ACCOUNTING FOR LEASES UNDER ASC 842 1
A PRACTICE AID FROM BDO’S PROFESSIONAL PRACTICE GROUP
Accounting for Leases Under ASC 842
UPDATED DECEMBER 2021
ACCOUNTING FOR LEASES UNDER ASC 842 2
Table of Contents
INTRODUCTION ............................................................................................................................. 5
ASC 842 in a Nutshell .................................................................................................................... 6
Lease Classification ...................................................................................................................... 7
Lessee Accounting ........................................................................................................................ 8
Lessor Accounting ........................................................................................................................ 9
Adoption Dates .......................................................................................................................... 10
About the Practice Aid ................................................................................................................. 10
CHAPTER 1 - SCOPE OF ASC 842 ....................................................................................................... 12
Scope and Scope Exceptions ........................................................................................................... 12
Specific Considerations for Land Easements ........................................................................................ 14
Interaction with Other Standards ..................................................................................................... 17
CHAPTER 2 - IDENTIFYING A LEASE .................................................................................................... 18
Overview .................................................................................................................................. 18
Identified Asset .......................................................................................................................... 20
Right to Control Use of Identified Asset ............................................................................................. 27
Other Illustrations ....................................................................................................................... 42
CHAPTER 3 - IDENTIFYING AND SEPARATING COMPONENTS ...................................................................... 48
Overview .................................................................................................................................. 48
Identifying Lease and Nonlease Components ....................................................................................... 52
Separating Components - Lessees .................................................................................................... 60
Separating Components - Lessors ..................................................................................................... 69
Portfolio Approach ...................................................................................................................... 80
Contract Combination .................................................................................................................. 80
CHAPTER 4 - LEASE CLASSIFICATION AND KEY TERMS ............................................................................. 81
Overview .................................................................................................................................. 81
Commencement Date ................................................................................................................... 84
Lease Term ............................................................................................................................... 89
Lease Payments ......................................................................................................................... 95
Initial Direct Costs .................................................................................................................... 101
Discount Rate .......................................................................................................................... 102
Economic Life .......................................................................................................................... 106
Fair Value ............................................................................................................................... 106
Lease Classification ................................................................................................................... 107
ACCOUNTING FOR LEASES UNDER ASC 842 3
CHAPTER 5 - ACCOUNTING FOR LEASES – LESSEES ............................................................................... 111
Overview ................................................................................................................................ 111
Lease Classification by Lessees ..................................................................................................... 112
Summary Accounting Requirements Based on Lease Classification ........................................................... 113
Short-Term Leases .................................................................................................................... 114
Recognition and Initial Measurement .............................................................................................. 119
Subsequent Measurement ............................................................................................................ 123
Remeasurements ...................................................................................................................... 130
Variable Lease Payments that Depend on an Index or a Rate .................................................................. 137
Modifications ........................................................................................................................... 139
Impairment ............................................................................................................................. 152
Derecognition .......................................................................................................................... 158
CHAPTER 6 - ACCOUNTING FOR LEASES – LESSORS ............................................................................... 159
Overview ................................................................................................................................ 159
Lease Classification by Lessors ...................................................................................................... 160
Summary Accounting Requirements Based on Lease Classification ........................................................... 161
Sales-Type Leases – A Deeper Dive ................................................................................................. 163
Direct Financing Leases – A Deeper Dive .......................................................................................... 176
Operating leases ....................................................................................................................... 183
Modifications ........................................................................................................................... 185
Impairment ............................................................................................................................. 191
Other Transactions .................................................................................................................... 195
CHAPTER 7 - OTHER TOPICS .......................................................................................................... 196
Overview ................................................................................................................................ 196
Sale and Leaseback Transactions ................................................................................................... 197
Business Combinations (or Acquisitions by Not-For-Profit Entities) ........................................................... 227
Subleases ............................................................................................................................... 233
Accounting for Income Taxes ........................................................................................................ 238
CHAPTER 8 - PRESENTATION AND DISCLOSURES .................................................................................. 242
Overview ................................................................................................................................ 242
Presentation ........................................................................................................................... 243
Disclosure Requirements ............................................................................................................. 248
CHAPTER 9 - ADOPTING ASC 842 .................................................................................................... 256
Overview ................................................................................................................................ 256
Effective Dates ........................................................................................................................ 258
Transition Methods .................................................................................................................... 260
Transition Disclosures ................................................................................................................ 263
Transition Practical Expedients ..................................................................................................... 264
Transition – Lessees ................................................................................................................... 271
Transition - Lessors ................................................................................................................... 282
Other Transition Requirements ..................................................................................................... 286
Application of the Portfolio Approach in Transition ............................................................................. 289
CONTACTS ................................................................................................................................ 290
ACCOUNTING FOR LEASES UNDER ASC 842 4
THIS PRACTICE AID
The Practice Aid includes detailed guidance and flowcharts on analyzing and accounting for contracts under
Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 842, Leases. The graphics
and illustrations in this Practice Aid are provided to assist readers in understanding various aspects of the lease
accounting guidance. Accounting for contracts may vary based on the specific facts and circumstances of each
contract and therefore may differ from the illustrations provided in the Practice Aid.
The Practice Aid focuses on the accounting for lease contracts under ASC 842 only. Additional information on the
accounting for leases under International Financial Reporting Standards (IFRS) is available here
.
ACCOUNTING FOR LEASES UNDER ASC 842 5
Introduction
In February 2016, the Financial Accounting Standards Board (“FASB”) issued new lease accounting guidance in ASU
2016-02, Leases (“ASC 842”). Under its core principle, a lessee recognizes a right-of-use (“ROU”) asset and a related
lease liability on the balance sheet for most leases. The most significant change is on the balance sheet for lessees. For
the income statement, the pattern of expense recognition depends on a lease’s classification but is generally
consistent with current U.S. GAAP (ASC 840, Leases, or “ASC 840”).
The objective for updating lease accounting was to increase transparency and comparability among entities by
recognizing lease assets and lease liabilities on the balance sheet by lessees for most leases and by disclosing key
information about leasing arrangements. This new guidance addressed stakeholder concerns that the previous lease
accounting guidance did not result in a faithful representation of leasing transactions; specifically, that the rights and
obligations associated with operating leases were not recognized on the balance sheet.
Under ASC 840, lessees recognized capital leases on the balance sheet but only disclosed operating leases as off-balance
sheet arrangements. There were no major differences in the accounting treatment for an operating lease versus a service
contract. ASC 842 now changes that and, as such, the key determination will be whether a contract is or contains a
lease as that will drive whether a contract is recognized on the balance sheet.
The leases project began as one of several joint projects between the FASB and the International Accounting Standards
Board (IASB) aimed at converging U.S. GAAP and International Financial Reporting Standards (IFRS). However, after
several years of deliberations and two exposure drafts, the FASB and IASB reached different conclusions on various
aspects of lease accounting (such as classification of leases by lessees), and each of FASB and IASB issued separate
guidance early in 2016. Additional information on the accounting for leases under IFRS is available here
.
ACCOUNTING FOR LEASES UNDER ASC 842 6
ASC 842 IN A NUTSHELL
The following flowchart summarizes at a high level what an entity considers when applying ASC 842, which we will
explore in further details throughout the Practice Aid.
*
Exceptions exist when a lessee or lessor elect a practical expedient not to separate nonlease component(s) from the associated
lease component (see Identifying and Separating Components
).
ACCOUNTING FOR LEASES UNDER ASC 842 7
LEASE CLASSIFICATION
The following flowchart summarizes classification of a lease by lessees and lessors under ASC 842 (after adoption of
ASU 2021-05):
ACCOUNTING FOR LEASES UNDER ASC 842 8
LESSEE ACCOUNTING
As illustrated on the previous page, a lessee classifies a lease as either an operating lease or a finance lease using
classification criteria that are generally consistent with ASC 840. The lease (whether operating or finance) is
recognized on balance sheet at the commencement date unless the practical expedient for short-term leases is elected
(see below). The following table summarizes a lessee’s accounting for leases:
Finance Leases Operating Leases
ROU Asset Lease Liability ROU Asset Lease Liability
Balance
Sheet
ROU asset is initially
measured at the amount
of the lease liability,
plus initial direct costs
and prepaid lease
payments, less lease
incentives received.
Lease liability is
initially measured at
the present value of
the unpaid lease
payments.
Initial measurement is the same as for finance
leases.
Subsequently, ROU asset
is typically amortized on
a straight-line basis to
the earlier of the end of
its useful life or lease
term.
1
Subsequently, lease
liability is increased to
reflect interest using
the effective interest
method and decreased
for lease payments
made.
Amortize based on
difference between
periodic straight-line
lease cost (incl.
amortization of initial
direct costs) and
periodic interest
accretion.
Subsequent
measurement is the
same as for finance
leases.
Income
Statement
Recognize amortization on ROU asset, interest on
lease liability, and recognize variable lease
payments not included in the lease liability when
incurred.
2
Recognize single lease cost (i.e., lease
payments plus initial direct costs) generally on a
straight-line basis, and variable lease payments
not included in lease liability when incurred.
2
Cash Flow
Statement
Classify repayments of principal portion of lease
liability within financing activities and payments
of interest on the lease liability and variable lease
payments within operating activities.
Classify all cash payments for leases within
operating activities.
Once recognized on balance sheet, ASC 842 includes requirements for lessees to update the measurement of leases for
certain lease modifications and other reassessment events. Lessees will need robust processes and controls to timely
and completely identify and account for such events. When the lease liability is remeasured and the ROU asset
adjusted, amortization of the ROU asset is adjusted prospectively from the date of remeasurement.
The FASB also provided lessees with a practical expedient not to recognize short term leases on balance sheet. A short-
term lease is a lease with a lease term of 12 months or less and that does not include a lessee option to purchase the
underlying asset that is reasonably certain of exercise. This election is by asset class and, if elected, a lessee
recognizes lease payments on a straight-line basis over the lease term along with variable lease payments when
incurred, consistent with ASC 840.
1
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 amortizes the right-of-use asset to the end of the useful life of the underlying asset.
2
If the ROU asset is impaired under ASC 360, an impairment loss is also recognized. For operating leases only, recognition in the income statement
post-impairment no longer is on a straight-line basis (but still recognized as a single lease cost).
ACCOUNTING FOR LEASES UNDER ASC 842 9
LESSOR ACCOUNTING
Lessor accounting remains largely consistent with ASC 840, and a lessor will continue to classify leases as either sales-
type, direct financing or operating leases. But lessor accounting has also been updated for consistency with the new
lessee accounting model and with the new revenue standard in ASC 606, Revenue from Contracts with Customers (“ASC
606”).
The following table summarizes a lessor’s accounting for leases under ASC 842.
Sales-Type Leases Direct Financing Leases Operating Leases
Balance
Sheet
Derecognize underlying asset
and recognize net investment
in the lease at commencement
date if collectability of lease
payments and lessee residual
value guarantee is probable.
3
Derecognize underlying asset
and recognize net investment
in the lease (which includes
selling profit and initial direct
costs) at commencement
date.
Continue to recognize underlying
asset.
Defer initial direct costs.
Income
Statement
Recognize selling profit or loss.
Expense initial direct costs
(unless fair value of the
underlying asset equals its
carrying amount, in which case
initial direct costs are included
in the net investment in the
lease).
Recognize selling loss, if any.
Recognize lease payments
generally on a straight-line basis
over the lease term if collectability
is probable. Otherwise, lease
income is limited generally to lease
payments collected.
Recognize variable lease payments
in period when changes in facts and
circumstances on which payments
are based occur.
Expense initial direct costs on same
basis as lease income over the
lease term.
Recognize depreciation expense
(and impairment of underlying
asset, if any).
Recognize interest income on net investment in the lease.
Recognize variable lease payments not included in net
investment in the lease in period when changes in facts and
circumstances on which payments are based occur.
Recognize impairment (or credit losses) on net investment in the
lease.
Cash Flow
Statement
Classify all payments received as operating cash flows, except
for entities within the scope of ASC 942, Financial Services—
Depository and Lending, which present principal payments
within investing activities.
Classify all payments received as
operating cash flows.
Also, leveraged lease accounting no longer exists for leases that are entered into or modified after ASC 842’s effective
date. As a result, new or modified leases that previously met the definition of a leveraged lease will be accounted for
as one of the three types of leases described in the above table. But existing leveraged leases are grandfathered even
once ASC 842 is adopted and will continue to be accounted for by a lessor similarly to under ASC 840 until they expire
or are modified.
3
If collectability is not probable at commencement date, a lessor does not derecognize the underlying asset and instead recognizes lease payments
received, including variable lease payments, as a deposit liability until further conditions are met.
ACCOUNTING FOR LEASES UNDER ASC 842 10
ADOPTION DATES
For calendar-year public business entities, certain not-for-profit organizations and certain employee benefit plans, the
new standard took effect in 2019, and interim periods within that year.
For all other calendar-year entities, ASC 842 was initially required to take effect in 2020, and interim periods in 2021.
However, in November 2019 the FASB issued ASU 2019-10 which initially deferred the effective date of ASC 842 for all
other calendar-year entities to 2021 with interim periods in 2022. Also, because of the disruption caused by the
Coronavirus Disease 2019 (also referred to as COVID-19), including resource constraints, dislocation, and other
priorities that entities faced with the COVID-19 pandemic, the FASB decided to further defer the effective date of ASC
842 by an additional year for private companies and certain not-for-profit entities (NFPs). Specifically, for private
companies and private NFPs, ASC 842 will be effective for fiscal years beginning after December 15, 2021, and interim
periods within fiscal years beginning after December 15, 2022. For public NFPs that have not yet issued financial
statements or made financial statements available for issuance as of June 3, 2020, ASC 842 takes effect for fiscal years
beginning after December 15, 2019, including interim periods within those fiscal years.
Early adoption continues to be permitted for all entities.
ABOUT THE PRACTICE AID
The Practice Aid reflects key aspects of the following accounting standards updates (all of which are referred to as ASC
842 in this publication):
ASU 2016-02, Leases (Topic 842)
ASU 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, which
generally simplifies adoption for entities with land easements that exist or expire before the entity’s
adoption of ASC 842.
ASU 2018-10, Codification Improvements to Topic 842, Leases, which affects narrow aspects of the guidance
in ASC 842 and corrects cross-reference inconsistencies.
ASU 2018-11, Leases (Topic 842): Targeted Improvements, which the FASB issued to reduce costs for entities
in adopting ASC 842 and to ease the application of the separation and allocation guidance for lessors.
ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors, which simplifies lessor’s
accounting for sales taxes, certain lessor costs, and clarifies the recognition of certain variable payments for
contracts with lease and nonlease components.
ASU 2019-01, Leases (Topic 842): Codification Improvements, which clarifies the application of certain
aspects of ASC 842 primarily for financial institutions.
ASU 2019-10, Financial Instruments—Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and
Leases (Topic 842): Effective Dates, which deferred the effective of ASC 842 for certain entities.
ASU 2020-02, Financial Instruments—Credit Losses (Topic 326) and Leases (Topic 842): Amendments to SEC
Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 119 and Update to SEC Section on Effective Date
Related to Accounting Standards Update No. 2016-02, Leases (Topic 842), which clarifies the SEC’s views on
ASC 842’s effective date for certain public business entities
.
ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on
Financial Reporting, which was issued to simplify an entity’s accounting associated with modifications to
agreements related to the reference rate reform, including lease contracts.
ASU 2020-05, Revenue from Contracts with Customers (Topic 606) and Leases (Topic 842): Effective Dates for
Certain Entities, which further defers the effective date of ASC 842 for certain entities due to COVID-19.
ASU 2021-05, Leases (Topic 842): Lessors—Certain Leases with Variable Lease Payments, to address the
recognition of a day-one loss issue by lessors in certain leases.
ACCOUNTING FOR LEASES UNDER ASC 842 11
ASU 2021-09, Leases (Topic 842): Discount Rate for Lessees That Are Not Public Business Entities.
While the Practice Aid does not include all requirements of ASC 842, it summarizes key aspects of ASC 842 that will
commonly arise in applying ASC 842. It also includes practical examples and interpretive guidance to assist companies
and practitioners in their adoption and continued application of ASC 842.
The Practice Aid has been divided into chapters, which address key aspects of the new lease standard. These chapters
are generally organized in the order in which an entity would apply ASC 842, and the questions that an entity would
need to answer as it proceeds through the evaluation. For example, the first chapter discusses whether a contract is
within the scope of ASC 842, and if so, a reader moves to the next chapter
that addresses whether the contract
contains a lease, and so on. Other aspects of ASC 842 related to specific transactions and interactions with other areas
of GAAP have been grouped into one chapter “
Other Topics” which includes accounting for subleases, sale and
leaseback transactions, business combinations, and income taxes. Finally, there is a detailed chapter discussing
effective dates and how to
transition to ASC 842.
The illustration below depicts how the chapters are organized. At the start of each chapter, the flowchart will be
repeated, and your location in the overall flowchart will be identified.
ACCOUNTING FOR LEASES UNDER ASC 842 12
Chapter 1 - Scope of ASC 842
SCOPE AND SCOPE EXCEPTIONS
ASC 842 is limited to leases of property, plant or equipment. Accordingly, it does not apply to any of the following:
LEASED ASSET RELEVANT GUIDANCE AND OBSERVATIONS
Leases of intangible
assets, like licenses
of IP
Apply ASC 350, Intangibles—Goodwill and Other
Leases to explore for
or use minerals, oil,
natural gas, and
similar
nonregenerative
resources
Apply ASC 930, Extractive Activities—Mining, and ASC 932, Extractive Activities—Oil
and Gas
The FASB clarified that the scope exception applies to the intangible right to
explore for those natural resources and rights to use the land in which those
natural resources are contained, unless those rights of use include more than the
right to explore for natural resources. The scope exception does not apply to
equipment used to explore for the natural resources. See Example 1 below for an
illustration.
Leases of biological
assets, like plants and
living animals
Apply ASC 905, Agriculture
Note that this scope exception includes timber to be consistent with ASC 840.
Leases of inventory
Apply ASC 330, Inventory
Leases of assets
under construction
Apply ASC 360, Property, Plant, and Equipment
Note that transactions in which the underlying asset needs to be constructed or
redesigned for use by the lessee may be in scope of the sale-leaseback guidance if
the lessee controls the asset under construction before the lease commencement
date. See chapter 7, Other Topics
for additional details.
ACCOUNTING FOR LEASES UNDER ASC 842 13
Scope of ASC 842 Consistent with ASC 840
The scope of ASC 842 is generally consistent with the scope of the legacy lease guidance in ASC 840 and applies only
to leases of property, plant or equipment (that is, land and/or depreciable assets). The Board acknowledged in
paragraph BC110 in the Basis for Conclusions of ASU 2016-02 that the conceptual basis for excluding some other assets
such as intangible assets, inventory and assets under construction from the scope of ASC 842 was unclear, but it
nonetheless decided to continue to limit the scope to only property, plant or equipment for pragmatic reasons
including cost-benefit reasons.
Long Term Leases of Land Not Excluded from ASC 842
The scope of ASC 842 includes long-term leases of land, such as a 99-year lease of land. While some may view these
long-term leases of land as economically similar to purchases of land, the Board noted that there is no conceptual
basis for differentiating long-term leases of land from other leases and that any definition of “long-term” would be
arbitrary in nature. Accordingly, those long-term leases of land are in the scope of ASC 842.
Example 1 - Rights to Explore for or Use Natural Resources and Additional Rights
Entity A obtains the intangible right to explore for or use natural resources along with rights to use the land that
contains those natural resources (Land 1). To access Land 1 and explore for those natural resources, Entity A obtains
access rights to an adjacent parcel (Land 2). The following picture summarizes Entity A’s arrangements.
Which of the above rights, if any, are outside the scope of ASC 842?
ASC 842-10-15-1(b) states that the scope exception includes “the intangible right to explore for those natural
resources and rights to use the land in which those natural resources are contained […]”. Accordingly, the intangible
right to explore for or use natural resources along with rights to use Land 1 are outside the scope of ASC 842. This
would be true even if Entity A entered into separate contracts with different parties for the rights to Land 1 and for
the rights to explore for the underlying natural resources (for example, if the surface rights are legally separated
from the mineral rights and are owned by different parties).
However, the scope exception does not apply to the rights to use Land 2 as the scope exception is limited to the
rights to use the land in which the natural resources are contained and for which Entity A has exploration rights (i.e.,
which is Land 1 only). Accordingly, Entity A should determine whether its right to access or use Land 2 meets the
definition of a lease. See also section below on specific considerations for land easements.
Note that if Entity A were also to lease (rather than own) the equipment used for the exploration or use of the
natural resources (such as the drilling rigs in the picture above), those would be in the scope of ASC 842 and Entity A
would need to determine whether its right to use the equipment meets the definition of a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 14
SPECIFIC CONSIDERATIONS FOR LAND EASEMENTS
Land easements (also commonly referred to as rights of way) represent the right to use, access, or cross another
entity’s land for a specified purpose. Easements are used in various industries, such as in the energy, utilities,
transportation and telecom industries. For example:
A midstream energy company might acquire a land easement for the right to pass a pipeline over, under, or
through an existing area of land while allowing the landowner continued use of the land for other purposes
(farming, hunting, etc.) if the landowner does not interfere with the rights of the midstream energy
company.
An electric utility might acquire a series of contiguous easements so that it can construct and maintain its
electric transmission system on land owned by others.
Terms of land easements can vary greatly between agreements. For example, a land easement may be perpetual or
term based, provide for exclusive or nonexclusive use of the land, may be prepaid or paid over a defined term, and so
forth. The grantor (landowner) also may retain rights associated with access and use of the land area, or it may be
restricted in its ability to access and use the land area.
Diversity in practice has historically existed in U.S. GAAP in the accounting for land easements before ASC 842. For
example:
Some entities have accounted for their land easements as intangible assets based on the guidance in Example
10 of ASC 350-30, Intangibles—Goodwill and Other—General Intangibles Other than Goodwill, which refers to
land easements in that example as intangible assets.
Some entities have applied ASC 360 and considered the prepaid land easement as a cost to bring property,
plant or equipment (for example, a pipeline) to the condition and location necessary for its intended use.
Some entities have applied ASC 840 (for example, a cell tower company entering into a land easement for
the right to erect a communication tower).
Because of that diversity, in January 2018, the FASB issued ASU 2018-01, Land Easement Practical Expedient for
Transition to Topic 842, to clarify that land easements are in the scope of ASC 842. However, considering the existing
diversity in accounting and to reduce the cost and complexity associated with assessing whether all existing and
expired land easements meet the definition of a lease for entities transitioning to ASC 842, ASU 2018-01 allows entities
that previously did not account for land easements as leases under ASC 840 to elect a transition practical expedient to
not assess those land easements under ASC 842 when adopting the new standard. Instead, entities will continue to
account for those land easements under other GAAP unless the land easement is modified on or after ASC 842’s
adoption date. An entity that currently accounts for land easements as leases under ASC 840 cannot elect this practical
expedient for those easements.
Because the Board clarified in ASU 2018-01 that land easements are in the scope of ASC 842, once an entity adopts the
new lease standard, it must apply that guidance prospectively to all new or modified land easements to determine
whether those arrangements meet the definition of a lease under ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 15
Example 2 - Land Easements in Transition
Electric Company obtained a series of easements years before its adoption of ASC 842. The easements were obtained
so that Electric Company could install poles to which its power lines would be attached. In addition to installing its
poles, Electric Company has the right to access the poles via a corridor leading from the nearest road to the pole.
Electric Company will make payments over time under the easement agreement in return for long-term access
rights. Electric Company has historically accounted for those land easements along with its poles as property, plant
and equipment under ASC 360.
Because Electric Company did not account for those land easements as leases under ASC 840, it can elect the
practical expedient provided in ASU 2018-01. This means Electric Company will continue to account for those land
easements under ASC 360 unless the agreement is modified on or after ASC 842’s adoption date, in which case
Electric Company would need to assess whether those easements meet the definition of a lease under ASC 842. If
elected, the practical expedient must be applied to all Electric Company’s land easements not accounted for as
leases under ASC 840.
Alternatively, if Electric Company does not elect the land easements practical expedient, it should evaluate all of its
existing land easements when adopting the new standard to determine whether those easements meet the definition
of a lease under ASC 842.
Practical Expedient Provided for Cost-Benefit Reasons
Through outreach with stakeholders in industries most involved with land easements, the FASB learned that many
land easements are perpetual (and therefore would not meet the definition of a lease because they are not “for a
period of time”) and that many land easements are prepaid and therefore already recognized on the balance sheet.
The Board therefore did not want entities to incur significant time and effort (considering the volume of land
easements and age of those agreements) to evaluate them under ASC 842, especially considering that adoption of
the new standard was generally not expected to have a material impact for these existing land easements.
While diversity in practice in accounting for land easements exists before ASC 842, it generally would be
inappropriate for an entity to change its accounting policy prior to adoption of ASC 842 from accounting for those as
leases under ASC 840 to accounting for those under ASC 350 or ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 16
Unit of Account Questions on Land Easements and Subsurface Rights Not Addressed
As part of its project leading to the issuance of ASU 2018-01, the FASB became aware of several unit of account
questions commonly arising with land easements impacting the lease evaluation under ASC 842. For example, a
midstream energy company may acquire a land easement for the right to pass a pipeline under an existing area of
land in which the landowner retains rights associated with the use of the land surface. In this example, a question
arises as to whether the subsurface area represents its own unit of evaluation, or whether the subsurface and
surface should be considered together when evaluating whether the contract contains a lease. This question is
important as it is more likely that the arrangement would contain a lease if the subsurface is considered its own unit
of evaluation. Despite those questions, the FASB decided not to provide additional clarity as it did not view these
issues as being limited to land easements. If an entity determines that an arrangement does not contain a lease, it
applies other GAAP such as ASC 350 or ASC 360 to account for the arrangement.
For arrangements similar to the midstream energy company example above, we believe that it would be acceptable
for the entity to either apply ASC 842 and evaluate whether the arrangement contains a lease, or to analogize the
subsurface rights to air rights (i.e., an intangible asset, which is outside the scope of ASC 842) to the extent the
rights conveyed relate to subsurface (underground) space that cannot be inhabited or otherwise be accessed (which
are characteristics shared with air rights). In the latter situation, the entity would not apply the definition of a lease
in ASC 842 but would apply other GAAP such as ASC 350 to its arrangement. However, we do not believe that an
analogy to air rights is acceptable in all cases. For example, it would be inappropriate for an entity to analogize to
air rights for leases of underground retail space in a subway station, a basement of a commercial office building, or
underground parking garage. Careful consideration should also be given when determining the appropriate
accounting for land easements as terms and conditions may vary greatly between arrangements.
Diversity in Accounting When a Land Easement is Not a Lease Also Not Addressed
When an entity evaluates a land easement under ASC 842 and determines it is not a lease, the diversity in
accounting observed outside of the lease guidance is not addressed in ASU 2018-01. As previously discussed, some
entities have applied ASC 350 while others have applied ASC 360. The FASB noted in paragraph BC11 of ASU 2018-01
that it did not intend to address diversity in the guidance applied when a land easement does not meet the
definition of a lease. For example, consider an entity that accounts for its land easements as intangible assets
before adoption of ASC 842 based on the guidance in Example 10 of ASC 350-30. If that entity enters into a land
easement after adoption of ASC 842 but the contract does not include a lease, the entity’s past practice of
accounting for those arrangements as intangible assets is not affected by ASU 2018-01.
ACCOUNTING FOR LEASES UNDER ASC 842 17
INTERACTION WITH OTHER STANDARDS
DERIVATIVES AND HEDGING
ASC 815-10-15-79 on scope and scope exceptions explains that leases that are within the scope of ASC 842 are not
derivative instruments subject to the guidance on derivatives and hedging. However, a derivative instrument
embedded in a lease may be subject to the requirements of ASC 815-15-25 on recognition of embedded derivatives.
ASC 815-10-15-80 also explains that residual value guarantees that are subject to the guidance in ASC 842 are not
subject to the guidance on derivatives and hedging. However, ASC 815-10-15-80 clarifies that a third-party residual
value guarantor should consider the guidance on derivatives 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 ASC
815-10 on derivatives and hedging.
SERVICE CONCESSION ARRANGEMENTS
ASC 853-10-25-2 notes that the infrastructure that is the subject of a service concession arrangement within the scope
of ASC 853 should not be recognized as property, plant, or equipment of the operating entity and that those service
concession arrangements are not within the scope of ASC 842.
REVENUE FROM CONTRACTS WITH CUSTOMERS
ASC 606-10-55-68 notes that 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. That paragraph also notes that if the entity can or must repurchase the asset for an amount
that is less than the original selling price of the asset, the entity accounts for the contract as a lease (unless the
contract is part of a sale-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 ASC 842-40.
ACCOUNTING FOR LEASES UNDER ASC 842 18
Chapter 2 - Identifying a Lease
OVERVIEW
The 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.”
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).
A contract is or contains a lease if there is an identified asset and the contract grants the customer throughout the
period of use both:
The right to obtain substantially all of the economic benefits from the asset’s use (the economic criterion),
and
The right to direct the use of the identified asset (the power criterion).
Accordingly, the definition of a lease focuses on three criteria as described in the following flowchart:
If the customer in the contract is a joint operation or a joint arrangement, the entity should consider whether the joint
operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.
ACCOUNTING FOR LEASES UNDER ASC 842 19
Also, for an entity to appropriately evaluate the three criteria in the above flowchart, it is important to understand the
following:
The contract must be for a period of time (See Example 1), and
The evaluation of whether a contract is or contains a lease is performed based on the period of use, which is
the total period of time an asset is used to fulfill the contract with the customer, including the sum of any
nonconsecutive periods of time. That period is not always the same as the contract term (See Example 2).
Once determined, this period of use is applied to evaluate whether supplier substitution rights are
substantive, and whether the economics and power criteria are met. Accordingly, it is a key concept of the
evaluation.
The evaluation of whether a contract contains a lease is performed at contract inception, and an entity does not
subsequently reassess its conclusion unless the terms and conditions of the contract are modified.
Example 1 - Contract Must Be for a Period of Time – Perpetual Land Easement
Electric Company obtained a series of easements from Southern Railroad after its adoption of ASC 842 (see Chapter 1
on scope for a practical expedient available in transition for certain land easements). The easements were obtained
so that Electric Company could install poles to which its power lines would be attached. In addition to installing its
poles, Electric Company has the right to access the poles via a corridor leading from the nearest road to the pole.
Electric Company made an upfront payment under the easement agreement in return for perpetual access rights.
