FASB Votes to Finalize ASU on Practical Expedient for Lessor’s Separation of Lease and Nonlease Components
At its meeting on March 28, 2018, the FASB discussed comments received on its proposed Accounting Standards Update (ASU)1 related to a practical expedient for lessors to elect not to separate lease and nonlease components when certain conditions are met. The amendments in the proposed ASU are consistent with the tentative decisions made by the Board at its November 29, 2017, meeting.2 At this week’s meeting, the Board voted to move forward with drafting a final ASU related to the proposed practical expedient for lessors, subject to certain adjustments explained in further detail below.
In addition, the FASB discussed other implementation requests received from stakeholders related to the presentation of sales taxes and property taxes and insurance included in lease contracts under the new leasing standard.3
Connecting the Dots:
The proposed ASU, issued on January 5, 2018, includes an amendment to provide an additional transition method that entities could elect to adopt the new leasing standard. The FASB discussed the amendment at its March 7, 2018, meeting4 and voted to move forward with drafting a final ASU. The Board did not provide an update on that topic during its March 28, 2018, meeting.
Lessor’s Separation of Lease and Nonlease Components
ASU 2016-02, as initially issued, requires lessors to separate lease and nonlease components in all circumstances. Once separate components are identified, lessors are required to use the relative stand-alone selling price allocation methodology in ASC 6065 to allocate the consideration in the contract to the separated components. ASC 842 (including the presentation and disclosure guidance) applies to the lease component, while other guidance, typically ASC 606 (including the presentation and disclosure guidance), applies 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 proposed to amend ASC 842 to include a practical expedient for lessors to not separate lease and nonlease components, provided that both of the following conditions are met:
- Criterion A — “The timing and pattern of revenue recognition for the lease components and nonlease component(s) . . . are the same.”
- Criterion B — “The combined single lease component is classified as an operating lease.”
Further, the amendment in the proposed ASU required that a lessor disclose (1) that it has elected the practical expedient and (2) the nature of the items that are being combined.
Feedback Received From Stakeholders on the Main Provisions of the Proposed Lessor Practical Expedient
Although respondents were supportive of the proposed practical expedient, many expressed significant concerns that Criterion A and Criterion B were unnecessarily restrictive and would result in many arrangements that seemingly should be permitted to use the practical expedient not to qualify. Specifically, respondents commented that:
- “[B]y requiring the ‘timing and pattern of revenue recognition’. . . contracts with variable consideration may not be eligible for the practical expedient” because of the differences in guidance for variable payments under ASC 606 and ASC 842. Some respondents suggested that the FASB amend the criterion to focus on the timing and pattern of transfer, rather than revenue recognition. (Criterion A)
- The requirements that the combined single component be classified as an operating lease under ASC 842 would most likely result in contracts with large nonlease components and small lease components (i.e., big service, little lease) not qualifying for the practical expedient. Respondents highlighted that “including the payments for the nonlease component in the present value lease classification test greatly increases the likelihood that the combined component will be classified as a sales-type lease,” rather than an operating lease. (Criterion B)
In addition to the comments received on the criteria for applying the practical expedients, respondents “disagreed with the requirement that all combined components be accounted for within [ASC] 842, regardless of the magnitude of the nonlease component(s)” when determining whether the combined component should be accounted for under ASC 606 or ASC 842. Specifically, respondents requested that the FASB permit lessors to account for the combined component under ASC 606 when the nonlease component is the predominant component of the contract. Also, some respondents argued that the second criterion was unnecessary since it restricted sales-type and direct financing leases from being eligible for the practical expedient.
Decisions Made at the March 28, 2018, Board Meeting on the Main Provisions of the Proposed Lessor Practical Expedient
At this week’s Board meeting, the FASB reaffirmed its prior decision to provide lessors with a practical expedient to elect not to separate lease and nonlease components in a contract if it meets certain conditions.
On the basis of stakeholder feedback, the FASB voted to amend the two criteria for applying the practical expedient, as follows:
- Criterion A — The Board agreed to amend the language in Criterion A from “the timing and pattern of revenue recognition” to “the timing and pattern of transfer.”
- Criterion B — The Board agreed to change Criterion B to require that the lease component, if accounted for separately, would be classified as an operating lease under ASC 842. That is, a lessor should consider the classification of only the lease component when determining whether this criterion is met, rather than the classification of the combined lease and nonlease components. The Board suggested that this could be performed on a qualitative basis in many circumstances.
