain that a lessee will exercise a renewal
or purchase option or not exercise a termination option.
Given the subjectivity involved in the evaluation of
these economic factors, the longer the period from the
commencement date of the lease to the date of exercising
the option, the more difficult it would generally be to
determine whether a lessee will be reasonably certain to
exercise or not exercise an option to renew or terminate
a lease (for example, it would be difficult to precisely
predict the importance of an underlying asset to the
lessee’s operations further into the future). In
addition, to apply the short-term lease recognition
exemption (discussed in detail in Section 8.2.1), lessees
must perform this assessment and determine the lease
term.
|
Connecting the Dots
“Reasonably Certain” and
“Reasonably Assured”
Under IAS 17 (the predecessor standard to IFRS 16), an
entity used the “reasonably certain” threshold to evaluate the lease
term; this threshold is generally interpreted as high. When developing
ASC 842, the Board decided to use the term “reasonably certain” to be
consistent with IFRS 16 (which supersedes IAS 17). However, paragraph
BC195 of ASU 2016-02 indicates that the “reasonably certain” threshold
is substantially the same as the “reasonably assured” threshold under
ASC 840. Therefore, we do not expect that ASC 842 will change the
threshold used to determine the lease term; that is, “reasonably
certain” will also be considered a high threshold of probability under
ASC 842, as the FASB indicates in paragraph BC71(b) of ASU 2016-02.
ASC 842-10 — Glossary
Penalty
Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following:
- Disburse cash
- Incur or assume a liability
- Perform services
- Surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment. Factors to consider in determining whether an economic detriment may be incurred include, but are not limited to, all of the following:
-
The uniqueness of purpose or location of the underlying asset
-
The availability of a comparable replacement asset
-
The relative importance or significance of the underlying asset to the continuation of the lessee’s line of business or service to its customers
-
The existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the underlying asset
-
Adverse tax consequences
-
The ability or willingness of the lessee to bear the cost associated with relocation or replacement of the underlying asset at market rental rates or to tolerate other parties using the underlying asset.
-
As described in ASC 842-10-20 above, a penalty is any requirement associated with a lease agreement or outside of the lease agreement that could have an adverse financial impact on a lessee (e.g., require disbursement of cash, performance of service, surrendering of an asset). While a penalty may impose a requirement on a lessee to make an additional payment or payments to a lessor, it could also be linked to payments to an independent party or result in a loss of future economic benefits to the lessee as a whole. For example, if a lease termination will result in a loss of a significant amount of income for a lessee, that termination could be viewed as a penalty.
The existence of a penalty, if large enough, could affect the evaluation of lease term, lease payments, and renewal and purchase options. For example, if a lessee is required to pay the lessor a significant penalty for not renewing a lease, it would be appropriate to conclude at lease commencement that the lease term would include the renewal period because the potential to pay the penalty economically compels the lessee to renew the lease. Similarly, an entity may conclude that it is reasonably certain to exercise a purchase option to the extent that the lease agreement includes a significant penalty payable by the lessee to the lessor for failure to exercise such an option (as discussed in Section 5.3). A penalty is included in lease payments (see Chapter 6) when it is not significant enough to make the exercise of a renewal or purchase option reasonably certain at lease commencement.
5.2.2.1 Contract-Based Factors
Contract-based factors affecting the determination of the likelihood that a lessee will exercise or not exercise an option are linked to the terms of the lease agreement. Examples of contract-based factors include:
- The existence of a bargain renewal option.
- The existence of contingent or variable payments.
- The nature and terms of renewal or termination options.
- The costs the lessee would incur to restore the asset before returning it to the lessor.
5.2.2.1.1 Renewal Option
ASC 840 required entities to include in the lease term
“[a]ll periods, if any, covered by ordinary renewal options preceding
the date as of which a bargain purchase option is exercisable.” In
contrast, ASC 842 requires an entity to include in the lease term
“[p]eriods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option.” ASC 842-10-55-26 expands on
the term “reasonably certain,” stating, in part:
At the commencement date, an entity assesses
whether the lessee is reasonably certain to exercise or not to
exercise an option by considering all economic factors relevant
to that assessment — contract-based, asset-based, market-based,
and entity-based factors. An entity’s assessment often will
require the consideration of a combination of those factors
because they are interrelated. Examples of economic factors to
consider include, but are not limited to, any of the
following:
-
Contractual terms and conditions for the optional periods compared with current market rates, such as: . . .3. The terms and conditions of any options that are exercisable after initial optional periods (for example, the terms and conditions of a purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates).
ASC 842 does not explicitly include a requirement to
identify a bargain purchase option and to include any ordinary renewal
options preceding the exercise date of the bargain purchase option.
However, ASC 842-10-55-26(a)(3) requires an entity to consider renewal
options preceding a “purchase option that is exercisable at the end of
an extension period at . . . below market rates.” Accordingly, while an
entity may need to use greater judgment in applying the above guidance
from ASC 842, we believe that the accounting outcome achieved under ASC
842 should generally be consistent with that achieved under the more
explicit guidance in ASC 840.
We believe that, in evaluating bargain purchase options
that are exercisable after a renewal period, an entity should consider
all relevant facts and circumstances, including, but not limited to, the
utility of the PP&E to the lessee during the renewal period. In
addition, we believe that when an ordinary (i.e., nonbargain) renewal
option exists, the lease can be considered to have a noncancelable term
followed immediately by a purchase option. The exercise price of that
purchase option would represent the present value at the end of the
noncancelable term of the renewal-period lease payments and the price of
the purchase option.
Example 5-2
Consider the following
example:
-
Entity X, the lessee, enters into a lease for equipment with an initial term of five years. The lease includes two lessee-specific options: (1) a five-year renewal option at market rates and (2) an option to purchase the equipment for $100 at the end of the renewal period (i.e., at the end of 10 years). At lease commencement, the equipment is expected to have a fair value significantly greater than $100 when the purchase option is exercisable.
-
Entity X plans to use the equipment for a specific project that is expected to be completed at the end of the initial five-year lease term. The project is unique and X does not have an alternative use for the equipment outside of the identified project. Therefore, there is no clear utility of the equipment to X over the five-year renewal term.
-
Entity X concludes that the present value, at the end of the initial term, of the lease payments for the renewal period, plus the purchase option exercise price of $100, does not represent a bargain purchase option when compared with the expected fair value of the equipment at the end of the initial term.
On the basis of the factors (not
all-inclusive) outlined above, X is not required
to include the renewal period in the lease term
because the purchase option at a below market rate
does not represent an
economic incentive that would cause the lessee to
determine that it is reasonably certain to
exercise the renewal option. A purchase option at
a below market rate will often provide an economic
incentive for the lessee to exercise the
intervening renewal option. However, in this case,
the utility of the equipment during the renewal
period is uncertain and therefore significantly
reduces the lessee’s incentive to exercise the
renewal option. In addition, the present value, at
the end of year 5, of the renewal-period lease
payments, plus the purchase option price of $100,
does not represent a bargain purchase option when
compared with the expected fair value of the
equipment. Therefore, it is not reasonably certain
that X will exercise the renewal option even
though the renewal period is followed by a bargain
purchase option.
Connecting the Dots
Residual Value Guarantee
Affecting Lease Term and Lease Payments
Some lease agreements may allow a lessee to
early terminate a lease only if the lessee guarantees the
residual value of the underlying asset as of the termination
date. In these cases, the lessee should evaluate the residual
value guarantee when determining whether it is reasonably
certain that the option to terminate early will not be
exercised. That is, the lessee should evaluate the impact of the
residual value guarantee when considering whether it will be
economically compelled to terminate the lease before the end of
the lease term or whether the residual value guarantee itself
would result in the lessee’s continuation of the lease for the
full term. This evaluation and the resulting conclusions may
affect both the determination of the lease term and the lease
payments. See Section 6.7 for additional discussion of
residual value guarantees.
5.2.2.2 Asset-Based Factors
Asset-based factors depend on specific characteristics of the underlying asset. Examples of asset-based
factors include:
- The existence of significant lessee-installed leasehold improvements that would still have economic value when the option becomes exercisable.
- The physical location of the asset.
-
The specialized nature of the asset.
- The costs that would be incurred to replace or find an alternative asset (including costs associated with lost production).
5.2.2.2.1 Lease Term
If a lease contains renewal options, the lessee’s
investment in leasehold improvements should be considered in the
determination of whether renewal periods need to be included in the
lease term.
The value of leasehold improvements at the end of the
noncancelable lease period could be considered an economic penalty and
could provide reasonable certainty that the lessee will renew the lease
rather than surrender the value of the leasehold improvements.
When evaluating whether the abandonment or relocation of
leasehold improvements constitutes a significant penalty, an entity
should consider, among other things, the lessee’s ability or willingness
to (1) bear the cost of relocating or replacing the leased property at
market rental rates or (2) tolerate other parties using the leased
property. Ordinarily, lessees would be expected to be unwilling to
abandon leasehold improvements or other assets that are expected to have
a significant remaining fair value that would not otherwise be available
to the lessee at the end of the lease’s fixed noncancelable term.
Similarly, lessees typically would not be expected to be willing to
incur significant costs, directly or indirectly, to relocate leasehold
improvements.
Therefore, when it is expected that there will be a loss
of significant fair value or an incurrence of significant costs, (1)
there is usually an economic penalty and (2) the penalty causes the
lessee to conclude that exercise of the renewal options is reasonably
certain. As a result, the lessee includes the renewal periods in the
lease term.
Further, situations in which the lessee is prepared to
incur a significant economic penalty rather than extend the lease term
beyond its fixed noncancelable term (i.e., lease renewal is not
reasonably certain) are expected to be rare. In cases in which the
lessee is prepared to abandon the leasehold improvements and incur the
economic penalty, the leasehold improvements should be depreciated to a
residual value of zero over the fixed noncancelable term of the
lease.
5.2.2.3 Entity-Based Factors
The impact of entity-based factors depends on the entity’s historical practice, management’s intent, and common industry practice. Examples of entity-based factors include:
- The financial impact on the entity of extending or terminating the lease.
- The importance of the leased asset to the entity’s operations.
5.2.2.4 Market-Based Factors
Market-based factors include the market rental or purchase rates for comparable assets and any potential implications of local regulations and statutory requirements.
5.2.3 Periods Within the Control of the Lessor
ASC 842-10-30-1(c) states that “[p]eriods covered by an option to extend (or not
to terminate) the lease in which exercise of the option is controlled by the
lessor” should be included in the lease term. Effectively, under ASC 842, it is
assumed that when a lessor has the sole option to continue the lease into
optional periods, it will choose to do so. Note, however, that unlike the
assessment for options exercisable solely by the lessor, the required assessment
for any options to extend or not terminate a lease controlled or effectively
controlled by a third party unrelated to the lessor or lessee (e.g., a
sublessee), would be the same as that for an option exercisable by the lessee
(see Section 5.2.2) in the determination
of whether the unrelated third party is reasonably certain to extend or not
terminate the lease.
See Section 5.2.4.1 for discussion of how to
differentiate between a cancelable lease and a lease with a lessor-controlled
option to terminate.
5.2.4 Application of the Lease Term Guidance
The next sections further discuss application of, and issues related to, the
lease term guidance.
5.2.4.1 Cancelable Leases
ASC 842-10
55-24 If only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term, as described in paragraph 842-10-30-1(b). If only a lessor has the right to terminate a lease, the lease term includes the period covered by the option to terminate the lease, as described in paragraph 842-10-30-1(c).
A lease contract would not be considered enforceable (i.e., it would be
considered cancelable) if the lessee and lessor each have the separate right
to terminate the lease without incurring a more than insignificant penalty
(see Section
5.2.1 for more information). If the lessee or the lessor
individually has the separate right to terminate the lease, those
termination options would be assessed as follows:
-
If a lease contract includes a termination option that gives only the lessee the right to terminate the lease, an entity would evaluate whether it is reasonably certain that the lessee will not exercise that termination option (as discussed in Section 5.2.2).
-
If a lease contract includes a termination option that gives only the lessor the right to terminate the lease, an entity would not consider that termination option when evaluating the lease term (i.e., it should be assumed that the lessor will not elect to terminate early, as discussed in Section 5.2.3).
5.2.4.2 Evergreen Leases
In addition to contracts that specify a period that includes renewal options occurring on an “as
exercised” basis, ASC 842 also applies to contracts that automatically renew. For example, leases
characterized as “evergreen,” “month to month,” “perpetual,” or “rolling” would meet the definition of a
contract and would be subject to ASC 842 if such a contract includes enforceable rights and obligations.
In determining the lease term for such arrangements, an entity would consider
the same factors as it would for all other leases. That is, an entity would
need to consider contract-based, asset-based, market-based, and entity-based
factors to determine the term over which the lessee is reasonably certain to
extend the lease.
5.2.4.3 Short-Term Leases
ASC 842-10 — Glossary
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.
A lessee can elect (by asset class) not to record on the balance sheet a lease
whose term is 12 months or less and does not include a purchase option that
the lessee is reasonably certain to exercise (i.e., treat the lease as an
operating lease under ASC 840). When determining whether the lease qualifies
for this election, the lessee would include renewal options only if they are
considered part of the lease term (i.e., those options the lessee is
reasonably certain to exercise). If the lease term increases to more than 12
months, or if it is reasonably certain that the lessee will exercise an
option to purchase the underlying asset, the lessee would no longer be able
to apply the short-term lease exception and would account for the lease as
it would other leases. See Section 8.2.1 for more information about a lessee’s
accounting for a lease that qualifies for the short-term exemption and
Section
15.2.7 for discussion of the disclosure requirements related
to the short-term lease recognition exemption.
5.2.4.4 Impact of a Sublease on Lease Term
A lessee that enters into an agreement to sublease the underlying asset needs to
assess whether the sublease term will affect the term of the head lease. For
example, if the sublease includes renewal options that would, if exercised,
extend past the initial term of the head lease, the head lessee would need
to evaluate whether it would incur any penalty for not exercising its
renewal options in the head lease. The head lessee would consider this
factor in addition to other relevant contract-based, asset-based,
entity-based, and market-based factors when evaluating whether it is
reasonably certain that it will (1) exercise an option to renew, (2) not
exercise an option to terminate, or (3) exercise an option to purchase the
underlying asset. The existence of a renewal provision in the sublease does
not automatically indicate that it is reasonably certain that the head
lessee will exercise the renewal options on its head lease. See Section 12.2.1 for
further discussion.
5.2.4.5 Lease Term When a Lease Consists of Nonconsecutive Periods of Use
An entity may enter into an arrangement for the right to use an asset during nonconsecutive periods.
Such an arrangement may contain a lease as defined in ASC 842-10. Questions have arisen about
whether the lease term in such an arrangement should consist of only the nonconsecutive periods of
use or the entire period of the arrangement. The lease term is important to the determination of the
lease classification and how, and the period over which, to recognize rental expense.
The ASC master glossary defines a lease as a “contract, or
part of a contract, that conveys the right to control the use of identified
property, plant, or equipment (an identified asset) for a period of time in
exchange for consideration.” Control of the use of the underlying property
depends on whether, over the period of use, the lessee has the right to (1)
substantially all of the economic benefits from use of the identified asset
and (2) direct the use of the identified asset. (The period of use related
to identifying a lease is further discussed in Section 3.5.)
Further, ASC 842-10-20 defines the period of use as the
“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).”
Therefore, in evaluating the lease term, a lessee must determine the period
over which it has the right to control the use of the underlying asset,
which may comprise only the sum of nonconsecutive periods.
Example 5-3
Retailer A enters into a lease arrangement for the
use of mall space for only three consecutive months
of the year (the holiday period) for 10 years.
Because A only has the right to control the use of
the asset for 30 months (i.e., the total of the
nonconsecutive periods), A determines that the lease
term consists of only the nonconsecutive periods.
Therefore, A should use a lease term of 30 months
for classification purposes and should recognize
rental expense only during these periods, provided
that the lease is an operating lease.
Example 5-4
Company B owns a commercial parking
garage in a large retail shopping district and
charges customers a higher rate to use the garage
between the hours of 10 a.m. and 10 p.m. (peak
hours). Company B enters into an arrangement with
Retailer X that will give X the exclusive right to
use the parking garage during peak hours for the
next three years. Companies other than X have the
right to use the parking garage during off-peak
hours.
In this example, the lease term is
18 months (i.e., 12 hours a day for 36 months).
Company B and Retailer X should therefore use this
lease term when determining the lease
classification.
Connecting the Dots
Interaction Between Nonconsecutive Periods and
the Short-Term Lease Recognition Exemption
As discussed above, the lease term comprises the
period of use and the period of use comprises the sum of
nonconsecutive periods. Therefore, if the aggregate of the
nonconsecutive periods (that comprise the period of use) is 12
months or less, the lease term would also be 12 months or less.
Accordingly, the short-term lease recognition exemption (see
Section
8.2.1) may be elected.
The examples below illustrate this notion.
Example 5-5
RetailCo enters into a
three-year agreement with Landlord under which
RetailCo will lease a store in a mall during the
months of October, November, and December in each
year. Landlord agrees to provide the same store
for each of the three years. The aggregate of the
nonconsecutive periods (i.e., the period of use)
during which the store will be leased by RetailCo
is nine months (i.e., three months for each year
of the agreement). Accordingly, the lease term is
also nine months. RetailCo may elect the
short-term lease recognition exemption in this
scenario.
Example 5-6
TeamCo enters into a 30-year
agreement with City for a lease of a stadium. The
terms of the agreement stipulate that TeamCo will
have the right to use the stadium for 10 home
games a year. The home games are played on various
days (i.e., would be nonconsecutive). Because the
period of use is 300 days (i.e., 10 days per year
for 30 years), the lease term is also 300 days.
TeamCo may elect the short-term lease recognition
exemption in this scenario.
5.2.4.6 Fiscal Funding Clauses
ASC 842-10 — Glossary
Fiscal Funding Clause
A provision by which the lease is cancelable if the legislature or other funding authority does not appropriate
the funds necessary for the governmental unit to fulfill its obligations under the lease agreement.
ASC 842-10
55-27 The existence of a fiscal funding clause in a lease agreement requires an assessment of the likelihood of
lease cancellation through exercise of the fiscal funding clause. If it is more than remote that the fiscal funding
clause will be exercised, the lease term should include only those periods for which funding is reasonably
certain.
A fiscal funding clause in a lease gives a governmental agency the option to
cancel the lease if it does not receive funding through the appropriation
process to meet its payment obligation under the terms of the lease. Under
ASC 842, the lessor must evaluate the likelihood that the fiscal funding
clause will be exercised.1
If exercise of the fiscal funding clause is deemed remote, the lease would be
considered noncancelable. In contrast, if the exercise of the fiscal funding
clause is considered more than remote, the lease term would include only
periods for which it is considered reasonably certain that the government
agency will obtain the funding.
5.2.4.7 Terminal Rental Adjustment Clauses
A terminal rental adjustment clause (TRAC) is a clause that is generally
included in a vehicle lease arrangement. A TRAC stipulates a final rental
payment to the lessor of any shortfall, or a receipt by the lessee of any
surplus, in the selling price of the vehicle compared with the remaining
book value at the end of the lease. The specifics of a TRAC may vary by
contract. For example, the amount payable (or receivable) by a lessee under
a TRAC would depend on whether the lessee (or lessor) is obligated to pay
the entire amount of the shortfall (or surplus) as well as on the
depreciation method used to calculate the remaining book value of the
vehicle. These terms are generally explicitly stipulated in the contract. If
a lease containing a renewal option exercisable by the lessee also contains
a TRAC, the terms of the TRAC would need to be considered to ascertain
whether it is reasonably possible that the TRAC would result in a
significant payment by the lessee to the lessor at the end of the lease
term. The existence of a TRAC that is reasonably possible to result in a
significant payment by the lessee is an economic factor that would need to
be considered in the assessment of whether the lessee is reasonably likely
to extend the lease to avoid this payment. (Example 8-1, Scenario B, in Section 8.2.1 illustrates this concept.) However, the
existence of a TRAC would not, in isolation, dictate whether a lessee is
reasonably certain to exercise an option to extend the lease; the lessee and
lessor would also need to consider other economic factors (e.g.,
contract-based, asset-based, entity-based, and market-based factors). See
Section 5.2.2 for further
details.
5.2.4.8 Examples Illustrating the Lease Term Guidance
The scenarios in the example below illustrate the application of the guidance on
lease term discussed in Section 5.2.
Example 5-7
Scenario 1 — Exercise of the Renewal Option Is Not Reasonably Certain
On January 15, 20Y5, Company A enters into a lease for a machine that includes a noncancelable period of five years, with a three-year renewal option that will require payments based on market rents. The machine has not been customized and the arrangement does not include a termination penalty for not renewing the lease.
At lease commencement, A determines that the lease term is limited to the noncancelable period of five years. This determination is made on the basis that A is not economically compelled to exercise the three-year renewal option because (1) the lease payments during the renewal period are at market, (2) there is no termination penalty if it does not renew the lease, and (3) the machine has not been customized.
Scenario 2 — Exercise of the Renewal Option Is Reasonably Certain
On May 15, 20Y5, Company B enters into an equipment lease that includes a noncancelable period of five years, with a three-year renewal option that includes payments based on market rents. Company B modifies and configures the underlying asset at a significant cost. In addition, the equipment is a vital asset in B’s manufacturing process (i.e., B’s production output would be significantly affected if this asset were not in place).
At lease commencement, the lease term would be eight years. After considering the asset-based factors, B concludes that it would suffer a significant penalty if it were to exit the lease at the end of the noncancelable period because it would abandon the costs associated with modifying and configuring the equipment. Further, since this asset is vital to B’s manufacturing process, nonrenewal of the lease may adversely affect the company’s operations. On the basis of these factors, B concludes that it is reasonably certain that it will exercise the renewal option. As a result, the lease term is eight years.
Scenario 3 — Lessee and Lessor Both Have Right to
Terminate
On April 9, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B with no renewal or purchase options. Under the terms of the lease, A and B have the unilateral right to terminate the lease at the end of the lease’s second year without cause or penalty.
In this scenario (in the absence of other contract-, market-, or entity-based
factors), the noncancelable period, as well as the
lease term, would be two years. According to the
terms of the arrangement, B has the right to
terminate the lease at the end of year two, thereby
limiting A’s ability to extend the lease past this
period. In addition, because A can terminate the
lease at the end of year two, it does not have an
obligation to make lease payments past that period.
Scenario 4 — Lessor Has the Right to Terminate
On June 1, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B
in which B has the right to terminate the lease at
the end of year two without cause or penalty.
In this scenario, the noncancelable period and the lease term are four years. The lease term would always include optional periods that are controlled by the lessor.
Scenario 5 — Lessee Has the Right to Terminate
On June 1, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B in which A has the right to terminate the lease at the end of year 2.
In this scenario, both parties must assess whether it is reasonably certain that
A will not terminate the
lease after year 2 (in considering the factors
described in ASC 842-10-55-26). The lease term would
be two years unless the parties conclude that it is
reasonably certain that A will not terminate the
lease.
ASC 842-10
30-4 See paragraphs 842-10-55-19 through 55-21 for implementation guidance on commencement date and
paragraphs 842-10-55-23 through 55-27 for implementation guidance on lease term and purchase options.
See Examples 23 through 24 (paragraphs 842-10-55-210 through 55-224) for illustrations of the requirements
on purchase options.
Illustration of Lessee Accounting for Purchase Options
55-210 Examples 23 through 24 illustrate the evaluation of whether a lessee is reasonably certain to exercise
an option to purchase the underlying asset.
The Codification examples referenced in ASC 842-10-30-4 and ASC 842-10-55-210 are reproduced as
follows:
- Example 23 in ASC 842-10-55-211 through 55-217 is reproduced in Section 8.9.2.1.
- Example 24 in ASC 842-10-55-218 through 55-224 is reproduced in Section 8.9.2.2.
Footnotes
1
We would generally expect the governmental agency,
as lessee, to apply GASB accounting standards and not ASC 842.
5.3 Purchase Options
ASC 842-10
30-3 At the commencement date, an entity shall assess an option to purchase the underlying asset on the
same basis as an option to extend or not to terminate a lease, as described in paragraph 842-10-30-2.
When evaluating the lease term, an entity would consider a purchase option in
the same manner as it would an option to extend or not terminate a lease. If it is
reasonably certain that a lessee will exercise the option to purchase the underlying
asset at the end of the lease term, the lessee will (1) classify the lease as a
finance lease (see Section
8.3.3.4) and (2) amortize the ROU asset over the underlying asset’s
remaining useful life and not over the lease term (see Section 8.4.3.1). Similarly, a lessor that
concludes that the lessee is reasonably certain to exercise the purchase option will
(1) classify the lease as a sales-type lease and (2) include the option purchase
price as a lease payment that is used in the measurement of the net investment in
the lease (see Section 9.2.1.2). Section 6.4 discusses the
effect on lease payments of determining that the exercise of a purchase option is
reasonably certain.
5.4 Reassessment of Lease Term and Purchase Options
5.4.1 Lessees
ASC 842-10
35-1 A lessee shall reassess the lease term or a lessee option to purchase the underlying asset only if and at
the point in time that any of the following occurs:
- There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
- There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease.
- The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
- The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.
35-2 See paragraphs 842-10-55-28 through 55-29 for implementation guidance on reassessing the lease term and lessee options to purchase the underlying asset.
55-28 Examples of significant events or significant changes in circumstances that a lessee should consider in accordance with paragraph 842-10-35-1 include, but are not limited to, the following:
- Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable
- Making significant modifications or customizations to the underlying asset
- Making a business decision that is directly relevant to the lessee’s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset)
- Subleasing the underlying asset for a period beyond the exercise date of the option.
55-29 A change in market-based factors (such as market rates to lease or purchase a comparable asset) should not, in isolation, trigger reassessment of the lease term or a lessee option to purchase the underlying asset.
After lease commencement, a lessee must be on the lookout for the occurrence of certain discrete events or changes in circumstances that are within the control of the lessee, as described in ASC 842-10-35-1 and ASC 842-10-55-28. Upon the occurrence of such an event or change in circumstances that is within the control of the lessee, a lessee must reassess the lease term or its conclusion about whether exercise of a purchase option is reasonably certain. A lessee would not reassess the lease term or its conclusion about whether exercise of a purchase option is reasonably certain on the basis of the occurrence of events that are outside its control (e.g., on the basis of only market-driven factors, like changes in fair market rental rates).
When there is a change in lease term or in the conclusion about whether it is reasonably certain that an option to purchase the underlying asset will be exercised, a lessee must (1) reassess lease classification, (2) remeasure the lease liability by using revised inputs as of the reassessment date, and (3) adjust the associated ROU asset. For more information, see Sections 8.3.1 and 8.5.1.
The example below illustrates a scenario in which the lessee would not be
required to perform a lease term reassessment.
Example 5-8
On June 15, 20Y1, Company A leases a building to be used as a storage and
distribution warehouse for a 10-year term, with two
5-year renewal options. Company A initially determines
that, on the lease commencement date, it is not
reasonably certain that it will exercise either of the
renewal options and therefore concludes that the lease
term is 10 years.
On January 15, 20Y5, the city in which the warehouse is located significantly improves its highway system, thereby making the warehouse location more desirable for A’s distribution needs. This by itself would not result in the need for A to reassess whether it will exercise any remaining renewal options, since the significant event or change in circumstances is outside of A’s control.
5.4.1.1 Reassessing the Lease Term and Purchase Options Upon Construction of Leasehold Improvements
In addition to evaluating the impact of leasehold improvements at lease commencement, an entity
should consider the effect of leasehold improvements that are made after lease commencement. As
discussed in Section 5.4.1, a lessee is required to reassess the lease term or a lessee option to purchase
the underlying asset when a significant event or a significant change in circumstances that is within
the control of the lessee directly affects whether the lessee is reasonably certain to exercise its related
option.
In accordance with ASC 842-10-55-28, a lessee should assess the nature and
effect of significant leasehold improvements constructed after the lease
commencement date to determine whether the lessee is required, as a result
of such improvements, to reassess the lease term and the probability of
exercising a purchase option, if applicable.
Example 5-9
On June 15, 20Y1, Company A leases a building to be used as a storage and
distribution warehouse for a 10-year term, with two
5-year renewal options. Company A initially
determines that, on the lease commencement date, it
is not reasonably certain that it will exercise
either of the renewal options and therefore
concludes that the lease term is 10 years.
On January 15, 20Y5, A installs leasehold improvements with a 10-year estimated
useful life. The cost of the improvements is
significant, and it is now reasonably certain that A
will exercise at least one of its renewal options to
avoid losing the value associated with the
improvements. In this case, since the change in
circumstances is directly attributable to A’s
actions, reassessment of the lease term would be
required.
5.4.1.2 Impact of ROU Asset Impairment Indicator on Lease Term
As discussed in Section 8.4.4, lessees are required to
test ROU assets for impairment in accordance with ASC 360 when events or
changes in circumstances indicate that the carrying amount of an asset group
containing an ROU asset may not be recoverable (i.e., an impairment
indicator). In some cases, a lessee may have concluded at lease commencement
that it was reasonably certain to exercise a renewal option (or not exercise
a termination option); however, upon the occurrence of an impairment
indicator, the lessee may no longer be reasonably certain that it will
exercise the renewal option. Therefore, if the lessee were to reassess the
lease term upon the occurrence of the impairment indicator, it would no
longer include the renewal period in the lease term. If this reassessment
was allowed, the ROU asset subject to the ASC 360 impairment test would
decrease and the total potential impairment would most likely be
reduced.
However, an ROU asset impairment indicator alone should not
trigger a reassessment of the lease term. ASC 842-10-35-1 states that a
lessee should only reassess the lease term when one of the following
conditions is met:
-
There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
-
There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease.
-
The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
-
The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.
Under ASC 842-10-35-1(a), for a significant event or change
in circumstances to trigger a lease term reassessment, the event or change
in circumstances must be within the lessee’s control. ASC 842-10-55-28 and
55-29 provide implementation guidance on the types of events that would or
would not meet this requirement:
55-28 Examples of significant events or significant changes in
circumstances that a lessee should consider in accordance with paragraph
842-10-35-1 include, but are not limited to, the following:
-
Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable
-
Making significant modifications or customizations to the underlying asset
-
Making a business decision that is directly relevant to the lessee’s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset)
-
Subleasing the underlying asset for a period beyond the exercise date of the option.
55-29
A change in market-based factors (such as market
rates to lease or purchase a comparable asset) should not, in
isolation, trigger reassessment of the lease term or a lessee
option to purchase the underlying asset. [Emphasis added]
Therefore, a lessee should not reassess the lease term
solely because of external events or changes in circumstances that are
outside the lessee’s control.
On the other hand, ASC 360-10-35-21 gives the following
examples of impairment indicators:
-
A significant decrease in the market price of a long-lived asset (asset group)
-
A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition
-
A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator
-
An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)
-
A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group)
-
A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.
Accordingly, a significant event or change in circumstances
driven solely by market-based factors (e.g., a significant decrease in
market price) may constitute an impairment indicator under ASC 360 but would
not qualify, in isolation, as a lease term reassessment event.
Furthermore, in many situations involving asset group
impairments, management may have made an internal decision not to exercise
the renewal option and may have communicated this decision publicly or to
the board of directors. However, we do not believe that such an internal
decision alone constitutes a lease term reassessment event, because no
significant event or change in circumstances within the lessee’s control has
yet taken place.
Therefore, upon the occurrence of an impairment indicator,
entities should separately consider whether one of
the conditions in ASC 842-10-35-1 related to reassessing the lease term has
also been met. If none of those conditions are met, a lessee would not be
permitted to change the lease term, even though the lessee may no longer be
reasonably certain to exercise a renewal option previously included in the
lease term.
Example 5-10
Scenario 1
On July 1, 20X2, Retailer L enters
into a 10-year operating lease of a building with a
10-year renewal option. At lease commencement, L is
reasonably certain that it will exercise the renewal
option because of its installation of significant
leasehold improvements; therefore, L determines that
the initial lease term is 20 years. However, as a
result of a significant decrease in market demand
for L’s products, L concludes that an impairment
indicator exists on June 30, 20X7, at which point L
is no longer reasonably certain that it will
exercise the renewal option; accordingly, L’s
management communicates to L’s board of directors
that it no longer intends to exercise the option.
The change in L’s conclusion
regarding the exercise of the renewal option is
solely a result of the decrease in market demand. No
significant event or change in circumstances has
occurred that is within L’s control and directly
affects whether L will exercise the renewal option.
Therefore, L would not reassess the 15-year
remaining lease term on June 30, 20X7, and would
test the asset group containing the full ROU asset
for impairment in accordance with ASC 360.
Scenario
2
Assume that in addition to
experiencing a significant decrease in market demand
for its products (as addressed in Scenario 1 above),
L disposes of its significant leasehold improvements
on June 30, 20X7. In this scenario, L concludes that
the disposal constitutes a significant change in
circumstances that is within its control and
directly affects whether it will exercise the
renewal option. Therefore, L would reassess the
lease term on June 30, 20X7, and since it is no
longer reasonably certain that it will exercise the
renewal option, L would reduce the remaining lease
term from 15 years to 5 years and would remeasure
the lease, resulting in a decrease in the lease
liability and the corresponding ROU asset. Then, L
would test the asset group containing this lower ROU
asset for impairment in accordance with ASC 360.
5.4.2 Lessors
ASC 842-10
35-3 A lessor shall not reassess the lease term or a lessee option to purchase the underlying asset unless
the lease is modified and that modification is not accounted for as a separate contract in accordance with
paragraph 842-10-25-8. When a lessee exercises an option to extend the lease or purchase
the underlying asset that the lessor previously determined the lessee was not reasonably certain to exercise or exercises an option to terminate the lease that the lessor previously determined the lessee was reasonably certain not to exercise, the lessor shall account for the exercise of that option in the same manner as a lease
modification.
A lessor does not reassess the lease term or a lessee purchase option unless the
lease is modified and the modification is not accounted for as a separate
contract. A lessee’s exercise of an option to extend or terminate the lease or
purchase the underlying asset would be accounted for by the lessor in a manner
similar to a lease modification unless the initial lease term
determination includes the effects of those options. If a lessor includes in its
lease term an optional renewal period because it is reasonably certain that the
lessee would exercise that option, the lessor would not account for the lessee’s
exercise of the renewal option as a lease modification. See Section
9.3.4 for detailed discussion of the contract modification
guidance for lessors.
Chapter 6 — Lease Payments
Chapter 6 — Lease Payments
6.11.1 Payment Made by a Lessor to a Lessee
to Induce Early Termination of a Lease
6.11.2 “Key Money” Payment Made to an
Existing Lessee to Assume a Lease
6.1 General
To determine the appropriate lease classification and measure a lessee’s ROU
asset and lease liability and a lessor’s net investment in the lease at lease
commencement, lessees and lessors, respectively, must determine the lease payments
related to the use of the underlying asset during the lease term. Lease payments are
determined after the lease term has been established (see Chapter 5). This determination will include an
assessment of any payments during renewal periods for which exercise is deemed
reasonably certain. The graphic below depicts the types of payments that are and are not
included in the calculation of the lease payments at lease commencement.
Connecting the Dots
Lease Payments May Be an Allocated
Amount
As discussed in Chapter 4, once an entity determines that a contract contains a lease, the entity must identify and separate the lease and nonlease components in the contract. While this process for lessees differs slightly from that for lessors, in both cases the total consideration in the contract must be measured and allocated to the lease and nonlease components by maximizing the use of observable inputs. ASC 842-10-30-5 indicates that lease payments are amounts related to the use of the underlying asset (i.e., the lease component(s) in the contract). Therefore, when nonlease components are present, the lease payments are the consideration in the contract that is allocated to the lease component(s) rather than the total consideration in the contract.
Example 6-1
Company L (the lessee) enters into an arrangement to lease a building for 10
years. As part of the arrangement, the lessor is
required to provide CAM services for the 10-year lease
term. In exchange for the right to use the building and
obtain the CAM services, L will make fixed monthly
payments of $5,000. Company L concludes that the right
to use the building and the CAM are separate lease and
nonlease components in the contract, respectively, for
which the consideration in the contract should be
allocated on a stand-alone price basis. The stand-alone
price of the monthly building lease and CAM is $4,750
and $500, respectively.
The following table illustrates the allocation of the monthly contractual consideration of $5,000 between the lease and nonlease components in the contract.
Company L’s monthly lease payments are equal to $4,525, which is the amount allocated to the lease component of the contract. The $475 monthly amount allocated to the nonlease component (i.e., the CAM service) is not included in L’s lease payments.
For additional information on separating lease and nonlease components and allocating the consideration in the contract to those components, see Chapter 4.
Changing Lanes
Treatment of Executory Costs
Under ASC 840, some lessees may have determined that the definition of minimum
lease payments included “executory costs such as insurance, maintenance, and
taxes to be paid by the lessor, including any profit thereon” (although
executory costs may have been excluded from classification, measurement, or
disclosure — for example, in accordance with ASC 840-10-25-1(d)). See Q&As 16-1 and 16-2A for additional discussion.
Under ASC 842, an entity needs to distinguish between lease and nonlease
components in accounting for payments made for insurance, maintenance, and taxes
as part of a lease contract. Components for separate services, such as CAM,
represent a nonlease component in the contract to which a portion of the
consideration is allocated. (See Section 4.3.1 for detailed
discussion of nonlease components.) However, in other cases, such as
reimbursements of lessor costs, no good or service is transferred to the
customer and, accordingly, such payments do not represent a lease or nonlease
component in the contract (e.g., insurance and taxes). (See Section 4.3.2
for detailed discussion of “noncomponents.”) In such cases, no portion of the
consideration is allocated to items that do not transfer a good or service to
the customer (i.e., to the noncomponents). See Chapter 4 for further discussion
of separating lease and nonlease components and allocating the consideration in
the contract.
Example 6-2
Company L (the lessee) enters into an arrangement to lease a
building for 10 years. As part of the arrangement, the lessor is
required to provide CAM services for the 10-year lease term. In
exchange for the right to use the building and obtain the CAM
services, L will make fixed monthly payments of $5,000. In
addition, L agrees to pay the lessor a fixed monthly payment of
$300, which is intended to reimburse the lessor for its property
taxes and insurance for the building. The stand-alone price of
the monthly building lease and CAM is $5,050 and $500,
respectively.
Under ASC 840, the fixed monthly payment of $300 to reimburse the
lessor for its property taxes and insurance would not be
included in the measurement of minimum lease payments.
Under ASC 842, the property taxes
and insurance on the building do not represent a lease or
nonlease component in the contract. Therefore, the related fixed
monthly payment of $5,300 should be allocated between the lease
(i.e., building) and nonlease (i.e., CAM) components in the
contract, as shown in the following table:
6.1.1 Including Noncash Consideration in Lease Payments
Some leases require the lessee to make some or all of the lease
payments with noncash consideration. For example, a lessee could be required to
provide value in the form of hard assets, stock of the lessee or others, or
guarantees of certain of the lessor’s obligations.
An entity generally should include noncash consideration in its
determination of lease payments and should measure such consideration at fair
value at lease commencement. That is, we believe that the fair value of the
noncash consideration would generally be akin to an index or rate, which is
included in lease payments at commencement.1 Any fluctuations in the fair value of noncash consideration to be provided
between the initial measurement of the ROU asset and liability, or the net
investment in the lease, and the final measurement determined in accordance with
other U.S. GAAP should be recognized as variable lease income or expense. For
noncash consideration in the form of a guarantee (other than a residual value
guarantee and a guarantee of the lessor’s debt, the latter of which is discussed
below), the amounts accrued and ultimately paid under the guarantee would not be
considered variable lease payments. Rather, the providing of
the guarantee is the lease payment because the lessee has delivered its
stand-ready obligation under the guarantee.
Note, however, that a guarantee of the lessor’s debt is outside
the scope of lease payments.2
Example 6-3
Company A provides Company B with
materials and labor needed to build a tavern, and A has
agreed to lease the tavern from B at the end of the
construction period. Company A does not control the
asset under construction.3 The fair value of the materials and labor
provided to B should be recognized by A as a prepaid
lease payment and should be included in the measurement
of the ROU asset at lease commencement.
Example 6-4
Company X (the lessee) enters into an
arrangement to lease an aerosol can factory from Company
Y (the lessor) for three years. As consideration for the
right to use the aerosol can factory, X agrees to
transfer to Y 50, 60, and 70 shares of stock in Company
Z, in arrears each year, respectively. As of lease
commencement, the fair value per share of Z’s stock is
$20. Company X uses its incremental borrowing rate of 9
percent when discounting the lease payments since the
rate implicit in the lease is not known.
In accordance with the lease
classification tests (for lessees and lessors) under ASC
842-10-25-2(d), the lease payments should include the
three payments made in shares of Z’s stock. Assume that
the lease is an operating lease. The lessee’s lease
obligation should be measured at $3,009.4 Further assume that the fair value of the stock at
the end of year 1 of the lease (transfer date of the 50
shares) is $25 per share. The lessee should recognize
the incremental fair value not included in the lease
liability as a variable lease cost (i.e., $250, which
represents 50 shares multiplied by the increase in the
value of the stock since lease commencement). However,
the shares to be delivered in years 2 and 3 should not
be adjusted to their fair value at the end of year 1
because the fair value of the stock is an index or rate
that is not adjusted after lease commencement unless the
lease is remeasured for other reasons.
6.1.2 Security Deposits
Certain leasing arrangements may include a security deposit that
must be paid to the owner of the leased asset at or before lease commencement.
The security deposit is generally provided to support the lessee’s intent and
commitment to lease the underlying asset (i.e., upon receipt of a security
deposit, the lessor typically stops marketing the asset for lease).
ASC 842-10 defines lease payments with respect to identifying the types of
payments that an entity should consider when determining the classification,
initial measurement, and subsequent measurement of a lease. Specifically, ASC
842-10-30-5 states, in part:
At the commencement date, the lease payments shall consist of the
following payments relating to the use of the underlying asset during
the lease term:
-
Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
Security deposits can be either nonrefundable or refundable depending on the
terms of the contract, which affects whether such deposits are considered lease
payments.
6.1.2.1 Nonrefundable Deposits
A nonrefundable deposit is an amount the lessee pays the
lessor to secure the terms of the contract for both parties. This payment
represents a portion of the consideration to be transferred during the
contract term and is not refunded by the lessor. Because the payment to the
lessor is nonrefundable, it is considered a fixed payment under ASC
842-10-30-5. See Section 6.2 for further discussion of fixed lease payments.
6.1.2.2 Refundable Deposits
A refundable security deposit is an amount that the lessee
is required to submit to the lessor to protect the lessor’s interest in the
contract and the property. The lessor holds this amount until the occurrence
of an event that would allow it to use some or all of the deposit to meet
the contract requirements (e.g., use the deposit to recover any shortfall in
the lessee’s payment or to repair any damages to the leased property). In
the absence of such a need, the lessor would generally be required under the
contract to return the remaining, unused security deposit to the lessee at
the end of the lease. Because the payment is refundable, it would not meet the definition of a lease payment.
Note that when the lessor recovers a portion of a refundable
security deposit to recover a shortfall in a lease payment, the lessor would
effectively be settling a portion of the lease liability associated with the
missed payment. In contrast, any portion of the refundable security deposit
retained by the lessor for other reasons (e.g., excess wear and tear on the
underlying asset) would generally be considered a variable lease payment.5 As with other variable payment requirements, lessees should consider
the implementation guidance in ASC 842-20-55-1 and 55-2 when evaluating
whether a lessee should recognize costs from variable payments before the
achievement of a specified target (see Section 8.4.3.3.1).
In addition, to the extent that the arrangement provides for
interest to be earned on the deposit, any interest earned on the refundable
security deposit that the lessee forgoes (i.e., that the lessor is entitled
to retain) should be considered a variable lease payment.
Footnotes
1
See ASC 842-10-30-5(b), reproduced in Section 6.3.
2
See ASC 842-10-30-6(b), reproduced in Section
6.9.2.
3See ASC 842-40-55-3 through
55-6.
4
Calculated as the sum of the
present value of the lease payments — $1,000 ($20
× 50 shares) paid at the end of year 1, $1,200
($20 × 60 shares) paid at the end of year 2, and
$1,400 ($20 × 70 shares) paid at the end of year 3
— discounted at 9 percent.
5
ASC 842 defines variable lease payments as
“[p]ayments made by a lessee to a lessor for the right to use an
underlying asset that vary because of changes in facts or
circumstances occurring after the commencement date, other than the
passage of time.” Therefore, any portion of a refundable security
deposit that is retained by a lessor because of changes in facts and
circumstances after the lease commencement date represents a
variable lease payment and should be recognized as an expense from
the lessee’s perspective and as income in profit or loss from the
lessor’s perspective in the period when incurred (lessee) or earned
(lessor).
6.2 Fixed Payments
ASC 842-10
30-5 At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term:
- Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31). . . .
Lease payments, as defined in ASC 842-10, are the types of payments that an
entity should consider when determining the classification, initial measurement, and
subsequent measurement of a lease. Known cash flows in a lease contract are the
simplest inputs to recognition and measurement. Fixed payments in the contract that
are related to the right to use the underlying asset (including those that are
“in-substance fixed”) are included in the lease payments, regardless of their
timing. For example, fixed payments made by the lessee before lease commencement
should be included in lease payments.
The next sections further discuss common ways in which payments may be
fixed.
6.2.1 In-Substance Fixed Payments
ASC 842-10
55-31 Lease payments include in substance fixed lease payments. In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following:
- Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance)
- The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments.
Paragraph BC203 of ASU 2016-02 states, in part, that “[i]n substance fixed lease
payments are payments that may, in form, appear to contain variability but are,
in effect, fixed and unavoidable” and that the Board included these payments “in
the measurement of lease assets and lease liabilities because those payments are
unavoidable and, thus, are economically indistinguishable from fixed lease
payments.”
ASC 842-10-30-5 and 30-6 indicate that lease payments include in-substance fixed
lease payments but exclude variable lease payments that do not depend on an
index or rate. Because the treatment of lease payments may differ depending on
whether the payment is a variable or in-substance fixed payment, an entity will
need to carefully evaluate such payments to determine whether a lease payment is
truly variable or in-substance fixed. The example below illustrates the
accounting for an in-substance fixed lease payment.
Example 6-5
Company P (the lessee) leases an automobile for a two-year lease term. In exchange for the right to use the
automobile, P has the option to pay either (1) a fixed monthly payment of $250 or (2) $0.25 per mile driven with
a minimum monthly payment of $100. Company P makes its election at the beginning of each month.
In accordance with ASC 842-10-55-31(b), because P must choose between the two sets of payments, both
containing a fixed amount, its monthly payment is an in-substance fixed payment. The amount that should be
included in lease payments is equal to the lesser of the two fixed amounts. Because the payment under the
second option is, in part, variable and is not tied to an index or a rate, the in-substance fixed portion equals the
minimum monthly amount of $100. Given that the unavoidable monthly amount of $100 in the second option
is lower than the fixed monthly payment of $250 in the first option, the lease payments are $100 per month.
Connecting the Dots
Virtually Certain Variable Lease Payments Do Not Represent
In-Substance Fixed Lease Payments
In some cases, a contract includes a variable lease payment that depends on the performance
or usage of the underlying asset and a payment is virtually certain (e.g., a variable payment
for highly predictable output from a solar farm or a variable payment for retail space that is
based on a fixed percentage of a minimal retail sales volume). Although the probability of these
payments may be virtually certain, we do not believe that the payments are in-substance fixed
because they are contingent on the performance or usage of the underlying asset and thus are
avoidable if the triggering event does not occur. However, we believe that, in accordance with
ASC 842-10-55-31(a), an exception applies to situations in which contingent rental provisions are
nonsubstantive and appear to be designed so that rental escalation is excluded from the lease
payments.
Example 6-6 illustrates a scenario in
which virtually certain lease payments depend on the performance or
usage of the underlying asset, while Example
6-7 addresses a situation in which contingent rental
provisions are designed to enable exclusion of rental escalation from
lease payments.
Example 6-6
Company H (the lessee) enters into an arrangement to lease a space in a building for two years to use
as a retail store. In exchange for the right to use the building space, H pays the lessor a fixed monthly
fee of $1,500 and 5 percent of any sales exceeding $10,000 each month. Company H is virtually
certain that its retail sales will be at least $12,000 each month.
Although H is virtually certain that it will exceed the $10,000 sales threshold each month, such
amounts do not represent in-substance fixed payments and thus should not be included in H’s or the
lessor’s lease payments. Company H’s lease payments and the lessor’s lease payments consist only of
the $1,500 fixed monthly rental fee.
Example 6-7
Company M (the lessee) leases a piece of equipment for three years. Company M’s lease payments for the first year are $750 per month. After the first year, the lease payments are subject to the lesser of a 2 percent increase or 1 percent for every 0.1 percent increase in CPI from the previous year. On the basis of historical evidence, there is a remote likelihood that the CPI will increase by less than 0.3 percent each year. Because the likelihood of an increase less than 0.3 percent each year is remote, this represents a form of nongenuine variability (i.e., any variability below 0.3 percent is not a genuine form of variability) in accordance with ASC 842-10-55-31(a).
The SEC has indicated that under ASC 840 there did not appear to be any economic
reason for the leverage factor described above and
it appears that the CPI adjustment provision was
put in place to avoid inclusion of the higher
fixed rentals in the minimum lease payments. Our
general view is that ASC 842 would not change this
conclusion.
Because there is a remote likelihood that the CPI will increase by less than 0.3
percent each year, we believe that M should adjust
its lease payments by 2 percent. Therefore, M
calculates its lease payments as follows:
-
Year 1: $9,000 ($750/month multiplied by 12 months)
-
Year 2: $9,180 ($9,000 prior-year payment adjusted by 2 percent)
-
Year 3: $9,364 ($9,180 prior-year payment adjusted by 2 percent)
Connecting the Dots
Consistency With Other Topics in U.S. GAAP
The guidance on in-substance fixed lease payments is generally consistent with existing interpretive guidance on in-substance fixed payments in other areas of U.S. GAAP. Paragraph BC204 of ASU 2016-02 notes that although the FASB decided not to provide specific examples of what constitutes an in-substance fixed lease payment, “the examples that exist in practice and that are included in various pieces of interpretive guidance provide useful information on how the Board [FASB] intends this concept to apply in Topic 842.” One example that the FASB specifically points out in paragraph BC204 of ASU 2016-02 is the determination of whether a notional amount exists in the accounting for derivatives under ASC 815. On the basis of such comparisons, we do not expect the accounting for in-substance fixed lease payments under ASC 842 to differ from that under other literature.
6.2.2 Lease Incentives
ASC 842-10
55-30 Lease incentives include
both of the following:
-
Payments made to or on behalf of the lessee
-
Losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease for use of the assumed underlying asset.
As indicated above, lease incentives include both (1) payments
made by the lessor “to or on behalf of the lessee” and (2) any “losses incurred
by the lessor as a result of assuming a lessee’s preexisting lease with a third
party.” Lease incentives reduce the lease payments that are used to determine
the appropriate lease classification and to measure the ROU asset (and the lease
liability if not yet received) or the net investment in the lease at lease
commencement.
Example 6-8
Company D (the lessee) is currently
leasing a building from an unrelated third party and is
obligated to continue leasing the building for six
additional months in exchange for a fixed monthly fee of
$1,000 (i.e., D is obligated to pay an additional $6,000
under its current lease).
Although D’s current lease is still
effective, D enters into a separate agreement with
Company T (the lessor) to lease a different building for
a five-year term in exchange for fixed monthly payments
of $1,500. To incentivize D to enter into the new lease,
T agrees to pay D a lump-sum amount of $5,000, which is
intended to defray a portion of D’s remaining costs
under its existing lease.
The
lease payments under the new lease are equal to $85,000,
which are calculated as follows:
Fixed lease
payments: $90,000 ($1,500 monthly payment multiplied by
the 60-month lease term)
Less: Lease
incentives: $5,000 payment made by T to D.
Connecting the Dots
No Changes in the Definition of
Lease Incentives
The description of lease incentives in ASC 842-10-55-30
is consistent with the definition of lease incentives under ASC
840-20-25-7. For information on accounting for lease incentives that
reduce lease payments by lessees and lessors, see Chapters 8 and
9,
respectively.
6.2.2.1 Treatment of Payments to a Lessee When a Lease Is Terminated and the Lessee Enters Into a New Lease for Similar Assets
In certain situations, a lessor may pay a lessee
consideration to terminate a lease before its originally negotiated end
date.
If, as a result of the lease termination, the lessee enters
into a new lease agreement for the same type of equipment with the same lessor, the lessee generally must account
for the consideration received in connection with the termination of the
first lease (i.e., as compensation for terminating the lease) as a lease
incentive for its new lease. This treatment is consistent with the guidance
in ASC 842-10-55-30(a), which indicates that “[p]ayments made to or on
behalf of the lessee” are lease incentives.
Even though the payment made by the lessor in this case is
explicitly related to terminating the first lease, it also incentivizes the
lessee to enter into the new lease. Therefore, we believe that the substance
of the payment is typically an incentive for the new lease, which the lessee
should defer as part of the ROU asset related to the new lease.
When the lessee in the same scenario enters into a new lease
agreement for the same type of equipment with a new lessor, the
accounting for the consideration received will depend on the specific facts
and circumstances.
If, as part of the termination of the existing lease, the
lessee is contractually required to enter into the new lease, we believe
that the payment typically represents an incentive that the lessee should
defer as part of the ROU asset related to the new lease. However, if the
lessee is not contractually required to enter into the new lease with a new
lessor, we believe that the payment typically does not represent an
incentive for the new lease and that the lessee should instead take into
account the payment received in determining the gain or loss upon
termination of the original lease, as discussed in Section 8.7.2.
Example 6-9
Lessee enters into a nonassignable
agreement to lease a 3-D printer from Lessor A.
During the current year, A decides to sell its
entire portfolio of printers to Lessor B. To
facilitate the sale, A agrees to pay Lessee $1,000
as consideration for the termination of the existing
lease. In addition, A requires that Lessee enter
into a new lease with B for a 3-D printer. Even if
the specific model of 3-D printer is not specified,
Lessee should account for the $1,000 payment from A
as an incentive to enter into the new lease with B
and should defer that incentive as part of the ROU
asset related to the new lease. On the other hand,
if Lessee had no contractual obligation to enter a
new lease with B, Lessee would instead account for
the $1,000 payment as part of its gain or loss upon
termination of its original lease with A. This would
be the case even if Lessee decides, or (because of
its reliance on the leased asset) is economically
compelled, to lease a replacement 3-D printer from
another lessor.
6.2.2.2 Payments From a Lessor to a Lessee During the Lease Agreement
Lease incentives are not always paid by the lessor to the lessee before lease
commencement. In some cases, a lessor may make a payment to the lessee
during the lease term (i.e., after the lease commencement date). Payments
made by a lessor to a lessee, regardless of the timing of the payment,
should be accounted for as lease incentives that reduce the lessee’s and
lessor’s lease payments.
Although payments from the lessor may be specifically
identified for items such as “business interruption” or “lost revenues,” it
is difficult to separate a transaction into components when a continuing
lease arrangement exists. Applying, by analogy, the accounting guidance on
business interruption insurance or litigation settlement to payments from a
lessor to a lessee is generally inappropriate even when the payments may be
related to certain costs or accounting periods.
Example 6-10
Entity A, a retailer, leases retail
space in a building owned by Entity B, a real estate
investment trust (REIT). The lease is an operating
lease with a term of 20 years. Entity A leases a
portion of the building, and the remaining portions
of the building are vacant. In the lease contract, B
agrees to make a payment to A at the end of each of
the first five years of the lease in accordance with
a fixed schedule.
The payment from B to A represents a
lease incentive so that A would agree to lease a
portion of the building while B attempts to fill the
remaining portions with other tenants. Therefore,
both A and B should include the annual payments as a
reduction to the lease payments at commencement.
Example 6-11
Entity A, a retailer, leases retail
space in a building owned by Entity B, a REIT. The
lease is an operating lease with a term of 20 years.
Entity A leases a portion of the building, and the
remaining portions of the building are vacant. In
year 5, A and B agree that A will vacate the
premises for an indefinite period so that B can
refurbish the building. In exchange for vacating the
premises, B will make monthly payments to A during
the renovation period to compensate A for business
interruption, employee termination costs, and lost
profits. Once the renovation is complete, A will
return to the space and resume making lease payments
under the preexisting lease agreements.
The payments from B to A represent a
lease incentive. Therefore, both A and B should
include the monthly payments as a reduction to the
lease payments at the time the payment obligation
arises (see Section
8.5.4.3 for a more detailed discussion
of how a lessee should account for such
incentives).
6.3 Variable Lease Payments That Depend on an Index or a Rate
ASC 842-10
30-5 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:
. . .
b. Variable lease payments that depend on an
index or a rate (such as the Consumer Price Index
or a market interest rate), initially measured
using the index or rate at the commencement date.
. . .
ASC 842-10 — Glossary
Variable
Lease Payments
Payments made by a lessee to a
lessor for the right to use an underlying asset
that vary because of changes in facts or
circumstances occurring after the commencement
date, other than the passage of time.
Leases frequently contain terms that revise or
reset the amounts payable to the lessor over the
lease term. Those adjustments to the amounts
payable to the lessor are described in ASC 842 as
variable lease payments. Generally, ASC 842
differentiates between two categories of
variability in lease payments:
-
Variability based on an index or rate (e.g., escalators based on the CPI, or rents that are referenced to or are increased on the basis of SOFR).6
-
Other variability, including variability that is typically described as based on performance or usage of the asset (e.g., rents based on the percentage of retail store sales or on mileage driven in a leased car).
ASC 842 requires only that limited types of
variable payments be included in the lease
payments that will affect the lease classification
and measurement. Specifically, ASC 842-10-30-5
states that “[a]t the commencement date, the lease
payments shall consist [in part] of the following
payments relating to the use of the underlying
asset during the lease term”:
b. Variable lease payments that depend on an
index or a rate (such as the Consumer Price Index
or a market interest rate), initially measured
using the index or rate at the commencement date.
In addition, ASC 842-10-30-6 explicitly states
that “[l]ease payments do not include [v]ariable
lease payments other than those in paragraph
842-10-30-5(b).”
Paragraph BC211 of ASU 2016-02
states the following regarding the FASB’s decision
to include variable lease payments that depend on
an index or a rate in the lease payments:
For reasons similar to those for
including in substance fixed payments in the
measurement of lease assets and lease liabilities,
the Board also decided to include variable lease
payments that depend on an index or a rate in the
measurement of lease assets and lease liabilities.
Those payments meet the definition of assets (for
the lessor) and liabilities (for the lessee)
because they are unavoidable (that is, a lessee
has a present obligation to make, and the lessor
has a present right to receive, those lease
payments). Any uncertainty, therefore, relates to
the measurement of the asset or liability that
arises from those payments and not to the
existence of the asset or liability.
See Section 6.2.1
for information about in-substance fixed payments.
An entity should include
variable lease payments that depend on an index or
a rate in its lease payments on the basis of the
spot index or rate at lease commencement.
In their initial proposals,
the boards suggested that a lessee should
remeasure variable lease payments that depend on
an index or a rate whenever there is a change in
contractual cash flows (e.g., a change in the
CPI). However, as explained in paragraph BC236 of
ASU 2016-02, some respondents “indicated concerns
about the cost of performing reassessments and
questioned whether the benefits for users of
financial statements would justify the costs for
preparers.” During redeliberations, the FASB
agreed that the benefits of requiring lessees to
remeasure variable lease payments upon changes in
contractual cash flows would not outweigh the cost
of performing the remeasurement. Consequently, as
stated in paragraph BC237 of ASU 2016-02, the FASB
decided that a lessee only “should
remeasure variable lease payments that depend on
an index or a rate when the lessee remeasures the
lease liability for another reason.”7 See Sections
6.3.2 and 6.10 for
additional guidance on the remeasurement of
variable lease payments that depend on an index or
a rate.
6.3.1 Initial Measurement of a Lease When There Are Variable Payments Based on an Index or Rate
The FASB included Example 25,
Case A, in ASC 842-10-55-226 through 55-231 to illustrate the requirements related to
measuring variable payments that depend on an index or a rate.
ASC 842-10
30-8 See
Example 25 (paragraphs 842-10-55-225 through
55-234) for an illustration of the requirements on
lessee accounting for variable lease payments . .
. .
55-225
Example 25 illustrates how a lessee accounts for
variable lease payments that depend on an index or
a rate . . . .
Example 25 — Variable Lease
Payments That Depend on an Index or a Rate . . .
Case A — Variable Lease
Payments That Depend on an Index or a Rate
55-226 Lessee
enters into a 10-year lease of a building with
annual lease payments of $100,000, payable at the
beginning of each year. The contract specifies
that lease payments for each year will increase on
the basis of the increase in the Consumer Price
Index for the preceding 12 months. The Consumer
Price Index at the commencement date is 125. This
Example ignores any initial direct costs. The
lease is classified as an operating lease.
55-227 The
rate implicit in the lease is not readily
determinable. Lessee’s incremental borrowing rate
is 8 percent, which reflects the rate at which
Lessee could borrow an amount equal to the lease
payment in the same currency, over a similar term,
and with similar collateral as in the lease.
55-228 At the
commencement date, Lessee makes the lease payment
for the first year and measures the lease
liability at $624,689 (the present value of 9
payments of $100,000 discounted at the rate of 8
percent). The right-of-use asset is equal to the
lease liability plus the prepaid rent
($724,689).
55-229 Lessee
prepares financial statements on an annual basis.
Lessee determines the cost of the lease to be $1
million (the total lease payments for the lease
term). The annual lease expense to be recognized
is $100,000 ($1 million ÷ 10 years).
55-230 At the
end of the first year of the lease, the Consumer
Price Index is 128. Lessee calculates the payment
for the second year, adjusted to the Consumer
Price Index, to be $102,400 ($100,000 × 128 ÷
125).
55-231
Because Lessee has not remeasured the lease
liability for another reason, Lessee does not make
an adjustment to the lease liability to reflect
the Consumer Price Index at the end of the
reporting period; that is, the lease liability
continues to reflect annual lease payments of
$100,000 (8 remaining annual payments of $100,000,
discounted at the rate of 8 percent is $574,664).
However, the Year 2 payment amount of $102,400
(the $100,000 annual fixed payment + $2,400
variable lease payment) will be recognized in
profit or loss for Year 2 of the lease and
classified as cash flow from operations in
Lessee’s statement of cash flows. In its
quantitative disclosures, Lessee will include
$100,000 of the $102,400 in its disclosure of
operating lease cost and $2,400 in its disclosure
of variable lease cost.
A lessee’s8 initial measurement of its lease liability and ROU asset should be determined on the
basis of the lease payments, which, as stated in ASC 842-10-30-5(b), include “[v]ariable
lease payments that depend on an index or a rate (such as the Consumer Price Index or a
market interest rate).” An entity initially measures variable payments based on an index
or rate by using the index or rate at lease commencement (i.e., the spot or gross index or
rate applied to the base rental amount). The use of the spot rate at lease commencement is
largely based on the FASB’s view that (1) the cost associated with forecasting future
rates would outweigh the benefits provided and (2) the use of forecasted rates or indexes
would be inconsistent among preparers and often imprecise.
In contrast, payments based on
a change in an index or a rate should
not be considered in the determination of
lease payments. Given the cost-benefit
considerations related to the use of forecasting
techniques, ASC 842 does not allow an entity to
forecast changes in an index or rate to determine
lease payments. Rather, adjustments to lease
payments that are based on a change in an index or
rate are treated as variable lease payments and
recognized in the period in which the obligation
for those payments was incurred (as illustrated in
Example 25, Case A, in ASC 842-10-55-226 through
55-231, reproduced above).
For example, assume that lease
payments are made in arrears and are based on a
fixed amount (e.g., a $100,000 base amount)
adjusted each year by SOFR at the end of the year.
If SOFR at lease commencement was 2.7 percent, the
total lease payments used to measure the lease
liability would be $102,700 per year of the lease,
which includes $2,700 in variable lease payments
based on an index or rate at lease commencement.
In contrast, if the payments were based on a fixed
amount ($100,000) that will subsequently be
adjusted in a manner corresponding to the
change in SOFR each year throughout the
lease term, the initial measurement of the lease
liability and ROU asset would not take into
account the future expected adjustments in SOFR.
Therefore, the initial measurement of the lease
liability and ROU asset would be based only on the
fixed payments through the lease term (see the
example below).
Example 6-12
A retailer enters into a lease
of a retail space for five years with the
following terms:
The first lease payment was
made on January 1. Each subsequent payment is made
on December 31. There were no initial direct costs
or lease incentives. The lessee recognizes total
lease expense and measures the lease liability and
ROU asset in the manner shown in the table below
(also see Chapter 8 for a
detailed discussion of the lessee accounting
requirements).
6.3.2 Subsequent-Measurement Implications of Index- or Rate-Based Payment Adjustments
The subsequent remeasurement
of a lease depends on whether the variability is
associated with an index or rate or arises for
other reasons. Specifically, ASC 842-10-35-4 and
35-5 require, in part, the following:
35-4 A
lessee shall remeasure the lease payments if any
of the following occur:
-
The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
-
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. 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).
-
There is a change in any of the following:
-
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.
-
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.
-
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.
-
35-5 When one or more of the events described
in paragraph 842-10-35-4(a) or (c) occur or when a
contingency unrelated to a change in a reference
index or rate under paragraph 842-10-35-4(b) is
resolved, variable lease payments that depend on
an index or a rate shall be remeasured using the
index or rate as of the date the remeasurement is
required. [Emphasis added]
A lessee would not be required
to remeasure a lease solely because of changes in
an index or rate. On the basis of discussions with
the FASB staff9 and of ASU 2018-10
on Codification improvements to ASC 842, we
understand that 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 as variable
lease expense and of the ROU asset. As a result,
the additional payments for increases in the CPI
will be recognized in the period in which they are
incurred.
However, as highlighted in ASC
842-10-35-5, if a lessee remeasures the lease
payments for any of the other reasons detailed in
ASC 842-10-35-4, the lessee is required to
remeasure variable lease payments that depend on
an index or rate by using the index or rate in
effect on the remeasurement date.
Bridging the GAAP
Lease
Payments Based on an Index or Rate
While ASC 842 and IFRS 16 are
generally converged with respect to the
recognition and measurement of variable lease
payments, there is a notable difference. Under
IFRS 16, for lease payments based on an index or
rate, the lease liability and ROU asset are
remeasured when there is a change in cash flows as
a result of a change in the index or rate.
Therefore, entities that are subject to dual
reporting under both U.S. GAAP and IFRS Accounting
Standards (e.g., a parent entity that applies U.S.
GAAP and has international subsidiaries applying
IFRS Accounting Standards for statutory reporting)
will be required to account for their leases under
two different remeasurement models.
CPI and market interest rates
are explicitly noted as examples of indexes and
rates that should be considered in accordance with
ASC 842-10-30-5(b). However, IFRS 16, which is
converged with ASC 842 with respect to the initial
measurement of variable lease payments that depend
on an index or rate, also includes “payments that
vary to reflect changes in market rental rates” as
an additional example of variable payments that
depend on an index or rate.
The next section discusses our
interpretation under ASC 842 of the applicability
of ASC 842-10-30-5(b) to variable payments based
on fair market rental rates.
6.3.3 Rents Based on Market Rates
Some lease agreements
(typically real estate leases) include variability
in the form of a rent reset provision that
requires the future lease payments after a
specified point in time to be reset to the fair
market rental rates at that time. For example, a
10-year lease of property in Chicago that requires
annual rental payments of $100,000 for years 1–5
may also include a provision to reset the rental
payments in years 6–10 of the lease to the updated
fair market rent as benchmarked to published rates
for Chicago.
Such a fair market rent reset
feature should be accounted for in accordance with
the guidance on variable payments that are based
on an index or rate.
Paragraph BC211 of ASU 2016-02
states the FASB’s rationale for including certain
variable lease payments that depend on an index or
rate in the measurement of the lease liability and
ROU asset:
For reasons similar
to those for including in substance fixed payments
in the measurement of lease assets and lease
liabilities, the Board also decided to include
variable lease payments that depend on an index or
a rate in the measurement of lease assets and
lease liabilities. Those payments meet the
definition of assets (for the lessor) and
liabilities (for the lessee) because they are
unavoidable (that is, a lessee has a present
obligation to make, and the lessor has a present
right to receive, those lease payments). Any
uncertainty, therefore, relates to the measurement
of the asset or liability that arises from those
payments and not to the existence of the asset or
liability.
While ASC 842 does not define
“index” or “rate,” we believe that an index or
rate is based on underlying economic performance
(e.g., the CPI measures the variation in prices
paid by a consumer household for certain retail
goods and services). Similarly, fair market rent
is indicative of the economic performance of a
specific geographic region and is analogous to a
formally published index or rate. Further, the
FASB and IASB converged certain aspects of their
guidance on leases, including the treatment of
payments subject to market rate resets as lease
payments that vary on the basis of an index or
rate. Paragraph 28 of IFRS 16 explicitly states
that a variable payment that is based on an index
or rate would include, among other things,
“payments that vary to reflect changes in fair
market rental rates.”
Since variable payments based
on fair market rental rates were determined to be
analogous to variable payments based on an index
or rate, we believe that the specific guidance on
variable payments based on an index or rate (see
Sections
6.3.1 and 6.3.2) should be applied to variable
payments based on fair market rental rates
(including those based on the fair market value of
the underlying asset). Accordingly, a lessee
should measure the lease liability and ROU asset
and a lessor should measure the net investment in
the lease on the basis of the fair market rental
rate in effect at lease commencement. The lessee’s
lease liability and ROU asset and the lessor’s net
investment in the lease would not be remeasured as
a result of any subsequent change in the fair
market rental rate (although remeasurement could
be required for another reason); such a change
would be recorded as variable lease expense or
income, respectively, in the appropriate period
depending on the change in the fair market rental
rate.
Footnotes
6
Note that an index or rate for these purposes
does not include tax rates such as sales tax or
VAT rates.
7
The IASB decided not to limit
the remeasurement of variable lease payments that
depend on an index or a rate to situations in
which the lessee remeasures the lease liability
for another reason. Rather, IFRS 16 requires
lessees to remeasure variable lease payments that
depend on an index or a rate whenever there is a
change in contractual cash flows (e.g., changes in
the CPI). See Appendix B for a
summary of differences between ASC 842 and IFRS
16.
8
While this discussion specifically focuses on the consideration of
variable payments based on an index or a rate when a lessee initially measures its
lease liability and ROU asset, the concept would similarly apply when a lessor
initially measures its net investment in a sales-type or direct financing lease.
9
In July 2018, the FASB issued
ASU
2018-10, which makes Codification
improvements to ASC 842 and amends ASC
842-10-35-4(b) and ASC 842-10-35-5 to clarify that
changes in an index or rate alone would not give
rise to a requirement to remeasure the lease. See
Section 17.3.1.3 for further
discussion of the ASU.
6.4 Exercise Price of a Purchase Option Reasonably Certain to Be Exercised
ASC 842-10
30-5 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: . . .
c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to
exercise that option (assessed considering the factors in paragraph 842-10-55-26). . . .
When calculating the lease payments, the lessee and the lessor should consider
whether the lessee has the option of purchasing the leased asset and, if so, the likelihood
that the lessee will exercise the purchase option. (See Section 5.3 for a discussion of the effect of this
assessment on the lease term.) If it is reasonably certain that the lessee will exercise its
option of purchasing the leased asset, the lease payments should include the exercise price
of the purchase option. This assessment is consistent with the evaluation of the lease
classification criterion in ASC 842-10-25-2(b)10 and is based on the economic factors in ASC 842-10-55-26 for determining whether a
lessee is reasonably certain to exercise an option. Such factors include:
-
Contract-based factors (e.g., the terms and conditions of a purchase option in the contract).
-
Asset-based factors (e.g., impact of significant leasehold improvements).
-
Market-based factors (e.g., costs associated with exercising the purchase option versus separately buying a similar asset or entering into a new lease for a similar asset).
-
Entity-based factors (e.g., the lessee’s intent and past experience with exercising purchase options).
A lessee should remeasure its lease payments when there is a change in the
assessment of whether the lessee is reasonably certain to exercise its purchase option in
accordance with ASC 842-10-35-1. However, the lessor would not remeasure its lease payments
in such circumstances. See Section
6.10 for more information about the requirements for lessees and lessors to
remeasure lease payments. The example below illustrates the effect of purchase options on
lease payments.
Example 6-13
Company S (lessee) enters into an arrangement to lease a building for 10 years
in exchange for fixed annual payments of $100,000. At the end of the 10-year
lease term, S has the option of purchasing the building for $326,000.
Case A — Company S Is Reasonably Certain to Exercise Its
Purchase Option
On the basis of the factors outlined in ASC 842-10-55-26, S has concluded that it is reasonably certain to exercise its purchase option. Therefore, the lease payments are equal to $1,326,000 ($100,000 per year multiplied by 10 years plus the $326,000 purchase price of the building).
Case B — Company S Is Not Reasonably Certain to Exercise
Its Purchase Option
If S determines that it is not reasonably certain to exercise its purchase option, it would not include the $326,000 purchase price in its lease payments. Rather, the lease payments would only consist of $1,000,000 ($100,000 per year multiplied by 10 years).
Footnotes
10
ASC 842-10-25-2(b) requires that a lease be classified as a finance
lease (lessee) or sales-type lease (lessor) if the lease grants the lessee an option of
purchasing the underlying asset and it is reasonably certain that the lessee will
exercise that option.
6.5 Penalties for Terminating a Lease
ASC 842-10
30-5 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. . . .
As discussed in Chapter
5, the lease term includes any periods
covered by an option of terminating the lease if
it is reasonably certain that the lessee will
not exercise that option. In a manner
consistent with the determination of the lease
term, the lease payments would not include a
termination penalty if it is reasonably certain
that the lessee will not exercise that termination
option. However, if it is not reasonably certain
that the lessee will not terminate the lease, the
term would not include the
period past the termination date and the lease
payments would include any
related termination penalty.
The same treatment would apply to renewal options. That is, to the extent that a
lessee exercising a renewal option would be
required to pay a renewal fee, the lease payments
would include the renewal fee if it is reasonably
certain that the lessee will exercise the renewal
option. Conversely, the lease payments would not
include the renewal fee if it is not reasonably
certain that the lessee will exercise the renewal
option.
The FASB included Example 26 in ASC 842-10-55-235 through 55-238 to illustrate
the impact of termination penalties on lease payments.
ASC 842-10
30-8 . . . Example 26 (paragraphs 842-10-55-235 through 55-238) for an illustration of the requirements on
termination penalties.
55-235 Example 26 illustrates how a lessee accounts for termination penalties.
Example 26 — Termination Penalties
55-236 Lessee enters into a
10-year lease of an asset, which it can terminate
at the end of each year beginning at the end of
Year 6. Lease payments are $50,000 per year during
the 10-year term, payable at the beginning of each
year. If Lessee terminates the lease at the end of
Year 6, Lessee must pay a penalty to Lessor of
$20,000. The termination penalty decreases by
$5,000 in each successive year.
55-237 At the commencement date, Lessee concludes that it is not reasonably certain it will continue to
use the underlying asset after Year 6, having considered both the significance of the termination penalty (in
absolute terms and in relation to the remaining lease payments after the date the termination option becomes
exercisable) and the other factors in paragraph 842-10-55-26.
55-238 Accordingly, Lessee determines that the lease term is six years. At the commencement date, Lessee
measures the lease liability on the basis of lease payments of $50,000 for 6 years plus the penalty of $20,000
payable at the end of Year 6.
6.6 Fees Paid by the Lessee to Owners of Special-Purpose Entities
ASC 842-10
30-5 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: . . .
e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d). . . .
In the case of SPEs, lease payments should include any amounts paid by the
lessee to the owners of the SPE for structuring
the transaction. Although these fees are included
in the lease payments, the fees should be excluded
from the calculation of the fair value of the
underlying asset in the determination of the
appropriate lease classification under ASC
842-10-25-2(d).
Example 6-14
Lessor LLC (a VIE) holds a single real estate asset that it leases to Lessee.
The lease contains a residual value guarantee (see the next
section). Lessee accounts for the lease as an operating
lease. Further, Lessee has a variable interest in Lessor LLC
through the residual value guarantee.
Although Lessee has a variable interest, Lessor LLC is consolidated by REIT, which is the primary beneficiary of Lessor LLC. REIT is in the business of owning real estate and leasing it to tenants as a source of financing. Lessor LLC was created by REIT to own the specific underlying real estate. REIT charges Lessee certain fees as compensation for the initial setup costs of Lessor LLC.
The lease payments should include the fees charged to Lessee by REIT for structuring the transaction.
6.7 Amounts That It Is Probable That the Lessee Will Owe Under a Residual Value Guarantee
ASC 842-10
30-5 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: . . .
f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).
ASC 842-10 — Glossary
Residual Value Guarantee
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.
ASC 842-10
55-34 A lease provision requiring the lessee to make up a residual value deficiency that is attributable to damage, extraordinary wear and tear, or excessive usage is similar to variable lease payments in that the amount is not determinable at the commencement date. Such a provision does not constitute a lessee guarantee of the residual value.
55-35 If the lessor has the right to require the lessee to purchase the underlying asset by the end of the lease term, the stated purchase price is included in lease payments. That amount is, in effect, a guaranteed residual value that the lessee is obligated to pay on the basis of circumstances outside its control.
If a lease contract contains a provision under which the lessee guarantees to the lessor the residual value of the leased asset at the end of the lease term, the lessee should include in its lease payments the amount that it is probable that the lessee will owe at the end of the lease term. Paragraph BC214 of ASU 2016-02 explains the FASB’s rationale for requiring lessees to include in their lease payments amounts that it is probable that the lessee will owe under residual value guarantees:
In the Board’s view, payments probable of being owed under residual value guarantees meet the definition of a liability and are part of the cost of the right-of-use asset and, thus, should be recognized and measured as part of the lease liability and the right-of-use asset. That is because those payments cannot be avoided by the lessee — the lessee has an unconditional obligation to pay the lessor if the market price of the underlying asset moves in a particular way. Accordingly, any uncertainty does not relate to whether the lessee has an obligation. Instead, it relates to the amount that the lessee may have to pay, which can vary on the basis of movements in the market price for the underlying asset. In that respect, residual value guarantees are similar to variable lease payments that depend on an index or a rate for the lessee.
A lessee should remeasure its lease payments when there is a change in the
amount that it is probable that the lessee will owe under a residual value
guarantee. However, a lessor would not remeasure its lease payments in such
circumstances. See Section
6.10 for more information about the requirements for lessees and
lessors to remeasure lease payments.
Connecting the Dots
Requirements Related to Residual Value Guarantees for Lessees Differ
From Those for Lessors
The requirement to include a portion of any residual value guarantee in the
lease payments applies only to lessees. Although the guidance states that a
lessor should not include any residual value guarantee amounts in its lease
payments, the lessor would initially measure residual value guarantee
amounts because, in accordance with ASC 842-30-30-1(a), a lessor would
include in its lease receivable the full amount at which the residual asset
is guaranteed by the lessee (or a third party). (See Chapter 9 for more
information about how to calculate a lessor’s lease receivable.) In
addition, a lessor would consider the full amount at which the residual
asset is guaranteed when classifying a lease in accordance with ASC
842-10-25-2(d) and ASC 842-10-25-3(b). The example below illustrates how the
accounting for a residual value guarantee for lessees differs from that for
lessors.
Example 6-15
A lessor leases equipment to a lessee for five years at $10,000 per year. The lessee guarantees that the equipment will have a residual value of at least $9,000 at the end of the lease. The expected residual value at the end of the lease term is $20,000.
Lessee Accounting
In its lease payment calculation, the lessee would only include the amount that it is probable that the lessee will owe under the residual value guarantee at the end of the lease term. Accordingly, the lessee would not include any amount in the initial measurement of the lease liability and ROU asset, because the expected residual value ($20,000) is greater than the guaranteed amount ($9,000). If the expected residual value was $8,000 instead of $20,000, the lessee would include the $1,000 difference between the expected residual value and the guaranteed residual value in its lease payments.
Lessor Accounting
The lessor would not include any amount of the residual value guarantee in its lease payment calculation. However, if the lease were classified as a sales-type lease or a direct financing lease in measuring its lease receivable, the lessor would include the entire portion of the residual asset guaranteed by the lessee (or any other party). Accordingly, in addition to the present value of the five annual lease payments of $10,000, the lessor would include the present value of the $9,000 guaranteed amount in its calculation of the lease receivable. The lessor’s net investment in the lease would consist of the total receivable (including the residual value guarantee) and the present value of the unguaranteed residual asset of $11,000.
Changing Lanes
Full Amount of Residual Value Guarantee Versus Amount That It Is
Probable That the Lessee Will Owe in Lease Payments
Under ASC 840, a lessee included in its minimum lease payments the entire amount
of the residual value guarantee; however, under ASC 842, a lessee only
includes in its lease payments those amounts that it is probable that the
lessee will owe under the residual value guarantee at the end of the lease
term. As a result, a lower ROU asset and lease liability will generally be
recognized on the lessee’s balance sheet for new leases under ASC 842
compared with situations in which that lease was classified as a capital
lease under ASC 840.
However, with respect to performing the lease classification test in ASC 842-10-25-2(d), we do not expect a difference between ASC 840 and ASC 842 because ASC 842-10-25-2(d) requires a lessee to include the full amount of any residual value guarantee, regardless of whether it is probable that the amount will be owed. (See Section 8.3.3.6 for a detailed discussion of a lessee’s application of the classification criterion in ASC 842-10-25-2(d).) This is consistent with the requirement under ASC 840 for the lessee to include the full amount of any residual value guarantee in its minimum lease payments when performing the lease classification test.
Entities should also consider whether the lessee has guaranteed the residual
value for a group of leased assets when performing the lease classification test in
ASC 842-10-25-2(d). Lessees often enter into lease agreements to lease multiple
similar assets from a lessor. In these circumstances, lessees will often guarantee
the residual value for the group of assets being leased rather than that for each
individual underlying asset. Lessees should take into account the impact of the
portfolio residual value guarantee (PRVG) when classifying the individual leases
within a portfolio. Depending on the facts and circumstances, lessees should use
either an “all-in approach” or a “pro-rata approach” to allocate the PRVG when
classifying a lease. See Section
8.3.3.6.1 for further discussion of the impact of PRVGs on lessees
and an example illustrating application of the all-in approach and pro rata
approach. In addition, we believe that, in certain circumstances, lessors may take
into account the impact of PRVGs when classifying the individual leases within a
portfolio. See Section
9.2.1.4.4 for further discussion of the impact of PRVGs on
lessors.
Connecting the Dots
Synthetic Lease Arrangements
As discussed above, under ASC 842, a lessee would include in its lease payments
only those amounts related to a residual value guarantee that it is probable
that the lessee will owe at the end of the lease term. Lease arrangements (e.g.,
synthetic lease arrangements) in which a significant portion of the lease
payments is structured as a residual value guarantee could therefore result in
ROU assets and lease liabilities that are significantly lower than those in
arrangements in which more of the lessee’s obligation takes the form of fixed
rental payments. For example, since many real estate assets are expected to hold
their value over the lease term, amounts that it is probable the lessee will owe
under residual value guarantees may be nominal. Accordingly, while these
arrangements will be brought onto the balance sheet, synthetic leases and other
lease arrangements in which a significant portion of the economics of the lease
are structured as a residual value guarantee may continue to yield favorable
accounting results (e.g., reduced leverage) under the new leasing guidance.
6.7.1 Sales Proceeds in Excess of Residual Value Guarantee
Some lease contracts may include a provision under which the
lessee is entitled to receive any proceeds in excess of the residual amount
guaranteed by the lessee upon the sale of the underlying asset at the end of the
lease term. Sales proceeds in excess of the residual value guaranteed by the
lessee represent a contingent gain for the lessee. Therefore, the lessee should
apply the guidance in ASC 450-30 on gain contingencies in accounting for such
proceeds. ASC 450-30-25-1 precludes an entity from recognizing a gain
contingency in its financial statements until the underlying contingency is
resolved. Accordingly, a lessee should not recognize anticipated excess sales
proceeds as a reduction in lease payments, or as a gain in its income statement,
until the underlying asset is sold and the contingency is resolved.
6.7.2 Residual Value Guarantee Obtained From Unrelated Third Party
ASC 842-10
55-36 A residual value guarantee obtained by the lessee from an unrelated third party for the benefit of the lessor should not be used to reduce the amount of the lessee’s lease payments under paragraph 842-10-30-5(f) except to the extent that the lessor explicitly releases the lessee from obligation, including the secondary obligation, which is if the guarantor defaults, a residual value deficiency must be made up. Amounts paid in consideration for a guarantee by an unrelated third party are executory costs and are not included in the lessee’s lease payments.
To reduce its exposure associated with a residual value guarantee, a lessee may obtain a guarantee from an unrelated third party, such as an insurance company, for part or all of the value of the lessee’s residual value guarantee owed to the lessor.
The residual value guarantee obtained from an unrelated third
party reduces the lessee’s lease payments only if the lessor explicitly releases
the lessee from its obligation under the residual value guarantee provision in
the lease contract between the lessee and lessor. The lessor must release the
lessee not only from its primary obligation but also from any secondary
obligation (i.e., the lessee’s obligation to pay the lessor if the insurance
company defaults on its obligation).
Example 6-16
Lessee K leases equipment from Lessor W
for five years in exchange for a fixed payment of
$10,000 per year. Lessee K guarantees that the equipment
will have a residual value of at least $5,000 at the end
of the lease. To reduce its exposure associated with the
$5,000 residual value guarantee, K obtains a matching
guarantee from an insurance company. Therefore, in the
event that the residual value of the equipment is less
than $5,000 at the end of the lease term, the insurance
company has agreed to pay the lessor the difference. The
expected residual value at the end of the lease term is
$1,000.
Case A — Lessor Does
Not Release the Lessee From Its Obligation
In this case, W does not explicitly
release K from its obligation to pay the residual value
guarantee if the insurance company defaults on its
obligation. Therefore, even though K may not be
primarily obligated to pay the residual value guarantee,
it still has a secondary obligation to W. Lessee K
should not reduce its lease payments for the guarantee
provided by the insurance company because W has not
explicitly released K from its obligations related to
the residual value guarantee. Therefore, K should
include $4,000 in its lease payments, which represents
the amount that it is probable W will be owed at the end
of the lease term ($5,000 guaranteed amount less $1,000
expected residual value).
Case B — Lessor
Fully Releases the Lessee From Its Obligation
In this case, because W has fully
released K from any primary or secondary obligation
related to the residual value guarantee, K should not
include any amounts related to the residual value
guarantee in its lease payments.
In certain situations, a lessee may be obligated by the lessor
or the lease agreement to obtain residual value insurance for the benefit of the
lessor. In such cases, the lessee should include the costs incurred to secure
the third-party guarantee of residual value in its lease payments (e.g., the
amount of the insurance premium needed to obtain the residual value insurance).
These types of costs are similar to payments made to an insurance company in
which the payor does not benefit (i.e., the lessee pays the insurance company
but the lessor is the beneficiary of the policy).
6.8 Costs Imposed to Dismantle and Remove an Underlying Asset at End of Lease Term
ASC 842-10
55-37 . . . In contrast, costs to dismantle and remove an underlying asset at the end of the lease term that are imposed by the lease agreement generally would be considered lease payments or variable lease payments.
A lessee may need to incur certain costs at the end of the lease term so that the lessee may return the asset to the lessor in accordance with the lease agreement. Those costs are generally considered to be either of the following:
- Lease payments, because the costs, which benefit the lessor and not the lessee, are imposed by the lease agreement and incurred to restore functionality of the leased asset or to dismantle or remove the actual underlying asset for return to the lessor (further discussed below).
- Asset retirement obligations in accordance with ASC 410-20, because the costs are incurred to remove lessee installations (e.g., leasehold improvements) so that the lessee may restore the underlying asset to its original condition (see Section 6.9.4).
In certain situations, a lessee may agree to pay for the costs of
removing and returning leased equipment to the lessor at the end of the lease. In
such circumstances, the lessee would be required to include its best estimate of
those costs in the lease payments at lease commencement. For example, for an asset
being leased, such as manufacturing equipment that must be returned to the lessor at
the end of the lease, the amount that the lessee expects to incur to ship or
otherwise return the manufacturing equipment to the lessor would be included in the
lease payments.
Connecting the Dots
Costs of Dismantling and Removing an Underlying Asset
Although costs imposed to dismantle and remove an underlying asset at the end
of the lease term should generally be included in lease payments,
obligations to return an underlying asset to its original condition would
not qualify as lease payments. See Section
6.9.4 for further discussion.
In addition, if the costs will vary on the basis of how much the lessee uses
the asset during the lease term, such costs are considered to be variable
lease payments and therefore are not estimated at lease commencement.
6.9 Amounts Not Considered a Lease Payment
6.9.1 Variable Lease Payments That Do Not Depend on an Index or Rate
ASC 842-10
30-6 Lease payments do not include any of the following:
- Variable lease payments other than those in paragraph 842-10-30-5(b) . . . .
Lease payments should exclude variable lease payments that do not depend on an index or a rate. Common examples of such variable lease payments include payments that depend on the lessee’s performance or use of the underlying asset (i.e., whether a payment will be required is contingent on a future event). Paragraph BC210 of ASU 2016-02 explains that the Board decided to exclude such amounts from the lease payments because “variable [lease] payments contingent on future events (for example, performance or use) do not represent a present obligation of the lessee or a right of the lessor and, therefore, do not meet the definition of an asset or a liability.”
A lessee should remeasure its lease payments when the contingency underlying such variable payments is resolved and, as a result, some (or all) of the remaining payments become fixed for some (or all) of the remaining lease term (e.g., when the underlying asset is used and the payment becomes required and fixed). However, a lessor would not remeasure its lease payments in such circumstances. See Section 6.10 for more information about the requirements for when lessees and lessors remeasure lease payments.
Connecting the Dots
Lessee Financial Statement Impact of Excluding Variable Lease
Payments That Do Not Depend on an Index or a Rate
The Board’s decision to exclude variable lease payments
that do not depend on an index or a rate from lease payments will result
in different accounting outcomes for lessees that have economically
similar transactions with different payment structures (i.e., fixed
lease payments versus variable lease payments that depend on performance
or usage of the underlying asset).
Balance Sheet Impact
As discussed in Chapter 8, the initial measurement
of a lessee’s ROU asset and lease liability includes the present value
of the lease payments. There is a direct correlation between the amount
of the lease payments and the amount that is recorded as the ROU asset
and lease liability on the lessee’s balance sheet. Because a lessee
includes fixed amounts in its lease payments but not variable payments
that depend on something other than an index or a rate, lease contracts
that are structured with fixed lease payments will result in a higher
ROU asset and lease liability than those structured with contingent
rentals.
Income Statement Impact
Under ASC 842, a lessee’s expense recognition pattern
depends on whether the lease is classified as a finance lease or an
operating lease. Lease classification is governed, in part, by the value
of the lease payments compared with the fair value of the underlying
asset (i.e., the higher the lease payments, the more likely that a lease
will be classified by the lessee as a finance lease rather than as an
operating lease). Therefore, lease contracts that are structured with
fixed lease payments may result in a different expense recognition
pattern than lease contracts structured with contingent rentals.
ASC 842-10
55-225 Example 25 illustrates how a lessee accounts for . . . variable lease payments that are linked to performance.
Example 25 — . . . Variable Lease Payments Linked to Performance . . .
Case B — Variable Lease Payments Linked to Performance
55-232 Lessee enters into a 10-year lease of a building with annual lease payments of $100,000, payable at the beginning of each year. The contract specifies that Lessee also is required to make variable lease payments each year of the lease, which are determined as 2 percent of Lessee’s sales generated from the building.
55-233 At the commencement date, Lessee measures the lease liability and right-of-use asset at the same amounts as in Case A (paragraphs 842-10-55-226 through 55-231) because the 2 percent royalty that will be paid each year to Lessor under the lease is a variable lease payment, which means that payment is not included in the measurement of the lease liability (or the right-of-use asset) at any point during the lease.
55-234 During the first year of the lease, Lessee generates sales of $1.2 million from the building and, therefore, recognizes total lease cost of $124,000 ($100,000 + [2% × $1.2 million]). In its quantitative disclosures, Lessee will include $100,000 of the $124,000 in its disclosure of operating lease cost and $24,000 in its disclosure of variable lease cost.
The example below illustrates the accounting for a lease liability and a
corresponding ROU asset in a contract manufacturing arrangement.
Example 6-17
A customer (lessee) enters into a
contract manufacturing arrangement with a supplier
(lessor). The customer has appropriately determined that
the contract manufacturing arrangement meets the
definition of a lease under ASC 842 (see Section
3.2). In this example, assume the
following:
-
The customer has contracted with a supplier for exclusive use of a manufacturing line over a four-year period.
-
The contract establishes a price per unit of product purchased and, periodically throughout the arrangement, the customer issues noncancelable purchase orders to the supplier when the customer wishes to procure manufactured products from the supplier.
-
The purchase order establishes a time frame (e.g., one month, two months) over which the related products will be produced as well as an unconditional obligation for the customer to purchase the products from the supplier.
-
The customer is not required to order a minimum volume of products over the four-year period. However, on the basis of its anticipated orders, the customer expects to use substantially all of the capacity of the supplier’s manufacturing line during the four-year term.
-
The supplier ships manufactured products free on board to the customer’s facility, and the customer is contractually obligated to pay the supplier upon the delivery of products to the customer’s facility.
-
The customer has identified a separate lease component (i.e., the right to use the supplier’s manufacturing line) and nonlease components associated with the arrangement.
In this example, when submitting a noncancelable purchase
order, the customer should establish a lease liability
and ROU asset related to the lease component associated
with the committed purchases (i.e., the committed use of
the manufacturing line during the time frame established
by the purchase order).11
Although, at commencement, all payments in the
arrangement are variable (given the lack of a minimum
purchase quantity in the arrangement), at the time when
the purchase order is issued, the payments related to
the lease component associated with the committed
purchases meet the definition of lease payments since
the contingency upon which the variable lease payments
are based is resolved. At that point, the customer has
an unconditional obligation to purchase products from
the supplier and therefore also has payments that meet
the definition of lease payments in accordance with ASC
842-10-35-4(b), which states, in part:
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.
The lessee would then recognize a lease liability and a
corresponding ROU asset. We believe that each individual
purchase order effectively creates fixed payments in the
arrangement, in which the amount of the purchase order
associated with the lease component is the minimum fixed
amount that is owed to the supplier upon delivery of the
manufactured products. Each subsequent purchase order
would trigger another resolution of a contingency in
accordance with ASC 842-10-35-4(b) and, as a result, the
payments associated with the lease component of the
purchase order become lease payments. The lessee thus
recognizes a separate lease liability and a
corresponding ROU asset for the amount allocated to the
lease component for each individual purchase order.
ASC 842 does not provide any clear guidance on the period over which
such an ROU asset should be amortized. Therefore,
various approaches may be acceptable.
The following are two such approaches:
-
Approach 1 — Because the purchase order has a specific production and payment schedule, the lease costs12 should be recognized over the purchase order term. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]We believe that recognition of the costs over the purchase order term is a systematic and rational approach given that the consumption of the benefit associated with the ROU asset (manufacturing line) is directly aligned with the purchase order term. Under this approach, the ROU asset will be fully amortized over the period of the purchase order. This accounting will continue for the remainder of the lease term as each discrete ROU asset is amortized over the production period to which it is related. This approach may be less complex to apply than Approach 2 below and may better reflect the economics of a leasing structure that is based on purchase orders submitted.
-
Approach 2 — Recognize the lease costs over the full remaining lease term. This approach is also consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]Likewise, an entity should recognize lease costs on the basis of whether it has the right to use an asset, not the pattern of use, in accordance with ASC 842-20-55-3, which states:This Subtopic considers the right to control the use of the underlying asset as the equivalent of physical use. If the lessee controls the use of the underlying asset, recognition of lease cost in accordance with paragraph 842-20-25-6(a) or amortization of the right-of-use asset in accordance with paragraph 842-20-35-7 should not be affected by the extent to which the lessee uses the underlying asset.This approach would result in the layering on of each additional ROU asset once a purchase order is issued. For example, on the basis of the facts in the example above, the total lease cost for the initial purchase order (provided that it is issued on the first day of the arrangement) would be recognized over the entire four-year lease term. The total lease cost incurred in connection with the second purchase order would be recognized over the remaining lease term at that time. The subsequent impact on the ROU asset each year would reflect all purchase orders previously submitted. This accounting would continue for the remainder of the lease arrangement. This approach will generally result in a more back-loaded lease cost recognition pattern than Approach 1.
Note that depending on the time frame established by the
purchase order and the frequency of purchase order
submission by the customer, there may be scenarios in
which the accounting in this example is not material to
the financial statements. For example, under Approach 1
above, if purchase orders are submitted every month and
establish a one-month production time frame, the
customer’s lease costs would be appropriately
apportioned to the production month and the impact on
the balance sheet on a particular reporting cut-off date
may be immaterial. On the other hand, if the customer in
the example above submitted a two-year purchase order,
the accounting described above would most likely be
necessary so that lease costs can be appropriately
apportioned and the lessee’s lease obligation can be
properly reflected as of the intervening balance sheet
dates.
6.9.2 Lessee’s Guarantee of the Lessor’s Debt
ASC 842-10
30-6 Lease payments do not include any of the following: . . .
b. Any guarantee by the lessee of the lessor’s debt . . . .
ASC 842-10-30-6(b) states that a lessee’s guarantee of the
lessor’s debt should be excluded from the calculation of lease payments.
Instead, the lessee should consider the guarantee under ASC 460. If the
guarantee is recognized on the balance sheet and initially measured in
accordance with ASC 460, it may be reasonable to recognize the offset (i.e., the
debit) as part of the ROU asset.
However, a lessee’s guarantee of a lessor’s loan in effect at
the end of the lease term may, in substance, be a residual value guarantee that
should be considered part of the lease payments in accordance with ASC
842-10-30-5(f). For example, when the lessor owns no significant assets other
than the leased asset, a lessee’s guarantee of the debt is economically
equivalent to the lessee’s providing a residual value guarantee, since the value
of the property is the sole means of repaying the debt. Accordingly, a lessee’s
guarantee of debt issued by an entity that has no significant assets other than
the leased asset should be included in the lessee’s computation of lease
payments when the fair value test in ASC 842-10-25-2(d) is applied, as long as
the guarantee remains in effect at the end of the lease term.
For similar reasons, a lessee’s guarantee of a lessor’s loan
that is nonrecourse to the lessor should also be treated as a residual value
guarantee if the guarantee will remain in effect at the end of the lease term,
since the value of the property is the sole means of repaying the loan.
Treating these loan guarantees as residual value guarantees may
cause the lease to be classified as a finance lease. See Section 6.7 for further
discussion of how residual value guarantees affect lease payments.
Connecting the Dots
Consistency With ASC 840 With Respect to a Lessee’s Guarantee of
the Lessor’s Debt
The requirement in ASC 842-10-30-6(b) to exclude
guarantees by the lessee of the lessor’s debt is consistent with the
previous requirement in ASC 840-10-25-5(b). We therefore do not expect
the application of this guidance under ASC 842 to differ from that under
ASC 840.
6.9.3 Amounts Allocated to Nonlease Components
ASC 842-10
30-6 Lease payments do not include any of the following: . . .
c. Amounts allocated to nonlease components in accordance with paragraphs 842-10-15-33 through 15-42.
As discussed in Section 6.1, lease payments are based on the consideration in the contract that is allocated to the lease component(s) in the contract. Any amounts allocated to the nonlease components in the contract should not be included in the calculation of lease payments. See Chapter 4 for a discussion of separating and allocating consideration to the lease and nonlease components in a contract.
6.9.4 Obligations to Return an Underlying Asset to Its Original Condition
ASC 842-10
30-7 Paragraph 410-20-15-3(e) addresses the scope application of Subtopic 410-20 on asset retirement obligations to obligations of a lessee in connection with a lease (see paragraph 842-10-55-37).
55-37 Obligations imposed by a lease agreement to return an underlying asset to its original condition if it has been modified by the lessee (for example, a requirement to remove a lessee-installed leasehold improvement) generally would not meet the definition of lease payments or variable lease payments and would be accounted for in accordance with Subtopic 410-20 on asset retirement and environmental obligations. . . .
To the extent that a lessee has agreed to remove modifications it has made to a
leased asset so that it can return the asset to the lessor in its original
condition, estimated future payments for such work would not be considered a
future lease payment. For example, at the end of the lease term, a lessee may
incur costs to remove leasehold improvements from the leased asset. Under ASC
842-10-55-37, the removal of lessee-installed leasehold improvements is an
example of a cost of returning an underlying asset that has been modified by a
lessee to its original condition and such a cost should not be included in lease
payments. Such an obligation would instead be accounted for under ASC 410-20 on
asset retirement and environmental obligations.
However, as discussed in Section 6.8, a lessee may also be required to restore
functionality, at the end of the lease term, to a leased asset that benefits the
lessor but not the lessee. The obligation related to such restorations would be
considered a future lease payment.
Example 6-18
Entity B (the lessee) leases an aircraft under a 10-year lease. The
terms of the lease require B to perform an overhaul of
the aircraft (a C-check) every three years to comply
with regulations. The cost of each C-check is $10,000.
In addition, at the end of the lease term, B must
perform a C-check when returning the plane to the lessor
regardless of whether it recently performed one. This
final C-check does not benefit the lessee since it is
returning the aircraft; however, it does benefit the
lessor, which will not need to perform another C-check
on the aircraft for three years.
The determination of whether the overhaul costs should be
included in the lease payments depends on whether the
lessee has a present obligation to perform the
overhauls, and therefore to incur the expenditure, at
lease commencement for the benefit of the lessor.
In this scenario, the cost of the final C-check (i.e.,
the C-check that the lessee must perform immediately
before returning the plane to the lessor) should be
included in the lease payments because it represents a
present obligation of the lessee and does not benefit
the lessee. Because there is no present obligation for
the lessee to perform any other C-checks throughout the
lease term for the benefit of the lessor, the cost of
those C-checks should not be included in the lease
payments at lease commencement.
6.9.5 Indemnification Clauses for Certain Tax Benefits
ASC 842-10
55-38 Some leases contain indemnification clauses that indemnify lessors on an after-tax basis for certain tax benefits that the lessor may lose if a change in the tax law precludes realization of those tax benefits. Although the indemnification payments may appear to meet the definition of variable lease payments, those payments are not of the nature normally expected to arise under variable lease payment provisions.
55-39 Because of the close association of the indemnification payments to specific aspects of the tax law, any payments should be accounted for in a manner that recognizes the tax law association. The lease classification should not be changed.
ASC 842-30
55-16
Indemnification payments related to tax effects other
than the investment tax credit should be reflected by
the lessor in income consistent with the classification
of the lease. That is, the payments should be accounted
for as an adjustment of the lessor’s net investment in
the lease if the lease is a sales-type lease or a direct
financing lease or recognized ratably over the lease
term if the lease is an operating lease.
Some lease contracts include provisions under which the lessee commits to compensate the lessor for certain tax benefits that the lessor may lose if there is a change in the tax law. Although these indemnification payments vary because of changes in facts or circumstances occurring after the commencement date (i.e., a change in the tax law) and thus appear to meet the definition of a variable payment, the boards decided that these payments should not be accounted for as variable lease payments because of the strong correlation between the indemnification payment and the related tax law. Rather, such payments should be accounted for in accordance with ASC 460 in such a way that the tax law association is recognized.
Conversely, as discussed in Section 4.3.2, some lease contracts
include provisions under which the lessee commits to compensating the lessor for
sales taxes or other similar taxes. In such cases, these taxes may or may not
represent payments associated with the contract that contains a lease. See
Section 4.3.2.3 for further
details.
Footnotes
11
Depending on materiality, the accounting
described in this example (recognition of a lease
liability and ROU asset for each discrete purchase
order) may not be required in all circumstances.
For example, there may be short-duration or
low-dollar purchase orders for which the
application of ASC 842 would not have a material
impact on the financial statements.
12
The reference to “lease costs” can include
amounts that are recognized in other line items in
the income statement besides line items in which
lease expenses are recorded. For example, it may
be common in a contract manufacturing arrangement
for an entity to record costs associated with the
use of a manufacturing line as capitalizable
inventory costs. Those costs would ultimately be
reflected within cost of goods sold in the income
statement rather than in lease expense.
6.10 Subsequent Measurement of Lease Payments
ASC 842-10
35-4 A lessee shall remeasure the lease payments if any of the following occur:
- The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
- 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. 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).
- There is a change in any of the following:
- 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.
- 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.
- 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.
35-5 When one or more of the events described in paragraph 842-10-35-4(a) or (c) occur or when a contingency unrelated to a change in a reference index or rate under paragraph 842-10-35-4(b) is resolved, variable lease payments that depend on an index or a rate shall be remeasured using the index or rate as of the date the remeasurement is required.
35-6 A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
The table below summarizes the guidance in ASC 842-10-35-4 through 35-6 for both
lessees and lessors.
|
Lessee Remeasures Lease
Payments Under ASC 842?
|
Lessor Remeasures Lease
Payments Under ASC 842?
|
---|---|---|
The lease is modified, and
that modification is not accounted for as a
separate contract (Chapters 8 and
9)
|
X
|
X
|
Contingency underlying
variable lease payments that do not depend on an
index or a rate is resolved and, as a result, some
(or all) of the remaining payments become fixed
for some (or all) of the remaining lease term
(Section 6.9.1)
|
X
|
|
Change in the lease term
(Section 5.4)
|
X
|
|
Change in whether the lessee
is reasonably certain to exercise a purchase
option (Section 6.4)
|
X
|
|
Change in the amount that it
is probable the lessee will owe under a residual
value guarantee (Section 6.7)
|
X
|
|
Bridging the GAAP
Remeasurement of Lease Payments
Under ASC 842, when a lessee remeasures its lease payments for any of the
reasons illustrated in the table above, the lessee
should remeasure variable lease payments that
depend on an index or a rate by using the index or
rate as of the remeasurement date. As noted in
Section 6.3, this requirement differs
from the requirement under IFRS 16 to remeasure
variable lease payments that depend on an index or
a rate whenever there is a change in contractual
cash flows (e.g., changes in the CPI).
6.10.1 Accounting for a Lease Liability and Corresponding ROU Asset in an Arrangement Involving a “Minimum Annual Guarantee” Payment Structure in Which a New Lease Payment Floor Is Established Each Year
Leasing arrangements may have
a “minimum annual guarantee” (MAG) payment
structure in which a lessee guarantees a minimum
annual payment and only the minimum amount for the
first year is known upon lease commencement. After
year 1, the MAG will reset on the basis of the
revenue, usage, consumption, or another similar
factor for year 1. The reset mechanism can result
in an increase or decrease compared with the
amount of the year 1 MAG, indicating that, at
lease commencement, there is no established floor
for any year after year 1.
Example 6-19
Company B enters into a
three-year real estate lease. The arrangement
includes a rent payment structure in which the
annual rent is an amount equal to 5 percent of
annual revenue, with a MAG in year 1 of $210,000
(i.e., a fixed payment). For each subsequent year,
the MAG is an amount equal to 5 percent of the
prior year’s revenue, which establishes a payment
floor for that year (e.g., the rent in year 2 will
be the greater of 5 percent of year 2 revenue or 5
percent of year 1 revenue). Importantly, as of
lease commencement, there are no fixed or
in-substance fixed payments other than the MAG in
year 1 of $210,000, since the sales each year,
which are unknown, could result in a MAG that is
higher or lower (or potentially zero) for
subsequent years. The lease is classified as an
operating lease.14 The table below illustrates the MAG for each
year, which is based on the assumed annual revenue
over the lease term.
When analyzing arrangements
such as the one in the example above, it is critical for an entity to determine the
substance of the pricing mechanism. We believe that these mechanisms are designed to
establish minimum payments for future use rather than to impose incremental payments for
past use. The discussion below reflects our views on the accounting related to these
arrangements; these views are based on our view of the substance of the MAG payment
structure.
6.10.1.1 Measuring and Accounting for the Lease Liability
The MAG in year 1 of the real
estate lease represents an in-substance fixed
payment for year 1 only, because a floor is being
set by the MAG (see Section 6.2.1
for additional discussion of in-substance fixed
payments). In the example above, B would calculate
the lease liability at lease commencement on the
basis of the present value of the MAG for the
first year. We believe that the in-substance fixed
payment is limited to the MAG in year 1 because
the MAG amounts after year 1 (the MAG amounts
applicable to years 2 and 3) could increase or
decrease. Since the subsequent-year MAG amounts
can decrease, as of the commencement date of the
lease, a payment floor does not exist beyond year
1.
At the end of each year,15 B would calculate a new MAG for the
following year (e.g., a MAG calculated on the
basis of year 1 revenue establishes a rent floor
for year 2), which constitutes a remeasurement
event in accordance with ASC 842-20-35-5(c), since
the resolved uncertainty associated with year 1
revenue represents the resolution of a contingency
affecting B’s future lease payments. When a
contingency is resolved, a lessee must remeasure
the lease liability to reflect changes to the
lease payments, as described in ASC
842-10-35-4(b), which states, in part:
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.
See Section 8.5.4.2 for more information about
accounting for a change in lease payments resulting from the resolution of a
contingency. Through the effective interest method, the year 1 lease liability will be
reduced to zero by the time the MAG is reset at the end of year 1 (once the total sales
for year 1 are known), at which point the new MAG will be used to determine the year 2
liability (the new MAG represents an in-substance fixed payment for year 2 since it
establishes a payment floor for that year). Similarly, the year 2 liability will
subsequently be amortized as B makes the year 2 payments. This accounting will continue
over the remainder of the lease term. The expense recognition profile of the
corresponding lease cost is discussed in the section below.
6.10.1.2 Subsequent Measurement and Recognition of the Lease Cost
As discussed above, when the
MAG is reset each year, Company B must consider the guidance in ASC 842-10-35-4(b) and
remeasure the lease liability and ROU asset as of each reset date.
We believe that there may be
more than one acceptable approach to recognizing
the lease cost. We have outlined two acceptable
alternative approaches below that we believe an
entity can use to recognize the in-substance fixed
payment (i.e., lease cost) on a straight-line
basis over (1) the remaining lease term or (2) the
year to which the MAG is related:16
-
Recognize the lease cost for each MAG over the remaining lease term — The in-substance fixed payment in the form of a MAG represents payment for the right to use the underlying asset over the remaining lease term. This approach is supported by the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]Under this approach, each additional ROU asset would be layered on once the MAG is reset in each annual period. That is, in the example above, the MAG lease cost of $210,000 in year 1 would be recognized over the entire three-year lease term (i.e., $70,000 of lease cost in all three periods). The lease cost of $230,000 related to the reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would be recognized over the remaining two-year lease term (i.e., an additional $115,000 of lease cost in the two remaining periods). Accordingly, the balance of the ROU asset at the end of year 2 would include the remaining unamortized balance from both the year 1 MAG and the year 2 MAG. This accounting would continue for the remainder of the lease arrangement. This approach will result in higher expense recognition in the latter years of the contract (i.e., back-loaded lease cost), as illustrated in the table below.
-
Recognize the lease cost for each MAG in the year to which the MAG is related — Under this approach, the lease cost would be reflected for each MAG on the basis of the use of the underlying asset for one year only. Such cost recognition is aligned with the frequency at which lease payments are reset and in turn would be aligned with the physical-use pattern of the space. This approach is consistent with the guidance in ASC 842-20-25-6(a), which states, in part:After the commencement date, a lessee shall recognize . . . in profit or loss, [a] single lease cost, calculated so that the remaining cost of the lease . . . is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. [Emphasis added]The lease cost resulting from the year 1 MAG would be recognized on a straight-line basis over year 1, and the corresponding ROU asset would thus be fully amortized by the end of year 1. The reset of the MAG at the end of year 1 (i.e., the year 2 MAG) would trigger a resolution of a contingency in accordance with ASC 842-20-35-5(c) (see Section 6.10.1.1), in which the payments associated with the MAG for year 2 become an in-substance fixed payment. Accordingly, the lessee would recognize a separate lease liability and a corresponding ROU asset for the year 2 MAG only, which would be completely amortized in year 2. This accounting would continue for the remainder of the lease term. The table below illustrates the total lease cost recognized in each year (and is based on the same facts as those in the example above). Overall, this approach may be easier to apply than the previous approach since an entity will not have to track separate layers of an ROU asset as a MAG is reset over time. Rather, the entity will record a new ROU asset and lease liability each time a reset occurs, both of which will be exhausted during the year to which they are related. This approach may also better reflect the economics of a variable payment leasing structure with a floor mechanism that fluctuates over time.Note that we are aware of different views in practice regarding the substance of, and appropriate accounting for, leases that contain pricing reset mechanisms similar to the MAG structure discussed above. According to one such view, the MAG reset is considered to be a variable lease expense associated with the period that establishes the new MAG. For example, the year 2 MAG of $230,000 in the example above would be treated as variable lease cost for year 1. This view therefore has a front-loading effect on recognition of lease costs. Given the diversity of views on the substance of these reset mechanisms and the related accounting requirements, we encourage entities affected by this issue to discuss their proposed accounting treatment with their auditors or accounting advisers.
Footnotes
14
This section is written with
an operating lease in mind, but similar considerations would apply to a
finance lease. However, one notable difference between the two
classifications pertains to the expense recognition pattern of the lease
cost and the corresponding amortization of the ROU asset. Operating lease
cost is recognized on a straight-line basis, while the expense recognition
pattern for finance lease cost is front-loaded. The corresponding ROU
asset amortization also depends on the classification. See Section 6.10.1.2 for more information about
the expense recognition pattern for the lease cost and ROU asset
amortization.
15
For simplicity, we have
assumed that the metric that establishes the MAG for each year can increase or
decrease over the course of the entire year and therefore does not establish an
in-substance fixed payment for the following year until the measurement period ends.
This could be the case with revenues, for example, which can decrease on the basis
of customer returns. Depending on materiality to interim reporting, to the extent
that the metric that establishes the MAG cannot decrease over time (i.e., in future
interim periods), the accounting described in Section
6.10.1.1 may be accelerated and may involve multiple
remeasurements.
16
The amortization of the ROU
asset will be consistent with the method outlined
in ASC 842-20-35-3(b) for an operating lease in
which the amortization of the ROU asset generally
increases in each period as the liability
accretion decreases as a result of a declining
lease liability balance. In contrast, the
amortization of an ROU asset for a finance lease
will generally be on a straight-line basis in
accordance with ASC 842-20-35-7. Only the
operating lease cost is illustrated in this
example.
6.11 Initial Direct Costs
ASC 842-10 — Glossary
Initial Direct Costs
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
ASC 842-10
30-9 Initial direct costs for a lessee or a lessor may include, for example, either of the following:
- Commissions
- Payments made to an existing tenant to incentivize that tenant to terminate its lease.
30-10 Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs:
- General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
- Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities
- Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.
Connecting the Dots
Definition of Initial Direct Costs
Consistent With ASC 606
In a manner consistent with ASC 606, initial direct costs for both lessees and lessors include only those costs that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained. Paragraph BC307 of ASU 2016-02 explains the FASB’s decision for aligning the definition of initial direct costs under ASC 842 with that in ASC 606:
The Board [FASB] concluded that a lessor and a seller of the same good, including an entity that both sells and leases assets, should account for similar costs in the same way. In addition, the Board noted that the guidance on initial direct costs in previous GAAP was aligned with one of the two acceptable methods for accounting for costs to obtain a contract in previous revenue recognition guidance, and, therefore, the Board’s decision on initial direct costs in Topic 842 maintains alignment between the leases and revenue recognition guidance for these types of costs.
Changing Lanes
Fewer Costs Qualify as Initial Direct
Costs Under ASC 842
The definition of initial direct costs under ASC 842 is considerably more restrictive than the definition under ASC 840. For example, under ASC 842, commissions paid and payments made to existing tenants to obtain the lease are considered initial direct costs, whereas allocated internal costs and costs to negotiate and arrange the lease agreement that would have been incurred regardless of lease execution (e.g., professional fees such as those paid for legal and tax advice) no longer qualify as initial direct costs.
The FASB included Example 27 in ASC 842 to illustrate the types of costs that
qualify as initial direct costs under ASC 842.
ASC 842-10
Illustration of Initial Direct Costs
55-239 Example 27 illustrates initial direct costs.
Example 27 — Initial Direct Costs
55-240 Lessee and Lessor enter into an operating lease. The following costs are incurred in connection with the lease:
55-241 Lessor capitalizes initial direct costs of
$10,000, which it recognizes ratably over the lease term, consistent with its
recognition of lease income. The $10,000 in broker commissions is an initial
direct cost because that cost was incurred only as a direct result of obtaining
the lease (that is, only as a direct result of the lease being executed). None
of the other costs incurred by Lessor meet the definition of initial direct
costs because they would have been incurred even if the lease had not been
executed. For example, the employee salaries are paid regardless of whether the
lease is obtained, and Lessor would be required to pay its attorneys for
negotiating and drafting the lease even if Lessee did not execute the lease.
55-242 Lessee includes $20,000 of initial direct costs
in the initial measurement of the right-of-use asset. Lessee amortizes those
costs ratably over the lease term as part of its total lease cost. Throughout
the lease term, any unamortized amounts from the original $20,000 are included
in the measurement of the right-of-use asset. The $20,000 payment to the
existing tenant is an initial direct cost because that cost is only incurred
upon obtaining the lease; it would not have been owed if the lease had not been
executed. None of the other costs incurred by Lessee meet the definition of
initial direct costs because they would have been incurred even if the lease had
not been executed (for example, the employee salaries are paid regardless of
whether the lease is obtained, and Lessee would be required to pay its attorneys
for negotiating and drafting the lease even if the lease was not executed).
Connecting the Dots
Initial
Direct Costs May Be an Allocated Amount
As discussed in Section
6.1, when nonlease components are
present in a contract, the consideration in the
contract must be allocated to the lease and
nonlease components. In a manner consistent with
this requirement, ASC 842-10-15-38 requires that
lessors allocate capitalized costs (including
initial direct costs) to the separate components
in the contract. As a general rule, we believe
that lessors should allocate these costs on the
same basis as the consideration in the contract
(i.e., on the basis of stand-alone selling price).
However, when the capitalized costs (e.g.,
commissions) are entirely related to the lease
component(s) in the contract rather than to the
overall contract (which contains both lease and
nonlease components), we believe that it is
acceptable to allocate these costs entirely to the
lease component(s) in the contract.
On the other hand, ASC
842-10-15-33 requires that lessees allocate
initial direct costs to the separate lease components in the
contract on the same basis as lease payments
(i.e., on the basis of stand-alone price).
Example 6-20
Company L (the lessee) enters into an arrangement to lease a
building for 10 years. As part of the arrangement, the lessor is required to
provide CAM services for the 10-year lease term. In exchange for the right to
use the building and obtain the CAM services, L will make fixed monthly payments
of $5,000. The stand-alone price of the monthly building lease and CAM is $4,750
and $500, respectively. As compensation for executing the contract, the lessor
pays a one-time commission of $1,000 to its employee.
The following table illustrates the allocation of the $1,000
commission between the lease and nonlease components in the contract:
The $905 commission allocated to the lease component in the
contract should be accounted for in accordance with the guidance on initial
direct costs in ASC 842. The $95 commission allocated to the nonlease component
in the contract should be accounted for in accordance with the guidance on
incremental costs to obtain a contract in ASC 606 (see Section 13.2 of Deloitte’s
Roadmap Revenue
Recognition). The accounting treatment of the $905 commission
under ASC 842 may not be aligned with that of the $95 commission under ASC
606.
See Chapters
8 and 9 for a discussion of the recognition
and subsequent measurement of initial direct costs
for lessees and lessors, respectively.
6.11.1 Payment Made by a Lessor to a Lessee to Induce Early Termination of a Lease
A lessor may make a payment
(or payments) to a lessee to induce the lessee to
terminate the lease before the end of the lease
term. Such a situation may arise, for instance,
when the rental rate is unfavorable from the
lessor’s perspective (i.e., below the prevailing
market rate) or the lessor has an opportunity to
lease the space to a more attractive tenant.
Generally, at the time the payment is made, the
lessor either will have secured a replacement
lessee for the space (perhaps with eviction of the
current tenant being the only unresolved matter)
or, at a minimum, will have identified a
replacement lessee and will be in the process of
negotiating the lease.
A payment made by a lessor to
a lessee to induce the lessee to terminate the lease before the end of the lease term
generally qualifies as an initial direct cost of the lessor in obtaining the new lease.
(Similarly, such a payment received by the lessee generally qualifies as a lease incentive
in the lessee’s accounting for its new lease, as discussed in Section 6.2.2.1.)
Provided that, at the time of
the payment, the lessor has identified a replacement lessee for the space and entering
into the new lease with that identified replacement lessee is reasonably certain, the
payment made to induce the current lessee to terminate the lease qualifies as an initial
direct cost of obtaining the new lease. The lessor should defer the payment as an initial
direct cost of obtaining the new lease and recognize it into income over the term of the
new lease.
However, deferral of the
payment would not be appropriate in situations in
which, at the time the payment is made, either (1)
a specific replacement lessee has not been
identified or (2) a replacement lessee has been
identified but entering into the new lease with
that replacement lessee is not reasonably certain.
In these situations, the payment would not
constitute an initial direct cost and instead
should be expensed as incurred.
6.11.2 “Key Money” Payment Made to an Existing Lessee to Assume a Lease
In certain jurisdictions,
lessees are able to renew leases at below-market
rates because of the regulatory restrictions
placed on lessors. Therefore, an entity is
economically incentivized to assume a below-market
lease from an existing lessee rather than
negotiate a new lease at market rates. The entity
will often pay the existing lessee to assume the
lease; this payment is commonly referred to as a
“key money” payment.
We believe that key money
payments typically should be accounted for as
initial direct costs. ASC 842-10-20 defines
initial direct costs as “[i]ncremental costs of a
lease that would not have been incurred if the
lease had not been obtained.” Further, ASC
842-10-30-9 gives examples of two types of initial
direct costs:
Initial direct
costs for a lessee or a lessor may include, for
example, either of the following:
-
Commissions
-
Payments made to an existing tenant to incentivize that tenant to terminate its lease. [Emphasis added]
Although key money payments
are made to assume an existing lease with
favorable market terms rather than simply to
induce an existing tenant to terminate its lease,
both represent costs incurred to obtain the right
to use the underlying asset over the lease term
and would not have been incurred if the lease had
not been obtained. We therefore believe that key
money payments typically meet the definition of
initial direct costs.
Likewise, under the new
leasing standard, lessees no longer record
separate intangible assets for below-market lease
payments upon acquiring an operating lease in a
business combination; rather, such amounts are
capitalized as part of the ROU asset in accordance
with ASC 805-20-25-12. Therefore, we believe that
entities should generally capitalize the entire
key money payment as an initial direct cost — and
thus as part of the ROU asset — and amortize this
cost over the life of the ROU asset (i.e., over
the lease term unless the lease transfers
ownership or contains a purchase option that the
lessee is reasonably certain to exercise).
Chapter 7 — Discount Rates
Chapter 7 — Discount Rates
7.1 General
ASC 842-10 — Glossary
Discount Rate for the Lease
For a lessee, the discount rate for the lease 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.
For a lessor, the discount rate for the lease is the rate implicit in the lease.
Incremental Borrowing Rate
The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.
Initial Direct Costs
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
Rate Implicit in the Lease
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.
An entity uses discount rates to calculate the present value of lease payments when (1) determining lease classification (see Section 8.3 for the lessee’s determination and Section 9.2 for the lessor’s determination), (2) measuring a lessee’s lease liability (see Section 8.4), and (3) measuring a lessor’s net investment in a lease for sales-type and direct financing leases (see Section 9.3). Under ASC 842, the discount rate used by a lessee and a lessor is determined on the basis of information as of the lease commencement date. A lessor will always use the rate implicit in the lease. A lessee will typically use its incremental borrowing rate for the reasons discussed in Section 7.2.
Connecting the Dots
Discount Rate for Lessors Rarely the
Same as That for Lessees
As described above, the lessor is required to use the rate implicit in the lease when calculating the present value of lease payments. In contrast, a lessee will generally use its incremental borrowing rate, since many of the inputs used to calculate the rate implicit in the lease are not readily determinable from the lessee’s perspective (e.g., initial direct costs of the lessor and the lessor’s estimate of the residual value of the underlying asset). Therefore, the lessor discount rate and the lessee discount rate would rarely be the same.
Bridging the GAAP
Differences Between Discount-Rate
Terminology Under U.S. GAAP and That Under IFRS Accounting
Standards
While the principles in ASC 842 behind the definitions of
the rate implicit in the lease and the incremental borrowing rate are
generally consistent with those in IFRS 16, the wording in the definitions
varies.
Specifically, ASC 842 defines the rate
implicit in the lease as follows:
The rate of
interest that, at a given date, causes the aggregate present value of
(a) the lease payments and (b) the amount that a lessor expects to
derive from the underlying asset following the end of the lease term to
equal the sum of (1) the fair value of the underlying asset minus any
related investment tax credit retained and expected to be realized by
the lessor and (2) any deferred initial direct costs of the lessor.
However, if the rate determined in accordance with the preceding
sentence is less than zero, a rate implicit in the lease of zero shall
be used.
In contrast, IFRS 16 defines the interest rate implicit in the lease as:
The
rate of interest that causes the present value of (a) the lease payments
and (b) the unguaranteed residual value to equal the sum of (i) the fair
value of the underlying asset and (ii) any initial direct costs of the
lessor.
Further, ASC 842 defines the incremental
borrowing rate as:
The rate of interest that a
lessee would have to pay to borrow on a collateralized basis over a
similar term an amount equal to the lease payments in a similar economic
environment.
On the other hand, IFRS 16 defines the lessee’s incremental borrowing rate as:
The rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment.
As a result of these wording differences, the accounting
outcome for an entity that applies the above definitions under U.S. GAAP
could slightly differ from that under IFRS Accounting Standards. For more
information about the differences between ASC 842 and IFRS 16, see Appendix B.
7.1.1 Rate Implicit in the Lease
The “rate implicit in the lease” is the interest rate that ”causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained . . . by the lessor and (2) any deferred initial direct costs of the lessor” (emphasis added).1
Changing Lanes
Impact of Initial Direct Costs on
the Rate Implicit in the Lease
During redeliberations, the FASB and IASB evaluated whether it would be appropriate to include initial direct costs in the determination of the lease’s implicit rate (in a manner similar to IAS 17’s requirement) or whether they should be excluded (in a manner similar to ASC 840’s requirement). Ultimately, the boards concluded that it would be more appropriate for an entity to include initial direct costs when determining the rate implicit in the lease because a lessor would generally price the lease to obtain a specific return by considering all costs associated with entering into the lease, including initial direct costs. Therefore, the inclusion of initial direct costs in the calculation of the lease’s implicit rate under ASC 842 differs from the calculation of the lease’s implicit rate under ASC 840 and will result in a lower interest rate.
7.1.2 Incremental Borrowing Rate
The incremental borrowing rate is the “rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
Connecting the Dots
Appropriate Forms of
Collateral
On the basis of discussions with the FASB and SEC staffs, we think that in determining the incremental borrowing rate, a lessee should evaluate the collateral considered for the borrowing as follows:
- The lessee should start with a rate that is obtained for a general, unsecured, recourse borrowing and should adjust that rate for the effects of collateral. This should have the effect of reducing the rate.
- The lessee should assume full collateralization and should not assume undercollateralization or overcollateralization.
- The collateral considered does not have to be the leased asset. It can be the leased asset, but it may also be any form of collateral that a creditor would be expected to accept to secure a borrowing for a similar term (i.e., collateral that is at least as liquid as the leased asset).
Connecting the Dots
Incremental Borrowing Rate for
Leases Denominated in a Foreign Currency
In determining an incremental borrowing rate for a lease denominated in a foreign currency, a lessee, rather than using its functional currency, should calculate its incremental borrowing rate by using assumptions that would be consistent with a rate that it would obtain to borrow — on a collateralized basis and in the same currency in which the lease is denominated — an amount equal to the lease payments in that currency over the lease term.
Changing Lanes
Changes in the Definition of
Incremental Borrowing Rate
The incremental borrowing rate under ASC 842 differs from the incremental
borrowing rate under ASC 840. For example, under ASC 842, the
incremental borrowing rate is the rate that the lessee would pay to
borrow an amount equal to the lease payments on a collateralized
basis over a similar term. Under ASC 840, however, the incremental
borrowing rate was the rate the lessee could obtain to borrow the funds
necessary to purchase the underlying asset.
In addition, under ASC 842, the incremental borrowing rate is the rate of
interest that a lessee would have to pay to borrow on a collateralized
basis (i.e., a secured borrowing). In contrast, under ASC 840, a lessee
was not required to use a rate that takes collateral into account but
should use a rate that is “determinable, reasonable, and consistent with
the financing that would have been used in the particular
circumstances,” regardless of whether the rate is secured.
Footnotes
1
ASC 842-10-25-4 states, in part, that “a lessor shall assume that no initial
direct costs will be deferred if, at the
commencement date, the fair value of the
underlying asset is different from its carrying
amount.” Therefore, in a sales-type lease, initial
direct costs will be recognized as an expense at
lease commencement unless no selling profit or
loss is recognized upon the derecognition of the
leased asset.
7.2 Determination of the Discount Rate for Lessees
ASC 842-20
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 instead of
its incremental borrowing rate, determined using a
period comparable with that of the lease term, as
an accounting policy election made by class of
underlying asset.
30-4 See Example 2 (paragraphs 842-20-55-17 through 55-20) for an illustration of the requirements on the discount rate.
7.2.1 Initial Determination of the Discount Rate
At lease commencement, a lessee must develop a discount rate to calculate the present value of the lease payments so that it can determine lease classification and measure the lease liability. When determining the discount rate to be used at lease commencement, a lessee must use the rate implicit in the lease unless that rate cannot be readily determined. When the rate implicit in the lease cannot be readily determined (which we expect to generally be the case), the lessee should use its incremental borrowing rate.
Changing Lanes
Required Use of Rate Implicit in the Lease (When Readily
Determinable)
Under ASC 842, when the rate implicit in the lease is readily determinable, the
lessee must use this rate regardless of whether it
is greater than the lessee’s incremental borrowing
rate. This requirement differs from that under ASC
840, which indicated that a lessee can only use
the rate implicit in a lease when that rate does
not exceed the lessee’s incremental borrowing rate
and is readily determinable.
The example and discussion below further explain the considerations related to
the initial determination of the discount rate. In
addition, Example 2 in ASC 842-20-55-17 through
55-20 (reproduced in Section 7.2.5)
also illustrates this determination.
Example 7-1
Determination of the Discount Rate for Lessees
Company A enters into an arrangement to lease a crane from Supplier for five years, beginning on January 1, 20Y1. Assume the following facts:
- The estimated fair value of the crane is $195,000.
- Company A must pay Supplier $37,500 annually, with the payment due at the end of each year.
- The estimated residual value of the crane at the end of the lease term is $60,000.
- Company A does not know the total initial direct costs deferred by Supplier.
- Company A cannot readily determine Supplier’s estimate of the residual value of the crane at lease commencement.
- There are no separate nonlease components in the contract.
- Company A has an unsecured line of credit with a lending institution that bears an interest rate of 7.75 percent.
- Company A receives an interest rate quote of 6.50 percent from its lender for a five-year loan of $187,500 that is secured by commercial equipment.
Evaluation of the Rate Implicit in the Lease
A lessee must use the rate implicit in the lease as its discount rate unless that rate is not readily determinable. In this example, while certain components of the rate implicit in the lease are readily determinable (e.g., estimated fair value and the lease payments), A does not know the initial direct costs that Supplier deferred or Supplier’s estimate of the crane’s expected residual value. Therefore, A would be required to use its incremental borrowing rate.
Evaluation of the Incremental Borrowing Rate
As indicated in Section 7.1.2, the incremental borrowing rate is the rate that reflects the interest a lessee would have to pay to borrow funds on a collateralized basis over a similar term and in a similar economic environment. As a result, when determining its incremental borrowing rate, the lessee is not limited to a rate that is collateralized by the leased asset; rather, the lessee can use any interest rate as long as the rate reflects a term similar to the lease term and the borrowing is fully collateralized.
In this example, A cannot use the rate on its unsecured line of credit because the borrowing is not collateralized. Instead, A would use as its discount rate the interest rate quoted on its five-year loan secured by commercial equipment because that interest rate is fully collateralized and is based on a term similar to the lease term (i.e., five years).
7.2.1.1 Lessee’s Consideration of Whether the Rate Implicit in the Lease Is Readily Determinable
ASC 842-20-30-3 states, in
part, “A lessee should use the rate implicit in
the lease whenever that rate
is readily determinable” (emphasis added).
Generally, the rate implicit
in the lease would be considered readily
determinable when all of
the material inputs used to calculate the rate are
readily determinable (i.e., the lessee can readily
determine the fair value of the underlying asset,
the amount the lessor expects to derive from the
underlying asset at the end of the lease term, and
the lessor’s initial direct costs, provided that
each of these has a material effect on the rate —
see Section 7.1 for
the definition of “rate implicit in the lease”).
In contrast, the rate implicit in the lease would not be considered
readily determinable when any of the material
inputs are not readily determinable.
In scenarios in which material
inputs are deemed readily determinable but
immaterial inputs are not, it may be reasonable
for a lessee to estimate those inputs when
determining the rate implicit in the lease if such
inputs are not expected to materially affect the
resulting calculations (e.g., when the lessee does
not know the lessor’s initial direct costs but the
lack of precision in an estimate of a reasonable
amount of initial direct costs would not have a
meaningful impact on the calculated rate).
Connecting the Dots
“Readily Determinable” Is a High Hurdle
We believe that the phrase
“readily determinable” is indicative of a high
hurdle. That is, the information a lessee needs to
determine the rate implicit in the lease would
generally not be considered readily determinable
from the lessee’s perspective because of its
limited visibility into the actual inputs needed
to calculate the precise rate (e.g., the lessee
will generally not know the amount that the lessor expects to derive
from the underlying asset at the end of the lease
term). At the same time, lessees should not ignore
available information about the inputs to the rate
implicit in the lease.
Some may believe that a lessee
can never readily determine the rate implicit in
the lease unless all of
the lessor’s inputs are fully transparent to the
lessee. As discussed above, we believe that there
may be limited exceptions to this view.
Specifically, when a lessee is able to reasonably
estimate the immaterial inputs used to calculate
the rate implicit in the lease, we would not
object to the use of an estimated implicit rate.
However, a lessee is not required to attempt to
estimate such inputs if they are not readily
determinable in these circumstances and,
therefore, may use its incremental borrowing rate
when discounting its lease payments.
In January 2019, the FASB
received an agenda request to include additional or amended guidance
in ASC 842 regarding when a lessee should apply the rate implicit in
a lease as its discount rate. This topic was further discussed at
the September 2020 public roundtable (see discussion in Section 17.3.3.1). On the basis of
the feedback received at the roundtable and other venues, the FASB
elected not to further evaluate or change these provisions. As a
result, we do not believe that there will be any subsequent changes
and the FASB currently has no items related to ASC 842 on its
technical agenda.
7.2.1.2 Factors to Consider in Determining the Lessee’s Incremental Borrowing Rate
A determination of the
lessee’s incremental borrowing rate at the
commencement date of a lease may be difficult. If
a lessee did not incur borrowings at or near the
commencement date of a lease that were for a term
similar to the lease term, the lessee may need to
determine its incremental borrowing rate through
discussions with bankers, or other lenders, or by
reference to obligations of a similar term issued
by others with a credit rating similar to that of
the lessee. The incremental borrowing rate should
be an effective borrowing rate that takes into
account any compensating balance or other
requirements affecting the stated interest rate.
When the lessee obtains a third-party guarantee of
its lease payments, it should adjust its
incremental borrowing rate to reflect the impact
of that guarantee if obtaining a third-party
guarantee for a similar borrowing that could have
been used to purchase the leased asset would have
affected the lessee’s borrowing rate for that
debt.
7.2.1.3 Collateralization-Related Factors to Consider
An entity’s collateralized rate cannot be
higher than its general unsecured borrowing rate.
The starting point for determining a
collateralized incremental borrowing rate is an
entity’s general unsecured borrowing rate, given
the term of the lease and the amount of the lease
payments. That base rate is then adjusted to
reflect the effect of collateral. Since adding
collateral only improves the lender’s level of
security, this should lower the applicable
borrowing rate.
When estimating an incremental
borrowing rate, it would generally be acceptable
for an entity to use the leased asset itself as
the assumed collateral. This view is consistent
with most collateralized borrowings in which the
lender can foreclose on the asset that was
purchased with the proceeds of the loan. However,
on the basis of discussions with the FASB and SEC
staffs, we understand that other forms of
collateral can also be used if they are likely to
be accepted by a lender. For example, a lender
that requires collateral would most likely accept
U.S. Treasury securities instead of a fixed asset
(e.g., building, equipment) because the Treasury
securities are more liquid and therefore offer
more security to the lender. In general, lender
acceptance would most likely depend on the
proposed collateral’s level of liquidity in
relation to the leased asset. Assets that are more
liquid than the leased asset would most likely be
accepted as collateral, while assets that are less
liquid would not. In addition, the more liquid the
collateral, the greater the effect we would expect
on the incremental borrowing rate.
On the basis of discussions
with the FASB and SEC staffs, we understand that
an entity should generally assume full
collateralization (not undercollateralization or
overcollateralization) and that it is not expected
or required to establish levels of
collateralization that would typically be required
by lenders in similar circumstances (i.e.,
collateralization based on traditional
loan-to-value requirements for loans related to
different asset types).