In this example, the agreement does not contain a lease. ASC 842-10-15-3 states that a lease conveys the right to
control the use of identified property, plant or equipment for a period of time in exchange for consideration. The
fact that the contract is perpetual means that it is not for a period of time, and, therefore, the agreement does not
contain a lease. This view is consistent with conforming amendments made to the intangible assets’ guidance in ASU
2018-01. Specifically, Example 10 of ASC 350-30 (paragraph 350-30-55-30) was amended to clarify that the perpetual
easements that the entity owns were “evaluated under Topic 842 and determined to 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).”
Example 2 - Period of Use – Customer Uses Asset During Nonconsecutive Periods
Calendar Co. sells calendars and holiday merchandise. In order to sell its products, it enters into a contract for the
right to use a storefront in a mall for the months of November and December each year for five years.
Calendar Co. considers the “period of use” as defined in ASC 842-10-20 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).” Because the
periods of time are not consecutive, Calendar Co. must consider the aggregate term for which it has the right to use
the storefront. In this example, the period of use is ten months (two months per year for five years); it is not the
five-year contract term. Accordingly, the evaluation of whether the contract contains a lease considers the ten-
month period that the storefront is used to fulfill the contract.
ACCOUNTING FOR LEASES UNDER ASC 842 20
IDENTIFIED ASSET
An asset is typically identified when it is either explicitly specified in the contract, or implicitly specified when the
asset is made available for use by the customer. Importantly, paragraph BC128 of ASU 2016-02 notes that “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.”
A capacity portion of an asset also can be an identified asset if it is physically distinct (for example, a floor of a
building). 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. The following examples illustrate this requirement
(assume for now that there are no supplier substitution rights).
Physically Distinct Asset Capacity Portion of Asset
A customer enters into a 15-year
contract with a supplier for the
right to use 3 of 10 specific
strands of a fiber optic cable
connecting Paris and London.
A customer enters into a 15-year
contract with a supplier for the right
to use a specified amount of capacity
(95%) within a cable connecting Paris
and London. The specified amount is
equivalent to the customer having
the full capacity of 14 fiber strands
within a 15-strand cable.
A customer enters into a 15-year
contract with a supplier for the right to
use a specified amount of capacity
(20%) within a cable connecting Paris
and London. The specified amount is
equivalent to the customer having the
full capacity of 3 fiber strands within a
15-strand cable.
The strands of fiber optic cable
are distinct from one another.
Each strand is an identified
asset.
The capacity specified is not
physically distinct, but it represents
substantially all the capacity of the
cable.
The cable is an identified asset.
The capacity specified is not physically
distinct and does not represent
substantially all the capacity of the
cable.
There is no identified asset.
However, even if an asset is specified, there is no identified asset if the supplier has the substantive right to substitute
the asset throughout the period of use. That is, when a supplier substitution right is considered substantive, the
supplier (rather than the customer) controls the use of the asset.
Supplier substitution rights are considered substantive when the following two conditions are met:
The evaluation of supplier substitution rights is key because if it is determined that the supplier right is substantive,
then there is no identified asset and thus the contract does not contain a lease.
Supplier has the
practical ability
to substitute
alternative
assets
throughout the
period of use
Supplier would
benefit
economically
from
substituting the
asset
Substantive
substitution
right
ACCOUNTING FOR LEASES UNDER ASC 842 21
A supplier has the practical ability to substitute alternative assets when, for example, the customer
cannot prevent the supplier from exercising its right of substitution and the supplier has other
alternative assets readily available (or the supplier could source alternative assets within a
reasonable period of time).
A supplier would benefit economically from substituting the asset if the economic benefits of doing
so exceed the related costs of substitution (e.g., transportation, installation costs, etc.). ASC 842
further states that if the asset is located at the customer’s premises, the costs of substituting the
asset are generally higher than when located at the supplier’s premises, and therefore are more
likely to exceed the related benefits. If the supplier costs to substitute exceed the related benefits,
the substitution right is not substantive and, therefore, there is an identified asset.
ASC 842 provides additional guidance to evaluate whether supplier substitution rights are substantive.
Fact Pattern Conclusion
Supplier can substitute the asset only in circumstances
that are unlikely to occur at contract inception (for
example, an agreement with a future customer to pay
an above-market price for use of the asset).
Substitution right is not substantive.
Supplier can substitute the asset only on or after a
specified future date or specified event.
Substitution right is not substantive because the supplier
does not have the right to substitute the asset
throughout the period of use.
Supplier can substitute the asset for repairs and
maintenance or based on the availability of a technical
upgrade.
Substitution right is not substantive.
Customer cannot readily determine whether a
substitution right is substantive (for example, a
customer may not have information about the supplier’s
costs of substitution).
Customer must presume that the substitution right is not
substantive (that is, there is an identified asset).
Concept of Identified Asset under ASC 842 versus ASC 840
The concept of a lease contract being based on an identified asset is not new and existed in ASC 840. Under ASC
840 an asset could be explicitly specified or implicitly specified (for example, when the supplier owned or leased
only one asset with which to fulfill its obligation to the customer/purchaser and it was not economically feasible or
practicable for the supplier to perform its obligation through the use of alternative property, plant, or equipment).
ASC 842 retains a similar concept on identifying an asset but is more explicit on the evaluation of supplier
substitution rights, now requiring that the supplier benefit economically from substitution. Accordingly, more
contracts may be leases under ASC 842, and this determination becomes more important under the new guidance
due to the balance sheet implications for lessees.
ACCOUNTING FOR LEASES UNDER ASC 842 22
Example 3A (Adapted from paragraph 842-10-55-52 through 55-54) – Concession Space
FACTS
Retailer enters into a contract with Airport Operator for the use of a space in an airport terminal for a
five-year period.
Retailer owns and utilizes a booth that is easily transferrable to different boarding areas.
Airport Operator has many areas in the terminal that are available and would meet Retailer’s
specifications. Airport Operator can at its sole discretion relocate Retailer to different boarding areas in
the terminal throughout the period of use. Airport Operator also would incur minimal costs associated
with changing the space that Retailer uses.
ANALYSIS
Is there an identified asset? No
Although the contract specifies that Retailer will utilize a specific space in the airport to operate its booth:
There are several other similar areas that Retailer may be assigned to, which Airport Operator has the
right to change, without Retailer’s approval, throughout the period of use. That is, Airport Operator has
the practical ability to substitute Retailer’s space.
The costs to move Retailer’s booth are minimal, and substitution allows Airport Operator to use its airport
space in the most effective way, for example by relocating Retailer to other boarding areas to meet
changing circumstances. Those conditions are likely to occur at contract inception considering Airport
Operator’s historical experience, business and operations. That is, Airport Operator would benefit
economically from substituting Retailer’s space.
Accordingly, Airport Operator’s substitution right is substantive.
CONCLUSION
The contract does not contain a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 23
Example 3B (Adapted from paragraph 842-10-55-63 through 55-71) – Retail Space
FACTS
Retailer enters into a contract with Airport Operator for the use of retail unit A for a five-year period.
Retail unit A is part of a terminal with many retail units.
Airport Operator can require Retailer to relocate to another retail unit in the terminal. In that case,
Airport Operator is required to provide Retailer with a retail unit of similar quality and specifications as
retail unit A and to pay for Retailer’s relocation costs, including reimbursement for any leasehold
improvements that cannot be relocated.
Airport Operator would benefit economically from relocating Retailer 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 Retailer and other tenants for the space that the new tenant would occupy. Although it is
possible that those circumstances will arise, at contract inception it is not likely that those circumstances
will arise, and whether such circumstances occur is highly susceptible to factors outside of Airport
Operator’s control.
ANALYSIS
Is there an identified asset? Yes
Retail unit A is explicitly specified in the contract, and Airport Operator’s substitution right is not substantive
because Airport Operator would benefit economically from substitution only in specific circumstances that at
inception of the contract are not likely to occur. That is, Airport Operator’s substitution right is not substantive
and, therefore, there is an identified asset.
CONCLUSION
The analysis continues to determine whether Retailer has the right to control the use of retail unit A. See Right to
Control Use of Identified Asset section for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 24
Example 4A (Adapted from paragraph 842-10-55-48 through 55-51) – Rail Cars
FACTS
Smith & Company (SmithCo) enters into an agreement with Freight Systems Limited (Freight) to transport
a specified quantity of products 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 products specified are economically equivalent
to SmithCo having the use of ten rail cars for five years.
Freight has a large pool of similar rail cars that can be used to fulfill the requirements of the contract.
The rail cars are stored at Freight’s location when not in use.
ANALYSIS
Is there an identified asset? No
The rail cars used to transport SmithCo’s products are not identified assets. Freight has the practical ability to
substitute each rail car throughout the period of use without SmithCo’s approval, and Freight would benefit
economically from substituting each car because the costs to substitute, if any, would be minimal, and substitution
allows Freight to use the cars in the most efficient way for the task, for example because cars are currently at a rail
yard close to the point of origin. Those conditions are likely to occur at contract inception considering Freight’s
historical experience, business and operations. Accordingly, Freight’s substitution right is substantive. Therefore,
although SmithCo has the right to use the equivalent of ten rail cars for five years, Freight directs the use of those
rail cars by determining which cars will be used for each particular delivery.
CONCLUSION
The agreement does not contain a lease.
Example 4B (Adapted from paragraphs 842-10-55-42 through 55-47) – Rail Cars
FACTS
Smith & Company (SmithCo) enters into an agreement with Freight Systems Limited (Freight) under which
Freight provides SmithCo with the use of ten rail cars of a particular type for five years. The contract
specifies the rail cars, which are owned by Freight.
The agreement provides certain limitations on what types of goods SmithCo can transport, such as
hazardous materials or explosives, but otherwise, SmithCo has the right to determine whether the rail
cars are used, and if so, where, when and which products are transported using the rail cars. When the
rail cars are not in use, they are stored at SmithCo’s property.
If a particular car needs to be serviced or repaired, Freight is required to substitute a rail car of the same
type. Otherwise, Freight cannot retrieve the rail cars during the five-year period of the contract other
than on default by SmithCo.
ANALYSIS
Is there an identified asset? Yes
There are ten identified rail cars. Once the cars are delivered to SmithCo, they can only be substituted when they
need to be serviced or repaired, which is not considered a substantive substitution right based on the guidance in
paragraph 842-10-15-14.
ACCOUNTING FOR LEASES UNDER ASC 842 25
CONCLUSION
The analysis continues to determine whether SmithCo has the right to control the use of the rail cars. See Right to
Control Use of Identified Asset section for additional discussion.
Example 5 – Contract for Hosting Arrangement
FACTS
Bank Company (“Bank”) enters into a hosting arrangement with Regional Hosting Co. (“Regional Hosting”)
under which Regional Hosting will provide a specific number of servers on which it will host software
licenses owned by Bank. In addition, Regional Hosting will provide connectivity to allow Bank to access
the software hosted by Regional Hosting.
Because of the number of users in Bank’s environment and the complexity of the software environment,
Regional Hosting must host Bank’s software on dedicated servers with specific security requirements, and
no other customer can be hosted on the same servers. However, Regional Hosting has the right to
rehome Bank’s software onto different servers with similar security requirements without Bank’s approval
so long as access to its software licenses is uninterrupted.
ANALYSIS
Is there an identified asset? No (Regional Hosting), Yes (Bank)
Regional Hosting considers whether its arrangement with Bank contains identified assets (i.e., each server) and
notes that:
It has numerous servers that meet Bank’s security requirements and from which it can host Bank’s
software. Bank cannot prevent Regional Hosting from switching servers so long as access to Bank’s
software is uninterrupted. Accordingly, Regional Hosting concludes it has the practical ability to
substitute Bank’s servers throughout the period of use.
There are minimal costs to substitute servers, and Regional Hosting would benefit economically from
substitution. Specifically, it is common for new hosting customers to be obtained, at which time Regional
Hosting often reconfigures its server space. In addition, to maximize performance on its servers, Regional
Hosting regularly adds or deletes servers and moves customers as needed. Accordingly, Regional Hosting
concludes that its right of substitution is substantive.
Regional Hosting concludes that the contract does not include identified assets and thus is not a lease.
Bank, however, does not have visibility into Regional Hosting’s operations and business (including how many servers
Regional Hosting has with similar security requirements and how many customers it serves). Therefore, it
concludes pursuant to the guidance in paragraph 842-10-15-15 that Regional Hosting’s right of substitution is not
substantive, which means the agreement includes identified assets.
CONCLUSION
Regional Hosting concludes that it does not have a lease.
Bank continues its evaluation to determine whether it has the right to control the use of each identified asset (i.e.,
each server). See Right to Control Use of Identified Asset section for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 26
Example 6 – Contract for Medical Equipment
FACTS
Outpatient Services, Inc. (“OSI”) signs a contract with Medical Equipment Company (“MEC”) under which
OSI will use five chemotherapy machines for a period of three years. The contract does not explicitly
identify specific machines, but instead only requires five machines to be available at all times. The
machines are delivered to OSI’s location, and OSI has the right to use the machines in any way and at any
time it deems appropriate during the three-year term of the agreement, subject to restrictions requiring
the machines to be used pursuant to manufacturer-provided and FDA-approved use guidelines.
Each machine is expected to be able to provide up to 1,000 treatments before needing maintenance, and
each machine has an expected useful life of approximately 5,000 treatments, which normally equates to
five to six years. However, each machine can only be used to provide up to 10 chemotherapy treatments
before being recalibrated pursuant to FDA guidelines, at which time MEC is required to provide the
services necessary to allow OSI to continue providing its chemotherapy services. When OSI contacts MEC
to request recalibration of one of its machines, MEC retrieves that machine and replaces it with a fresh
machine.
MEC maintains a large pool of chemotherapy machines at specified locations (which are within a
reasonable distance from its customers) which have been properly cleaned and calibrated.
MEC also has the right to replace the machines at its convenience, which it regularly does when replacing
other machines in the same geographic area.
ANALYSIS
Is there an identified asset? No
While the machines are housed at OSI’s location, MEC has the right to substitute another equivalent machine
throughout the three-year period and that right is considered substantive because:
MEC has the practical ability to substitute each machine throughout the period of use considering its large
pool of machines and reasonable distance from its customers. MEC also does not need OSI’s approval to
substitute the machines.
MEC would benefit economically because MEC has centralized calibration operations in a single facility
within a reasonable distance from its customers which allows it to reduce costs of calibration (including
transportation) in excess of the costs that it otherwise would incur to calibrate the machines at the
clients’ location, while ensuring constant access to calibrated machines for its customers as required per
the agreement. In addition, MEC would benefit from replacing a machine prior to a customer’s request if
MEC is replacing another machine in that customer’s general vicinity, as that further reduces MEC’s
transportation costs. Those events are likely to occur at contract inception considering MEC’s historical
experience, business and operations.
CONCLUSION
The contract does not contain a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 27
RIGHT TO CONTROL USE OF IDENTIFIED ASSET
Even if a contract includes an identified asset, a contract does not contain a lease unless the customer has the right to
control the use of that asset, which is met when the customer has throughout the period of use both:
The right to obtain substantially all of the economic benefits from the asset’s use (the economics criterion),
and
The right to direct the use of the identified asset (the power criterion).
Right to Control Use under ASC 842 similar to ASC 606 and ASC 810
Although the right to control the use of an identified asset is not a new concept, the application in ASC 842 is
different than in ASC 840. Specifically, under the guidance in ASC 840, a contract contained a lease if:
(a)
The customer controlled the operation of the asset while obtaining more than a minor portion of the output
of the asset,
(b)
The customer controlled physical access to the asset while obtaining more than a minor portion of the output
of the asset, or
(c)
It was remote that any other party would receive more than a minor portion of the output of the asset and
the price for the output was neither fixed per unit nor equal to the market price at time of delivery.
Accordingly, under ASC 840 a customer could have the right to control the use of an asset solely based on obtaining
substantially all the output from that asset, assuming the contract is priced in a certain way. This criterion defined
control based on a benefits element only. However, ASC 606 on revenue from contracts with customers and ASC 810
on consolidation define control based on a benefits element and a power element. Likewise, ASC 842 now requires a
customer to have throughout the period of use not only the right to obtain substantially all the economic benefits
from use of an asset (the economics criterion), but also the ability to direct the use of that asset (the power
criterion). In other words, 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 the asset’s use. Without such decision-making rights, the
customer has no more control over the use of an asset than any customer purchasing supplies or services. As a result,
certain contracts that met the definition of a lease under ASC 840 (for example certain power purchase agreements)
may no longer meet the definition of a lease under ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 28
RESTRICTIONS AND SUPPLIER PROTECTIVE RIGHTS
Both the economic and power criteria are evaluated within the defined scope of the customer’s right to use the asset.
Terms that limit the use of the asset a certain way (for example, specifying a maximum amount of usage of the asset)
or that protect the supplier’s interest in the asset (such as requiring the customer to follow industry-standard
operating procedures, or requiring notification of changes in how or where the asset will be used) do not, in isolation,
prevent the customer from having the right to direct the use of the identified asset.
Accordingly, the analysis should focus on what the customer can do within that scope of use of the asset. Consider the
following examples:
Corporate Jet Commercial Truck Retail Unit
Contract Contract for the use of a
corporate jet for a two-year
period.
Contract for the use of a
commercial truck for a five-year
period.
Contract for the use of a retail
unit within a larger mall for a
five-year period.
Defines the
scope of
use
Restrictions within the contract
limit the number of hours the
jet can fly and/or which
territories the aircraft can fly
over.
Restrictions within the contract
limit the number of miles the
truck can be driven, and
customer cannot transport
hazardous or explosive goods.
Restrictions within the contract
limit the hours of operations of
the store from 10am to 10pm.
But within
that scope
of use
Customer has exclusive use of
the corporate jet and decides
whether the aircraft flies,
where and when the aircraft
flies (subject to the limits) and
whether to transport passengers
and/or cargo.
Customer has exclusive use of
the truck and decides where
and when the truck will be
used, how many miles (subject
to the limit) and what cargo
(other than explosives) it will
transport.
Customer has exclusive use of
the retail unit and decides when
to open (subject to the limit),
the mix of goods to sell, and at
what price to sell the goods.
In all the above examples, even though the contract includes restrictions or limitations on the use of the asset, the
contracts would include a lease as further explained in the Economic Criterion and Power Criterion sections below.
ACCOUNTING FOR LEASES UNDER ASC 842 29
ECONOMIC CRITERION
A customer can obtain economic benefits from use of an asset directly or indirectly in various ways, including 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.
ASC 842 clarifies that only the economic benefits arising from use of an asset should be considered when assessing
whether a customer has the right to obtain substantially all economic benefits. In many cases, the evaluation will be
straightforward. For example, when the customer has exclusive use of an identified asset, it typically obtains 100% of
the economic benefits from use of that asset. This is true for the corporate jet, commercial truck, and retail unit
examples previously presented in the Restrictions and Supplier Protective Rights section. However, in other situations
this evaluation will require the use of professional judgment.
Economic benefits arising from ownership of an asset (for example, tax benefits from owning an asset) are excluded in
the evaluation. This is because a lease does not convey ownership of an underlying asset, but instead conveys the right
to use that asset. To illustrate this, consider a utility company (customer) that enters into a contract with a power
company (supplier) to purchase all electricity produced by a specific solar farm. Supplier owns the solar farm and will
receive tax credits related to its ownership of the solar farm. Customer will receive renewable energy credits related
to the use of the farm. The following table summarizes the relevant outputs to consider in determining whether the
customer obtains substantially all the economic benefits from use of the asset.
Include Exclude
Electricity produced by the solar farm (customer),
Renewable energy credits because they relate to
the
use
of the solar farm (customer).
Tax credits because they relate to the
ownership
of the asset, not the use of the asset (supplier).
In the above example, the customer receives 100% of the economic benefits from use of the asset, and therefore the
economic criterion is met. If, instead, the supplier was to receive the renewable energy credits, the entity should
determine whether the customer obtains substantially all of the economic benefits from use of the solar farm, which
may require the use of professional judgment.
Also, if a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use
of the asset, those cash flows paid as consideration are considered economic benefits that the customer obtains from
use of the asset. For example, if a retailer is required to pay a mall owner 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. The cash flows arising from those sales are
considered economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to
the mall owner as consideration for the right to use that retail space.
Meaning of Substantially All
In practice, the term “substantially all” is generally interpreted to be at or around 90% or more. This term is also
used in the lease classification test (see paragraphs 842-10-25-2 and 25-3), and paragraph 842-10-55-2c notes that a
reasonable approach is to conclude that 90% or more amounts to substantially all. That threshold also is mentioned in
many other areas of U.S. GAAP and generally has been applied in a similar manner.
ACCOUNTING FOR LEASES UNDER ASC 842 30
Example 3B – Retail Space (Continued)
FACTS
Retailer enters into a contract with Airport Operator for the use of retail unit A for a five-year period.
Retail unit A is part of a larger airport terminal with many retail units.
Retailer is required to use retail unit A to operate its well-known store brand to sell its goods during the
hours that the airport terminal is open.
Retailer pays Airport Operator $50,000 per month plus 6% of monthly net sales.
ANALYSIS
Is there an identified asset? Yes
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes
Retailer has exclusive use of retail unit A and therefore obtains substantially all of the economic benefits from use of
the retail unit throughout the period of use. Although Retailer will pay Airport Operator a portion of the cash flows
derived from sales in retail unit A (i.e., 6% of monthly net sales), this represents consideration that Retailer pays to
Airport Operator for the use of retail unit A and it does not affect the evaluation of the economic criterion in
accordance with paragraph 842-10-15-19.
CONCLUSION
The analysis continues to determine whether Retailer has the right to direct the use of retail unit A. See Power
Criterion section for additional discussion.
Example 4B – Rail Cars (Continued)
FACTS
Smith & Company (SmithCo) enters into an agreement with Freight Systems Limited (Freight) under which
Freight provides SmithCo with the use of ten rail cars of a particular type for five years.
The contract specifies the rail cars, which are owned by Freight. When the rail cars are not in use, they
are stored at SmithCo’s property.
ANALYSIS
Is there an identified asset? Yes
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes
SmithCo has the right to obtain substantially all of the economic benefits related to the use of the rail cars over the
five-year period of use because SmithCo has exclusive use of the cars during that period.
CONCLUSION
The analysis continues to determine whether SmithCo has the right to direct the use of the rail cars. See Power
Criterion section for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 31
Example 5 – Contract for Hosting Arrangement (Continued)
FACTS
Bank Company (“Bank”) enters into a hosting arrangement with Regional Hosting Co. (“Regional Hosting”)
under which Regional Hosting will provide a specific number of servers on which it will host software
licenses owned by Bank. In addition, Regional Hosting will provide connectivity to allow Bank to access the
software hosted by Regional Hosting.
Because of the number of users in Bank’s environment and the complexity of the software environment,
Regional Hosting must host Bank’s software on dedicated servers with specific security requirements, and
no other customer can be hosted on the same servers.
ANALYSIS
Is there an identified asset? Yes (Bank), No (Regional Hosting)
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes (Bank Only)
Regional Hosting must host Bank’s software on dedicated servers, which means no other customer can be hosted on
those servers. Accordingly, Bank has exclusive use of the servers and therefore it obtains substantially all of the
economic benefits from use of those servers.
CONCLUSION
The analysis continues to determine whether Bank has the right to direct the use of the servers. See Power Criterion
section for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 32
Example 7 (Adapted from paragraph 842-10-55-100 through 55-107) – Contract for Shirts
FACTS
Brand X enters into an agreement with Contract Manufacturing Company (“CMC”) 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.
CMC has only one factory that can meet the needs of Brand X and it is unable to supply the shirts from
another factory or source the shirts from a third-party supplier. The capacity of the factory significantly
exceeds the output for which Brand X has contracted.
CMC 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
Brand X’s contract.
ANALYSIS
Is there an identified asset? Yes
The agreement contains an implicitly specified asset because CMC can only fulfill the contract through the use of this
factory.
Is the economic criterion met? No
Brand X does not have the right to obtain substantially all of the economic benefits from use of the factory. CMC
could decide to use the factory to fulfill orders from other customers during the three-year term of the agreement,
and the capacity of the factory significantly exceeds the output for which Brand X has contracted.
Note that Brand X’s rights are also limited to specifying output from the factory in its contract, and it has only the
same rights regarding use of the factory as do any other customers purchasing shirts or other products from the
factory. CMC has the right to direct the use of the factory because it can decide how and for what purpose the
factory is used. Accordingly, the power criterion also would not be met.
CONCLUSION
The agreement does not contain a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 33
Example 8 – Contract for Gas Gathering
FACTS
Midstream Company (“Midstream”) owns and operates an oil and gas gathering system in a specific area
within the Permian basin. Midstream enters into a gas gathering agreement with Oil & Gas Company
(“O&G”) to provide gathering services for O&G in the area covered by Midstream’s gathering system for a
period of 10 years. The pipeline lateral used to fulfill the contract is connected to Midstream’s integrated
pipeline system.
The contract provides Midstream with the exclusive right to receive, gather and transmit all gas produced
by O&G in the area, and the system must always be available to transmit the gas produced by O&G.
However, Midstream retains certain rights associated with the pipeline lateral. For example, Midstream can
use the pipeline lateral to store other customers products, to use it for system balancing purposes, or to
take advantage of market price fluctuations through park and loan services. Midstream also has the right to
connect other pipelines to the pipeline lateral without O&G’s consent as long as Midstream continues to
service the volumes produced by O&G.
ANALYSIS
Is there an identified asset? Yes
The pipeline lateral is explicitly identified, and Midstream does not have an alternative asset that could be used to
fulfill the contract. Paragraph 842-10-15-16 also describes “a segment of a pipeline that connects a single customer
to the larger pipeline” as one example that is considered an identified asset.
Is the economic criterion met? No
Although Midstream’s system must always be available to transmit the gas produced by O&G, O&G does not have
exclusive use of the pipeline lateral because Midstream has the right to use the pipeline for other purposes. The
pipeline lateral can handle more capacity than the capacity requested by O&G and Midstream also can increase the
capacity of the pipeline lateral through various mechanisms. Midstream has the right to use that excess capacity for
its own economic benefits throughout the 10 years (for example, to store other customers’ products, for system
balancing purposes, to take advantage of market price fluctuations through park and loan services, etc.) and those
economic benefits are considered significant.
Note that O&G also can only request that Midstream transports the quantity of gas that it produces and does not
have the right to direct how and for what purpose the pipeline is used. Midstream retains the relevant decisions
about the use of the pipeline lateral throughout the 10 years. Those decisions include whether to store other
customers’ products or use excess capacity for other purposes, whether to connect additional pipelines, etc.
Midstream makes those decisions throughout the 10-year contract. Accordingly, the power criterion also would not
be met.
CONCLUSION
The agreement does not contain a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 34
POWER CRITERION
Paragraph 842-10-15-20 notes that the power criterion is met if:
a)
The customer can direct how and for what purpose the asset is used throughout the period of use (i.e., the
customer directs the relevant decisions during the period of use), or
b)
When
all
the relevant decisions are predetermined (for example, by design of the asset or contractual
restrictions), either:
1.
The customer has the right to operate (or direct others in operating) the asset throughout the period of use
with the supplier having no right to change those operating instructions, or
2.
The customer designed the asset (or specific aspects of it) in a way that predetermined the relevant
decisions throughout the period of use.
Determining which guidance in paragraph 842-10-15-20 to apply (i.e., a or b above) is key. So long as there is at least
one relevant decision to be made throughout the period of use, the guidance in (a) above should be applied. In other
words, the guidance in (b) applies only in situations in which all relevant decisions are predetermined in the contract.
We illustrate these considerations through the following scenarios:
ACCOUNTING FOR LEASES UNDER ASC 842 35
Accordingly, appropriately identifying the relevant decisions and determining whether those are predetermined or not
will be important. Example of relevant decision-making rights to consider in the analysis include the following:
Example Relevant
Decisions About How and
For What Purpose an Asset
Is Used
Corporate Jet Commercial Truck Retail Unit
Right to change the type of
output produced by the
asset
Deciding whether to
transport passengers
and/or cargo.
Deciding on the mix of
goods to transport.
Deciding on the mix of
products sold in the retail
store.
Right to change when the
output is produced
Deciding when the aircraft
flies.
Deciding when the truck is
used.
Deciding when the retail
store is open to customers.
Right to change where the
output is produced
Deciding where the
aircraft flies.
Deciding where the truck
will transport goods.
Not applicable.
Right to change whether
the output is produced and
how much output is
produced
Deciding whether to fly
the aircraft, how many
times the aircraft flies in a
specific period, and how
much cargo to transport.
Deciding whether to use
the truck, how many times
the truck is used, and how
much goods it transports.
Deciding whether to open
the retail store, how long
it is open, and how much
goods to sell to customers
during that period.
These rights are examples only and are neither determinative nor prescriptive. For example, a requirement to use an
asset in a specified location does not necessarily imply that the customer does not direct the use of the asset.
Example of decision-making rights that are not relevant include maintaining the asset or operating the asset (unless all
relevant decision-making rights are predetermined). While a right to operate the asset is essential to the use of the
asset, it is dependent on the decisions about how and for what purpose the asset is used. Accordingly, rights to
maintain or operate the asset can be held by the customer or the supplier but typically will not affect the analysis.
However, a right to operate the asset is a relevant decision when all relevant decision-making rights are
predetermined.
ACCOUNTING FOR LEASES UNDER ASC 842 36
The following flowchart summarizes the thought process for determining whether the customer has the right to direct
the use of an identified asset, and whether there is a lease (assuming all other conditions are met).
ACCOUNTING FOR LEASES UNDER ASC 842 37
Example 3B – Retail Space (Continued)
FACTS
Retailer enters into a contract with Airport Operator for the use of retail unit A for a five-year period.
Retail unit A is part of a larger airport terminal with many retail units.
Retailer is required to use retail unit A to operate its well-known store brand to sell its goods during the
hours that the airport terminal is open.
Retailer makes all the decisions about the use of retail unit A during the period that the airport terminal is
open (e.g., deciding on the mix of goods to sell, and at what price to sell the goods).
Retailer pays Airport Operator $50,000 per month plus 6% of monthly net sales.
ANALYSIS
Is there an identified asset? Yes
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes
See Economic Criterion section for additional discussion.
Is the power criterion met? Yes
The contractual restrictions on the types of goods that can be sold and when the store must be open define the
scope of Retailer’s use of retail unit A. Within that scope, Retailer makes the relevant decisions about how and for
what purpose the space is used (for example, how much inventory to hold at the store, the mix of its goods to sell,
the price of goods sold, etc.).
CONCLUSION
The contract contains a lease of retail space.
ACCOUNTING FOR LEASES UNDER ASC 842 38
Example 4B – Rail Cars (Continued)
FACTS
Smith & Company (SmithCo) enters into an agreement with Freight Systems Limited (Freight) under which
Freight provides SmithCo with the use of ten rail cars of a particular type for five years. The contract
specifies the rail cars, which are owned by Freight.