In addition, the FASB agreed to remove the requirement that a lessor always account for the combined component as a lease under ASC 842. The Board concurred that a lessor should consider the magnitude of the nonlease component(s) to determine whether the combined component should be accounted for under ASC 842 or ASC 606. Specifically, the FASB agreed that the lessor should account for the combined component under ASC 606 if the nonlease component(s) is the predominant component in the combined component.
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. The FASB acknowledged that “predominant” is used elsewhere in U.S. GAAP, including in ASC 8426 and ASC 606.7 In addition, the Board discussed a fact pattern whereby the components were evenly split (e.g., a 50/50 split of value) and suggested that in this scenario, the default position would be to account for the combined component under ASC 842. Alternatively, a Board member highlighted that in this case an entity could elect not to take the practical expedient.
Connecting the Dots:
One Board member observed that the key difference between accounting for the combined component under ASC 842 and ASC 606 relates to the treatment of variable payments. That is, ASC 842 and ASC 606 have different requirements related to the accounting for variable payments received from a lessee/customer. ASC 606 requires that an entity estimate any variable consideration to which it is entitled from the customer and include that amount in its initial estimate of the transaction price, subject to the constraint, whereas ASC 842 excludes from a lessor’s lease payments any variable lease payments that do not depend on an index or rate (i.e., those that depend on usage or performance). The Board noted that the other key difference between ASC 842 and ASC 606 is the required disclosure package for the combined component.
The flowchart below summarizes the FASB’s decisions related to when a lessor may apply the practical expedient to not separate lease and nonlease components in a contract.
Other Decisions Made Related to the Proposed Lessor Practical Expedient
In addition to making the decisions discussed above, the FASB tentatively agreed with the following decisions related to the application of the lessor separation practical expedient:
- The presence of a nonlease component that is ineligible for the practical expedient does not preclude a lessor from electing the practical expedient for the lease component and the nonlease component(s) that meet the criteria. Rather, the lessor would separately account for the nonlease component(s) that do not qualify for the practical expedient from the combined lease and nonlease components that do qualify for the practical expedient. This tentative decision will be formalized through an amendment to ASC 842.
- ASC 842 should not be amended to clarify the interaction of the practical expedient with the guidance on consideration in the contract in ASC 842-10-15-39 and the recognition of variable payments in ASC 842-10-15-40. Rather than amending the guidance in ASC 842, the Board supported including language in the Basis for Conclusions of the new leasing standard regarding this interaction. Specifically, the Board’s intent is that when the combined component is accounted for in accordance with ASC 842 as a lease (or in ASC 606 as a service), all variable payments should follow that scoping. That is, when the combined component is accounted for as a lease, there are no longer any nonlease variable payments — only variable payments related to the combined lease component.
- Upon transition to ASC 842, a lessor electing the practical expedient would be required to apply the practical expedient to all existing transactions within a class of underlying assets. 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.
- Early adopters of the new leasing standard would be permitted to elect the practical expedient as of either (1) the lessor’s first reporting period (quarterly or annual) following the issuance of a final ASU related to this topic or (2) the mandatory effective date of ASC 842 (i.e., January 1, 2019, for calendar-year-end public companies).
The FASB tentatively agreed that, other than the tentative decisions discussed at this week’s Board meeting, no other changes to the lessor separation practical expedient are required.
Effective Date and Transition
The FASB reaffirmed its proposals that the effective date and transition related to the practical expedient be consistent with the effective date and transition of the new leasing guidance in ASU 2016-02.
Other Implementation Requests
In addition to discussing the proposed practical expedient at this week’s meeting, the FASB addressed certain other implementation requests received from stakeholders related to ASU 2016-02, specifically the accounting for:
- Sales taxes collected from the lessee.
- Property taxes and insurance that are either (1) paid directly by the lessee or (2) paid by the lessor and subsequently reimbursed by the lessee.
As summarized below, the key issue related to both topics is whether a lessor should be permitted to analogize to certain guidance in ASC 606.
ASC 606, as amended by ASU 2016-12,8 provides entities with an accounting policy election to present 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).