Connecting the Dots
A
Lessee’s Consideration of Its Credit Rating When Determining
Its Incremental Borrowing Rate
As described in the discussion
above, the determination of an incremental
borrowing rate depends on a number of factors,
including the amount of the borrowing, a lessee’s
credit rating, and the lease term. Therefore,
irrespective of whether the lessee has an
excellent credit rating, it would generally be
inappropriate for the lessee to use the same
incremental borrowing rate for all of its leases,
since it will need to consider all relevant
factors in determining this rate.
As noted in Section
7.2.1, the incremental borrowing rate
used by a lessee should reflect the interest rate
that the lessee would have to pay to borrow funds
from a third party on a collateralized basis. In
certain instances, a lessee may not be able to
obtain financing from a third party because of its
overall financial condition and
creditworthiness.
In such circumstances, the
incremental borrowing rate may not be readily
available and the lessee should instead use the
interest rate available for the lowest-grade debt
in the marketplace, adjusted for the effects of
collateral.
The “rate” used as the
incremental borrowing rate should be consistent
with the lessee’s cost of borrowing for the
specific purpose. That cost should be the
effective cost of borrowing, including fees paid
to originate the loan. Accordingly, the lessee
should consider reasonable loan origination fees
in computing its incremental borrowing rate.
7.2.2 Reassessment of the Discount Rate
A lessee must update the discount rate when the lease liability is remeasured (see Section 8.5 for a detailed discussion of lessee remeasurement), unless the remeasurement results from changes in one of the following:
- The lease term or the assessment of whether a purchase option will be exercised, and the discount rate already reflects the lessee’s option to extend or terminate the lease or purchase the asset.
- Amounts that it is probable the lessee will owe under a residual value guarantee.
- Lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments are based.
In addition, a lessee would be required to reassess the discount rate when the contract is modified and that modification does not result in a separate contract. See Section 8.6 for more information.
7.2.3 Use of a Risk-Free Rate by Lessees That Are Not PBEs
In November 2021, the FASB issued ASU 2021-09,
which allows lessees that are not PBEs to make an
accounting policy election by class of underlying
asset, rather than on an entity-wide basis, to use
a risk-free rate as the discount rate when
measuring and classifying leases.
As indicated below, ASU
2021-09 amends the current guidance in ASC
842-20-30-3 to allow a non-PBE lessee to make an
accounting policy election, by class of underlying
assets, to use a risk-free rate as the discount
rate when the rate implicit in the lease is not
readily determinable.
ASC 842-20
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 instead of
its incremental borrowing rate, determined using a
period comparable with that of the lease term,
as an accounting policy election made by class
of underlying asset.
In addition to allowing lessees to elect to use
the risk-free rate as an accounting policy by
asset class rather than on an entity-wide level,
the ASU requires lessees to:
- Disclose their election, including the asset class(es) for which they have elected the accounting policy.
- Use the rate implicit in the lease instead of the risk-free rate when the former is readily determinable, regardless of whether the practical expedient has been elected.
See Section 17.3.1.9 for a detailed discussion
of ASU 2021-09, including the transition requirements.
As clarified by ASU 2021-09, the risk-free rate
can only be applied by a lessee for leases when
the rate implicit in the lease is not readily
determinable. Before the issuance of this ASU,
non-PBE lessees that had adopted ASC 842 were
required to use the risk-free rate as the discount
rate to measure all of their leases if they had
elected this practical expedient. Upon adopting
the ASU, lessees that previously applied this
requirement may choose to discontinue using the
risk-free rate as the discount rate for any class
of underlying asset. Conversely, lessees that did
not elect to apply the risk-free rate to all their
leases upon adopting ASC 842 may now choose to
apply the risk-free rate as the discount rate for
any class of underlying asset. A lessee’s policy
election regarding the classes of underlying asset
to which it will apply the risk-free rate should
be consistently applied.
Connecting the Dots
Underlying Asset Class
ASC 842 does not address or
further define the phrase “class of underlying asset.” Before ASU
2021-09, entities were allowed to make other accounting policy elections
by class of underlying asset, so entities may already have policies in
place for how they define asset class. See Section 4.3.3.1 for information
about applying this concept in ASC 842.
Connecting the Dots
Use of
a Risk-Free Rate May Have Unintended Consequences
While a lessee’s use of a
risk-free discount rate may reduce some of the
complexities related to measuring its lease
liabilities and ROU assets, there may be some
unintended consequences. For example, using a
risk-free discount rate would result in a lease
liability and ROU asset that are larger than those
that would have been calculated by using the
lessee’s incremental borrowing rate. In addition,
using the risk-free rate could result in a present
value calculation that may equal or exceed
substantially all of the fair value of the
underlying leased asset, causing the lease to be
classified as a finance lease rather than an
operating lease. An entity should exercise caution
in using the alternative accounting policies
applicable to private companies (non-PBEs) if the
entity expects that it may undergo an IPO or that
its financial statements or other financial
information may be included in another company’s
SEC filings. See Section 18.8 for further discussion of
an entity’s use of private-company (non-PBE)
elections.
7.2.4 Incremental Borrowing Rate Used at a Subsidiary Level
In paragraph BC201 of ASU 2016-02, the FASB acknowledges that it may sometimes be appropriate for a subsidiary to use an incremental borrowing rate other than its own. That is, depending on the nature of the lease negotiations and the resulting terms and conditions of the agreement, it may be more appropriate to use a parent entity’s or consolidated group’s incremental borrowing rate if the borrowing power of these entities is factored into the lease negotiations.
7.2.4.1 Determining a Subsidiary’s Incremental Borrowing Rate When the Lease Terms Are Influenced by Parent or Group Credit
In some cases, a parent
negotiates leases on behalf of its subsidiary so that the subsidiary can
benefit from the parent’s superior credit. In other cases, a consolidated
group might have a centralized treasury function that negotiates on behalf
of all of its subsidiaries for the same reason. The negotiations often
include guarantees or other payment mechanisms that allow the lessor to look
beyond just the subsidiary for payment. This raises the question of whether
it would be appropriate for an entity to use a rate other than the
subsidiary’s incremental borrowing rate when accounting for a lease at the
subsidiary level (if it is assumed that the implicit rate cannot be readily
determined).
The appropriate incremental
borrowing rate for measuring the lease liability
would generally be based on the terms and
conditions negotiated between the lessee and the
lessor. Often, the pricing of the lease will
solely depend on the credit standing of the
subsidiary itself (i.e., the lessee in the
arrangement). In other cases, the pricing may be
significantly influenced by the credit risk
evaluated at another level in an organization
(e.g., the parent or consolidated group) on the
basis of guarantees or other payment mechanisms
that allow the lessor to look beyond just the
subsidiary for payment. If the pricing of the
lease depends solely on the lessee’s credit
standing when the lease was negotiated, the
lessee’s incremental borrowing rate should be used
to measure the lease liability. However, if the
pricing of the lease depends on the credit risk of
an entity other than the lessee when the lease was
negotiated (e.g., the lessee’s parent or a
consolidated group), it will generally be more
appropriate to use the incremental borrowing rate
of that other entity.
Decentralized treasury
functions within an organization may be an
indicator that it is appropriate for the reporting
entity to use the incremental borrowing rate of
the subsidiary (i.e., the lessee in the
arrangement) when measuring the lease liability.
However, this fact is not individually
determinative and should be considered along with
the determination of whether the subsidiary’s
(lessee’s) credit standing was used in the
negotiation of the lease agreement. This view is
consistent with paragraph BC201 of ASU 2016-02,
which states, in part:
The
Board . . . considered that, in some cases, it
might be reasonable for a subsidiary to use a
parent entity or group’s incremental borrowing
rate as the discount rate. Depending on the terms
and conditions of the lease and the corresponding
negotiations, the parent entity’s incremental
borrowing rate may be the most appropriate rate to
use as a practical means of reflecting the
interest rate in the contract, assuming the
implicit rate is not readily determinable. For
example, this might be appropriate when the
subsidiary does not have its own treasury function
(all funding for the group is managed centrally by
the parent entity) and, consequently, the
negotiations with the lessor result in the parent
entity providing a guarantee of the lease payments
to the lessor. Therefore, the pricing of the lease
is more significantly influenced by the credit
standing of the parent than that of the
subsidiary.
The two examples below
highlight scenarios commonly encountered in
practice. In both examples, the credit of the
parent or group is assumed to be superior to the
credit of the subsidiary/lessee.
Example 7-2
On January 15, 20X1, Group A
negotiates and executes a lease on behalf of
Subsidiary B, one of the subsidiaries consolidated
by A. The treasury function is maintained at A’s
level (i.e., B does not have a stand-alone
treasury function), and pricing of the lease is
based on A’s creditworthiness. While both A and B
are the named parties in the lease agreement, B is
identified as the party that will occupy the
leased property.
Since treasury operations
(including the negotiation of lease agreements)
are conducted centrally at A’s level, it would
generally be appropriate for B to use A’s
incremental borrowing rate (as opposed to B’s
rate) when measuring B’s lease liability. This is
because the negotiations with the lessor and the
resulting pricing of the lease are based on the
creditworthiness of A rather than that of B.
Example 7-3
On April 15, 20X1, Lessee A
negotiates a building lease with Lessor B. Lessee
A has its own treasury function that negotiates
all significant agreements, including leases.
However, A’s parent, ParentCo, provides a
guarantee of lease payments to B as part of the
negotiated terms of the lease.
Although A has its own
treasury function and negotiates the term of its
lease, it would be reasonable to conclude that the
pricing of the lease was significantly influenced
by the creditworthiness of ParentCo (as evidenced
by ParentCo’s guarantee to the lessor). As a
result, it would generally be appropriate for A as
the reporting entity to measure the lease
liability by using ParentCo’s incremental
borrowing rate.
7.2.5 Determining a Discount Rate at a Portfolio Level
ASC 842-20
55-17 Example 2 illustrates the determination of the discount rate for the lease.
Example 2 — Portfolio Approach to Establishing the Discount Rate for the Lease
55-18 Lessee, a public entity, is the parent of several consolidated subsidiaries. During the current period, 2 subsidiaries entered into a total of 400 individual leases of large computer servers, each with terms ranging between 4 and 5 years and annual payments ranging between $60,000 and $100,000, depending on the hardware capacity of the servers. In aggregate, total lease payments for these leases amount to $30 million.
55-19 The individual lease contracts do not provide information about the rate implicit in the lease. Lessee is BBB credit rated and actively raises debt in the corporate bond market. Both subsidiaries are unrated and do not actively engage in treasury operations in their respective markets. On the basis of its credit rating and the collateral represented by the leased servers, Lessee’s incremental borrowing rate on $60,000 through $100,000 (the range of lease payments on each of the 400 leases) would be approximately 4 percent. Lessee notes that 5-year zero-coupon U.S. Treasury instruments are currently yielding 1.7 percent (a risk-free rate). Because Lessee conducts its treasury operations centrally (that is, at the consolidated group level), it is reasonably assumed that consideration of the group credit standing factored into how each lease was priced.
55-20 Lessee may determine the discount rate for the lease for the 400 individual leases entered into on different dates throughout the current period by using a portfolio approach. That is, Lessee can apply a single discount rate to the portfolio of new leases. This is because during the period, the new leases are all of similar terms (four to five years), and Lessee’s credit rating and the interest rate environment are stable. Because the pricing of the lease is influenced by the credit standing and profile of Lessee rather than the subsidiaries (that is, because Lessee conducts treasury operations for the consolidated group), Lessee concludes that its incremental borrowing rate of 4 percent is an appropriate discount rate for each of the 400 leases entered into by Lessee’s 2 subsidiaries during the period. Because Lessee is a public entity, it is not permitted to use a risk-free discount rate.
The FASB concluded that it may be appropriate in certain circumstances for an entity to apply the lease accounting guidance at a portfolio level. One such circumstance could be the lessee’s determination of the discount rate. When applying the guidance at a portfolio level, the lessee would need to appropriately stratify the lease population subject to this approach in such a manner that application of the lease guidance at the portfolio level results in an outcome that would not materially differ from the outcome that results from applying the guidance on a lease-by-lease basis. Examples of attributes that the lessee should consider in this exercise include lease term, form of underlying collateral, and amount of lease payments.
Connecting the Dots
Determining a Discount Rate at a Portfolio Level
During its redeliberations, the FASB considered how costly and complex it would be for preparers to apply the guidance in ASC 842. To alleviate this burden, the FASB decided to permit both lessees and lessors to apply the guidance in ASC 842 at a portfolio level. The Board noted that, when a portfolio approach is applied, it would be less costly not only to group similar leases together but also in other respects (e.g., when an entity uses judgments and estimates in recognizing a lease).
For example, paragraph BC121 of ASU 2016-02 indicates that it may be useful for an entity to use a portfolio approach when determining a discount rate:
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. For example, rather than establishing a specific discount rate for a single leased asset, an entity might conclude that it can establish a single discount rate applied to all leases in a portfolio because using that discount rate would not result in a materially different answer than using a discount rate determined for each.
We believe that determining a discount rate at a portfolio level could help reduce the cost and complexity of applying this guidance.
7.3 Determination of the Discount Rate for Lessors
ASC 842-10
25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1) using the rate implicit in the lease. For purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.
7.3.1 Initial Determination of the Discount Rate
A lessor should use the rate implicit in the lease (i.e., the rate it charges
the lessee) when evaluating lease classification and measuring its net
investment in a lease, if applicable. (See Section 7.1.1 for the definition of the
rate implicit in the lease.) Importantly, however, a lessor’s consideration of
initial direct costs in its calculation of the rate implicit in the lease will
be different depending on whether the rate is being used to determine lease
classification or when the lease is initially measured. As a result, a lessor
may determine different rates implicit in a lease depending on whether the rate
will be used to initially classify a lease or to initially recognize and measure
the lease. See Section 9.2.1.4.1 for more
information on how a lessor should consider initial direct costs when
calculating the rate implicit in the lease.
As discussed in Section
9.3.7.1, it is possible for the lessor to have a sales-type or
direct financing lease when the lease payments are entirely or significantly
variable. In such situations, the calculation of the rate implicit in the lease
may result in a negative discount rate. However, at its November 30, 2016, Board
meeting, and as codified in ASU 2018-10, the FASB clarified that it would be
inappropriate to use a negative discount rate. Therefore, lessors would use a 0
percent discount rate to measure the net investment in the lease. See Section 9.3.7.1.2 for a detailed discussion of
lessor accounting in these situations (e.g., the possibility of a
commencement-date loss when a sales-type or direct financing lease includes
significant variable payments).2
7.3.2 Reassessment of the Discount Rate
A lessor would only reassess the discount rate used for determining lease
classification when a lease is modified and the modification is not accounted
for as a separate contract or when an option is exercised that was originally
determined to be not reasonably certain (including both lessee options to extend
the lease term or purchase the underlying asset and lessor options to terminate
the lease). This would occur, for example, when there is a change in the terms
or conditions of the contract that affects the overall scope of or consideration
received as part of the contract. The discount rate to be used depends on the
classification of the lease before and after the lease modification. See
Section 9.3.4
for additional discussion of lessor lease modifications.
Footnotes
2
In July 2018, the FASB issued ASU 2018-10,
which makes Codification improvements to ASC 842 and amends the ASC
master glossary’s definition of the term “rate implicit in the lease” to
clarify that, under ASC 842, this rate cannot be less than zero.
Therefore, the rate implicit in the lease would default to zero if it is
calculated as less than zero. See Section 17.3.1.3 for further
discussion of the ASU. In addition, in July 2021, the FASB issued
ASU
2021-05, which amends ASC 842 to require lessors to
classify certain leases with variable lease payments that result in a
day 1 loss as an operating lease; accordingly, the uneconomic outcome of
a day 1 loss would generally be eliminated. See Section 17.3.1.8
for further discussion of the ASU.
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.
Chapter 9 — Lessor Accounting
Chapter 9 — Lessor Accounting
9.1 Overview
ASC 842-30
05-1 This Subtopic addresses accounting by lessors for leases that have been classified as sales-type leases, direct financing leases, or operating leases in accordance with the requirements in Subtopic 842-10. Lessors should 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; see Section 842-10-15.
This chapter discusses the different steps in a lessor’s accounting for leases. Specifically, Section 9.2 discusses classification of the various lease types and Section 9.3 addresses recognition and measurement considerations related to each of these classifications. Section 9.4 covers other lessor reporting issues. Section 9.5 covers leveraged leases.
As discussed in Chapter
1, the primary objective of the Board’s
leasing project was to require presentation of the
lessee’s off-balance-sheet liabilities. However, a
common misconception is that lessor accounting has
not changed much under the new leasing guidance.
While it is true that the lessor’s classification
and resulting accounting are largely unchanged,
there are key differences between ASC 842 and ASC
840 that companies should focus on during their
implementation of ASU 2016-02. Specific
improvements the Board made to lessor accounting
include those to align ASC 842 with (1)
enhancements made to its revenue standard,
ASU 2014-09
(codified as ASC 606), and (2) updates to key
terms related to lessee accounting.
Regarding the alignment with the revenue standard, because lessors’ adoption of
ASC 842 was after their adoption of ASC 606,
preparers need to establish the timing of changes
and how such changes should be reflected. (See
Chapter 16 for guidance on the
transition provisions of ASC 842.) Further, both
the revenue and lease models now underscore the
principle of control transfer rather than the
transfer of risks and rewards, the latter of which
was the principle under ASC 605 and ASC 840.
Although lease classification for lessees under ASC 842 is similar to that for
lessors, it is not fully symmetrical. For
instance, there are two classes of leases for a
lessee and three for a lessor. In addition,
because of the amendments made by ASU
2021-05 (see Section
9.2.1.6 for more information), the
existence of variable lease payments in a lease
sometimes could influence classification for a
lessor.
We recommend supplementing a review of this section of the Roadmap with a review of the following chapters:
- Chapter 2, which discusses how to identify whether an arrangement is within the scope of the leasing standard.
- Chapter 3, which discusses whether an arrangement is, or contains, a lease.
- Chapter 4, which discusses how to identify the separate lease components and nonlease components within a contract and how the consideration is allocated to components.
- Chapter 5, which discusses the term over which a lessor recognizes consideration related to the lease component.
- Chapter 6, which discusses the initial and subsequent measurement of consideration that must be allocated to the components identified.
The changes addressed in Chapter 4 are particularly significant for lessors, since they may
find the guidance discussed therein challenging to apply and inconsistent with ASC
840. For example, while lessors now have a practical expedient under ASU 2018-11 (see below)
to elect not to separate lease and nonlease components, lessors must meet certain
conditions to apply such an expedient. Lessors that do not elect the practical
expedient must allocate consideration in the contract to the separate lease and
nonlease components on a relative stand-alone selling price basis in a manner
consistent with ASC 606. This chapter of the Roadmap focuses on the accounting for
the lease component and presumes that the lessor has already applied the provisions
discussed in Chapter 4.
As noted above, in July 2018, the FASB issued ASU 2018-11, which contains a new practical expedient under
which lessors can elect, by class of underlying asset, not to separate lease and nonlease components,
provided that the associated nonlease component(s) otherwise would be accounted for under the revenue guidance in ASC 606 and both of the following conditions are met:
- Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.
- Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
The ASU also clarifies that the presence of a nonlease component that is
ineligible for the practical expedient does not
preclude a lessor from electing the expedient when
the criteria are met for the lease component and
any other nonlease component(s). Rather, the
lessor would account for the ineligible nonlease
component(s) separately from the combined eligible
lease and nonlease component(s).
See Section 4.3.3.2
for further details about the practical expedient
related to a lessor’s separation of lease and
nonlease components. In addition, see Section
15.3.2.4 for the disclosure
requirements, and Section 16.4.6
for the transition requirements, related to ASU
2018-11.
Connecting the Dots
Variable Consideration
While there are conceptual consistencies between ASC 606 and ASC 842, principally with respect
to their reliance on control transfer, the two standards sometimes differ in their recognition
and measurement principles. For example, under ASC 606, variable payments are estimated
and included in the transaction price subject to a constraint; under ASC 842, however, variable
lease payments not linked to an index or rate are generally excluded from the determination
of a lessor’s lease receivable. Variable consideration may be allocated in a contract to a lease
component (recognition governed by ASC 842) and a nonlease component (recognition most
likely governed by ASC 606 — see below). In paragraph BC163 of ASU 2016-02, the FASB
addresses its decisions regarding the differences between accounting for variable payments
under ASC 842 and accounting for variable consideration under ASC 606:
The Board decided that providing guidance on consideration in the contract was necessary to ensure
consistent application of the allocation guidance in Topic 842, particularly for lessors because of the
differences between how the Board decided a lessor should account for variable lease payments and
how an entity accounts for variable consideration in Topic 606. The Board concluded that accounting
for a variable payment that relates partially to a lease component (for example, a performance bonus
that relates to the leased asset and the lessor’s operation of that asset) in the same manner as a
variable lease payment (that is, with respect to recognition and measurement) will be less costly and
complex than accounting for that variable payment in accordance with the variable consideration
guidance in Topic 606.
Because an entity may be permitted to recognize revenues under ASC 606 earlier
than revenues generated from lease components, it
is critical to determine the allocation of the
consideration to the appropriate component. See
Section
4.4.2.2.1 for more information.
9.2 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. . . .
The five criteria that a lessor uses to
determine whether a lease is a sales-type lease are the same
as those that a lessee uses to establish whether a lease is
a finance lease. If none of those criteria are met, the
lessor evaluates whether the lease is a direct financing
lease; two criteria must be met for the lease to be
considered a direct financing lease. If neither the
sales-type lease criteria nor the direct financing lease
criteria are met, the lease is an operating lease. In
addition, because of the amendments in ASU 2021-05, even a
lease that meets one of the five criteria to be a sales-type
lease (or is classified as a direct financing lease) should
be classified as an operating lease when the lessor would
have recognized a selling loss and the arrangement includes
variable lease payments that do not depend on an index or a
rate. A lessor performs its lease classification assessment
at lease commencement (i.e., when the lessee obtains the
right to use the asset).
|
The decision tree below illustrates the lessor’s classification assessment as well as the criteria that must be met for each type of lease.
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 lessor 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 rate implicit in the lease). The
diagram below illustrates the difference between lease inception and lease
commencement.
Leveraged Leases
ASC 840 addressed a fourth type of lease, a leveraged lease.
Leveraged lease accounting was a special type of accounting that a lessor
employed for certain direct financing leases. Special accounting was
required for a leveraged lease because of the unique economic effect on the
lessor. This unique economic effect stemmed from a combination of
nonrecourse financing and a cash flow pattern that typically enabled the
lessor to recover its investment in the early years of the lease (as a
result of tax benefits generated by depreciation, interest, and ITC
deductions) and subsequently afforded it the temporary use of funds from
which additional income could be derived.
The FASB did not include leveraged leases in the guidance in
ASC 842 on lease classification. In the Background Information and Basis for
Conclusions of ASU 2016-02, the FASB addresses why it decided not to retain
leveraged leases in the new leasing model, indicating that some Board
members objected to the net presentation related to leveraged leases and
others believed that the accounting for such leases was too complex.
However, the Board decided to grandfather in existing leveraged leases given
that “there would be significant complexities relating to unwinding existing
leveraged leases” during transition. Therefore, a lessor must continue to
apply the accounting in ASC 840 for such a lease (as carried forward in ASC
842) and classify the lease as a leveraged lease provided that it enters
into the lease before the effective date of ASC 842. See Chapter 16 for a
discussion of the effective date and Section 9.5 for more information about
how to account for grandfathered leveraged leases.
Bridging the GAAP
IFRS 16 Does Not Distinguish Between
Sales-Type and Direct Financing Leases
IFRS 16 does not differentiate sales-type leases from direct
financing leases. Rather, lessors will account for leases as either
operating or finance leases, as is required under IAS 17. Although ASC 842
requires a lessor to classify a finance lease as either a sales-type or a
direct financing lease, we do not believe that there will be any differences
besides the differences between ASC 840 and IAS 17 in this area. See
Appendix B
for a summary of the differences between ASC 842 and IFRS 16.
9.2.1 Sales-Type Lease
In a sales-type lease, the lessor transfers control of the underlying asset to
the lessee. In paragraph BC93 of ASU 2016-02, the FASB acknowledges that “[e]ven
though a sales-type lease is not necessarily identical to a sale, the
transactions are economically similar (for example, because sales-type lessors
often use leasing as an alternative means to sell their assets and have no
intention of reusing or re-leasing assets leased under a sales-type lease).”
Paragraph BC93 of ASU 2016-02 further points out that the hallmark of a
sales-type lease is the recognition of “selling profit at lease commencement”
and that such recognition “is consistent with the principle of a sale in Topics
606 and 610.”
Changing Lanes
Sales-Type Leases Affected by Shift From Risks-and-Rewards Model to
Control Model
A sales-type lease results in the recognition of profit (or loss). Therefore, to
be consistent with ASC 606, the FASB decided to align the
transfer-of-control notion, as it applies to the evaluation of whether a
lease qualifies as a sales-type lease, with that in ASC 606. In
paragraph BC121 of ASU 2014-09, the Board observes:
[T]he assessment of when control has transferred
could be applied from the perspective of either the entity
selling the good or service or the customer purchasing the good
or service. Consequently, revenue could be recognized when the
seller surrenders control of a good or service or when the
customer obtains control of that good or service. Although in
many cases both perspectives lead to the same result, the Boards
decided that control should be assessed primarily from the
perspective of the customer. That perspective minimizes the risk
of an entity recognizing revenue from undertaking activities
that do not coincide with the transfer of goods or services to
the customer.
The evaluation of whether a lease qualifies as a sales-type lease therefore focuses on whether
the lessee effectively obtains control of the entire underlying asset (i.e., and not just the right
to use it) rather than whether the lessor has relinquished control. Accordingly, an arrangement
that a lessor historically classified as a sales-type lease because it transferred a portion of the
risks and rewards of the underlying asset to the lessee and a portion to a third party through
a residual value guarantee (e.g., residual value insurance) may no longer qualify as a sales-type
lease.
ASC 842-10
25-2 [A] lessor shall classify a lease as a sales-type 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.
25-3A 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.
The criteria in ASC 842-10-25-2 for a lessor’s sales-type lease classification
are identical to the criteria lessees use to identify a finance lease. (See
Section 8.1 for
a discussion of the lessee’s classification.) Therefore, the lessee’s
classification will often be similar to the lessor’s; however, as further
discussed below, there are differences between the two, such as leases with a
day 1 selling loss for the lessor or differences in the assumptions (e.g.,
residual asset value) or discount rate used (rate implicit in the lease for the
lessor and the incremental borrowing rate for the lessee).
Changing Lanes
Sales-Type Leases for Real Estate
When performing the ASC 840 lease classification test, a
lessor may have determined that a lease met the criteria used by a
lessee to identify a capital lease. However, the lessor only used those
criteria as gating criteria to further identify the classification. If
any of those criteria were met, the lessor was then required to assess
whether the underlying asset was real estate or non–real estate. If the
underlying asset was considered real estate within the scope of ASC 360,
a lease could not have been a sales-type lease unless the lease
transferred the title of the property to the lessee by the end of the
lease.
Because a lease may qualify as a sales-type lease
without a title transfer under ASC 842, more leases will qualify for
sales-type classification. ASC 842 does not distinguish between the
accounting for real estate and that for non–real estate. In paragraph
BC99 of ASU 2016-02, the FASB states, in part:
Previous GAAP included different lessor
requirements for leases of real estate (for example, a lease of
real estate could only be a sales-type lease if it transferred
title to the real estate to the lessee by the end of the lease
term) because the revenue requirements in previous GAAP for the
sale of real estate differed from the revenue requirements in
previous GAAP applicable to the sale of other assets. The
creation of Topic 606 eliminated those different revenue
accounting requirements; therefore, there is no longer a reason
for the accounting for leases of real estate to differ from the
accounting for leases of other assets.
Connecting the Dots
Real Estate Lessors Must Perform Classification Test
As discussed above, under ASC 840, real estate lessors did not spend
considerable time evaluating sales-type lease classification because
title transfer was required for a real estate lease to qualify as a
sales-type lease. However, because ASC 842 does not distinguish between
real estate leases and non-real-estate leases and does not require that
title transfer occur before a sales-type lease is recognized, real
estate lessors will need to evaluate whether leases meet the criteria
for classification as a sales-type lease.
Changing Lanes
Collectibility Does Not Affect Classification as Sales-Type
Lease
Under ASC 840, collectibility of minimum lease payments had to be reasonably predictable for a
lease to qualify as a sales-type lease. While collectibility affects recognition related to sales-type
leases under ASC 842 (discussed in Section 9.3.7.2), ASC 842 does not address collectibility with
respect to the classification of such leases. Therefore, because the classification criteria in this
regard are less strict, more leases will qualify as sales-type leases.
9.2.1.1 Transfer of Ownership at the End of the Lease Term
ASC 842-10
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).
If the lease transfers ownership, such as through the transfer of title at or
shortly after the end of the lease term, the above criterion in ASC
842-10-25-2(a) would be met. In substance, such a transaction is akin to a
financed purchase (i.e., the asset was purchased and financed through lease
payments). Historically, such a finance lease has been accounted for as a
sale/purchase. For example, ASC 840-10- 10-1 stated that “a lease that
transfers substantially all of the benefits and risks incident to the
ownership of property should be accounted for as . . . a sale or financing
by the lessor.” While the model has evolved from a risks-and-rewards model
(i.e., benefits and risks) to a control-based model, the principle is the
same. If the lessee is required to pay a nominal fee for title transfer, the
lease would meet the criterion in ASC 842-10-25-2(a). If paying the fee
(even in circumstances in which the fee is nominal) is optional, the lease
would not meet this criterion, although the lease should be evaluated under
the “reasonably certain purchase option” criterion in ASC 842-10-25-2(b);
see further discussion in the next section.
9.2.1.2 Purchase Option Reasonably Certain to Be Exercised
As indicated in ASC 842-10-25-2(b), when a “lease grants the lessee an option to purchase the
underlying asset,” it must be reasonably certain that the lessee will exercise that option, at which point
the lessor is required to classify the lease as a sales-type lease. “Reasonably certain” is a high threshold.
A purchase option’s exercise may be reasonably certain for many reasons (e.g., an economic compulsion
or incentive for the lessee to exercise its option). See Section 5.2.2 for a discussion of the notion of
“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.
Example 9-1
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 9-2
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.
9.2.1.3 Major Part of the Remaining Economic Life
ASC 842-10
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph] 842-10-25-2(c) . . . 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. . . .
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.” As noted above, if the “lease term is for the major
part of the remaining economic life of the underlying asset,” the lease is a
sales-type lease; however, if the lease term begins “at or near the end of
the economic life of the underlying asset,” the lessor should not use this
criterion in its evaluation. (For further discussion, see Section 9.2.1.3.1.)
ASC 840 required an entity to classify a lease on the basis
of an evaluation of, among other things, certain quantitative bright-line
thresholds. That is, under ASC 840, a lease would have been 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.
While entities are not required to use bright lines when classifying a lease
under ASC 842, 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. Specifically,
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 were to apply ASC 840’s
bright-line thresholds and determine that a lease term is equal to 76
percent of an asset’s useful life, the entity should classify the lease as a
sales-type lease. The entity should not attempt to overcome the assessment
with qualitative evidence to the contrary. Likewise, if the same entity were
to determine 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 (provided
that other lease classification criteria are not met). We would expect that
if an entity were to decide 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.
9.2.1.3.1 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 9-3
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.
9.2.1.3.2 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.
9.2.1.3.3 Impact of Lessor’s Intent to Sell Leased Property at the End of the Lease Term on Determination of the Estimated Economic Life of Leased Property
As described in ASC 842-10-25-2(c), the third criterion
for classifying a lease as a sales-type lease is that the “lease term is
for the major part of the remaining economic life of the underlying
asset.” However, an entity should not use this criterion to classify the
lease “if the commencement date falls at or near the end of the economic
life of the underlying asset.”
The lessor’s intention to sell the leased property
immediately after the end of the lease term should not influence the
asset’s estimated economic life if the asset can still be used for its
intended purpose by other users. Generally, decisions concerning
economic lives for leased property will be similar to those for owned
assets. Thus, the estimated economic life of a leased asset generally
will be the same as the depreciable life of a similar asset for
financial reporting purposes (except as discussed in Section
9.2.1.3.1).
Changing Lanes
25 Percent Fair Value
Test for Land Is Removed
Under ASC 840, in classifying a lease involving
both land and a building, an entity was required to assess the
land separately from the building when (1) the lease met either
the transfer-of-ownership or the bargain-purchase-price
classification criterion or (2) the fair value of the land was
25 percent or more of the total fair value of the leased
property at lease inception. Under ASC 842, an entity would no
longer consider this “25 percent fair value” criterion in
assessing classification and therefore may identify separate
units for classification purposes (i.e., a land component and a
separate building component). See Chapter 4 for more
information on how to identify lease components.
9.2.1.3.4 Lease Agreement Covering a Group of Assets That Have Different Economic Lives
A lease contract often includes a package of equipment.
For example, an equipment lease may include virtually all pieces of
equipment necessary to operate a store (e.g., refrigeration cases, air
conditioning units, alarm and phone systems, cash registers, and store
furniture).
When pieces of equipment that have different useful
economic lives are leased in the aggregate, an entity should consider
the guidance in ASC 842-10-15-28, which states that a right to use an
asset would be considered a separate lease component when it meets the
following two criteria:
-
The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events).
-
The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.
To the extent that the above guidance does not require
separation, an entity should then consider the provisions of ASC
842-10-25-5, which indicates that “[i]f 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).”
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.
Chapter 4 discusses, in detail, the guidance in ASC
842-10-15-28 on separating leasing components.
9.2.1.3.5 At or Near the End of the Remaining Economic Life
ASC 842-10
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph]
842-10-25-2(c) . . . would be to conclude: . . .
b. 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. . . .
If a lease component is at or near the end of its economic life, it is not
subject to the economic-life test. In its 2013 leasing ED, the FASB
contemplated not including this exception. Paragraph BC71 of ASU 2016-02
addresses the Board’s reasons for ultimately including the exception in
the leasing guidance and states, in part:
The exception to considering this criterion when
the lease commences at or near the end of the economic life of
the underlying asset is contrary to the lease classification
principle because a lessee can direct the use of and obtain
substantially all the remaining benefits from a significantly
used asset just the same as it can a new or slightly used asset.
However, the Board determined that an exception is appropriate
because it would be inconsistent to require that a lease
covering the last few years of an underlying asset’s economic
life be recorded as a finance lease by a lessee (or sales-type
lease by a lessor) when a similar lease of that asset earlier in
its economic life would have been classified as an operating
lease. The Board concluded that this would not appropriately
reflect the economics of those leases.
9.2.1.4 Substantially All of the Fair Value of the Underlying Asset
ASC 842-10
25-4 A lessor shall assess the criteria in paragraphs 842-10-25-2(d) . . . using the rate implicit in the lease. For purposes of assessing the criterion in paragraph 842-10-25-2(d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount.
55-2 When determining lease classification, one reasonable approach to assessing the [criterion in paragraph 842-10-25-2(d)] 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.
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.
As indicated in ASC 842-10-25-2(d), if 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,” the lease is classified as a sales-type lease. The present value is calculated by using a discounted cash flow approach. (See Chapter 6 for details on the amounts included in this calculation.) While a lessee will generally use its incremental borrowing rate (if the rate implicit in the lease is not readily determinable) to calculate the present value of its lease payments, as discussed in Section 7.2, a lessor must use the rate implicit in the lease. The ASC master glossary defines the rate implicit in the lease as follows:
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate
determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall
be used.
An entity may solve for the rate implicit in the lease by
using the internal-rate-of-return calculation function through either a
spreadsheet database (as shown in the example below) or another calculator
mechanism.
Example 9-4
A lessor leases a yacht with a fair
value of $256,300 to an actor for three years for an
annual payment made in arrears of $75,000. When the
actor returns the yacht, the fair value of the asset
is expected to be $90,000. Using an
internal-rate-of-return functionality, the lessor
determines that its rate implicit in the lease is
9.57 percent.
Note that, in this example, no ITCs
were received and no initial direct costs were
incurred.
Connecting the Dots
Calculating a Negative “Rate Implicit in the Lease”
We have observed situations in which the outcome of
the calculation of the “rate implicit in the lease,” which is based
on how that term is defined in ASC 842-30-20, may result in a
negative discount rate. However, at the FASB’s November 30, 2016,
meeting, the Board acknowledged that using a negative discount rate
to determine the rate implicit in the lease (as defined in ASC
842-10-20) is inappropriate. ASU 2018-10 clarifies
that lessors should use a 0 percent discount rate when measuring the
net investment in a lease if the rate implicit in the lease is
negative. See Section 17.3.1.3 for
further discussion of the ASU.
Evaluating “Substantially All”
One of the most notable aspects of ASC 842 is the
exclusion of “bright lines” (e.g., the 90 percent previously used in
the 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. See Section 9.2.1.3 for more
information.
Changing Lanes
At or Near the End of Its Economic Life and “Substantially
All”
Under ASC 840, an entity was not allowed to use the
90 percent fair value test when classifying a lease if the beginning
of the lease term fell within the last 25 percent of the total
estimated economic life of the leased property, including earlier
years of use. However, the FASB chose to no longer include that
prohibition under ASC 842. As a result, an entity will need to
evaluate the “substantially all” criterion when classifying a lease
under ASC 842, regardless of when the lease term begins.
Evaluating 89.9 Percent Lease Payments
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. Because the FASB has taken 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 a non-sales-type lease. However, this would depend on the
entity’s accounting policies (see Section
9.2.1.3), which should be consistently applied.
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. Under ASC 840, these provisions needed to be
carefully considered and often directly affected the classification
of the lease. The guidance in ASC 840 on nonperformance-related
default provisions was not carried over to
ASC 842. For more information about this issue and about lessees’
treatment of payments associated with nonperformance-related default
provisions under ASC 842, see Section 8.3.3.6. In line with
the discussion in that section, lessors should generally treat these
payments as variable and should consider the guidance in ASC 842-30.
See Section
9.3 for more information about a lessor’s treatment
of variable lease payments.
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.
9.2.1.4.1 Lessor’s Consideration of Initial Direct Costs Related to the Rate Implicit in the Lease
In considering initial direct costs when calculating the
rate implicit in the lease, a lessor must first assess the appropriate
classification of the lease, starting with determination of whether the
lease meets any of the criteria in ASC 842-10-25-2 for classification as
a sales-type lease. If none of those criteria are met, the lessor is
next required to determine whether the lease must be classified as a
direct financing lease in accordance with ASC 842-10-25-3(b); if not,
the lease would be classified as an operating lease.
ASC 842-10-25-2(d), which contains one of the criteria
for sales-type lease classification, states:
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.
To determine the “present value of the sum of the lease
payments and any residual value guaranteed by the lessee,” the lessor
must determine the “rate implicit in the lease.” The ASC master glossary
defines the rate implicit in the lease as follows:
The rate of interest that, at a given date,
causes the aggregate present value of (a) the lease payments and
(b) the amount that a lessor expects to derive from the
underlying asset following the end of the lease term to equal
the sum of (1) the fair value of the underlying asset minus any
related investment tax credit retained and expected to be
realized by the lessor and (2) any deferred initial direct costs
of the lessor. However, if the rate determined in accordance
with the preceding sentence is less than zero, a rate implicit
in the lease of zero shall be used.
ASC 842-10-25-4 clarifies that "[f]or purposes of
assessing the criterion in paragraph 842-10-25-2(d), a lessor shall
assume that no initial direct costs will be deferred if, at the
commencement date, the fair value of the underlying asset is different
from its carrying amount.”
As a result, when determining whether a lease is a
sales-type lease under ASC 842-10-25-2(d) (quoted above), the lessor does not include initial direct costs in its
determination of the rate implicit in the lease if the underlying
asset’s fair value differs from its carrying value.
In all other cases (i.e., when the underlying asset’s
fair value equals its carrying value in the determination of whether a
lease is a sales-type lease under ASC 842-10-25-2(d) or whether a lease
is a direct financing lease under ASC 842-10-25-3(b)), the lessor would
include initial direct costs in its
determination of the rate implicit in the lease.
With respect to initial recognition and measurement, a
lessor is required to recognize (at commencement) a net investment in
the lease for sales-type and direct financing leases. The net investment
in the lease comprises the sum of the lease receivable and any
unguaranteed residual value, both of which are measured at present value
by using the same rate implicit in the lease that was used for lease
classification purposes.
For sales-type leases, ASC 842-30-25-1(c) requires that
initial direct costs be expensed “if, at the commencement date, the fair
value of the underlying asset is different from its carrying amount.” In
these cases, because the rate implicit in the lease (as determined
during lease classification) did not include
initial direct costs because they were not eligible for deferral, those
costs are automatically excluded from the net investment in the lease
(i.e., there is no need to remove them separately).
In all other cases (i.e., when the underlying asset’s
fair value equals its carrying value in the determination of whether a
lease is a sales-type lease or whether a lease is a direct financing
lease under ASC 842-10-25-3(b)), “[i]f the fair value of the underlying
asset equals its carrying amount, initial direct costs . . . are
deferred at the commencement date and included in the measurement of the
net investment in the lease” in accordance with ASC 842-30-25-1(c).
Therefore, because the initial direct costs are eligible for deferral
and were included in the determination of the
rate implicit in the lease for classification purposes, they are
automatically included in the rate used to calculate the net investment
in the lease.2
This is consistent with ASC 842-30-25-1(c) (sales-type lease recognition)
and ASC 842-30-25-8 (direct financing lease recognition), each of which
suggests that the rate implicit in the lease is defined in such a way
that initial direct costs eligible for deferral “are included
automatically in the net investment in the lease; there is no need to
add them separately.”
9.2.1.4.2 Unit of Account for Assessing Lease Classification
The lessor must classify a lease as a sales-type lease
if any of the lease classification criteria in ASC 842-10-25-2 are met.
This requirement differs from that in ASC 840, under which real estate
lessors needed to meet the transfer-of-title condition to qualify for
sales-type treatment.
In evaluating the criterion in ASC 842-10-25-2(d) (i.e.,
in assessing whether the lease is a sales-type lease), a multiunit real
estate lessor would use the fair value of the unit allocable to the
lease component in its present value test. In other words, the lessor
would identify the underlying asset at the level associated with the
space being leased and not beyond the identified lease component (e.g.,
at the level of a retail store in a shopping mall, not at the level of
the shopping mall itself).
Example 9-5
Lessor A leases a retail store
at the mall it owns. The fair value of the mall is
$10 million, and the fair value of the individual
retail store is $500,000. The present value of the
lease payments for the retail store is $450,000
(there is no residual value guarantee). To
determine the classification of the lease, the
lessor should compare the fair value of the
portion of the building allocable to the lease
component ($500,000) with the present value of the
lease payments ($450,000).
Connecting the Dots
ASU 2019-01 on
Acquisition Costs for Lessors That Are Not Manufacturers
or Dealers
In March 2019, the FASB issued ASU
2019-01, which provides guidance on how
lessors that are not manufacturers or dealers (qualifying
lessors) should determine the fair value of the underlying asset
and apply it to lease classification and measurement.
Specifically, for qualifying lessors, the fair value of the
underlying asset at lease commencement should be its cost,
including any acquisition costs, such as sales taxes or delivery
charges. Accordingly, many costs related to the fulfillment of
sales-type leases and direct financing leases should be
capitalized as part of the net investment in the lease for
qualifying lessors. However, if a significant lapse of time
occurs between the acquisition of the underlying asset and lease
commencement, lessors are required to determine fair value in
accordance with ASC 820, which does not include such costs.
Moreover, since this ASU does not apply to manufacturers and
dealers, such lessors are always required to determine fair
value in accordance with ASC 820. See Section 17.3.1.7 for more
information about ASU 2019-01.
9.2.1.4.3 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 lessor would not be able to determine the
fair value of an underlying asset, including portions of larger assets.
Lessors that consider this paragraph to be applicable to their facts and
circumstances should consult their accounting advisers.
In determining whether to classify a lease as a
sales-type or direct financing lease, a lessor 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 9.2.1.4). Accordingly,
when classifying the lease (i.e., as a sales-type, direct financing, or
operating lease), the lessor 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 (see Section
9.2.1.4.2). This level could be a portion of a larger asset,
such as a floor of an office building. If it is impracticable for a
lessor to determine the fair value of an underlying asset in accordance
with ASC 842-10-55-3, the lessor should assess the lease classification
without considering the criterion in ASC 842-10-25-2(d) and ASC
842-10-25-3(b)(1). In this context, “practicable” means that fair value
can be reasonably estimated without undue cost or effort.
Consider an example in which a lessor leases space on a
cell tower (e.g., a hanger) to a lessee. The lessor previously recorded
the entire cell tower (i.e., the larger asset) on its books, and the
hanger is considered a portion of the larger asset. The lessor has a
practice of leasing individual hangers within the cell tower to lessees;
thus, the individual hanger would be the unit of account from a leasing
perspective. A similar situation may arise when a lessor leases a floor
of a building to a lessee. The entire building (i.e., the larger asset)
is recorded on the lessor’s books. The lessor commonly leases individual
floors in the building to lessees. As stated above, when classifying the
lease, the lessor 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 how a lessor should
determine the fair value of a portion of a larger asset, we believe that
the lessor can use various methods to determine the fair value of a
portion of a larger asset, depending on the facts and circumstances.
Because a lessor will typically be 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 will often 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 that the lessor leases. 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 generally believe that it would be unusual for a
lessor not to be able to determine the fair value of a portion of an
underlying asset. Further, we would expect that a lessor that can
estimate the fair value of the larger asset (which will generally be the
case) would typically be able to reasonably allocate an appropriate
percentage of that fair value to the portion being leased without undo
cost or effort.
9.2.1.4.4 Residual Value Guarantees Provided for a Portfolio of Assets
ASC 842-10
55-9 Lessors may obtain residual value guarantees for a portfolio of underlying assets for which settlement is not solely based on the residual value of the individual underlying assets. In such cases, the lessor is economically assured of receiving a minimum residual value for a portfolio of assets that are subject to separate leases but not for each individual asset. Accordingly, when an asset has a residual value in excess of the “guaranteed” amount, that excess is offset against shortfalls in residual value that exist in other assets in the portfolio.
55-10 Residual 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. Consequently, no such amounts should be considered when evaluating the lease classification criteria in paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1).
Although a lessor would consider residual value guarantees on individual leases
as part of the lease payments when performing the lease classification
test, such guarantees would generally be excluded from the test when
they are provided for a portfolio of assets under ASC 842-10-55-10.
However, as discussed below, there is a potential exception to this
rule.
Lessors often enter into lease agreements to lease
multiple similar assets to lessees. 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 not 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.”
The guidance in ASC 842 on how lessors should treat
residual value guarantees of a portfolio of underlying assets when
classifying a lease is similar to historical practice under ASC 840.
Specifically, in an inquiry, the SEC was asked to give its views on how
a lessor should apply ASC 840-10-25-1(d) and ASC 840-10-25-5 in
determining the minimum lease payments for lease classification purposes
when the lessee provided a guarantee of the aggregate residual value of
a portfolio of leased assets. ASC 840-30-S99-1 states that, in response
to this inquiry, the SEC staff indicated the following:
The SEC staff believes that residual value
guarantees of a portfolio of leased assets preclude a lessor
from determining the amount of the guaranteed residual value of
any individual leased asset within the portfolio at lease
inception and, accordingly, no such amounts should be included
in minimum lease payments.
Therefore, the general practice under ASC 840 was for a
lessor not to include residual value guarantees for a portfolio of
leased assets in the determination of minimum lease payments, since it
is not possible to identify the individual residual value guarantee for
any individual leased asset within the portfolio. Because the
classification analysis under ASC 840 was performed on an
individual-asset basis, it is rare for a lessor to include a residual
value guarantee of a portfolio of assets in the determination of minimum
lease payments. However, in certain circumstances, it is appropriate to
do so. Specifically, under ASC 840, if a group of leased assets
associated with the PRVG met the following criteria, the PRVG should be
factored into the calculation of minimum lease payments:
-
The leases 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).
Under ASC 842, a lessor can account for a group of
leases at a portfolio level provided that (1) the leases are similar in
nature (e.g., have similar underlying assets) and (2) have identical or
nearly identical contract provisions (see Section 8.2.2). In addition,
paragraph BC120 of ASU 2016-02 states, in part:
[T]he Board decided to explicitly state that
lessees and lessors are permitted to apply the leases guidance
at a portfolio level. The Board acknowledged that an entity
would need to apply judgment in selecting the size and
composition of the portfolio in such a way that the entity
reasonably expects that the application of the leases model to
the portfolio would not differ materially from the application
of the leases model to the individual leases in that
portfolio.
Because ASC 842 can be applied at a portfolio level,
lessors have questioned whether it is appropriate for them to factor in
a residual value guarantee for a group of assets being leased when
determining the lease classification of each separate lease. We believe
that, when certain facts and circumstances exist, it may be appropriate
for a lessor to consider a PRVG for a group of assets being leased.
Consider the example below.
Example 9-6
A lessor enters into an
agreement to lease 10 physically similar laptops
to a lessee. The leases commence and end on the
same day. The agreement has no stated renewal or
purchase options. The individual assets have a
fair value at commencement of $500 each and an
expected residual value at the end of the lease
term of $150 each. The variability associated with
the expected residual value of each laptop is
expected to be highly correlated. The lessee
guarantees that the combined residual value of the
leased assets will be $1,500. If the PRVG were
excluded from the lease classification test, all
of the individual leases would be operating
leases. However, if the PRVG were included,
classification may change depending on the
attribution of the PRVG to the individual leases
in the portfolio.
We believe that, as described in the example above,
there are circumstances in which it may be acceptable for a lessor to
include a PRVG in the classification of leased assets that are subject
to a residual value guarantee for the group of assets. In such
circumstances, we would expect the PRVG to be apportioned equally to
each leased asset (e.g., $150 per laptop in the above example).
In addition, we believe that the lessor may consider a
PRVG when classifying the individual leases within a portfolio when an
arrangement meets the following criteria that were applied in practice
under ASC 840 (outlined above and repurposed below):
-
The leases 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.
While ASC 842-10-55-10, read literally, suggests that a
PRVG should never be considered in the lessor’s determination of lease
classification, we believe that the FASB did not intend to change this
historical practice under ASC 840. Further, we believe that use of the
criteria above will result in a lease classification that is consistent
with the underlying economics of the leasing arrangement.
Changing Lanes
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.
9.2.1.5 Underlying Asset Is Specialized and Has No Alternative Use to the Lessor at the End of the Lease Term
ASC 842-10
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.
The criterion in ASC 842-10-25-2(e) states that if 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 lease is a
sales-type lease. 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. The
substantive lack of alternative use can be identified if there is a contractual restriction or an anticipated
significant economic loss related to directing the asset for another use.
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 by companies that follow 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 that do not depend
on an index or a rate (and the lease therefore does not meet the
criterion in ASC 842-10-25-2(d)), the lease may be more likely to
meet criterion (e) in isolation. However, if such leases result in a
selling loss, they may need to be classified as operating leases in
accordance with the amendments made by ASU 2021-05, as discussed in
the section below.
9.2.1.5.1 Significant Economic Losses to Direct an Underlying Asset for Another Use
ASC 842-10-55-7 states, in part:
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 [economic] loss.
Although ASC 842 does not define the term “significant
economic loss,” the standard and the Background Information and Basis
for Conclusions of ASU 2016-02 discuss the term “significant economic
incentive.” When an entity has a significant economic incentive, it may
conclude that the exercise of a purchase option or renewal option is
reasonably certain in accordance with ASC 842-10-30-1 through 30-3.
Because “reasonably certain” is a high threshold in the assessment of
renewal (termination) options and purchase options (as discussed in
Section
5.2.2), we would expect the threshold for a significant
economic loss to also be high.
In addition, an entity can consider ASC 606-10-55-10
when assessing situations in which a significant loss exists. ASC
606-10-55-10 states:
A practical limitation on an entity’s ability to
direct an asset for another use exists if an entity would incur
significant economic losses to direct the asset for another use.
A significant economic loss could arise
because the entity either would incur significant costs to
rework the asset or would only be able to sell the asset at
a significant loss. For example, an entity may be
practically limited from redirecting assets that either have
design specifications that are unique to a customer or are
located in remote areas. [Emphasis added]
Example 9-7
An entity leases a highly
specialized underwater vehicle with patented
technology to another entity. The asset took three
years to produce. The lessee uses the asset to
search the deep ocean floor for buried treasure in
a remote area of the Arctic Ocean. The cost of
transporting the asset to the search site was
approximately half the cost of the asset itself,
and it is not expected that any other entity is
going to want to use that asset in that specific
location. The lessor would incur significant
losses in transporting the asset to its
manufacturing facility in Chicago at the end of
the lease term for refurbishment and redeployment.
The lessor does not believe that any other
entities would be interested in a similar use
(searching the Arctic Ocean for buried treasure),
and the asset is designed for that particular
environment and no other. As a result, the lessor
in this example would meet the criterion for
classifying the lease as a sales-type lease (i.e.,
the criterion in ASC 842-10-25-2(e)). We believe
that it is likely that other criteria for
sales-type classification (e.g., the
“substantially all of the fair value” test) would
also be met in such situations.
9.2.1.6 Lessor’s Accounting for Certain Leases With Variable Lease Payments
In July 2021, the FASB issued
ASU
2021-05, which requires a lessor to
classify a lease with variable lease payments that
do not depend on an index or rate as an operating
lease on the lease commencement date if specified
criteria are met. ASC 842-10-25-3A (added by ASU
2021-05) requires a lessor to classify a lease with
variable lease payments that do not depend on an
index or rate as an operating lease at lease
commencement if both of the following conditions are
met:
|
Because these leases will be classified as operating leases, when applying
the guidance in ASC 842-10-25-3A, the lessor would not derecognize the
underlying asset upon lease commencement but would continue to depreciate
the underlying asset over its useful life. Further, in accordance with ASC
842-30-25-11(a), the lessor would recognize fixed lease payments as “income
. . . over the 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 use of the underlying asset.” Variable lease
payments would be recognized as “income in profit or loss in the period in
which the changes in facts and circumstances on which the variable lease
payments are based occur,” as indicated in ASC 842-30-25-11(b).
Note that the ASU does not prescribe a threshold for the amount of variable
payments; the ASU’s guidance must be applied when a lease contains any
amount of variable payments (in addition to the requirement that the lessor
would have otherwise recognized a selling loss at lease commencement).
Connecting the Dots
Impacts of ASU 2021-05
We expect that, under ASU 2021-05, more lessors will
be required to classify leases as operating leases rather than as
sales-type or direct financing leases. Accordingly, additional
leases will qualify for the lessor practical expedient in ASC
842-10-15-42A, which allows lessors to combine lease and nonlease
components into a single component if certain scope requirements are
met. One of these requirements is that the underlying lease
component must be classified as an operating lease. See Section
4.3.3.2 for more information about the lessor
practical expedient. In addition, the classification as an operating
lease may allow certain sale-and-leaseback transactions to qualify
as successful sales. See Section 10.3 for more
information about evaluating sale-and-leaseback transactions.
9.2.2 Direct Financing Lease
If a lease does not meet any of the criteria for classification as a sales-type lease, the lessor must assess whether it has relinquished control of the underlying asset but has not transferred control to the lessee. The lessor would classify a lease that does not meet any of the criteria for a sales-type lease as a direct financing lease if two criteria are met, as described below.
Changing Lanes
Fewer Leases Expected to Be Direct Financing Leases
Under ASC 840, selling profit or loss was required for sales-type lease
classification; as a result, leases were often classified as direct
financing leases. ASC 842 no longer contains this requirement, so we
would expect there to be more sales-type leases and fewer direct
financing leases under ASC 842. Further, unlike ASC 840, ASC 842 does
not limit the classification of leases with selling profit or loss to
sales-type leases; direct financing leases also can give rise to selling
profit or loss under ASC 842. However, such selling profit or loss will
be recognized over the lease term as an adjustment to yield under ASC
842 (as discussed in Section 9.3.8).
Direct Financing Lease and 90 Percent of Fair Value Test
To be a direct financing lease under ASC 840, a lease
had to meet one of the capital lease criteria in ASC 840-10-25-1.
However, if a lease meets any of those criteria under ASC 842, the lease
would be a sales-type lease. A key difference between a sales-type lease
and a direct financing lease under ASC 842 is that a lessor would
include residual value guarantees from third
parties in its fair value test for direct financing leases. In
fact, the only reason a lessor could classify a lease as a direct
financing lease is because it obtains a third-party residual value
guarantee.
Bridging the GAAP
Different Treatment of Selling Profit in Direct Financing
Leases
Under ASC 842, a lessor in a direct financing lease must
defer selling profit at lease commencement and recognize it over the
lease term. In contrast, IFRS 16 requires a lessor to recognize profit
or loss in a finance lease at lease commencement. While the two
standards may significantly differ in this respect, this issue may not
arise frequently given the scarcity of leases with third-party residual
value guarantees that result in a selling profit.
9.2.2.1 Criteria
ASC 842-10
25-3 When none of the criteria in paragraph 842-10-25-2 are met: . . .
b. A lessor shall classify the lease as either a direct financing lease or an operating lease. A lessor shall
classify the lease as an operating lease unless both of the following criteria are met, in which case the
lessor shall classify the lease as a direct financing lease:
1. 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) and/
or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of
the underlying asset.
2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a
residual value guarantee.
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.
9.2.2.1.1 First Criterion — Present Value of Lease Payments and Any Residual Value Guarantee Equals or Exceeds Substantially All of the Fair Value of the Underlying Asset
The present value of lease payments includes any payments described in ASC 842-10-30-5 (see Chapter 6). However, when determining whether a lease is a sales-type or direct financing lease, a lessor includes different amounts in the lease payments with respect to residual value guarantees. In performing the sales-type lease classification test, lessors only include the residual value guarantee provided by the lessee. The direct financing lease classification test takes it one step further and requires a lessor to include any residual value guaranteed by any third party unrelated to the lessor. When performing the direct financing lease test, an entity would apply the “substantially all” criterion in the same manner as it would when performing the sales-type classification test addressed in ASC 842-10-25-2(d) (e.g., 90 percent of the fair value). See Section 9.2.1.4 for more information.
Residual value guarantees provided for a portfolio of leased assets and not for
individual leased assets should not be included in the lessor
classification assessment, as described in Section 9.2.1.4.4.
A lease that does not meet the “substantially all” criterion in ASC
842-10-25-3(b)(1) is an operating lease.
When performing the direct financing lease
classification test as described above an entity may solve for the rate
implicit in the lease for a direct financing lease by using the
internal-rate-of-return calculation function through either a
spreadsheet database or another calculator mechanism, as described in
Section 9.2.1.4.
Example 9-8
A lessor leases a luxury tour
bus with a fair value of $7,230,589 (which equals
the bus’s carrying value) to a music group for
three years for an annual payment made in arrears
of $2,000,000. The lessor incurs $25,000 in
initial direct costs. When the music group returns
the tour bus, the fair value of the asset is
expected to be $4,023,023. Using an
internal-rate-of-return functionality, the lessor
determines that its rate implicit in the lease is
14.68 percent.
Note that, in this example, no
ITCs were received. Also, because the fair value
of the bus equals its carrying value, the initial
direct costs were included in the calculation of
the rate implicit in the lease. See Section
9.2.1.4.1 for more information about
how to consider initial direct costs in the
determination of the lease’s implicit rate.
9.2.2.1.1.1 Impact of a Lessor’s Subsequent Purchase of Residual Value Insurance on Lease Classification
Under ASC 842-10-25-3(b)(1), when a lessor
calculates lease payments to assess whether the lease should be
classified as a direct financing lease or operating lease, the
lessor must classify a lease as a direct financing lease if 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 . . . and/or any other third party unrelated to the
lessor equals or exceeds substantially all of the fair value of the
underlying asset.” Accordingly, if a lessor purchases residual value
insurance at the commencement of the lease, the amount of the
residual covered by the insurance would be included in the lessor’s
computation as part of the direct-financing lease classification
test. In some circumstances, a lessor may purchase residual value
insurance for property leased under an operating lease after the
commencement of that lease in an amount that would have required the
lease to be classified as a direct financing lease had that
insurance been purchased at the commencement of the lease.
A lessor’s purchase of residual value insurance from
a third party (unrelated to the lessor or the lessee) after the
commencement of the lease would not constitute a lease modification
and trigger a reevaluation of the lease’s classification in
accordance with ASC 842-10-25-8.
A lessor’s acquisition of residual value insurance
after the lease commencement date, in the absence of a change in the
lease’s provisions that the lessor and lessee mutually agree to,
does not represent a change in the lease provisions as contemplated
by the definition of a “lease modification” in ASC 842-10-20.
Accordingly, the lessor’s purchase of this insurance does not create
a modified lease (that is not a separate contract) that must be
reclassified in accordance with ASC 842-10-25-1 and ASC 842-10-25-8
through 25-10 (see Section 9.3.4 for more information).
Note that if residual value insurance from a third
party was contemplated or entered into at or near the same time of
lease commencement, the lessor should consider whether to include
this information in its lease classification assessment.
9.2.2.1.2 Second Criterion — It Is Probable That the Lessor Will Collect the Lease Payments
The second criterion for direct financing lease classification in ASC 842-10-25-3(b) indicates that it must
be “probable that the lessor will collect the lease payments plus any amount necessary to satisfy a
residual value guarantee.” In this context, collectibility is only assessed at lease commencement; changes
in collectibility will not result in a change in classification.
If the lease does not meet this criterion, the lease is an operating lease.
Connecting the Dots
Collectibility Issues Related to Concepts in ASC
606
For a contract to be within the scope of ASC
606, collectibility must be probable (step 1). Similarly, under
ASC 842, no lease-related recognition or measurement occurs when
collectibility is not probable. Therefore, ASC 606 and ASC 842
are aligned with respect to the deposit liability concept.
When the sales-type lease consideration does not
meet the probability threshold, the sale is only recognized when
either (1) the contract has been terminated and the lease
payments received from the lessee are nonrefundable or (2) the
lessor has repossessed the underlying asset, the lessor has no
further obligation under the contract to the lessee, and the
lease payments received from the lessee are nonrefundable.
The underlying principles in ASC 606 are
similar. Specifically, ASC 606-10-25-7 states:
When a contract with a customer does not
meet the criteria in paragraph 606-10-25-1 and an entity
receives consideration from the customer, the entity
shall recognize the consideration received as revenue
only when one or more of the following events have
occurred:
-
The entity has no remaining obligations to transfer goods or services to the customer, and all, or substantially all, of the consideration promised by the customer has been received by the entity and is nonrefundable.
-
The contract has been terminated, and the consideration received from the customer is nonrefundable.
-
The entity has transferred control of the goods or services to which the consideration that has been received relates, the entity has stopped transferring goods or services to the customer (if applicable) and has no obligation under the contract to transfer additional goods or services, and the consideration received from the customer is nonrefundable.
The ongoing evaluation of (or lack thereof)
whether the lease payments and any residual value guarantees
become probable over the lease term is similar to the ongoing
assessment required by ASC 606. However, an important
distinction is that a lessor would never reassess the
probability threshold once it is met, since the single
obligation to deliver the leased asset has already been
fulfilled (i.e., there is no future performance, which may occur
in a revenue contract as future goods and services are
delivered).
9.2.3 Operating Lease
If the lease does not meet any of the five criteria for a sales-type lease or the two criteria for a direct financing lease, the lease is an operating lease.
In addition, certain leases with variable lease payments that do not depend on an
index or rate that would have been classified as sales-type or direct financing
leases, and for which the lessor would have recognized a selling loss, will also
be classified as operating leases. See Section
9.2.1.6 for more information.
Connecting the Dots
Operating Lease Classification
Lessors are required to first evaluate whether a lease is a sales-type lease; if
the lease is not a sales-type lease, the lessor must assess whether it
is a direct financing lease. A lessor can only conclude that a lease is
an operating lease if it does not meet the criteria for either of the
other two classifications. With the exception of the provisions of ASU
2021-05, there are no separate criteria for classifying an operating
lease.
Footnotes
1
If a lease component is at or near the end of its economic
life, it is not subject to the economic life test. See Section 9.2.1.3.1 for
more information.
2
For example, the inclusion of initial direct
costs in the determination of the rate implicit in the lease
results in a lower rate (see Cases A and C in Example 1, which
begins in ASC 842-30-55-19). This lower implicit rate applied to
the future lease payments effectively results in a higher net
investment in the lease, which inherently includes the initial
direct costs.
9.3 Recognition and Measurement
The next subsections provide guidance on how a
lessor should account for each type of lease in each phase of the lease “life cycle.”
Not all leases will reach all points in the life cycle (e.g., not every lease will be modified), but the
recognition and measurement requirements related to each phase are unique. How the lessor reflects
these events in its financial statements largely depends on the type of lease.
9.3.1 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. In accordance with ASC 842-10-15-2, at contract inception,
an entity identifies whether a contract is or contains a lease, as well as the components in the contract
(e.g., a service component) and allocates consideration on the basis of stand-alone selling prices. See
Chapter 3 for more information on how to identify a lease and Chapter 4 for a discussion on identifying
components in a contract.
9.3.2 Lease Commencement (Initial Measurement and Recognition)
The table below summarizes the recognition
implications associated with lease commencement and initial measurement for each of the three
lease classification types and includes cross-references to the sections of this Roadmap that
contain additional details.
Lease Classification | Balance Sheet Recognition | Income Statement Recognition |
---|---|---|
Sales-type lease — collectibility is probable (see Section 9.3.7.1) | Recognize a net investment in the lease. The net investment in the lease comprises the sum of the lease receivable and the present value of the unguaranteed residual value. Derecognize the carrying value of the underlying asset. If the fair value of the underlying asset equals the carrying value, defer any initial direct costs. | Recognize any selling profit or selling loss immediately. If the fair value of the underlying asset does not equal the carrying value, expense any initial direct costs immediately. |
Sales-type lease — collectibility is not probable (see Section 9.3.7.2) | None, unless the payments are made up front. If the payments are up front, recognize consideration received as a deposit liability. | Recognize any selling loss immediately. If the fair value of the underlying asset does not equal the carrying value, expense any initial direct costs immediately. |
Direct financing lease
(see Section 9.3.8.1) | Recognize a net investment in the lease. The net investment in the lease comprises the sum of the lease receivable and the present value of the unguaranteed residual value. Defer the initial direct costs and selling profit within the net investment in the lease. Derecognize the carrying value of the underlying asset. | Recognize any selling loss immediately. Do not recognize any selling profit at commencement. |
Operating lease
(see Section 9.3.9.1) | Defer initial direct costs. If lease payments are received up front, recognize
consideration received as a deferred rent liability. | None. |
Connecting the Dots
Treatment of Initial Direct Costs Under ASC 842 Is Similar to Treatment of Contract
Costs Under ASC 606
The recognition of initial direct costs in connection with a sales-type lease is
analogous to that related to a product sale under ASC 606. When an entity sells a product in
accordance with ASC 606, any costs of obtaining a contract (i.e., initial direct costs) are
recognized in connection with that product sale. Similarly, when a sales-type lease is
recognized, initial direct costs are expensed immediately when the fair value of the asset
differs from its carrying amount.
When initial direct costs associated with an operating lease are recognized,
they are deferred and expensed over the lease term, similarly to how such costs (e.g., sales
commissions paid) would be recognized in an arrangement in which services are being delivered
over time. In both the operating lease and services arrangement, such costs are recognized
over time to align with the delivery of the service.
9.3.2.1 Lessor’s Accounting for Lease “Fulfillment” Costs
In addition to the costs of negotiating and arranging the lease, lessors
often incur certain costs related to fulfillment of the lease (e.g., costs of mobilizing the
asset) after lease inception but before lease commencement. Since these costs are related to
fulfilling, rather than obtaining, the lease, they would not meet the definition of initial
direct costs. Because the cost accounting guidance in ASC 842 is limited to initial direct
costs, questions have arisen about how a lessor should account for the costs of fulfilling the
lease before the lease commences.
ASC 842 provides guidance on accounting for initial direct costs, which ASC
842-10-20 defines as “[i]ncremental costs of a lease that would not have been incurred if the
lease had not been obtained.” Further, ASC 842-10-30-9 and 30-10 provide the following
guidance on the types of costs that are and are not deemed to be initial direct costs:
30-9 Initial direct costs for a lessee or a
lessor may include, for example, either of the following:
-
Commissions
-
Payments made to an existing tenant to incentivize that tenant to terminate its lease.
30-10 Costs to negotiate or arrange a lease that
would have been incurred regardless of whether the lease was obtained, such as fixed
employee salaries, are not initial direct costs. The following items are examples of costs
that are not initial direct costs:
-
General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
-
Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities
-
Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.
The definition of initial direct costs in ASC 842 is largely consistent
with the definition of “incremental costs of obtaining a contract with a customer” in ASC
340-40, which applies to costs related to contracts within the scope of the revenue
recognition guidance in ASC 606. The FASB discussed the link between “initial direct costs”
and “incremental costs of obtaining a contract with a customer” at its May 2014 meeting.
Specifically, the Board rejected an alternative approach related to expanding the definition
of initial direct costs and confirmed that these costs should only include the costs of
negotiating and arranging the lease.
In addition to guidance on incremental costs of obtaining a contract, ASC
340-40 provides guidance on accounting for certain contract fulfillment costs incurred by a
seller in a revenue arrangement. However, unlike ASC 340-40, ASC 842 does not provide lessors
with any additional cost guidance beyond the guidance on initial direct costs.
On the basis of a technical inquiry with the FASB staff, we understand that
a lessor should first consider whether the costs of fulfilling a lease before lease
commencement are within the scope of other GAAP. If these costs are not within the scope of
other GAAP, a lessor could elect, as an accounting policy, to account for the costs under
either of the following approaches:
-
Approach A — Analogize to the guidance on contract fulfillment costs in ASC 340-40 (for more information, see Chapter 13 of Deloitte’s Roadmap Revenue Recognition) and capitalize such costs as appropriate. A lessor that elects this approach would be required to evaluate the criteria in ASC 340-40-25-5 to determine whether such costs should be capitalized. ASC 340-40-25-5 states:An entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of the following criteria:
-
The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).
-
The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.
-
The costs are expected to be recovered.
-
-
Approach B — Expense the costs as incurred.3
On the basis of the aforementioned technical inquiry, lessors 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 lessor may incur costs to transport a leased asset to the
lessee. If the specific lessor costs are not within the scope of other GAAP, and to the
extent the costs would qualify for deferral if the lease was within the scope of Topic 606,
in lieu of recognizing those costs in current period earnings, the staff did not object to a
lessor’s analogy to Subtopic 340-40 as an accounting policy election. [Footnote omitted]
If a lessor elects to follow Approach A, its subsequent accounting should
be in line with the guidance in ASC 340-40-35-1 that requires any asset recognized from
contract fulfillment costs to be “amortized on a systematic basis that is consistent with the
transfer to the customer of the goods or services to which the asset relates.” Therefore, for
operating leases, a lessor applying Approach A would typically amortize (i.e., expense) any
capitalized costs over the lease term, which is aligned with a view that the lessor in an
operating lease is providing the use of its asset to the lessee over the lease term (i.e., the
related goods or services are being provided over time in a manner similar to a service). In
contrast, for sales-type leases or direct financing leases, the related good or service is
typically delivered at lease commencement with the transfer of the asset to the lessee (in a
manner similar to the sale of a good that may include a significant financing component).
Therefore, any eligible fulfillment costs in a sales-type or direct financing lease that meet
the criteria in ASC 340-40 for capitalization would typically be amortized (i.e., expensed)
fully at lease commencement.
In addition, see the Connecting the Dots in Section
9.2.1.4.2 for discussion of ASU 2019-01, under which lessors other than manufacturers or dealers should
capitalize lease fulfillment costs as part of the net investment in the lease for sales-type
leases and direct financing leases when certain conditions are met.
Example 9-9
A shipowner enters into a contract with a charterer (i.e., the
customer) to give the charterer exclusive use of its vessel for two years in exchange
for fixed consideration of $1,000 per month (i.e., total contractual consideration of
$24,000). The contract is structured as a time charter in which the charterer has full
discretion over the ports visited, routes taken, vessel speeds (within the limits
established in the contract), and number of trips the vessel makes during the contract
term. Because of contractual restrictions, the charterer is only permitted to send the
vessel to safe ports and the vessel can only carry lawful cargo. The contract explicitly
prevents the shipowner from substituting the vessel during the contract term unless the
vessel is damaged. The shipowner has concluded that the vessel represents an identified
asset and that the charterer has the right to control the use of the vessel during the
contract term; therefore, the contract contains a lease of the vessel. In addition, the
shipowner (lessor) has evaluated the lease and has determined that it is an operating
lease.
Before the lease commences, the shipowner incurs certain lease
fulfillment costs (e.g., transporting the vessel to the contractual point of origin).
Because such costs are not related to negotiating and arranging a lease, they do not
meet the definition of initial direct costs under ASC 842. The shipowner should first
evaluate whether these costs are within the scope of any other GAAP. In the absence of
directly relevant guidance, the shipowner may elect to do either of the following:
-
Analogize to the contract fulfillment guidance in ASC 340-40 to account for such costs. Specifically, the shipowner would evaluate the criteria in ASC 340-40-25-5 (quoted above) to determine whether the costs should be capitalized.
-
Expense the costs as incurred.
The shipowner should apply its election consistently to all leases
and disclose the accounting policy elected, if material.
9.3.3 Subsequent Measurement
The table below summarizes recognition
implications associated with subsequent measurement for each of the three classification types
and includes cross-references to the sections of this Roadmap that contain additional
details.
Lease Classification | Balance Sheet Recognition | Income Statement Recognition |
---|---|---|
Sales-type lease —
collectibility is probable
(see Section 9.3.7.1) | Reduce the net investment in the lease
for consideration received from the
lessee. Increase the net investment in
the lease for interest income earned.
Reduce the carrying value of the net
investment in the lease due to any
impairment. | Recognize interest income on the basis
of the net investment in the lease at the
implicit rate in the lease. Recognize any
impairments. |
Sales-type lease —
collectibility is not
probable (see Sections
9.3.7.2 and 9.3.7.3) | If collectibility remains not probable, recognize consideration received as a
deposit liability and continue to measure the underlying asset in accordance with ASC
360. If collectibility becomes probable during
the lease term, derecognize any deposit
liability, derecognize the underlying
asset, and recognize a net investment
in the lease (taking into account the
sum of the lease receivable and the
unguaranteed residual value). | If collectibility remains not probable,
recognize depreciation expense for the
underlying asset and any impairments.
If collectibility becomes probable during the lease term, recognize selling
profit or loss. Over the remainder of the lease term, recognize interest income on the
basis of the net investment in the lease at the implicit rate in the lease. Recognize any
impairments. |
Direct financing lease
(see Section 9.3.8.1) | Reduce the net investment in the lease
for consideration received from the
lessee. Increase the net investment in
the lease for interest income earned.
Reduce the carrying value of the net
investment in the lease due to any
impairment. | Recognize interest income on the basis
of the net investment in the lease at the
implicit rate in the lease. Recognize any
impairments. |
Operating lease
(see Section 9.3.9.1) | Recognize any deferred rent receivable/liability. Reduce capitalized initial
direct costs for amortization. Measure the underlying asset in accordance with ASC
360. | Recognize lease income on a straight-line basis (or by using another systematic
and rational basis, if appropriate). Amortize any initial direct costs. Recognize
depreciation expense for the underlying asset and any impairments. |
9.3.4 Lease Modification
ASC 842-10-20 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).
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.
On the other hand, for rent concessions that do not qualify for the COVID-19 relief,
regardless of whether such concessions are offered by the lessor or negotiated by the lessee,
an entity must evaluate (1) the lessee’s enforceable rights under the contract to receive
such concessions (for example, force majeure or other similar clauses that apply upon the
occurrence of unforeseen events or circumstances may trigger rent concessions) and (2)
whether other terms and conditions of the contract have changed that result in a change in
the scope of or consideration related to the lease. If, on the basis of an evaluation of the
factors mentioned above, it is concluded that the lessee possesses an enforceable right to
receive the rent concession under the original lease contract and no other terms and
conditions have changed, the rent concession would be accounted for under the original lease
contract (for example, as negative variable rent). Otherwise, the rent concession should be
accounted for as a lease modification in accordance with the guidance discussed in this
section.
When a lease modification occurs, an entity may or may not be required to
reevaluate the lease classification.
ASC 842-10
25-1 . . . 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. . . .
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.
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.
25-10 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.
25-18 See Examples 15 through 22 (paragraphs 842-10-55-159 through 55-209) for illustrations of the requirements on lease modifications.
55-159 Examples 15 through 22 illustrate the accounting for lease modifications.
Whenever there is a substantive change in the terms and conditions of a
contract, the lessor should reassess whether the contract is or contains a lease. (See
Section 8.6.1.1 for additional
discussion.4) In addition, as noted above, when the terms and conditions of a lease contract are
modified, resulting in a change in the scope of or consideration for a lease, the lessor must
evaluate whether (1) “an additional right of use not included in the original lease” is being
granted as a result of the modification and (2) there is an increase in the lease payments that
is “commensurate with the standalone price for the additional right of use.” If the
modification does not meet both of these conditions, the lessor must reassess the lease’s
classification. See Section 8.3.4
for considerations related to lease classification reassessment. In a manner similar to the ASC
606 modification framework, any remaining consideration in the contract, including any
termination penalty received from or paid to a lessee as part of a partial termination of a
lease, should be reallocated to the remaining components in the contract and recognized
prospectively. See Section 8.6.3.7.1 for additional
discussion.5
If both of the conditions are met, the entity would account for a lease
modification as a separate contract and would apply the guidance in ASC 842 to the separate
contract. See Section 8.6.2 for
additional discussion of the accounting for a modification as a separate contract.6
Example 9-10
Modification Resulting in a Separate Contract
A lessor enters into an arrangement to lease 15,000 square feet of retail space in a shopping mall for 20 years. At the beginning of year 10, the lessor agrees to amend the original lease to include an additional 5,000 square feet of space adjacent to the existing space currently being leased when the current tenant vacates the property in 18 months. The increase in lease consideration as a result of the amendment is commensurate with the market rate for the additional 5,000 square feet of space in the shopping mall. The lessor would account for this modification (i.e., the lease of the additional 5,000 square feet) as a separate contract because the modification provides the lessee with a new ROU asset at a price that reflects its stand-alone price.
Example 9-11
Modification Not Resulting in a Separate Contract
A lessor enters into an arrangement to lease 15,000 square feet in a shopping mall for 20 years. At the
beginning of year 10, the lessor agrees to amend the original lease by reducing the annual rental payments
from $60,000 to $50,000 for the remaining 10 years of the agreement. Because the modification results in a
change only to the lease consideration (i.e., the modification does not result in an additional ROU asset), the
lessor would not account for this modification as a separate contract.
Changing Lanes
In a Lease Modification, Entities Are No Longer Required to Consider
Previous Terms and Conditions in Determining Lease Classification
Under ASC 840, there was a two-step process related to an entity’s
determination of whether a change in lease classification was required. Specifically, an
entity determined whether the substitution of the modified lease provisions would have
resulted in a different lease classification at inception of the lease, as though such terms
had been in place since inception. If so, the lease was considered a new agreement to be
assessed for classification by using updated assumptions. The guidance in ASC 840 therefore
differs from that in ASC 842, which neither requires nor permits a lessor to consider the
terms and conditions or facts and circumstances present as of lease inception (or
commencement). As the Board suggests in paragraph BC169 of ASU 2016-02, it is making this
change to reduce the complexity of the lease modification guidance and make it “more
intuitive to apply.”
Connecting the Dots
Contract Modifications Accounted for as a Separate Contract Under ASC 842 Are Similar
but Not Identical to Those Under ASC 606
ASC 606-10-25-12 indicates that a contract modification must be accounted for as
a separate contract if both of the following conditions are met:
-
“The scope of the contract increases because of the addition of promised goods or services that are distinct.”
-
“The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract.”
These conditions are similar to those in ASC 842 that apply to the determination
of whether a lease modification should be accounted for as a separate contract. The aligned
modification guidance should reduce the complexity of accounting for the modification of a
contract that includes both (1) lease components and (2) nonlease components within the scope
of ASC 606.
However, there is a key distinction between modifications under ASC 842
and those under ASC 606 with respect to the first condition related to accounting for a
modification as a separate contract. That is, for the modification to be accounted for as a
separate contract under ASC 842-10-25-8(a), it must grant “an additional right of use not
included in the original lease”; on the other hand, ASC 606-10-25-12(a) requires that the
modification result in “the addition of promised goods or services that are distinct.” On the
surface, these two requirements appear similar, since both mandate the addition of something
new to the contract. However, ASC 842 requires that this addition be a new right of use “not
included in the original lease.” As a result, a modification that extends the right to use
the same underlying asset subject to the existing lease does not qualify to be accounted for
as a separate contract under ASC 842, even if that extension is priced at its stand-alone
price. In contrast, an extension of the same service (e.g., maintenance) subject to an
existing revenue arrangement could qualify to be accounted for as a separate contract under
ASC 606. If a lessor has not elected the practical expedient not to separate lease and
nonlease components and a modification includes an extension of both
an existing right of use and an existing service, the modification would not qualify to be
accounted for as a separate contract since it would include more than just the addition of
promised goods or services that are distinct. This is because the modification guidance is
applied at the contract level rather than at the level of the agreement’s individual
components, even when different Codification topics apply to such components.
9.3.4.1 Evaluation of “Terms and Conditions” and “Facts and Circumstances”
ASC 842-10-25-9 requires a lessor to reassess a lease’s classification as
of the effective date of the modification in accordance with ASC 842-10-25-1. This assessment
is made on the basis of the lease’s “modified terms and conditions” as well as the “facts and
circumstances” as of the effective date. “Terms and conditions” are legal stipulations in the
contract; facts and circumstances are factors outside the contract. Examples of each that may
affect lease classification include:
-
Terms and conditions:
-
Purchase option on underlying asset.
-
Transfer of the title of the underlying asset at the end of the lease term.
-
Change in a contractual right or obligation in the contract (e.g., lease term or lease payment).
-
-
Facts and circumstances:
-
Change in the fair value of the asset.
-
Change in the economic life of the asset.
-
No alternative use of the underlying asset for the lessor.
-
Change in the entity’s view on whether there is a significant economic incentive to purchase or renew the lease.
-
Note that changes in facts and circumstances alone would never constitute a
lease modification; an entity would only need to determine whether a lease classification
reassessment must be performed when there are actual changes in the terms and conditions of
the contract. However, the lease classification assessment should take into account facts and
circumstances present as of the modified lease classification date.
Connecting the Dots
Significant Asset Improvements7
Although changes in facts and circumstances alone would never constitute
a lease modification, questions have arisen about whether a change in rights and obligations
that results in a change in the scope of or the consideration for a lease could constitute a
lease modification without a written amendment to the contract. For example, a lessor may
decide to make a significant improvement to an underlying asset during the lease term
without making a corresponding change to the lease contract. In these circumstances, we
believe that the lessor should consider whether the significant asset improvement has
enhanced the scope of the lessee’s right of use and whether the lessee’s enhanced right of
use is legally enforceable. If the significant asset improvement has changed the conditions
of the lease by providing the lessee with a legally enforceable, enhanced right of use, we
believe that it would generally be appropriate for the lessor to conclude that a lease
modification has taken place.8
Likewise, we believe that a lessor should also consider whether a
significant asset improvement has resulted in such a significant change in the nature of the
asset that it has effectively substituted the underlying asset with a new asset. See
Section 3.3.3.5 for additional
information on how parties to a contract should account for the supplier’s exercise of a
nonsubstantive substitution right.
The decision tree below illustrates the
lessor’s evaluation of a change in terms and conditions of a contract that is, or contains, a
lease component.
The diagram below illustrates the different
types of potential lease modifications. The Roadmap sections cross-referenced in the diagram
discuss each of the modification types in detail.
9.3.4.2 Circumstances in Which a Lessor Is Required to Update Stand-Alone Selling Prices
Lessors are required to allocate the consideration in the contract to the
separate lease and nonlease components in accordance with step 4 of the revenue recognition
model in ASC 606-10-32-28 through 32-41. That is, lessors will generally allocate the
consideration in the contract on the basis of the relative stand-alone selling price. The
stand-alone selling price, in accordance with ASC 606-10-32-32, is “the price at which an
entity would sell a promised good or service separately to a customer.” See Section 4.4.2.2 for further discussion of
allocating consideration in the contract.
Generally, a lessor does not remeasure its net investment in a lease
(sales-type lease or direct financing lease) or its assets and liabilities associated with an
operating lease. However, if a lease modification is not accounted for as a separate contract
in accordance with ASC 842-10-25-8 (as discussed above), the lease balance may need to change.
Specifically, ASC 842-10-35-6 states that a “lessor shall not remeasure the lease payments
unless the lease is modified and that modification is not accounted for as a separate contract
in accordance with paragraph 842-10-25-8.” See Section 6.10 for more information about subsequent
measurement of lease payments.
Under ASC 842-10-15-41, if a lease modification is not accounted for as a
separate contract (as discussed in Section
4.4.2.3), a “lessor shall remeasure and reallocate the remaining consideration in
the contract when there is a contract modification that is not accounted for as a separate
contract in accordance with paragraph 842-10-25-8.”
While the guidance explicitly specifies that a lessor should reallocate
consideration in the contract when there is a contract modification that is not accounted for
as a separate contract, it is not clear on whether the lessor would need to reevaluate
stand-alone selling prices as of the modification date or whether it would be appropriate to
retain the original inception-date relative stand-alone selling prices and thus to carry
forward the original allocation percentages determined in accordance with ASC 606. However,
the guidance in ASC 842 is intentionally aligned with several concepts in ASC 606, including
guidance on contract modifications. Therefore, a lessor’s contract modification is similar to
a revenue contract modification in accordance with ASC 606-10-25-12 and 25-13, under which an
entity must account for a contract modification as if it were a termination of the existing
contract, and the creation of a new contract, when certain conditions are met (as explained in
the Connecting the Dots above).
As a result, an entity would need to evaluate updated stand-alone selling prices for the newly
created contract.
Therefore, when a lease contract is modified and is not accounted for as a
separate contract, the allocation to the remaining lease and nonlease components is performed
on the basis of the facts and circumstances (and the modified terms and conditions, if
applicable) that exist as of the date of the modification (see Section 9.3.4.1). Given that the lessee and lessor have agreed to the modified
terms and conditions as of the modification date, the economic split between the lease and
nonlease components should also be revised.
We believe that it would be counterintuitive not to revise the relative
stand-alone selling prices and related allocation percentages since there could be additional
(or fewer) components in the contract after the modification. For example, if the lessor
modifies the contract, the modification does not result in a separate contract, and the
modification results in the addition (or elimination) of the right to use one or more
underlying assets, it would not make sense to retain the allocation percentages that were
determined at lease inception. The reason such retention would not make sense in such
circumstances is that either (1) any new components in the contract would not have been
included in the initial determination (when new components are added) or (2) any eliminated
components would have been included in the initial determination and would no longer be
subject to allocation (when there are partial terminations — see the next section).
In addition, a lessor would apply the revenue contract modification
guidance to the nonlease (revenue) components that are accounted for in accordance with ASC
606. For those components, an entity would be required to evaluate the updated stand-alone
selling prices at the time of modification in accordance with ASC 606-10-25-12 and 25-13. (For
more information, see Sections
9.2.1 and 9.2.2 of
Deloitte’s Roadmap Revenue
Recognition.) Therefore, the allocation of consideration among the nonlease
components would change. This guidance further supports the view that a lessor should apply
the same method to the lease components. The entire arrangement, including both lease and
nonlease components, would be subject to an evaluation of the updated stand-alone selling
prices at the time of modification.
9.3.5 Lease Termination
The table below summarizes recognition
implications associated with a lease termination for each of the three classification types and
includes cross-references to the sections of this Roadmap that contain additional details.
Lease Classification
|
Balance Sheet Recognition
|
Income Statement Recognition
|
---|---|---|
Sales-type lease — collectibility is probable (see Section 9.3.7.8)
|
Derecognize the net investment in the lease and measure the carrying
value of the asset recognized on the basis of the net investment in the lease, less any
impairments.
|
Recognize any ASC 310 or ASC 326 impairments.
|
Sales-type lease — collectibility is not probable (see Section 9.3.7.8)
|
Derecognize the deposit liability if the balance is nonrefundable to
the lessee and either (1) the lease is terminated or (2) the lessor has repossessed the
underlying asset and has no further obligation under the contract.
|
If the lessor can derecognize any deposit liability, recognize the
amounts as selling profit.
|
Direct financing lease (see Section
9.3.8.5)
|
Derecognize the net investment in the lease and measure the carrying
value of the asset recognized on the basis of the net investment in the lease, less any
impairments.
|
Recognize any ASC 310 or ASC 326 impairments.
|
Operating lease (see Section 9.3.9.6)
|
Write off any deferred rent receivables (or prepaid lease liability if
amounts are nonrefundable to the lessee) or initial direct costs.
|
Recognize any impact of the write-offs.
|
Note that if the lease termination occurs on a future date, for accounting purposes, the
change represents a lease modification rather than a termination and the lessor will recognize
remaining payments as income over the remaining lease life.
Any termination penalty received from or paid to a lessee as part of a full termination of a lease should be included in the determination of
any gain or loss upon termination. However, any termination penalty received from or paid to a
lessee as part of a partial9 termination of a lease should be reallocated to the remaining components in the contract
and recognized prospectively. See Section 8.6.3.7.1 for
additional discussion.10
9.3.6 End of Lease
The table below summarizes recognition
implications associated with lease expiration for each of the three classification types and
includes cross-references to the sections of this Roadmap that contain additional details.
Lease Classification
|
Balance Sheet Recognition
|
Income Statement Recognition
|
---|---|---|
Sales-type lease — collectibility is probable (see Section 9.3.7.9)
|
Derecognize the net investment in the lease and measure the carrying
value of the asset recognized on the basis of the net investment in the lease, less any
impairments.
|
Recognize any ASC 310 or ASC 326 impairments.
|
Sales-type lease — collectibility is not probable (see Section 9.3.7.9)
|
Derecognize the deposit liability if the balance is nonrefundable to
the lessee and either (1) the lease is terminated or (2) the lessor has repossessed the
underlying asset and has no further obligation under the contract.
|
If the lessor can derecognize any deposit liability, recognize the
amounts as selling profit.
|
Direct financing lease (see Section 9.3.8.6)
|
Derecognize the net investment in the lease and measure the carrying
value of the asset recognized on the basis of the net investment in the lease, less any
impairments.
|
Recognize any ASC 310 or ASC 326 impairments.
|
Operating lease
|
No impact.
|
No impact.
|
9.3.7 Sales-Type Lease
In a sales-type lease, the lessee gains control of the underlying asset and the lessor therefore relinquishes control to the lessee. Accordingly, the lessor derecognizes the underlying asset and in its place recognizes its new asset, the net investment in the lease (which consists of the sum of the lease receivable and the present value of the unguaranteed residual asset). Any selling profit or loss created as a result of the difference between those two amounts (net investment in the lease less carrying amount of asset) would be recognized at lease commencement. Initial direct costs would be recognized as an expense at lease commencement unless there is no selling profit or loss. If there is no selling profit or loss, the initial direct costs would be deferred and recognized over the lease term. In addition, the lessor would recognize interest income from the lease receivable over the lease term to reflect its new position with respect to the asset as a creditor of the “loan” provided to the customer (lessee).
Connecting the Dots
Sales-Type Leases When Fair Value Equals Carrying Value of the Underlying
Asset
When the fair value of the asset subject to a sales-type lease is equal to
its carrying value, the subsequent measurement is similar to the accounting for a direct
financing lease because there is no gain (or loss) to immediately recognize. Therefore, all
of the “income” associated with the lease is interest income (with no selling profit
incorporated into the activity). Further, the initial direct costs are deferred (included in
the net investment in the lease) and recognized over the term of the lease. This approach is
the same as that used for direct financing leases.
In a manner consistent with ASC 606, if collectibility of the lease payments
plus any lessee-provided residual value guarantee is not probable,11 the lessor would not record a sale. That is, the lessor would not derecognize the
underlying asset and would account for lease payments received as a deposit liability until (1)
collectibility of those amounts becomes probable or (2) the amounts received are nonrefundable
and either the contract has been terminated or the lessor has repossessed the underlying asset.
Once collectibility of those amounts becomes probable, the lessor would derecognize the
underlying asset and recognize a net investment in the lease. If the contract has been
terminated or the lessor has repossessed the underlying asset, and the amounts received are
nonrefundable, the lessor would derecognize the deposit liability and recognize a corresponding
amount of lease income.
9.3.7.1 Recognition, Initial Measurement, and Subsequent Measurement
9.3.7.1.1 Recognition and Initial Measurement
ASC 842-30
25-1 At the commencement date, a lessor shall recognize each of the following and derecognize the underlying asset in accordance with paragraph 842-30-40-1:
- A net investment in the lease, measured in accordance with paragraph 842-30-30-1
- Selling profit or selling loss arising from the lease
- Initial direct costs as an expense if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. If the fair value of the underlying asset equals its carrying amount, initial direct costs (see paragraphs 842-10-30-9 through 30-10) are deferred at the commencement date and included in the measurement of the net investment in the lease. The rate implicit in the lease is defined in such a way that those initial direct costs eligible for deferral are included automatically in the net investment in the lease; there is no need to add them separately.
40-1 At the commencement date, a lessor shall derecognize the carrying amount of the underlying asset (if
previously recognized) unless the lease is a sales-type lease and collectibility of the lease payments is not
probable (see paragraph 842-30-25-3).
If collectibility for the sales-type lease is probable at lease commencement, the underlying asset is
derecognized on the commencement date and a “net investment in the lease” is recognized. The
difference between the net investment in the lease, or sales price, and the carrying value of the
underlying asset must be recognized as selling profit or selling loss. See Section 9.3.7.2 for information
on how to account for a sales-type lease when collectibility is not probable at lease commencement.
While ASC 842 indicates that selling loss could be recognized on the commencement date, lessors
should ensure the completeness of their ASC 360 impairment analysis if they determine that a selling
loss exists.
ASC 842-30
30-1 At the commencement date, for a sales-type lease, a lessor shall measure the net investment in the lease
to include both of the following:
- The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of:
- The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
- The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
- The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease.
See Chapter 6 for more information on amounts included in and excluded from lease payments.
Connecting the Dots
Estimated Residual Value of Land
Under ASC 840, the estimated residual value of land in a sales-type or direct
financing lease was limited to the land’s fair value determined at lease inception. While
ASC 842 is silent on this issue, we believe that the same principle applies under ASC 842.
That is, a lessor’s estimate of a land’s residual value in a sales-type or direct financing
lease should be limited to the land’s fair value as of lease commencement. As a result, the
land’s estimated residual value will never exceed the land’s fair value at lease
commencement.
Any initial direct costs are recognized as an expense if, on the commencement
date, the fair value of the underlying asset differs from the lessor’s carrying amount (see
the Connecting the Dots discussion in Section 9.2.1.4.2 for considerations related to how lessors that
are not manufacturers or dealers determine the fair value of the underlying asset). If the
fair value of the underlying asset equals the carrying amount, initial direct costs are
deferred on the commencement date and are included in the measurement of the net investment
in the lease. See Section 6.11
for more information about what amounts constitute initial direct costs.
Changing Lanes
Narrower Definition of Initial Direct Costs
ASC 842 narrows the definition of initial direct costs. Previously, many lessors
capitalized amounts related to overhead from their leasing departments (e.g., employees’
salaries in that department). Because such costs would be incurred regardless of whether a
lease was executed, lessors will be prohibited from capitalizing them as a result of this
narrower definition.
9.3.7.1.2 Subsequent Measurement
ASC 842-30
25-2 After the commencement date, a lessor shall recognize all of the following:
- Interest income on the net investment in the lease, measured in accordance with paragraph 842-30-35-1(a)
- Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur . . . .
While selling profit is recognized in a sales-type lease at lease commencement, it is also necessary to recognize interest income for the financing provided by the lessor (i.e., to reflect that, through the contract, the lessor has effectively converted the leased asset into a financial asset).
ASC 842-30
35-1 After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following:
- Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease.
- Reducing the carrying amount to reflect the lease payments collected during the period.
35-2 After the commencement date, a lessor shall not remeasure the net investment in the lease unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
Interest income should generally be recognized during all reporting periods, regardless of payment
timing. Any interest income not yet paid would be included as an increase in the basis of the net
investment in the lease. The rate the lessor uses should be a constant periodic discount rate with
respect to the remaining balance of the net investment in the lease (i.e., the lessor should subsequently
measure the net investment in the lease by using the effective interest method and the rate implicit in
the lease).
Because variable lease payments are not included in the net investment in the
lease, any amounts receivable or received (allocated to the lease component) must be
recognized as income in the period in which the changes in facts and circumstances on which
the variable lease payments are based occur. See Chapter 6 for more information on how to identify whether
a lease payment is variable and Section 4.4.2.2.1 for a
discussion about recognizing variable payments for which a portion is attributable to a
nonlease component.
The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates a
lessor’s accounting for a sales-type lease.
ASC 842-30
30-3 See Example 1 (paragraphs 842-30-55-18 through 55-43) for an illustration of the requirements for sales-type
. . . leases.
Illustration of Lessor Accounting
55-18 Example 1 illustrates how a lessor would account for sales-type leases and direct financing leases.
Example 1 — Lessor Accounting Example
Case A — Lessor Accounting — Sales-Type Lease
55-19 Lessor enters into a 6-year lease of equipment with Lessee, receiving annual lease payments of $9,500,
payable at the end of each year. Lessee provides a residual value guarantee of $13,000. Lessor concludes
that it is probable it will collect the lease payments and any amount necessary to satisfy the residual value
guarantee provided by Lessee. The equipment has a 9-year estimated remaining economic life, a carrying
amount of $54,000, and a fair value of $62,000 at the commencement date. Lessor expects the residual value
of the equipment to be $20,000 at the end of the 6-year lease term. The lease does not transfer ownership of
the underlying asset to Lessee or contain an option for Lessee to purchase the underlying asset. Lessor incurs
$2,000 in initial direct costs in connection with obtaining the lease, and no amounts are prepaid by Lessee to
Lessor. The rate implicit in the lease is 5.4839 percent.
55-20 Lessor classifies the lease as a sales-type lease because the sum of the present value of the lease payments and the present value of the residual value guaranteed by the lessee amounts to substantially all of the fair value of the equipment. None of the other criteria to be classified as a sales-type lease are met. In accordance with paragraph 842-10-25-4, the discount rate used to determine the present value of the lease payments and the present value of the residual value guaranteed by Lessee (5.4839 percent) for purposes of assessing whether the lease is a sales-type lease under the criterion in paragraph 842-10-25-2(d) assumes that no initial direct costs will be capitalized because the fair value of the equipment is different from its carrying amount.
55-21 Lessor measures the net investment in the lease at $62,000 at lease commencement, which is equal
to the fair value of the equipment. The net investment in the lease consists of the lease receivable (which
includes the 6 annual payments of $9,500 and the residual value guarantee of $13,000, both discounted at
the rate implicit in the lease, which equals $56,920) and the present value of the unguaranteed residual value
(the present value of the difference between the expected residual value of $20,000 and the residual value
guarantee of $13,000, which equals $5,080). Lessor calculates the selling profit on the lease as $8,000, which
is the difference between the lease receivable ($56,920) and the carrying amount of the equipment net of
the unguaranteed residual asset ($54,000 – $5,080 = $48,920). The initial direct costs do not factor into the
calculation of the selling profit in this Example because they are not eligible for deferral on the basis of the
guidance in paragraph 842-30-25-1(c) (that is, because the fair value of the underlying asset is different from its
carrying amount at the commencement date).
55-22 At the commencement date, Lessor derecognizes the equipment (carrying amount of $54,000) and recognizes the net investment in the lease of $62,000 and the selling profit of $8,000. Lessor also pays and recognizes the initial direct costs of $2,000 as an expense.
55-23 At the end of Year 1, Lessor recognizes the receipt of a lease payment of $9,500 and interest on the net investment in the lease (the beginning balance of the net investment in the lease of $62,000 × the rate implicit in the lease of 5.4839% = $3,400), resulting in a balance in the net investment of the lease of $55,900. For disclosure purposes, Lessor also calculates the separate components of the net investment in the lease: the lease receivable and the unguaranteed residual asset. The lease receivable equals $50,541 (the beginning balance of the lease receivable of $56,920 – the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $3,121, which is $56,920 × 5.4839%). The unguaranteed residual asset equals $5,360 (the beginning balance of the unguaranteed residual asset of $5,081 + the interest income on the unguaranteed residual asset during Year 1 of $279, which is $5,081 × 5.4839%).
55-24 At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $9,500/year beginning at the end of year 1.
- Residual value guarantee provided by lessee: $13,000.
- Collectibility of the lease payments and residual value guarantee as of commencement is probable.
- Economic life of equipment: 9 years.
- Carrying amount: $54,000.
- Fair value: $62,000.
- Expected residual value at end of term: $20,000.
- No transfer of ownership and no purchase options.
- Lessor incurs $2,000 in initial direct costs.
Step 2: Determine the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate so that the sum equals
the fair value of the asset. Because the fair value of the asset differs from the carrying
value, the initial direct costs are not included in the calculation of the rate implicit in
the lease (since such amounts are immediately expensed).
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
Because the lease meets the criterion in ASC 842-10-25-2(d), the lessor determines that the lease is a
sales-type lease.
Step 4: Record the Commencement-Date Journal Entries
Because control of the asset was lost, the lessor must derecognize the asset and record the net investment in the lease.
The net investment in the lease is measured as
the present value of the sum of the (1) lease payments not yet received by the lessor, (2)
residual value guaranteed by the lessee or a third party unrelated to the lessor, and (3)
residual value that is not guaranteed by the lessee or a third party unrelated to the
lessor. The lessor determines the present value of the lease payments not yet received as
$47,482, and the present value of the residual asset that is guaranteed and unguaranteed
that the lessor expects to receive is $14,518 ($9,437 and $5,081, respectively). The net
investment in the lease is therefore $62,000 (or the fair value of the underlying asset), as
reflected in the following journal entry:
The difference between the net investment in the
lease and the carrying value of the underlying asset is recognized as selling profit at
lease commencement. Because the fair value of the underlying asset differs from the carrying
amount of the underlying asset as of the commencement date, initial direct costs are not
eligible for deferral:
Step 5: Record the Activities Related to the Sales-Type Lease
In year 1, the lessee pays the lessor $9,500. A
portion of the payment is allocable to interest income, since the lessor is effectively
financing the lessee’s purchase. The interest income is recognized as $3,400 ($62,000 ×
5.4839%). Note that this income should be recognized over the reporting period and is not
governed by when the amount is paid by the lessee. The other portion of the lessee’s payment
results in a reduction in the lessor’s net investment in the lease (which represents the
receivable from the lessee). Embedded within the interest income (and related increase in
the net investment in the lease) is the accretion of the unguaranteed residual value of the
asset.
The remainder of the cash payments received over
the life of the lease should be recognized as follows through year 6:
Step 6: Record the Return of the Underlying Asset to the Lessor
The ending net investment in the lease
represents the estimated value the lessor will receive from the lessee when the lessor
regains control over the underlying asset. The balance of the net investment in the lease
will equal the expected value of the residual asset estimated at commencement (less any
impairments). Note no increases in the expected underlying value of the asset should be
recognized during the lease term. The lessor would record the following journal entry to
reflect the return of the underlying asset at the residual value expected at the end of the
lease term:
Connecting the Dots
Commencement Loss Resulting From a Significant Variable Payment in a Sales-Type or
Direct Financing Lease (Before the Adoption of ASU 2021-05)
While the FASB’s goal was to align lessor accounting with the revenue
guidance in ASC 606, an important distinction between the two may affect lessors in a
number of industries. Under ASC 606, variable payments are estimated and included in the
transaction price subject to a constraint. By contrast, under ASC 842, variable lease
payments not linked to an index or rate are generally excluded from the determination of a
lessor’s lease receivable.
Accordingly, sales-type or direct financing leases that have a
significant variable lease payment component may result in an entity’s recognition of a
loss at commencement because the measurement of the lease receivable plus the unguaranteed
residual asset is less than the net carrying value of the underlying asset. This could
occur, for example, if lease payments are based entirely on the number of units produced
by the leased asset (i.e., payments are 100 percent variable) or when a portion of the
expected cash flows from the lease is variable (e.g., 50 percent of the total expected
cash flows are variable). However, these transactions typically do not represent an
economic loss for the lessor.
In line with views the FASB expressed at it’s November 30, 2016,
meeting, a lessor should recognize a loss at lease commencement when its initial
measurement of the net investments in a sales-type or direct financing lease is less than
the current value of the underlying asset. The Board acknowledged that a lessor’s initial
measurement of a sales-type or direct financing lease that includes a significant
variable-lease payment component may result in a loss at lease commencement if the lease
receivable plus the unguaranteed residual asset is less than the net carrying value of the
underlying asset being leased. The Board discussed whether a loss at commencement would be
appropriate in these situations or whether other possible approaches would be acceptable,
such as (1) incorporating variable lease payments subject to a constraint (by reference to
ASC 606) or (2) using a negative discount rate to avoid the loss at commencement. The
Board expressed its belief that while stakeholders may disagree with the outcome of
recognizing a loss at commencement, ASC 842 is clear on how the initial measurement
guidance should be applied to sales-type and direct financing leases.
In discussions with the FASB staff, we observed that in situations
similar to those outlined in Examples 9-12 and
9-13, the outcome of the calculation of the “rate
implicit in the lease,” which is based on how that term is defined in ASC 842-30-20, may
result in a negative discount rate. However, at the FASB’s November 30, 2016, meeting, the
Board acknowledged that using a negative discount rate to determine the rate implicit in
the lease (as defined in ASC 842-30-20) is inappropriate.12 ASU 2018-10 clarifies that lessors should use a 0 percent discount rate when
measuring the net investment in a lease if the rate implicit in the lease is negative.
Changing Lanes
Issuance of ASU 2021-05
In July 2021, the FASB issued ASU 2021-05, which amends a lessor’s accounting
for leases that contain variable lease payments and that result in a day 1 loss. See
Section 17.3.1.8 for more
information.
Example 9-12
A lessee and manufacturer lessor enter into a five-year
sales-type lease of the lessor’s R2-series equipment. Before lease commencement, the
lessor customizes the R2-series equipment specifically for the lessee.13 The asset has a carrying value of $100, a fair value at commencement of $120,
and an estimated unguaranteed residual value of $50 at the end of the lease term.
Payments are based entirely on the lessee’s usage of the R2-series equipment. The
lessor has significant insight into the lessee’s equipment needs over the five-year
term, and although the payments are 100 percent variable, the lessor has priced the
lease with the expectation that it will receive an annual payment of $20. The lessor
thus charges the lessee a rate of 6.4 percent.14
The tables below illustrate the terms of the sales-type lease and
the lessor’s accounting for the lease under ASC 842.
Example 9-13
Assume the same facts as in Example 9-12. The lessor still
charges the lessee a rate of 6.4 percent based on expected annual cash flows of
$20.15 However, the lessor prices the lease with 50 percent of the cash flows fixed
and 50 percent of the cash flows variable based on the lessee’s usage of the
R2-series equipment.
The tables below illustrate the terms of the sales-type lease and
the lessor’s accounting for the lease under ASC 842.
Connecting the Dots
Arrangements With Significant Variable Lease Payments (Before the Adoption of ASU
2021-05)
It is common for lease arrangements in a number of industries to
include significant or wholly variable lease payments. It is not uncommon for such
arrangements to result in sales-type or direct financing lease classification.
Arrangements in the energy sector are frequently accounted for as
leases with wholly variable payment streams. For example, PPAs related to renewable energy
(i.e., from solar or wind generation facilities) (1) are commonly long-term and for the
major part of the economic life of the generation facility, (2) provide for payments at a
fixed price per unit of electricity output (e.g., $50 per megawatt hour [MWh]), and (3)
require the lessee to take all of the output produced by the facility but do not specify a
minimum level of production (i.e., the volume of output is wholly variable). Although the
output quantity is weather-dependent, the lessor expects the arrangement to be profitable
on the basis of historical weather data.
We are also aware of arrangements in the oil and gas industry in which
a company builds a gathering and processing system and leases it to a single user under a
variable payment structure. For example, an exploration company with rights to multiple
oil wells on dedicated acreage may contract with a midstream company to construct and
lease the infrastructure necessary to gather and process the oil extracted from the wells.
The arrangement may be long term and for a major part of the economic life of the
infrastructure, and the payment for the use of the infrastructure may be 100 percent
variable (e.g., a fixed price per unit multiplied by the number of units gathered or
processed) without a minimum volume requirement. The midstream company would be willing to
accept variable consideration in the arrangement if reserve data related to the wells
suggest that a sufficient volume of oil will be extracted over the term of the contract to
make the arrangement profitable.
In the real estate sector, a commercial real estate lease arrangement
(e.g., a lease of retail space) may be priced in such a way that a significant amount of
the expected payments is contingent on the lessee’s sales (e.g., payments that are a fixed
percentage of the retail store’s sales for a month). The lessor would account for the
arrangement as a sale-type lease if the lease (1) is for a major part of the economic life
of the retail location or (2) contains a purchase option that the lessee is reasonably
certain to exercise. Arrangements of this type allow the property owner to participate in
the upside of the retail store’s business and are expected to be profitable.
Finally, in the health care industry, it is not uncommon for a hospital
to contract with a medical device owner for the use of specific medical equipment for a
major part of the economic life of the equipment. This type of arrangement is often priced
in such a way that the consideration is based entirely on the hospital’s ongoing purchase
of “consumables,” which allow the equipment to function as designed and may have no
minimum volume requirement. The medical device owner is willing to accept variable
consideration in the arrangement because demand for the associated health care services
suggests that a sufficient volume of consumables will be purchased by the hospital over
the term of the contract to make the arrangement profitable.
9.3.7.2 Accounting for Lack of Collectibility
ASC 842-30
25-3 The guidance in paragraphs 842-30-25-1 through 25-2 notwithstanding, if collectibility of the lease
payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, is not
probable at the commencement date, the lessor shall not derecognize the underlying asset but shall recognize
lease payments received — including variable lease payments — as a deposit liability until the earlier of either
of the following:
- Collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, becomes probable. If collectibility is not probable at the commencement date, a lessor shall continue to assess collectibility to determine whether the lease payments and any amount necessary to satisfy a residual value guarantee are probable of collection.
- Either of the following events occurs:
- The contract has been terminated, and the lease payments received from the lessee are nonrefundable.
- The lessor has repossessed the underlying asset, it has no further obligation under the contract to the lessee, and the lease payments received from the lessee are nonrefundable.
As indicated above, the lessor would not derecognize the underlying asset if collectibility is not probable
as of the commencement date; instead, in such circumstances, any proceeds would be recognized as a
deposit liability. See Section 9.3.7.3 for information on accounting for changes in collectibility.
Changing Lanes
Lack of Collectibility Results in More Restrictive Recognition
If the collection of lease payments was not reasonably predictable under ASC
840, the lease may not have been classified as a sales-type lease. Nonetheless, the lease
payments may have been recognized in profit or loss under the operating lease model. In an
identical scenario in which a lease meets all of the ASC 842 sales-type criteria, a lessor
would be required to record any payments received as a deposit liability and income
recognition would be delayed. Because ASC 842 would still require the lease to be classified
as a sales-type lease (not as an operating lease, as would have been required under ASC 840)
despite the collectibility concerns, a lessor would not be able to recognize lease payments
in profit or loss as quickly as it did under ASC 840.
9.3.7.3 When Collectibility Becomes Probable
ASC 842-30
25-4 When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(a) is met (that is, the date at which collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee provided by the lessee is assessed as probable), the lessor shall do all of the following:
- Derecognize the carrying amount of the underlying asset
- Derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3
- Recognize a net investment in the lease on the basis of the remaining lease payments and remaining lease term, using the rate implicit in the lease determined at the commencement date
- Recognize selling profit or selling loss calculated as:
- The lease receivable; plus
- The carrying amount of the deposit liability; minus
- The carrying amount of the underlying asset, net of the unguaranteed residual asset.
25-5 When collectibility is not probable at the commencement date, at the date the criterion in paragraph 842-30-25-3(b) is met, the lessor shall derecognize the carrying amount of any deposit liability recognized in accordance with paragraph 842-30-25-3, with the corresponding amount recognized as lease income.
25-6 If collectibility is probable at the commencement date
for a sales-type lease or for a direct financing lease, a lessor shall not reassess
whether collectibility is probable. Subsequent changes in the credit risk of the lessee
shall be accounted for in accordance with the credit loss guidance applicable to the net
investment in the lease in paragraph 842-30-35-3.
Changes in collectibility after lease commencement do not affect the lease’s classification but do affect subsequent measurement. If collectibility is not probable at lease commencement, no sale is recognized. However, if collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, does become probable during the lease term, the lessor may recognize the sale at such time. Further, at such time, the lessor must derecognize the carrying amount of the underlying asset, as well as any deposit liability, and must recognize a net investment in the lease. The lessor should measure the net investment in the lease as the present value of the remaining lease payments, discounting the payments by using the rate implicit in the lease. The difference between these amounts is recorded as selling profit or loss.
The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates the lessor’s accounting for
a sales-type lease when collectibility of the lease payments is not probable. Certain facts in this scenario
are the same as those in Case A of Example 1, which is reproduced in Section 9.3.7.1.
ASC 842-30
Case B — Lessor Accounting — Sales-Type Lease — Collectibility of the Lease
Payments Is Not Probable
55-25 Assume the same facts and circumstances as in Case A (paragraphs 842-30-55-19 through 55-24),
except that it is not probable Lessor will collect the lease payments and any amount necessary to satisfy the
residual value guarantee provided by Lessee. In reaching this conclusion, the entity observes that Lessee’s
ability and intention to pay may be in doubt because of the following factors:
- Lessee intends to make the lease payments primarily from income derived from its business in which the equipment will be used (which is a business facing significant risks because of high competition in the industry and Lessee’s limited experience)
- Lessee has limited credit history and no significant other income or assets with which to make the payments if the business is not successful.
55-26 In accordance with paragraph 842-30-25-3, Lessor does not derecognize the equipment and does not
recognize a net investment in the lease or any selling profit or selling loss. However, consistent with Case A,
Lessor pays and recognizes the initial direct costs of $2,000 as an expense at the commencement date.
55-27 At the end of Year 1, Lessor reassesses whether it is probable it will collect the lease payments and
any amount necessary to satisfy the residual value guarantee provided by Lessee and concludes that it is
not probable. In addition, neither of the events in paragraph 842-30-25-3(b) has occurred. The contract has
not been terminated and Lessor has not repossessed the equipment because Lessee is fulfilling the terms
of the contract. Consequently, Lessor accounts for the $9,500 Year 1 lease payment as a deposit liability in
accordance with paragraph 842-30-25-3. Lessor recognizes depreciation expense on the equipment of $7,714
($54,000 carrying value ÷ 7-year useful life).
55-28 Lessor’s accounting in Years 2 and 3 is the same as in Year 1. At the end of Year 4, Lessee makes the
fourth $9,500 annual lease payment such that the deposit liability equals $38,000. Lessor concludes that
collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided
by Lessee is now probable on the basis of Lessee’s payment history under the contract and the fact that Lessee
has been successfully operating its business for four years. Lessor does not reassess the classification of the
lease as a sales-type lease.
55-29 Consequently, at the end of Year 4, Lessor derecognizes the equipment, which has a carrying amount of
$23,143, and recognizes a net investment in the lease of $35,519. The net investment in the lease consists of
the lease receivable (the sum of the 2 remaining annual payments of $9,500 and the residual value guarantee
of $13,000, discounted at the rate implicit in the lease of 5.4839 percent determined at the commencement
date, which equals $29,228) and the unguaranteed residual asset (the present value of the difference between
the expected residual value of $20,000 and the residual value guarantee of $13,000, which equals $6,291).
Lessor recognizes selling profit of $50,376, the difference between (a) the sum of the lease receivable and the
carrying amount of the deposit liability ($29,228 lease receivable + $38,000 in lease payments already made
= $67,228) and (b) the carrying amount of the equipment, net of the unguaranteed residual asset ($23,143 –
$6,291 = $16,852).
55-30 After the end of Year 4, Lessor accounts for the remaining two years of the lease in the same manner as
any other sales-type lease. Consistent with Case A, at the end of Year 6, Lessor reclassifies the net investment
in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $9,500/year beginning at the end of year 1.
- Residual value guarantee provided by lessee: $13,000.
- Collection of the lease payments and residual value guarantee as of commencement is not probable but becomes probable at the end of year 4.
- Economic life of equipment: 7 years.16
- Carrying amount: $54,000.
- Fair value: $62,000.
- Expected residual value at end of term: $20,000.
- No transfer of ownership and no purchase options.
- Lessor incurs $2,000 in initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
All else being equal, the rate implicit in the lease would be unchanged by the collectibility assessment, although the rate of return would be expected to be higher in situations in which collectibility is in doubt than in arrangements in which collectibility is probable. As in Case A above (see Section 9.3.7.1), the implicit rate in the lease in this scenario is 5.4839 percent.
Step 3: Determine the Lease Classification
None of the lease classification criteria for a sales-type lease require a lessor to consider collectibility. Therefore, the change in fact (i.e., it is not probable at commencement that the lease payments are collectible) has no impact on the sales-type lease classification.
Step 4: Record the Commencement-Date Journal Entries
Because of the collectibility concerns, a sale
has not occurred and the only entry that the lessor records at lease commencement is to
recognize the initial direct costs. The fair value of the underlying asset differs from the
carrying amount of the underlying asset as of the commencement date; thus, initial direct
costs are not eligible for deferral. The following entry would be recorded:
Step 5: Record the Activities Related to the Sales-Type Lease
In year 1, the lessee must pay the lessor
$9,500. The lessor determines that collectibility is not yet probable. The lease contract has
not been terminated, and the lessor has not repossessed the underlying asset. Consequently,
the lessor accounts for the $9,500 payment as a deposit liability:
Moreover, since the underlying asset was not
derecognized because sale accounting was not achieved, the lessor should recognize
depreciation expense on the basis of the remaining useful life (7 years) and the carrying
value of the underlying asset, $54,000:
In years 2 and 3, (1) the lessor maintains its
assessment that collectibility is not yet probable, (2) the lease contract has not been
terminated, and (3) the lessor has not repossessed the underlying asset. Balances and
activities are recognized as shown below.
At the end of year 4, the lessee completes its fourth $9,500 payment; thus, the deposit liability is $38,000
($28,500 + $9,500). Contemporaneously, the lessor concludes that collectibility of the payments and
any amount necessary to satisfy the residual value guarantee provided by the lessee is now probable.
Classification is not revisited.
Because a sale has occurred, the lessor must
derecognize the asset and record the net investment in the lease. In calculating the “net
investment in the lease,” the lessor determines that the present value of the lease payments
not yet received is $17,544. The present value of the residual asset that is guaranteed and
unguaranteed that the lessor expects to receive is $17,975. The net investment in the lease
is therefore $35,519.
The lessor would recognize, as selling profit,
the difference between (1) the net investment in the lease, the deposit liability, and the
cash received for the fourth payment and (2) the carrying value of the underlying asset. The
selling profit is recognized as of the date collectibility becomes probable.
As shown below, the lease receivable is
subsequently measured as it was in Case A.
Step 6: Record the Return of the Underlying Asset to the Lessor
The ending net investment in the lease
represents the amount the lessor will receive from the lessee when the lessor regains control
over the underlying asset. The entry to reflect the return of the underlying asset at the
residual value expected at the end of the lease term is depicted below.
9.3.7.4 Collectibility Is Probable at Commencement — Subsequent Changes in Credit Risk
ASC 842-30
25-6 If collectibility is probable at the commencement date
for a sales-type lease or for a direct financing lease, a lessor shall not reassess
whether collectibility is probable. Subsequent changes in the credit risk of the lessee
shall be accounted for in accordance with the credit loss guidance applicable to the net
investment in the lease in paragraph 842-30-35-3.
Changes in the lessee’s credit risk after lease commencement are accounted for
in accordance with the impairment guidance discussed in the next section.
9.3.7.5 Impairment
ASC 842-30
25-2 After the commencement date, a lessor shall
recognize all of the following: . . .
c. Credit losses on the net investment in the lease (as described in paragraph
842-30-35-3).
35-3 A lessor shall determine the loss allowance
related to the net investment in the lease and shall record any loss allowance in
accordance with Subtopic 326-20 on financial instruments measured at amortized cost.
When determining the loss allowance for a net investment in the lease, a lessor shall
take into consideration the collateral relating to the net investment in the lease. The
collateral relating to the net investment in the lease represents the cash flows that
the lessor would expect to receive (or derive) from the lease receivable and the
unguaranteed residual asset during and following the end of the remaining lease
term.
The net investment in the lease must be monitored for impairment in
accordance with ASC 310 or — after the adoption of ASU 2016-13 — ASC 326, which introduces the
CECL model that is based on expected losses rather than historical incurred losses. See
Section 5.3 of Deloitte’s
Roadmap Current Expected Credit
Losses for further discussion of the application of the CECL model to lease
receivables.
When evaluating the net investment in a sales-type or direct financing lease for impairment,
a lessor should apply the guidance in ASC 842-30-35-3, which indicates that a lessor should
use the cash flows it expects to derive from the “lease receivable and the unguaranteed
residual asset during and following the end of the remaining lease term.” Accordingly, the
unit of account used when the impairment model is applied from the lessor’s perspective is
meant to encompass amounts related to the entire net investment in the lease, which would
include the residual asset, and the cash flows in impairment testing would include those that
the lessor expects to derive from the underlying asset at the end of the lease term. When
determining the cash flows to be derived from the underlying asset at the end of the lease
term, a lessor should consider amounts it would receive for re-leasing or selling the
underlying asset to a third party but should not consider the expected credit risk of the
potential lessee or buyer of the underlying asset (i.e., it would not be appropriate for the
lessor to include a credit risk assumption in its analysis since it does not know the identity
of the theoretical buyer).
Because impairment of the net investment in the lease is recognized in
accordance with ASC 310 (or ASC 326, if adopted), any deterioration in the credit quality of
the lessee must be reflected in the impairment recognized. Note that after lease commencement,
changes in collectibility do not affect the classification of the lease. When measuring the
impairment of the net investment in the lease, the lessor should consider the collateral
(underlying asset) to be a cash flow that it would expect to derive from the underlying asset,
including cash flows expected to be derived after the end of the lease term. In other words,
amounts expected to be earned from re-leasing the asset would be considered. When using a
discounted cash flow approach to measure impairment related to the net investment in leases,
the lessor should employ the rate implicit in the lease.
Changing Lanes
ASC 842 Introduces Single Asset Impairment Model
Under ASC 840, a lessor was required to assess the net investment in the
lease for impairments by assessing (1) the lease receivable in accordance with ASC 310 and
(2) the unguaranteed residual asset in accordance with ASC 360. However, the FASB did not
carry forward the dual model for assessing impairment of the net investment in the lease. In
paragraphs BC310 and BC311 of ASU 2016-02, the FASB indicates that including two impairment
models is overly complex and would result in financial statement information whose benefits
would not justify its costs. Moreover, the Board notes that the net investment in a lease
primarily comprises a financial lease receivable (i.e., the unguaranteed residual asset is
often insignificant) and therefore should be accounted for as a financial asset under ASC
310.
Issuance of ASU 2016-13
In June 2016, the FASB issued ASU 2016-13, which supersedes ASC 310 and therefore
changes how lessors measure impairment in the net investment in the lease. Under ASU
2016-13, lessors with net investments in leases are required to recognize an allowance for
credit losses. For PBEs that meet the definition of an SEC filer, the guidance in the ASU
became effective for annual periods beginning after December 15, 2019 (i.e., calendar
periods beginning after January 1, 2020), and interim periods therein. For all other
entities, the guidance is effective for annual periods beginning after December 15, 2022
(i.e., calendar periods beginning after January 1, 2023), and interim periods therein. Early
adoption was permitted for all entities as of fiscal years beginning after December 15,
2018, and interim periods therein.
9.3.7.6 Sale of Lease Receivable
ASC 842-30
35-4 If a lessor sells substantially all of the lease receivable associated with a sales-type lease or a direct financing lease
and retains an interest in the unguaranteed residual asset, the lessor shall not continue to accrete the
unguaranteed residual asset to its estimated value over the remaining lease term. The lessor shall report any
remaining unguaranteed residual asset thereafter at its carrying amount at the date of the sale of the lease
receivable and apply Topic 360 on property, plant, and equipment to determine whether the unguaranteed
residual asset is impaired.
If a lessor sells a lease receivable, an entity should consider the guidance in ASC 860 to determine
whether the transfer of a financial asset (i.e., the lease receivable) has occurred and may be
derecognized. However, such guidance does not address how the lessor should account for the sale of
a sales-type lease receivable when it retains an interest in the unguaranteed residual asset. If the lessor
retains an interest in the unguaranteed residual asset, this asset would no longer be accreted to its
estimated value over the lease term. Instead, the lessor would keep the asset at its carrying value, less
any necessary impairments determined in accordance with ASC 360.
ASC 842-40
Determining Whether the Transfer of the Asset Is a Sale
25-1 An entity shall apply the following requirements in Topic 606 on revenue from contracts with customers when determining whether the transfer of an asset shall be accounted for as a sale of the asset:
- Paragraphs 606-10-25-1 through 25-8 on the existence of a contract
- Paragraph 606-10-25-30 on when an entity satisfies a performance obligation by transferring control of an asset.
To gain liquidity, a lessor may enter into a transaction to sell its interest in
lease receivables. In addition to the receivable itself, the lessor may sell its interest in
the unguaranteed residual asset; from an accounting perspective, the lessor would have already
derecognized the underlying asset as part of its leasing transaction. ASC 842 does not
indicate how to account for the sale of an unguaranteed residual asset in a sales-type lease.
An entity should consider ASC 842-40-25-1 in evaluating whether the sale and derecognition of
the unguaranteed residual value of the asset are appropriate. For more information, see
Deloitte’s Roadmap Revenue
Recognition.
9.3.7.7 Lease Modification
9.3.7.7.1 Modified Lease Is a Sales-Type or Direct Financing Lease
ASC 842-10
25-17 If a sales-type lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .
- If the modified lease is classified as a sales-type or a direct financing lease, in the same manner as described in paragraph 842-10-25-16(a) . . . .
25-16 . . .
- [T]he lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification. . . .
35-6 A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8.
Upon concluding that a lease modification has occurred and that the modification is not accounted for as a separate contract (see Section 9.3.4), the lessor should adjust the discount rate so that the present value of the lease payments equals the carrying value of the net investment in the lease as of the effective date. In performing this calculation, the lessor should remeasure the lease payments as necessary. For example, if the lease payments included an amount that was a variable payment based on an index or rate, the lessor would reset the amount that it previously used in its calculation. Effectively, no additional selling profit would be recognized as a result of the modification; however, the amount of interest income that is recognized prospectively could change (because of the change in the discount rate). Note that a negative discount rate cannot be used and that a lessor should consider whether its net investment in the lease is impaired.
Connecting the Dots
Modification From Fixed Lease Payments to Variable Lease Payments
Lessors may need to consider circumstances in which lease payments are modified
so that they become variable (after being previously fixed). In such circumstances, the
lessor may need to consider whether the lease classification would be modified to that of
an operating lease in accordance with the guidance in ASU 2021-05. We encourage lessors to
consult with their auditors and accounting advisers on this topic.
9.3.7.7.2 Modified Lease Is an Operating Lease
ASC 842-10
25-17 If a sales-type lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .
b. If the modified lease is classified as an operating lease, in the same manner as described in paragraph
842-10-25-16(c).
25-16 . . .
c. If the modified lease is classified as an operating lease, the carrying amount of the underlying asset
equals the net investment in the original lease immediately before the effective date of the modification.
As noted in ASC 842-10-25-16, if a sales-type lease is modified in such a way that the lease is classified
as an operating lease, ”the carrying amount of the underlying asset equals the net investment in the
original lease immediately before the effective date of the modification.” The subsequent measurement
of the underlying asset should be accounted for in accordance with ASC 360, and the balance should be
classified in the appropriate category of assets.
9.3.7.8 Lease Termination
ASC 842-30
40-2 If a sales-type lease or a direct financing lease is
terminated before the end of the lease term, a lessor shall do all of the following:
-
Measure the net investment in the lease for credit losses in accordance with Subtopic 326-20 on financial instruments measured at amortized cost and record any credit loss identified
-
Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset
-
Account for the underlying asset that was the subject of the lease in accordance with other Topics.
If a sales-type lease is terminated before the end of the lease term, the net investment in the lease must be tested for impairment and reclassified in the manner described above. The underlying asset must then be subsequently measured in accordance with ASC 360.
ASC 842-30
40-3 If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease as provided in paragraph 842-30-40-2 and shall classify and account for the new lease as a separate transaction.
40-4 For guidance on the acquisition of the residual value of an underlying asset by a third party, see paragraph 360-10-25-2.
9.3.7.9 End of Lease Term
ASC 842-30
35-5 At the end of the lease term, a lessor shall reclassify the net investment in the lease to the appropriate category of asset (for example, property, plant, and equipment) in accordance with other Topics, measured at the carrying amount of the net investment in the lease. The lessor shall account for the underlying asset that was the subject of a lease in accordance with other Topics.
At commencement, the net investment in the lease is recognized, including the expected residual value of the asset (on either a guaranteed or an unguaranteed basis), at the net investment’s then present value. At the end of the lease, the net investment in the lease should have been accreted to its estimated fair value as determined at lease commencement (i.e., no gains will be recognized as a result of the increase in the asset’s fair value); when this balance is removed, the asset recorded should reflect the balance of the net investment in the lease at the end of the lease.
9.3.7.10 Definition of the “Carrying Amount”
In the determination of the value at which a lessor should record a
previously leased asset upon the completion or termination of a sales-type lease, the
“carrying amount” of the asset is the carrying value of the lessor’s net investment in the
lease at the time of termination, including impairments, even though that amount may exceed
the depreciated cost of the asset that would have been recorded by the lessee.
9.3.8 Direct Financing Lease
In a direct financing lease, the lessee does not individually obtain control of the asset but the lessor does relinquish control. This would occur, for example, if (1) the present value of the lease payments and any residual value guarantee (which could be provided entirely by a third party or consist of a lessee guarantee coupled with a third-party guarantee) represents substantially all of the fair value of the underlying asset and (2) it is probable that the lessor will collect the lease payments and any amounts related to the residual value guarantee(s). In a direct financing lease (in a manner consistent with a sales-type lease), the lessor derecognizes the underlying asset and recognizes a net investment in the lease
(which consists of the lease receivable and unguaranteed residual asset). However, unlike the lessor in
a sales-type lease, the lessor in a direct financing lease defers profit and amortizes it as interest income
over the lease term. As a result, in a direct financing lease, there is no gain recognition in the income
statement upon lease commencement.
9.3.8.1 Recognition, Initial Measurement, and Subsequent Measurement
ASC 842-30
25-7 At the commencement date, a lessor shall recognize both of the following and derecognize the underlying
asset in accordance with paragraph 842-30-40-1:
- A net investment in the lease, measured in accordance with paragraph 842-30-30-2
- Selling loss arising from the lease, if applicable.
30-2 At the commencement date, for a direct financing lease, a lessor shall measure the net investment in the
lease to include the items in paragraph 842-30-30-1(a) through (b), reduced by the amount of any selling profit.
40-1 At the commencement date, a lessor shall derecognize the carrying amount of the underlying asset (if
previously recognized) unless the lease is a sales-type lease and collectibility of the lease payments is not
probable (see paragraph 842-30-25-3).
As noted in Section 9.2.2.1.2, for the classification criteria to be met for a direct financing lease, collection
of the lease payments and any residual value guarantee must be probable. In a sales-type lease,
however, collectibility is considered when the sale is evaluated for recognition, not during classification.
In a direct financing lease, the underlying asset is derecognized, and the net investment in the lease is
recognized, as of the commencement date. If the net investment in the lease is less than the carrying
value of the underlying asset, a selling loss should be immediately recognized. If the net investment
in the lease is greater than the carrying value, the difference (i.e., the selling profit) should be offset
against the net investment in the lease and there would therefore be no recognition in profit and loss. In
paragraph BC97 of ASU 2016-02, the FASB addresses why it would be inconsistent with the principle of
direct financing leases (i.e., financings) to recognize selling profit at commencement:
If a direct financing lease gives rise to selling profit (which the Board understands to be infrequent), a lessor
does not recognize the selling profit at lease commencement, reducing the lessor’s net investment in the lease.
A lessor then recognizes the profit over the lease term in such a manner so as to produce, when combined with
the interest income on the remainder of the net investment (that is, the lease receivable and the unguaranteed
residual asset), a constant periodic rate of return on the lease. A direct financing lessor recognizes selling profit
in this manner over the lease term because that accounting reflects that the lessor generally prices the lease
to achieve a reasonable return on its investment in the underlying asset and would not position itself to incur a
loss on disposition of the residual asset after the end of the lease.
ASC 842-30
25-8 Selling profit and initial direct costs (see paragraphs 842-10-30-9 through 30-10) are deferred at the
commencement date and included in the measurement of the net investment in the lease. The rate implicit
in the lease is defined in such a way that initial direct costs deferred in accordance with this paragraph are
included automatically in the net investment in the lease; there is no need to add them separately.
30-1 At the commencement date . . . a lessor shall measure the net investment in the lease to include both of the following:
- The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of:
- The lease payments (as described in paragraph 842-10-30-5) not yet received by the lessor
- The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor
- The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease.
30-2 At the commencement date, for a direct financing lease, a lessor shall measure the net investment in the lease to include the items in paragraph 842-30-30-1(a) through (b), reduced by the amount of any selling profit.
See Chapter 6 for more information on amounts included in and excluded from lease payments.
In a direct financing lease, any initial direct costs are included in the net investment in the lease (and therefore are deferred). Note that there is no need to add these amounts separately, since they are included in the rate implicit in the lease. In other words, when calculating the implicit rate in the lease, the lessor includes the outflow of initial direct costs in the initial cash outflow. Therefore, when the lessor recognizes the interest income over the term of the lease, the rate incorporates the recognition of initial direct costs.
ASC 842-30
25-9 After the commencement date, a lessor shall recognize all of the following:
- Interest income on the net investment in the lease, measured in accordance with paragraph 842-30-35-1(a)
- Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur . . . .
In a direct financing lease, interest income is earned over the lease term and is recognized during all
reporting periods, regardless of whether the payment is received at such times. Any profit (an excess
of the net investment in the lease over the carrying value of the underlying asset) is recognized through
interest income, since the lessor is not “selling” the asset (according to the classification tests) but is
providing financing to the lessee for its lease investment.
ASC 842-30
35-1 After the commencement date, a lessor shall measure the net investment in the lease by doing both of
the following:
- Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease.
- Reducing the carrying amount to reflect the lease payments collected during the period.
The commencement-date measurement considerations in ASC 842-30-35-1 that apply to sales-type
leases also apply to direct financing leases. See Section 9.3.7.1 for more information.
The scenario below, reprinted from Example 1 in ASC 842-30-55, illustrates the accounting for a direct
financing lease.
ASC 842-30
Case C — Lessor Accounting — Direct Financing Lease
55-31 Assume the same facts and circumstances as in Case A
(paragraphs 842-30-55-19 through 55-24), except that the $13,000 residual value
guarantee is provided by a third party, not by Lessee. Collectibility of the lease
payments and any amount necessary to satisfy the third-party residual value guarantee is
probable.
55-32 None of the criteria in paragraph 842-10-25-2 to be classified as a sales-type lease are met. In accordance with paragraph 842-10-25-4, the discount rate used to determine the present value of the lease payments (5.4839 percent) for purposes of assessing whether the lease is a sales-type lease under the criterion in paragraph 842-10-25-2(d) assumes that no initial direct costs will be capitalized because the fair value of the equipment is different from its carrying amount.
55-32A Rather, Lessor classifies the lease as a direct financing lease because the sum of the present value
of the lease payments and the present value of the residual value guaranteed by the third party amounts to
substantially all of the fair value of the equipment, and it is probable that Lessor will collect the lease payments
plus any amount necessary to satisfy the third-party residual value guarantee. The discount rate used to
determine the present value of the lease payments and the present value of the third-party residual value
guarantee for purposes of assessing whether the lease meets the criterion in paragraph 842-10-25-3(b)(1) to
be classified as a direct financing lease is the rate implicit in the lease of 4.646 percent, which includes the initial
direct costs of $2,000 that Lessor incurred.
55-33 At the commencement date, Lessor derecognizes the equipment and recognizes a net investment in the lease of $56,000, which is equal to the carrying amount of the underlying asset of $54,000 plus the initial direct costs of $2,000 that are included in the measurement of the net investment in the lease in accordance with paragraph 842-30-25-8 (that is, because the lease is classified as a direct financing lease). The net investment in the lease includes a lease receivable of $58,669 (the present value of the 6 annual lease payments of $9,500 and the third-party residual value guarantee of $13,000, discounted at the rate implicit in the lease of 4.646 percent), an unguaranteed residual asset of $5,331 (the present value of the difference between the estimated residual value of $20,000 and the third-party residual value guarantee of $13,000, discounted at 4.646 percent), and deferred selling profit of $8,000.