The agreement provides certain limitations on what types of goods SmithCo can transport, such as
hazardous materials or explosives, but otherwise, SmithCo has the right to determine whether the rail cars
are used, and if so, where, when and which products are transported using the rail cars. When the rail
cars are not in use, they are stored at SmithCo’s property.
If a particular car needs to be serviced or repaired, Freight is required to substitute a rail car of the same
type. Otherwise, Freight cannot retrieve the rail cars during the five-year period of the contract other
than on default by SmithCo.
ANALYSIS
Is there an identified asset? Yes
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes
See Economic Criterion section for additional discussion.
Is the power criterion met? Yes
SmithCo has the right to direct the use of the cars throughout the five-year period of use. The contractual
restrictions on the cargo that can be transported are protective rights of Freight and those define the scope of
SmithCo’s right to use the rail cars. Within that scope, SmithCo has the right to determine whether the rail cars are
used, and if so, where, when and which products are transported using the rail cars.
CONCLUSION
The contract contains a lease of ten rail cars.
ACCOUNTING FOR LEASES UNDER ASC 842 39
Example 5 – Contract for Hosting Arrangement (Continued)
FACTS
Bank Company (“Bank”) enters into a hosting arrangement with Regional Hosting Co. (“Regional Hosting”)
under which Regional Hosting will provide a specific number of servers on which it will host software
licenses owned by Bank. In addition, Regional Hosting will provide connectivity to allow Bank to access
the software hosted by Regional Hosting.
Because of the number of users in Bank’s environment and the complexity of the software environment,
Regional Hosting must host Bank’s software on dedicated servers with specific security requirements, and
no other customer can be hosted on the same servers. However, Regional Hosting has the right to rehome
Bank’s software onto different servers with similar security requirements without Bank’s approval so long
as access to its software licenses is uninterrupted.
Although Regional Hosting will provide monitoring services, Bank makes all decisions about which software
to load onto the servers, and what types and how much data to transmit using the servers.
ANALYSIS
Is there an identified asset? Yes (Bank), No (Regional Hosting)
See Identified Asset section for additional discussion.
Is the economic criterion met? Yes (Bank Only)
See Economic Criterion section for additional discussion.
Is the power criterion met? Yes (Bank Only)
Bank makes all decisions about which software to load onto the servers, and what types and how much data to
transmit using the servers. Those are the relevant how and for what purpose decisions.
CONCLUSION
Bank concludes the contract contains a lease of the servers.
ACCOUNTING FOR LEASES UNDER ASC 842 40
Example 9A (Adapted from paragraph 842-10-55-108 through 55-111) – Solar Farm
FACTS
County Electric Company (“CEC”) enters into a contract with Solar Power Co. (“Solar”) to purchase all of
the electricity produced by a new solar farm for 20 years. The solar farm is explicitly specified in the
contract, Solar has no substitution rights, and the energy cannot be provided from another asset.
CEC designed the solar farm before it was constructed – CEC hired experts in solar energy to assist in
determining the location of the farm and the engineering of the equipment to be used. Solar is
responsible for building the solar farm to CEC’s specifications and then operating and maintaining it on a
daily basis in accordance with industry-approved operating practices.
Solar will receive tax credits related to the construction and ownership of the solar farm, while CEC
receives renewable energy credits that accrue from the use of the solar farm.
ANALYSIS
Is there an identified asset? Yes
There is an identified asset because the solar farm is explicitly specified in the contract, and Solar does not have the
right to substitute the specified solar farm.
Is the economic criterion met? Yes
CEC takes all the electricity produced by the farm, as well as receives the renewable energy credits that are a by-
product from the use of the farm. Although Solar receives economic benefits from the solar farm in the form of tax
credits, those credits relate to the ownership of the solar farm rather than from its use, and thus are not considered
in the evaluation of the economic criterion. Accordingly, CEC receives 100% of the economic benefits from use of the
solar farm.
Is the power criterion met? Yes
There are no decisions to be made during the period of use about whether, when, or how much electricity will be
produced because the design of the asset has predetermined these decisions.
Although CEC does not operate the solar farm, its design of the farm has given it the right to direct the use of the
farm. Because the design of the solar farm has predetermined how and for what purpose the asset will be used
throughout the period of use, CEC’s control over that design is substantially no different from CEC controlling those
decisions.
CONCLUSION
The contract contains a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 41
Example 9B (Adapted from paragraph 842-10-55-112 through 55-116) – Solar Farm
FACTS
Assume the same fact pattern as in Example 9A, except that Solar designed the solar farm when it was
constructed prior to entering into the contract with CEC, and CEC had no involvement in that design.
ANALYSIS
Is there an identified asset? Yes
Same as Example 9A.
Is the economic criterion met? Yes
Same as Example 9A.
Is the power criterion met? No
As in Example 9A, the relevant decisions about how and for what purpose the solar farm is used are predetermined.
However, in contrast to Example 9A, CEC is not considered to direct the relevant decision-making rights about the
use of the solar farm because it did not design the solar farm and it does not operate the solar farm. Solar designed
the solar farm and operates it, and therefore Solar has the right to direct the use of the farm.
CONCLUSION
The contract does not contain a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 42
OTHER ILLUSTRATIONS
The three concepts (identified asset, economic criterion and power criterion) are explored further through various
additional examples below. Note that some of the examples may include nonlease components (which is discussed
further in the next chapter on Identifying and Separating Components
). The examples provided herein, and
conclusions reached focus solely on whether the contract is or contains a lease.
Example 10 – Contract for Printer
FACTS
Paper Co enters into a contract with Printers R Us for the exclusive use of a copy machine for three years.
Under the contract, the copier is explicitly specified by serial number, but Printers R Us has the right to
replace the copier at any time during the agreement, including in lieu of repairing it, without Paper Co’s
approval.
While the contract specifies a location for the copier, Paper Co has the right to move the copier to any of
its facilities upon three days written notice to Printers R Us which approval cannot be unreasonably
withheld, conditioned or delayed. Paper Co also has the right to decide when to use the copier and when
it uses it, how many copies it makes (subject to a limit of 5,000 copies per month).
ANALYSIS
Is there an identified asset? Yes
Although Printers R Us has the right to replace the copy machine at any time and without Paper Co’s approval, such
substitution would likely not generate an economic benefit for Printers R Us. As noted in paragraph 842-10-15-12, if
the asset is located at the customer’s premises, then the costs associated with substitution are likely to exceed the
benefits associated with substituting the asset. Specifically, in this example Printers R Us would incur costs to
substitute the copy machine, such as employee time and costs of transporting and installing another copy machine
and removing and transporting back the original copy machine. It is not likely that events or circumstances would
arise at contract inception from which Printers R Us would generate more cash flows by substituting the copy
machine than the costs it would incur. In addition, as noted in paragraph 842-10-15-14, rights to substitute identified
equipment solely for repairs and maintenance are not substantive. Accordingly, Printers R Us’ substitution right is
not substantive and there is an identified asset.
Is the economic criterion met? Yes
Paper Co has the right to obtain substantially all of the economic benefits from the use of the copier because it has
exclusive use of the copier.
Is the power criterion met? Yes
While Printers R Us has the right to approve before Paper Co can move the printer to another location, Printers R Us’
right is protective in nature. The 5,000-copy limit per month also protects Printers R Us’ copier and in effect defines
the scope of the contract. Within that scope, Paper Co has the right to direct the use of the copier, including when
to use it and for how long, how many copies to make (subject to the limit) and where to use it throughout the three-
year period. Those decisions are the relevant decisions that impact the economic benefits from use of the copier.
CONCLUSION
Therefore, the contract contains a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 43
Example 11 – Contract for Syrup Dispensers and Supplies
FACTS
Pizzeria Co. enters into a syrup supply agreement with Beverage Co. under which Beverage Co. agrees to
supply soft drink syrup to Pizzeria Co. for three years. In addition, Beverage Co. will provide dispensers
that combine the syrup with CO
2
to deliver soft drinks to Pizzeria Co.’s customers.
Pizzeria Co. is responsible for purchasing the CO
2
and for maintaining the dispensers, and the agreement
prohibits Pizzeria Co. from using the dispensers with another supplier’s syrup.
Beverage Co. will provide two maintenance services per year per store to repair the dispensers at no
charge, but additional maintenance visits will be charged on a time and materials basis.
The contract stipulates a fixed monthly payment and a variable payment based on the volume of syrup
purchased by Pizzeria Co.
4
ANALYSIS
Is there an identified asset? Yes
While the agreement does not explicitly specify the individual beverage dispensers, the units are implicitly specified
because the dispensers are required for Beverage Co. to fulfill its promise under the arrangement, and once
installed, Beverage Co. has no right to substitute the installed equipment.
Is the economic criterion met? Yes
Pizzeria Co. has exclusive use of the beverage dispensers.
Is the power criterion met? Yes
Pizzeria Co. has the right to direct the use of the dispensers including determining when and how often to use them.
The fact that the agreement prohibits Pizzeria Co. from using the dispensers with another supplier’s products is a
protective right that defines the scope of the contract but does not prevent Pizzeria Co. from controlling the use of
the dispensers.
CONCLUSION
The contract contains a lease.
4
Other contract types with only variable payments and the right, but not the obligation, for Pizzeria Co. to purchase syrup from
Beverage Co. require careful consideration of the specific facts and circumstances, including the price at which the consumables are
sold and the significance of the equipment in the context of the contract.
ACCOUNTING FOR LEASES UNDER ASC 842 44
Example 12 – Contract for Servers and Other IT Equipment Space
FACTS
The owner of a co-location warehouse (“Co-Lo”) enters into an agreement with Software Company
(“Software”) under which Software will install its servers and other IT equipment used to host and run its
software platform.
The agreement identifies specific space within the larger warehouse for Software to use, and indicates
that Co-Lo does not have the right to relocate Software’s equipment once it is installed.
The space that Software will occupy does not represent substantially all of the capacity of the warehouse.
However, Software is required to install cages and other barriers that segregate its equipment from the
rest of the warehouse, thus effectively physically segregating the space it is using.
ANALYSIS
Is there an identified asset? Yes
Although the space is not initially a physically distinct portion of the larger warehouse and the space occupied does
not represent substantially all of the capacity of the warehouse, the caging and other barriers required to be
installed by Software render the space physically distinct and allow Software to control access to that specific
space. In addition, Co-Lo has no ability to substitute comparable space throughout the term of the contract.
Therefore, there is an identified asset.
Is the economic criterion met? Yes
Because Software has the right to control access to the specified space, it has the right to obtain substantially all of
the economic benefits from use of the space (it has exclusive use of it).
Is the power criterion met? Yes
Software has the ability to make decisions about whether to use the space, and if so, when, how and how much to
use the space.
CONCLUSION
The contract contains a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 45
Example 13 – Contract for Smart Safes
FACTS
EZ Co owns and operates a group of convenience stores. EZ Co enters into an agreement with State Bank
in which State Bank will provide armored car services to EZ Co for three years.
During the term of the contract, State Bank will collect cash and checks from each store location three
times per week, and those dates and times are predetermined in the contract and cannot be changed
absent emergency situations.
Assume that the armored car services do not include a lease because State Bank serves many customers
with the armored cars and therefore those are not the subject of this example.
State Bank also provides one smart safe for each store location. Once installed at EZ Co’s locations, State
Bank cannot substitute the smart safe. The smart safe is connected electronically to State Bank’s system
and will transmit the value of cash and checks deposited into the safe to State Bank such that EZ Co
receives credit in its bank account with State Bank within 24 hours of that deposit.
Only State Bank has the right and ability to access the smart safes. Once an EZ Co employee deposits cash
or checks into the safe, EZ Co cannot retrieve those items prior to State Bank’s armored car service
collecting them. However, EZ Co decides when to make deposits, as well as how much cash to deposit
versus how much to retain for operating purposes.
ANALYSIS
Is there an identified asset? Yes
Each smart safe is implicitly specified once it is installed at the convenience store location, and State Bank does not
have any substitution rights.
Is the economic criterion met? Yes
EZ Co obtains substantially all of the economic benefits from use of the safes throughout the three-year period of
use because it has exclusive use of those safes. No other customer of State Bank can use the safes.
Is the power criterion met? Yes
Although State Bank has the right to access the safes to collect the funds deposited in them, that access is
predetermined in the contract (the dates and times are predetermined in the contract and cannot be changed
absent emergency situations). The ability to access the safes also would not grant State Bank the right to determine
how and for what purpose the safe is used given the fact that State Bank gives EZ Co access to funds deposited in the
safe in EZ Co’s bank account prior to the funds actually being collected by State Bank. On the other hand, EZ Co
determines whether to use the safe, and if so, when to use it and how much cash and checks to deposit into the safe
throughout the period of use. Those are the most relevant decision-making rights that affect the economic benefits
from use of the safes, and EZ Co (the customer) controls them.
CONCLUSION
The contract contains a lease (each smart safe is a lease).
ACCOUNTING FOR LEASES UNDER ASC 842 46
Example 14 – Contract for Offshore Drilling Rig
FACTS
Big Oil Inc. (“BOI”) enters into an agreement with Drilling Company (“DrillCo”) whereby DrillCo will
provide BOI with a specific offshore drilling rig for use in a specified geographical area in the Gulf of
Mexico in which BOI has exclusive exploration rights. DrillCo has no other drilling rig in the Gulf of Mexico
which could be used to fulfill the contract and DrillCo could not source another similar drilling rig within a
reasonable period of time.
DrillCo will provide the employees and management expertise necessary to operate the drilling rig.
However, DrillCo will operate the rig under BOI’s instructions (for example, where to drill, how long to
drill and at what depth, and where to drill next).
The initial term of the agreement is two years and the agreement automatically renews for additional
three-month periods unless either party provides a notice of non-renewal.
During the period of the agreement, DrillCo will provide drilling services to BOI using the identified drilling
rig.
ANALYSIS
Is there an identified asset? Yes
The agreement specifies the drilling rig and DrillCo has no other rig which can be used to fulfill the contract or that
DrillCo could source within a reasonable period of time.
Is the economic criterion met? Yes
BOI receives substantially all of the output from use of the drilling rig because it has exclusive use of the rig. DrillCo
cannot use the rig to provide services to any other customer during the term of the agreement, both contractually
and practically, because BOI has exclusive exploration rights in that geographical area.
Is the power criterion met? Yes
Although DrillCo operates the drilling rig, and operating the rig is essential to the efficient use of the rig, the right to
operate the rig is dependent on the relevant how and for what purpose decisions the rig is used (which are where to
drill, how long to drill and at what depth, and where to drill next, etc.). BOI is the party that controls those relevant
decisions throughout the period of use.
CONCLUSION
The contract contains a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 47
Example 15 – Contract for Processing Return of Handsets
FACTS
Telco enters into an agreement with Logistics Company which requires Logistics Company to build a
warehouse in a specified geographic area. Logistics Company is the legal owner of the warehouse and
continues to be throughout the term of the contract.
Assume that the agreement does not result in Telco controlling the warehouse under construction based on
the guidance in paragraph 842-40-55-5.
While Logistics Company has some latitude in selecting the location of the warehouse, it must be located
in the specified area, and once constructed it cannot be relocated or substituted, even within the
specified area, absent extraordinary circumstances (for example, destruction by fire).
For the five-year term of the agreement, Logistics Company will process all returned handsets directed by
Telco to this warehouse pursuant to repair instructions provided by Telco. If Telco does not direct
handsets to the warehouse, then the warehouse does not operate. Logistics Company is not allowed to
service any customers other than Telco in the warehouse under the agreement.
Logistics Company is required to operate and maintain the warehouse daily in accordance with industry-
approved operating procedures.
ANALYSIS
Is there an identified asset? Yes
Once the location is selected and the warehouse constructed, Logistics Company does not have the right to
substitute the specified warehouse location.
Is the economic criterion met? Yes
If Telco does not direct handsets to the warehouse, the warehouse does not operate because Logistics Company is
not allowed to service other customers. In other words, Telco has exclusive use of the warehouse.
Is the power criterion met? Yes
Telco makes the relevant decisions about how and for what purpose the warehouse is used because it has the right
to determine whether, when and how many handsets are processed in the warehouse. Because Logistics Company is
precluded from using the warehouse for any other customer or purpose, Telco’s decision making about the timing
and quantity of handsets processed in effect determines whether and when the warehouse will be utilized.
CONCLUSION
The contract contains a lease.
ACCOUNTING FOR LEASES UNDER ASC 842 48
Chapter 3 - Identifying and Separating
Components
OVERVIEW
In Chapter 2, we discussed how to identify a lease. Once an entity concludes that a contract is or contains a lease, the
next step is to identify the components of the contract. Those components are the units of account that determine
which GAAP applies, and they only include those items or activities that transfer a good or service to the lessee. The
definition of a lease is based on the right to use an identified asset and, therefore, the lease component typically
represents the right to use that identified asset (such as the right to use a retail store). A contract may also include
one or more nonlease components (such as maintenance or security services for that retail store). In that scenario, the
lease component is accounted for under ASC 842, while the nonlease component(s) are generally accounted for under
other GAAP.
A contract may also include the lease of more than one asset. In those situations, the entity should evaluate how many
lease components there are. Generally, the right to use each individual asset represents a separate lease component.
For example, in a contract for the right to use two cars, each car represents a separate lease component, and the
contract therefore includes two lease components. But sometimes leases of multiple assets are accounted for as one
lease component depending on how dependent and interrelated, they are to each other. There are also specific
considerations for leases of land.
ACCOUNTING FOR LEASES UNDER ASC 842 49
Some items or activities do not transfer a good or service to the lessee and, therefore, are not considered components
of the contract. Those include:
Administrative tasks to set up the contract,
Cost that a lessor would incur in its role as a lessor or as owner of the underlying asset (e.g., property taxes
for which the lessor is the primary obligor and insurance that protects the lessor’s asset).
In addition to identifying the components of the contract, the entity must determine the consideration in the contract.
It typically includes fixed payments (including in-substance fixed payments) less incentives to the lessee, and variable
payments based on an index or a rate, measured using the index or rate at the commencement date. The consideration
may also include other payments depending on the contract’s terms, such as the exercise price of a lessee purchase
option if reasonably certain of exercise, or termination penalties if the lease term reflects exercise of a lessee
termination option. A lessee does not include variable payments other than those based on an index or a rate, while
lessors sometimes must include certain variable payments that relate specifically to nonlease components.
The following graph summarizes the consideration in the contract for lessees and lessors.
When a contract includes more than one lease component (for example, a contract with two lease components), or
includes a lease component and at least a nonlease component, the entity typically must separate and allocate the
consideration in the contract to those components, unless a practical expedient is elected (see below).
The allocation of the consideration is generally made on a relative standalone (selling) price basis, although lessors
must apply the allocation guidance in ASC 606.
Also, items or activities that do not transfer a good or service to the lessee do not receive an allocation of the
consideration in the contract because they are not considered components of the contract. This means that any
payments in the contract for these items or activities, whether fixed or variable, will generally be allocated to the
components of the contract as illustrated on the next page.
ACCOUNTING FOR LEASES UNDER ASC 842 50
However, lessees and lessors can elect a practical expedient by asset class not to separate the nonlease component(s)
from the associated lease component.
Lessees can generally apply the practical expedient without regard to conditions, and the combined component is
accounted for under ASC 842.
Lessors may account for each separate lease component and the nonlease components associated with that lease
component as a single lease component if the following three conditions are met:
The nonlease component(s) otherwise would be accounted for under ASC 606,
The timing and pattern of transfer of the lease component and nonlease component(s) associated with that
lease component are the same, and
The lease component, if accounted for separately, would be classified as an operating lease.
The accounting for the combined component then depends on which component of the contract is predominant which
will dictate whether the lessor applies ASC 842 or ASC 606.
ACCOUNTING FOR LEASES UNDER ASC 842 51
The following flowchart summarizes the key steps an entity should perform, which we will discuss in further details in
this chapter.
Note that the above flowchart assumes that for a lessor, the nonlease component(s) in the contract will either meet
the conditions to be combined with the lease component or won’t. Sometimes, there may be nonlease components
that meet the conditions, while some others don’t. For example, a contract may include a lease of equipment,
maintenance services related to that equipment, and a sale of consumables. In that situation, the lease component
and maintenance services may meet the criteria to be combined, but the consumables will not because they are not
provided over time. Therefore, if the lessor elected the practical expedient for the asset class, the lessor should
allocate the consideration in the contract between the combined component (the lease component and maintenance)
and the other nonlease component, which is the consumables. We will discuss this in further details in Separating
Components – Lessors section below.
ACCOUNTING FOR LEASES UNDER ASC 842 52
IDENTIFYING LEASE AND NONLEASE COMPONENTS
IDENTIFYING COMPONENTS OF THE CONTRACT
Components of a contract include only those items or activities that transfer a good or service to the lessee. Some
other items or activities are not components.
Lease component examples Nonlease component examples Noncomponent examples
Right to use real estate,
such as a retail store.
Right to use computer
equipment.
Right to use a vehicle, such
as a truck.
Repairs and maintenance,
common area maintenance.
Other goods or services
provided to the lessee,
such as security services,
operating the asset (e.g., a
vessel, a drilling rig), sale
of consumables, etc.
Certain administrative tasks
to initiate the contract
(e.g., set up activities).
Reimbursement of lessor
costs related to ownership
of the leased asset (such as
property taxes and
insurance that protects the
lessor’s asset).
Lessees and lessors must identify the individual lease components and nonlease components of the contract, but do not
have to separate the nonlease components from the associated lease component if a practical expedient to not
separate is elected (see discussion below).
LEASE COMPONENT SEPARATION GUIDANCE
ASC 842 provides guidance in paragraph 842-10-15-28 on identifying separate lease components:
In assessing the first condition, 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). An entity may consider the following questions in determining
whether this condition is met:
•
Is the asset readily sold or leased separately by the lessor or other suppliers?
•
Could the lessee readily lease or purchase an alternative asset to use with the other leased asset?
Lessee can benefit
from right of use
either on its own
or together with
other readily
available
resources
Right of use is
neither highly
dependent nor
highly interrelated
with other leased
assets
Separate lease
component
ACCOUNTING FOR LEASES UNDER ASC 842 53
In evaluating the second condition, a lessee’s right to use an underlying asset is highly dependent on or
highly interrelated with the right to use another underlying asset if each right of use significantly affects the
other. An entity may consider the following questions in determining whether this condition is met:
•
Can the lessor fulfill each of its obligations to lease one of the underlying assets independently of its
fulfilment of the other lease obligations?
•
Would there be significant costs and time for the lessor to be able to fulfill its obligation on each
leased asset?
•
Is the lessee’s ability to derive benefits from the lease of each asset significantly affected by its
decision to lease or not lease the other asset(s) from the lessor?
Lease Component Separation Guidance Similar to Guidance in ASC 606
The guidance in paragraph 842-10-15-28 on determining whether one or more lease components should be
accounted for separately is similar to the guidance in paragraphs 606-10-25-19 through 25-21 on determining
whether a good or service promised in a revenue contract is distinct, and therefore represents a separate
performance obligation. This linkage was intentional as ASC 842 incorporates concepts from ASC 606, and therefore
paragraph 842-10-15-28 should be applied in a manner similar to application of the guidance in ASC 606.
When applying paragraph 842-10-15-28, generally the right to use an underlying asset represents a separate lease
component. For example, in a contract for the right to use two cars, each car represents a separate lease component,
and the contract therefore includes two lease components. Also, while there are several potential underlying
components that comprise each car, including the engine, seats, etc., the integral parts of the car do not meet the
criteria for treatment as separate lease components. That is, the car is the lease component.
But in some cases, the right to use multiple underlying assets will represent a single lease component. Example 13 in
ASC 842-10-55 illustrates a contract for the lease of a gas-fired turbine plant that consists of the turbine housed within
a building together with the land on which the building sits. In that example, 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 the
lessee contracted (i.e, the right to use a gas-fired turbine plant that can produce electricity for distribution to the
lessee’s customers). Accordingly, they represent a single lease component (absent additional considerations for land –
see below). However, the fact that a lessee will use multiple underlying assets for one purpose is not sufficient to
conclude that the rights of use are highly interrelated or interdependent of each other. The FASB illustrated this in
Example 11 of ASC 842-10-55. We also illustrate it in the following examples.
ACCOUNTING FOR LEASES UNDER ASC 842 54
Example 1 - Lease of Helicopter and Jet
FACTS
Lessee enters into a lease of a helicopter and a private jet from Lessor for two years for its key
executives in the company for a specific project requiring significant travel.
Lessor agrees to maintain the helicopter and the jet throughout the contract term.
ANALYSIS
Lessee can benefit from each of the two assets on its own or together with other readily available
resources. For example, Lessee could readily lease or purchase an alternative helicopter or jet to use
with the other asset.
Although Lessee is leasing the helicopter and jet for one purpose (key executives’ travel related to a
specific project), the helicopter and jet are not highly dependent nor highly interrelated with each other.
The two assets are not, in effect, inputs to a combined 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 obligation, and Lessee’s ability to derive benefits from the lease of each asset is not
significantly affected by its decision to lease or not lease the other equipment from Lessor.
The maintenance services represent nonlease components because they provide Lessee with goods or
services separate from the lease of the jet and helicopter. Also, Lessor determines under ASC 606 that its
maintenance services for each piece of leased equipment are distinct and therefore are separate
performance obligations.
CONCLUSION
There are two separate lease components and two separate nonlease components, unless the entity elects the
practical expedient not to separate for this asset class, in which case:
For Lessee, the contract has two separate lease components under ASC 842 (see Separating Components –
Lessee section for additional details),
For Lessor, the contract has either two separate lease components under ASC 842 or two separate
performance obligations under ASC 606 depending on predominance (see Separating Components – Lessor
section for additional details).
ACCOUNTING FOR LEASES UNDER ASC 842 55
Example 2 - Lease of Air Purification System
FACTS
Clean Air Co. provides air purification systems, primarily to hospitals and other healthcare facilities,
under leasing arrangements.
Each system consists of multiple air filters and related equipment installed throughout the lessee’s
facility, in an amount and at locations determined based on the size and design of the facility.
Lessee enters into a contract with Clean Air Co. for an air purification system that can filter the air at
Lessee’s healthcare facility and for maintenance of the system.
Assume the contract contains a lease.
ANALYSIS
Because of airflow throughout Lessee’s facility, any individual air filter is ineffective on its own.
Achieving air purification requires the full complement of air filters and related equipment provided in
the arrangement.
Therefore, the use of each air filter and related equipment used for the air purification system is highly
dependent on the use of the other air filters and equipment. Each is an input to the customized combined
item for which Lessee has contracted (that is, the right to use an air purification system that can filter
the air at Lessee’s healthcare facility).
The maintenance services represent a nonlease component because they provide Lessee with goods or
services separate from the lease. Also, Clean Air Co. determines under ASC 606 that its maintenance
services represent a single performance obligation.
CONCLUSION
The contract contains one lease component (the right to use the air purification system) and one nonlease
component (maintenance of the system), unless the entity elects the practical expedient not to separate for this
asset class, in which case:
For Lessee, the contract has one lease component under ASC 842 (see Separating Components – Lessee
section for additional details).
For Lessor, the contract has either one lease component under ASC 842 or one performance obligation
under ASC 606 depending on predominance (see Separating Components – Lessor section for additional
details).
ACCOUNTING FOR LEASES UNDER ASC 842 56
Example 3 - Lease of Light Fixtures
FACTS
Lighting Co. provides energy-efficient light fixtures, primarily in industrial settings, under leasing
arrangements. Payments under the leasing arrangements are based on calculated cost savings to lessees.
Each arrangement consists of multiple light fixtures installed throughout the lessee’s facility, in an
amount and at locations determined based on the size and design of the facility.
Lessee enters into a contract with Lighting Co. for energy-efficient light fixtures.
Assume the contract meets the definition of a lease.
ANALYSIS
Lessee can benefit from each of the light fixtures on its own or together with other readily available
resources. For example, Lessee could readily lease or purchase alternative light fixtures.
The purpose of the light fixtures is to provide a lower cost alternative to traditional lighting solutions.
However, each light fixture provides a similar estimated cost saving and would provide the same level of
cost savings regardless of whether each light fixture was installed on its own, or as part of a larger
installation. Therefore, the right to use each light fixture is neither highly dependent on nor highly
interrelated with the use of the other light fixtures.
CONCLUSION
The contract contains multiple lease components; that is, each light fixture is a separate lease
component.
Lessee and Lighting Co cannot apply the practical expedient not to separate to this contract because
there are no nonlease components in the contract. However, the entity may consider applying a portfolio
approach (see Portfolio Approach section).
ACCOUNTING FOR LEASES UNDER ASC 842 57
SPECIFIC CONSIDERATIONS FOR LAND
Irrespective of the guidance discussed above on separating lease components, ASC 842 requires a lease of land to be
accounted for as a separate lease component unless the accounting effects of such separation would be insignificant.
Paragraph 842-10-15-29 discusses two examples in which the accounting effect is insignificant:
Separating the land component would not affect lease classification of any lease components,
The amount recognized for the land lease component would be insignificant.
The Board noted in paragraph BC147 of ASU 2016-02 that “land, by virtue of its indefinite economic life and
nondepreciable 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.”
Identifying Leases of Land
Determining whether a contract includes a lease of land will depend on the facts and circumstances. In some cases,
the analysis will be straightforward. For example, a contract for a lessee to lease an entire office building will
include a lease of land on which the building sits, regardless of whether such lease of land is explicitly stated in the
contract, because the lessee is leasing the entire building and therefore also exclusively benefits from the use of
the land. In other cases, further analysis may be required. For example, in a contract for a lessee to lease retail
space in a shopping mall, the analysis may depend on whether the lessee is the anchor tenant (and whether that
anchor tenant occupies substantially all the shopping mall space), or another tenant that leases a smaller space
(e.g., a lessee that leases a retail space on the second floor).
If it is determined that the contract includes a lease of land, the entity must account for the lease of land
separately from the lease of the other assets unless doing so would be immaterial (e.g., lease classification would
not change for either components, or the lease of land is immaterial).
ACCOUNTING FOR LEASES UNDER ASC 842 58
Example 4 - Lease of Land and Building
FACTS
Lessor and Lessee enter into a five-year lease of a single-story commercial office building.
Lessee has exclusive use of the building (i.e., it is a single-tenant office building).
The contract requires Lessee to pay Lessor for real estate taxes and insurance. Lessor is the primary
obligor for the real estate taxes (regardless of whether Lessor leases the building and who the lessee is).
Lessor is also the named insured on the insurance, which protects Lessor’s investment in the building.
The lease requires Lessor to perform landscaping services for Lessee.
ANALYSIS
Regardless of whether the contract explicitly provides for the lease of land, the contract includes a lease
of land because Lessee has exclusive use of the commercial office building, and therefore also exclusively
benefits from use of the land on which the building sits.