The new leasing standard does not provide lessors with a similar practical expedient for sales taxes collected from lessees. Feedback from stakeholders cited operational challenges with applying the new leasing guidance without a similar practical 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. As such, these stakeholders requested that the FASB provide a similar practical expedient for lessors to present sales taxes collected from lessees on a net basis.
The Board tentatively decided to allow lessors to analogize to the guidance in ASC 606 to present sales taxes collected from lessees on a net basis.
Property Taxes and Insurance
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, following the issuance of the new 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 2016-08,9 it specifically addressed this question in paragraph BC38(c) of the Background Information and Basis for Conclusions of ASU 2016-08:
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 accordance with the guidance in the Basis for Conclusions of ASU 2016-08, some lessor stakeholders requested that the FASB provide similar practical expedients for lessors to not recognize lease revenue (and the corresponding expense) for certain property taxes and insurance costs that are considered lessor costs under ASC 842. Specifically, these stakeholders requested a similar practical expedient be provided to lessors in the following two situations:
- Situation 1 — Property taxes and insurance that are paid directly by the lessee (but for which the lessor is still the primary obligor).
- Situation 2 — Property taxes and insurance that are paid by the lessor but subsequently reimbursed by the lessee.
The Board tentatively decided to permit lessors to apply the same principles in paragraph BC38(c) of ASU 2016-08 about excluding amounts from the transaction price when the uncertainty in the transaction price is not expected to ultimately be resolved. However, the Board observed that the application may not apply to all situations. The Board emphasized that this concept would only apply in situations in which the lessor does not know the amount of the property taxes and insurance paid to the taxing authority (i.e., the uncertainty is not expected to ultimately be resolved). Specifically, in some instances (e.g., Situation 1), the lessor may not reasonably know the amounts the lessee pays related to property taxes and insurance, and therefore could apply the methodology outlined in paragraph BC38(c) of ASU 2016-08 above. However, in other instances (e.g., Situation 2), the application would not be appropriate because the lessor would know the amounts paid by the lessee.
Connecting the Dots:
We observe that the lessor stakeholders that requested a similar practical expedient requested that the FASB allow the practical expedient to be applied when the property taxes and insurance are either paid directly by the lessee or paid by the lessor and subsequently reimbursed by the lessee. However, on the basis of the FASB’s tentative decision explained above, a lessor will need to evaluate whether it can reasonably determine the amount of the property taxes and insurance to determine whether it may apply the concepts in paragraph BC38(c) of ASU 2016-08 by analogy.
Next Steps Related to the Other Amendments
The FASB discussed potential paths for communicating its tentative decisions related to the other implementation requests (i.e., sales taxes and property taxes and insurance). Certain Board members questioned whether formal standard setting was necessary, or if communicating these decisions on the FASB’s Web site would be sufficient for stakeholders to analogize to ASC 606. However, one Board member noted that this approach could result in confusion for stakeholders about what provisions within ASC 606 may be analogized to for lessors. As a result, the Board agreed to add a project to its technical agenda to address these matters and to immediately expose its tentative decisions in a proposed ASU. The FASB did not decide on a comment letter period for the proposed ASU. Rather, the Board requested that the staff draft an external review draft, solicit feedback, and present its findings to the Board at a later date. The FASB also directed its staff to consider any other implementation requests when drafting the proposed ASU and decided to reconvene at a later date to discuss the comment letter period.
FASB Proposed Accounting Standards Update, Leases (Topic 842): Targeted Improvements.
See Deloitte’s December 5, 2017, Heads Up for a detailed discussion of the tentative decisions made by the FASB at its November 29, 2017, meeting.
For purposes of this publication, the new leasing standard refers to FASB Accounting Standards Update No. 2016-02, Leases (Topic 842).
See Deloitte’s March 8, 2018, journal entry for a summary of the FASB’s March 7, 2018, meeting.
For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”
As it relates to the lease classification of a single lease component that contains the right to use more than one underlying asset, ASC 842-10-25-5 states that “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)” (emphasis added).
ASC 606-10-55-65A uses the term “predominant” as a threshold for determining whether the sales-based and usage-based royalty exception for licenses of intellectual property may be applied.
FASB Accounting Standards Update No. 2016-12, Revenue From Contracts With Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients.
FASB Accounting Standards Update No. 2016-08, Revenue From Contracts With Customers (Topic 606): Principal Versus Agent Considerations (Reporting Revenue Gross Versus Net).