55-34 Lessor calculates the deferred selling profit of $8,000 in this Example as follows:
- The lease receivable ($58,669); minus
- The carrying amount of the equipment ($54,000), net of the unguaranteed residual asset ($5,331), which equals $48,669; minus
- The initial direct costs included in the measurement of the net investment in the lease ($2,000).
55-35 At the end of Year 1, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease of $4,624 (the beginning balance of the net investment in the lease of $56,000 × the discount rate that, at the commencement date, would have resulted in the sum of the lease receivable and the unguaranteed residual asset equaling $56,000, which is 8.258 percent), resulting in a balance in the net investment of the lease of $51,124.
55-36 Also at the end of Year 1, Lessor calculates, for disclosure purposes, the separate components of the net investment in the lease: the lease receivable, the unguaranteed residual asset, and the deferred selling profit. The lease receivable equals $51,895 (the beginning balance of the lease receivable of $58,669 – the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $2,726, which is $58,669 × 4.646%). The unguaranteed residual asset equals $5,578 (the beginning balance of the unguaranteed residual asset of $5,331 + the interest income on the unguaranteed residual asset during Year 1 of $247, which is $5,331 × 4.646%). The deferred selling profit equals $6,349 (the initial deferred selling profit of $8,000 – $1,651 recognized during Year 1 [the $1,651 is the difference between the interest income recognized on the net investment in the lease during Year 1 of $4,624 calculated in paragraph 842-30-55-35 and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 1]).
55-37 At the end of Year 2, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease (the beginning of Year 2 balance of the net investment in the lease of $51,124 × 8.258%, which is $4,222), resulting in a carrying amount of the net investment in the lease of $45,846.
55-38 Also at the end of Year 2, Lessor calculates the separate components of the net investment in the lease. The lease receivable equals $44,806 (the beginning of Year 2 balance of $51,895 – the annual lease payment received of $9,500 + the interest income earned on the lease receivable during Year 2 of $2,411, which is $51,895 × 4.646%). The unguaranteed residual asset equals $5,837 (the beginning of Year 2 balance of the unguaranteed residual asset of $5,578 + the interest income earned on the unguaranteed residual asset during Year 2 of $259, which is $5,578 × 4.646%). The deferred selling profit equals $4,797 (the beginning of Year 2 balance of deferred selling profit of $6,349 – $1,552 recognized during Year 2 [the $1,552 is the difference between the interest income recognized on the net investment in the lease during Year 2 of $4,222 and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 2]).
55-39 At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal
entries it would record.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $9,500/year beginning at the end of year 1.
- Residual value guarantee provided by a third party: $13,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Economic life of equipment: 9 years.
- Carrying amount: $54,000.
- Fair value: $62,000.
- Expected residual value at end of term: $20,000.
- No transfer of ownership and no purchase options.
- Lessor incurred $2,000 in initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by
a rate in such a way that the sum equals the fair value of the asset. Because the lessor must first assess
sales-type lease classification and the fair value of the underlying asset differs from its carrying amount,
the lessor initially does not include the initial direct costs in its calculation of the rate implicit in the lease.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. The remaining economic life of the equipment is nine years, and
the lease term is six years. Management concludes that this does not constitute a major
part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $47,482. As it is
required to do in performing the sales-type lease classification test, a lessor must
include the present value of the entire residual value guarantee provided by the lessee. Because no residual value guarantees were provided
by the lessee, the total present value is $47,482. Management concludes that the lease
payments do not constitute substantially all of the fair value of the asset
($62,000).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor would then use the criteria in ASC 842-10-25-3 to
determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $48,770,
and the lessee has not provided any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $13,000, and its present value is $9,899. The sum
of $48,770 and $9,899 is $58,669.
Management concludes that the lease payments and the residual value
guarantee provided by the third party constitute substantially all of the fair value of
the asset ($62,000).
Note that the discount rate used to determine the present value of
the lease payments and the residual values is 4.646 percent because, when determining
whether the lease is a direct financing lease, the lessor includes initial direct costs
in its determination of the rate implicit in the lease.
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because both of these criteria are met, the lease is a direct financing lease.
Step 4: Record the Commencement-Date Journal Entries
At lease commencement, the lessor must
derecognize the asset and record the net investment in the lease. The discount rate to be
applied should cause the unguaranteed residual asset and lease payments (which include the
guaranteed residual asset) to equal the fair value of the asset plus any initial direct
costs. In calculating the net investment in the lease, the lessor determines that the present
value of the lease payments not yet received is $48,770. The present value of the
unguaranteed and guaranteed residual assets the lessor expects to receive is $15,230. The
fair value of the underlying asset ($62,000) is $8,000 greater than the carrying value
($54,000); therefore, the net investment in the lease should be reduced by $8,000, since no
selling profit is immediately recognizable for a direct financing lease. The basis in the net
investment in the lease includes the initial direct costs paid. In other words, in the
calculation of the implicit rate in the lease, the outflow payment includes the $2,000 in
initial direct costs.
Using the amounts calculated above, the lessor
would record the following journal entry at lease commencement:
Step 5: Record the Activities Related to the Direct Financing Lease
In year 1, the lessee must pay the lessor
$9,500. The payment is related to the accretion on the residual asset, the recognition of a
portion of the deferred profit, interest income, and a payment toward the receivable balance.
The interest is the net investment in the lease multiplied by the rate, 8.258 percent, that
would have caused the sum of the lease receivable and the unguaranteed residual asset to
equal $56,000.
The cash payments should be recorded as follows
through year 6:
Step 6: Record the Return of the Underlying Asset to the Lessor
The ending net investment in the lease
represents the expected value of the underlying asset when it is returned by the lessee. The
entry to reflect the return of the underlying asset is depicted below.
9.3.8.2 Impairment
When it is not probable that the lease payments will be collected at commencement, it is not possible to classify a lease as a direct financing lease and, provided that the lease is not a sales-type lease, it will be considered an operating lease (see Section 9.2.2.1). In other words, the underlying asset would not be derecognized and would be subject to an impairment analysis under ASC 360.
Other impairment considerations related to direct financing leases are similar to those for sales-type leases. See Section 9.3.7.5 for more information.
9.3.8.3 Sale of Lease Receivable
The guidance on sales of lease receivables for direct financing leases is the same as that for sales-type
leases. See Section 9.3.7.6 for further details.
9.3.8.4 Lease Modification
The example below from the implementation guidance in ASC 842-10-55-201 through
55-203 illustrates the modification of a direct financing lease and applies to Cases A–C,
which are discussed in the sections below.
ASC 842-10
Example 22 — Modification of a Direct Financing Lease
55-201 Lessor enters into a six-year lease of a piece of new, nonspecialized equipment with a nine-year
economic life. The annual lease payments are $11,000, payable in arrears. The estimated residual value of the
equipment is $21,000, of which $15,000 is guaranteed by a third-party unrelated to Lessee or Lessor. The lease
does not contain an option for Lessee to purchase the equipment, and the title does not transfer to Lessee as
a consequence of the lease. The fair value of the equipment at lease commencement is $65,240, which is equal
to its cost (and carrying amount). Lessor incurs no initial direct costs in connection with the lease. The rate
implicit in the lease is 7.5 percent such that the present value of the lease payments is $51,632 and does not
amount to substantially all of the fair value of the equipment.
55-202 The Lessor concludes that the lease is not a sales-type lease because none of the criteria in paragraph
842-10-25-2 are met. However, the sum of the present value of the lease payments and the present value
of the residual value of the underlying asset guaranteed by the third-party guarantor is $61,352, which
is substantially all of the fair value of the equipment, and collectibility of the lease payments is probable.
Consequently, the lease is classified as a direct financing lease. Lessor recognizes the net investment in the
lease of $65,240 (which includes the lease receivable of $61,352 and the present value of the unguaranteed
residual value of $3,888 [the present value of the difference between the expected residual value of $21,000
and the guaranteed residual value of $15,000]) and derecognizes the equipment with a carrying amount of
$65,240.
55-203 At the end of Year 1, Lessor receives a lease payment of $11,000 from Lessee and recognizes interest
income of $4,893 ($65,240 × 7.5%). Therefore, the carrying amount of the net investment in the lease is
$59,133 ($65,240 + $4,893 – $11,000).
9.3.8.4.1 Modified Lease Is a Sales-Type Lease
ASC 842-10
25-16 If a direct financing lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .
b. If the modified lease is classified as a sales-type lease, the lessor shall account for the modified
lease in accordance with the guidance applicable to sales-type leases in Subtopic 842-30, with the
commencement date of the modified lease being the effective date of the modification. In calculating
the selling profit or selling loss on the lease, the fair value of the underlying asset is its fair value at the
effective date of the modification and its carrying amount is the carrying amount of the net investment
in the original lease immediately before the effective date of the modification. . . .
Upon concluding that a lease modification has occurred and that the modification is not accounted for as a separate contract (see Section 9.3.4), the lessor should apply the guidance applicable to a sales-type lease if the terms and conditions and facts and circumstances present as of the modification effective date indicate the lease is a sales-type lease. The commencement date of the sales-type lease is the effective date of the modification. The selling profit recognized is the difference between the fair value as of the modification date and the carrying value of the net investment in the original lease immediately before the effective date of the modification.
The scenario below, reprinted from Example 22 in ASC 842-10-55, illustrates the
modification from a direct financing lease to a sales-type lease.
ASC 842-10
Case B — Direct Financing Lease to Sales-Type Lease
55-206 At the end of Year 1, the lease term is extended for two
years. The lease payments remain $11,000 annually, paid in arrears, for the remainder
of the lease term. The estimated residual value is $6,500, of which none is guaranteed.
The rate implicit in the modified lease is 7.58 percent. At the effective date of the
modification, the remaining economic life of the equipment is 8 years, and the fair
value of the equipment is $62,000. Because the modified lease term is now for the major
part of the remaining economic life of the equipment, the modified lease is classified
as a sales-type lease.
55-207 On the effective date of the modification, Lessor recognizes a net investment in the sales-type lease of $62,000, which is equal to the fair value of the equipment at the effective date of the modification, and derecognizes the carrying amount of the net investment in the original direct financing lease of $59,133. The difference of $2,867 is the selling profit on the modified lease. After the effective date of the modification, Lessor accounts for the sales-type lease in the same manner as any other sales-type lease in accordance with Subtopic 842-30.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record. To account for the original lease before modification, see steps 1–5. To account for the lease after modification, see steps 6–9.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $11,000/year beginning at the end of year 1.
- Residual value guarantee provided by third party: $15,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Remaining economic life of equipment: 9 years.
- Carrying amount: $65,240.
- Fair value: $65,240.
- Expected residual value at end of term: $21,000.
- No transfer of ownership and no purchase options; the economic-life criterion is not met.
- Lessor incurred no initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a
rate in such a way that the sum equals the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. Management concludes that the lease term does not constitute a
major part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $51,632. As it is
required to do in performing the sales-type lease classification test, a lessor must
only include the present value of the entire residual value guarantee provided by the
lessee. The lessee does not provide any residual value guarantees. Management
concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($65,240).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor would then apply the criteria in ASC 842-10-25-3
to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $51,632;
the lessee has not provided any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $15,000, and its present value is $9,719. The sum
of $51,632 and $9,719 is $61,351.
Management concludes that the lease payments and the residual value
guarantee provided by the third party constitute substantially all of the fair value
of the asset ($65,240).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because both of these criteria are met, the lease is a direct financing lease.
Step 4: Record the Commencement-Date Journal Entries
At lease commencement, the lessor must derecognize the asset and record the net investment in the lease. The discount rate to be applied should cause the unguaranteed residual asset and lease payments (which include the guaranteed residual asset) to equal the fair value of the asset plus any initial direct costs. In calculating the net investment in the lease, the lessor identifies the present value of the lease payments not yet received as $51,632. The present value of the unguaranteed and guaranteed residual assets the lessor expects to receive is $13,608. The fair value of the underlying asset ($65,240) is equal to the carrying value ($65,240); therefore, the net investment in the lease does not need to be reduced by any amount since there is no implied selling profit to be deferred. The basis in the net investment in the lease should include the initial direct costs paid, but no amounts were paid in this example.
Using the amounts calculated above, the lessor
would record the following journal entry at lease commencement:
Step 5: Record the Premodification Activities Related to the Direct Financing Lease
In year 1, the lessee must pay the lessor
$11,000. The payment is related to the accretion on the residual asset, interest income, and
a payment toward the receivable balance. The interest is the net investment in the lease
multiplied by the rate (7.5 percent) that would cause the sum of the lease receivable and
the unguaranteed residual asset to equal $65,240. The following journal entry would be
recorded:
This results in a $59,133 balance in the net investment in the lease at the end of year 1.
Step 6: Gather the Facts Related to the Modification
- Lease term is extended for 2 years (total remaining lease term after modification is 7 years).
- Lease payments are the same, $11,000/year.
- Estimated residual value is $6,500, no guarantees provided.
- Remaining economic life of the equipment is 8 years.
- Fair value of the equipment is $62,000.
Step 7: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.
Step 8: Determine the Lease Classification
The lessor reevaluates the lease in accordance
with the criteria in ASC 842-10-25-2:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
Yes. Management concludes that the lease term constitutes a major
part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
Not assessed because the criterion in ASC 842-10- 25-2(c) is
already met.
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because the criterion in ASC 842-10-25-2(c) is now met, the lease is a sales-type lease.
Step 9: Record Journal Entries Related to the Modification
As of the effective date of the modification,
the lessor must derecognize the existing net investment in the lease of $59,133. The selling
profit will be recognized immediately and represents the difference between the fair value
of the underlying asset and the carrying value of the net investment in the lease
immediately before the modification. The following journal entry would be recorded:
9.3.8.4.2 Modified Lease Is a Direct Financing Lease
ASC 842-10
25-16 If a direct financing lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows:
- If the modified lease is classified as a direct financing lease, the lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification. . . .
The scenario below, reprinted from Example 22 in ASC 842-10-55 (see the facts
that apply to this scenario in Section
9.3.8.4), illustrates the modification of a direct financing lease to another
direct financing lease.
ASC 842-10
Case A — Direct Financing Lease to Direct Financing Lease
55-204 At the end of Year 1, the lease term is reduced by 1 year and the annual lease payment is reduced to
$10,000 for the remaining 4 years of the modified lease term. The estimated residual value of the equipment
at the end of the modified lease term is $33,000, of which $30,000 is guaranteed by the unrelated third party,
while the fair value of the equipment is $56,000. The remaining economic life of the equipment is 8 years, and
the present value of the remaining lease payments, discounted using the rate implicit in the modified lease of
8.857 percent, is $32,499. Lessor concludes that the modified lease is not a sales-type lease because none of
the criteria in paragraph 842-10-25-2 are met. However, the sum of the present value of the lease payments
and the present value of the residual value of the underlying asset guaranteed by the third-party guarantor,
discounted using the rate implicit in the modified lease of 8.857 percent, is $53,864, which is substantially all of
the fair value of the equipment, and collectibility of the lease payments is probable. As such, the modified lease
is classified as a direct financing lease.
55-205 In accounting for the modification in accordance with paragraph 842-10-25-16(a), Lessor carries
forward the balance of the net investment in the lease of $59,133 immediately before the effective date of
the modification as the opening balance of the net investment in the modified lease. To retain the same net
investment in the lease even while the lease payments, the lease term, and the estimated residual value have
all changed, Lessor adjusts the discount rate for the lease from the rate implicit in the modified lease of 8.857
percent to 6.95 percent. This discount rate is used to calculate interest income on the net investment in the
lease throughout the remaining term of the modified lease and will result, at the end of the modified lease
term, in a net investment balance that equals the estimated residual value of the underlying asset of $33,000.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record. To account for the original lease before modification, see steps 1–5. To account for the lease after modification, see steps 6–9.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $11,000/year beginning at the end of year 1.
- Residual value guarantee provided by third party: $15,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Carrying amount: $65,240.
- Remaining economic life of equipment: 9 years.
- Fair value: $65,240.
- Expected residual value at end of term: $21,000.
- No transfer of ownership and no purchase options; the economic-life criterion is not met.
- Lessor incurred no initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate so that the sum equals the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. Management concludes that the lease term does not constitute a
major part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $51,632. As it is
required to do in performing the sales-type lease classification test, a lessor must
only include the present value of the entire residual value guarantee provided by the
lessee. The lessee does not provide any residual value guarantees. Management
concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($65,240).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor would then apply the criteria in ASC 842-10-25-3
to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $51,632
(as shown above), and the lessee does not provide any residual value guarantees that
are not already reflected in the lease payments. The residual value guarantee provided
by the third party is $15,000, and its present value is
$9,719. The sum of $51,632 and $9,719 is $61,351.
Management concludes that the lease payments and the residual value
guarantee provided by the third party constitute substantially all of the fair value
of the asset ($65,240).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because both of these criteria are met, the lease is a direct financing lease.
Step 4: Record the Commencement-Date Journal Entries
At lease commencement, the lessor must
derecognize the asset and record the net investment in the lease. The discount rate to be
applied should cause the unguaranteed residual asset and lease payments (which include the
guaranteed residual asset) to equal the fair value of the asset plus any initial direct
costs. To calculate the net investment in the lease, the lessor identifies the present value
of the lease payments not yet received as $51,632. The present value of the unguaranteed and
guaranteed residual assets the lessor expects to receive is $13,608. The fair value of the
underlying asset ($65,240) is equal to the carrying value ($65,240) and the net investment
in the lease therefore does not need to be reduced by any amount since there is no implied
selling profit to be deferred. The basis in the net investment in the lease should include
the initial direct costs paid, but no amounts were paid in this example.
Using the amounts calculated above, the lessor
would record the following journal entry at lease commencement:
Step 5: Record the Premodification Activities Related to the Direct Financing Lease
In year 1, the lessee must pay the lessor
$11,000. The payment is related to the accretion on the residual asset, interest income, and
a payment toward the receivable balance. The interest is the net investment in the lease
multiplied by the rate (7.5 percent) that would have caused the sum of the lease receivable
and the unguaranteed residual asset to equal $65,240. The following journal entry would be
recorded:
This results in a balance in the net investment in the lease of $59,133 at the end of year 1.
Step 6: Gather the Facts Related to the Modification
- Lease term is reduced by 1 year.
- Remaining lease payments are reduced to $10,000/year.
- Estimated residual value is $33,000, of which $30,000 is guaranteed by an unrelated third party.
- Fair value of the equipment is $56,000.
- Remaining economic life of the equipment is 8 years.
Step 7: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate in such a way that the
sum equals the fair value of the asset.
Step 8: Determine the Lease Classification
The lessor reevaluates the lease in accordance
with the criteria in ASC 842-10-25-2:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. Management concludes that the lease term does not constitute a
major part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $32,499. As it is
required to do in performing the sales-type lease classification test, a lessor must
only include the present value of the entire residual value guarantee provided by the
lessee. The lessee does not provide any residual value guarantees. Management
concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($56,000).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor then applies the criteria in ASC 842-10-25-3 to
determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $32,499,
and the lessee has not provided any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $30,000, and its present value is $21,365.
The sum of $32,499 and $21,365 is $53,864. Management concludes
that the lease payments and the residual value guarantee provided by the third party
constitute substantially all of the fair value of the asset ($56,000).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because both of these criteria are met, the lease is a direct financing lease.
Step 9: Record Journal Entries Related to the Modification
As of the effective date of the modification,
the lessor should adjust the discount rate for the modified lease so that the initial net
investment in the modified lease equals the carrying amount of the net investment in the
original lease immediately before the effective date. Therefore, the lessor will carry
forward the balance of the net investment in the lease immediately before the modification,
which is $59,133. The discount rate will change from 8.857 percent to 6.95 percent. The
discount rate is used to calculate interest income on the net investment in the lease
throughout the remaining term of the modified lease and will result, at the end of the
modified term, in a net investment balance of $33,000 that is equal to the estimated
residual value of the underlying asset. No journal entries are necessary as of the
modification date.
The direct financing lease would be subsequently measured in accordance with the guidance described
in Section 9.3.8.
9.3.8.4.3 Modified Lease Is an Operating Lease
ASC 842-10
25-16 If a direct financing lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modified lease as follows: . . .
c. If the modified lease is classified as an operating lease, the carrying amount of the underlying asset
equals the net investment in the original lease immediately before the effective date of the modification.
Upon concluding that a lease modification has occurred and the modification is not accounted for as a
separate contract, the lessor should apply the guidance applicable to operating leases if the terms and
conditions and facts and circumstances present as of the modification effective date indicate that the
lease is an operating lease.
The scenario below, reprinted from Example 22 in ASC 842-10-55 (see the facts
that apply to this scenario in Section
9.3.8.4), illustrates the modification of a direct financing lease to an
operating lease.
ASC 842-10
Case C — Direct Financing Lease to Operating Lease
55-208 At the end of Year 1, the lease term is reduced by 2 years, and the lease payments are reduced to $9,000 per year for the remaining 3-year lease term. The estimated residual value is revised to $33,000, of which only $13,000 is guaranteed by an unrelated third party. The fair value of the equipment at the effective date of the modification is $56,000. The modified lease does not transfer the title of the equipment to Lessee or grant Lessee an option to purchase the equipment. The modified lease is classified as an operating lease because it does not meet any of the criteria to be classified as a sales-type lease or as a direct financing lease.
55-209 Therefore, at the effective date of the modification, Lessor derecognizes the net investment in the lease, which has a carrying amount of $59,133, and recognizes the equipment at that amount. Collectibility of the lease payments is probable; therefore, Lessor will recognize the $27,000 ($9,000 × 3 years) in lease payments on a straight-line basis over the 3-year modified lease term, as well as depreciation on the rerecognized equipment.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal entries it would record. To account for the original lease before modification, see steps 1–5. To account for the lease after modification, see steps 6–9.
Step 1: Gather the Facts
- Lease term: 6 years.
- Lease payments: $11,000/year beginning at the end of year 1.
- Residual value guarantee provided by third party: $15,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Carrying amount: $65,240.
- Remaining economic life of equipment: 9 years.
- Fair value: $65,240.
- Expected residual value at end of term: $21,000.
- No transfer of ownership and no purchase options; the economic-life criterion is not met.
- Lessor incurred no initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate so that the sum equals
the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. Management concludes that the lease term does not constitute a
major part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $51,632. As it is
required to do in performing the sales-type lease classification test, a lessor must
only include the present value of the entire residual value guarantee provided by the
lessee. The lessee does not provide any residual value guarantees.
Management concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($65,240).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor would then apply the criteria in ASC 842-10-25-3
to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $51,632,
and the lessee does not provide any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $15,000, and its present value is $9,719. The sum
of $51,632 and $9,719 is $61,351.
Management concludes that the lease payments and the residual value
guarantee provided by the third party constitute substantially all of the fair value
of the asset ($65,240).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because both of these criteria are met, the lease is a direct financing lease.
Step 4: Record the Commencement-Date Journal Entries
At lease commencement, the lessor must
derecognize the asset and record the net investment in the lease. The discount rate to be
applied should cause the unguaranteed residual asset and lease payments (which include the
guaranteed residual asset) to equal the fair value of the asset plus any initial direct
costs. To calculate the net investment in the lease, the lessor identifies the present value
of the lease payments not yet received as $51,632. The present value of the unguaranteed and
guaranteed residual asset the lessor expects to receive is $13,608. The fair value of the
underlying asset ($65,240) is equal to the carrying value ($65,240), and the net investment
in the lease therefore does not need to be reduced by any amount since there is no implied
selling profit to be deferred. The basis in the net investment in the lease should include
the initial direct costs paid, but no amounts were paid in this example.
Using the amounts calculated above, the lessor
would record the following journal entry at lease commencement:
Step 5: Record the Premodification Activities Related to the Direct Financing Lease
In year 1, the lessee must pay the lessor
$11,000. The payment is related to the accretion on the residual asset, interest income, and
a payment toward the receivable balance. The interest is the net investment in the lease
multiplied by the rate (7.5 percent) that would have caused the sum of the lease receivable
and the unguaranteed residual asset to equal $65,240. The following journal entry would be
recorded:
This results in a balance in the net investment in the lease of $59,133 at the end of year 1.
Step 6: Gather the Facts Related to the Modification
At the end of year 1:
- The lease term is reduced by 2 years.
- Lease payments are reduced to $9,000/year for the remaining 3 years.
- The estimated residual value is $33,000, of which $13,000 is guaranteed by an unrelated third party.
- The fair value of the equipment is $56,000.
Step 7: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate in such a way that the
sum equals the fair value of the asset.
Step 8: Determine the Lease Classification
The lessor reevaluates the lease in accordance
with the criteria in ASC 842-10-25-2:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. Management concludes that the lease term does not constitute a
major part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $25,580. In a manner
consistent with the requirements related to performing the sales-type lease
classification test, a lessor must only include the present value of the entire
residual value guarantee provided by the lessee. The lessee does not provide any
residual value guarantees.
Management concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($56,000).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor then applies the criteria in ASC 842-10-25-3 to
determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
No. The present value of the sum of the lease payments is $25,580,
and the lessee does not provide any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $13,000, and its present value is $11,984. The
sum of $25,580 and $11,984 is $37,564.
Management concludes that the lease payments and the residual value
guarantee provided by the third party do not constitute substantially all of the fair
value of the asset ($56,000).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because the lease does not meet both of these criteria, the lease is not a direct financing lease but is an operating lease.
Step 9: Record Journal Entries Related to the Modification
As of the effective date of the modification,
the lessor should derecognize the net investment in the lease and recognize the carrying
value of the equipment at the basis in the net investment in the lease. The following
journal entry would be recorded:
The operating lease would be subsequently accounted for in accordance with the guidance in Section
9.3.9.1; similarly, the asset would be subject to depreciation and impairment under ASC 360.
9.3.8.5 Lease Termination
ASC 842-30
40-2 If a . . . direct financing lease is terminated before the end of the lease term, a lessor shall do all of the
following:
- Measure the net investment in the lease for credit losses in accordance with Subtopic 326-20 on financial instruments measured at amortized cost and record any credit loss identified
- Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset
- Account for the underlying asset that was the subject of the lease in accordance with other Topics.
40-3 If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account
for the termination of the original lease as provided in paragraph 842-30-40-2 and shall classify and account for
the new lease as a separate transaction.
40-4 For guidance on the acquisition of the residual value of an underlying asset by a third party, see paragraph
360-10-25-2.
If a direct financing lease is terminated before the end of the lease term, the net investment in the
lease must be tested for impairment in the manner described above and any impairment loss must be
recognized. The underlying asset must then be appropriately reclassified and subsequently accounted
for in accordance with ASC 360.
9.3.8.6 End of Lease Term
The guidance on the end of the lease term is the same for direct financing
leases as it is for sales-type leases. See Section 9.3.7.9 for more information.
9.3.9 Operating Lease
With operating leases, the underlying asset remains on the lessor’s balance sheet and is depreciated consistently with other owned assets. Income from an operating lease is recognized on a straight-line basis unless another systematic and rational basis is more appropriate. Any initial direct costs (i.e., those that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained) are deferred and expensed over the lease term in a manner consistent with the way lease income is recognized.
9.3.9.1 Recognition, Initial Measurement, and Subsequent Measurement
ASC 842-30
25-10 At the commencement date, a lessor shall defer initial direct costs.
25-11 After the commencement date, a lessor shall recognize all of the following:
- The lease payments as income in profit or loss over the 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 use of the underlying asset, subject to paragraph 842-30-25-12
- Variable lease payments as income in profit or loss in the period in which the changes in facts and circumstances on which the variable lease payments are based occur
- Initial direct costs as an expense over the lease term on the same basis as lease income (as described in (a)).
55-17 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 income in accordance with paragraph 842-30-25-11(a) should not be affected by the extent to which the lessee uses the underlying asset.
As noted above, for operating leases, lessors must recognize “income in profit or loss over the 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 use of the underlying asset.”
Example 9-14
Assume that Company A leases a building to Company B for a 10-year period under an
operating lease. The first-year lease payment is $1 million, which increases by $100,000
per year for each subsequent year. Assume that all amounts are allocable to the lease
component. Collection of the lease payments is probable.
Company A should recognize lease revenue of $1.45 million per year (total receipts of
$14.5 million ÷ 10 years). In years 1–5, A should record the difference between the
rental income and rent collected each year as an asset. In years 6–10, the rent payments
collected in excess of the rental income recognized each year should be credited to the
asset.
The journal entry to record the initial lease payment would be as follows:
Connecting the Dots
Recognizing Rental Revenues on an Other Than
Straight-Line Basis
Upon the issuance of ASC 842, many believed that lessors should consider
the recognition pattern for uneven rents in an operating lease and potentially recognize
revenue on an other than straight-line basis if the uneven rents were designed to reflect
market conditions. That view was based principally on the language in paragraph BC327 of ASU
2016-02, which states, in part, that “a lessor is expected to recognize uneven fixed lease
payments on a straight-line basis when the payments are uneven for reasons other than to reflect or compensate for market rentals or market
conditions” (emphasis added). However, on the basis of discussions with the FASB staff, we
understand that paragraph BC327 was not intended to require or permit a lessor to deviate
from straight-line recognition, even when uneven rents are designed to reflect market
conditions. Accordingly, in a manner similar to their accounting under ASC 840, lessors will
continue to recognize rental income from operating leases 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 use of the underlying asset.
Lessor’s Sale or Assignment of Operating Lease
Payments
A lessor may enter into a transaction to sell or assign lease payments
due under an operating lease. The lessor’s sale or assignment of lease payments due under an
operating lease should be accounted for as a borrowing because a lessor’s economic interest
in an operating lease is not a receivable but a right to future revenues under an executory
contract. The presumption is that lessors have an obligation to provide services to earn the
lease revenues, even when such an obligation involves minimal effort. Therefore, proceeds
from such a sale or assignment should be accounted for as a borrowing.
Curtailment of the Lessee’s Right to Use the Underlying Asset
In certain situations, the lessee’s ability to derive its intended
economic benefits from the use of a leased asset may be significantly curtailed. For
example, during natural disasters or periods of civil unrest, a lessee leasing retail space
may be forced not to sell goods from the leased space for an extended period. In such
circumstances, as long as the lessee retains its right to use the underlying asset, the
lessor would still be fulfilling its obligation under the lease and should not suspend its
revenue recognition during the curtailment period on the basis of an estimate of a reduction
in the asset’s utility or in the economic benefits that the lessee derives from use of the
asset. However, in assessing the accounting implications of such situations, an entity must
perform a holistic analysis that takes into account, among other factors, the impact of any
(1) resulting changes to the terms and conditions of the original contract (see Section 9.3.4 for guidance on lease
modifications) and (2) rent concessions offered or negotiated (see the Connecting the Dots in Section 9.3.4).
9.3.9.2 Collectibility
ASC 842-30
25-12 If collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee (provided by the lessee or any other unrelated third party) is not probable at the commencement date, lease income shall be limited to the lesser of the income that would be recognized in accordance with paragraph 842-30-25-11(a) through (b) or the lease payments, including variable lease payments, that have been collected from the lessee.
25-13 If the assessment of collectibility changes after the commencement date, any difference between the lease income that would have been recognized in accordance with paragraph 842-30-25-11(a) through (b) and the lease payments, including variable lease payments, that have been collected from the lessee shall be recognized as a current-period adjustment to lease income.
25-14 See Example 1 (paragraphs 842-30-55-18 through 55-43) for an illustration of the requirements when collectibility is not probable.
The scenario below, reprinted from Example 1, Case D, in ASC 842-30-55,
illustrates the lessor’s accounting for an operating lease when collectibility is not
probable.
ASC 842-30
Example 1 — Lessor Accounting Example
Case D — Lessor Accounting — Collectibility Is Not Probable
55-40 Assume the same facts and circumstances as Case C (paragraphs 842-30-55-31 through 55-39), except that collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is not probable and the lease payments escalate every year over the lease term. Specifically, the lease payment due at the end of Year 1 is $7,000, and subsequent payments increase by $1,000 every year for the remainder of the lease term. Because it is not probable that Lessor will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party in accordance with paragraph 842-10-25-3, Lessor classifies the lease as an operating lease.
55-41 Lessor continues to measure the equipment in accordance with Topic 360 on property, plant, and equipment.
55-42 Because collectibility of the lease payments is not probable, Lessor recognizes lease income only when Lessee makes the lease payments, and in the amount of those lease payments. Therefore, Lessor only recognizes lease income of $7,000 at the point in time Lessee makes the end of Year 1 payment for that amount.
55-43 At the end of Year 2, Lessor concludes that collectibility of the remaining lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is probable; therefore, Lessor recognizes lease income of $12,000. The amount of $12,000 is the difference between lease income that would have been recognized through the end of Year 2 ($57,000 in total lease payments ÷ 6 years = $9,500 per year × 2 years = $19,000) and the $7,000 in lease income previously recognized. Collectibility of the remaining lease payments remains probable throughout the remainder of the lease term; therefore, Lessor continues to recognize lease income of $9,500 each year.
The lessor in the above scenario would perform the following steps and record
the following journal entries:
Step 1: Gather the Facts
-
Lease term: 6 years.
-
Lease payments: $7,000 at end of year 1, increasing by $1,000 every year for the remainder of the term.
-
Residual value guarantee provided by a third party: $13,000.
-
Collection of the lease payments and residual value guarantee as of commencement is not probable.
-
Economic life of equipment: 9 years.
-
Carrying amount: $54,000.
-
Fair value: $62,000.
-
Expected residual value at end of term: $20,000.
-
No transfer of ownership and no purchase options.
-
Lessor incurred $2,000 in initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived
or calculated. The expected cash flows should be discounted by a rate in such a way that the
sum equals the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease should be classified as a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
No. The remaining economic life of the equipment is nine years and
the lease term is six years. Management concludes that this does not constitute a major
part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
No. The present value of the lease payments is $47,219. As it is
required to do in performing the sales-type lease classification test, the lessor must
include the present value of the entire residual value guarantee provided by the lessee. Because the lessee did not provide any residual
value guarantees, the total present value is $47,219.
Management concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($62,000).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because none of the above criteria are
met, the lease is not a sales-type lease. The lessor would then evaluate the criteria in ASC
842-10-25-3(b) to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
Yes. The present value of the sum of the lease payments is $48,538,
and the lessee has not provided any residual value guarantees that are not already
reflected in the lease payments. The residual value guarantee provided by the third party is $13,000 and its present value is $10,050. The sum
of $48,538 and $10,050 is $58,588.
Management concludes that the lease payments and the residual value
guarantee provided by a third party constitute substantially all of the fair value of
the asset ($62,000).
Note that the discount rate used to determine the present value of
the lease payments and the residual values is 4.383 percent because, when determining
whether the lease is a direct financing lease, the lessor includes initial direct costs
in its determination of the rate implicit in the lease.
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
No.
|
Because collectibility is not probable, the lease is not a direct
financing lease and is an operating lease.
Step 4: Commencement-Date Entries
Because no assets are derecognized, there are no entries on the
commencement date.
Step 5: Year 1 Entry
Because collectibility is not probable,
the lessor recognizes lease income only when the lessee makes the lease payment and in the
amount of those lease payments.
Step 6: Year 2 Entry
At the end of year 2, the lessor concludes that collectibility of the
remaining lease payments and any amount necessary to satisfy the residual value guarantee
provided by the third party is probable; therefore, the lessor recognizes income of $12,000.
The calculation is as follows:
-
$57,000 in total lease payments ÷ 6 years = $9,500 per year; $9,500 × 2 = $19,000; recognized to date = $7,000.
-
$19,000 – $7,000 = $12,000, recognized in year 2.
Importantly, the lessor is not required or
permitted to reassess classification as a result of the change in the collectibility
assessment (i.e., for a direct financing lease to exist, collectibility must be probable at
commencement).
Step 7: Entries During the Remaining Lease Term
Because collectibility of the payments is probable throughout the
remaining lease term, the lessor continues to recognize $9,500 each year.
The lessor in the above scenario would
have recorded the following lease income (revenue) and straight-line operating lease
receivable over the life of the lease:
On the basis of the above guidance, the operating lease collectibility
model in ASC 842-30 indicates that a lessor must assess whether the collectibility of future
operating lease payments is probable. Under the ASC 842-30 collectibility model, an entity
continually evaluates whether it is probable that future operating lease payments will be
collected. This collection assessment is based on the individual lessee’s credit risk, as
opposed to potential disputed charges. When collectibility of lease payments17 is probable, the lessor will apply an accrual model; for example, it will recognize a
straight-line lease receivable to ensure ratable recognition of revenue over the lease term.
See Example 9-14, which
illustrates this concept. When collectibility is not probable, the lessor will limit lease
income to cash received, as described above in ASC 842-30-25-13.
Connecting the Dots
Collectibility Assessment of Disputed Charges
Questions have been raised regarding “disputed” charges and whether or
in what circumstances disputed amounts should be assessed for whether it is probable that
the lease payments will be collected. We believe that it would be appropriate for a lessor
to evaluate the “enforceable” lease payments first before assessing collectibility; this
evaluation should be performed in a manner consistent with ASC 606.18 That is, the lessor first evaluates its invoiced amounts to determine whether certain
payments may be subject to dispute with its customer (tenant). In circumstances in which it
is known or expected that all, or some portion, of an invoiced amount will be subject to a
future reduction in the amount expected to be collected for the right to use the lessor’s
asset, the lessor should consider any adjustment for these items in a manner similar to the
accounting for a price concession within the scope of the revenue standard (see Section 4.3.5 of Deloitte’s Roadmap
Revenue Recognition
for further discussion). Therefore, an evaluation of any future reduction in an invoiced
amount should be considered before the assessment in ASC 842-30-25-12 regarding the
probability of collection.
The lessor would generally not consider disputed amounts (e.g., a lessee
that disputes a variable charge for CAM) in its collectibility assessment under ASC 842
since such disputes would not represent “enforceable” rights in the contract. In a manner
consistent with ASC 606-10-25-1(e), the lessor would need to evaluate the disputes before
it assesses collectibility. The lessor would then evaluate the customer’s intention and
ability to pay promised consideration. As a result, in many cases, disputed amounts may not
be recognized as a receivable (i.e., there is no enforceable right to cash); this means
there is less revenue (lease income) because of the disputed amount.
9.3.9.2.1 Lessor’s Accounting for an Operating Lease When Collectibility Subsequently Becomes Not Probable
If a lessor determines that collectibility is probable at lease
commencement but subsequently is no longer probable (i.e., the assessment of probability
changes from favorable to unfavorable), the lessor should apply the guidance in ASC
842-30-25-12 and 25-13, as illustrated in Example 1, Case D, above.
Although the illustrative example above demonstrates a lessor’s accounting
for an operating lease when collectibility is not probable at lease
commencement and subsequently becomes probable, the same principle should be followed in
accounting for an operating lease for which the lessor determines that collectibility is
probable at lease commencement but subsequently is no longer probable. This is supported by
the guidance in ASC 842-30-25-13, which refers to changes in the collectibility
assessment after the commencement date. The lessor must apply this guidance regardless of the
direction of its change in conclusion about collectibility (i.e., it goes from probable to
not probable or not probable to probable).
To demonstrate this accounting, we have used the same facts and
circumstances as in Example 1, Case D, except that collectibility of the lease payments19 is probable at lease commencement (assume that the lease is still classified as an
operating lease). In year 1, the lessor will recognize straight-line lease income of $9,500
(i.e., $57,000 in total lease payments ÷ 6 years = $9,500 per year) and will record the cash
lease payment of $7,000, with the remaining amount recorded as an operating lease receivable
of $2,500 (i.e., $9,500 of lease income − $7,000 cash received).
The year 1 journal entry is as
follows:
If, at the end of year 2, the lessor concludes that collectibility of the
remaining lease payments is not probable, the lessor recognizes lease
income of $5,500 (i.e., the difference between the $8,000 of cash lease payments received in
year 2 and the $2,500 straight-line receivable balance recorded at the end of year 1). As
long as the lessor’s assessment of collectibility remains not probable for the entire lease
term, the lessor should record lease income equal to only the amount of cash payments
received on a cumulative basis from the lessee.
The lessor in this scenario would have
recorded the following lease income and straight-line operating lease receivable over the
life of the lease:
9.3.9.2.2 Assessing Impairment of Operating Lease Receivables
In June 2016, the FASB issued ASU 2016-13 (codified as ASC 326), which adds to U.S.
GAAP an impairment model — known as the current CECL model — that is based on expected losses
rather than incurred losses. The ASU significantly change the accounting for credit
impairment.20
In November 2018, the FASB issued ASU 2018-19 to clarify certain aspects of ASU
2016-13, including that operating lease receivables are not within the scope of ASC 326-20.
Instead, an entity would need to apply other U.S. GAAP to account for changes in the
collectibility assessment for operating leases.
Although ASU 2018-19 amended only ASC 326, which became effective on January 1,
2020, for calendar-year PBEs and January 1, 2023, for calendar-year non-PBEs, we believe that
the Board’s clarification that operating lease receivables are within the scope of other
guidance, namely ASC 842, rather than ASC 326 may result in a change in how some lessors
account for the collectibility of operating lease receivables upon the adoption of ASC 842.
We understand that there is currently diversity in practice in how some lessors account for
credit losses related to operating lease receivables under ASC 840. Specifically, under
current practice, certain lessors account for the collectibility of operating lease
receivables in a manner consistent with the way they account for the collectibility of trade
receivables (i.e., recognize an allowance for uncollectible accounts and a corresponding
bad-debt expense), whereas other lessors account for these credit losses as an adjustment to
the related lease income. However, ASC 842 requires all lessors to apply the collectibility
guidance discussed above (i.e., no receivable should be recorded when collection of the
remaining lease payments is not probable).
9.3.9.2.3 Recognition of a General Allowance for Operating Lease Receivables
Certain lessors recognize a general allowance for credit losses (on a
collective or pooled basis) and corresponding bad-debt expense for billed and straight-line
operating lease receivables on the basis of the guidance in ASC 450-20 when factors indicate
that some or all of the balance is no longer collectible. This guidance was amended by the
new CECL impairment model in ASC 326, and most financial assets subject to the guidance in
ASC 450-20 are subject to the guidance in ASC 326. In addition, as discussed above, ASC 842
requires lessors to evaluate the collectibility of individual operating leases in accordance
with ASC 842-30.
Therefore, questions have arisen about whether an entity can continue to
recognize a general allowance for credit losses (on a collective or pooled basis) and
corresponding bad-debt expense for operating lease receivables on the basis of the guidance
in ASC 450-20.
Two views have emerged regarding whether, after the adoption of ASC 326, a
lessor can continue to recognize a general allowance for operating lease receivables for
which collectibility is probable. After the adoption of ASC 842, a lessor must apply the
guidance in ASC 842-30, as discussed above, for any receivable when collectibility is not
probable. That is, any valuation reserve accounting method may be used only after an
assessment of whether the collection of future lease payments is deemed probable. Only if the
collection of the lease payments over the lease term is deemed probable would the incremental
approaches described below be appropriate. If collectibility is not deemed probable, the
guidance in ASC 842-30 should be applied and no lease income should be recognized before cash
collection.
On the basis of a technical inquiry with the FASB staff, we believe that
either of the following approaches is acceptable as an accounting policy choice. A lessor
should apply its accounting policy consistently and disclose its election.
-
View 1: Record an allowance for operating lease receivables — In the Background Information and Basis for Conclusions of ASU 2018-19, the FASB explains that ASC 326-20 was not intended to change historical lessor accounting for operating leases:BC13. The Board noted that the guidance in Topic 842 provides an operational model for determining the collectibility of lease payments that is well understood by lessors. The Board did not intend to change lessor accounting for operating leases when it issued Update 2016-13. Therefore, the amendments in this Update clarify that receivables resulting from operating leases accounted for by lessors under Topic 842 are not within the scope of Subtopic 326-20. [Emphasis added]Therefore, although the amendments in ASU 2018-09 clarify that operating lease receivables are outside the scope of ASC 326-20, it continues to be acceptable for a lessor to apply other U.S. GAAP to ensure that receivables for operating leases for which collectibility of lease payments is probable are not overstated when the lessor does not expect to collect 100 percent of its outstanding receivables.Under this view, in a manner consistent with the current practice described above, a lessor would recognize an allowance for credit losses for operating lease receivables in accordance with ASC 450-20. This would generally be calculated on the total portfolio of operating lease receivables for which collectibility is probable. The example below demonstrates the recording of an allowance for operating lease receivables.Example 9-15Lessor X enters into three leases that are each classified as operating leases for which collectibility of future lease payments21 at commencement is probable. For each lease, the term is six years, the lease payment due at the end of year 1 is $7,000, and subsequent payments increase by $1,000 every year for the remainder of the lease term. Lessor X will record the lease payments on a straight-line basis to lease income over the life of the lease and establish a corresponding straight-line operating lease receivable.Further, X continues to consider whether the operating lease receivables, at a portfolio level, are appropriately valued by using principles that are consistent with those applied under ASC 450-20 (because ASC 326 does not apply) to ensure that its receivables and its income are not overstated. Lessor X has established a policy (on the basis of historical evidence and expectations of future collections) that creates an allowance for 10 percent of all operating lease receivables at the end of each reporting period, recorded as a contra asset. The offset of the 10 percent allowance is recorded to the income statement. (See Section 9.3.9.2.4 for a discussion regarding presentation in the income statement.)Lessor X would have recorded the following lease income, straight-line operating lease receivable, allowance for the operating lease receivable, and corresponding income statement impact22 over the life of the lease (only the first three years of X’s entries are shown):
-
View 2: No allowance for operating lease receivables — As stated above, ASU 2018-19 in other places suggests that ASC 842 may be the sole guidance to apply when an entity is considering the impairment of operating lease receivables after the adoption of ASC 326. Under this view, the Codification will no longer provide a basis for evaluating operating lease receivables under ASC 450-20.Therefore, on the basis of this interpretation of the amendments in ASU 2018-19, a lessor may elect not to record any allowance for operating lease receivables for which collection is deemed probable. Operating lease receivables should be adjusted, and will be taken against lease income, only when a lessor specifically identifies a lease for which collectibility becomes not probable. The lessor will apply the guidance in ASC 842-30-25-12 through 25-14 above to account for changes in collectibility assessments. Under this view, there is no incremental or supplemental general allowance, and no corresponding income statement impact (as illustrated in View 1) would be recorded.
Connecting the Dots
Complexities With General Allowances
Although a lessor can establish an accounting policy of recording an
allowance for operating lease receivables for leases for which collectibility is probable
(i.e., as in View 1 above), the lessor should understand that maintaining a general
allowance in addition to specifically identifying and accounting for leases for which
collectibility is not probable may involve more effort than would applying a policy to
adjust operating lease receivables only when collectibility is not probable (i.e., as in
View 2 above).
However, if the lessor applies only the ASC 842 collectibility guidance
(i.e., as in View 2 above) or establishes a general allowance through a reduction of lease
income as described in Section
9.3.9.2.4, it will create inconsistency with the accounting for revenue
receivables that are within the scope of ASC 606 and therefore within the scope of ASC 326.
Given this inconsistent treatment, if a lessor’s leases include nonlease components that
are not combined with the lease component under the lessor practical expedient, the lessor
will need to apply two separate subsequent-measurement accounting models for contract
receivables that contain lease and nonlease (revenue) components.
Additional questions have arisen regarding how an entity that has established an
accounting policy of recording an allowance for operating lease receivables through
bad-debt expense should account for changes in a collectibility assessment. Specifically,
questions have been asked about what accounting is required when a receivable whose
collectibility was originally deemed probable and was therefore included in the general
allowance subsequently has a collectibility that is not probable (i.e., accounting for the
write-off of the operating lease receivable).
We believe that multiple approaches may be acceptable. When determining the appropriate
accounting for changes in collectibility, lessors should consider their policies for
establishing the general allowance of operating leases for which collectibility is probable
and whether, for such an allowance, they contemplated the future write-off of an operating
lease receivable within the portfolio of leases. We encourage lessors to consult with their
auditors and accounting advisers on this topic.
9.3.9.2.4 Income Statement Classification of General Allowance for Operating Lease Receivables
An entity that establishes an accounting policy of recording a general
allowance for operating lease receivables (i.e., as in View 1 in Section 9.3.9.2.3) can record the allowance
through either a reduction to lease income (revenue) or through bad-debt expense.
-
Reduction of lease income — This approach is based on the model established in ASC 842-30 and discussed above. Although the reduction-of-lease-income model in ASC 842-30 is specific to leases for which collectibility is not probable, an entity can apply this same approach and establish an allowance against lease income for expected, but not yet specifically identified, credit issues in the portfolio of leases.
-
Bad-debt expense — As outlined in View 1 in Section 9.3.9.2.3, in many respects the FASB did not intend to change lessor accounting for operating leases when it issued ASC 326. Under legacy U.S. GAAP, general allowances for operating lease receivables were usually established through bad-debt expense. Therefore, it would be appropriate for an entity to continue using the same approach after the adoption of ASC 842 to be consistent with the FASB’s statement that entities should continue current practice when recording the general allowance.
Connecting the Dots
Disclosure
On the basis of our discussions with the FASB staff, we understand that
the SEC staff is aware of the potential diversity that will exist in practice in this area
and has noted that entities should ensure that they apply a consistent policy and provide
transparent disclosures regarding this policy. Disclosure of such an accounting policy is
consistent with the guidance in ASC 842-30-50-1, which states, in part, that “[t]he
objective of the disclosure requirements is to enable users of financial statements to
assess the amount, timing, and uncertainty of cash flows arising
from leases” (emphasis added).
No Near-Term Changes
ASU 2018-19 clarifies that operating lease receivables are not within
the scope of ASC 326. Although stakeholders have expressed opposing views on the
appropriateness of this scope clarification, only future standard setting would change the
existing accounting. That is, the collectibility of an operating lease receivable is
assessed on the basis of the guidance in ASC 842 and not that in ASC 326. Although the FASB
is conducting its postimplementation review of the new leasing standard more broadly, this
topic is currently not on its technical agenda. However, our views on the inclusion of
operating lease receivables within the scope of ASC 326 are expressed in our September 19,
2018, comment letter in response to the FASB's ED that was finalized in ASU 2018-19.
9.3.9.3 Accounting for the Underlying Asset
ASC 842-30
30-4 A lessor shall continue to measure the underlying asset subject to an operating lease in accordance with
other Topics.
35-6 A lessor shall continue to measure, including testing for impairment in accordance with Section 360-10-35
on impairment or disposal of long-lived assets, the underlying asset subject to an operating lease in accordance
with other Topics.
Because the underlying asset is not derecognized in operating leases, it should be tested for impairment
in accordance with ASC 360. The underlying asset should also be subsequently measured under ASC 360
(e.g., depreciation).
9.3.9.4 Sale of Future Operating Lease Payments
If a lessor obtains proceeds from the sale of future operating lease payments that do not
meet the definition of a receivable, the sale would be accounted for in a manner similar to a
transaction in which proceeds are received from the sale of future revenues under ASC 470,
when the seller has significant continuing involvement in the generation of the revenues, and
the proceeds from such a sale should be accounted for as debt (see Section 7.2.3.3 of Deloitte’s Roadmap Issuer’s
Accounting for Debt for more information).
9.3.9.5 Lease Modification
9.3.9.5.1 Modified Lease Is a Sales-Type Lease
ASC 842-10
25-15 If an operating lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8, the lessor shall account for the modification as if it were a termination of the existing lease and the creation of a new lease that commences on the effective date of the modification as follows: . . .
b. If the modified lease is classified as a direct financing lease or a sales-type lease, the lessor shall derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or selling loss accordingly.
As indicated above, when “an operating lease is modified and the modification is
not accounted for as a separate contract,” the lessor should apply the guidance applicable to
sales-type leases if the terms and conditions and facts and circumstances present as of the
modification’s effective date indicate that the lease is a sales-type lease. The commencement
date of the sales-type lease is the effective date of the modification.
The scenario below, reprinted from Example 21, Case A, in ASC 842-10-55,
illustrates the modification of an operating lease to a sales-type lease.
ASC 842-10
Example 21 — Modification of an Operating Lease That Changes Lease
Classification
Case A — Operating Lease to Sales-Type Lease
55-194 Lessor enters into a four-year lease of a piece of nonspecialized equipment. The annual lease payments are $81,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The estimated residual value of the equipment is $90,000, of which none is guaranteed. The remaining economic life of the equipment at lease commencement is seven years. The carrying amount of the equipment and its fair value are both $425,000 at the commencement date. The lease is not for a major part of the remaining economic life of the equipment, and the present value of the lease payments is not substantially all of the fair value of the equipment. Furthermore, title does not transfer to Lessee as a result of the lease, the lease does not contain an option for Lessee to purchase the underlying asset, and because the asset is nonspecialized, it is expected to have an alternative use to Lessor at the end of the lease term. Consequently, the lease is classified as an operating lease.
55-195 At the beginning of Year 3, Lessee and Lessor agree to extend the lease term by two years. That is, the modified lease is now a six-year lease, as compared with the original four-year lease. The additional two years were not an option when the original lease was negotiated. The modification alters the Lessee’s right to use the equipment; it does not grant Lessee an additional right of use. Therefore, Lessor does not account for the modification as a separate contract from the original four-year lease contract.
55-196 On the effective date of the modification, the fair value of the equipment is $346,250, and the remaining economic life of the equipment is 5 years. The estimated residual value of the equipment is $35,000, of which none is guaranteed. The modified lease is for a major part of the remaining economic life of the equipment at the effective date of the modification (four years out of the five-year-remaining economic life of the equipment). Consequently, the modified lease is classified as a sales-type lease.
55-197 In accounting for the modification, Lessor determines the discount rate for the modified lease (that is,
the rate implicit in the modified lease) to be 7.6 percent. Lessor recognizes the net investment in the modified
lease of $346,250 and derecognizes both the accrued rent and the equipment at the effective date of the
modification. Lessor also recognizes, in accordance with paragraph 842-10-25-15(b), selling profit of $34,169
($320,139 lease receivable – $8,510 accrued rent balance – the $277,460 carrying amount of the equipment
derecognized, net of the unguaranteed residual asset [$277,460 = $303,571 – $26,111]). After the effective
date of the modification, Lessor accounts for the modified lease in the same manner as any other sales-type
lease in accordance with Subtopic 842-30.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal
entries it would record. To account for the original lease before modification, see steps 1–5. To account
for the lease after modification, see steps 6–9.
Step 1: Gather the Facts
- Lease term: 4 years.
- Lease payments: $81,000 in first year, increasing by 5 percent each year thereafter.
- Expected residual value of the equipment: $90,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Remaining economic life of equipment is 7 years.
- Carrying amount: $425,000.
- Fair value: $425,000.
- No transfer of ownership and no purchase options; lease term not for major part of economic life.
- Lessor incurred no initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate in such a way that the
sum equals the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor would apply the criteria in ASC
842-10-25-2 to determine whether the lease is a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the equipment to the lessee by the end of the lease term? | No. |
ASC 842-10-25-2(b) — Does the lease contain a purchase option that the lessee is reasonably certain to exercise? | No. |
ASC 842-10-25-2(c) — Does the lease term represent a major part of the remaining economic life of the underlying asset? | No. The remaining economic life of the equipment is seven years and the lease term is four years. Management concludes that this does not constitute a major part of the economic life of the asset. |
ASC 842-10-25-2(d) — Does the present value of the sum of the lease payments and any residual value guaranteed by the lessee equal or exceed substantially all of the fair value of the underlying asset? | No. The present value of the lease payments is $339,038. As it is required to do in performing the sales-type lease classification test, a lessor must include the present value of the entire residual value guarantee provided by the lessee. The lessee does not provide any residual value guarantees.
Management concludes that the lease payments do not constitute substantially all of the fair value of the asset ($425,000). |
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it is expected to have no alternative use to the lessor at the end of the lease? | No, the underlying asset is not specialized. |
Because none of the above criteria are met, the
lease is not a sales-type lease. The lessor would then apply the criteria in ASC
842-10-25-3(b) to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the
lease payments and a residual value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying asset?
|
No. The present value of the sum of the lease payments is $339,038,
and the lessee does not provide any residual value guarantees that are not already
reflected in the lease payments. There are no residual value guarantees provided by
third parties.
Management concludes that the lease payments do not constitute
substantially all of the fair value of the asset ($425,000).
|
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect
the lease payments plus amounts necessary to satisfy a residual value guarantee?
|
Yes.
|
Because these two criteria are not met, the lease is not a direct financing lease and is an operating lease.
Step 4: Record the Commencement-Date Journal Entries
Because no assets are derecognized, there are no entries on the commencement date.
Step 5: Record Entries for Years 1 and 2
Because collectibility is probable, the lessor
recognizes lease payments on a straight-line basis. The sum of the lease payments (including
the 5 percent adjustment) is $349,120. The amount divided by the term of the lease (4 years)
is $87,280. The year 1 and year 2 entries are as follows:
Step 6: Gather the Facts for the Modification as of the Beginning of Year 3
- Lease term is extended by 2 years (and lease payments continue to increase by 5 percent each year).
- Fair value of equipment: $346,250.
- Remaining economic life: 5 years.
- Estimated residual value: $35,000.
- Accrued rent receivable balance: $8,510.
- Carrying value of asset is $303,571.
Step 7: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate in such a way that the
sum equals the fair value of the asset.
Step 8: Determine the Lease Classification
The lessor would reevaluate the lease to
determine whether the criteria in ASC 842-10-25-2 are met:
ASC 842-10-25-2(a) — Does the lease transfer ownership of the
equipment to the lessee by the end of the lease term?
|
No.
|
ASC 842-10-25-2(b) — Does the lease contain a purchase option that
the lessee is reasonably certain to exercise?
|
No.
|
ASC 842-10-25-2(c) — Does the lease term represent a major part of
the remaining economic life of the underlying asset?
|
Yes. Management concludes that the lease term constitutes a major
part of the economic life of the asset.
|
ASC 842-10-25-2(d) — Does the present value of the sum of the lease
payments and any residual value guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset?
|
Yes. The present value of the lease payments is $320,139.23 As it is required to do in performing the sales-type lease classification test,
the lessor must include the present value of the entire residual value guarantee
provided by the lessee. The lessee does not provide any residual value guarantees.
Management concludes that the lease payments constitute
substantially all of the fair value of the asset ($346,250).
|
ASC 842-10-25-2(e) — Is the underlying asset so specialized that it
is expected to have no alternative use to the lessor at the end of the lease?
|
No, the underlying asset is not specialized.
|
Because the criterion in ASC 842-10-25-2(c) or ASC 842-10-25-2(d) is met, the lease is a sales-type lease.
Step 9: Record Journal Entries Related to the Modification
As of the effective date of the modification,
the lessor must derecognize the existing net accrued rent receivable. The selling profit
will be recognized immediately and represents the difference between the fair value of the
underlying asset and the carrying value of the underlying asset immediately before the
modification, reduced by the accrued rent receivable balance.
9.3.9.5.2 Modified Lease Is a Direct Financing Lease
ASC 842-10
25-15 If an operating lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modification as if it were a termination
of the existing lease and the creation of a new lease that commences on the effective date of the modification
as follows: . . .
b. If the modified lease is classified as a direct financing lease or a sales-type lease, the lessor shall
derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or selling loss
accordingly.
The scenario below, reprinted from Example 21, Case B, in ASC 842-10-55,
illustrates the modification of an operating lease to a direct financing lease. In Case B,
the facts and circumstances are assumed to be the same as those for Case A in ASC
842-10-55-194 (see Section
9.3.9.5.1).
ASC 842-10
Example 21 — Modification of an Operating Lease That Changes Lease
Classification
Case B — Operating Lease to Direct Financing Lease
55-198 At the beginning of Year 3, Lessee and Lessor enter into a modification to extend the lease term by 1
year, and Lessee agrees to make lease payments of $108,000 per year for each of the remaining 3 years of the
modified lease. No other terms of the contract are modified. Concurrent with the execution of the modification,
Lessor obtains a residual value guarantee from an unrelated third party for $40,000. Consistent with Case
A (paragraphs 842-10-55-194 through 55-197), at the effective date of the modification the fair value of the
equipment is $346,250, the carrying amount of the equipment is $303,571, and Lessor’s accrued rent balance
is $8,510. The estimated residual value at the end of the modified lease term is $80,000. The discount rate for
the modified lease is 7.356 percent.
55-199 Lessor reassesses the lease classification as of the effective date of the modification and concludes that
the modified lease is a direct financing lease because none of the criteria in paragraph 842-10-25-2 and both
criteria in paragraph 842-10-25-3(b) are met.
55-200 Therefore, at the effective date of the modification, Lessor recognizes a net investment in the modified
lease of $312,081, which is the fair value of the equipment ($346,250) less the selling profit on the lease
($34,169 = $313,922 lease receivable – $8,510 accrued rent balance – the $271,243 carrying amount of the
equipment derecognized, net of the unguaranteed residual asset [$271,243 = $303,571 – $32,328]), which is
deferred as part of the net investment in the lease. After the effective date of the modification, Lessor accounts
for the modified lease in the same manner as any other direct financing lease in accordance with Subtopic
842-30.
Below is a summary of the steps the lessor in the above scenario would perform as well as the journal
entries it would record. To account for the original lease before modification, see steps 1–5. To account
for the lease after modification, see steps 6–9.
Step 1: Gather the Facts
- Lease term: 4 years.
- Lease payments: 81,000 in first year, increasing by 5 percent each year thereafter.
- Expected residual value of the equipment: $90,000.
- Collection of the lease payments and residual value guarantee as of commencement is probable.
- Remaining economic life of equipment: 7 years.
- Carrying amount: $425,000.
- Fair value: $425,000.
- No transfer of ownership and no purchase options, lease term not for major part of economic life.
- Lessor incurred no initial direct costs.
Step 2: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or calculated. The expected cash flows should be discounted by a rate such that the sum equals the fair value of the asset.
Step 3: Determine the Lease Classification
The lessor applies the criteria in ASC
842-10-25-2 to determine whether the lease is a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer
ownership of the equipment to the lessee by the end
of the lease term? | No. |
ASC 842-10-25-2(b) — Does the lease contain a
purchase option that the lessee is reasonably certain
to exercise? | No. |
ASC 842-10-25-2(c) — Does the lease term represent
a major part of the remaining economic life of the
underlying asset? | No. Management concludes that the lease term does
not constitute a major part of the economic life of the
asset. |
ASC 842-10-25-2(d) — Does the present value of the
sum of the lease payments and any residual value
guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset? | No. The present value of the lease payments is
$339,038. As it is required to do in performing the
sales-type lease classification test, the lessor must
include the present value of the entire residual value
guarantee provided by the lessee. The lessee does not
provide any residual value guarantees. Management concludes that the lease payments do not constitute substantially all
of the fair value of the asset ($425,000). |
ASC 842-10-25-2(e) — Is the underlying asset so
specialized that it is expected to have no alternative
use to the lessor at the end of the lease? | No, the underlying asset is not specialized. |
Because none of the criteria above are met, the
lease is not a sales-type lease. The lessor must then apply the criteria in ASC
842-10-25-3(b) to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value
of the sum of the lease payments and a residual
value guaranteed by a third party equal or exceed
substantially all of the fair value of the underlying
asset? | No. The present value of the sum of the lease
payments is $339,038, and the lessee does not provide
any residual value guarantees that are not already
reflected in the lease payments. There are no residual
value guarantees provided by third parties.
Management concludes that the lease payments do
not constitute substantially all of the fair value of the
asset ($425,000). |
ASC 842-10-25-3(b)(2) — Is it probable that the lessor
will collect the lease payments plus amounts necessary
to satisfy a residual value guarantee? | Yes. |
Because these two criteria are not met, the lease is not a direct financing lease and is an operating lease.
Step 4: Record the Commencement-Date Journal Entries
Because no assets are derecognized, there are no entries on the commencement date.
Step 5: Entries for Years 1 and 2
Because collectibility is probable, the lessor
recognizes lease payments on a straight-line basis. The sum of the lease payments (including
the 5 percent adjustment) is $349,120. The amount divided by the term of the lease (4 years)
is $87,280. The entries recorded for years 1 and 2 are as follows:
Step 6: Gather the Facts for the Modification as of the Beginning of Year 3
- Lease term is extended by 1 year.
- New lease payments: $108,000/year.
- Fair value of equipment: $346,250.
- Carrying amount: $303,571.
- Remaining economic life: 5 years.
- Residual value guarantee from third party: $40,000.
- Accrued rent receivable balance: $8,510.
- Estimated residual value: $80,000.
Step 7: Solve for the Rate Implicit in the Lease
The rate implicit in the lease is derived or
calculated. The expected cash flows should be discounted by a rate so that the sum equals
the fair value of the asset.
Step 8: Determine the Lease Classification
The lessor would reevaluate the lease to
determine whether it is a sales-type lease:
ASC 842-10-25-2(a) — Does the lease transfer
ownership of the equipment to the lessee by the end
of the lease term? | No. |
ASC 842-10-25-2(b) — Does the lease contain a
purchase option that the lessee is reasonably certain
to exercise? | No. |
ASC 842-10-25-2(c) — Does the lease term represent
a major part of the remaining economic life of the
underlying asset? | No. Management concludes that the lease term does
not constitute a major part of the economic life of the
asset. |
ASC 842-10-25-2(d) — Does the present value of the
sum of the lease payments and any residual value
guaranteed by the lessee equal or exceed substantially
all of the fair value of the underlying asset? | No. The present value of the lease payments is
$281,593. As it is required to do in performing the
sales-type lease classification test, the lessor must
only include the present value of the entire residual
value guarantee provided by the lessee. There are no
residual value guarantees provided by the lessee. |
ASC 842-10-25-2(e) — Is the underlying asset so
specialized that it is expected to have no alternative
use to the lessor at the end of the lease? | No, the underlying asset is not specialized. |
Because none of the above criteria are met, the lease is not a sales-type lease.
The lessor must then apply the criteria in ASC
842-10-25-3(b) to determine whether the lease is a direct financing lease:
ASC 842-10-25-3(b)(1) — Does the present value of the sum of the lease payments and a residual value guaranteed by a third party equal or exceed substantially all of the fair value of the underlying asset? | Yes. The present value of the sum of the lease payments is $281,593, and the
lessee has not provided any residual value guarantees that are not already reflected
in the lease payments. The present value of the residual value guarantee provided by
the third party ($40,000) is $32,328. The sum of the present values of the residual
value guarantees and the lease payments is $313,922.24 Management concludes that the lease payments constitute substantially all of the fair value of the asset ($346,250). |
ASC 842-10-25-3(b)(2) — Is it probable that the lessor will collect the lease payments plus amounts necessary to satisfy a residual value guarantee? | Yes. |
Because both criteria are met, the lease is a direct financing lease.
Step 9: Record Journal Entries Related to the Modification
As of the effective date of the modification,
the lessor must derecognize the existing net accrued rent receivable. The lessor must also
derecognize the asset and record the net investment in the lease.
The discount rate to be applied should cause the
unguaranteed residual asset, guaranteed residual asset, and lease payments to equal the fair
value of the asset plus any initial direct costs. In calculating the net investment in the
lease, the lessor identifies the present value of the lease payments not yet received as
$281,593. The present value of the unguaranteed and guaranteed residual assets the lessor
expects to receive is $64,657. The fair value of the underlying asset ($346,250) is $42,679
greater than the carrying value ($303,571); when adjusted for the accrued rent receivable
balance ($8,510), the net investment in the lease should be reduced by $34,169 since no
selling profit is immediately recognizable for a direct financing lease.
The direct financing lease is subsequently accounted for in accordance with the guidance described in
Section 9.3.8.
9.3.9.5.3 Modified Lease Is an Operating Lease
ASC 842-10
25-15 If an operating lease is modified and the modification is not accounted for as a separate contract in
accordance with paragraph 842-10-25-8, the lessor shall account for the modification as if it were a termination
of the existing lease and the creation of a new lease that commences on the effective date of the modification
as follows:
- If the modified lease is classified as an operating lease, the lessor shall consider any prepaid or accrued lease rentals relating to the original lease as a part of the lease payments for the modified lease. . . .
Example 20 — Modification of an Operating Lease That Does Not Change Lease
Classification
55-190 Lessor enters into a 10-year lease with Lessee for 10,000 square feet of office space. The annual lease
payments are $100,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The
lease term is not for a major part of the remaining economic life of the office space (40 years), and the present
value of the lease payments is not substantially all of the fair value of the office space. Furthermore, the title
does not transfer to Lessee as a consequence of the lease, the lease does not contain an option for Lessee to
purchase the office space, and the asset is not specialized such that it clearly has an alternative use to Lessor at
the end of the lease term. Consequently, the lease is classified as an operating lease.
55-191 At the beginning of Year 6, Lessee and Lessor agree to amend the original lease for the remaining 5
years to include an additional 10,000 square feet of office space in the same building for a total annual fixed
payment of $150,000. The increase in total consideration is at a discount both to the current market rate for
the new 10,000 square feet of office space and in the context of that particular contract. The modified lease
continues to be classified as an operating lease.
55-192 At the effective date of the modification (at the beginning of Year 6), Lessor has an accrued lease rental
asset of $76,331 (rental income recognized on a straight-line basis for the first 5 years of the lease of $628,895
[$1,257,789 ÷ 10 years = $125,779 per year] less lease payments for the first 5 years of $552,564 [that is,
$100,000 in Year 1, $105,000 in Year 2, $110,250 in Year 3, $115,763 in Year 4, and $121,551 in Year 5]).
55-193 Because the change in pricing of the lease is not commensurate with the standalone price for the
additional right-of-use asset, Lessor does not account for the modification as a new lease, separate from the
original 10-year lease. Instead, Lessor accounts for the modified lease prospectively from the effective date of
the modification, recognizing the lease payments to be made under the modified lease of $750,000 ($150,000
× 5 years), net of Lessor’s accrued rent asset of $76,331, on a straight-line basis over the remaining 5-year lease
term ($673,669 ÷ 5 years = $134,734 per year). At the end of the lease, Lessor will have recognized as lease
income the $1,302,564 in lease payments it receives from Lessee during the 10-year lease term.
ASC 842-10-25-15(a) states that if an operating lease is modified and the
modified lease is an operating lease, “the lessor shall consider any prepaid or accrued lease
rentals relating to the original lease as a part of the lease payments for the modified
lease.”
When a lessor has recorded an accrued rent receivable for scheduled rent
increases under an operating lease, the lessor subsequently renegotiates the terms of the
lease, and the modification results in an operating lease classification, the lessor should
continue to amortize the accrued rent receivable over the remaining lease term as a reduction
of future rental income.
Example 9-16
Assume that Lessor A leases a building to Lessee B for a 10-year
period under an operating lease. The first-year lease payment is $1 million and
increases by $100,000 per year for each subsequent year. Assume that the payments are
allocable only to a lease component. Because of the escalation in rent, A is
recognizing rental income on a straight-line basis and is recording the difference
between rental income and the rent collected in years 1–5 as an accrued rent
receivable.
At the end of year 5, A and B renegotiate the lease by fixing the
rent amount at $1.7 million per year and extending the lease term by two years. The
modification does not result in a change in lease classification. In this situation, A
should continue to amortize the existing accrued rent receivable balance as a reduction
of rental income on a straight-line basis over the remaining seven-year term of the new
lease.
9.3.9.6 Lease Termination
If an operating lease is terminated, a lessor should write off any related balance sheet amounts (e.g., accrued rent receivable, initial direct costs) and evaluate whether the useful lives of certain lessor-owned tenant improvements should be shortened or whether the balances should be written off.
9.3.10 Subleases
ASC 842-30
35-7 If the original lessee enters into a sublease or the original lease agreement is sold or transferred by the original lessee to a third party, the original lessor shall continue to account for the lease as it did before.
See Chapter 12 for more information on subleases.
Footnotes
3
On the basis of the technical inquiry, we believe that, if a lessor
does not analogize to the contract fulfillment guidance in ASC 340-40, it must elect to
expense the costs as incurred (i.e., the lessor may not analogize to another
capitalization model in another area of GAAP).
4
Although Section
8.6 is written from the perspective of a lessee, the concepts described also
apply to lessors.
5
See footnote
4.
6
See footnote 4.
7
Although written from the perspective of a lessor, the concepts
described in this Connecting the Dots also apply to lessees.
8
Since a change in the conditions of the contract has taken place that
results in a change in the scope of the lease, we believe that the conclusion that a lease
modification has taken place is appropriate regardless of whether a corresponding change
in the contract consideration has occurred.
9
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), (2) a portion of an asset (e.g., one of several leased floors in an
office building), or (3) a portion of time (e.g., the last year in a multiyear lease).
10
See footnote
4.
11
The definition of probable in this context is that “the future event or events are likely to occur” and is aligned with the definition in ASC 450 (formerly FASB Statement 5).
12
This is consistent with the amendments that ASU 2018-10 made to the definition of the term “rate
implicit in the lease” in the glossary of ASC 842. See Section 17.3.1.3 for further discussion of the
ASU.
13
Accordingly, the lease would meet the criterion in ASC
842-10-25-2(e) for classification as a sales-type lease.
14
The lessor determined the rate it used to price the lease by
discounting expected annual cash inflows of $20, plus a terminal cash inflow of
$50 for the expected residual value of the asset, to the asset’s fair value of
$120.
15
See footnote
14.
16
Although the beginning of Example B in ASC 842-30-55-25 states that
the reader should "[a]ssume the same facts and circumstances as in Case A,” the
FASB staff indicated to us that the economic life in Case B should be seven years and
not nine years as stipulated in Case A.
17
Throughout this Roadmap, references to the “collectibility of lease
payments” also should be read to include the collectibility of any residual value
guarantees in the contract.
18
We believe that the FASB supports this view in paragraph BC102 of ASU
2016-02.
19
For simplicity, in this example, it is assumed that there are no
residual value guarantees in the contract to consider for probability of collection.
20
ASC 326 includes both legacy impairment guidance moved from other
Codification sections and new credit loss guidance introduced by ASU 2016-13. In addition,
ASU 2016-13 amended some of the legacy guidance moved to ASC 326 from other Codification
sections. See Deloitte’s June 17, 2016, Heads Up for more information about the guidance in ASU 2016-13.
21
See footnote
19.
22
See Section 9.3.9.2.4 for
a discussion of the income statement classification.
23
The calculation of this amount is subject to rounding
differences.
24
The calculation of this amount is subject to rounding
differences.
9.4 Other Lessor Reporting Issues
9.4.1 Commitments to Guarantee Performance of Underlying Asset
ASC 842-10
55-33 A lessor should evaluate a commitment to guarantee performance of the underlying asset or to
effectively protect the lessee from obsolescence of the underlying asset in accordance with paragraphs
606-10-55-30 through 55-35 on warranties. If the lessor’s commitment is more extensive than a typical product
warranty, it might indicate that the commitment is providing a service to the lessee that should be accounted
for as a nonlease component of the contract.
For more information about commitments to guarantee performance of underlying
assets, see Deloitte’s Roadmap Revenue Recognition.
9.4.2 Sales of Equipment With Guaranteed Minimum Resale Amount
ASC 842-30
55-1 This implementation guidance addresses the application of the provisions of this Subtopic in the
following circumstances. A manufacturer sells equipment with an expected useful life of several years to end
users (purchasers) utilizing various sales incentive programs. Under one such sales incentive program, the
manufacturer contractually guarantees that the purchaser will receive a minimum resale amount at the time
the equipment is disposed of, contingent on certain requirements.
55-2 The manufacturer provides the guarantee by agreeing to do either of the following:
- Reacquire the equipment at a guaranteed price at specified time periods as a means to facilitate its resale
- Pay the purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the guaranteed minimum resale value.
There may be dealer involvement in these types of transactions, but the minimum resale guarantee is the
responsibility of the manufacturer.
55-3 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees
that it has either a right or an obligation to reacquire the equipment at a guaranteed price (or prices) at a
specified time (or specified time periods) as a means to facilitate its resale should be evaluated in accordance
with the guidance on satisfaction of performance obligations in paragraph 606-10-25-30 and the guidance on
repurchase agreements in paragraphs 606-10-55-66 through 55-78. If that evaluation results in a lease, the
manufacturer should account for the transaction as a lease using the principles of lease accounting in Subtopic
842-10 and in this Subtopic.
55-4 A sales incentive program in which an entity (for example, a manufacturer) contractually guarantees that it
will pay a purchaser for the deficiency, if any, between the sales proceeds received for the equipment and the
guaranteed minimum resale value should be accounted for in accordance with Topic 460 on guarantees and
Topic 606 on revenue from contracts with customers.
55-5 The lease payments used as part of the determination of whether the transaction should be classified
as an operating lease, a direct financing lease, or a sales-type lease generally will be the difference between
the proceeds upon the equipment’s initial transfer and the amount of the residual value guarantee to the
purchaser as of the first exercise date of the guarantee.
55-6 If the transaction qualifies as an operating lease, the net proceeds upon the equipment’s initial transfer
should be recorded as a liability in the manufacturer’s balance sheet.
55-7 The liability is then subsequently reduced on a pro rata basis over the period to the first exercise date of the guarantee to the amount of the guaranteed residual value at that date with corresponding credits to revenue in the manufacturer’s income statement. Any further reduction in the guaranteed residual value resulting from the purchaser’s decision to continue to use the equipment should be recognized in a similar manner.
55-8 The equipment should be included in the manufacturer’s balance sheet and depreciated following the manufacturer’s normal depreciation policy.
55-9 The Impairment or Disposal of Long-Lived Assets Subsections of Subtopic 360-10 on property, plant, and equipment provide guidance on the accounting for any potential impairment of the equipment.
55-10 At the time the purchaser elects to exercise the residual value guarantee by selling the equipment to another party, the liability should be reduced by the amount, if any, paid to the purchaser. The remaining undepreciated carrying amount of the equipment and any remaining liability should be removed from the balance sheet and included in the determination of income of the period of the equipment’s sale.
55-11 Alternatively, if the purchaser exercises the residual value guarantee by selling the equipment to the manufacturer at the guaranteed price, the liability should be reduced by the amount paid to the purchaser. Any remaining liability should be included in the determination of income of the period of the exercise of the guarantee.
55-12 The accounting for a guaranteed minimum resale value is not in the scope of Topic 815 on derivatives and hedging. In the transaction described, the embedded guarantee feature is not an embedded derivative instrument that must be accounted for separately from the lease because it does not meet the criterion in paragraph 815-15-25-1(c).
55-13 Specifically, if freestanding, the guarantee feature would be excluded from the scope of paragraph 815-10-15-59(b) because of both of the following conditions:
- It is not exchange traded.
- The underlying on which settlement is based is the price of a nonfinancial asset of one of the parties, and that asset is not readily convertible to cash. It is assumed that the equipment is not readily convertible to cash, as that phrase is used in Topic 815.
55-14 Paragraph 815-10-15-59(b)(2) states that the related exception applies only if the nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. (In some circumstances, the exclusion in paragraph 815-10-15-63 also would apply.)
55-15 Lastly, Topic 460 on guarantees does not affect the guarantor’s accounting for the guarantee because that Topic does not apply to a guarantee for which the underlying is related to an asset of the guarantor. Because the manufacturer continues to recognize the residual value of the equipment guaranteed by the manufacturer as an asset (included in the seller-lessor’s net investment in the lease) if recording a sales-type lease, that guarantee does not meet the characteristics in paragraph 460-10-15-4 and is, therefore, not subject to the guidance in Topic 460. Additionally, if the lease is classified as an operating lease, the manufacturer does not remove the asset from its books, and its guarantee would be a market value guarantee of its own asset. A market value guarantee of the guarantor’s own asset is not within the scope of Topic 460, and the guidance in paragraphs 842-10-55-32 through 55-33 for an operating lease is not affected. As a result, the guarantor’s accounting for the guarantee is unaffected by Topic 460.
In certain arrangements, a supplier may provide a minimum resale value guarantee on equipment sold
to a customer. The guarantee may be satisfied if the manufacturer either reacquires the equipment at
a guaranteed price or pays the customer an amount representing the difference between the proceeds
from selling the equipment and the amount of the guarantee. The supplier may need to consider the
guidance in ASC 606 regarding whether the obligation to reacquire the equipment precludes sale
accounting and whether, as a result of the guarantee, the arrangement would need to be accounted for
as a lease.
For more information about whether a supplier may be required to account for the
transaction as a lease because of a right or obligation (i.e., a call option or
a forward) to reacquire an asset, see Section 2.3.1.1 or Deloitte’s Roadmap
Revenue
Recognition.
9.4.3 Accounting for Tenant Improvements and Lease Incentives
ASC 842-10
55-30 Lease incentives include both of the following:
- Payments made to or on behalf of the lessee
- Losses incurred by the lessor as a result of assuming a lessee’s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee’s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease for use of the assumed underlying asset.
ASC 842 largely does not change the accounting for tenant improvements and lease
incentives. Lessor funding of lessee expenditures may be direct or indirect
(e.g., cash paid directly to the lessee or cash paid to third parties on behalf
of the lessee). The appropriate accounting for such lessor funding must be
determined on the basis of the substance of the arrangement. The determination
of whether amounts payable under the lease are a lease incentive should be made
on the basis of the contractual rights of the lessee and lessor as well as
considerations related to the specific asset.
Though superseded, the guidance in FASB Technical Bulletin 88-1 continues to be relevant to lease incentives by analogy. Paragraph 7 of Technical Bulletin 88-1
states, in part:
Payments made to or on behalf of the lessee represent
incentives that should be considered reductions of rental expense by the
lessee and reductions of rental revenue by the lessor over the term of
the new lease. Similarly, losses incurred by the lessor as a result of
assuming a lessee’s preexisting lease with a third party should be
considered an incentive by both the lessor and the lessee. Incentives
should be recognized on a straight-line basis over the term of the new
lease.
Further, in a February 7, 2005, letter to the Center for Public Company Audit Firms, the SEC chief accountant discussed the accounting for lease incentives as follows:
Landlord/Tenant Incentives — The staff believes that: (a) leasehold improvements made by a lessee that are funded by landlord incentives or allowances under an operating lease should be recorded by the lessee as leasehold improvement assets and amortized over a term consistent with the guidance in item 1 above; (b) the incentives should be recorded as deferred rent and amortized as reductions to lease expense over the lease term in accordance with paragraph 15 of SFAS 13 and the response to Question 2 of FASB Technical Bulletin 88-1 (“FTB 88-1”), Issues Relating to Accounting for Leases, and therefore, the staff believes it is inappropriate to net the deferred rent against the leasehold improvements; and (c) a registrant’s statement of cash flows should reflect cash received from the lessor that is accounted for as a lease incentive within operating activities and the acquisition of leasehold improvements for cash within investing activities. The staff recognizes that evaluating when improvements should be recorded as assets of the lessor or assets of the lessee may require significant judgment and factors in making that evaluation are not the subject of this letter.
ASC 842-10-55-30(b) is clear on the accounting for payments made by a landlord
to, or on behalf of, a tenant to fund items that would be an expense or
obligation of the tenant, such as moving expenses or assumption of the tenant’s
preexisting lease. However, when a landlord pays a tenant (or a third party) for
improvements, the accounting is more complicated. In some situations, such
payments may be lease incentives (e.g., leasehold improvements owned by the
lessee), which the landlord would account for as such and amortize as a
reduction of rental income over the lease term. In other situations, the
landlord may be acquiring tangible assets (e.g., tenant improvements) to lease
to the tenant, which the lessor would account for as its PP&E and depreciate
over their useful life.
If, after considering the contractual terms of the arrangement and determining
its substance, the landlord concludes that it is acquiring PP&E (e.g.,
tenant improvements) that is subject to a lease, it would be appropriate to
account for such payments to the tenant as the acquisition of PP&E. However,
notwithstanding the designation of the payment as a “tenant improvement
allowance” in the lease agreement, if it is determined that, in substance, the
landlord is not acquiring property, the landlord should account for such
payments as lease incentives. Many lease agreements contain general provisions
related to payments to fund such improvements. Such provisions may include
those:
-
Stating that the intent of the payment is to fund “tenant improvements.”
-
Indicating that title to all “tenant improvements” is transferred to the landlord as soon as the improvements are installed.
-
Requiring the tenant to provide proof of the release of mechanics liens before the payment is made.
-
Requiring the tenant to submit architectural drawings and construction plans to the landlord for approval before construction.
By themselves, these provisions are not necessarily indicative of the
arrangement’s substance and are not sufficient evidence that the landlord is
acquiring property from the tenant. For example, an agreement may specify that
the tenant intends to use the allowance to fund “tenant improvements” but (1)
may not require that the tenant provide the landlord with proof of spending for
such improvements or (2) may not otherwise provide for a mechanism under which
the landlord can monitor the tenant’s usage of the allowance. In such instances,
in the absence of other factors strongly indicating that landlord is acquiring
PP&E (see factors listed below), it generally should be presumed that the
payment to the tenant represents a lease incentive and not the acquisition of
PP&E.
In other instances, the lease arrangement may require proof of expenditures
related to improvements but give the tenant the right to retain or receive any
allowance amounts that are greater than actual improvement costs. In such
instances, in the absence of other factors strongly indicating that the landlord
is acquiring PP&E (see factors listed below), it generally should be
presumed that if a lease arrangement permits the tenant to retain this excess
allowance as either cash or as a reduction of rent, the substance of the
arrangement is that all or a portion of the allowance is a lease incentive and
not the acquisition of property. Similarly, if the tenant has discretion
regarding use of the funds received by the landlord (even if it is probable that
such funds will be used to construct tenant improvements), the arrangement may,
in substance, be the landlord’s provision of a lease incentive; in such an
arrangement, any improvements may be considered assets of the tenant for
accounting purposes.
If it is determined that, in substance, the improvements are assets of the
tenant, the landlord should treat the funding provided to the tenant as a lease
incentive in accordance with Technical Bulletin 88-1.
It is more difficult and subjective to determine the substance of a lease arrangement that does not
(1) allow the tenant to retain the excess of landlord funding over actual improvement costs, (2) give the
tenant discretion in how the allowance is spent, or (3) specifically identify the leased property as not
including the leasehold improvements.
Generally, the terms of a lease arrangement obligate the landlord to deliver the property subject to
the lease. However, the terms associated with the construction of related leasehold improvements
typically vary from arrangement to arrangement. In some circumstances, a landlord may appropriately
be considered owner of the leasehold improvements and therefore should not account for tenant
allowances as a lease incentive. Factors to consider include, but are not limited to, whether the:
- Lease agreement’s terms obligate the tenant to construct or install specifically identified assets (i.e., the leasehold improvements).
- 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).
- Tenant is permitted to alter or remove the leasehold improvements without the landlord’s consent or without compensating the landlord for any lost utility or diminution in fair value.
- 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.
- Landlord is obligated to fund cost overruns for the construction of leasehold improvements.
- Leasehold improvements are unique to the tenant or could reasonably be used by the lessor to lease to other parties.
- 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.
9.4.4 Accounting for Reimbursements of Repairs and Capital Improvements
Leases sometimes include provisions that require the lessor to perform routine
repairs and maintenance for the underlying asset or that permit the lessor to
make capital improvements to this asset (e.g., to replace the roof on a leased
building). The contract may also allow the lessor to collect reimbursements of
its costs for these activities from the lessee.
In determining how to account for lessee reimbursements of
lessor repairs and capital improvements, the lessor should first consider
whether its activities constitute a nonlease component of the contract. For
example, lessee reimbursements to the lessor for routine repairs to the roof of
the leased building may be part of a CAM nonlease component. See Section 4.3.1 for
detailed discussion of identifying nonlease components in a contract, including
CAMs. If the activity for which the lessor is being reimbursed represents a
nonlease component of the contract, the lessor should follow the steps outlined
in Section 4.4.2.2
by allocating the consideration in the contract to this nonlease component and
recognizing revenue in accordance with ASC 606 (or other applicable GAAP).
In other circumstances, a lessor is reimbursed for a capital
improvement that is not a nonlease component of the contract but part of the
existing lease component. For example, lessors may have lease contracts that
include provisions permitting them to charge their tenants for capital
improvements to the leased property. In these types of contracts, the capital
improvements are only made at the discretion of the lessor and the contract does
not require that the lessor make any such improvements. In many circumstances,
if the improvements are made by the lessor, the contract requires the lessee to
reimburse the lessor for these capital improvements on a straight-line basis
over the useful lives of such improvements; such reimbursements are made
proportionately with respect to the lessee’s remaining lease term. If the lessee
were to terminate the lease before the lease term expires, the lessor would have
the right to recover all rents under the lease, including any remaining
reimbursements. However, if the lessor terminates the lease early or the lease
term expires, the lessee would not have any obligation to continue reimbursing
the lessor.
Example 9-17
Lessee C enters into a 15-year lease of
a building from Lessor B. The contract gives B the right
to make capital improvements to the building and be
reimbursed by C in the manner described above.
Accordingly, at the end of year 5 of the lease, B spends
$200,000 to replace the roof of the building. Lessor B
concludes that the roof has a 20-year useful life, so it
bills C $10,000 ($200,000 cost ÷ 20-year useful life)
for reimbursement in each of the 10 years remaining in
the lease. Therefore, B will recover half of the total
cost of the roof from C by the end of the lease term.
Lessor B concludes that the roof replacement does not
constitute a nonlease component of the contract, since B
is not providing a separate good or service to C by
replacing the roof.
In the example above, provided that the lease is not modified as
a result of the capital improvement,25 B should recognize variable lease revenue for the improvement-related
reimbursements in the periods after the improvement is performed and as it
continues to provide C with the right to use the leased asset (including the new
roof), upon which reimbursement in future periods is contingent. Accordingly, B
should recognize $10,000 of variable lease revenue per year over the remaining
10 years of the lease.
Since B knows that it will have the right to recover a total of
$100,000 from C over the remaining lease term, some may argue that the condition
in ASC 842-30-25-11(b) to recognize variable lease income is met as soon as the
capital improvement is completed. However, we believe that it would be
inappropriate for B to recognize the full $100,000 of future reimbursements as
revenue when the improvement is completed because the amount is not earned at
that point in time. Rather, the reimbursements depend not only on the completion
of the new roof but also on the stipulation that B will continue to make the
underlying leased asset available for C’s use for the remaining lease term
(i.e., will continue to allow C to use the leased asset).
9.4.5 Accounting for Short Payments by Lessee
In some situations, a lessee may decide to make rent payments that are less than
the amount contractually owed under the lease contract (i.e., short payments).
In such cases, the lessee would be required to evaluate whether the terms and
conditions of the lease contract provide the lessee with an enforceable right to
make a payment less than the contractually stated amount (for example, force
majeure or other similar clauses that apply upon the occurrence of unforeseen
events or circumstances may allow the lessee to make short payments while the
situation persists). If so, the lessor would treat such short payments from the
lessee as variable lease payments (albeit negative variable lease payments). As
a result, the lessor would recognize the difference between the periodic lease
income determined at lease commencement and the revised payments from the lessee
due to short payments as variable lease revenue (albeit negative variable rent)
in the applicable period.
On the other hand, if the terms and conditions of the lease contract do not
provide the lessee with an enforceable right to make short payments, the lessor
should continue to account for the lease in accordance with its original terms,
unless the contract is modified to incorporate changes to lease payments (see
Section 9.3.4 for discussion of the
lessor’s lease modification accounting, and see Section 17.3.4 for more information about short payments related
to rent concessions resulting from COVID-19). However, short payments by the
lessee may be indicative of a change in the lessee’s credit risk, which makes it
no longer probable that the lessor will collect substantially all of the lease
payments to which it is entitled under the lease contract. (For a detailed
discussion of accounting implications associated with changes in a lessee’s
credit risk after lease commencement, see Section
9.3.7.4 for sales-type and direct financing leases and Section 9.3.9.2.1 for operating leases.)
Footnotes
25
See the Connecting the Dots in Section 9.3.4.1
for additional discussion of when a significant asset improvement may
qualify as a lease modification. If the lease is modified as a result of
the capital improvement, the reimbursements would similarly be accounted
for prospectively.
9.5 Leveraged Lease Accounting
9.5.1 History of and Accounting for Leveraged Leases
Under ASC 840, leveraged lease accounting was a special type of accounting that
a lessor applied to certain direct financing leases because of its unique economic effect
on the lessor. This unique economic effect stems from a combination of nonrecourse
financing and a cash flow pattern that typically enables the lessor to recover its
investment in the early years of the lease (as a result of tax benefits generated by
depreciation, interest, and ITC deductions) and, thereafter, affords it the temporary use
of funds from which additional income can be derived.
ASC 840-10-25-43(c) required that a lease be classified as a leveraged lease if
it had all of the following characteristics:
-
It met the criteria in ASC 840-10-25-43(b) to be classified as a direct financing lease.
-
At least three parties were involved (i.e., a long-term creditor in addition to the lessee and lessor).
-
“The financing that the long-term creditor provided was “nonrecourse as to the general credit of the lessor.”
-
The lessor’s net investment in the lease declined in the lease’s early years and rose in its later years.
The accounting for leveraged leases under ASC 840 was very complex but followed
two basic premises:
-
The lessor’s balance sheet reflected the lessor’s equity in the property on an after-tax basis, net of the related debt.
-
The lessor’s income statement reflected an after-tax constant rate of return on the lessor’s net investment. During those periods in which the net investment was zero or below zero, no income was recognized.
Bridging the GAAP
No Leveraged Lease Accounting Under IFRS
Accounting Standards
IFRS Accounting Standards do not address leveraged leases. Therefore, the
considerations in this section and the remainder of Section 9.5 do not apply to entities applying IFRS
Accounting Standards. See Appendix
B for a listing of the differences between ASC 842 and IFRS 16.
9.5.2 Impact of ASC 842 on Leveraged Lease Accounting
ASC 842-50 — Glossary
Leveraged Lease
From the perspective of a lessor, a lease that was classified as a leveraged
lease in accordance with the leases guidance in effect before the effective
date and for which the commencement date is before the effective date.
ASC 842-50
05-1 This Subtopic addresses accounting for leases that meet the definition of a leveraged lease.
ASC 842-10
65-1 . . .
z. For leases that were classified as leveraged leases in accordance
with Topic 840, and for which the commencement date is before the
effective date, a lessor shall apply the requirements in Subtopic 842-50.
If a leveraged lease is modified on or after the effective date, it shall
be accounted for as a new lease as of the effective date of the
modification in accordance with the guidance in Subtopics 842-10 and
842-30. . . .
Leases previously classified as leveraged leases under ASC 840 will be subject
to the guidance in ASC 842-50. The legacy accounting requirements are grandfathered in for
leases that were entered into and accounted for as leveraged leases before the effective
date of ASC 842. A leveraged lease modified on or after the effective date of ASC 842
would be accounted for as a new lease under the lessor model in ASC 842, which is
discussed throughout this chapter. Entities are not permitted to account for any new or
subsequently amended lease arrangements as leveraged leases after the effective date of
ASC 842.
Paragraph BC397 of ASU 2016-02 summarizes the FASB’s reasoning for eliminating leveraged lease
accounting for new leases under ASC 842 and grandfathering in the guidance for existing leveraged
leases in ASC 842-50:
The Board decided that the existing accounting model for leveraged leases should not be retained. That is, all
leases should be accounted for in a consistent manner and special rules should not exist for leases with certain
characteristics. One reason is because leveraged lease accounting provides net presentation and some Board
members do not agree with allowing a net presentation for only a subset of certain lease transactions. Another
reason is to limit some of the complexity in the lease accounting guidance by eliminating the unique accounting
for leveraged leases. As such, lessors should not distinguish leveraged leases from other leases in Topic 842.
This is consistent with the proposed requirements in the 2010 and 2013 Exposure Drafts. However, the Board
decided to grandfather existing leveraged leases during transition. Respondents to the 2013 Exposure Draft
noted that the transition of existing leveraged leases to the current lessor model would require particular
challenges when unwinding the income tax effects of the leveraged leases and income statement results on
transition that would not properly depict the economics of the transaction. The Board recognized that there
would be significant complexities relating to unwinding existing leveraged leases and that the outcome of
doing so would not be beneficial to users. Therefore, the Board decided to grandfather the accounting under
previous guidance for existing leveraged lease transactions.
ASC 842-50
15-1 This Subtopic addresses accounting for leases that meet the criteria in transition paragraph 842-10-65-1(z).
If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph 842-10-65-1(z)
that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a
lease modification as described in paragraph 842-10-65-1(z).
Pending Content (Transition Guidance: ASC 805-60-65-1)
15-1 This Subtopic addresses accounting for leases that
meet the criteria in transition paragraph 842-10-65-1(z). If a
lessee exercises an option to extend a lease that meets the
criteria in transition paragraph 842-10-65-1(z) that it was not
previously reasonably assured of exercising, the exercise of that
option shall be considered a lease modification as described in
paragraph 842-10-65-1(z). A joint venture formation accounted for
in accordance with Subtopic 805-60 shall apply the guidance in
this Subtopic applicable to the acquiring entity in a business
combination. The joint venture shall be viewed as analogous to the
acquiring entity in a business combination, and any recognized
businesses and/or assets shall be viewed as analogous to an
acquiree.
9.5.3 Impact of Exercising Renewal Options on Leveraged Leases
ASC 842-10-65-1(z) states that if a leveraged lease is modified after
the effective date of ASC 842, the lease would be accounted for as a new lease under ASC
842 and thus would no longer be classified as a leveraged lease. Questions have arisen
about whether a lessee’s exercise of a renewal option would constitute a lease
modification in accordance with the transition guidance related to leveraged leases in ASC
842-10-65-1(z). ASC 842-50-15-1 states, in part, “If a lessee exercises an option to
extend a lease that meets the criteria in transition paragraph 842-10-65-1(z) that it was not previously reasonably assured of exercising, the
exercise of that option shall be considered a lease modification as described in paragraph
842-10-65-1(z)” (emphasis added).
That is, to determine whether the exercise of a renewal option
represents a lease modification, a lessor should consider whether the exercised option was
previously contemplated and whether its exercise was deemed reasonably assured. In such
circumstances, the option period would have been included in the original lease
classification test and would have been reflected in the lessor’s net investment in the
lease. If the lessor previously determined that the lessee’s exercise of the renewal
option was reasonably assured, the actual exercise of the renewal option would not
represent a lease modification. Because the leveraged lease is not modified in this
scenario, the lessor would continue to account for the leveraged lease in accordance with
ASC 842-50 upon the lessee’s exercise of the renewal option.
If, on the other hand, the lessor did not previously consider the
exercise of the renewal option to be reasonably assured, the lessee’s exercise of the
renewal option would represent a lease modification in accordance with ASC 842-50-15-1. In
this case, upon the lessee’s exercise of the renewal option, the lessor would account for
the modification in accordance with ASC 842-10 and ASC 842-30 and would no longer apply
the guidance in ASC 842-50 on leveraged lease accounting.
9.5.4 Accounting for Existing Leveraged Leases Upon Adoption of ASC 842
As noted in Section
9.5.2, existing leveraged leases previously accounted for under ASC 840 will
be grandfathered in during the transition to ASC 842 and subsequently accounted for in
accordance with ASC 842-50. The guidance quoted in this section is being carried forward
from ASC 840.26
Recognition of Leveraged Leases | |
---|---|
Location of Guidance in ASC 840 | Location of Guidance in ASC 842 |
ASC 840-30-25-8 | ASC 842-50-25-1 |
ASC 840-30-25-9 | N/A — see explanation below |
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity | |
ASC 840-30-25-10 | ASC 842-50-25-2 |
ASC 842-50
General
25-1 A lessor shall record its investment in a leveraged lease. The net of the balances of the following accounts as measured in accordance with this Subtopic shall represent the lessor’s initial and continuing investment in leveraged leases:
- Rentals receivable
- Investment-tax-credit receivable
- Estimated residual value of the leased asset
- Unearned and deferred income.
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
25-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall retain the
classification of the acquired entity’s investment as a lessor in a leveraged lease at the date of the combination.
The net investment of the acquired leveraged lease shall be disaggregated into its component parts, namely
net rentals receivable, estimated residual value, and unearned income including discount to adjust other
components to present value.
As noted in the table above, the existing leveraged lease guidance in ASC
840-30-25-9 was not carried forward under ASC 842. ASC 840-30-25-9 stated the
following:
If the projected net cash receipts (that is, gross cash receipts
minus gross cash disbursements exclusive of the lessor’s initial investment) over the
term of the leveraged lease are less than the lessor’s initial investment, the
deficiency shall be recognized by the lessor as a loss at lease inception.
The reason that this guidance was not carried forward under ASC 842 is because
it addressed the recognition of a loss at lease inception for leases classified as
leveraged leases. Upon adoption of ASC 842, new leases (and modified leases) will not be
classified as leveraged leases. Therefore, this guidance is no longer relevant for lessors
upon adoption of ASC 842.
Initial Measurement of Leveraged Leases | |
---|---|
Location of Guidance in ASC 840 | Location of Guidance in ASC 842 |
ASC 840-30-30-14 | ASC 842-50-30-1 |
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity | |
ASC 840-30-30-15 | ASC 842-50-30-2 |
ASC 842-50
General
30-1 A lessor shall initially measure its investment in a leveraged lease net of the nonrecourse debt (as
discussed in paragraph 842-50-25-1). The net of the balances of the following accounts shall represent the
initial and continuing investment in leveraged leases:
- Rentals receivable, net of that portion of the rental applicable to principal and interest on the nonrecourse debt.
- A receivable for the amount of the investment tax credit to be realized on the transaction.
- The estimated residual value of the leased asset. The estimated residual value shall not exceed the amount estimated at lease inception except if the lease agreement includes a provision to escalate minimum lease payments either for increases in construction or acquisition cost of the leased property or for increases in some other measure of cost or value (such as general price levels) during the construction or preacquisition period. In that case, the effect of any increases that have occurred shall be considered in the determination of the estimated residual value of the underlying asset at lease inception.
- Unearned and deferred income consisting of both of the following:
-
The estimated pretax lease income (or loss), after deducting initial direct costs, remaining to be allocated to income over the lease term.
-
The investment tax credit remaining to be allocated to income over the lease term.
-
Leveraged Lease Acquired in a Business Combination or an Acquisition by a Not-for-Profit Entity
30-2 In a business combination or an acquisition by a not-for-profit entity, the acquiring entity shall assign an amount to the acquired net investment in the leveraged lease in accordance with the general guidance in Topic 805 on business combinations, based on the remaining future cash flows and giving appropriate recognition to the estimated future tax effects of those cash flows.
9.5.5 Tax Considerations Related to Leveraged Leases Acquired in a Business Combination
In a business combination, an acquired entity’s individual assets and
liabilities are generally assigned fair values before taxes are considered. In accordance
with ASC 842-50-30-2, in recording a leveraged lease acquired in a business combination,
the acquiring entity should use the remaining future cash flows while “giving appropriate
recognition to the estimated future tax effects of those cash flows.” Therefore, the fair
value assigned to an acquired leveraged lease is determined on an after-tax basis (i.e.,
net of tax), and deferred taxes should not be established for temporary differences
related to acquired leveraged leases as of the acquisition date.
See ASC 842-50-55-27 through 55-33 (reproduced later in this chapter)
for an example illustrating the accounting for a leveraged lease acquired in a business
combination.
Subsequent Measurement of Leveraged Leases
| |
---|---|
Location of Guidance in ASC 840
|
Location of Guidance in ASC 842
|
Leveraged Lease Acquired in a Business Combination or an
Acquisition by a Not-for-Profit Entity
| |
ASC 840-30-35-32
|
ASC 842-50-35-1
|
Income Recognition on a Leveraged Lease
| |
ASC 840-30-35-33 through 35-36
|
ASC 842-50-35-2 through 35-5
|
Changes in Assumptions
| |
ASC 840-30-35-38 through 35-47
|
ASC 842-50-35-6 through 35-15
|
Effect of Alternative Minimum Tax
| |
ASC 840-30-35-48 through 35-52
|
ASC 842-50-35-16 through 35-20
|
Transfer of Minimum Rental Payments
| |
ASC 840-30-35-53
|
ASC 842-50-35-21
|
ASC 842-50
General
Leveraged Lease Acquired in a Business Combination or an
Acquisition by a Not-for-Profit Entity
35-1 In a business combination or an
acquisition by a not-for-profit entity, the acquiring entity shall
subsequently account for its acquired investment as a lessor in a leveraged
lease in accordance with the guidance in this Subtopic as it would for any
other leveraged lease.
Income Recognition on a Leveraged
Lease
35-2 The investment in leveraged
leases minus deferred taxes arising from differences between pretax accounting
income and taxable income shall represent the lessor’s net investment in
leveraged leases for purposes of computing periodic net income from the
leveraged lease. Given the original investment and using the projected cash
receipts and disbursements over the term of the lease, the rate of return on
the net investment in the years in which it is positive shall be computed. The
rate is that rate that, when applied to the net investment in the years in
which the net investment is positive, will distribute the net income to those
years and is distinct from the interest rate implicit in the lease. In each
year, whether positive or not, the difference between the net cash flow and
the amount of income recognized, if any, shall serve to increase or reduce the
net investment balance. The use of the term years is not intended to preclude
application of the accounting prescribed in this paragraph to shorter
accounting periods.
35-3 The net income (or loss) that a
lessor recognizes on a leveraged lease shall be composed of the following
three elements:
-
Pretax lease income (or loss)
-
Investment tax credit
-
Tax effect of pretax lease income (or loss).
35-4 The pretax lease income (or
loss) and investment tax credit elements shall be allocated in proportionate
amounts from the unearned and deferred income included in the lessor’s net
investment (as described in paragraph 842-50-30-1(d)). The tax effect of the
pretax lease income (or loss) recognized shall be reflected in tax expense for
the year. The tax effect of the difference between pretax accounting income
(or loss) and taxable income (or loss) for the year shall be charged or
credited to deferred taxes.
35-5 If, at any time during the lease
term the application of the method prescribed in this Subtopic would result in
a loss being allocated to future years, that loss shall be recognized
immediately. This situation might arise in circumstances in which one of the
important assumptions affecting net income is revised (see paragraphs
842-50-35-6 through 35-15).
Changes in Assumptions
35-6 Any estimated residual value and
all other important assumptions affecting estimated total net income from the
leveraged lease shall be reviewed at least annually. The rate of return and
the allocation of income to positive investment years shall be recalculated
from lease inception following the method described in paragraphs 842-50-35-2
through 35-4 and using the revised assumption if, during the lease term, any
of the following conditions occur:
-
The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
-
The revision of another important assumption changes the estimated total net income from the lease.
-
The projected timing of the income tax cash flows is revised.
35-7 The lessor shall update all
assumptions used to calculate total and periodic income if the lessor is
performing a recalculation of the leveraged lease. That recalculation shall
include actual cash flows up to the date of the recalculation and projected
cash flows following the date of recalculation.
35-8 The accounts constituting the
net investment balance shall be adjusted to conform to the recalculated
balances, and the change in the net investment shall be recognized as a gain
or loss in the year in which the assumption is changed. The gain or loss shall
be recognized as follows:
-
The pretax gain or loss shall be included in income from continuing operations before income taxes in the same line item in which leveraged lease income is recognized.
-
The tax effect of the gain or loss shall be included in the income tax line item.
-
An upward adjustment of the estimated residual value (including any guaranteed portion) shall not be made.
35-9 The projected timing of income
tax cash flows generated by the leveraged lease is an important assumption and
shall be reviewed annually, or more frequently, if events or changes in
circumstances indicate that a change in timing has occurred or is projected to
occur. The income effect of a change in the income tax rate shall be
recognized in the first accounting period ending on or after the date on which
the legislation effecting a rate change becomes law.
35-10 A revision of the projected
timing of the income tax cash flows applies only to changes or projected
changes in the timing of income taxes that are directly related to the
leveraged lease transaction. For example, a change in timing or projected
timing of the tax benefits generated by a leveraged lease as a result of any
of the following circumstances would require a recalculation because that
change in timing is directly related to that lease:
-
An interpretation of the tax law
-
A change in the lessor’s assessment of the likelihood of prevailing in a challenge by the taxing authority
-
A change in the lessor’s expectations about settlement with the taxing authority.
35-11 In contrast, as discussed in
paragraph 842-50-35-20, a change in timing of income taxes solely as a result
of an alternative minimum tax credit or insufficient taxable income of the
lessor would not require a recalculation of a leveraged lease because that
change in timing is not directly related to that lease. A recalculation would
not be required unless there is an indication that the previous assumptions
about total after-tax net income from the leveraged lease were no longer
valid.
35-12 Tax positions shall be
reflected in the lessor’s initial calculation or subsequent recalculation on
the recognition, measurement, and derecognition criteria in paragraphs
740-10-25-6, 740-10-30-7, and 740-10-40-2. The determination of when a tax
position no longer meets those criteria is a matter of individual facts and
circumstances evaluated in light of all available evidence.
35-13 If the lessor expects to enter
into a settlement of a tax position relating to a leveraged lease with a
taxing authority, the cash flows following the date of recalculation shall
include projected cash flows between the date of the recalculation and the
date of any projected settlement and a projected settlement amount at the date
of the projected settlement.
35-14 The recalculation of income
from the leveraged lease shall not include interest or penalties in the cash
flows from the leveraged lease.
35-15 Advance payments and deposits
made with a taxing authority shall not be considered an actual cash flow of
the leveraged lease; rather, those payments and deposits shall be included in
the projected settlement amount.
Effect of Alternative Minimum Tax
35-16 An entity shall include
assumptions about the effect of the alternative minimum tax, considering its
consolidated tax position, in leveraged lease computations.
35-17 Any difference between
alternative minimum tax depreciation and the tax depreciation assumed in the
leveraged lease or between income recognition for financial reporting purposes
and alternative minimum tax income could, depending on the lessor’s overall
tax situation, result in alternative minimum tax or the utilization of
alternative minimum tax credits.
35-18 If alternative minimum tax is
paid or an alternative minimum tax credit is utilized, the total cash flows
from the leveraged lease could be changed and the lessor’s net investment in
the leveraged lease and income recognition would be affected.
35-19 If a change to the tax
assumptions changes total estimated after-tax net income, the rate of return
on the leveraged lease shall be recalculated from inception, the accounts
constituting the lessor’s net investment shall be adjusted, and a gain or loss
shall be recognized in the year in which the assumption is changed.
35-20 However, an entity whose tax
position frequently varies between alternative minimum tax and regular tax
shall not be required to recalculate the rate of return on the leveraged lease
each year unless there is an indication that the original assumptions
regarding total after-tax net income from the lease are no longer valid. In
that circumstance, the entity shall be required to revise the leveraged lease
computations in any period in which total net income from the leveraged lease
changes because of the effect of the alternative minimum tax on cash flows for
the lease.
Transfer of Minimum Rental Payments
35-21 If a lessor sells substantially
all of the minimum rental payments associated with a leveraged lease and
retains an interest in the residual value of the leased asset, the lessor
shall not recognize increases in the value of the lease residual to its
estimated value over the remaining lease term. The lessor shall report any
remaining interest thereafter at its carrying amount at the date of the sale
of the lease payments. If it is determined subsequently that the fair value of
the residual value of the leased asset has declined below the carrying amount
of the interest retained and that decline is other than temporary, the asset
shall be written down to fair value, and the amount of the write-down shall be
recognized as a loss. That fair value becomes the asset’s new carrying amount,
and the asset shall not be increased for any subsequent increase in its fair
value before its sale or disposition.
9.5.6 Accounting for the Sale of a Leveraged Lease
ASC 842 does not specifically address the accounting for sales of
leveraged leases. ASC 842-50-35-6 states that if revisions to the significant cash flow
assumptions change the estimated total net income for the lease, the “rate of return and
the allocation of income to positive investment years shall be recalculated from lease
inception.”
The sale of a leveraged lease should not be treated as a change to the
projected cash flows of the lease and should not be accounted for in accordance with ASC
842-50-35-6. Such a sale should not be considered a revision of an important assumption
that would result in a recalculation of the estimated total net income for the lease and
affect the rate of return and the allocation of income to the positive investment years of
the lease.
9.5.7 Impact of Altering Significant Assumptions
9.5.7.1 Revised Assumptions Existing at the Inception of the Lease
Questions have arisen regarding situations in which an assumption in a
leveraged lease is altered in such a way that the lease would not have qualified as a
leveraged lease if the revised assumptions had existed at the inception of the
lease.
The appropriate accounting in such situation would depend on the
change in assumptions. First, the lessor would need to consider whether the leveraged
lease has been modified in accordance with the lease modification guidance in ASC 842
(if the lease is considered modified, leveraged lease accounting would no longer be
appropriate — see Section
9.3.4). If it is determined that the leveraged lease has not been modified,
the lease must be reviewed in accordance with ASC 842-50-35-6, which states:
Any estimated residual value and all other important assumptions
affecting estimated total net income from the leveraged lease shall be reviewed at
least annually. The rate of return and the allocation of income to positive
investment years shall be recalculated from lease inception following the method
described in paragraphs 842-50-35-2 through 35-4 and using the revised assumption
if, during the lease term, any of the following conditions occur:
-
The estimate of the residual value is determined to be excessive, and the decline in the residual value is judged to be other than temporary.
-
The revision of another important assumption changes the estimated total net income from the lease.
-
The projected timing of the income tax cash flows is revised.
Example 9-18
Assume that a lessor is in current negotiations with a
lessee regarding its leveraged lease investments. The lessor is proposing to
alter the residual value of the leased properties. The change in residual
values would be considered a change in estimate and thus would not represent
a lease modification for accounting purposes. However, the leveraged lease
would have to be reviewed in accordance with ASC 842-50-35-6 because this
might be considered an event that would affect the estimated total income
from the leveraged lease. If the estimated total income were changed, the
lessor would record the adjustment in accordance with ASC 842-50-35-6.
9.5.7.2 Impact of Altering Significant Tax Assumptions
When there is a change in income tax rates in a leveraged lease, an
entity should recalculate the lease from its inception and record any differences in
current-period earnings. In accordance with ASC 842-50-35-9, the entity would record the
effect of the tax rate change on a leveraged lease “in the first accounting period
ending on or after the date on which the legislation effecting a rate change becomes
law.” ASC 842-50-S99-1 further clarifies that the “difference between the amounts
originally recorded and the recalculated amounts must be included in income of the year
in which the tax law is enacted.”
If the timing of deductions is changed, the entity would perform a
review in accordance with ASC 842-50-35-6. On the basis of that review, if the total
estimated income is changed, the entity would recalculate (1) the estimated total net
income from the lease, (2) the rate of return, and (3) the allocation of income to
positive investment years. To recalculate these amounts, the entity would apply the
method described in ASC 842-50-35-2 through 35-5 and use the revised assumption. The
accounts constituting the net investment balance would be adjusted to conform to the
recalculated balances, and the change in the net investment would be recognized as a
gain or loss in the year in which the assumption is changed. The estimated residual
value would not be adjusted upward.
9.5.7.3 Accounting for a Change or Projected Change in the Timing of Cash Flows Related to Income Taxes Generated by a Leveraged Lease Transaction
A change or projected change in the timing of cash flows related to
income taxes generated by a leveraged lease should be accounted for in accordance with
ASC 842-50-35-6 through 35-15. Tax cash flows should be reflected in the lessor’s
initial calculation or subsequent recalculation on the basis of the recognition,
derecognition, and measurement criteria in ASC 740. The example below illustrates the
application when the only assumption that has changed is the timing of cash flows
related to income taxes generated by a leveraged lease.
Example 9-19
Assumptions:
At the inception of the arrangement, the lessor is
expected to deduct one-half of the cost of the asset in its tax returns for
each of the first two years of the lease (i.e., accelerated tax
depreciation). Accordingly, the lessor’s estimated cash flows from the
leveraged lease are as follows:
To allocate the earnings of the leveraged lease, the
lessor has to determine the rate of return necessary to distribute the net
income from the lease to only those years in which the net investment is
positive. From the following, the lessor would determine that the
appropriate rate is approximately 15.4 percent:
Accordingly, at the inception of the leveraged lease, the
lessor would record the following net accounting entries:
During the first year of the leveraged lease, the lessor
would have recorded the following net accounting entries:
Note that pre-tax income is recognized in proportion to
after-tax income. In year one, for example, $308 of $600 of after-tax income
was allocated to year one. Accordingly, 308/600 of $1,000 of pre-tax income
is recognized in year one. Also note that deferred income taxes are provided
for the difference between book and taxable income at the applicable tax
rate.
Similarly, in year two of the leveraged lease, the lessor
would record the following net accounting entries:
For illustration purposes, assume that at the end of year
two, the lessor concludes, in a manner consistent with ASC 740, that the
taxing authority is more likely than not to deny the previously taken
accelerated depreciation deduction and, rather, will require that it be
recognized on a straight-line basis over the term of the lease. As a result,
the lessor’s expected cash flows (recalculated from the inception of the
lease in accordance with the method described in ASC 842-50-35-2 through
35-4) are as follows:27
To reallocate the earnings of the leveraged lease, the
lessor has to determine the rate of return necessary to distribute the net
income from the lease to only those years in which the net investment is
positive. From the following, the lessor would determined that the
appropriate rate is approximately 6.64 percent:
At the end of year two, the lessor’s net investment in the
leveraged lease would be:
At the end of year two, after the lessor has revised its
expected timing of income-tax-related cash flows, the lessor’s net
investment in the lease should be $1,757 (not the negative $464 actually
recognized). As a result, the lessor needs to recognize a (net) $2,221
adjustment to appropriately state its net investment after determining the
effects of the revised cash flows. The accounting entries to record the net
adjustment are as follows:28
These entries have the effect of (1) revising the amount
of unearned income so that the current balance is equal to the amount that
would exist if the revised cash flows had been known at the inception of the
lease, (2) recognizing an income tax benefit attributable to the reversal of
leveraged lease income, and (3) appropriately recognizing a liability for
unrecognized tax benefits for income tax deductions taken that have not been
determined to be more likely than not to be realized.
Note that the amount of the liability for unrecognized tax
benefits to recognize should equal the tax-effected difference between the
“unrecognized tax benefit liability” basis and the “as filed” tax basis of
an asset or liability. In this example, at the end of year two, the lessor
has an as-filed tax basis of the leased equipment of $0 ($10,000 original
cost less accelerated depreciation of $10,000 over the first two years of
the lease). However, at the end of year two, the lessor concludes, on a
more-likely-than-not measurement basis, that the unrecognized tax benefit
liability basis of the leased equipment is $6,000 ($10,000 original cost
less two years of straight-line depreciation totaling $4,000). The
tax-effected difference equals $2,400, or ($0 – $6,000) × 40%.
Note that it is inappropriate to reflect the liability for
unrecognized tax benefits as a component of the lessor’s net investment in the leveraged
lease.
Presentation of Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
ASC 840-30-45-5
|
ASC 842-50-45-1
|
Income Taxes and Leveraged Leases
| |
ASC 840-30-45-6 and 45-7
|
ASC 842-50-45-2 and 45-3
|
ASC 842-50
General
45-1 For purposes of presenting the
investment in a leveraged lease in the lessor’s balance sheet, the amount of
related deferred taxes shall be presented separately (from the remainder of
the net investment). In the income statement or the notes to that statement,
separate presentation (from each other) shall be made of pretax income from
the leveraged lease, the tax effect of pretax income, and the amount of
investment tax credit recognized as income during the period.
45-2 Integration of the results of
income tax accounting for leveraged leases with the other results of
accounting for income taxes under Topic 740 on income taxes is required if
deferred tax credits related to leveraged leases are the only source (see
paragraph 740-10-30-18) for recognition of a tax benefit for deductible
temporary differences and carryforwards not related to leveraged leases. A
valuation allowance is not necessary if deductible temporary differences and
carryforwards will offset taxable amounts from future recovery of the net
investment in the leveraged lease. However, to the extent that the amount of
deferred tax credits for a leveraged lease as determined in accordance with
this Subtopic differs from the amount of the deferred tax liability related
to the leveraged lease that would otherwise result from applying the
guidance in Topic 740, that difference is preserved and is not a source of
taxable income for recognition of the tax benefit of deductible temporary
differences and operating loss or tax credit carryforwards.
45-3 This Subtopic requires that
the tax effect of any difference between the assigned value and the tax
basis of a leveraged lease at the date of a business combination or an
acquisition by a not-for-profit entity shall not be accounted for as a
deferred tax credit. Any tax effects included in unearned and deferred
income as required by this Subtopic shall not be offset by the deferred tax
consequences of other temporary differences or by the tax benefit of
operating loss or tax credit carryforwards. However, deferred tax credits
that arise after the date of a combination shall be accounted for in the
same manner as for leveraged leases that were not acquired in a
combination.
Pending Content (Transition Guidance: ASC 805-10-65-1)
|
---|
45-3 This Subtopic requires that the tax effect of any
difference between the assigned value and the tax basis of a
leveraged lease at the date of a business combination, an
acquisition by a not-for-profit entity, or a joint venture
formation shall not be accounted for as a deferred tax credit.
Any tax effects included in unearned and deferred income as
required by this Subtopic shall not be offset by the deferred
tax consequences of other temporary differences or by the tax
benefit of operating loss or tax credit carryforwards. However,
deferred tax credits that arise after the date of a combination
shall be accounted for in the same manner as for leveraged
leases that were not acquired in a combination.
|
Disclosure of Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
ASC 840-30-50-5 and 50-6
|
ASC 842-50-50-1 through 50-3
|
ASC 842-50
General
50-1 If leveraged leasing is a
significant part of the lessor’s business activities in terms of revenue,
net income, or assets, the components of the net investment balance in
leveraged leases as set forth in paragraph 842-50-25-1 shall be disclosed in
the notes to financial statements.
50-2 For guidance on disclosures
about financing receivables, which include receivables relating to a
lessor’s rights to payments from leveraged leases, see the guidance in
Subtopic 326-20 on financial instruments measured at amortized cost and
paragraph 310-10-50-31.
Pending Content (Transition Guidance: ASC 326-10-65-5)
50-2 For guidance on disclosures about financing
receivables, which include receivables relating to a lessor's
rights to payments from leveraged leases, see the guidance in
Subtopic 326-20 on financial instruments measured at amortized
cost.
50-3 If accounting for the effect
on leveraged leases of the change in tax rates results in a significant
variation from the customary relationship between income tax expense and
pretax accounting income and the reason for that variation is not otherwise
apparent, the lessor shall disclose the reason for that variation.
Implementation Guidance for Leveraged Leases
| |
---|---|
Location of Guidance in ASC
840
|
Location of Guidance in ASC
842
|
Leveraged Lease Involving an Existing Asset of a Regulated
Entity
| |
ASC 840-30-55-14
|
ASC 842-50-55-1
|
Delayed Equity Investment
| |
ASC 840-30-55-15 and 55-16
|
ASC 842-50-55-2 and 55-3
|
Income Taxes Related to Leveraged Leases
| |
ASC 840-30-55-17 and 55-18
|
ASC 842-50-55-4 and 55-5
|
Example: Lessor’s Accounting for a Leveraged Lease
| |
ASC 840-30-55-29 through 55-38
|
ASC 842-50-55-6 through 55-15
|
Example: Income Taxes Related to a Leveraged Lease
| |
ASC 840-30-55-39 through 55-46
|
ASC 842-50-55-16 through 55-23
|
Example: Effect of Advance Payments and Deposits on
Recalculation of a Leveraged Lease
| |
ASC 840-30-55-47 through 55-49
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ASC 842-50-55-24 through 55-26
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Example: Leveraged Lease Acquired in a Business
Combination or an Acquisition by a Not-for-Profit Entity
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ASC 840-30-55-50 through 55-56
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ASC 842-50-55-27 through 55-33
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ASC 842-50
General
Implementation Guidance
Leveraged Lease Involving an
Existing Asset of a Regulated Entity
55-1 Although the carrying amount
of an asset acquired previously may not differ significantly from its fair
value, it is unlikely that the two will be the same. However, regulated
utilities have argued that the carrying amounts of certain of their assets
always equal the fair value based on the utility’s ability to recover that
cost in conjunction with a franchise to sell a related service in a
specified area. That argument is not valid when considering the value of the
asset to a third-party purchaser that does not own that franchise.
Delayed Equity Investment
55-2 A delayed equity investment
frequently obligates the lessor to make up the shortfall between rent and
debt service in the first several years of the transaction. The type of
recourse debt resulting from the delayed equity investment does not
contradict the notion of nonrecourse and, therefore, does not preclude
leveraged lease accounting as long as other requirements of leveraged lease
accounting are met. The lessor’s related obligation should be recorded as a
liability at present value at lease inception.
55-3 Recognition of the liability
would increase the lessor’s net investment on which the lessor bases its
pattern of income recognition. While the increase to the net investment
results in an increase in income, it may be offset by the accrual of
interest on the liability.
Income Taxes Related to Leveraged
Leases
55-4 The accounting for income
taxes related to leveraged leases set forth in this Subtopic is not
consistent with the guidance in Topic 740 on income taxes.
55-5 The integration of the results
of accounting for income taxes related to leveraged leases with the other
results of accounting for income taxes as required by Topic 740 is an issue
if all of the following exist:
-
The accounting for a leveraged lease requires recognition of deferred tax credits.
-
The guidance in Topic 740 limits the recognition of a tax benefit for deductible temporary differences and carryforwards not related to the leveraged lease.
-
Unrecognized tax benefits in this paragraph could offset taxable amounts that result from future recovery of the net investment in the leveraged lease.
Example 1: Lessor’s Accounting for
a Leveraged Lease
55-6 This Example illustrates a
lessor’s accounting for a leveraged lease in accordance with the guidance in
this Subtopic. It also illustrates one way of meeting the disclosure
requirements in paragraphs 842-50-45-1 and 842-50-50-1 as applied to a
leveraged lease. The Example does not encompass all circumstances that may
arise about leveraged leases; rather, the Example is based on a single
instance of a leveraged lease. The elements of accounting and reporting
illustrated for this Example of a leveraged lease are as follows:
-
Cash flow analysis by years (see paragraph 842-50-55-8)
-
Allocation of annual cash flow to investment and income (see paragraph 842-50-55-9)
-
Journal entries for lessor’s initial investment and first year of operation (see paragraph 842-50-55-10)
-
Financial statements including notes at end of second year (see paragraph 842-50-55-11)
-
Accounting for a revision in the estimated residual value of the leased asset assumed to occur in the eleventh year of the lease (from $200,000 to $120,000):
-
Revised allocation of annual cash flow to investment and income (see paragraph 842-50-55-12)
-
Balances in investment accounts at beginning of the eleventh year before revised estimate (see paragraph 842-50-55-13)
-
Journal entries (see paragraph 842-50-55-14)
-
Adjustment of investment accounts (see paragraph 842-50-55-15).
-
55-7 This Example has the following
terms and assumptions.
55-8 Cash flow analysis by years
follows.
55-9 Allocation of annual cash flow
to investment and income follows.
55-10 Illustrative journal entries
for the year ending December 31, 1975, follow.
Lessor’s Initial Investment
First Year of Operation
Journal Entry 1
Journal Entry 2
Journal Entry 3
Journal Entry 4
Journal Entry 5
The following are notes to the illustrative financial
statements included in this Example.
Investment in Leveraged Leases
Entity is the lessor in a leveraged lease agreement entered into in
1975 under which mining equipment having an estimated economic life of
18 years was leased for a term of 15 years. Entity’s equity investment
represented 40 percent of the purchase price; the remaining 60 percent
was furnished by third-party financing in the form of long-term debt
that provides for no recourse against Entity and is secured by a first
lien on the property. At the end of the lease term, the equipment is
turned back to Entity. The residual value at that time is estimated to
be 20 percent of cost. For federal income tax purposes, Entity receives
the investment tax credit and has the benefit of tax deductions for
depreciation on the entire leased asset and for interest on the
long-term debt. During the early years of the lease, those deductions
exceed the lease rental income, and substantial excess deductions are
available to be applied against Entity’s other income. In the later
years of the lease, rental income will exceed the deductions and taxes
will be payable. Deferred taxes are provided to reflect this reversal.
Entity’s net investment in leveraged leases is composed of the following
elements.
55-12 Allocation of annual cash
flow to investment and income follows, revised to include new residual value
estimate.
55-13 Balances in investment
accounts before revised estimate of residual value follow.
Journal Entry 2
55-15 Adjustment of investment
accounts for revised estimates of residual value follows.
Example 2: Income Taxes Related to
a Leveraged Lease
55-16 This Example illustrates
integration of the results of a lessor’s income tax accounting for leveraged
leases (in accordance with the guidance in this Subtopic) with the other
results of accounting for income taxes as required by Topic 740.
55-17 At the end of Year 1 (the
current year), an entity has two temporary differences.
55-18 The first temporary
difference is for a leveraged lease that was entered into in a prior year.
During Year 1, the enacted tax rate for Year 2 and thereafter changes from
40 percent to 35 percent.
55-19 After adjusting for the
change in estimated total net income from the lease as a result of the
change in tax rates, the components of the investment in the leveraged lease
at the end of Year 1 are as follows.
55-20 The second temporary
difference is a $120,000 estimated liability for warranty expense that will
result in a tax deduction in Year 5 when the liability is expected to be
paid. Absent consideration of the deferred tax credits attributable to the
leveraged lease, the weight of available evidence indicates that a valuation
allowance is needed for the entire amount of the deferred tax asset related
to that $120,000 deductible temporary difference.
55-21 The tax basis of the
investment in the leveraged lease at the end of Year 1 is $41,000. The
amount of the deferred tax liability for that leveraged lease that would
otherwise result from the application of guidance in Topic 740 on income
taxes is determined as follows.
55-22 Loss carryback (to Year 2)
and loss carryforward (to Year 20) of the $120,000 tax deduction for
warranty expense in Year 5 would offset the $100,000 of taxable amounts
resulting from future recovery of the net investment in the leveraged lease
over the remainder of the lease term.
55-23 At the end of Year 1, the
entity recognizes a $42,000 ($120,000 at 35 percent) deferred tax asset and
a related $7,000 valuation allowance. The effect is to recognize a $35,000
net deferred tax benefit for the reduction in deferred tax credits
attributable to the leveraged lease. Deferred tax credits attributable to
the leveraged lease determined under the guidance in this Subtopic are
$39,000. However, the deferred tax liability determined is only $35,000. The
$4,000 difference is not available for offsetting.
Example 3: Effect of Advance
Payments and Deposits on Recalculation of a Leveraged Lease
55-24 This Example illustrates how
(in accordance with the guidance in paragraph 842-50-35-13 and other
paragraphs) a lessor would include advance payments and deposits in a
recalculation of a leveraged lease resulting from a determination by the
lessor that it would enter into a settlement of a tax position arising from
a leveraged lease.
55-25 This Example assumes that the
lessor has concluded that the position originally taken on the tax return
would meet the more-likely-than-not threshold in Subtopic 740-10 on income
taxes. It also assumes that the lessor would conclude that the estimate of
$50 for the projected lease-in, lease-out settlement is consistent with the
measurement guidance in that Subtopic.
55-26 A lessor makes an advance
payment of $25 on July 1, 2007, $10 of which is estimated to be associated
with issues arising from a lease-in, lease-out transaction. On July 1, 2007,
the lessor changes its assumption about the timing of the tax cash flows and
projects a settlement with the Internal Revenue Service on September 1,
2009. The projected settlement would result in a payment to the taxing
authority of $125 of which $50 is associated with the lease-in, lease-out
transaction. On July 1, 2007, when the lessor recalculates the leveraged
lease, the lessor would include a $50 cash flow on September 1, 2009, as a
projected outflow in the leveraged lease recalculation.
Example 4: Leveraged Lease Acquired
in a Business Combination or an Acquisition by a Not-for-Profit
Entity
55-27 This Example illustrates one
way that a lessor’s investment in a leveraged lease might be valued by the
acquiring entity in a business combination or an acquisition by a
not-for-profit entity and the subsequent accounting for the investment in
accordance with the guidance in this Subtopic. The elements of accounting
and reporting illustrated for this Example are as follows:
-
Acquiring entity’s cash flow analysis by years (see paragraph 842-50-55-29)
-
Acquiring entity’s valuation of investment in the leveraged lease (see paragraph 842-50-55-30)
-
Acquiring entity’s allocation of annual cash flow to investment and income (see paragraph 842-50-55-31)
-
Journal entry for recording allocation of purchase price to net investment in the leveraged lease (see paragraph 842-50-55-32)
-
Journal entries for the year ending December 31, 1984 (Year 10 of the lease) (see paragraph 842-50- 55-33).
55-28 This Example has the
following terms and assumptions.
55-29 Acquiring entity’s cash flow
analysis by years follows.
55-30 Acquiring entity’s valuation
of investment in the leveraged lease follows.
55-31 Acquiring entity’s allocation
of annual cash flow to investment and income follows (see footnote (a)).
55-32 Illustrative journal entry
for recording allocation of purchase price to net investment in the
leveraged lease follows.
55-33 Illustrative journal entries
for year ending December 31, 19Y4, follows.
Third Year of Operation After the
Business Combination (Year 10 of the Lease)
Journal Entry 1
Journal Entry 2
Journal Entry 3
Footnotes
26
There are minor grammatical differences between the leveraged lease
guidance in ASC 840 and that in ASC 842; however, such differences are minor and not
expected to result in a change in the interpretation or application of the guidance
for lessors. Therefore, those differences are not highlighted in this chapter.
27
In this example, it is assumed that the lessor did not
make any advance, deposit, or settlement payments to the tax authority
up to the date of the recalculation and that a projected settlement
amount was not included in the recalculation. ASC 842-50-35-13 provides
guidance on how, when a lessor has entered into (or expects to enter
into) a settlement with a tax authority, such payments, cash flow
projections, or both should be included in a recalculation.
28
Note that if these journal entries were being made as
of the lessor’s initial adoption of this guidance, the amounts affecting
the statement of operations would be recorded as an adjustment to the
beginning balance of retained earnings as of the beginning of the period
in which the guidance is adopted.
Chapter 10 — Sale-and-Leaseback Transactions
Chapter 10 — Sale-and-Leaseback Transactions
10.1 Introduction and Overview
A sale-and-leaseback transaction is a common and important financing method for
many companies; these transactions involve the transfer of an asset by an owner
(“seller-lessee”) to an acquirer (“buyer-lessor”) and a transfer of the right to
control the use of that same asset back to the original owner for a period.
Sale-and-leaseback transactions offer seller-lessees a number of advantages, including:
- The ability to free up the cash invested in the asset and invest that cash in more profitable or more pressing projects (e.g., paying off corporate debt, reinvesting the cash into operations, funding stock buybacks). This may be particularly advantageous in tight credit markets.
- In a sale-and-leaseback arrangement, essentially 100 percent of the asset is financed. This may be a higher level of financing than the seller-lessee ordinarily would be able to obtain.
- Under the legacy sale-and-leaseback accounting requirements in ASC 840, a seller-lessee may have been allowed to remove the asset and any related debt from its balance sheet; as a result, the seller-lessee’s financial ratios may improve. However, the lessee accounting model in ASC 842 (see Chapter 8) removes the off-balance-sheet benefits of sale-and-leaseback transaction structures for seller-lessees. That is, while the underlying asset and corresponding debt may be removed, they are replaced with the ROU asset and lease liability, albeit typically at a lower value.
- The transaction also may improve the seller-lessee’s income statement. Depreciation expense and interest expense could be reduced, and the cash freed up by the transaction could be invested to obtain a greater return than could be obtained when the cash was invested in the asset. In addition, the seller-lessee may have lower income tax expense, since tax deductions arising from the rental payments could exceed the deductions that had been generated by debt payments. These favorable income statement effects may be offset to some extent by the additional rental expense that will be recognized and reduced tax deductions for depreciation expense.
- The transaction allows the seller-lessee to refocus its resources on its primary business operations instead of managing and maintaining fixed assets or real estate.
The buyer-lessor in a sale-and-leaseback transaction benefits from receiving a steady return on its investment in the form of annual rental payments and may receive certain tax advantages. Furthermore, the buyer-lessor will receive benefits through owning the asset, including any future asset appreciation.
10.2 Scope of the Sale-and-Leaseback Accounting Guidance
10.2.1 General Scope Considerations
ASC 842-40
05-1 This Subtopic addresses accounting for sale and leaseback transactions when a lease has been accounted for in accordance with Subtopic 842-10 and either Subtopic 842-20 or Subtopic 842-30.
15-1 This Subtopic follows the same Scope and Scope Exceptions as outlined in the Overall Subtopic; see Section 842-10-15.
15-2 If an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) and leases that asset back from the buyer-lessor, both the seller-lessee and the buyer-lessor shall account for the transfer contract and the lease in accordance with Sections 842-40-25, 842-40-30, and 842-40-50.
15-3 See paragraphs 842-40-55-1 through 55-21 for implementation guidance on the scope of this Subtopic. See Example 3 (paragraphs 842-40-55-39 through 55-44) for an illustration of the scope of this Subtopic.
As noted in paragraph BC349 of ASU 2016-02, the guidance on accounting for
sale-and-leaseback transactions in ASC 842-40 substantially differs from that in
ASC 840-40. The decision tree below illustrates how an entity would apply the
guidance in ASC 842-40 to identify the appropriate accounting for situations in
which it transfers an asset to another entity and obtains the right to use that
asset.
Changing Lanes
Scope of Sale-and-Leaseback Accounting Guidance for
Buyer-Lessors
As illustrated in the decision tree above, the scope of ASC 842-40 applies to
both the seller-lessee and the buyer-lessor in a sale-and-leaseback
transaction. Thus, the scope of sale-and-leaseback accounting in ASC
842-40 differs from the scope in ASC 840-40, which applied only to the
seller-lessee. ASC 842 will therefore result in a significant change for
buyer-lessors in sale-and-leaseback transactions, since they must now
also assess whether the seller-lessee has transferred control of the
underlying asset in the sale leg of the transaction (i.e., they must
assess whether they have obtained control).