The lease of land and building are highly dependent on or highly interrelated with each other because
each right of use significantly affects the other. However, because the contract contains a lease of land,
Lessee and Lessor must consider the guidance in paragraph 842-10-15-29. Lessor and Lessee each
conclude that the effect of accounting for the land lease component separately would be insignificant. In
this contract, Lessee’s right to use the land and building is coterminous and separating the two
components would not change lease classification of either the land or building lease component.
The real estate taxes and insurance on the building are not considered components of the contract
because they are considered reimbursements of Lessor’s costs for the land and building. See Separating
Components – Lessee section and Separating Components – Lessor section for additional considerations on
taxes and insurance.
Finally, the landscaping services is a nonlease component because it transfers a good or service to Lessee
separate from the lease of land and building. Lessor also determines under ASC 606 that the landscaping
nonlease component represents a single performance obligation.
CONCLUSION
The contract includes two components: a single lease component (comprising the right to use the land
and building), and a nonlease component (landscaping services), unless the entity elects the practical
expedient not to separate for this asset class.
See Separating Components – Lessee section for additional guidance on accounting for the components
and Example 4A for a continuation of this Example for Lessee.
See Separating Components – Lessor section for additional guidance on accounting for the components
and Example 4B for a continuation of this Example for Lessor.
ACCOUNTING FOR LEASES UNDER ASC 842 59
Example 5 - Lease of Office Space
FACTS
Lessor and Lessee enter into a five-year lease for one floor in a 30-story office building in New York City.
Lessee has exclusive use of the floor.
The lease requires Lessor to perform common area maintenance (CAM) services.
The contract requires Lessee to reimburse Lessor for its pro-rata share of real estate taxes and insurance
incurred by Lessor on the building, and CAM charges. The CAM charges can be adjusted upward and
downward based on actual work performed by Lessor.
ANALYSIS
The contract does not include a lease of land because Lessee does not occupy substantially all of the
building (i.e., the land on which the building sits is shared by all of the tenants in the building).
The real estate taxes and insurance Lessee will pay to Lessor are not considered components of the
contract because they are considered reimbursements of Lessor’s costs for the building. See Separating
Components – Lessee section and Separating Components – Lessor section for additional considerations on
taxes and insurance.
The common area maintenance service is a nonlease component because it transfers a good or service to
Lessee separate from the lease of the floor. Lessor also determines under ASC 606 that the common area
maintenance represents a single performance obligation.
CONCLUSION
The contract includes two components: one lease component and one nonlease component (common area
maintenance services), unless the entity elects the practical expedient not to separate.
See Separating Components – Lessee section for additional guidance on accounting for the components
and Example 5A for a continuation of this Example for Lessee.
See Separating Components – Lessor section for additional guidance on accounting for the components
and Examples 5B and 5C for a continuation of this Example for Lessor.
ACCOUNTING FOR LEASES UNDER ASC 842 60
SEPARATING COMPONENTS - LESSEES
DETERMINING THE CONSIDERATION IN THE CONTRACT
The consideration in the contract for a lessee is determined by applying paragraphs 842-10-15-35 and 842-10-30-5 and
includes the following payments that will be made during the lease term:
For a lessee, the sum of the above payments represents the total consideration in the contract, which the lessee
allocates to the separate lease and nonlease components of the contract, unless the lessee elects the practical
expedient to not separate for this asset class (see discussion below).
Variable payments that depend on an index or a rate are initially measured using the index or rate at the
commencement date. Subsequent changes to the index or rate during the lease term are accounted for as variable
payments, unless the lessee is required to remeasure the lease for other reasons (see Accounting for Leases – Lessees
for details).
Variable payments that do not depend on an index or a rate are not included in the determination of the total
consideration in the contract. This includes variable payments based on the performance of the asset, such as
payments based on a percentage of sales of the lessee, or reimbursement of actual costs incurred by the lessor (such as
property taxes and insurance).
Chapter 4 on Lease Classification and Key Terms
discusses further details on in-substance fixed payments, lease
incentives, purchase options and termination options.
ACCOUNTING FOR LEASES UNDER ASC 842 61
PROPERTY TAXES AND INSURANCE CONSIDERATIONS
A lessee’s requirement to pay costs that the lessor may incur in its role as a lessor or as owner of the underlying asset
do not transfer a good or service to the lessee separate from the lease. Example 12, Case A of ASC 842-10-55 provides
an example of a real estate lease and explains that:
The property taxes on the building would be owed by the lessor regardless of whether it leased the building
and who the lessee is; and
For the insurance, the lessor is the named insured on the building insurance policy and therefore the
insurance protects the lessor’s investment in the building.
Accordingly, the lessee paying those costs solely represents a reimbursement of the lessor’s costs. The fact that the
lessee pays a third-party, including the taxing authority, rather than reimbursing the lessor does not change this
conclusion. Also, the classification of a lease (e.g., as operating versus finance lease for the lessee) does not affect the
analysis of whether costs are considered lessor costs or lessee costs.
The accounting by a lessee for reimbursement of lessor costs depends on whether the payments are fixed or variable.
Payments are fixed Payments are variable
Payments are included in the consideration in the
contract, which is allocated to the lease and nonlease
components in the contract on a relative standalone
price basis, unless the lessee elects the practical
expedient not to separate for the asset class. Those
payment amounts (or a portion of those if there are
nonlease components) will affect the measurement of
the lease on balance sheet.
Payments do not represent variable payments based on
an index or a rate and, therefore, are not included in
the consideration in the contract. Once the variable
payments are incurred, they will be allocated between
the lease and nonlease components using the same
allocation as at contract’s inception, or most recent
reallocation.
Example: Lessee is required to pay lessor a fixed
amount per year for insurance coverage on the leased
asset.
Example: Lessee is required to reimburse lessor for
actual property taxes due on the asset under lease.
Property taxes do not represent an index or a rate, and
therefore are considered variable payments.
In some cases, there may be additional complexity in differentiating between lessee costs and lessor costs, particularly
for insurance contracts for which there may be elements benefitting the lessor (e.g., protecting the leased asset) and
others benefitting the lessee (e.g., protecting the lessee’s owned assets or other contingencies). In those situations,
additional analysis may be required to determine the portion of the payments that represent lessor costs (i.e., portion
of the premium that protects the lessor’s asset). Amounts that are considered lessee costs (i.e., portion of the
premium protecting the lessee’s assets) do not affect the accounting for the lease.
ACCOUNTING FOR LEASES UNDER ASC 842 62
SALES TAXES AND SIMILAR TAXES
When an entity enters into a lease, taxes may be assessed on the contract by a governmental authority. Those taxes
may be both imposed on and concurrent with a specific lease revenue-producing transaction and collected by the
lessor from a lessee. This includes for example sales, use, value added, and some excise taxes. Unlike lessors (see
Separating Components – Lessor section), lessees do not have a practical expedient to not assess such taxes.
Accordingly, a lessee is required to analyze sales taxes and other similar taxes on a jurisdiction-by-jurisdiction basis to
determine whether those taxes are the primary obligation of the lessor as owner of the underlying asset being leased
(i.e., the tax is a lessor cost) or whether those taxes are collected by the lessor on behalf of third parties (i.e., the tax
is a lessee cost).
If a lessor cost, the tax is accounted for either as part of the consideration in the contract (if the payments
are fixed) or as variable payments that do not depend on an index or a rate.
If a lessee cost, the tax typically does not impact lease accounting for the contract.
Like property taxes and insurance discussed above, the fact that the lessee pays a third-party directly rather than
reimbursing the lessor for the tax does not impact this conclusion.
PRACTICAL EXPEDIENT NOT TO SEPARATE
A lessee may elect as an accounting policy election by asset class, to not separate nonlease components from lease
components and instead, to account for each separate lease component and nonlease components associated with that
lease component as a single lease component.
The FASB provided this practical expedient to reduce cost and complexity in applying ASC 842. However, the election
of the practical expedient results in a larger right-of-use asset and lease liability on balance sheet, and it may also
change classification from an operating to a finance lease (See Chapter 4
). Accordingly, companies will need to
consider the pros (e.g., simplicity) and cons (e.g., impact on accounting for the lease, including balance sheet) of
electing the practical expedient for their asset classes.
Nonlease Components “associated with” the Lease Component
ASC 842 does not define or provide guidance for determining whether a nonlease component is “associated with”
the lease component. A literal read of the requirements for the practical expedient may suggest that all nonlease
components, whether provided at a point in time or over time, that are associated with the lease component should
be combined with that lease component when the lessee elects the practical expedient. However, we note that ASC
842 illustrates in Example 11 of ASC 842-10-55 the application of the practical expedient to a contract in which the
nonlease component is maintenance services on construction vehicles. Paragraph BC 149 of ASU 2016-02 also notes
that “[t]he Board also decided that lessees should account for lease and nonlease (typically, service) components
separately (unless they elect the practical expedient) [Emphasis added].” Accordingly, we believe the practical
expedient to not separate was primarily intended for services and other nonlease components transferred over time
and that relate to the lease component (e.g., maintenance of a leased equipment, common area maintenance for a
lease of office space). For nonlease components provided at a point in time such as inventory purchases, we believe
a lessee will frequently conclude that the component is not associated with the lease component because the
lessee usually will be able to redirect the inventory and use it with a different asset, or to resell it in the market.
ALLOCATION OF CONSIDERATION TO LEASE AND NONLEASE COMPONENTS
If a lessee does not elect the practical expedient not to separate for an asset class, once the consideration in the
contract is determined and the components are identified, a lessee allocates the consideration to the lease and
nonlease components on a relative standalone price basis, based on the observable standalone price of each
component. A price is observable if it is the price at which either the lessor or similar suppliers sell similar lease or
nonlease components on a standalone basis.
ACCOUNTING FOR LEASES UNDER ASC 842 63
If observable standalone prices are not readily available, a lessee must estimate standalone prices maximizing the use
of observable information. A residual approach may be acceptable if the standalone price for a component is highly
variable or uncertain.
Paragraph BC156 in ASU 2016-02 states in part that “the allocation guidance for lessees is similar to that for lessors and
also is broadly consistent with that in previous GAAP.”
A lessee also allocates initial direct costs to the separate lease components on the same basis as the lease payments.
Example 6 – Lease of a Car
FACTS
Lessee leases a car for its salesperson from Dealership for three years.
Lessee has the right to drive the car for up to 15,000 miles per calendar year and to bring the car into the
maintenance department of Dealership once per quarter for regularly scheduled maintenance as defined
in the lease agreement.
The contract provides for a fixed payment of $415 per month.
Lessee is required to maintain full coverage insurance on the car to protect Dealership’s asset. Lessee
must contract directly with an insurance agency of its choice.
Lessee is required to pay for any maintenance services required beyond regularly scheduled maintenance
defined in the contract.
At the end of the lease term, Lessee is required to make additional fixed payments on a per mile basis for
any mileage greater than 45,000 miles.
Assume there are no lease incentives or initial direct costs.
WHAT ARE THE COMPONENTS?
The contract contains two components: a lease component (lease of the car) and a nonlease component
(maintenance services). The insurance coverage is not a component. It does not transfer a good or
service separate from the lease of the car (it represents a lessor cost of owning the asset).
However, Lessee may elect to apply the practical expedient not to separate for this asset class, in which
case the contract would contain a single lease component.
WHAT IS THE CONSIDERATION IN THE CONTRACT?
The contract includes a fixed monthly payment of $415, payments for insurance (paid by Lessee directly
to the insurance company of its choice), payments for excess mileage at the end of the lease term, and
payments for extra maintenance.
Only the fixed monthly payment of $415 is included in the consideration in the contract. The other
payments are variable payments that do not depend on an index or a rate.
The consideration in the contract is $14,940 ($415 x 36 months).
ACCOUNTING FOR LEASES UNDER ASC 842 64
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
SCENARIO 1: Lessee elects practical expedient not to separate for this asset class.
In that situation, the contract includes only one component (i.e., the lease component).
The consideration in the contract of $14,940 is allocated entirely to the lease component and is used to
account for the lease (e.g., assess lease classification, recognize the lease on balance sheet, etc.).
All variable payments (for insurance, excess mileage and extra maintenance, if any) are considered
variable lease payments, which will be recognized in the period in which the obligation for those
payments is incurred. Lessee will also consider the guidance in paragraph 842-20-55-1 for variable
payments based on the attainment of 45,000 miles.
SCENARIO 2: Lessee does not elect practical expedient not to separate for this asset class.
In that case, Lessee allocates the consideration in the contract to the lease and maintenance components
on a relative standalone price basis. Lessee identifies observable standalone prices for the vehicle lease
and maintenance services. Lessee determines that it could enter into a maintenance agreement with an
unrelated service center for $30 per month, and Dealership commonly leases the same car on a
standalone basis for $400 per month. Therefore, the consideration in the contract is allocated to the
lease and non-lease components as follows:
Standalone Price
Relative
Standalone Price
Car lease
$14,400
$13,898 (93.02%)
Maintenance
1,080
1,042 (
6.98%)
$15,480
$14,940
The amount of the consideration allocated to the lease component ($13,898) is used to account for the
lease component (e.g., assess lease classification, recognize the lease on balance sheet, etc.).
The amount of consideration for the maintenance component ($1,042) is accounted for under other
GAAP.
All variable payments for insurance, excess mileage and extra maintenance will be allocated when
incurred using the same allocation basis as for the consideration in the contract (i.e., on a 93.02%/6.98%
basis).
ACCOUNTING FOR LEASES UNDER ASC 842 65
Example 4A - Lease of Land and Building (Continued) – Lessee Accounting
FACTS
Let’s continue with Example 4 in which Lessor and Lessee enter into a five-year lease of a single-story
commercial office building.
Lessee has exclusive use of the building (i.e., it is a single-tenant office building).
The lease requires Lessor to perform landscaping services for Lessee.
Lessee pays a fixed monthly payment of $12,000 per month in arrears which includes rent, landscaping
services, and reimbursement of Lessor’s costs.
Assume there are no lease incentives or initial direct costs.
WHAT ARE THE COMPONENTS?
As previously evaluated, the contract includes two components: a single lease component (comprising
the right to use the land and building), and a nonlease component (landscaping services).
However, Lessee may elect to apply the practical expedient not to separate for this asset class, in which
case the contract would contain a single lease component.
WHAT IS THE CONSIDERATION IN THE CONTRACT?
The consideration in the contract is $12,000 X 12 months X 5years = $720,000
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
SCENARIO 1: Lessee elects practical expedient not to separate for this asset class.
In that situation, the contract includes a single lease component.
The consideration in the contract of $720,000 is allocated entirely to the lease component and is used to
account for the lease (e.g., assess lease classification, recognize the lease on balance sheet, etc.).
SCENARIO 2: Lessee does not elect practical expedient not to separate for this asset class.
In that case, Lessee allocates the consideration in the contract to the lease component and landscaping
services component on a relative standalone price basis. Lessee determines the standalone prices for the
lease component and nonlease component are $680,000 and $50,000, respectively. Therefore, the
consideration in the contract is allocated to the lease and non-lease components as follows:
Standalone Price
Relative
Standalone Price
Lease component
$680,000
$670,685 (93.15%)
Maintenance component
50,000
49,315 (
6.85%)
$730,000
$720,000
The amount of the consideration in the contract allocated to the lease component ($670,685) is used to
account for the lease component (e.g., assess lease classification, recognize the lease on balance sheet,
etc.). The amount of consideration for the maintenance component ($49,315) is accounted for under
other GAAP.
ACCOUNTING FOR LEASES UNDER ASC 842 66
Example 5A - Lease of Office Space (Continued) – Lessee Accounting
FACTS
Let’s continue Example 5 in which Lessor and Lessee enter into a five-year lease for one floor in a 30-
story office building in New York City.
The lease requires Lessor to perform common area maintenance (CAM) services.
The contract requires Lessee to pay rent of $50,000 per month in arrears and to reimburse Lessor for
Lessee’s pro-rata share of real estate taxes and insurance incurred by Lessor on the building, and CAM
charges.
The pro rata share of those reimbursements is initially estimated at $9,000 per month ($5,000 for taxes
and insurance and $4,000 for CAM). The CAM charges can be adjusted upward and downward based on
actual work performed by Lessor.
Assume there are no lease incentives or initial direct costs.
WHAT ARE THE COMPONENTS?
As previously evaluated, the contract includes two components: one lease component (lease of the floor)
and one nonlease component (CAM services).
However, Lessee may elect to apply the practical expedient not to separate for this asset class, in which
case the contract would contain a single lease component.
WHAT IS THE CONSIDERATION IN THE CONTRACT?
The consideration in the contract is $50,000 X 12 months X 5years = $3,000,000.
The other payments Lessee will make to Lessor for its prorata share of real estate taxes, insurance and
CAM are variable payments that do not depend on an index or a rate. Therefore, they are not included in
the consideration in the contract.
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
SCENARIO 1: Lessee elects practical expedient not to separate for this asset class.
In that situation, the contract includes only one component (i.e., the lease component).
The consideration in the contract of $3,000,000 is allocated entirely to the lease component and is used
to account for the lease (e.g., assess lease classification, recognize the lease on balance sheet, etc.).
Lessee’s payments for its prorata share of property taxes, insurance and CAM are variable lease payments
that do not depend on an index or a rate and are excluded from the measurement of the lease liability.
Those variable lease payments are recognized in profit or loss when incurred.
ACCOUNTING FOR LEASES UNDER ASC 842 67
SCENARIO 2: Lessee does not elect practical expedient not to separate for this asset class.
In that case, Lessee allocates the consideration in the contract to the lease and CAM components on a
relative standalone price basis. Lessee determines the standalone prices for the lease component and
CAM component are $3,270,000 and $270,000, respectively. Therefore, the consideration in the contract
is allocated to the lease and non-lease components as follows:
Standalone Price
Relative
Standalone Price
Lease component
$3,270,000
$2,771,186 (92.37%)
CAM component
(1)
270,000
228,814 ( 7.63%)
$3,540,000
$3,000,000
(1)
Includes an appropriate profit margin
The amount of the consideration allocated to the lease component ($2,771,186) is used to account for the
lease component (e.g., assess lease classification, recognize the lease on balance sheet, etc.).
The amount of consideration allocated to CAM services ($228,814) is accounted for under other GAAP.
All variable payments for Lessee’s prorata share of real estate taxes, insurance, and CAM are allocated
using the same allocation basis as for the consideration in the contract (i.e., on a 92.37%/7.63% basis).
In the prior example, it is important to note that if the practical expedient not to separate is not elected, the variable
payments must be allocated between the lease and nonlease components despite the fact that the lease clearly
provides for specific charges related to the nonlease services, i.e. CAM. This is because a lessee is not allowed to
allocate variable consideration solely to the nonlease component, as lessors are allowed to.
APPLYING THE RESIDUAL APPROACH
In accordance with paragraph 842-10-15-33, if a lessee has elected to separate lease and non-lease components, then
it must allocate the consideration in the contract between the lease component(s) and the non-lease component(s) on
a relative standalone price basis. The guidance further states that “if observable standalone prices are not readily
available, the lessee shall estimate the standalone prices, maximizing the use of observable information.” The
guidance also indicates that “a residual estimation approach may be appropriate if the standalone price for a
component is highly variable or uncertain.”
Paragraph BC156 of ASU 2016-02 states in part that “the allocation guidance for lessees is similar to that for lessors and
also is broadly consistent with that in previous GAAP.” Lessors apply the allocation requirements in ASC 606, including
paragraph 606-10-32-34, which provides the guidance on the suitable methods for estimating the standalone selling
prices (including a residual approach). In accordance with paragraph 606-10-32-34(c), under the 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. [Emphasis added]” However,
the following criteria must also be met in order to use the residual approach:
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); or
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).
ACCOUNTING FOR LEASES UNDER ASC 842 68
As suggested by the guidance above, a lessee must have observable standalone prices for at least some of the
components in the contract to apply the residual approach. In other words, if the lessee does not have observable
standalone prices for any of the components, it must estimate the standalone price for all components. That is, the
lessee cannot use the residual approach.
In addition, in order for a lessee to meet the additional criteria and thus use the residual approach in a lease, the
entity i) would need to lease similar assets (for example, similar asset types and in a similar location) for a very broad
range of amounts indicating a representative standalone price is not discernible from past transactions or ii) has not
previously leased the applicable type of assets and is unable to determine a standalone price because there are no
similar transactions that the entity can use as a benchmark. It should be noted that the criteria in paragraph 606-10-
32-34(c) are deliberately very restrictive. Consequently, although a lessee could use the residual method if the criteria
are met, it is considered very unlikely that this will occur frequently in practice.
REMEASURING AND REALLOCATING THE CONSIDERATION
Inevitably, modifications to contracts and changes in facts and circumstances may occur during the contract term.
Paragraph 842-10-15-36 requires a lessee to remeasure the consideration in the contract and to reallocate the
consideration to the components in the contract when certain events occur. Those are:
The effective date of a contract modification that is not accounted for as a separate contract per paragraph
842-10-25-8, and
Remeasurements of the lease liability, such as a remeasurement resulting from a change in the lease term or
change in assessment of a lessee purchase option, per paragraph 842-20-35-4.
Events that require remeasurement will be discussed in further detail in Chapter 5, Accounting for Leases - Lessees.
However, a lessee’s requirement to reallocate the consideration in the contract would depend on whether it elected
the practical expedient not to separate for the relevant asset class.
ACCOUNTING FOR LEASES UNDER ASC 842 69
SEPARATING COMPONENTS - LESSORS
DETERMINING THE CONSIDERATION IN THE CONTRACT
The consideration in the contract for a lessor includes as a starting point the payments described in paragraphs 842-10-
15-35 and 842-10-30-5 (that is, the same payment amounts as those determined by the lessee, except that a lessor
does not include amounts probable of being owed under a lessee residual value guarantee).
The consideration also includes certain variable payments related to the lessor’s efforts in transferring (or an outcome
in transferring) one or more goods or services that are not leases, consistent with the guidance in ASC 606.
There are also additional considerations for sales taxes and similar taxes, and reimbursements of lessor costs which we
will discuss separately.
The following graph summarizes a lessor’s consideration in the contract.
VARIABLE PAYMENTS RELATED TO LESSOR’S EFFORTS OR OUTCOME
The consideration for a lessor includes variable payment amounts that would be included in the transaction price in
accordance with the guidance on variable consideration in ASC 606 when they relate specifically to:
the lessor’s efforts to transfer one or more goods or services that are not leases, or
an outcome from transferring one or more goods or services that are not leases.
Those amounts are included in the consideration in the contract if it is probable that a significant revenue reversal in
the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable
consideration is subsequently resolved (consistent with the constraint on variable consideration in ASC 606).
However, if the terms of a variable payment amount (other than those that depend on an index or a rate) relate to a
lease component, even partially, the lessor does not include those payments in the consideration in the contract.
Example 14 in ASC 842-10-55 illustrates this guidance to a contract for the lease of equipment that includes
maintenance for which consideration is a fixed amount plus a variable payment amount based on a minimum number of
hours that the asset operates at a specified level of productivity. In Cases B and C of that example, the variable
payment amounts for maintenance are included in the consideration in the contract because the maintenance services
on the equipment are highly specialized and no entity would expect the equipment to meet the performance metrics
without the specialized maintenance services.
In real estate scenarios, examples of variable payments that would not be included in the consideration in the contract
include variable payments of the lessor’s property taxes and insurance, or payments based on sales of the lessee. This
is because those payment amounts relate at least partially to the lease component. Example of variable payments that
would be included in the consideration in the contract include payments for common area maintenance (CAM) services
if such payments relate solely to the lessor’s efforts to provide the CAM services.
ACCOUNTING FOR LEASES UNDER ASC 842 70
However, even if variable payments relate specifically to the nonlease component(s), when a lessor elects the
practical expedient not to separate for the asset class (assuming the nonlease component qualifies for combination
with the lease component and the lease component is the predominant component), the variable payments are not
included in the consideration in the contract. This is because the lessor elected the practical expedient and the
variable payments now relate to the lease component. See further discussion below on the lessor practical expedient.
Assessment on Variable Payments by Lessor in accordance with ASC 606
The treatment of variable payments other than those based on an index or a rate is one major difference in the
determination of the consideration in the contract between lessees and lessors. Determining whether certain
variable payments relate solely to a nonlease component may require significant judgment, as may estimating the
consideration, subject to the constraint in accordance with ASC 606. Lessors that engage in transactions with
significant variable payments may consider developing a policy to assess in a consistent manner the nature of
variable payments including earning mechanisms and triggering points for payment to assess whether such
payments are solely related to a nonlease component in accordance with paragraph 842-10-15-39.
REIMBURSEMENT OF LESSOR COSTS
As previously explained, lessor costs such as property taxes on the underlying asset and insurance that protects the
lessor’s asset, are not considered a component of the contract. Absent guidance to the contrary, a lessor would be
required to report such lessor costs on a gross basis (i.e., as revenue and expenses) whether the lessee reimburses the
lessor or pays such costs on lessor’s behalf to a third-party. However, when the lessee pays a third-party directly,
lessors noted that reporting those costs in profit or loss would be costly and complex because the lessor may not have
visibility into the actual amounts paid by the lessee and therefore may need to estimate those amounts. Lessors also
questioned the usefulness of amounts reported because those often would be based on estimates that are affected by
lessee-specific factors (for example, insurance premiums paid by the lessee for a policy that protects both the lessor’s
asset and other assets that the lessee owns, amount of deductible selected by the lessee, etc.).
Accordingly, notwithstanding the guidance on variable payments discussed previously, the accounting for lessor costs is
as follows:
Lessee pays lessor costs directly to a third-party Lessor pays costs and is reimbursed by lessee
Exclude from variable payments.
In other words, treat like a lessee cost, which
does not affect the accounting for the lease.
Account for costs excluded from the consideration
in the contract as lessor costs (i.e., as variable
payments).
In other words, recognize on a gross basis.
SALES TAXES AND SIMILAR TAXES
A lessor can make an accounting policy election to exclude from the consideration in the contract and from variable
payments not included in the consideration 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. This
includes for example sales, use, value added, and some excise taxes. Absent that practical expedient, the analysis of
sales taxes and similar taxes could be costly and complex depending on the number of jurisdictions and the variation
of, and changes in, tax laws among those jurisdictions.
This practical expedient is consistent with the practical expedient provided in ASC 606 and reduces costs and
complexity in assessing sales taxes and similar taxes. When the lessor makes the election, it should comply with the
disclosure requirements in paragraph 842-30-50-14.
However, taxes assessed on a lessor’s total gross receipts or on the lessor as owner of the underlying asset (e.g.,
property taxes – see discussion above) are excluded from the scope of this election.
ACCOUNTING FOR LEASES UNDER ASC 842 71
PRACTICAL EXPEDIENT NOT TO SEPARATE
In July 2018, the FASB issued ASU 2018-11, which provides lessors with a practical expedient similar to lessees to not
separate lease and nonlease components by asset class, if certain criteria are met.
As provided by paragraph 842-10-15-42A, a lessor may, as an accounting policy election by asset class, 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 lease component if the following three
conditions are met:
The nonlease component(s) otherwise would be accounted for under ASC 606,
The timing and pattern of transfer of the lease component and nonlease component(s) associated with that
lease component are the same, and
The lease component, if accounted for separately, would be classified as an operating lease.
Also, in accordance with paragraph 842-10-15-42B, for arrangements that qualify for the scope of this practical
expedient, the way in which a lessor accounts for the combined component depends on predominance:
Nonlease component(s) is (are) predominant Lease component is predominant
Account for combined component as a single
performance obligation under ASC 606.
Account for the combined component as a single
lease component under ASC 842.
Use same measure of progress used in
determining whether the arrangement qualified
for the expedient (i.e., the lessor uses a straight-
line measure of progress).
Account for the lease as an operating lease.
Account for all variable payments related to any
good or service,
including the lease
, that is part
of the combined component under the variable
consideration guidance in ASC 606.
Account for all variable payments related to any
good or service that is part of the combined
component as variable
lease
payments.
In assessing predominance, a lessor should evaluate whether the lessee would be reasonably expected to ascribe more
value to the nonlease component(s) than to the lease component.
Also, when a contract includes a lease component and multiple nonlease components, some of the nonlease
components may meet the conditions to be combined with the lease component, while other nonlease components
may not (for example, a nonlease component that transfers at a point in time). In this case, this does not preclude the
lessor from applying the practical expedient to the contract. However, the lessor is required to separate and allocate
the consideration in the contract between the combined component on one hand (i.e., the lease component and
nonlease components that meet the conditions) and the nonlease components (those that do not qualify) on the other
hand.
ACCOUNTING FOR LEASES UNDER ASC 842 72
Application Considerations for Lessor Practical Expedient Not to Separate
The following considerations are important in understanding and evaluating whether a lessor qualifies for the
practical expedient:
The practical expedient applies only to nonlease components that otherwise would be accounted for
under ASC 606. It does not apply, for example, to a contract that includes a lease component and a loan
component accounted for under ASC 310 on receivables.
Determining whether the lease component would be classified as an operating lease if accounted for
separately generally should not require a detailed quantitative analysis and may often be determined
using either a reasonable qualitative assessment, or a simplified quantitative approach in which all
payments in the contract are used to perform the present value classification test (to test if the lease
would be classified as an operating lease even with all payments) in addition to assessing the other lease
classification tests. However, in certain situations, additional analysis may be required.
Because the timing and pattern of transfer of the nonlease components must be the same as the timing
and pattern of transfer of the lease, the nonlease components will generally need to be recognized on a
straight-line basis (i.e., over time, time-based) to qualify for the practical expedient (see Note 1 below).
Performance obligations satisfied over time but using a measure of progress different from a time-
elapsed measure of progress, or performance obligations satisfied at a point in time (even if satisfied
ratably throughout the lease term), do not qualify for the practical expedient (See Note 2).
A lessor should be able to reasonably determine which component is predominant (i.e., a lessor does not
have to perform a detailed quantitative analysis or theoretical allocation). We also believe entities may
use a >50% threshold in determining which component is predominant for this lessor practical expedient
as discussed by the FASB in a public Board meeting.
We believe many lessor entities (including real estate entities and cable providers, to name a few) will take
advantage of this lessor practical expedient, as it generally may enable them to account for their transactions
under ASC 842 or ASC 606 in a manner similar to how they have accounted for them in the past, and how users of
their financial statements have used the information.
Note 1: Paragraph 842-30-25-11(a) requires a lessor to recognize operating lease payments on a straight-line basis
unless another systematic and rational basis is more representative of the pattern in which the lessee benefits
from use of the underlying asset. However, in practice, it generally is infrequent for anything other than straight-
line recognition to be applied.
Note 2: It is important to note that while the pattern of transfer of the nonlease components must be the same as
the lease component, the recognition of revenue does not have to be the same. For example, if the contract
includes variable consideration, the recognition pattern under ASC 606 for the nonlease component may not be the
same as the pattern of recognition under ASC 842. The fact that the two different standards provide for
differences in the recognition of variable consideration would not preclude a lessor from electing the practical
expedient if the timing and pattern of transfer of the lease and nonlease components are the same.
ACCOUNTING FOR LEASES UNDER ASC 842 73
Applying Lessor Practical Expedient May Change Amount of Consideration in the Contract
A key consequence of the lessor practical expedient not to separate is that it may change the consideration in the
contract for a lessor when the contract includes variable payments. For example, a real estate contract may
provide for the right to use an office building along with common area maintenance (CAM) services. The contract
may stipulate that the lessee will pay a fixed payment amount per month and will reimburse the lessor for property
taxes, insurance, and CAM costs incurred by the lessor. Absent the lessor applying the practical expedient for this
asset class, the lessee’s reimbursements for CAM services would meet the conditions in paragraph 842-10-15-39 to be
included in the consideration in the contract because the payments relate specifically to the lessor’s efforts in
transferring a good or service to the lessee that is not the lease. However, when the lessor has elected and applies
the practical expedient for this asset class, the contract includes only one lease component (assuming there are no
other nonlease components in the contract that do not qualify for the practical expedient). Accordingly, variable
payments the lessee will make to the lessor under the contract are all considered to relate to the lease component
(even the payments for CAM services), and therefore no variable payment amounts will be included in the
consideration in the contract. We illustrate this in Examples 5B and 5C below.
ALLOCATION OF CONSIDERATION TO LEASE AND NONLEASE COMPONENTS
If a lessor does not elect the practical expedient not to separate, or elects it but the criteria for combination are not
met for one or more nonlease components, the lessor allocates the consideration in the contract using the revenue
guidance in paragraphs 606-10-32-28 through 32-41.
Also, as previously discussed, lessors should include in the consideration in the contract (subject to the constraint)
variable payments that relate specifically to:
The lessor’s efforts to transfer one or more goods or services that are not leases, or
An outcome from transferring one or more goods or services that are not leases.
If included in the consideration, those variable payment amounts are 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.
However, if the terms of the variable payment amount (other than those that depend on an index or a rate) relate to a
lease component, even partially, the lessor cannot 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 should allocate those payments to the lease and nonlease components of the
contract. In doing so, the allocation should 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). After this allocation then:
Variable payment amounts allocated to the lease component(s) are recognized as income in profit or loss in
accordance with ASC 842,
Variable payment amounts allocated to nonlease component(s) are recognized in accordance with other
Topics such as ASC 606.
A lessor also allocates any capitalized costs (for example, initial direct costs or contract costs capitalized under ASC
340-40 on other assets and deferred costs) to the separate lease components or nonlease components to which those
costs relate.
ACCOUNTING FOR LEASES UNDER ASC 842 74
Example 4B - Lease of Land and Building (Continued) – Lessor Accounting
FACTS
Let’s continue with Example 4 in which Lessor and Lessee enter into a five-year lease of a single-story
commercial office building.
Lessee has exclusive use of the building (i.e., it is a single-tenant office building).
The lease requires Lessor to perform landscaping services for Lessee.
Lessee pays a fixed monthly payment of $12,000 per months in arrears which includes rent, landscaping
services, and reimbursement of Lessor’s costs.
Assume there are no lease incentives or initial direct costs.
WHAT ARE THE COMPONENTS?
SCENARIO 1: Lessor elects practical expedient not to separate for this asset class.
Lessor determines that it meets the scope conditions of the practical expedient under paragraph 842-10-
15-42A because:
•
The landscaping services would otherwise be accounted for under ASC 606.
•
The lease component would be accounted for as an operating lease. Lessor performed this
assessment qualitatively considering the terms of the contract (Additional guidance on lease
classification will be covered in Chapter 4,
Lease Classification and Key Terms
).
•
The lease component and nonlease component have the same timing and pattern of transfer (i.e.,
overtime, time-based). Lessor determined that the pattern of transfer of the landscaping services
would be time-based and over time under ASC 606 based on the nature of the performance
obligation.
Lessor also determines that the nonlease component is not the predominant component, because Lessee
would be reasonably expected to ascribe more value to the lease component than the nonlease
component.
Lessor notes that paragraph 842-10-15-42C is not applicable because there is only one nonlease
component and it qualifies for the practical expedient not to separate.
Accordingly, the contract includes one lease component (i.e., the combined components), which Lessor
accounts for as an operating lease under ASC 842 consistent with paragraph 842-10-15-42B.
SCENARIO 2: Lessor does not elect practical expedient not to separate for this asset class.
As previously evaluated in Example 4, the contract includes two components: a single lease component
(comprising the right to use the land and building), and a nonlease component (landscaping services).
Also, Lessor determines under ASC 606 that its landscaping services represent a single performance
obligation.
WHAT IS THE CONSIDERATION IN THE CONTRACT?
There are no variable payments in the contract. Therefore, the guidance in paragraph 842-10-15-39 does
not apply.
The consideration in the contract for Lessor is $12,000 X 12 months X 5years = $720,000.
ACCOUNTING FOR LEASES UNDER ASC 842 75
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
SCENARIO 1: Lessor elects practical expedient not to separate for this asset class.
The consideration in the contract of $720,000 is allocated entirely to the lease component.
Lessor accounts for the lease component as an operating lease in accordance with paragraph 842-10-15-
42B, and therefore recognizes $720,000 on a straight-line basis over the lease term.
SCENARIO 2: Lessor does not elect practical expedient not to separate for this asset class.
In that case, Lessor allocates the consideration in the contract to the lease and nonlease components on a
relative standalone selling price basis. Lessor determines that the standalone selling prices for the lease
component and nonlease component are $680,000 and $50,000, respectively, using the guidance in ASC
606.
Therefore, the consideration in the contract is allocated to the lease and non-lease components as
follows:
Standalone
Selling Price
Relative Standalone
Selling Price
Lease component
$680,000
$670,685 (93.15%)
Maintenance component
50,000
49,315 ( 6.85%)
$730,000
$720,000
The amount of the consideration in the contract allocated to the lease component ($670,685) is used to
account for the lease component (e.g., assess lease classification, recognize lease revenue, etc.).
The amount of consideration for the landscaping component ($49,315) is accounted for under ASC 606.
ACCOUNTING FOR LEASES UNDER ASC 842 76
Example 5B - Lease of Office Space (Continued) – Lessor Accounting, Practical Expedient Not to Separate Is
Elected
FACTS
Let’s continue Example 5 in which Lessor and Lessee enter into a five-year lease for one floor in a 30-
story office building in New York City.
The lease requires Lessor to perform common area maintenance (CAM) services.
The contract requires Lessee to pay rent of $50,000 per month in arrears and to reimburse Lessor for
Lessee’s pro-rata share of real estate taxes and insurance incurred by Lessor on the building, and CAM
charges.
The pro rata share of those reimbursements is initially estimated at $9,000 per month ($5,000 for taxes
and insurance and $4,000 for CAM). The CAM charges can be adjusted upward and downward based on
actual work performed by Lessor.
Assume there are no lease incentives or initial direct costs.
Lessor elects the practical expedient not to separate for this asset class.
WHAT ARE THE COMPONENTS?
Lessor determines that it meets the scope conditions of the practical expedient in paragraph 842-10-42A
because:
•
The CAM services would otherwise be accounted for under ASC 606.
•
The lease component would be accounted for as an operating lease. Lessor performed this
assessment qualitatively considering the terms of the contract (Additional guidance on lease
classification will be covered in Chapter 4,
Lease Classification and Key Terms
).
•
The lease component and nonlease component have the same timing and pattern of transfer (i.e.,
over time, time-based). Lessor determined that the pattern of transfer of CAM would be time-
based and over time under ASC 606 based on the nature of the performance obligation.
Lessor also determines that the nonlease component is not the predominant component, because Lessee
would be reasonably expected to ascribe more value to the lease component than the nonlease
component.
Lessor notes that paragraph 842-10-15-42C is not applicable because there is only one nonlease
component and it qualifies for the practical expedient not to separate.
Accordingly, the contract includes one lease component (i.e., the combined components).
ACCOUNTING FOR LEASES UNDER ASC 842 77
WHAT IS THE CONSIDERATION IN THE CONTRACT?
The consideration in the contract starts with the same amount as determined by Lessee, which is $50,000
X 12 months X 5years = $3,000,000
There are variable payments in the contract. Therefore, Lessor applies the guidance in paragraph 842-10-
15-39. However, Lessor determines that the payments Lessee will make to Lessor for its prorata share of
real estate taxes and insurance are variable payments that are not based on an index or a rate, and they
relate to the lease component.
Also, although the CAM payments relate specifically to the CAM services, Lessor elected the practical
expedient and therefore those payments are considered to relate to the lease component.
Accordingly, the expected amounts for property taxes, insurance and CAM are excluded from the
consideration in the contract in accordance with paragraph 842-10-15-40.
The consideration in the contract for Lessor is $3,000,000.
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
The lease is accounted for as an operating lease consistent with paragraph 842-10-15-42B.
The consideration in the contract of $3,000,000 is allocated entirely to the lease component and is used
to recognize lease revenue on a straight-line basis over the lease term.
Because Lessee reimburses Lessor for property taxes and insurance (as opposed to paying directly a third-
party), Lessee’s payments for its prorata share of those activities are considered lessor costs in
accordance with paragraph 842-10-15-40A and are recognized on a gross basis in profit or loss.
Since Lessor elected the practical expedient not to separate, variable payments for property taxes,
insurance and CAM are considered variable lease payments and are recognized in accordance with
paragraph 842-30-25-11(b), which is when the changes in facts and circumstances on which the variable
payments are based occur.
ACCOUNTING FOR LEASES UNDER ASC 842 78
Example 5C - Lease of Office Space (Continued) – Lessor Accounting, Practical Expedient Not to Separate Is Not
Elected
FACTS
Let’s continue Example 5 in which Lessor and Lessee enter into a five-year lease for one floor in a 30-
story office building in New York City.
The lease requires Lessor to perform common area maintenance (CAM) services.
The contract requires Lessee to pay rent of $50,000 per month in arrear and to reimburse Lessor for
Lessee’s pro-rata share of real estate taxes and insurance incurred by Lessor on the building, and CAM
charges.
The pro rata share of those reimbursements is initially estimated at $9,000 per month ($5,000 for taxes
and insurance and $4,000 for CAM). The CAM charges can be adjusted upward and downward based on
actual work performed by Lessor.
Assume there are no lease incentives or initial direct costs.
Lessor does not elect the practical expedient not to separate for this asset class.
WHAT ARE THE COMPONENTS?
As previously evaluated in Example 5, the contract includes two components: one lease component (lease
of the floor) and one nonlease component (CAM services).
Also, Lessor determines under ASC 606 that its CAM services represent a single performance obligation.
WHAT IS THE CONSIDERATION IN THE CONTRACT?
The consideration in the contract starts with the same amount as determined by Lessee, which is $50,000
X 12 months X 5years = $3,000,000.
There are also variable payments in the contract. Therefore, Lessor applies the guidance in paragraph
842-10-15-39.
Lessor determines that Lessee’s payments for CAM services relate specifically to Lessor’s efforts to
transfer the CAM services.
Therefore, Lessor evaluates the variable payments in accordance with the variable consideration
guidance in paragraphs 606-10-32-5 through 32-13.
•
Lessor estimates that it will be entitled to receive $240,000 in variable payments for the CAM
services ($4,000 x 12 x 5years = $240,000).
•
Lessor also determines that it is probable that including that amount in the consideration would
not result in a significant reversal in cumulative revenue when the uncertainty of the payments is
resolved.
•
Accordingly, Lessor includes the amount it expects to be entitled to receive for the CAM services
of $240,000 in the consideration in the contract.
The other payments Lessee will make to Lessor for its prorata share of real estate taxes and insurance are
not based on an index or a rate. They also relate at least partially to the lease component. Accordingly,
the expected reimbursement amounts for property taxes and insurance are not included in the
consideration in the contract in accordance with paragraph 842-10-15-40.
The consideration in the contract for Lessor is $3,240,000 (3,000,000 + 240,000).
ACCOUNTING FOR LEASES UNDER ASC 842 79
WHAT ARE THE AMOUNTS ALLOCATED TO THE LEASE COMPONENT?
Lessor allocates the consideration in the contract to the lease and nonlease components using the
guidance in ASC 606. For example, if the CAM charges are not at their standalone selling price (for
example, CAM services are charged at cost without a profit margin), one acceptable allocation approach
may be for Lessor to allocate the entire amount of expected CAM reimbursements to the CAM component,
plus a portion of the fixed consideration to reflect an appropriate profit margin on the CAM services, if
that reasonably depicts the consideration Lessor expects to be entitled for each of the lease component
and CAM component.
The amount of the consideration in the contract allocated to the lease component is then used to account
for the lease component under ASC 842 (e.g., assess lease classification, recognize lease revenue on a
straight-line basis over the lease term if an operating lease, etc.).
The amount of consideration allocated to CAM services is accounted for in accordance with the guidance
on satisfaction of performance obligations in paragraphs 606-10-25-23 through 25-37. In this case, Lessor
determines that CAM services are provided over time, using a time-based measure of progress (i.e., on a
straight-line basis).
Lessor will consider the guidance on variable consideration in ASC 606 and update the amounts it expects
to be entitled for CAM services each reporting period. Lessor will allocate those changes consistent with
its initial allocation. For example, if Lessor initially allocated the estimated CAM payments entirely to the
CAM component, subsequent changes to that estimate may be allocated entirely to the CAM component.
Because Lessee reimburses Lessor for property taxes and insurance (as opposed to paying directly a third-
party), Lessee’s payments for its prorata share of those activities are considered lessor costs in
accordance with paragraph 842-10-15-40A and are recognized on a gross basis in profit or loss.
Also, Lessor will allocate the variable payments for property taxes and insurance to the lease and
nonlease components in accordance with paragraph 842-10-15-40; that is, on the same basis as the initial
allocation of the consideration in the contract (or most recent modification not accounted for as a
separate contract, if any), unless the variable payment meets the criteria in paragraph 606-10-32-40 to
be allocated only to the lease component. For example, Lessor may allocate the entire payments for
property taxes and insurance to the lease component if that is consistent with the initial allocation
performed and the allocation objective.
Then,
•
Variable payment amounts allocated to the lease component are recognized as income in profit or
loss in accordance with paragraph 842-30-25-11(b) which is when the changes in facts and
circumstances on which the variable payments are based occur.
•
Variable payment amounts allocated to the nonlease component, if any, are recognized in
accordance with ASC 606.
ACCOUNTING FOR LEASES UNDER ASC 842 80
REMEASURING AND REALLOCATING THE CONSIDERATION
A lessor remeasures and reallocates the remaining consideration in the contract when there is a contract modification
that is not accounted for as a separate contract under paragraph 842-10-25-8. This also includes situations described in
paragraph 842-10-35-3 (for example, when the lessee exercises a renewal or purchase option that the lessor previously
determined was not reasonably certain of exercise).
Also, a lessor allocates subsequent changes in variable consideration in accordance with the requirements in
paragraphs 606-10-32-42 through 32-45. For example, in Example 5C above the lessor included estimated CAM
payments in the consideration in the contract. If the estimate subsequently changes, the additional consideration
should be allocated to the lease and nonlease components on the same basis that the initial consideration was
allocated.
PORTFOLIO APPROACH
Paragraph 120 in the Basis for Conclusions in ASU 2016-02 indicates that ASC 842 permits an entity (lessee or lessor) to
apply the leases guidance at a portfolio level for leases with similar characteristics as long as the use of the portfolio
approach would not differ materially from the application of ASC 842 to the individual leases in the portfolio.
Paragraphs 842-20-55-18 through 55-20 also provide an example in which the portfolio approach is utilized in
determining the discount rate for the lease.
The portfolio approach may also be used to account for multiple lease components that have the same characteristics
including commencement date, lease term, and lease classification, such as a lease of three vehicles, or a lease of
multiple floors in a multi-floor building. However, the application of the portfolio approach could result in additional
complexity when the entity applies the subsequent measurement guidance of ASC 842 (for example, for a lessee, on
impairment and abandonment considerations, or contract modification considerations – see
Accounting for Leases -
Lessees for further details).
CONTRACT COMBINATION
Two or more contracts must be combined, at least one of which is or contains a lease, when they are entered into at or
near the same time with the same counterparty (or related parties) and consider those contracts as a single transaction
if either:
They were negotiated as a package with the same commercial purpose,
The amount of consideration to be paid in one contract depends on the price or performance of the other
one, or
The rights to use the underlying assets conveyed in the contracts are a single lease component based on the
separation guidance described above.
Combination Guidance Aligned with Revenue Guidance
The guidance in paragraph 842-10-25-19 on contract combination is consistent with the guidance in paragraph 606-
10-25-9 on combining revenue contracts. This linkage was intentional, as the new lease standard incorporates
concepts from the new revenue recognition guidance.
ACCOUNTING FOR LEASES UNDER ASC 842 81
Chapter 4 - Lease Classification and
Key Terms
OVERVIEW
In Chapter 3, Identifying and Separating Components, we discussed how an entity identifies and separates
components in a lease contract. An entity then generally accounts for the lease component(s) under ASC 842, and the
nonlease component(s) under other GAAP (e.g., ASC 606 for a lessor). An entity also applies the guidance in ASC 842 at
the lease component level, and the accounting for that lease component is governed by how that lease component is
classified.
In some cases, however, as we discussed in the previous chapter an entity may elect a practical expedient by asset
class not to separate the nonlease component(s) from the associated lease component. In those situations:
A lessee generally applies the practical expedient without regard to conditions, and accounts for the
combined component as a single lease component. The lessee then applies the guidance in ASC 842,
including lease classification, to that single (combined) lease component. Accordingly, a lessee applies the
lease classification guidance after it combines the lease and related nonlease component(s).
A lessor must meet certain conditions to apply the practical expedient not to separate. One condition is that
the lease component,
if accounted for separately
, would be classified as an operating lease. Accordingly, a
lessor applies the lease classification guidance at the individual lease component before it combines the
lease and related nonlease component(s). This lease classification assessment will determine whether the
lessor meets the scope conditions to apply the practical expedient not to separate. If the lessor meets all the
scope conditions, the accounting for the combined component then depends on which component of the
contract is predominant. If the nonlease component(s) are predominant, the lessor accounts for the
combined component under ASC 606. Otherwise, it accounts for the combined component as an
operating
lease. In other words, a lessor does not reassess lease classification once the components are combined.
ACCOUNTING FOR LEASES UNDER ASC 842 82
This is summarized in the following table:
Lessee Lessor
Assess lease classification at the
combined
lease component level, if the lessee elected
the practical expedient not to separate for
the asset class.
Assess lease classification at the
individual
lease component level, irrespective of
whether the lessor elected the practical
expedient to not separate for the asset
class.
A lease component is initially classified and recognized in the financial statements at the commencement date. For
example, a lessee assesses lease classification, and recognizes the lease on balance sheet, at the commencement date.
It is therefore important for an entity to appropriately identify that date. That analysis is not always straightforward,
including for example when the lease involves construction of improvements.
An entity will also need to answer several other questions to perform the lease classification tests and determine the
accounting for the lease component. Some of those questions include:
What is the lease term? For example, in a lease with a noncancelable period of five years with a one-year
renewal option, is the lease term five years, or six years? What should be considered in making that
determination?
What are the lease payments? For example, are variable payments based on sales of the lessee included? Do
all payments from the lessor to the lessee (e.g., incentives) affect the accounting for the lease component?
What is the discount rate for the lease, and how is it determined? For example, is the discount rate for the
lease the same for all entities, or are there differences between lessees and lessors, and between public
business entities and other entities? Is it based on the lease term, or should it consider other options (e.g.,
renewal options) not included in the lease term?
What is the fair value of the underlying asset? For example, is fair value the same for all entities, whether
lessee or lessor, or are there specific exceptions for certain entities (e.g., lessors that are not manufacturers
or dealers)?
We will discuss those questions in further detail in this chapter, along with how to determine lease classification once
those questions have been answered. For lessees, leases are classified as either an operating or a finance lease. For
lessors, leases are classified as either a sales-type, a direct financing, or an operating lease. ASC 842 no longer
includes leveraged lease classification for lessors for leases that are entered into or modified after ASC 842’s effective
date. Existing leveraged leases are grandfathered into ASC 842 and continue to be accounted by the lessor under prior
guidance until they expire or are modified.
ACCOUNTING FOR LEASES UNDER ASC 842 83
Note that in this chapter we will discuss only the initial assessment (i.e., at the commencement date). Subsequent
changes to the lease term, lease payments, discount rate, etc. are discussed in chapter 5 for lessees and chapter 6
for
lessors.
ACCOUNTING FOR LEASES UNDER ASC 842 84
COMMENCEMENT DATE
The glossary defines the commencement date as:
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.
The commencement date of a lease is when the lessee takes possession of or is given control over the use of the
underlying asset. The commencement date is not always stated in the contract. Often, a lessee and lessor negotiate an
expected commencement date based on availability of the asset. Other times, there will be a contractual
commencement date in the contract, but that date may not coincide with the commencement date for accounting
purposes. Example documents to consider in determining the commencement date include letters acknowledging the
transfer of possession, certificates of occupancy, construction start dates, etc. It is important to note that the
commencement date may or may not coincide with the date at which payments under the lease begin.
The commencement date of the lease also may be different from the inception date of the contract, which is usually
the date that the contract was executed. ASC 842 makes a distinction between those two dates and provides for
different accounting requirements at those two dates as illustrated below.
Paragraph 842-10-55-19 highlights that the lessor makes the underlying asset available for use by the lessee when the
lessee is given control over the use of the underlying asset. Accordingly, in evaluating the commencement date of a
lease, we believe it is useful to look to the definition of a lease, and more specifically, at what comprises the right to
control the use of the asset, which is discussed in paragraph 842-10-15-4. That paragraph provides for two conditions:
(a) the right to obtain substantially all of the economic benefits from use of the identified asset, and (b) the right to
direct the use of the asset. In many cases, those two conditions are met when the lessee has exclusive use of the asset
– even if the lessee is using the period to construct leasehold improvements (lessee assets) and has not yet commenced
operations – and therefore the lease typically has commenced at that date.
Sometimes, an agreement may involve leases of multiple assets that are determined to be separate lease components
(generally referred to as master lease arrangements). In those cases, there may be multiple commencement dates,
which affects the timing of lease classification and recognition of each lease component in the financial statements.
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.
ACCOUNTING FOR LEASES UNDER ASC 842 85
Accounting Owner of Improvements Affects Commencement Date and Lease Payments
Paragraph 842-10-55-19 explains that in some lease arrangements, the lessor may make the underlying asset
available for use by the lessee before the lessee begins operations or makes lease payments. During this period, the
lessee may have the right to use the underlying asset to construct a lessee asset (for example, leasehold
improvements). Paragraph 842-10-55-20 then notes that the terms of the contract may vary as to whether the lessee
is required to make lease payments before or after construction is completed and the lessee begins operations, but
that the timing of the payments does not impact the determination of the lease commencement date.
ASC 842 does not explicitly discuss how to determine whether improvements are a lessee asset or a lessor asset.
However, it is important to determine if the improvements relate to a lessee asset (e.g., leasehold improvements),
or a lessor asset (e.g., lessor constructs its own improvements, or the lessee performs services on behalf of the
lessor) as it may affect the determination of the commencement date, and of the consideration in the contract (and
therefore the lease payments). Determining the accounting owner of the improvements will require the use of
professional judgment based on the terms of the lease contract and the nature of the improvements made.
Questions to consider include, but are not limited to:
Does the lease or other contract require the lessee to construct specific improvements, including to the
lessor’s design? A “yes” answer would be an indicator that the lessor controls the improvements, whereas
the lessee’s discretion about whether to construct the improvements and/or their design may indicate that
the lessee controls the improvements.
Is the lessee permitted to remove or alter the improvements without the lessor’s approval? A “yes” answer
would be an indicator that the lessee controls the improvements.
Does the lessor legally own upon completion any improvements, alterations and additions made by the
lessee? A “yes” answer would be an indicator that the lessor controls the improvements.
Are the improvements specific to the lessee such that they do not have an economic value to the lessor at
the end of the lease term (e.g., the lessor would not be able to use the improvements in arrangements
with other lessees)? A “yes” answer would be an indicator that the lessee controls the improvements.
If the lessee is the accounting owner of the improvements, any payments from the lessor, including those made
directly to a third party providing the construction services, are considered an incentive to the lessee which reduce
the consideration in the contract consistent with the guidance in paragraphs 842-10-15-35(a) and 842-10-30-5(a).
The lessee being the accounting owner of the improvements also affects the commencement date of the lease,
which is when the lessor makes the underlying asset available for use by the lessee (e.g., when the lessee takes
possession of the underlying asset and starts constructing its leasehold improvements). There is also no distinction
between the right to use the underlying asset during and after the construction period. In other words, lease costs
(or income) associated with building and ground leases incurred (or earned) during and after the construction is
complete are both for the right to use the underlying asset and therefore are recognized by the lessee (or lessor) in
accordance with the guidance in Subtopics 842-20 and 842-30, respectively. The timing of when lease payments
begin does not affect the commencement date.
If the lessor is the accounting owner of the improvements, payments made by the lessor generally do not affect the
consideration in the contract (e.g., payments from the lessor to the lessee to reimburse the lessee for costs incurred
on behalf of the lessor to construct the lessor asset). But in that scenario, the commencement date of the lease will
likely not occur until construction of the lessor improvements is substantially complete, and the lessee obtains
control over the use of the underlying asset, including the improvements. Also, lessee 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.
ACCOUNTING FOR LEASES UNDER ASC 842 86
Example 1 – Retail Store
FACTS
Retail Lessee enters into a lease with Realty Lessor on December 1, 2019 for the use of a retail store for
five years.
As part of the contract, Realty Lessor pays Retail Lessee $50,000 as reimbursement for improvements to
the retail space, which are specific to Retail Lessee. Retail Lessee has the right to remove or alter the
improvements made throughout the lease term without Realty Lessor’s permission.
Realty Lessor gives Retail Lessee the keys to the store on January 1, 2020, at which point Retail Lessee
can start constructing the improvements.
Retail Lessee completes the construction of the improvements, and opens its retail store, on March 1,
2020.
The contract requires Retail Lessee to make monthly payments in arrears of $10,000 starting on March 31,
2020.
WHO IS THE ACCOUNTING OWNER OF THE IMPROVEMENTS?
Retail Lessee is the accounting owner of the improvements because the improvements are specific to
Retail Lessee’s brand and therefore the improvements could not be used by Realty Lessor in arrangements
with other lessees. Retail Lessee also has the right to remove or alter the improvements at any time
during the lease term without Realty Lessor’s permission.
Because Retail Lessee is the accounting owner of the improvements, the $50,000 payment from Realty
Lessor to Retail Lessee is a lease incentive in accordance with paragraph 842-10-55-30.
The lease incentive reduces the consideration in the contract, and reduces the amounts allocated to the
lease component and nonlease component(s), if any.
Retail Lessee separately accounts for the leasehold improvements as an asset in accordance with ASC
360.
WHAT IS THE COMMENCEMENT DATE?
Since Retail Lessee is the accounting owner of the improvements, the commencement date of the lease is
January 1, 2020, which is the date at which Realty Lessor makes the space available for use by Retail
Lessee and at which point Retail Lessee can start constructing its improvements. Starting at that date,
including during the construction of its leasehold improvements, Retail Lessee has exclusive use of the
retail store and directs its use.
In accordance with paragraph 842-10-55-20, the timing of when Retail Lessee is required to make lease
payments is not relevant to this analysis. Recognition of the lease liability and right-of-use asset, as well
as lease expense, begins on January 1, 2020.
ACCOUNTING FOR LEASES UNDER ASC 842 87
Example 2 – Medical Office Building
FACTS
Medical Lessee enters into a lease with Healthcare Lessor on December 1, 2018 for the use of a medical
office building for ten years.
At contract inception, the medical office building was in relatively poor condition, and required
significant renovations. As part of the negotiations with Medical Lessee, Healthcare Lessor agrees to
spend up to $6.0 million to renovate the building, including mechanical upgrades, roof replacement,
replacing and reconfiguring certain interior walls, and making other improvements. The renovations are
expected to take between 12 to 15 months.
The lease indicates that all improvements are the legal property of Healthcare Lessor, and Medical Lessee
cannot remove or alter the improvements during the lease term without Healthcare Lessor’s approval,
which Healthcare Lessor may reject at its sole discretion.
The improvements have an average expected economic life of 20 years and are not specific to Medical
Lessee. That is, the improvements could be used by Healthcare Lessor in arrangements with other lessees
operating in the medical and healthcare industry.
Healthcare Lessor provides Medical Lessee with limited access to the building on October 31, 2019 so that
Medical Lessee can inspect the renovations and plan for construction of its own leasehold improvements.
However, Medical Lessee does not yet have the right to construct its leasehold improvements.
Healthcare Lessor substantially completes the renovations on January 1, 2020, at which point Medical
Lessee is given full access to the building to install its own leasehold improvements.
Medical Lessee starts operations in the building on March 1, 2020.
The contract requires Medical Lessee to make monthly payments in arrears of $150,000 once construction
is substantially complete, with fixed annual increases of 5%.
WHO IS THE ACCOUNTING OWNER OF THE IMPROVEMENTS?
Healthcare Lessor is the accounting owner of the improvements (renovations) because the improvements
are not specific to Medical Lessee. Healthcare Lessor can use the improvements at the end of the lease
term for other lessees in the medical and healthcare field. Healthcare Lessor also controls whether
alterations are made to the improvements and is the legal owner of the improvements.
Healthcare Lessor’s payments for the improvements do not affect the consideration in the contract and
the lease payments.
Note 1: We believe the above conclusions would be true even if Medical Lessee made the improvements on
behalf of Healthcare Lessor and Healthcare Lessor reimbursed Medical Lessee for costs incurred on its behalf
because, in substance, Medical Lessee acted as an agent for Healthcare Lessor.
Note 2: If Medical Lessee made payments to Healthcare Lessor to fund some or all of the construction costs
related to the improvements owned by Healthcare Lessor, those payments would be considered lease payments
(assuming there are no nonlease components). This is because payments by a lessee for the right to use the
underlying asset are lease payments, regardless of the timing of those payments or the form of those payments.
Alternatively, if Healthcare Lessor also constructed Medical Lessee’s improvements on its behalf, then any
related payments would be accounted for under ASC 360 by Medical Lessee. It may require judgment in order
to determine which payments relate to the lease and which relate to assets owned by the lessee in similar
situations.