The decision tree above outlines the scope of the sale-and-leaseback guidance
under ASC 842-40 in its simplest form. The implementation guidance in ASC
842-40-55 addresses specific transactions (not all-inclusive) that may be within
the scope of the sale-and-leaseback guidance in ASC 842-40. Further, as stated
above, the guidance in ASC 842-40-15-2 applies to transactions in which “an
entity (the seller-lessee) transfers an asset to another entity (the
buyer-lessor) and leases that asset back from the buyer-lessor” but does not
specify the type of consideration received from the buyer-lessor in exchange for
the transfer of the asset from the seller-lessee. As described in Section 10.1, most
sale-and-leaseback transactions are entered into for financing purposes and will
involve cash consideration. However, we are aware of transactions that involve
all or some nonmonetary consideration (e.g., equity interests in the
buyer-lessor in exchange for an asset).
Moreover, the “leaseback” in a sale-and-leaseback transaction must meet the
definition of a lease as outlined in Chapter
3. While this determination may be straightforward for real
estate or equipment, for which sale-and-leaseback transactions are most common,
entities in certain industries such as power and utilities may sometimes enter
into unique transactions and may find it more challenging to determine whether a
lease exists in such situations.
Connecting the Dots
Sale and Contemporaneous
Agreement to Receive the Output of an Asset by the Original
Owner
It can be challenging to determine the scope of the sale-and-leaseback
guidance in scenarios in which the ongoing exchange transaction may or
may not involve the use of an underlying asset. In such cases, it is
important to carefully consider whether the leaseback transaction meets
the definition of a lease. Specifically, exchange transactions may
involve an asset for which HAFWP the asset is used throughout the period
of use is predetermined (see Section
3.4.2.3). In such situations, an entity needs to consider
whether the customer operates the asset throughout the period of use or
whether the customer designed the asset.
Such considerations may apply to exchange transactions
in which energy-generating fixed assets (e.g., a solar farm) are sold by
the original owner of the asset (that was also involved in building the
asset) and the original owner enters into a contemporaneous agreement to
receive the asset’s output for a period after the sale. With such
assets, it is often common for HAFWP the asset is used throughout the
period to be predetermined and for the original owner not to have the
right to operate the asset during the period after sale. Accordingly,
regarding the determination of whether the contemporaneous agreement to
receive the asset’s output is a lease, the original owner must assess
whether it designed the asset (see Section 3.4.2.3.2). We believe
that because the seller is the original owner that was also involved in
building the asset, most will conclude that the seller designed the
asset and that, accordingly, this arrangement will be subject to the
accounting guidance in ASC 842-40. These arrangements may be common in
the power and utilities industry but may also exist for other types of
assets such as cell towers and technology servers.
10.2.2 Control of the Underlying Asset Before Lease Commencement
Under ASC 842-40-55-1 through 55-6, transactions in which a lessee controls an
underlying asset before the commencement date of the lease are within the scope
of the sale-and-leaseback guidance. That is, under ASC 842-40, if a lessee
controls an underlying asset before lease commencement, it would recognize the
entire asset on its balance sheet and determine whether derecognition is
appropriate at lease commencement as a sale-and- leaseback transaction. ASC
842-40-55-1 and 55-2 cover transactions in which the lessee obtains control of
the asset before transferring it to the lessor, and ASC 842-40-55-3 through 55-6
address transactions in which the lessee obtains control of a construction
project (i.e., the underlying asset that will be subject to the lease is in the
process of being constructed).
See Chapter 11 for further details on the guidance in ASC 842-40-55-1 through 55-6 on when the lessee controls an underlying asset before the commencement date of the lease as well as on the subsequent accounting that results.
10.2.2.1 Sale or Transfer of a Purchase Option by a Lessee
Questions have arisen about whether the scope of ASC 842-40
includes transactions in which (1) a company transfers an option to purchase an
asset to an unaffiliated third party and the third party is required to exercise
the option and lease back the asset to the company, (2) the third party
exercises the option, and (3) the company leases back the asset.
If the entity only held the option to purchase the asset but
never held title to the asset itself, it must analyze the substance of the
purchase option to determine whether possession of the option was substantially
the same as control of the asset before it was owned by the unaffiliated third
party. The entity must assess the purchase option itself by applying the
guidance in ASC 842-40-25-1 to determine whether and, if so, when (further
discussed in Section
10.3.1) it transfers control of the asset to the buyer-lessor.
An option that grants to the potential seller-lessee the right
to purchase the underlying asset may convey control by conveying certain rights
related to the asset before exercise. Although certain risks and rewards of the
asset may be transferred to a company when the option is first conveyed to the
company (e.g., a fixed-price purchase option that conveys the right to
participate in any future appreciation in the asset’s value), we believe that
the company typically does not control the underlying
asset at that point. Rather, we think that the company controls the underlying asset at the point when it effectively
exercises the option itself or by transferring it to an unaffiliated third party
(a buyer-lessor) and requiring that the third party exercise it. At that point,
the company controls the underlying asset and what happens to it by requiring
someone else to exercise the option (the owner of the asset is compelled to
transfer the asset in accordance with the option) and requiring the buyer to
provide the company with the right to use the asset. Therefore, such a
transaction would be subject to the sale-and-leaseback accounting guidance in
ASC 842-40. In contrast, simply facilitating the negotiation and sale of an
underlying asset between two unaffiliated third parties with an agreement to
lease the asset from the buyer would not by itself
convey control of the underlying asset to a company.
Example 10-1
Company A writes a call option on real
estate in Orange County, California, to Company B on
January 1, 2020. Company B transfers the call option to
Company C on December 31, 2021, requiring that C
exercise the call option and lease the real estate to B.
In accordance with this requirement, C exercises the
option on December 31, 2021, and leases the real estate
to B for five years.
On December 31, 2021, B controls the
underlying real estate because it effectively exercised
the option by transferring it to C under the condition
of exercise. Accordingly, on December 31, 2021, for both
B and C, the transaction is subject to the
sale-and-leaseback accounting guidance in ASC
842-40.
The discussion and example above represent our perspective on
these arrangements. These issues continue to evolve, and it is possible that the
FASB and SEC staffs will want to share perspectives on this or related fact
patterns. Companies that are involved in these types of arrangements should
consult with their accounting advisers and monitor developments on the topic.
See also Section 7.6.3.1 of Deloitte’s
Roadmap Statement of Cash Flows for
a discussion of cash flow impacts resulting from these transactions.
We also believe that the assessment may differ in a transaction
in which a company holds an option to purchase an asset that is under
construction only at the point at which construction of the asset is complete.
This is because, when a company transfers the purchase option to a third party,
the third party often is required to exercise the purchase option and lease the
asset back to the company only upon completion of
construction, and such a transaction is different from the transactions
described above. In the transaction described in the example above, the
transferred purchase option includes a present right to exercise that option
and, accordingly, differs from a purchase option that can only be exercised upon
completion of construction, since the right associated with that purchase option
is in the future. Accordingly, in these situations, an entity may be required to
perform additional analysis to determine whether the transaction is subject to
the accounting guidance in ASC 842-40.
10.2.3 Other Scope Considerations
The next sections address other scope considerations related to the
sale-and-leaseback accounting guidance in ASC 842-40.
10.2.3.1 Lessee Indemnification for Environmental Contamination
ASC 842-40
55-7 A provision that requires lessee indemnifications for preexisting environmental contamination does not,
on its own, mean that the lessee controlled the underlying asset before the lease commenced regardless of the
likelihood of loss resulting from the indemnity. Consequently, the presence of such a provision does not mean
the transaction is in the scope of this Subtopic.
10.2.3.2 Sale Subject to a Preexisting Lease
ASC 842-40
55-8 An entity owns an interest in an underlying asset and also is a lessee under an operating lease for all or a portion of the underlying asset. Acquisition of an ownership interest in the underlying asset and consummation of the lease occurred at or near the same time. This owner-lessee relationship can occur, for example, when the entity has an investment in a partnership that owns the underlying asset (or a larger asset of which the underlying asset is a distinct portion). The entity subsequently sells its interest or the partnership sells the underlying asset to an independent third party, and the entity continues to lease the underlying asset under the preexisting operating lease.
55-9 A transaction should be subject to the guidance in this Subtopic if the scope or price of the preexisting lease is modified in connection with the sale. If the scope or the price of the preexisting lease is not modified in conjunction with the sale, the sale should be accounted for in accordance with other Topics.
55-10 A lease between parties under common control should not be considered a preexisting lease. Accordingly, the guidance in this Subtopic should be applied to transactions that include nonfinancial assets within its scope, except if Topic 980 on regulated operations applies. That is, if one of the parties under common control is a regulated entity with a lease that has been approved by the appropriate regulatory agency, that lease should be considered a preexisting lease.
The example below illustrates the application of the guidance in ASC 842-40-55-8 and 55-9.
Example 10-2
Company A has a 50 percent ownership interest in a property that consists of
warehouse space and office space. Currently, A
leases all of the warehouse space, which comprises
75 percent of the building’s total square footage,
and the lease is classified as an operating lease.
Company A proposes to sell its entire ownership
interest in the property to an unrelated third
party, Acquirer X, but to continue to lease the
warehouse space.
To the extent that A and X do not modify the price or scope of A’s lease of the warehouse space, neither party would need to assess this transaction by using the sale-and-leaseback accounting guidance in ASC 842-40.
The section below further discusses the
application of the guidance in ASC 842-40-55-10.
10.2.3.2.1 Intercompany Sale-and-Leaseback Transactions
Consider a scenario in which a subsidiary owns equipment
that it leases to its parent company or to other subsidiaries, and the
subsidiary sells the equipment subject to the existing intercompany lease to
an unrelated third party. The subsidiaries are consolidated with the parent
company for financial reporting purposes. Neither of the parties to the
transaction is a regulated entity.
The sale of equipment subject to an existing intercompany
lease should be assessed in accordance with the sale-and-leaseback
accounting guidance in ASC 842-40. The equipment lease that was in effect
before the sale was eliminated in consolidation. Therefore, at the
consolidated level, there was no lease. Since the parent and the subsidiary
had the ability to cancel the lease before the sale to the unrelated third
party but chose not to, there is a presumption that the sale and the terms
of the leaseback were considered together in the seller-lessee’s discussions
with the buyer-lessor and that the transactions should be treated as one
integrated transaction within the scope of ASC 842-40. It would not be
appropriate to consider the lease a preexisting lease in such cases.
10.2.3.2.2 Leaseback of Assets by an Acquiree After a Business Combination
If a seller leases back an asset that was acquired by the acquirer in a
business combination accounted for under ASC 805, the transaction is
outside the scope of the sale-and-leaseback guidance in ASC 842-40. That
is, the lease is evaluated as a new lease and is accounted for in
accordance with other guidance in ASC 842. For more information about
the accounting for leases in a business combination, see Chapter 4 of Deloitte’s Roadmap
Business
Combinations.
10.2.3.2.3 Third-Party Lessor Involvement in a Business Combination
In a business combination, a third party may acquire assets
directly from the acquiree before the business combination and subsequently
lease those assets to the acquirer after the acquisition.
When a third party acquires assets directly from an acquiree
before a business combination to subsequently lease those assets to the
acquirer, and that transaction is either contingent on or in contemplation
of the business combination, we believe the assets have been transferred to
the acquirer (i.e., the acquirer has obtained control of the assets) just
before, or concurrently with, the business combination. This is because the
acquirer could preclude the sale of the assets to the third party by not
completing the business combination. Therefore, the assets acquired by the
third party are effectively controlled by the acquirer, albeit momentarily,
before the sale to the third party can be completed. In this scenario, we
believe that it should be presumed that sale of the assets from the acquiree
to the third party and subsequent leaseback of the assets from the third
party to the acquirer were entered into in contemplation of one another and
in connection with the business combination. In substance, the
acquirer/lessee directed the acquiree to sell the assets to the third party
with a subsequent leaseback to the acquirer, which has the effect of
financing part of the business combination.
We believe that the acquirer/lessee has gained control of
the assets before the third party (lessor) and therefore that the guidance
in ASC 842-40-55-1 would be applicable. This guidance states, in part:
If the lessee controls the underlying asset (that is,
it can direct its use and obtain substantially all of its remaining
benefits) before the asset is transferred to the lessor, the transaction
is a sale and leaseback transaction that is accounted for in accordance
with this Subtopic.
Accordingly, we believe the acquirer/lessee should account
for the transaction as (1) a business combination in which the assets are
included in the acquired asset set and (2) a sale-and-leaseback transaction
with the third party for the assets in accordance with ASC 842-40; it would
not be appropriate to instead exclude the assets from the acquired asset set
in the business combination and record a separate lease of the assets from a
third party. The amount of consideration transferred by the acquirer to
effect the business combination should include the amount paid by the third
party to the acquiree for the assets,1 since it is in effect a payment being made on behalf of the
acquirer.
10.2.3.3 Sale-Leaseback-Sublease Transactions
ASC 842-40
55-18 An entity enters into a sale and leaseback of an asset that meets either of the following criteria:
- The asset is subject to an operating lease.
- The asset is subleased or intended to be subleased by the seller-lessee to another party under an operating lease.
55-19 A sale-leaseback-sublease transaction is within the scope of this Subtopic. The existence of the sublease (that is, the operating lease in paragraph 842-40-55-18(a) or (b)) does not, in isolation, prevent the buyer-lessor from obtaining control of the asset in accordance with paragraphs 842-40-25-1 through 25-3, nor does it prevent the seller-lessee from controlling the asset before its transfer to the buyer-lessor (that is, the seller-lessee is subject to the same requirements for determining whether the transfer of the asset is a sale as it would be without the sublease). All facts and circumstances should be considered in determining whether the buyer-lessor obtains control of the underlying asset from the seller-lessee in a sale-leaseback-sublease transaction.
A seller-lessee (seller-sublessor) and buyer-lessor may enter into a sale-and-leaseback transaction involving an asset that either (1) is subject to an existing operating lease (i.e., such that the original owner sells the asset subject to the operating lease and leases it back to continue performing economically as a lessor) or (2) is or will be subleased to a third party under an operating lease (i.e., such that the original owner sells the asset, leases it back, and executes a sublease agreement with a third party). Contractual provisions allowing a seller-lessee to sublease the underlying asset are common in leaseback arrangements because they allow the seller-lessee to sublease the property without having to renegotiate the terms of its lease with the buyer-lessor. The seller-lessee may wish to retain a right to sublease the property in case its continued leasing of the property becomes uneconomic in light of its business plan. For example, a restaurant owner may want to retain its right to sublease the property in case several years into the lease term the surrounding area’s demographics change and adversely affect the restaurant’s operations.
Such transactions are within the scope of the sale-and-leaseback accounting guidance in ASC 842-40. The seller-sublessor and buyer-lessor must follow the steps in the decision tree in Section 10.2.1 and assess whether the seller-sublessor transfers control of the asset to the buyer-lessor.
See Chapter 12 for a detailed discussion of the sublease accounting requirements in ASC 842.
10.2.3.4 Other Transaction Types
Although ASC 842-40-55 identifies certain scope considerations, it may be
difficult to tell whether other complex transaction types reflect the
economic substance of a sale and leaseback or a financing arrangement. The
sections below address various transaction types that we think should be
assessed in accordance with the guidance in ASC 842-40 on sale-and-leaseback
transactions.
10.2.3.4.1 Separate Analysis of the Land and Building Components of a Lease
If undeveloped land is sold to a developer to construct a
building and the developer leases the completed building and land back to
the seller, the lease of the land and the building should not be accounted
for as a single sale-and-leaseback transaction.
Rather, in this circumstance, the lease of the land and the
building should be accounted for as separate lease components in accordance
with ASC 842-10-15-29. Since the land element was previously controlled by
the lessee, the leaseback of the land should be accounted for as a
sale-and-leaseback transaction. The lease of the building element is not
within the scope of the sale-and-leaseback guidance in ASC 842-40 because
the building was never controlled by the lessee and thus control of an asset
(the building) was not transferred. The building lease should be accounted
for in accordance with the lease classification criteria in ASC 842-10-25-1
and 25-2.
10.2.3.4.2 Treatment of Sales Agreements in Which the Seller Retains an Option to Lease the Asset Transferred
Transactions involving the transfer of an asset to a
purchaser, if the seller has the contractual obligation, or has been granted
the option, to enter into a leasing arrangement with the purchaser for use
of that same asset, generally should be accounted for in accordance with ASC
842-40. The same is presumed when an asset transfer is subsequently followed
by a separate transaction in which the original seller agrees to lease the
same asset from the original purchaser.
An entity would need to have persuasive evidence to support an assertion that
such a transaction is not within the scope of ASC 842-40.
10.2.3.4.3 Concurrent Sale and Leasing Transactions That Involve Different Assets but the Same Counterparty2
When an entity transfers an asset to a purchaser while
entering into a concurrent arrangement to lease a similar, but not the same,
asset from the same purchaser, there is a rebuttable presumption that such
an arrangement should be accounted for as one integrated sale-and-leaseback
transaction, even if the asset being leased is not the exact asset that was
sold. This presumption can only be overcome when there is sufficient
evidence that the transactions are, in fact, independent transactions. If
the presumption cannot be overcome, the seller-lessee and buyer-lessor
should account for the transactions together as a sale-and-leaseback
transaction in accordance with ASC 842-40.
10.2.3.4.4 Sale of Construction in Process With a Leaseback of the Asset After Completion of Construction
A company (the “seller” or “seller-lessee”) may enter into an arrangement
with a developer (the “buyer” or “buyer-lessor”) to transfer construction in
process (CIP) to the developer. In such an arrangement, the developer will
complete construction of the asset (the “completed construction”) and lease
it back to the seller. The CIP that the seller transfers to the buyer can be
in different phases of development. For example, a building may be in the
following phases of construction when transferred to a buyer:
- Only soft costs3 have been incurred.
- The land has been cleared or graded to prepare for construction of the building.
- A physical structure has begun to take form, such as a foundation and steel beams.
- Progress has been made toward a building with an unfinished interior.
- Substantial progress has been made toward completion of a building.
Under the previous leasing guidance in ASC 840-40-55-44, an
entity was subject to the ASC 840 sale-and-leaseback requirements if the
entity had begun construction activities, including the following:
- Begun construction (broken ground)
- Incurred hard costs (no matter how insignificant the hard costs incurred may be in relation to the fair value of the property to be constructed)
- Incurred soft costs that represent more than a minor amount of the fair value of the leased property (that is, more than 10 percent of the expected fair value of the leased property).
ASC 840 included indicators of when an entity with CIP may
be subject to the sale-and-leaseback requirements. However, no such
indicators exist under ASC 842. Rather, ASC 842 does not explicitly address
whether the sale of CIP that will be leased back at completion of the
construction is subject to sale-and-leaseback guidance. On the basis of a
technical inquiry with the FASB staff, we understand that there may be a
range of acceptable approaches to determining whether the transfer of CIP is
subject to sale-and-leaseback accounting. For example, we understand that it
would be acceptable to conclude that the transfer of CIP accompanied by an
agreement to lease the completed construction is always subject to
sale-and-leaseback accounting (regardless of the stage of construction or
the amount of costs incurred). On the other end of the spectrum, we also
understand that it would be acceptable for entities to consider whether (on
the basis of the stage of construction) the CIP sold is substantially
similar to the underlying asset that will be leased back. That is, in some
cases, the CIP might not yet be substantially similar to the asset to be
leased back and, as a result, sale-and-leaseback accounting may not be
required. In determining whether this is the case, an entity will most
likely need to use judgment and consider various qualitative factors. We
believe that it also may be appropriate for an entity to consider
quantitative thresholds (e.g., whether the fair value of the CIP represents
90 percent or more of the expected value of the completed construction) to
help inform an overall qualitative assessment of whether the CIP is
substantially similar to the underlying asset to be leased back at the end
of construction. If an entity chooses to apply a quantitative threshold, the
approach should be applied to real estate on a comparable basis in such a
way that the fair value of the completed construction is not computed by
using inputs in which the subsequent use of the completed asset is
considered. For example, in real estate to be leased, this analysis should
be performed on the basis of the fair value of the partially completed asset
and the vacant completed asset, rather than a completed asset with an
in-place lease.
Although the approaches described above result in very different accounting
treatments, on the basis of the technical inquiry with the FASB staff, we
believe that each of these approaches represents a reasonable application of
the guidance.4 We believe that companies should elect one approach as an accounting
policy and should apply it consistently.
10.2.3.4.5 Seller-Lessee’s Subsequent Accounting for Arrangements Involving the Transfer of CIP
When an arrangement involving the transfer of CIP is subject
to the sale-and-leaseback guidance in ASC 842, questions have arisen about
the subsequent accounting for that arrangement for the seller-lessee. One of
the primary conditions for derecognizing an asset in a sale-and-leaseback
transaction is that the leaseback is not a finance lease. Since certain
components of the lease classification analysis cannot be known as of the
date of the transfer of CIP, such as the discount rate and the fair value of
the property as of the commencement date, it is not possible to assess and
achieve sale-and-leaseback accounting until the lease commencement date.
This conclusion holds true even if the seller-lessee expects
the leaseback to be an operating lease and no purchase option will exist
after the lease commencement date. That is, once the seller-lessee is deemed
the owner of an asset under construction (even if the seller-lessee loses
control of the asset), it will not be possible to achieve sale-and-leaseback
accounting until lease classification is determined, which is not possible
under ASC 842 until lease commencement.
In addition, we believe that costs incurred both before and
after the transfer of CIP to the buyer- lessor are related to a single unit
of account. Therefore, the seller-lessee would perform the following
accounting when the transfer of CIP is subject to the sale-and-leaseback
guidance in ASC 842:
-
Continue to record the existing CIP on the balance sheet (i.e., do not derecognize the partially completed asset).
-
Capitalize all incremental costs of construction (whether funded by the seller-lessee or the buyer-lessor).
-
Record an associated financing obligation (see Section 10.4.2) for costs funded by the buyer-lessor, including any funds received for the transfer of CIP.
-
Upon completion of construction, apply the sale-and-leaseback guidance to determine whether the completed construction can be derecognized (see Section 10.3).
When an arrangement involving the transfer of CIP is determined not to be
subject to the accounting guidance in ASC 842-40 after the substantially
similar quantitative threshold described above is applied, both the
seller-lessee and buyer-lessor will need to apply build-to-suit accounting
to determine whether the lessee is the accounting owner of the CIP (see
Chapter 11). If the lessee is
deemed to be the accounting owner, the lessee should not derecognize the CIP
on the legal sale date. However, if the lessee is not the accounting owner
after the legal sale date, the lessee must apply the appropriate
derecognition framework (for example, ASC 610-20 or, in some cases, ASC 606)
to determine whether a sale occurred.
10.2.3.4.6 Partial Sales Transactions Under ASC 842-40
The guidance in ASC 842-40 also applies to sales and subsequent
leasebacks of nonfinancial assets. For example, if a seller transfers a
real estate asset into a newly formed joint venture, retains a
noncontrolling interest in the joint venture, and subsequently leases
back the real estate asset from the joint venture, the seller would need
to evaluate whether the transfer of the asset represents a successful
sale in accordance with ASC 842-40.
Footnotes
1
We have assumed that the amount paid by the third
party to the acquiree would be known by the acquirer. However, to
the extent this amount is not known, the acquirer should impute a
purchase price for the assets by considering the fair market value
of the assets purchased and any off-market lease terms in the
leaseback.
2
This section addresses the applicability of
sale-and-leaseback guidance to concurrent sales and leases of
similar, completed assets. See Section 10.2.3.4.4 for a
discussion of the applicability of sale-and-leaseback guidance to
sales of CIP with a leaseback of the completed asset.
3
The legacy guidance in ASC 840-40-55-42 states, “In some
build-to-suit lease transactions, the lessee may incur
certain development costs before entering into a lease
agreement with the developer-lessor. Those costs may include
both soft costs (for example, architectural fees, survey
costs, and zoning fees) and hard costs (for example, site
preparation, construction costs, and equipment
expenditures).”
4
In addition, we believe that there may be a range of other acceptable
approaches between the two approaches outlined above. Companies that
are involved in these types of arrangements should consult with
their accounting advisers when electing an approach.
10.3 Determining Whether the Transfer of an Asset Is a Sale
The sale-and-leaseback accounting guidance in ASC 842-40 is aligned with ASC 606
in that both focus on the notion of control transfer. In other words, the
seller-lessee and buyer-lessor must determine whether the seller-lessee transfers to
the buyer-lessor control of the underlying asset. If so, the transfer of the asset
is a sale and both parties may apply successful sale-and-leaseback accounting. If
not, the transaction is economically a financing arrangement for both parties and
must be accounted for as such.
The decision tree below illustrates how the
seller-lessee and buyer-lessor would perform the control transfer assessment.
Changing Lanes
Transfer of Control Is a Simpler Concept for All Asset
Types
ASC 842-40 is simpler than ASC 840-40 with respect to using the transfer of
control of an underlying asset in a transaction to determine when a sale has
occurred and sale-and-leaseback accounting may be applied. The
sale-and-leaseback accounting guidance in ASC 840 differed depending on the
type of asset and is, by design, very onerous for real estate assets.
Specifically, under ASC 840-40, a seller-lessee of real estate was required
to perform a comprehensive and complex assessment of the
continuing-involvement provisions of the legacy real estate sales guidance
in ASC 360-20.
Going forward, and in a manner consistent with ASC 606, transferring control of — and thus selling — real estate is treated no differently than transferring control of any other type of asset. In other words, while there is an intentionally high hurdle under ASC 360-20 with respect to demonstrating that real estate has been sold for accounting purposes (and thus that a sale-and-leaseback has occurred) and control has been transferred, ASC 606 (and thus ASC 842-40) establishes no such hurdle.
As a result, we think that seller-lessees will find that the sale-and-leaseback
accounting guidance in ASC 842-40 is easier to apply to real estate than the
accounting requirements in ASC 840-40.
Connecting the Dots
Seller-Lessee and Buyer-Lessor May Reach Different Conclusions
As noted in Section 10.2.1, the buyer-lessor in a
transaction involving the transfer and lease of an underlying asset is
subject to the sale-and-leaseback accounting guidance in ASC 842-40. That
is, the buyer-lessor must assess whether it obtains control of the
underlying asset before leasing it back to the seller-lessee.
However, although the accounting requirements are
symmetrical, there is no requirement in ASC 842-40 for the seller-lessee and
buyer-lessor to reach symmetrical conclusions about whether a sale has
occurred. Accordingly, it may be reasonable for the seller-lessee and
buyer-lessor to reach different conclusions about whether control of the
underlying asset is transferred from the seller-lessee to the buyer-lessor.
This could be the case when the two entities’ judgments about the following
are different:
-
Lease classification assumptions (e.g., the economic life and fair value of the asset; the discount rate to be used), when one entity concludes that the lease is a finance lease or a sales-type lease and the other does not.
-
Control indicators in ASC 606-10-25-30, when one entity concludes that control has been transferred to the buyer-lessor and the other does not (see the next section).
This could also be the case when the buyer-lessor has adopted ASU 2021-05 (see
Section 17.3.1.8) and is required
to classify certain leases with significant variable lease payments that do
not depend on an index or rate as an operating lease on the lease
commencement date.
10.3.1 Transfer of Control in Accordance With ASC 606
ASC 842-40
25-1 An entity shall apply the following requirements in Topic 606 on revenue from contracts with customers when determining whether the transfer of an asset shall be accounted for as a sale of the asset:
- Paragraphs 606-10-25-1 through 25-8 on the existence of a contract
- Paragraph 606-10-25-30 on when an entity satisfies a performance obligation by transferring control of an asset.
The FASB decided that for an entity to apply the sale-and-leaseback accounting
guidance in ASC 842-40, it is necessary for control of the asset to be
transferred in accordance with ASC 606. Under ASC 606, the notion of control
transfer governs the determination of when to recognize revenue. That is, an
entity recognizes revenue when it transfers control of a good or service to a
customer. For more information about the control transfer notion in ASC 606, see
Deloitte’s Roadmap Revenue
Recognition.
When appropriate, the FASB has tried to make its use of the control transfer
notion consistent with that in ASC 606. For example, like ASC 842-40, the
guidance in ASC 610-20 on sales of nonfinancial assets to noncustomers relies on
the concepts in ASC 606 related to determining when control of a nonfinancial
asset is transferred. (See Chapter 17 of Deloitte’s Roadmap Revenue Recognition for further
discussion.) In addition, when developing ASC 842, the FASB changed the lessor
model to make it more consistent with the control transfer concepts in ASC 606.
(See Chapter 9 for
further discussion of the lessor accounting model in its entirety.) Accordingly,
having developed a robust control transfer framework related to determining when
a sale occurs, the FASB acknowledges in paragraph BC350 of ASU 2016-02 that it
was appropriate to use that same framework to determine when to apply
sale-and-leaseback accounting.
10.3.1.1 Identifying the Contract
Step 1 of the revenue model requires that a contract exist. This requirement is necessary to establish that there is a valid transaction with economic substance and that it is thus appropriate to proceed with applying the rest of the model in ASC 606 and recognize revenue. The same can be said for the requirements in ASC 842-40-25-1(a); if a contract does not exist for accounting purposes, it would be inappropriate to conclude that the seller-lessee has transferred control of — and sold — an asset to the buyer-lessor.
Generally, when a contract has legally enforceable rights and obligations, it
will meet the criterion in ASC 842-40-25-1(a). However, both the
seller-lessee and the buyer-lessor should assess any such transaction in
accordance with ASC 606-10-25-1 through 25-8. Chapter 4 of Deloitte’s Roadmap
Revenue Recognition
contains a comprehensive analysis of these requirements in ASC 606, and an
entity should use that analysis in evaluating whether the criterion in ASC
842-40-25-1(a) is met.
10.3.1.2 Transferring Control at a Point in Time
Once a seller-lessee and a buyer-lessor apply the guidance on identifying a
contract in ASC 606 and conclude that a contract exists, each party must
assess whether control of the underlying asset has been transferred to the
buyer-lessor at a point in time. This assessment of control is also required
for asset sales that are accounted for under ASC 610-20, including sales of
assets in exchange for legal-entity ownership.
Connecting the Dots
Buyer-Lessor Must Use ASC 606 to Determine Whether It Has
Purchased the Asset
As noted in Section 10.2.1, a buyer-lessor must assess whether it has obtained control of the underlying asset in a transfer and lease arrangement to determine whether it has purchased the asset and must apply the sale-and-leaseback accounting guidance in ASC 842-40. Accordingly, the buyer-lessor effectively applies the revenue recognition guidance in ASC 606 to determine whether it has obtained control of the underlying asset. If so, the arrangement reflects a purchase of the underlying asset and the buyer-lessor must recognize that asset.
No other standards in U.S. GAAP (e.g., ASC 805, ASC 330, ASC 350, ASC 360) contain a requirement under which a buyer of an asset uses the control transfer notion developed for revenue recognition to determine when it has obtained control of the asset and must recognize that asset.
In accordance with the control transfer principle in ASC 606-10-25-25, to have
control, the buyer-lessor must have “the ability to direct the use of, and
obtain substantially all of the remaining benefits from, the asset.”
Further, under ASC 842-40-25-1(b), the parties to the contract should use
the guidance and indicators in ASC 606-10-25-30 to determine whether and, if
so, when control has been transferred to the buyer-lessor.
However, paragraph BC155 of ASU 2014-09 cautions that the indicators in ASC 606-10-25-30 “are not a list of conditions that must be met before an entity can conclude that control of a good . . . has transferred to a customer.” Rather, the indicators “are a list of factors that are often present if a customer has control of an asset and that list is provided to assist entities in applying the principle of control.” Accordingly, an entity must assess all relevant facts and circumstances to determine when control has been transferred to the buyer-lessor.
The implementation guidance in ASC 842-40 contains an example of when certain
contractual provisions — in this case, a seller-provided residual value
guarantee — may lead to different conclusions about whether control of the
asset has been transferred to the buyer-lessor in accordance with ASC
606-10-25-30.
ASC 842-40
55-20 The seller-lessee may guarantee to the lessor that the residual value will be a stipulated amount at the end of the lease term. If the transfer of the asset is a sale in accordance with paragraphs 842-40-25-1 through 25-3, the seller-lessee residual value guarantee should be accounted for in the same manner as any other residual value guarantee provided by a lessee.
55-21 The residual value guarantee does not, on its own, preclude accounting for the transaction as a sale and leaseback, but should be considered in evaluating whether control of the asset has transferred to the buyer-lessor in accordance with paragraph 606-10-25-30. For example, a significant residual value guarantee by the seller-lessee may affect an entity’s consideration of the transfer of control indicator in paragraph 606-10-25-30(d).
ASC 842-40-55-21 above is careful to note that (1) the seller-provided residual value guarantee may (or may not) affect an entity’s assessment of the indicator in ASC 606-10-25-30(d) (i.e., whether significant risks and rewards of ownership have been transferred to the buyer-lessor) and (2) an entity’s assessment of the indicator in ASC 606-10-25-30(d), by itself, is not determinative of whether control of the asset has been transferred. These points are further emphasized in paragraph BC353 of ASU 2016-02, where the FASB acknowledges that “there may be substantial judgment involved in determining whether a sale has occurred.”
Paragraph BC353 of ASU 2016-02 goes on to note that, because of the significant judgments involved, an assessment of the indicators in ASC 606-10-25-30 may depend on the facts and circumstances of an arrangement:
For example, in determining when and whether a sale occurs, a seller-lessee may conclude that the buyer-lessor has obtained control of the asset if the buyer-lessor has obtained legal title to the asset, the seller-lessee has a present right to payment for the asset for the sale price, and the buyer-lessor has accepted the significant risks and rewards of ownership. In contrast, an entity may not reach the same conclusion if, for example, the seller-lessee provides a significant residual value guarantee such that the buyer-lessor has not accepted the significant risks and rewards of ownership. If the buyer-lessor has not accepted the significant risks and rewards of ownership . . . , careful evaluation of the facts and circumstances to determine when and whether a sale occurs in accordance with the principle in Topic 606 may be required.
Connecting the Dots
Potential for Additional Emphasis on Risks and Rewards
In applying the indicators in ASC 606-10-25-30 to a typical sale-and-leaseback transaction, an entity may need to place additional emphasis on its assessment of whether the buyer-lessor has obtained the significant risks and rewards of owning the underlying asset. In a typical sale-and-leaseback transaction, the buyer-lessor takes legal title to the underlying asset and is obligated to pay the seller-lessee for the asset. However, the seller-lessee generally retains physical possession of the underlying asset through the leaseback, and the buyer-lessor’s acceptance of the asset is generally not applicable. Accordingly, additional emphasis may need to be placed on (1) assessing contractual provisions that affect whether the risks and rewards of owning the underlying asset are conveyed to the buyer-lessor and (2) the control principle in ASC 606, to the extent that an assessment of the indicators in ASC 606-10-25-30 alone does not prove conclusive in the determination of which party has control.
In addition, ASC 606-10-25-30 directs entities to consider not only the indicators listed therein but also the guidance in ASC 606 on repurchase agreements and their effect on control transfer. See Section 10.3.3 for further discussion of repurchase options.
Therefore, we think that a seller-lessee and a buyer-lessor should consider the
comprehensive discussion in Section 8.6 of Deloitte’s Roadmap
Revenue
Recognition about when control of an asset is
transferred at a point in time. Further, Section 8.7 of Deloitte’s Roadmap
Revenue Recognition
includes a robust discussion of the guidance that applies when repurchase
agreements affect an entity’s conclusion about whether control of a good has
been transferred.
Connecting the Dots
Relinquishing Control Is Not Enough
Conceptually, the transfer of control can be assessed from both the buyer’s and
the seller’s perspective; however, the principle in ASC 606 is clear
that control should be viewed from the buyer’s perspective. While
the timing of control transfer will often be the same from both
perspectives (i.e., when the seller surrenders control and the buyer
obtains control), under ASC 606-10-25-30 — and thus under ASC
842-40-25-1(b) — the transfer of control is determined on the basis
of “the point in time at which a customer obtains control of a
promised asset.” Accordingly, to proceed with applying the
sale-and-leaseback accounting guidance in ASC 842-40, an entity must
perform an assessment from the perspective of the customer and
conclude that the buyer-lessor has obtained control of the
asset.
While the FASB decided that an entity should use the control transfer notion in ASC 606 to determine when a seller-lessee has sold an underlying asset to a buyer-lessor in a sale-and-leaseback transaction, the Board acknowledges in paragraph BC352 of ASU 2016-02 that the leaseback is a unique feature of such arrangements. Accordingly, the Board decided to clarify the application of ASC 606’s control transfer notion in sale-and-leaseback transactions as follows:
- Under ASC 842-40-25-2, the existence of the leaseback, by itself, does not prevent the seller-lessee from transferring control of the underlying asset to the buyer-lessor. See the next section for further discussion.
- ASC 842-40-25-2 further suggests that if the leaseback is classified by the seller-lessee as a finance lease (by the buyer-lessor as a sales-type lease), the seller-lessee retains control of the underlying asset. See the next section for further discussion.
- In accordance with ASC 842-40-25-3, the seller-lessee retains control of the underlying asset if it holds an option to repurchase the asset, unless (1) the option is exercisable only at fair value and (2) there are alternative assets, readily available in the marketplace, that are substantially the same as the underlying asset. See Section 10.3.3 for further discussion.
10.3.2 Leaseback Is a Finance Lease or a Sales-Type Lease
ASC 842-40
25-2 The existence of a leaseback (that is, a seller-lessee’s right to use the underlying asset for a period of time) does not, in isolation, prevent the buyer-lessor from obtaining control of the asset. However, the buyer-lessor is not considered to have obtained control of the asset in accordance with the guidance on when an entity satisfies a performance obligation by transferring control of an asset in Topic 606 if the leaseback would be classified as a finance lease or a sales-type lease.
An operating lease, by itself, does not transfer control of the entire underlying asset to the lessee; rather, the operating lease transfers control of the right to use the underlying asset to the lessee for a period of time. The right to use an underlying asset for a period of time represents only certain rights associated with the entirety of the asset. The lessor retains all rights associated with the asset once it is returned by the lessee as well as other rights of ownership while the asset is out on lease. In addition, the lessor obtains benefits from the asset through payments made by the lessee during the lease and controls all benefits associated with the residual asset. Accordingly, while the underlying asset is out on lease, a lessor, when considering the principle in ASC 606-10-25-25 and the indicators in ASC 606-10-25-30, still controls the asset.
In paragraph BC352(a) of ASU 2016-02, the FASB indicates that the same is true when a buyer-lessor obtains control of the underlying asset in a sale-and-leaseback transaction. The fact that the buyer-lessor is a lessor of the underlying asset in an operating lease does not preclude the buyer-lessor from obtaining control of that asset. Paragraph BC352(a) of ASU 2016-02 further notes that a sale-and-leaseback transaction is no different from other types of lease arrangements, in which a lessor purchases an asset from a third-party dealer only when all the terms of the lease are in place and the lessor never receives physical possession until the end of the lease term.
However, paragraph BC352(b) of ASU 2016-02 states that when a lessor leases an
underlying asset to a lessee under a finance lease or a sales-type lease, “the
lessee, in effect, obtains the ability to direct the use of, and obtain
substantially all the remaining benefits from, the underlying asset.” That is,
the lessee obtains control of the entire underlying asset. See Chapters 8 and 9 for further discussion
of the concepts behind lease classification by lessees and lessors,
respectively.
Accordingly, when an asset is transferred and leased back through a finance lease or a sales-type lease, the seller-lessee never effectively transfers control of the underlying asset to the buyer-lessor. Thus, a sale of the underlying asset has not occurred and both parties should account for the arrangement as a financing.
Bridging the GAAP
No Leaseback Classification Restrictions in IFRS 16
As described in the Bridging
the GAAP in Section 8.3.3.1, 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, but 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. As a result, IFRS 16 does not contain any leaseback
classification restriction to sale accounting. See Appendix B for more information about
the differences between ASC 842 and IFRS 16.
10.3.2.1 Real Estate With Finance or Sales-Type Leaseback of Building and Operating Leaseback of Land
In accordance with ASC 842-10-15-29, land must always be accounted for as a
separate lease component unless the impact of doing so would be insignificant.
Therefore, lease classification must be performed separately for land lease
components and, as a result, there may be scenarios in which entities that
engage in sale-and-leaseback transactions of real estate reach differing land
and building leaseback classification conclusions. More specifically, because
the economic life test is considered for building and not land (given its
indefinite economic life), a building lease component may be classified as a
finance or sales-type lease and land may be classified as an operating lease.
We believe that there may be two acceptable approaches to
accounting for situations in which the real estate is single-tenant or
single-floor real estate with a single combined title for the entire property,
and the building (the finance or sales-type lease component) is a more than
minor portion of the entire property:
- Successful sale-and-leaseback of the combined parcel would be precluded — This approach is acceptable under ASC 606-10-25-30(b), which describes one of the indicators of the transfer of control as the transfer of legal title to the buyer-lessor, potentially establishing a unit of account for sale accounting purposes since the land and building are not separately titled. Accordingly, the sale of the land and building is one distinct performance obligation involving a binary outcome of an either successful or failed sale. As a result, if one of the lease components has a failed sale-leaseback (building) and comprises a more than minor portion, sale accounting would be precluded for the real estate property as a whole and neither the land nor the building would be derecognized.
-
Successful sale-and-leaseback of the land may be possible — This approach may also be acceptable. ASC 610-20-25-6 states that the sale of nonfinancial assets to noncustomers should be evaluated for “each distinct nonfinancial asset” and ASC 360-10 identifies land as a nondepreciating asset (i.e., an asset with different attributes compared with other PP&E assets within the scope of ASC 360-10). Accordingly, land may be treated separately for sale accounting purposes.In addition, paragraph BC147 of ASU 2016-02, as well as the guidance in ASC 842-10-15-29 that requires preparers to identify land, when not insignificant, as a separate lease component, further supports the view that land is always a distinct asset. See Section 4.2.2 for more information.
We recommend that entities consult their auditors or accounting advisers in the
situations described above. Further, similar considerations may arise when an
entity sells an entire building (and, potentially, land) to another party (the
buyer-lessor) and only leases back a portion of the building. See Section 10.3.5 for further details on those
considerations.
10.3.3 Repurchase Options
ASC 842-40
25-3 An option for the seller-lessee to repurchase the asset would preclude accounting for the transfer of the asset as a sale of the asset unless both of the following criteria are met:
- The exercise price of the option is the fair value of the asset at the time the option is exercised.
- There are alternative assets, substantially the same as the transferred asset, readily available in the marketplace.
As stated in ASC 606-10-55-68 (and further discussed in Section 8.7 of Deloitte’s
Roadmap Revenue
Recognition), a seller’s option or obligation to
repurchase an asset generally precludes a buyer from obtaining control of that
asset because the buyer “is limited in its ability to direct the use of, and
obtain substantially all of the remaining benefits from, the asset even though
the [buyer] may have physical possession of the asset.” In short, an arrangement
to transfer an asset when the seller retains an option, or is obligated, to
repurchase that asset is not a sale. The guidance that follows in ASC 606
describes the accounting, which will depend on the facts and circumstances of
the repurchase agreement.
The control transfer notion from ASC 606, as applied in ASC 842-40, is no
different — control of the underlying asset generally is not transferred to the
buyer-lessor when the seller-lessee has the option or obligation to repurchase
the same asset. However, paragraph BC352(c) of ASU 2016-02 notes that when an
option (1) only permits the seller-lessee to repurchase the asset at its then
fair value and (2) other, similar assets are available
in the marketplace such that the buyer-lessor could easily obtain a replacement,
the buyer-lessor is not “constrained in its ability to direct the use of and
obtain substantially all the remaining benefits from the asset.” Accordingly,
when a sale of an underlying asset with a call option meets both of the conditions in ASC 842-40-25-3, neither the seller-lessee
nor the buyer-lessor is prevented from applying sale-and-leaseback accounting
because of the existence of a repurchase option. An entity must use judgment in
applying the criterion in ASC 842-40-25-3(b), under which other assets must be
“readily available in the marketplace” and “substantially the same.” This
criterion is generally regarded as a high hurdle, given that the FASB used the
words “substantially the same,” rather than merely “similar,” to refer to the
assets (“substantially the same” would be closer to “the same” or “identical”).
Factors that an entity may consider in assessing whether non-real-estate assets
(see discussion of real estate assets in Section
10.3.3.1) are substantially the same may include, but are not
limited to, whether the assets (1) can be easily exchanged, (2) have the same
technological functionality and features (e.g., the same make, model, and year
of production with similar features), (3) have similar uses, and (4) have values
that are affected similarly by macroeconomic factors.
Changing Lanes
Sale-and-Leaseback Accounting May Be Harder to Achieve for
Equipment
Under ASC 840-40, a repurchase option generally does not
preclude sale-and-leaseback accounting for non-real-estate assets (i.e.,
equipment) unless the option is a bargain. Therefore, it is common for
sale-and-leaseback transactions of equipment that are structured under
the accounting requirements in ASC 840-40 to contain a fixed-price
repurchase option. Contrastingly, any repurchase option on real estate —
at any strike price — is generally a form of continuing involvement that
precludes sale-and-leaseback accounting under ASC 840-40.
As a result, under ASC 842-40, it will be harder for
sale-and-leaseback transactions of equipment that contain a repurchase
option to meet the conditions in ASC 842-40-25-3 (reproduced above).
Accordingly, we expect that more equipment transactions may be
structured to contain fair value repurchase options rather than
fixed-price repurchase options (or may contain no repurchase options at
all). Otherwise, we would expect more equipment transactions to result
in a failed sale conclusion in the assessment of the sale-and-leaseback
accounting guidance in ASC 842-40.
As discussed in Section
10.3.3.1, any repurchase option on real estate will
continue to preclude sale- and-leaseback accounting under ASC 842.
10.3.3.1 Alternative Assets for Real Estate
ASC 842-40-25-3(b) indicates that purchase options would
preclude accounting for the transfer of an asset as a sale if there are no
“alternative assets, substantially the same as the transferred asset, readily
available in the marketplace.” For real estate, alternative assets that are
substantially the same as the asset transferred are generally not readily
available in the marketplace. This observation is based on paragraph BC352(c) of
ASU 2016-02, which states, in part:
Board members generally
observed that real estate assets would not meet [the] criterion [in ASC
842-40-25-3(b)]. This is because real estate is, by nature, “unique” (that
is, no two pieces of land occupy the same space on this planet) such that no
other similar real estate asset is “substantially the same.”
Accordingly, an entity could never achieve successful
sale-and-leaseback accounting under ASC 842-40 in an arrangement involving (1)
the transfer of real estate and a leaseback of that same real estate and (2) an
option (or obligation) held by the seller to repurchase that real estate. This
would be the case regardless of the option’s (or obligation’s) pricing. The
seller and buyer would account for the arrangement as a financing. (See
Section 10.4.2
for further discussion of the accounting requirements that apply when an
arrangement subject to the scope of ASC 842-40 does not qualify as a sale.)
Example 10-3
Developer A develops and owns four
office buildings as well as the land on which they are
built. All of the buildings are designed and built to
the same specifications, and all are located on the same
street next to each other. Developer A uses building 1,
in its entirety, for its own office space.
Developer A sells buildings 2–4 to REIT
B. Control of all three buildings is transferred to REIT
B in accordance with ASC 610-20. In a separate
transaction, Developer A sells building 1 to Partnership
C, a real estate venture, and leases the entire building
back for 15 years to continue to use it as office space.
As part of the arrangement with Partnership C, Developer
A holds a call option, exercisable at the
then-prevailing market value of the building, to
repurchase building 1 at any point during the lease
term.
Although there are three other office
buildings in the marketplace that (1) could serve as
alternative office space for Developer A, (2) are
located in substantially the same location, and (3) are
designed and built substantially the same, Developer A’s
repurchase option on building 1 would not meet the
condition in ASC 842-40-25-3(b). This is because land
and real estate are so unique that they cannot occupy
the exact same spot; therefore, they cannot be
“substantially the same” by definition.
10.3.3.2 Sale and Leaseback With a Residual Value Guarantee and a Fair Value Purchase Option
In assessing sale-and-leaseback transactions under ASC
842-40-25-3, some have asked whether the existence of a residual value guarantee
that includes a fair value purchase option would preclude sale accounting for an
equipment asset. This concern stems from a view that the existence of the
residual value guarantee effectively changes the exercise price of the purchase
option from “fair value at date of exercise” to “the greater of fair value at
date of exercise or the guaranteed residual value,” thus deviating from the
prescriptive pricing guidance in ASC 842-40-25-3(a).
The existence of a residual value guarantee5
combined with a fair value purchase option6 in an operating leaseback does not preclude the buyer-lessor from
obtaining control of an equipment asset and therefore should not preclude
accounting for the transfer of the asset as a sale.
The notion of control used in determining whether a sale has
occurred is generally the same as that used in assessing when control of an
asset is transferred to a customer in accordance with ASC 606 or ASC 610-20. In
paragraph BC352(c) of ASU 2016-02, the FASB described the impact of a fair value
purchase option on this control assessment, stating, “a buyer-lessor is not
constrained in its ability to direct the use of and obtain substantially all the
remaining benefits from the asset if the seller-lessee can only repurchase the
asset at its then-prevailing fair market value and the buyer-lessor could use
the proceeds from the repurchase to acquire an asset that is substantially the
same in the marketplace. This notion was expressed in a similar manner in the
basis for conclusions in Update 2014-09.”
The addition of a residual value guarantee does not result in a conclusion that
the buyer-lessor does not obtain control of the asset. Paragraph BC431 of ASU
2014-09 explains that “when the entity guarantees that the customer will receive
a minimum amount of sales proceeds, the customer is not constrained in its
ability to direct the use of, and obtain substantially all of the benefits from,
the asset.” Further, the residual value guarantee would only be triggered if the
fair value of the asset declined below that guaranteed amount. That is, the
buyer-lessor would always receive consideration at least equal to the fair value
of the asset.
In these situations, the buyer-lessor obtains control of the
equipment asset because it is not restricted by either the residual value
guarantee or the fair value purchase option (individually or together) from
directing the use of and obtaining substantially all the economic benefits from
the underlying asset.
Although the guidance in ASC 842-40-25-3 is derived from, and
consistent with, principles in ASC 606,the relationship between the guidance in
ASC 842-40-25-3 and that in ASC 606-10-55 on repurchase agreements (through ASC
842-40-25-1) can be difficult to navigate. The decision tree below7 helps clarify this relationship with respect to situations in which there
is a forward or call option on the underlying asset; Section 10.3.3.3 helps clarify this relationship with respect to
situations in which there is a put option.
10.3.3.3 Buyer-Lessor Holds a Put Option
ASC 606 contains guidance on sales of assets in which the buyer
has written an option to put the asset back to the seller. ASC 606-10-55-72 and
ASC 606-10-55-74 through 55-76 state the following with respect to the effect of
that put option on determining whether control of the asset has been
transferred:
ASC 606-10
55-72 If an entity has an
obligation to repurchase the asset at the customer’s
request (a put option) at a price that is lower than the
original selling price of the asset, the entity should
consider at contract inception whether the customer has
a significant economic incentive to exercise that right.
The customer’s exercising of that right results in the
customer effectively paying the entity consideration for
the right to use a specified asset for a period of time.
Therefore, if the customer has a significant economic
incentive to exercise that right, the entity should
account for the agreement as a lease in accordance with
Topic 842 on leases unless the contract is part of a
sale and leaseback transaction. If the contract is part
of a sale and leaseback transaction, the entity should
account for the contract as a financing arrangement and
not as a sale and leaseback transaction in accordance
with Subtopic 842-40.
55-74 If the customer does not
have a significant economic incentive to exercise its
right at a price that is lower than the original selling
price of the asset, the entity should account for the
agreement as if it were the sale of a product with a
right of return as described in paragraphs 606-10-55-22
through 55-29.
55-75 If the repurchase price
of the asset is equal to or greater than the original
selling price and is more than the expected market value
of the asset, the contract is in effect a financing
arrangement and, therefore, should be accounted for as
described in paragraph 606-10-55-70.
55-76 If the repurchase price
of the asset is equal to or greater than the original
selling price and is less than or equal to the expected
market value of the asset, and the customer does not
have a significant economic incentive to exercise its
right, then the entity should account for the agreement
as if it were the sale of a product with a right of
return as described in paragraphs 606-10-55-22 through
55-29.
In an arrangement in which an asset is transferred and leased
back and the buyer holds an option to put the asset back to the seller, the put
option is not subject to the guidance in ASC 842-40-25-3 in the determination of
whether sale-and-leaseback accounting may be applied.
ASC 842-40-25-3 only addresses “option[s] for the seller-lessee
to repurchase the asset” (i.e., call options). However, ASC 606 contains
guidance on accounting for the sale of an asset in which the seller is obligated
to repurchase that asset at the buyer’s request. ASC 606-10- 55-72
specifically addresses arrangements in which the transfer with the put option is
part of a potential sale-and-leaseback transaction and, accordingly,
circumstances in which the transaction would be accounted for as a financing
arrangement.
The sections below address other facts and circumstances related
to sale-and-leaseback transactions in which the seller-lessee holds (in
substance) a repurchase option.
10.3.3.4 Impact of Contingent Repurchase Provisions on Sale-and- Leaseback Accounting
A seller-lessee’s option8 to repurchase the underlying asset generally precludes sale-and-leaseback
accounting unless the conditions in ASC 842-40-25-3 are met.9 However, ASC 842 does not address whether an option to repurchase the
underlying asset upon the occurrence of a contingent event should preclude
sale-and-leaseback accounting.
If the seller-lessee can unilaterally trigger the contingent
event, the repurchase option would generally be assessed in the same manner as a
repurchase option without a contingency (see Section 10.3.3). Conversely, if the
contingent event is entirely within the control of the buyer-lessor, the
repurchase option should generally be assessed in the same manner as a
buyer-lessor put option (see Section 10.3.3.3). If the contingency is not entirely within the
control of the seller-lessee or buyer-lessor, an entity must consider the
substance of the contingent event to determine whether control has been
transferred to the buyer-lessor in a manner consistent with the framework in ASC
606 (see Sections
8.7 and 8.7.1.1 in Deloitte’s Roadmap Revenue Recognition for a detailed
discussion of analyzing contingent call options).
10.3.3.5 Renewal Options in Which a Leaseback Could Potentially Be Extended for the Entire Economic Life of the Underlying Asset
The mere existence of renewal rights that cover substantially
all the estimated economic life of the asset is not determinative that a sale is
not achieved. If it is reasonably certain that the renewal options will be
exercised, the lease term would represent a major part of the economic life of
the asset and the leaseback would be classified as a finance lease. In that
case, the transaction would fail to qualify for sale-and-leaseback accounting in
accordance with ASC 842-40-25-2. Key to this failed-sale determination is the
conclusion that the inclusion of the renewal option(s) will result in finance
lease (or sales-type lease) classification and, because control of the leased
asset has thus not been transferred (see ASC 842-40-25-2), a sale has not been
achieved. However, the existence of renewal rights that do not result in a
finance lease (or sales-type lease) classification would not automatically lead
to a failed sale even when such rights cover a term that comprises substantially
all of the estimated economic life of the underlying asset.10 Rather, if the renewal rights do not result in a finance lease
classification, the transaction should be assessed in a manner consistent with
the discussion below.
Legacy guidance in ASC 840-40 indicates that the buyer-lessor’s
obligation to share any portion of the appreciation of the property with the
seller-lessee is a form of continuing involvement that precludes
sale-and-leaseback accounting. Therefore, under ASC 840, renewal options for
substantially all of the remaining estimated economic life of the leased asset,
at any rate other than a fair market value rate as determined at the time of
renewal (e.g., rents that increase by the CPI but are not otherwise adjusted to
a market rate at renewal), represent continuing involvement that precludes
sale-and-leaseback accounting.
However, the sale-and-leaseback accounting guidance in ASC
842-40 moves away from focusing on continuing involvement to determining whether
a sale in a sale-and-leaseback transaction has occurred. Under ASC 842-40, the
control transfer principle in ASC 606 is used to determine whether the transfer
of the underlying asset is a sale. Specifically, under ASC 842-40-25-1, an
entity must consider the guidance in ASC 606-10-25-30 on when it satisfies a
performance obligation by transferring control of an asset (see Section 10.3.1.2).
ASC 606-10-25-30 refers to the guidance on control transfer in
ASC 606-10-25-23 through 25-26 and the guidance on repurchase agreements in ASC
606-10-55 and provides five indicators for an entity to consider when
determining whether a customer has obtained control of an asset. However, as
discussed in Section
10.3.1.2, paragraph BC155 of ASU 2014-09 cautions that the
indicators in ASC 606-10-25-30 are not a list of conditions that need to be met
for an entity to conclude that control has been transferred. Rather, the
assessment should be based on the underlying principle in ASC 606-10-25-25,
which states, in part, that “[c]ontrol of an asset refers to the ability to
direct the use of, and obtain substantially all of the remaining benefits from,
the asset” and that “[c]ontrol includes the ability to prevent other entities
from directing the use of, and obtaining the benefits from, an asset.”
Accordingly, under ASC 842-40, a sale-and-leaseback transaction
in which the leaseback grants a seller-lessee the right to renew the lease for a
term that comprises substantially all of the economic life of the underlying
asset should be assessed to determine whether the buyer-lessor has obtained
control of that asset. In such transactions, at least three of the indicators in
ASC 606-10-25-30 often will be met (i.e., the buyer-lessor has accepted the
asset, has a present obligation to pay for the asset, and has legal title to the
asset). Therefore, in line with the discussion in the Connecting the Dots in Section 10.3.1.2, the
assessment is likely to focus on whether the renewal options affect the
buyer-lessor’s ability to direct the use of, and obtain, substantially all of
the remaining economic benefits of the asset.
In a manner similar to the guidance in legacy GAAP noted above,
we do not believe that fair market value renewal options that extend throughout
the economic life of the underlying asset would preclude a successful sale
determination. In addition, under the control principle that underlies ASC 842
(and ASC 606), we believe that fixed-price renewal options that extend
throughout the entire economic life of the underlying asset would not
automatically preclude a successful sale conclusion. In each of these
circumstances, the buyer-lessor and seller-lessee must evaluate whether the
buyer-lessor obtains control of the underlying asset. If the buyer-lessor is
able to control the asset (i.e., has the ability to direct the use of and obtain
substantially all of the economic benefits from the asset), we believe that sale
recognition is appropriate. However, if the seller-lessee retains control of the
asset, the transaction would represent a failed sale and leaseback and should be
accounted for as a financing arrangement.
10.3.3.6 Seller-Lessee’s Right of First Offer or Right of First Refusal
In certain circumstances, sale-and-leaseback arrangements include provisions that
give the seller-lessee a right of first offer (ROFO), a right of first refusal
(ROFR), or both. An entity should carefully analyze such provisions to determine
whether they create a purchase option that would preclude the sale-and-leaseback
from being accounted for as a successful sale.
A ROFO provision gives the seller-lessee the right to make an
offer to repurchase the underlying asset in a sale-and-leaseback arrangement
before the buyer-lessor receives offers from third parties. A ROFR provides the
seller-lessee with the right to repurchase the underlying asset in a
sale-leaseback arrangement in the event that the buyer-lessor receives a bona
fide offer from a third party. In a sale-and-leaseback arrangement, an entity
should contemplate both ROFOs and ROFRs in determining whether control has truly
been transferred to the buyer-lessor and whether sale accounting is achieved.
See Section 8.7 of
Deloitte’s Roadmap Revenue
Recognition for further discussion of repurchase options,
including considerations and examples related to whether a ROFO or ROFR would
prevent the transfer of control and, accordingly, preclude sale accounting.
10.3.4 Transfer of Tax Benefits
The frequency of cross-border tax-benefit lease transactions has declined because many foreign countries have eliminated the related tax advantages. However, ASC 842 contains certain implementation guidance on applying the sale-and-leaseback accounting provisions of ASC 842-40 to determine whether it is appropriate to recognize income in such transactions.
ASC 842-40
55-11 A U.S. entity purchases an asset and enters into a contract with a foreign investor that provides that foreign investor with an ownership right in, but not necessarily title to, the asset. That ownership right enables the foreign investor to claim certain benefits of ownership of the asset for tax purposes in the foreign tax jurisdiction.
55-12 The U.S. entity also enters into a contract in the form of a leaseback for the ownership right with the foreign investor. The contract contains a purchase option for the U.S. entity to acquire the foreign investor’s ownership right in the asset at the end of the lease term.
55-13 The foreign investor pays the U.S. entity an amount of cash on the basis of an appraised value of the asset. The U.S. entity immediately transfers a portion of that cash to a third party, and that third party assumes the U.S. entity’s obligation to make the future lease payments, including the purchase option payment. The cash retained by the U.S. entity is consideration for the tax benefits to be obtained by the foreign investor in the foreign tax jurisdiction. The U.S. entity may agree to indemnify the foreign investor against certain future events that would reduce the availability of tax benefits to the foreign investor. The U.S. entity also may agree to indemnify the third-party trustee against certain future events.
55-14 The result of the transaction is that both the U.S. entity and the foreign investor have a tax basis in the same depreciable asset.
55-15 An entity should determine whether the transfer of the ownership right is a sale based on the guidance in paragraphs 842-40-25-1 through 25-3. Consistent with paragraphs 842-40-25-2 through 25-3, if the leaseback for the ownership right is a finance lease or if the U.S. entity has an option to repurchase the ownership right at any exercise price other than the fair value of that right on the exercise date, there is no sale. If the transfer of the ownership right is not a sale, consistent with the guidance in paragraph 842-40-25-5, the entity should account for the cash received from the foreign investor as a financial liability in accordance with other Topics.
55-16 If the transfer of the ownership right is a sale, income recognition for the cash received should be determined on the basis of individual facts and circumstances. Immediate income recognition is not appropriate if there is more than a remote possibility of loss of the cash consideration received because of indemnification or other contingencies.
55-17 The total consideration received by the U.S. entity is compensation for both the tax benefits and the indemnification of the foreign investor or other third-party trustee. The recognition of a liability for the indemnification agreement at inception in accordance with the guidance in Topic 460 on guarantees would reduce the amount of income related to the tax benefits that the seller-lessee would recognize immediately when the possibility of loss is remote.
10.3.5 Considerations Related to Sale and Partial Leaseback
Rather than selling and subsequently leasing back an entire property, some entities
may want to sell an entire property and then subsequently lease back a
portion of the property. For example, a seller-lessee may sell its
10-story corporate headquarters, after which it will only lease back five of the
floors. An entity must carefully consider the sale-and-leaseback accounting
requirements in these scenarios since the legal structure of the property that is
sold as well as the leaseback terms may affect the resulting accounting. For
example, if the property subject to the sale is not legally subdivided and the
portion of the property that is being leased back is classified as a finance lease,
the arrangement will not qualify for sale treatment unless the portion being leased
back is only a minor portion of the overall property. If, in contrast, the property
subject to the leaseback has been legally subdivided, it may be appropriate to
separately evaluate each legally subdivided portion of the larger asset when
applying the sale-and-leaseback model.
We have also observed complexities in the application of the
financing method when some space is leased back and other space is not. For example,
questions have arisen about whether a seller-lessee in a failed sale-and-leaseback
transaction should assume that space that is not leased back is being leased to the
buyer-lessor (since it was previously concluded that the space was not sold to the buyer-lessor but nonetheless that it is the
party that controls that space). At issue in such circumstances is whether that
imputed lease could qualify as a sales-type lease, thus leading to partial
derecognition on the balance sheet and potentially a gain or loss on sale. Because
accounting professionals’ views on such issues may differ, we recommend that
entities contemplating such a transaction consult their auditors or accounting
advisers.
Footnotes
5
Assume that the residual value guarantee, in and of
itself, would not preclude transfer of control in the assessment of the
risk/reward control indicator in ASC 606-10-25-30(d). See ASC
842-40-55-21 and paragraph BC353 of ASU 2016-02 for further
discussion.
6
Assume that the fair value purchase option would satisfy
the conditions in ASC 842-40-25-3 to achieve sale accounting. That is,
the exercise price of the option is the fair value of the asset at the
time the option is exercised and alternative assets, substantially the
same as the transferred asset, are readily available in the
marketplace.
7
Note that this decision tree is intended to reflect how
an entity would proceed with applying the relevant guidance (the
appropriate Codification paragraphs are cited) when a contract contains
a forward or call option to repurchase the asset for less than its
original selling price; it should be read in conjunction with the
referenced Codification paragraphs. For example, if such a contract is
not with a customer, an entity would be required to apply the scoping
guidance in ASC 610-20 to determine whether the contract is part of a
sale-and-leaseback transaction. If not, the entity must consider the
control transfer guidance in ASC 606-10-25-30 as well as the guidance on
repurchase agreements in ASC 606-10-55.
8
Although this section focuses on a seller-lessee’s
option to repurchase the underlying asset, we believe that the same
concepts would apply to a seller-lessee’s obligation to repurchase the
underlying asset upon the occurrence of a contingent event.
9
If the underlying asset is real estate, as discussed in
Section 10.3.3.2, the
condition in ASC 842-40-25-3(b) cannot be met and sale-and-leaseback
accounting is therefore always precluded for a transaction that includes
an unconditional repurchase option (or obligation) because there are no
alternative assets available in the marketplace that are substantially
the same as the real estate transferred in the arrangement.
10
In developing our view, we considered the discussion in
paragraph BC218 of ASU 2016-02, which suggests that purchase options and
extension options for all of the remaining economic life of the
underlying asset should be accounted for in the same way. Ultimately,
however, we did not think that the Board’s intent was to create a form
of double jeopardy for sale-and-leaseback transactions that satisfy the
condition in ASC 842-40-25-2 after considering the probability of
exercise of the lessee’s extension options.
10.4 Recognition and Measurement
As illustrated in the decision tree in Section 10.2.1, the analysis performed to determine whether the transfer of the underlying asset is a sale (as discussed in Section 10.3) governs the recognition and measurement of the transaction. Effectively, if the transfer of the asset by the seller-lessee to the buyer-lessor is determined to be a sale, the transaction is accounted for as a sale and leaseback. In addition, if the transfer of the asset is a sale, the measurement of the sale and leaseback further depends on whether the transfer is at fair value. However, if the transfer of the asset by the seller-lessee to the buyer-lessor is not determined to be a sale, both parties would account for the transaction as a financing arrangement.
The decision tree below illustrates the
recognition and measurement guidance.
10.4.1 Transfer of the Asset Is a Sale
ASC 842-40
25-4 If the transfer of the asset is a sale in accordance with paragraphs 842-40-25-1 through 25-3, both of the following apply:
- The seller-lessee shall:
- Recognize the transaction price for the sale at the point in time the buyer-lessor obtains control of the asset in accordance with paragraph 606-10-25-30 in accordance with the guidance on determining the transaction price in paragraphs 606-10-32-2 through 32-27
- Derecognize the carrying amount of the underlying asset
- Account for the lease in accordance with Subtopic 842-20.
- The buyer-lessor shall account for the purchase in accordance with other Topics and for the lease in accordance with Subtopic 842-30.
Effectively, when the transfer of the asset is determined to be a sale, both the seller-lessee’s and the buyer-lessor’s accounting can be divided into two steps:
Step
| Seller-Lessee | Buyer-Lessor |
---|---|---|
1 | At the time the buyer-lessor obtains control of the underlying asset in accordance with ASC 606-10-25-30 (see Section 10.3.1), (1) derecognize the carrying amount of the asset and (2) recognize the profit or loss on sale, calculated as the difference between the transaction price determined in accordance with ASC 606 and the carrying amount of the asset | At the time the buyer-lessor obtains control of the underlying asset in accordance with ASC 606-10-25-30 (see Section 10.3.1), recognize the underlying asset under other U.S. GAAP (e.g., ASC 330, ASC 360) |
2 | Account for the lease in accordance with the lessee accounting model in ASC 842-20 (see Chapter 8) | Account for the lease in accordance with the lessor accounting model in ASC 842-30 (see Chapter 9) |
ASC 842-40-25-4(a)(1) requires the seller-lessee to consider the transaction
price guidance in ASC 606. Therefore, we think that a seller-lessee should consider the
comprehensive discussion in Chapter
6 of Deloitte’s Roadmap Revenue Recognition to determine the transaction price for the
sale. If the sale-and-leaseback transaction is at market, the transaction price and the
fair value of the underlying asset should be equal. However, when the transaction is not
at market, the transaction price for the seller-lessee’s profit recognition would include
an “adjustment” to arrive at market-based terms as indicated in ASC 842-40-30-1 and ASC
842-40-30-3 (reproduced below). Such adjustments are further discussed in Section 10.4.1.1.
Connecting the Dots
Buyer-Lessor’s Measurement of the Underlying Asset
ASC 842-40-25-4 (reproduced above) clarifies that ASC 842’s sale-and-leaseback accounting guidance is more prescriptive regarding the seller-lessee’s recognition and initial measurement requirements than it is regarding the buyer-lessor’s. ASC 842-40-25-4(b) does not address the transaction price determined in accordance with ASC 606 and directs the buyer-lessor to other U.S. GAAP for guidance on determining the appropriate recognition and measurement requirements for the underlying asset. Therefore, as discussed in Section 10.3.1.2, while a buyer-lessor clearly must apply ASC 606 to determine whether and, if so, when it obtains control of an asset (i.e., step 5 of the revenue model), it is unclear whether it should apply the measurement concepts in ASC 606 (i.e., step 3 of the revenue model) to initially measure the asset it must recognize. For example, it is unclear whether the buyer-lessor should apply the guidance in ASC 606 on estimating variable consideration. This could create an inconsistency in the extent to which the concepts in ASC 606 are used in sale-and-leaseback accounting.
The buyer-lessor should consider the relevant measurement concepts in other applicable U.S. GAAP (e.g., ASC 330, ASC 360).
Changing Lanes
All or None
The existing sale-and-leaseback accounting guidance in ASC 840-40 restricted the
amount of profit that a seller-lessee may recognize and requires deferral of profit
amounts depending on the extent of the seller-lessee’s retained use of, or continuing
involvement in, the underlying asset.
This is not the case under ASC 842’s sale-and-leaseback accounting guidance. That is, if the transfer of the underlying asset is a sale, the full profit or loss (to the extent that the terms of the sale are at fair value) is recognized when the buyer-lessor obtains control of the asset. Alternatively, if the transfer of the asset is not a sale, no profit or loss may be recognized. There is no accounting that is “in between” those two recognition requirements, so either all or none of the profit or loss on the transaction is recognized.
In paragraph BC360 of ASU 2016-02, the FASB noted that certain stakeholders had suggested that the sale-and-leaseback guidance should require deferral of profit or loss in certain situations. Accordingly, the Board considered recognition and measurement guidance that would have precluded recognizing the amount of profit or loss associated with the rights in the underlying asset retained by the seller-lessee through the leaseback. However, the Board ultimately rejected such an approach on the basis that the accounting for the transfer of control (i.e., the sale) of the underlying asset, as well as the accounting for the transfer of the right to use (i.e., the lease of) the asset, should not be affected by each other when the transaction in its entirety is priced at fair value.
Bridging the GAAP
Gains Limited Under IFRS Accounting
Standards
As described above, under ASC 842, If the transaction qualifies as a
sale, the entire gain on the transaction would be recognized by the seller-lessee (if
the transaction is at fair value). However, under IFRS 16, the seller-lessee measures
the ROU asset arising from the leaseback at the proportion of the previous carrying
amount of the PP&E related to the right of use retained by the seller-lessee.
Accordingly, under IFRS Accounting Standards, the seller-lessee only recognizes a gain
related to the rights transferred to the buyer-lessor (i.e., the portion of the asset
sold). See Appendix B for additional information
about the differences between ASC 842 and IFRS 16.
10.4.1.1 Determining Whether the Sale Is at Fair Value
ASC 842-40
30-1 An entity shall determine whether a sale and leaseback transaction is at fair value on the basis of the difference between either of the following, whichever is more readily determinable:
- The sale price of the asset and the fair value of the asset
- The present value of the lease payments and the present value of market rental payments.
30-3 A sale and leaseback transaction is not off market solely because the sale price or the lease payments include a variable component. In determining whether the sale and leaseback transaction is at fair value, the entity should consider those variable payments it reasonably expects to be entitled to (or to make) on the basis of all of the information (historical, current, and forecast) that is reasonably available to the entity. For a seller-lessee, this would include estimating any variable consideration to which it expects to be entitled in accordance with paragraphs 606-10-32-5 through 32-9.
30-5 See Examples 1 and 2 (paragraphs 842-40-55-22 through 55-38) for illustrations of the requirements for a sale and leaseback transaction.
ASC 842-40 requires that a sale-and-leaseback transaction be accounted for at
market (i.e., at fair value). Accordingly, the seller-lessee’s profit or loss on the
transaction will be calculated as the difference between the carrying amount of the
underlying asset and its fair value.
Connecting the Dots
Off-Market Terms
Because the sale and the leaseback are negotiated together as a single transaction, there is an opportunity to structure payment terms and move cash flows between the two to achieve a certain result. The FASB acknowledged this in paragraph BC361 of ASU 2016-02:
The lease payments and the sales price in a sale and leaseback transaction are interdependent because they are negotiated as a package (for example, as part of the same contract or in two or more contracts that will be combined in accordance with the contract combinations guidance in paragraph 842-10-25-19). That is, the sales price might be more than the fair value of the asset because the leaseback lease payments are above a market rate; conversely, the sales price might be less than the fair value because the leaseback lease payments are below a market rate. That could result in the misstatement of both gains and losses on disposal of the asset for the seller-lessee and the carrying amount of the asset for the buyer-lessor, as well as result in misleading lease expense (for the seller-lessee) or lease income (for the buyer-lessor) related to the leaseback.
To remove this structuring opportunity, the Board decided to require that the accounting for sale-and-leaseback transactions be at fair value. Any difference from market terms is reflected as an adjustment in the amount of profit or loss (see Section 10.4.1.3).
ASC 842-40-30-1 indicates that in determining whether the transaction is at fair value, the parties to the transaction must compare either the (1) sale price and fair value or (2) present value of lease payments and present value of market rental rates. The parties are required to use whichever benchmark is more readily determinable. In addition, paragraph BC364 of ASU 2016-02 notes that the parties should “maximize the use of observable prices and observable information” when selecting the most appropriate benchmark.
In a transaction negotiated between independent parties, the sale price of the asset is generally the best indicator of its fair value. However, there may be instances in which the stated fair value of the asset does not equal its sale price. In those instances, a valuation specialist should determine the fair value of the asset by using other standard valuation techniques (e.g., comparison to the sale price of comparable assets, discounted cash flow analysis, calculation of replacement cost), keeping in mind the guidance noted above from ASC 842-40-30-1 and paragraph BC364 of ASU 2016-02.
In accordance with ASC 842-40-30-3, the “sale price” referred to in ASC
842-40-30-1(a) could be described as the transaction price determined in accordance with
ASC 606 before constraining any estimate of variable consideration. (The same could be
said for the “present value of lease payments” referred to in ASC 842-40-30-1(b).) That
is, the transaction is not off-market solely because the sale price includes (or lease
payments include) variable amounts. To determine whether the sale-and-leaseback
transaction is at fair value, the sale price (or present value of lease payments) should
include an estimate of variable payments.
Example 10-4
Seller-Lessee agrees to sell tower assets to Buyer-Lessor and lease them back under the following terms:
- Carrying amount of assets: $3 million.
- Fair value of assets: $9 million.
- Economic life of assets: 7 years.
- Sale price of assets: $7 million paid up front, with a bonus of $2 million if certain local government permits are approved.
- Lease term: 5 years.
- Lease payments: $2 million fixed annually.
- Seller-Lessee’s incremental borrowing rate: 9.00 percent.11
- Buyer-Lessor’s rate implicit in the lease: 7.35 percent.
Seller-Lessee concludes that the transfer of the tower assets is a sale (i.e., control has been transferred to Buyer-Lessor) in accordance with ASC 842-40-25-1 through 25-3.
Seller-Lessee estimates its sale price to be $9 million in accordance with ASC 842-40-30-3. Seller-Lessee used a most likely amount of $2 million to estimate variable consideration (before any constraint) in the sale price. Seller-Lessee recognizes the full profit on the sale of the tower assets. Profit is unadjusted because, in accordance with ASC 842-40-30-1, the sale price is equal to fair value.
In accordance with ASC 842-40-25-2, control has not been transferred to Buyer-Lessor from Buyer-Lessor’s perspective. In using the rate implicit in the lease (which is lower than Seller-Lessee’s incremental borrowing rate), Buyer-Lessor concludes that the present value of the lease payments represents substantially all of the fair value of the tower assets and the lease is therefore a sales-type lease. As noted in Section 10.3, it may be reasonable for a seller-lessee and a buyer-lessor to reach different conclusions about whether control of the asset is transferred to the buyer-lessor.
See Example 10-7 in
Section
10.4.2.2 for Buyer-Lessor’s accounting for this transaction as
well as its basis for the lease classification conclusions described
above.
10.4.1.1.1 Sale and Leaseback of an Asset Portfolio
When a company sells a portfolio of assets to a single purchaser and
leases back all of the assets under the terms of a master leasing arrangement, each
sale-and-leaseback transaction in the portfolio should be accounted for separately as
long as there is sufficient evidence that the terms of the transaction were not affected
by other sale-and-leaseback transactions in the portfolio entered into at approximately
the same time. If the terms of a transaction are such that the sale price of the asset
does not represent a market price or the lease arrangement provides for off-market
rental rates, that transaction should be accounted for collectively with other similar
transactions.
Regardless of whether the transactions are accounted for individually
or collectively, each individual transaction must be evaluated to determine whether the
fair value of the individual asset is less than its carrying amount. In such
circumstances, a loss should be recognized immediately.
Example 10-5
Company A sells and leases back five shopping centers, all
of which are physically separated and in different locations. The transfer
of the assets is a sale in accordance with ASC 842-40-25-1 through 25-3. The
sale price of the properties equals their fair market value on a portfolio
basis but not on an individual property basis. Because the terms of the
individual transactions were affected by the fact that they were negotiated
at the same time, A should calculate its gain on a portfolio basis. If,
however, A determines that there is a loss on one or more of the shopping
centers (i.e., the carrying value of the shopping center exceeds its fair
value), that loss should be recognized immediately and should not be offset
against the gain for the portfolio.
10.4.1.2 Sale Is Not at Fair Value
ASC 842-40
30-2 If the sale and leaseback transaction is not at fair value, the entity shall adjust the sale price of the asset on the same basis the entity used to determine that the transaction was not at fair value in accordance with paragraph 842-40-30-1. The entity shall account for both of the following:
- Any increase to the sale price of the asset as a prepayment of rent
- Any reduction of the sale price of the asset as additional financing provided by the buyer-lessor to the seller-lessee. The seller-lessee and the buyer-lessor shall account for the additional financing in accordance with other Topics.
As indicated in Section 10.4.1.1 and in ASC 842-40-30-1,
sale-and-leaseback transactions are always accounted for at fair value. The profit or
loss on the transactions is determined by reference to the fair value of the asset and
its carrying value. Accordingly, the sale price may need to be adjusted to reflect the
appropriate profit or loss calculation, resulting in the following:
When the sale price is above market, both the seller-lessee and the buyer-lessor
in the transaction must allocate the payments under the leaseback between those for the
lease and those for the additional financing (i.e., for the financial liability or the
financial asset). For the seller-lessee, the allocation must result in a zero balance at
the end of the lease term for both the financial liability and the lease liability. For
the buyer-lessor, the allocation must result in a zero balance at the end of the lease
term for the financial asset (and if the lease is classified as a direct financing
lease, a zero balance in the lease receivable in the net investment).
Any adjustment of lease payments that results from off-market terms must also be
considered in the classification assessment of the lease component. For example, an
increase in prepaid rent that results when a sale price is concluded to be below market
should be included in the assessment of all lease payments when an entity evaluates the
classification of that leased-back asset.
Example 1 in ASC 842-40-55-23 through 55-30 illustrates the accounting by both
parties in a sale-and-leaseback transaction when the sale is not at fair value.
ASC 842-40
Illustration of Sale and Leaseback
Transaction
55-22 Examples 1 and 2 illustrate the accounting for sale and leaseback transactions.
Example 1 — Sale and Leaseback Transaction
55-23 An entity (Seller) sells a piece of land to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the land has a carrying amount of $1 million. At the same time, Seller enters into a contract with Buyer for the right to use the land for 10 years (the leaseback), with annual payments of $120,000 payable in arrears. This Example ignores any initial direct costs associated with the transaction. The terms and conditions of the transaction are such that Buyer obtains substantially all the remaining benefits of the land on the basis of the combination of the cash flows it will receive from Seller during the leaseback and the benefits that will be derived from the land at the end of the lease term. In determining that a sale occurs at commencement of the leaseback, Seller considers that, at that date, all of the following apply:
- Seller has a present right to payment of the sales price of $2 million.
- Buyer obtains legal title to the land.
- Buyer has the significant risks and rewards of ownership of the land because, for example, Buyer has the ability to sell the land if the property value increases and also must absorb any losses, realized or unrealized, if the property value declines.
55-24 The observable fair value of the land at the date of sale is $1.4 million. Because the fair value of the land is observable, both Seller and Buyer utilize that benchmark in evaluating whether the sale is at market term. Because the sale is not at fair value (that is, the sales price is significantly in excess of the fair value of the land), both Seller and Buyer adjust for the off-market terms in accounting for the transaction. Seller recognizes a gain of $400,000 ($1.4 million – $1 million) on the sale of the land. The amount of the excess sale price of $600,000 ($2 million – $1.4 million) is recognized as additional financing from Buyer to Seller (that is, Seller is receiving the additional benefit of financing from Buyer). Seller’s incremental borrowing rate is 6 percent. The leaseback is classified as an operating lease.
55-25 At the commencement date, Seller derecognizes the land with a carrying amount of $1 million. Seller recognizes the cash received of $2 million, a financial liability for the additional financing obtained from Buyer of $600,000, and a gain on sale of the land of $400,000. Seller also recognizes a lease liability for the leaseback at the present value of the portion of the 10 contractual leaseback payments attributable to the lease of $38,479 ($120,000 contractual lease payment – $81,521 of that lease payment that is attributable to the additional Buyer financing), discounted at the rate of 6 percent, which is $283,210, and a corresponding right-of-use asset of $283,210. The amount of $81,521 is the amount of each $120,000 annual payment that must be attributed to repayment of the principal of the financial liability for that financial liability to reduce to zero by the end of the lease term.
55-26 After initial recognition and measurement, at each period of the lease term, Seller will do both of the following:
- Decrease the financing obligation for the amount of each lease payment allocated to that obligation (that is, $81,521) and increase the carrying amount of the obligation for interest accrued using Seller’s incremental borrowing rate of 6 percent. For example, at the end of Year 1, the balance of the financial obligation is $554,479 ($600,000 – $81,521 + $36,000).
- Recognize the interest expense on the financing obligation (for example, $36,000 in Year 1) and $38,479 in operating lease expense.
55-27 At the end of the lease term, the financing obligation and the lease liability equal $0.
55-28 Also, at the commencement date, Buyer recognizes the land at a cost of $1.4 million and a financial asset for the additional financing provided to Seller of $600,000. Because the lease is an operating lease, at the date of sale Buyer does not do any accounting for the lease.
55-29 In accounting for the additional financing to Seller, Buyer uses 6 percent as the applicable discount rate, which it determined in accordance with paragraphs 835-30-25-12 through 25-13. Therefore, Buyer will allocate $81,521 of each lease payment to Buyer’s financial asset and allocate the remaining $38,479 to lease income. After initial recognition and measurement at each period of the lease term, Buyer will do both of the following:
- Decrease the financial asset for the amount of each lease payment received that is allocated to that obligation (that is, $81,521) and increase the carrying amount of the obligation for interest accrued on the financial asset using Seller’s incremental borrowing rate of 6 percent. Consistent with Seller’s accounting, at the end of Year 1, the carrying amount of the financial asset is $554,479 ($600,000 – $81,521 + $36,000).
- Recognize the interest income on the financing obligation (for example, $33,269 in Year 2) and $38,479 in operating lease income.
55-30 At the end of the lease term, the carrying amount of the financial asset is $0, and Buyer continues to recognize the land.
Example 10-6
Seller-Lessee agrees to sell a ship to Buyer-Lessor and lease it back under the following terms:
- Carrying amount of assets: $10 million.
- Fair value of assets: $8 million.
- Economic life of assets: 20 years.
- Sale price of assets: $6 million.
- Lease term: 5 years.
- Lease payments: $500,000 fixed annually.
- Seller-Lessee’s incremental borrowing rate: 10.00 percent.12
- Buyer-Lessor’s rate implicit in the lease: 10.32 percent.
Both Seller-Lessee and Buyer-Lessor conclude that the transfer of the ship is a sale (i.e., control of the ship has been transferred to Buyer-Lessor) in accordance with ASC 842-40-25-1 through 25-3. As part of that analysis, both classify the lease as an operating lease in accordance with ASC 842-10-25-2.
In accordance with ASC 842-40-30-1, the sale is off-market because the sale
price is below market (i.e., the sale price is less than fair value).
Accordingly, Seller-Lessee and Buyer-Lessor must adjust both the sale price
and purchase price, respectively, to account for the transaction at fair
value in accordance with ASC 842-40-30-2.
Each party would record the transaction at commencement as follows:
10.4.1.3 Related-Party Leases
ASC 842-40
30-4 If the transaction is a related party lease, an entity shall not make the adjustments required in paragraph 842-40-30-2, but shall provide the required disclosures as discussed in paragraphs 842-20-50-7 and 842-30-50-4.
In a manner similar to the guidance in ASC 842-10-55-12, a related-party lease in a sale-and-leaseback transaction should be accounted for according to its contractually stated — and legally enforceable — terms rather than according to economic substance as required by ASC 840. Accordingly, an entity is not required to adjust the sales price for off-market terms in these arrangements.
See Section 13.2
for more information about related-party leases. See Chapter 15 for a detailed discussion of the
disclosure requirements in ASC 842. See Section 17.3.1.10 for a discussion of ASU 2023-01
(released in March 2023), which provides guidance on leasing arrangements between
entities under common control.
10.4.2 Transfer of the Asset Is Not a Sale
10.4.2.1 Seller-Lessee Accounting
ASC 842-40
25-5 If the transfer of the asset is not a sale in accordance with paragraphs 842-40-25-1 through 25-3, both of the following apply:
- The seller-lessee shall not derecognize the transferred asset and shall account for any amounts received as a financial liability in accordance with other Topics. . . .
The accounting by a seller-lessee for a failed sale and leaseback is fairly straightforward. The substance of the transaction when control of the underlying asset is not transferred to the buyer-lessor is that of a financing arrangement. Accordingly, in such cases, the seller-lessee should keep the asset on its books and recognize a corresponding financial liability for the cash received from the buyer-lessor.
The seller-lessee’s accounting for a failed sale-and-leaseback transaction is consistent with the accounting for failed sale-and-leaseback transactions in ASC 840 as well as with the accounting for a failed sale in ASC 606 (e.g., when a sale with a repurchase agreement prevents the customer from obtaining control of the good or service). The FASB acknowledges the consistency with both standards in paragraph BC368 of ASU 2016-02.
The asset should continue to be subsequently measured as any other owned asset
in accordance with ASC 360 (e.g., depreciated, subject to impairment testing). See
Section 11.4 for additional discussion of the
subsequent measurement of an asset in a failed sale-and-leaseback transaction. The
initial and subsequent measurement of the financial liability should generally be
determined in accordance with other applicable GAAP (e.g., ASC 470, ASC 835-30).
However, ASC 842-40 does provide limited guidance on the interest rate to be used in
measuring the financial liability.
ASC 842-40
30-6 The guidance in paragraph 842-40-25-5 notwithstanding, the seller-lessee shall adjust the interest rate on its financial liability as necessary to ensure that both of the following apply:
- Interest on the financial liability is not greater than the payments on the financial liability over the shorter of the lease term and the term of the financing. The term of the financing may be shorter than the lease term because the transfer of an asset that does not qualify as a sale initially may qualify as a sale at a point in time before the end of the lease term.
- The carrying amount of the asset does not exceed the carrying amount of the financial liability at the earlier of the end of the lease term or the date at which control of the asset will transfer to the buyer-lessor (for example, the date at which a repurchase option expires if that date is earlier than the end of the lease term).
In paragraph BC370 of ASU 2016-02, the FASB notes that the guidance in ASC 842-40-30-6 under which an entity must adjust the seller-lessee interest rate “is generally consistent with practice in previous GAAP” (i.e., with practice under the sale-and-leaseback accounting guidance in ASC 840-40).
In addition, paragraph BC369 of ASU 2016-02 clarifies certain aspects of the subsequent measurement of the financial liability recognized by the seller-lessee:
As the seller-lessee makes the scheduled payments in the contract, it will allocate those payments between interest expense on the financial liability and repayment of principal on the financial liability. At the end of the “leaseback” period (or at the point in time the buyer-lessor obtains control of the underlying asset), the seller-lessee will recognize any remaining balance of the financial liability as the proceeds on the sale of the asset. The gain or loss recognized at that point will reflect any difference between those proceeds and the carrying amount of the asset.
Connecting the Dots
Transaction Subsequently Qualifies as a Sale and Leaseback
Paragraph BC369 of ASU 2016-02 (reproduced above) notes an additional important point: control of the underlying asset may be transferred to the buyer-lessor after contract commencement. In other words, the “failed” sale may be rectified, and the transaction may qualify for sale-and-leaseback accounting, at the point when the buyer-lessor obtains control of the underlying asset. This could occur if a seller-lessee repurchase option expires unexercised, the classification of the leaseback changes from a finance lease to an operating lease in accordance with ASC 842-10-25-1, or control is transferred before the end of the contract term in a manner consistent with the control principle and indicators in ASC 606.
When this happens, in a manner similar to the seller-lessee’s accounting at the end of the contract term when control of the asset is never transferred, the seller-lessee would derecognize the underlying asset, derecognize the financial liability, and recognize profit or loss for the difference between the two. The leaseback would be accounted for in accordance with the lessee accounting model in ASC 842-20 (see Chapter 8), as indicated in Section 10.4.1.
However, the guidance in ASC 842-40-30-6 indicates that the interest rate on the financial liability should be adjusted to avoid recognition of a loss at the time when control of the asset is transferred. Therefore, when control of the underlying asset is subsequently transferred, we would expect loss recognition to be rare (i.e., only in situations in which control is transferred earlier than expected).
Example 2 in ASC 842-40-55-31 through 55-38 (reproduced in Section 10.4.2.3) illustrates the accounting for a transaction that subsequently qualifies as a sale and leaseback.
10.4.2.1.2 Recognition of an Impairment Loss in a Failed Sale and Leaseback
When the carrying value of an asset exceeds its fair value, questions
have arisen about whether the seller-lessee should recognize an immediate loss if the
transaction does not meet the requirements for sale-and-leaseback accounting under ASC
842-40.
If the transaction is a financing arrangement because the buyer-lessor
does not obtain control of the underlying asset, the seller-lessee should determine
whether an impairment charge is required under ASC 360. Under the ASC 360 model, an
impairment charge is required if the sum of the cash flows (undiscounted) expected to
result from the use of the asset and its eventual disposition is less than the carrying
amount of the asset. The amount of the impairment is measured as the amount by which the
carrying amount of the asset exceeds the fair value of the asset.
If, thereafter, control of the underlying asset is subsequently
transferred to the buyer-lessor and the transaction subsequently meets the requirements
in ASC 842-40 for sale-and-leaseback accounting, an immediate loss should be recognized
for the excess of the carrying amount of the underlying asset over the carrying amount
of the financial liability as of the date on which sale-and-leaseback accounting becomes
appropriate.
10.4.2.1.3 Interest Rate Considerations for a Failed Sale and Leaseback
Under ASC 842-40-30-6(b), the seller-lessee’s interest rate applied to
the deemed financing arrangement in a failed sale and leaseback must be adjusted to
avoid a “built-in loss” at the end of the arrangement. Specifically, ASC 842-40-30-6(b)
stipulates that the interest rate on a seller-lessee’s financial liability must be
adjusted, as necessary, to ensure that “[t]he carrying amount of the asset does not
exceed the carrying amount of the financial liability at the earlier of the end of the
lease term or the date at which control of the asset will transfer to the buyer-lessor.”
However, ASC 842-40-30-6(b) is silent on whether the interest rate should be
subsequently adjusted if the underlying asset is impaired, thereby reducing or
eliminating the original built-in loss.
Under a financing model, the asset accounting is divorced or delinked
from the liability accounting after initial recognition and measurement of the financing
arrangement. Accordingly, we believe that it would not be appropriate to make
corresponding adjustments to the interest rate on the liability upon the recognition of
an impairment of the underlying asset. Thus, a seller-lessee is required to adjust its
interest rate to avoid a built-in loss upon initial recognition of the financing.
However, the seller-lessee should not subsequently adjust this interest rate to avoid a
built-in-loss resulting from a later impairment of the underlying asset.
10.4.2.2 Buyer-Lessor Accounting
ASC 842-40
25-5 If the transfer of the asset is not a sale in accordance with paragraphs 842-40-25-1 through 25-3, both of the following apply: . . .
b. The buyer-lessor shall not recognize the transferred asset and shall account for the amounts paid as a receivable in accordance with other Topics.
A buyer-lessor’s accounting for a failed sale and leaseback is also straightforward. The substance of the transaction when the buyer-lessor does not obtain control of the underlying asset is that of a financing arrangement. Accordingly, under ASC 842, the buyer-lessor should not recognize the underlying asset but should instead recognize a financial asset for the cash paid. The buyer-lessor should look to other GAAP (e.g., ASC 310, ASC 835-30, ASC 326) to determine the appropriate initial and subsequent measurement of the financial asset. Note that the seller-lessee interest rate guidance in ASC 842-40-30-6 does not apply to the buyer-lessor’s accounting for the financial asset.
Changing Lanes
Accounting for a Failed Purchase and Leaseback
As mentioned previously in this chapter, ASC 842-40 provides guidance on the
buyer-lessor’s accounting. The same is true when the transfer of the underlying
asset in the transaction is not a sale. The sale-and-leaseback accounting guidance
in ASC 840 did not prescribe accounting requirements for buyer-lessors in a failed
sale and leaseback. Accordingly, it was entirely possible for the asset to remain on
the books of the seller-lessee but for the buyer-lessor to recognize that same asset
in accordance with ASC 360, ASC 805, or both. That is no longer the case under ASC
842, which requires both parties to account for the substance of a failed
sale-and-leaseback transaction as a financing arrangement.
Connecting the Dots
Transaction Subsequently Qualifies as a Purchase and Leaseback
Paragraph BC369 of ASU 2016-02 and Section 10.4.2.1 of this Roadmap indicate that
the buyer-lessor may obtain control of the underlying asset after contract
commencement (i.e., after the initial assessment of whether control has been
transferred). However, paragraph BC369 of ASU 2016-02 does not mention the
buyer-lessor’s accounting for situations in which this occurs, nor does it discuss
the buyer-lessor’s accounting at the end of the contract term.
In either situation, the buyer-lessor would derecognize the
financial asset and recognize the underlying asset at the same amount. The leaseback
would be accounted for in accordance with the lessor accounting model in ASC 842-30
(see Chapter 9), as
indicated in Section
10.4.1.
Example 2 in ASC 842-40-55-31 through 55-38 (reproduced in
Section 10.4.2.3)
illustrates the accounting for a transaction that subsequently qualifies as a sale
and leaseback.
Example 10-7
This example is a continuation of the fact pattern from Example 10-4.
Buyer-Lessor has concluded that the present value of the lease payments
($8,123,34713) represents substantially all (90.26 percent) of the fair value of the
tower assets ($9,000,000). The lease would therefore be classified as a
sales-type lease and, in accordance with ASC 842-40-25-2, Buyer-Lessor has
not obtained control of the tower assets.
Buyer-Lessor accounts for the financing arrangement at commencement as follows:
10.4.2.3 Illustrative Example
Example 2 in ASC 842-40-55-31 through 55-38 illustrates the accounting by both parties when the transfer of the underlying asset is not a sale.
ASC 842-40
Example 2 — Accounting for a Failed Sale and Leaseback Transaction
55-31 An entity (Seller) sells an asset to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the asset has a carrying amount of $1.8 million and has a remaining useful life of 21 years. At the same time, Seller enters into a contract with Buyer for the right to use the asset for 8 years with annual payments of $200,000 payable at the end of each year and no renewal options. Seller’s incremental borrowing rate at the date of the transaction is 4 percent. The contract includes an option to repurchase the asset at the end of Year 5 for $800,000.
55-32 The exercise price of the repurchase option is fixed and, therefore, is not the fair value of the asset on the exercise date of the option. Consequently, the repurchase option precludes accounting for the transfer of the asset as a sale. Absent the repurchase option, there are no other factors that would preclude accounting for the transfer of the asset as a sale.
55-33 Therefore, at the commencement date, Seller accounts for the proceeds of $2 million as a financial liability and continues to account for the asset. Buyer accounts for the payment of $2 million as a financial asset and does not recognize the transferred asset. Seller accounts for its financing obligation, and Buyer accounts for its financial asset in accordance with other Topics, except that, in accordance with paragraph 842-40-30-6, Seller imputes an interest rate (4.23 percent) to ensure that interest on the financial liability is not greater than the payments on the financial liability over the shorter of the lease term and the term of the financing and that the carrying amount of the asset will not exceed the financial liability at the point in time the repurchase option expires (that is, at the point in time Buyer will obtain control of the asset in accordance with the guidance on satisfying performance obligations in Topic 606). Paragraph 842-40-30-6 does not apply to the buyer-lessor; therefore, Buyer recognizes interest income on its financial asset on the basis of the imputed interest rate determined in accordance with paragraphs 835-30-25-12 through 25-13, which in this case Buyer determines to be 4 percent.
55-34 During Year 1, Seller recognizes interest expense of $84,600 (4.23% × $2 million) and recognizes the payment of $200,000 as a reduction of the financial liability. Seller also recognizes depreciation expense of $85,714 ($1.8 million ÷ 21 years). Buyer recognizes interest income of $80,000 (4% × $2 million) and recognizes the payment of $200,000 as a reduction of its financial asset.
55-35 At the end of Year 1, the carrying amount of Seller’s financial liability is $1,884,600 ($2 million + $84,600 – $200,000), and the carrying amount of the underlying asset is $1,714,286 ($1.8 million – $85,714). The carrying amount of Buyer’s financial asset is $1,880,000 ($2 million + $80,000 – $200,000).
55-36 At the end of Year 5, the option to repurchase the asset expires, unexercised by Seller. The repurchase option was the only feature of the arrangement that precluded accounting for the transfer of the asset as a sale. Therefore, upon expiration of the repurchase option, Seller recognizes the sale of the asset by derecognizing the carrying amount of the financial liability of $1,372,077, derecognizing the carrying amount of the underlying asset of $1,371,429, and recognizing a gain of $648. Buyer recognizes the purchase of the asset by derecognizing the carrying amount of its financial asset of $1,350,041 and recognizes the transferred asset at that same amount. The date of sale also is the commencement date of the leaseback for accounting purposes. The lease term is 3 years (8 year contractual leaseback term – 5 years already passed at the commencement date). Therefore, Seller recognizes a lease liability at the present value of the 3 remaining contractual leaseback payments of $200,000, discounted at Seller’s incremental borrowing rate at the contractually stated commencement date of 4 percent, which is $555,018, and a corresponding right-of-use asset of $555,018. Seller uses the incremental borrowing rate as of the contractual commencement date because that rate more closely reflects the interest rate that would have been considered by Buyer in pricing the lease.
55-37 The lease is classified as an operating lease by both Seller and Buyer. Consequently, in Year 6 and each year thereafter, Seller recognizes a single lease cost of $200,000, while Buyer recognizes lease income of $200,000 and depreciation expense of $84,378 on the underlying asset ($1,350,041 ÷ 16 years remaining useful life).
55-38 At the end of Year 6 and at each reporting date thereafter, Seller calculates the lease liability at the present value of the remaining lease payments of $200,000, discounted at Seller’s incremental borrowing rate of 4 percent. Because Seller does not incur any initial direct costs and there are no prepaid or accrued lease payments, Seller measures the right-of-use asset at an amount equal to the lease liability at each reporting date for the remainder of the lease term.
10.4.3 Subsequent Business Combinations
There may be situations in which an entity (either a seller-lessee or buyer-lessor) that
meets the definition of a business has previously entered into sale-and-leaseback
transactions and is acquired in a business combination accounted for in accordance with ASC
805-10. Accounting questions may arise regardless of (1) which party to a sale-and-leaseback
transaction is being acquired and (2) whether the past transactions were successful or
failed sales.
If the initial transfer of the asset in the sale-and-leaseback transaction was determined
to be a sale in accordance with ASC 842-40, the acquirer in a business combination should
account for the leaseback in the manner described in Section
8.3.5.1.1.
If the seller-lessee or buyer-lessor in a failed sale-and-leaseback
transaction is subsequently acquired in a business combination, the acquirer should not
reassess the transaction. For example, the acquirer may continue to use the acquiree’s
accounting for the failed sale-and-leaseback transaction until the transaction meets the
requirements in ASC 842-40 and ASC 606 for the transfer to be accounted for as a sale as
described in the Connecting the Dots in Section 10.4.2.1 and the Connecting the Dots in Section 10.4.2.2 for seller-lessees and buyer-lessors,
respectively. The assets and liabilities related to the arrangement should be measured at
their acquisition-date fair values.
See Chapter 4 of Deloitte’s Roadmap Business Combinations for more information.
Footnotes
Chapter 11 — Control of the Underlying Asset Before Commencement
Chapter 11 — Control of the Underlying Asset Before Lease Commencement
11.1 Overview
Transactions in which a lessee controls an underlying asset before the commencement date of the lease (in a manner discussed below) are within the scope of the sale-and-leaseback guidance in ASC 842-40. That is, if a lessee controls an underlying asset in the manner discussed in ASC 842-40-55 before the commencement date, the lessee must determine whether derecognition is appropriate as a sale-and-leaseback transaction. Sections 10.2.2 and 10.3 discuss control transfer in accordance with the sale-and-leaseback guidance in ASC 842-40.
The guidance in ASC 842-40-55 effectively categorizes these transactions into two groups:
- ASC 842-40-55-1 and 55-2 cover transactions in which the lessee is involved with an asset before that asset is transferred to the lessor. See Section 11.2 for more information.
- ASC 842-40-55-3 through 55-6 address transactions in which the lessee is involved with a construction project (i.e., the underlying asset that will be subject to the lease is in the process of being constructed). See Section 11.3 for more information.
In addition, see Section 11.4 for a discussion of the lessee’s accounting for an underlying asset it controls before lease commencement (i.e., accounting by the “deemed owner” of the asset).
Changing Lanes
Scope of Accounting Guidance for a Future Lessor in Transactions in
Which a Future Lessee (Potentially a Seller-Lessee) Controls the
Underlying Asset Before Lease Commencement
As stated above, the sale-and-leaseback guidance in ASC
842-40 addresses transactions in which a lessee controls the underlying
asset before lease commencement. The scope of ASC 842-40 applies to both the
future lessee and the future lessor in these types of transactions. Thus,
the scope of sale-and-leaseback accounting in ASC 842-40 differs from that
in ASC 840-40, which applied only to the future lessee (i.e., the
seller-lessee). ASC 842 therefore results in a significant change for
lessors engaged in these transactions, since they must now also assess
whether the counterparty in the arrangement (the lessee) has control of the
underlying asset before the commencement date of the lease (i.e., they must
determine whether the seller-lessee has obtained control of the underlying
asset before control is transferred to the buyer-lessor and the asset is
leased back to the seller-lessee).
Entities (both parties) involved in arrangements in which a
construction period is followed by a lease should carefully consider the
lessee’s involvement in the construction project to determine whether the
arrangement is within the scope of the guidance on sale-and-leaseback
accounting in ASC 842-40 as a result of such involvement. The implementation
guidance in ASC 842-40-55 addresses specific situations (not all-inclusive)
that would indicate that an arrangement is within the scope of the
sale-and-leaseback guidance in ASC 842-40. See Section 11.3.2 for additional
information.
11.2 Lessee’s Involvement With an Asset Before Lease Commencement
ASC 842-40
55-1 A lessee may obtain legal title to the underlying asset before that legal title is transferred to the lessor and the asset is leased to the lessee. If the lessee controls the underlying asset (that is, it can direct its use and obtain substantially all of its remaining benefits) before the asset is transferred to the lessor, the transaction is a sale and leaseback transaction that is accounted for in accordance with this Subtopic.
55-2 If the lessee obtains legal title, but does not obtain control of the underlying asset before the asset is transferred to the lessor, the transaction is not a sale and leaseback transaction. For example, this may be the case if a manufacturer, a lessor, and a lessee negotiate a transaction for the purchase of an asset from the manufacturer by the lessor, which in turn is leased to the lessee. For tax or other reasons, the lessee might obtain legal title to the underlying asset momentarily before legal title transfers to the lessor. In this case, if the lessee obtains legal title to the asset but does not control the asset before it is transferred to the lessor, the transaction is accounted for as a purchase of the asset by the lessor and a lease between the lessor and the lessee.
ASC 842-40-55-1 and 55-2 clarify that the notion of control is used to determine
whether a transaction is within the scope of the sale-and-leaseback guidance — if
the lessee controls the underlying asset before transferring it to the lessor (and
is thus the deemed owner), the transaction is accounted for in accordance with ASC
842-40. Section
10.2.2.1 includes an example illustrating such a scenario.
When the lessee obtains legal title to the underlying asset before transferring title to the lessor (i.e., the lessee obtains “flash title”) and the lessee does not control the underlying asset before transferring the asset to the lessor, the transaction is not accounted for in accordance with ASC 842-40. ASC 842-40-55-2 provides an example of such a situation, in which an entity often obtains financing or a certain tax treatment.
These same concepts apply to the transfer of an asset under construction, as discussed in Section 11.3.
11.3 Lessee’s Involvement in Construction Before Lease Commencement (Build-to-Suit Arrangements)
Build-to-suit arrangements can broadly be defined as arrangements in which a lessee is involved in construction of an asset it will eventually lease, including projects undertaken from the ground up and construction of major structural improvements related to existing assets.
Changing Lanes
Accounting for Build-to-Suit
Arrangements
Under ASC 840, an entity considered whether it had taken on substantially all of
the risks of construction and therefore whether it had to be considered,
from an accounting perspective, the deemed owner during construction. Under
this guidance, a lessee that was the deemed owner was required to record the
entire cost of the asset and a corresponding financing obligation (for the
portion of the cost funded by the lessor) on its balance sheet for amounts
not directly funded during the construction period. Further, upon completion
of construction, the lessee was required to apply sale-and-leaseback
accounting to determine whether it could derecognize the project. Many
entities were unable to derecognize the project after construction because
of various forms of continuing involvement that precluded sale treatment.
This was a particularly pervasive outcome for build-to-suit arrangements
that involved real estate. Overall, the build-to-suit rules in ASC 840 were
widely considered to be overly complex to apply and to result in overly
punitive accounting outcomes.
ASC 842 removes the risk principle governing the determination of the deemed owner and replaces it with a model in which a lessee will be considered to own an asset during construction only if the lessee has “control” of the asset during the construction period.
11.3.1 Costs Related to the Construction or Design of an Underlying Asset
ASC 842-40
55-3 An entity may negotiate a lease before the underlying asset is available for use by the lessee. For some leases, the underlying asset may need to be constructed or redesigned for use by the lessee. Depending on the terms and conditions of the contract, a lessee may be required to make payments relating to the construction or design of the asset.
55-4 If a lessee incurs costs relating to the construction or design of an underlying asset before the commencement date, the lessee should account for those costs in accordance with other Topics, for example, Topic 330 on inventory or Topic 360 on property, plant, and equipment. Costs relating to the construction or design of an underlying asset do not include payments made by the lessee for the right to use the underlying asset. Payments for the right to use the underlying asset are lease payments, regardless of the timing of those payments or the form of those payments (for example, a lessee might contribute construction materials for the asset under construction).
A lessee may be required to make payments related to the underlying asset before the commencement date of the lease. In such cases, the lessee and the lessor should first assess whether the lessee controls the underlying asset before commencement (see Section 11.3.2). If the lessee controls the underlying asset before commencement, the lessee should account for the asset in accordance with Section 11.4 as if it were the deemed owner. If the lessee does not control the underlying asset before commencement, the lessee should do the following in accordance with ASC 842-40-55-3 and 55-4:
- Determine whether those payments are for (1) costs related to the construction or design of the underlying asset to be leased or (2) the right to use the underlying asset.
- If the payments are for costs related to the asset’s construction or design, they should be accounted for in accordance with other applicable GAAP (e.g., ASC 330, ASC 360).
- If the payments are for the right to use the asset, they are lease payments, as discussed in Chapter 6.
Changing Lanes
Costs Incurred by Lessee Are No
Longer Determinative of Whether Lessee Is the Deemed Owner of
Construction
Under ASC 840-40, the lessee’s payment of “hard costs” before inception (e.g.,
payments for site preparation, construction costs, or equipment that is
related to components to be used in a construction project) generally
resulted in a sale-and-leaseback transaction, since the lessee was
considered the deemed owner of the construction project before entering
into the lease agreement. ASC 840-40 generally required the same outcome
when the lessee paid for “soft costs” before inception (e.g., payments
for architectural fees, survey costs, or zoning fees that are related to
components to be used in the construction of a project) and the soft
costs represented more than a minor amount of the expected fair value of
the asset under construction.
However, under ASC 842-40, payments made for costs related to the asset’s construction or design are not indicative of whether the lessee is the deemed owner of the asset under construction. Provided that the lessee does not control the asset under construction before lease commencement (see Section 11.3.2), costs related to the asset’s construction or design should be accounted for in accordance with other applicable GAAP, as indicated in ASC 842-40-55-4, regardless of whether those costs are considered hard costs or soft costs. Effectively, under ASC 842-40, the concepts of hard costs and soft costs no longer exist.
Example 11-1
Company X enters into a build-to-suit transaction to construct a building (i.e., X will be involved in the construction of the building before its lease of the building commences). Company X acts as construction agent. Before lease inception, X graded the land to prepare the site for construction of the building.
Under ASC 840, since the hard cost incurred involved construction of the asset
(site preparation), X was considered the owner of
the construction project and the transaction was
treated as a sale-and-leaseback transaction. Under
ASC 842, provided that either (1) the lease
commenced before the effective date of ASC 842
(see Section 16.8) or
(2) the lease has not commenced but X does not
control the asset under construction before lease
commencement (see Section 11.3.2),
X would not be considered the deemed owner during
construction and would account for the costs of
preparing the site for construction under ASC
842-40-55-3 and 55-4.
In determining whether payments made by the lessee before the commencement date
of the lease should be considered lease payments for the future right to use the
underlying asset or whether the payments should be accounted for as costs
related to the asset’s construction or design that are within the scope of other
applicable GAAP (e.g., ASC 330, ASC 360), the lessee should consider the nature
and substance of the payments made. Factors to consider include, but are not
limited to, the nature of the construction costs or activities paid for by the
lessee and whether the cash lease payments negotiated with the lessor that are
due after lease commencement appear to be at market rates (e.g., the cash lease
payments that would have otherwise been due in the absence of lease prepayments
may be decreased below market rates as a result of those prepayments). Costs
incurred by the lessee for leasehold improvements for the benefit of the lessee
are generally accounted for in accordance with ASC 360. Payments made by the
lessee before lease commencement for the lessee’s right to use the lessor’s
asset, rather than for leasehold improvements, are generally accounted for as
lease payments. An entity should use judgment in determining the appropriate
guidance to apply to payments made before lease commencement.
Example 11-2
Company Y enters into a build-to-suit transaction to construct a building. Company Y enters into a lease agreement with the lessor before the start of construction. The lease commencement date will be 30 days after the building is fully constructed. Company Y does not control the asset under construction and therefore is not considered the deemed owner. During the construction period, Y purchases slabs of granite that it expects to use throughout the leased floors of the building. The granite purchased by Y can be seen as a leasehold improvement since it will be used by the lessee and is not related to the right to use the lessor’s asset. Therefore, Y would account for the cost incurred in accordance with ASC 360.
Example 11-3
Company Y enters into a build-to-suit transaction to construct a building. Company Y enters into a lease agreement with the lessor before the start of construction. The lease commencement date will be 30 days after the building is fully constructed. Company Y does not control the asset under construction and therefore is not considered the deemed owner. During the construction period, Y purchases various construction materials specified under the terms of the lease agreement with the lessor. The construction materials purchased by Y can be viewed as consideration paid to the lessor for the right to use the lessor’s asset, which reduces the amount of future cash lease payments required after lease commencement. Therefore, Y would account for the cost incurred for construction materials as a prepayment of rent in accordance with ASC 842.
11.3.2 Control of the Underlying Asset During Construction
ASC 842-40
55-5 If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:
- The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).
- The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.
- The lessee legally owns either:
- Both the land and the property improvements (for example, a building) that are under construction
- The non-real-estate asset (for example, a ship or an airplane) that is under construction.
- The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.
- The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.
The list of circumstances above in which a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date.
Even if a lessee determines that it does not meet any of the
criteria in ASC 842-40-55-5, it may still “control an underlying asset” during
construction on the basis of the concept of control in ASC 606.1 The first three criteria in ASC 842-40-55-5 are grounded in principles of
ASC 606, which indicate that the lessee has control of the asset during
construction if (1) the lessee holds a call option, (2) the lessor has an
enforceable right to payment for performance to date and the asset does not have
an alternative use, or (3) the lessee has title to the asset under construction.
The concept in the last two criteria is not in ASC 606 but, in our view, is
based on an assumption that the lessor should be able to legally use the
underlying land (e.g., cannot be forced to vacate the property) during
substantially all of the economic life of the property improvement that is being
constructed on the land.
We do not believe that the concept of controlling an asset under construction
should be based on the definition of a lease in ASC 842, which includes guidance
on whether a contract conveys the right to control the use of an identified
asset. Although the concepts sound similar, the FASB explicitly excluded from
the scope of ASC 842 leases of assets under construction, partially because it
is difficult to apply the lease definition before an asset is placed in service
(e.g., it is difficult to assess the economic benefits associated with an asset
that is not yet operational).
When the above principles are applied, it would not be appropriate to conclude
that a lessee controls the asset under construction solely because of its
involvement in designing the asset or acting as the general contractor during
the construction project. This involvement is typical of many “build-to-suit”
arrangements. In these cases, the lessee would typically not control the asset
during construction because the lessee does not (1) take title to the asset, (2)
provide the lessor with an enforceable right to payment, or (3) prevent the
lessor from using the underlying land for substantially all of the economic life
of the property improvements.
Example 11-4
A lessee enters into a construction and lease agreement
with a lessor to build a new corporate headquarters. The
lessor will retain title to the building throughout the
construction period and agrees to pay up to $50 million
toward construction. The lessee designed the building to
its specifications and is contracted by the lessor to be
the general contractor during the construction project.
Assume that none of the criteria in ASC 842-40-55-5 are
met.
The lessee would not control the asset during
construction because its role as general contractor and
designer of an asset is not an indicator of control
under the criteria in ASC 842-40-55-5 or the principles
of control in ASC 606. Likewise, the lessee’s exposure
to overrun risk (since the lessor will pay only up to
$50 million of the construction costs) does not affect
the control analysis; before the adoption of ASC 842,
however, the lessee would have been considered the
deemed accounting owner because of its exposure to
construction risk.
Connecting the Dots
Control of Asset Under Construction Is Similar to Control in ASC
606
ASU 2016-02’s Background Information and Basis for
Conclusions notes that (1) a lessee can be, and thus should assess
whether it is, the owner of an asset under construction before lease
commencement and (2) the assessment should be based on control (i.e.,
when the lessee controls the asset under construction). This is a
departure from the requirements under ASC 840-40, which focused on
construction risk assumed by a lessee, and is another example of the
Board’s effort to align the guidance on leases and revenue when
appropriate. Two of the indicators of a lessee’s control of an
underlying asset that is under construction closely mirror those used by
suppliers under ASC 606 to determine whether customers gain control of
their work as they perform (i.e., as construction progresses). Under ASC
606, when a supplier’s “performance creates or enhances an asset (for
example, work in process) that the customer controls as the asset is
created or enhanced,” the supplier is satisfying its performance
obligation over time. A lessee that controls an asset as it is created
or enhanced by the supplier’s performance owns the asset throughout the
work in process and should therefore apply the sale-and-leaseback
accounting guidance in ASC 842-40 upon lease commencement. ASC 842-40
also provides indicators of legal ownership of the asset under
construction as well as control, through lease or ownership, of the
underlying land.
However, it is important to differentiate control of an
asset during construction from control of the right to use an asset
during construction. The latter reflects the lease of an asset under
construction, an arrangement that is outside the scope of ASC 842 (see
Chapter
3).
11.3.2.1 Lessee Has the Right to Obtain the Partially Constructed Underlying Asset at Any Point During the Construction Period
ASC 842-40-55-5(a), which provides one criterion under which the lessee would
control the underlying asset during construction before the lease commences,
states that the “lessee has the right to obtain the partially constructed
underlying asset at any point during the construction period (for example,
by making a payment to the lessor).”
In other words, if a call option is exercisable by the
lessee at any point during construction, the lessee controls the underlying
asset and should recognize the CIP. Importantly, “at any point” does not
mean at all points; therefore, entities must also consider options that
arise (or become exercisable) during the construction period regardless of
whether they are based on the passage of time or a substantive contingency.
In the case of a substantive contingency, an entity would be deemed to
control the asset under construction once it has the current ability to
exercise the option. On the other hand, we believe that if the only barrier
preventing exercise is the passage of time, an entity would be deemed to
control the asset under construction from the beginning of the construction
period.
An entity should carefully analyze a call option that
becomes exercisable upon the occurrence of a contingent event to determine
whether the lessee can unilaterally cause the call option to become
exercisable. For example, some construction and lease agreements stipulate
that if the lessee defaults on its obligation to perform under the
agreement, the lessee would be obligated to purchase the CIP. Under this
provision, the lessee would control the underlying asset because it could
unilaterally default under the agreement and thereby become able to obtain
the underlying asset. In contrast, if the obligation or option to purchase
the CIP was outside the control of the lessee (e.g., bankruptcy or
third-party events), the lessee would not have control over the CIP until
the contingent event occurred. Once the lessee is deemed to control the CIP,
it must apply sale-and-leaseback accounting rules to determine whether it
can derecognize the project, typically upon the completion of construction
or at lease commencement. Scenarios in which the lessee must apply
sale-and-leaseback accounting rules to make such a determination include
those in which the lessee maintains control up to completion of
construction, as well as those in which the option that conveyed control
expires unexercised during the construction period.
Example 11-5
A lessee enters into a construction
and lease agreement with a lessor to build a new
corporate headquarters. The lessor will retain title
to the building throughout the construction period
and agrees to pay up to $50 million toward
construction. The construction is expected to be
completed in 18 months. At any point during the
construction, the lessee has the right (but not the
obligation) to purchase the CIP at the lessor’s cost
plus a profit margin. If the call option is not
exercised and construction is completed, the lessee
will lease the asset from the lessor for a lease
term of 15 years with an option to purchase the
building at the end of the lease term at a fixed
price.
The lessee would control the asset
during construction and recognize the CIP. At the
end of construction, the lessee must consider the
sale-and-leaseback guidance in ASC 842-40-25-1
through 25-3. In this case, the lessee would not
qualify for sale accounting because of the call
option that exists at the end of the lease period
(see Section
10.3.3.1).
Connecting the Dots
Lessor Put Options
Lessor put options should also be considered in
scenarios involving construction of an asset to be leased. In a
manner consistent with the guidance on put options in ASC 606, an
entity should assess a put option held by the lessor to determine
whether the lessor has a significant economic incentive to exercise
the option.
If such an incentive exists, it would be assumed
that the lessee controls the CIP.
11.3.2.2 Lessor Has Enforceable Right to Payment for Its Performance to Date and the Asset Does Not Have an Alternative Use
ASC 842-40-55-5(b), which provides one criterion under which the lessee would control the underlying asset during construction before the lease commences, states the following:
The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.
The criterion in ASC 842-40-55-5(b) would apply only when
(1) the lessor has an enforceable right to payment for all of its
performance to date (i.e., throughout the development or construction of the
asset) and (2) the asset has no alternative use to the owner-lessor. This
criterion is derived from the guidance in ASC 606 on recognizing revenue as
control is transferred to a customer over time (e.g., when the transfer of
control results in the customer’s ownership of a partially completed asset
during the asset’s development or construction).
We expect the circumstances listed above to be uncommon for
an asset under construction because a lessee is not typically required to
pay for all of the performance to date throughout construction. Rather, the
lessor will be paid, at least in part, through lease payments over the
period of the lease term after construction has ended. A significant amount
of required prepaid rent would not meet the criterion in ASC 842-40-55-5(b)
unless the lease provided for the nonrefundable right to payment for all the
costs incurred by the lessor plus a reasonable profit margin. That is, for
the future lessee to control the asset and, therefore, to be the deemed
owner of the asset during construction under this condition, the required
payments must compensate the developer for all construction efforts
throughout the asset’s construction.2
Further, many build-to-suit arrangements may require the
lessee to pay the lessor upon the occurrence of certain contingent events
outside the lessor’s control (e.g., default by the lessee). This requirement
alone would not meet the criterion in ASC 842-40-55-5(b) because the lessor
cannot force the lessee to pay in the absence of a default under the lease
agreement.
Finally, in the rare circumstances in which the first part
of this criterion is met, the asset under construction may have an
alternative use to the lessor under ASC 842-10-55-7. This criterion is
intended to be the same as that in ASC 606-10-25-27(c) and 25-28. See
Section
8.4.5.1 of Deloitte’s Roadmap Revenue Recognition for a
detailed discussion of this criterion.
11.3.2.3 Lessee Controls the Underlying Land
ASC 842-40-55-5(d), which provides one criterion under which the lessee would control the underlying asset during construction before the lease commences, states the following:
The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements. [Emphasis added]
In this context, the lease term should take into account all renewal options,
regardless of whether it is reasonably certain that the renewal options will
be exercised. Note that the consideration of renewal options in accordance
with this criterion differs from the consideration of renewal options in the
determination of lease term under ASC 842-10-30-1. (See Section 5.2.2 for
further discussion.) Examples of when the transfer of land may not qualify
as a sale include circumstances in which the seller-lessee retains a call
option on the land or the leaseback is determined to be a finance lease.
In our view, the concept in the criterion in ASC
842-40-55-5(d) is based on an assumption that the lessor of the property
improvements should be able to use the underlying land during substantially
all of the economic life of the property improvements that are being
constructed on the land. When the lessor does not have appropriate rights to
the land, the lessee would control the property improvements during
construction if the following conditions are met:
-
The lessee of the property improvements controls the land — This condition is met if any of the following is true:
-
The lessee holds title to the land.
-
The lessee previously sold the land but did not qualify for sale accounting.
-
The lessor of the property improvements has title to the land, but the lessee sold the land to the lessor in a failed sale and leaseback.
-
-
The lessee controls the constructed asset — Even if the first condition is met (i.e., the lessee controls the land), the lessee does not control the constructed asset if it has leased the land to the lessor for substantially all of the economic life of the to-be-constructed asset.
Read literally, the second condition can never be met in a
financing of the land through a previous failed sale or sale and leaseback
because the lessee cannot lease out the land that it has already legally
sold to the lessor. However, we believe that the principle underlying the
criterion in ASC 842-40-55-5(d) should be considered. That is, an entity
should consider whether the lessor has the right to legally use the land for
substantially all of the economic life of the property improvements. The
entity must consider all facts and circumstances when making this
determination.
Example 11-6
Company A sells land to Company B
and contemporaneously enters into a construction and
lease agreement for B to build a new corporate
headquarters for A. Upon completing construction of
the new headquarters building, B will lease the land
and the building to A for a period of 40 years. At
the end of 40 years, A will have the right to
purchase the land and corporate headquarters at a
fixed price. The corporate headquarters has an
estimated economic life of 40 years. Company A must
evaluate whether it meets the criteria in ASC
842-40-55-5(d). In this example, it is assumed that
none of the other criteria in ASC 842-40-55-5 apply
to the arrangement related to the to-be-constructed
property improvements.
Company A determines, in accordance
with ASC 842-40-25-3, that the call option precludes
accounting for the transfer of the land as a sale.
The first condition in ASC 842-40-55-5(d) is met
since the failed sale-and-leaseback of the land
indicates that the seller/lessee (A) still controls
the land during construction.
However, even if the first condition
is met, A must also evaluate the second condition
related to whether it also controls the constructed
asset. (Importantly, the right to use the
constructed asset is not the same as controlling the
constructed asset.) In assessing whether A controls
the corporate headquarters, A notes that B has the
legal right to use the land (as lessor of the
corporate headquarters) for the entire 40-year
economic life of the asset to be constructed. That
is, the land purchase option is not exercisable
until the property improvement has no remaining
economic life. Therefore, on the basis of these
facts and circumstances, A (as the seller/lessee)
concludes that it does not control the corporate
headquarters during construction since the second
condition in ASC 842-40-55-5(d) is not met.
11.3.2.4 Codification Examples
Example 3, Cases A and B, reproduced below, illustrate applications of the guidance in ASC 842-40-55-5.
ASC 842-40
55-6 See Example 3 (paragraphs 842-40-55-39 through 55-44) for an illustration of the scope of this Subtopic.
55-39 Example 3 illustrates the guidance on determining whether a lessee controls an underlying asset that is under construction before the commencement date.
Example 3 — Lessee Control Over an Asset Under Construction
55-40 Lessee and Lessor enter into a contract whereby Lessor will construct (whether itself or using subcontractors) a building to Lessee’s specifications and lease that building to Lessee for a period of 20 years once construction is completed for an annual lease payment of $1,000,000, increasing by 5 percent per year, plus a percentage of any overruns above the budgeted cost to construct the building. The building is expected to have an economic life of 50 years once it is constructed. Lessee does not legally own the building and does not have a right under the contract to obtain the building while it is under construction (for example, a right to purchase the construction in process from Lessor). In addition, while the building is being developed to Lessee’s specifications, those specifications are not so specialized that the asset does not have an alternative use to Lessor.
Case A — Lessee Does Not Control the Asset Under Construction
55-41 Assume Lessee controls (that is, Lessee is the owner for accounting purposes) the land upon which the building will be constructed and, as part of the contract, Lessee agrees to lease the underlying land to Lessor for an initial period of 25 years. Lessor also is granted a series of six 5-year renewal options for the land lease.
55-42 None of the circumstances in paragraph 842-40-55-5 exist. Even though Lessee owns the land (whether legally or for accounting purposes only) upon which the building will be constructed, Lessor legally owns the property improvements and has rights to use the underlying land for at least substantially all of the economic life of the building. Lessee does not own the building and does not have a right under the contract to obtain the building (for example, a right to purchase the building from Lessor). In addition, the building has an alternative use to Lessor. Therefore, Lessee does not control the building under construction. Consequently, the arrangement is not within the scope of this Subtopic. Lessee and Lessor will account for the lease of the building in accordance with Subtopics 842-20 and 842-30, respectively. If Lessee incurs costs related to the construction or design of the building (for example, architectural services in developing the specifications of the building), it will account for those costs as lease payments unless the costs are for goods or services provided to Lessee, in which case Lessee will account for those costs in accordance with other Topics.
Case B — Lessee Controls the Asset Under Construction
55-43 Assume Lessee leases, rather than owns, the land upon which the building will be constructed. Lessee has a 20-year lease of the underlying land and five 10-year renewal options. Therefore, Lessee’s lease of the underlying land, together with the renewal options, is for at least substantially all of the economic life of the building under construction. Lessee enters into a sublease with Lessor for the right to use the underlying land for 20 years that commences upon completion of the building. The sublease has a single 10-year renewal option available to Lessor.
55-44 Lessee controls the building during the construction period and, therefore, the arrangement is within the scope of this Subtopic. Lessee and Lessor will apply the guidance in this Subtopic to determine whether this arrangement qualifies as a sale and a leaseback or whether this arrangement is, instead, a financing arrangement. Lessee controls the building during the construction period because, in accordance with paragraph 842-40-55-5(e), Lessee controls the use of the land upon which the building will be constructed for a period that is at least substantially all of the economic life of the building and the sublease entered into with Lessor does not both (a) grant Lessor the right to use the land before the beginning of construction and (b) permit Lessor to use the land for substantially all the economic life of the building (that is, the sublease, including Lessor renewal options, only is for 30 years as compared with the 50-year economic life of the building).
Footnotes
1
Paragraph BC400(b) of ASU 2016-02 states, in part,
that the FASB “observed that, in concept, the evaluation under Subtopic
842-40 on whether an entity controls an asset that is under construction
is similar to the evaluation undertaken in the revenue recognition
guidance in accordance with paragraph 606-10-25-27 to determine whether
a performance obligation is satisfied over time.”
2
This example contemplates a scenario in which the
lessee is able to instruct the lessor to stop construction and thus
is liable for only cost plus a reasonable margin incurred through
the date of ceased construction. However, the example does not
contemplate a specific performance scenario in which, despite the
lessee’s request to cease construction, the lessor could elect to
complete construction and therefore require the lessee to pay the
full consideration in the agreement (cost plus margin). The latter
arrangement suggests that the lessee has control over the CIP in a
manner consistent with the guidance in ASC 606-10-55-13.
11.4 Accounting by the Deemed Owner of an Asset
When a lessee is the deemed owner of an asset, the lessee must recognize the
asset in accordance with other applicable GAAP (e.g., ASC 360). Therefore, when the
lessee is the deemed owner of an asset under construction (see Section 11.3.2), the lessee
must recognize CIP in accordance with ASC 360 as it would for any other owned asset
under construction. That is, when the lessee determines that it is the deemed owner
of the CIP, it must account for the asset during the construction period as if it is
the party responsible for the construction costs, with a deemed loan from the
lessor, as construction progresses. Accordingly, the lessee must recognize on the
balance sheet (1) the costs incurred by the lessee to construct the asset, (2) the
costs incurred by the lessor to construct the asset, and (3) an offsetting financing
obligation for the amount funded by the lessor.
After recognizing the asset, the lessee must apply sale-and-leaseback accounting
as of the commencement date of the lease (which is typically the end of the
construction period) to determine whether it can derecognize the asset (see
Chapter 10 for more
information about sale-and-leaseback transactions). If the lessee cannot derecognize
the asset because the transaction fails to meet the criteria for sale-and-leaseback
accounting, the lessee would continue to account for the asset as if it were the
asset’s owner, as further discussed below.
In addition, the seller-lessee would continue to account for the financing obligation
in the same manner as it would for any other failed sale-and-leaseback transaction.
If the seller-lessee expects the balance of the financing obligation to be
lower than the net carrying value of the underlying asset when control of
the asset is transferred to the buyer-lessor (which is typically the end of the
lease term), the interest rate on the financing obligation should be increased to
avoid this “built-in loss.” This adjustment generally causes the balance of the
financing obligation to be equal to the net carrying value of the underlying asset
when control of the asset is transferred.
On the other hand, if the seller-lessee expects the balance of the financing
obligation to be higher than the net carrying value of the underlying asset
when control of the asset is transferred to the buyer-lessor, the interest rate on
the financing obligation should not be adjusted (i.e., a “built-in gain” is not
prohibited). See Section 10.4.2.1 for further
discussion of the accounting for a financing obligation in a failed
sale-and-leaseback transaction.
As discussed above, if a sale and leaseback of the asset fails to
meet the sales recognition criteria in ASC 842-40, the seller-lessee would continue
to account for the asset as it always has — as the owner. However, when the lessee
is deemed the accounting owner of an asset during the construction period, the
lessee would not have begun depreciating the asset because the asset would not yet
have been placed in service. In other words, rather than account for the asset as it
always has, the deemed owner must apply an appropriate depreciation method at the
end of the construction period.
The fact that the deemed owner of an asset (e.g., a constructed
building) is typically not the owner of the underlying land further complicates the
adoption of a depreciation method because treatment of the asset would be akin to
that of a leasehold improvement. If the lease meets either the transfer-of-ownership
criterion in ASC 842-10-25-2(a) or the reasonably certain purchase option criterion
in ASC 842-10-25-2(b), the asset should be depreciated in a manner consistent with
the lessee’s normal depreciation policy for owned assets.
If the lease does not meet either criterion, the asset should be
depreciated in a manner consistent with the lessee’s normal depreciation policy
except that the depreciable life must not exceed the lease term. In a manner
consistent with the depreciation of other owned assets, the asset should be
depreciated to its expected residual value at the end of its depreciable life. As
discussed above, the depreciable life of such assets is often restricted to the
lease term, which may result in a significant expected residual value. In these
circumstances, the residual value of the asset is effectively the final payment
against the associated financing obligation. Importantly, as discussed above, ASC
842-40-30-6 precludes the expected balance of the financing obligation from being
lower than the expected residual value of the asset when control of the asset is
transferred. However, this guidance stipulates that, in those cases, an entity is
required to adjust the interest rate on the financing obligation to avoid a
“built-in loss” rather than adjusting the residual value of the asset.
11.5 Lessor Accounting
In the scenario described above in which a lessee controls and is deemed the
accounting owner of an underlying asset that is under construction before the lease
commencement date, the lessor should account for the arrangement as a
sale-and-leaseback transaction (in a manner consistent with the requirement for the
lessee to account for the arrangement as a sale-and-leaseback transaction). In other
words, the lessor’s cost of constructing the asset that it does not own for
accounting purposes is accounted for as a financing arrangement (i.e., a loan to the
lessee). Once construction is completed, the lessor applies the sale-and-leaseback
guidance to determine when to recognize the underlying asset (which would be
consistent with when the seller-lessee would also derecognize the underlying asset).
See Chapter 10 for further details related to
sale-and-leaseback accounting.
Chapter 12 — Sublease Accounting
Chapter 12 — Sublease Accounting
12.1 Overview
ASC 842-10 — Glossary
Sublease
A transaction in which an underlying asset
is re-leased by the lessee (or intermediate lessor) to a
third party (the sublessee) and the original (or head) lease
between the lessor and the lessee remains in effect.
For information on subleases that are part of a sale-and-leaseback transaction, see Section 10.2.3.3.
For information on required disclosures for sublease transactions, see Section 15.2.4.5.
12.2 Classification of a Sublease
ASC 842-10
25-6 When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset.
In a manner consistent with that in other leases, the lessee/intermediate lessor
should classify the sublease on the basis of the criteria in ASC 842-10-25-2 (see
Section 9.2). In
applying these criteria, the lessee/intermediate lessor should look through the
sublease to the underlying asset (i.e., the lessee/intermediate lessor should not
classify the sublease by reference to the ROU asset that results from the head
lease). Paragraph BC116 of ASU 2016-02 explains the FASB’s rationale for using the
underlying asset in this assessment:
The Board decided that
when classifying a sublease, an entity (that is, the intermediate lessor) should
evaluate the sublease with reference to the underlying asset rather than the
right-of-use asset arising from the head lease. The lessee in a sublease may not
know the terms and conditions of the head lease, and, accordingly, referring to
the item of property, plant, and equipment that is subject to the lease should
be easier to apply than referring to the right-of-use asset arising from the
head lease. In addition, the Board noted that it may be difficult to understand
and explain why a lessor would account for similar leases differently. That
could occur if an entity were required to refer to the right-of-use asset when
classifying a sublease. For example, if subleases were classified with reference
to the right-of-use asset, a lessor that leases two similar assets on similar
terms for five years could account for those leases differently if the lessor
owned one of the two assets and leased the other.
Bridging the GAAP
Classification of Sublease Different Under IFRS 16
Unlike ASC 842, IFRS 16 requires the lessee/intermediate lessor to determine the
classification of the sublease with reference to the ROU asset arising from
the head lease rather than to the underlying asset. Therefore, because the
lease term of the ROU asset is typically less than the economic life of the
underlying asset, we generally believe that the lessee/intermediate lessor
may classify more subleases as sales-type or direct financing under IFRS
Accounting Standards than under U.S. GAAP.
Example 12-1
Company A, a lessee, enters into a building lease with a third party. The term
of the lease is 30 years, and the estimated economic
life of the building is 40 years. Immediately after
entering into the head lease arrangement, A
subleases the building to SubCo. The term of the
sublease is 25 years. As an accounting policy, A
uses a 75 percent threshold when evaluating the
“major part” of the economic life of the underlying
asset in accordance with the classification
criterion in ASC 842-10-25-2(c).
ASC 842 Evaluation
From the head lease perspective, A (as the head lessee) will classify the lease
as a finance lease since the lease term is for a
“major part” of the remaining economic life of the
underlying asset (i.e., A is leasing the building
for 30 years — or 75 percent — of the 40-year
economic life). From the sublease perspective, A (as
the intermediate lessor) will classify the sublease
as an operating lease since the lease term does not
represent a “major part” of the remaining economic
life of the underlying asset (i.e., a sublease with
a lease term of 25 years, when evaluated against the
40-year economic life of the underlying asset, does
not meet the “major part” criterion). Remember that
in evaluating the sublease classification under ASC
842, an entity considers the remaining economic life
of the underlying asset (i.e., the building) that is
subject to the lease.
IFRS 16 Evaluation
From the head lease perspective, A (as the head lessee) will account for the
lease in a manner consistent with finance lease
accounting under U.S. GAAP, since classification is
not relevant for lessees under IFRS 16. From the
sublease perspective, A (as the intermediate lessor)
will classify the sublease as a finance lease since
the lease term represents a “major part” of the
remaining economic life of the ROU asset that was
recorded as a result of the head lease (i.e., a
sublease with a lease term of 25 years, when
evaluated against the 30-year term of the ROU asset
in the head lease, represents 83.3 percent of the
overall term and meets the “major part” indicator).