ACCOUNTING FOR LEASES UNDER ASC 842 88
WHAT IS THE COMMENCEMENT DATE?
Since Healthcare Lessor is the accounting owner of the improvements, the commencement date of the
lease is January 1, 2020, which is the date at which Healthcare Lessor substantially completes the
improvements and makes the space available for use by Medical Lessee.
The lease does not commence on October 31, 2019 because Healthcare Lessor only provides limited
access to Medical Lessee (for it to plan for its own leasehold improvements). From October 31, 2019 up to
January 1, 2020, Medical Lessee does not obtain substantially all of the economic benefits from use of the
building, nor does it direct its use.
The date at which Medical Lessee starts operations is also not relevant in determining the
commencement date, consistent with paragraph 842-10-55-19. This is because Medical Lessee has
exclusive use of the building and directs its use even during the construction of its own leasehold
improvements.
ACCOUNTING FOR LEASES UNDER ASC 842 89
Example 3 – Restaurant Space
FACTS
Burgers R Us enters into a lease for a new restaurant on May 1, 2019, at which time both lessee and lessor
begin the work to obtain the relevant permits required to operate a Burgers R Us restaurant in that
location.
The lease provides for payments of $16,000 per month if Burgers R Us begins operations in the location on
or before November 1, 2019. Monthly lease payments increase by $500 for every month the grand opening
is delayed beyond November 1, 2019.
The lease term ends ten years after the first payment, which is due when the restaurant opens for
business.
The relevant permits are obtained, and the lessor grants access to Burgers R Us to the site on August 1,
2019. At that time, Burgers R Us begins constructing leasehold improvements to conform the building to
its brand requirements. Assume the improvements are a lessee asset.
The restaurant opens for business on December 1, 2019, at which time payments under the lease begin.
WHAT IS THE COMMENCEMENT DATE?
The commencement date of the lease is August 1, 2019 because it is the date at which Burgers R Us has
the right to control access to and use of the building, as evidenced by its starting construction of
leasehold improvements.
In accordance with paragraph 842-10-55-20, the timing of when Burgers R Us is required to make lease
payments is not relevant to this analysis. However, because Burgers R Us does not know at lease
commencement when lease payments will begin and, therefore, what the payment amounts will be and
what the end of the lease term is; the total payments and term must be estimated. Burgers R Us should
update its estimates and remeasure the payments when the contingency upon which the payments are
based is resolved (i.e., when Burgers R Us begins operations) to reflect any difference between the
estimates at lease commencement and the final determinations.
LEASE TERM
The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the
lessor. Paragraph 842-10-30-1 addresses how to determine the lease term as follows:
ACCOUNTING FOR LEASES UNDER ASC 842 90
The following table provides additional guidance on how to determine the lease term:
Step Additional Guidance
Determine the
noncancellable period
of the lease.
Paragraph 842-10-55-23 explains that when an entity assesses the length of the
noncancellable period of a lease, it should apply the definition of a contract and
determine the period for which the contract is enforceable. See below for additional
discussion and analysis.
If there is a lessee
extension option,
determine if the lessee
is reasonably certain to
exercise the option. If
so, the extension period
is included in the lease
term.
“Reasonably certain” is a high threshold that is intended to be interpreted consistently
with “reasonably assured” under ASC 840 and is generally understood to be as
encompassing economic compulsion. However, ASC 842 provides the following additional
implementation guidance: In determining whether it is reasonably certain that a lessee
option will be exercised (or not exercised), an entity considers all relevant economic and
contractual factors (contract-based, asset-based, entity-based, and market-based)
consistent with paragraph 842-10-55-26, which include:
Contractual terms and conditions, such as amount of lease payments or variable
lease payments in optional periods compared with current market rates,
Significant leasehold improvements that are expected to have significant
economic value for the lessee when the lessee option becomes exercisable,
Costs related to exiting the lease and signing a new lease, including negotiating
costs, relocation costs, costs of returning the underlying asset in a contractually
specified condition and/or location, installation costs for the new leased asset,
and
The importance of the underlying asset to the lessee’s operations, including
whether the asset is specialized and/or in a remote location, lost revenue or
other economic losses (e.g., when the lessee does not have an equivalent asset
and must identify and locate a replacement asset).
The assessment requires the use of professional judgment and will often consider a
combination of the above factors, along with how far in the future the option is
exercisable (e.g., an option exercisable in one year versus one exercisable in five or ten
years). All things equal, the further away the option is exercisable, the more evidence will
be needed to conclude that a lessee is reasonably certain to exercise (or not exercise) the
option. Also, an expectation of exercise alone (and without a significant economic
incentive to do so) is not sufficient, and a company’s historical practice of exercising
renewal options may not indicate the existence of significant economic factors, and
therefore should not be determinative.
See also Example 26 in ASC 842-10-55 for an illustration of the assessment of a lessee
termination option.
If there is a lessee
termination option,
determine if the lessee
is reasonably certain
not to exercise the
option. If so, the period
covered by the
termination option is
included in the lease
term.
If there are periods
covered by a lessor
option to extend (or not
to terminate), include
those periods in the
lease term.
Periods controlled by a lessor are included in the lease term, irrespective of likelihood of
exercise.
ACCOUNTING FOR LEASES UNDER ASC 842 91
Noncancellable Period and Enforceability of the Contract
Assessing the noncancellable period and enforceability of a lease are critical in the determination of the lease term.
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. Thus, the lease term cannot be
longer than the enforceable period of the contract. For example, assume a lease that has an initial term of five years
that neither the lessee nor the lessor can cancel and, after the initial five years, the lessee has a one-year extension
option. In this example the noncancellable period of the lease is five years, and the lease is enforceable for six years
because if the lessee elects to extend the lease for one year after the initial term, the lessor is obligated to make the
underlying asset available for use by the lessee. Once the noncancellable and enforceable periods are determined,
the entity can then assess the lease term, which will either be five years (the noncancellable period only) or six years
(the noncancellable period plus the one-year extension period) depending on whether the lessee is reasonably certain
to extend; but the lease term cannot be longer than six years (the period the contract is enforceable).
The enforceability of a contract depends in part on whether both parties can cancel the contract with no more than
an insignificant penalty. The term penalty is not limited to cash payments nor contractual penalties, but is more
broadly defined as shown below:
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:
a.
Disburse cash
b.
Incur or assume a liability
c.
Perform services
d.
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:
1.
The uniqueness of purpose or location of the property
2.
The availability of a comparable replacement property
3.
The relative importance or significance of the property to the continuation
of the lessee's line of business or service to its customers
4.
The existence of leasehold improvements or other assets whose value would
be impaired by the lessee vacating or discontinuing use of the leased
property
5.
Adverse tax consequences
6.
The ability or willingness of the lessee to bear the cost associated with
relocation or replacement of the leased property at market rental rates or
to tolerate other parties using the leased property.”
If only the lessee has the right to terminate a lease, it is evaluated like an option to terminate consistent with the
previous table.
If only the lessor has the right to terminate the lease, the lease term includes the period covered by the option to
terminate the lease.
ACCOUNTING FOR LEASES UNDER ASC 842 92
Example 1 – Retail Store (Continued)
FACTS
Let’s continue with Example 1 in which Retail Lessee enters into a lease with Realty Lessor for the use of
a retail store for five years and for which Retail Lessee must pay $10,000 monthly in arrears.
The initial term of five years cannot be terminated by either party.
The contract includes two one-year extension options. If Retail Lessee elects to extend the term, it must
pay $11,000 monthly in arrears in the first extension period, and $12,000 in the second extension period.
WHAT IS THE LEASE TERM?
The starting point is to determine the noncancellable period of the lease. In this example, it is five years.
Then, Retail Lessee and Realty Lessor each evaluate Retail Lessee’s extension options. In this example,
there are no economic factors that would indicate Retail Lessee is reasonably certain to exercise its
extension options, and, therefore, both Retail Lessee and Realty Lessor conclude that Retail Lessee is not
reasonably certain to extend the lease for either one or two years.
Accordingly, the lease term is initially five years.
Example 1A – Retail Store (Continued)
FACTS
Assume the same as in Example 1, except that:
•
The lease has a fixed term of five years, but there are no extension options. Instead, Retail
Lessee can terminate the lease with a six months’ notice prior to exiting the space.
•
There is no stated termination penalty for Retail Lessee should it decide to exit the space early.
•
Retail Lessee did not construct significant leasehold improvements because the store is in a new
geographical area and market that Retail Lessee is testing.
WHAT IS THE LEASE TERM?
In this example, Retail Lessee has no significant economic penalty that would require it to stay in the
lease for longer than the notice period. As such, the lease term is initially six months.
ACCOUNTING FOR LEASES UNDER ASC 842 93
Example 1B – Retail Store (Continued)
FACTS
Assume the same as in Example 1, except that:
•
The lease has a fixed term of five years, but after the fifth year, the lease converts to a month-
to-month arrangement with rent at $11,000 per month in arrears.
•
Either party can cancel the lease after the initial term without permission from the other party.
There is no stated penalty in the contract for canceling.
•
The retail location is important to Retail Lessee, and it constructed significant leasehold
improvements such as retail shelving, reception counters, and other layout and design specific to
Retail Lessee, for which Realty Lessor did not provide reimbursement to Retail Lessee.
•
If Retail Lessee were to terminate the lease before the end of the eighth year, the shelving and
other leasehold improvements would be dismantled and abandoned prior to the end of their
useful lives, and Retail Lessee would incur a more than insignificant economic penalty.
WHAT IS THE LEASE TERM?
The starting point is to determine the noncancellable period of the lease and how long the contract is
enforceable. Consistent with paragraph 842-10-55-23, an entity applies the definition of a contract and
determines 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.
The determination of whether a penalty exists, and its magnitude, are important and require the use of
professional judgment. In this example, the presence of significant leasehold improvements results in
Retail Lessee incurring a more than insignificant penalty through the end of the eighth year. Therefore,
based on the economic penalty the lessee would continue to renew (not cancel) the contract on a month-
to-month basis through the end of the eighth year and thus the contract is enforceable for eight years.
After the eighth year, the contract is no longer enforceable because either party may terminate the lease
without permission from the other with no more than an insignificant penalty.
Retail Lessee also determines that it is reasonably certain not to terminate the lease until the end of the
eighth year.
The fact that Realty Lessor could terminate the lease between the end of the fifth year and eighth year is
not relevant because the lease term includes any periods covered by a lessor’s option to terminate the
lease in accordance with paragraph 842-10-30-1c.
Accordingly, the lease term is initially eight years.
ACCOUNTING FOR LEASES UNDER ASC 842 94
Example 1C – Lease with Nonconsecutive Periods
FACTS
Assume the same as in Example 1, except that:
•
Retail Lessee specializes in selling accessories (tablecloths, décor, etc.) for Thanksgiving.
•
The contract with Realty Lessor is for a space in a shopping mall, rather than a specific retail
store, and the contract meets the definition of a lease.
•
The lease has a fixed term of five years, but Retail Lessee controls the use of the space in the
mall only during the months of October and November of each year.
•
There are no extension or termination options.
WHAT IS THE LEASE TERM?
The definition of a lease in ASC 842 depends in part on whether the customer has the right to control the
use of an identified asset throughout the period of use (paragraph 842-10-15-4). The “period of use” is
defined 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).
As noted previously, the lease term includes the noncancelable period for which the lessee has the right
to use an underlying asset. If the period of use of a lease includes nonconsecutive periods, the lease term
will also include those nonconsecutive periods. Conversely, the lease term cannot include periods for
which a lessee does not have the right to use the underlying asset (in this example, the months other
than October and November, for which Realty Lessor has the right to lease the space to other lessees).
Accordingly, the lease term is the aggregate period of use for which Retail Lessee has the right to use the
underlying asset, which in this example is two months per year for five years, for a total of a ten- month
lease term.
Example 1D – Retail Store (Continued)
FACTS
Assume the same as in Example 1, except that:
•
The lease is initially for five years, and neither party can cancel the lease without significant
cancellation fees.
•
After the initial term, there are two additional extension periods. However, Retail Lessee and
Realty Lessor must both agree on the renewal terms, including rental payments.
There is no penalty to either party for not agreeing to one or both of extension options.
There are ample other retail stores or spaces that are available in the marketplace to consider after the
fifth year.
WHAT IS THE LEASE TERM?
The lease term is the noncancellable period of five years as neither party can cancel the lease without
significant cancellation fees.
Since both parties must agree on the terms of the renewal period, including rental payments, the periods
after the initial term are not enforceable and therefore are not included in the lease term. The lease
term is five years.
ACCOUNTING FOR LEASES UNDER ASC 842 95
LEASE PAYMENTS
Once the lease term is identified, the lease payments can be determined. Paragraph 842-10-30-5 defines lease
payments, which are the following payments related to the use of the underlying asset during the lease term:
Step Additional Guidance
Determine the fixed
payments, including in-
substance fixed payments,
less lease incentives paid or
payable to the lessee.
In-substance fixed payments are payments that may appear to contain
variability, but they are
unavoidable
. Examples include:
•
Payments with no genuine variability (i.e., clauses with no economic
substance).
•
Lower of set of payments for which the lessee has a choice, but it must
make at least one set of payments.
See below for further discussion of in-substance fixed payments.
In some leases, the lessee may provide noncash consideration (e.g., equity
shares of the lessee). Noncash lease payments should be treated the same as
cash for purposes of determining whether they represent fixed payments or
variable payments. See also below for further discussion.
Deduct lease incentives paid or payable to the lessee, which include:
•
Payments made to (or on behalf of) the lessee,
•
Losses incurred by the lessor for assuming a lessee’s preexisting lease.
See Commencement Date section above for a discussion of the assessment of
the accounting owner of improvements, which affects whether payments by the
lessor are considered lease incentives.
See Example 4 below for whether certain lease incentives are considered
payable.
Add variable lease payments
based on an index or a rate.
Variable payments based on an index or a rate are included using the index or
rate at the commencement date.
Examples of variable payments based on an index or a rate include payments
based on the consumer price index (CPI), the London Interbank Offered Rate
(LIBOR) or Secured Overnight Financing Rate (SOFR), and market rental rates.
Subsequent changes in the index or rate are generally recognized as variable
lease payments. See
Accounting for Leases - Lessees
and
Accounting for
Leases - Lessors
for further details.
See Example 25 Case A in ASC 842-10-55 for an illustration of the accounting for
variable lease payments based on an index or a rate.
ACCOUNTING FOR LEASES UNDER ASC 842 96
Step Additional Guidance
Add the exercise price of a
lessee purchase option (if
reasonably certain of
exercise).
Assess the lessee purchase option the same way as a lessee extension or
termination option, as discussed in Lease Term section above. Because
“reasonably certain” is a high threshold, also consider the significance of any
discount between the fixed price of the purchase option and the expected fair
value of the underlying asset when the option is exercisable, and how
consistent expected values have historically been for the underlying asset.
See Examples 23 and 24 in ASC 842-10-55 for illustrations of the assessment of
lessee purchase options.
Add termination penalty
payments (if reflected in
the lease term).
See Lease Term section above for discussion of lessee termination options.
Add fees paid by lessee to
owners of special purpose
entity for structuring the
transaction.
Note that the fees are added to the lease payments but are excluded from the
fair value of the underlying asset.
For lessees only, determine
and add the amount
probable of being owed
under residual value
guarantees.
“Probable” means that the future event or events are likely to occur.
This requirement is applicable for lessees only.
See below for discussions on in-substance residual value guarantees and other
guarantees provided by a lessee.
ACCOUNTING FOR LEASES UNDER ASC 842 97
Noncash Lease Payments
In some instances, the lessee may provide noncash consideration to the lessor in lieu of cash lease payments for the
right to use the underlying asset. For example, the lessee may grant equity instruments to the lessor, or it may
contribute goods or services (for example, materials, equipment, or labor) to facilitate the construction of the lessor
controlled asset, as payment for the use of the underlying asset.
In those situations, we believe the entity (lessee or lessor) should generally recognize the fair value of the noncash
consideration as lease payments, unless specifically excluded from the definition of lease payments.
It is also important for the entity to assess whether the transfer of noncash assets is within the scope of other
accounting standards. For example, if the lessee issues shares or other equity instruments such as warrants to the
lessor, that grant will be in the scope of ASC 718 on stock compensation subsequent to the adoption of ASU 2018-07,
Compensation – Stock Compensation: Improvements to Nonemployee Share-Based Payment Accounting. ASC 718
addresses measurement and classification (equity versus liability) of the award but does not address the periods or
the manner (capitalize versus expense) in which an entity granting the share-based payment award to a
nonemployee should recognize the cost of the share-based payment award that will be issued. It only requires that
an asset or expense be recognized (or previous recognition reversed) in the same periods and in the same manner as
if the grantor had paid cash for the goods or services instead of paying with or using the share-based payment
award.
The following are not considered lease payments:
Variable lease payments other than those based on an index or a rate (e.g., payments based on a percentage
of sales of the lessee, payments based on energy produced by a solar farm, etc.).
Lessee guarantees of the lessor’s debt, which a lessee generally accounts for under ASC 460 on guarantees.
However, consistent with practice under ASC 840, if the guarantee is in-substance a residual value
guarantee, a lessee should apply the guidance in the table on the previous page on estimating amounts
probable of being owed under residual value guarantees. This could occur for example if the lender has
recourse only to the leased asset (i.e., the debt is nonrecourse to the lessor), or if the lessor entity does not
have significant assets other than the underlying asset subject to the lease.
Remember that the amount of lease payments results from an allocation of the consideration in
the contract to the lease and nonlease component(s). Amounts allocated to the nonlease
components are therefore not considered lease payments, unless:
-
For a lessee, it elected the practical expedient not to separate for the asset class.
-
For a lessor, it elected the practical expedient not to separate for the asset class, it met
the scope conditions, and the nonlease component(s) are not the predominant
component(s).
See Chapter 3 for further discussion of separation of components, allocation of the consideration
in the contract to the components, and the lessee and lessor practical expedients not to separate.
ACCOUNTING FOR LEASES UNDER ASC 842 98
Identifying Unavoidable Fixed Payments
Leases may include in-substance fixed payments and other unavoidable payments that must be included in the lease
payments. In-substance fixed payments include for example payments that require the lower of two payments to be
made when a lessee has a choice about a set of payments it makes, and payments that do not create genuine
variability (such as those that result from clauses that do not have economic substance). For example, if a lease
contract includes payments based on the lower of (a) X times a change in CPI, and (b) Y% (a fixed percentage), this
may not have any economic substance if based on historical changes in the CPI, the application of the leverage (X)
results in Y% always being reached. In those situations, the increase based on Y% should be included in the lease
payments.
In-substance fixed payments do not include payments based on performance of the asset, such as sales of a retail
store, energy produced by a solar plant, or units produced by a machinery, even if there is a high likelihood based on
historical and other data that a certain amount of sales, energy, or units, will be produced. This is because those
payments relate directly and proportionately to the use or performance of the underlying asset. The variable
payments have economic substance.
Reviewing the terms of the lease are important, and an entity should focus on identifying payments that are
unavoidable. For example, in a lease whereby lease payments increase by the greater of (i) the change in CPI, or (ii)
a fixed percentage, such as 2%, the payments will always increase by at least 2%, making an increase of 2% an
unavoidable payment that should be included as lease payments. Similarly, in a lease whereby lease payments are a
fixed percentage of sales of the lessee subject to a floor, such as $1,000, the $1,000 represents an unavoidable
payment that should be included as lease payments.
When assessing whether payments are unavoidable, an entity should determine whether there is a minimum or floor
amount that the lessee must pay. If so, the payments are in effect unavoidable and therefore should be included as
lease payments. Common phrases to look for in leases that may signal those payments include: “...the greater of…”,
“…not to be less than ...”, and “…minimum amount of …”. But entities should also be mindful about phrases like the
“…the lower of…” particularly when a multiplier is applied, as illustrated with the CPI example above.
Example 4 – Accounting for Contingent Lease Incentives
FACTS
Lessee enters into a lease contract with a lessor for a retail store.
The lease is an operating lease and there are no nonlease components.
Lessee is entitled to a lease incentive from the lessor for leasehold improvements, which are to be
constructed by Lessee.
At the commencement date of the lease, Lessee intends to construct the improvements, the construction
is within its control, and it is reasonably certain that the cost of the improvements will equal or exceed
the maximum incentive amount specified in contract.
Lessee completes the improvements two months after the commencement date of the lease.
ACCOUNTING FOR LEASES UNDER ASC 842 99
HOW SHOULD LESSEE ACCOUNT FOR THE CONTINGENT LEASE INCENTIVE?
Scenario 1 – Monthly rent is a fixed amount and the lease payments exceed the lease incentive amount
We believe one acceptable approach would be to include the lease incentive amount as being receivable
at the commencement date. In this situation, the lease incentive is included in the determination of the
lease payments at the commencement date, which will affect the initial measurement of the lease
liability and the right-of-use asset (essentially reduce the amounts reported on the balance sheet).
We believe it would also be acceptable to account for the lease incentive as a contingent lease incentive
which is not included in the lease payments at the commencement date, but for which the lessee applies
paragraph 842-10-35-4(d) on resolution of a contingency. In that case, the lessee would remeasure the
lease payments when the contingency on which the variable lease incentive is based is resolved.
Scenario 2 – Monthly rent is a fixed percentage of lessee’s gross sales each month
Because the payments to the lessor are entirely variable, there are no lease payments at the
commencement date in accordance with paragraph 842-10-30-6(a).
Because ASC 842 does not specifically address this question, we believe there are two approaches to
accounting for these contingent lease incentives (like in scenario 1 above). However, the analysis differs
from scenario 1 because in this scenario there are no lease payments (i.e., there is no lease liability or
right-of-use asset against which to offset the lease incentive amounts):
Approach 1: Consider the lease incentive as being receivable at the commencement date. Therefore,
recognize a lease receivable and a corresponding liability for the lease incentive at the commencement
date. When/as the lessor reimburses the lessee, the lessee reduces the amount of the lease receivable
initially recognized. The liability should be reduced on a straight-line basis over the lease term as an
offset to lease expense, not to exceed the amount of lease expense recognized for the current period.
Approach 2: Lessee does not recognize any lease incentive at the commencement date. When the
contingency on which the lease incentive is based is resolved, the lessee would remeasure the lease
payments. Since there continues to be no lease payments other than the incentive, we believe the
recognition of the incentive should be recorded as a liability, rather than as a contra-asset (i.e., a right-
of-use asset that is less than zero). The liability should then be reduced on a straight-line basis over the
lease term as an offset to lease expense, not to exceed the amount of lease expense recognized for the
current period.
ACCOUNTING FOR LEASES UNDER ASC 842 100
RESIDUAL VALUE GUARANTEES
As previously discussed, a lessee includes in the lease payments the amounts probable of being owed under residual
value guarantees. However, there may be additional factors for a lessee to consider, depending on the terms of the
lease contract:
Facts Analysis
Contract requires the lessee to make up a
residual value deficiency for damage,
extraordinary wear and tear, or excessive
usage.
This provision does not constitute a lessee residual value guarantee.
Any payments are instead treated like variable lease payments.
Contract provides for lessor the right to
require lessee to purchase the underlying
asset by the end of the lease term.
The lessee is obligated (i.e., it is outside its control) to pay the
guaranteed residual value. Therefore, the stated purchase price is
included in lease payments.
Lessee obtains a residual value guarantee
from an unrelated third-party for lessor’s
benefit.
The existence of a third-party guarantee should not reduce the
estimate of lessee’s amounts probable of being owed under residual
value guarantees, unless the lessor releases the lessee from
obligation (including secondary obligation).
Also, the amounts paid by a lessee for third-party residual value
guarantees are executory costs of the lessee (i.e., they are not
included in lease payments).
OBLIGATIONS IMPOSED AT END OF LEASE TERM
Some lease contracts impose obligations on the lessee to return the underlying asset to specific conditions at the end
of the lease term. The accounting for such obligations depends on which asset (lessor or lessee asset) the obligation
relates to:
If the lessee has an obligation to return the underlying asset to its original condition because the lessee
modified it (i.e., a lessee asset such as lessee installed leasehold improvements), payments to repair the
underlying asset generally do not meet the definition of lease payments or variable lease payments. Instead,
the obligation is accounted for under ASC 410-20 on asset retirement and environmental obligations.
If the lessee has an obligation for costs to dismantle and remove the underlying asset at the end of the lease
term (i.e., a lessor asset), those costs generally are considered lease payments or variable lease payments.
Because the accounting for such payments is governed by ASC 842, the guidance in ASC 410-20 does not
apply, as noted in paragraph 410-20-15-3(e).
TAX BENEFIT INDEMNIFICATIONS
Some leases contain indemnification clauses that indemnify a lessor 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. Those payments are not of
the nature normally expected to arise under variable lease payment provisions and, 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.
ACCOUNTING FOR LEASES UNDER ASC 842 101
INITIAL DIRECT COSTS
Initial direct costs are defined as:
Incremental costs that would not have been incurred if the lease had not been
obtained.
Initial direct costs include, for example, commissions and payments made to an existing tenant to incentivize that
tenant to terminate its lease.
Costs to prepare a lease that would have been incurred regardless of whether the lease was obtained are not
considered initial direct costs and therefore should be expensed as incurred. Those include:
Fixed employee salaries (e.g., allocation of employee costs for time negotiating lease terms and conditions),
General overheads such as depreciation, occupancy and equipment costs, unsuccessful origination efforts,
and idle time,
Costs for advertising and similar activities, and
Other costs related to activities that occur before a lease is obtained, such as external legal and tax fees,
costs of evaluating a prospective lessee’s financial condition, travel costs related to the lease proposal.
The guidance in ASC 842 about initial direct costs represents a significant change from ASC 840, and is aligned with the
definition of costs to acquire a contract under ASC 606. See Example 27 in ASC 842-10-55 for an illustration of the
determination of initial direct costs for a lessee and a lessor.
A lessee allocates initial direct costs to the separate lease components on the same basis as the lease payments. A
lessor allocates any capitalized costs (for example, initial direct costs or contract costs capitalized under ASC 340-40
on other assets and deferred costs) to the separate lease components or nonlease components to which those costs
relate.
ACCOUNTING FOR LEASES UNDER ASC 842 102
DISCOUNT RATE
DEFINITIONS
Discount Rate for the Lease Rate Implicit in the Lease Incremental Borrowing Rate
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.
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.
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.
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 (see section below
for additional details).
Except for certain leases (for
example, some related party
leases), a lessee typically cannot
readily determine the rate
implicit in the lease because it
does not have all required inputs.
Accordingly, a lessee will
typically use its incremental
borrowing rate.
How the rate is calculated as it
relates to initial direct costs will
depend on the lease classification
test performed (see Lease
Classification section below for
additional details).
If the residual value of the
underlying asset is expected to
increase over the lease term
(e.g., land), we believe a lessor
should use the fair value at the
commencement date in
determining the rate implicit in
the lease.
A risk-free rate is typically lower
than a collateralized rate and as
such, will result in a higher right-
of-use asset and lease liability
for lessees. It could also result in
a different classification of the
lease.
ACCOUNTING FOR LEASES UNDER ASC 842 103
INCREMENTAL BORROWING RATE
What the standard
says…
What it means…
The rate of interest that a lessee
would have to pay
The rate should be based on the credit standing of the lessee (which may
also be the credit standing of the parent entity – see further discussion
below).
to borrow on a collateralized basis It is a secured (recourse) rate that is fully collateralized (i.e., it cannot be
under-collateralized). The lessee is not limited to the underlying asset (i.e.,
other collateral may work if accepted by a lender) although the lessee
should consider the nature and quality (liquidity) of the collateral used.
over a similar term ASC 842 does not explicitly refer to the “lease term”. We believe a lessee
may use either the lease term or consider the lease term plus options not
reasonably certain of exercise, as an accounting policy – see observation
below for additional details.
an amount equal to the lease
payments
Payments are determined based on ASC 842’s definition of lease payments in
paragraph 842-10-30-5. Accordingly, variable payments other than those
based on an index or a rate are not considered. See Lease Payments section
above for additional discussion on lease payments.
in a similar economic environment. It should reflect a rate that would be paid by the entity on borrowings that
are entered into at or near the same time, in the same or similar
jurisdiction, and in the same currency.
In determining the incremental borrowing rate, a lessee may find the following useful:
A lessee may consider its existing debt arrangements and whether those can be used to derive the
incremental borrowing rate, with appropriate adjustments to materially comply with the definition of the
incremental borrowing rate as described above (for example, adjusted to reflect a similar term as the lease,
etc.). If a lessee borrows on an unsecured basis only, the entity may still use that rate as a starting point
with further appropriate adjustments.
A lessee with little or no debt may use published reference rates such as government rates as a starting
point, and adjust those rates for the lessee’s credit risk, financing term, and quality of collateral, etc.
A lessee with a high volume of leases may consider constructing a synthetic corporate yield curve in which it
considers an appropriate risk-free rate and a credit spread (whether based on its public credit rating or
implied credit rating). Further adjustments would be made, for example, for the collateral, for which the
lessee may use a “notching approach” or a “recovery rate approach” to reflect a secured rate. A lessee using
yield curves to determine its incremental borrowing rate should develop processes and controls to
periodically review and update the assumptions used in the development of the yield curve. For example, a
lessee could develop a process to periodically pull market data and compare that market data to the inputs
used in the yield curve to monitor for changes, and establish appropriate thresholds for determining
whether/when to update the inputs of the yield curve. A lessee would also need to periodically monitor for
changes in its credit profile (i.e., enhancements or deterioration in credit profile).
A lessee may use a portfolio approach when determining the incremental borrowing rate of multiple leases
when the leases have similar characteristics, such as a similar lease term, similar lease payments, and similar
economic environment, as illustrated in Example 2 of ASC 842-20-55. A single discount rate applied to all
leases in a portfolio should not result in a materially different answer than using a discount rate determined
for each lease.
ACCOUNTING FOR LEASES UNDER ASC 842 104
We also believe that the determination of the incremental borrowing rate should be consistent with the pattern of
lease payments and how such payments are reflected in the measurement of the lease liability, which generally should
result in the use of a rate that reflects an amortizing loan.
The following rates typically cannot be used as the incremental borrowing rate:
Weighted-average cost of capital,
Property yields,
Cost of money,
Blended rate (e.g., mix of secured and unsecured rate) as it may have been used under ASC 840.
A Rate Determined Over a Similar Term
ASC 842 notes that 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. However, questions may arise as to whether “similar term” is intended to mean the “lease term”, as
defined in ASC 842.
When the lease includes options (such as a lessee extension option) and those are not reasonably certain of exercise
at the commencement date, we believe a lessee may use either (a) the lease term as defined in ASC 842 and
described in paragraph 842-10-30-1, or (b) a rate that reflects the existence of the option(s). This is consistent with
the guidance in paragraph 842-20-35-5(a) on subsequent remeasurement of the lease liability which indicates that
the discount rate does not have to be updated for a change in lease term or assessment of a purchase option if the
rate already reflects that the lessee had such option. We believe that this is a policy election that should be applied
consistently to all leases.
However, if a lessee that is not a public business entity elects to use the risk-free discount rate (see section below),
it should use the lease term only. This is because paragraph 842-20-30-3 explicitly notes that the risk-free rate is
determined over a period comparable with that of the lease term.
Use of Parent Versus Subsidiary Rate
Paragraph BC201 of ASU 2016-02 discusses that in some situations, it may be reasonable for a subsidiary to use a
parent entity’s incremental borrowing rate. The example given is when the subsidiary does not have its own treasury
function and the parent entity provided a guarantee of the lease payments. In concluding on that example, the FASB
noted that pricing of the lease was more significantly influenced by the credit standing of the parent than the
subsidiary. Example 2 in Subtopic 842-20-55 also illustrates the use of a parent’s incremental borrowing rate because
pricing of the lease was influenced by the parent’s credit standing although the parent entity did not provide a
guarantee in that example.
A lessee subsidiary should consider its specific facts and circumstances in determining whether it can use the parent
rate or is required to use its own (subsidiary) rate. We believe a lessee subsidiary may use its parent rate in
situations in which pricing of the lease was more significantly influenced by the credit standing of the parent than
that of the subsidiary (for example, when the lessee subsidiary does not have its own treasury function and the
parent entity was involved in negotiations for the lease).
ACCOUNTING FOR LEASES UNDER ASC 842 105
DISCOUNT RATE FOR LESSEES THAT ARE NOT PUBLIC BUSINESS ENTITIES
The FASB initially provided lessees that are not public business entities with an accounting policy to use a risk-free
discount rate applicable for all leases. The discount rate is an important input in the accounting for a lease as it may
impact lease classification and it directly affects the amounts of leases recognized on the balance sheet and the
amounts of interest and amortization expense reported for finance leases. However, because the practical expedient
had to be elected for all leases, some private companies were reluctant to elect it based on those financial statement
impacts resulting from the current economic environment in which the risk-free rate is very low.
The FASB issued ASU 2021-09 in November 2021 which now permits lessees to make the risk-free rate election by asset
class rather than for all leases. Accordingly, a lessee now has more flexibility in electing the risk-free rate accounting
policy. For example, a lessee may elect to use the risk-free discount rate for asset classes that have lower values
and/or greater volumes of leases (e.g., some office equipment leases), while using their incremental borrowing rate
for more material asset classes (such as real estate). Some Board members and FASB staff observed at the September
15, 2021 public meeting that there is no prescribed requirements for determining asset classes, and that therefore a
lessee has flexibility in identifying its asset classes for purposes of applying ASC 842.
The accounting policy is limited to entities that are not public business entities. Because not-for-profit entities
(including conduit bond obligors) and employee benefit plans are not public business entities (according to the
definition in the Master Glossary), they are permitted to make the risk-free discount rate election. A lessee that elects
the practical expedient should disclose that fact and the asset classes for which it has elected it.
Rate Implicit in the Lease and Risk-Free Rate Election
In considering changes to the risk-free rate election, the FASB learned that the interaction
between a lessee’s requirement to use the rate implicit in the lease when readily determinable
and the lessee’s application of the risk-free rate election was unclear under ASC 842 because the
risk-free rate election initially applied to all leases. The FASB therefore decided to clarify that a
lessee should use the rate implicit in the lease when it is readily determinable, even if the lessee
elects the risk-free rate election. While the rate implicit in the lease is typically not readily
determinable, it may be in certain leases (for example, common control leasing transactions).
The following flowchart summarizes a lessee’s decision steps in determining the discount rate for the lease for a lessee
that is not a public business entity:
ACCOUNTING FOR LEASES UNDER ASC 842 106
ECONOMIC LIFE
ASC 842 defines economic life as:
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.
We believe this definition is largely consistent with the prior definition of economic life in ASC 840 for lease
classification purposes and therefore should lead to similar determinations of economic life.
FAIR VALUE
ASC 842 defines fair value as:
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.
This is the same definition of fair value used in ASC 820 on fair value measurement. As a result, an entity should apply
the guidance in ASC 820 when determining the fair value of an underlying asset. However, for lessors that are not a
manufacturer or dealer (i.e., generally financial institutions and captive finance companies), the fair value of the
underlying asset at lease commencement is defined as its cost, reflecting any volume or trade discounts that apply.
This exception applies only if there has not been a significant lapse of time between the acquisition of the underlying
asset and lease commencement. If there has been a significant lapse of time, the lessor must apply the ASC 820
definition of fair value. This fair value exception is consistent with the fair value exception that existed under ASC 840,
which the FASB added to ASC 842 with the issuance of ASU 2019-01 following feedback from lessors previously
qualifying for the exception in ASC 840.
Determining Fair Value Without Undue Costs and Efforts
Paragraph 842-10-55-3 notes that in some cases, it may not be practicable for an entity to determine the fair value
of an underlying asset, meaning that a reasonable estimate cannot be made without undue cost or effort. That
paragraph also notes that if 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 present value classification criteria (i.e.,
paragraphs 842-10-25-2(d) and 842-10-25-3(b)(1) which we discuss further below in the Lease Classification section).
We believe fair value can be determined without undue cost or effort in most cases. However, an entity is not
always required to obtain an appraisal or similar valuation. Instead, in many cases an entity may be able to make a
reasonable estimate of fair value. For example, for the lease of one floor of a building, it may be appropriate to
determine fair value of the portion leased by taking the fair value of the building as a whole and applying an
appropriate percentage based on floors leased to total number of floors, or square feet leased to total square feet
of the building if more representative of the space used, with appropriate adjustments as needed (for example, if a
market participant would ascribe more value to higher floors in the building). However, a more precise estimate of
fair value generally should be made (and appraisal or similar valuation may need to be obtained) if it is likely that
lease classification could change, and such change in classification would be significant to the financial statements.
One exception is for leases of spaces owned by a governmental unit or authority. For leases involving terminal space
and other airport facilities, ports and bus terminals and similar spaces owned by a governmental unit or authority, it
may not be practicable to determine the fair value of the underlying asset. In those situations, paragraph 842-10-55-
13 notes that such leases are classified as operating leases if they do not provide for a transfer of ownership or a
lessee purchase option that is reasonably certain of exercise. However, certain conditions must be met to apply that
guidance as outlined in paragraph 842-10-55-13.
ACCOUNTING FOR LEASES UNDER ASC 842 107
LEASE CLASSIFICATION
Once an entity has obtained all relevant inputs described above, it can perform the lease classification assessment.
Lease classification is determined at the commencement date of the lease. The analysis is summarized in the
following flowchart based on paragraphs 842-10-25-2 through 25-3A.
ACCOUNTING FOR LEASES UNDER ASC 842 108
The following table provides additional guidance on the lease classification analysis described in the above graph:
Step Additional Guidance
Transfer of ownership
criterion
This criterion is met in leases that provide that the lessor 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,
upon the lessee’s performance in accordance with the terms of the lease.
This criterion is also met when the lease
requires
the payment by the lessee of a
nominal amount (e.g., minimum fee required by statutory regulation to transfer
ownership) in connection with the transfer of ownership.
But if the lease transfers ownership of the asset if the lessee
elects
to pay a specified
fee (whether nominal or otherwise) to complete the transfer, it does not satisfy the
transfer-of-ownership criterion. Instead, an entity assesses it as an option to purchase
the underlying asset (see below).
Purchase option
criterion
If a lessee is reasonably certain to exercise a purchase option, the exercise price of
the option is included in the lease payments and the lease is classified as a finance
lease by the lessee and a sales-type lease by the lessor (unless there are variable lease
payments not based on an index or a rate and it would result in a selling loss). See
Lease Payments section for a discussion of the assessment of purchase options.
Lease term criterion
One reasonable approach to assess this criterion is that 75% or more of the remaining
economic life of the asset represents a major part of the asset’s remaining economic
life, and that a commencement date that falls within the last 25% of the total
economic life of the underlying asset results in a commencement date that falls at or
near the end of the asset’s economic life.
If the lease contract includes the right to use multiple underlying assets that represent
a single lease component under paragraphs 842-10-15-28 and 15-29 (see
Identifying
and Separating Components
), use the remaining economic life of the predominant
asset.
Present value criteria
One reasonable approach to assess these criteria is that 90% or more of the asset’s fair
value amounts to substantially all.
Any related investment tax credit retained by the lessor and expected to be realized
by the lessor reduces the fair value of the underlying asset.
Fees paid by a lessee to owners of a special purpose entity for structuring the
transaction, while included in lease payments, are not included in the fair value of the
underlying asset when assessing the sales-type lease present value criterion.
For a lessor only, for the sales-type lease present value criterion the rate implicit in
the lease should exclude any initial direct costs if the fair value of the underlying
asset differs from its carrying amount. For assessing the direct-financing lease present
value criterion, initial direct costs are included in all cases. We illustrate this further
in
Accounting for Leases - Lessors
on lessor accounting.
Residual value guarantees of a portfolio of underlying assets (for which settlement is
not solely based on the residual value of the individual underlying assets, and for
which excess is offset against shortfalls in residual value that exist in other assets in
the portfolio) preclude a lessor from determining the amount of the guaranteed
residual value of any individual underlying asset within the portfolio and, therefore,
no such amounts should be considered by the lessor when evaluating these criteria.
ACCOUNTING FOR LEASES UNDER ASC 842 109
Step Additional Guidance (Continued)
Alternative Use
Criterion
In assessing this criterion, an entity considers the effects of (1) contractual
restrictions and (2) practical limitations on the lessor’s ability to readily direct that
asset for another use (e.g., 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, such as if 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. Examples include when the underlying asset has design
specifications unique to the lessee or the asset is in a remote area.
The possibility of the contract with the customer being terminated does not affect
the assessment of this criterion.
Probability of
Collection Criterion
The question of collectibility is no longer relevant for determining whether a lease is
classified as a sales-type lease, which is a change from prior GAAP. However, the
collectibility assessment is still relevant for determining whether a lease is classified
as a direct-financing lease. If collection is not probable, the lease is classified as an
operating lease by the lessor.
The following guidance is also important for specific transactions or provisions in lease contracts:
Transaction Additional Guidance
Business combinations
or acquisition by not-
for-profit entity
The acquiring entity should retain the previous lease classification unless there is a
lease modification that is not accounted for as a separate contract.
For asset acquisitions, refer to Chapter 7 on
Other Topics
.
Related party leases
These leases are classified in accordance with the lease classification criteria
applicable to all other leases based on 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.
Legally enforceable terms and conditions should be utilized even if they are not
consistent with rates or terms that would be required in a transaction between
unrelated market participants.
It is important to consider whether provisions beyond those included in the written
contract are legally enforceable, which may require judgment and sometimes input
from legal counsel.
Lessee indemnification
for environmental
contamination
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 lease classification. Those indemnifications are
accounted for under other GAAP (ASC 410-20 or ASC 460-10 depending on the
indemnification).
ACCOUNTING FOR LEASES UNDER ASC 842 110
Classification with Removal of the Legacy “Bright Lines”
The lease classification tests in paragraphs 842-10-25-2 and 25-3 do not refer to bright-line thresholds as previously
required under ASC 840. Instead, those bright lines were replaced with terminologies such as “major part” when
discussing the lease term criterion, or “substantially all” when discussing the present value criteria. When
determining how to apply this guidance, paragraph 842-10-55-2 permits the continued use of those bright lines. This
was provided to assist companies in establishing internal accounting policies and controls and in applying the
requirements in an operational and scalable manner. While application of those bright lines is not required, if an
entity deviates from those bright lines, it should consider how best to articulate accounting policies in order to
achieve consistent classification for similar leases, while adhering to the economic structure of the arrangement and
the lease classification principles in ASC 842. While companies could adopt a policy that establishes ranges, like the
approach taken when determining whether a contingent liability is probable under ASC 450-20, entities should also
consider how those terms are applied in other areas of GAAP and ensure consistent application. For example,
“substantially all” is used in many other areas of GAAP and is understood to generally be at or around 90%. A
reporting entity should document its definition of “substantially all” and “major part.” Deviating from the use of
the bright lines allowed by paragraph 842-10-55-2 will require an entity to document its considerations in arriving at
the thresholds used, and to demonstrate that the use of such thresholds is appropriate.
Alternative Use Test
ASC 842 added a classification criterion on whether a lease is a finance lease for a lessee or a sales-type lease for a
lessor that did not exist under ASC 840; specifically, whether 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. We expect that for leases of this
nature, most lessors would structure such contracts to ensure that they recover their investment in the underlying
asset through the required lease payments, and that therefore the present value of the lease payments would
represent substantially all of the fair value of the underlying asset, thereby meeting at least one other lease
classification criterion. However, this may not always be the case, such as when a significant portion of the
payments are variable. Even so, an inability by the lessor to repurpose the asset without undue cost at the end of
the lease term will result in finance/sales-type lease treatment for the lessee and for the lessor (unless there are
variable lease payments not based on an index or a rate and it would result in a selling loss), respectively.
Example 5 – Alternative Use Criterion Met
FACTS
Widget Co. enters into a lease agreement with Bob’s Custom Manufacturing.
Under the agreement, Bob’s will construct a piece of equipment to be used in Widget’s production
process.
The requirements for the asset will be provided by Widget and are subject to a U.S. patented design.
It would also be cost prohibitive for Bob’s to modify the equipment in such a way that it no longer
complies with the patented design requirements.
WHAT IS THE CLASSIFICATION OF THE LEASE?
Because of the existence of the patent, Bob’s would be precluded from reusing the equipment at the end
of the lease through redirecting it through a sale or subsequent lease.
The alternative use criterion is met. Widget Co. should account for the lease as a finance lease, and Bob’s
should account for the lease as a sales-type lease (unless there are variable lease payments not based on
an index or a rate and it would result in a selling loss).
ACCOUNTING FOR LEASES UNDER ASC 842 111
Chapter 5 - Accounting for Leases –
Lessees
OVERVIEW
We discussed in Lease Classification and Key Terms important concepts such as the commencement date, lease term,
lease payments, discount rate, and so forth, and how an entity classifies a lease. Once the entity has determined all
those relevant inputs, it can recognize and measure the lease on balance sheet at the commencement date.
Users of financial statements indicated that previous lease accounting guidance did not provide sufficient useful
information with regards to an entity’s leasing activities because most leases (that is, operating leases) were not
recognized on the balance sheet. As a result, users often adjusted lessees’ financial statements to capitalize operating
leases to better reflect lessees’ leverage and exposure to credit risk, but different estimation approaches and limited
information available created information asymmetry in the market, and adjustments varied significantly based on
different assumptions.
ASC 842 is intended to address those issues because most leases (whether operating or finance) are now recognized on
balance sheet at the commencement date unless the practical expedient for short-term leases is elected (see below).
The new model reflects that at the commencement date of a lease, a lessee has a financial obligation to make lease
payments to the lessor in exchange for its right to use the underlying asset, and accordingly it should recognize a right-
of-use (ROU) asset and a lease liability for these rights and obligations.
The lessee accounting model in ASC 842 still retains the distinction between operating and finance leases because the
FASB viewed economic differences among those leases. Specifically, the FASB determined that finance leases are
generally economically similar to purchased PP&E because the lessee essentially obtains control of the underlying asset
rather than merely obtaining control over the use of the underlying asset for the lease term. In contrast, in an
operating lease the lessee does not obtain substantially all of the remaining benefits from the underlying asset;
frequently, the lessee obtains only a minor portion of the remaining benefits and will not be exposed to or benefit from
any changes in the underlying asset’s value during the lease term.
The FASB also provided lessees with a practical expedient not to recognize short-term leases on balance sheet. A short-
term lease is a lease with a lease term of 12 months or less and that does not include a lessee purchase option that is
reasonably certain of exercise. This election is by asset class and, if elected, a lessee recognizes lease payments on a
straight-line basis over the lease term along with variable lease payments when incurred, consistent with ASC 840.
ACCOUNTING FOR LEASES UNDER ASC 842 112
LEASE CLASSIFICATION BY LESSEES
As a reminder, the following flowchart summarizes a lessee’s classification of a lease under ASC 842, which we
discussed in further details in the Lease Classification and Key Terms
.
ACCOUNTING FOR LEASES UNDER ASC 842 113
SUMMARY ACCOUNTING REQUIREMENTS BASED ON LEASE CLASSIFICATION
Finance Leases Operating Leases
ROU Asset Lease Liability ROU Asset Lease Liability
Balance
Sheet
ROU asset is initially
measured at the amount
of the lease liability,
plus initial direct costs
and prepaid lease
payments, less lease
incentives received.
Lease liability is initially
measured at the present
value of the unpaid
lease payments.
Initial measurement is the same as for finance
leases.
Subsequently, ROU asset
is typically amortized on
a straight-line basis to
the earlier of the end of
its useful life or lease
term.
5
Subsequently, lease
liability is increased to
reflect interest using
the interest method and
decreased for lease
payments made.
Amortize based on
difference between
periodic straight-line
lease cost (incl.
amortization of initial
direct costs) and
periodic interest
accretion.
Subsequent
measurement is the
same as for finance
leases.
Income
Statement
Recognize amortization of ROU asset,
Recognize interest on lease liability,
Recognize variable lease payments not
included in the lease liability when incurred,
and
Recognize an impairment loss if the ROU
asset is impaired under ASC 360.
Recognize a single lease cost generally on a
straight-line basis,
Recognize variable lease payments not
included in the lease liability when
incurred, and
Recognize an impairment loss if the ROU
asset is impaired under ASC 360. Also, after
an impairment, recognition of lease cost is
no longer on a straight-line basis (but still
recognized as a single lease cost).
Also, note the following:
ASC 842 considers the right to control the use of the underlying asset as the equivalent of physical use. That is,
recognition of lease cost under the operating lease model, or amortization of the right-of-use asset for finance
leases, should not be affected by the extent to which the lessee uses the underlying asset, and therefore
typically is on a straight-line basis.
The right-of-use asset is a nonmonetary asset while the lease liability is a monetary liability. Therefore, when
accounting for a lease 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.
Once recognized on balance sheet, ASC 842 also includes requirements for lessees to update the measurement
of leases for certain lease modifications and other reassessment events. Lessees will need robust processes and
controls to timely and completely identify and account for such events.
5
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 amortizes the right-of-use asset to the end of the useful life of the underlying asset.
ACCOUNTING FOR LEASES UNDER ASC 842 114
SHORT-TERM LEASES
The 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.”
ASC 842 provides lessees with a practical expedient related to short-term leases under which the ASC 842 balance
sheet recognition provisions are not applied to these leases. This election is made by class of underlying asset to which
the right of use relates (e.g. office equipment, real estate, vehicles). If elected, leases that qualify for the exemption
are not recognized on balance sheet and lease payments are recognized on a straight-line basis over the lease term,
consistent with legacy guidance for operating leases. Variable lease payments are also recognized in the period in
which the obligation for those payments is incurred.
If the lease term or the assessment of a lessee purchase option 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 purchase option, the lease no longer meets the definition of a short-term lease and
the lessee should apply the general guidance, including balance sheet recognition, as if the date of the change in
circumstances is the commencement date of the lease.
This practical expedient was provided to simplify the accounting for such short-term leases. However, a lessee still
must apply the ASC 842 requirements related to initial assessment of the lease term and lessee purchase options,
including whether the lessee is reasonably certain to exercise an extension or purchase option. This also means that
short-term leases are subject to the lease term and purchase option reassessment requirements in ASC 842. Short-term
leases also are subject to specific disclosure requirements. Accordingly, even with the practical expedient, short-term
leases are not scoped out of ASC 842 entirely.
In deliberating whether to include the short-term lease exception, the FASB considered the risk that entities may wish
to structure a lease in order to obtain short-term lease accounting; for example, by setting a noncancelable lease
period which is shorter than 12 months while incorporating a series of one-year renewal options, or by entering into a
longer-term lease that includes a series of termination options. However, the FASB noted in paragraph BC381 of ASU
2016-02 “that there are significant economic disincentives to both parties to entering into a series of short-term leases
in place of longer-term leases such that there is not a significant structuring risk throughout the system. For example,
lessees may have to pay a premium rental price to compensate the lessor for its increased residual asset risk, and some
lessors will be unable to enter into short-term leases depending on the terms of the financing they obtained to acquire
the underlying asset.”
ACCOUNTING FOR LEASES UNDER ASC 842 115
Example 1 - Lease is a short-term lease
FACTS
Dom Co. is an auto leasing company.
Lessee enters into a lease with Dom Co. for the use of 20 cars for use by its sales force.
The stated term of the lease is 12 months, with the lessee having the right to renew the lease for an
additional 12 months.
The monthly lease payments during the renewal period are the same as the monthly payments in the
initial period.
There are no purchase options.
The cars are not specialized, and alternative cars are available in the market at similar lease rates.
Lessee has made an accounting policy election not to recognize right-of-use assets and lease liabilities
arising from short-term leases for any class of underlying asset.
ANALYSIS
Lessee considered all relevant factors at the commencement date and determined that it is not
reasonably certain to exercise the renewal option.
CONCLUSION
The lease meets the definition of a short-term lease because the lease term is 12 months or less, there
are no purchase options, and it is not reasonably certain that Lessee will exercise the renewal option.
Lessee does not recognize the right-of-use asset and lease liability arising from the lease. Rather, the
lease payments are recognized on a straight-line basis over one year.
ACCOUNTING FOR LEASES UNDER ASC 842 116
Example 2 - Lease is not a short-term lease – Termination options
FACTS
Ironside Co. manufactures heavy machinery for construction.
Lessee enters into a lease with Ironside Co. for the use of two cranes.
The stated term of the lease is 3 years, with the lessee having the right to terminate it at any time after
one year.
The contract specifies an early termination penalty equal to 15% of the total lease payments.
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.
ANALYSIS
Lessee concludes that due to the significant termination penalty and other factors it is reasonably certain
not to exercise the termination option.
CONCLUSION
Lessee concludes that the lease term is 3 years. Therefore, the lease does not qualify for the short-term
lease exception.
Accordingly, Lessee applies the general requirements in ASC 842 to this lease, including recognizing a
right-of-use asset and lease liability.
ACCOUNTING FOR LEASES UNDER ASC 842 117
Example 3 - Lease is a short-term lease – Renewal options
FACTS
Assume the same facts as in Example 2 apply, in which Lessee entered into a lease with Ironside Co. for
the use of two cranes, except that the contract does not specify a stated term.
Instead, the cranes are subject to a daily rental rate, and the lease can be renewed indefinitely.
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.
ANALYSIS
Lessee analyzes the lease term considering all relevant factors at the commencement date. Lessee
determines the most likely period of use based on expected need is six months, and considers the
physical difficulties of replacing a crane during that period with another crane with the same
functionality along with the limited number of available cranes of this magnitude in the market.
Consequently, Lessee determines that it is reasonably certain to exercise the renewal option for a period
of six months.
CONCLUSION
Lessee concludes that the lease term is six months and therefore the lease meets the definition of a
short-term lease because the lease term is twelve months or less and there are no purchase options.
Lessee does not recognize the right-of-use asset and lease liability arising from the lease. Rather, the
lease payments are recognized on a straight-line basis over the 6-month period.
ACCOUNTING FOR LEASES UNDER ASC 842 118
Example 4 - Lease is not a short-term lease – Purchase option
FACTS
Bellamy Inc. manufactures music instruments and related equipment.
Lessee is a music band (assume it is a legal entity) that enters into a lease with Bellamy Inc. for the use
of 3 guitars, 4 amplifiers, 2 loopers, and a drum set for the band’s 3-month summer tour.
The stated term of the lease is 3 months, with the Lessee having the right to purchase the equipment at a
15% discount at the end of the summer tour.
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.
ANALYSIS
Lessee considers all relevant factors at the commencement date (including prevailing market prices for
similar equipment and the lessee’s need for the equipment in future gigs) and determines that it is
reasonably certain to exercise the purchase option.
CONCLUSION
Lessee concludes that the leases do not qualify for the short-term lease exception.
Lessee applies the general requirements in ASC 842 to the leases, including recognizing a right-of-use
asset and lease liability.
ACCOUNTING FOR LEASES UNDER ASC 842 119
In some arrangements, the lease will not include a continuous and uninterrupted period of use, but rather will consist
of non-consecutive periods of use. This can be due to the availability of the right-of-use asset to the lessee or the
specific needs of the lessee. With regards to the definition of a lease, the Master Glossary 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). [Emphasis Added]”
Therefore, the determination of whether a lease is a short-term lease is not performed based on each time increment
separately, but rather based on the sum of the nonconsecutive periods for which the lessee uses the underlying asset.
Example 5 - Lease is not a short-term lease - Non-consecutive periods
FACTS
Lessee is a basketball association that wishes to host its playoffs in a large venue each season.
Lessee enters into a lease with Ball-is-Life Co. for the use of 2 basketball arenas.
Lessee has the right to use the arenas only during the months of May and June every year during a 10-year
period.
The lease contract does not include any options.
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.
ANALYSIS
While each time increment (each playoff season) is shorter than 12 months (i.e., two months), Lessee
determines that the lease term is 20 months (two months every year times ten years).
CONCLUSION
Lessee concludes that the lease does not qualify for the short-term lease exception.
Lessee applies the general requirements in ASC 842 to this lease, including recognizing a right-of-use
asset and lease liability.
RECOGNITION AND INITIAL MEASUREMENT
RECOGNITION
A lessee recognizes a right-of-use asset and a lease liability at the commencement date of the lease, which is the date
on which the lessor makes the underlying asset available for use by the lessee. In some arrangements, the lessor may
make the underlying asset available for use by the lessee before the lessee begins operations or makes lease payments.
See Lease Classification and Key Terms
for additional details.
INITIAL MEASUREMENT
The initial measurement of the lease at the commencement date is the same for operating and financing leases.
A lessee initially measures the lease liability at the present value of the unpaid lease payments, discounted using the
discount rate for the lease. The discount rate for the lease is calculated based on information available at the
commencement date. A lessee uses the rate implicit in the lease whenever that rate is readily determinable, or
otherwise uses its incremental borrowing rate. A lessee that is not a public business entity is permitted to use a risk-
ACCOUNTING FOR LEASES UNDER ASC 842 120
free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting
policy election by asset class. See Lease Classification and Key Terms
for additional details.
The right-of-use asset is initially measured at cost as follows:
Example 6 below illustrates the initial measurement of a lease on balance sheet.
Also note that for the illustrations throughout this chapter:
The fact pattern in Example 6 will serve as the basis for most of the subsequent Examples in this
chapter.
The tables presented in each Example are consistent with how they would be displayed in a
spreadsheet, with amounts shown with no decimals, and no rounding function used.
Example 6 - Initial measurement of lease liability and right-of-use asset
FACTS
Retailer Co. enters into a 10-year lease for 10,000 square feet of retail space.
Annual lease payment is initially $100,000, paid in arrears, and increases 5 percent each year during the
lease term.
The rate implicit in the lease is not readily determinable. Retailer Co’s incremental borrowing rate (IBR)
at lease commencement is 6 percent.
The lease does not transfer ownership of the retail space to Retailer Co or grant it an option to purchase
the space.
Retailer Co. does not provide a residual value guarantee.
At the commencement date, the lessor paid Retailer Co $30,000 as an incentive to enter into the lease.
Retailer Co. incurred the following costs related to the lease:
•
$10,000 for employee wages for negotiating lease terms and conditions.
•
$20,000 for commissions paid to a broker.
•
$15,000 for external legal fees.
There are no nonlease components.
Assume the lease is classified as an operating lease.
Lease payments
made on or
before the
commencement
date
Initial direct
costs incurred
Lease incentives
received
Right-of-use
asset
Initial
measurement of
lease liability
ACCOUNTING FOR LEASES UNDER ASC 842 121
ANALYSIS
The lease payments are discounted using a 6% discount rate (that is, Retailer Co’s IBR), since the rate
implicit in the lease is not readily determinable.
The lease incentive of $30,000 is reflected in the initial measurement of the right-of-use asset but does
not affect the initial measurement of the lease liability, since it was received at the commencement
date.
The lease liability at the commencement date is $904,337, calculated as follows:
PMT
Year 1
100,000
Year 2
105,000
Year 3
110,250
Year 4
115,763
Year 5
121,551
Year 6
127,628
Year 7
134,010
Year 8
140,710
Year 9
147,746
Year 10
155,133
Undiscounted PMTs
1,257,789
PV(6%) =
904,337
Retailer Co. recognizes as initial direct costs only the fees paid to the broker. This is because the external
legal fees and employee wages would have been incurred even if Retailer Co. had not obtained the lease.
Retailer Co. initially measures the right-of-use asset at $894,337, calculated as follows:
Initial measurement of the lease liability
$904,337
Plus, prepaid lease payments
-
Plus, initial direct costs
20,000
Less, lease incentive received
(30,000)
Initial measurement of ROU asset
$894,337
Accordingly, at the commencement date, Retailer Co records the following entry:
$
$
Right-of-use asset
894,337
Operating expenses*
25,000
Lease liability
904,337
Cash**
15,000
* Legal fees and employee wages. For simplification, this Example assumes that those expenses are
incurred at the commencement date.
** All of Retailer Co’s expenses less the lease incentive. For simplification, this Example assumes that initial
direct costs and the operating expenses were incurred and paid at the commencement date.
Note that initial measurement of the lease on balance sheet is the same regardless of lease classification.
Subsequent accounting will be discussed in the following sections.
ACCOUNTING FOR LEASES UNDER ASC 842 122
The definition of initial direct costs is substantially narrower under ASC 842 as compared to legacy
guidance. This is due to the alignment with the concept of contract costs for revenue contracts
(see ASC 340-40-25-1 through 25-3). That is, lessees may capitalize only incremental costs of a
lease that would not have been incurred if the lease had not been obtained. Accordingly, many
costs that were previously capitalized as a separate asset under operating leases (or as part of the
leased asset for capital leases) are now required to be expensed when incurred.
A lessee may incur costs to ready the leased asset for its intended use, such as shipping,
installation and similar costs. If the lessee pays the lessor for those activities, the payments are
either part of the consideration in the contract or are variable payments that do not depend on an
index or a rate. However, the guidance is not clear when such costs are paid to a party other than
the lessor or when the lessee incurs the costs itself. Costs for such activities are not initial direct
costs because those are not costs to obtain a lease contract. Therefore, a lessee cannot capitalize
such costs by applying the guidance on initial direct costs.
However, the SEC staff addressed this question at the 2018 AICPA Conference on Current SEC
and PCAOB Developments:
Andrew W. Pidgeon
Professional Accounting Fellow, Office of the Chief Accountant
“Certain lessee and lessor costs
[…] we have received application questions related to the new leases standard, including questions
regarding lessee and lessor accounting for certain costs relating to a lease.