Remember that when evaluating the sublease
classification under IFRS 16, an entity considers
the term of the ROU asset that is subject to the
lease (versus the economic life of the underlying
asset itself).
12.2.1 Impact of Sublease Renewals on Head Lease Term
An entity must determine the lease term to perform lease
classification and measurement. ASC 842-10-30-1 requires an entity to determine
the lease term as follows:
An entity shall determine the
lease term as the noncancellable period of the lease, together with all of
the following:
-
Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
-
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
-
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. [Emphasis added]
ASC 842-10-55-26 indicates that an entity should consider all
economic factors in determining whether it is reasonably certain that a renewal
option will be exercised. Further, an entity must consider a sublease in
determining the lease term of the head lease.
At the FASB’s November 30, 2016, meeting, the Board indicated
that the head lessee must determine whether the sublessee is reasonably certain
to exercise its renewal options because the head lessee must determine the lease
term for the head lease. If the exercise of the sublease renewal options is
reasonably certain, the renewal of the head lease is also reasonably certain.
However, if the head lessee determines that it is not reasonably certain that
the sublessee will exercise its renewal options, the head lessee should not
include additional renewal options that extend past the sublessee’s
noncancelable term in the absence of other economic factors. That is, the
sublease is one of many factors for an entity to consider in determining the
lease term of the head lease.
Note that the head lessee would reassess its lease term in
accordance with ASC 842-10-55-28 upon the occurrence of certain events,
including “[s]ubleasing the underlying asset for a period beyond the exercise
date of the option.” Therefore, upon notice by the sublessee that it is renewing
or extending its sublease, the head lessee must reassess the lease term of the
head lease, including whether the exercise of any remaining renewal options is
reasonably certain.
Example 12-2
Under a lease agreement (the “head
lease”), Company A leases equipment from Company B.
Under another lease agreement (the “sublease”), A
immediately leases the equipment to Company C. The
noncancelable lease period of the head lease is 10
years, with two 5-year renewals at A’s option for a
fixed amount. The sublease has a mirrored 10-year
noncancelable period, with two 5-year renewals at C’s
option. If C exercises its renewal option on the
sublease, A will be forced to renew the head lease.
If it is not reasonably certain that C
will exercise its renewal options, A could determine, in
the absence of other asset- or market-based factors,
that the lease term of the head lease is limited to 10
years (i.e., the noncancelable period). If and when C
renews its sublease, A must reassess the lease term by
including the first 5-year renewal and determining
whether C’s exercise of the second 5-year renewal option
is reasonably certain.
12.3 Accounting for a Sublease by the Lessee/Intermediate Lessor
A lessee/intermediate lessor should generally account for the head lease and sublease as separate contracts. Paragraph BC115 of ASU 2016-02 summarizes the rationale for accounting for the head lease and sublease separately:
In addition, the Board decided that an entity should account for a head lease and a sublease as two separate contracts unless those contracts meet the contract combinations guidance. Even if entered into at close to the same date, each contract is generally negotiated separately, with the counterparty to the sublease being a different entity from the counterparty to the head lease. Because of this, the obligations that arise from the head lease for the lessee are generally not extinguished by the terms and conditions of the sublease. Therefore, it is appropriate to account for a head lease and sublease separately, and the head lease right-of-use asset is not considered to be held for sale.
A lessee/intermediate lessor’s accounting depends on whether the lessee/intermediate lessor is relieved of its primary obligation under the head lease as a result of the sublease.
12.3.1 Lessee/Intermediate Lessor Is Not Relieved of Its Primary Obligation Under the Head Lease
ASC 842-20
35-14 If the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original lease, the original lessee (as sublessor) shall continue to account for the original lease in one of the following ways:
- If the sublease is classified as an operating lease, the original lessee shall continue to account for the original lease as it did before commencement of the sublease. If the lease cost for the term of the sublease exceeds the anticipated sublease income for that same period, the original lessee shall treat that circumstance as an indicator that the carrying amount of the right-of-use asset associated with the original lease may not be recoverable in accordance with paragraph 360-10-35-21.
- If the original lease is classified as a finance lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph 842-30-40-1 and continue to account for the original lease liability as it did before commencement of the sublease. The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph 842-30-35-3.
- If the original lease is classified as an operating lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph 842-30-40-1 and, from the sublease commencement date, account for the original lease liability in accordance with paragraphs 842-20-35-1 through 35-2. The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph 842-30-35-3.
35-15 The original lessee (as sublessor) in a sublease shall use the rate implicit in the lease to determine the classification of the sublease and to measure the net investment in the sublease if the sublease is classified as a sales-type or a direct financing lease unless that rate cannot be readily determined. If the rate implicit in the lease cannot be readily determined, the original lessee may use the discount rate for the lease established for the original (or head) lease.
ASC 842-20-35-14 indicates that if the lessee/intermediate lessor is not
relieved of its primary obligation under the head lease, its accounting for the
lease depends on the classification of both the sublease and the head lease, as
depicted in the decision tree below.
Example 12-3
Accounting for a Lease Assignment
Entity B has opted to exit a particular
retail location and will assign the rights and
obligations of the existing lease arrangement (the
“original lease”) to the new tenant (the “sublessee”)
through an agreement with the sublessee (the “lease
assignment”).
The lease assignment is a contract
between B and the sublessee (i.e., the lessor is not a
party to the lease assignment). There is no alteration
or termination to the original lease that takes place at
the time of the lease assignment. Therefore, the terms
in the original lease are in full effect notwithstanding
execution of the lease assignment. In addition, the
terms in the original lease do not state that B’s
obligations would change if B enters into a lease
assignment with a sublessee.
From an operational perspective, once
the original lease has been assigned to the sublessee, B
no longer has use of, or operational oversight over, the
underlying property subject to the original lease. The
sublessee and head lessor will transact directly with
each other regarding lease payments and operational
oversight of the leased property, and B is not involved
in the management of the leased property or in the
relationship between the head lessor and the sublessee.
It would not be appropriate for B to
account for the lease assignment as a lease termination
because B has not legally been released as the primary
obligor for the original lease. Rather, the lease
assignment should be accounted for as a sublease in
accordance with ASC 842-20-35-14 and 35-15. In
accordance with ASC 842-20-35-14 and as discussed above,
B’s accounting will depend on the classification of both
the original lease and the lease assignment (i.e., the
sublease).
12.3.2 Lessee/Intermediate Lessor Is Relieved of Its Primary Obligation Under the Head Lease
In a manner consistent with ASC 840-10-40-2, if the nature of the sublease is
such that the lessee/intermediate lessor is legally relieved of its primary
obligation under the head lease, the transaction would be considered a
termination of the head lease. As a result, 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. If the lessee/intermediate
lessor remains secondarily liable under the head lease, then it is a guarantor
in accordance with ASC 405-20-40-2 and its guarantee is accounted for in
accordance with ASC 460.
See Section 8.7.4 for additional discussion about when the lessee/intermediate lessor is relieved of its primary obligation under the head lease.
12.3.3 Classifying an ROU Asset as Held for Sale
As with other PP&E, ROU assets for both operating leases and
finance leases are subject to the requirements in ASC 360, including the “held
for sale” requirements. In a manner consistent with paragraph BC115 of ASU
2016-02, we generally believe that when a head lease and sublease exist, the
head lease ROU asset is not considered held for sale. However, we think that a
lessee should classify an ROU asset as held for sale in certain
circumstances.
An ROU asset would be considered held for sale when (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.
In addition, since an ROU asset
is considered part of a long-lived asset (or disposal group), 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.
If an entity subsequently changes its plans to dispose of the long-lived asset
(or disposal group), the asset would be reclassified from “held for sale” back
to “held and used” in accordance with ASC 360-10-45-6. 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.
See Section 8.4.4.3.1 for
more information about the amortization considerations related to ROU assets
that are classified as held for sale.
12.4 Lessor’s Accounting for a Sublease
ASC 842-30
35-7 If the original lessee enters into a sublease or the original lease agreement is sold or transferred by the original lessee to a third party, the original lessor shall continue to account for the lease as it did before.
40-3 If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease as provided in paragraph 842-30-40-2 and shall classify and account for the new lease as a separate transaction.
In a manner consistent with ASC 840-10-35-10, the lessor should continue to account for the head lease as it did before the execution of the sublease. See Chapter 9 for additional information about the lessor’s accounting model.
In addition, if the original lease is replaced by a new agreement with a new lessee, the lessor should account for the replacement as a termination of the original lease. The lessor should classify and account for the new lease as a separate transaction from the termination of the original lease.
12.5 Sublessee’s Accounting for a Sublease
A sublessee’s accounting for a sublease is consistent with its accounting for other leases in which it is the lessee. The existence of the head lease does not affect the sublessee’s accounting for the sublease. See Chapter 8 for additional information on the lessee’s accounting model.
Chapter 13 — Other Key Provisions
Chapter 13 — Other Key Provisions
13.1 Overview
This chapter discusses other key provisions in ASC 842, including those related to the following topics:
- Related-party leases (Section 13.2).
- Income taxes (Section 13.3).
- Master lease agreements (Section 13.4).
13.2 Related-Party Leases
ASC 842-10
55-12 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.
Pending Content (Transition Guidance: ASC 842-10-65-7)
55-12 Except for leases between entities under common control accounted for in accordance
with the practical expedient in paragraph
842-10-15-3A, 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. Additionally,
except for leases between entities under common
control accounted for in accordance with paragraph
842-10-15-3A, the classification and accounting
for the leases should be the same as for leases
between unrelated parties in the separate
financial statements of the related parties.
Related parties often enter into lease arrangements for tax structuring or other reasons. Under ASC 842, an entity should classify a lease with a related party on the basis of the legally enforceable terms and conditions of the contract rather than the substance of the arrangement (see Section 8.3.5.2 for additional discussion of a lessee’s classification of related-party leases). That is, a lease between related parties should be accounted for in a manner similar to a lease between unrelated parties.
Changing Lanes
Form Over Substance
Unlike ASC 842, ASC 840 required entities to consider the substance of the
contract when classifying and accounting for a
related-party lease. Specifically, the guidance in
ASC 840-10-25 stated:
Except
as noted in the following sentence, leases between
related parties (see paragraph 840-10-55-27) shall
be classified in accordance with the lease
classification criteria in paragraphs 840-10-25-1,
840-10-25-31, and 840-10-25-41 through 25-44.
Insofar as the separate financial statements of
the related parties are concerned, the
classification and accounting shall be the same as
for similar leases between unrelated parties,
except in circumstances in which it is clear that
the terms of the transaction have been
significantly affected by the fact that the lessee
and lessor are related. In such circumstances the classification and accounting
shall be modified as necessary to recognize
economic substance rather than legal form.
[Emphasis added]
On the other hand, before the adoption of ASU 2023-01, ASC 842-10-55-12
indicates that “[l]eases 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” (emphasis
added).
This change in guidance may significantly affect lessees and lessors that enter into related-party leasing arrangements. Paragraph BC374 of ASU 2016-02 explains the FASB’s rationale for changing the accounting for related-party leasing arrangements and states, in part:
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.
In addition to accounting for related-party leasing arrangements under ASC 842, lessees and lessors must disclose the information required by ASC 850 for all such arrangements. ASC 850-10-50-1 indicates that such disclosures should include the following:
- “The nature of the relationship(s) involved.”
- “A description of the transactions . . . for each of the periods for which income statements are presented” and “other information deemed necessary to an understanding of the effects of the transactions on the financial statements.”
- “The dollar amounts of [the] transactions . . . and the effects of any change.”
- “Amounts due from or to related parties as of the date of each balance sheet presented and . . . the terms and manner of settlement.”
- ”The information required by paragraph 740-10-50-17.”
Connecting the Dots
Issuance of ASU 2023-01 on Leases Between
Related Parties Under Common Control
In March 2023, the FASB issued ASU 2023-01,
which amends certain provisions of ASC 842 that
apply to arrangements between related parties
under common control. ASU 2023-01 allows non-PBEs,
as well as not-for-profit entities that are not
conduit bond obligors, to elect, as an accounting
policy, to use the written terms and conditions of
a common-control arrangement when determining
whether a lease exists and the subsequent
accounting for the lease, including lease
classification, on an arrangement-by-arrangement
basis. Therefore, if they elect this option,
non-PBEs, as well as not-for-profit entities that
are not conduit bond obligors, may not be required
to consider the legal enforceability of such
written terms and conditions, as described
above.
ASU 2023-01 also amends the accounting for
leasehold improvements in common-control
arrangements for all entities.
See Section 17.3.1.10 for a detailed
discussion of ASU 2023-01 on leasing arrangements
between entities under common control, including
the transition requirements.
13.3 Income Taxes
A lease’s classification for accounting purposes does not affect its classification for tax purposes. An entity will therefore continue to be required to determine the tax classification of a lease under the applicable tax laws. While the classification may be similar for either purpose, the differences between tax and accounting principles and guidance often result in book/tax differences. Thus, once an entity implements ASU 2016-02, it will need to establish a process (or leverage its existing processes) to account for these differences.
Connecting the Dots
Potential for Additional Deferred Tax Assets and Liabilities
ASC 842 does not significantly affect the accounting for income taxes under ASC
740. In a manner consistent with ASC 840,
differences between accounting and tax guidance
will result in book/tax differences. Because the
lessee will recognize a new ROU asset and lease
liability for operating leases as a result of
adopting ASC 842, there may be more book/tax
differences under ASC 842 than under ASC 840.
Because ASC 842 requires entities to reevaluate their leases, they may have the opportunity to reassess the tax treatment of such leases as well as their data collection and processes. Since the IRS considers a taxpayer’s tax treatment of leases to be a method of accounting, an entity may need to obtain IRS consent if it makes any changes to its existing methods.
Entities should also consider the potential state tax issues that may arise as a result of ASC 842, including how the classification of the ROU asset may affect the apportionment formula in the determination of state taxable income and how the significant increase in recorded lease assets could affect the determination of franchise tax payable.
Since the potential tax implications are many and varied, it is essential for a company’s tax department to be involved in the evaluation of the impact of ASC 842 as well as in discussions related to policy adoption and system modifications. See Appendix D for additional implementation considerations.
13.4 Master Lease Agreements
ASC 842-10
55-17 Under a master lease agreement, the lessee may gain control over the use of additional underlying assets during the term of the agreement. If the agreement specifies a minimum number of units or dollar value of equipment, the lessee obtaining control over the use of those additional underlying assets is not a lease modification. Rather, the entity (whether a lessee or a lessor) applies the guidance in paragraphs 842-10-15-28 through 15-42 when identifying the separate lease components and allocating the consideration in the contract to those components. Paragraph 842-10-55-22 explains that a master lease agreement may, therefore, result in multiple commencement dates.
55-18 If the master lease agreement permits the lessee
to gain control over the use of additional underlying assets during the term of
the agreement but does not commit the lessee to doing so, the lessee’s taking
control over the use of an additional underlying asset should be accounted for
as a lease modification in accordance with paragraphs 842-10-25-8 through
25-18.
55-22 There may be multiple commencement dates resulting from a master lease agreement. That is because a master lease agreement may cover a significant number of underlying assets, each of which are made available for use by the lessee on different dates. Although a master lease agreement may specify that the lessee must take a minimum number of units or dollar value of equipment, there will be multiple commencement dates unless all of the underlying assets subject to that minimum are made available for use by the lessee on the same date.
A master lease agreement may specify that the lessee will obtain control over the right to use multiple underlying assets (e.g., equipment) at various points during the term of the master lease agreement. In these cases, the lessee’s accounting depends on whether the master lease agreement commits the lessee to gaining control over the right to use a minimum quantity (units or dollar value) of assets.
13.4.1 Lessee Is Obligated or Committed to Use a Minimum Quantity
Under ASC 842-10-55-17, if the lessee is obligated or committed to the right to use a minimum quantity of assets, the entity should include the minimum quantity when separating lease components and allocating the consideration in the contract to the separate lease components (see Chapter 4). Because the minimum quantity is included in the initial separation of, and allocation to, the lease components, the lessee’s attainment of control of the right to use 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 right to use the underlying assets at different points during the term of the master lease agreement, the separate lease components may have different lease commencement dates, as explained in ASC 842-10-55-22. For rights to use underlying assets that have yet to commence, the lessee should consider the disclosure requirements in ASC 842-20-50-3(b) (see Section 15.2.2) related to leases that have not yet commenced.
Example 13-1
On January 1, 20X1, Lessor C enters into a master lease agreement with Lessee P related to various pieces of equipment throughout a five-year term. Under the master lease agreement, P leases the following pieces of equipment from C for one-year lease terms commencing on the following dates:
- March 26, 20X1: Equipment X.
- June 7, 20X2: Equipment Y.
- September 9, 20X3: Equipment Z.
The master lease agreement states that P is obligated to lease three pieces of equipment (i.e., Equipment X, Equipment Y, and Equipment Z) at some point during the five-year term of the master lease agreement.
In accordance with ASC 842-10-55-17, because P is obligated to use a minimum
quantity of equipment, the entities (both C and P) must
consider the minimum quantity of equipment (i.e., three
pieces of equipment) when identifying the separate lease
components and allocating the consideration in the
contract. Because P obtains control of the right to use
the equipment at different points during the master
lease agreement, each lease component (i.e., for
Equipment X, Equipment Y, and Equipment Z) has a
different lease commencement date. Accordingly, P should
consider the disclosure requirement in ASC
842-20-50-3(b) for leases that have not yet commenced.
In addition, because each right of use is considered in
the initial identification and separation of lease
components, the fact that P obtains control of each
right of use at different times does not result in a
lease modification.
13.4.2 Lessee Is Not Obligated or Committed to Use a Minimum Quantity
Under ASC 842-10-55-18, if the lessee is not obligated or committed to the right to use a minimum quantity of assets, the lessee must account for the attainment of control of each additional right to use an underlying asset as a lease modification in accordance with ASC 842-10-25-8 through 25-18 (e.g., each additional right of use could be a lease modification accounted for as a separate contract in accordance with ASC 842-10-25-8). Because the lessee is not subject to a minimum commitment, the entity would not include the right to use any additional underlying assets in the initial separation of, and allocation to, the lease components in the contract. See Section 8.6 for additional information on accounting for lease modifications.
Example 13-2
Assume the same facts as in Example 13-1,
except that under the master lease agreement, Lessee P
is not obligated or committed to use a minimum quantity
of equipment throughout the five-year term of the master
lease agreement.
Because P is not obligated to use a minimum quantity of equipment, the entities
(both P and Lessor C) should account for P’s obtaining control over the right
to use each additional piece of equipment as a lease modification on the date
on which control is obtained (e.g., each modification may be accounted for as
a separate contract in accordance with ASC 842-10-25-8). In this example, the
entities will account for the master lease agreement as follows:
-
First lease commences on March 26, 20X1, when P obtains control of Equipment X.
-
First modification on June 7, 20X2, when P obtains control of Equipment Y.
-
Second modification on September 9, 20X3, when P obtains control of Equipment Z.
See Section 8.6 for additional information on accounting for lease modifications.
Chapter 14 — Presentation
Chapter 14 — Presentation
14.1 Overview
Concerns about the lease presentation requirements in ASC 840, particularly those for lessees, provided the impetus for the issuance of ASC 842. Specifically, in developing ASC 842, the Board decided to remove the classification disparity between operating leases and capital leases, bring all leases onto the balance sheet, and require lessees to recognize lease assets and lease liabilities in the statement of financial position. As indicated in the summary portion of ASU 2016-02, the primary objective of the new presentation requirements is to increase financial statement transparency and give users a more “complete and understandable picture of an entity’s leasing activities.”
Below is a more detailed discussion of ASC 842’s financial statement presentation requirements for both lessees and lessors.
14.2 Lessee
14.2.1 Statement of Financial Position
ASC 842-20
Statement of Financial Position
45-1 A lessee shall either present in the statement of financial position or disclose in the notes all of the following:
- Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets
- Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities. . . .
45-2 If a lessee does not present finance lease and operating lease right-of-use assets and lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those right-of-use assets and lease liabilities.
45-3 In the statement of financial position, a lessee is prohibited from presenting both of the following:
- Finance lease right-of-use assets in the same line item as operating lease right-of-use assets
- Finance lease liabilities in the same line item as operating lease liabilities.
A lessee must present in the statement of financial position (or disclose in the
notes thereto) (1) finance lease ROU assets separately from operating lease ROU assets and
(2) finance lease liabilities separately from operating lease liabilities. The rationale
for separate presentation is that the lease classifications differ with respect to the
subsequent-measurement patterns for their respective assets and, in the Board’s view,
represent economically different transactions. In addition, as discussed in paragraph BC57
of ASU 2016-02, finance lease liabilities
may not be presented with operating liabilities because finance lease liabilities are the
equivalent of debt and are generally treated as such in the event of an entity’s
bankruptcy. ASC 842 does not specifically prescribe which financial statement line item is
appropriate for presentation (e.g., separate presentation of finance-lease ROU assets in a
PP&E financial statement line item).
Connecting the Dots
Balance Sheet Presentation Is Favorable for
Debt Covenants
Preparers may be in favor of the requirement to present finance leases
separately from operating leases because this requirement may reduce an entity’s
exposure to potential debt covenant violations that could have resulted if the entity
was required to characterize all lease liabilities as debt. See Section 8.1.1 for more
information.
While the standard does not require distinct presentation on the face of the
statement of financial position, the assets and liabilities related to each lease
classification must be presented separately (i.e., in either distinct or separate
financial statement line items). A lessee that discloses the amounts in the notes must
also disclose in which financial statement line items the amounts are included in the
statement of financial position.
Connecting the Dots
SEC Regulation S-X Requirements Related to
Separate Presentation of Assets and Liabilities
SEC Regulation S-X, Rule 5-02, requires registrants to separately present, in
the balance sheet or a note thereto, (1) “other assets” that are in excess of 5
percent of total assets and (2) any item in excess of 5 percent of other current
liabilities and any other liability in excess of 5 percent of total liabilities.
Although these SEC Regulation S-X requirements do not appear to mandate any
disclosures that are not already prescribed by ASC 842, companies should nonetheless
consider the requirements in evaluating whether separate presentation on the face of
the financial statements is warranted.
14.2.1.1 Considerations Related to Presentation of ROU Assets and Lease Liabilities in a Classified Statement of Financial Position
ASC 842-20
Statement of Financial Position
45-1 . . . Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position.
14.2.1.1.1 Presentation of ROU Assets in a Classified Statement of Financial Position
As stated above in ASC 842-20-45-1, the ROU asset “shall be subject
to the same considerations as other nonfinancial assets . . . in classifying them as
current and noncurrent in classified statements of financial position.” Therefore, an
entity that presents a classified balance sheet is not required to classify its ROU
assets as current and noncurrent. Entities typically exclude depreciated or amortized
assets (e.g., PP&E and intangible assets, respectively) from current assets in
accordance with ASC 210-10-45-4(f). Under ASC 842, ROU assets must be amortized and
are therefore akin to other amortizable assets.
14.2.1.1.2 Presentation of Lease Liabilities in a Classified Statement of Financial Position
As stated above in ASC 842-20-45-1, “lease liabilities shall be
subject to the same considerations as other . . . financial liabilities in classifying
them as current and noncurrent in classified statements of financial position.”
Therefore, an entity that presents a classified balance sheet must classify its lease
liabilities as current and noncurrent. ASC 210-10-45-6 states, in part, that the
“concept of current liabilities includes estimated or accrued amounts that are
expected to be required to cover expenditures within the year for known obligations.”
Therefore, an entity should classify the portion of its lease liabilities that it
expects to be required to pay within the year (or the entity’s operating cycle) as a
current liability.
As illustrated in the example below, the calculation of the current
portion of the liability includes the portion of the lease payments that will be
applied to the liability’s principal over the next 12 months. This observation is
consistent with the guidance in ASC 210-10-45-9, which states, in part, that current
liabilities should include “[o]ther liabilities whose regular and ordinary liquidation
is expected to occur within a relatively short period of time, usually 12 months.”
Example 14-1
On December 31, 20X2, Company X, a lessee, commenced a
lease with a term of three years and an annual lease payment of $4,660 due
on each anniversary of the commencement date. Company X uses a year (12
months) to classify other current assets and liabilities in its classified
balance sheet in accordance with ASC 210. After discounting the lease
payments at a discount rate of 8 percent, X determines that (1) its total
lease liability is $12,009 and (2) $3,699 of the liability will be paid
within one year from the balance sheet date. As of December 31, 20X2, X
classifies $3,699 as a current liability and the remaining $8,310 as a
noncurrent liability when it presents its classified balance sheet.
The table below illustrates the calculation of the
current liability in each year of the lease term by using an approach in
which the current portion of the liability is equal to the payment amount
to be applied to the liability’s principal.
In addition to the approach described above, we are aware of certain
alternatives that entities may apply in determining the current portion of the lease
liability. We recommend that entities consult with their accounting advisers in
evaluating the reasonableness of any alternative applied.
14.2.1.1.3 Considerations When the Current Portion of a Lease Liability Would Be Negative
Section
6.2.2 discusses certain lease agreements that may include provisions
requiring lessors to make payments to lessees during the lease term (e.g.,
contractual lease incentives in the form of reimbursements for leasehold
improvements). These lease incentives reduce a lessee’s total lease payments during
the lease term. In some circumstances, for example, when in conjunction with a
rent-free period at the beginning of a lease, it is possible that a lessee could
expect to receive lease incentives within one year from the balance sheet date that
exceed the fixed rental payments (i.e., outflows) due within that same period,
resulting in a net cash inflow for the next 12 months of the lease term. ASC
842-20-45-1 states that “lease liabilities shall be subject to the same
considerations as other . . . financial liabilities in classifying them as current
and noncurrent in classified statements of financial position.” However, there is
limited guidance in other GAAP that applies to the classification of a financial
liability with a current portion that is a net cash inflow in the next 12 months.
In these situations, there is diversity in practice. We are aware of the following
two approaches that entities have applied in such circumstances:
-
Noncurrent lease liability — Under this common approach, an entity presents the entire lease liability, including the net cash inflow in the next 12 months, as a noncurrent lease liability. As discussed in Sections 6.2.2 and 8.5.3.2, lease incentives to be received during the lease term are lease payments that entities may treat1 as reductions of the lease liability. Because a lease arrangement is a single contract, the associated lease liability may be considered a single unit of account; accordingly, it is acceptable to present the lease liability as a single noncurrent lease liability even when the next 12 months are expected to yield a net cash inflow (i.e., representing a present right to receive cash). Supporters of this view believe that the arrangement is analogous to an unexercised draw-down of future debt in a manner consistent with the presentation guidance in ASC 842-20-45-1, which states that the “lease liabilities shall be subject to the same considerations as other . . . financial liabilities.” Accordingly, proponents of this view think that it is appropriate to present a lower noncurrent liability as of the balance sheet date since the lease liability is a single unit of account that, like a financial liability, the entity has the intent to repay over a term greater than 12 months and for which the obligation to repay that higher amount over the long term has not yet occurred. That is, when the cash is received, the noncurrent (financial) liability will increase to the amount of the expected future cash flows calculated in the lease’s amortization table.
-
Present current portion (to be received) as a current receivable — Another acceptable approach in our view is one in which an entity presents cash flows representing the current portion (i.e., the net cash inflow for the next 12 months) as a current asset (receivable). The ASC master glossary defines current assets as “other assets or resources commonly identified as those that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business.” This definition supports the view that entities that are party to these leasing arrangements have a contractual right to receive cash in the normal operating cycle (i.e., within the next 12 months) and may record a current asset that provides a faithful representation of liquidity for the next 12 months. This view is similar to our views on classifying derivatives in hedging relationships with multiple settlements. That is, we believe that the amounts related to (all) the cash flows that must occur within one year of the balance sheet date would represent the current asset or current liability (see Section 6.2.2 of Deloitte’s Roadmap Hedge Accounting for more information).
We do not believe that it would be appropriate for a lessee to net
the current receivable associated with one lease arrangement against other
short-term lease liabilities from other lease contracts. In other words, when
applying the current receivable approach, an entity must present an asset as current
either separately or within an appropriate asset category. Also, in both approaches,
entities must present a current portion of a lease liability in accordance with the
approach outlined in Section
14.2.1.1.2 once there is no longer a net cash inflow under the lease
arrangement for the next 12 months.
The example below illustrates a leasing arrangement in which a lessee must
determine the classification of a lease liability that includes lease incentives to
be received in the next 12 months in excess of fixed rental payments (i.e.,
outflows) to be made to the lessor in the next 12 months (i.e., the current portion
is a net cash inflow).
Example 14-2
Company A (Lessee) is party to a 10-year lease for an
office building with Landlord B (Lessor). The lease commencement date is
July 1, 20X1. The lease contains an 18-month free rent holiday between
July 1, 20X1, and December 31, 20X2; accordingly, fixed rental payments
commence on January 1, 20X3, and continue until the end of the lease
term. As an incentive for signing the lease, Lessor will provide Lessee
with $10 million in reimbursements for leasehold improvements that
Lessee is planning on making to the property. While Lessee must submit
receipts for eligible expenditures to Lessor on or before June 31, 20X2
(for payment on July 15, 20X2), Lessee has an expenditure budget greater
than $15 million and, upon lease commencement, has determined that it is
probable that it will receive the entire $10 million lease improvement
allowance. Further, Lessee has elected a policy of including the
leasehold improvement allowance in the measurement of the lease
liability upon commencement. Assume that other than fixed rental
payments commencing on January 1, 20X3, and the leasehold improvement
allowance to be received by Lessee, no other lease payments are included
in the contract.
As of lease commencement, Lessee has concluded the following:
- The reimbursements received from Lessor represent lease incentives for leasehold improvements (rather than reimbursements for landlord-owned assets).
- Lessee is reasonably certain to complete the construction of leasehold improvements and receive 100 percent of the $10 million of reimbursements on July 15, 20X2. In a manner consistent with the discussion in Section 8.5.3.2, Lessee elects an accounting policy of including the lease incentive of $10 million within lease payments. Because Lessee believes that it is probable at lease commencement that the payments will be received, there is a reduction in the ROU asset and the lease liability.
- The lease is classified as an operating lease.
During the initial 18-month “free” rent period, the lease contract does
not require Lessee to make rental payments to Lessor, and the only lease
payment included in the measurement of the lease liability is the $10
million lease incentive expected to be received (a cash inflow to
Lessee) on July 15, 20X2, which results in a net cash inflow as of
December 31, 20X1. In preparing the annual financial statements as of
December 31, 20X1, Lessee may present the entire lease liability —
including the measurement of (1) the $10 million lease incentive
receivable and (2) all contractual fixed rent payments commencing on
January 1, 20X3, and through the end of the lease term — as a noncurrent
lease liability.
It would also be acceptable for Lessee to present the measurement of
the net cash inflow in the next 12 months (i.e., the $10 million lease
incentive) as a current receivable and to separately present, as a
noncurrent lease liability, the measurement of the combined contractual
fixed rent payments commencing on January 1, 20X3, and continuing
through the end of the lease term.
As discussed above, because of the complexities associated with such lease
arrangements, we recommend that entities consult with their accounting advisers and
auditors when establishing an acceptable policy in such situations.
14.2.2 Statement of Comprehensive Income
ASC 842-20
Statement of Comprehensive Income
45-4 In the statement of comprehensive income, a lessee shall present both of the following:
- For finance leases, the interest expense on the lease liability and amortization of the right-of-use asset are not required to be presented as separate line items and shall be presented in a manner consistent with how the entity presents other interest expense and depreciation or amortization of similar assets, respectively
- For operating leases, lease expense shall be included in the lessee’s income from continuing operations.
14.2.2.1 Finance Leases — Presentation of Interest Expense on the Lease Liability and Amortization Expense Related to the ROU Asset
The requirements for finance leases in ASC 842-20-45-4(a) with respect to presentation of interest expense and amortization expense are consistent with the capital lease presentation requirements under ASC 840-10-45-3. These provisions of ASC 842 are in line with the FASB’s view that a finance lease is economically similar to a financed asset purchase (i.e., the proceeds of a loan used to acquire an asset). Therefore, in a manner consistent with a financed purchase transaction, an entity would incur interest expense on its financing (loan) and would depreciate its asset acquired.
Connecting the Dots
Variable Lease Payments in Finance Leases
(or Sales-Type Leases and Direct Financing Leases)
ASC 842 is silent on the appropriate classification of variable lease expense arising from finance leases. Many preparers have asked whether such expense should be recognized as amortization, interest expense, or lease expense (in a manner similar to recognition of an operating lease expense). Because of the variable and often contingent nature of such expense and its exclusion from the balance sheet ROU asset and liability, it does not involve the amortization of an asset or, similarly, the accrual of interest against a liability balance. Therefore, questions have arisen about how this expense should be recognized once the variability or contingency is resolved (or is deemed probable in accordance with ASC 842-20-55-1) and recognized as an expense.
Paragraph BC271 of ASU 2016-02 states:
[T]he Board decided that cash flows from operating leases and variable lease payments that are not included in the lease liability should be classified as operating activities because the corresponding lease costs, if recognized in the statement of comprehensive income, will be presented in income from continuing operations. The previous sentence notwithstanding, Topic 842 states that lease payments capitalized as part of the cost of another asset (for example, inventory or a piece of property, plant or equipment) should be classified in the same manner as other payments for that asset. [Emphasis added]
Paragraph BC271 of ASU 2016-02 seems to indicate that, from the lessee’s
perspective, variable lease payments would be recognized in income from continuing
operations in a manner similar to operating lease expense. (By analogy, this could
also mean that variable lease payments from sales-type or direct financing leases
should be recognized as a component of income from continuing operations, rather
than as interest income.) Therefore, we believe that there is a basis for presenting
variable lease expense as lease expense (i.e., instead of as amortization or
interest).
However, we would accept presentation of variable lease expense in the statement of comprehensive income as either (1) interest expense or (2) a component of income from continuing operations (e.g., lease expense). (Similarly, we believe that lessors could present variable lease income related to payments that are not included in the initial measurement of a net investment in a sales-type or direct financing lease as either interest income or lease income.) Entities should disclose their presentation approach, if material.
14.2.2.2 Operating Leases — A Single Lease Expense
A lessee should evaluate its lease cost and, in a manner consistent with other types of expenses, should classify the single lease expense as cost of sales; selling, general, and administrative expenses; or another operating expense line item in the entity’s statement of comprehensive income.
14.2.2.2.1 Presentation of Lease Expense for Operating Leases With Impaired ROU Assets
As discussed in Section 8.4.4, when recognizing an impairment of an ROU asset associated
with an operating lease, a lessee subsequently amortizes the ROU asset by using a
finance lease model approach (i.e., the ROU asset is amortized on a straight-line
basis, and incremental expense is recognized under the effective interest method). In
accordance with ASC 842-20-25-7, while the recognition pattern changes for operating
leases after impairment (i.e., the finance lease exhibits a “front-loaded” expense
profile because a higher liability corresponds to higher interest in earlier periods
of the lease coupled with a straight-line amortization of the ROU asset), the
character of the expense does not. Specifically, ASC 842-20-25-7 states:
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.
Despite the different pattern of expense recognition after impairment, an operating
lessee should not separately present its expense incurred between interest expense and
amortization of the ROU asset. Rather, these expenses must continue to be presented as
a “single” lease expense and must be included in the operating lessee’s income from
continuing operations in a manner consistent with its operating lease
classification.
Similarly, when a lessee recognizes a gain or loss upon the early termination of an
operating lease, the lessee should present that gain or loss within the “single” lease
expense in the operating lessee’s income from continuing operations.
14.2.3 Statement of Cash Flows
ASC 842-20
Statement of Cash Flows
45-5 In the statement of cash flows, a lessee shall classify all of the following:
- Repayments of the principal portion of the lease liability arising from finance leases within financing activities
- Interest on the lease liability arising from finance leases in accordance with the requirements relating to interest paid in Topic 230 on cash flows
- Payments arising from operating leases within operating activities, except to the extent that those payments represent costs to bring another asset to the condition and location necessary for its intended use, which should be classified within investing activities
- Variable lease payments and short-term lease payments not included in the lease liability within operating activities.
Upon commencement of an operating lease, a lessee records an ROU asset and a
lease liability. Such noncash activity should be disclosed (see Section 15.2.4.8). For operating leases, repayments of
liabilities should be classified in operating activities. Similarly, in a manner
consistent with the income statement presentation discussed in Section 14.2.2, when a lessee recognizes a gain or
loss upon the early termination of an operating lease, the lessee should present that
activity within operating activities in the statement of cash flows. If any payments made
for operating leases represent the costs of bringing another asset to the condition and
location necessary for its intended use, such amounts should be classified as investing
activities.
Upon commencement of a finance lease, a lessee records an ROU asset and lease liability. The noncash activities will be reflected in the noncash investing and financing disclosures (see Section 15.2.4.8). Such noncash activity should be included in the investing and financing activities sections of the statement of cash flows for the asset and liability, respectively. This is consistent with the guidance in ASC 230-10-50-4, which states:
Examples of noncash investing and financing transactions are converting debt to equity; acquiring assets by assuming directly related liabilities, such as purchasing a building by incurring a mortgage to the seller; obtaining a right-of-use asset in exchange for a lease liability; obtaining a beneficial interest as consideration for transferring financial assets (excluding cash), including the transferor’s trade receivables, in a securitization transaction; obtaining a building or investment asset by receiving a gift; and exchanging noncash assets or liabilities for other noncash assets or liabilities. [Emphasis added]
In addition to noncash disclosures associated with the initial recognition of a lease, a lessee should also consider noncash disclosure requirements based on other noncash changes (increases or decreases) to the lease balances, such as those resulting from lease modifications or reassessment events.
When the lessee makes lease payments under a finance lease, the lessee should reflect the principal portion of the payments as a cash outflow from a financing activity in the statement of cash flows. The portion of finance lease payment that reflects the interest payment should be classified as a cash outflow from an operating activity.
The example below illustrates the financial statement presentation for a finance lease and operating lease.
Example 14-3
A lessee enters into a three-year lease and agrees to make the following annual payments at the end of each year: $10,000 in year 1, $15,000 in year 2, and $20,000 in year 3. The initial measurement of the ROU asset and liability to make lease payments is $38,000 at a discount rate of 8 percent.
This table highlights the differences in accounting for the lease as a finance lease and an operating lease:
For the finance lease model, the interest expense calculated is a function of the lease liability balance and the discount rate (i.e., $38,000 multiplied by 8 percent in year 1). For the finance lease, the lessee includes amortization expense as a noncash add-back to the operating activities section of the statement of cash flows, which is calculated on a straight-line basis ($38,000 divided by 3). The principal portion of the cash payment is reflected in the financing section as principal paid. There is no need to separately add interest expense since it is already included in net income in the operating section. The supplemental section includes interest paid.
For the operating lease model, the lessee may include noncash lease expense as a noncash add-back to the operating section of the statement of cash flows ($15,000 – $3,038 = $11,962); this reflects the portion of the lease expense that amortized the ROU asset. While this presentation reflects a best practice, there may be other acceptable methods of presentation for the change in ROU assets; however, it would be inappropriate to present the change in ROU assets in amortization expense. Entities contemplating a different method of presentation are encouraged to discuss the method with their accounting advisers. The cash payment is reflected in the operating section as a change in operating liabilities. Because interest expense is not included in operating leases, there are no separate disclosures for this activity.
Footnotes
1
If the lease payments to be received during the lease
term are fixed, they must be treated as reductions to the lease liability.
However as described in Section 8.5.3.2, lessees that receive lease incentives
during the term that are based on the resolution of future contingencies
may elect an accounting policy of including lease payments in the
measurement of the lease liability at lease commencement if the receipt of
those incentives from the lessor is probable at lease commencement.
14.3 Lessor
14.3.1 Sales-Type and Direct Financing Leases
14.3.1.1 Statement of Financial Position
ASC 842-30
Sales-Type and Direct Financing Leases
Statement of Financial Position
45-1 A lessor shall present lease assets (that is, the aggregate of the lessor’s net investment in sales-type leases and direct financing leases) separately from other assets in the statement of financial position.
45-2 Lease assets shall be subject to the same considerations as other assets in classification as current or noncurrent assets in a classified balance sheet.
As noted above, “the aggregate of the lessor’s net investment in sales-type
leases and direct financing leases” must be presented “separately from other
assets in the statement of financial position.” In other words, these
balances must be presented discretely in the statement of financial position
and cannot be combined with other financial statement balances.
When presenting a classified balance sheet, a lessor must
classify its net investments in leases as current and noncurrent. While a
lessee does not need to present its ROU assets as current and noncurrent,
the same logic cannot be applied to a lessor’s net investment in the lease.
The net investment in a lease is a financial asset that is within the scope
of ASC 310; therefore, there is often a current balance, the amount that is
reasonably expected to be realized in cash during the normal operating cycle
of the business.
14.3.1.2 Statement of Comprehensive Income
ASC 842-30
Statement of Comprehensive Income
45-3 A lessor shall either present in the statement of comprehensive income or disclose in the notes income arising from leases. If a lessor does not separately present lease income in the statement of comprehensive income, the lessor shall disclose which line items include lease income in the statement of comprehensive income.
45-4 A lessor shall present any profit or loss on the lease recognized at the commencement date in a manner that best reflects the lessor’s business model(s). Examples of presentation include the following:
- If a lessor uses leases as an alternative means of realizing value from the goods that it would otherwise sell, the lessor shall present revenue and cost of goods sold relating to its leasing activities in separate line items so that income and expenses from sold and leased items are presented consistently. Revenue recognized is the lesser of:
- The fair value of the underlying asset at the commencement date
- The sum of the lease receivable and any lease payments prepaid by the lessee.
Cost of goods sold is the carrying amount of the underlying asset at the commencement date minus the unguaranteed residual asset. - If a lessor uses leases for the purposes of providing finance, the lessor shall present the profit or loss in a single line item.
Any income from sales-type leases (selling profit or loss and interest income)
or direct financing leases (interest income) must be included in the
statement of comprehensive income. To the extent that the amounts are not
presented separately, they should be disclosed in the notes to the financial
statements. See the Connecting the Dots in Section 14.2.2.1 for a discussion of
the presentation of income from variable lease payments.
Connecting the Dots
SEC Regulation S-X
Requirements Related to Income Statement
Presentation
SEC Regulation S-X, Rule 5-03, indicates the various
line items that should appear on the face of the income statement.
Specifically, a registrant should separately present any amounts
that represent 10 percent of the sum of income derived from net
sales of tangible products, operating revenues from public utilities
or others, income from rentals, revenues from services, and other
revenues. Although these SEC Regulation S-X requirements do not
appear to mandate any disclosures that are not already prescribed by
ASC 842, registrants should nonetheless consider the rule’s mandates
in evaluating whether separate presentation on the face of the
financial statements is warranted.
Revenue
Recognized
ASC 842-30-45-4(a) states that revenue recognized by
a lessor that “uses leases as an alternative means of realizing
value from the goods that it would otherwise sell” must be the
lesser of (1) the “fair value of the underlying asset at the
commencement date” or (2) the “sum of the lease receivable and any
lease payments prepaid by the lessee.” The intent of this guidance
is to ensure that a lessor reflects the substance of its
transactions — as either a seller or financier of a good —
regardless of whether the lease is a sales-type lease in form. It
would be more appropriate for a seller of a good to present the
gross sales proceeds and cost of the good sold, whereas a financier
may only present profit and interest income.
Example 14-4
Case A
One of Loman Inc.’s traveling salespeople enters into an arrangement to lease
props and other theater equipment to a customer,
Miller Theater Company. Although Loman typically
sells its equipment, Miller prefers to enter into a
lease because the lease requires payment streams
that are preferable to the full up-front selling
price. Loman determines that the lease is a
sales-type lease. The fair value of the theater
equipment is $10,000, and Loman’s cost is $8,000.
The appropriate income statement presentation of Loman sales-type lease at
commencement is:
Case B
Assume the same facts as in Case A except that Loman Inc. is a financial institution and provides financing to various customers to purchase equipment. In this case, Loman uses leasing as a means of providing financing to customers rather than selling its assets. The only amount presented in the financial statements at commencement would be selling profit of $2,000 (the net effect of the prior calculated balances — that is, the net impact of $10,000 less $8,000). (Note that with the changes to the lessor’s lease classification, it is possible for a financier to obtain sales-type lease classification — see Section 9.2.)
14.3.1.2.1 Presentation of Sublease Income
The ASC master glossary defines a sublease as “[a]
transaction in which an underlying asset is re-leased by the lessee (or
intermediate lessor) to a third party (the sublessee) and the original
(or head) lease between the lessor and the lessee remains in effect.”
From a balance sheet perspective, subleases generally must be presented
on a gross basis since they do not relieve the sublessor’s legal
obligation under the head lease. However, ASC 842 does not directly
address income statement presentation of subleases. While the amounts
paid to the original, third-party lessor are generally presented in the
income statement as a component of selling, general, and administrative
expenses or as part of cost of goods sold, questions have arisen
regarding how sublease income should be presented under ASC 842 — that
is, whether it would be appropriate to recognize sublease income on a
net basis (i.e., as an offset to the head lease expense) rather than on
a gross basis.
ASC 842 does not explicitly indicate whether it would be
acceptable to net, for income statement presentation purposes, sublease
income against the related head lease expense. Because subleases
generally must be presented on the balance sheet on a gross basis under
ASC 842, one might conclude that gross income statement presentation is
required as well. However, we believe that net presentation of sublease
activity in the income statement may be appropriate when the sublease
activity is outside an entity’s normal business operations (and thus
occurs infrequently) and when doing so would result in more meaningful
financial reporting information for financial statement users. For
example, in some instances, net presentation may better reflect the true
cost of leasing the underlying asset or may avoid distortion of
important financial statement metrics such as operating income (e.g.,
scenarios in which the recognition of the sublease income and head lease
expense on a gross basis would understate total operating income because
the sublease income would be recognized as a component of “other
income/expense (net)”). In such circumstances, net presentation within
selling, general, and administrative expenses or cost of goods sold may
be appropriate.
14.3.1.3 Statement of Cash Flows
ASC 842-30
Statement of Cash Flows
45-5 In the statement of cash
flows, a lessor shall classify cash receipts from
leases within operating activities. However, if the
lessor is within the scope of Topic 942 on financial
services — depository and lending, it shall follow
the guidance in paragraph 942-230-45-4 for the
presentation of principal payments received from
leases.
The guidance in ASC 842-30-45-5, as originally issued, was clear that cash
receipts from sales-type leases or direct financing leases are included in
operating activities in the statement of cash flows. However, the FASB staff
received questions from stakeholders because the example in ASC 942-230-55-2
conflicted with the guidance in ASC 842-30-45-5, as originally issued.
Specifically, the example in ASC 942 illustrates the direct method of cash
flows and presents “principal payments received under leases” in cash flows
from investing activities. (This example existed before, and was not
consequentially amended by, the issuance of ASC 842.) Accordingly, in March
2019, the Board issued ASU 2019-01, which addresses this
conflicting guidance by retaining the current guidance in ASC 942. Thus,
depository and lending lessors (those entities within the scope of ASC 942)
should continue to classify principal payments received from sales-type and
direct financing leases within “investing activities.” See Section 17.3.1.7 for
a detailed discussion of ASU 2019-01.
14.3.2 Operating Leases
14.3.2.1 Statement of Financial Position
ASC 842-30
Statement of Financial Position
45-6 A lessor shall present the underlying asset subject to an operating lease in accordance with other Topics.
Because a lessor’s operating lease does not result in derecognition of the underlying asset, the lessor should present the underlying asset in accordance with other U.S. GAAP (e.g., ASC 360 on PP&E). Although there is no prescriptive guidance on presenting deferred rent balances (i.e., straight-line rent), an entity should present such balances in accordance with ASC 210.
14.3.2.2 Statement of Comprehensive Income
See ASC 842-30-45-3 for the discussion of the statement of comprehensive income
in Section
14.3.1. The same guidance would apply to a lessor’s operating
leases.
Connecting the Dots
Presentation of Lease Revenue and Tenant Reimbursements in the
Financial Statements
As discussed in Section
4.4.1.1, in a typical gross lease of real estate, the
lessee pays a single fixed payment that covers rent, property taxes,
insurance, and CAM. The portion of the single fixed payment
attributable to property taxes, insurance, and CAM has historically
been presented by real estate lessors as “tenant reimbursements,” a
separate revenue line item in a lessor’s income statement. Under ASC
842, CAM is considered a nonlease component (see Section 4.3.1) whereas
reimbursements for property taxes and insurance are noncomponents
(see Section 4.3.2). Nonlease
components are separated from lease components and are generally
accounted for in accordance with ASC 606 unless the lessor qualifies
for and elects the practical expedient related to combining the
components (see Section
4.3.3.2). Furthermore, as discussed in Section 4.3.2, consideration in the
contract is not allocated to noncomponents because they do not
transfer a good or service to the lessee. Consideration for
noncomponents is deemed part of the overall consideration in the
contract, which is allocated to lease and nonlease components on a
relative stand-alone selling price basis.
If a lessor elects the practical expedient in ASU 2018-11 (discussed
in Section 4.3.3.2) and
therefore combines lease and associated nonlease components
(provided that certain criteria are met), the lessor should present
a single rental revenue line item (as long as the lease component is
predominant2) that includes the combined lease and nonlease components.
However, if a lessor does not qualify for or elect the practical
expedient, it should present the lease and nonlease components
separately. The resulting separate presentation typically will not
be aligned with the historical presentation when the Comparatives
Under 840 Option is elected.
Example 14-5
Lessor and Lessee enter into a five-year lease of a
floor in an office building. The contract stipulates
that Lessee is required to reimburse Lessor for the
costs related to the asset, including the real
estate taxes and Lessor’s performance of CAM at the
building. The lease commences on March 1, 2016.
Lessor’s ASC 842 adoption date will be January 1,
2019, and it will elect the transition relief under
ASU 2018-11 (i.e., the Comparatives Under 840 Option
— see Section
16.1.1) and thus will not be recasting
prior periods.
Lessee’s total
payments for 2016–2018 are as follows:
Presentation Under ASC 840 for Year Ended December
31, 2018
Many real estate lessors have historically presented
the revenue components for this type of lease
agreement in two separate revenue line items in the
income statement. The two separate line items are
usually titled “Rental Revenue” and “Tenant
Reimbursement Revenue.”
Sample Presentation Under ASC 842
for Year Ended December 31, 2019
If Lessor elects the practical expedient related to
not separating lease and nonlease components
(provided that the lease meets the criteria under
ASU 2018-11), rental revenue (the lease component)
and CAM (the nonlease component(s)) should be
presented in a single line item in the financial
statements (i.e., rental revenues), beginning in the
year of adoption.
The following is a
sample presentation if Lessor elects the practical
expedient under ASU 2018-11 (in this example, it is
assumed that 2019 gross lease payments are the same
as those for 2018):
If Lessor does not elect the practical expedient,
lease and nonlease components would be presented
separately in the income statement. Lease components
are accounted for under ASC 842, while nonlease
components are accounted for in accordance with
other U.S. GAAP (typically ASC 606). Assume that the
stand-alone selling prices for the lease of the
underlying asset and maintenance services are
$50,000 and $8,000, respectively. The property taxes
paid by Lessee are a noncomponent, and no
consideration would be allocated to the
noncomponents. The total consideration would be
allocated between the lease component and the
nonlease component on the basis of the stand-alone
selling price.3
The table below
illustrates a sample presentation if Lessor does not
elect the practical expedient under ASU 2018-11.
Note that while we believe that the income statement presentation of “tenant
reimbursements” will change from historical practice (as described above),
we understand that many real estate lessors will want to continue providing
this information given the performance metrics used by analysts that cover
the sector. Lessors that wish to disclose such information in the financial
statement footnotes should work with their auditors to develop appropriate
disclosures and, in doing so, should take into consideration the rules
related to non-GAAP measures.
14.3.2.3 Statement of Cash Flows
ASC 842-30
45-7 In the statement of cash flows, a lessor shall classify cash receipts from leases within operating activities.
Cash receipts from operating leases are included in operating activities in the statement of cash flows.
Footnotes
2
See Section 4.3.3.2.2
for further discussion of how an entity determines which
component is predominant when applying the lessor practical
expedient to combine lease and nonlease components.
3
The allocation of the total
consideration in this example is calculated as
follows (see Section
4.4 for further details on allocating
consideration in a contract.
Chapter 15 — Disclosure
Chapter 15 — Disclosure
15.1 Background and Objective
The disclosure objective of ASC 842 is to “enable users of financial statements to assess the amount,
timing, and uncertainty of cash flows arising from leases.” Accordingly, disclosures (both qualitative and
quantitative) are intended to supplement the amounts recorded in the financial statements so that
financial statement users can better understand the nature of an entity’s leasing activities from the
standpoint of both lessees and lessors.
Although disclosure requirements were also a critical aspect of ASC 840, users
believed that the information presented was often inadequate. ASC 842 therefore
contains expanded disclosure requirements that are significantly more comprehensive
than those in ASC 840. Accordingly, as with disclosures under the FASB’s revenue
recognition standard, disclosures about an entity’s leasing transactions are likely
to increase under the leasing requirements in ASC 842 even though they may have
decreased in many other areas of accounting (e.g., pensions, stock compensation,
fair value, and income taxes) because of the Board’s recent focus on reducing
disclosure overload (i.e., making disclosures more effective and coordinated and
less redundant).
The Board has therefore emphasized that entities need to remain focused on the
underlying disclosure objective so that they avoid obscuring useful information by
providing extraneous detail or losing relevance by furnishing significantly
aggregated information. Further, a “one-size-fits-all” approach would be
inconsistent with the disclosure objective of ASC 842; thus, to meet this objective,
it is critical that an entity use significant judgment and evaluate these
requirements against its own leasing activities.
Throughout ASC 842, the FASB consistently uses the word “shall” to indicate that
an entity would generally be required to provide a specific disclosure. However, in
paragraph BC276 of ASU 2016-02, the
FASB acknowledges that an entity needs to consider both relevance and materiality
when determining which disclosures to provide:
The Board also
rejected including an explicit statement that the disclosure requirements are
not required in all circumstances. That is because it is implicit to the overall
disclosure objective that the level of detail in the disclosures should equate
to the significance of an entity’s leasing activity (for example, if leasing is
a significant part of an entity’s business activities, the disclosures would be
more comprehensive than for an entity whose leasing activities are less
significant to its business activities).
For example, a lessee would most likely not discuss judgments and assumptions used to
allocate consideration in a contract between lease and nonlease components if there
are no nonlease components or if management concludes that the quantitative and
qualitative impact of the disclosure requirement is immaterial. However, as with
other materiality assessments, entities should carefully consider whether the
omission of a required disclosure represents an error. Entities are encouraged to
consult with their financial advisers when making such determinations.
Further, while the disclosures specified in ASC 842 are generally viewed as
mandatory, how an entity complies with these disclosure requirements may vary
significantly. An entity should assess which disclosures need to be provided for
each reporting period since a disclosure deemed irrelevant or immaterial in previous
reporting periods may subsequently become material (e.g., as a result of increases
in the monetary values to be disclosed or changes in qualitative factors).
Although the SEC staff has thus far issued relatively few comments on the application
of ASC 842, the staff has made certain observations related to this topic. For
example, registrants have received comments on (1) how ASC 842 applies or does not
apply in certain arrangements and (2) the discount rate used to calculate the amount
of the lease liability and corresponding ROU asset. Other topics addressed in SEC
staff comments on ASC 842 include, but are not limited to, the nature of expenses
treated as initial direct costs; the determination of lease classification;
accounting for leasehold improvements, including amortization; and impairment
considerations related to ROU assets. For further details about the staff’s
observations on each of these topics, see Deloitte’s Roadmap SEC Comment Letter Considerations, Including Industry
Insights.
As regulators review disclosures and issue comments, entities should evaluate their
peers’ filings and look for opportunities to improve existing disclosures. We
encourage such continual improvement and remind preparers to focus on the disclosure
objective stated above.
Connecting the Dots
System and Implementation Challenges
Entities should be proactive in developing the disclosures required by the standard because of
the substantive system and implementation challenges that may arise when entities (1) gather
the information necessary for drafting the required disclosures and (2) implement controls to
review related disclosures and underlying data.
This chapter is divided into the following overall subsections:
15.2 Lessee Disclosure Requirements
ASC 842-20
50-1 The objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To achieve that objective, a lessee shall disclose qualitative and quantitative information about all of the following:
- Its leases (as described in paragraphs 842-20-50-3(a) through (b) and 842-20-50-7 through 50-10)
- The significant judgments made in applying the requirements in this Topic to those leases (as described in paragraph 842-20-50-3(c))
- The amounts recognized in the financial statements relating to those leases (as described in paragraphs 842-20-50-4 and 842-20-50-6).
50-2 A lessee shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. A lessee shall aggregate or disaggregate disclosures so that useful information is not obscured by including a large amount of insignificant detail or by aggregating items that have different characteristics.
In addition to considering the above disclosure requirements for lessees, an entity that is both a lessee and lessor or engages in sale-and-leaseback transactions will need to review the lessor and sale-and-leaseback requirements separately (see Sections 15.3 and 15.4, respectively). Further, as noted in ASC 842-20-50-2, a lessee should consider the appropriate level of disclosure aggregation or disaggregation so that it avoids including “a large amount of insignificant detail or . . . aggregating items that have different characteristics.”
Illustrative Example — Disclosure Disaggregation
The following are examples of
ways a lessee may choose to disaggregate its
lessee disclosures:
The lessee disclosure requirements can be further subdivided into the following topics:
- Information about the nature of an entity’s leases (including subleases) (Section 15.2.1).
- General description of leases (Section 15.2.1.1).
- Basis and terms and conditions on which variable lease payments are determined (Section 15.2.1.2).
- Terms and conditions of options to extend or terminate leases (Section 15.2.1.3).
- Residual value guarantees (Section 15.2.1.4).
- Restrictions or covenants imposed by leases (Section 15.2.1.5).
- Leases that have not yet commenced (Section 15.2.2).
- Significant assumptions and judgments (Section 15.2.3).
-
Whether a contract contains a lease (Section 15.2.3.1).
-
Allocation of consideration in a contract (Section 15.2.3.2).
-
Discount rate (Section 15.2.3.3).
-
- Amounts recognized in the financial statements (Section 15.2.4).
- Finance lease cost (Section 15.2.4.1).
- Operating lease cost (Section 15.2.4.2).
- Short-term lease cost (Section 15.2.4.3).
- Variable lease cost (Section 15.2.4.4).
- Sublease income (Section 15.2.4.5).
- Net gain or loss from sale-and-leaseback transactions (Section 15.2.4.6).
- Cash paid for amounts included in measurement of lease liabilities (Section 15.2.4.7).
- Supplemental noncash information (Section 15.2.4.8).
- Weighted-average remaining lease term (Section 15.2.4.9).
- Weighted-average discount rate (Section 15.2.4.10).
- Maturity analysis of liabilities (Section 15.2.5).
- Lease transactions with related parties (Section 15.2.6).
- Practical-expedient disclosure related to short-term leases (Section 15.2.7).
- Practical-expedient disclosure related to not separating lease and nonlease components (Section 15.2.8).
- Electing transition practical expedients:
-
Hindsight practical expedient (Section 16.5.1).
-
Practical expedient package (Section 16.5.2).
-
- Election not to restate comparative periods in the period of adoption (Section 16.1.1).
15.2.1 Information About the Nature of an Entity’s Leases (Including Subleases)
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including:
- A general description of those leases.
- The basis and terms and conditions on which variable lease payments are determined.
- The existence and terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right-of-use assets and lease liabilities and those that are not.
- The existence and terms and conditions of residual value guarantees provided by the lessee.
- The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring additional financial obligations.
A lessee should identify the information relating to subleases included in the disclosures provided in (1) through (5), as applicable. . . .
The information that a lessee discloses about the nature of its leases should be consistent with the disclosure objective of ASC 842 and generally is qualitative (e.g., the extent to which terms or conditions exist and a description of those terms or conditions). As noted in ASC 842-20-50-3, a lessee should also consider providing such disclosures for subleases when appropriate.
Below is a discussion of, and examples illustrating, each of the requirements in (1)–(5) of ASC 842-20-50-3(a) above.
15.2.1.1 General Description of Leases
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including:
-
A general description of those leases. . . .
-
ASC 842 does not explicitly define the phrase “general description of leases.” This disclosure
requirement is intentionally broad, and a lessee should consider the level of detail it needs to provide
to satisfy the disclosure objective as well as how much emphasis to place on this and other disclosure
requirements. The lessee should also consider whether its existing disclosures meet this requirement,
since ASC 840 did not include a disclosure objective (though it did contain the “general description”
disclosure requirement).
Illustrative Example — General Description of an Entity’s Leases
15.2.1.2 Basis and Terms and Conditions on Which Variable Lease Payments Are Determined
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including: . . .2. The basis and terms and conditions on which variable lease payments are determined. . . .
As discussed in Section 6.3, only some variable lease payments (those based on an index or rate) are included in the initial and subsequent measurement of a lessee’s lease liability and ROU asset. Because variable lease costs are treated in different ways, the determination of what type of variability exists within a lease contract and whether that variability is included in, or excluded from, the recognized lease liability is critical to understanding lease costs and to achieving the disclosure objective (i.e., to understanding the timing and uncertainty of the entity’s cash flows). Therefore, the terms and conditions that create, and expose the entity to, that variability provide the user with information about amounts that are not recorded in the balance sheet because variable lease payments not based on an index or rate are not included in the measurement of the ROU asset or lease liability.
Although it is not expressly required to do so, it may be helpful for an entity
to describe the sources of the variability in two separate groups: (1) amounts included
in the lease liability and (2) variability that is excluded. In addition, an entity must
explain the types of variability that exists in its contracts, and this explanation
should include a discussion of key terms and conditions. For example, an entity may
encounter variability because a retail store location’s rent is determined on the basis
of a percentage of its store’s sales. From that simple description, a user may
understand the direct relationship between the sales and the rent increases. Sometimes,
however, the variability may be more complex, in which case an entity may need to
provide additional explanation and align key financial metrics.
Illustrative Example — Basis and Terms and Conditions on Which Variable Lease Payments Are
Determined
Variable lease payments that
are based on an index or rate:
Variable lease payments not
based on an index or rate:
15.2.1.3 Terms and Conditions of Options to Extend or Terminate Leases
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including: . . .3. The existence and terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right-of-use assets and lease liabilities and those that are not. . . .
The requirement to disclose terms and conditions related to options to extend or terminate leases
should increase the transparency of the lessee’s rights and obligations. This requirement is in line
with the disclosure objective because it allows users to more easily understand the future cash flows
expected to be incurred (i.e., extension) or eliminated (i.e., termination) if the entity elects these options.
The extent of such disclosures may depend on how integral a lease is to a business.
Illustrative Example — Terms and Conditions of Options to Extend or Terminate Leases
15.2.1.4 Residual Value Guarantees
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including: . . .4. The existence and terms and conditions of residual value guarantees provided by the lessee. . . .
The ASC master glossary defines a residual value guarantee as “[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.” As further discussed in Section 6.7, with respect to such a guarantee, a lessee is only required to include the amounts whose payment is probable in the measurement of the lease liability and ROU asset.
Therefore, as outlined above, a lessee must explain the existence and terms and conditions of any residual value guarantees associated with its leases (e.g., the full amount that a lessee has guaranteed under its leases). Providing such information is consistent with the disclosure objective since the lessee’s future cash outflows may be affected if an asset’s value at the end of the lease term is less than the residual value that the lessee has guaranteed for the lessor. To the extent that amounts have been deemed probable and have therefore been included in the lease liability, it may be appropriate for an entity to explain its determination of such amounts — in particular, the circumstances that may subsequently change the amount included in the liability or future amounts that will be owed to the lessor.
Illustrative Example — Residual Value Guarantees
15.2.1.5 Restrictions or Covenants Imposed by Leases
ASC 842-20
50-3 A lessee shall disclose all of the following:
- Information about the nature of its leases, including: . . .5. The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring additional financial obligations. . . .
This requirement is similar to the requirement in ASC 840-10-50-2(c), under
which a lessee must disclose “[r]estrictions imposed by lease agreements, such as those
concerning dividends, additional debt, and further leasing.” Therefore, an entity would
typically have already been disclosing this information for existing leases.
Nevertheless, an entity should consider the extent to which such information is in line
with ASC 842’s disclosure objective. In addition, while the requirements in ASC 840
focused on the cash flows directly related to the lessee’s use of the underlying asset
(i.e., the cash flows associated with the expected rental payments for that use), the
requirement in ASC 842 is a bit broader and an entity may want to consider whether the
lease imposes other restrictions or covenants that constrain the entity’s cash flows for
other purposes (e.g., restricting the payment of dividends, restricting the use of
additional leases or other debt financing).
Illustrative Example — Restrictions or Covenants Imposed by Leases
15.2.2 Leases That Have Not Yet Commenced
ASC 842-20
50-3 A lessee shall disclose all of the following: . . .
b. Information about leases that have not yet commenced but that create significant rights and obligations for the lessee, including the nature of any involvement with the construction or design of the underlying asset. . . .
In complying with the requirement to disclose “[i]nformation about leases that have not yet commenced but that create significant rights and obligations for the lessee,” an entity is providing users with information that will affect the entity’s future cash flows as a result of leasing activities that would not yet appear on the balance sheet, in particular as a lease liability. The requirements specifically highlight disclosures related to two common circumstances: (1) a forward-starting lease and (2) a future lessee’s involvement in the “construction or design” of an asset that it will lease upon completion of construction at some future date (e.g., a build-to-suit arrangement).
A forward-starting lease is a lease whose inception precedes the time when the
asset is made available for use by the customer (i.e., lease commencement). As discussed
in Section 3.3, a
forward-starting lease may result from an arrangement that includes a front-loaded
substitution right such that when that substitution right expires, the customer and the
supplier will have an identified asset that they can use to assess whether the contract is
or contains a lease. Note that a lease amendment (that is accounted for as a modification)
that extends the term but involves the same asset is not a forward-starting lease while a
lease amendment that grants an additional right of use in the future (e.g., by adding a
new floor to an existing lease of office space) would be considered a forward-starting
lease.
As discussed in Chapter 11, there are specific recognition and measurement requirements that
apply when a future lessee is involved in the construction or design of an asset that it will lease in the
future. As a result of those requirements, the future lessee may need to recognize the asset during
the construction period and then assess the arrangement in accordance with the sale-and-leaseback
requirements outlined in Chapter 10.
Illustrative Example — Leases That Have Not Yet Commenced
15.2.3 Significant Assumptions and Judgments
ASC 842-20
50-3 A lessee shall disclose all of the following: . . .
c. Information about significant assumptions and judgments made in applying the requirements of this
Topic, which may include the following:
1. The determination of whether a contract contains a lease (as described in paragraphs 842-10-15-2
through 15-27)
2. The allocation of the consideration in a contract between lease and
nonlease components (as described in paragraphs
842-10-15-28 through 15-32)
3. The determination of the discount rate for the lease (as described in paragraphs 842-20-30-2
through 30-4).
The requirement for an entity to disclose the significant assumptions and judgments it used in applying
ASC 842 in itself involves judgment. That is, the three types of information about significant assumptions
and judgments listed above in ASC 842-20-50-3 (and discussed below) may not always be applicable
and, in some cases, another significant assumption or judgment may be critical and material to an
entity’s financial statements.
15.2.3.1 Whether a Contract Contains a Lease
A lessee should consider disclosing information about the significant
assumptions and judgments used to determine whether a contract is or contains a lease.
(See Chapter 3 for more
information.) Specifically, a customer must consider whether (1) explicitly or
implicitly identified assets have been deployed in the contract and (2) the customer
obtains substantially all of the economic benefits from the use of that underlying asset
and directs HAFWP the asset is used during the term of the contract. The
standard indicates that, when preparing such disclosures, the lessee should consider the
discussion in ASC 842-10-15-2 through 15-27 regarding the definition of a lease. For
example, we believe that if a customer considers its involvement in the design of the
asset when determining whether a contract contains a lease, significant judgment may be
required and disclosure may be warranted.
Illustrative Example — Whether a Contract Contains a Lease
15.2.3.2 Allocation of Consideration in a Contract
A lessee should consider disclosing information about the significant assumptions and judgments used to determine its allocation of consideration in a contract or contracts. (See Chapter 4 for more information.) Specifically, the stand-alone prices used to allocate consideration may be estimated and subject to significant fluctuations over time. For example, such estimates may be significantly lower or higher than another entity’s estimates or the estimates may change in future periods and be incorporated into new leases. (Keep in mind that while estimates made to allocate consideration in a lease in the current period may differ from those made in prior periods for different leases, a lessee is
not required to revisit its estimates made in prior periods for different leases.) An entity should consider
describing the method used to determine stand-alone prices and how those estimates may involve less
or greater judgment for various lease types (e.g., leases based on geography or an asset such as real
estate/equipment whose value may fluctuate depending on economic factors).
ASC 842 indicates that, when preparing such disclosures, a lessee should consider the discussion in ASC
842-10-15-28 through 15-32 regarding allocation of consideration in a contract.
Illustrative Example — Allocation of Consideration in a Contract
15.2.3.3 Discount Rate
A lessee should consider disclosing information about the significant assumptions and judgments used to determine its discount rate(s). For example, a lessee may need to disclose information regarding its determination of the incremental borrowing rate, such as collateral assumptions, the term used, and the economic environment in which the lease is denominated. To the extent that a portfolio approach is used to determine discount rates, an entity should consider disclosing information about the composition of the portfolios. (See Chapter 7 for more information about discount rates.)
Connecting the Dots
Discount Rate
In comments in recent years, the SEC staff has requested that
registrants explain and revise their disclosures about the determination of the
discount rate used to measure the lease liability and ROU assets recorded in
accordance with ASC 842. In addition, since ASC 842-20-50-4(g)(4) requires lessees
to disclose the weighted-average discount rate for both operating and finance
leases, a lessee should consider whether the discount rate it used for some of its
leases differs significantly from the discount rate it used for other leases and is
therefore affecting the weighted-average calculation disclosed. In these situations,
a lessee may want to consider providing additional disclosures about the discount
rates that are affecting the lessee’s disclosed weighted-average rate. Further, a
lessee with multiple asset classes of leases should consider disclosing how the
weighted-average discount rate was determined for each asset class, including any
significant assumptions or judgments used in that calculation.
For more information about SEC comment letter trends related to
the disclosure requirements in ASC 842, see Deloitte’s Roadmap SEC Comment Letter Considerations,
Including Industry Insights.
15.2.4 Amounts Recognized in the Financial Statements
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions:
- Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities.
- Operating lease cost determined in accordance with paragraphs 842-20-25-6(a) and 842-20-25-7.
- Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less, determined in accordance with paragraph 842-20-25-2.
- Variable lease cost determined in accordance with paragraphs 842-20-25-5(b) and 842-20-25-6(b).
- Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense.
- Net gain or loss recognized from sale and leaseback transactions in accordance with paragraph 842-40-25-4.
- Amounts segregated between those for finance and operating leases for the following items:
-
Cash paid for amounts included in the measurement of lease liabilities, segregated between operating and financing cash flows
-
Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets
-
Weighted-average remaining lease term
-
Weighted-average discount rate.
-
50-5 See paragraphs 842-20-55-11 through 55-12 for implementation guidance on preparing the weighted-average remaining lease term and the weighted-average discount rate disclosures. See Example 6 (paragraphs 842-20-55-52 through 55-53) for an illustration of the lessee quantitative disclosure requirements in paragraph 842-20-50-4.
While the disclosure requirements discussed in Section 15.2.3 are largely qualitative, those addressed in this section are mostly quantitative. When preparing such disclosures, a lessee will need to gather certain quantitative information about amounts (1) recognized in the financial statements and (2) derived from the underlying leases recognized in the financial statements. Such amounts should include those that are recognized in profit or loss during the period and capitalized as part of the cost of another asset in accordance with other U.S. GAAP (e.g., a cost that is capitalized into inventory and that will be recognized as a cost of sales when the inventory is subsequently sold to a customer).
Given the different ways such costs are treated (e.g., inclusion in and
exclusion from recognition on the balance sheet), the FASB found it appropriate to
disaggregate lease costs to increase the transparency of the cash flows expected from
leasing. Further, the Board provides the example below from ASC 842-20-55-53 to illustrate
the disclosure requirements from ASC 842-20-50-4.
ASC 842-20
Illustration of Lessee Quantitative Disclosure
Requirements
55-52 Example 6 illustrates how a lessee may meet the
quantitative disclosure requirements in paragraph 842-20-50-4.
Example 6 — Lessee Quantitative Disclosure Requirements in Paragraph 842-20-50-4
55-53 The following Example illustrates how a lessee may meet the quantitative disclosure requirements in
paragraph 842-20-50-4.
15.2.4.1 Finance Lease Cost
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions:
- Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities. . . .
The finance lease cost disclosed represents the entire amount recognized for finance leases that are recognized on the balance sheet (i.e., excluding variable lease payments presented as interest expense or a component of income from continuing operations). In providing this disclosure, the lessee must disaggregate the total finance lease cost to indicate the amount recorded for the amortization of the ROU asset and the amount recognized as interest. The lessee should also disclose the financial statement line item in which these amounts are included if they are not presented separately on the face of the financial statements. Note that as discussed in Section 14.2.2.1, we would accept presentation of variable lease payments in the statement of comprehensive income as either (1) interest expense or (2) a component of income from continuing operations (e.g., lease expense). Lessees should disclose their presentation accordingly.
15.2.4.2 Operating Lease Cost
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: . . .
b. Operating lease cost determined in accordance with paragraphs 842-20-25-6(a) and 842-20-25-7. . . .
The operating lease cost disclosed represents the entire amount recognized for operating leases that are recognized on the balance sheet (i.e., excluding variable lease expense). This cost is determined in accordance with ASC 842-20-25-6(a) and ASC 842-20-25-7, which state, in part:
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. 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 . . . .
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.
The entire amount recognized as a “single lease cost” is the expense recognized for the operating lease
during the period. Note that while the expense recognition pattern for an operating lease differs from
that for a finance lease model (i.e., “interest” expense plus straight-line expense of the ROU asset), such
“single lease cost” is not disaggregated into its underlying component parts (i.e., amortization of the ROU
asset and the change in the lease liability) for presentation purposes.
Connecting the Dots
Operating Lease Cost When ROU Asset Is Impaired
As discussed in Section 8.4.4, in accordance with ASC 842-20-25-7, after an impairment is
recognized on an ROU asset for a lessee’s operating lease, the “straight-line” lease expense is no
longer maintained as the ROU asset is subsequently amortized on a straight-line basis (unless
another systematic basis is more representative of the pattern of use). Despite “breaking” the
straight-line lease pattern, the operating lease expense is still presented as a “single lease cost”
and would be included in the above quantitative disclosure of operating lease cost rather than
being broken into its two component parts for disclosure as a finance lease cost.
15.2.4.3 Short-Term Lease Cost
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts
relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the
period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and
the cash flows arising from lease transactions: . . .
c. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less,
determined in accordance with paragraph 842-20-25-2. . . .
While lessees may elect not to recognize short-term leases on the balance sheet (i.e., leases with a lease
term of 12 months or less), lessees are required to disclose short-term lease cost determined under
ASC 842-20-25-2. However, expenses related to leases with a lease term of one month or less are
excluded from this requirement.
Although we expect that most entities will find respite in the “one
month or less” exclusion, entities may sometimes find it more burdensome to extract
leases with a term of one month or less and may prefer to disclose expenses related to
all short-term leases. We believe that an entity may elect to include all expenses
related to leases with a term of one month or less (or all short-term lease expenses by
class of underlying asset) in the short-term lease expense disclosure (despite the
explicit exclusions). We understand that the one month or less exclusion was intended to
provide relief and therefore believe that it would not be inconsistent with the
disclosure principles to disclose all of the short-term lease expenses (including
expenses related to leases with a term of one month or less) if doing so would be less
burdensome. Entities should consider disclosing their policy if leases with a term of
one month or less are included in their short-term lease expense disclosures and the
effect is material.
15.2.4.4 Variable Lease Cost
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: . . .
d. Variable lease cost determined in accordance with paragraphs 842-20-25-5(b) and 842-20-25-6(b). . . .
The variable lease cost disclosure should include the costs discussed in ASC 842-20-25-5(b) and ASC 842-20-25-6(b) — that is, variable lease payments that are not included in the measurement of the lease liability. Such payments may include amounts that are entirely variable and therefore never would have been included in the measurement of the lease liability, or they may represent the difference between (1) the variable amount based on an index or rate and therefore reflected in the lease liability and (2) what is actually incurred. The disclosure requirements do not stipulate that variable lease cost related to finance leases must be disclosed separately from that for operating leases; however, in some instances, entities may find it helpful to perform such disaggregation. In addition, an entity may have short-term lease costs that are also considered variable lease costs. In these circumstances, we believe that it would be acceptable for an entity to include such costs in either the short-term lease cost disclosure or the variable lease cost disclosure. An entity should apply the selected approach consistently between reporting periods and should disclose the approach taken, if material.
Connecting the Dots
Variable Lease Cost
If an entity discloses that it elected to use the practical
expedient of not separating lease and nonlease components for real estate leases and
also discloses that it has triple net leases (i.e., leases in which the lessee pays
a single fixed payment for rent but the lessee’s share of property taxes, insurance,
and CAM is generally variable), the entity would be expected to disclose the
variable lease cost related to such triple net leases. This is because the property
taxes, insurance, and CAM are all deemed to be part of the lease component.
15.2.4.5 Sublease Income
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: . . .
e. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense. . . .
A lessee should disclose any sublease income it has received on a gross basis
separately from its operating and finance lease expenses. That is, cash inflows received
as a sublessor must be disclosed, on a gross basis, separately from cash outflows the
entity incurs with respect to that same asset that it leases as a lessee in a head
lease. See Section 14.3.1.2.1 for discussion of
whether it would be appropriate to net head lease expense with sublease income in the
income statement.
15.2.4.6 Net Gain or Loss From Sale-and-Leaseback Transactions
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts
relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the
period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and
the cash flows arising from lease transactions: . . .
f. Net gain or loss recognized from sale and leaseback transactions in accordance with paragraph 842-40-25-4. . . .
To the extent applicable, a seller-lessee should disclose any recognized net gains or losses associated
with any sale-and-leaseback transactions for assets previously owned (or recognized as a result of the
lessee’s involvement in the asset’s construction, as described in Chapter 11) and sold by the lessee.
15.2.4.7 Cash Paid for Amounts Included in Measurement of Lease Liabilities
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts
relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the
period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and
the cash flows arising from lease transactions: . . .
g. Amounts segregated between those for finance and operating leases for the following items:
1. Cash paid for amounts included in the measurement of lease liabilities, segregated between
operating and financing cash flows. . . .
A lessee should separately disclose its cash paid for finance and operating lease liabilities during the
reporting period. In some cases, these amounts will be separately presented in the statement of cash
flows and such presentation may be sufficient to meet the disclosure requirement. Nonetheless, an
entity should consider separate disclosure, especially if such amounts are not separately presented in
the statement of cash flows in their own activity line items.
15.2.4.8 Supplemental Noncash Information
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts
relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the
period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and
the cash flows arising from lease transactions: . . .
g. Amounts segregated between those for finance and operating leases for the following items: . . .
2. Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets . . . .
A lessee records an ROU asset upon entering into operating and finance leases. At lease
commencement, the lessee would account for the lease transaction (other than any lease payments
made at lease commencement) as a noncash investing and financing transaction, as discussed in ASC
230-10-50-4. The standard requires separate disclosure of the supplemental noncash information
related to this activity. Amounts for noncash activities related to operating leases should be disclosed
separately from those for finance leases.
In addition to ASC 842-20-50-4(g)(2), other areas of U.S. GAAP include requirements
related to providing noncash disclosures. For example, ASC 230-10-50-3 states, in part,
that “[i]nformation about all investing and financing activities of an entity during a period that affect recognized assets or liabilities but that do not result in cash receipts or cash payments in the period shall be disclosed.” Further, in paragraph 70 of the Basis for Conclusions of Statement 95, the FASB contemplated disclosure requirements
related to situations in which “transactions result in no cash inflows or outflows in
the period in which they occur but generally have a significant effect on the
prospective cash flows of a company.”
We believe that the word “obtaining,” as used in ASC 842-20-50-4(g)(2), should be
interpreted as including all noncash increases (debits) to an ROU asset. In addition,
events that affect a recognized asset and liability as well as prospective cash flows,
including noncash decreases to an ROU asset (credits), should be disclosed as a noncash transaction in light of the guidance in ASC 230-10-50-3 and the Basis for Conclusions of FASB Statement 95 (discussed above).
Accordingly, the requirement to disclose a noncash transaction would also be triggered
in the following circumstances:
- Any lease modification that (1) grants the lessee an additional ROU asset or (2) removes an ROU asset (i.e., physical increases or decreases related to a lessee’s right to use the underlying leased assets). The modification does not need to be accounted for as a separate contract.
- Any other modification or reassessment event that results in increases or decreases (debits or credits) to the ROU asset.
15.2.4.9 Weighted-Average Remaining Lease Term
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: . . .
g. Amounts segregated between those for finance and operating leases for the following items: . . .
3. Weighted-average remaining lease term . . . .
Weighted-Average Remaining Lease Term and Weighted-Average Discount Rate Disclosures
55-11 The lessee should calculate the weighted-average remaining lease term on the basis of the remaining lease term and the lease liability balance for each lease as of the reporting date.
A lessee must disclose — separately for both its operating leases and its finance leases — the weighted-average remaining lease term. Below is an example illustrating how to calculate the weighted-average lease term as of the reporting date. In this example, the reporting date is December 31, 2032, and the entity has six leases outstanding: three operating leases and three finance leases.
As calculated above, in this example, the weighted-average lease term for the operating lease liabilities is approximately 3 years (or approximately 39 months), and the weighted-average lease term for the finance lease liabilities is approximately 4.5 years (or approximately 54 months).
15.2.4.10 Weighted-Average Discount Rate
ASC 842-20
50-4 For each period presented in the financial statements, a lessee shall disclose the following amounts
relating to a lessee’s total lease cost, which includes both amounts recognized in profit or loss during the
period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and
the cash flows arising from lease transactions: . . .
g. Amounts segregated between those for finance and operating leases for the following items: . . .
4. Weighted-average discount rate.
Weighted-Average Remaining Lease Term and Weighted-Average Discount Rate Disclosures
55-12 The lessee should calculate the weighted-average discount rate on the basis of both of the following:
- The discount rate for the lease that was used to calculate the lease liability balance for each lease as of the reporting date
- The remaining balance of the lease payments for each lease as of the reporting date.
A lessee must disclose — separately for both its operating leases and its
finance leases — the weighted-average discount rate. Below is an example
illustrating how to calculate the weighted-average discount rate as of the
reporting date (in the example below, the reporting date is December 31,
2026).
15.2.5 Maturity Analysis of Liabilities
ASC 842-20
50-6 A lessee shall disclose a maturity analysis of its finance lease liabilities and its operating lease liabilities separately, showing the undiscounted cash flows on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessee shall disclose a reconciliation of the undiscounted cash flows to the finance lease liabilities and operating lease liabilities recognized in the statement of financial position.
A lessee must disclose a maturity analysis on an undiscounted basis, aggregating all of its finance lease liabilities separately from its aggregated operating lease liabilities. Paragraph BC287 of ASU 2016-02 provides further details regarding the disclosure requirements in ASC 842-20-50-6 and states, in part:
Topic 842 requires that a lessee disclose a maturity analysis of the contractual lease payments included in its lease liabilities at the reporting date to assist users of financial statements in understanding and evaluating the nature and extent of liquidity risks. A lessee should disclose, at a minimum, the amounts due on an annual basis for each of the first five years after the reporting date, plus a lump sum for the remaining years. Those maturity analyses are similar to the maturity analyses that were required in previous GAAP.
In the below example, as of the reporting date (December 31, 20X6), the entity
has five leases — three operating and two finance — and has presented a maturity table
summarizing those lease payments. The total amount of lease payments, on an undiscounted
basis, is reconciled to the lease liability in the statement of financial position
(discounted cash flows).
15.2.6 Lease Transactions With Related Parties
ASC 842-20
50-7 A lessee shall disclose lease transactions between related parties in accordance with paragraphs 850-10-
50-1 through 50-6.
Pending Content (Transition Guidance: ASC 842-10-65-8)
50-7A When the useful life of leasehold improvements to
the common control group determined in accordance with paragraph
842-20-35-12A exceeds the related lease term, a lessee shall
disclose the following information:
-
The unamortized balance of the leasehold improvements at the balance sheet date
-
The remaining useful life of the leasehold improvements to the common control group
-
The remaining lease term.
Lease transactions between related parties should be disclosed in accordance with the guidance in ASC
850. In accordance with ASC 850, a lessee should consider disclosing the nature of the related-party
lease, the related-party relationship, and the terms of the lease that are affected by the relationship.
See Chapter
17 for a discussion of ASU
2023-01, which provides guidanceon leasing arrangements between entities
under common control.
15.2.7 Practical-Expedient Disclosure Related to Short-Term Leases
ASC 842-20
50-8 A lessee that accounts for short-term leases in accordance with paragraph 842-20-25-2 shall disclose that
fact. If the short-term lease expense for the period does not reasonably reflect the lessee’s short-term lease
commitments, a lessee shall disclose that fact and the amount of its short-term lease commitments.
When a lessee elects the short-term lease recognition exemption by class of underlying asset (which results in off-balance-sheet accounting for the lease), it should disclose that it has done so. While a lessee may continue to apply a short-term lease exemption, if its activities in the reporting period do not give financial statement users a reasonable reflection of upcoming liabilities, the lessee should disclose that fact and adequately disclose the amount of its short-term lease commitments.
15.2.8 Practical-Expedient Disclosure Related to Not Separating Lease and Nonlease Components
ASC 842-20
50-9 A lessee that elects the practical expedient on not separating lease components from nonlease components in paragraph 842-10-15-37 shall disclose its accounting policy election and which class or classes of underlying assets it has elected to apply the practical expedient.
When a lessee elects the practical expedient under which it does not need to separate lease components from nonlease components, it should disclose this fact as well as the “class or classes of underlying assets” for which it has made the election. (See further discussion of this practical expedient in Section 4.3.3.1.)
15.3 Lessor Disclosure Requirements
ASC 842-30
50-1 The objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To achieve that objective, a lessor shall disclose qualitative and quantitative information about all of the following:
- Its leases (as described in paragraphs 842-30-50-3(a), 842-30-50-4, and 842-30-50-7)
- The significant judgments made in applying the requirements in this Topic to those leases (as described in paragraph 842-30-50-3(b))
- The amounts recognized in the financial statements relating to those leases (as described in paragraphs 842-30-50-5 through 50-6 and 842-30-50-8 through 50-13).
50-2 A lessor shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. A lessor shall aggregate or disaggregate disclosures so that useful information is not obscured by including a large amount of insignificant detail or by aggregating items that have different characteristics.
50-8 In addition to the disclosures required by paragraphs 842-30-50-3 through 50-7, a lessor also shall provide the disclosures in paragraphs 842-30-50-9 through 50-10 for sales-type leases and direct financing leases.
50-11 In addition to the disclosures required by paragraphs 842-30-50-3 through 50-7, a lessor also shall provide the disclosures in paragraphs 842-30-50-12 through 50-13 for operating leases.
The disclosure objective for lessors is the same as that for lessees (i.e., “to enable users of financial
statements to assess the amount, timing, and uncertainty of cash flows arising from leases”). However,
a lessor should consider the different, lessor-related information that a user of its financial statements
may be concerned about. Paragraph BC16 of ASU 2016-02 indicates that part of the reason the FASB
increased the lessor disclosure requirements was because disclosures under ASC 840 were insufficient:
Some users of financial statements also criticized previous GAAP applicable to lessors because that guidance
did not provide adequate information about a lessor’s exposure to credit risk (arising from a lease) and
exposure to asset risk (arising from the lessor’s retained interest in the underlying asset), particularly for those
leases of assets that were previously classified as operating leases.
Illustrative Example — Disclosure Disaggregation
The following are examples of ways a lessor may choose to disaggregate its lessor disclosures:
Another reason ASC 842 requires more disclosures for lessors is that the Board views a lessor’s activities
as similar to other revenue-generating activities, and the lack of disclosure regarding revenue was a key
issue that the Board addressed in its project on revenue from contracts with customers.
The lessor disclosure requirements are further subdivided into the following topics:
- Information about the nature of an entity’s leases (Section 15.3.1).
- General description of leases (Section 15.3.1.1).
- Basis and terms and conditions on which variable lease payments are determined (Section 15.3.1.2).
- Terms and conditions of options to extend or terminate leases (Section 15.3.1.3).
- Existence of terms and conditions for a lessee to purchase a leased asset (Section 15.3.1.4).
- Significant assumptions and judgments (Section 15.3.2).
- Whether a contract contains a lease (Section 15.3.2.1).
- Allocation of consideration in a contract (Section 15.3.2.2).
- Amount lessor expects to derive from underlying asset after the end of the lease term (Section 15.3.2.3).
- Practical-expedient disclosure related to not separating lease and nonlease components (Section 15.3.2.4).
- Lease transactions with related parties (Section 15.3.3).
- Residual assets and risk management (Section 15.3.4).
- Amounts recognized in the financial statements (Section 15.3.5).
-
Sales-type leases and direct financing leases (Section 15.3.5.1).
-
Tabular disclosures (Section 15.3.5.1.1).
-
Components of net investments in leases (Section 15.3.5.1.2).
-
Significant changes in the balance of unguaranteed residual assets and deferred selling profit (Section 15.3.5.1.3).
-
Maturity analysis of lease receivables (Section 15.3.5.1.4).
-
-
Operating leases (Section 15.3.5.2).
-
Tabular disclosures (Section 15.3.5.2.1).
-
Maturity analysis of lease payments (Section 15.3.5.2.2).
-
Separate ASC 360 disclosures (Section 15.3.5.2.3).
-
- Variable lease income (Section 15.3.5.3).
-
- Practical-expedient disclosure related to sales taxes and other similar taxes collected from lessees (Section 15.3.6).
15.3.1 Information About the Nature of an Entity’s Leases
ASC 842-30
50-3 A lessor shall disclose both of the following:
- Information about the nature of its leases, including:
- A general description of those leases
- The basis and terms and conditions on which variable lease payments are determined
- The existence and terms and conditions of options to extend or terminate the lease
- The existence and terms and conditions of options for a lessee to purchase the underlying asset. . . .
A lessor should disclose information about its leases in a manner consistent with the disclosure objective described above. Generally, disclosures provided under this requirement are more qualitative.
15.3.1.1 General Description of Leases
ASC 842-30
50-3 A lessor shall disclose both of the following:
- Information about the nature of its leases, including:
- A general description of those leases . . . .
The considerations related to a lessor’s disclosure of a general description of its leases are similar to those for lessees. See Section 15.2.1.1 for more information.
Illustrative Example — General Description of an Entity’s Leases
15.3.1.2 Basis and Terms and Conditions on Which Variable Lease Payments Are Determined
ASC 842-30
50-3 A lessor shall disclose both of the following:
- Information about the nature of its leases, including: . . .2. The basis and terms and conditions on which variable lease payments are determined . . . .
As discussed in Section 6.3, only some variable lease payments (those based on an index or rate) are
included in the initial and subsequent measurement of any (1) recognized net investment in the lease
for sales-type or direct financing leases or (2) lease receivables for operating leases. Because variable
lease payments are treated in different ways, the determination of what type of variability exists in a
lease contract and whether that variability is included or excluded from amounts recognized on the
balance sheet is critical to understanding lease income and achieving the disclosure objective (i.e.,
information about the timing and uncertainty of the entity’s cash flows). Therefore, the terms and
conditions related to variability provide the user with information about amounts that are not recorded
on the balance sheet because variable lease payments not based on an index or rate are not included in
recorded balance sheet amounts and could be considered more volatile forms of revenue and potential
future cash inflows.
Therefore, although it is not expressly required to do so, it may be helpful for an entity to describe the
sources of the variability in two separate groups: (1) the amounts included in the net investment in the
lease and (2) the variability that is excluded. In addition, an entity must explain the types of variability
within its contracts, and that explanation must include a discussion of key terms and conditions. For
example, an entity may receive variable lease payments because a lessee’s rental payment is determined
on the basis of a percentage of its store’s sales. Because of its volatility, users view this variability
differently from how they view a fixed rental payment; the more transparent the source of that volatility,
the better a user can understand the nature, timing, and uncertainty of the entity’s future cash flows. Sometimes, however, the variability in future lease payments may be more complex, in which case a lessor may need to provide additional information.
Illustrative Example — Basis and Terms and Conditions on Which Variable Lease Payments Are Determined
Variable lease payments that are based on an index or rate:
15.3.1.3 Terms and Conditions of Options to Extend or Terminate Leases
ASC 842-30
50-3 A lessor shall disclose both of the following:
- Information about the nature of its leases, including: . . .3. The existence and terms and conditions of options to extend or terminate the lease . . . .
Disclosures about terms and conditions related to options to extend or terminate leases should allow a user to assess the rights of the entity’s customers in the contracts. Such information may be helpful for users who want to understand situations in which lessors have contractually agreed to lease payments that may not be at market terms in the future (i.e., fixed-price renewal options on real estate).
Illustrative Example — Terms and Conditions of Options to Extend or Terminate Leases
15.3.1.4 Existence of Terms and Conditions for a Lessee to Purchase a Leased Asset
ASC 842-30
50-3 A lessor shall disclose both of the following:
- Information about the nature of its leases, including: . . .4. The existence and terms and conditions of options for a lessee to purchase the underlying asset. . . .
Regardless of whether it is reasonably certain that a lessee will exercise a
right to purchase an underlying asset, a lessor should disclose the
existence of such terms and conditions. Such disclosure allows a user to
understand when there may be an effective cap on the cash flows realizable
in the contract (e.g., if the purchase option is a fixed-price purchase
option).
15.3.2 Significant Assumptions and Judgments
ASC 842-30
50-3 A lessor shall disclose both of the following: . . .
b. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following:
1. The determination of whether a contract contains a lease (as described in paragraphs 842-10-15-2 through 15-27)
2. The allocation of the consideration in a contract between lease and
nonlease components (as described in paragraphs
842-10-15-28 through 15-32), unless a lessor
elects the practical expedient in paragraph
842-10-15-42A and all nonlease components in the
contract qualify for that practical
expedient
3. The determination of the amount the lessor expects to derive from the underlying asset following the end of the lease term.
50-3A An entity that elects the practical expedient in paragraph 842-10-15-42A on not separating nonlease components from associated lease components (including an entity that accounts for the combined component entirely in Topic 606 on revenue from contracts with customers) shall disclose the following, by class of underlying asset:
- Its accounting policy election and the class or classes of underlying assets for which it has elected to apply the practical expedient
- The nature of:
- The lease components and nonlease components combined as a result of applying the practical expedient
- The nonlease components, if any, that are accounted for separately from the combined component because they do not qualify for the practical expedient
- The Topic the entity applies to the combined component (this Topic or Topic 606).
The considerations related to a lessor’s disclosures about significant assumptions and judgments are
similar to those for lessees. For more information, see Section 15.2.3.
15.3.2.1 Whether a Contract Contains a Lease
ASC 842-30
50-3 A lessor shall disclose both of the following: . . .
b. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following:
1. The determination of whether a contract contains a lease (as described
in paragraphs 842-10-15-2 through 15-27) . . .
.
The lessor’s considerations related to disclosures about significant judgments used to determine whether a contract contains a lease are similar to those for lessees. For more information, see Section 15.2.3.1.
Illustrative Example — Whether a Contract Contains a Lease
15.3.2.2 Allocation of Consideration in a Contract
ASC 842-30
50-3 A lessor shall disclose both of the following: . . .
b. Information about significant assumptions and judgments made in applying the requirements of this
Topic, which may include the following: . . .
2. The allocation of the consideration in a contract between lease and
nonlease components (as described in paragraphs
842-10-15-28 through 15-32), unless a lessor
elects the practical expedient in paragraph
842-10-15-42A and all nonlease components in the
contract qualify for that practical expedient . .
. .
The lessor’s considerations related to disclosures about significant judgments used to determine the
allocation of consideration in a contract are similar to those for lessees. For more information, see
Section 15.2.3.2.
Illustrative Example — Allocation of Consideration in a Contract
Note that in July 2018, the FASB issued ASU 2018-11, which contains a
practical expedient under which lessors can elect, by class of underlying
asset, not to separate lease and nonlease components, provided that the
associated nonlease component(s) otherwise would be accounted for under the
revenue guidance in ASC 606 and both of the following conditions are met:
-
Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.
-
Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
The ASU also clarifies that the presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the expedient for the lease component and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease components that do not qualify for the practical expedient separately from the combined lease and nonlease components that do qualify.
See Section 4.3.3.2
for further details about the practical expedient related to a lessor’s
separation of lease and nonlease components. In addition, see Section 15.3.2.4 for
the disclosure requirements, and Section 16.4.6 for the transition
requirements, related to ASU 2018-11.
15.3.2.3 Amount Lessor Expects to Derive From the Underlying Asset After the End of the Lease Term
ASC 842-30
50-3 A lessor shall disclose both of the following: . . .
b. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following: . . .
3. The determination of the amount the lessor expects to derive from the underlying asset following the end of the lease term.
An entity considers various inputs when evaluating the amount it expects to
derive from its leased assets at the end of the lease terms, including the
following:
-
The remaining useful life.
-
Expected market conditions:
-
Fair value of lease payments.
-
Expected fair values of underlying assets.
-
-
Expected deployment of underlying asset in business (e.g., re-lease or sell).
The estimated amount of the residual asset directly affects the gain (in a sales-type lease) or loss (in either a sales-type or a direct financing lease) the entity recognizes upon commencement of the lease. Therefore, this estimate and any related assumptions should be disclosed because they are critical to a user’s understanding of the amount of the gain or loss recognized and potential future cash flows.
15.3.2.4 Practical-Expedient Disclosure Related to Not Separating Lease and Nonlease Components
ASC 842-30
50-3A An entity that elects the practical expedient in paragraph 842-10-15-42A on not separating nonlease
components from associated lease components (including an entity that accounts for the combined
component entirely in Topic 606 on revenue from contracts with customers) shall disclose the following, by
class of underlying asset:
- Its accounting policy election and the class or classes of underlying assets for which it has elected to apply the practical expedient
- The nature of:
- The lease components and nonlease components combined as a result of applying the practical expedient
- The nonlease components, if any, that are accounted for separately from the combined component because they do not qualify for the practical expedient
- The Topic the entity applies to the combined component (this Topic or Topic 606).
When a lessor elects the practical expedient to combine lease and nonlease components in a contract,
it is required to provide certain disclosures. Such disclosures include (1) the lessor’s election to combine
lease components with associated nonlease components, (2) the class(es) of underlying asset(s) for
which the election was made, (3) the nature of the items that are being combined, (4) any nonlease
components that were not eligible for the practical expedient, and (5) which standard applies to the
combined component (i.e., ASC 842 or ASC 606). (See Section 4.3.3.2 for further discussion of this
practical expedient.)
15.3.3 Lease Transactions With Related Parties
ASC 842-30
50-4 A lessor shall disclose any lease transactions between related parties (see Topic 850 on related party
disclosures).
Lessors should disclose lease transactions between related parties in a manner consistent with the
guidance in ASC 850. In accordance with ASC 850, a lessor should consider disclosing the nature of the
related-party lease, the related-party relationship, and the terms of the lease that are affected by the
relationship.
See Chapter
17 for a discussion of ASU
2023-01, which provides guidance on leasing arrangements
between entities under common control.
15.3.4 Residual Assets and Risk Management
ASC 842-30
50-7 A lessor shall disclose information about how it manages its risk associated with the residual value of its
leased assets. In particular, a lessor should disclose all of the following:
- Its risk management strategy for residual assets
- The carrying amount of residual assets covered by residual value guarantees (excluding guarantees considered to be lease payments for the lessor, as described in paragraph 842-30-30-1(a)(2))
- Any other means by which the lessor reduces its residual asset risk (for example, buyback agreements or variable lease payments for use in excess of specified limits).
Paragraph BC331 of ASU 2016-02 describes the FASB’s rationale for including the above disclosure
requirements related to residual assets in ASC 842-30-50-7:
While users generally said that the lessor accounting model in previous GAAP provided them with the financial
information they needed, many users indicated that they needed more information about the lessor’s residual
assets and exposure to residual asset risk. The latter (exposure to residual asset risk) is addressed by the
lessor disclosure requirements discussed in paragraphs BC339 and BC340. Regarding the former (information
about the lessor’s residual assets), the Board noted that users will benefit from the disclosure of a lessor’s
unguaranteed residual assets separate from the lessor’s lease receivable. That is, because, although linked,
those assets (that is the unguaranteed residual asset and the lease receivable) have different natures, risks,
and liquidity. Separate disclosure of those assets will improve the transparency of information provided to
users of financial statements about a lessor’s exposure to credit risk (relating to the lease receivable, which
includes any guaranteed portion of the underlying assets’ estimated residual value) and asset risk (relating to
the unguaranteed residual asset).
Further, paragraph BC340 of ASU 2016-02 states the following regarding the Board’s reasoning behind
changing the previous U.S. GAAP guidance on this topic:
A primary concern of users on the disclosure requirements in previous GAAP is the lack of transparency
about how the lessor manages its exposure to residual value risk. While users generally said that the lessor
accounting model in previous GAAP provided them with the financial information they needed, many users
indicated that additional information was needed about the lessor’s residual assets and exposure to residual
risk. Uncertainty about the residual value of the underlying asset at the end of the lease is a lessor’s primary
risk, particularly for a lessor of equipment and vehicles. This is because a decline in the market value of leased
equipment and vehicles at a rate greater than the rate the lessor projected (on the basis of its policy on residual
value measurement) would adversely affect the profitability of the lease. Residual value realization at the end of
the lease term might be affected by several factors (for example, rapid technological or economic obsolescence,
unusual wear and tear, excess use, or manufacturer’s warranties). Consequently, the Board decided that a
lessor should disclose how it manages its residual value risk to enable users to assess the uncertainty of cash flows arising from a lessor’s leases and from its leased assets. The Board considered that producing residual risk disclosures will carry an incremental cost to preparers, but it decided to require the disclosures on the basis that this is an area in which users have consistently requested additional information and told the Board that the financial reporting for lessors in previous GAAP was inadequate for their information needs in many cases.
Connecting the Dots
Disclosures About Residual Asset Risk May Not Be as Applicable to
Lessors of Real Estate
Residual value risk might not be a primary risk for many lessors of property
(i.e., land or buildings in this context) because of the long-lived
nature of those assets as well as the propensity for such assets to hold
their value or, in many cases, to appreciate. In such cases, a
lessor may consider providing more limited narrative disclosures.
15.3.5 Amounts Recognized in the Financial Statements
15.3.5.1 Sales-Type Leases and Direct Financing Leases
15.3.5.1.1 Tabular Disclosures
ASC 842-30
50-5 A lessor shall disclose lease income recognized in each annual and interim reporting period, in a tabular format, to include the following:
a. For sales-type leases and direct financing leases:
1. Profit or loss recognized at the commencement date (disclosed on a gross basis or a net basis consistent with paragraph 842-30-45-4)
2. Interest income either in aggregate or separated by components of the
net investment in the lease. . . .
The table below outlines information that an entity would need to disclose for sales-type or direct financing leases to comply with the requirements in ASC 842-30-50-5 above.
Lessor Uses Leasing to “Sell” PP&E It Would Otherwise Sell | ||
---|---|---|
Sales-Type Lease | Direct Financing Lease | |
Selling profit at lease commencement | Gross selling price, cost of leased property, selling profit | Not applicable — no selling profit is recognized at lease commencement for direct financing leases |
Selling loss | Gross selling price, cost of leased property, selling loss | |
Interest income | Disclose interest income either in aggregate or separated by components of the net investment in the lease. That is, disclose interest income related to (1) the interest earned on the lease receivable and (2) the accretion of the unguaranteed residual value of the asset. | Disclose interest income either in the aggregate or separated by components of the net investment in the lease. That is, disclose interest income related to (1) the interest earned on the lease receivable, (2) the accretion of the unguaranteed residual value of the asset, and (3) any deferred selling profit included in the net investment balance. |
Lessor Uses Leasing to Provide Financing to Lessees | ||
---|---|---|
Sales-Type Lease | Direct Financing Lease | |
Selling profit
at lease
commencement | Selling profit | Not applicable — no selling profit is
recognized at lease commencement for
direct financing leases |
Selling loss | Selling loss | |
Interest income | Disclose interest income either in
aggregate or separated by components
of the net investment in the lease. That is,
disclose interest income related to (1) the
interest earned on the lease receivable
and (2) the accretion of the unguaranteed
residual value of the asset. | Disclose interest income either in the
aggregate or separated by components
of the net investment in the lease. That is,
disclose interest income related to (1) the
interest earned on the lease receivable, (2)
the accretion of the unguaranteed residual
value of the asset, and (3) any deferred
selling profit included in the net investment
balance. |
Example 15-1
Disclosures Related to Sales-Type Lease
The following disclosures are based on the calculations in Section
9.3.7:
Example 15-2
Disclosures Related to Direct Financing Lease
The following disclosures are based on the calculations in Section
9.3.8:
15.3.5.1.2 Components of Net Investments in Leases
ASC 842-30
50-6 A lessor shall disclose in the notes the components of its aggregate net investment in sales-type and direct financing leases (that is, the carrying amount of its lease receivables, its unguaranteed residual assets, and any deferred selling profit on direct financing leases).
The following is an example of a disclosure an
entity might provide to comply with the above requirement in ASC
842-30-50-6 regarding disclosure of components of net investments in
leases:
Changing Lanes
ASC 842 Amends Disclosure Requirements Pertaining to the
Components of Net Investments in Leases
Under ASC 840-30-50-4, all of the following components of the net investment in sales-type or direct financing leases were disclosed: (1) future minimum lease payments to be received (with certain separate deductions), (2) unguaranteed residual values accruing to the lessor’s benefit, (3) initial direct costs (for direct financing leases only), and (4) unearned income. Unearned income in a sales-type lease was initially measured as the difference between the gross investment in the lease and the sum of the present values of the two components of the gross investment. Unearned income in a direct financing lease was initially measured as the difference between the gross investment in the lease and the cost or carrying amount of the underlying asset. Accordingly, under ASC 840, disclosures about the components of the net investment in a sales-type or a direct financing lease needed to include the gross amount of the components, with an unearned income adjustment to arrive at a total that corresponded to the balance sheet amount. On the other hand, ASC 842 requires that the carrying amount of the components of the net investment be disclosed. That is, each individual component should be presented at a discounted value.
15.3.5.1.3 Significant Changes in the Balance of Unguaranteed Residual Assets and Deferred Selling Profit
ASC 842-30
50-9 A lessor shall explain significant changes in the balance of its unguaranteed residual assets and deferred selling profit on direct financing leases.
Significant changes in the “balance of [a lessor’s] unguaranteed residual assets and deferred selling profit on direct financing leases” must be disclosed and could arise from fluctuations in the residual asset value governed by technological or other market influences, termination or completion of the lease, or impairment of the underlying asset.
15.3.5.1.4 Maturity Analysis of Lease Receivables
ASC 842-30
50-10 A lessor shall disclose a maturity analysis of its lease receivables, showing the undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessor shall disclose a reconciliation of the undiscounted cash flows to the lease receivables recognized in the statement of financial position (or disclosed separately in the notes).
The below example3 includes a maturity analysis of lease receivables as well as a reconciliation to the
total amount of receivables recognized in the statement of financial position.
15.3.5.2 Operating Leases
A lessor should treat assets subject to operating leases as a major class of depreciable assets.
Specifically, paragraph BC341 of ASU 2016-02 states, in part:
[A] lessor should provide the required property, plant, and equipment disclosures for assets subject to
operating leases separately from owned assets held and used by the lessor. In the Board’s view, leased assets
often are subject to different risks than owned assets that are held and used (for example, the decrease in the
value of the underlying asset in a lease could be due to several factors that are not within the control of the
lessor), and, therefore, users will benefit from lessors segregating their disclosures related to assets subject to
operating leases from disclosures related to other owned property, plant, and equipment.
15.3.5.2.1 Tabular Disclosures
ASC 842-30
50-5 A lessor shall disclose lease income recognized in each annual and interim reporting period, in a tabular
format, to include the following: . . .
b. For operating leases, lease income relating to lease payments. . . .
In interim and annual reporting periods, a lessor should disclose, within its tabular disclosure of lease
income, lease income related to lease payments from operating leases.
15.3.5.2.2 Maturity Analysis of Lease Payments
ASC 842-30
50-12 A lessor shall disclose a maturity analysis of lease payments, showing the undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessor shall present that maturity analysis separately from the maturity analysis required by paragraph 842-30-50-10 for sales-type leases and direct financing leases.
With respect to the requirement in ASC 842-30-50-12 for a lessor to disclose a maturity analysis of operating lease payments, a reconciliation of the cash flows to the receivable balance is not required because a receivable similar to that recorded under a direct financing or sales-type lease is not recorded under an operating lease. (See Section 15.3.5.1.4.)
15.3.5.2.3 Separate ASC 360 Disclosures
ASC 842-30
50-13 A lessor shall provide disclosures required by Topic 360 on property, plant, and equipment separately for underlying assets under operating leases from owned assets.
To comply with the disclosure requirement above, an entity will need to consider the disclosure requirements in ASC 360-10-50, including those related to items such as depreciation, balances of major classes of assets, and impairment considerations.
15.3.5.3 Variable Lease Income
ASC 842-30
50-5 A lessor shall disclose lease income recognized in each annual and interim reporting period, in a tabular format, to include the following: . . .
c. Lease income relating to variable lease payments not included in the measurement of the lease receivable.
In interim and annual reporting periods, a lessor should disclose, within its tabular disclosure of lease income, lease income related to variable lease payments. This amount should include variable lease income associated with all lease classifications, but it should exclude any lease income already disclosed within the sales-type lease, direct-financing lease, or operating lease disclosures (i.e., it should exclude lease income related to payments included in the measurement of the lease receivable or in the calculation of straight-line operating lease income).
15.3.6 Practical-Expedient Disclosure Related to Sales Taxes and Other Similar Taxes Collected From Lessees
ASC 842-30
50-14 A lessor that makes the accounting policy election in paragraph 842-10-15-39A shall disclose its accounting policy election and comply with the disclosure requirements in paragraphs 235-10-50-1 through 50-6.
When a lessor elects, as an accounting policy, to exclude from revenue and expenses sales taxes and other similar taxes assessed by a governmental authority and collected by the lessor from a lessee, it should disclose that it has done so. See Section 17.3.1.5 for detailed discussion of ASU 2018-20, including transition requirements.
Footnotes
3
Assume that the lessor has one lease with a remaining lease term of six years and annual lease payments of $9,500.
15.4 Sale-and-Leaseback Transactions
ASC 842-40
50-1 If a seller-lessee or a
buyer-lessor enters into a sale and leaseback transaction
that is accounted for in accordance with paragraphs
842-40-25-4 and 842-40-30-1 through 30-3, it shall provide
the disclosures required in paragraphs 842-20-50-1 through
50-10 for a seller-lessee or paragraphs 842-30-50-1 through
50-13 for a buyer-lessor.
50-2 In addition to the
disclosures required by paragraphs 842-20-50-1 through
50-10, a seller-lessee that enters into a sale and leaseback
transaction shall disclose both of the following:
-
The main terms and conditions of that transaction
-
Any gains or losses arising from the transaction separately from gains or losses on disposal of other assets.
An entity that enters into a sale-and-leaseback transaction must provide disclosures in addition to those outlined in Sections 15.2 and 15.3 for lessees and lessors, respectively. In addition, a seller-lessee must disclose the terms and conditions of the sale-and-leaseback transaction and present the gains and losses resulting from the transaction separately from those arising from other asset disposals.
15.5 Annual and Interim Disclosures
This section outlines the comparative period disclosure requirements (i.e., for the comparative annual periods presented in an entity’s financial statements) and interim disclosure requirements under ASC 842.
15.5.1 Comparative Periods
Some of the disclosure requirements outlined in the sections above start with the phrase “for each
period presented in the financial statements, a lessee shall disclose.” These statements typically
accompany quantitative requirements such as those in ASC 842-20-50-4 (lessee amounts recognized
in the balance sheet). Therefore, these quantitative disclosures should be presented comparatively
with respect to the prior annual periods presented. Other requirements, such as the qualitative
requirements, do not necessarily lend themselves to separate disclosures for the comparative balance
sheet dates presented and therefore may be discussed only as of the reporting date (rather than on a
comparative basis).
15.5.2 Interim Disclosures
Interim disclosure requirements are outlined in ASC 270. Generally, ASC 270 requires that entities report
significant changes in financial position (see ASC 270-10-50-4) and changes in accounting principles
and estimates (see ASC 270-10-45-12 through 45-16), along with other information that helps users
understand the interim financial reporting results compared with those for its most recent annual
period.
In addition, ASC 270 requires lessors to provide the following disclosure on
both an interim and annual basis:
ASC 270-10
50-6A A lessor shall disclose a table of all lease-related income items in its interim financial statements (see
paragraph 842-30-50-5 for lease-related income items).
Other than this one explicit requirement for lessors, no disclosures are
prescribed for lessees and lessors on an interim basis. The aforementioned
lease-related income items required for lessors are detailed in ASC 842-30-50-5
and further discussed in Section
15.3.5.1.1.
Connecting the Dots
Interim Disclosures
While there are no explicit interim requirements (in the
year after adoption), an entity may elect to provide interim lease
disclosures in a manner consistent with how it provides disclosures in
its annual financial statements if the entity’s leasing activities are
significant or if there are significant changes in its leasing
activities on an interim basis. Further, we believe that providing the
required annual lease disclosures for each interim period could
alleviate a significant amount of work at year-end. That is, it will
most likely take entities significant time to compile the amount of
information required, and discussed throughout this chapter, if it is
accumulated at year-end for a full year of activity. Therefore, entities
that have controls and processes in place to accumulate this information
throughout the year may find it less burdensome to prepare their annual
disclosures.
For more information about what annual disclosures an entity needs to provide in
its first quarterly filing after adoption, see Section 16.11.
Chapter 16 — Effective Date and Transition
Chapter 16 — Effective Date and Transition
16.1 Overview
ASC 842-10
65-1 The following represents
the transition and effective date information related to
Accounting Standards Update . . . No. 2016-02, Leases
(Topic 842) . . .
-
A public business entity, a not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market (with an exception for those entities that have not yet issued their financial statements or made financial statements available for issuance as described in the following sentence), and an employee benefit plan that files or furnishes financial statements with or to the U.S. Securities and Exchange Commission shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. A not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market that has not yet issued financial statements or made financial statements available for issuance as of June 3, 2020 shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. Earlier application is permitted.
-
All other entities shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application is permitted. . . .
In November 2019, the FASB issued ASU 2019-10, which (1)
provided a framework for staggering the effective dates of future major accounting
standards and (2) amended the effective dates of certain major new accounting
standards to give implementation relief to certain types of entities. In June 2020,
the FASB issued ASU
2020-05, which further amended the effective dates to give
implementation relief to certain types of entities in response to the COVID-19
pandemic. ASU 2020-05 amended the effective dates of ASU 2016-02 as follows:
Public Companies1
|
Public NFPs2
|
All Other
Entities
| |
As originally issued (ASU 2016-02)
|
Fiscal years beginning after December 15,
2018, and interim periods therein
|
Fiscal years beginning after December 15,
2018, and interim periods therein
|
Fiscal years beginning after December 15,
2019, and interim periods within fiscal years beginning
after December 15, 2020
|
As amended by ASU 2019-10
|
No changes
|
No changes
|
Fiscal years beginning after December 15,
2020, and interim periods within fiscal years beginning
after December 15, 2021
|
As amended by ASU 2020-05
|
No changes
|
Fiscal years beginning after December 15,
2019, and interim periods therein
|
Fiscal years beginning after December 15,
2021, and interim periods within fiscal years beginning
after December 15, 2022
|
Bridging the GAAP
Comparison With IFRS 16
The effective date of IFRS 16 is similar to the effective date of ASU 2016-02 for PBEs. However,
the IASB decided that an entity would only be allowed to early adopt IFRS 16 if it has also
adopted IFRS 15 (the IASB’s revenue standard). The IASB decided to limit early adoption of IFRS
16 because, as noted in paragraph BC272 of IFRS 16, “some of the requirements in IFRS 16
depend on an entity also applying the requirements of IFRS 15 (and not the Standards that were
superseded by IFRS 15).”
ASC 842-10
65-1 The following represents
the transition and effective date information related to
Accounting Standards Update . . . No. 2016-02, Leases
(Topic 842) . . .
c. In the financial statements in which an entity
first applies the pending content that links to this
paragraph, the entity shall recognize and measure
leases within the scope of the pending content that
links to this paragraph that exist at the
application date, as determined by the transition
method that the entity elects. An entity shall apply
the pending content that links to this paragraph
using one of the following two methods:
1. Retrospectively to each
prior reporting period presented in the financial
statements with the cumulative effect of initially
applying the pending content that links to this
paragraph recognized at the beginning of the
earliest comparative period presented, subject to
the guidance in (d) through (gg). Under this
transition method, the application date shall be the
later of the beginning of the earliest period
presented in the financial statements and the
commencement date of the lease.
2. Retrospectively at the
beginning of the period of adoption through a
cumulative-effect adjustment, subject to the
guidance in (d) through (gg). Under this transition
method, the application date shall be the beginning
of the reporting period in which the entity first
applies the pending content that links to this
paragraph.
d. An entity shall adjust equity and, if the entity
elects the transition method in (c)(1), the other
comparative amounts disclosed for each prior period
presented in the financial statements, as if the
pending content that links to this paragraph had
always been applied, subject to the requirements in
(e) through (gg).
e. If a lessee elects not to apply the recognition
and measurement requirements in the pending content
that links to this paragraph to short-term leases,
the lessee shall not apply the approach described in
(k) through (t) to short-term leases.
See Examples 28 through 29 (paragraphs
842-10-55-243 through 55-254) for illustrations of the
transition requirements for an entity that applies the
pending content that links to this paragraph in accordance
with (c)(1). . . .
An entity adopts ASC 842 by using a modified retrospective
transition approach. Under this approach, the standard is effectively implemented
either (1) as of the earliest period presented and through the comparative periods
in the entity’s financial statements or (2) as of the effective date of ASC 842,
with a cumulative-effect adjustment to equity (see Section 16.1.1). The modified nature of
this transition approach is intended to maximize comparability while reducing the
complexity of transition compared with the full retrospective approach, under which
financial statements would be prepared as if ASC 842 was always effective.
ASC 842 provides for certain practical expedients in transition.
Depending on the expedients elected, certain aspects of ASC 842 will not be
implemented until the standard’s effective date, regardless of whether an entity
elects to recast comparative periods under ASC 842. The practical expedients are
intended to reduce the cost and complexity of adoption while maintaining financial
statement comparability after adoption.
Connecting the Dots
Modified Retrospective Transition
Under ASC 842 Differs From That Under ASC 606
An entity that elects the modified retrospective transition
option in ASC 606 is permitted to apply ASC 606 only to the current-year
financial statements (i.e., the financial statements for the year in which
ASC 606 is first implemented). Such an entity will record a
cumulative-effect adjustment to the opening balance of retained earnings in
the year in which it first adopts ASC 606. By contrast, an entity that uses
the modified retrospective transition approach under ASC 842 may record an
adjustment as of the beginning of either the earliest year presented or the
first year of adoption.
16.1.1 Entities Permitted to Elect Not to Restate Comparative Periods in the Period of Adoption
In July 2018, the FASB issued ASU 2018-11, which amended certain
aspects of ASC 842 to provide relief from the costs of implementing the new
leasing standard. ASU 2018-11 allows an entity to elect not to recast its
comparative periods in the period of adoption when transitioning to ASC 842 (the
“Comparatives Under 840 Option”). Effectively, an entity would be permitted to
change its date of initial application to the beginning of the period of
adoption of ASC 842 (e.g., January 1, 2019, for a calendar-year-end PBE or
January 1, 2022, for a calendar-year-end non-PBE). In doing so, the entity
would:
-
Apply ASC 840 in the comparative periods.
-
Provide the disclosures required by ASC 840 for all periods that continue to be presented in accordance with ASC 840.
-
Recognize the effects of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of the effective date (e.g., January 1, 2019, for a calendar-year-end PBE or January 1, 2022,3 for a calendar-year-end non-PBE); under the Comparatives Under 840 Option, this date would represent the date of initial application.
The entity would not:
- Restate comparative periods for the effects of applying ASC 842.
- Provide the disclosures required by ASC 842 for the comparative periods.
- Change how the transition requirements apply, only when the transition requirements apply.
Therefore, an entity that elects the Comparatives Under 840 Option under ASU 2018-11 may find transition (as well as navigating the complicated concepts in this chapter) easier.
Connecting the Dots
Implementation Challenges Remain When the Comparatives Under 840
Option Is Used
Although the Comparatives Under 840 Option does not change how an entity applies the transition requirements, the lease-related balances recorded as of the effective date may still differ from the balances that would be remaining as of that date if comparative periods had been restated for the effects of applying ASC 842.
The Board expects that the new transition election will relieve entities from the cost burdens that are associated with restating comparative periods for the effects of applying ASC 842. However, many entities will still need to enhance their lease-related IT systems as a result of ASC 842’s data requirements. In addition, ASC 842’s requirements related to judgments and estimations have not changed, and new processes and internal controls will still need to be instituted accordingly. Therefore, we do not think that entities should slow their implementation efforts because of the issuance of ASU 2018-11.
Throughout this chapter, we use the phrase “date of initial application” to mean either of the following:
- The beginning of the earliest comparative period presented — if the entity does not elect the Comparatives Under 840 Option.
- The date on which the entity adopts ASC 842 — if the entity elects the Comparatives Under 840 Option.
See Section 16.11
for additional discussion of the transition disclosures related to ASU 2018-11
and Section
17.3.1.4.1 for further discussion of this additional transition
method.
16.1.2 Adoption Timelines
16.1.2.1 PBE With a Calendar Year-End
Assumes no early adoption (and
no election of the Comparatives Under 840 Option)
16.1.2.2 Non-PBE With a Calendar Year-End
Assumes no early adoption (and no election of the Comparatives
Under 840 Option)
The above charts indicate the transition timelines for
calendar-year-end PBEs and non-PBEs, respectively, with two comparative periods
presented. Differences in assets and liabilities as of the earliest comparative
period are recognized as a cumulative-effect adjustment in equity at such time.
Lessors apply the modified retrospective transition approach similarly to how
lessees apply it.
Connecting the Dots
Meaning of “Earliest Comparative
Period Presented”
PBEs that present three years of income statements and
statements of cash flows must prepare the balance-sheet effect of the
adoption of ASC 842 as of January 1, 2017, even though they generally
provide only two years of balance sheets in their financial statements.
That is, PBEs need the balance sheet so that they can (1) prepare the
income statement in the earliest year presented and a statement of cash
flow reconciliation and (2) properly roll forward the balance sheet.
Modified Retrospective Transition
Method Required
Because the FASB wanted to limit the number of potential
transition methods that an entity could apply, full retrospective
transition is not permitted; rather, the modified retrospective
transition method is required. However, as discussed later in this
chapter, the level of modification depends on the extent to which an
entity elects optional practical expedients (see Section
16.5).
“Earliest Period Presented” for a
Non-PBE’s Stand-Alone Financial Statements
While PBEs are subject to the SEC’s public-company
reporting requirements, other entities may prepare single or multi-year
comparative financial statements in accordance with their own reporting
requirements. An entity that does not elect the Comparatives Under 840
Option must apply the modified retrospective transition approach to the
earliest period presented in its financial statements. If a non-PBE is
consolidated by a PBE, the PBE will technically have an “earliest period
presented” that is different from (earlier than) the period in which the
non-PBE will prepare financial statements for its users. Nonetheless, we
believe that in the PBE’s consolidated financial statements, the PBE is
required to determine its subsidiary’s lease balance as of the PBE’s
earliest period presented. We do not believe that the FASB intended for
the lease balances to be calculated as of multiple dates (one for the
parent and one for the subsidiary) in the PBE’s consolidated financial
statements.
Example 16-1
Roses Inc., a PBE that does not
elect the Comparatives Under 840 Option, prepares
its 2019 financial statements for which the
earliest comparative period begins on January 1,
2017. One of its consolidated subsidiaries, Free
LLC, prepares separate financial statements for
which the earliest comparative period begins on
January 1, 2018. Roses is required to determine
its lease balances as of January 1, 2017, which
include lease balances that roll up from Free.
Further, it would be acceptable for Free to use
the January 1, 2017, lease balances and roll
forward the balances to January 1, 2018, for
transition and disclosure purposes.
Footnotes
1
Public companies are PBEs, as well
as certain not-for-profit entities and employee
benefit plans as described above in ASC
842-10-65-1(a).
2
The deferral in ASU 2020-05 applied
to public NFPs that had not issued financial
statements or made financial statements available
for issuance as of June 3, 2020. Public NFPs that
have issued financial statements or have made
financial statements available for issuance before
that date must comply with the effective dates
prescribed for public companies above.
3
In accordance with ASU 2020-05.
16.2 Considerations Related to Applying Transition Guidance
ASC 842 requires all entities to apply the modified retrospective approach. The determination of lease
balances under this approach is generally based on the remaining lease payments and discount rate
as of the date of initial application. Under the full retrospective approach (which is not permitted),
by contrast, lease balances would be determined as of lease commencement and rolled forward. In
addition, an entity may elect various transition-related accounting policies under ASC 842, which could
affect its comparability to other entities.
Specifically, ASC 842 offers relief from implementing the transition provisions by permitting an entity
(lessee or lessor) to elect not to reassess:
- Whether any expired or existing contract is or contains a lease.
- The lease classification of any expired or existing leases.
- Initial direct costs for any existing leases.
An entity that elects this transition relief (i.e.,
the “practical expedient package”) is required to adopt all three relief provisions
and is prohibited from applying the relief on a lease-by-lease basis. In addition,
the entity must disclose that it has elected the practical expedient package.
Separately, the entity is also allowed to use hindsight in evaluating the lease term
(e.g., renewal, termination, and purchase options for existing leases) and
impairment of the ROU asset. As a result, when preparing for transition, entities
must consider the following transition and accounting policy elections:
Transition Elections
(Entity-Wide for All Leases)
|
Accounting Policy
Elections
|
---|---|
|
|
Connecting the Dots
Considerations Related to Selecting Expedients and Accounting
Policies
As companies prepare to implement ASU 2016-02 and assess its impact, the
appropriateness to their organization of policies
related to practical expedients may continue to
evolve. For example, although the practical
expedient package may be an efficient manner of
adopting the standard, an entity that elects this
package may miss the opportunity to reassess
whether a lease under ASC 840 would be outside the
scope of ASC 842. In addition, some may find the
income statement presentation of a finance lease
to be more favorable than that of an operating
lease and therefore may wish to assess lease
classification under ASC 842. We recommend that
companies work with various stakeholders at their
organizations (e.g., accounting, finance, real
estate, and IT professionals, as well as the audit
committee) to determine the impact and
costs/benefits of the above elections for each
stakeholder. Further, companies should consider
discussing the impact of the elections with their
professional advisers.
Hindsight Expedient May Increase Complexity
While the hindsight practical expedient only applies to
lease term and impairment considerations (see Section 16.5.1), we believe that the
expedient could make adoption more complex given that both of these matters
affect other aspects of lease accounting.
16.3 Lessee
The transition approach for lessees — except for reporting entities that elect,
as an accounting policy, to exclude short-term leases4 (see Section
5.2.4.3) — is to recognize all lease obligations and ROU assets on
the balance sheet. For leases previously classified as operating under ASC 840, this
approach represents a significant change because ASC 840 required that only capital
leases be included on the balance sheet. For leases previously classified as a
capital lease, the finance lease transition generally carries forward the previous
capital lease balances, subject to the application of the practical expedients
described in Section
16.5.
16.3.1 Lease Previously Classified as an Operating Lease Under ASC 840
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
k. A lessee shall initially recognize a right-of-use asset and a lease liability at the application date as determined in (c).
l. Unless, on or after the effective date, the lease is modified (and that modification is not accounted for
as a separate contract in accordance with paragraph 842-10-25-8) or the lease liability is required to be
remeasured in accordance with paragraph 842-20-35-4, a lessee shall measure the lease liability at the
present value of the sum of the following, using a discount rate for the lease (which, for entities that are
not public business entities, can be a risk-free rate determined in accordance with paragraph 842-20-30-3) established at the application date as determined in (c):
1. The remaining minimum rental payments (as defined under Topic 840).
2. Any amounts probable of being owed by the lessee under a residual value guarantee. . . .
p. If a lessee does not elect the practical expedients described in (f), any unamortized initial direct costs that do not meet the definition of initial direct costs in this Topic shall be written off as an adjustment to equity unless the entity elects the transition method in (c)(1) and the costs were incurred after the beginning of the earliest period presented, in which case those costs shall be written off as an adjustment to earnings in the period the costs were incurred.
q. If a modification to the contractual terms and conditions occurs on or after the effective date, and the
modification does not result in a separate contract in accordance with paragraph 842-10-25-8, or the
lessee is required to remeasure the lease liability for any reason (see paragraphs 842-20-35-4 through
35-5), the lessee shall follow the requirements in this Topic from the effective date of the modification or
the remeasurement date.
Leases previously classified as an operating lease under ASC 840 could be accounted for as either an
operating lease or a finance lease under ASC 842. The classification under ASC 842 depends on whether
an entity elects the practical expedient package (see Section 16.5.2.2). If so, the entity does not reassess
the ASC 840 classification (i.e., the classification is carried forward when the entity adopts ASC 842).
However, if the practical expedient package is not elected, the lease must be assessed under the ASC
842 classification criteria. Because there are only minor differences between the lease classification
criteria under ASC 840 and those under ASC 842, the lease classification conclusion often will remain
unchanged even if the practical expedient package is not elected.
The two transition scenarios for an operating
lease under ASC 840 are as follows:
As discussed further below, transition in both of these scenarios is the same with respect to (1) the timing of recognizing the ROU asset and lease liability, (2) the initial measurement of the lease liability, (3) unamortized initial direct costs that do not meet the definition of initial direct costs under ASC 842, and (4) modifications on or after the effective date of ASC 842. Sections 16.3.1.1 and 16.3.1.2 discuss these two scenarios and highlight how the accounting differs between the two with regard to the initial measurement of the ROU asset.
Timing of Recognition
In both scenarios, a lessee recognizes the ROU asset and lease liability at the later of the date of initial application or the commencement date of the lease.
Initial Measurement of the Lease Liability
The lease liability is measured in the same manner regardless of whether lease classification has changed. In both scenarios, the lease liability should represent the present value of the sum of:
- The remaining minimum rental payments (as defined under ASC 840).
- Any amounts that it is probable the lessee will owe under a residual value guarantee (see Section 6.7 for guidance on how to measure these amounts).
These amounts are measured at their present value by using a discount rate established at the later of (1) the date of initial application or (2) the commencement date of the lease. See Chapter 7 for more information on the identification of the appropriate discount rate.
Q&A 16-1 Identifying Minimum Rental Payments
In the transition to ASC 842, the lease obligation for an operating lease is typically measured by using the remaining minimum rental payments, as described in ASC 840.
Question
What is included in minimum rental payments?
Answer
Although ASC 840 does not define the term “minimum rental payments,” ASC 840-20-50-2 indicates that lessees must disclose future minimum rental payments as of the balance sheet date for operating leases that meet certain conditions:
For operating leases having initial or remaining noncancelable lease terms in excess of one year, the lessee shall disclose both of the following:
- Future minimum rental payments required as of the date of the latest balance sheet presented, in the aggregate and for each of the five succeeding fiscal years
- The total of minimum rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented. [Emphasis added]
The FASB has confirmed that the intent of requiring, in transition, lessees to measure operating leases by using the ASC 840 minimum rental payments is to ease the burden of determining the lease liability in transition. That is, in referencing the above disclosure under ASC 840, a lessee should be able to determine the gross amounts due under the lease and discount those required payments to determine the initial lease liability under ASC 842. This is consistent with paragraph BC390 of ASU 2016-02, which states that the application of the term “minimum rental payments” should be similar to that under prior guidance.
We have noted diversity in practice related to two aspects of the disclosure of future minimum rental payments under ASC 840:
- Lease payments that depend on an index or rate — Some entities have included the most current rate as of the balance sheet date when disclosing future minimum rental payments, whereas other entities have included the rate in effect at the inception of the lease. ASC 840-10-25-4 and 25-5 define what does or does not constitute a minimum lease payment (as opposed to a minimum “rental” payment):25-4 This guidance addresses what constitutes minimum lease payments under the minimum-lease-payments criterion in paragraph 840-10-25-1(d) from the perspective of the lessee and the lessor. Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. . . . However, lease payments that depend on an existing index or rate, such as the consumer price index or the prime interest rate, shall be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and thus affect the determination of income as accruable.25-5 For a lessee, minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
- Contingent rentals
- Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property. [Emphasis added]
At the 2018 AICPA Conference on Current SEC and PCAOB Developments (the “2018 AICPA Conference”), the SEC staff indicated that either historical approach is acceptable and that an entity may, depending on the facts and circumstances, deviate from its historical policy when measuring its leases as of the date of initial application. See Q&A 16-2 for further discussion of lease payments that fluctuate on the basis of a variable index or rate in the context of transition of a company’s operating leases under ASC 840 to the new leasing guidance under ASC 842. - Executory costs (i.e., insurance, property taxes, and CAM) — Some entities have concluded that executory costs are part of minimum rental payments under ASC 840 and other entities have not. A technical inquiry with the FASB staff has confirmed that either interpretation is acceptable under ASC 840. See Q&A 16-2A for additional information regarding the inclusion or exclusion of executory costs in the determination of a lessee’s lease liability for existing operating leases in transition, including considerations for entities that wish to change their historical approach under ASC 840.
Q&A 16-2 Operating Lease Payments That Fluctuate on the Basis of a Variable Rate or
Index — Transition Considerations
In transitioning its operating leases under ASC 840 to the new leasing guidance under ASC 842, a lessee must measure its lease liabilities as of the date of initial application by using the remaining minimum rental payments, as defined in ASC 840. Like ASC 842, ASC 840 contains guidance designed to address variable payments that depend on an index or rate, including how an entity should view these payment mechanisms when determining minimum rental payments for classification and measurement purposes. While ASC 842 is clear on the treatment of variable lease payments that depend on an index or rate, we are aware of diversity in practice related to how such payments have been treated under ASC 840, particularly with respect to the disclosure of future operating lease payments required by ASC 840-20-50-2(a) (commonly referred to as the “lease commitments table”). While ASC 840 appears clear on the treatment of such payments for classification and initial measurement purposes (if applicable), it is less clear on how the lease commitments table should be constructed in the required footnote disclosures. For classification and initial measurement purposes, ASC 840 requires lessees to compute the minimum rental payments on the basis of the index or rate existing at lease inception. However, ASC 840 does not discuss how to determine future lease payments for disclosure purposes, and some entities have used updated index/rate information for this purpose under the belief that the disclosure is primarily a liquidity disclosure and therefore should reflect updated information about an entity’s obligations as of each balance sheet date. Other entities have continued to present future lease payments for disclosure purposes by using the index or rate existing at lease inception.
Question 1
In making the transition to ASC 842, what date should a lessee in an operating lease use to determine the rate or index that it should employ to determine the lease payments that are included in the calculation of the lessee’s lease liability under ASC 842?
Answer
It depends. ASC 842-10-65-1(l) addresses the transition for operating leases and states, in part:
[A] lessee shall measure the lease liability at the present value of the sum of the following, using a discount rate for the lease . . . established at the application date . . .
- The remaining minimum rental payments (as defined under Topic 840).
- Any amounts probable of being owed by the lessee under a residual value guarantee.
As discussed in paragraph BC390 of ASU 2016-02, the FASB intended for a lessee to effectively “run off” leases existing under ASC 840 upon adopting ASC 842 (i.e., the lessee should use its minimum rental payment table disclosed under ASC 840 as the basis for initially measuring its operating lease liabilities under ASC 842). However, the transition guidance in ASC 842-10-65 is silent on the index or rate that should be used to determine lease payments in transition, other than via the reference to minimum rental payments under ASC 840, which, as described above, has been interpreted differently in practice for purposes other than classification and initial measurement. For this reason, stakeholders have expressed two potential alternatives:
- Alternative 1 — Use the index or rate that was employed to calculate the lessee’s minimum lease payments as of lease inception.
- Alternative 2 — Use the index or rate existing as of the date of initial application of ASC 842.
At the 2018 AICPA Conference, the SEC staff stated that it would be acceptable for a lessee to use the same approach for initial application as it has historically used for disclosure purposes under ASC 840. In other words, if a lessee used the inception rate for its ASC 840 disclosure, it would be acceptable for the lessee to apply Alternative 1 upon adopting ASC 842. Likewise, if a lessee used an updated index or rate for its ASC 840 disclosure, it would be acceptable for the lessee to apply Alternative 2 upon adopting ASC 842. The SEC staff indicated that it considers the definition of minimum rental payments in ASC 840 — for purposes other than classification and initial measurement — to be ambiguous and that it is therefore acceptable either to use the original index/rate or to update the index/rate for ASC 840 disclosure purposes. The SEC staff also indicated that it views the historical approach related to developing the ASC 840 disclosure as a policy election and therefore would generally expect an entity to apply its chosen approach consistently when making the transition to ASC 842. However, an entity may be able to change its historical approach on the basis of various factors, including the materiality of the historical policy to the overall financial statements, the direction of the change (e.g., changing from inception rate to initial application rate or vice versa), and the basis for making the change. The following are considerations related to each of these factors:
- Materiality5 — An entity should first assess the significance of its policy (the use of the inception rate as opposed to an updated rate) in the context of the overall financial statements. We generally believe that an entity can change its historical approach to the extent that the policy is immaterial to the overall financial statements.
- Direction of the change — We believe that an entity can change from using an updated rate to using the inception rate when determining its lease liabilities upon adopting ASC 842. A change in this direction is consistent with formal feedback received from the FASB staff regarding the requirements of ASC 840, and many entities have relied on such feedback as part of their implementation processes. Such a change is also more consistent with a literal read of the definition of minimum lease payments in ASC 840. Therefore, we do not believe that an entity would be required to apply the accounting guidance in ASC 250-10 when making such a change. However, we also believe that, under certain circumstances, a company can change from using the inception rate to using an updated rate when determining its lease liabilities upon adopting ASC 842. An entity wishing to do so may be subject to the preferability requirements in ASC 250-10, as discussed in the next bullet.
- Basis for the change — If an entity that has historically used the inception rate for its ASC 840 disclosure wishes to change the rate (i.e., wishes to use the rate as of the date of initial application) to determine its lease liabilities upon adopting ASC 842, it may be able to do so if the change is appropriate on the basis of the guidance in ASC 250-10 on accounting changes. In other words, if the historical approach represents a material policy and the entity wants to change its historical treatment, it would be subject to the preferability requirements in ASC 250-10-45-2(b). In this regard, the SEC staff stated in its prepared remarks at the 2018 AICPA Conference that “it would be reasonable for a registrant to consider as part of its Topic 250 analysis, if the lease obligation that results from using current index or rate values represents a better measurement of the registrant’s current lease obligations.” Therefore, we believe that the SEC staff would generally view the use of an updated index/rate as preferable.
The table below summarizes our understanding of the SEC staff’s and FASB staff’s
views on whether it is acceptable for an entity to change its
historical disclosure approach upon transition to ASC 842 when
calculating its initial lease liability under ASC 842.
Historical ASC 840 Disclosure Approach | ASC 842 Transition Approach |
Views on Acceptability
|
---|---|---|
Inception rate | Inception rate | SEC staff views as acceptable |
Updated rate | Updated rate | SEC staff views as acceptable |
Inception rate | Updated rate | Assess preferability6 — SEC staff |
Updated rate | Inception rate | FASB staff views as acceptable |
Question 2
If an entity changes its accounting policy from using the rate at lease inception to using an updated rate when calculating its lease liability upon adopting ASC 842, must that change be reflected retrospectively in accordance with ASC 250?
Answer
It depends. If the use of an inception rate (as opposed to an updated rate)
represents a material accounting policy, the change to an updated
rate would need to be preferable and retrospective application would
be required in accordance with ASC 250. However, if the policy is
not deemed material to the overall financial statements, an entity
could make the change without establishing preferability and would
not be required7 to reflect the change in prior periods.
As discussed in Question 1, on the basis of prepared remarks by the SEC staff at the 2018 AICPA Conference, we understand that it would generally be preferable to use an updated rate since the use of such a rate results in better information regarding a lessee’s future commitments upon adoption of the new guidance.
Question 3
The discussion above refers to the appropriate rate for an entity to use in making the transition from ASC 840 to ASC 842 for operating lease liabilities. Does an entity’s decision to change its approach (i.e., use a different rate for adoption) affect its recognition of lease liabilities in transition for capital/finance leases?
Answer
It depends. We generally believe that the analysis in Questions 1 and 2 is limited to an entity’s operating lease portfolio and would not affect the measurement of capital/finance lease liabilities in transition. An exception to this rule could arise for entities that do not elect the “practical expedient package” and that have capital leases under ASC 840 that become operating leases under ASC 842.
When the practical expedient package is elected or when classification of a capital lease otherwise remains unchanged upon adoption of ASC 842, we would not expect a change related to the measurement of operating leases to affect the measurement of capital/finance leases. We do not believe that a policy choice (inception rate vs. updated rate) existed for capital leases under ASC 840. ASC 840 is clear on the initial measurement of capital lease liabilities and does not require (or allow) remeasurement for changes in an index/rate. Since the initial measurement of capital lease liabilities is clear and footnote disclosures of total outstanding capital lease liabilities under ASC 840 are tied directly to the balance sheet, there is no ambiguity in the index/rate used to meet the disclosure requirements for capital leases under ASC 840. Furthermore, the transition guidance in ASC 842 for capital/finance leases indicates that they should be recognized at the carrying amount of the lease asset and capital lease liability immediately before adoption (i.e., the balances are simply carried forward).
When the practical expedient package is not elected and the classification of a lease changes from capital to operating, the lessee is required to derecognize the previous capital lease recorded under ASC 840 and record the new operating lease under ASC 842 by measuring an operating lease liability and ROU asset. We believe that, in such circumstances, an entity should measure its lease liability in a manner consistent with its other operating lease liabilities recognized upon transition. In doing so, the entity should consider a change in the index/rate used to measure these liabilities in transition, if applicable.
Q&A 16-2A Approaches to Accounting for Executory Costs for Operating Leases in Transition
Under ASC 840, executory costs include three primary components: (1) property taxes, (2) insurance, and (3) maintenance (e.g., CAM). Since ASC 840 does not distinguish between these three components, a historically acceptable approach has been to fully include executory costs in (or fully exclude them from) disclosures about remaining rental payments provided under ASC 840. However, under ASC 842, maintenance is considered a nonlease component while property taxes and insurance are considered neither a lease component nor a nonlease component; instead, the consideration attributable to property taxes and insurance is allocated to the components in the arrangement.
As described above and further discussed in Q&A 16-1, it was
acceptable under ASC 840 for executory costs to be included in or
excluded from the disclosure of minimum rental payments for
operating leases. Further, the FASB has generally indicated that a
lessee (1) would use its ASC 840 disclosure to determine the lease
payments when calculating the lease liability upon adopting ASC 842
and (2) would “run off” the balance.8 In addition, at the 2018 AICPA Conference, the SEC staff
stated that it “did not object to registrants consistently applying
their historical accounting policy regarding the composition of
minimum rental payments when concluding whether executory costs
should be included in remaining minimum rental payments for purposes
of establishing the lease liability in transition.”
However, given the differences in how these costs are treated under ASC 842, questions have arisen about whether it would be acceptable for an entity, upon adopting ASC 842, to treat executory costs differently when calculating the lease liability in transition than it has historically treated the costs for disclosure purposes (e.g., changing from including executory costs in, to excluding them from, the determination of lease payments).
Question 1
Is it acceptable for an entity’s treatment of executory costs to differ from historical practice when the entity is initially measuring the lease liability as part of its transition from ASC 840 to ASC 842?
Answer
It depends. On the basis of remarks made by the SEC staff at the 2018 AICPA
Conference, if an entity’s policy on executory costs has a material
impact9 on the entity’s financial statements, a change in whether
executory costs are included in minimum rental payments meets the
definition of an “accounting change” and would be subject to the
preferability requirements in ASC 250-10-45-2(b). ASC 250-10-20
defines a “change in accounting principle,” in part, as a “change
from one generally accepted accounting principle to another
generally accepted accounting principle when there are two or more
generally accepted accounting principles that apply.” Thus, a
lessee’s change in the treatment of executory costs as of the
effective date of ASC 842 represents a change from its historical
policy under ASC 840.
In assessing preferability, an entity must conduct a well-reasoned analysis and should consider, among other factors, the prospective accounting policy of the lessee under ASC 842, including an entity’s election to combine lease and nonlease components. We believe that an entity may elect the practical expedient for either (1) both the existing lease population and new or modified leases or (2) only new or modified leases. For example, if a lessee plans to elect the practical expedient to account for the nonlease components in a contract as part of the single lease component to which they are related under ASC 842 for new or modified leases only (i.e., the entity is not choosing to elect the practical expedient to combine lease and nonlease components for existing leases), this election would generally be a factor supporting the preferability of changing from excluding executory costs from minimum rental payments under ASC 840 to including them under ASC 842 for the existing lease population (see Question 3). We also understand that a change from including executory costs to excluding such costs would be viewed negatively by the SEC staff, and would generally not be preferable, if the change is made solely to reduce the lease liability at transition.
Further, we believe that when an entity makes the transition from ASC 840 to ASC 842 and elects both (1) to change its historical practice related to accounting for executory costs on the basis of the preferability requirement in ASC 250 and (2) the Comparatives Under 840 Option, the change must be applied retrospectively. The change in this historical practice is an elective accounting policy change made on the basis of ASC 250 and is not required by ASC 842. Therefore, the historical financial statement disclosures (i.e., the future minimum rental payments required by ASC 840-20-50-2(a), commonly referred to as the “lease commitments table”) that will be presented when an entity adopts ASC 842 by using the Comparatives Under 840 Option should take into account the accounting change made in accordance with ASC 250.
In summary, when making the transition to ASC 842, a lessee may be allowed to change the approach it has historically used under ASC 840 to include or exclude executory costs. If the existing approach under ASC 840 has a material impact on the financial statements, a change would need to be made on the basis that it is preferable. On the other hand, if an entity’s historical approach related to executory costs does not have a material impact on the financial statements, the entity may change its historical approach under ASC 840 and would not be required to assess preferability. In developing the transition requirements, the FASB expected that a lessee could “run off” its existing minimum rental payments. Therefore, in making the transition to ASC 842, a lessee should consider the following principles in determining its approach related to executory costs:
- It was acceptable for an entity to either include executory costs in, or exclude them from, a disclosure of minimum rental payments; therefore, diversity in practice has arisen. Either historical approach would have never affected measurement of operating leases (because of off-balance-sheet treatment under ASC 840), and the historical policy may have never been material to the financial statement disclosures.
- If the inclusion (exclusion) of executory costs does not have a material impact on the financial statements, a lessee may change its treatment of executory costs before or upon adopting ASC 842 without assessing preferability and would not be required10 to reflect the ASC 840 policy change in prior periods, since those periods would continue to be presented under ASC 840 if the entity is electing the Comparatives Under 840 Option. If a lessee has explicitly disclosed in its financial statements its approach for including (excluding) executory costs under ASC 840, such disclosure may be an indication that the policy is material.
- As discussed above, a choice between two acceptable methods of presenting disclosure information is an accounting principle for which a change in method must be preferable under ASC 250-10-45-11 through 45-13 if an entity’s policy on executory costs has a material impact on its financial statements. This change must be retrospectively applied to all periods presented under ASC 840. Practically, the only impact of retrospective application should be a revision of the lease commitments table disclosure for the year ended immediately before the date of initial application. This historical table must be included again in the financial statements (quarterly and annual) in the year of adoption if the Comparatives Under 840 Option is elected.
Question 2
When making the transition from ASC 840 to ASC 842, how should an entity treat executory costs if the entity elects, as a practical expedient, to combine lease and nonlease components for existing leases at transition?
Answer
A lessee may elect, as an accounting policy for each underlying asset class,11 not to separate lease and nonlease components (including
executory costs) on the effective date. We believe that a lessee may
elect such a policy for both the existing lease population and new
or modified leases, since the lessee may prefer comparability and
consistent application for all leases regardless of whether they
commenced before the effective date.
The guidance on the practical expedient under which a lessee may elect not to separate lease and nonlease components is silent on the treatment of noncomponents in a contract (i.e., executory costs such as property taxes and insurance). Specifically, ASC 842-10-15-37 only discusses lease and nonlease components, stating the following:
As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.
When the practical expedient is elected, any portion of the consideration in the contract that would otherwise be allocated to the nonlease components is instead accounted for as part of the related lease component for classification, recognition, and measurement purposes. In addition, any payments related to noncomponents would be accounted for as part of the related lease component (i.e., the associated payments would not be allocated between the lease and nonlease components since they are all treated as a single lease component). Therefore, an entity electing the practical expedient would do so for both the nonlease components and noncomponents of the contract (e.g., executory costs). An entity that elects this accounting policy for existing leases would therefore account for all executory costs as part of its lease payments, regardless of whether the entity had included or excluded executory costs when determining the minimum rental payments (i.e., the “lease commitments table”) under ASC 840.
As discussed in Question
1, the SEC staff indicated in prepared remarks at the
2018 AICPA Conference that a change in whether executory costs are
included in minimum rental payments meets the definition of a
“change in accounting principle,” and would be subject to the
preferability requirements in ASC 250-10-45-2(b), if an entity’s
policy on executory costs has a material impact on its financial
statements. However, we do not believe that the same requirement
would apply when an entity elects the practical expedient to combine
lease and nonlease components, including noncomponents of a contract
(e.g., executory costs), for existing leases at transition. The
question raised to the SEC staff that it discussed at the 2018 AICPA
Conference involved a registrant’s ability to change its treatment
of executory costs but was not premised on the election of the
practical expedient. We believe that an entity can elect to apply
the practical expedient in transition to all existing leases,
regardless of the entity’s prior treatment of executory costs,
without being subject to the preferability requirement in ASC
250-10-45-2(b).
Question 3
When making the transition from ASC 840 to ASC 842, how should an entity treat executory costs if the entity elects, as a practical expedient, to combine lease and nonlease components for new or modified leases only?
Answer
As discussed in Question 2, a lessee may elect, as an accounting policy for each underlying asset class, not to separate lease and nonlease components (including executory costs) on the effective date. We believe that the lessee may elect such a policy for either (1) both the existing lease population and new or modified leases or (2) only new or modified leases. With respect to new or modified leases, this election only applies to those that commence or are modified on or after the effective date of ASC 842. When this election is made for new or modified leases only, a lessee that has historically excluded executory costs from its minimum rental payment disclosures under ASC 840 may be able to change to including executory costs under ASC 842 for the existing lease population, as described below.
As discussed in Question
1, the SEC staff indicated in prepared remarks at the
2018 AICPA Conference that a change in whether executory costs are
included in “minimum rental payments” meets the definition of a
“change in accounting principle,” and would be subject to the
preferability requirements in ASC 250-10-45-2(b), if an entity’s
policy on executory costs has a material impact on its financial
statements. We believe that this requirement would apply when an
entity does not elect the practical
expedient to combine lease and nonlease components, including
noncomponents of a contract (e.g., executory costs), for the existing lease population at transition
(i.e., the entity elects the practical expedient for new or modified
leases only) but wishes to change from excluding executory costs
under ASC 840 to including executory costs when determining the
opening lease liability under ASC 842. See Question 4 below for
considerations that may be relevant to the evaluation of
preferability. As discussed in Question 2, if the entity had
elected to apply the practical expedient in transition to all
existing leases, a change regarding the entity’s prior treatment of
executory costs would not be subject to the preferability
requirement in ASC 250-10-45-2(b).
Question 4
In what situations is it appropriate for an entity to change its ASC 840 disclosure approach for executory costs for existing leases at transition?
Answer
We do not believe that it would be appropriate (depending on the materiality of the impact under ASC 840) for a lessee to change its ASC 840 disclosure approach for executory costs, as discussed in Question 1, in a manner that reduces comparability to its ASC 842 accounting, including the impact of the lessee’s election to include or exclude nonlease components.
We expect that one of the scenarios below will apply to an entity that wishes to change its disclosure approach for executory costs in transition. We further expand on whether we believe it may be appropriate for an entity to change its ASC 840 disclosure approach for existing leases at transition, depending on the scenario.
- Scenario 1 — An entity historically excluded executory costs from its minimum rental payment disclosures under ASC 840 but intends to elect the practical expedient related to combining lease and nonlease components for new or modified leases only (see Question 3). The entity may prefer to change from excluding executory costs under ASC 840 to including them under ASC 842 for the existing lease population. Such an entity will be subject to the preferability determination discussed in Question 1 if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements.
- Scenario 2 — An entity historically excluded executory costs from its minimum rental payment disclosures under ASC 840 and intends to elect the practical expedient to combine lease and nonlease components for both existing and new or modified leases. The entity will then include nonlease components under ASC 842 in the calculation of the lease liability for the existing lease population at transition. Such an entity will not be subject to the preferability determination, as discussed in Question 2, when the entity elects the practical expedient to combine lease and nonlease components, including noncomponents of a contract (e.g., executory costs), for existing leases at transition.
- Scenario 3 — An entity historically included executory costs in its minimum rental payment disclosures under ASC 840 and does not intend to elect the practical expedient to combine lease and nonlease components for new or existing leases. The entity wishes to exclude executory costs for existing leases when initially calculating its lease liability upon adopting ASC 842. Such an entity will be subject to the preferability determination discussed in Question 1 if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements. An entity in this scenario should also contemplate the makeup of the executory costs under ASC 840 as follows:
- Scenario 3A — The entity’s executory costs under ASC 840 predominantly consist of maintenance costs, which are considered a nonlease component under ASC 842. In this situation, changing from including executory costs under ASC 840 to excluding executory costs in the transition to ASC 842 generally enhances comparability between existing and new or modified leases.
- Scenario 3B — The entity’s executory costs under ASC 840 predominantly consist of property taxes and insurance (i.e., noncomponents under ASC 842). In this situation, changing from including executory costs under ASC 840 to excluding executory costs in the transition to ASC 842 generally does not enhance comparability between existing and new or modified leases.
Achieving perfect comparability between ASC 840 and ASC 842 may be difficult
(unless all lease and nonlease components are combined for new and
existing leases) because “executory costs” is an ASC 840 concept and
the components of executory costs are characterized differently
under ASC 842, as described above. In the above scenarios, the
entity’s treatment of costs for property taxes, insurance, and
maintenance upon adoption of ASC 842 changes from the historical
treatment under ASC 840. We believe that such a change should
enhance comparability between ASC 840 and ASC 842, as illustrated in
Scenarios 1, 2, and 3A above. Scenario 3B will
not enhance comparability since property taxes and insurance
(i.e., noncomponents) are greater than
maintenance. Therefore, when assessing preferability, lessees should
carefully consider the significance of property taxes and insurance
compared with that of maintenance.
As indicated above, we do not believe that it would be appropriate for an entity to change its ASC 840 disclosure approach in a manner that reduces comparability to its ASC 842 election to include or exclude nonlease components. Consider the following additional scenario in which comparability is not enhanced:
- Scenario 4 — An entity historically included executory costs in its minimum rental payment disclosures under ASC 840 and intends to elect the practical expedient to combine lease and nonlease components for new or modified leases. The entity wishes to change its treatment to exclude executory costs when initially calculating its lease liability upon adopting ASC 842 for the existing lease population. An entity electing to do so would be subject to the preferability determination, as discussed in Question 1, if the inclusion/exclusion of executory costs under ASC 840 has a material impact on the financial statements. However, we believe that it would be inappropriate for such an entity to change its treatment of executory costs for existing leases upon adoption of ASC 842, since doing so would reduce comparability between ASC 840 and ASC 842.
The table below summarizes whether (1) the scenarios above enhance comparability between the disclosure approach under ASC 840 and the measurement approach under ASC 842; (2) an entity in these scenarios is required to determine preferability under ASC 250 to change its historical approach of accounting for costs related to property taxes, insurance, and maintenance; and (3) the change in treatment of such costs is appropriate.
Enhances Comparability?
|
Preferability Determination
Required Under ASC 250?12
|
Change in Treatment of
Executory Costs Appropriate?13
| |
---|---|---|---|
Scenario 1 | Yes | Yes | Generally yes, subject to a well-reasoned preferability analysis |
Scenario 2 | Yes | No | Yes |
Scenario 3A | Yes | Yes | Generally yes, subject to a well-reasoned preferability analysis |
Scenario 3B | No | Yes | Generally no |
Scenario 4 | No | Yes | Generally no |
Because executory costs are characterized differently under ASC 840 than they are under ASC 842, the following are generally true:
- The lease liability in a gross lease of real estate that excludes executory costs under ASC 840, and for which the lessee elects to separate nonlease components, will be lower if the lease commences before the effective date of ASC 842 than it will if the lease commences on or after the effective date of ASC 842. The reason for the lower liability in this case is that property taxes and insurance would be excluded under ASC 840 but would be allocated primarily (or totally) to the lease component under ASC 842.
- Conversely, the lease liability in a gross lease of real estate that includes executory costs under ASC 840, and for which the lessee elects to separate nonlease components, will be higher if the lease commences before the effective date of ASC 842 than it will if the lease commences on or after the effective date of ASC 842. The reason for the higher liability in this case is that maintenance would be included under ASC 840 but would represent a nonlease component under ASC 842.
- The chosen approach for including or excluding executory costs under ASC 840 in a triple net lease should not have a significant impact, because the executory costs are typically variable (and reimbursed, or paid directly, by the lessee) and therefore are not included in the minimum rental payments.
Q&A 16-2B Determining the Lease Term at Transition
On January 1, 2010, Company W enters into a lease that includes a noncancelable
period of 10 years with two, five-year renewal options. At lease
inception, the lease term is determined to be 10 years. In 2016, W
completes significant leasehold improvements and, as a result, it is
reasonably certain that W will exercise the first five-year renewal
option. Under ASC 840, the installment of leasehold improvements
does not trigger a reassessment of the lease term. Company W has
elected the Comparatives Under 840 Option (see Section
16.1.1), and its ASC 842 adoption date is January 1,
2019; however, W has not elected the “use-of-hindsight” practical
expedient.
Question
How should W determine the lease term at transition?
Answer
Because W did not elect the use-of-hindsight practical expedient, it would be inappropriate
for W to reconsider the remaining lease term at transition. Although the addition of leasehold
improvements would be a reassessment event under ASC 842-10, the renewal options should
not be reassessed since the event occurred before the ASC 842 adoption date. Rather, W would
determine the ROU asset and lease liability on the basis of the remaining minimum rental
payments for the remaining term, as was determined under ASC 840 (i.e., the lease term at
transition would be the one year that is remaining in the original lease term).
This conclusion is supported by the fact that the FASB’s overall objective with
transition is to allow lessees to run off their existing leases by
using the assumptions that were in place under ASC 840. For this
reason, the “remaining minimum rental payments” under ASC 840 are
used to initially measure the lease liability in transition (the
amounts that are included in the lease commitments table). This is
consistent with the discussion in paragraph BC390 of ASU
2016-02, which states, in part:
Entities will, in
effect, “run off” existing leases, as described, unless
the lease is either modified (and that modification is
not accounted for as a separate contract) or, for
lessees only, the lease liability is remeasured in
accordance with the subsequent measurement guidance in
Subtopic 842-30[14]
on or after the effective date. To
ensure that the financial statements provide relevant and
reliable financial information, lessees and lessors should
apply the subsequent measurement guidance in Topic 842
beginning on the effective date. For lessees, this includes the subsequent
measurement guidance in Subtopic 842-30[15] on lease term and purchase option
reassessments and assessing impairment of right-of-use
assets. [Emphasis added]
Paragraph BC390 of ASU 2016-02 highlights that transition is designed to allow entities to “run
off” their legacy leases unless there is (1) a modification or (2) a liability remeasurement event
on or after the effective date of ASC 842. We believe that this conclusion would also apply
to the determination of lease term. Therefore, it does not appear appropriate to revise the
lease term to reflect events or changes in facts and circumstances that occurred before the
application date of ASC 842. On the other hand, if an entity elects the use-of-hindsight practical
expedient, the lease term (and assessment of impairment) should be evaluated by using facts
and circumstances up to the effective date of the standard. (See Section 16.5.1 for discussion
of the use-of-hindsight practical expedient.) We do not believe that the determination of
lease term, as discussed above, would be affected by whether the entity elected the practical
expedient package. (See Section 16.5.2 for more information about the practical expedient package.) For example, if the practical expedient package is not elected, an entity is required to
reassess, upon transition, (1) lease classification, (2) whether a contract is or contains a lease,
and (3) initial direct costs. In performing this reassessment, an entity would not reevaluate the
lease term unless it elects the use-of-hindsight practical expedient. Likewise, if an entity elects
the practical expedient package, the lease term would not be reassessed unless the use-of-hindsight
practical expedient is elected.
Connecting the Dots
Hindsight Impact Related to Lease Term and Liability
Measurement (Lease Classified as an Operating Lease Under
ASC 840)
The measurement of the lease liability is affected by the identification of the lease term. If a
lessee elects the hindsight practical expedient, any changes to expectations regarding renewals
during the comparative period should be reflected in the measurement of the lease liability
as of the date of initial application or at lease commencement, if later. (See Section 16.5.1 for more
information on the hindsight practical expedient.) Further, an entity must identify the amounts
that it is probable will be owed under a residual value guarantee as of the later of the date of
initial application or the lease commencement date. This amount should be measured on the
basis of the facts and circumstances as of that date, which should include the impact of any change in lease term.
Q&A 16-2C Transition for Leasehold Improvements With Amortization
Period Greater Than Remaining Lease Term
In some cases under ASC 840, leasehold improvements installed significantly
after lease inception or acquired in a business combination can have
an amortization period greater than the remaining lease term. As a
result, questions have arisen about whether the amortization period
for such leasehold improvements existing as of the date of initial
application of ASC 842, when that period is greater than the
remaining lease term, should be retained or whether it should be
updated to align with the “lease term,” as defined under ASC 842.
ASC 840-10-35-6 states:
Leasehold improvements in operating leases that are placed in service significantly after and not
contemplated at or near the beginning of the lease term shall be amortized over the shorter of the
following terms:
- The useful life of the assets
- A term that includes required lease periods and renewals that are deemed to be reasonably assured (as used in the context of the definition of lease term) at the date the leasehold improvements are purchased. [Emphasis added]
In addition, ASC 840-10-35-9 states:
Paragraph 805-20-35-6 requires that leasehold improvements acquired in a
business combination or an acquisition by a not-for-profit
entity be amortized over the shorter of the useful life of
the assets or a term that includes
required lease periods and renewals that are deemed to
be reasonably assured (as used in the definition of
[the] lease term) at the date of acquisition.
[Emphasis added]
The above guidance suggests that the period for amortization of certain leasehold
improvements under ASC 840 could differ from the “lease term” used for lease classification
and disclosure of remaining rental payments. That is, notwithstanding the requirement to
determine the appropriate amortization period for leasehold improvements (1) placed in service
significantly after the beginning of the lease term or (2) acquired in a business combination, ASC
840 does not permit lessees to reassess the lease term related to accounting for the lease itself.
Upon the adoption of ASC 842, the above guidance is superseded.
Example
Company X, a public company with a calendar-year-end, acquires 100 store leases
as part of a business combination transaction on
January 1, 2018. The acquiree’s remaining lease
term immediately before the transaction is three
years, which represents the remaining
noncancelable term of the lease and excludes one
lease renewal option of five years (exercise of
the option was originally determined not to be
reasonably assured as of lease inception).
However, upon acquiring the store leases in a
business combination, X determines that the
exercise of the five-year renewal option is
reasonably assured. The lease does not transfer
ownership of the leased stores to X at the end of
the lease term, and X does not have the option of
purchasing the stores. The leases are classified
as operating leases under ASC 840.
In accordance with ASC 840-10-25-27, X did not revisit the lease term and classification of the store
leases acquired in the business combination. Therefore, X considers the remaining lease term of the
100 store leases to be three years (i.e., X continues to exclude the five-year renewal option from the
lease term, even though exercise of the renewal option is now reasonably assured).
Each of the stores also includes certain leasehold improvements that have a useful life of 10 years. In
determining the amortization period of the leasehold improvements, X concludes that the renewal is
reasonably assured. In accordance with ASC 840-10-35-9, X determines that the amortization period
for the acquired leasehold improvements should be eight years, because this period represents
the lesser of (1) the useful life of the improvements (10 years) or (2) eight years (i.e., the remaining
noncancelable lease term of three years plus the five-year renewal option whose exercise is deemed
reasonably assured as of the acquisition date).
On January 1, 2019, X adopts ASC 842 by using the “Comparatives Under 840 Option” transition
method (i.e., elects not to restate comparative periods under ASC 842). Company X elects the
“package of three” practical expedients in ASC 842-10-65-1(f) and therefore does not reassess
the lease classification of its existing leases, including the 100 store leases acquired on January 1,
2018. However, X does not elect the hindsight practical expedient in ASC 842-10-65-1(g) related to
reassessing the lease term.
Question
Upon adopting ASC 842, over what period should X amortize the leasehold improvements
related to the 100 store leases previously acquired in the business combination?
Answer
ASC 842-20-35-12 states:
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.
Further, ASC 842-20-35-13 states:
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.
Under ASC 842 (after transition), any leasehold improvements installed after
commencement or purchased in a business combination would be
reassessed in conjunction with a reassessment of the lease term used
for measuring the lease. That is, there will be no disconnect
between the “lease term” for measuring the lease and the
amortization period for leasehold improvements arising after the
initial application of ASC 842, because both are reassessed.
However, since lease term is not reassessed under ASC 840, it is
less clear whether the previous amortization periods should be
conformed to the remaining lease term used for measuring the lease
liability in transition. The following two approaches have
emerged:
-
Approach A — Under this approach, X should retain the amortization period in place at the time of adoption. We do not believe that the FASB intended to shorten the amortization period of leasehold improvements in situations in which a lessee elects not to apply hindsight in determining the lease term upon adopting ASC 842. Further, use of the amortization period already in place at the time of adoption better reflects the economics of the arrangement and the fact that the leasehold improvements will continue to be used for a period longer than the remaining lease term under ASC 842; therefore, under this approach, it is acceptable to use the longer amortization period of seven years.
-
Approach B — Under this approach, X should shorten the amortization period as of the date of initial application of ASC 842 so that it is aligned with the remaining lease term for measuring the lease, because only a single remaining lease term is contemplated in ASC 842-20-35-12. Therefore, if X uses this approach, upon adopting ASC 842, it would shorten the amortization period of the leasehold improvements to align it with the remaining lease term.16In the example above, because X did not elect the hindsight practical expedient, the remaining lease term upon the adoption of ASC 842 is two years (i.e., three years as of the date of the business combination less one year that has passed before the adoption of ASC 842). We believe that because ASC 842-10-65-1 does not specifically address amortization of leasehold improvements, a lessee applying Approach B may recognize a cumulative-effect adjustment to retained earnings for the change in amortization period. In the example above, X amortized one-eighth of the leasehold improvements as of the effective date of ASC 842, but if the amortization period would have always been consistent with the three-year remaining lease term at the time of the business combination, one-third of the leasehold improvements would have been amortized before the effective date.
We believe that either of the above approaches is acceptable, provided that it is applied consistently as an accounting policy.
Q&A 16-3 Discount Rate Considerations in Transition
In transition, the present value of the lease liability is determined by using a discount rate
“established at the application date.”
Question
On what date should entities identify the discount rate applied to measure the minimum rental
payments used in the lease liability?
Answer
The discount rate (generally, for the lessee, its incremental borrowing rate) used to
measure the lease liability is established as of the later of the (1) date of initial application or
(2) commencement date of the lease. This has been consistently interpreted as meaning that a
lessee should use the interest rate environment as of the appropriate later-of date. Factors
that affect the interest rate environment include, but are not limited to, the credit standing of
the lessee and the economic environment on the initial measurement date (see Chapter 7 for
additional information on determining the appropriate discount rate). However, an incremental
borrowing rate is also affected by the lease term (i.e., the length of the borrowing) and the
lease payments (i.e., how much is being borrowed). Questions have arisen about whether
(1) the original lease term and lease payments should be determined and incorporated into the
discount rate calculation or (2) those inputs should be determined as of the same date on which
the interest rate environment is considered (i.e., whether the remaining lease term and lease
payments should be considered).
On the basis of a technical inquiry with the FASB staff, we believe that either approach is
acceptable as an accounting policy choice. Although the lease term and lease payments
should be higher under approach 1 (resulting in a higher discount rate), we expect that the
information an entity needs to apply approach 2 will be more readily available. In addition, the
SEC staff confirmed this position at the 2017 AICPA Conference on Current SEC and PCAOB
Developments, stating that “the selection of either of these rates, that is either the rate based on
the original lease term or the remaining lease term, is reasonable” and that the staff “ultimately
did not object to a registrant’s consistent application of either approach to determine the
lessee’s lease liabilities in transition.”
Connecting the Dots
Hindsight Impact on Discount Rate
When hindsight is applied, any impact on the lease term will indirectly affect the discount rate (e.g., a longer term will generally result in a higher discount rate). As discussed above, an entity must also consider the credit standing of the lessee, the nature and quality of the security provided, and the economic environment in which the transaction occurs. Because these factors are unrelated to the lease term, we do not believe that an entity can elect to apply hindsight when evaluating them.
Unamortized Initial Direct Costs Not Capitalized Under ASC 842
The accounting for initial direct costs when the practical expedient package is not elected is the same regardless of whether classification changes upon an entity’s adoption of ASC 842. ASC 842 reduces the types (and therefore amounts) of costs that qualify as initial direct costs. As discussed in Section 16.5.2.3, lessees that elect the practical expedient package do not need to reassess previously capitalized initial direct costs. However, if the practical expedient package is not elected, previously capitalized initial direct costs that no longer meet the definition of initial direct costs under ASC 842 must be accounted for as follows:
- Any costs incurred before the date of initial application should be recognized as an adjustment to equity.
- Any costs incurred on or after the date of initial application should be recognized in earnings for the respective comparative period under ASC 842, if applicable.
Modifications and Reassessment of Lease Liability in Comparative Periods (Only Applicable if the Comparatives Under 840 Option Is Not Elected)
The transition guidance is clear that the provisions of ASC 842 should be applied to modifications on or after the effective date as well as to any reassessments of the lease liability (see Section 8.5). However, the guidance is less clear on the framework for modifications and potential reassessments that occur during the transition period. Entities may therefore encounter significant complexities in transition, since the modification and reassessment guidance in ASC 842 significantly differs from that in ASC 840. For leases previously classified as operating leases under ASC 840, the transition paragraphs ASC 842-10-65-1(k)–(q) do not mention modifications or reassessments during the transition period. However, the transition guidance for capital leases does provide some insight into the potential framework. Specifically, ASC 842-10-65-1(r)(4) indicates that if a capital lease under ASC 840 is classified as a finance lease under ASC 842 (i.e., classification did not change), the lease should be subsequently measured in accordance with ASC 840 during the transition period. In contrast, ASC 842-10-65-1(s)(4) stipulates that if a capital lease under ASC 840 is classified as an operating lease under ASC 842 (i.e., classification changed), the lease should be subsequently measured under ASC 842 during the transition period.
On the basis of these insights, we believe that the modification and reassessment guidance should generally be governed by whether lease classification changes when an entity adopts ASC 842. That is, if lease classification changes upon the adoption of ASC 842 (which can only occur if the practical expedient package is not elected), an entity should apply ASC 842 modification and reassessment guidance throughout the transition period. However, if lease classification does not change upon the adoption of ASC 842 (irrespective of whether the practical expedient package was elected), an entity should apply ASC 840’s guidance on modifications and reassessment.
We note that there is no “measurement” guidance in ASC 840 for operating leases because they are off-balance-sheet. Therefore, although an entity would apply the ASC 840 modification guidance to determine whether lease classification has changed, the general ASC 842 measurement principles
would be applied to the revised lease payments. That is, unless lease classification changes as of the
earliest period presented (e.g., a company that does not elect the practical expedient package and has
a lease whose classification changes from operating to finance), this framework creates a mixed model
in transition. The lease classification and impact on the income statement during transition is governed
by previous ASC 840 treatment. However, the balance sheet is governed by the ASC 842 measurement
principles applied to the minimum rental payments, as described in Q&A 16-1.
16.3.1.1 Lease Is an Operating Lease Under ASC 840 and ASC 842
The graphic below outlines the steps lessees should perform in transition for leases that were
previously classified as operating leases and that are considered operating leases under ASC 842
because either (1) an entity elected the practical expedient package and therefore would not reassess
lease classification or (2) classification was assessed in transition to ASC 842 and the lease retains its
classification as an operating lease. In this transition scenario (i.e., operating lease classification was
retained), the election of the practical expedient package only affects the amounts that qualify as initial
direct costs for inclusion in the ROU asset.
Example 29 from ASC 842 illustrates the measurement of the lease liability and
ROU asset in transition.
ASC 842-10
Illustration of Lessee Transition — Existing Operating Lease
55-248 Example 29 illustrates lessee accounting for the transition of existing operating leases when an entity elects the transition method in paragraph 842-10-65-1(c)(1).
Example 29 — Lessee Transition — Existing Operating Lease
55-249 The effective date of the guidance in this Topic for Lessee is January 1, 20X4. Lessee enters into a
five-year lease of an asset on January 1, 20X1, with annual lease payments payable at the end of each year.
Lessee accounts for the lease as an operating lease. At lease commencement, Lessee defers initial direct costs
of $500, which will be amortized over the lease term. On January 1, 20X2 (and before transition adjustments),
Lessee has an accrued rent liability of $1,200 for the lease, reflecting rent that was previously recognized as
an expense but was not yet paid as of that date. Four lease payments (1 payment of $31,000 followed by 3
payments of $33,000) and unamortized initial direct costs of $400 remain.
55-250 January 1, 20X2 is the beginning of the earliest comparative period presented in the financial statements in which Lessee first applies the guidance in this Topic. On January 1, 20X2, Lessee’s incremental borrowing rate is 6 percent. Lessee has elected the package of practical expedients in paragraph 842-10-65-1(f). As such, Lessee accounts for the lease as an operating lease, without reassessing whether the contract contains a lease or whether classification of the lease would be different in accordance with this Topic. Lessee also does not reassess whether the unamortized initial direct costs on January 1, 20X2, would have met the definition of initial direct costs in this Topic at lease commencement.
55-251 On January 1, 20X2, Lessee measures the lease liability at $112,462, which is the present value of 1 payment of $31,000 and 3 payments of $33,000 discounted using the rate of 6 percent. The right-of-use asset is equal to the lease liability before adjustment for accrued rent and unamortized initial direct costs, which were not reassessed because Lessee elected the practical expedients in paragraph 842-10-65-1(f).
55-252 On January 1, 20X2, Lessee recognizes a lease liability of $112,462 and a right-of-use asset of $111,662 ($112,462 – $1,200 + $400).
55-253 From the transition date (January 1, 20X2) on, Lessee will continue to measure and recognize the lease liability at the present value of the sum of the remaining minimum rental payments (as that term was applied under Topic 840) and the right-of-use asset in accordance with this Topic.
55-254 Beginning on the effective date of January 1, 20X4, Lessee applies the subsequent measurement guidance in Section 842-20-35, including the reassessment requirements.
The following is a summary of the steps a lessee
would perform in calculating the lease liability and the ROU asset in the
scenario above:
Step 1: Measure the Lease
Liability as of the Earliest Period Presented
Step 2: Measure the ROU
Asset
Lease liability – accrued rent + unamortized
initial direct costs
$112,462 – $1,200 + 400 = $111,662
Step 3: Record the Journal
Entries
16.3.1.1.1 Lease Is an Operating Lease Under ASC 840 and ASC 842 — Initial Measurement of Lease Liability
In transition, when a lease is an operating lease under ASC 840 and ASC 842, the lease liability is
calculated as the present value of the minimum rental payments and expected payment under any
residual value guarantee discounted by the rate determined at the later of the date of initial application
or the lease commencement date.
16.3.1.1.2 Lease Is an Operating Lease Under ASC 840 and ASC 842 — Initial Measurement of ROU Asset
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
m. For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2 through
25-3, a lessee shall initially measure the right-of-use asset at the initial measurement of the lease liability
adjusted for both of the following:
1. The items in paragraph 842-20-35-3(b), as applicable.
2. The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost
obligations for the lease. . . .
In transition, when a lease is an operating lease under ASC 840 and ASC 842, the ROU asset is calculated
as follows:
- The sum of:
- The lease liability calculated in accordance with the guidance in Section 16.3.1.1.1.
- Prepaid rent (i.e., any amounts prepaid but not yet expensed under ASC 840).
- Unamortized initial direct costs — after consideration of whether the practical expedient package is applied in the manner described in Section 16.5.2.3.
- Less the sum of:
- Accrued rent (i.e., any amounts previously recognized under ASC 840 but not yet paid).
- Lease incentives (i.e., recorded and not yet expensed in accordance with ASC 840-20-25-6 and 25-7).
- Impairment (as described below).
- The carrying amount of any ASC 420 liability (as described below).
Q&A 16-3A Initial Measurement in Transition of an
Operating Lease When the ROU Asset Would Be Reduced Below Zero
Because of Accrued Rent
In the transition to ASC 842, the ROU asset is
measured at the amount of the lease liability adjusted by (1)
accrued or prepaid rents, (2) remaining unamortized initial
direct costs and lease incentives, (3) impairments of the ROU
asset, and (4) the carrying amount of any liability recognized
under ASC 420. An accrued rent balance would have been
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 accrued rent balance can be greater than the lease liability
balance as of the date of initial application. Therefore, if the
full amount of the accrued rent were applied against the lease
liability, the ROU asset in transition would be negative (i.e.,
the measurement exercise described in ASC 842-10-65-1(m) would
yield an amount below zero).
Question
When applying the transition guidance related to
an operating lease, how should a lessee account for the ROU
asset when the accrued rent balance is greater than the lease
liability as of the date of initial application?
Answer
We believe that when the ROU asset would be
reduced below zero because the accrued rent balance is greater
than the lease liability, the ROU asset should be reclassified
and presented as a liability as of the date of initial
application. This presentation would be retained until the
balance of the ROU asset returns to a positive amount, at which
point the balance should be presented as an ROU asset rather
than as a liability. 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). See
Section 8.4.3.2.1 for
a discussion of accrued rent balances that would result in a
negative ROU asset after the date of initial application (which
could apply to leases that commenced before or after the
adoption date), along with a discussion of the subsequent
accounting and an illustrative example.
Impairment
The ROU asset should initially be measured net of impairment. However, several implementation
questions have arisen regarding how impairment should be measured during the transition period,
if at all, because the ROU asset will generally be included with other assets in a preexisting asset group.
On the basis of the Q&As below, an entity is generally not required to consider the ROU asset separately
for impairment in the comparative periods presented under ASC 842, if applicable. See also Section
16.5.1.2 for a discussion of the impact of electing the hindsight practical expedient.
Q&A 16-4 Reallocating Prior Impairment Losses Within
an Asset Group
ASC 360 provides guidance on identifying,
recognizing, and measuring an impairment of a long-lived
asset or asset group that is held and used. Under the ASC
360 impairment testing model, a lessee is required to test a
long-lived asset (asset group) for impairment when
impairment indicators are present. Under this testing
approach, a lessee would be required to test the asset
(asset group) for recoverability and, when necessary,
recognize an impairment loss that is calculated as the
difference between the carrying amount and the fair value of
the asset (asset group).
A lessee must subject an ROU asset to
impairment testing in a manner consistent with its treatment
of other long-lived assets (i.e., in accordance with ASC
360). Also, upon transition, a lessee is required to include
any associated impairment losses in its initial measurement
of an ROU asset (see Q&A
16-4A).
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. 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 amortization and interest expense
together as a single line item.
Question
Upon transition to ASC 842, is a lessee
required to reallocate prior impairment losses of an asset
group to the ROU asset?
Answer
No. An ROU asset will typically be added to
a preexisting asset group under ASC 360. However, the effect
of recognizing an ROU asset on an asset group’s allocation
of a prior impairment loss is an indirect effect of a change
in accounting principle. In accordance with ASC 250-10-45-3
and ASC 250-10-45-8, indirect effects of a change in
accounting principle should not be recognized.
At the FASB’s November 30, 2016, meeting,
the Board indicated that on the effective date of ASC 842
and in all comparative periods presented under ASC 842 (if
applicable), a lessee should not revisit prior impairment
loss allocations within the asset group. In addition, the
Board indicated that a lessee should not include in the
initial measurement of an ROU asset at transition any
allocation of prior impairment losses recognized within the
asset group. Therefore, lessees should not revisit any
impairment losses that were allocated to the asset group
before the effective date of the standard regardless of
whether an impairment loss was recognized in a comparative
period.
Q&A 16-4A Accounting for Impairment (Including
“Hidden” Impairments) Upon Adoption of ASC 842
Questions have arisen regarding whether the
guidance in Q&A 16-4
implies that a lessee may never recognize an impairment
related to a newly created ROU asset as an adjustment to
equity upon adopting ASC 842. That is, because operating
leases were not previously subject to an impairment test
under ASC 360, stakeholders have questioned whether an ROU
asset should only be reduced in transition if the lessee
previously recognized a liability under ASC 840 or ASC 420.
Although that is generally the implication, there are
limited situations in which an impairment to an ROU asset
may need to be recognized as of the effective date17 of ASC 842 (i.e., as an adjustment to equity).
For example, a retailer may have fully
impaired all of the long-lived assets (e.g., leasehold
improvements) in an asset group (e.g., an individual store)
before adopting ASC 842. That is, long-lived assets in an
asset group may have been previously written down to their
individual fair values (which may have been zero). In those
instances, it is not uncommon for unrecorded “hidden”
impairments to exist as of the previous impairment date for
the asset group. A hidden impairment can occur because of
the mechanics of the ASC 360 impairment test. If an asset
group is tested for recoverability (see ASC 360-10-35-21)
and the undiscounted cash flows are less than the carrying
amount of the asset group, the impairment loss is measured
as the amount by which the carrying amount of the 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 that asset group
cannot be written down below their individual fair values
(see ASC 360-10-35-28). As a result of these limitations,
additional economic impairment could have been previously
measured but not previously recognized as a loss in the
income statement.
Question 1
Should a lessee consider whether impairment
indicators exist for ROU assets recognized upon the adoption
of ASC 842?
Answer
Yes. A lessee should consider whether events
or changes in circumstances exist that indicate that the
carrying value of the asset group (which includes or solely
consists of an ROU asset) is not recoverable as part of the
adoption of ASC 842. That is, the lessee should determine
whether impairment indicators exist upon adoption.
The requirement to consider whether
impairment indicators exist is not equivalent to a
requirement to perform the two-step impairment test in ASC
360. ASC 360 does not require an entity to perform the ASC
360 impairment test for all asset groups. Rather, ASC 360
requires entities to consider whether there are indicators
that the carrying value of an asset group may not be
recoverable (i.e., the asset group may be impaired). When
such indicators are identified, the entity must perform the
recoverability test (step 1) for any affected asset group
and would be required to evaluate fair value in step 2 of
the test if the asset group does not pass step 1. (See
Section 8.4.4.2
for additional considerations related to performing the ASC
360 impairment test.)
ASC 360-10-35-21 lists examples of
indicators of potential impairment. In addition, decisions
to sublease or cease use of an asset under lease (even if
the conditions for recognizing a liability in accordance
with ASC 420 have not been met) may be indicators of
potential impairment because, in both cases, future cash
flows may not be sufficient to cover the contractual lease
payments. Further, previous impairments to asset groups are
indicators of potential impairment when the assets subject
to ASC 360 in the asset group were written down to their
fair values (which may have been zero) and an additional
unrecognized economic impairment remained. (See Question
5 for more information.)
Questions
2, 3,
and 4 below only apply
to asset groups that existed before adoption (i.e., they do
not solely consist of a newly recognized ROU asset). Asset
groups that solely consist of newly recognized ROU assets
would not have existed as of the reporting date immediately
before the adoption of ASC 842. See Question
5 for further considerations related to
situations in which an asset group solely consists of a
newly recognized ROU asset.
Question 2
As of which date should a lessee consider
whether impairment indicators exist for preexisting asset
groups that include newly recognized ROU assets (“asset
groups”)?
Answer
ASC 842 must be applied as of the first day
of an entity’s fiscal year of adoption. However, while ASC
842 requires lessees to recognize new assets at adoption, it
does not introduce any new requirements for how the lessee
should consider asset groups for potential impairment.
Therefore, a lessee should evaluate whether impairment
indicators exist for asset groups as of the last day of the
lessee’s reporting period before the adoption of ASC 842, as
the entity otherwise would have been required to do under
ASC 360.
Accordingly, at the end of the reporting
period immediately before the adoption of ASC 842, a lessee
should follow its normal processes and procedures (as
supported by relevant internal controls) in an effort to
determine whether there have been events or changes in
circumstances indicating that the carrying value of an asset
group may not be recoverable.
Question 3
If no impairment indicators for a
preexisting asset group are identified as of the reporting
date immediately before the adoption of ASC 842, or if
indicators existed but the asset group’s carrying value was
determined to be recoverable, is a lessee required to test
the asset group for impairment upon the adoption of ASC
842?
Answer
No. A lessee does not need to test the asset
groups for recoverability on the adoption date when there
are no impairment indicators or when the lessee concluded
that the asset group’s carrying value was recoverable at the
end of the previous reporting period. The addition of an ROU
asset to an asset group should not change the conclusion
that the asset group’s carrying value is recoverable (i.e.,
recognition of adoption-date ROU assets is a neutral event
in the determination of whether the asset group’s carrying
value is recoverable). This is because a lessee will either
(1) include the corresponding lease liability in the asset
group in such a way that the net carrying value of the asset
group is unchanged (because the ROU asset and lease
obligation would generally offset) and the net undiscounted
cash flows would not decrease or (2) exclude the lease
liability from the asset group and adjust the cash outflows
used in performing the step 1 impairment test to exclude the
corresponding lease payments in such a way that the
increased carrying value of the asset group is offset by an
increase in future net cash flows. See Section 8.4.4.2 for
considerations related to including or excluding the lease
liability in an asset group for both finance and operating
leases.
Question 4
Are there situations in which impairment
indicators exist for a preexisting asset group as of the
reporting date immediately before the adoption of ASC 842
but the lessee would not be required to test the asset group
for impairment upon the adoption of ASC 842?
Answer
Yes. A lessee would not be required to test
asset groups for impairment on the adoption date of ASC 842
when the lessee performed the ASC 360 test as of the
reporting date immediately before the adoption of ASC 842
and concluded either of the following:
-
The asset group was not impaired because there were sufficient net future cash flows to recover the asset group’s carrying value or the fair value of the asset group exceeded its carrying value.
-
There was an impairment to the asset group but the assets subject to ASC 360 in the asset group were not fully written down to their respective fair values, or such assets were written down to their respective fair values and there was no additional unrecognized economic impairment (i.e., no hidden impairment).
In these situations, a carrying value (which
may be the fair value of individual assets in the asset
group when an impairment is recognized) related to the asset
group generally remains and this remaining carrying value is
recoverable. Therefore, despite the existence of impairment
indicators, we do not believe that a lessee would be
required to test asset groups for impairment upon the
adoption of ASC 842 in these circumstances for the reasons
noted in the answer to Question 3. That is,
the recognition of new ROU assets is generally expected to
be a neutral event that should not change the conclusion
that the asset group’s carrying value is recoverable.
Question 5
Provided that a lessee adopts ASC 842 by
using the Comparatives Under 840 Option (rather than
presenting comparative periods under ASC 842), are there
situations in which it would be appropriate for a lessee to
recognize an impairment of a newly created ROU asset as an
adjustment to equity upon adopting ASC 842?
Answer
Yes. We believe that a lessee will generally
only have an impairment of an ROU asset upon the adoption of
ASC 842, and thus recognize a transition-period adjustment
to equity, in either of the following situations:
-
There was a hidden impairment, as discussed above and illustrated in the retail example below. That is, the lessee previously fully impaired all of the long-lived assets in the asset group that now includes the ROU asset (e.g., fully impaired leasehold improvements for an individual retail store), and an additional economic impairment was measured but was not previously recognized as a loss in the income statement. Further, the events and conditions that resulted in the previous impairment (an impairment that was not recognized to the extent that it was measured) continue to exist as of the ASC 842 adoption date.
-
The ROU asset represents its own asset group under ASC 360 and is determined to be impaired as of the effective date of ASC 842. That is, impairment indicators existed before (and continue to exist upon) the adoption of ASC 842, but because there were no ROU assets recognized for operating leases under ASC 840 and there are no other long-lived assets in the asset group, no impairment exercise was performed and no impairment charge was recognized in the lessee’s historical financial statements.
In these situations, when impairment
indicators continue to exist, we believe (as discussed
above) that a lessee must apply the ASC 360 impairment
guidance (as described in Section
8.4.4.2) as of the effective date of ASC
842.18 If an impairment exists, the lessee should recognize a
reduction of the ROU asset in transition that is equal to
the lesser of (1) an amount to adjust the ROU asset
to its fair value or (2) an amount to adjust the asset
group’s excess carrying value to fair value. This
impairment should generally be recognized as an adjustment
to equity on the date of adoption, unless the impairment
conditions did not exist as of the reporting date
immediately before the adoption of ASC 842.
Although expected to be rare, there may be
events or changes in circumstances occurring on the adoption date that indicate
that the carrying value of the asset group may not be
recoverable. Because such events or changes in circumstances
occurred after the adoption of ASC 842, if an asset group is
impaired as a result, the associated impairment charge
should be recognized through earnings (i.e., not through
equity).
Example
Retailer A leases two store
locations under operating leases. The two stores
are separate asset groups under ASC 360. Retailer
A uses the Comparatives Under 840 Option to adopt
ASC 842 on January 1, 2019.
Store
1
Store 1 has had and continues
to have robust sales and positive cash flows and
is located in a metropolitan area in which the
real estate market is (and has been) strong. In
addition, Store 1 has had no prior impairments. As
of December 31, 2018, because there were no events
or changes in circumstances to suggest that Store
1’s carrying value is not recoverable, Retailer A
did not test Store 1 for recoverability in
accordance with ASC 360. When Retailer A adopts
ASC 842 on January 1, 2019, and recognizes an
adoption-date ROU asset, it would be reasonable
for Retailer A to conclude that there is no reason
to test the asset group containing the
adoption-date ROU asset for impairment.
Store
2
Store 2 is located in a
depressed economic area and has had significantly
reduced sales and cash flows. In 2017, on the
basis of impairment indicators at that time,
Retailer A tested Store 2 for recoverability under
ASC 360 and concluded that Store 2 was impaired.
Retailer A reduced the long-lived assets
(consisting completely of leasehold improvements)
to zero, but an excess unrecognized impairment
remained. Sales and cash flows have not
sufficiently recovered since 2017 and, although
impairment indicators existed as of December 31,
2018, no impairment testing was performed because
there were no additional assets in the asset group
that could be reduced in accordance with ASC
360.
Because of Store 2’s hidden
impairment and conditions (i.e., impairment
indicators) that continue to exist as of the date
of adoption of ASC 842, Retailer A should test
Store 2 for recoverability at adoption. That is,
because the recoverability test is a new test
(rather than a reallocation of a previous
impairment), Retailer A should perform the ASC 360
test for the asset group as of January 1, 2019
(i.e., the asset group should include the ROU
asset).19 Further, because (1) the events and
conditions that led to the recognition of the
adoption-date impairment existed before the
adoption date and (2) Retailer A elected the
Comparatives Under 840 Option, any impairment
should be recognized as an adjustment to Retailer
A’s beginning equity on January 1, 2019.
The decision tree below summarizes the
discussion in this Q&A regarding how to determine
whether an asset group containing a newly created ROU asset
should be evaluated for impairment upon the adoption of ASC
842, provided that an entity elects the Comparatives Under
840 Option.
As noted above, throughout this Q&A, we
have assumed that the lessee used the Comparatives Under 840
Option to adopt ASC 842 and, therefore, does not present
comparative periods under ASC 842. However, the same
concepts would apply if the lessee presented comparative
periods under ASC 842 upon adoption.
We generally believe that, if the lessee
presents comparative periods under ASC 842, the timing of
recognizing the hidden impairment should be based on an
assessment of when the impairment economically
occurred/existed. Therefore, the lessee should consider
whether the incremental impairment should be recognized as
(1) an adjustment to equity as of the beginning of the
earliest period presented or (2) an impairment loss in the
income statement for a comparative period. Nevertheless, on
the basis of discussions with the FASB staff, we also
believe that it would be permissible for a company to
recognize those impairments (whether related to (1) or (2)
in the preceding sentence) in the income statement as of the
effective date (e.g., January 1, 2019, for a
calendar-year-end public company). We think that such an
approach is consistent with Q&A
16-4 and may limit the need for entities to
search for previous “hidden” impairments as well as new
impairment indicators during the comparative periods, which
could be numerous for some entities. Under this approach,
the impact of the impairments would be recorded as a charge
to income in the first period after the effective date
(e.g., January 1, 2019, for a calendar-year-end public
company), since it would be inappropriate to record an
adjustment to equity on that date when the date of initial
application (the only date on which an equity adjustment
would be appropriate) is January 1, 2017. This approach is
meant to simplify the transition accounting and is
restricted to entities that choose to recast the comparative
periods upon adoption. That is, we generally do not believe
that it would be appropriate for a company that elects the
Comparatives Under 840 Option to record an impairment charge
to earnings on January 1, 2019, if the impairment
economically occurred/existed on December 31, 2018. If a
company is contemplating an alternative approach to the
recognition of an impairment charge in these circumstances,
discussion with the company’s accounting advisers and
auditors is highly encouraged.
Transition for Cease-Use Liabilities and Sublease Liabilities
ASC 420 required entities to recognize a liability for the cost associated with an exit or disposal activity, including operating leases when an entity ceases to use a leased asset and the underlying asset has no remaining benefit to the entity. ASC 420-10-25-11 describes “contract termination costs” as either of the following:
- Costs to terminate the contract before the end of its term
- Costs that will continue to be incurred under the contract for its remaining term without economic benefit to the entity.
Entities accrue for the remaining costs to be incurred under the lease and, if applicable, the cost of terminating the lease contract. Therefore, to the extent that such balances were recognized, the balances should reduce the ROU asset balance as of transition. This balance should be recognized against the ROU asset as of the later of the date of initial application or the date the ASC 420 liability was recognized.
Consider the example below from ASC 420.20
ASC 420-10
55-12 An entity leases a facility under an operating lease that requires the entity to pay lease rentals of $100,000 per year for 10 years. After using the facility for five years, the entity commits to an exit plan. In connection with that plan, the entity will cease using the facility in 1 year (after using the facility for 6 years), at which time the remaining lease rentals will be $400,000 ($100,000 per year for the remaining term of 4 years). In accordance with paragraphs 420-10-30-7 through 30-9, a liability for the remaining lease rentals, reduced by actual (or estimated) sublease rentals, would be recognized and measured at its fair value at the cease-use date (as illustrated in the following paragraph). In accordance with paragraphs 420-10-35-1 through 35-4, the liability would be adjusted for changes, if any, resulting from revisions to estimated cash flows after the cease-use date, measured using the credit-adjusted risk-free rate that was used to measure the liability initially (as illustrated in paragraph 420-10-55-15).
55-13 Based on market rentals for similar leased property, the entity determines that if it desired,
it could sublease the facility and receive sublease rentals of $300,000 ($75,000 per year for the
remaining lease term of 4 years). However, for competitive reasons, the entity decides not to sublease
the facility (or otherwise terminate the lease) at the cease-use date. The fair value of the liability at
the cease-use date is $89,427, estimated using an expected present value technique. The expected
net cash flows of $100,000 ($25,000 per year for the remaining lease term of 4 years) are discounted
using a credit-adjusted risk-free rate of 8 percent. In this case, a risk premium is not considered in
the present value measurement. Because the lease rentals are fixed by contract and the estimated
sublease rentals are based on market prices for similar leased property for other entities having
similar credit standing as the entity, there is little uncertainty in the amount and timing of the expected
cash flows used in estimating fair value at the cease-use date and any risk premium would be
insignificant. In other circumstances, a risk premium would be appropriate if it is significant. Thus, a
liability (expense) of $89,427 would be recognized at the cease-use date.
55-14 Accretion expense would be recognized after the cease-use date in accordance with the
guidance beginning in paragraph 420-10-35-1 and in paragraph 420-10-45-5. (The entity will recognize
the impact of deciding not to sublease the property over the period the property is not subleased. For
example, in the first year after the cease-use date, an expense of $75,000 would be recognized as the
impact of not subleasing the property, which reflects the annual lease payment of $100,000 net of the
liability extinguishment of $25,000).
55-15 At the end of one year, the competitive factors referred to above are no longer present. The
entity decides to sublease the facility and enters into a sublease. The entity will receive sublease
rentals of $250,000 ($83,333 per year for the remaining lease term of 3 years), negotiated based on
market rentals for similar leased property at the sublease date. The entity adjusts the carrying amount
of the liability at the sublease date to $46,388 to reflect the revised expected net cash flows of $50,000
($16,667 per year for the remaining lease term of 3 years), which are discounted at the credit-adjusted
risk-free rate that was used to measure the liability initially (8 percent). Accretion expense would be
recognized after the sublease date in accordance with the guidance beginning in paragraph 420-10-35-1 and in paragraph 420-10-45-5.
On the basis of the facts in the above example,
the entity would have recorded the following (assume that rental
payments and sublease income receipts are paid at the beginning of
each year):
Only the initial measurement of the ROU asset should be affected by any ASC 420 liability
associated with the lease. Therefore, if the ASC 420 liability is recorded before the date of
initial application, the balance as of the date of initial measurement should be recognized as a
reduction to the ROU asset.
Assume that the entity is a calendar-year-end public company, it did not elect
the Comparatives Under 840 Option, and that January 1, 2017, is the
beginning of Year 8 in the example above. The entity would initially
measure the ROU asset reduced by the ASC 420 liability balance
(including any true-ups) as of December 31, 2016. Further assume a
discount rate of 14 percent.
Measurement of the ROU Asset as of January 1,
2017
Reclassification of Incremental ASC 420
Liability During the Periods Ended December 31, 2017, and
December 31, 2018
Connecting the Dots
Impact of Hindsight Practical Expedient on ASC 420
Liabilities Versus That on Impairment
We do not believe that the hindsight practical expedient can be applied to ASC 420 liabilities. For example, if an entity ceases use of a leased asset during the comparative periods, it would not be appropriate to push back that conclusion to the earliest period presented. While the impact of incorporating ASC 420 liabilities is similar to the impact of an impairment, they are nonetheless not the same, because the triggering event for an ASC 420 liability is related to terminating or ceasing use of the property, which should not be moved into a reporting period different from that in which the event occurred.
Q&A 16-5A Transition Considerations Related to Lease
Measurement When an Entity Ceases Use of a Leased Asset
Before the Adoption of ASC 842
Under ASC 840, when an entity ceases use of
an asset subject to an operating lease, the entity applies
the guidance in ASC 420 to determine whether to recognize a
liability for its costs related to terminating the operating
lease and costs that will continue to be incurred without
economically benefiting the entity. Provided that the
criteria in ASC 420 related to recognizing a liability are
met, the liability is measured as the difference between the
remaining lease costs to be paid by the lessee, offset by an
assumption for sublease income. In accordance with ASC
420-10-30-8, an entity would record the liability in this
manner regardless of whether the lessee has the intent to
sublease the asset. ASC 420-10-30-8 states:
If the contract is an operating
lease, the fair value of the liability at the
cease-use date shall be determined based on the
remaining lease rentals, adjusted for the effects of
any prepaid or deferred items recognized under the
lease, and reduced by estimated
sublease rentals that could be reasonably obtained
for the property, even if the entity does not
intend to enter into a sublease. Remaining
lease rentals shall not be reduced to an amount less
than zero. [Emphasis added]
Therefore, under ASC 420 and ASC 840, an
entity is considered to have ceased use of an asset even if
the entity has the intent and ability to sublease the asset.
However, under ASC 842, the cease-use determination is no
longer relevant; rather, an entity must determine whether
the leased asset is abandoned in accordance with ASC 360.
Under ASC 842, if an entity plans to abandon
the leased asset, we believe that the entity should change
the useful life of the ROU asset prospectively in such a way
that the ROU asset is fully amortized by the abandonment
date.
Question
1
Under ASC 842, is an ROU asset considered
abandoned if an entity has ceased use of the underlying
asset but is currently subleasing (or plans to sublease) the
asset?
Answer
No. Under ASC 842, an ROU asset is
recognized during the period in which an entity has the
right to use an asset subject to a lease. One of the
conditions for a lease is that the entity must obtain
substantially all of the economic benefits from the use of
the underlying asset. In a sublease scenario, although the
entity itself is not using the asset, the entity’s receipt
of sublease payments would be considered as obtaining
economic benefits from use of the underlying asset under ASC
842. ASC 842-10-15-17 provides evidence for this notion and
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]
Because the entity is still obtaining
economic benefits from use of the asset through subleasing
the asset, we do not believe that a lessee has abandoned an
asset if an entity has both the intent and ability to
sublease. This holds true even if the lessee has not yet
identified a sublessee before the lessee ceases use of the
asset.
Question
2
If an entity ceases use of a leased asset
before adopting ASC 842 and does not have the intent and
ability to sublease the asset, should the entity recognize
an ROU asset upon adopting ASC 842?
Answer
No. We do not believe that it is appropriate
to recognize an ROU asset upon adopting ASC 842 if an entity
both (1) has ceased using an asset before the adoption date
of ASC 842 and that designation has not changed as of the
adoption date and (2) does not have the intent and ability
to sublease the asset. However, the entity would still be
required to recognize a lease liability equal to the present
value of the remaining lease payments under the contract.
Normally, the entity would recognize a corresponding ROU
asset; however, in this situation, any liabilities
previously recognized under ASC 420 (e.g., cease-use
liabilities) would be recognized as a reduction to the
carrying amount of the ROU asset. Furthermore, to the extent
that the ASC 420 liability is less than the carrying amount
of the ROU asset that would otherwise be recognized to
offset the corresponding lease liability, any remaining
portion of the ROU asset not offset by the ASC 420 liability
would be written off as an adjustment to equity. We believe
that it is appropriate to record the adjustment through
equity because the cease-use event occurred before the date
of initial application of ASC 842. See the Q&A below for
discussion of the effect of a previously recognized ASC 420
liability that exceeds the lease liability that must be
recognized in transition.
Q&A 16-5B Initial Measurement of an ROU Asset When a
Previously Recognized ASC 420 Liability Exceeds the Lease
Liability Recognized in Transition
Before adopting ASC 842, a lessee may have
recognized, in accordance with ASC 420, a liability for the
cost associated with an exit or disposal activity related to
an operating lease. Specifically, ASC 420-10-30-9 states
that a “liability for costs that will continue to be
incurred under a contract for its remaining term without
economic benefit to the entity shall be [recognized and]
measured at its fair value” when the entity ceases using the
right conveyed by the contract. In addition, ASC 420-10-30-8
indicates that “[i]f the contract is an operating lease, the
fair value of the liability at the cease-use date shall be
determined based on the remaining lease rentals.”
Under ASC 840, a lessee may have included
amounts related to maintenance (including CAM), insurance,
and property taxes in the measurement of its ASC 420
liability. The lessee would have done so regardless of
whether such costs were fixed or variable, in which case
they would be estimated.
When a lessee is applying the transition
requirements in ASC 842, to the extent that ASC 420
liabilities were recognized, such balances should reduce the
carrying amount of the ROU asset in accordance with ASC
842-10-65-1(m)(2), which states, in part:
For each lease classified as an
operating lease in accordance with paragraphs
842-10-25-2 through 25-3, a lessee shall initially
measure the right-of-use asset at the initial
measurement of the lease liability adjusted for both
of the following: . . .
2. The carrying amount of any liability
recognized in accordance with Topic 420 on exit or
disposal cost obligations for the lease.
In certain circumstances, the carrying
amount of a lessee’s ASC 420 liability immediately before
the ASC 842 effective date for an existing operating lease
may exceed the amount that will be recognized for the lease
liability as of the effective date (e.g., if the lessee’s
ASC 420 liability included CAM, insurance, and property
taxes). Consequently, measuring the ROU asset, including the
full adjustment for an ASC 420 liability in accordance with
ASC 842-10-65-1(m)(2), may result in an ROU asset carrying
amount below zero.
Question
How should a lessee account for a lease at
transition in which the existing ASC 420 liability exceeds
the ROU asset that would otherwise be recognized at
transition?
Answer
We do not believe that it would be
appropriate for a lessee to recognize a negative ROU asset
at transition. Although ASC 842 does not provide clear
guidance on this situation, we think that it would be
acceptable for a lessee to use one of the following
approaches:
-
Approach 1: Retain the ASC 420 liability for amounts that exceed the initial ROU asset — An entity could reduce the ROU asset to zero, with a corresponding decrease to the ASC 420 liability. The remaining portion of the ASC 420 liability would be retained and would be accounted for after the effective date in the same manner as it was accounted for before the effective date (i.e., in accordance with ASC 420). We believe that this approach is acceptable because it would allow a lessee to effectively “run off” its remaining liability. As part of this approach, an entity would not be required to recognize those costs through the income statement a second time (i.e., once when the ASC 420 liability was established before the effective date and again when those costs are actually incurred after the effective date).
-
Approach 2: Retain the portion of the ASC 420 liability related to the executory costs — As discussed in Q&A 16-5A, if an entity (1) has ceased using an asset before the adoption date of ASC 842 and that designation has not changed as of the adoption date and (2) does not have the intent and ability to sublease the asset as of the adoption date, we do not believe that it is appropriate for an entity to recognize an ROU asset upon adoption. Accordingly, the application of Approach 2 will depend on an entity’s intent and ability to sublease.
-
Approach 2(a) — If the entity has the intent and ability to sublease, the entity could reduce the ROU asset by the portion of the ASC 420 liability related to the lease costs. An entity would also reduce the ASC 420 liability by a corresponding amount and retain the portion of the ASC 420 liability to the extent that it is related to executory costs.
-
Approach 2(b) — If the entity does not have the intent and ability to sublease, the entity could reduce the ROU asset to zero, with a corresponding decrease to the ASC 420 liability, retaining the ASC 420 liability only for the remaining portion related to executory costs.
In both Approach 2(a) and Approach 2(b), the ASC 420 liability that remains would be accounted for after the effective date in the same manner as it was accounted for before the effective date (i.e., in accordance with ASC 420). As with Approach 1, we believe that this approach is acceptable because it would allow a lessee to effectively “run off” its remaining liability. As part of this approach, an entity would not be required to recognize those costs through the income statement a second time (i.e., once when the ASC 420 liability was established before the effective date and again when those costs are actually incurred after the effective date). -
-
Approach 3: Derecognize any remaining ASC 420 liability, after the ROU asset is written to zero, through an adjustment to equity — An entity could reduce the ASC 420 liability by the same amount that reduced the ROU asset to zero. The remaining portion of the ASC 420 liability could be written off with an adjustment through equity. The costs underlying the amount that would be adjusted to equity would be recognized through the income statement in future periods as an expense since they are incurred after the effective date. Accordingly, under this approach, a lessee will recognize certain costs through the income statement twice (i.e., once in periods before the adoption of ASC 842 when the ASC 420 liability was established with its corresponding expense, and again when those costs are incurred after the adoption of ASC 842, because an offsetting liability on the balance sheet no longer exists). Although we do not think that this is an intended outcome of the transition guidance in ASC 842 or a desirable outcome for lessees, we do believe that this approach is acceptable because it would allow the removal of the existing ASC 420 liability, as contemplated under the ASC 842 transition guidance.
Q&A 16-5C Treatment of Existing Sublease Liabilities
Under ASC 840 Upon Transition to ASC 842
Under ASC 842, when the costs expected to be
incurred under an operating sublease exceed the expected
related revenue, a sublessor should consider whether the ROU
asset of the head lease is impaired in accordance with ASC
842-20-35-9. However, under ASC 840, the sublessor would
have instead recognized a sublease liability for this
anticipated loss. Specifically, ASC 840-20-25-15 states:
If costs expected to be incurred
under an operating sublease (that is, executory
costs and either amortization of the leased asset or
rental payments on an operating lease, whichever is
applicable) exceed anticipated revenue on the
operating sublease, a loss shall be recognized by
the sublessor.
The transition guidance in ASC
842-10-65-1(m) states:
For each lease classified as an
operating lease in accordance with paragraphs
842-10-25-2 through 25-3, a lessee shall initially
measure the right-of-use asset at the initial
measurement of the lease liability adjusted for both
of the following:
-
The items in paragraph 842-20-35-3(b), as applicable.
-
The carrying amount of any liability recognized in accordance with Topic 420 on exit or disposal cost obligations for the lease.
Therefore, the ROU asset is established in
transition and adjustments are made for items in ASC
842-20-35-3(b), including “impairment of the [ROU] asset”
and the carrying amount of ASC 420 liabilities.
Question
How should a sublessor account for an
existing sublease liability recognized under ASC
840-20-25-15 upon transition to ASC 842?
Answer
ASC 842 does not provide explicit guidance
on accounting for existing sublease liabilities upon
transition. The ASC 842 transition guidance states that the
initial ROU asset recognized in transition should be net of
ASC 420 liabilities and ROU impairment but does not mention
existing sublease liabilities. In the absence of explicit
guidance, we believe that the following are acceptable
approaches for a sublessor to use in accounting for an
existing sublease liability upon transition:
-
Approach A — The sublessor writes off the existing sublease liability upon transition to ASC 842, with a credit to equity. Contemporaneously, the sublessor must test the asset group containing the ROU asset for impairment in accordance with ASC 842 (see Q&A 16-4A), because subleasing at an amount less than the head lease payments may be an indicator of impairment. If the ROU asset is impaired, any impairment would also be an adjustment to equity in transition.
-
Approach B — The sublessor nets the existing sublease liability recognized under ASC 840-20-25-15 against the ROU asset established upon transition to ASC 842. Under this approach, the existing sublease liability is considered akin to an impairment loss. As a result, in accordance with ASC 842-20-25-7, the sublessor would subsequently amortize the remaining ROU asset balance on a straight-line basis; accordingly, the sublessor would not recognize total lease expense on a straight-line basis (see Section 8.4.4 for additional discussion of subsequent measurement of the ROU asset after an impairment is recognized).
A sublessor should elect one of the above
approaches and apply it consistently to all existing
sublease liabilities in transition.
16.3.1.1.3 Subsequent Measurement
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
n. For each lease classified as an operating lease in accordance with paragraphs 842-10-25-2
through 25-3, a lessee shall subsequently measure
the right-of-use asset throughout the remaining
lease term in accordance with paragraph
842-20-35-3(b). If the initial measurement of the
right-of-use asset in (m) is adjusted for the
carrying amount of a liability recognized in
accordance with Topic 420 on exit or disposal cost
obligations for the lease, the lessee shall apply
the recognition and subsequent measurement
guidance in Sections 842-20-25 and 842-20-35,
respectively, when the right-of-use asset has been
impaired. . . .
For operating leases whose balance neither reflects an impairment nor includes
an ASC 420 liability upon transition, the ROU asset and liability should
be subsequently measured in accordance with ASC 842-20-35-3(b). A
lessee’s expense recognition pattern for lease payments is the same
under ASC 840 as it is under ASC 842 (i.e., generally straight-line).
Therefore, during the comparative periods under ASC 842 (if applicable),
the expense recognized under ASC 840 does not need to be altered. For
operating leases whose balance reflects an impairment21 or includes an ASC 420 liability, the lessee should subsequently
measure the ROU asset and liability in accordance with ASC 842-20-25 and
ASC 842-20-35 as if the ROU asset had been impaired. The ROU asset
should be amortized on a straight-line basis over the remaining lease
term, unless a more 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. The entity should
accrete the lease liability initially measured at the amount that
produces a constant periodic discount rate related to the remaining
balance of that liability.
Further, as discussed in Section 16.3.1, an entity should apply the provisions of ASC 842 to the
accounting for modifications and the reassessment of the lease liability on and after the effective
date. During the comparative periods presented under ASC 842 (if applicable), the accounting for
modifications and the reassessment of the lease liability should be in line with the provisions of ASC 840
(if lease classification did not change upon the adoption of ASC 842) or ASC 842 (if lease classification did
change upon the adoption of ASC 842).
16.3.1.2 Lease Is a Finance Lease Under ASC 842 (Operating Lease Under ASC 840)
The graphic below outlines the steps lessees should perform in transition for leases that were previously
classified as operating leases and are considered finance leases under ASC 842.
16.3.1.2.1 Initial Measurement of Lease Liability
For more information about the initial measurement of the lease liability, see Section 16.3.1.1. For
leases classified as operating under ASC 840, the initial measurement of lease liabilities in transition is
the same, regardless of whether classification changes.
16.3.1.2.2 Initial Measurement of ROU Asset
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
o. For each lease classified as a finance lease in accordance with paragraph 842-10-25-2, a lessee shall measure the right-of-use asset as the applicable proportion of the lease liability at the commencement date, which can be imputed from the lease liability determined in accordance with (l). The applicable proportion is the remaining lease term at the application date as determined in (c) relative to the total lease term. A lessee shall adjust the right-of-use asset recognized by the carrying amount of any prepaid or accrued lease payments and the carrying amount of any liability recognized in accordance with Topic 420 for the lease. . . .
The measurement of the ROU asset is intended to reflect the proportion of the
ROU asset that would have remained if the lease had always been
classified as a finance lease, including any prepaid (or accrued)
balances and ASC 420 liabilities. However, the guidance above
indicates that this amount “can be imputed from the lease liability
determined in accordance with (l).” This appears to be an
accommodation, because the calculation of the lease liability under
ASC 842-10-65-1(l) only takes into account remaining lease payments
as of the date of initial application for any lease that commences
before that time. That is, a true calculation of the lease liability
as of the commencement date would include payments that were made
before the date of initial application. ASC 842 does not provide
additional guidance on how a lessee may impute the lease liability
without using all the payments since lease commencement. However,
the 2013 ED of the leases standard did illustrate how this may be
done. Under the approach discussed in the ED, an entity would
average the remaining minimum rental payments from the calculation
in ASC 842-10-65-1(l) and would assume that those average payments
existed for the entire lease term. This calculation could materially
differ from a true calculation of the original lease liability at
lease commencement. For example, this could occur if the lease
payments significantly differed from those on a straight-line basis
(e.g., step rents or significant deferred payments). Therefore, we
believe that a lessee could either calculate the original lease
liability at lease commencement (Alternative 1 below) or develop a
policy that is consistent with imputing the amount related to the
components from the calculation in ASC 842-10-65-1(l) (Alternative 2
below).
Example 16-2
Assume the same facts as in Example 29 of ASC 842 (see Section 16.3.1.1) except that the lessee did not elect
the practical expedient package and the lease was determined to be a finance lease in transition. Further
assume that the entity did not elect the Comparatives Under 840 Option and that the remaining balance of
initial direct costs as of the earliest period presented is $250 because of the exclusion of certain initial direct
costs capitalized under ASC 842. Finally, assume that the payment made in 20X1 was $31,000.
Step 1: Measure the Lease Liability as of the Earliest Period Presented
Alternative 1
Step 2: Measure the ROU Asset
Calculate the present value of the lease payments from lease commencement and multiply this amount by the
remaining lease term divided by the original lease term.
Step 3: Record the Journal Entries
Alternative 2
Step 2: Measure the ROU
Determine the average lease payments over the remaining term as of the earliest
period presented, as calculated in step 1 (31,000
+ 33,000 + 33,000 + 33,000) ÷ 4 = $32,500.
Calculate the present value of the average lease payments imputed over the entire lease term and multiply this amount by the remaining lease term divided by the original lease term.
Step 3: Record the Journal Entries
16.3.1.2.3 Subsequent Measurement
There are no separate paragraphs in the transition guidance on subsequent measurement for a lease that was an operating lease under ASC 840 and becomes a finance lease upon the adoption of ASC 842. However, since the lease classification in this scenario changed to a finance lease in accordance with ASC 842, the finance lease must be subsequently measured in accordance with ASC 842 after the date of initial application.
16.3.2 Lease Previously Classified as a Capital Lease Under ASC 840
Leases previously classified as a capital lease under ASC 840 could be accounted for as either a finance lease or an operating lease under ASC 842. The classification considerations related to the practical expedient package are the same as those for leases previously classified as operating leases (see Section 16.3.1).
The two transition scenarios for
a capital lease under ASC 840 are as follows:
16.3.2.1 Lease Is a Finance Lease Under ASC 842 (Capital Lease Under ASC 840)
The graphic below illustrates how an entity should recognize the ROU asset and
lease liability for leases that were previously classified as capital leases
and are considered finance leases under ASC 842 because either (1) an entity
elected the practical expedient package so that lease classification would
not be reassessed or (2) classification is assessed in transition to ASC 842
and the lease is determined to be a finance lease.
In short, other than changing the characterization of the asset (to an ROU asset) and obligation (to a
lease liability), the lessee does not record any entries as part of the transition from a capital lease to
a finance lease, except the impact of any nonqualifying initial direct costs, if any, when the practical
expedient package is not applied. Example 28 in ASC 842 illustrates this transition as follows:
ASC 842-10
Illustration of Lessee Transition — Existing Capital Lease
55-243 Example 28 illustrates lessee accounting for the transition of existing capital leases when an entity elects the transition method in paragraph 842-10-65-1(c)(1).
Example 28 — Lessee Transition — Existing Capital Lease
55-244 The effective date of the guidance in this Topic for Lessee is January 1, 20X4. Lessee enters into a
7-year lease of an asset on January 1, 20X1, with annual lease payments of $25,000 payable at the end of
each year. The lease includes a residual value guarantee by Lessee of $8,190. Lessee’s incremental borrowing
rate on the date of commencement was 6 percent. Lessee accounts for the lease as a capital lease. At lease
commencement, Lessee defers initial direct costs of $2,800, which will be amortized over the lease term. On
January 1, 20X2 (and before transition adjustments), Lessee has a lease liability of $128,707, a lease asset of
$124,434, and unamortized initial direct costs of $2,400.
55-245 January 1, 20X2 is the beginning of the earliest comparative period presented in the financial
statements in which Lessee first applies the guidance in this Topic. Lessee has elected the package of practical
expedients in paragraph 842-10-65-1(f). As such, Lessee accounts for the lease as a finance lease, without
reassessing whether the contract contains a lease or whether classification of the lease would be different
in accordance with this Topic. Lessee also does not reassess whether the unamortized initial direct costs on
January 1, 20X2, would have met the definition of initial direct costs in this Topic at lease commencement.
55-246 On January 1, 20X2, Lessee recognizes a lease liability at the carrying amount of the capital lease
obligation on December 31, 20X1, of $128,707 and a right-of-use asset at the carrying amount of the capital
lease asset of $126,834 (which includes unamortized initial direct costs of $2,400 that were included in the
capital lease asset). Lessee subsequently measures the lease liability and the right-of-use asset in accordance
with Subtopic 840-30 until the effective date.
55-247 Beginning on the effective date, Lessee applies the subsequent measurement guidance in Section
842-20-35, including the reassessment requirements, except for the requirement to reassess amounts
probable of being owed under residual value guarantees. Such amounts will only be reassessed if there is a
remeasurement of the lease liability for another reason, including as a result of a lease modification (that is, not
accounted for as a separate contract).
16.3.2.1.1 Initial Measurement of Lease Liability and ROU Asset
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
r. For each lease classified as a finance lease in accordance with this Topic, a lessee shall do all of the following:
1. Recognize a right-of-use asset and a lease liability at the carrying amount of the lease asset and the capital lease obligation in accordance with Topic 840 at the application date as determined in (c).
2. Include any unamortized initial direct costs that meet the definition of initial direct costs in this Topic in the measurement of the right-of-use asset established in (r)(1).
3. If a lessee does not elect the practical expedients described in (f),
write off any unamortized initial direct costs
that do not meet the definition of initial direct
costs in this Topic and that are not included in
the measurement of the capital lease asset under
Topic 840 as an adjustment to equity unless the
entity elects the transition method in (c)(1) and
the costs were incurred after the beginning of the
earliest period presented, in which case those
costs shall be written off as an adjustment to
earnings in the period the costs were incurred. .
. .
If a lease was previously classified as a capital lease under ASC 840 and the
lease remains a finance lease, the entity should recognize an ROU asset
and lease liability in transition at their existing carrying amounts as
lease assets and capital lease obligations, respectively. That is, the
transition guidance for a capital lease that is classified as a finance
lease under ASC 842 results in the carryforward of existing assets and
liabilities recognized under ASC 840.22 The amounts should be recognized at the later of the date of
initial application or the commencement date of the lease.
In addition, any unamortized initial direct costs (after an entity considers the
ASC 842 definition, unless the practical expedient described in
Section
16.5.2.3 is applied) should be added to the ROU
asset.
Connecting the Dots
Hindsight Impact Related to Lease Term and Liability
Measurement (Lease Classified as a Capital Lease Under
ASC 840)
The measurement of the lease liability is affected by the identification of the lease term. If an entity elects the hindsight practical expedient, any changes to the lease term during the comparative period should be reflected in the measurement of the lease liability as of the later of the date of initial application or lease commencement. Therefore, a different initial measurement of the finance lease could be required in transition, since balances under ASC 840 will reflect a different lease term assumption. See Section 16.5.1 for more information on the hindsight practical expedient.
For capital leases that are finance leases under ASC 842, the only difference between electing and
not electing the practical expedient package is that an entity that does not apply the package would
only include in its ROU asset initial direct costs that qualify as such costs under ASC 842. Previously
capitalized initial direct costs that no longer meet the definition of initial direct costs under ASC 842
must be accounted for as follows:
- Any costs incurred before the date of initial application should be recognized as an adjustment to equity.
- Any costs incurred on or after the date of initial application should be recognized in earnings for the respective comparative period under ASC 842, if applicable.
16.3.2.1.2 Subsequent Measurement
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
r. For each lease classified as a finance lease in accordance with this Topic, a lessee shall do all of the
following: . . .
4. If an entity elects the transition method in (c)(1), subsequently measure the right-of-use asset and the lease liability in accordance with Section 840-30-35 before the effective date.
5. Regardless of the transition method selected in (c), apply the
subsequent measurement guidance in paragraphs
842-20-35-4 through 35-5 and 842-20-35-8 after the
effective date. However, when applying the pending
content in paragraph 842-20-35-4, a lessee shall
not remeasure the lease payments for amounts
probable of being owed under residual value
guarantees in accordance with paragraph
842-10-35-4(c)(3).
6. Classify the assets and liabilities held under capital leases as right-of-use assets and lease liabilities
arising from finance leases for the purposes of presentation and disclosure. . . .
t. If a modification to the contractual terms and conditions occurs on or after the effective date, and the
modification does not result in a separate contract in accordance with paragraph 842-10-25-8, or the
lessee is required to remeasure the lease liability in accordance with paragraph 842-20-35-4, the lessee
shall subsequently account for the lease in accordance with the requirements in this Topic beginning on
the effective date of the modification or the remeasurement date. . . .
A finance lease must be subsequently measured in accordance with ASC 840 in the comparative periods
before the effective date. That is, if classification does not change as of the earliest period presented, the
ASC 840 reassessment, modification, and measurement principles should be retained (other than those
related to the classification of the assets and liabilities as ROU assets and lease liabilities, respectively,
for presentation and disclosure purposes). On and after the effective date, an entity must apply the ASC
842 subsequent-measurement guidance, including that on modifications and reassessment of the lease
liability.
Connecting the Dots
Lessee Does Not Remeasure Residual Value Guarantee Upon
Transition
Under ASC 840, a lessee includes in its minimum lease payments the entire amount
of the residual value guarantee; however, under ASC 842, a
lessee only includes in its lease payments those amounts that it
is probable the lessee will owe under the residual value
guarantee at the end of the lease term. As a result, the ROU
asset and lease liability recognized on the lessee’s balance
sheet for a new lease under ASC 842 will generally be lower than
it would have been had the same lease been classified as a
capital lease under ASC 840.
However, for existing leases that were classified as capital leases under ASC 840 and that will be classified as finance leases under ASC 842, ASC 842 specifically states that a lessee is not allowed to “remeasure [upon transition] the lease payments for amounts probable of being owed under residual value guarantees.” As a result, a lessee’s lease payments would not be reduced only to reflect the change in the amount of the residual value guarantee that is included in lease payments under the two standards.
16.3.2.2 Lease Is an Operating Lease Under ASC 842 (Capital Lease Under ASC 840)
For leases that were previously classified as capital leases
and are considered operating leases under ASC 842 (which can only occur if
the practical expedient package is not elected), the lessee must derecognize
the previous capital lease amounts at the later of the date of initial
application or the commencement date. Upon derecognition of the previous
capital lease amounts, the lease is accounted for as an operating lease
under ASC 842, as discussed further below.
16.3.2.2.1 Initial Measurement
ASC 842-10
65-1 The following represents
the transition and effective date information
related to Accounting Standards Update . . . No.
2016-02, Leases (Topic 842) . . .
s. For each lease classified as an operating
lease in accordance with this Topic, a lessee
shall do the following:
1. Derecognize the
carrying amount of any capital lease asset and
capital lease obligation in accordance with Topic
840 at the application date as determined in (c).
Any difference between the carrying amount of the
capital lease asset and the capital lease
obligation shall be accounted for in the same
manner as prepaid or accrued rent.
2. If an entity elects
the transition method in (c)(1) and the lease
commenced before the beginning of the earliest
period presented in the financial statements or if
the entity elects the transition method in (c)(2),
recognize a right-of-use asset and a lease
liability in accordance with paragraph 842-20-35-3
at the application date as determined in (c).
3. If an entity elects
the transition method in (c)(1) and the lease
commenced after the beginning of the earliest
period presented in the financial statements,
recognize a right-of-use asset and a lease
liability in accordance with paragraph 842-20-30-1
at the commencement date of the lease. . . .
5. Write off any
unamortized initial direct costs that do not meet
the definition of initial direct costs in this
Topic as an adjustment to equity unless the entity
elects the transition method in (c)(1) and the
costs were incurred after the beginning of the
earliest period presented, in which case those
costs shall be written off as an adjustment to
earnings in the period the costs were incurred. .
. .
The lessee should measure the ROU asset and lease
liability under ASC 842-20-30-1 as of the later of the date of initial
application or the date the lease commenced. Before measuring the ROU
asset and lease liability, the lessee would need to identify and
allocate the consideration to the separate lease and nonlease components
in the contract (see Chapter 4). Because the lessee could not have elected
the practical expedient package if the classification of a lease changes
upon the adoption of ASC 842, any unamortized initial direct costs that
would not be capitalized under the changed definition of such costs in
ASC 842 should be written off as an (1) adjustment to equity if the
costs are incurred before the date of initial application or (2) expense
in the period in which the costs are incurred, which is only applicable
if the Comparatives Under 840 Option is not elected.
16.3.2.2.2 Subsequent Measurement
ASC 842-10
65-1 The following represents
the transition and effective date information
related to Accounting Standards Update . . . No.
2016-02, Leases (Topic 842) . . .
s. For each lease classified as an operating
lease in accordance with this Topic, a lessee
shall do the following: . . .
4. Account for the
operating lease in accordance with the guidance in
Subtopic 842-20 after initial recognition in
accordance with (s)(2) or (s)(3). . . .
After the commencement date, the lessee should
subsequently measure the operating lease under ASC 842 in a manner
similar to how it would measure any other operating lease that commenced
after the effective date (see Section 8.4.3.2). That is, since
lease classification changed upon the adoption of ASC 842, an entity
should apply all of the guidance on subsequent measurement (including
that on modifications and reassessment of the lease liability) under ASC
842 during the comparative periods presented (if applicable) and on or
after the effective date.
Footnotes
4
We do not believe that the short-term lease exemption
applies to leases that, upon transition, have a remaining term of 12 months
or less if the original term was greater than 12 months. The ASC master
glossary defines a short-term lease as “[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.” While a lease may have a remaining lease term of less than 12
months at transition, it would not meet the definition of a short-term lease
if the lease term as of the original commencement date would have been
greater than 12 months.
5
An entity is not required to
apply U.S. GAAP to immaterial items; therefore,
materiality is always a consideration in the
preparation of financial statements. The
assessment of materiality is company-specific and
involves qualitative and quantitative
considerations. A company’s explicit financial
statement disclosure of its historical approach
under ASC 840 may serve as qualitative evidence
that the policy is material.
6
A preferability determination
is required under ASC 250 if an entity that is
making the transition from ASC 840 to ASC 842
wishes to change from using an inception rate to
using an updated rate to calculate its lease
liability, provided that the historical policy has
a material impact on the financial statements.
7
While an entity is not required to reflect
the change in historical periods in this circumstance, we
believe that an entity is permitted to do so since the
change would increase comparability.
8
Paragraph BC390 of ASU 2016-02 states, in
part, that the “practical effect of the modified
retrospective transition method, particularly when combined
with the practical expedients that are offered, is that an
entity will ‘run off’ those leases
existing at the beginning of the earliest comparative
period presented in accordance with previous GAAP”
(emphasis added).
9
See footnote 5.
10
While not required to reflect
the change in the historical periods in this
circumstance, we believe that an entity is
permitted to do so since the change would increase
comparability.
11
Depending on an entity’s election (made by
underlying asset class) to combine lease and nonlease
components, all or a portion of an entity’s leases may be
affected by this election. In contrast, an entity’s ASC 840
policy choice for including or excluding executory costs is
an entity-wide election. Accordingly, inconsistencies
between ASC 840 and ASC 842 may arise in such
circumstances.
12
The preferability
determination is required under ASC 250 if an
entity wishes to treat executory costs differently
than historical practice when making the
transition from ASC 840 to ASC 842 and the
inclusion (exclusion) of executory costs has a
material impact on the financial statements (see
Question 1).
13
An entity should perform a
well-reasoned preferability analysis to determine
whether a change in executory costs is appropriate
(see Question 1). The
fact that the change enhances comparability
between ASC 840 and ASC 842 is not solely
determinative of whether a change in policy is
preferable. Other factors to consider in a
preferability analysis include, but are not
limited to, whether the change in policy is
consistent with guidance under ASC 842, the
composition of costs associated with expected
leasing activity after adoption, comparability
with relevant peer companies, and whether the
change results in relevant measurement of the
liability upon adoption of ASC 842.
[14]
ASC 842-20, not ASC 842-30, contains
the subsequent-measurement guidance for lessees; we
believe that this is a typographical error.
[15]
See footnote 14.
16
Since this approach uses the
remaining lease term as of the date of initial
application of ASC 842 as the revised amortization
period of the leasehold improvements, it would not
be appropriate to fully write off leasehold
improvements that have remaining utility through
equity as of the date of initial application of
ASC 842.
17
Throughout this Q&A, we have
assumed that the lessee used the Comparatives Under
840 Option to adopt ASC 842 and therefore does not
present comparative periods under ASC 842. However,
the same concepts would apply if the lessee
presented comparative periods under ASC 842 upon
adoption. See Question 5 for
more information.
18
We do not believe that it would be
appropriate for a lessee to impair the ROU asset
simply because it would have been previously
impaired if it existed at the time that a
historical impairment was recognized for the asset
group. A lessee should only recognize an impairment
of the ROU asset as of the date of initial
application of ASC 842 if an economic impairment
exists as of that date.
19
See Section 8.4.4.2 for additional
information regarding testing the asset group that
is or includes an ROU asset.
20
ASU 2016-02 supersedes the four paragraphs
below.
21
As discussed in Q&A 16-5C, we believe
that netting an existing sublease liability against an ROU asset
in transition (i.e., Approach B in the Q&A) is akin to an
impairment loss and thus should result in the same subsequent
measurement as an impairment.
22
We believe that in addition to carrying forward
the existing assets and liabilities recognized under ASC 840, an
entity should also carry forward the discount rate used under
ASC 840.
16.4 Lessor
The table below summarizes the ASU’s modified retrospective transition requirements
for lessors (and assumes that the practical expedient package has not been
elected).
16.4.1 Lease Classified as an Operating Lease Under Both ASC 840 and ASC 842
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
v. For each lease classified as an operating lease in accordance with this Topic, a lessor shall do all of the
following:
1. Continue to recognize the carrying amount of the underlying asset and any lease assets or
liabilities at the application date as determined in (c) as the same amounts recognized by the lessor
immediately before that date in accordance with Topic 840.
2. Account for previously recognized securitized receivables as secured borrowings in accordance with
other Topics.
3. If a lessor does not elect the practical expedients described in (f), write off any unamortized initial direct costs that do not meet the definition of initial direct costs in this Topic as an adjustment to equity unless the entity elects the transition method in (c)(1) and the costs were incurred after the beginning of the earliest period presented, in which case those costs shall be written off as an adjustment to earnings in the period the costs were incurred. . . .
For leases that were previously classified as operating leases and are considered operating leases under
ASC 842 either because the practical expedient package was elected and lease classification therefore
was not reassessed or because classification was assessed in transition to ASC 842 and the lease
retained its classification as an operating lease, the lessor must continue to recognize any underlying
assets and liabilities (e.g., the leased asset, deferred or accrued rent, and initial direct costs) on the later
of the date of initial application or the lease commencement date. The amounts recognized should
be the same as those under ASC 840. The lessor will continue to account for previously recognized
securitized receivables as secured borrowings in accordance with other GAAP because operating leases
are still not recognized financial assets for the lessor under ASC 842. In this transition scenario (i.e.,
operating lease classification was retained), the election of the practical expedient package only affects
what amounts qualify as initial direct costs. If the lessor did not elect the practical expedient package,
any unamortized initial direct costs that would not be capitalized under the changed definition of such
costs in ASC 842 should be written off as an (1) adjustment to equity if they are incurred before the date
of initial application or (2) an expense in the comparative period in which they were incurred if the lessor
does not elect the Comparatives Under 840 Option.
Connecting the Dots
Effect of Hindsight Practical Expedient on Lease Term and
Straight-Line Rent Revenue
The hindsight practical expedient may affect a lessor’s measurement of lease
component revenue. If an entity elects hindsight, the lease may include
a renewal term whose exercise was not previously considered reasonably
certain (or exclude a term whose exercise is no longer reasonably
certain but was deemed reasonably certain at lease commencement). When
there is level rent in both the initial term and renewal term, there may
be no practical effect on the measurement of lease component revenue.
However, if a lessor receives uneven rent payments (e.g., escalating
payments), the lessor may need to adjust its straight-line rent revenue
recognized (and any lease-related balance sheet items).
Example 16-3
Hummingbird Inc., a public calendar-year-end entity, leases an office building
to a tenant beginning on January 1, 2014, and
receives $12,000 per annum with a 2 percent annual
increase for a four-year noncancelable term as
well as one four-year renewal option at a 2
percent annual increase. As of lease commencement,
it is not reasonably certain that the lessee will
exercise its renewal option. On January 1, 2018,
the lease is renewed. Also, Hummingbird did not
elect the Comparatives Under 840 Option under
which it would not restate its comparative-period
financial statements under ASC 842 in the period
of adoption. Assume the following:
16.4.2 Lease Is a Direct Financing Lease or a Sales-Type Lease Under ASC 842 (Operating Lease Under ASC 840)
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards
Update . . . No. 2016-02, Leases (Topic 842) . . .
w. For each lease classified as a direct financing or a sales-type lease in accordance with this Topic, the
objective is to account for the lease, beginning on the application date as determined in (c) as if it had
always been accounted for as a direct financing lease or a sales-type lease in accordance with this Topic.
Consequently, a lessor shall do all of the following:
1. Derecognize the carrying amount of the underlying asset at the application date as determined in (c).
2. Recognize a net investment in the lease at the application date as determined in (c) as if the lease
had been accounted for as a direct financing lease or a sales-type lease in accordance with Subtopic
842-30 since lease commencement.
3. Record any difference between the amounts in (w)(1) and (w)(2) as
follows:
i. If an entity elects the transition method in (c)(1), as an adjustment to equity (if the commencement
date of the lease was before the beginning of the earliest period presented or if the lease was
acquired as part of a business combination; see also (h)(3)) or earnings (if the commencement
date of the lease was on or after the beginning of the earliest period presented).
ii. If an entity elects the transition method in (c)(2), as an adjustment to equity.
4. Account for the lease in accordance with this Topic after the application date as determined in (c). . . .
An entity that has not elected the practical expedient package must reassess the
classification of its leases under ASC 842. As noted above, for leases that were
previously classified as operating leases under ASC 840 but that are accounted
for as direct financing leases or sales-type leases under ASC 842, an entity
must “account for the lease, beginning on the application date . . . as if it had always been accounted for as a direct
financing lease or a sales-type lease” (emphasis added). That is, if the
lease classification changes for a lease that commenced before the date of
initial application, the lessor will be required to retrospectively determine
the lease balances as of lease commencement so that it can roll those balances
forward to the date of initial application. As of this date, the underlying
asset subject to the lease should be derecognized, a net investment in the lease
should be recognized, and any difference between the two balances should be
reflected as an adjustment to equity (or earnings if the lease commenced during
the comparative periods and the lessor does not elect the Comparatives Under 840
Option). After the initial recognition date, the lessor should subsequently
account for the lease (including any modifications) in accordance with ASC 842.
See Chapter 9 for
more information on the lessor’s accounting for sales-type and direct financing
leases.
Example 16-4
Company B, a calendar-year-end PBE, did not elect the practical expedient
package and, in transition, a lease of real estate that
was classified as an operating lease under ASC 840 was
determined to be a sales-type lease under ASC 842.
Further, B did not elect the practical expedient that
permits it not to restate its comparative-period
financial statements in the period of adoption. The
lease commenced in 2012. As of the date of the earliest
comparative period presented, the carrying amount of the
leased asset was $3 million. The net investment in the
lease was determined to be $3.5 million, which
represents the present value of the lease payments and
unguaranteed residual value determined as of the
commencement date and then rolled forward to the
earliest period presented. Company B would record the
following transition-related journal entry on January 1,
2017:
Connecting the Dots
Hindsight Practical Expedient May Affect Lease
Classification
The hindsight practical expedient may affect a lessor’s
classification test if the practical expedient package is not elected.
If an entity elects hindsight, the lease may include a renewal term
whose exercise was not previously considered reasonably certain (or
exclude a term whose exercise is no longer reasonably certain but was
deemed reasonably certain at lease inception), which could affect the
lease classification. Specifically, the lease term is relevant to the
determination of whether the lease term represents a major part of the
remaining economic life of the asset and whether the present value of
the lease payments exceeds substantially all of the fair value of the
underlying asset. We believe that this is only possible if the practical
expedient package is not elected. We believe that if that package is
elected, it is appropriate to retain the ASC 840 classification
regardless of the potential for hindsight to alter the lease term
assumptions used in that lease classification.
16.4.3 Lease Classified as a Direct Financing Lease or a Sales-Type Lease Under ASC 840 (and Is Still Classified as a Direct Financing Lease or a Sales-Type Lease Under ASC 842)
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards
Update . . . No. 2016-02, Leases (Topic 842) . . .
x. For each lease classified as a direct financing lease or a sales-type lease in accordance with this Topic, do
all of the following:
1. Continue to recognize a net investment in the lease at the application date as determined in (c) at
the carrying amount of the net investment at that date. This would include any unamortized initial
direct costs capitalized as part of the lessor’s net investment in the lease in accordance with Topic
840.
2. If an entity elects the transition method in (c)(1), before the effective date, a lessor shall account for
the lease in accordance with Topic 840.
3. Regardless of the transition method selected in (c), beginning on the effective date, a lessor shall
account for the lease in accordance with the recognition, subsequent measurement, presentation,
and disclosure guidance in Subtopic 842-30.
4. Beginning on the effective date, if a lessor modifies the lease (and
the modification is not accounted for as a
separate contract in accordance with paragraph
842-10-25-8), it shall account for the modified
lease in accordance with paragraph 842-10-25-16 if
the lease is classified as a direct financing
lease before the modification or paragraph
842-10-25-17 if the lease is classified as a
sales-type lease before the modification. A lessor
shall not remeasure the net investment in the
lease on or after the effective date unless the
lease is modified (and the modification is not
accounted for as a separate contract in accordance
with paragraph 842-10-25-8). . . .
As noted above, if the lease was classified as a direct financing lease or a
sales-type lease under ASC 840 and continues to be classified as a direct
financing lease or a sales-type lease under ASC 842, the lessor should
“[c]ontinue to recognize a net investment in the lease at the application date .
. . at the carrying amount of the net investment at that date.” In other words,
the lessor should generally carry over its ASC 840 accounting during the
transition period. The only exception to this general rule concerns initial
direct costs. If the lessor does not elect the practical expedient package, any
unamortized initial direct costs not capitalizable under ASC 842 must be written
off to equity (if the lease commenced before the date of initial application) or
earnings in the comparative period in which they were incurred, which is only
applicable if the lessor does not elect the Comparatives Under 840 Option.
The lessor should subsequently measure the lease (including modifications)
during the transition period in accordance with ASC 840. Beginning on the
effective date, the lessor should apply the subsequent measurement,
presentation, and disclosure guidance in ASC 842-30 as well as the modification
guidance in ASC 842-10-25 (see Section 9.3.4 for guidance on modifications).
Connecting the Dots
Impact of Hindsight on Lease Classification and Measurement of
Direct Financing Leases or Sales-Type Leases
The use of hindsight may affect the lease term and, in turn, the measurement of
direct financing or sales-type leases, because a different lease term
will typically result in different lease payments with respect to
determining the net investment in the lease.
Note that the use of hindsight will not affect lease classification if the lessor applies the practical expedient package, because that election precludes a reassessment of ASC 840 lease classification determinations.
16.4.4 Lease Is an Operating Lease Under ASC 842 (Direct Financing or Sales-Type Lease Under ASC 840)
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
y. For each lease classified as an operating lease in accordance with this Topic, the objective is to account for the lease, beginning on the application date as determined in (c), as if it had always been accounted for as an operating lease in accordance with this Topic. Consequently, a lessor shall do all of the following:
1. Recognize the underlying asset at what the carrying amount would have been had the lease been classified as an operating lease under Topic 840.
2. Derecognize the carrying amount of the net investment in the lease.
3. Record any difference between the amounts in (y)(1) and (y)(2) as follows:
i. If an entity elects the transition method in (c)(1), as an adjustment to equity (if the commencement date of the lease was before the beginning of the earliest period presented or if the lease was acquired as part of a business combination) or earnings (if the commencement date of the lease was on or after the beginning of the earliest period presented).
ii. If an entity elects the transition method in (c)(2), as an adjustment to equity.
4. Subsequently account for the operating lease in accordance with this Topic and the underlying asset in accordance with other Topics. . . .
An entity that has not elected the practical expedient package must reassess
lease classification under ASC 842. For leases previously classified as
sales-type or direct financing leases under ASC 840 that are operating leases
upon the adoption of ASC 842, the lessor should perform the steps in ASC
842-10-65-1(y) above. Further, as discussed in the Q&A below, although this
transition guidance does not specifically address other lease-related balances,
we believe that the broad objective would apply to all balances that would have
otherwise been recognized had the lease always been accounted for as an
operating lease.
Q&A 16-6 Accounting for Other Lease-Related Balances When
Transitioning From a Direct Financing Lease or Sales-Type Lease to an
Operating Lease
Example
On October 1, 2010, Company A acquired an office building that had various leases in place; as a
result, A became a lessor of office space. The lease agreements with the existing tenants included
escalating lease payments over the contract period. On the basis of the lease classification criteria
in ASC 840, A determined that the existing leases should be classified as direct financing leases.
Therefore, on the acquisition date, A recognized a net investment in the leases and accounted for
them in accordance with ASC 840.
On January 1, 2019, A adopts ASC 842 and does not elect the practical expedients
in ASC 842-10-65-1(f) or the Comparatives Under
840 Option. As a result, A evaluates the
classification criteria in ASC 842 and concludes
that its existing direct financing leases should
be classified as operating leases under ASC 842.
Such an outcome could arise for various reasons,
including use of hindsight that results in a
different assumption regarding the lease term.
Assume that the lease had been classified as an operating lease in accordance with ASC 840. As a
result of the rent escalations in the lease agreement, A then would have recognized a “straight-line
rent receivable” of $25,000 as of the earliest period presented. Similarly, as of lease commencement, A
would have recognized an in-place lease intangible, net of amortization, of $55,000, which represents
the inherent value associated with full occupancy of the property by tenants on the acquisition date.
Question
Should A recognize the straight-line rent receivable and the in-place lease intangible asset when
the lease’s classification changes from a direct financing lease under ASC 840 to an operating
lease under ASC 842?
Answer
Yes. The straight-line rent receivable and the in-place lease intangible should be established in
transition as if they had always been recorded in connection with the operating lease.
The transition method in ASC 842 is not a full retrospective approach. However, the objective
under ASC 842-10-65-1(y) is to account for a lease as if it had always been accounted for as an
operating lease in accordance with ASC 842. Therefore, while the transition guidance discusses
only certain balances (e.g., the recognition of the underlying asset at what the carrying amount
would have been had the lease been classified as an operating lease under ASC 840), we believe
that the guidance is not intended to be all-inclusive and that the broad objective would apply to
all balances that would have otherwise been recognized had the lease always been accounted
for as an operating lease.
Straight-Line Rent Receivable
On the basis of the analysis above, when A transitions to ASC 842, it should do the following as of the beginning of the earliest period presented (i.e., January 1, 2017):
- Derecognize the net investment in the lease.
- Recognize the underlying asset at what its carrying amount would have been if the lease were always accounted for as an operating lease under ASC 840.
- Recognize a straight-line rent receivable balance in the amount at which it would have been recorded if the lease was always accounted for as an operating lease under ASC 842 (i.e., $25,000, which is the build-up of a straight-line rent receivable from lease commencement to the earliest period presented when A makes the transition to ASC 842).
In addition, A should recognize any resulting difference as an adjustment to opening equity and subsequently account for the operating lease in accordance with ASC 842.
In-Place Lease Intangible
Company A should apply the guidance in ASC 805-20-25-10A and recognize an in-place lease intangible as of January 1, 2017 (i.e., the beginning of the earliest period presented). That is, A should determine what the in-place lease intangible would have been as of October 1, 2010 (the date of initial acquisition), and factor in amortization of the intangible through January 1, 2017, the beginning of the earliest year presented. The resulting amount would be the in-place lease intangible amount that would have been recognized if the lease had always been accounted for as an operating lease. Company A should recognize an in-place lease intangible of $55,000 and amortize it over the remaining lease term.
The response to this question was informally discussed with the FASB staff, which agreed with the overall conclusion reached.
Connecting the Dots
Principle Related to Accounting for the Operating Lease in
Transition
Although the scenario in the example above may not be common for many entities upon transition, we believe that the principle outlined therein — account for the operating lease in transition as if it had always been an operating lease — is critical. Specifically, we think that it is important to consider the objective of the transition guidance in each relevant paragraph of ASC 842-10-65-1.
For example, while ASC 842-10-65-1(h) describes the applicability of the
guidance as depending on whether “an entity has previously recognized an
asset or a liability in accordance with Topic 805 on business
combinations relating to favorable or unfavorable terms of an operating
lease acquired as part of a business combination,” we believe that it
would be similarly necessary to consider and carry forward other
lease-related balances that would have been recognized, such as in-place
lease intangibles.
16.4.5 Leveraged Leases
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
z. For leases that were classified as leveraged leases in accordance with Topic 840, and for which the
commencement date is before the effective date, a lessor shall apply the requirements in Subtopic 842-50. If a leveraged lease is modified on or after the effective date, it shall be accounted for as a new lease
as of the effective date of the modification in accordance with the guidance in Subtopics 842-10 and
842-30.
1. A lessor shall apply the pending content that links to this paragraph to a leveraged lease that meets
the criteria in (z) that is acquired in a business combination or an acquisition by a not-for-profit entity
on or after the effective date. . . .
Leveraged lease accounting is a special type of accounting that a lessor can
apply under ASC 840 for certain direct financing leases that meet specific
criteria (see ASC 840-10-25-43(c)). The unique economic effect of leveraged
lease accounting stems from a combination of nonrecourse financing and a cash
flow pattern that typically enables the lessor to recover its investment in the
early years of the lease (as a result of tax benefits generated by depreciation,
interest, and ITC deductions) and, thereafter, affords it the temporary use of
funds from which additional income can be derived.
The accounting for leveraged leases is complex but is based on two basic
premises:
-
The lessor’s balance sheet reflects the lessor’s equity in the property on an after-tax basis, net of the related debt.
-
The lessor’s income statement reflects an after-tax constant rate of return on the lessor’s net investment. During periods in which the net investment is zero or below zero, no income is recognized.
Although ASC 842 removed leveraged lease accounting, leases that met the definition of a leveraged
lease under ASC 840 and commenced before the effective date of ASC 842 are grandfathered in and are
addressed in ASC 842-50 (see Section 9.5). A leveraged lease that is modified on or after the effective
date (including an extension option whose exercise was not previously reasonably assured) must be
accounted for as a new lease in accordance with ASC 842 (i.e., because leveraged lease accounting has
been discontinued).
16.4.6 Leases for Which a Lessor Elects the Practical Expedient Related to Not Separating Lease and Nonlease Components
ASC 842-10
65-2 The following represents the transition and effective date information related to Accounting Standards Update No. 2018-11, Leases (Topic 842): Targeted Improvements:
- An entity that has not yet adopted the pending content that links to paragraph 842-10-65-1 shall apply the pending content that links to paragraph 842-10-65-2, by class of underlying asset, to all new and existing leases when the entity first applies the pending content that links to paragraph 842-10-65-1 and shall apply the same transition method elected for the pending content that links to paragraph 842-10-65-1.
- An entity that has adopted the pending content that links to paragraph 842-10-65-1 shall apply the pending content that links to this paragraph, by class of underlying asset, to all new and existing leases either:
- In the first reporting period following the issuance of the pending content that links to paragraph 842-10-65-2
- At the original effective date of this Topic for that entity as determined in paragraph 842-10-65-1(a) and (b).
- An entity that has adopted the pending content that links to paragraph 842-10-65-1 shall apply the pending content that links to this paragraph, by class of underlying asset, to all new and existing leases either:
- Retrospectively to all prior periods beginning with the fiscal years in which the pending content that links to paragraph 842-10-65-1 was initially applied
- Prospectively.
In July 2018, the FASB issued ASU 2018-11, which provided a
practical expedient under which lessors can elect, by class of underlying asset,
not to separate lease and nonlease components when certain criteria are met. The
effective date of ASU 2018-11 was aligned with that of ASU 2016-02.23
Entities that early adopted ASU 2016-02 before the issuance of ASU 2018-11 could
apply the lessor practical expedient to all new and existing leases either
retrospectively or prospectively and could elect to apply it as of either (1)
the lessor’s first reporting period (interim or annual) after the issuance of
ASU 2018-11 or (2) the mandatory effective date of ASC 842 (i.e., January 1,
2019, for calendar-year-end public entities). For example, an entity that early
adopted ASU 2016-02 and elected the practical expedient may have decided not to
recast past periods already presented under ASC 842, thereby choosing
prospective application. However, from its date of initial application forward,
the election would apply to all existing and new leases.
A lessor electing the practical expedient would be required to apply it to all
new and existing transactions within a class of underlying assets that qualify
for the expedient as of the date elected. That is, a lessor would not be
permitted to apply the practical expedient only to new or modified transactions
within a class of underlying assets. (See Sections 4.3.3.2 and 17.3.1.4.2 for further
discussion of this practical expedient.)
16.4.7 ASU 2018-20 on Narrow-Scope Improvements for Lessors
ASC 842-10
65-3 The following represents the transition and effective date information related to Accounting Standards Update No. 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors:
- An entity that has not yet adopted the pending content that links to paragraph 842-10-65-1 shall apply the pending content that links to this paragraph [842-10-65-3] to all new and existing leases when the entity first applies the pending content that links to paragraph 842-10-65-1 and shall apply the same transition method elected for the pending content that links to paragraph 842-10-65-1.
- An entity that has adopted the pending content that links to paragraph 842-10-65-1 before the issuance of the pending content that links to this paragraph shall adopt the pending content that links to this paragraph to all new and existing leases at the original effective date of this Topic for that entity as determined in paragraph 842-10-65-1(a) through (b). Alternatively, an entity that has adopted the pending content that links to paragraph 842-10-65-1 may adopt the pending content that links to this paragraph to all new and existing leases either:
-
In the first reporting period ending after the issuance of the pending content that links to this paragraph
-
In the first reporting period beginning after the issuance of the pending content that links to this paragraph
-
- An entity that has adopted the pending content that links to paragraph 842-10-65-1 before the issuance of the pending content that links to this paragraph shall apply the pending content that links to this paragraph to all new and existing leases either:
-
Retrospectively to all prior periods beginning with the fiscal years in which the pending content that links to paragraph 842-10-65-1 was initially applied
-
Prospectively.
-
In December 2018, the FASB issued ASU 2018-20, which
addresses certain requests made by stakeholders regarding implementation issues
associated with ASU 2016-02, specifically the accounting for the following by
lessors:
-
“Sales taxes and other similar taxes collected from lessees.”
-
Lessor costs paid by a lessee directly to a third party.
-
“Recognition of variable payments for contracts with lease and nonlease components.”
See Section
17.3.1.5 for detailed discussion of this ASU.
The effective date of ASU 2018-20 was aligned with that of ASU 2016-02.
If an entity had already adopted ASU 2016-02 as of the date of issuance of ASU
2018-20, the entity could adopt ASU 2018-20 by using the mandatory effective
dates of ASU 2016-02. Alternatively, an entity could elect to apply ASU 2018-20
as of either (1) the first reporting period ending after the issuance of the ASU
or (2) the first reporting period beginning after the issuance of the ASU. In
addition, entities that elected to early adopt the ASU could apply it either (1)
prospectively or (2) retrospectively to all prior periods beginning with the
fiscal years in which ASC 842 was initially applied.
All entities should consistently apply the amendments to all leases existing as of the date on which ASU 2018-20 is initially applied and to new leases entered into after that date.
16.4.8 ASU 2019-01 on Codification Improvements
ASC 842-10
65-4 The following represents
the transition and effective date information related to
Accounting Standards Updates No. 2019-01, Leases
(Topic 842): Codification Improvements, No.
2019-10, Financial Instruments — Credit Losses (Topic
326), Derivatives and Hedging (Topic 815), and
Leases (Topic 842): Effective Dates, and No.
2020-05, Revenue From Contracts With Customers (Topic
606) and Leases (Topic 842): Effective Dates for
Certain Entities:
-
All entities within the scope of paragraph 842-10-65-1(a) shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years (with an exception for those entities that have not yet issued their financial statements or made financial statements available for issuance as described in the following sentence). A not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market that has not yet issued financial statements or made financial statements available for issuance as of June 3, 2020 shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. All other entities shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application is permitted.
-
An entity shall apply the pending content that links to this paragraph as of the date that it first applied the pending content that links to paragraph 842-10-65-1 and shall apply the same transition method elected for the pending content that links to paragraph 842-10-65-1 in accordance with paragraph 842-10-65-1(c).
In March 2019, the FASB issued ASU 2019-01, which makes
Codification improvements related to the following three issues under ASC 842:
- Determination of the fair value of the underlying asset by lessors that are not manufacturers or dealers.
- Presentation in the statement of cash flows for sales-type and direct financing leases by lessors within the scope of ASC 942.
- Clarification of interim disclosure requirements during transition.
See Section 17.3.1.7 for detailed
discussion of this ASU.
The ASU became effective for (1) public companies for fiscal
years beginning after December 15, 2019, and interim periods therein; (2) public
NFP entities (that have not issued or made financial statements available for
issuance as of June 3, 2020) for fiscal years beginning after December 15, 2019,
and interim periods therein; and (3) all other entities for fiscal years
beginning after December 15, 2021, and interim periods beginning after December
15, 2022. Early adoption was permitted.
All entities should consistently apply the transition method elected for ASU
2016-01 and its subsequent amendments when adopting the guidance in this ASU.
Footnotes
23
ASU 2019-10 delayed the effective date of ASU 2016-02
for all nonpublic companies. ASU 2020-05 further delayed the effective
date for all nonpublic companies as well as for certain public NFPs.
(See further discussion in Section 16.1.) The new effective
date for nonpublic companies was annual periods beginning after December
15, 2021, and interim periods within fiscal years beginning after
December 15, 2022. The effective date for public NFPs that qualify for
the deferral under ASC 842-10-65-1(a) was annual periods beginning after
December 15, 2019, and interim periods therein. The effective date for
all other public companies remained unchanged. The delayed effective
date for nonpublic companies also applied to all other ASUs associated
with ASU 2016-02.
16.5 Transition Relief
Under ASC 842’s modified transition approach, an entity must apply the standard
as of the earliest period presented (or as of the effective date if the Comparatives
Under 840 Option is elected). In addition, the standard contains practical
expedients that an entity may elect when adopting the standard as well as other
transition guidance intended to make adoption easier. For example, the so-called
run-off approach described in the Background Information and Basis for Conclusions
of ASU 2016-02 was meant to make the transition from providing ASC 840 disclosures
to recognizing a lease under ASC 842 less cumbersome. Specifically, paragraph BC390
of ASU 2016-02 states, in part:
The practical effect of the modified retrospective
transition method, particularly when combined with the practical expedients
that are offered, is that an entity will “run off” those leases existing at
the beginning of the earliest comparative period presented in accordance
with previous GAAP with the exception that, for operating leases, a
lessee will present a lease liability in the statement of financial position
at each reporting date equal to the present value of the remaining
minimum rental payments (as that term was applied in previous
GAAP) and a right-of-use asset that is derived from the lease liability in
the manner described in paragraph 842-20-35-3. Entities will, in effect,
“run off” existing leases, as described, unless the lease is either
modified (and that modification is not accounted for as a separate contract)
or, for lessees only, the lease liability is remeasured in accordance with
the subsequent measurement guidance in [ASC 842-3024] on or after the effective date.
In theory, a lessee should be able to measure its lease obligations on the basis of the amounts disclosed in its future minimum rental payments table under ASC 840 (see Q&A 16-1 for additional discussion). Similarly, a lessor should be able to run off its existing leases by using its ASC 840 allocation to income streams deemed within the scope of the leasing standard. The transition relief of the run-off approach for preparers is premised on the fact that the entity prepared its previous ASC 840 disclosures completely and accurately.
16.5.1 Hindsight Practical Expedient
ASC 842-10
65-1 The following
represents the transition and effective date information
related to Accounting Standards Update . . . No.
2016-02, Leases (Topic 842) . . .
g. An entity also may elect a practical
expedient, which must be applied consistently by
an entity to all of its leases (including those
for which the entity is a lessee or a lessor) to
use hindsight in determining the lease term (that
is, when considering lessee options to extend or
terminate the lease and to purchase the underlying
asset) and in assessing impairment of the entity’s
right-of-use assets. This practical expedient may
be elected separately or in conjunction with
either one or both of the practical expedients in
(f) and (gg). . . .
As noted above, as part of its transition to ASC 842, an entity may elect to use hindsight “in determining the lease term . . . and in assessing impairment” of ROU assets. The hindsight practical expedient does not need to be elected in conjunction with the practical expedient package (see Section 16.5.2).
Q&A 16-7 Application of the Use-of-Hindsight Practical
Expedient
Paragraph BC394 of ASU 2016-02 states, in part:
While an entity does not need to use hindsight, the FASB contends
that using hindsight in transition results in better information for
users.
[T]he Board considered that a similar practical
expedient related to the use of hindsight in determining the
transaction price (that is, estimating variable consideration)
was provided in the transition requirements in Topic 606.
Similar to the rationale for that expedient, the Board decided
that reflecting expectations that an entity knows at the time of
reporting are incorrect does not provide useful information to
users. In the context of this practical expedient, the Board
considered that it would generally not provide useful
information to recognize a lease liability on the basis of a
lease term that assumes the entity is reasonably certain to
exercise an option to extend the lease when at the time of
reporting the entity knows that it did not exercise that option.
Question 1
When applying the use-of-hindsight practical expedient,
should an entity consider only discrete events (e.g., the lessee’s
renewal of the lease) that occurred between the original lease
commencement date and the date of adoption?
Answer
No. In addition to discrete events, an entity that
applies the use-of-hindsight practical expedient should consider changes
in facts and circumstances from commencement through the effective date
of ASC 842 when determining the lease term and assessing the impairment
of the ROU asset. For example, in addition to known events, such as the
lessee’s exercise of renewal options, an entity should consider other
events and changes, as discussed in ASC 842-10-55-26 (e.g., a strategic
shift in business, changes in market rentals, evolution of the industry
as a whole), that may affect whether it is reasonably certain that the
lessee will exercise (or not exercise) any remaining renewal options.
The response to this question was informally discussed with the FASB
staff, which agreed with the overall conclusion reached.
Question 2
To which date does the hindsight assessment extend when
an entity applies the use-of-hindsight practical expedient?
Answer
When performing its hindsight assessment, an entity must
consider events and circumstances that occurred up to the effective date
of ASC 842.
Example
In 2003, Company A entered into
a 15-year lease of a store that included three
5-year renewal options. None of the renewals were
deemed reasonably assured to be exercised at
inception. On January 1, 2019, when A adopts ASC
842, it elects to apply the use-of-hindsight
practical expedient. Since the execution of the
lease, the following events occurred:
-
On November 9, 2017, A exercised the first of the three 5-year renewal options.
-
During 2018, the market rent in the area had increased to a point such that A’s rent is now significantly discounted.
-
On January 15, 2019, A’s CEO decided on a strategic shift in business such that the company would exit brick-and-mortar retail and move to online only.
When applying hindsight in
determining the lease term, A should consider the
events that occurred up to the effective date of
ASC 842. Therefore, since A adopted ASU 2016-02 as
of January 1, 2019, A should consider (1) that it
exercised the first renewal option in 2017 and (2)
the effect of the significant increase in market
rent in 2018 in its assessment of whether it would
exercise additional renewal options. Company A
should not consider its decision to exit
brick-and-mortar retail when evaluating the lease
term, since this event occurred after the
effective date of ASC 842.
16.5.1.1 Impact of Hindsight on the Lease Term
The use of hindsight in transition may affect the lease term (see Section 5.2 for a discussion of lease term).
If the practical expedient package described in Section 16.5.2 is not elected, the
impact of the hindsight practical expedient on lease term could affect lease
classification (e.g., a renewal option that is assumed to be exercised
results in a longer lease term and therefore higher lease payments, both of
which increase the likelihood that a lease is a finance lease or sales-type
lease). Regardless of whether lease classification is affected, an entity’s
application of hindsight in establishing the lease term may affect the
initial measurement of a lease. Any change in the lease term as a result of
applying the use-of-hindsight practical expedient should be reflected in the
measurement of the related lease assets and lease liabilities (i.e., any
lease assets or liabilities should be adjusted as if the lease term
determined by using hindsight had always applied). For example, when
operating lease payments are not even throughout the lease term, the
application of a different lease term would have changed the cumulative
straight-line income or expense recognized as of the date of initial
application of ASC 842. This cumulative difference should be reflected in
the lease assets and liabilities as of the date of initial application of
ASC 842, with a corresponding cumulative-effect adjustment to equity. This
is consistent with the overall objective of the use-of-hindsight practical
expedient, which, as described in paragraph BC394 of ASU 2016-02, is to
provide “more accurate, updated information to users.”
Example 16-5
Retailer, a calendar-year-end PBE, enters into a 10-year operating lease of
retail space on January 1, 2014. Annual lease
payments are $50,000 for the first five years and
$60,000 for the next five years. Retailer has a
five-year renewal option for $70,000 per year, for
which exercise is not reasonably assured as of lease
inception. Therefore, as of the adoption date of ASC
842 on January 1, 2019, Retailer has recorded
cumulative straight-line lease expense of $275,000
and has a deferred rent balance of $25,000.
Retailer elects the Comparatives Under 840 Option and the use-of-hindsight practical expedient. Because significant leasehold improvements have been installed in 2018, Retailer concludes that exercise of
the renewal option is reasonably certain as of January 1, 2019. Accordingly, Retailer recalculates the deferred rent balance as if the lease
term had always been 15 years. Since the cumulative straight-line lease expense would have been $300,000
instead of $275,000, Retailer increases the deferred rent balance in transition from $25,000 to $50,000 (which
is then subtracted from the opening ROU asset balance), with a corresponding debit to equity.
Q&A 16-7A Impact of Hindsight on Lease Classification
Question
If an entity elects both the use-of-hindsight practical expedient and the “package of three” practical expedients, is the entity required or permitted to reassess lease classification when the lease term changes as a result of applying the use-of-hindsight practical expedient?
Answer
No. We believe that the “package of three” practical expedients has priority over the use-of-hindsight practical expedient with respect to lease classification. Because one of the practical expedients in the “package of three” allows an entity not to reassess lease classification for existing leases, a change in the lease term resulting from the use-of-hindsight practical expedient would not override the entity’s election not to reassess lease classification. However, as stated above, if an entity does not elect the “package of three” practical expedients, a change in the lease term resulting from the use-of-hindsight practical expedient could affect the lease classification.
Connecting the Dots
Hindsight May Increase Complexity
While the election of hindsight may result in a more accurate reflection of the
measurement of ROU assets and liabilities in transition, it creates
complexity for lessors or lessees. The modified retrospective
approach, in combination with the practical expedient package, gives
entities the opportunity to apply the existing ASC 840 accounting
and disclosure requirements during the transition period (provided
that the entity does not elect the Comparatives Under 840 Option,
which would eliminate the transition period). For example, a lessee
can use the original assumptions for operating leases for its
existing ASC 840 disclosures and to capitalize the present value of
those minimum rental payments. Because hindsight directly affects
the lease term, the inclusion of additional periods in the lease
term may affect straight-line rent calculations for lessors and
lessees as well as the measurement of lease liabilities.
16.5.1.2 The Impact of Hindsight on Impairment
ASC 842 indicates that, if hindsight is elected in transition, the impairment of
an ROU asset by a lessee may be affected. However, as discussed in Q&As 16-4 and
16-4A, an ROU asset does not
generally need to be tested for impairment during the transition period,
given the interaction with ASC 360 and feedback from the FASB staff.
Therefore, we generally believe that the use of hindsight in the assessment
of impairment will not affect the measurement of an ROU asset in transition,
except when (1) an entity does not elect the Comparatives Under 840 Option,
(2) a hidden impairment exists within an asset group that includes an ROU
asset (as discussed in Q&A 16-4A), and (3) the impairment event arose during
the comparative periods.
16.5.2 Practical Expedient Package
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients, which must be elected as a package and applied
consistently by an entity to all of its leases (including those for which the entity is a lessee or a lessor),
when applying the pending content that links to this paragraph to leases that commenced before the
effective date:
1. An entity need not reassess whether any expired or existing contracts are or contain leases.
2. An entity need not reassess the lease classification for any expired or existing leases (for example, all
existing leases that were classified as operating leases in accordance with Topic 840 will be classified
as operating leases, and all existing leases that were classified as capital leases in accordance with
Topic 840 will be classified as finance leases).
3. An entity need not reassess initial direct costs for any existing leases. . . .
An entity has the option of electing the practical expedient package in transition, provided that it elects
all of them and applies them consistently to all of its leases.
16.5.2.1 Whether a Contract Is or Contains a Lease
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
1. An entity need not reassess whether any expired or existing contracts are or contain leases. . . .
An entity that elects this practical expedient would not revisit whether a
contract is or contains a lease under the ASC 842 definition of a lease. In
other words, if an entity appropriately determines whether a contract is or
contains a lease under ASC 840 before the effective date of ASC 842, the
entity would not reevaluate that conclusion (i.e., the entity would carry
forward the conclusions reached under ASC 840 even though it may reach a
different conclusion under ASC 842). After the effective date of ASC 842, if
there is a substantive change to the terms and conditions of a contract, the
entity should reassess whether the contract is or contains a lease under ASC
842. See Section 8.6.1.1 for
additional discussion.
Changing Lanes
Definition of a Lease
The definition of a lease under ASC 842 is broadly similar to that under ASC
840; however, there are differences that can affect the
determination of whether a lease exists. For example, under ASC 840,
a lease can exist if it is remote that more than a minor amount of
the output or other utility of PP&E will be received by a party
other than the reporting entity. Under ASC 842, that condition alone
would not cause a contract to contain a lease. Rather, in addition
to receiving substantially all of the output (benefits), a reporting
entity must have control over HAFWP the asset is used. Therefore, in
some instances, a contract containing a lease under ASC 840 will not
contain a lease under ASC 842. The inverse is less likely (i.e., a
contract that does not meet the definition of a lease under ASC 840
but does meet the definition under ASC 842). See Chapter 3 for
more information on how to identify a lease within the definition of
ASC 842, including a description of the changes from ASC 840.
Connecting the Dots
Identification Errors May Not Be Carried Forward
In applying the practical expedient in ASC 842-10-65-1(f)(1), entities may not
carry forward any previous “errors” (i.e., incomplete identification
of leases). In certain circumstances, for example, an entity may not
have previously identified contracts that met the definition of a
lease under ASC 840. This lack of identification may not have had a
material impact on the entity’s financial statements because the
resulting accounting may have had a similar impact on profit or loss
(e.g., an executory contract and an operating lease may have had
similar profit and loss profiles). Similarly, lessors may not have
properly identified which income streams are within the scope of ASC
840 and which are within the scope of the revenue recognition
guidance in ASC 605 or ASC 606. This failure to identify the scope
of the contracts may not have had a material impact on the financial
statements of an entity under ASC 840 because the resulting
accounting would have a similar impact on profit or loss. However,
because ASC 842 prescribes on-balance-sheet treatment for most
leases, the accounting related to properly identifying all leases
may materially affect the entity’s financial statements under ASC
842. Similarly, it will be important for a lessor to identify
contracts that contain leases because of differences between ASC 842
and ASC 606 regarding classification, recognition, subsequent
measurement, and disclosures.
An entity that applies the practical expedient in ASC 842-10-65-1(f)(1) should
ensure that its identification of leases under ASC 840 was complete
and accurate.
Q&A 16-8 Whether Arrangements Entered Into Before May 28,
2003, Are Accounted for as Leases
EITF Issue 01-8 (codified in ASC 840) was updated in 2003 and defined the scope of contracts (or parts of contracts) that should be accounted for as leases. EITF Issue 01-8 indicated that it
only applied to “(a) arrangements agreed to or committed to,
[footnote omitted] if earlier, after the beginning of an entity’s next reporting period beginning after May 28, 2003, (b) arrangements modified after the beginning of an entity’s next reporting period beginning after May 28, 2003, and (c) arrangements acquired in business combinations initiated after the beginning of an entity’s next reporting period beginning after May 28, 2003.” Therefore, there are contracts that otherwise would have been considered leases in accordance with the definition in EITF Issue 01-8 (as codified in
ASC 840) but were previously not accounted for as leases because
they did not meet the effective-date criteria in (a)–(c) above.
Question
If an entity elects the practical expedient package,
would a contract that was not previously accounted for as a lease
because of the above effective dates (but that otherwise meets the
definition of a lease in accordance with ASC 840) need to be
considered a lease in the transition to ASC 842?
Answer
No. Contracts that qualified for exclusion from the
scope of ASC 840 would not be considered leases in the transition to
ASC 842. Since the practical expedient applies, an entity is not
required to change any of its conclusions that it appropriately
reached under ASC 840.
16.5.2.2 Lease Classification
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
2. An entity need not reassess the lease classification for any expired or existing leases (for example, all
existing leases that were classified as operating leases in accordance with Topic 840 will be classified
as operating leases, and all existing leases that were classified as capital leases in accordance with
Topic 840 will be classified as finance leases). . . .
By electing the above practical expedient, an entity can retain its classification conclusion under ASC
840. In other words, a lease that was deemed an operating lease under ASC 840 will be an operating
lease in the transition to ASC 842 (conversely, a lease that was deemed a capital lease under ASC
840 will be a finance lease). This practical expedient applies to all comparative periods presented,
if applicable. On or after the effective date, the previous lease classification is retained (and not
reassessed) unless the contract is modified or a reassessment event described in ASC 842-10-25-1 takes place.
Q&A 16-9 Impact of Electing the Practical Expedient Package on
Separating Land From a Building
Under ASC 840, in classifying a lease involving both land and a building, an entity is required to assess the land separately from the building when (1) the lease meets either the transfer-of-ownership or the bargain-purchase-option classification criteria or (2) the fair value of the land is 25 percent or more of the total fair value of the leased property at lease inception. Under ASC 842, as discussed in Section 4.2.2, land must be accounted for as a separate lease component (regardless of its relative fair value) unless the accounting effect of doing so would be insignificant.
Question
Does an entity that elects the practical expedient package need to separately
assess lease classification for the land in transition to ASC 842 if
it was considered part of a single lease component with a building
under ASC 840?
Answer
No. An entity should not assess lease classification for the land separately upon adopting ASC 842. Rather, the practical expedient package applies to all lease classification determinations appropriately made in accordance with ASC 840.
Changing Lanes
Classification Under ASC 842 May Differ From That Under ASC
840
The impact of this practical expedient will depend on whether an entity’s policies for lease classification under ASC 842 differ from those under ASC 840. The terminology in two of the lease criteria is more principles-based under ASC 842. Specifically, in ASC 842, the FASB substituted the terms (1) “major part” for the 75 percent bright line related to the length of the lease term and (2) “substantially all” for the 90 percent bright line related to the present value of lease payments. However, the Board acknowledged that an entity may use those bright lines to apply the principles. Further, while the lease classification assessment under ASC 842 is performed as of lease commencement, ASC 840 requires entities to determine classification as of lease inception. See Chapters 8 and 9 for more information on how lessees and lessors, respectively, classify a lease under ASC 842, including a description of the changes from ASC 840.
Connecting the Dots
Classification Errors May Not Be Carried Forward
In applying the practical expedient in ASC 842-10-65-1(f)(2), an entity may not
carry forward any previous “errors” (i.e., incorrect lease
classification).
An entity that applies the practical expedient in ASC 842-10-65-1(f)(2) should ensure that its classification of leases under ASC 840 was accurate.
Q&A 16-10 Inception Date Before Effective Date but Commencement
Date After Effective Date
If an entity elects the practical expedient package and therefore retains its ASC 840 lease
classification conclusions up to ASC 842’s effective date, the entity must determine the
appropriate cutoff for contracts that are within the scope of the ASC 840 classification.
Question
For an entity that elects the practical expedient package, if the inception date
of a lease contract (i.e., the date the contract is executed)
precedes the effective date of ASC 842 but the commencement date of
the lease is on or after the effective date of ASC 842, should the
entity carry forward its classification25 conclusion under ASC 840 or apply the ASC 842 classification
criteria as of the commencement date?
Answer
The entity should apply ASC 842 as of the commencement date. In accordance with ASC 842-10-
65-1(f), the practical expedient package applies to “leases that commenced before the effective
date.” Therefore, while an entity may have evaluated classification at the inception of the lease
agreement under ASC 840, such considerations should be disregarded even if the practical
expedient is elected.
Connecting the Dots
Impact of Hindsight on Lease Classification
Considerations
The application (or lack thereof) of hindsight has
no impact on the lease classification considerations when the
practical expedient package is also elected. However, hindsight
would affect measurement for lessees and lessors in situations in
which the exercise (or nonexercise) of options that existed in the
original contracts became reasonably certain before the effective
date.
Q&A 16-11 Classification Date When Practical Expedient
Package Is Not Elected
Question
Upon transition to ASC 842, if a lease commenced
before the date of initial application and an entity did not elect
the practical expedient package, what date should the entity use to
determine lease classification as of the date of initial
application?
Answer
In such cases, the lease should be classified in
accordance with the ASC 842 lease classification criteria and facts
and circumstances as of the later of the (1) lease commencement date
or (2) date the lease was last modified in accordance with ASC 840.
If a lease was renewed or extended before the date of initial
application, the renewal or extension date would be considered the
lease commencement date for this purpose unless the renewal was
assumed to be reasonably certain as of the initial lease
commencement date.
Example
Entity A, a public
calendar-year-end entity, enters into a lease
agreement and obtains the right to use an office
building on June 1, 2013. On June 1, 2016, A and
the lessor modify the terms of the lease to reduce
the leased space and increase the lease payments
on the remaining space to reflect current market
rates. The change to the terms represents a
modification in accordance with ASC 840-10-35-4.
As a public calendar-year-end entity that did not
elect the practical expedient package, A must
determine the appropriate classification of the
lease as of the date of initial application.
Because the lease was modified after lease
commencement, the lease classification assessment
is performed under ASC 842 as of June 1, 2016 (the
ASC 840 modification date).
The Q&A above addresses
the date as of which to assess lease
classification and what inputs should be used as
of the assessment date. The inputs used (e.g.,
lease payments and discount rate) as of the
classification date would not be the same for
measurement of the lease. For example, for an
operating lease that commenced before the date of
initial application, an entity should measure the
lease obligation and ROU asset by using the
remaining lease payments and discount rate that
existed as of the date of initial application.
16.5.2.3 Initial Direct Costs
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards Update . . . No. 2016-02, Leases (Topic 842) . . .
f. An entity may elect the following practical expedients . . .
3. An entity need not reassess initial direct costs for any existing leases. . . .
This practical expedient permits a company to carry forward previously capitalized initial direct costs under ASC 840, which would be included in the ROU asset. ASC 842 narrows the definition of initial direct costs as follows:
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
See Section 6.11
for more information on the scope of, and accounting for, initial direct
costs.
16.5.3 Land Easements
ASC 842-10
65-1 The following represents the transition and effective date information related to Accounting Standards
Update . . . No. 2016-02, Leases (Topic 842) . . .
gg. An entity also may elect a practical expedient to not assess whether existing or expired land easements
that were not previously accounted for as leases under Topic 840 are or contain a lease under this
Topic. For purposes of (gg), a land easement (also commonly referred to as a right of way) refers to
a right to use, access, or cross another entity’s land for a specified purpose. This practical expedient
shall be applied consistently by an entity to all its existing and expired land easements that were not
previously accounted for as leases under Topic 840. This practical expedient may be elected separately
or in conjunction with either one or both of the practical expedients in (f) and (g). An entity that elects
this practical expedient for existing or expired land easements shall apply the pending content that
links to this paragraph to land easements entered into (or modified) on or after the date that the entity
first applies the pending content that links to this paragraph as described in (a) and (b). An entity that
previously accounted for existing or expired land easements as leases under Topic 840 shall not be
eligible for this practical expedient for those land easements. . . .
The FASB received a significant amount of feedback from stakeholders in several
industries who were concerned about the cost and complexity of evaluating all
existing land easements under ASC 842’s definition of a lease at transition. The
Board observed that the costs of requiring an entity to evaluate all existing
land easements under ASC 842’s definition of a lease outweighed the benefits to
financial statement users. Accordingly, the FASB provided transition relief in
the form of a practical expedient. See Section 2.4 for more information about the
scope of, and accounting for, land easements.
An entity that elects the expedient is relieved from applying ASC 842 to
evaluate all existing land easements that were not previously accounted for in
accordance with ASC 840. The FASB explains in paragraph BC15 of ASU 2018-01 that
the historical accounting treatment for existing land easements — when the
expedient is elected — would be “run off” unless or until the arrangement is
modified on or after the date the entity adopts ASU 2016-02.
The transition practical expedient for existing land easements may be elected alone or with any of
the other transition practical expedients. In a manner consistent with the other transition practical
expedients, entities must disclose whether they are electing the transition practical expedient for land
easements.
The effective date of ASU 2018-01 is aligned with that of ASU 2016-02.
Footnotes
24
See footnote 13.
25
Although this Q&A specifically addresses
classification, we believe that the same conclusion would
apply to the entire practical expedient package. For
example, an entity that has elected the practical expedient
package should reassess whether a contract is or contains a
lease (under the ASC 842 definition of a lease) if the lease
commencement date would be on or after the effective date of
ASC 842.
16.6 Illustrative Examples — Transition Approaches
In summary, there are several potential
transition approaches an entity may select, some of which will affect lease
classification:
As discussed above, hindsight does not affect lease classification, when the
practical expedient package is also elected, but may have an impact on lease
measurement in transition. The examples below illustrate the potential impact of
these approaches on sample leases. These examples should be read in conjunction with
the guidance above and the “Modifications and Reassessment of Lease Liability in
Comparative Periods” discussion in Section 16.3.1. In all examples, assume that the entity is a
calendar-year-end public entity; the entity’s adoption date is January 1, 2019; the
entity did not elect the Comparatives Under 840 Option; and the entity’s earliest
comparative period presented is January 1, 2017.
Lease A | Transition Impact |
---|---|
Lessee or Lessor? Lessee Lease Inception: February 10, 2015 Lease Commencement: February 14, 2015 Original Lease Term: 10 years ASC 840 Lease Classification: Operating
Other Terms: No renewal options or purchase
options | |
Approaches A and B | Retain the operating lease classification upon transition,
because the practical expedient package was elected. The
election of hindsight has no impact on lease term because
there are no renewal options to consider. |
Approaches C and D | Assess lease classification under ASC 842 as of the
commencement date of the lease (i.e., February 14, 2015).
The election of hindsight has no impact on lease term
because there are no renewal options to consider. |
Lease B | Transition Impact |
---|---|
Lessee or Lessor? Lessee Lease Inception: February 10, 2015 Lease Commencement: February 14, 2015 Lease Term: Three years, exercise of renewal option not reasonably
assured as of lease inception ASC 840 Lease Classification: Operating Other Terms: One two-year renewal option, no purchase option; renewal
option was exercised in 2018 Previous ASC 840 Considerations: Upon renewal, the lease was also
classified as an operating lease under ASC 840 | |
Approach A | Retain the operating lease classifications in all periods
presented, because the practical expedient package was
elected. For measurement purposes, since hindsight was
elected, the renewal exercised in 2018 would be included
retrospectively, as if its exercise were reasonably certain,
in the measurement of the lease as of the earliest period
presented. |
Approach B | Retain the operating lease classifications in all periods presented, because the practical expedient package was elected. Do not alter ASC 840 accounting performed in 2018 other than to increase the lease liability and the ROU asset (because the renewal option is exercised). |
Approach C | Assess lease classification under ASC 842 as of the commencement date (i.e., February 14, 2015). Since hindsight is elected, the exercised renewal would affect lease term for both the ASC 842 classification test and the measurement of the lease as of the earliest period presented. |
Approach D | Assess lease classification under ASC 842 as of the commencement date (i.e., February 14, 2015). Since hindsight was not elected, the exercised renewal would not affect the original lease term as of lease commencement for the ASC 842 classification test. If lease classification did not change upon the adoption of ASC 842, do not alter ASC 840 accounting performed in 2018 other than to increase the lease liability and the ROU asset (because the renewal option is exercised). However, if the lessee concludes that the lease is a finance lease upon adopting ASC 842 (i.e., classification changed), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods.
See “Modifications and Reassessment of Lease Liability” in Section 16.3.1 for more information. |
Lease C | Transition Impact |
---|---|
Lessee or Lessor? Lessee
Lease Inception: February 10, 2015
Lease Commencement: February 14, 2015 Lease Term: 8 years ASC 840 Lease Classification: Capital
Other Information: The lessee and lessor modified
the terms of the contract so that the lessee would
pay less rent over the remaining lease term on
August 6, 2017
Previous ASC 840 Considerations: Modification
would have changed classification if the terms
were in effect as of the original lease inception;
new contract was deemed an operating lease as
of August 6, 2017 | |
Approaches A and B | Because the practical expedient package was elected, ASC
840 accounting should be retained in the comparative
periods. Therefore, the lessee should retain finance (capital)
lease classification as of the earliest comparative period
through the date of modification and retain operating
lease classification as of the modification date for the new
lease contract. Further, hindsight does not affect this fact
pattern because the modification only affected the amount
the lessee would pay, which had no effect on the lease
term. In addition, a modification should never result in an
adjustment to the lease balances in transition before the
modification date. |
Approaches C and D | Assess lease classification under ASC 842 as of the commencement date (i.e.,
February 14, 2015). The transition guidance is not
clear on situations in which the practical
expedient package is not elected and a
modification occurs during the transition period.
In accordance with the principles discussed in
Section 16.3.1, when lease
classification does not change upon the adoption
of ASC 842, the ASC 840 subsequent-measurement
guidance would be applied until the effective date
(i.e., January 1, 2019). However, this principle
appears incompatible with Approaches C and D,
because the practical expedient package was not
elected. That is, for a modification date of
August 6, 2017, an entity is required to perform
an additional lease classification determination
under ASC 842. We believe that there may be
multiple acceptable approaches to analyzing this
lease, including applying the ASC 842 modification
and reassessment guidance entirely under ASC 842
or a mixed model that takes into account relevant
concepts from both ASC 840 and ASC 842. If the lessee concludes that the lease is an operating lease at lease
commencement upon adopting ASC 842 (i.e., classification
changed), all of the ASC 842 reassessment and
subsequent-measurement guidance should be applied during the
comparative periods (see Section 16.3.2.2). Hindsight does not affect this fact pattern because the modification only affected the amount the lessee would pay, which had no effect on the lease term. In addition, a modification should never result in an adjustment to the lease balances in transition before the modification date. |
Lease D | Transition Impact |
---|---|
Lessee or Lessor? Lessor Lease Inception: August 9, 2006 Lease Commencement: September 2, 2006 Lease Term: 12 years ASC 840 Lease Classification: Operating
Other Terms: The lessor and lessee modified the
terms of the contract for the lessee to extend the
lease for an additional five years on June 6, 2016 Previous ASC 840 Considerations: Modification changed classification to a
sales-type lease as of the modification date | |
Approaches A and B | Since the practical expedient package was elected (and
the classification changed before the earliest comparative
period presented), sales-type lease classification would
be retained upon adopting ASC 842. In addition, since the
extension occurred before the earliest period presented
and there are no lessee-controlled options after the earliest
period presented, the application of hindsight would not
have any impact on lease term at adoption. |
Approach C | Assess lease classification under ASC 842 as of the
modification date (i.e., June 6, 2016). In addition, since
the extension occurred before the earliest period presented
and there are no lessee-controlled options after the earliest
period presented, the application of hindsight would not
have any impact on lease term at adoption. |
Approach D | Assess lease classification under ASC 842 as of the
modification date (i.e., June 6, 2016). |
Lease E | Transition Impact |
---|---|
Lessee or Lessor? Lessor
Lease Inception: August 9, 2006
Lease Commencement: September 2, 2006 Lease Term: 12 years ASC 840 Lease Classification: Operating
Other Terms: The lessor and lessee modified the terms of the contract for the lessee to extend the lease for an additional five years on June 6, 2018 Previous ASC 840 Considerations: Modification changed classification to a
sales-type lease as of the modification date | |
Approach A | Since the practical expedient package was elected, the lessor would not change
lease classification upon adopting ASC 842 (i.e.,
the lease would be an operating lease as of the
earliest period presented and the ASC 840
modification guidance would apply to the
modification of a sales-type lease). In addition,
although hindsight was elected, since the
extension was the result of a mutual negotiation
to modify and extend the lease (rather than a
lessee-controlled option to extend), the
application of hindsight would not have any impact
on lease term. |
Approach B | Since the practical expedient package was elected, the lessor would not change
lease classification upon adopting ASC 842 (i.e.,
the lease would be an operating lease as of the
earliest period presented and the ASC 840
modification guidance would apply to the
modification of a sales-type lease). |
Approaches C and D | Assess lease classification under ASC 842 as of lease commencement (i.e., September 2, 2006). In addition, even if hindsight was elected under Approach C, since the extension was the result of a mutual negotiation to modify and extend the lease (rather than a lessee-controlled option to extend), the application of hindsight would not have any impact on lease term. If lease classification did not change upon the adoption of ASC 842, the ASC 840
modification and subsequent-measurement guidance should be
applied (including the guidance on the assessment,
classification and measurement of the lease on June 6, 2018,
the date of the extension). If lease classification changed upon the adoption of ASC 842, all of the modification and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. |
Lease F | Transition Impact |
---|---|
Lessee or Lessor? Lessee
Lease Inception: July 10, 2010
Lease Commencement: July 13, 2010 Lease Term: 10 years; the lessee has a 5-year renewal option for which
exercise was determined not to be reasonably assured as of
the inception date ASC 840 Lease Classification: Operating Other Information: On September 15, 2018, the lessee installs and pays
for tenant improvements with a useful life that extends
through 2025. The tenant improvements would be costly to
remove and, at that time, it is reasonably assured that the
lessee will exercise the renewal option. Previous ASC 840 Considerations: There are no
changes to the lease as a result of the exercise of
the renewal option becoming reasonably assured.
That is, there are no reassessment requirements
in ASC 840 other than modifications, extensions,
or renewals. | |
Approach A | Retain the operating lease classification in all periods
presented because the practical expedient package
was elected. We believe that, under this approach, lease
classification would not need to be reassessed as of the
effective date despite the change in facts and circumstances
before this date. However, for measurement purposes,
since hindsight was elected, the renewal would be included
retrospectively as if its exercise were reasonably certain
in the measurement of the lease as of the earliest period
presented. |
Approach B | Since the practical expedient package was elected, the
operating lease classification should be retained during
comparative periods. We believe that lease classification
would not need to be reassessed as of the effective date
despite the change in facts and circumstances before this
date. In accordance with ASC 842-10-35-1, lease term is
reassessed when an event “occurs.” However, because the
lessee elected the practical expedient package and did not
elect hindsight, we do not believe that the lessee should
consider events that occurred before the effective date but
did not result in a modification under ASC 840. |
Approach C | Assess lease classification under ASC 842 as of the commencement date (i.e., July 13, 2010). Since hindsight is elected, the change in facts and circumstances regarding the renewal would affect the lease term for both the ASC 842 classification test and the measurement of the lease as of the earliest period presented. If lease classification did not change upon the adoption of ASC 842, the ASC 840
subsequent-measurement guidance should be applied until the
effective date (i.e., January 1, 2019). However, if the lessee concludes that the lease is a finance lease at lease commencement upon adopting ASC 842 (i.e., classification did change), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. Therefore, in accordance with ASC 842-10-35-1, lease term is reassessed as of September 15, 2018, because an event occurred (installing leasehold improvements) for which reassessment was required under ASC 842 and that was controlled by the lessee. |
Approach D | Assess lease classification as of the commencement date (i.e., July 13, 2010). If lease classification did not change upon the adoption of ASC 842, the ASC 840 subsequent-measurement guidance should be applied until the effective date (i.e., January 1, 2019).
However, if the lessee concludes that the lease is a finance lease at lease commencement upon adopting ASC 842 (i.e., classification did change), all of the reassessment and subsequent-measurement guidance in ASC 842 should be applied during the comparative periods. Therefore, in accordance with ASC 842-10-35-1, lease term is reassessed as of September 15, 2018, because an event occurred (installing leasehold improvements) for which reassessment was required under ASC 842 and that was controlled by the lessee. |
16.7 Separation and Allocation of Consideration to Components in a Contract in Transition
16.7.1 Separation of Lease and Nonlease Components for Lessors Upon Adoption of ASC 606
As stated in ASC 606-10-15-2, the revenue standard does not apply to lease
contracts within the scope of ASC 840 (or ASC 842, upon adoption of the new
leasing standard). Although lease contracts are generally outside the scope of
the revenue standard, ASC 606-10-15-4 states that a “contract with a customer
may be partially within the scope of this Topic [ASC 606] and partially within
the scope of other Topics listed in paragraph 606-10-15-2.” An example of a
contract that may be partially within the scope of ASC 606 and partially within
the scope of another ASC topic is a lease contract entered into by a lessor that
contains both lease and service elements.26
Under ASC 840, the scope guidance in ASC 840-10-15-19 states the following:
For purposes of applying this Topic, payments and other
consideration called for by the arrangement shall be separated at the
inception of the arrangement or upon a reassessment of the arrangement
into:
-
Those for the lease, including the related executory costs and profits thereon
-
Those for other services on a relative standalone selling price basis, consistent with the guidance in paragraph 606-10-15-4 and paragraphs 606-10-32-28 through 32-41. [Emphasis added]
ASC 840 further states that executory costs (such as a lessor’s property taxes,
insurance, and maintenance) are excluded from the lessor’s minimum lease
payments for purposes of lease classification and measurement. Although these
costs are excluded from the lessor’s minimum lease payments, the costs are
generally still considered part of the lease contract in accordance with ASC
840-10-15-19(a) rather than “other services” or substantial services27 that are separated and excluded from the scope of ASC 840 and therefore
typically within the scope of revenue recognition guidance (historically, under
ASC 605 or industry guidance). That is, executory costs are generally not
separately accounted for under the legacy revenue recognition guidance in ASC
605.
In addition, before the effective date of ASU 2014-09, ASC 605-25-55-3 contained
the following example clarifying when to apply the allocation guidance in ASC
605 and that in ASC 840:
For example, leased assets are required to be accounted
for separately under the guidance in Subtopics 840-20 and 840-30.
Consider an arrangement that includes the lease of equipment under an
operating lease, the maintenance of the leased equipment throughout the
lease term (executory cost), and the sale of additional equipment
unrelated to the leased equipment. The arrangement consideration should
be allocated between the deliverables subject to the guidance in
Subtopic 840-20 and the other deliverables using the relative selling
price method. (Although Topic 840 does not provide guidance regarding
the accounting for executory costs, it does provide guidance regarding
the allocation of arrangement consideration between the lease and the
executory cost elements of an arrangement. Therefore, this example
refers to the leased equipment and the related maintenance as
deliverables subject to the guidance in that Topic.) The guidance in
Topic 840 would then be applied to separate the maintenance from the
leased equipment and to allocate the related arrangement consideration
to those two deliverables. This Subtopic would be applied to further
separate any deliverables not subject to the guidance in Topic 840 and
to allocate the related arrangement consideration.
In accordance with this illustrative example in ASC 605, deliverables within the scope of the leasing guidance (including both the leased asset and executory costs) would be within the scope of ASC 840 and subject to the allocation guidance in ASC 840. However, the separate deliverable of the sale of additional equipment would not be covered by ASC 840 and would instead be subject to the accounting and allocation guidance in ASC 605.
In contrast to this approach under ASC 840, upon adoption of the new leasing standard, a lessor will be required to separate lease and nonlease components in a contract (unless the scope criteria in ASC 842-10-15-42A are met and the lessor elects to use the practical expedient of combining lease and nonlease components, as discussed in Section 16.7.2). As illustrated above, a common example of a nonlease component under ASC 842 is maintenance services (commonly referred to as CAM services) performed by the lessor, which may be currently accounted for as an executory cost under ASC 840. That is, upon a lessor’s adoption of ASC 842, maintenance services will be considered a service within the scope of ASC 606 rather than an executory cost accounted for under lease accounting guidance.
Connecting the Dots
Questions About Effect of Interaction Between ASC 606 and ASC 842
on Accounting for Nonlease Components
Because the effective dates of ASC 60628 and ASC 84229 are not the same, questions have been raised about whether and, if
so, when a lessor would be required to separate nonlease components
currently accounted for as executory costs (e.g., CAM) and account for
those activities as services within the scope of ASC 606. Specifically,
stakeholders have questioned whether a lessor would be required to
separately account for CAM under ASC 606 (1) upon the adoption of ASC
606, (2) upon the adoption of ASC 842, or (3) in some other manner.
After these questions were raised, we participated in
informal meetings with both the FASB staff and the SEC staff to discuss
the interaction between ASC 606 and ASC 842 and how adoption of the
revenue and new leasing standards will affect the accounting for
nonlease components (e.g., CAM). On the basis of our discussions with
both parties, our understanding is that a lessor would not be required,
upon adoption of the revenue standard, to separate existing executory
costs accounted for under ASC 840 that will meet the definition of a
nonlease component under ASC 842 (e.g., CAM) and account for those
activities as services within the scope of ASC 606. However, we believe
that while a lessor would not be required to separate nonlease
components, it would be acceptable for a lessor to elect to separate
nonlease components and account for them as revenue-generating
activities upon adoption of ASC 606.
Upon adoption of ASC 842, a lessor’s accounting for executory costs in existing leases that historically have been accounted for under ASC 840 would depend on whether:
- The lessor elects the practical expedient in ASC 842-10-65-1(f) of not reassessing lease classification for existing leases at transition.
- The lessor does not elect the practical expedient in ASC 842-10-65-1(f), and the lessor’s lease classification changes.
- The lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components.
Accordingly, a lessor should consider the following scenarios:
- Scenario 1: The lessor does not elect the practical expedient in ASC 842-10-65-1(f), and the lessor’s lease classification changes upon adoption of ASC 842 (excluding a change from sales-type to direct financing) — If a lessor’s lease classification changes upon adoption of ASC 842, the lessor must apply the guidance in the new leasing standard on separating components of a contract as of the lessor’s date of initial application, which, depending on the transition method elected, could be either (1) the beginning of the earliest period presented under ASC 842 (e.g., January 1, 2017, for calendar-year-end public entities) or (2) the date of adoption (e.g., January 1, 2019, for calendar-year-end public entities) when the lessor uses the Comparatives Under 840 transition method. Accordingly, the lessor would be required to separate, and allocate consideration to, nonlease components (e.g., CAM services) unless the lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components. If the lessor either does not qualify for the practical expedient in ASC 842-10-15-42A or does not elect to use it, the nonlease components would be accounted for in accordance with the revenue recognition guidance in ASC 606.
- Scenario 2: The lessor’s lease classification does not change upon adoption of ASC 842 because the lessor either (1) elects to apply the practical expedient in ASC 842-10-65-1(f) of not reassessing lease classification for existing leases at transition or (2) elects instead to reevaluate classification, but the lease classification does not change (or changes only from sales-type to direct financing) upon reassessment at transition — We believe that if a lessor’s lease classification does not change upon adoption of ASC 842 for either of the reasons stated above, the lessor’s accounting for executory costs in existing leases would depend on whether the lessor elects to use the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components:
- Scenario 2(a): The lessor elects the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components — In this scenario, any executory costs historically accounted for under ASC 840 should be combined with the lease and nonlease components and accounted for under either ASC 606 (if the nonlease component is the predominant component in the contract) or ASC 842 (if the nonlease component is not the predominant component in the contract).
- Scenario 2(b): The lessor does not elect the practical expedient in ASC 842-10-15-42A of combining lease and nonlease components — We believe that in this scenario, it is acceptable for a lessor to account for executory costs that transfer a good or service to the lessee, including CAM, either as (1) a nonlease component under ASC 606 (i.e., separately from the lease component) by aligning existing leases to the lessor’s policy election of separating nonlease components under ASC 842 or (2) part of the lease component under ASC 842 (i.e., as if the lessor were “running off” its existing leases in a manner consistent with its accounting treatment under ASC 840).
In contrast to the discussion above on executory costs (including maintenance services), an entity should account for “other services” or substantial services that are not within the scope of ASC 840 in accordance with the guidance in ASC 606 as of the effective date applicable to the entity.
16.7.2 Lessor Practical Expedient
ASC 842-10
15-42A As a practical
expedient, a lessor may, as an accounting policy
election, by class of underlying asset, choose to not
separate nonlease components from lease components and,
instead, to account for each separate lease component
and the nonlease components associated with that lease
component as a single component if the nonlease
components otherwise would be accounted for under Topic
606 on revenue from contracts with customers and both of
the following are met:
- The timing and pattern of transfer for the lease component and nonlease components associated with that lease component are the same.
- The lease component, if accounted for separately, would be classified as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3A.
In July 2018, the FASB issued ASU 2018-11, under which lessors
could elect not to separate lease and nonlease components when certain
conditions are met. A lessor could elect to combine lease and associated
nonlease components provided that the nonlease component(s) would otherwise be
accounted for under ASC 606 and both of the conditions in ASC 842-10-15-42A(a)
and (b) (“Criterion A” and “Criterion B”) are met. For further considerations
related to these two criteria, see Section 4.3.3.2.1.
The ASU also clarifies that the presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the expedient for the lease component and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease components that do not qualify for the practical expedient separately from the combined lease and nonlease components that do qualify.
Connecting the Dots
Assessing the Timing and Pattern of Transfer
In ASU 2018-11, the Board amended Criterion A to focus on the timing and pattern of transfer (i.e., a “straight-line pattern of transfer . . . to the customer over the same time period”) rather than on the timing and pattern of revenue recognition (as was originally proposed). The purpose of this amendment was to address concerns that the originally proposed practical expedient was unnecessarily restrictive and excluded contracts with variable consideration from its scope, since variable payments are accounted for differently under ASC 606 than they are under ASC 842.
16.7.2.1 Determining Which Component Is Predominant
The FASB originally proposed that a lessor should always be required to account for the combined component as a lease under ASC 842 in a manner consistent with a similar practical expedient afforded to lessees. However, on the basis of feedback it received, the Board revised the final ASU to require an entity to perform another evaluation to determine whether the combined unit of account is accounted for as a lease under ASC 842 or as a revenue contract under ASC 606. Specifically, an entity should determine whether the nonlease component (or components) associated with the lease component is the predominant component of the combined component. If so, the entity is required to account for the combined component in accordance with ASC 606. Otherwise, the entity must account for the combined component as an operating lease in accordance with ASC 842.
Connecting the Dots
An Entity Will Need to Use Judgment to Determine the
Predominant Component
As indicated in ASU 2018-11’s Background Information and Basis for Conclusions, the FASB decided not to include a separate definition or threshold for determining whether “the nonlease component is the predominant component of the combined component.” Rather, the Board indicates that a lessor should consider whether the lessee would “ascribe more value to the nonlease component(s) than to the lease component.” Further, the Board acknowledged that the term “predominant” is used elsewhere in U.S. GAAP, including ASC 842 and ASC 606.
The Board also explains that it does not expect that an entity will need to perform a quantitative analysis or allocation to determine whether the nonlease component is predominant. Rather, it is sufficient if an entity can reasonably determine whether to apply ASC 842 or ASC 606.
Therefore, we expect that entities will need to use judgment in making this determination.
At its March 28, 2018, meeting, the Board discussed a scenario in which the components were evenly split (e.g., a 50/50 split of value) and suggested that, in such circumstances, the combined component should be accounted for under ASC 842 because the nonlease component is not predominant. That is, the entity would need to demonstrate that the predominant element is the nonlease component; otherwise, the combined unit of account would be accounted for as a lease under ASC 842.
We believe that the final language in ASU 2018-11 was intended to indicate that
an entity would need to determine whether the lease or nonlease component
(or components) is larger (i.e., has more value); only when the nonlease
component is larger should the combined component be accounted for under ASC
606.
Footnotes
26
Note that this would not apply to lessees because a
lessee does not perform services or generate revenue under a lease
contract.
27
“Substantial services” is a term used in EITF Issue 01-8
to differentiate services not accounted for under lease accounting from
executory costs accounted for under lease accounting. This distinction
between maintenance services, which are executory costs that
historically have been accounted for under ASC 840, and substantial services, which historically have been accounted for under ASC 605, was raised in EITF Issue 08-2 but was not further clarified.
28
For public companies, ASC 606 became effective
for annual reporting periods beginning after December 15, 2017,
and interim periods therein.
29
For public companies, ASC 842 became effective
for annual reporting periods beginning after December 15, 2018,
and interim periods therein (i.e., one year after the effective
date of ASC 606).
16.8 Build-to-Suit Transition
ASC 842-10
65-1 The following
represents the transition and effective date information
related to Accounting Standards Update . . . No. 2016-02,
Leases (Topic 842) . . .
u. A lessee shall apply a modified retrospective
transition approach for leases accounted for as
build-to-suit arrangements under Topic 840 that are
existing at, or entered into after, the beginning of
the earliest comparative period presented in the
financial statements (if an entity elects the
transition method in (c)(1)) or that are existing at
the beginning of the reporting period in which the
entity first applies the pending content that links
to this paragraph (if an entity elects the
transition method in (c)(2)) as follows:
1. If an entity has recognized
assets and liabilities solely as a result of a
transaction’s build-to-suit designation in
accordance with Topic 840, the entity shall do the
following:
i. If an entity elects the
transition method in (c)(1), the entity shall
derecognize those assets and liabilities at the
later of the beginning of the earliest comparative
period presented in the financial statements and the
date that the lessee is determined to be the
accounting owner of the asset in accordance with
Topic 840.
ii. If an entity elects the
transition method in (c)(2), the entity shall
derecognize those assets and liabilities at the
beginning of the reporting period in which the
entity first applies the pending content that links
to this paragraph.
iii. Any difference in (i) or
(ii) shall be recorded as an adjustment to equity at
the date that those assets and liabilities were
derecognized in accordance with (u)(1)(i) or (ii).
iv. The lessee shall apply the
lessee transition requirements in (k) through (t) to
the lease.
2. If the construction period
of the build-to-suit lease concluded before the
beginning of the earliest comparative period
presented in the financial statements (if the entity
elects the transition method in (c)(1)) or if it
concluded before the beginning of the reporting
period in which the entity first applies the pending
content that links to this paragraph (if the entity
elects the transition method in (c)(2)), and the
transaction qualified as a sale and leaseback
transaction in accordance with Subtopic 840-40
before that date, the entity shall follow the
general lessee transition requirements for the
lease. . . .
Under ASC 840, a lessee may have capitalized the construction cost of an asset under construction
with an offsetting liability on the basis of an assessment of the involvement during construction, which
is primarily based on the risks to which the lessee was exposed. In addition, if a lessee is deemed the
owner of the construction project, it is required to assess whether a sale and leaseback is achieved,
which often results in a failed sale and leaseback because of continuing involvement. ASC 842
significantly changes the assessment of whether a lessee is the accounting owner of the asset during
construction, which is an assessment of control (see Chapter 11 for a general overview of these
arrangements). As a result, it will be common for a lessee to be the deemed owner of the asset under
ASC 840; however, the lessee may not be the deemed owner of an asset under ASC 842 because it
does not meet ASC 842’s concept of control. The general transition provisions indicate that a lessee that
recognized an asset solely because it was the deemed owner under the ASC 840 build-to-suit guidance
would derecognize the related assets and liabilities as of the later of the date of initial application or the
date the lessee was determined to be the deemed owner.
Although the transition guidance indicates that the difference between the asset and liability should be recognized as an adjustment to equity as of that later-of date, we think that a lessee should carefully consider the impact of such adjustments as follows:
- If a lease has not commenced as of the date of initial application, the asset and liability will generally be equal, because the lessee’s accounting as the deemed owner before placing the asset into service is a gross-up of the asset with an offsetting financing obligation. Therefore, the adjustments in transition to ASC 842 generally will not affect equity for leases that commenced after the date of initial application.
- A lessee should reverse any of the accounting entries that were recognized during the comparative periods for the respective line items (e.g., depreciation expense, interest expense) rather than as an adjustment to equity. That is, it would not be appropriate to reverse the accounting after placing the asset into service through equity if those comparative periods are shown in accordance with ASC 842.
- If a lease commenced before the date of initial application and the lessee continued to recognize the asset and liability as a failed sale and leaseback under ASC 840, there typically will be a difference between the asset and liability that should be recognized in equity as of the date of initial application.
- Although the transition guidance related to build-to-suit arrangements does not specifically address situations in which the lessee is the deemed owner of an asset under construction in accordance with ASC 842, we have provided our interpretive guidance on such scenarios in the Q&A below.
Q&A 16-12 Derecognition of Existing Build-to-Suit Assets and Liabilities in Transition
The build-to-suit transition guidance specifies that any build-to-suit assets and liabilities
recognized under ASC 840 should be derecognized in transition. However, the transition
guidance does not explicitly address whether ASC 842’s principles related to controlling an
asset under construction should be applied during the comparative periods under ASC 842, if
applicable.
Question 1
Must ASC 842’s principles related to controlling an asset during construction be
applied when construction was completed and the lease commenced before ASC 842’s effective date?
Answer
No. An entity is not required to assess ASC 842’s principles of control (regardless of whether
the lessee was the deemed owner under ASC 840) as long as construction is complete and the
lease commenced before the ASU’s effective date. The FASB staff agreed with this application
of transition for build-to-suit arrangements. This answer is applicable regardless of whether an
entity elects the Comparatives Under 840 Option.
Therefore, in such circumstances, the transition derecognition guidance in ASC 842-10-65-1(u)
should be applied. ASC 842-10-65-1(u) states:
A lessee shall apply a modified retrospective transition approach for leases
accounted for as build-to-suit arrangements under Topic 840 that are
existing at, or entered into after, the beginning of the earliest
comparative period presented in the financial statements (if an
entity elects the transition method in (c)(1)) or that are existing
at the beginning of the reporting period in which the entity first
applies the pending content that links to this paragraph (if an
entity elects the transition method in (c)(2)) as follows:
-
If an entity has recognized assets and liabilities solely as a result of a transaction’s build-to-suit designation in accordance with Topic 840, the entity shall do the following:
-
If an entity elects the transition method in (c)(1), the entity shall derecognize those assets and liabilities at the later of the beginning of the earliest comparative period presented in the financial statements and the date that the lessee is determined to be the accounting owner of the asset in accordance with Topic 840.
-
If an entity elects the transition method in (c)(2), the entity shall derecognize those assets and liabilities at the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph.
-
Any difference in (i) or (ii) shall be recorded as an adjustment to equity at the date that those assets and liabilities were derecognized in accordance with (u)(1)(i) or (ii).
-
The lessee shall apply the lessee transition requirements in (k) through (t) to the lease.
-
-
If the construction period of the build-to-suit lease concluded before the beginning of the earliest comparative period presented in the financial statements (if the entity elects the transition method in (c)(1)) or if it concluded before the beginning of the reporting period in which the entity first applies the pending content that links to this paragraph (if the entity elects the transition method in (c)(2)), and the transaction qualified as a sale and leaseback transaction in accordance with Subtopic 840-40 before that date, the entity shall follow the general lessee transition requirements for the lease. [Emphasis added]
Accordingly, the lessee should (1) derecognize any build-to-suit assets and liabilities that
were recognized solely as a result of the lessee’s being the deemed accounting owner and
(2) recognize the difference, if any, in equity. However, lessee-paid costs that were included
in the build-to-suit asset may not have been capitalized solely as a result of the build-to-suit
designation. For example, the deemed accounting owner may have funded part of the
construction costs and such costs may be considered prepaid lease payments or payments for
lessee-owned improvements when the arrangement is accounted for as a lease. Accordingly, in
transition, these costs would be carried over and retained at their currently recognized amount
(i.e., the amortized or depreciated balance). That is, these costs would have been recognized in
the absence of the build-to-suit designation and therefore should not be derecognized through
equity upon transition.
Example
Company C, a calendar-year public entity that has elected the option not to
recast the comparative periods presented when
transitioning to ASC 842 (the Comparatives Under 840
Option), entered into an agreement with Developer D
to lease a newly constructed corporate
headquarters.30 Developer D began building the corporate
headquarters on August 1, 2016, and construction is
expected to be complete on November 12, 2018, at
which time the lease will commence. Company C funded
$6 million of the construction costs during the
construction period, and the total project costs are
expected to be $40 million. Therefore, D will fund
$34 million of the construction costs. In addition,
C incurred $1 million for furniture and fixtures
(the “improvements”). Assume that C was considered
the accounting owner of the corporate headquarters
during construction and that sale-and-leaseback
accounting would not be achieved upon lease
commencement under ASC 840. The various journal
entries to account for the construction project
resulted in the following account balances as of
November 12, 2018:
Upon transition to ASC 842, C is required to derecognize the amounts related to the build-to-suit
accounting because construction of the corporate headquarters was completed, and the lease
commenced, before January 1, 2019 (the effective date of ASC 842). Therefore, on its adoption date
(January 1, 2019), C would derecognize the entire financing obligation because it was recognized
solely as a result of the build-to-suit designation. Company C would retain a portion of its PP&E
balance related to the amount it paid before lease commencement less adjustments for subsequent
measurement (i.e., depreciation), even though this amount was included in the carrying amount of the
build-to-suit asset. As a result, the unamortized portion of the $6 million construction funding payment
should be carried forward into the ROU asset because it represents a prepaid lease payment.
Similarly, the unamortized balance of the $1 million for improvements paid by the lessee should be
carried forward in transition and not written off as an equity adjustment. The remaining build-to-suit
asset would be derecognized. The offset between the resulting build-to-suit asset balance and the
financing obligation, if any, would be recognized in equity.
The subsequent accounting for the improvements should be consistent with that for other leasehold
improvements. That is, the amortization period would be limited to the lease term in accordance with
ASC 842-20-35-12.
The journal entries in transition are shown below. Note that, for simplicity,
there are no adjustments for subsequent measurement
between November 12, 2018, and the effective date of
ASC 842 (i.e., depreciation of the building,
amortization of the $6 million in prepaid rent, or
payments on the financing obligation). These
subsequent-measurement adjustments would most likely
result in an adjustment to equity, which is not
depicted below.
Company C would also recognize any
remaining lease payments as a lease liability, along
with an offsetting ROU asset, in accordance with the
lessee transition requirements in ASC
842-10-65-1(k)–(t).
Question 2
How should a lessee approach the transition for a build-to-suit arrangement when construction
was not completed, and the lease had not commenced, as of the effective date of ASC 842?
Answer
The table below summarizes the transition approach an entity should use in those
circumstances.
ASC 840 Determination
|
ASC 842 Determination
|
Transition Approach
|
---|---|---|
Lessee was the deemed
owner | Lessee has control during
construction | No change in accounting; asset and financing
obligation remain on the balance sheet
during the comparative periods and as of the
effective date. |
Lessee was the deemed
owner | Lessee does not
have control during
construction | If the lessee was determined to be the deemed accounting owner under ASC 840 before the date of initial
application, derecognize the asset and financing
obligation recognized solely as a result of
the build-to-suit designation and reflect the
difference, if any, in equity. If the lessee was
determined to be the accounting owner of the asset
during the comparative
periods (i.e., construction commenced during the
comparative periods), and the Comparatives Under 840
Option was not elected, the lessee should reverse
the impact of the accounting for the appropriate
line items and not reverse the impact through
equity. |
Lessee was not the
deemed owner | Lessee has control during
construction | Recognize the asset and financing obligation
as of the later of the date of initial application
or the date as of which the lessee is
determined to be the accounting owner of
the asset in accordance with ASC 842. If a
lessee elects the Comparatives Under 840
Option, the asset and financing obligation will
be recognized as of the effective date of ASC
842. See the example below. |
Example
Company A, a calendar-year-end public entity that has not elected the
Comparatives Under 840 Option, has entered into an
agreement with Company B to lease a newly
constructed television studio. Company B began
building the television studio on June 8, 2017, and
construction is expected to be complete on November
5, 2019. The lease will commence once construction
is complete. During the construction period, A can
acquire the television studio in process of
construction and therefore is deemed to control the
construction project under ASC 842. Assume that A
was not determined to be the deemed owner in
accordance with ASC 840. When A initially applies
ASC 842, because A is deemed to control the
construction project under ASC 842 as of the
effective date, it must recognize the cost of the
in-process asset (and an offsetting financing
obligation) during the comparative periods beginning
June 8, 2017.
If A had elected the Comparatives Under 840 Option, A would first recognize the
asset and financing obligation as of January 1, 2019
(the ASC 842 effective date).
Connecting the Dots
Lease Classification Assessment for Derecognized Build-to-Suit
Arrangements in Transition
If a previous build-to-suit arrangement (for which construction was completed
and the lease commenced before the effective date of ASC 842) was
capitalized under ASC 840 and reversed upon the adoption of ASC 842, we
generally believe that the appropriate framework for determining lease
classification will depend on multiple factors as follows:
-
If the practical expedient package is not elected, lease classification should be determined under ASC 842, as follows:
-
If the lease commenced before the date of initial application, lease classification would generally be determined as of the later of the (1) lease commencement date or (2) date the lease was last modified. If a lease was renewed or extended before the date of initial application, the renewal or extension date would be considered the lease commencement date for this purpose unless the renewal was assumed to be reasonably certain as of the initial lease commencement date.
-
If the lease commenced after the date of initial application, the initial lease classification would generally be determined as of the lease commencement date.
-
-
The transition guidance is not clear on situations in which the practical expedient package is elected and the lessee has accounted for the transaction as a failed sale and leaseback through the effective date of ASC 842. We believe that, notwithstanding the election of the practical expedient package, it would be acceptable to determine lease classification in accordance with ASC 842 (i.e., as of the later of the (1) lease commencement date or (2) date the lease was last modified — see bullet above), because the lease (for accounting purposes) was never recognized or assessed under ASC 840 (i.e., the lease classification is assessed for the first time upon adopting ASC 842). However, we understand that others believe, because of the lack of clear guidance, that it would also be acceptable to determine lease classification as of lease inception under ASC 840. We think that either approach would be acceptable as an accounting policy that must be applied consistently.
Q&A 16-12A Accounting for a Previously Impaired Build-to-Suit
Asset
Under ASC 840, a build-to-suit asset and financing
obligation may be recognized on a lessee’s balance sheet as a result of a
transaction’s build-to-suit designation, as described in Q&A 16-12.
Thereafter, under ASC 360, a lessee could have determined that the asset
group containing the build-to-suit asset was impaired, resulting in the
measurement of an impairment loss, of which a portion was recognized against
the build-to-suit asset.
The general transition provisions in ASC 842 indicate that a
lessee that recognized an asset because it was the deemed owner under the
ASC 840 build-to-suit guidance would, in accordance with ASC
842-10-65-1(u),31 (1) derecognize the asset and financing recognized solely as a
result of the build-to-suit designation and (2) apply the general
lessee transition requirements. Further, ASC 842-10-65-1(m)(2) and ASC
842-10-65-1(o), which apply to operating leases and finance leases,
respectively, provide the following guidance on accounting for the ROU asset
at transition when there is an existing ASC 420 liability:
m. For each lease classified as an operating lease
in accordance with paragraphs 842-10-25-2 through 25-3, a lessee
shall initially measure the right-of-use asset at the initial
measurement of the lease liability adjusted for both of the
following: . . .
2. The carrying amount of any liability recognized in
accordance with Topic 420 on exit or disposal cost
obligations for the lease. . . .
o. For each lease classified as a finance lease in
accordance with paragraph 842-10-25-2, a lessee shall measure the
right-of-use asset as the applicable proportion of the lease
liability at the commencement date, which can be imputed from the
lease liability determined in accordance with (l). The applicable
proportion is the remaining lease term at the application date as
determined in (c) relative to the total lease term. A lessee shall
adjust the right-of-use asset recognized by the carrying amount of
any prepaid or accrued lease payments and the carrying amount of any
liability recognized in accordance with Topic 420 for the lease.
On the basis of the above guidance, it is clear that the
initial ROU asset is generally recorded net of any ASC 420 liability at
transition. However, under a deemed ownership model, entities have
historically looked to the impairment guidance in ASC 360 instead of the
exit cost guidance in ASC 420. As a result, entities have questioned how
previous impairment charges recognized on a build-to-suit asset should be
treated in transition given that the asset to which the impairment is
related will be derecognized upon adoption of ASC 842. In other words,
entities have asked whether the historical ASC 360 impairment charge should
or could affect the measurement of the ROU asset in transition.
Question
When a lessee previously recognized impairment for a
build-to-suit asset subject to derecognition under ASC 842-10-65-1(u)(1),
how should the lessee consider the historical impairment when recognizing
and measuring the related ROU asset at transition?
Answer
We believe that a lessee should subject the newly recognized
ROU asset to a full impairment test in accordance with ASC 360 as of the
effective date of ASC 842 if an impairment indicator continues to exist as
of this date. Accordingly, a lessee would determine a “new” impairment
amount on the basis of the test conducted as of the effective date. In
addition, we believe that it is acceptable to recognize the impairment loss,
if any, determined as of the date of initial application of ASC 842 through
an adjustment to equity, with a corresponding reduction to the carrying
amount of the ROU asset. We think that recognition of the impairment loss in
equity is appropriate since it reflects a unique circumstance in which the
adjustment effectively results from an impairment indicator that arose
before the date of initial application of ASC 842.
However, since ASC 842 does not provide clear guidance on
this situation, there may be other acceptable approaches. We encourage
stakeholders who are affected by this issue to consult with their accounting
advisers and auditors to understand their views.
Footnotes
16.9 Transition for Sale-and-Leaseback Transactions
ASC 842-10
65-1 The following
represents the transition and effective date information
related to Accounting Standards Update . . . No. 2016-02,
Leases (Topic 842) . . .
Sale and Leaseback Transactions Before the Effective
Date
aa. If a previous sale and leaseback transaction
was accounted for as a sale and a leaseback in
accordance with Topic 840, an entity shall not
reassess the transaction to determine whether the
transfer of the asset would have been a sale in
accordance with paragraphs 842-40-25-1 through
25-3.
bb. If a previous sale and leaseback transaction
was accounted for as a failed sale and leaseback
transaction in accordance with Topic 840 and remains
a failed sale at the effective date:
1. If an entity elects the
transition method in (c)(1), the entity shall
reassess whether a sale would have occurred at any
point on or after the beginning of the earliest
period presented in the financial statements in
accordance with paragraphs 842-40-25-1 through 25-3.
The sale and leaseback transaction shall be
accounted for on a modified retrospective basis from
the date a sale is determined to have occurred.
2. If an entity elects the
transition method in (c)(2), the entity shall
reassess whether a sale would have occurred at the
beginning of the reporting period in which the
entity first applies the pending content that links
to this paragraph in accordance with paragraphs
842-40-25-1 through 25-3 and recognize the sale as
an adjustment to equity. The entity shall then
account for the leaseback in accordance with the
guidance in Subtopic 842-20 after the beginning of
the reporting period in which the entity first
applies the pending content that links to this
paragraph.
cc. An entity shall account for the leaseback in
accordance with the lessee and lessor transition
requirements in (k) through (y).
dd. If a previous sale and leaseback transaction
was accounted for as a sale and capital leaseback in
accordance with Topic 840, the transferor shall
continue to recognize any deferred gain or loss that
exists at the later of the beginning of the earliest
comparative period presented in the financial
statements and the date of the sale of the
underlying asset (if an entity elects the transition
method in (c)(1)) or that exists at the beginning of
the reporting period in which the entity first
applies the pending content that links to this
paragraph (if an entity elects the transition method
in (c)(2)), as follows:
1. If the underlying asset is
land only, straight line over the remaining lease
term.
2. If the underlying asset is
not land only and the leaseback is a finance lease,
in proportion to the amortization of the
right-of-use asset.
3. If the underlying asset is
not land only and the leaseback is an operating
lease, in proportion to the recognition in profit or
loss of the total lease cost.
ee. If a previous sale and leaseback transaction
was accounted for as a sale and operating leaseback
in accordance with Topic 840, the transferor shall
do the following:
1. Recognize any deferred gain
or loss not resulting from off-market terms (that
is, where the consideration for the sale of the
asset is not at fair value or the lease payments are
not at market rates) as a cumulative-effect
adjustment to equity unless the entity elects the
transition method in (c)(1) and the date of sale is
after the beginning of the earliest period
presented, in which case any deferred gain or loss
not resulting from off-market terms shall be
recognized in earnings in the period the sale
occurred.
2. Recognize any deferred loss
resulting from the consideration for the sale of the
asset not being at fair value or the lease payments
not being at market rates as an adjustment to the
leaseback right-of-use asset at the later of the
beginning of the earliest comparative period
presented in the financial statements and the date
of the sale of the underlying asset (if an entity
elects the transition method in (c)(1)) or at the
beginning of the reporting period in which the
entity first applies the pending content that links
to this paragraph (if an entity elects the
transition method in (c)(2)).
3. Recognize any deferred gain
resulting from the consideration for the sale of the
asset not being at fair value or the lease payments
not being at market rates as a financial liability
at the later of the beginning of the earliest
comparative period presented in the financial
statements and the date of the sale of the
underlying asset (if an entity elects the transition
method in (c)(1)) or at the beginning of the
reporting period in which the entity first applies
the pending content that links to this paragraph (if
an entity elects the transition method in
(c)(2)).
According to the transition provisions for sale-and-leaseback transactions, (1) previous transactions that were accounted for as successful sale-and-leaseback transactions are grandfathered from consideration under the ASC 842 sale-and-leaseback derecognition rules and (2) previous transactions that were accounted for as failed sales are reassessed for possible derecognition under ASC 842. The real estate sale-and-leaseback rules are much less onerous under ASC 842, which will result in the unwinding of certain failed sales in the transition to ASC 842. Specifically, if a transaction was a failed sale-and-leaseback transaction under ASC 840 and remains so as of the effective date, the entity must reassess whether a sale would have occurred at any point on or after the date of initial application in accordance with the sale-and-leaseback provisions in ASC 842 (see Chapter 10). The sale-and-leaseback transaction must be recognized from the date a sale is determined to have occurred under ASC 842; if the sale occurred before the date of initial application, any gain or loss will be reflected in equity, and if the sale occurred during the comparative periods (which is only possible if a lessee does not elect the Comparatives Under 840 Option), any gain or loss must be recognized in the respective period. For successful sales, the related lease should be recorded in accordance with the ASC 842 transition requirements in a manner consistent with any other lease.
Connecting the Dots
Lease Classification Assessment in Transition for Unsuccessful
Sale-and-Leaseback Transactions Under ASC 840
The lease classification determination in transition for
previously unsuccessful sale-and-leaseback transactions is important because
the classification of the lease is one of the primary conditions for
achieving a sale in a sale-and-leaseback transaction under ASC 842. That is,
a sale can only be recognized under ASC 842 if the leaseback would be classified as an operating lease (see
Section
10.3.2). Since the lease (from an accounting perspective) did
not exist under ASC 840 and a lease cannot be recognized under
ASC 842 unless the leaseback would not be classified
as a finance lease, the seller-lessee must determine the appropriate “would
be” classification of the lease in transition before achieving
sale-and-leaseback accounting under ASC 842.
The transition guidance is not clear on whether ASC 840 or
ASC 842 should be used in these circumstances as the basis for determining
the classification of the leaseback. However, we generally believe that if a
previously unsuccessful sale-and-leaseback transaction meets the other
criteria necessary to achieve a sale under ASC 842 (see Section 10.3), the
“would be” classification of the lease will depend on the following:
-
If the practical expedient package is not elected, lease classification should be determined under ASC 842 as follows:
-
If the lease commenced before the date of initial application, lease classification would generally be determined as of the later of the (1) lease commencement date or (2) date the lease was last modified. If a lease was renewed or extended before the date of initial application, the renewal or extension date would be considered the lease commencement date for this purpose unless the renewal was assumed to be reasonably certain as of the initial lease commencement date.
-
If the lease commenced after the date of initial application, the initial lease classification would generally be determined as of the lease commencement date.
-
-
The transition guidance is not clear on situations in which the practical expedient package is elected and the lessee has accounted for the transaction as a failed sale and leaseback through the effective date of ASC 842. We believe that, notwithstanding the election of the practical expedient package, it would be acceptable to determine lease classification in accordance with ASC 842 (i.e., as of the later of the (1) lease commencement date or (2) date the lease was last modified — see bullet above), because the lease (for accounting purposes) was never recognized or assessed under ASC 840 (i.e., the lease classification is assessed for the first time upon adopting ASC 842). However, we understand that others believe, because of the lack of clear guidance, that it would also be acceptable to determine lease classification as of lease inception under ASC 840. We think that either approach would be acceptable as an accounting policy that must be applied consistently.
On the other hand, if a previously successful sale-and-leaseback transaction was accounted for as a sale and capital leaseback under ASC 840, the lessee continues to
recognize any deferred gain or loss that exists at the later of the date of initial application presented in
the financial statements or the date of the sale of the underlying asset. The deferred gain or loss should
be subsequently recognized into income as follows:
- If the underlying asset is land only, straight-line over the remaining lease term.
- If the underlying asset is not land only and the leaseback is a finance lease under ASC 842, in proportion to the amortization of the ROU asset.
- If the underlying asset is not land only and the leaseback is an operating lease under ASC 842, in proportion to the recognition in profit or loss of the total lease cost.
If a previously successful sale-and-leaseback transaction was accounted for as a sale and operating leaseback
under ASC 840, as long as the sale and the leaseback were at fair value and market terms, respectively,
the lessee should recognize any deferred gain or loss as (1) a cumulative-effect adjustment to equity
(if the sale would have occurred before the date of initial application) or (2) earnings in the respective
comparative period (if the sale would have occurred during the comparative periods and provided that
the entity does not elect the Comparatives Under 840 Option). If the sale and leaseback were not at fair
value and market terms, respectively, at the time the sale-and-leaseback transaction was entered into,
the amount by which the transaction was not at fair value and market terms should not be recognized
in transition. Rather, the lessee should recognize any such deferred loss or deferred gain that results
because the consideration for the sale of the asset was not at fair value or the lease payments were
not at market rates as an adjustment to the ROU asset or finance liability, respectively, at the later of
lease commencement or the date of initial application. Any remaining gain/loss after the lessee adjusts
for off-market values and terms would be recognized in a manner consistent with the criterion in ASC
842-10-65-1(ee)(1).
Connecting the Dots
Buyer-Lessors Do Not Reassess Previous Sale-and-Leaseback
Accounting
ASC 840 did not require that buyer-lessors assess whether the seller was able to
obtain sale recognition. That is, accounting symmetry was not required
between the buyer-lessor and the seller-lessee; instead, the buyer-lessor
would generally account for a sale-and-leaseback transaction as a purchase
with a leaseback to the lessee even if the lessee accounts for the sale as a
financing. Under ASC 842, such accounting symmetry is required, as described
in Section
10.2. In transition, because the lessor generally considered all
sale-and-leaseback transactions to be successful purchase-leasebacks, the
lessor does not have to reassess any sale-and-leaseback transactions
executed before the effective date of ASC 842. Therefore, there will
continue to be asymmetry in the accounting for certain sale-and-leaseback
transactions entered into under ASC 840 in which the lessee continues to
fail sale-and-leaseback transaction under ASC 842 (i.e., both the lessor and
lessee will continue to recognize the asset). In the unusual circumstance in
which a lessor did conclude that an arrangement was a financing under ASC
840, we would expect it to revisit that accounting under ASC 842.
16.10 Amounts Previously Recognized From Business Combinations
ASC 842-10
65-1 The following
represents the transition and effective date information
related to Accounting Standards Update . . . No. 2016-02,
Leases (Topic 842) . . .
h. If an entity has previously recognized an asset
or a liability in accordance with Topic 805 on
business combinations relating to favorable or
unfavorable terms of an operating lease acquired as
part of a business combination, the entity shall do
all of the following:
1. Derecognize that asset and
liability (except for those arising from leases that
are classified as operating leases in accordance
with Topic 842 for which the entity is a lessor).
2. Adjust the carrying amount
of the right-of-use asset by a corresponding amount
if the entity is a lessee.
3. Make a corresponding
adjustment to equity if assets or liabilities arise
from leases that are classified as sales-type leases
or direct financing leases in accordance with Topic
842 for which the entity is a lessor. Also see (w).
. . .
Lessee
For any assets or liabilities recognized in accordance with ASC
805 that are related to favorable or unfavorable terms of an operating lease for
which an entity is a lessee, the entity should derecognize the asset or
liability and commensurately adjust the ROU asset. In other words, if a lessee
has a favorable lease intangible (asset), the lessee should derecognize the
intangible asset and add an offsetting amount to the ROU asset. If a lessee has
an unfavorable lease intangible (liability), the lessee should derecognize the
liability and reduce the ROU asset by the same amount.
Lessor
When a lessor has previously recognized assets or liabilities
for an off-market operating lease in a business combination, the asset or
liability should continue to be recognized separately from the lease accounting.
Generally, an acquirer in a business combination that is a lessor under a
sales-type or direct financing lease would include any off-market assets or
liabilities in the net investment in the lease (i.e., a separate asset or
liability would not be recognized). In those cases, the lessor would not make
any adjustment for the off-market terms. However, if any separate balances exist
regarding a lessor’s sales-type or direct financing lease (other than in-place
lease intangibles), the entity should derecognize the asset or liability and
“make a corresponding adjustment to equity” in accordance with ASC
842-10-65-1(h).
16.11 Transition Disclosures
ASC 842-10
65-1 The
following represents the transition and effective
date information related to Accounting Standards
Update . . . No. 2016-02, Leases (Topic
842) . . .
Disclosure
i. An entity shall provide the transition
disclosures required by Topic 250 on accounting
changes and error corrections, except for the
requirements in paragraph 250-10-50-1(b)(2) and
paragraph 250-10-50-3. An entity that elects the
transition method in (c)(2) shall provide the
transition disclosures in paragraph
250-10-50-1(b)(3) as of the beginning of the
period of adoption rather than at the beginning of
the earliest period presented.
Note: See paragraph
250-10-S99-6 on disclosure of the impact that
recently issued accounting standards will have on
the financial statements of a registrant.
j. If an entity uses one or more of the
practical expedients in (f), (g), and (gg), it shall disclose that
fact.
jj. An entity electing the transition method
in (c)(2) shall provide the required Topic 840
disclosures for all periods that continue to be in
accordance with Topic 840. . . .
An entity adopting ASC 842
should provide the transition disclosures required by ASC 250, excluding the disclosure in
ASC 250-10-50-1(b)(2) about the effect of the change on income from continuing operations,
net income, any other financial statement line item, and any per-share affected amounts for
any of the periods. Moreover, entities do not need to provide the corresponding interim
disclosures required by ASC 250-10-50-3. The disclosure required by ASC 250-10-50-1(b)(3)
regarding “[t]he cumulative effect of the change on retained earnings or other components of
equity or net assets in the statement of financial position” must be provided as of the date
of initial application of ASC 842.
An entity adopting ASC 842
must also disclose the transition practical
expedients used, as applicable.
An entity electing the
Comparatives Under 840 Option must provide the ASC
840 disclosures for all periods that are presented
in accordance with ASC 840 (see Section
16.1.1).
Connecting the Dots
ASC 840 Disclosures Required in the Comparative Periods
The Board revised the language
in ASU 2018-11 to
clarify that an entity must provide the ASC 840 disclosures for all periods that are
presented in accordance with ASC 840. As part of this requirement, the entity must apply
the guidance in ASC 840-20-50-2(a) (commonly referred to as the “lease commitments
table”) as of the latest balance sheet presented. Further, paragraph BC14 of ASU 2018-11
indicates that the latest balance sheet date presented should be the latest balance
sheet date presented under ASC 840 (e.g., December 31, 2018, for a PBE with a calendar
year-end). Therefore, for a PBE with a calendar year-end, the ASC 840-20-50-2(a) lease
commitments table as of December 31, 2018, will be presented in the annual financial
statements for the year ended December 31, 2019. Also, paragraph BC14 of ASU 2018-11
indicates that the ASU does not change, or create additional, “interim disclosure
requirements that entities previously were not required to provide.” In discussions with
the FASB staff regarding what disclosures are required in interim periods during the
year of adoption, the staff clarified that it would expect an entity to disclose the
lease commitments table as of December 31, 2018 (on the basis of the fact pattern
described above) in each interim period in the year of adoption. For example, an entity
would present the lease commitments table for the year ended December 31, 2018, in the
first-quarter 2019 Form 10-Q. The table would not be updated to reflect a run-off of
three months of activity that occurred during the first quarter of 2019, nor would the
entity need to present a lease commitments table as of March 31, 2018. Rather, the table
presented in the December 31, 2018, Form 10-K would be carried forward to the
first-quarter 2019 Form 10-Q.
While ASC 842 may not require
entities to provide certain of the above prescribed disclosures in interim financial
statements, SEC rules and staff interpretations require SEC registrants to provide both
annual and interim disclosures in the first interim period after the adoption of a new
accounting standard and in each subsequent quarter in the year of adoption.
Specifically, Section 1500
of the SEC Division of Corporation Finance Financial Reporting Manual (FRM) states:
[Regulation] S-X Article 10 requires disclosures about material
matters that were not disclosed in the most recent annual financial statements.
Accordingly, when a registrant adopts a new accounting standard in an interim
period, the registrant is expected to provide both the annual and the interim period
financial statement disclosures prescribed by the new accounting standard, to the
extent not duplicative. These disclosures should be included in each quarterly
report in the year of adoption.
See Chapter 18 for
further discussion of SEC reporting considerations
for SEC registrants, including SAB Topic 11.M
disclosure requirements.
Chapter 17 — Stakeholder Activities
Chapter 17 — Stakeholder Activities
17.1 Overview
Since the issuance of ASU 2016-02 several years ago, the FASB has released
various additional ASUs to (1) provide a practical expedient that offers entities
transition relief related to reassessing land easement arrangements, (2) make
certain technical corrections and improvements to the standard, (3) make targeted
amendments to lessor accounting and provide transition relief to help decrease the
costs of applying the standard’s guidance, (4) make certain narrow-scope
improvements for lessors, and (5) amend certain provisions of ASC 842 that apply to
arrangements between related parties under common control. Regulators, such as the
SEC, have also been involved in this standard-setting process. Given the
far-reaching impact that ASC 842 will have on many industries, the level of
implementation activity is not surprising.1 Stakeholders should continue to monitor activity at the FASB, SEC, and other
standard setters or regulators for any relevant developments or interpretations.
For a comprehensive collection of news and publications about the latest
developments related to ASC 842, see DART.
Footnotes
1
See Section 17.3.3 for information on ongoing FASB activity.
17.2 SEC Activities
The SEC is a critical stakeholder given its role in standard setting and in regulating the U.S. capital markets. The legacy SEC guidance on leases, which is codified in ASC 840-30-S99 and ASC 840-40-S99, is more limited than that on revenue. However, the SEC staff has been following the implementation efforts of registrants and has updated (and may still update) its interpretive guidance accordingly.
17.2.1 Removal of Certain SEC Staff Announcements and SEC Staff Observer Comments
Upon the effective date of ASC 842, an SEC staff announcement and certain SEC observer comments will be removed (i.e., will no longer be effective) in accordance with ASU 2017-13. The removed SEC staff announcement and SEC staff observer comments include those in ASC 840-30-S99 and ASC 840-40-S99. See Section 17.3.1.1 for further discussion of ASU 2017-13, which details the rescission of certain SEC guidance.
See Chapter 18 for further discussion of reporting considerations for SEC registrants.
17.3 FASB Activities
This Roadmap discusses the FASB’s standard setting through September 30, 2023.
17.3.1 Final ASUs and Expected Proposed ASU
As noted above, the FASB has released various final and proposed ASUs to amend and clarify the
guidance in ASC 842. These final and proposed standards, which were largely issued in response to
stakeholder feedback, are discussed throughout this Roadmap as applicable.
- ASU 2017-13 on amendments to SEC paragraphs (Section 17.3.1.1).
- ASU 2018-01 on the land easement practical expedient for transition (Section 17.3.1.2).
- ASU 2018-10 on technical corrections and improvements (Section 17.3.1.3).
- ASU 2018-11 on targeted improvements (Section 17.3.1.4).
- ASU 2018-20 on narrow-scope improvements for lessors (Section 17.3.1.5).
- ASUs 2016-13 and 2018-19 on TRG activities — billed operating lease receivables (Section 17.3.1.6).2
- ASU 2019-01 on Codification improvements (Section 17.3.1.7).
-
ASUs 2019-10 and 2020-05 on deferrals of the effective dates of the leasing standard (Section 16.1).
-
ASU 2020-02 on amendments to ASC 842 in response to SEC guidance (Section 18.4).
-
ASU 2021-05 on the lessor’s accounting for leases with variable lease payments (Section 17.3.1.8).
-
ASU 2021-09 on improvement of discount rate practical expedient for lessees that are not PBEs (Section 17.3.1.9).
-
ASU 2023-01 on improvements for related-party leases under common control (Section 17.3.1.10).
17.3.1.1 ASU 2017-13 on Amendments to SEC Paragraphs
In September 2017, the FASB issued ASU 2017-13, which rescinds certain SEC guidance in light of ASUs
2014-09 and 2016-02. Specifically, ASU 2017-13 rescinds the following SEC guidance upon the adoption
of ASU 2016-02:
- ASC 840-30-S99-1 on a lessor’s consideration of third-party value guarantees.
- ASC 840-40-S99-1 on sale treatment in sale-and-leaseback transactions with a repurchase option.
- ASC 840-40-S99-2 on the effect of the lessee’s involvement in asset construction.
- ASC 840-40-S99-3 on applying sale-and-leaseback guidance to certain sale-and-leaseback transactions.
In addition, ASU 2017-13 moved certain guidance in ASC 840-30-S99-2 on the effect of a change in tax
law or rates on leveraged leases, which resulted from an SEC observer comment, to ASC 842-50-S99-1.
ASU 2017-13 also codified in ASC 842-10-S65-1 comments made by the SEC observer at the July 20,
2017, EITF meeting. In those comments, the SEC staff announced that it would not object when certain
PBEs elect to use the non-PBE effective dates solely to adopt the FASB’s new standards on revenue and
leases. See Section 18.4 for further discussion of this election.
17.3.1.2 ASU 2018-01 on the Land Easement Practical Expedient for Transition
The FASB received a significant amount of feedback from stakeholders in several industries who were concerned about the cost and complexity of evaluating all existing land easements under ASC 842’s definition of a lease at transition. Entities in these industries have potentially tens of thousands of existing land easements, many of which were executed decades ago, and the same complexities described in Section 2.4.3 would be relevant to these arrangements.
The Board observed that the costs of requiring an entity to evaluate all existing land easements under ASC 842’s definition of a lease outweighed the benefits to financial statement users. Accordingly, the FASB provided transition relief in the form of a practical expedient in ASC 842-10-65-1(gg):
An entity also may elect a practical expedient to not assess whether existing or expired land easements that were not previously accounted for as leases under Topic 840 are or contain a lease under this Topic. For purposes of (gg), a land easement (also commonly referred to as a right of way) refers to a right to use, access, or cross another entity’s land for a specified purpose. This practical expedient shall be applied consistently by an entity to all its existing and expired land easements that were not previously accounted for as leases under Topic 840. This practical expedient may be elected separately or in conjunction with either one or both of the practical expedients in (f) and (g). An entity that elects this practical expedient for existing or expired land easements shall apply the pending content that links to this paragraph to land easements entered into (or modified) on or after the date that the entity first applies the pending content that links to this paragraph as described in (a) and (b). An entity that previously accounted for existing or expired land easements as leases under Topic 840 shall not be eligible for this practical expedient for those land easements.
In short, an entity that elects the expedient is relieved from applying ASC 842
to evaluate all existing land easements that were not previously accounted for in
accordance with ASC 840. The FASB explains in paragraph BC15 of ASU 2018-01 that an
entity may thus elect to “run off” all such easements by using its historical accounting
approach for land easements unless or until the arrangement is modified on or after the
date on which the entity adopts ASU 2016-02.
The objectives of the land easement amendments in ASU 2018-01 are to:
-
Clarify that land easements entered into (or existing land easements modified) on or after the effective date of ASC 842 must be assessed under ASC 842.
-
Provide a transition practical expedient for existing or expired land easements that were not previously accounted for in accordance with ASC 840. The practical expedient would allow entities to elect not to assess whether those land easements are, or contain, leases in accordance with ASC 842 when transitioning to ASC 842.
The amendments in ASU 2018-01 do not, and are not intended to:
- Provide illustrative or application guidance on whether land easements are, or contain, leases in accordance with the definition of a lease in ASC 842.
- Help entities identify the appropriate accounting framework for situations in which a land easement is not determined to be a lease under ASC 842.
See Section 2.4 for more information about the land easement practical expedient for transition.
17.3.1.2.1 Scope
ASU 2018-01 only addresses land easements. Although the FASB does not define this term, ASC 842-10-
65-1(gg) and paragraph BC3 of ASU 2018-01 describe both a land easement and a right of way as a
“right to use, access, or cross another entity’s land for a specified purpose.”
Further, ASU 2018-01 effectively breaks land easements into two groups on the basis of the effective
date of ASU 2016-02: (1) land easements entered into (or existing easements modified) on or after the
effective date (collectively, “new land easements”) and (2) land easements that existed as of, or expired
before, the effective date (collectively, “existing land easements”). See Section 2.4.2 for further discussion
of the scope of ASU 2018-01.
17.3.1.2.2 Identifying a Lease
ASU 2018-01 is not intended to provide illustrative or application guidance about whether new land easements meet the definition of a lease in ASC 842. Therefore, stakeholders and respondents may continue to raise questions about the application of the definition of a lease to new land easement arrangements, and it is possible that the FASB, IASB, and SEC staffs will want to share their perspectives as those questions are raised. Companies involved in land easement arrangements should consult with their accounting advisers and monitor developments on the topic. See Section 2.4.3 for further discussion of whether new land easements meet the definition of a lease in ASC 842.
17.3.1.2.3 Effective Date and Transition
The transition practical expedient for existing land easements may be elected
alone or with any of the other transition practical expedients. In a manner consistent
with the other transition practical expedients, entities must disclose whether they
are electing the transition practical expedient for land easements.
The effective date of ASU 2018-01 is aligned with that of ASU 2016-02. See
Section 16.5.3 for more
information about the effective date and transition provisions of ASU 2018-01.3
17.3.1.3 ASU 2018-10 on Technical Corrections and Improvements
In July 2018, the FASB issued ASU 2018-10 to make narrow-scope amendments
(i.e., minor changes and clarifications) to certain aspects of the leasing standard
(i.e., ASC 842). The table below, reproduced from ASU 2018-10, summarizes the 16
amendments that were made to ASC 842.
Area for Improvement
|
Summary of Amendments
|
---|---|
Issue 1: Residual Value Guarantees
| |
Stakeholders noted that paragraph 460-10-60-32 incorrectly
refers readers to the guidance in Topic 842 about
sale-[and-]leaseback-sublease transactions, when, in fact, it should refer
readers to the guidance about guarantees by a seller-lessee of the
underlying asset’s residual value in a sale and leaseback transaction.
|
The amendment corrects the cross-reference in paragraph
460-10-60-32. [See Section
10.3.1.2 of this Roadmap.]
|
Issue 2: Rate Implicit in the Lease
| |
Stakeholders raised questions about the treatment of
certain sales-type leases with significant variable payments under Topic 842
and whether the application of Topic 842 could result in a negative rate
implicit in the lease, rather than a loss at the commencement date of the
lease.
|
The amendment clarifies that a rate implicit in the lease
of zero should be used when applying the definition of the term rate
implicit in the lease results in a rate that is less than zero. [See
Sections
7.3.1 and 9.3.7.1 of this Roadmap.]
|
Issue 3: Lessee Reassessment of
Lease Classification
| |
Topic 842 is clear that when a lease is modified and that
modification is not accounted for as a separate contract, an entity (that
is, a lessee or a lessor) should reassess, at the effective date of the
modification, lease classification on the basis of the modified terms and
conditions and the facts and circumstances existing as of that date.
Although Topic 842 also requires a lessee to reassess lease classification
if there is a change in the lease term or the assessment of a lessee option
to purchase the underlying asset, stakeholders expressed that it is not
clear whether the lessee should reassess lease classification on the basis
of the facts and circumstances existing as of the date the reassessment is
required.
|
The amendment consolidates the requirements about lease
classification reassessments into one paragraph and better articulates how
an entity should perform the lease classification reassessment, that is, on
the basis of the facts and circumstances, and the modified terms and
conditions, if applicable, as of the date the reassessment is required. [See
Sections 8.3,
8.3.4, and
8.6.3 of this
Roadmap.]
|
Issue 4: Lessor Reassessment of
Lease Term and Purchase Option
| |
Topic 842 requires a lessor to not reassess the lease term
or a lessee purchase option unless the lease is modified and that
modification is not accounted for as a separate contract. Topic 842 also
requires a lessor to account for the exercise of a lessee option to extend
or terminate the lease, or to purchase the underlying asset, in the same
manner as a lease modification. Stakeholders questioned why a lessor should
account for a lessee exercise of such options in a manner similar to a lease
modification when the exercise of those options is consistent with the
assumptions that the lessor made in accounting for the lease at the
commencement date of the lease (or the most recent effective date of a
modification that is not accounted for as a separate contract).
|
The amendment clarifies that a lessor should account for
the exercise by a lessee of an option to extend or terminate the lease or to
purchase the underlying asset as a lease modification unless the exercise of
that option by the lessee is consistent with the assumptions that the lessor
made in accounting for the lease at the commencement date of the lease (or
the most recent effective date of a modification that is not accounted for
as a separate contract). [See Section 5.4.2 of this Roadmap.]
|
Issue 5: Variable Lease Payments
That Depend on an Index or a Rate
| |
Stakeholders noted that the guidance in paragraph
842-10-35-4(b) about remeasurement of the lease payments when a contingency
upon which some or all of the variable lease payments are based is resolved
might be perceived as applying to any variable lease payments, including
those that depend on an index or rate, which would be inconsistent with the
Board’s decisions on this issue.
|
The amendment clarifies that a change in a reference index
or 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 the guidance in paragraph 842-10-35-4(b).
Variable lease payments that depend on an index or a rate
should be remeasured, using the index or rate at the remeasurement date,
only when the lease payments are remeasured for another reason (that is,
when one or more of the events described in paragraph 842-10-35-4(a) or (c)
occur or when a contingency unrelated to a change in a reference index or
rate under paragraph 842-10-35-4(b) is resolved). [See Sections 6.3 and
8.5.3.2 of
this Roadmap.]
|
Issue 6: Investment Tax Credits
| |
Stakeholders indicated that there is an inconsistency in
terminology used about the effect that investment tax credits have on the
fair value of the underlying asset between the definition of the term rate
implicit in the lease and the lease classification guidance in paragraph
842-10-55-8.
|
The amendment removes that inconsistency in terminology.
[See Sections 8.3.3.6.2 and 9.2.1.4 of this
Roadmap.]
|
Issue 7: Lease Term and Purchase
Option
| |
Stakeholders indicated that the description in paragraph
842-10-55-24 about lessor-only termination options is inconsistent with the
description in paragraph 842-10-55-23 about the noncancellable period of a
lease.
|
The amendment removes that inconsistency by clarifying
that the period covered by a lessor-only option to terminate the lease is
included in the lease term. [See Section 5.2.4.1 of this Roadmap.]
|
Issue 8: Transition Guidance for
Amounts Previously Recognized in Business Combinations
| |
Stakeholders indicated that the transition guidance for
lessors in paragraph 842-10-65-1(h)(3) is unclear because it relates to
leases classified as direct financing leases or sales-type leases under
Topic 840, while the lead-in sentence to paragraph 842-10-65-1(h) provides
transition guidance for leases classified as operating leases under Topic
840.
|
The amendment clarifies that paragraph 842-10-65-1(h)(3)
applies to lessors for leases classified as direct financing leases or
sales-type leases under Topic 842, not Topic 840. In other words, paragraph
842-10-65-1(h)(3) applies when an entity does not elect the package of
practical expedients in paragraph 842-10-65-1(f), and, for a lessor, an
operating lease acquired as part of a previous business combination is
classified as a direct financing lease or a sales-type lease when applying
the lease classification guidance in Topic 842. The amendment also
cross-references to other transition guidance applicable to those changes in
lease classification for lessors. [See Section 16.10 of this Roadmap.]
|
Issue 9: Certain Transition
Adjustments
| |
When an entity initially applies Topic 842 retrospectively
to each prior reporting period and does not elect the package of practical
expedients in Topic 842, paragraph 842-10-65-1(p) requires a lessee to write
off, as an adjustment to equity, any unamortized initial direct costs that
do not meet the definition of initial direct costs under Topic 842 for
leases previously classified as operating leases under Topic 840.
Stakeholders questioned why those nonqualifying costs should be charged to
equity when those costs are incurred after the beginning of the earliest
period presented in the financial statements in which an entity adopts Topic
842. Similar issues also were noted elsewhere in the transition guidance
when an entity initially applies Topic 842 retrospectively to each prior
reporting period.
|
The amendments clarify whether to recognize a transition
adjustment to earnings rather than through equity when an entity initially
applies Topic 842 retrospectively to each prior reporting period. [See
Sections
16.3.1, 16.3.2.1.1, 16.3.2.2, 16.4.1, 16.4.2, and 16.4.4 of this Roadmap.]
|
Issue 10: Transition Guidance for
Leases Previously Classified as Capital Leases Under Topic 840
| |
Paragraph 842-10-65-1(r) provides guidance to lessees for
leases previously classified as capital leases under Topic 840 and
classified as finance leases under Topic 842. Paragraph 842-10-65-1(r)(4)
provides subsequent measurement guidance before the effective date when an
entity initially applies Topic 842 retrospectively to each prior reporting
period, but it refers readers to the subsequent measurement guidance in
Topic 840 about operating leases. It should refer them to the subsequent
measurement guidance applicable to capital leases.
|
The amendment corrects that reference. [See Section 16.3.2.1.2 of
this Roadmap.]
|
Issue 11: Transition Guidance for
Modifications to Leases Previously Classified as Direct Financing or
Sales-Type Leases Under Topic 840
| |
Paragraph 842-10-65-1(x) provides transition guidance
applicable to lessors for leases previously classified as direct financing
leases or sales-type leases under Topic 840 and classified as direct
financing leases or sales-type leases under Topic 842. For modifications to
those leases beginning after the effective date, paragraph 842-10-65-1(x)(4)
refers readers to other applicable guidance in Topic 842 to account for the
modification, specifically paragraphs 842-10-25-16 through 25-17, depending
on how the lease is classified after the modification. Stakeholders noted
that it should refer to how the lease is classified before the
modification to be consistent with the guidance provided in paragraphs
842-10-25-16 through 25-17.
|
The amendment corrects that inconsistency. [See Section 16.4.3 of this
Roadmap.]
|
Issue 12: Transition Guidance for
Sale and Leaseback Transactions
| |
Stakeholders noted that the heading above the transition
guidance on sale and leaseback transactions appears to suggest that there is
no transition guidance for sale and leaseback transactions that occur after
the earliest comparative period presented in the financial statements in
which an entity adopts Topic 842 but before the effective date. Some
stakeholders also questioned some of the references included in paragraph
842-10-65-1(bb).
|
The amendments clarify that the transition guidance on
sale and leaseback transactions in paragraph 842-10-65-1(aa) through (ee)
applies to all sale and leaseback transactions that occur before the
effective date and corrects the referencing issues noted. [See Section 16.9 of this
Roadmap.]
|
Issue 13: Impairment of Net
Investment in the Lease
| |
Paragraph 842-30-35-3 provides guidance to lessors for
determining the loss allowance of the net investment in the lease and
describes the cash flows that should be considered when the lessor
determines that loss allowance. Stakeholders questioned whether the
guidance, as written, would accelerate and improperly measure the loss
allowance because the cash flows associated with the unguaranteed residual
asset appear to be excluded from the evaluation.
|
The amendment clarifies the application of the guidance
for determining the loss allowance of the net investment in the lease,
including the cash flows to consider in that assessment. [See Section 9.3.7.5 of this
Roadmap.]
|
Issue 14: Unguaranteed Residual
Asset
| |
Paragraph 842-30-35-4 provides guidance explaining that if
a lessor sells the lease receivable associated with a direct financing lease
or a sales-type lease and retains an interest in the residual value of the
asset, the lessor should not continue to accrete the unguaranteed residual
asset to its estimated value over the remaining lease term. Stakeholders
questioned whether the Board intended to change the application as compared
with current generally accepted accounting principles (GAAP) because the
guidance in paragraph 840-30-35-53 (which will be superseded by the
amendments in Update 2016-02) requires a lessor to continue to recognize
interest resulting from accretion of the unguaranteed residual asset to its
estimated value unless the lessor sells substantially all of the minimum
rental payments.
|
The amendment clarifies that a lessor should not continue
to accrete the unguaranteed residual asset to its estimated value over the
remaining lease term to the extent that the lessor sells substantially all
of the lease receivable associated with a direct financing lease or a
sales-type lease, consistent with Topic 840. [See Section 9.3.7.6 of this Roadmap.]
|
Issue 15: Effect of Initial Direct
Costs on the Rate Implicit in the Lease
| |
Stakeholders noted that the ordering of the illustration
in Case C of Example 1 in paragraphs 842-30-55-31 through 55-39 has raised
questions about how initial direct costs factor into determining the rate
implicit in the lease for lease classification purposes for lessors
only.
|
The amendment more clearly aligns the illustration to the
guidance in paragraph 842-10-25-4. [See Sections 9.3.7.1.2 and 9.3.8.1 of this
Roadmap.]
|
Issue 16: Failed Sale and Leaseback
Transaction
| |
In accordance with Subtopic 842-40, Leases — Sale and
Leaseback Transactions, when a sale and leaseback transaction does not
qualify as a sale, the entity should account for the transaction as a
financing arrangement. Paragraph 842-40-30-6(a) further requires a
seller-lessee to adjust the interest rate as necessary to prevent negative
amortization of the financial liability recognized. Some stakeholders
questioned whether the language used in paragraph 842-40-30-6(a) actually
meets the objective of preventing negative amortization of the financial
liability recognized by a seller-lessee in a failed sale and leaseback
transaction.
|
The amendment clarifies that a seller-lessee in a failed
sale and leaseback transaction should adjust the interest rate on its
financial liability as necessary to ensure that the interest on the
financial liability does not exceed the total payments (rather than the
principal payments) on the financial liability. This clarification is also
reflected in the relevant illustration on failed sale and leaseback
transactions that is contained in Subtopic 842-40. [See Sections 10.4.2.1 and
10.4.2.3 of
this Roadmap.]
|
17.3.1.3.1 Effective Date and Transition
The effective date of the amendments in ASU 2018-10 is aligned with that of ASU
2016-02.4 For entities that have early adopted ASC 842, the ASU is effective upon issuance
and its transition requirements are the same as those in ASC 842.
17.3.1.4 ASU 2018-11 on Targeted Improvements
In July 2018, the FASB issued ASU 2018-11 to provide entities with relief
from the costs of implementing certain aspects of the leasing standard. Specifically,
under the amendments in ASU 2018-11:
-
Entities may elect not to recast their comparative periods in the period of adoption when transitioning to ASC 842.
-
Lessors may elect not to separate lease and nonlease components when certain conditions are met.
The scope of the amendments in the ASU is as follows:
- Transition relief — These amendments, which allow entities to report the comparative periods presented in the period of adoption under ASC 840, affect all entities with lease contracts that elect not to restate their comparative periods in transition.
- Lessor relief — These amendments, which give lessors the option of electing, as a practical expedient by class of underlying asset, not to separate the lease and nonlease components of a contract, only affect lessors whose lease contracts meet certain criteria (discussed below).
Note that while the transition relief amendments may benefit both lessees and lessors, the lessor relief amendments will benefit only lessors.
17.3.1.4.1 Transition Relief
ASC 842, as initially issued, required entities to use a “modified retrospective” transition approach that is intended to maximize comparability and be less complex than a full retrospective approach. See Chapter 16 for further discussion of the effective date and transition guidance.
Under the modified retrospective approach, ASC 842 is effectively implemented as of the beginning of the earliest comparative period presented in an entity’s financial statements. That is, a public entity for which the standard becomes effective on January 1, 2019, would first apply ASC 842 and recognize an adjustment for the effects of the transition as of January 1, 2017 (i.e., the date of initial application).
However, ASU 2018-11 amends ASC 842 so that entities may elect not to recast
their comparative periods in transition (the Comparatives Under 840 Option).
Effectively, ASU 2018-11 allows entities to change their date of initial application
to the beginning of the period of adoption of ASC 842 (e.g., January 1, 2019, for a
calendar-year PBE). In doing so, the entity would:
-
Apply ASC 840 in the comparative periods.
-
Provide the disclosures required by ASC 840 for all periods that continue to be presented in accordance with ASC 840.
-
Recognize the effects of applying ASC 842 as a cumulative-effect adjustment to retained earnings as of the effective date (e.g., January 1, 2019); under the Comparatives Under 840 Option, this date would represent the date of initial application.
The entity would not:
- Restate comparative periods for the effects of applying ASC 842.
- Provide the disclosures required by ASC 842 for the comparative periods.
- Change how the transition requirements apply, only when the transition requirements apply.
17.3.1.4.1.1 Effective Date and Transition
The transition relief amendments in ASU 2018-11 apply to entities that have not
yet adopted ASC 842.5 Entities that have early adopted ASC 842 cannot elect the Comparatives Under
840 Option.
See Sections 16.1.1
and 16.11 for further
discussion of the transition relief amendments in ASU 2018-11, including the related
disclosure requirements.
17.3.1.4.2 Lessor’s Separation of Lease and Nonlease Components
ASU 2016-02, as initially issued, required lessors to separate lease and nonlease components in all
circumstances. Once separate components were identified, lessors were required to use the relative
stand-alone selling price allocation method in ASC 606 to allocate the consideration in the contract to
the separated components. ASC 842 (including its presentation and disclosure guidance) applied to
the lease component, while other guidance, typically ASC 606 (including its presentation and disclosure
guidance), applied to the nonlease component.
As a result of feedback received from stakeholders indicating that the costs of complying with the
separation and allocation requirements for lessors outweigh the benefits, the FASB amended ASC 842
to give lessors the option of electing a practical expedient under which they would not be required to
separate lease and nonlease components, provided that the nonlease component(s) otherwise would
be accounted for under the revenue guidance in ASC 606 and both of the following conditions are
met:
- Criterion A — The timing and pattern of transfer for the lease component are the same as those for the nonlease components associated with that lease component.
- Criterion B — The lease component, if accounted for separately, would be classified as an operating lease.
The practical expedient can be elected by class of underlying asset and should be applied, as of the date
elected, to all transactions within those classes of underlying assets that qualify for the expedient.
Further, ASC 842-10-15-42C clarifies that the presence of a nonlease component that is ineligible for
the practical expedient does not preclude a lessor from electing the expedient for the lease component
and nonlease component(s) that meet the criteria. Rather, the lessor would account for the nonlease
components that do not qualify for the practical expedient separately from the combined lease and
nonlease components that do qualify.
See Section 4.3.3.2
for more information about the practical expedient related to a lessor’s separation of
lease and nonlease components.
17.3.1.4.2.1 Disclosure Requirements
When a lessor elects the practical expedient to combine lease and nonlease components in a contract,
it is required to provide certain disclosures. Such disclosures include (1) the lessor’s election to combine
lease components with associated nonlease components, (2) the class(es) of underlying asset(s) for
which the election was made, (3) the nature of the items that are being combined, (4) any nonlease
components that were not eligible for the practical expedient, and (5) which standard applies to the
combined component (i.e., ASC 842 or ASC 606). (See Section 15.3.2.4 for additional discussion of the
disclosure requirements related to ASU 2018-11.)
17.3.1.4.2.2 Effective Date and Transition
For entities that have not yet adopted ASU 2016-02, the effective date of ASU
2018-11 is aligned with the leasing standard’s effective date and transition
requirements.6
Upon transition to ASU 2018-11, a lessor electing the practical expedient would be required to apply it to all new and existing transactions within a class of underlying asset that qualify for the expedient as of the date elected. That is, a lessor would not be permitted to apply the practical expedient only to new or modified transactions within a class of underlying asset. See Section 16.4.6 for further discussion of transition requirements related to ASU 2018-11.
17.3.1.5 ASU 2018-20 on Narrow-Scope Improvements for Lessors
In December 2018, the FASB issued ASU 2018-20, which addresses certain concerns raised by lessors regarding the guidance in ASU 2016-02. Specifically, ASU 2018-20 includes amendments related to the following items:
- Item 1 — “Sales taxes and other similar taxes collected from lessees.”
- Item 2 — “Certain lessor costs.”
- Item 3 — “Recognition of variable payments for contracts with lease and nonlease components.”
17.3.1.5.1 Sales Taxes and Other Similar Taxes Collected From Lessees
Under ASC 606, as amended by ASU 2016-12, entities can elect an accounting policy of presenting sales taxes collected from customers on a net basis. Specifically, ASC 606-10-32-2A states, in part:
An entity may make an accounting policy election to exclude from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and collected by the entity from a customer (for example, sales, use, value added, and some excise taxes).
As issued, ASU 2016-02 did not provide lessors with a similar practical
expedient for sales taxes collected from lessees. Feedback from stakeholders cited
operational challenges with applying the leasing guidance without such an expedient.
Stakeholders noted that although lessors are not within the scope of ASC 606, they are
performing a revenue-generating activity in a manner similar to a service accounted
for under ASC 606. Therefore, these stakeholders requested that the FASB provide a
similar practical expedient under which lessors could elect to present sales taxes
collected from lessees on a net basis.
Accordingly, ASU 2018-20 offers lessors an accounting policy election under
which they can exclude from lease revenue sales taxes and other similar taxes assessed
by a governmental authority and collected by the lessor from a lessee. This is a
policy election by the entity. Lessors making this accounting policy election must
disclose that they have done so in addition to complying with the disclosure
requirements in ASC 235-10-50-1 through 50-6. See Section 15.3.6 for further details about the
disclosure requirements in ASU 2018-20 and Section
4.4.2.1.3 for a general discussion of ASU 2018-20.
17.3.1.5.2 Lessor Costs
A lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement
for the lessee to pay those costs, whether directly to a third party on behalf of the lessor or as a
reimbursement to the lessor, does not transfer a good or service to the lessee separately from the right
to use the underlying asset. ASU 2016-02, as initially issued, required a lessor to report those amounts,
regardless of the payor, as revenue and expenses.
Under ASC 606, an entity must evaluate whether it is acting as the principal or
the agent in the transaction to determine whether revenue should be presented on a
gross or net basis. However, after the issuance of the revenue standard, stakeholders
raised questions about whether an entity should be required to estimate gross revenue
when it is acting as the principal but there is uncertainty in the transaction price
that is not expected to ultimately be resolved. As a result, when the FASB issued
amendments to the principal-versus-agent guidance in ASU 2016-08, it specifically addressed this
question in paragraph BC38(c) of the Background Information and Basis for Conclusions
of that ASU:
The determination of whether revenue may be estimated or not is
based on an assessment of the transaction price guidance in Section 606-10-32 on
measurement (such as, the amount of consideration which the entity expects to be
entitled to for transferring promised goods or services to a customer and the
constraint on variable consideration). The guidance on variable consideration is
instructive as to whether amounts should be recognized as revenue. A key tenet of
variable consideration is that at some point the uncertainty in the transaction
price ultimately [will] be resolved. When the uncertainty is not expected to
ultimately be resolved, the guidance indicates that the difference between the
amount to which the entity is entitled from the intermediary and the amount
charged by the intermediary to the end customer is not variable consideration and,
therefore, is not part of the entity’s transaction price.
In light of the guidance in the Background Information and Basis for Conclusions of ASU 2016-08,
some lessor stakeholders requested that the FASB provide a similar accounting policy election under
which lessors would not be required to recognize lease revenue (and the corresponding expense) for
certain costs that are considered lessor costs under ASC 842.
Accordingly, ASU 2018-20 addresses stakeholder concerns about the challenges related to determining
costs paid by lessees directly to third parties on behalf of lessors by requiring lessors to exclude such
costs from variable payments, and thus from lease revenue. Lessor costs are not a component in the
contract because they are neither lease components nor nonlease components (e.g., services). Some
common examples of lessor costs include property taxes and insurance in a real estate lease.
Although stakeholders requested a policy election, the amendments in ASU 2018-20
indicate that lessor costs that are paid directly to a third party by a lessor and
then reimbursed by the lessee must be accounted for as
variable payments. Paragraph BC28 of ASU 2018-20 notes that “[a]lthough the economics
between Lessee-Paid and Lessee-Reimbursed are similar in that both may be costs of the
lessor, the Board highlighted that all Lessee-Reimbursed costs are known amounts to
the lessor and concluded that those costs should be accounted for as lessor
costs.”
See Section 4.4.2.1.2 for a detailed
discussion of ASU 2018-20.
17.3.1.5.3 Recognition of Variable Payments for Contracts With Lease and Nonlease Components
ASU 2016-02 initially required lessors to recognize variable payments “in profit or loss in the period when changes in the facts and circumstances on which the variable payment is based occur,” regardless of whether the variable payment is related to the lease or nonlease component in the contract.
Stakeholders observed that the guidance, as originally issued, may lead a lessor to recognize as revenue a variable payment related to a nonlease component before the nonlease component is transferred to the customer. That is, as issued, ASC 842-10-15-40, read literally, implied that as soon as an uncertainty that created variability in the consideration is resolved, that amount should be recognized as revenue regardless of whether the item to which it is related has been delivered to the customer-lessee.
To clarify the paragraph’s intent, ASU 2018-20 amended ASC 842 to require a
lessor to allocate (rather than recognize) certain variable payments to the lease and
nonlease components when the changes in facts and circumstances on which the variable
payment is based occur. After the allocation, the amount of variable payments
allocated to the lease component would be “recognized as income in profit or loss in
accordance with this Topic [ASC 842], while variable payment amounts allocated to
nonlease component(s) [would] be recognized in accordance with other Topics (for
example, Topic 606 . . .).”
See Section 4.4.2.2
for more information about allocating the consideration in the contract and
recognizing variable payments in accordance with ASC 842-10-15-40 when a portion is
attributable to the nonlease component(s).
17.3.1.5.4 Effective Date and Transition
If an entity has not yet adopted ASU 2016-02 on the date of issuance of ASU
2018-20 (i.e., December 10, 2018), the effective date of ASU 2018-20 is aligned with
that of ASU 2016-02.7
In addition, such an entity should consistently apply the amendments to all new and existing leases and apply the same transition method elected for ASU 2016-02.
17.3.1.6 TRG Activities — Billed Operating Lease Receivables
In June 2016, the FASB issued ASU 2016-13, which adds to U.S. GAAP an
impairment model — known as the CECL model — that is based on expected losses rather
than incurred losses. ASU 2016-13 significantly changes the accounting for credit
impairment under ASC 326.8 (See Deloitte’s June 17, 2016, Heads Up for more information about the guidance in ASU 2016-13.)
Upon issuing ASU 2016-13, the
FASB formed a credit losses transition resource group (TRG).9 At the TRG’s June 11, 2018, meeting,10 a stakeholder asked the FASB staff “whether billed operating lease receivables are
within the scope of the guidance in Subtopic 326-20.” The stakeholder noted that views
on this issue differ and that such views include the following:
-
“Topic 842 has specific guidance . . . indicating that if the assessment of collectibility of an operating lease changes, any amount of lease income recognized that has not been collected should be reversed through a current-period adjustment to lease income.”
-
“[T]he scope of Subtopic 326-20 includes financing receivables and billed operating lease receivables appear to meet that definition.”
In response to this inquiry, the FASB staff stated its belief that “operating
lease receivables are not within the scope of Topic 326-20” and that “it was never the
Board’s intent to include operating leases within the scope.” In November 2018, the FASB
issued ASU
2018-19 to clarify certain aspects of ASU 2016-13, including that
operating lease receivables are within the scope of ASC 842 rather than ASC 326.
Therefore, an entity would apply ASC 842 rather than ASC 326-20 to account for changes
in the collectibility assessment for operating leases. When applying ASC 842, an entity
would recognize changes in the collectibility assessment for an operating lease
receivable as an adjustment to lease income in accordance with ASC 842-10-25-13.
See additional discussion in Section 9.3.9.2.1.
17.3.1.7 ASU 2019-01 on Codification Improvements
In March 2019, the FASB issued ASU 2019-01 on Codification improvements related to the following three ASC 842 issues:
- Determination of the fair value of the underlying asset by lessors that are not manufacturers or dealers.
- Presentation in the statement of cash flows for sales-type and direct financing leases by lessors within the scope of ASC 942.
- Clarification of interim disclosure requirements during transition.
17.3.1.7.1 Determination of the Fair Value of the Underlying Asset by Lessors That Are Not Manufacturers or Dealers
ASC 840-10-55-44 provided guidance on determining fair value and applying it to
lease classification and measurement for lessors that are not manufacturers or dealers
(“qualifying lessors”), stating that:
If the lessor is not a manufacturer or dealer, the fair value of
the property at lease inception ordinarily will be its cost, reflecting any volume
or trade discounts that may apply. However, if there has been a significant lapse
of time between the acquisition of the property by the lessor and lease inception,
the determination of fair value should be made in light of market conditions
prevailing at lease inception, which may indicate that the fair value of the
property is greater or less than its cost or carrying amount, if different.
ASC 842, as originally issued, eliminated this fair value exception and instead required that the definition of fair value established in ASC 820 be applied for all aspects of lease accounting in ASC 842.
Stakeholders communicated to the FASB that not carrying forward the fair value
exception to ASC 842 would have significant adverse financial reporting consequences
for qualifying lessors in certain industries. Specifically, a lessor that is not a
manufacturer or dealer would be required to recognize (i.e., expense) acquisition
costs (e.g., sales taxes and delivery charges) at lease commencement regardless of how
long the lessor has held the asset. Consequently, a lessor whose business model
consists of financing the cost of the underlying asset to the lessee would need to
record a day 1 loss under ASC 842 in many cases. Further, to recover these costs, the
lessor would recognize interest income for sales-type and direct financing leases that
is significantly greater than that being recognized under ASC 840. Stakeholders
expressed their belief that this accounting outcome is neither useful to investors nor
representative of the business model of these lessors.
In response to this issue, the Board issued the amendment in ASU 2019-01 to provide a
fair value exception similar to that in ASC 840-10-55-44. Therefore, unless a
significant lapse of time has occurred, lessors that are not manufacturers or dealers
(generally financial institutions and captive finance companies) will continue to use
their cost, reflecting any volume or trade discounts that may apply, as the fair value
of the underlying asset.
17.3.1.7.2 Statement of Cash Flows Presentation for Sales-Type and Direct Financing Leases by Lessors Within the Scope of ASC 942
ASC 842, as originally issued, contained guidance that conflicted with industry-specific GAAP for depository and lending lessors on the presentation of principal payments received from sales-type and direct financing leases. That is, ASC 842 initially required all lessors to classify cash receipts from leases within “operating activities” in accordance with ASC 842-30-45-5, while ASC 942 provides an example in which principal payments received under leases are classified as investing activities for entities within the scope of ASC 942. (This example existed before, and was not consequentially amended by, the issuance of ASC 842.)
The Board issued the amendment in ASU 2019-01 to clarify that the existing
guidance in ASC 942 should continue to be applied after the adoption of ASC 842.
Accordingly, depository and lending lessors should continue to classify principal
payments received from sales-type and direct financing leases within “investing
activities.”
17.3.1.7.3 Clarification of Interim Disclosure Requirements During Transition
ASU 2019-01 also clarifies the transition guidance in ASC 842-10-65-1(i), noting that entities adopting ASC 842 need not provide the interim-period disclosures required by ASC 250-10-50-3, which states:
In the fiscal year in which a new accounting principle is adopted, financial information reported for interim periods after the date of adoption shall disclose the effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), and related per-share amounts, if applicable, for those post-change interim periods.
Accordingly, interim disclosures about the effect on income in the year of adoption of ASC 842 are excluded from the required disclosures in transition. The similar annual disclosures in ASC 250-10-50-1(b)(2) about the effect on income have always been excluded from the ASC 842 disclosures in transition.
17.3.1.7.4 Transition and Effective Date
There is no separate effective date and transition guidance for the Codification
improvement related to interim disclosure requirements because that amendment
represents a clarification of existing guidance. However, the effective date of the
other two amendments in ASU 2019-01 (related to the determination of fair value and
presentation in the statement of cash flows) is aligned with the effective dates of
ASU 2016-02.11
Early adoption is permitted for all entities. In accordance with ASC 842-10-65-1(c), for entities that early adopt the ASU, the amendments are effective as of the date on which the entity first applies ASU 2016-02.
17.3.1.8 ASU 2021-05 on Lessor’s Accounting for Certain Leases With Variable Lease Payments
In July 2021, the FASB issued ASU 2021-05, which requires a lessor to
classify a lease with variable lease payments that do not depend on an index or rate as
an operating lease on the lease commencement date if specified criteria are met.
Before the release of the ASU, sales-type leases or direct financing
leases with significant variable payments may have resulted in a day 1 loss on the
arrangement even if the overall economics of the arrangement were expected to be
profitable. This is because, under ASC 842, variable payments are excluded from the
definition of lease payments for both lessees and lessors. Accordingly, lessors exclude
variable payments when measuring the net investment in the lease. As a result, the
amount recognized for the net investment in the lease may be less than that derecognized
for the underlying asset. See Section 9.3.7.1.2
for more information about the accounting for such leases before the adoption of ASU
2021-05.
17.3.1.8.1 Key Provisions of ASU 2021-05
ASC 842-10-25-3A (added by ASU 2021-05) requires a lessor to classify a lease with
variable lease payments that do not depend on an index or rate as an operating lease
at lease commencement if both of the following conditions are met:
- The lease would have been classified as a sales-type lease or direct financing lease in accordance with the classification criteria in ASC 842-10-25-2 and 25-3, respectively.
- The lessor would have recognized a selling loss at lease commencement.
When applying the guidance in ASC 842-10-25-3A, the lessor would not
derecognize the underlying asset upon lease commencement but would continue to
depreciate the underlying asset over its useful life. Further, in accordance with ASC
842-30-25-11(a), the lessor would recognize fixed lease payments as “income . . . over
the 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 use of the underlying asset.” Variable lease payments would be recognized as
“income in profit or loss in the period in which the changes in facts and
circumstances on which the variable lease payments are based occur,” as indicated in
ASC 842-30-25-11(b).
Note that the ASU does not prescribe a threshold for the amount of variable payments;
the ASU’s guidance must be applied when a lease contains any amount of variable
payments (in addition to the requirement that the lessor would have otherwise
recognized a selling loss at lease commencement).
Connecting the Dots
Impacts of ASU 2021-05
We expect that, under ASU 2021-05, more lessors will be required
to classify leases as operating leases rather than as sales-type or direct
financing leases. Accordingly, additional leases will qualify for the lessor
practical expedient in ASC 842-10-15-42A, which allows lessors to combine lease
and nonlease components into a single component if certain scope requirements are
met. One of these requirements is that the underlying lease component must be
classified as an operating lease. See Section 4.3.3.2 for more information about the
lessor practical expedient.
We also expect more arrangements to qualify as a successful
purchase by the buyer-lessor in a sale-and-leaseback transaction, since the lease
from the buyer-lessor to the seller-lessee must be classified as an operating
lease for such a purchase to be successful. Accordingly, under ASU 2021-05, more
buyer-lessors will be able to obtain control of the underlying asset in the
sale-and-leaseback arrangement. However, this ASU will not affect the
seller-lessee’s accounting in a sale-and-leaseback transaction since it does not
change the lessee’s determination of lease classification. See Section 10.3 for additional guidance on evaluating
whether the transfer of an asset is a sale in a sale-and-leaseback
transaction.
17.3.1.8.2 Transition and Effective Date
Lessors that have not adopted ASC 842 on or before July 19, 2021, should apply the
transition requirements in ASC 842-10-65-1 when adopting ASU 2021-05. Those entities
should adopt the ASU on the same date on which they adopt ASC 842.
ASC 842-10
Transition Related to Accounting Standards Update No. 2021-05,
Leases (Topic 842): Lessors — Certain Leases With Variable Lease
Payments
65-5 The following
represents the transition and effective date information related to
Accounting Standards Update No. 2021-05, Leases (Topic 842): Lessors —
Certain Leases With Variable Lease Payments:
-
An entity that has not yet adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph when it first applies the pending content that links to paragraph 842-10-65-1 and shall apply the same transition method elected for the pending content that links to paragraph 842-10-65-1.
-
An entity within the scope of paragraph 842-10-65-1(a) that has adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2021, and interim periods within those fiscal years. Earlier application is permitted.
-
An entity within the scope of paragraph 842-10-65-1(b) that has adopted the pending content that links to paragraph 842-10-65-1 as of July 19, 2021, shall apply the pending content that links to this paragraph for fiscal years beginning after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. Earlier application is permitted.
-
An entity within the scope of (b) or (c) shall apply the pending content that links to this paragraph by using one of the following two methods:
-
Retrospectively to the date in which the pending content that links to paragraph 842-10-65-1 was adopted (the beginning of the period of adoption of Topic 842). Under this transition method, the entity shall apply the pending content that links to this paragraph to leases that commence or are modified on or after the beginning of the period of its adoption of Topic 842 and do not meet the conditions in paragraph 842-10-25-8.
-
Prospectively to leases that commence or are modified on or after the date that the entity first applies the pending content that links to this paragraph and do not meet the conditions in paragraphs 842-10-25-8.
-
- An entity within the scope of (b) or (c) that elects the transition
method in (d)(1) shall provide the following transition
disclosures:
-
The applicable transition disclosures required by Topic 250 on accounting changes and error corrections, except for the requirements in paragraph 250-10-50-1(b)(2) and paragraph 250-10-50-3
-
The transition disclosures in paragraph 250-10-50-1(b)(3) as of the beginning of the earliest period presented but not before the date in which the pending content that links to paragraph 842-10-65-1 was adopted.
-
- An entity within the scope of (b) or (c) that elects the transition
method in (d)(2) shall provide the following transition
disclosures:
-
The nature of and reason for the change in accounting principle
-
The transition method
-
A qualitative description of the financial statement line items affected by the change.
-
Lessors that have adopted ASC 842 as of July 19, 2021, should apply the transition
requirements for fiscal years beginning after December 15, 2021.12 Entities should use either of the following approaches to apply the ASU’s
amendments:
- Retrospective application to leases that commence or are modified on or after the adoption of ASC 842, when the modification does not meet the conditions to be accounted for as a separate contract (as defined in ASC 842-10-25-8).
- Prospective application to leases that commence or are modified on or after the date on which a lessor first applies the amendments in ASU 2021-05, when the modification does not meet the conditions to be accounted for as a separate contract (as defined in ASC 842-10-25-8).
An entity is permitted to early adopt ASU 2021-05 as long as it does not do so before
adopting ASC 842.
Changing Lanes
Proposed ASU
The FASB initially addressed the day 1 loss issue in a proposed ASU released on October 20, 2020, that
suggested targeted improvements to the leasing guidance in ASC 842. This proposal
also discussed two additional issues that stakeholders have raised regarding the
implementation of ASC 842:
- Option to remeasure lease liability — lessee only — The purpose of this issue was to converge U.S. GAAP and IFRS accounting requirements related to remeasuring lease liabilities and the associated ROU assets when future lease payments are based on a reference index or rate. While ASC 842 precludes a lessee from remeasuring a lease liability associated with a change in lease payments as a result of changes in the reference index or rate, IFRS 16 requires a lessee to remeasure the lease liability in such circumstances. The proposed ASU would have given lessees the option of performing such remeasurement. This proposed guidance was ultimately rejected, and the project was removed from the FASB’s technical agenda.
- Modifications reducing the scope of a lease contract — The initial proposal would have amended the lease modification framework for master lease agreements or lease arrangements with multiple components. Specifically, if the scope of a lease agreement had changed (i.e., one lease component was terminated) but the remaining lease components were not economically affected, an entity would have been exempt from applying modification accounting to the remaining lease components in the lease contract. The FASB ultimately decided to remove this issue from the proposed ASU and instead added a project on lease modifications to its technical agenda. See Section 17.3.3 for further discussion of this project.
17.3.1.9 ASU 2021-09 on the Discount Rate for Lessees That Are Not PBEs
In November 2021, the FASB issued ASU 2021-09, which allows lessees that are not
PBEs to make an accounting policy election by class of underlying asset, rather than on
an entity-wide basis, to use a risk-free rate as the discount rate when measuring and
classifying leases.
In September 2020, the FASB held public roundtables to discuss lease
implementation topics. During those discussions, stakeholders expressed concerns about
the cost and complexity of applying ASC 842, specifically regarding the determination of
the discount rate used to measure a lessee’s lease liabilities and ROU assets.
Before the issuance of ASU 2021-09, ASC 842-20-30-3 permitted non-PBE
lessees 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” (emphasis added). However, during the roundtables, the FASB learned that
many entities would not benefit from electing this practical expedient because such
entities did not want to use the risk-free rate for all of their leases for which they
are a lessee. In response, private-company stakeholders proposed a more practicable
alternative that would allow lessees to elect to use the risk-free rate as their
discount rate for certain classes of underlying assets, as opposed to only having the
option of making that election at an entity-wide level.13
17.3.1.9.1 Key Provisions of ASU 2021-09
ASU 2021-09 amends the current guidance in ASC 842-20-30-3 to allow a non-PBE lessee to
make an accounting policy election, by class of underlying assets, to use a risk-free
rate as the discount rate when the rate implicit in the lease is not readily
determinable. Specifically, ASU 2021-09 amends the guidance in ASC 842-20-30-3 to
state:
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 instead of its
incremental borrowing rate, determined using a period comparable with that of the
lease term, as an accounting policy election made by class of underlying asset.
[Emphasis added]
In addition to allowing lessees to elect to use the risk-free rate as
an accounting policy by asset class rather than on an entity-wide level, the ASU
requires lessees to:
-
Disclose their election, including the asset class(es) for which they have elected the accounting policy.14
-
Use the rate implicit in the lease instead of the risk-free rate when the former is readily determinable, regardless of whether the practical expedient has been elected.
Connecting the Dots
Lessees Must Use Rate Implicit in the Lease if Determinable
Before ASU 2021-09, it was unclear whether non-PBE lessees that made the
entity-wide risk-free rate election were still required to use the rate implicit in
the lease when it was readily determinable. The ASU clarifies that this requirement
applies even if a lessee elected the risk-free rate for the relevant class of
underlying asset. In practice, many lessees cannot readily determine the rate
implicit in a lease since they may not know all material inputs in the lessor’s
calculation of that rate. See Section 7.2.1
for further discussion of how to evaluate whether the rate implicit in a lease is
readily determinable.
17.3.1.9.2 Transition and Effective Date
Lessees that did not adopt ASC 842 on or before November 11, 2021, should apply the
transition requirements in ASC 842-10-65-1 when adopting ASU 2021-09. The ASU should be
adopted on the same date on which an entity adopts ASC 842.
Lessees that have adopted ASC 842 as of November 11, 2021, should
apply the transition requirements below for fiscal years beginning after December 15,
2021, and interim periods within fiscal years beginning after December 15, 2022.
- An entity should apply a modified retrospective transition method to leases affected by the amendments existing as of the beginning of the year of adoption by adjusting the lease liability and corresponding ROU asset at the beginning of the fiscal year in which the ASU is adopted.15
- When adopting the ASU, an entity is not permitted to:
- Remeasure and reallocate the consideration in the contract.
- Reassess the lease term or a lessee’s election to exercise a purchase option on the underlying asset.
- Remeasure the lease payments.
- Reassess lease classification.
- The following must be disclosed as of the beginning of the year
of adoption:
- The applicable information in ASC 250-10-50-1(a) and ASC 250-10-50-1(b)(3).
- The amount of the change in the lease liability and the corresponding ROU asset resulting from the adoption of the ASU.
Early adoption of ASU 2021-09 is permitted, as long as an entity does not adopt the ASU
before adopting ASC 842.
Before the issuance of this ASU, non-PBE lessees that had adopted ASC 842 were required
to use the risk-free rate as the discount rate to measure all of their leases if they
had elected this practical expedient.16 Upon adopting the ASU, lessees that previously applied this requirement may choose
to discontinue using the risk-free rate as the discount rate for any class of underlying
asset. Conversely, lessees that did not elect to apply the risk-free rate to all their
leases upon adopting ASC 842 may now choose to apply the risk-free rate as the discount
rate for any class of underlying asset. A lessee’s policy election regarding the classes
of underlying asset to which it will apply the risk-free rate should be consistently
applied.
17.3.1.10 ASU 2023-01 on Common-Control Arrangements
In March 2023, the FASB issued ASU
2023-01, which amends certain provisions of ASC 842 that apply to
arrangements between related parties under common control. Specifically, the ASU:
- Offers private companies, as well as not-for-profit entities that are not conduit bond obligors, a practical expedient that gives them the option of using the written terms and conditions of a common-control arrangement when determining whether a lease exists and the subsequent accounting for the lease, including the lease’s classification.
- Amends the accounting for leasehold improvements in common-control arrangements for all entities.
17.3.1.10.1 Practical Expedient That Allows the Evaluation of Written Terms and Conditions of a Common-Control Arrangement
ASC 842 requires entities to determine whether a related-party arrangement between
entities under common control is a lease on the basis of the legally enforceable terms
and conditions of the arrangement. 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). See
Section 8.3.5.2 for further discussion of the
accounting for related-party leases between entities under common control.
As part of the FASB’s postimplementation review of ASC 842, private companies asserted
that this requirement 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.
Therefore, stakeholders have indicated that it is challenging to determine the legally
enforceable terms and conditions of these arrangements and that legal counsel may need
to be involved in making this determination, thereby incurring additional cost.
In response to that feedback, the ASU 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. This practical expedient can be
applied on an arrangement-by-arrangement basis, and an entity is not required to
consider the legal enforceability of such written terms and conditions. However, if no
written terms and conditions of an arrangement between entities under common control
exist, an entity is not allowed to elect the practical expedient and is required to
apply ASC 842 in a manner consistent with how it is applied to other arrangements.
17.3.1.10.2 Accounting for Leasehold Improvements in Common-Control Arrangements
Under ASC 842, a lessee is generally required to amortize leasehold improvements that
it owns over the shorter of the useful life of those improvements or the lease term. See
Section 8.8.3 for further discussion of lessee
accounting related to leasehold improvements.
As part of the FASB’s postimplementation review of ASC 842, some stakeholders stated
that leasehold improvements associated with leases between entities under common control
are economically different from those associated with leases between entities not under
common control. In lease arrangements between entities not under common control,
leasehold improvements made by the lessee can either be for the lessee’s own benefit or
for the benefit of the lessor. However, leasehold improvements made under leases between
entities under common control are expected to benefit the parties under the
common-control arrangement. Therefore, private-company stakeholders have noted that, in
a lease arrangement between entities under common control, the amortization requirements
of ASC 842 are inconsistent with the underlying economics of the arrangement, since (1)
the lessee may continue to control the use of the underlying asset after the lease term
and (2) another party in the common-control group may benefit from the leasehold
improvements after the lessee no longer controls the use of the underlying asset.
In response to that feedback, ASU
2023-01 requires a lessee in a common-control lease arrangement to
amortize leasehold improvements that it owns over the improvements’ useful life17 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.
In situations in which a lessee obtains control of an underlying asset through a lease
with an unrelated party not under common control and subsequently subleases the asset to
an entity under common control, the sublessee would generally amortize the leasehold
improvements over a period that does not exceed the term of the lease between the
lessee/intermediate lessor and the unrelated party. However, if the lease between the
lessee/intermediate lessor and the unrelated party contains an option to purchase the
underlying asset and the lessee/intermediate lessor is reasonably certain to exercise
that option, the leasehold improvements should be amortized over the useful life to the
common-control group.
Further, a lessee that no longer controls the use of the underlying asset will account
for the transfer of the underlying asset as an adjustment to equity (i.e., as with a
transfer of assets between entities under common control).
This amendment applies to all entities. The FASB believes that this issue is pervasive
and that all entities are currently applying multiple methods to account for leasehold
improvements in leases between related parties under common control. For example,
according to the FASB, some entities are accounting for these leasehold improvements by
(1) amortizing them over the shorter of the lease term or the useful life of the
leasehold improvements, (2) amortizing them over the lease term to an estimated salvage
value and accounting for the unamortized balance as a transfer between entities under
common control at the end of the lease term, or (3) amortizing them over the lease term
with a portion recognized as a lease payment. Accordingly, the FASB’s objective is to
eliminate this diversity in practice by requiring both public and private entities to
apply these amendments.
17.3.1.10.3 Transition and Effective Date
ASU 2023-01 is effective for fiscal years beginning after December 15, 2023,
including interim periods within those fiscal years. Early adoption is permitted in
any annual or interim period as of the beginning of the related fiscal year.
In relation to the practical expedient offered by ASU 2023-01, entities that have not
adopted ASC 842 on or before the effective date of ASU 2023-01 must apply the
transition requirements of ASU 2016-02. Entities that have adopted ASC 842 before the
effective date of ASU 2023-01 can apply the amendments in either of the following ways:
- Prospectively to arrangements that commence or are modified on or after when the entity first applies ASU 2023-01.
- Retrospectively to the beginning period in which an entity applied ASC 842 for arrangements that existed as of the adoption date of ASU 2023-01. The practical expedient cannot be applied to common-control arrangements that no longer exist as of the adoption date.
In addition, ASC 842-10-65-7(d) states, in part, that “[a]n entity may document any
existing unwritten terms and conditions of an arrangement between entities under
common control before the date on which the entity’s first interim (if applicable) or
annual financial statements are available to be issued.”
Regarding the amendment related to accounting for leasehold improvements in
common-control arrangements, entities that have not adopted ASC 842 on or before the
effective date of ASU 2023-01 may apply the transition requirements of ASU 2016-02.
However, entities that elect to retrospectively apply ASU 2016-02 to the beginning
period of adoption are allowed to apply either of the prospective approaches described
below to avoid retrospectively accounting for leasehold improvements associated with
common-control leases.
Entities that have adopted ASC 842 before the effective date of ASU 2023-01 have the
option of using one of the following adoption methods:
- Prospective application to all new leasehold improvements recognized on or after the date on which the entity first applies the amendments in ASU 2023-01.
- Prospective application to all new and existing leasehold improvements recognized on or after the date on which the entity first applies the amendments in ASU 2023-01, with any remaining balance of leasehold improvements amortized over their remaining useful life to the common-control group determined as of that date.
- Retrospective application to the beginning of the period in which an entity first applied ASC 842; any leasehold improvements that otherwise would not have been amortized or impaired would be recognized through a cumulative-effect adjustment to opening retained earnings at the beginning of the earliest period presented in accordance with ASC 842.
17.3.2 Other FASB Activity
Since its issuance of ASU 2016-02 in February 2016, the FASB has met on numerous
occasions to discuss implementation and interpretive issues that have arisen in practice
and that various stakeholders have communicated to the Board. The table below summarizes
the topics discussed at these meetings (organized by subject matter) and provides links to
where each issue, the related guidance, or both are discussed in more detail in this
Roadmap. When a topic was discussed at several meetings, only the meeting that reflects
the final status of the topic is included. Further, the table below does not include the
topics that ultimately resulted in standard setting (e.g., land easements, transition
relief, lessor’s separation of lease and nonlease components, narrow-scope improvements
for lessors, and common control arrangements), since these are discussed elsewhere in this
Roadmap.
Topic or Issue
|
Summary of Board Discussion
|
Meeting Date
|
Roadmap Reference
|
---|---|---|---|
Scope, Identifying a Lease, and Components of a Contract
| |||
Pipeline laterals | The Board discussed “whether a pipeline lateral is an identified asset under
Topic 842, and, if so, how an entity determines whether the customer has the
right to control the use of that pipeline lateral throughout the period of use
(that is, whether there is a lease of the pipeline lateral).” The Board agreed that, under ASC 842-10-15-16,
a pipeline lateral is an identified asset and that the
assessment of whether it is a lease must focus on
whether the customer has the right to control the
use of the identified asset in accordance with ASC
842-10-15-4. While highlighting that the specific facts
and circumstances of each arrangement must be
considered, the staff discussed two types of pipeline
laterals. | May 10, 2017 | |
Lease Term, Lease Payments, and Discount Rate
| |||
Determining
the term of a
head lease in a
lease/sublease
arrangement | Some have suggested that, when a sublease has
the same contractual terms as the head lease, it is
unclear how an entity determines the lease term of
the head lease. For example, some believe that if
lessee renewal options are included in a sublease,
the head lessee’s lease term (for the head lease) must
include the periods covered by those renewal options.
The Board, acknowledging that ASC 840 is silent on
this issue, does not believe that the guidance in ASC
842-10-30-1(c) should be interpreted as meaning that
all renewal options outside the lessee’s control must
be included in the term of the head lease. | November 30, 2016 | |
Testing operating leases for impairment | Stakeholders have questioned whether the interest portion of an operating lease payment should be included as a cash outflow in the determination of the undiscounted cash flows used in the asset group recoverability test. The Board generally agreed that lessees should exclude interest payments when calculating the undiscounted cash flows in the assessment of an asset group for impairment under ASC 360. However, some Board members also believe that an entity’s decision to include interest in its impairment analysis could be viewed as an accounting policy election. | November 30, 2016 | |
Lessor Accounting
| |||
Accounting for impairment of operating lease receivables
|
Stakeholders have raised questions about whether lessors
that are accounting for the impairment of operating lease receivables should
only apply the guidance in ASC 842-30, or whether they are allowed to also
apply ASC 450 to record a general allowance on a lease portfolio level.
Before adopting ASC 842, lessors would typically apply the
guidance in ASC 310, which refers to ASC 450 and requires an entity to accrue
a general allowance if certain conditions are met.
While the establishment of a general reserve under ASC
842-30 is not specifically prohibited, ASC 842-30-25-12 and 25-13 indicate
that a lessor must evaluate the collectibility of operating lease payments at
the individual lease level. If the collectibility of an individual lease is
determined not to be probable, the lessor must derecognize any receivable
previously recorded for this lease and must recognize revenue on an ongoing
basis only when cash is received. The lessor will continue to account for
revenue on a cash basis and will not establish a receivable until it is once
again probable that the operating lease payments for that lease will be
collected.
The Board observed that there is diversity in practice
related to whether an entity records a general reserve in addition to
performing the collectibility assessment on a lease-by-lease basis as
prescribed by ASC 842-30. The Board also acknowledged that when a general
reserve is applied, there is diversity in practice in the income statement
treatment of the allowance as either a reduction to revenue or bad-debt
expense.
In response to stakeholder concerns, the FASB staff cited
two methods that an entity can use to account for the impairment of operating
lease receivables:
The FASB staff agreed that under the second approach, the
income statement treatment of the general allowance (i.e., the offsetting
entry related to setting up and adjusting the allowance) could be a reduction
of revenue or a bad-debt expense.
The FASB staff determined that additional standard-setting activity related
to this issue is unnecessary at this time.
|
July 17, 2019
| |
Transition
| |||
Impact of prior asset group impairments of operating lease ROU asset measurement | Some stakeholders have suggested that it is unclear whether an entity would be expected to allocate prior-period asset group impairments to the operating lease ROU asset when transitioning to ASC 842. The Board stated that a lessee should not revisit prior impairment allocation conclusions and should not include any previous impairments in the measurement of an ROU asset upon adopting the guidance. | November 30, 2016 | |
Whether an
entity should
apply the
guidance in
ASC 840 or
ASC 842 during
transition | The FASB staff highlighted that it had “received several
specific transition inquiries.” Therefore, while not
answering any specific inquiry, the staff believed that it
was important to highlight the Board’s objectives in its
transition decisions in the hope that it would resolve
future questions that stakeholders may have. Two
core objectives of transition were discussed:
In addition, the discussion highlighted the following
key outcomes of the Board’s transition provisions:
The Board agreed with the staff’s analysis and did not
suggest any additional standard setting at this time. | May 10, 2017 | |
Lessor transition issue related to the allocation of contract consideration between revenue and lease components | ASC 606 requires entities to assess whether a contract is partially within the scope of ASC 606 and partially within the scope of other ASC topics (e.g., ASC 840). ASC 606 also provides guidance on how to separate the components of a contract that are within the scope of different ASC topics. Separation is based on the guidance in the other ASC topics if such guidance exists; otherwise, separation is based on the guidance in ASC 606 (i.e., it is based on the relative stand-alone selling price). As a result, the adoption of ASC 606 could affect contracts that include both revenue and lease components. The question addressed by the Board was whether the application of ASC 606 to prior periods should have an impact only on the revenue component of a contract or whether a lessor is required to reassess the accounting for the entire contract, including lease components. The accounting for the lease component could change if the transaction price is allocated on the basis of the relative stand-alone selling price and the amount allocated to the lease component is affected by the adoption of ASC 606. The Board decided that an entity is not required to reallocate contract consideration between revenue and lease components when it adopts ASC 606. In other words, application of ASC 606 should only affect the accounting for the revenue components of contracts and not the lease components. The Board indicated that it will reflect this discussion in the meeting minutes rather than requiring future standard setting. | June 21, 2017 |
17.3.3 Ongoing FASB Activity
The FASB currently has no items related to ASC 842 on its technical
agenda. The Board had directed its staff to identify potential improvements to the lease
modification model in response to both comment-letter feedback and discussion at the
September 2020 public roundtables (see the next section for more information about the
roundtables). However, although the Board will consider such improvements at future
meetings, it decided to remove the lease modification project from its technical agenda in
June 2022. The Board will most likely consider whether targeted refinements to the lease
modification model are warranted as part of its broader postimplementation review of ASC
842.
17.3.3.1 FASB 2020 Public Roundtables
On September 18, 2020, the FASB held two public roundtables to discuss
challenges with implementing ASC 842. These roundtables were part of the FASB’s broader
ongoing effort to solicit feedback from stakeholders on difficulties with applying or
interpreting the leasing guidance. Present at the roundtables were all then-current FASB
board members, members of industry groups, preparers (from both public and private
companies), users, and representatives from accounting firms (both large firms and
private-company auditors). Representatives from the SEC and PCAOB staffs also observed
the meeting.
The table below summarizes the five topics that were identified by the
FASB staff through its outreach efforts and discussed at the roundtables. In addition to
these five topics, roundtable participants discussed (1) related-party leases, (2)
useful lives of leasehold improvements, and (3) diversity in practice related to
multiple acceptable cash flow presentation methods. On the basis of the feedback
received during the roundtable discussion, the FASB staff plans to draft proposed action
steps for each topic, which may include conducting additional outreach, issuing
educational materials or interpretive guidance, proposing standard-setting activity, or
taking no further action (i.e., the current guidance in U.S. GAAP would remain unchanged
and no additional clarification would be required). The FASB’s public comments, if any,
regarding its plans related to each of these topics are noted in the table below.
For more information about the public roundtable discussions, see Deloitte’s September
28, 2020, Heads Up.
FASB Agenda Topics
|
Areas of Focus
|
---|---|
Lessee’s application of rate implicit in the lease
|
ASC 842-20-30-3 requires lessees to use the rate implicit
in the lease as an input in measuring the lease liability if that rate is
“readily determinable.” If that rate is not readily determinable, the
incremental borrowing rate is used. The FASB staff wanted to understand
whether the requirement for lessees to consider the implicit rate should be
eliminated from ASC 842.
Stakeholders at the roundtable discussion generally agreed
that no change to ASC 842 is required for this topic. Most large accounting
firms observed that they are not frequently receiving questions on how to
apply the phrase “readily determinable,” and preparers generally agreed that
they have not struggled with applying this phrase. However, certain
stakeholders noted that a lack of questions on this topic does not
necessarily mean that preparers would not rather use the rate implicit in
the lease. While most participants agreed that they would prefer not to
change existing GAAP, some either supported or were not opposed to an
option for lessees to determine and use the rate implicit in the
lease (such a determination would involve estimating lessor inputs), since
such an option would provide financial reporting results that are more
faithful to the economics of the underlying transaction. These individuals
argued that enhanced financial reporting in these scenarios would outweigh
the decrease in comparability that would result from introducing
optionality. In addition, stakeholders generally agreed that the rate
implicit in the lease can be readily determined when the lessee knows all
material inputs in the model (e.g., initial direct costs are
immaterial).
|
Lessee’s application of incremental borrowing rate
|
ASC 842 gives non-PBEs the option of using a risk-free
rate rather than an incremental borrowing rate. Given the time and effort it
takes to estimate the incremental borrowing rate, the FASB staff considered
whether ASC 842 should also give PBEs the option of using a risk-free rate
or some other specified rate.
Roundtable participants generally indicated that the
current incremental borrowing rate related requirements should not change
for public companies and that they would prefer that the FASB not release
incremental guidance or examples on this subject. Preparers indicated that,
though the cost of creating new processes for determining the incremental
borrowing rate was greater than they had initially expected, they did not
believe the postimplementation cost would be as significant because of the
investment in the processes during adoption. Financial statement users
indicated that they use the disclosure of an entity’s incremental borrowing
rate in evaluating and comparing different entities.
However, most participants were in favor of adjusting the
guidance for non-PBEs. Most supported amending ASC 842 to allow non-PBEs to
elect to use the risk-free rate on an asset-class basis rather than an
entity-wide basis. During the discussion, certain participants acknowledged
that giving non-PBEs the option of using the risk-free rate could be
arbitrary and may not have any conceptual basis. Most participants therefore
supported the Board’s consideration of whether it may be more appropriate
for non-PBEs to elect to use a different rate as an accounting policy on an
asset-class basis.
In response to these considerations, the FASB added to its
technical agenda a project on amending ASC 842 to allow non-PBEs to elect
the risk-free rate by asset class, which ultimately resulted in the issuance
of ASU 2021-09. See Section 17.3.1.9.
|
Embedded leases
|
Many entities have adopted capitalization thresholds for
identifying and accounting for embedded leases and do not record leases
below the established threshold. (See Section
2.2.5.2 for further discussion of considerations related to
capitalization policies.) The discussion of embedded leases at the public
roundtables focused on whether the FASB should amend ASC 842 to include a
specific quantitative or qualitative threshold for entities to use when
evaluating such leases.
Many roundtable participants were not in favor of amending
the guidance in ASC 842 on identifying embedded leases. Some participants
acknowledged that implementing a quantitative threshold would increase
convergence with IFRS Accounting Standards.17 However, many believed that such an amendment would create an
incentive for an entity to structure a contract to preclude arrangements
from being within the scope of ASC 842 even if the aggregation of
low-dollar-value leases could be material.
There was also discussion of the broader definition of a
lease and whether certain contracts that currently meet the definition are
conceptually appropriate. Specifically, participants discussed whether an
underlying asset operated by the lessor could be considered under the
lessee’s control and therefore result in the identification of a lease.
However, most participants did not support amending the U.S. GAAP definition
of a lease. See Section 3.2.2 for further discussion of
embedded leases.
|
Lease modifications
|
ASC 842 requires an entity to reassess whether a contract
is or contains a lease in the event of a lease modification. The standard
defines “lease modification,” in part, 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.” If the modified contract is or contains a lease,
the entity analyzes whether the modification should be accounted for as a
separate contract or a continuation of the existing contract. See Section 8.6 for more information about
evaluating lease modifications.
When the modification is not accounted for as a separate
contract, a lessee is required to reassess lease classification, remeasure
its lease liability (which includes updating the discount rate as of the
effective date of the modification), and reallocate consideration in the
contract by using updated stand-alone prices as of the effective date of the
modification. Similarly, if a modification is not accounted for as a
separate contract for a lessor, a lessee will also need to reassess lease
classification and reallocate consideration in the contract.
The complexity involved in applying the modification
framework led the FASB staff to address this discussion topic at public
roundtables.
In summary, all stakeholders agreed that they would
support the Board’s moving forward with exploring how to reduce the cost and
complexity for preparers in applying the modification framework. However,
the discussion did not focus on how the framework should change to
accomplish that objective. Representatives of the large firms discussed and
generally supported a simplified model for “minor” modifications. Preparers
were also receptive to this idea but questioned how a simplified model could
be employed within their systems and processes and whether “minor” should be
a quantitative or event-based threshold.
The FASB added a project to its technical agenda to
consider whether targeted improvements to the lease modification guidance in
ASC 842 are warranted. However, the Board subsequently removed this project
from its agenda in June 2022.
|
Lessee allocation of fixed and variable payments
|
ASC 842 requires a lessee to identify the separate lease
and nonlease components of a contract and allocate the total consideration
provided in that contract to each of those components on the basis of their
respective stand-alone prices.18 When a lease contract has lease and nonlease components along with
variable and fixed payments, the application of the guidance can be
difficult and, some have argued, can result in accounting that potentially
does not reflect the economics of lease transactions. However, ASC 842
already provides lessees with a practical expedient related to combining
lease and nonlease components and accounting for the entire contract as a
lease, which eliminates the operational burden of allocating payments
between lease and nonlease components.
On the basis of stakeholder feedback, the FASB staff
questioned whether ASC 842 should be amended to require the allocation of
fixed and variable payments solely to a lease or nonlease component if
certain conditions are met.
Preparers that participated in the roundtable and have
already adopted ASC 842 were not in favor of U.S. GAAP changes in this area.
They noted that most had adopted the practical expedient to combine lease
and nonlease components for asset classes for which the lease components
were expected to be greater than their capitalization thresholds. These
preparers expressed concern that changes to existing guidance would be
difficult and costly to implement retrospectively and that prospective
adoption would cause comparability concerns for a significant period given
the length of many lease contracts. Public-company preparers indicated that
if the amended guidance continued to allow for the combination of lease and
nonlease components, they would continue to make that election and would not
change their current accounting methods.
Private-company preparers expressed their belief that one
of the reasons entities have elected to combine lease and nonlease
components is that the allocation guidance is very difficult to understand
and implement. They argued that if the allocation guidance for lessees were
aligned with the allocation objective in ASC 606, more entities would be
able to separate lease and nonlease components and financial reporting would
improve as a result.
Large firms generally seemed to believe that a change to
align the allocation guidance for lessees with ASC 606 was conceptually
supportable but that such a change may not be necessary because they
expected most entities to adopt the practical expedient to combine lease and
nonlease components.
|
17.3.4 FASB’s Response to the COVID-19 Pandemic
On April 8, 2020, the FASB met to discuss its ongoing efforts to monitor
and respond to the impact of COVID-19 on the preparation of financial statements under
U.S. GAAP, including the related accounting and financial reporting implications.
Specifically, the Board discussed proposals to delay the effective dates of certain
recently issued standards, including ASC 842, for certain entities. The Board later
finalized this proposed deferral for certain entities on June 3, 2020, by issuing ASU
2020-05. (See Chapter 16 for
more information.) Further, the FASB discussed and provided feedback on technical
inquiries received from stakeholders regarding certain accounting topics affected by
COVID-19, including staff guidance on how to account for rent concessions provided as a
result of the pandemic.
On April 10, 2020, the FASB issued a staff Q&A (the “Staff Q&A”) to provide guidance on its remarks
at the April 8 Board meeting about accounting for rent concessions resulting from the
COVID-19 pandemic. Specifically, the Staff Q&A affirms the discussion at the April 8
meeting by allowing entities to forgo performing the lease-by-lease legal analysis to
determine whether contractual provisions in an existing lease agreement provide
enforceable rights and obligations related to lease concessions as long as the concessions
are related to COVID-19 and the changes to the lease do not result in a substantial
increase in the rights of the lessor or the obligations of the lessee. In addition, the
Staff Q&A affirms that entities may make an election to account for eligible
concessions, regardless of their form, either by (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 Deloitte’s March 25, 2020 (updated January 11, 2021), Financial Reporting Alert for
more information on applying the FASB’s relief related to qualifying concessions as well
as interpretive responses to frequently asked questions.
Footnotes
2
See Section
17.3.2 for additional FASB activity related to the accounting for
impairment of operating lease receivables.
3
ASU 2019-10 delayed the effective date of the leasing standard
(ASU 2016-02) for all nonpublic companies. ASU 2020-05 further delayed the
effective date for all nonpublic companies, as well as for certain public NFPs.
(See further discussion in Section 16.1.) The effective date for nonpublic companies is annual
periods beginning after December 15, 2021, and interim periods within fiscal years
beginning after December 15, 2022. The effective date for public NFPs that qualify
for the deferral under ASC 842-10-65-1(a) is annual periods beginning after
December 15, 2019, and interim periods therein. The effective date for all other
public companies remained unchanged. The delayed effective date also applies to
all ASUs associated with ASU 2016-02.
4
See footnote 3.
5
See footnote 3.
6
See footnote 3.
7
See footnote 3.
8
ASC 326 includes both legacy impairment guidance moved from other
Codification sections and credit losses guidance introduced by ASU 2016-13. Some of
the guidance moved from other Codification sections was also amended by ASU
2016-13.
9
The purpose of the TRG is not to issue guidance but instead to
seek and provide feedback on potential issues related to implementation of the
credit loss standard.
10
Quoted material is from the TRG’s June 11, 2018, meeting handout.
11
See footnote 3.
12
For PBEs and entities within the scope of ASC 842-10-65-1(a),
ASU 2021-05 is effective for fiscal years beginning after December 15, 2021, and
interim periods within those fiscal years. For all other entities within the scope
of ASC 842-10-65-1(b), the ASU is effective for fiscal years beginning after
December 15, 2021, and interim periods within fiscal years beginning after
December 15, 2022.
13
ASC 842 does not address what is meant by the phrase “class of
underlying asset.” Before ASU 2021-09, entities were allowed to make other
accounting policy elections by class of underlying asset, so entities may already
have policies in place for how to define asset class. See Section 4.3.3.1 for information about applying this concept.
14
ASC 842-20-50-10, which is added by ASU 2021-09, states: “A
lessee that makes the accounting policy election in paragraph 842-20-30-3 to
use a risk-free rate as the discount rate shall disclose its election and the
class or classes of underlying assets to which the election has been
applied.”
15
The cumulative-effect adjustment to the lease liability and
corresponding ROU asset should be calculated by using the remaining lease term
and the discount rate as of the date of the adoption of ASU 2021-09. This
calculation applies to all leases existing as of the ASU’s adoption date.
16
As clarified by ASU 2021-09, the risk-free rate can only be applied for lessee
leases when the rate implicit in the lease is not readily determinable.
17
This represents a change from the proposed ASU, which stated that
leasehold improvements associated with common-control leases should be amortized
over the economic life of the leasehold improvements rather than their useful life.
The FASB made the change primarily because (1) the amortization period should be
limited to the period in which the common-control group can direct the use of the
underlying asset, (2) amortizing the leasehold improvements over the useful life to
the common-control group would be consistent with the period used by a lessee when
applying the impairment guidance in ASC 360, and (3) it could be challenging for a
lessee to determine the economic life of a leasehold improvement since it may be
required to consider factors outside the common-control group in such
circumstances.
17
Under IFRS 16, an entity may exclude leases for which
the underlying asset is of low value from its ROU assets and lease
liabilities. See paragraphs B3–B8 of IFRS 16 for information on
assessing whether an asset is of low value. Also see Appendix B for a
summary of the differences between ASC 842 and IFRS 16.
18
See Sections 4.1 and 4.2 for additional guidance on
identifying the separate lease and nonlease components, respectively.
See Section
4.4 for guidance on determining and allocating
consideration in the contract to the identified lease components.
Chapter 18 — Reporting Considerations for SEC Registrants
Chapter 18 — Reporting Considerations for SEC Registrants
The SEC staff continues to focus on the relationship
between implementation issues under the leasing standard and certain
SEC reporting requirements. These requirements pertain mostly to the
inclusion, presentation, and disclosure of certain financial
information before and after adoption of the leasing standard.
18.1 SAB Topic 11.M Disclosures
The SEC staff has continued to emphasize the importance of providing investors
with disclosures that explain the impact that new accounting standards are expected
to have on an entity’s financial statements (“transition disclosures”).1 Such disclosures include information that investors may need to determine the
effects of adopting a new standard and how the adoption will affect comparability
from period to period. Transition disclosures should include not only an explanation
of the transition method elected (as discussed in Chapter 16) but also information about the
impact that the leasing standard is expected to have on an entity’s financial
statements. The SEC staff has highlighted that, in the past, transparent disclosures
about the anticipated effects of a new standard in multiple reporting periods
preceding its adoption have prevented market participants from reacting adversely to
significant accounting changes. In addition, the staff has indicated that it expects
to see robust qualitative and quantitative disclosures about (1) the anticipated
impact of new standards and (2) the status of management’s progress in
implementation as the adoption date of the new standard approaches. Registrants that
have not yet adopted the leasing standard, such as EGCs that have elected to use the
non-PBE effective date of ASC 842, should continue to focus on providing appropriate
disclosures in the periods leading up to adoption of the standard.
The SEC staff has also reiterated that a registrant should provide transparent
transition disclosures that comply with the requirements of SAB Topic 11.M and has
indicated that when a registrant is unable to reasonably estimate the quantitative
impact of adopting the leasing standard, the registrant should consider providing
additional qualitative disclosures about the significance of the impact on its
financial statements.2
There will not be a one-size-fits-all model for communicating the impact of
adoption, but entities could consider providing (1) a short narrative that
qualitatively discusses the impact of the change or, to the extent available, (2)
tabular information (or ranges) identifying the expected accounting under the
leasing standard, such as amounts or ranges of newly recognized ROU assets and
liabilities. The following are sample disclosures that an entity could provide about
qualitative aspects of the impact of adoption, depending on its specific facts and
circumstances:
-
ASC 842 provides a package of transition practical expedients that allow an entity to not reassess (1) whether any expired or existing contracts contain a lease, (2) the lease classification of any expired or existing lease, and (3) initial direct costs for any existing lease. We expect to elect the package of transition practical expedients.
-
As disclosed in note X, we currently have operating lease commitments of $X billion on an undiscounted basis. Upon adoption of ASC 842, we expect substantially all of these commitments will be recognized as ROU assets and liabilities, on a discounted basis.
-
We [are implementing/have implemented] a new enterprise-wide lease accounting system and are [implementing/modifying] internal controls to address the collection, recording, and accounting for leases in accordance with ASC 842.
If an entity chooses to provide quantitative disclosures, it should consider
including information reflecting the entity’s selected transition method (i.e., the
modified retrospective method either as of the beginning of the earliest comparative
period or as of the beginning of the year of adoption by using the Comparatives
Under 840 Option — see Section
16.1.1), since stakeholders would benefit from perspective on the
overall impact of adoption as well as any opening adjustments to retained
earnings.
Footnotes
1
See SAB Topic 11.M.
2
This was announced by the SEC observer at the September 22,
2016, EITF meeting. See Deloitte’s September 22, 2016, Financial Reporting
Alert for additional information about the SEC
staff’s comments on transition issues.
18.2 Financial Statements and Other Affected Financial Information in Exchange Act Reports, Registration Statements, and Other Nonpublic Offerings
18.2.1 Adoption as of the Beginning of the Year of Adoption by Using the Comparatives Under 840 Option
As discussed in Section
16.1.1, entities that elect to adopt the leasing standard as of
the beginning of the year of adoption by using the Comparatives Under 840 Option
will recognize the effects of applying ASC 842 as a cumulative-effect adjustment
to opening retained earnings but will not adjust prior periods. Thus, in both
quarterly and annual reports after adoption, an entity would not be required to
recast its prior-period financial statements and disclosures to comply with the
leasing standard since an entity applying this transition method is permitted to
report historical comparative periods in accordance with ASC 840.
18.2.1.1 Annual Disclosures Needed in Quarterly Filings for the Year of Adoption
Although ASC 842 may not require entities to provide certain of the prescribed
disclosures discussed in Chapter 15 in interim financial statements, SEC rules and
staff interpretations require registrants that first adopt a new accounting
standard in an interim period to include both annual and interim disclosures
in the first interim period after the adoption of the standard and in each
subsequent quarter in the year of adoption. Specifically, Section 1500 of the
FRM states:
[Regulation] S-X Article 10 requires disclosures
about material matters that were not disclosed in the most recent
annual financial statements. Accordingly, when a registrant adopts a
new accounting standard in an interim period, the registrant is
expected to provide both the annual and the interim period financial
statement disclosures prescribed by the new accounting standard, to
the extent not duplicative. These disclosures should be included in
each quarterly report in the year of adoption.
As a result, a registrant that first adopts the leasing standard in an interim
period will need to comply with ASC 842’s full suite of disclosure
requirements in that quarter and each subsequent quarter in the year of
adoption, to the extent that the disclosures are material and do not
duplicate existing information.
18.2.1.2 Registration Statements and Other Nonpublic Offerings
Because the Comparatives Under 840 Option transition method does not affect
prior-period financial statements, an entity is not required to provide any
additional retrospectively restated financial statement disclosures or
information beyond the transition disclosures discussed above for the
financial statements included or incorporated by reference into a
registration statement filed or other nonpublic offering document prepared
after the quarter of adoption.
18.2.2 Adoption as of the Beginning of the Earliest Comparative Period Presented
As discussed in Chapter
16, entities that elect to adopt the standard as of the beginning
of the earliest comparative period presented will recognize the effects of
applying ASC 842 as a cumulative-effect adjustment to retained earnings as of
the beginning of the earliest period presented in their annual financial
statements and restate the information for the prior years for all years
presented in their annual financial statements for the year of adoption. In its
quarterly reports, if the registrant first adopts the leasing standard in an
interim period, and in its annual report after adoption, an entity would recast
the prior-period financial statements, disclosures, and other information (e.g.,
MD&A3 and summarized financial information related to the statements of
comprehensive income for each affected quarterly period and the fourth quarter
in the affected year4) to comply with ASC 842.
Example 18-1
Form 10-Q That First Reports the Adoption of the Leasing
Standard
Company A adopts the leasing standard on January 1, 2019, and uses the “date of
initial application” method, retrospectively restating
comparative periods to reflect the standard. Provided
that A first adopts the standard in its interim periods,
when A files its Form 10-Q for the quarter ended March
31, 2019, it must retrospectively restate its financial
statements for the adoption of ASC 842 for the
comparative interim period ended March 31, 2018.
Further, A must update MD&A for the interim period
ended March 31, 2018, to reflect the retrospective
adoption of the leasing standard. However, there is no
immediate requirement for A to restate the annual
financial statements presented in its Form 10-K for the
year ended December 31, 2018. When A files its 2019 Form
10-K, it would restate the comparative 2018 and 2017
financial statements and disclosures to comply with ASC
842. The date of initial application is January 1, 2017,
because this is the first day of the comparative
three-year period presented in the 2019 Form 10-K.
Ordinarily, an entity is not required to present the restated annual
prior-period financial information (i.e., for 2018 and 2017) until the
subsequent Form 10-K is filed (i.e., the 2019 Form 10-K). However, Section 18.2.2.2
addresses circumstances in which the affected comparative periods (i.e., 2018
and 2017) may need to be restated before the filing of the subsequent Form
10-K.
In addition, under SEC Regulation S-K, Item 302(a), if a
registrant reports a material retrospective change (or changes), such as the
adoption of the leasing standard, for any of the quarters within the two most
recent fiscal years or any subsequent interim periods, the registrant must
disclose (1) an explanation for the material change(s) and (2) summarized
financial information reflecting such change(s) for the affected quarterly
periods, including the fourth quarter. Summarized financial information, which
is required in a Form 10-K and certain registration statements when a material
retrospective change occurs, should include, at a minimum:
- Net sales or gross revenues.
- Gross profit (or costs and expenses related to net sales or gross revenues).
- Income (loss) from continuing operations.
- Net income (loss).
- Net income (loss) attributable to the entity.
- Earnings (loss) per share.
Since this requirement only applies when there is a material
retrospective change, a registrant may not have provided such information in its
most recent Form 10-K. However, upon reporting a change in accounting policy
that represents a material retrospective change, a registrant would be required
to include such disclosures in its next Form 10-K or retrospectively restated
financial statements filed in conjunction with a registration statement, as
discussed below.
18.2.2.1 Annual Disclosures Needed in Quarterly Filings for the Year of Adoption
As discussed in more detail in Section 18.2.1.1, SEC rules and staff interpretations
require registrants that first adopt a new accounting standard in an interim
period to provide both annual and interim disclosures in the first interim
period after the adoption of a new accounting standard and in each
subsequent quarter in the year of adoption.
18.2.2.2 Registration Statements and Other Nonpublic Offerings
For registrants that adopt the leasing standard as of the beginning of the
earliest comparative period presented and first adopt a new standard in an
interim period, the requirement to retrospectively restate the annual
preadoption financial statements and other affected financial information
may be accelerated when the preadoption financial statements are reissued,
as discussed in ASC 855-10-25-4 (see also Form S-3, Item 11(b)(ii)). Such
reissuance may occur when a registrant (1) files a new or amended
registration statement, (2) files a Form S-8, (3) files a prospectus
supplement to a currently effective registration statement (e.g., an
existing Form S-3 that already is effective but upon which the registrant
wishes to draw down or issue securities), or (4) prepares an offering
document in connection with an issuance of securities in a nonpublic
offering. The discussion below addresses these requirements in the context
of the adoption of ASC 842. A registrant may need to similarly consider
other retrospective changes, such as changes in segment presentation under
ASC 280 and presentation of discontinued operations under ASC 205-20. These
considerations would not apply to an emerging growth company (EGC) that
elects to adopt the leasing standard for the first time in its annual report
rather than in its quarterly reports as permitted. See Section 18.7 for more
information.
18.2.2.2.1 New or Amended Registration Statements (Other Than Form S-8)
If a registrant files a new or amended registration statement (including
post-effective amendments)5
before it files the Form 10-Q that first reports
the adoption of the leasing standard (i.e., before the filing of the
first-quarter 2019 Form 10-Q), the registrant is not required (or
permitted6) to file updated financial statements for prior periods to reflect
the adoption of the leasing standard. However, the registrant should
consult with its legal counsel and independent accountants regarding the
appropriate disclosure to provide in the registration statement.
If a registrant files a new or amended registration statement after it files the Form 10-Q that first reports
the adoption of the leasing standard and chooses to adopt the standard
as of the earliest comparative period presented, the registrant
generally must file updated financial statements that reflect the
standard for the relevant comparative periods. Thus, a calendar-year-end
registrant would update the financial statements included in the 2018
Form 10-K (i.e., for 2018 and 2017) to reflect the leasing standard for
the applicable periods. Because the leasing standard refers to the
“earliest comparative period presented,” the SEC staff has clarified
that the reissuance of the financial statements in the 2018 Form 10-K
accelerates the requirement to retrospectively restate the financial
statements for 2018 and 2017; however, it does not change the date of
initial application (i.e., January 1, 2017, for a calendar-year-end
registrant). Accordingly, the financial statements for 2016 that are
included or incorporated by reference in the new or amended registration
statement would not be retrospectively restated for the leasing
standard. The financial statements for 2016, the earliest year
presented, will reflect the legacy ASC 840 accounting requirements. See
paragraph
11210.1 of the FRM for further discussion.
In addition, other affected financial information (e.g., MD&A7 and summarized financial information8) also should be updated to reflect the retrospectively restated
financial statements.
Connecting the Dots
Additional Disclosure
Requirements
As discussed above, a registrant that reports a
material retrospective change must disclose summarized financial
information. Since this requirement only applies when
there is a material retrospective change, a registrant’s
previous Form 10-K may not include such disclosures.
Nonetheless, when retrospectively restating the financial
statements and other affected financial information in advance
of filing a new or amended registration statement, a registrant
must include summarized financial information for the quarters
within the two most recent fiscal years to reflect the adoption
of the leasing standard or other material retrospective
changes.
For new or amended registration statement that normally
incorporate the financial statements by reference (e.g., Form S-3), the
registrant may file updated financial statements as well as other
affected financial information that reflects the retrospectively
restated financial statements on Form 8-K; alternatively, the registrant
can include the retrospectively restated financial statements and
related information in its registration statement. If the
retrospectively restated financial statements are filed on Form 8-K, the
Form 8-K will be incorporated by reference into the registration
statement and will update the affected sections of the registrant’s
previously filed Exchange Act reports (e.g., Form 10-K). Because they
were not incorrect when filed, prior Exchange Act reports should not be
amended (i.e., the registrant should not file a Form 10-K/A). For more
information, see Topic
13 of the FRM.
To prepare itself for a potential filing of a new or amended registration
statement, a registrant is permitted to file updated financial
statements and other affected financial information that reflect the
retrospectively restated financial statements in a Form 8-K once the
adoption of the leasing standard has been reported in the first-quarter
Form 10-Q. However, the registrant is not required to do so until
immediately before a registration statement is filed. If the registrant
expects to file a new or amended registration statement, it may file the
Form 8-K simultaneously with or any time after the filing of the Form
10-Q that reports the adoption of the leasing standard but before or
simultaneously with the filing of the new or amended registration
statement.
Example 18-2
Registration Statement Filed After Adoption of the Leasing
Standard
Facts
On February 28, 2019, Company A, an SEC registrant, files its Form 10-K for the
year ended December 31, 2018. ASC 842 is adopted
by A on January 1, 2019, and applied as of the
earliest comparative period presented. On April
28, 2019, A files its Form 10-Q for the quarter
ended March 31, 2019, and reflects the adoption of
the leasing standard for the periods presented.
Example 1
Company A files a new registration statement on May 15, 2019, and A must either
(1) include financial statements and other
affected financial information that reflect the
adoption of the leasing standard for the annual
periods ended December 31, 2018, and December 31,
2017, or (2) incorporate by reference a
previously filed Form 8-K that contains financial
statements and other affected financial
information that reflect the adoption of the
leasing standard for the annual periods ended
December 31, 2018, and December 31, 2017. In both
cases, the financial statements for December 31,
2016, included or incorporated by reference in
such filings would reflect the application of ASC
840.
Example 2
Company A files a new registration statement on April 10, 2019, before it files
the Form 10-Q reflecting the adoption of the
leasing standard. Company A is not required (or
permitted) to (1) include in its registration
statement updated financial statements that
reflect the adoption of the leasing standard or
(2) incorporate by reference a Form 8-K containing
updated financial statements and other affected
financial information that reflected the leasing
standard. However, A should consult with its legal
counsel and independent accountants regarding the
appropriate disclosure to provide in the new
registration statement.
18.2.2.2.2 Form S-8
The requirements for a Form S-8 are addressed in
Question 126.40 of the SEC
staff’s C&DIs on Securities Act forms:
C&DI — Securities Act Forms
Question 126.40
Question: After its Form 10-K is filed, a registrant has a change in accounting principles (or changes in
segment presentation or discontinued operations), which will cause the financial presentation in its subsequent
Form 10-Qs to differ from that in its most recent Form 10-K. In this situation, Item 11(b)(ii) of Form S-3 would
require the annual audited financial statements filed in the Form 10-K to be restated to reflect the change
in accounting principles (or changes in segment presentation or discontinued operations). Would General
Instruction G.2 of Form S-8, which requires that “material changes in the registrant’s affairs” be disclosed in the
registration statement, also require such restatement?
Answer: Not necessarily. Form S-8 does not contain express language similar to Item 11(b)(ii) of Form S-3,
requiring the restatement of financial statements to reflect specified events. The fact that financial statements
eventually will be retroactively restated does not necessarily mean that there are “material changes in the
registrant’s affairs,” thereby requiring the financial statements to be restated for inclusion, or incorporation
by reference, in a Form S-8. In other words, financial statements for which Item 11(b)(ii) of Form S-3 would
require restatement may not necessarily need to be restated for incorporation by reference in a Form S-8. The
registrant is responsible for determining if there has been a material change and, if so, the related information
that is required to be disclosed in a Form S-8. Correspondingly, it is the auditor’s responsibility to determine if it
will issue a consent to use of its report in a Form S-8 if there has been a change in the financial statements in a
subsequent Form 10-Q and the financial statements in the Form 10-K have not been retroactively restated.
Accordingly, if a registrant adopted ASC 842 as of the beginning of the earliest
comparative period presented, it is generally not required to update its
previously issued financial statements to reflect the adoption of the
leasing standard when these financial statements are incorporated by
reference into Form S-8, unless the adoption of ASC 842 constitutes a
“material change in the registrant’s affairs.”
18.2.2.2.3 Prospectus Supplements to Registration Statements That Currently Are Effective
For currently effective registration statements (e.g., an existing Form S-3) upon which a registrant wishes
to draw down or issue securities, the registrant may use a prospectus supplement. Paragraph 13110.2
of the FRM indicates that “a prospectus supplement used to update a delayed or continuous offering
registered on Form S-3 (e.g., a shelf takedown) is not subject to the Item 11(b)(ii) updating requirements.”
Rather, the prospectus must be updated “in accordance with S-K 512(a) with respect to any fundamental
change.”
The filing of a prospectus supplement does not constitute a reissuance of the
financial statements included or incorporated in the currently effective
registration statement. Management of a registrant that adopts the
leasing standard as of the beginning of the earliest comparative period
presented, in consultation with legal counsel, should determine whether
the retrospective presentation of leases under ASC 842 constitutes a
fundamental change. (For more information, see SEC Regulation S-K, Item
512(a).) If the registrant and its legal counsel determine that the
retrospective adjustment to present the adoption of the leasing standard
is a fundamental change, updated financial statements and other affected
financial information should be filed on Form 8-K or included in the
registration statement, as described above. However, if the registrant
and its legal counsel determine that the retrospective adjustment for
the adoption of the leasing standard is not a fundamental change, the
financial statements do not need to be updated but the registrant should
consult with its legal counsel and independent accountants regarding the
appropriate disclosure to provide in the prospectus supplement.
18.2.2.2.4 Nonpublic Offerings
Financial statements subject to retrospective changes may also be included in
(i.e., reproduced) or incorporated by reference into a nonpublic
offering document, such as a private placement memorandum in accordance
with SEC Regulation D or Rule 144A of the Securities Act:
-
Financial statements included in a nonpublic offering document — We believe that, under U.S. GAAP, entities are generally required to update the financial statements for prior periods to reflect the adoption of the leasing standard if it is adopted as of the earliest comparative period presented. Accordingly, the considerations related to updating the financial statements for the adoption of the leasing standard would be similar to those discussed in Section 18.2.2.2.1.
-
Financial statements incorporated by reference into a nonpublic offering document — We believe that the considerations related to restating the financial statements for the leasing standard would be the same as those discussed in Section 18.2.2.2.3.
Footnotes
3
See Section 9830 of the FRM for guidance on MD&A in
registration statements.
4
See SEC Regulation S-K, Item 302(a).
5
Registrants that file a proxy statement with the
SEC should also consult this guidance. For information about
Schedule TO (used to file tender offers), see paragraph
14310.3 of the FRM.
6
See the highlights of the June 23,
2009, CAQ SEC Regulations Committee joint meeting with the SEC
staff.
7
See footnote 3.
8
See footnote 4.
18.3 SEC Regulation S-X, Rules 3-09 and 4-08(g) — Financial Statements and Summarized Financial Information for Equity Method Investments
Under SEC Regulation S-X, Rules 3-09 and 4-08(g), registrants are required to
evaluate the significance of an equity method investee in accordance with the tests
in SEC Regulation S-X, Rule 1-02(w) (i.e., the asset, investment, or income test),
to determine whether they must provide the investee’s financial statements, the
investee’s summarized financial information, or both. Under these rules, the
prescribed significance tests are performed annually in connection with the filing
of a Form 10-K (i.e., at the end of the registrant’s fiscal year). Accordingly,
significance is not remeasured when updated financial statements that reflect
retrospective adjustments are filed in a Form 8-K (or are included in or
incorporated by reference into a registration statement).
As indicated in Topic
11 and paragraph
2410.8 of the FRM, when a change in accounting is retrospectively
applied in financial statements included in a registrant’s Form 10-K, the registrant
is not required to recalculate the significance of an equity method investee under
Rules 3-09 and 4-08(g). Therefore, for periods before the date of initial adoption
of the leasing standard, registrants may continue to measure the significance of
their equity method investees by using the information from their preadoption
financial statements.9
Footnotes
9
For a discontinued operation, a registrant should be mindful
that significance under Rules 3-09 and 4-08(g) should be measured for each
annual period presented in the financial statements on the basis of amounts
that were retrospectively restated. Consequently, as a result of
retrospective adjustments for a discontinued operation, a previously
insignificant equity method investee may become significant. For additional
information, see Deloitte’s Roadmap Impairments and Disposals of Long-Lived Assets
and Discontinued Operations.
18.4 Permissibility of Non-PBE Adoption Dates for Other Entities’ Financial Statements or Financial Information Required in a Registrant’s Filings
At the July 20, 2017, EITF meeting, the SEC staff announced that it would not object
when certain PBEs elect to use the non-PBE effective dates solely to adopt the
FASB’s revenue and leasing standards. The staff announcement clarifies that the
ability to use non-PBE effective dates to adopt the revenue and leasing standards is
limited to the subset of PBEs “that otherwise would not meet the definition of a
public business entity except for a requirement to include or inclusion of its
financial statements or financial information in another entity’s filings with the
SEC” (referred to herein as “specified PBEs”).
While the staff announcement is written in the context of specified PBEs, the
principal beneficiaries of the relief will be registrants that include financial
statements or financial information prepared by specified PBEs in their own filings.
Regulation S-X rules under which such filings may be prepared could include:
-
Rule 3-05, “Financial Statements of Businesses Acquired or to Be Acquired.”
-
Rule 3-09, “Separate Financial Statements of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons.”
-
Rule 3-14, “Special Instructions for Real Estate Operations to Be Acquired.”
-
Rule 4-08(g), “Summarized Financial Information of Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons.”
Under the leasing standard, there is one adoption date for PBEs and another
(later) adoption date for non-PBEs.
The ASC master glossary defines a PBE, in part, as a business entity that is “required by the [SEC]
to file or furnish financial statements, or [that] does file or furnish financial statements (including
voluntary filers), with the SEC (including other entities whose financial statements or financial
information are required to be or are included in a filing)” (emphasis added). The definition
further states that “[a]n entity may meet the definition of a public business entity solely because its
financial statements or financial information is included in another entity’s filing with the SEC. In that
case, the entity is only a public business entity for purposes of financial statements that are filed or
furnished with the SEC.”
Before the staff’s announcement, certain nonpublic companies applying the PBE
definition in the adoption-date criteria would have been required to use the PBE
adoption dates for the revenue and leasing standards. While the SEC staff
announcement provides considerable and welcome relief to registrants preparing to
adopt the leasing standard, it is purposely narrow in scope and should not be
applied by analogy to the adoption-date assessment for any other standards besides
the revenue and leasing standards. The SEC staff announcement does not preclude
specified PBEs from adopting the provisions of the revenue and leasing standards on
the adoption date applicable to all other PBEs if a specified PBE wishes to use the
PBE adoption date.
In November 2019, the FASB issued ASU 2019-10, which, among other things, amends the effective
dates of ASC 842 for non-PBEs to fiscal years beginning after December 15, 2020, and
interim periods within fiscal years beginning after December 15, 2021. At the 2019
AICPA Conference on Current SEC and PCAOB Developments, the SEC staff announced that
it would not object if specified PBEs adopt ASC 842 by using ASU 2019-10’s timelines
that apply to non-PBEs. This position was subsequently codified in ASU 2020-02. We understand that the SEC staff
will not object if specified PBEs adopt ASC 842 on the basis of the additional
deferral of the effective dates of ASC 842 for non-PBEs to fiscal years beginning
after December 15, 2021, under ASU
2020-05.
Example 18-3
Company A, a publicly traded manufacturer, holds equity method investments in
three of its nonpublic suppliers. After applying the
Regulation S-X significance tests, A has determined that it
must include summarized financial information for Suppliers
X, Y, and Z (under Regulation S-X, Rule 4-08(g)) in its SEC
filing. The only reason X, Y, and Z meet the definition of a
PBE is because they are required to include their financial
information in A’s SEC filing (i.e., they qualify as
specified PBEs). Consequently, X, Y, and Z plan to use the
non-PBE adoption dates of the revenue and leasing standards
when preparing their own stand-alone financial statements.
When including the summarized financial information of X, Y,
and Z in its own SEC filing, A is not required to adjust the
suppliers’ financial statements to reflect the PBE adoption
date of the revenue and leasing standards.
Connecting the Dots
Including Financial Statements or
Financial Information of Specified PBEs
A registrant that has passed certain significance tests required by SEC
Regulation S-X may need to include in its SEC filing the financial
statements or financial information of another entity. We believe that, in a
manner consistent with Topic
11 of the FRM, it is also appropriate for the registrant
to use financial information prepared by specified PBEs that apply non-PBE
adoption dates when performing these significance tests. However, on the
basis of paragraph
3250.1(m) of the FRM, if pro forma financial information is
being prepared under SEC Regulation S-X, Article 11, to reflect the
acquisition of a significant business, the registrant must still conform the
acquired company’s adoption dates and transition methods to its own in the
pro forma presentation for the periods after adoption.
Further, non-PBEs are permitted, as a practical expedient,
to use the risk-free rate as their discount rate when applying ASC 842 (see
Section 7.2.3). At
the October 21,
2020, CAQ SEC Regulations Committee joint meeting with the
SEC staff, the SEC staff discussed the impact of an acquired company’s use
of this practical expedient to adopt ASC 842 when a registrant must evaluate
the acquired company for significance and, in some cases, provide separate
financial statements for the acquired company. The SEC staff indicated that
it would not object if a registrant uses financial statements that reflect
the risk-free rate practical expedient to measure significance, since doing
so would result in higher ROU assets and thus would yield a higher measure
of significance under the asset test. The risk-free rate practical expedient
should be “the only difference between those financial statements and a PBE
set of financial statements.” However, the SEC staff stated that financial
statements provided in accordance with SEC Regulation S-X, Rule 3-05, are
PBE financial statements and thus may not reflect the risk-free rate
practical expedient. Therefore, a registrant would need to assess whether an
adjustment to use the relevant incremental borrowing rate that would apply
to each lease (as opposed to using the risk-free rate) would be material and
necessitate revision before such financial statements are provided in
accordance with Rule 3-05.
18.5 Changes in Internal Control Over Financial Reporting
Registrants are required to disclose any material changes in their ICFR in a
Form 10-Q or Form 10-K in accordance with SEC Regulation S-K, Item 308(c).
Accordingly, registrants will need to be mindful of these disclosure requirements
when establishing new controls and processes related to the adoption of the leasing
standard. For further discussion of ICFR, see Appendix E.
18.6 The Effects of Accounting Changes by a Successor Entity on the Predecessor-Period Financial Statements
At the March 23,
2017, CAQ SEC Regulations Committee joint meeting with the SEC staff
(the “March 2017 CAQ meeting”), the SEC staff discussed the effect on
predecessor-period financial statements of accounting changes by a successor,
specifically when the successor’s basis of accounting differs from that of its
predecessor because of a change in control, pushdown accounting, or fresh-start
reporting. For example, this situation would arise if (1) a transaction that occurs
on November 15, 2018, causes a change in basis for which a successor/predecessor
black-line presentation is required and (2) the successor entity retrospectively
adopts a new accounting standard that is effective as of January 1, 2019. This
matter is particularly important in light of the significance of the leasing
standard and the lack of comparability that would result if the registrant chooses
to adopt the standard as of the earliest comparative period presented but does not
adjust the predecessor-period financial statements. As noted in the highlights of
the March 2017 CAQ meeting, the SEC staff commented on the applicability of
paragraph 13210.2
of the FRM to this topic. In the staff’s view, the need to reflect the impact of
discontinued operations in predecessor periods “does not apply to any other
accounting changes.” Subsequently, at the September 26, 2017, CAQ SEC Regulations
Committee joint meeting with the SEC staff, the SEC staff observed that there is no
requirement in U.S. GAAP or other regulations to retrospectively adjust
predecessor-period financial statements in response to accounting changes by a
successor entity.
18.7 Adoption of ASC 842 for an EGC That Elected Private-Company (Non-PBE) Adoption Dates
An EGC may elect to adopt new accounting standards on the basis of effective
dates that apply to a private company that is not a PBE (this provision is referred
to as the extended transition provision), including the option to first adopt a new
standard in annual financial statements. However, such an election is available only
for as long as the entity qualifies as an EGC. Questions have been raised regarding
the transition provisions applicable when an entity loses EGC status after the
effective date for a PBE but before the effective date for an entity that is not a
PBE. As discussed in paragraph
10230.1 of the FRM, the SEC staff generally expects an EGC that loses
its EGC status to comply with PBE requirements in the first filing after loss of EGC
status. Further, the staff encourages EGCs to (1) review their plans to adopt
accounting standards upon the loss of EGC status and (2) consult with the Division
of Corporation Finance if they do not believe that they will be able to comply on a
timely basis with the requirement to reflect new accounting standards. The scenarios
discussed below reflect our general understanding of how an EGC that elected to use
the extended transition provision would reflect the leasing standard after the
deferral of adoption dates for non-PBEs (i.e., under ASU 2019-10 and ASU 2020-05).
18.7.1 Scenario 1: Calendar-Year-End Registrant Loses Its EGC Status on December 31, 2021
Assume that a registrant is a calendar-year-end EGC; has elected
to take advantage of the extended transition provisions and adopt the leasing
standard by using a private company (non-PBE) adoption date; has elected the
Comparatives Under 840 transition method; and loses its EGC status on December
31, 2021. We believe that such a registrant should adopt the leasing standard in
its next filing after losing status on the basis of the guidance in paragraph 10230.1(f) of
the FRM, which states, in part:
Generally, if an EGC loses
its status after it would have had to adopt a standard absent the extended
transition, the issuer should adopt the standard in its next filing after
losing status. However, depending on the facts and circumstances, the staff
may not object to other alternatives.
We understand that given the
above facts, the SEC staff would not object if the registrant were to:
Adopt ASC 842:
|
For the annual period beginning on
January 1, 2021.
|
First present the application of ASC 842
in its:
|
2021 annual financial statements
included in its 2021 Form 10-K.
|
Present the application of ASC 842 in
its summarized financial information (Item 302(a)) for
its:
|
2021 summarized financial information in
its 2021 Form 10-K. Further, we believe that the
registrant should provide clear and transparent
disclosures that the summarized financial information
for each quarterly period presented in its 2021 Form
10-K do not mirror the information in its 2021 Forms
10-Q for the current year.
Note that while the requirement in Item
302(a) only applies when a material retrospective change
has occurred, the SEC clarified that a registrant’s loss
of EGC status would represent a retrospective change
whose materiality would need to be evaluated because the
registrant would adopt ASC 842 in the Form 10-K for
“both the full fiscal year and interim periods within
that fiscal year.” See footnote 70 of SEC Final Rule No.
33-10890 for more information.
|
Present the application of ASC 842 in
its quarterly interim financial statements for its:
|
2021 comparable quarterly periods
presented in Forms 10-Q in 2022.
|
18.7.2 Scenario 2: Calendar-Year-End Registrant Loses Its EGC Status on December 31, 2022
Assume the same facts as in
Scenario 1, except the registrant loses its EGC status on December 31, 2022. On
the basis of the guidance outlined in Scenario 1, we believe that the SEC staff
would not object if the registrant were to:
Adopt ASC 842:
|
For the annual period beginning on
January 1, 2022.
|
First present the application of ASC 842
in its:
|
2022 annual financial statements
included in its 2022 Form 10-K.
|
Present the application of ASC 842 in
its summarized financial information (Item 302(a)) for
its:
|
2022 summarized financial information in
its 2022 Form 10-K. Further, we believe that the
registrant should provide clear and transparent
disclosures that the summarized financial information
for each quarterly period presented in its 2022 Form
10-K do not mirror the information in its 2022 Forms
10-Q for the current year.
Note that while the requirement in Item
302(a) only applies when a material retrospective change
has occurred, the SEC clarified that a registrant’s loss
of EGC status would represent a retrospective change
whose materiality would need to be evaluated because the
registrant would adopt ASC 842 in the Form 10-K for
“both the full fiscal year and interim periods within
that fiscal year.” See footnote 70 of SEC Final Rule No.
33-10890 for more information.
|
Present the application of ASC 842 in
its quarterly interim financial statements for its:
|
2022 comparable quarterly periods
presented in Forms 10-Q in 2023.
|
18.7.3 Scenario 3: Calendar-Year-End Registrant Qualifies as an EGC on or After December 31, 2022
Assume the same facts as in
Scenario 1, except the registrant qualifies as an EGC through the end of the
transition period (i.e., through December 31, 2022) or later. We believe that
the registrant could:
Adopt ASC 842:
|
For the annual period beginning on
January 1, 2022.
|
First present the application of ASC 842
in its:
|
2022 annual financial statements
included in its 2022 Form 10-K.
|
Present the application of ASC 842 in
its quarterly interim financial statements for its:
|
2023 quarterly periods presented in
Forms 10-Q in 2023. The registrant is encouraged, but
not required, to present the 2022 comparable quarters
under ASC 842 in its Forms 10-Q in 2023. If the
registrant does not present the comparable quarters
under the new standard, the SEC staff would expect the
registrant to provide clear and transparent disclosures
that the prior-period information is presented on a
basis different from that of the current year.
|
In accordance with Item 302(a), a registrant is required to
provide summarized financial information related to the statements of
comprehensive income for each affected quarterly period and the fourth quarter
in the affected year when a material retrospective change has occurred. However,
the SEC clarified that if a registrant qualifies as an EGC and adopts ASC 842
for the first time in its annual report on Form 10-K, the change would not be
viewed as retrospective when the registrant provides disclosures in accordance
with Item 302(a), because an EGC is permitted to use non-PBE adoption dates and
ASC 842 permits non-PBEs to first adopt the leasing standard in an annual period
rather than an interim period. This scenario differs from Scenarios 1 and 2
above since the registrants in those examples had lost EGC status and were no
longer permitted to use non-PBE adoption dates.10
The above would apply for a registrant that qualifies as an EGC
on December 31, 2022, and subsequently loses its EGC status.
Footnotes
10
See SEC Final Rule No. 33-10890, footnote 70, for
additional information.
18.8 PBE’s Use of Private-Company (Non-PBE) Elections
In November 2021, the FASB issued ASU 2021-09, which allows lessees that are
private companies (not PBEs) to make an accounting policy election by class of
underlying asset, rather than on an entity-wide basis, to use a risk-free rate as the
discount rate when measuring and classifying leases (see Section 7.2.3 for more information). Before the
issuance of ASU 2021-09, ASC 842-20-30-3 permitted such lessees 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” (emphasis
added).
An entity should exercise caution in using the alternative accounting
policies applicable to private companies (non-PBEs) if the entity expects that it may
undergo an IPO or that its financial statements or other financial information may be
included in another company’s SEC filing. Such an entity undergoing an IPO, even if it
qualifies as an EGC — or an entity whose financial statements or other financial
information may be included in another company’s SEC filing in the future under Rules
3-05, 3-09, and 4-08(g) — would be considered a PBE. Therefore, such an entity would no
longer be permitted to apply private-company (non-PBE) elections and any previously
elected private-company alternatives would need to be retrospectively eliminated from
the company’s historical financial statements before such statements or information can
be included in its IPO registration statement or other entities’ SEC filings.
18.9 Interaction Between Non-EGC’s ASC 842 Adoption Date and Its IPO Registration Statement
The financial statement impacts of adopting ASC 842 are significantly
affected by the adoption date, since all lease liabilities are discounted on the basis
of the discount rate as of that date. As discussed at the July 29, 2020, CAQ SEC Regulations Committee joint
meeting with the SEC staff, the SEC staff reiterated its “view that an IPO registration
statement of a non-EGC should apply the PBE adoption dates for all standards that apply
the PBE definition, including Topic 842. However, if an entity believes it has a
reasonable basis to support an alternative conclusion under GAAP and SEC rules and
regulations, the staff is available for consultation.” Thus, even a non-EGC that
undertakes an IPO several years after adopting ASC 842 (e.g., an IPO in 2026 after
adoption of ASC 842 in 2022) would need to push back the adoption date of ASC 842 to the
PBE adoption date, if the impact would be material.
Appendix A — Glossary of Terms in ASC 842-10-20, ASC 842-20-20, ASC 842-30-20, ASC 842-40-20, and ASC 842-50-20
Appendix A — Glossary of Terms in ASC 842-10-20, ASC 842-20-20, ASC 842-30-20, ASC 842-40-20, and ASC 842-50-20
This appendix includes defined terms from the glossary sections in ASC 842.
ASC 842 Glossary
Acquiree
The business or businesses that the acquirer obtains control of in a business combination. This term also includes a nonprofit activity or business that a not-for-profit acquirer obtains control of in an acquisition by a not-for-profit entity.
Acquirer
The entity that obtains control of the acquiree. However, in a business combination in which a variable interest entity (VIE) is acquired, the primary beneficiary of that entity always is the acquirer.
Acquisition by a Not-for-Profit Entity
A transaction or other event in which a not-for-profit acquirer obtains control of one or more nonprofit activities or businesses and initially recognizes their assets and liabilities in the acquirer’s financial statements. When applicable guidance in Topic 805 is applied by a not-for-profit entity, the term business combination has the same meaning as this term has for a for-profit entity. Likewise, a reference to business combinations in guidance that links to Topic 805 has the same meaning as a reference to acquisitions by not-for-profit entities.
Advance Refunding
A transaction involving the issuance of new debt to replace existing debt with the proceeds from the new debt placed in trust or otherwise restricted to retire the existing debt at a determinable future date or dates.
Business Combination
A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as true mergers or mergers of equals also are business combinations. See also Acquisition by a Not-for-Profit Entity.
Commencement Date of the Lease (Commencement Date)
The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.
Consideration in the Contract
See paragraph 842-10-15-35 for what constitutes the consideration in the contract for lessees and paragraph 842-10-15-39 for what constitutes consideration in the contract for lessors.
Contract
An agreement between two or more parties that creates enforceable rights and obligations.
Delayed Equity Investment
In leveraged lease transactions that have been structured with terms such that the lessee’s rent payments begin one to two years after lease inception, equity contributions the lessor agrees to make (in the lease agreement or a separate binding contract) that are used to service the nonrecourse debt during this brief period. The total amount of the lessor’s contributions is specifically limited by the agreements.
Direct Financing
Lease
From the perspective of a lessor, a lease that meets none of
the criteria in paragraph 842-10-25-2 but meets the criteria
in paragraph 842-10-25-3(b) and is not an operating lease in
accordance with paragraph 842-10-25-3A.
Discount Rate for the Lease
For a lessee, the discount rate for the lease 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.
For a lessor, the discount rate for the lease is the rate implicit in the lease.
Economic Life
Either 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.
Effective Date of the Modification
The date that a lease modification is approved by both the lessee and the lessor.
Estimated Residual Value
The estimated fair value of the leased property at the end of the lease term.
Fair Value
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Finance Lease
From the perspective of a lessee, a lease that meets one or more of the criteria in paragraph 842-10-25-2.
Fiscal Funding Clause
A provision by which the lease is cancelable if the legislature or other funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the lease agreement.
Incremental Borrowing Rate
The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.
Initial Direct Costs
Incremental costs of a lease that would not have been incurred if the lease had not been obtained.
Inventory
The aggregate of those items of tangible personal property that have any of the following characteristics:
- Held for sale in the ordinary course of business
- In process of production for such sale
- To be currently consumed in the production of goods or services to be available for sale.
The term inventory embraces goods awaiting sale (the merchandise of a trading concern and the finished goods of a manufacturer), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials and supplies). This definition of inventories excludes long-term assets subject to depreciation accounting, or goods which, when put into use, will be so classified. The fact that a depreciable asset is retired from regular use and held for sale does not indicate that the item should be classified as part of the inventory. Raw materials and supplies purchased for production may be used or consumed for the construction of long-term assets or other purposes not related to production, but the fact that inventory items representing a small portion of the total may not be absorbed ultimately in the production process does not require separate classification. By trade practice, operating materials and supplies of certain types of entities such as oil producers are usually treated as inventory.
Lease
A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.
Lease Inception
The date of the lease agreement or commitment, if earlier. For purposes of this definition, a commitment shall be in writing, signed by the parties in interest to the transaction, and shall specifically set forth the principal provisions of the transaction. If any of the principal provisions are yet to be negotiated, such a preliminary agreement or commitment does not qualify for purposes of this definition.
Lease Liability
A lessee’s obligation to make the lease payments arising from a lease, measured on a discounted basis.
Lease Modification
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).
Lease Payments
See paragraph 842-10-30-5 for what constitutes lease payments from the perspective of a lessee and a lessor.
Lease Receivable
A lessor’s right to receive lease payments arising from a sales-type lease or a direct financing lease plus any amount that a lessor expects to derive from the underlying asset following the end of the lease term to the extent that it is guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.
Lease Term
The noncancellable period for which a lessee has the right to use an underlying asset, together with all of the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
Legal Entity
Any legal structure used to conduct activities or to hold assets. Some examples of such structures are corporations, partnerships, limited liability companies, grantor trusts, and other trusts.
Lessee
An entity that enters into a contract to obtain the right to use an underlying asset for a period of time in exchange for consideration.
Lessor
An entity that enters into a contract to provide the right to use an underlying asset for a period of time in exchange for consideration.
Leveraged Lease
From the perspective of a lessor, a lease that was classified as a leveraged lease in accordance with the leases guidance in effect before the effective date and for which the commencement date is before the effective date.
Market Participants
Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
- They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms
- They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary
- They are able to enter into a transaction for the asset or liability
- They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so.
Minimum Lease Payments
Minimum lease payments comprise the payments that the lessee is obligated to make or can be required to make in connection with the leased property, excluding both of the following:
- Contingent rentals
- Any guarantee by the lessee of the lessor’s debt and the lessee’s obligation to pay (apart from the rental payments) executory costs such as insurance, maintenance, and taxes in connection with the leased property.
If the lease contains a bargain purchase option, only the minimum rental payments over the lease term and the payment called for by the bargain purchase option are required to be included in the minimum lease payments. Otherwise, minimum lease payments include all of the following:
- The minimum rental payments called for by the lease over the lease term.
- Any guarantee of the residual value at the expiration of the lease term, whether or not payment of the guarantee constitutes a purchase of the leased property or of rental payments beyond the lease term by the lessee (including a third party related to the lessee) or a third party unrelated to either the lessee or the lessor, provided the third party is financially capable of discharging the obligations that may arise from the guarantee. If the lessor has the right to require the lessee to purchase the property at termination of the lease for a certain or determinable amount, that amount is required to be considered a lessee guarantee of the residual value. If the lessee agrees to make up any deficiency below a stated amount in the lessor’s realization of the residual value, the residual value guarantee to be included in the minimum lease payments is required to be the stated amount, rather than an estimate of the deficiency to be made up.
- Any payment that the lessee must make or can be required to make upon failure to renew or extend the lease at the expiration of the lease term, whether or not the payment would constitute a purchase of the leased property. Note that the definition of lease term includes all periods, if any, for which failure to renew the lease imposes a penalty on the lessee in an amount such that renewal appears, at lease inception, to be reasonably assured. If the lease term has been extended because of that provision, the related penalty is not included in minimum lease payments.
- Payments made before the beginning of the lease term. The lessee is required to use the same interest rate to accrete payments to be made before the beginning of the lease term that it uses to discount lease payments to be made during the lease term.
- Fees that are paid by the lessee to the owners of the special-purpose entity for structuring the lease transaction. Such fees are required to be included as part of minimum lease payments (but not included in the fair value of the leased property).
Lease payments that depend on a factor directly related to the future use of the leased property, such as machine hours of use or sales volume during the lease term, are contingent rentals and, accordingly, are excluded from minimum lease payments in their entirety. However, lease payments that depend on an existing index or rate, such as the Consumer Price Index or the prime interest rate, are required to be included in minimum lease payments based on the index or rate existing at lease inception; any increases or decreases in lease payments that result from subsequent changes in the index or rate are contingent rentals and, thus, affect the determination of income as accruable.
Monetary Liability
An obligation to pay a sum of money the amount of which is fixed or determinable without reference to future prices of specific goods and services.
Net Investment in the Lease
For a sales-type lease, the sum of the lease receivable and the unguaranteed
residual asset.
For a direct financing lease, the sum of the lease receivable and the unguaranteed residual asset, net of any deferred selling profit.
Not-for-Profit Entity
An entity that possesses the following characteristics, in varying degrees, that distinguish it from a business entity:
- Contributions of significant amounts of resources from resource providers who do not expect commensurate or proportionate pecuniary return
- Operating purposes other than to provide goods or services at a profit
- Absence of ownership interests like those of business entities.
Entities that clearly fall outside this definition include the following:
- All investor-owned entities
- Entities that provide dividends, lower costs, or other economic benefits directly and proportionately to their owners, members, or participants, such as mutual insurance entities, credit unions, farm and rural electric cooperatives, and employee benefit plans.
Operating Lease
From the perspective of a lessee, any lease other than a finance lease.
From the perspective of a lessor, any lease other than a sales-type lease or a direct financing lease.
Orderly Transaction
A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale).
Penalty
Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following:
- Disburse cash
- Incur or assume a liability
- Perform services
- Surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment. Factors to consider in determining whether an economic detriment may be incurred include, but are not limited to, all of the following:
- The uniqueness of purpose or location of the underlying asset
- The availability of a comparable replacement asset
- The relative importance or significance of the underlying asset to the continuation of the lessee’s line of business or service to its customers
- The existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the underlying asset
- Adverse tax consequences
- The ability or willingness of the lessee to bear the cost associated with relocation or replacement of the underlying asset at market rental rates or to tolerate other parties using the underlying asset.
Period of Use
The 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).
Probable
The future event or events are likely to occur.
Public Business Entity
A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.
- It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing).
- It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
- It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer.
- It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market.
- It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including notes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity’s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC.
Rate Implicit in the Lease
The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.
Related Parties
Related parties include:
- Affiliates of the entity
- Entities for which investments in their equity securities would be required, absent the election of the fair value option under the Fair Value Option Subsection of Section 825-10-15, to be accounted for by the equity method by the investing entity
- Trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of management
- Principal owners of the entity and members of their immediate families
- Management of the entity and members of their immediate families
- Other parties with which the entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests
- Other parties that can significantly influence the management or operating policies of the transacting parties or that have an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.
Remote
The chance of the future event or events occurring is slight.
Residual Value Guarantee
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.
Right-of-Use Asset
An asset that represents a lessee’s right to use an underlying asset for the lease term.
Sales-Type Lease
From the perspective of a lessor, a lease that meets one or
more of the criteria in paragraph 842-10-25-2 and is not an
operating lease in accordance with paragraph 842-10-25-3A.
Security
A share, participation, or other interest in property or in an entity of the issuer or an obligation of the issuer that has all of the following characteristics:
- It is either represented by an instrument issued in bearer or registered form or, if not represented by an instrument, is registered in books maintained to record transfers by or on behalf of the issuer.
- It is of a type commonly dealt in on securities exchanges or markets or, when represented by an instrument, is commonly recognized in any area in which it is issued or dealt in as a medium for investment.
- It either is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations.
Selling Profit or Selling Loss
At the commencement date, selling profit or selling loss equals:
- The fair value of the underlying asset or the sum of (1) the lease receivable and (2) any lease payments prepaid by the lessee, if lower; minus
- The carrying amount of the underlying asset net of any unguaranteed residual asset; minus
- Any deferred initial direct costs of the lessor.
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.
Standalone Price
The price at which a customer would purchase a component of a contract separately.
Sublease
A transaction in which an underlying asset is re-leased by the lessee (or intermediate lessor) to a third party (the sublessee) and the original (or head) lease between the lessor and the lessee remains in effect.
Underlying Asset
An asset that is the subject of a lease for which a right to use that asset has been conveyed to a lessee. The underlying asset could be a physically distinct portion of a single asset.
Unguaranteed Residual Asset
The amount that a lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis.
Useful Life
The period over which an asset is expected to contribute directly or indirectly to future cash flows.
Variable Interest Entity
A legal entity subject to consolidation according to the provisions of the Variable Interest Entities Subsections of Subtopic 810-10.
Variable Lease Payments
Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time.
Warranty
A guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party. The obligation may be incurred in connection with the sale of goods or services; if so, it may require further performance by the seller after the sale has taken place.
Appendix B — Differences Between U.S. GAAP and IFRS Accounting Standards
Appendix B — Differences Between U.S. GAAP and IFRS Accounting Standards
Although the FASB and IASB conducted joint deliberations and intended to
converge their respective leasing standards (ASC 842 and IFRS 16), there are several
notable differences between the two standards. The table below summarizes these
differences.
Key Provision | ASC 842 | IFRS 16 |
---|---|---|
Scope | Scope includes leases of all PP&E and excludes:
| Scope includes leases of all assets (not limited to PP&E). Exceptions are similar to those in ASC 842. Lessees can elect to apply the guidance to rights to use certain intangible assets. |
Short-term lease definition | A short-term lease is defined as a lease that has a lease term of 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise. | A short-term lease is defined as a lease that has a lease term of 12 months or less and does not include a purchase option (i.e., the likelihood that the purchase option will be exercised is not considered). |
Leases of low-value assets | No exemption under U.S. GAAP. However, the FASB believes that an entity will be able to adopt a reasonable capitalization policy based on materiality. | A lessee may elect to recognize the payments for a lease of a low-value asset on a straight-line basis over the lease term (in a manner similar to its recognition of an operating lease under IAS 17). These leases would not be reflected on the lessee’s balance sheet. IFRS 16 does not define “low value”; however, the Basis for Conclusions refers to assets individually with a value, when new, of $5,000 or less.
In addition, an entity will be able to adopt a reasonable capitalization policy based on materiality. |
Lease classification | Lessee — There are two accounting models for leases, and the model will
dictate the pattern of expense recognition associated with
the lease. Therefore, a lessee must perform a lease
classification assessment as of the commencement
date. Under ASC 842-10-25-2, a lessee must classify a
lease as a finance lease if any of the following criteria
are met:
If none of these criteria are met, the lease would be classified as an operating lease.
Lessor — A lessor must perform a lease classification assessment as of the commencement date. The criteria governing when a lessor must classify a lease as a sales-type lease are the same as those that govern when a lessee must classify a lease as a finance lease (noted above). If none of these criteria are met, the lessor would classify the lease as a direct financing lease in accordance with ASC 842-10-25-3 if
(1) the sum of the lease payments and any third-party guarantee of the residual value “equals or exceeds substantially all of the fair value of the underlying asset” and (2) “[i]t is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee.” Otherwise, the lease would be classified as an operating lease. | Lessee — There is only a single accounting model for leases (i.e., all leases are effectively equivalent to finance leases under ASC 842), so classification of leases is unnecessary.
Lessor — A lessor must perform a lease classification assessment as of the inception date. A lease is classified as a finance lease if it transfers substantially all of the risks and rewards related to ownership; otherwise, it is classified as an operating lease. This determination is not based on meeting any criterion. However, examples of situations that individually or in combination would indicate a finance lease include:
Other situations in which a lease could be a finance lease include:
|
Lessee’s subsequent accounting for ROU asset and lease expense | The accounting depends on the lease classification:
Finance leases — The ROU asset is generally amortized on a straight-line basis. This amortization, when combined with the interest on the lease liability, results in a front-loaded expense profile. Interest and amortization are presented separately in the income statement.
Operating leases — Lease expense generally results in a straight-line expense profile that is presented as a single line in the income statement. As interest on the lease liability is generally declining over the lease term, amortization of the ROU asset is increasing over the lease term to provide a constant expense profile. | A single accounting model. The ROU asset is generally amortized on a straight-line basis. This amortization, when combined with the interest on the lease liability, results in a front-loaded expense profile. That is, the single lessee accounting model under IFRS 16 is similar to that of a finance lease under ASC 842. Interest expense on the lease liability and amortization of the ROU asset are presented separately in the income statement. |
Lessor accounting | Core model — Substantially retains the lessor measurement approach in ASC 840 for operating, direct financing, and sales-type leases.
Selling profit for a sales-type lease is recognized at lease commencement. Selling profit on a direct financing lease, if any, is deferred and recognized as interest income over the lease term. Separating lease and nonlease components — ASU 2018-11 offers lessors a practical expedient under which they are allowed not to separate lease and nonlease components when certain conditions are met.
Sales tax and lessor costs — ASU 2018-20 offers lessors a practical expedient under which they can present sales taxes collected from lessees on a net basis. ASU 2018-20 also added a requirement that lessor costs paid directly to a third party by a lessee should be excluded from variable payments. Fair value of underlying asset — ASU 2019-01 amends the definition of fair value for lessors that are not manufacturers or dealers in such a way that the fair value of the underlying asset is its cost unless a significant lapse of time has occurred. | Core model — Substantially retains the lessor measurement approach in IAS 17 for operating and finance leases.
Selling profit for a finance lease is recognized at lease commencement. Separating lease and nonlease components — A similar practical expedient is not available.
Sales tax and lessor costs — A similar practical expedient is not available. In addition, there are no similar provisions related to lessor costs paid directly to a third party by a lessee. Fair value of underlying asset — A similar amendment to the definition of fair value has not been made. |
Recognition of variable lease payments that do not depend on an index or rate | A lessee should recognize variable lease payments not included in its lease liability (e.g., payments based on the achievement of a target) in the period in which achievement of the target that triggers the variable lease payments becomes probable. | A lessee should recognize variable lease payments not included in its lease liability (e.g., payments based on the achievement of a target) in the period in which the target is achieved. |
Reassessment of variable lease payments that depend on an index or rate | A lessee reassesses variable payments based on an index or rate only when the lease obligation is remeasured for other reasons (e.g., a change in lease term or modification). | A lessee reassesses variable payments based on an index or rate whenever there
is a change in contractual cash flows (e.g., the lease
payments are adjusted for a change in the CPI) or when the
lease obligation is remeasured for other reasons. |
Lessee’s incremental borrowing rate | The lessee’s incremental borrowing rate is the rate a lessee would pay to
borrow, on a collateralized basis over a similar term, an amount equal to the lease
payments in a similar economic environment. | The lessee’s incremental borrowing rate is the rate a lessee would pay to borrow
over a similar term, and with a similar security, the funds
necessary to obtain an asset with a
value similar to the ROU asset in a similar economic
environment. |
Discount rate for private companies | Private-company lessees can elect to use a risk-free rate. | No exemptions provided for private-company lessees. |
Modifications of operating leases for
lessors
|
If an operating lease is modified and not
accounted for as a separate contract, the treatment depends
on the classification of the modified lease:
|
A lessor should account for a modification
to an operating lease (not accounted for as a separate
contract) as a new lease from the date of the modification.
The lessor should include any prepaid or accrued lease
payments related to the original lease in the lease payments
associated with the new lease.
|
Modifications that reduce the lease term for lessees
|
A reduction in the lease term is not considered a
decrease in the scope of the lease. A lessee should thus
remeasure the lease liability, with a corresponding
reduction in the ROU asset, but should not recognize
any gain or loss as of the effective date of the
modification unless the ROU asset is reduced to zero.
|
A reduction in the lease term is considered a decrease in the
scope of the lease. A lessee should thus remeasure the lease
liability, with a proportionate reduction in the ROU asset,
and recognize a gain or loss for any difference as of the
effective date of the modification.
|
Collectibility of lease payments
|
A lessor considers the collectibility of
lease payments when determining whether a lease should be
classified as a direct financing lease or an operating
lease. A lessor does not assess the collectibility of
lease payments when determining whether a lease should be
classified as a sales-type lease.
As a result of changes in the collectibility of lease
payments for an operating lease, lease income may be
recognized on a cash basis. (Collectibility of lease
payments for a direct financing or sales-type lease is
assessed under the CECL guidance in ASC 326.)
|
There is no explicit guidance on considering
the collectibility of lease payments within IFRS 16.
|
Modifications of sales-type or direct financing leases for lessors |
A lessor’s accounting for a modification to
a sales-type or direct financing lease depends on the
classification of the original and modified leases:
| A lessor’s accounting for a modification to a finance lease (not accounted for
as a separate contract) depends on whether the lease would
have been classified as an operating lease if the
modification had been in effect at lease inception:
|
Sublease | The intermediate lessor would classify a sublease by considering the underlying asset of the head lease (instead of the ROU asset) as the leased asset in the sublease. | The intermediate lessor would classify a sublease by considering the ROU asset of the head lease as the leased asset in the sublease. |
Sale-and-leaseback arrangements | The transaction would not be considered a sale if (1) it does not qualify as a sale under ASC 606 or (2) the leaseback is a finance lease.
A repurchase option would result in a failed sale unless (1) the exercise price of the option is at fair value and (2) alternative assets are readily available in the marketplace.
If the transaction qualifies as a sale, the entire gain on the transaction would be recognized. | The transaction would not be considered a sale if it does not qualify as a sale under IFRS 15.
A repurchase option would always result in a failed sale.
For transactions that qualify as a sale, the gain would be limited to the amount related to the residual portion of the asset sold. The amount of the gain related to the underlying asset leased back to the lessee would be offset against the lessee’s ROU asset. |
Balance sheet presentation | If a lessee does not separately present ROU assets and lease liabilities on the balance sheet, the lessee must disclose the line item in which its ROU assets and lease liabilities are included. This requirement applies to both finance leases and operating leases. | If a lessee does not separately present ROU assets and lease liabilities on the balance sheet, the lessee must present the ROU assets as if the underlying asset were owned and disclose the line item in which its ROU assets and lease liabilities are included. |
Statement of cash flows | A lessee should present payments associated with operating leases as an operating activity in the statement of cash flows. A lessee should present payments associated with finance leases in the statement of cash flows as (1) a financing activity, for the principal portion of the payment, and (2) an operating activity, for the interest portion of the payment. | As noted in the “Lessee’s subsequent accounting for ROU asset and lease expense” key provision above, a lessee is required to use a single approach (similar to the FASB’s finance lease approach) to subsequently account for the ROU asset. For this reason, the lessee should account for payments of interest as either a financing or an operating activity in the statement of cash flows, depending on the lessee’s accounting policy election under IAS 7. |
Effective date | Public entities — Effective for annual reporting periods beginning after
December 15, 2018.
Public NFPs1 — Effective for annual reporting periods beginning
after December 15, 2019. Nonpublic entities — Effective for annual reporting periods beginning
after December 15, 2021. Early adoption is permitted. | Effective for annual reporting periods beginning on or after January 1, 2019.
Early adoption is permitted provided that the entity has also adopted IFRS 15. |
Transition | ASC 842, as originally issued, required entities to transition to ASC 842 by using a modified retrospective approach.
Under the modified retrospective approach, entities must restate comparative periods under ASC 842, with certain practical reliefs. Thereafter, the FASB issued ASU 2018-11, which gives entities the option of not restating comparative periods and applying ASC 842 as of the adoption date.
Moreover, ASU 2018-01 provides a transition practical expedient for existing or expired land easements that were not previously accounted for as leases in accordance with ASC 840. The practical expedient allows entities to elect not to assess whether those land easements are, or contain, leases in accordance with ASC 842 when transitioning to ASC 842. | Entities may elect to transition to IFRS 16 by using either a full retrospective approach or a modified retrospective approach.
Under the modified retrospective approach, entities do not restate comparative periods. Entities should recognize a cumulative adjustment to retained earnings as of the date of initial adoption (e.g., January 1, 2019). A similar transition practical expedient for existing or expired land easements is not available.
|
Response to COVID-19
|
On April 10, 2020, the FASB issued a
staff Q&A that
allows entities to forgo performing a lease-by-lease legal
analysis to determine whether contractual provisions in an
existing lease agreement provide enforceable rights and
obligations related to lease concessions (i.e., not a
modification) as long as (1) the concessions are related to
the effects of the COVID-19 pandemic and (2) the changes to
the lease do not result in a substantial increase in the
rights of the lessor or the obligations of the lessee.
The staff Q&A affirms that entities may make an election
to account for eligible concessions, regardless of their
form, either by (1) applying the modification framework for
these concessions in accordance with 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 the modification
framework.
|
In May 2020, the IASB issued an
amendment2 to IFRS 16 that provides a practical expedient under
which a lessee (the amendment does not apply to lessors) can
elect not to assess whether a COVID-19-related rent
concession is a lease modification. A lessee applying this
practical expedient would account for a rent concession as
if it were not a lease modification under IFRS 16.
The practical expedient applies only to rent concessions that
are a direct consequence of the COVID-19 pandemic and only
if all of the following conditions are met: (1) the change
in lease payments results in revised consideration for the
lease that is substantially the same as, or less than, the
consideration for the lease immediately preceding the
change; (2) any reduction in lease payments affects only
payments that were originally due on or before June 30, 2022
(for example, a rent concession would meet this condition if
it results in reduced lease payments on or before June 30,
2022, and increased lease payments that extend beyond June
30, 2022); and (3) there are no substantive changes to other
terms and conditions of the lease.
|
Common-control lease arrangements
|
Upon adoption of ASU 2023-01:
|
There is no comparable practical expedient for common-control
arrangements under IFRS 16 and no specific consideration of
the amortization period of leasehold improvements in a
common-control arrangement under IAS 16.
|
In addition, while certain of the presentation and disclosure requirements in ASC 842 are similar to those in IFRS 16, there are also certain differences (quantitative and qualitative) in this area.
Other differences between ASC 842 and IFRS 16 may also arise as a result of
existing differences between U.S. GAAP and IFRS Accounting Standards, including
those related to (1) impairment of financial instruments and long-lived assets other
than goodwill and (2) the accounting for investment properties.
Footnotes
1
The deferral provided by
ASU
2020-05 applies to public NFPs
that have not issued financial statements or made
financial statements available for issuance as of
June 3, 2020. Public NFPs that have issued financial
statements or have made financial statements
available for issuance before that date must comply
with the effective dates prescribed for public
companies above.
2
IFRS Taxonomy Update,
COVID-19-Related Rent Concessions —
amendment to IFRS 16. Further, in March 2021, the
IASB issued Covid-19-Related Rent Concessions
Beyond 30 June 2021 — amendment to IFRS 16,
which extends the period during which the practical
expedient can be applied.
Appendix C — Differences Between ASC 840 and ASC 842
Appendix C — Differences Between ASC 840 and ASC 842
The table below illustrates the key differences between ASC 842 and ASC 840.
Key Provision
|
ASC 842
|
ASC 840
|
---|---|---|
Substantive substitution rights
|
For a substitution right to be substantive
and thus preclude lease accounting, the supplier must both
(1) have the practical ability to substitute the asset and
(2) economically benefit from the substitution. The concept
of economically benefitting from the substitution is a new
concept under ASC 842.
|
A lease does not exist if the supplier has
the right and ability to substitute other PP&E to
fulfill the arrangement. The supplier does not need to
economically benefit from the substitution for lease
accounting to be precluded (the substitution must be
practicable and economically feasible).
|
Right to control the use of the asset
|
To control the use of the asset, the
customer must have the right to (1) obtain substantially all
of the economic benefits from using the asset and (2) direct
the use of the asset (i.e., determine HAFWP the asset will
be used throughout the period of use).
|
A customer does not need to both obtain
substantially all of the economic benefits and direct the
use of the asset to control the use of the asset. For
example, the customer can control the use of the asset if
(1) it obtains substantially all of the output or other
utility generated by the asset and (2) the price it pays is
neither contractually fixed per unit of output nor equal to
the current market price of the output.
|
Separating land and other lease
components
|
A lessee should account for land and
buildings as separate lease components unless the accounting
effect of doing so would be insignificant (e.g., there would
be no impact on lease classification or the amount
recognized for the land component would be
insignificant).
|
When the lease meets either the
transfer-of-ownership or bargain-purchase-price
classification criteria, the lessee should account for the
land and other assets separately. Otherwise, when the fair
value of the land is 25 percent or more of the total fair
value of the leased property at lease inception, the lessee
should classify the land and other assets separately.
|
Separating lease and nonlease components
|
As a practical expedient,1 a lessee may elect not to separate lease and nonlease
components in the contract. If this practical expedient is
elected, the lessee must account for the combined components
as a single lease component.
|
A similar practical expedient does not exist
under ASC 840.
|
Maintenance
|
Maintenance services represent a nonlease
component that must be separated from the lease component(s)
in the contract (if the practical expedient described above
is not elected).
|
Amounts paid by the lessee to the lessor for
maintenance are generally considered executory costs.
|
Classification criteria
|
A lease should be classified as a finance
lease if it meets one of the following criteria:
Although the lease classification criteria
under ASC 842 differ from those under ASC 840, the FASB has
stated that an entity may use the bright lines established
under ASC 840 when evaluating the more principles-based
criteria in ASC 842.
|
A lease should be classified as a capital
lease if it meets one of the following criteria:
|
Executory costs
|
Executory costs (e.g., reimbursement for a
lessor’s property taxes and insurance) are allocated to both
lease and nonlease components in the contract on the same
basis as the other consideration in the contract. The
portion of executory costs allocated to the lease
component(s) in the contract is considered part of the lease
payments (to the extent that the payments are fixed).
|
All executory costs are excluded from the
determination of minimum lease payments for classification
and measurement purposes.
|
Residual value guarantees
|
A lessee should include in the lease
payments only the amount of the residual value guarantee
that it is probable the lessee will owe at the end of the
lease term.
|
A lessee should include in the minimum lease
payments the full amount of the residual value guaranteed by
the lessee.
|
Discount rate
|
A lessee should use the rate implicit in the
lease if it is readily determinable, regardless of whether
it is higher than the lessee’s incremental borrowing rate.
The rate implicit in the lease takes into
account the lessor’s initial direct costs.
The discount rate used must reflect a
secured borrowing rate.
|
A lessee should use the rate implicit in the
lease if it is readily determinable, unless that rate
exceeds the lessee’s incremental borrowing rate.
The rate implicit in the lease does not
incorporate the lessor’s initial direct costs.
The lessee’s incremental borrowing rate may
be unsecured if it is consistent with the financing that
would have been obtained to purchase the underlying asset
(and not leased).
|
Inception date vs. commencement date
|
A lease is classified and initially measured
on the lease commencement date.
|
A lease is classified and initially measured
on the lease inception date.
|
Lessee accounting
|
All leases (finance and operating) other
than those that qualify for the short-term scope exception
must be recognized on the lessee’s balance sheet. A lessee
recognizes a liability for its lease obligation and a
corresponding asset representing its right to use the
underlying asset over the lease term.
|
A lessee only recognizes capital leases on
its balance sheet. Leases classified as operating leases are
not capitalized on a lessee’s balance sheet.
|
Sales-type versus direct financing lease
|
The distinction between a sales-type lease
and a direct financing lease is based on whether the lessee
obtains control of the underlying asset. This assessment is
not affected by the relationship of the fair value to the
carrying amount of the underlying asset. If the lessee
obtains control of the underlying asset, the lease is
classified as a sales-type lease. If the lessee does not
obtain control of the underlying asset (but the lessor
relinquishes control), the lease is classified as a direct
financing lease.
|
The distinction between a sales-type lease
and a direct financing lease is based on whether there is a
difference between the fair value and carrying amount of the
underlying asset. If the fair value equals the carrying
amount of the underlying asset, the lease is classified as a
direct financing lease. Otherwise, the lease is classified
as a sales-type lease.
|
Collectibility
|
Lessors should consider collectibility in
accounting for their leases, and such consideration differs
depending on whether the lease is classified as a
sales-type, direct financing, or operating lease.
A lease can still be classified as a
sales-type lease if there are collectibility concerns. For a
sales-type lease to be recognized, collectibility of the
lease payments must be probable (in a manner consistent with
ASC 606).
The collectibility guidance for direct
financing and operating leases is aligned with ASC 840
(i.e., if the lease is not a sales-type lease, the lease
should be classified as an operating lease if collectibility
of the lease payments and any residual value guarantee is
not probable at lease commencement).
|
A lessor cannot recognize a capital lease
unless collectibility of the minimum lease payments is
reasonably predictable.
|
Lessor’s accounting for direct financing
leases
|
A lessor must defer selling profit for a
direct financing lease and recognize the deferred amount
over the lease term.
|
Because a direct financing lease can only
arise if the fair value equals the carrying amount of the
underlying asset, no profit or loss arises under a direct
financing lease.
|
Leases involving real estate
|
There is no unique guidance on classifying
and accounting for leases involving real estate. Leases
involving real estate are subject to the same general
classification and measurement guidance as leases involving
other PP&E.
|
Leases involving real estate are subject to
specific guidance that is unique to real estate (e.g., the
lessor will only classify a lease involving real estate as a
sales-type lease if it meets the transfer-of-ownership
criterion in ASC 840-10-25-1(a)).
|
Sale-and-leaseback arrangements
|
All assets are subject to the same
sale-and-leaseback guidance (i.e., there is no unique
guidance on sale-and-leaseback arrangements involving real
estate).
An entity should assess the criteria in ASC
606 to determine whether a sale has occurred. A repurchase
option precludes sale accounting unless (1) the option is
priced at the fair value of the asset on the date of
exercise and (2) alternative assets exist that are
substantially the same as the transferred asset and are
readily available in the marketplace.
The existence of a leaseback by itself would
not indicate that a sale has not occurred unless the
leaseback is classified as a finance lease.
|
There is specific guidance on
sale-and-leaseback arrangements involving real estate
(including integral equipment).
A sale-and-leaseback arrangement involving
nonintegral equipment that includes a repurchase option may
not result in a failed sale if the option does not
economically compel the seller-lessee to repurchase the
equipment.
|
Leveraged lease accounting
|
ASC 842 does not include guidance on
leveraged leases. Entities are not permitted to account for
any new lease arrangements as leveraged leases after the
effective date of ASC 842.
Leveraged leases existing as of the
effective date of ASC 842 would be subject to the guidance
in ASC 842-50, which is generally consistent with the legacy
accounting requirements for leveraged leases and effectively
grandfathers in that guidance. If a leveraged lease is
modified after the effective date of ASC 842, it would be
accounted for as a new lease.
|
A lease is a leveraged lease if it meets all
of the following characteristics:
|
Build-to-suit lease arrangements
|
ASC 842 supersedes the guidance in ASC 840
on build-to-suit arrangements. Under ASC 842, the accounting
for a build-to-suit arrangement depends on whether the
lessee controls the underlying asset during the construction
period.
|
A lessee is considered the owner of an asset
during the construction period if the lessee has
substantially all of the construction period risks. There
are certain automatic indicators of ownership, which have
historically caused a number of lessees to be deemed owners
of assets during the construction period.
|
Related-party leases
|
Entities should account for related-party
leasing arrangements on the basis of the legally enforceable
terms and conditions of the lease rather than the substance
of the arrangement.
Common-Control Arrangements
ASU 2023-01 allows private companies, as
well as not-for-profit entities that are not conduit bond
obligors, to elect a practical expedient in which the
written terms and conditions of the arrangement are used to
determine whether a lease exists and the subsequent
accounting for the lease.
|
Entities should account for related-party
leasing arrangements on the basis of the substance of the
contract.
|
Reassessment (identifying a lease)
|
An entity should only reassess whether the
contract is or contains a lease if the terms and conditions
of the contract are changed.
|
An entity should only reassess whether an
arrangement is or contains a lease if any of the following
occur:
|
Reassessment (lessee measurement)
|
Upon a reassessment event, a lessee should
remeasure its ROU asset and lease liability on its balance
sheet. A lessee should use the discount rate that applies as
of the date of the reassessment event to remeasure its ROU
asset and lease liability.
|
A lessee should not remeasure a capital
lease liability during the lease term unless the lease is
modified. If the lease is modified and remeasured, the
remeasurement should be based on the discount rate that was
used at lease inception (i.e., the discount rate should not
be updated).
|
Lease modifications
|
The lease modification guidance is more
extensive under ASC 842, and the two-step model from ASC 840
is not carried forward. The changes are primarily related to
aligning the modification guidance with the guidance in ASC
606.
|
A modification of a lease should be
accounted for as a new lease if the modification would have
resulted in a different lease classification had the changed
terms been in effect at lease inception. A lease
modification does not include renewals or extensions of the
lease if such renewals or extensions were already included
in the lease term.
|
Initial direct costs
|
Initial direct costs include only those
costs that are incremental to the arrangement and that would
not have been incurred if the lease had not been
obtained.
|
In addition to costs that are incremental to
the arrangement and that would not have been incurred if the
lease had not been obtained, initial direct costs include
costs directly related to the following activities:
|
Impairments
|
Operating leases are subject to the impairment guidance in
ASC 360.
|
Operating leases are subject to the guidance in ASC 420 on
exit and disposal activities.
|
Statement of cash flows (lessor)
|
A lessor must classify cash received from
leases in the operating activities section of its statement
of cash flows.2
|
ASC 840 does not include guidance on the
classification of cash received from leases in a lessor’s
statement of cash flows.
|
Disclosures
|
An entity must disclose significantly more
quantitative and qualitative information under ASC 842.
|
Lessees and lessors are subject to
relatively limited disclosure requirements.
|
Footnotes
1
In July 2018, the FASB issued
ASU
2018-11, which includes a practical
expedient that allows lessors, when certain
conditions are met, not to separate lease and
nonlease components. Under ASU 2018-11, lessors
availing themselves of this practical expedient
would not account for affected nonlease components
separately. See Section
17.3.1.4.2 for further discussion.
2
In March 2019, the FASB issued
ASU
2019-01, which amended the
presentation of the statement of cash flows for
entities within the scope of ASC 942. Such entities
are required to classify principal payments received
from sales-type and direct financing leases in the
investing activities section of their statement of
cash flows. This requirement is associated with an
illustrative example in ASC 942 that existed before
the adoption of, and was not amended by, ASC
842.
Appendix D — Implementation Activities
Appendix D — Implementation Activities
D.1 Introduction
In implementing ASU 2016-02 and other related ASUs (collectively referred to as “ASC 842” herein), entities will need to change not only their accounting for and financial reporting of leases but also their related systems and processes. It is important for all entities to develop an implementation plan well before ASC 842’s effective date. Though some of the accounting changes may seem intuitive, the data and systems requirements needed to bring about those changes are significant and, without preparation, may be overwhelming.
Further, because many companies have numerous lease agreements involving multiple decentralized locations and lease data may be maintained in spreadsheets or hard copies, the collection and abstraction of data can be resource-intensive and time-consuming. Although certain elements of a company’s lease data may be in an electronic format, such data may not have been subjected to Sarbanes-Oxley internal control procedures, may reside in disparate systems, and may be insufficient under the requirements in ASC 842. A centralized information repository may be critical to the development of a lease inventory.
The objectives of this appendix are to (1) help entities begin their planning and assessment process related to adopting ASC 842 and (2) provide entities whose adoption might be further along with some ideas to supplement their current implementation approach and ensure that they consider all critical steps in the process. This appendix is divided into the following sections:
- Getting Started (Section D.2) — This section provides readers with helpful tips and some suggested “dos and don’ts” for implementing the guidance in ASC 842.
- Phases of Implementation (Section D.3) — This section summarizes five phases of implementing the guidance in ASC 842, including activities that an entity may consider including in its implementation roadmap and factors governing the approximate length of time that each activity will take to complete.
- Important Decisions (Section D.4) — This section focuses on certain decisions that an entity will need to make to adopt ASC 842.
D.2 Getting Started
The adoption of ASC 842 may be a daunting task, but by developing a detailed and thoughtful implementation plan, entities can break down the transition into multiple stages so that they can work toward achievable goals.
Before charting a course for their transition to ASC 842, entities should consider the following “dos and don’ts”:
- Dos:
- Identify a cross-functional team of professionals from all key decision-making departments at the entity’s organization (e.g., accounting, finance, IT, tax, human resources, real estate, procurement, investor relations, legal, and internal audit) to ensure that all departments are represented before management agrees on a plan on how to adopt ASC 842. In doing so, an entity may need to establish a steering committee, program management team, or both, made up of individuals from various functions and business units. In addition, global or multinational entities should identify key contacts in each international region, especially if business models differ internationally.
- Keep all affected departments abreast of the transition plan. This is especially important given the extensive changes in ASC 842 with respect to the lessee accounting model. Historically, entities may not have involved departments outside of accounting (e.g., IT, tax, human resources, real estate, procurement, investor relations and legal) in decisions related to the implementation of new accounting guidance. An entity could consider developing a periodic communication detailing accomplishments and upcoming activities to keep personnel outside the steering committee and the program management team informed during the implementation period.
- Create a roadmap outlining realistic goals and key milestones for the entity to work toward in making the transition to ASC 842.
- Assess the various solutions available for complying with the requirements in ASC 842 and test the solutions against the entity’s business needs.
- Consider changing how the entity executes and manages leases (e.g., centralized vs. decentralized approach), since the entity may have an opportunity to change those historical practices during the implementation period.
- Leverage knowledge and efficiencies gained from the adoption of other accounting standards.
- Engage with auditors early in the implementation process to obtain concurrence on the entity’s accounting policies and positions under ASC 842.
- Don’ts:
- Do not assume that ASC 842 does not have a significant impact on the entity. Although the guidance focuses on changes to the lessee accounting model, the entity should also analyze the changes to the lessor accounting model.
- Do not underestimate the time and resources needed to appropriately implement ASC 842 and collect the necessary data. Start planning now to ensure that the entity is ready before the effective date.
- Do not include only a small group of accounting personnel on the transition/implementation team.
- Do not make decisions in silos. Specifically, do not (1) make IT design decisions before identifying business and functional requirements or (2) make business decisions without the involvement of IT.
- Do not overlook the new quantitative and qualitative disclosure requirements when identifying the data needs and building the business/functional requirements.
D.3 Phases of Implementation
One of the key ingredients for a successful adoption of ASC 842 is putting together a roadmap for implementation. The sections below highlight five phases of adopting ASC 842, including key activities that an entity may perform when developing such a roadmap as well as factors it may consider to gauge how much time and effort it will take to complete certain steps in the transition to ASC 842.
The activities and timing for each entity’s roadmap will vary depending on (1) the quantity and variability of the entity’s contracts, (2) its existing systems and processes, and (3) the amount of resources dedicated to its transition plan.
As illustrated below, stakeholders throughout the organization will need to be involved in the adoption of ASC 842. Further, while the initial steps of an adoption plan focus on understanding the technical accounting changes, other aspects of the project can occur contemporaneously. As certain technical accounting conclusions are reached, the total lease population can be identified, IT/systems implications can be assessed, and internal training can begin. During the implementation period, an entity’s normal operations do not cease; new leases are entered into and existing leases are modified or terminated. Accordingly, the adoption of ASC 842 should not be viewed as a linear process.
The five phases of adopting ASC 842, as discussed in the next sections, are (1)
assessment, readiness, and planning; (2) development of policies and selection
of a software or IT system solution, if applicable (collectively, “solution”);
(3) lease abstraction and data storage; (4) solution implementation; and (5)
deployment and aftercare. Key activities are associated with each phase of
adoption. Certain of these activities may be performed during multiple phases of
the adoption process, while others may apply to a single phase.
D.3.1 Phase 1: Assessment, Readiness, and Planning
The first phase of the adoption effort should focus on understanding the
accounting and disclosure requirements, understanding an entity’s lease
population, and performing a data gap analysis. The next sections discuss
these activities.
D.3.1.1 Understanding the Accounting and Disclosure Requirements
One of the first steps an entity must take in creating a transition plan is to understand the technical accounting changes and elections offered under ASC 842. Further, it is critical for entities with international operations that will be subject to statutory filing requirements to understand the differences between ASC 842 and IFRS 16 (see Appendix B for a summary of these differences).
Although entities frequently focus on the changes to a lessee’s recognition and
measurement for leases (see Chapter 8), it is also important
for entities to consider implications for lessors (see Chapter 9) and
the new disclosure requirements (see Chapter 15). In addition to
understanding the new disclosure requirements, an entity should
continually monitor the disclosure requirements of SAB Topic 11.M (SAB
74)1 during the implementation period. Furthermore, an entity should
consider the relevant principles and key points of COSO’s2
Internal Control — Integrated Framework, as updated in 2013 (see
Appendix
E). Further, SEC registrants are required to disclose any
material changes in their ICFR in a Form 10-Q or Form 10-K in accordance
with SEC Regulation S-K, Item 308(c). The implementation activities
related to disclosures may be monitored and considered in all phases of
the implementation period.
D.3.1.2 Understanding the Lease Population
As part of the first phase of the adoption process, an entity should determine its complete lease population. The purpose of understanding this information is to allow the entity to identify potential accounting, data, or other operational issues so that it can plan the level of effort it will need to expend to achieve compliance and align resources for the future phases.
To better understand the lease population, an entity could give a lease survey to all relevant personnel or business units. Such a survey should request the number of contracts by class of underlying asset for lessees, lessors, and subleases. It may also be helpful for the survey to contain questions about the existence of certain contract terms and attributes. These may include, but are not limited to, the following:
- Variable lease payments, including variable lease payments with a floor or minimum.
- Renewal, termination, and purchase options.
- Lease incentives.
- Refundable and nonrefundable security deposits.
- Residual value guarantees.
- Initial direct costs.
The survey could also include questions about the frequency and nature of
contract modifications as well as about the average term of the
contracts. If an entity has international operations, it is important to
learn the language of the contracts, if unknown. Finally, it may be
useful to ask a question regarding the existence of contracts with any
service providers that use their own assets to meet their obligations
under the service arrangement (i.e., in the delivery of services to the
entity). Such a question may help the entity begin to identify contracts
that are, or contain, leases and that were not previously accounted for
under ASC 840. Note that, as discussed in the Connecting the Dots in Section 16.5.2.1, entities may not carry
forward any previous “errors” (i.e., incomplete identification of
leases) in making the transition to ASC 842.
In addition to performing a lease survey, it may be necessary for an entity to sample leases for contract review to understand the lease population. It is recommended that contracts from various classes of underlying assets be selected for review. As part of the review, an entity should identify the contract terms and attributes and should corroborate the information gathered in the lease surveys.
D.3.1.3 Performing a Data Gap Analysis
Another key activity during the initial phase of lease implementation is a data gap analysis. In performing this analysis, an entity should reconcile the lease elements in its current system or spreadsheet to all the lease elements it needs to comply with the accounting and disclosure requirements of ASC 842. As part of this reconciliation, it is also recommended that the entity differentiate between gaps that must be filled for existing leases at transition and gaps that should be filled only on a go-forward basis for new leases.
The lease survey and contract review activities described in Section D.3.1.2 may also prove beneficial to
the data gap analysis, since certain lease elements may not be relevant
to an entity’s existing lease population and thus can be eliminated or
deescalated when an entity addresses the data gaps identified at
transition.
The data gap analysis is critical to understanding resource needs and required lead time in the later lease abstraction phase (see Section D.3.3).
D.3.2 Phase 2: Development of Policies and Solution Selection
The second phase of the adoption effort consists of two primary activities: the
development of accounting policies and selection of the long-term solution
(discussed in the next section and Section D.3.2.2). Entities are likely
to commence the activities in phase 3 before the activities in phase 2 are
substantially complete.
D.3.2.1 Development of Policies
The main technical accounting activities that an entity performs in developing accounting policies are (1) holding working sessions to understand lease strategies and practices; (2) understanding the lease population; and (3) documenting accounting policies, including practical expedient elections.
The development of policies is an iterative process. Consequently, there is no set rule on when an entity should perform this task. However, as the entity begins to understand more about its lease strategies and practices, it may be inclined to amend initial decisions. Accordingly, the development of accounting policies should be viewed as an ongoing part of the adoption process (i.e., an entity may perform this task during multiple phases of its adoption efforts).
The working sessions held to understand lease strategies and practices will be the key to determining accounting policies and supporting the ultimate decisions reached. The working sessions may highlight key attributes of certain agreements by underlying class of asset, the business decision for including the contract terms in the agreement, when options (e.g., purchase options or renewal options) are considered and exercised by the entity, and other relevant information. In addition, an entity is likely to hold working sessions with its treasury department regarding the determination of the discount rate, as defined under ASC 842 (see Chapter 7).
After completing these activities, an entity will be able to determine and document its updated accounting policies under ASC 842. These policies may address the following topics:
- Scope and definition of a lease (see Chapters 2 and 3, respectively), including conclusions about embedded leases.
- Lease term, including application of the “reasonably certain” threshold (see Chapter 5).
- Discount rate (see Chapter 7).
- Presentation and disclosures (see Chapters 14 and 15, respectively).
- Differences between U.S. GAAP and IFRS Accounting Standards (see Appendix B).
- Portfolio approach (see Chapter 8).
An entity should also determine which practical expedients it will elect in
adopting ASC 842, including those related to transition relief,
separating lease and nonlease components, short-term leases, and the
discount rate. These decisions are described in further detail in
Section
D.4.1. For assistance in making these decisions, the
entity should leverage the knowledge gained in phase 1 and in the
working sessions described above.
The entity’s tax department should also assess the impact of ASC 842 and document and implement changes to its existing processes. This assessment and these process changes may be completed during or after the other accounting policy development activities. The tax department may consult personnel from the core accounting function to better understand the lease landscape and changes.
In developing these policies, entities should ensure that they (1) dedicate enough time and resources to them and (2) obtain auditor concurrence before finalizing them.
D.3.2.2 Solution Selection
Activities related to solution selection include, but are not limited to, developing business and functional requirements. The purpose of developing business requirements is to (1) present and document the key requirements for any system changes that are needed and (2) identify the data requirements and ledger systems affected by ASC 842. The objective of developing functional requirements is to establish granular accounting calculation rules that an entity’s solution will need to perform, while also considering other business needs. That is, solutions do not need to be limited to compliance and can focus on other business efficiencies, such as lease administration (e.g., processing lease payments) or procurement decisions (e.g., lease vs. buy).
Although the development of business and functional requirements has historically been an IT activity, entities should review these requirements with other business functions, including the core accounting function, corporate real estate, and procurement, to ensure that the requirements are sufficient.
Ultimately, an entity may decide either to (1) enhance its existing IT infrastructure to better comprehend the storage, calculation, and reporting requirements or (2) select a new solution. If an entity is considering a new solution, it should build a vendor scorecard to ensure that all business functions provide feedback and that systems are compared on a similar basis. Often, it takes significant time to contract with the external technology vendor.
D.3.3 Phase 3: Lease Abstraction and Data Storage
The third phase of the adoption effort is centered on data readiness, which
includes activities related to lease abstraction and data storage. This is
often considered to be the most difficult phase of implementing ASC 842.
Many entities have entered into numerous lease agreements at decentralized
locations and have lease data in disparate spreadsheets or hard copies.
Furthermore, lease agreements may not contain required information (e.g.,
the incremental borrowing rate). Consequently, collecting and abstracting
lease data may be time-consuming and resource-intensive. As mentioned
previously, entities are likely to commence the activities in phase 3 before
the activities in phase 2 are substantially complete. The next sections
discuss the activities performed during this phase.
D.3.3.1 Data Validation, Normalization, and Migration
The initial step in addressing data readiness is to validate the data (i.e., ensure that it is accurate). Such data can take many forms and be applied in various ways. For example, one business unit may have updated the lease payment stream for an adjustment to an index, while another business unit may track the adjustment separately.
Upon determining which data will be leveraged in a new solution, an entity must
normalize the data (i.e., organize it in a consistent format to increase
readability and usability) and migrate it (e.g., upload it to the
system).
D.3.3.2 Supplemental or Comprehensive Lease Abstraction
When an entity completes the validation phase for existing data, it should use the results of the data gap analysis to identify which supplemental elements to abstract. For some entities, some or all leases may have to undergo comprehensive abstraction.
As mentioned previously, not all required data elements can be determined from the lease agreement. Furthermore, an entity will often need to use judgment in assessing whether certain data elements are required (e.g., when determining the lease term). Those performing the abstraction should work closely with the core accounting function to understand the appropriate method to use for this process.
The abstracted data may be stored, as applicable, in an offline template, a temporary solution, or the new long-term solution selected, depending on the timing of the other phase activities.
D.3.3.3 Process Change to Initial Data Capture and Data Maintenance
An entity should establish a process for capturing the normalized data, as soon as its format is known, to address the new requirements. For example, for new leases, entities may train personnel to appropriately abstract all relevant data so that the previous data activities described are completed on an ongoing basis. Also, entities should establish a process for identifying modifications or terminations for existing leases for which the previously described activities were not performed. That is, while the validation and abstraction are being completed, an entity’s data should not become stale.
D.3.4 Phase 4: Solution Implementation
The solution that is selected in phase 2, if applicable, will govern the timing and activities in the solution implementation phase, which may include technical integration with an entity’s existing system(s), customized configuration, and validation of functionality. These activities may be conducted (1) in house, (2) with an external vendor, or (3) both. An entity’s IT department is often heavily involved in a solution implementation; however, the core accounting function should also participate.
The solution implementation phase should also include revisions to the design and development of internal controls to address the changes to the lease accounting process for the new solution.
D.3.5 Phase 5: Deployment and Aftercare
Although adopting ASC 842 may seem like a one-time effort, the success of an entity’s adoption of the guidance in ASC 842 depends partly on the activities performed during the deployment and aftercare phase. After adoption, the entity should perform a postimplementation review to ensure that (1) any system modifications or upgrades are functioning as intended, (2) any changed or newly implemented internal controls are operating effectively, (3) the entity’s personnel are following the new accounting policies, and (4) disclosures are comparable to those prepared by others in the same industry or industries. Depending on the outcome of the postimplementation review, some entities may need to continually dedicate resources to ensure compliance with ASC 842.
D.4 Important Decisions
Discussed below are some of the important topics that all entities should consider while making the transition to ASC 842.
D.4.1 Entity Elections and Transition Reliefs
ASC 842 offers explicit practical expedients that can be elected by certain entities or in certain arrangements. These elections include the following:
- Elections by class of underlying asset:
- Short-term leases (see Section 8.2.1).
- Separating lease from nonlease components (see Section 4.3.3).
- Election for lessors for all leases:
- Sales taxes collected from a lessee (see Section 4.4.2.1.2).
- Election for private-company lessees for all leases:
- Discount rate (see Section 7.2.3).
-
Use of the written terms and conditions of a common-control arrangement (see Section 8.3.5.2.1).
- Transition reliefs:
- Use of hindsight (see Section 16.5.1).
- Package of practical expedients (see Section 16.5.2): whether a contract is or contains a lease, lease classification, and initial direct costs.
- Land easement practical expedient (see Section 2.4).
D.4.2 Individual-Contract Versus Portfolio Approach
In addition to making decisions about the expedients explicitly offered in ASC 842, an entity will need to determine whether to apply the guidance in ASC 842 on a contract-by-contract basis to all leases or whether to account for certain types of leases on a portfolio basis (see Section 8.2.2). Although ASC 842 should generally be applied on an individual-contract basis, an entity may apply a “portfolio approach” if it reasonably expects that the impact of such an approach on the financial statements would not be materially different.
The effort an entity needs to expend in gathering information will likely dictate whether it applies the portfolio approach to certain leases. For leases in which all contract terms are nearly the same and data elements can be summarized rather than abstracted from the individual lease contracts, the portfolio approach may be an effective option. That is, a primary benefit of the portfolio approach is to eliminate the cost of individually gathering data for all of the contracts.
D.4.3 Dual Reporting Requirements
An entity is required3 to restate prior periods under the modified retrospective method. That is, an entity will need to run parallel financial reporting systems during the period of transition to capture existing leases under ASC 842 and ASC 840.
An entity may leverage the new processes and systems established to comply with ASC 842 when applying ASC 840 during the dual reporting period. Conversely, an entity may decide not to disrupt the existing process and to apply both the existing and new processes during the dual reporting period. The entity’s resource limitations and system capabilities are key factors for it to consider in determining the best approach to use for dual reporting.
D.4.4 Capitalization Policy Considerations
Entities may want to consider establishing a materiality threshold for
evaluating whether to recognize, on the balance sheet, leases that otherwise
must be recognized under ASC 842. For more information, see Section 2.2.5.2.
Footnotes
1
SEC Staff Accounting Bulletin (SAB) 74 was
codified as SEC SAB Topic 11.M. See Deloitte’s September 22,
2016, Financial Reporting Alert for
further discussion.
2
The Committee of Sponsoring Organizations of the
Treadway Commission.
3
This transition requirement is not applicable if the lessee elects the Comparatives Under 840 Option. For more information, see Sections 16.1 and 17.3.1.4.1.
Appendix E — Internal Control Over Financial Reporting
Appendix E — Internal Control Over Financial Reporting
E.1 Preadoption Disclosure Controls
SEC registrants should be aware that the SEC has been emphasizing the importance
of transition-period disclosures (or preadoption disclosures) in accordance with
SAB 74.1 These disclosures should be both qualitative and quantitative and should
be included in MD&A (subject to disclosure controls and procedures) and the
footnotes to the financial statements (subject to ICFR). The SEC staff has also
made clear its expectation that the preadoption disclosures should become more
robust and quantitative as ASU 2016-02’s effective date approaches.
In light of the SEC’s guidance and recent comments from the SEC staff, such disclosures should address the impact ASU 2016-02 and other related ASUs (collectively referred to as “ASC 842” herein) are expected to have on the financial statements and should include:
- A comparison of the company’s current accounting policies with the expected accounting under ASC 842.
- The status of the implementation process.
- The nature of any significant implementation matters that have not yet been addressed.
A company that is able to reasonably estimate the quantitative impact of ASC 842 should also disclose those amounts.
Internal controls over these preadoption disclosures are important to
management’s ability to address the risks that the disclosures are inaccurate or
incomplete. Management should first identify whether appropriate internal
controls exist for the disclosures (e.g., controls over infrequent processes)
and then specify the information and analysis used to support those controls. In
some cases, management may need to revise existing controls or implement new
controls. Next, management needs to evaluate the design and test the operating
effectiveness of the relevant controls given that they should be included within
the scope of management’s report on ICFR in the year before the adoption of ASC
842, as applicable.
When assessing whether appropriate internal controls exist with respect to the preadoption disclosures, management may consider whether procedures are in place to evaluate:
- Competence — The preadoption disclosures are prepared by competent individuals with knowledge of ASC 842 and potential impacts on the company.
- Compliance — The disclosures meet the SEC’s requirements and guidelines.
- Data quality — The quantitative disclosures (if known and estimated) are calculated on the basis of reliable inputs that are subject to appropriate internal control.
- Review — The disclosures are reviewed by appropriate levels of management.
- Monitoring — The company’s monitoring function (e.g., internal audit, disclosure committee, or audit committee) appropriately reviews the internal controls in accordance with company protocols.
E.2 Internal Control Considerations Related to the Adoption of ASC 842
E.2.1 Internal Controls Over Adoption
There are often unique circumstances and considerations associated with the
adoption of a new accounting standard that can pose a greater risk of
material misstatement to the financial statements. Thus, companies should
consider the circumstances that may only be present during the adoption
period and evaluate whether there are any unique risks for which an entity
needs to design controls over infrequent processes that may operate
exclusively during the adoption period. Management should also consider the
internal controls, documentation, and evidence it needs to support:
-
Entity-level controls such as the control environment and general “tone at the top.”
-
Identification of a complete population of lease agreements or contracts in accordance with company policies.
-
Accounting conclusions reached (e.g., preparing accounting white papers or internal memos memorializing management’s considerations and conclusions).
-
Information used to support accounting conclusions, new estimates, adjustments to the financial statements, and disclosure requirements.
-
Identification and implementation of changes to relevant IT systems.
-
The modified retrospective transition approach.
-
The accounting logic used and journal entries (including the transition adjustments) that record the adoption’s impact.
-
Any practical expedients applied and related disclosures.
-
Changes to the monthly, quarterly, or annual close process and related reporting requirements (e.g., internal reporting, disclosure controls and procedures).
E.2.2 Lease-Related Risks, Internal Controls, and Documentation
It is possible that, as a result of ASC 842, new financial reporting risks will emerge, including new or modified fraud risks, and that new processes and internal controls will be required. Companies will therefore need to consider these new risks and how to change or modify internal controls to address the new risks.
Management will need to make significant assumptions and judgments because of
the requirements under ASC 842. For example, since almost all leases will be
recognized in the statement of financial position, management will need to
use significant judgment in evaluating matters such as whether an
arrangement is or contains a lease and in assessing a lease’s term, which
would affect whether the lease qualifies for the short-term exemption. It is
critical for management to (1) evaluate the risks of material misstatement
associated with these significant judgments, (2) design and implement
controls to address those risks, and (3) maintain documentation that
supports the assumptions and judgments that underpin its estimates.
See Section E.4 for a table summarizing sample risks and controls that may help entities consider how ASC 842 will affect them.
E.2.3 Significant Changes in Information and Related Data-Quality Needs
Companies will need to gather and track new information to comply with ASC 842,
including the related disclosure requirements. Management should consider
whether appropriate controls are in place to support (1) any necessary IT
changes (including change management controls and, once the IT changes have
been implemented, the evaluation of their design and testing of their
operating effectiveness) and (2) the completeness and accuracy of the
information used by the entity in recognizing lease assets and liabilities
and the related income and expense and providing the required disclosures.
The table below illustrates some potential challenges and examples of
practices related to internal control.
Potential Challenge | Example of Internal Control Practice |
---|---|
Information requirements have not been updated to support the reporting (e.g., interim and annual requirements, including those related to disclosures) required under ASC 842. | Management establishes data governance, policies, and standards for identifying and resolving data gaps and implements processes to verify the quality of information needed for implementation of ASC 842. |
Control expectations have not been considered for new information required under ASC 842. | The lease implementation team meets periodically with the ICFR or SOX team (and
control owners as appropriate) to share relevant
information about the adoption of ASC 842 so that
the ICFR or SOX team can prepare and plan
accordingly. |
Legacy internal controls over source data, report logic, or parameters have not
been reconsidered. | Management takes steps to update and review the appropriate flowcharts, data flow diagrams, process narratives, procedure manuals, and control procedures to reflect the new processes as a result of ASC 842 and to support management’s ICFR assessment. |
E.3 Evaluating Material Changes in Internal Control2
SEC registrants are required to disclose any material changes3 (including improvements) in their ICFR in each quarterly and annual report
in accordance with SEC Regulation S-K, Item 308(c). SEC guidance explains that
materiality is determined on the basis of the impact on ICFR and the materiality
standard articulated in TSC Industries Inc. v. Northway Inc.4 (i.e., that “an omitted fact is material if there is a substantial
likelihood that a reasonable shareholder would consider it important in deciding
how to vote”).
As discussed previously, when a company adopts ASC 842, management will probably need to implement new controls or modify existing ones to address new or modified risks of material misstatement. Disclosure requirements will also be triggered by the adoption of a new accounting standard if such changes in internal control are material. In addition, management should consider whether there are appropriate controls for identifying and disclosing material changes in ICFR.
For example, management may consider whether there are controls related to the following:
- Compliance — Processes are in place to identify and evaluate material changes in internal control. Further, protocols exist for developing appropriate disclosures and reporting such information to appropriate levels of management (e.g., those signing the quarterly and annual certifications required under SEC Regulation S-K, Item 601(b)(31)).
- Review — The disclosures are reviewed by appropriate levels of management (including, as warranted, those signing the quarterly and annual certifications).
- Monitoring — The company’s monitoring function (e.g., internal audit, disclosure committee, or audit committee) appropriately considers the state of the entity’s ICFR to identify changes and monitor controls in accordance with company protocols.
In developing the required disclosures, companies should clearly state whether a
material change has occurred and, if so, describe the nature of the change. The
SEC staff has commented when a registrant has not explicitly asserted whether
there has been a change in ICFR in the most recent fiscal quarter that could
have a material effect on its ICFR. The staff has further stressed that
registrants should avoid “boilerplate” disclosure in which they state that there
have been no material changes affecting ICFR in a period, particularly when
there have been identifiable events such as changes in accounting policies. For
examples of appropriate disclosures to provide in such circumstances, see
Section E.6.
E.4 Examples of Risks and Internal Control Considerations Related to the Adoption and Ongoing Accounting
The table5 below lists risks and internal control considerations related to the
adoption of ASC 842 and the ongoing accounting under ASC 842 (the risks and
considerations apply to both lessees and lessors, unless otherwise
specified).
| ||
---|---|---|
Adoption period |
| Internal controls related to:
|
Capturing leases |
| Internal controls related to:
|
Calculating leases |
| Internal controls related to:
|
Accounting for leases |
| Internal controls related to:
|
Presentation and disclosure for leases |
| Internal controls related to:
|
E.5 Applying the COSO Principles to Adoption
The 2013 COSO framework contains 17 principles that explain the concepts
associated with the five components of internal control (i.e., control
environment, risk assessment, control activities, information and communication,
and monitoring activities). The components are related to all aspects of an
organization’s objectives, which typically fall into three categories —
operations, reporting, and compliance. These objectives, as well as the
components, are also related to an entity’s structure. COSO uses the following
cube to depict the relationship between objectives, components, and an entity’s
structure:
In assessing the design of effective internal control with respect to ASC 842, a company may consider its objectives in terms of internal and external reporting and, on the basis of those objectives, may take into account the five components of internal control and the 17 principles within the components. The chart below summarizes the 17 principles and provides examples of how a company would apply them when implementing and adopting ASC 842.
| ||
---|---|---|
Control environment | 1. Demonstrates commitment to integrity and ethical values.
2. Board of directors exercises oversight responsibilities.
3. Establishes structure, authority, and responsibility.
4. Demonstrates commitment to competency. 5. Enforces accountability. | Principle 1
Principle 2
Principle 3
Principle 4
Principle 5
|
Risk assessment | 6. Specifies suitable objectives.
7. Identifies and analyzes risk.
8. Assesses fraud risk.
9. Identifies and analyzes significant change. | Principle 6
Principle 7
Principle 8
Principle 9
|
Control activities | 10. Selects and develops control activities.
11. Selects and develops general controls over technology.
12. Deploys through policies and procedures. | Principle 10
Principle 11
Principle 12
|
Information and communication | 13. Uses relevant, quality information.
14. Communicates internally.
15. Communicates externally. | Principle 13
Principle 14
Principle 15
|
Monitoring activities | 16. Conducts ongoing and/or separate evaluations.
17. Evaluates and communicates deficiencies. | Principle 16
Principle 17
|
E.6 Illustrative Disclosures — Material Change in Internal Control7
Example E-1
Several Quarters Before Adoption
During the quarter ended June 30, 20XX, we implemented new controls as part of our efforts to adopt ASU 2016-02. Those efforts resulted in changes to our accounting processes and procedures. In particular, we implemented new controls related to:
- Monitoring the adoption process.
- Implementing a new IT system to capture, calculate, and account for leases.
- Gathering the information and evaluating the analyses used in the development of disclosures required before ASU 2016-02’s effective date.
We evaluated the design of these new controls during the quarter ended June 30, 20XX. As we continue the implementation process, we expect that there will be additional changes in ICFR. However, there were no other changes in ICFR during the quarter ended June 30, 20XX, that materially affected ICFR or are reasonably likely to materially affect it.
Example E-2
Shortly Before Adoption
During the quarter ended December 31, 20XX, we implemented a plan that called for modifications to ICFR related to the accounting for leases as a result of ASU 2016-02. The modified controls have been designed to address risks associated with accounting for lease assets and liabilities and the related income and expense under ASC 842. We have therefore augmented ICFR as follows:
- Enhanced the risk assessment process to take into account risks associated with ASC 842.
- Modified existing controls that address risks associated with accounting for lease assets and liabilities and the related income and expense, including the revision of our contract review controls.
There were no other changes in ICFR during the quarter ended December 31, 20XX, that materially affected ICFR or are reasonably likely to materially affect it.
Example E-3
Upon Adoption
We implemented ASU 2016-02 as of January 1, 20XX. As a result, we made the following significant modifications to ICFR, including changes to accounting policies and procedures, operational processes, and documentation practices:
- Updated our policies and procedures related to accounting for lease assets and liabilities and related income and expense.
- Modified our contract review controls to consider the new criteria for determining whether a contract is or contains a lease, specifically to clarify the definition of a lease and align with the concept of control.
- Added controls for reevaluating our significant assumptions and judgments on a quarterly basis.
- Added controls to address related required disclosures regarding leases, including our significant assumptions and judgments used in applying ASC 842.
Other than the items described above, there were no changes in ICFR during the quarter ended March 31,
20XX, that materially affected ICFR or are reasonably likely to materially affect it.
Footnotes
1
SEC SAB 74 was codified as SEC SAB Topic 11.M. See
Deloitte’s September 22, 2016, Financial Reporting
Alert for further discussion.
2
This section is specific to SEC registrants.
3
SEC Final Rule No. 33-8238 states that ”management . . .
must evaluate, with the participation of the issuer’s principal
executive and principal financial officers, or persons performing
similar functions, any change in the issuer’s internal control over
financial reporting, that occurred during each of the issuer’s fiscal
quarters, or fiscal year in the case of a foreign private issuer, that
has materially affected, or is reasonably likely to materially affect,
the issuer’s internal control over financial reporting.”
4
426 U.S. 438 (1976). See also Basic Inc. v. Levinson,
485 U.S. 224 (1988).
5
This table does not take into account all possible
lease-related risks and an entity should also consider risks in other
accounting areas (e.g., income taxes, possible debt covenant
violations).
6
Reassessment of lease
contracts is not applicable if an entity (lessee
or lessor) elects the transition relief package
and discloses such election.
7
This section is specific to SEC registrants.
Appendix F — Titles of Standards and Other Literature
Appendix F — Titles of Standards and Other Literature
FASB Literature
ASC Topics
ASC 210, Balance Sheet
ASC 230, Statement of Cash Flows
ASC 250, Accounting Changes and Error Corrections
ASC 270, Interim Reporting
ASC 310, Receivables
ASC 326, Financial Instruments — Credit Losses
ASC 330, Inventory
ASC 350, Intangibles — Goodwill and Other
ASC 360, Property, Plant, and Equipment
ASC 405, Liabilities
ASC 410, Asset Retirement and Environmental
Obligations
ASC 420, Exit or Disposal Cost Obligations
ASC 450, Contingencies
ASC 460, Guarantees
ASC 470, Debt
ASC 606, Revenue From Contracts With Customers
ASC 610, Other Income
ASC 730, Research and Development
ASC 740, Income Taxes
ASC 805, Business Combinations
ASC 810, Consolidation
ASC 815, Derivatives and Hedging
ASC 830, Foreign Currency Matters
ASC 835, Interest
ASC 840, Leases
ASC 842, Leases
ASC 848, Reference Rate Reform
ASC 850, Related Party Disclosures
ASC 853, Service Concession Arrangements
ASC 860, Transfers and Servicing
ASC 905, Agriculture
ASC 930, Extractive Activities — Mining
ASC 932, Extractive Activities — Oil and Gas
ASC 942, Financial Services — Depository and
Lending
ASUs
ASU 2014-09, Revenue From Contracts With Customers (Topic
606)
ASU 2016-02, Leases (Topic 842)
ASU 2016-10, Revenue From Contracts With Customers (Topic
606): Identifying Performance Obligations and Licensing
ASU 2016-13, Financial Instruments — Credit Loses (Topic
326): Measurement of Credit Losses on Financial Instruments
ASU 2017-13, Revenue Recognition (Topic 605), Revenue
From Contracts With Customers (Topic 606), Leases (Topic 840), and
Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff
Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior
SEC Staff Announcements and Observer Comments (SEC Update)
ASU 2018-01, Leases (Topic 842): Land Easement Practical
Expedient for Transition to Topic 842
ASU 2018-10, Codification Improvements to Topic 842,
Leases
ASU 2018-11, Leases (Topic 842): Targeted
Improvements
ASU 2018-19, Codification Improvements to Topic 326,
Financial Instruments — Credit Losses
ASU 2018-20, Leases (Topic 842): Narrow-Scope
Improvements for Lessors
ASU 2019-01, Leases (Topic 842): Codification
Improvements
ASU 2019-10, Financial Instruments — Credit Losses (Topic
326), Derivatives and Hedging (Topic 815), and Leases (Topic 842):
Effective Dates
ASU 2020-05, Revenue From Contracts With Customers (Topic
606) and Leases (Topic 842): Effective Dates for Certain
Entities
ASU 2021-05, Leases (Topic 842): Lessors — Certain Leases
With Variable Lease Payments
ASU 2021-09, Leases (Topic 842): Discount Rate for
Lessees That Are Not Public Business Entities
ASU 2023-01, Leases (Topic 842): Common Control Arrangements
Proposed ASUs
No. 2013-270, Leases (Topic 842) — a revision of the
2010 proposed FASB Accounting Standards Update, Leases (Topic
840)
No. 2018-310, Leases (Topic 842): Codification
Improvements for Lessors
No. 2020-700, Leases (Topic 842): Targeted Improvements
Staff Q&A
Topic 842 and Topic 840, “Accounting for Lease Concessions
Related to the Effects of the COVID-19 Pandemic”
IFRS Literature
IAS 7, Statement of Cash Flows
IAS 17, Leases
IFRS 9, Financial Instruments
IFRS 11, Joint Arrangements
IFRS 15, Revenue From Contracts With Customers
IFRS 16, Leases
SEC Literature
Final Rule Releases
No. 33-8238, Management’s Report on Internal Control Over
Financial Reporting and Certification of Disclosure in Exchange Act
Periodic Reports
No. 33-10890, Management’s Discussion and Analysis, Selected Financial
Data, and Supplementary Financial Information
FRM
Topic 1, “Registrant’s Financial Statements”
Topic 2, “Other Financial Statements Required”
Topic 3, “Pro Forma Financial Information”
Topic 4, “Independent Accountants' Involvement”
Topic 9, “Management's Discussion and Analysis of Financial
Position and Results of Operations (MD&A)”
Topic 10, “Emerging Growth Companies”
Topic 11, “Reporting Issues Related to Adoption of New
Accounting Standards”
Topic 13, “Effects of Subsequent Events on Financial
Statements Required in Filings”
Topic 14, “Tender Offers”
Regulation S-K
Item 302(a), “Supplementary Financial Information; Selected
Quarterly Financial Data”
Item 308(c), “Internal Control Over Financial Reporting;
Changes in Internal Control Over Financial Reporting”
Item 512(a), “Undertakings; Rule 415 Offering”
Item 601(b), “Exhibits; Description of Exhibits”
Regulation S-X
Rule 1-02(w), “Definitions of Terms Used in Regulation S-X:
Significant Subsidiary”
Rule 3-05, “Financial Statements of Businesses Acquired or
to Be Acquired”
Rule 3-09, “Separate Financial Statements of Subsidiaries
Not Consolidated and 50 Percent or Less Owned Persons”
Rule 3-14, “Special Instructions for Real Estate Operations
to Be Acquired”
Rule 4-08(g), “Summarized Financial Information of
Subsidiaries Not Consolidated and 50 Percent or Less Owned Persons”
Rule 5-02, “Commercial and Industrial Companies; Balance
Sheets”
Rule 5-03, “Commercial and Industrial Companies; Income
Statements”
Article 10, “Interim Financial Statements”
Article 11, “Pro Forma Financial Information”
SAB Topics
No. 1.M (SAB 99), “Financial Statements; Assessing
Materiality”
No. 11.M (SAB 74), “Miscellaneous Disclosure; Disclosure of
the Impact That Recently Issued Accounting Standards Will Have on the
Financial Statements of the Registrant When Adopted in a Future Period”
Superseded Literature
EITF Abstracts
Issue No. 01-8, “Determining Whether an Arrangement Contains
a Lease”
Issue No. 08-2, “Lessor Revenue Recognition for Maintenance
Services”
FASB Interpretation
No. 48, Accounting for Uncertainty in Income Taxes —
an interpretation of FASB Statement No. 109
FASB Statements
No. 5, Accounting for Contingencies
No. 13, Accounting for Leases
No. 95, Statement of Cash Flows
FASB Technical Bulletin
No. 88-1, Issues Relating to Accounting for Leases
Appendix G — Abbreviations
Appendix G — Abbreviations
Abbreviation
|
Description
|
---|---|
AICPA
|
American Institute of Certified Public
Accountants
|
ASC
|
FASB Accounting Standards Codification
|
ASU
|
FASB Accounting Standards Update
|
C&DI
|
SEC Compliance and Disclosure
Interpretation
|
CAM
|
common-area maintenance
|
CAQ
|
Center for Audit Quality
|
CECL
|
current expected credit loss
|
CIP
|
construction in process
|
COSO
|
The Committee of Sponsoring Organizations of
the Treadway Commission
|
CPI
|
consumer price index
|
CWIP
|
construction work-in-progress
|
DART
|
Deloitte Accounting Research Tool
|
ED
|
exposure draft
|
EGC
|
emerging growth company
|
EITF
|
Emerging Issues Task Force
|
FASB
|
Financial Accounting Standards Board
|
FDIC
|
Federal Deposit Insurance Corporation
|
FIN
|
FASB Interpretation Number
|
FRM
|
SEC Division of Corporation Finance
Financial Reporting Manual
|
GAAP
|
generally accepted accounting principles
|
GPS
|
global positioning system
|
HAFWP
|
how and for what purpose
|
IAS
|
International Accounting Standard
|
IASB
|
International Accounting Standards Board
|
ICFR
|
internal control over financial
reporting
|
IFRS
|
International Financial Reporting
Standard
|
IT
|
information technology
|
ITC
|
investment tax credit
|
JOA
|
joint operating agreement
|
LIBOR
|
London Interbank Offered Rate
|
LILO
|
lease in, lease out
|
LLC
|
limited liability company
|
MAG
|
minimum annual guarantee
|
MD&A
|
Management’s Discussion & Analysis
|
OCA
|
SEC Office of the Chief Accountant
|
OCC
|
Office of the Comptroller of the
Currency
|
PBE
|
public business entity
|
PCAOB
|
Public Company Accounting Oversight
Board
|
PP&E
|
property, plant, and equipment
|
PPA
|
power purchase agreement
|
PRVG
|
portfolio residual value guarantee
|
PTC
|
production tax credit
|
Q&A
|
question and answer
|
REC
|
renewable energy credit
|
REIT
|
real estate investment trust
|
ROFO
|
right of first offer
|
ROFR
|
right of first refusal
|
ROU
|
right of use
|
RPS
|
renewable portfolio standard
|
SAB
|
Staff Accounting Bulletin
|
SEC
|
U.S. Securities and Exchange Commission
|
SOX
|
Sarbanes-Oxley Act of 2002
|
SPE
|
special-purpose entity
|
TRAC
|
terminal rental adjustment clause
|
VIE
|
variable interest entity
|
VIN
|
vehicle identification number
|
Appendix H — Q&A Conversion and Example Mapping for 2023 Update of Leasing Roadmap
Appendix H — Q&A Conversion and Example Mapping for the 2023 Update
The table below lists the Q&As from
prior editions of this Roadmap that are being incorporated into regular text as part of
the 2023 update.1
Leasing Roadmap Q&A Mapping
2022 Q&A
|
Title
|
2023 Section
|
Title
|
---|---|---|---|
4-1
|
Identifying Lease Components When the
Underlying Asset Is Replaced During the Lease Term
|
Identifying Lease Components When the
Underlying Asset Is Replaced During the Lease Term
(Question 2 of this Q&A changed to Section
4.2.3.1.1, Lessor Continually Provides a
Server That Meets Certain Minimum Performance Standards,
and Question 3 changed to Section 4.2.3.1.2,
Lessee and Lessor in an Arrangement That Contains the
Right or Obligation to Replace the Original Asset)
| |
4-2
|
Estimating the Stand-Alone Selling Price
of the Lease Component by Reference to a Gross Real
Estate Lease at Fair Value
|
Estimating the Stand-Alone Selling Price
of the Lease Component by Reference to a Gross Real
Estate Lease at Fair Value
| |
4-3
|
Allocating Consideration in Arrangements
Involving the Use of an Asset for “Free”
|
Allocating Consideration in Arrangements
Involving the Use of an Asset for “Free” (content from
Question 2 of former Q&A moved into Example
4-22)
| |
6-1
|
Including Noncash Consideration in Lease
Payments
|
Including Noncash Consideration in Lease
Payments
| |
6-2
|
Nonrefundable Deposits
|
Security Deposits (subdivided into
Section 6.1.2.1, Nonrefundable
Deposits)
| |
6-3
|
Refundable Deposits
|
Refundable Deposits
| |
6-4
|
Treatment of Payments to a Lessee When a
Lease Is Terminated and the Lessee Enters Into a New
Lease for Similar Assets
|
Treatment of Payments to a Lessee When a
Lease Is Terminated and the Lessee Enters Into a New
Lease for Similar Assets
| |
6-5
|
Payments From a Lessor to a Lessee
During the Lease Agreement
|
Payments From a Lessor to a Lessee
During the Lease Agreement
| |
6-6
|
Variable Payments Based on an Index or
Rate
|
Variable Lease Payments That Depend on
an Index or a Rate (Q&A content incorporated into
Section 6.3, and certain content from that section
placed beneath a new subheading 6.3.1, Initial
Measurement of a Lease When There Are Variable Payments
Based on an Index or Rate)
| |
6-7
|
Implications of Index- or Rate-Based
Payment Adjustments
|
Subsequent-Measurement Implications of
Index- or Rate-Based Payment Adjustments
| |
6-8
|
Rents Based on Market Rates
|
Rents Based on Market Rates
| |
6-9
|
Sales Proceeds in Excess of Residual
Value Guarantee
|
Sales Proceeds in Excess of Residual
Value Guarantee (Connecting the Dots previously located
in the Q&A moved to the end of Section
6.7, Amounts That It Is Probable That the
Lessee Will Owe Under a Residual Value Guarantee; former
Section 6.7.1 now Section 6.7.2,
Residual Value Guarantee Obtained From Unrelated Third
Party)
| |
6-10
|
Accounting for a Lease Liability and a
Corresponding ROU Asset in a Contract Manufacturing
Arrangement
|
Variable Lease Payments That Do Not
Depend on an Index or Rate (content from Q&A
incorporated into Example 6-17)
| |
6-11
|
Accounting for a Lease Liability and a
Corresponding ROU Asset in an Arrangement Involving a
“Minimum Annual Guarantee” Payment Structure in Which a
New Lease Payment Floor Is Established Each Year
|
Accounting for a Lease Liability and
Corresponding ROU Asset in an Arrangement Involving a
“Minimum Annual Guarantee” Payment Structure in Which a
New Lease Payment Floor Is Established Each Year
(Questions 1 and 2 of Q&A, respectively, are now
Sections 6.10.1.1, Measuring and
Accounting for the Lease Liability, and 6.10.1.2, Subsequent Measurement and
Recognition of the Lease Cost)
| |
6-12
|
Payment Made by a Lessor to a Lessee to
Induce Early Termination of a Lease
|
Payment Made by a Lessor to a Lessee to
Induce Early Termination of a Lease
| |
6-13
|
“Key Money” Payment Made to an Existing
Lessee to Assume a Lease
|
“Key Money” Payment Made to an Existing
Lessee to Assume a Lease (Connecting the Dots and
example from former Q&A incorporated into Section
6.11, Initial Direct Costs)
| |
8-1
|
Impact of Portfolio Residual Value
Guarantee on Lessee’s Lease Classification
|
Impact of Portfolio Residual Value
Guarantees on Lessee’s Lease Classification (former
Section 8.3.3.6.1 now Section 8.3.3.6.3,
Impracticable to Determine Fair Value)
| |
8-2
|
First-Dollar-Loss Residual Value
Guarantee
|
First-Dollar-Loss Residual Value
Guarantee (former Section 8.3.3.6.2 now Section
8.3.3.6.5, Investment Tax Credits;
content from Changing Lanes moved to Section 8.3.3.6,
Substantially All of the Fair Value of the Underlying
Asset
| |
8-3
|
Lessee’s Determination of the Fair Value
of a Portion of a Larger Asset
|
Lessee’s Determination of the Fair Value
of a Portion of a Larger Asset
| |
8-4
|
Accounting for Lease Incentives When
Lease Payments Are Highly or Totally Variable
|
Accounting for Lease Incentives When
Lease Payments Are Highly or Totally Variable (former
Section 8.4.2.3 now Section 8.4.2.5,
Leases Entered Into for R&D Activities)
| |
8-5
|
Lessee’s Accounting for Costs Related to
Shipping, Installation, and Other Similar Items When the
Lessor Does Not Provide Such Activities
|
Lessee’s Accounting for Costs Related to
Shipping, Installation, and Other Similar Items When the
Lessor Does Not Provide Such Activities
| |
8-6
|
Subsequent Measurement of an Operating
Lease When the ROU Asset Would Be Reduced Below Zero
Because of Accrued Rent
|
Subsequent Measurement of an Operating
Lease When the ROU Asset Would Be Reduced Below Zero
Because of Accrued Rent
| |
8-7
|
Lessee Timing of Variable Payments
|
Lessee’s Timing of Variable Payments
| |
8-8
|
Subsequent Measurement for Leases That
Include a Term Consisting of Nonconsecutive Periods of
Use
|
Subsequent Measurement for Leases That
Include a Term Consisting of Nonconsecutive Periods of
Use
| |
8-9
|
Impact of a Plan to Abandon the
Underlying Leased Asset Before the End of the Lease
Term
|
Impact of a Plan to Abandon the
Underlying Leased Asset Before the End of the Lease
Term
| |
8-10
|
Asset Group/Lease Component
Considerations Related to Subleasing a Portion of a
Larger ROU Asset
|
Unit of Account for Impairment Testing —
Asset Group/Lease Component Considerations Related to
Subleasing a Portion of a Larger ROU Asset
| |
8-11
|
ROU Assets That Are Held for Sale —
Amortization Considerations
|
Amortization Considerations
| |
8-12
|
Circumstances in Which a Lessee Is
Required to Update Stand-Alone Prices
|
Circumstances in Which a Lessee Is
Required to Update Stand-Alone Prices (the rest of the
subsections in Section 8.5,
Remeasurement of the Lease Liability, renumbered
accordingly)
| |
8-13
|
Accounting for Lease Incentives Not Paid
or Payable at Commencement
|
Accounting for Lease Incentives Not Paid
or Payable at Commencement
| |
8-14
|
Implications of Index- or Rate-Based
Payment Adjustments
|
Implications of Index- or Rate-Based
Payment Adjustments
| |
8-15
|
Impact of Cotenancy Clauses on
Determining Lease Payments
|
Impact of Cotenancy Clauses on
Determining Lease Payments
| |
8-16
|
Penalty for a Partial Termination
|
Penalty for a Partial Termination
| |
8-17
|
Reduction in Lease Term Versus Lease
Termination
|
Reduction in Lease Term Versus Lease
Termination
| |
9-1
|
Lessor Consideration of Initial Direct
Costs Related to the Rate Implicit in the Lease
|
Lessor’s Consideration of Initial Direct
Costs Related to the Rate Implicit in the Lease (former
Section 9.2.1.4.1 now Section 9.2.1.4.3,
Impracticable to Determine Fair Value)
| |
9-2
|
Unit of Account for Assessing Lease
Classification
|
Unit of Account for Assessing Lease
Classification (former Section 9.2.1.4.2 now Section
9.2.1.4.4, Residual Value Guarantees
Provided for a Portfolio of Assets)
| |
9-3
|
Significant Economic Losses to Direct an
Underlying Asset for Another Use
|
Significant Economic Losses to Direct an
Underlying Asset for Another Use (Connecting the Dots
from the former Q&A moved to Section
9.2.1.5, Underlying Asset Is Specialized
and Has No Alternative Use to the Lessee at the End of
the Lease Term)
| |
9-4
|
Impact of a Lessor’s Subsequent Purchase
of Residual Value Insurance on Lease Classification
|
Impact of a Lessor’s Subsequent Purchase
of Residual Value Insurance on Lease Classification
| |
9-5
|
Lessor’s Accounting for Lease
“Fulfillment” Costs
|
Lessor’s Accounting for Lease
“Fulfillment” Costs
| |
9-6
|
Evaluation of “Terms and Conditions” and
“Facts and Circumstances”
|
Evaluation of “Terms and Conditions” and
“Facts and Circumstances”
| |
9-7
|
Circumstances in Which a Lessor Is
Required to Update Stand-Alone Selling Prices
|
Circumstances in Which a Lessor Is
Required to Update Stand-Alone Selling Prices
| |
9-8
|
Commencement Loss Resulting From a
Significant Variable Payment in a Sales-Type or Direct
Financing Lease (Before Adoption of ASU 2021-05)
|
Subsequent Measurement (incorporated
into this section as Connecting the Dots)
| |
9-9
|
Impact of Exercising Renewal Options on
Leveraged Leases
|
Impact of Exercising Renewal Options on
Leveraged Leases (former Section 9.5.3 now Section
9.5.4, Accounting for Existing Leveraged
Leases Upon Adoption of ASC 842)
| |
9-10
|
Tax Considerations Related to Leveraged
Leases Acquired in a Business Combination
|
Tax Considerations Related to Leveraged
Leases Acquired in a Business Combination
| |
9-11
|
Accounting for the Sale of a Leveraged
Lease
|
Accounting for the Sale of a Leveraged
Lease
| |
9-12
|
Impact of Altering Significant
Assumptions
|
Impact of Altering Significant
Assumptions (additional subheading created at beginning
— Section 9.5.7.1, Revised Assumptions
Existing at the Inception of the Lease)
| |
9-13
|
Impact of Altering Significant Tax
Assumptions
|
Impact of Altering Significant Tax
Assumptions
| |
9-14
|
Accounting for a Change or Projected
Change in the Timing of Cash Flows Related to Income
Taxes Generated by a Leveraged Lease Transaction
|
Accounting for a Change or Projected
Change in the Timing of Cash Flows Related to Income
Taxes Generated by a Leveraged Lease Transaction
| |
15-1
|
Omission of Disclosures
|
Background and Objective
| |
15-2
|
Excluding Leases With a Term of One
Month or Less From Short-Term Lease Expense
Disclosure
|
Short-Term Lease Cost
| |
15-3
|
Noncash Disclosures Provided by a Lessee
Regarding Changes in ROU Assets
|
Supplemental Noncash Information
| |
15-4
|
Presentation of Lease Revenue and Tenant
Reimbursements in the Financial Statements
|
Statement of Comprehensive Income
(incorporated into this section as Connecting the Dots
with same title as Q&A)
| |
16-1A
|
Early Adoption of ASC 842 in an Interim
Period Other Than the First Interim Period in a Fiscal
Year
|
[Q&A deleted]
|
The table below lists the
changes in the numbering of examples in the Roadmap that resulted from the
Q&A conversion (since internal examples from the Q&As were converted to
examples in regular text).
Leasing Roadmap 2023 Example Mapping
Example No.
|
Previous Location or Numbering
|
---|---|
Part of Q&A 4-1
| |
Example 4-5
| |
Example 4-6
| |
Example 4-7
| |
Example 4-8
| |
Example 4-9
| |
Example 4-10
| |
Example 4-11
| |
Example 4-12
| |
Example 4-13
| |
Example 4-14
| |
Example 4-15
| |
Example 4-16
| |
Example 4-17
| |
Example 4-18
| |
Example 4-19
| |
Example 4-20
| |
Part of Q&A 4-3
| |
Example 4-21
| |
Example 4-22
| |
Part of Q&A 6-1
| |
Part of Q&A 6-1
| |
Example 6-3
| |
Example 6-4
| |
Example 6-5
| |
Example 6-6
| |
Part of Q&A 6-4
| |
Part of Q&A 6-5
| |
Part of Q&A 6-5
| |
Part of Q&A 6-6
| |
Example 6-7
| |
Example 6-8
| |
Example 6-9
| |
Example 6-10
| |
Part of Q&A 6-10
| |
Example 6-11
| |
Part of Q&A 6-11
| |
Part of Q&A 8-1
| |
Part of Q&A 8-2
| |
Example 8-6
| |
Example 8-7
| |
Example 8-8
| |
Part of Q&A 8-4
| |
Example 8-9
| |
Example 8-10
| |
Part of Q&A 8-6
| |
Part of Q&A 8-7
| |
Part of Q&A 8-8
| |
Q&A 8-9
| |
Part of Q&A 8-10
| |
Example 8-11
| |
Example 8-12
| |
Example 8-13
| |
Part of Q&A 8-16
| |
Example 8-14
| |
Part of Q&A 9-2
| |
Example 9-5
| |
Part of Q&A 9-3
| |
Example 9-6
| |
Part of Q&A 9-5
| |
Example 9-7
| |
Example 9-8
| |
Part of Q&A 9-8
| |
Part of Q&A 9-9
| |
Example 9-9
| |
Example 9-10
| |
Example 9-11
| |
Example 9-12
| |
Part of Q&A 9-12
| |
Part of Q&A 9-14
| |
Part of Q&A 15-4
|
Footnotes
1
With the exception of the Q&As in Chapter 16 pertaining to
ASU 2016-02’s effective date and transition, all remaining Q&As have been
converted into regular text as part of this year’s update. The Chapter 16
Q&As will be eliminated once the ASU becomes effective for all entities.
Appendix I — Roadmap Updates for 2023
Appendix I — Roadmap Updates for 2023
The tables below summarize the substantive changes made since the
2022 edition of this Roadmap as a result of FASB standard-setting activities,
discussions regarding implementation matters with the FASB and SEC staff, and other
practice developments.
New Content
Section
|
Title
|
Description
|
---|---|---|
ASC 810 — Consolidation
|
Discusses the interaction between ASC 842 and ASC
810.
| |
Terminal Rental Adjustment Clauses
|
Addresses considerations related to a
TRAC in a lease, specifically when it is reasonably
possible that the lessee would, as a result of the TRAC,
make a significant payment to the lessor at the end of
the lease term.
| |
Sale of Future Operating Lease Payments
|
Discusses accounting in situations in which a lessor
obtains proceeds from the sale of future operating lease
payments that do not meet the definition of a
receivable.
| |
Accounting for Short Payments by Lessee
|
Addresses accounting considerations for lessors in
situations in which a lessee makes rent payments that
are less than the amount contractually owed under the
lease contract.
| |
Leaseback of Assets by an Acquiree After a Business
Combination
|
Notes that when a seller leases back an asset that was
acquired by the acquirer in a business combination
accounted for under ASC 805, the transaction is outside
the scope of the sale-and-leaseback guidance in ASC
842-40.
| |
ASU 2023-01 on Common-Control Arrangements
|
Outlines the provisions of the FASB’s
ASU
2023-01 on related-party leases in
arrangements between entities under common control.
|
Amended Content
Section
|
Title
|
Description
|
---|---|---|
Derivatives Embedded in a Lease
|
Example 2-5 updated to reflect the
change from the LIBOR interest rate to the SOFR interest
rate.
| |
Economic Benefits From the Use of the
Asset Versus Ownership of the Asset (e.g., Tax
Attributes)
|
Connecting
the Dots added to address transferable
tax credit considerations in the evaluation of
transferable tax credits as economic benefits from using
the asset.
| |
Lessees
|
Clarifies that the lessee should consider whether its
ability to use or derive benefits from the nonlease
component is interrelated with that for the lease
component, and vice versa, when electing the practical
expedient to combine lease and nonlease components.
| |
Commencement Date of a Lease
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Discussion added of instances in which a lessee controls
an underlying asset before the commencement date of the
lease. Further, Changing Lanes
added to clarify the differences between ASC 840 and ASC
842 with respect to the date an entity would use
(inception date versus commencement date) when
classifying the lease and when to determine the inputs
used to initially measure the lease.
| |
Periods Covered by Options (Reasonably Certain)
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Clarifies that lessees and lessors may reach different
conclusions about whether it is reasonably certain that
a lessee will exercise a renewal or purchase option or
not exercise a termination option. Further, discussion
added regarding considering the length of time between
the commencement date of the lease and the date of
exercise of the option in the evaluation of whether a
lessee will be reasonably certain to exercise an option
or renew or terminate a lease.
| |
Asset-Based Factors
|
Includes “specialized nature of the asset” and “costs
associated with lost production” as asset-based factors
that depend on specific characteristics of the
underlying asset.
| |
Related-Party Leases
|
Reflects the issuance of the FASB’s new standard ASU
2023-01, which amends certain provisions of ASC 842 that
apply to arrangements between related parties under
common control.
| |
Leases Between Parties Under Common Control
|
Reflects the issuance of ASU 2023-01 and revises the
Changing Lanes to discuss the
legally enforceable terms versus the substance of
common-control arrangements.
| |
Unit of Account for Impairment Testing — Asset
Group/Lease Component Considerations Related to
Subleasing a Portion of a Larger ROU Asset
|
Clarifies Connecting the Dots to discuss the
accounting for ASC 420 liabilities when a lessee elects
the practical expedient offered in ASC 842-10-15-37, in
addition to the accounting for ASC 420 liabilities when
a lessee does not elect the practical expedient.
| |
Amortization of Leasehold Improvements
|
Reflects the issuance of ASU 2023-01.
| |
Lease Modification
|
Revises Connecting the Dots to
discuss the accounting for rent concessions that do not
qualify for the COVID-19 relief.
| |
Lease Termination
|
Clarifies that if a lease termination occurs on a future
date, the change represents a lease modification rather
than a termination for accounting purposes.
| |
Recognition, Initial Measurement, and
Subsequent Measurement
|
Adds discussion to Connecting the Dots
regarding a lessor’s accounting considerations in
situations in which the lessee’s ability to derive its
intended economic benefits from the use of a leased
asset may be significantly curtailed.
| |
Collectibility
|
Clarifies that a lessor is required to continually
evaluate whether it is probable that future operating
lease payments will be collected.
| |
Repurchase Options
|
Explains that an entity must use judgment when assessing
whether there are alternative assets that are
substantially the same as the transferred asset and
readily available in the marketplace under ASC
842-40-25-3(b) for a sale-and-leaseback transaction. In
addition, guidance is included on factors for an entity
to consider when making this assessment.
| |
Transfer of the Asset Is a Sale
|
Indicates that if a sale-and-leaseback
transaction qualifies as a sale but the transaction
price is not at market, profit recognition would include
an “adjustment” to arrive at market-based terms. Such
adjustments are further discussed in Section
10.4.1.1.
| |
Sale Is Not at Fair Value
|
Notes that any adjustment of lease payments that results
from off-market terms must be considered in the
classification assessment of the lease component.
| |
Lessee Controls the Underlying Land
|
Incorporates discussion of how renewal options are
considered in the determination of whether a lessee
controls the underlying land during construction in the
context of ASC 842-40.
| |
Related-Party Leases
|
Reflects the issuance of ASU 2023-01.
| |
Differences Between U.S. GAAP and IFRS Accounting
Standards
|
Reflects the issuance of ASU 2023-01.
| |
Differences Between ASC 840 and ASC 842
|
Reflects the issuance of ASU 2023-01.
| |
Entity Elections and Transition Reliefs
|
Reflects the new practical expedient available to private
companies, as well as not-for-profit entities that are
not conduit bond obligors, after the adoption of ASU
2023-01.
|