The first of those application questions related to lessee accounting for costs incurred to place a
leased asset into use. 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.[9] Since the asset is leased, not purchased, the lessee could determine that
the costs are in the scope of other GAAP,[10] 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.
[…] I encourage lessees and lessors that elect to apply either of those accounting policies to apply
the policies consistently and include appropriate disclosure of those policies if material.”
[9] FASB ASC Topic No. 360, Property, Plant, and Equipment (“Topic 360”); specifically, ASC 360-
10-30-1 states, in part, “… [t]hat 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. …”
[10] For example, costs incurred by a lessee could require deferral pursuant to FASB ASC Subtopic
No. 340-40, Other Assets and Deferred Costs – Contracts with Customers (“Subtopic 340-40”), or
capitalization pursuant to Topic 360, if the leased asset is used by the lessee to deliver goods or
services to a customer, or to construct property for the lessee, respectively.
Accordingly, we believe that to the extent the costs are not in the scope of other GAAP, either of
the following approaches is acceptable as an accounting policy election applied at the entity level
and disclosed if material:
ACCOUNTING FOR LEASES UNDER ASC 842 123
-
Expense the costs as incurred, or
-
Capitalize the costs by analogy to ASC 360 on property, plant or equipment for the costs
incurred to bring the asset to the condition and location necessary for its intended use. In
that situation, the costs capitalized under ASC 360 can either be recognized as a separate
asset or as part of the ROU asset. Regardless of its choice, the amortization pattern of such
costs should be the same and the lessee should include the assets in the same asset group
for impairment testing purposes.
SUBSEQUENT MEASUREMENT
FINANCE LEASES
After the commencement date, a lessee accounts for its finance leases as follows in its financial statements (absent
impairments, modifications and reassessments, which are discussed later):
Finance Leases
ROU Asset Lease Liability
Balance Sheet
Amortize the ROU asset on a straight-line
basis (unless another systematic basis is more
representative of the pattern in which the
lessee expects to consume the economic
benefits of the ROU asset) from the
commencement date to the earlier of the end
of its useful life or lease term. However, if
the lease transfers ownership of the
underlying asset to the lessee or the lessee is
reasonably certain to exercise a purchase
option, the lessee amortizes the right-of-use
asset to the end of the asset’s useful life.
Increase the lease liability to reflect interest
using the interest method and decrease it for
lease payments made during the period.
Income Statement*
Recognize amortization of the ROU asset. Recognize interest on the lease liability.
Recognize variable lease payments not included in the lease liability when incurred. If
variable lease payments are triggered based on a specified target, recognize costs from those
variable lease payments before the achievement of such target if achievement is probable.
Such variable lease costs should be reversed when it is probable the specified target will not
be met.
* Unless the costs are included in the carrying amount of another asset in accordance with other Topics.
As described above and as previously discussed, the accounting for a finance lease is consistent with the accounting for
a financed purchase of PP&E. This is because the FASB generally viewed finance leases as economically similar to the
purchase of a nonfinancial asset.
The lease liability is measured on an amortized cost basis and essentially reflects at each reporting period the present
value of the remaining lease payments discounted using the discount rate established at lease commencement (or at
the most recent lease modification not accounted for as a separate contract, or the most recent remeasurement
resulting from a reassessment of the lease term or purchase option, as discussed later in this chapter).
The ROU asset is measured at cost, net of accumulated amortization, and is amortized typically on a straight-line
basis, like PP&E under ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 124
Variable Lease Payments Based on Achievement of a Target
Lessees recognize variable lease payments in the period in which they are incurred, pursuant to
the guidance in ASC 842-20-25-5(b) and 25-6(b). ASC 842-20-55-1 and 55-2 provide additional
guidance when such payments are based on a cumulative target. Specifically, if variable lease
payments are triggered based on a specified target, then the costs are recognized before
achievement of that target assuming achievement is probable. The FASB included this provision to
ensure that lease payments are recognized in the periods in which the lessee benefits from use of
the leased asset.
For example, consider a situation in which an entity leases a vehicle for three years for $10,000
per year. If the lessee drives the car for more than 12,000 miles during the three-year period, then
the lease requires it to pay an extra $1,200. Assume that at lease commencement, it is probable
the lessee will drive the car more than 12,000 miles during the lease term. Under the guidance in
ASC 842-10-55-1, the lessee must accrue the additional $1,200 payment before it reaches 12,000
miles and therefore would recognize the additional $1,200 over the three-year lease term.
In contrast, if the lease required the lessee to pay $7,000 per year plus $1 for every mile driven,
the lessee would not assess probability and instead would recognize the $1 every time it drives one
mile, in accordance with ASC 842-20-25-5.
ACCOUNTING FOR LEASES UNDER ASC 842 125
Example 6.1 - Subsequent measurement of lease liability and right-of-use asset – Finance lease
FACTS
Assume the same facts as in Example 6 apply, in which the ROU asset and lease liability were initially
measured at $894,337 and $904,337 respectively, except that:
•
The lease is for a manufacturing equipment rather than retail space.
•
The remaining economic life of the equipment at lease commencement is 12 years.
ANALYSIS
Retailer Co. classifies the lease as a finance lease in accordance with ASC 842-10-25-2(c) as the lease
term (10 years) is for the major part of the remaining economic life of the underlying asset.
As there is no transfer of ownership or purchase option, the right-of-use asset is amortized from the
commencement date to the earlier of the useful life of the right-of-use asset and the lease term, which
in this Example is 10 years.
Lease liability accounting throughout the lease term (assuming no modifications and remeasurements)
Beg.
balance
Interest
(6%)
PMT
Closing
balance
Year 1
904,337
54,260
-100,000
858,598
Year 2
858,598
51,516
-105,000
805,114
Year 3
805,114
48,307
-110,250
743,170
Year 4
743,170
44,590
-115,763
671,998
Year 5
671,998
40,320
-121,551
590,767
Year 6
590,767
35,446
-127,628
498,585
Year 7
498,585
29,915
-134,010
394,491
Year 8
394,491
23,669
-140,710
277,450
Year 9
277,450
16,647
-147,746
146,352
Year 10
146,352
8,781
-155,133
0
Right-of-use asset amortization calculation
Annual amortization: 894,337/10 = 89,434
Journal entries (Year 1 shown only)
$
$
Interest expense
54,260
Lease liability
54,260
Lease liability
100,000
Cash
100,000
Amortization expense
89,434
Right-of-use asset
89,434
ACCOUNTING FOR LEASES UNDER ASC 842 126
OPERATING LEASES
After the commencement date, a lessee accounts for its operating leases as follows in its financial statements (absent
impairments, modifications and reassessments, which are discussed later):
Operating Leases
ROU Asset Lease Liability
Balance Sheet
ROU asset equals the amount of the lease
liability, adjusted for prepaid or accrued lease
payments, unamortized lease incentives, and
unamortized initial direct costs.
Alternatively, amortize the ROU asset for the
difference between the periodic lease cost and
periodic interest on the lease liability (see
discussion below).
Increase the lease liability to reflect interest
using the interest method and decrease it for
lease payments made during the period.
Income
Statement*
Recognize a single lease cost (i.e., lease payments plus initial direct costs) generally on a
straight-line basis over the lease term, unless another systematic basis is more representative of
the pattern in which the lessee expects to consume the economic benefits of the ROU asset.
Recognize variable lease payments not included in the lease liability when incurred. If variable
lease payments are triggered based on a specified target, recognize costs from those variable
lease payments before the achievement of such target if achievement is probable. Such variable
lease costs should be reversed when it is probable the specified target will not be met. Refer to
“Variable Lease Payments Based on Achievement of a Target” discussion in Finance Leases section
above for additional information.
* Unless the costs are included in the carrying amount of another asset in accordance with other Topics.
As previously discussed, the FASB concluded that operating leases are different from finance leases and purchases of
nonfinancial assets. Consequently, ASC 842 provides for different financial statement reporting of operating leases
from that of finance leases. The legacy guidance in ASC 840 required lessees to recognize operating lease expense
generally on a straight-line basis. This continues under ASC 842 whereby a lessee recognizes a single lease cost for
operating leases based on the pattern in which the benefits conveyed by the lease are consumed, which is generally
(though not always) on an equal basis over the lease term.
The lessee’s initial and subsequent accounting for operating lease liabilities is the same as for finance leases (i.e.,
reflecting the present value of the remaining lease payments), based on the view that the lessee should measure lease
liabilities in a manner similar to other similar financial liabilities (that is, on an amortized cost basis), regardless of
lease classification.
With the FASB’s intention to retain straight line expense recognition in the income statement while also accreting
interest on the lease liability under the interest method like other financial liabilities, the amortization of the ROU
asset essentially is the difference between the periodic lease cost and periodic interest accretion. Accordingly, while
ASC 842-20-35-3 describes the subsequent measurement of the right-of-use asset as shown in the table above (assuming
no impairment of the right-of-use asset), the lessee can determine the carrying value of right-of-use asset in
subsequent periods from the periodic lease cost and interest accretion.
ACCOUNTING FOR LEASES UNDER ASC 842 127
Initially, the total lease cost of an operating lease consists of the following:
The total lease payments (including those paid and those not yet paid); plus
The initial direct costs attributable to the lease.
Therefore, the periodic lease cost is the total lease cost divided by the lease term. Once the periodic lease cost is
determined, the carrying value of the ROU asset at each reporting period can be calculated as follows:
In other words, the periodic amortization of the right-of-use asset equals the difference between the periodic lease
cost and the periodic interest expense.
Example 6.2 - Subsequent measurement of lease liability and right-of-use asset – Operating lease
FACTS
Assume the same facts as in Example 6, in which:
•
The ROU asset and lease liability were initially measured at $894,337 and $904,337 respectively,
•
The unpaid lease payments were $1,257,789 on an undiscounted basis,
•
Initial direct costs were $20,000, and lease incentives received were $30,000, and
•
The lease is an operating lease.
ANALYSIS
The accounting for the lease liability is the same as in Example 6.1, assuming no modifications and
remeasurements, since there are no differences in accounting between operating lease liabilities and finance lease
liabilities.
Right-of-use asset accounting
Retailer Co. first calculates the total lease cost to be recognized over the lease term:
Total lease payments (paid and not yet paid)*
$1,227,789
Plus, initial direct costs
20,000
Total lease cost [A]
$1,247,789
Periodic lease cost [B] = [A] / 10
$124,779
* This amount reflects the total lease payments of $1,257,789, less the lease incentive received of $(30,000).
Closing balance
of right-of-use
asset
Opening balance
of right-of-use
asset
Periodic lease
cost
Periodic interest
expense
ACCOUNTING FOR LEASES UNDER ASC 842 128
Therefore, the accounting for the ROU asset, assuming no impairment, modifications or reassessments, can be
determined as follows:
Opening
balance
Periodic
lease cost
Interest
(6%)
Amortization
Closing
balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 1
894,337
-124,779
54,260
-70,519
823,819
Year 2
823,819
-124,779
51,516
-73,263
750,556
Year 3
750,556
-124,779
48,307
-76,472
674,084
Year 4
674,084
-124,779
44,590
-80,189
593,895
Year 5
593,895
-124,779
40,320
-84,459
509,436
Year 6
509,436
-124,779
35,446
-89,333
420,103
Year 7
420,103
-124,779
29,915
-94,864
325,239
Year 8
325,239
-124,779
23,669
-101,109
224,130
Year 9
224,130
-124,779
16,647
-108,132
115,998
Year 10
115,998
-124,779
8,781
-115,998
0
Journal entries (Year 1 shown only)
$
$
Lease liability
100,000
Cash
100,000
Lease expense
124,779
Right-of-use asset
70,519
Lease liability 54,260
As illustrated above and previously discussed, the lease cost of an operating lease is comprised of
both amortization and interest but it is recognized as a single cost generally on a straight-line basis
over the lease term.
Under the interest method, the periodic accretion of interest on the lease liability is higher in the
early periods of the lease than in the later periods, and interest amounts accreted decrease over
time as lease payments are made.
Accordingly, the amount attributed to the amortization of the right-of-use asset will be
correspondingly lower in the early periods and will increase over time. Therefore, in the early
periods of the lease, the right-of-use asset balance under operating leases will be higher than the
right-of-use asset balance for finance leases. However, the total lease cost recognized over the
entire lease term is the same.
ACCOUNTING FOR LEASES UNDER ASC 842 129
ASC 842 also notes that 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 or a modification (see separate sections below);
Plus, the initial direct costs attributable to the lease;
Less, the periodic lease cost recognized in prior periods.
However, if there are no modifications or reassessments and the operating lease ROU asset is not impaired, the
periodic lease cost remains the same throughout the lease term as illustrated in Example 6.2 above, and it does not
need to be recomputed each reporting period.
For example, the remaining lease cost of the lease in Example 6.2 at the end of Year 2 would be calculated as follows
and would result in the same periodic lease cost as in Year 1:
Total lease payments (paid and not yet paid)
$1,227,789
(see table in Example 6.2)
Plus, initial direct costs
20,000
(same as in Example 6.2)
Less, periodic lease cost recognized in Years 1 and 2
(249,558)
(i.e., $124,779 x 2 years)
Total lease cost [A]
$998,231
Periodic lease cost [B] = [A] / 8 years left
$124,779
Also note that, because the amortization of the ROU asset is the difference between the periodic lease cost and
periodic interest accretion, the remaining lease cost (and periodic lease cost) could also be determined as follows:
Carrying value of ROU asset at end of Year 2
$750,556
(same as in Example 6.2)
Plus, sum of interest accretion Years 3 – 10
247,675
Total remaining lease cost [A]
$998,231
Periodic lease cost [B] = [A] / 8 years left
$124,779
LEASEHOLD IMPROVEMENTS
Leasehold improvements are amortized over the shorter of the useful life of those 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 amortizes the leasehold
improvements to the end of their useful life. Also, as discussed in Chapter 4 on Lease Classification and Key Terms
,
the existence of significant leasehold improvements with a useful life longer than the noncancelable term of the lease
may indicate that it is reasonably certain that the lessee will exercise a renewal option. Therefore, the useful life of
the improvements should be considered when determining the remaining lease term.
Leasehold improvements acquired in a business combination or an acquisition by a not-for-profit entity are amortized
over the shorter of the useful life of the assets and the remaining lease term at the date of acquisition.
ACCOUNTING FOR LEASES UNDER ASC 842 130
REMEASUREMENTS
We discussed above the recognition and initial measurement of a lessee’s leases on balance sheet, which are based in
part on certain assumptions and judgment, such as assessing lessee options to extend or terminate the lease, or lessee
options to purchase the underlying asset. The Board noted in paragraph BC227 of ASU 2016-02 that “users of financial
statements receive more relevant information when entities reassess options on a regular basis because reassessment
reflects current economic conditions. For example, using a lease term established at lease commencement throughout
the lease could be misleading if there has been a change in facts or circumstances from those that existed at lease
commencement.” But the Board also noted that requiring reassessment of those options at each reporting date would
be costly for a lessee with many leases; and therefore, it limited this reassessment to certain specific events.
The FASB also considered situations in which entities might attempt to circumvent the balance sheet recognition of
leases. For example, a lease may initially provide for only nominal lease payments, or payments that are variable, but
which become fixed for the remainder of the lease term at a later date. Absent a remeasurement, the lessee would
continue to report a right-of-use asset and lease liability with little to no value. The FASB therefore requires lessees to
also remeasure the lease payments when a contingency on which some or all of the variable lease payments are based
is resolved such that the payments become fixed (the payments now meet the definition of lease payments).
Finally, the FASB decided that lessees should reassess amounts probable of being owed under residual value guarantees
because it provides more relevant information to users and reflects current economic conditions.
In summary, other than modifications which are discussed later, the FASB decided that after the commencement date,
a lessee should remeasure the lease payments only upon the occurrence of any of the following events:
Remeasurement Event
General Accounting Applicable to
All Remeasurement Events
Update the Discount
Rate?
Reassess Lease
Classification?
A change in the lease term or
the assessment of whether the
lessee is reasonably certain to
exercise a purchase option
Remeasure the lease payments
and the consideration in the
contract,
Reallocate the consideration to
the lease and nonlease
components (unless the
practical expedient not to
separate is elected), and
Remeasure the lease liability
and recognize the
remeasurement amount as an
adjustment to the ROU asset.
However, if the carrying amount
of the ROU asset is reduced to
zero, the remaining amount is
recognized in profit or loss.
Yes, unless the
discount rate already
reflects a lessee’s
extension,
termination or
purchase option
Yes
A contingency upon which some
or all of the variable lease
payments in the lease are based
is resolved such that those
payments become fixed
No No
A change in the amount
probable of being owed to the
lessor under a residual value
guarantee
No No
Note the following as well:
When the lessee updates the discount rate, it is performed at the remeasurement date based on the
remaining lease term and the remaining lease payments.
When lease classification is reassessed, it is done based on the facts and circumstances at the reassessment
date (e.g., based on the fair value and remaining economic life of the underlying asset at that date).
A lessee does not remeasure variable lease payments that depend on an index or a rate unless the lease
liability is remeasured for another reason (i.e., based on one of the above remeasurement events).
ACCOUNTING FOR LEASES UNDER ASC 842 131
CHANGE IN LEASE TERM OR ASSESSMENT OF PURCHASE OPTION
A lessee is required to reassess the lease term or its option to purchase the underlying asset only if and at the point in
time that any of the following occurs:
Examples of significant events or changes in circumstances within the lessee’s control include:
Constructing leasehold improvements that are expected to have significant value when the
option becomes exercisable;
Making significant modifications or customizations to the underlying asset;
Making a business decision that is directly relevant to the ability to exercise an option such
as extending the lease of a complementary asset; and
Subleasing the underlying asset for a period beyond the exercise date of the option.
However, note that:
Changes in market factors, such as market rates to lease comparable assets, do not in
isolation trigger a reassessment.
A requirement to test an asset group that includes the right-of-use asset for impairment does
not necessarily result in a requirement to reassess the lease term or purchase options.
Rather, the lessee should determine whether the impairment triggering event represents a
requirement to reassess the lease term or purchase option. For example, an asset group that
is tested for impairment because of a history of cash flow losses or because of a significant
decrease in the market price of a long-lived asset in isolation may not require a reassessment
of the lease term or purchase options.
Business decisions affect key estimates such as the lease term and the assessment of lessee purchase options.
Therefore, a lessee should work with business partners in the organization to develop a process to identify and track
which type of decisions are relevant to the assessment and when these decisions are made, such that these estimates
affecting the lease liability are updated timely for the financial statements. These decisions may not have a formal
paper trail and will need to be documented to arrive at key decisions regarding these estimates.
The requirements for a lessee to remeasure the lease payments for changes in the lease term and assessment of lessee
purchase options, remeasure and reallocate the consideration in the contract, remeasure the lease liability, update the
discount rate (except when the discount rate already reflects a lessee’s option), and reassess lease classification will
therefore require an entity to implement robust processes and controls to completely and timely identify events
requiring such remeasurements.
A significant event
or change in
circumstances
within the lessee's
control directly
affects whether
the lessee is
reasonably certain
to exercise (or not
to exercise) an
option
There is an event
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
ACCOUNTING FOR LEASES UNDER ASC 842 132
Example 6.3A - Reassessment of the lease term – Operating lease
FACTS
Assume the same facts as in Example 6 and Example 6.2 apply, in which the lease of the retail space is an
operating lease. Also assume the following:
•
The contract provides Retailer Co. with the option to extend the lease for an additional 10 years.
•
Annual lease payments during the optional period are $150,000.
•
At the commencement date, Retailer Co. concluded it was not reasonably certain to exercise the
extension option because payments in the renewal period are substantially the same as the
amount otherwise due in the final year of the initial period, there is significant uncertainty as to
whether Retailer Co. will need the underlying asset after ten years, and Retailer Co. did not
construct improvements with an economic life longer than the initial term. Therefore, Retailer
Co. determined that the lease term was 10 years.
•
The discount rate for the lease of 6 percent at the commencement date does not reflect that
Retailer Co. has an option to extend the lease.
•
At the beginning of Year 6 of the lease, the financial performance of the retail space is higher
than initially expected, and Retailer Co. installs significant leasehold improvements. Those
improvements are expected to have significant economic value for Retailer Co. at the end of Year
10. Consequently, construction of the leasehold improvements is considered a significant event or
change in circumstances that directly affects whether Retailer Co. is reasonably certain to
exercise the extension option.
The initial accounting for the lease throughout the lease term, absent a remeasurement or modification,
was discussed in the prior examples and is summarized in the following table:
Lease Liability
ROU Asset
Beg. Bal.
Interest
PMT
Ending Bal.
Beg. Bal.
Amort.
Ending Bal.
Year 1
904,337
54,260
-100,000
858,598
894,337
-70,519
823,819
Year 2
858,598
51,516
-105,000
805,114
823,819
-73,263
750,556
Year 3
805,114
48,307
-110,250
743,170
750,556
-76,472
674,084
Year 4
743,170
44,590
-115,763
671,998
674,084
-80,189
593,895
Year 5
671,998
40,320
-121,551
590,767
593,895
-84,459
509,436
Year 6
590,767
35,446
-127,628
498,585
509,436
-89,333
420,103
Year 7
498,585
29,915
-134,010
394,491
420,103
-94,864
325,239
Year 8
394,491
23,669
-140,710
277,450
325,239
-101,109
224,130
Year 9
277,450
16,647
-147,746
146,352
224,130
-108,132
115,998
Year 10
146,352
8,781
-155,133
0
115,998
-115,998
0
ACCOUNTING FOR LEASES UNDER ASC 842 133
ANALYSIS
Upon reassessing the lease term at the beginning of Year 6, Retailer Co. concludes that it is reasonably
certain to exercise the option to extend the lease for an additional 10 years.
Retailer Co. remeasures the lease payments (the consideration in the contract) to reflect the revised
lease term. Since there are no nonlease components and there is only one lease component, there is no
reallocation of the consideration necessary.
Since the discount rate at commencement did not reflect Retailer Co. having the extension option, the
discount rate is updated at the reassessment date. Considering the extended remaining lease term (15
years in total) and remaining lease payments, Retailer Co. determines that its incremental borrowing rate
at the beginning of Year 6 is 8 percent.
Retailer Co. reassesses lease classification based on the fair value of the underlying asset and remaining
economic life at the beginning of Year 6. Assume the lease continues to be an operating lease.
Retailer Co. remeasures the lease liability using the revised lease payments and updated discount rate.
This results in an updated lease liability of $1,243,959, or an increase of $653,192 (1,243,959 – 590,767).
The remeasurement of the lease liability is recognized as an adjustment to the ROU asset. Accordingly,
the carrying value of the ROU asset immediately after the remeasurement is $1,162,628 (509,436 +
653,192).
Retailer Co. updates the periodic lease cost for the remainder of the lease (15 years) as follows:
Total lease payments (paid and not yet paid)*
$2,727,789
Plus, initial direct costs
20,000
Less, periodic lease cost recognized in prior periods**
(623,895)
Total remaining lease cost [A]
$2,123,894
Periodic lease cost [B] = [A] / 15y
$141,593
* This amount reflects the total lease payments (including those paid in Years 1-5 and those not yet paid for Years
6-20), less the lease incentive received at the commencement date of $30,000.
** Prior periodic lease cost of $124,779 x 5 years
Following the remeasurement, Retailer Co. recognizes a single lease expense of $141,593 each year for
the remainder of the lease term assuming no impairment, modifications, or other reassessments.
The amortization of the right-of-use asset is determined as the difference between the single lease cost
of $141,593, and the periodic interest accretion on the lease liability. For example, for Year 6
amortization of the right-of-use asset is $42,076 (141,593 – 99,517).
ACCOUNTING FOR LEASES UNDER ASC 842 134
The accounting for the lease after the remeasurement, and throughout the lease term (assuming no impairment,
modifications, or other reassessments) is summarized in the following table:
Lease Liability
ROU Asset
Beg. Bal.
Interest
PMT
Ending Bal.
Beg. Bal.
Amort.
Ending Bal.
Year 6
1,243,959
99,517
-127,628
1,215,848
1,162,628
-42,076
1,120,552
Year 7
1,215,848
97,268
-134,010
1,179,106
1,120,552
-44,325
1,076,227
Year 8
1,179,106
94,329
-140,710
1,132,725
1,076,227
-47,264
1,028,962
Year 9
1,132,725
90,618
-147,746
1,075,597
1,028,962
-50,975
977,987
Year 10
1,075,597
86,048
-155,133
1,006,512
977,987
-55,545
922,442
Year 11
1,006,512
80,521
-150,000
937,033
922,442
-61,072
861,370
Year 12
937,033
74,963
-150,000
861,996
861,370
-66,630
794,740
Year 13
861,996
68,960
-150,000
780,956
794,740
-72,633
722,106
Year 14
780,956
62,476
-150,000
693,432
722,106
-79,117
642,990
Year 15
693,432
55,475
-150,000
598,907
642,990
-86,118
556,871
Year 16
598,907
47,913
-150,000
496,819
556,871
-93,680
463,191
Year 17
496,819
39,746
-150,000
386,565
463,191
-101,847
361,343
Year 18
386,565
30,925
-150,000
267,490
361,343
-110,668
250,676
Year 19
267,490
21,399
-150,000
138,889
250,676
-120,194
130,482
Year 20
138,889
11,111
-150,000
0
130,482
-130,482
0
Example 6.3B - Reassessment of the lease term – Operating lease
FACTS
Assume the same as in Example 6.3A, except that at the beginning of Year 6, Retailer Co. only refreshes
the store and spends $40,000 to repaint the interior of the store and reconfigure the floor space,
including relocating the registers and certain fixed display racks.
ANALYSIS
Although judgement would need to be applied, these expenditures are not typically considered leasehold
improvements, but rather typical maintenance activities that should be expected in the life cycle of an
asset. As such, in the above specific facts and circumstances, these expenditures would not trigger a
reassessment event for Retailer Co. and would be expensed as incurred.
The accounting for a lease that is remeasured because of a change in the assessment of the lease
term or a purchase option is essentially like the accounting for a new lease, since the lessee
reperforms all steps required for a new lease (e.g., measure and allocate the consideration in the
contract, determine the discount rate, assess lease classification, etc.). This was illustrated in
Example 6.3A above.
ACCOUNTING FOR LEASES UNDER ASC 842 135
RESOLUTION OF A CONTINGENCY UPON WHICH VARIABLE LEASE PAYMENTS ARE BASED
Example 6.4 - Resolution of a contingency – Operating lease
FACTS
Assume the same facts as in Example 6 and Example 6.2 apply, in which the lease of the retail space is an
operating lease. Also assume the following:
•
At lease inception, Retailer Co. was selling only Product A and was in the process of developing
Product B, a product that would complement the use of, and increase the customer experience
with, Product A.
•
In addition to the fixed annual payments described in Example 6, the contract requires Retailer
Co. to pay annually as additional rent an amount equal to 2% of Retailer Co.’s sales. However,
upon its launch of Product B, Retailer Co. will pay an additional annual payment amount for the
remainder of the lease term of $20,000 instead of the 2% payment on sales.
•
Retailer Co.’s sales in Years 1 and 2 are $350,000 and $500,000, respectively.
•
At the beginning of Year 3, Retailer Co. launches Product B in the market and starts selling it in
the retail store.
ANALYSIS
The payment determined as a percentage of sales is a variable lease payment that does not depend on an
index or a rate. Therefore, it is recorded as a periodic variable lease expense and it does not affect the
measurement of the lease liability. Retailer Co. recognizes variable lease expense of $7,000 and $10,000
in Years 1 and 2, respectively.
At the beginning of Year 3 (when the contingency is resolved), Retailer Co. remeasures the lease
payments in accordance with ASC 842-10-35-4(b) and discounts the revised lease payments using the
original discount rate consistent with ASC 842-20-35-5(c). The remeasurement amount is recognized as an
adjustment to the ROU asset.
At the beginning of Year 3, the carrying value of the lease liability and ROU asset are $805,114 and
$750,556, respectively.
Retailer Co. remeasures the lease liability to $929,309 as follows:
PMT
Interest
(6%)
Principal
Amort.
Closing
balance
Year 3
-130,250
55,759
-74,491
854,818
Year 4
-135,763
51,289
-84,473
770,345
Year 5
-141,551
46,221
-95,330
675,015
Year 6
-147,628
40,501
-107,127
567,887
Year 7
-154,010
34,073
-119,936
447,951
Year 8
-160,710
26,877
-133,833
314,118
Year 9
-167,746
18,847
-148,898
165,220
Year 10
-175,133
9,913
-165,220
0
Undiscounted PMTs
PV(6%)=
-1,212,789
-929,309
ACCOUNTING FOR LEASES UNDER ASC 842 136
This results in an increase to the lease liability of $124,195 ($929,309 - 805,114). The amount of the
remeasurement is recognized as an adjustment to the ROU asset.
$
$
Right-of-use asset
124,195
Lease liability
124,195
The updated balance of the right-of-use asset is therefore $874,751 ($750,556 + $124,195).
Because the lease liability was remeasured, Retailer Co. updates the periodic lease cost for the
remainder of the lease term (8 years):
Total lease payments (paid and not yet paid)*
$1,387,789
Plus, initial direct costs
20,000
Less, periodic lease cost recognized in prior periods**
(249,558)
Total remaining lease cost [A]
$1,158,231
Periodic lease cost [B] = [A] / 8y
$144,779
* This amount reflects the total revised lease payments. It includes those paid in Year 1 of $100,000 and Year 2 of
$105,000, plus the revised lease payments for the remaining lease term of $1,212,789, less the lease incentive
received at commencement of $(30,000).
** Represents prior periodic lease cost of $124,779 x 2 years (See Example 6.2)
Following the remeasurement, Retailer Co. recognizes a single lease expense of $144,779 each year for
the remainder of the lease term assuming no impairment, modifications, or other reassessments.
The accounting for the right-of-use asset after the remeasurement, and throughout the lease term
(assuming no impairment, modifications, or other reassessments) can be determined as follows:
Opening
balance
Periodic
lease cost
Interest
(6%)
Amortization
Closing
balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 3
874,751
-144,779
55,759
-89,020
785,730
Year 4
785,730
-144,779
51,289
-93,490
692,240
Year 5
692,240
-144,779
46,221
-98,558
593,682
Year 6
593,682
-144,779
40,501
-104,278
489,404
Year 7
489,404
-144,779
34,073
-110,706
378,698
Year 8
378,698
-144,779
26,877
-117,902
260,797
Year 9
260,797
-144,779
18,847
-125,932
134,865
Year 10
134,865
-144,779
9,913
-134,865
0
ACCOUNTING FOR LEASES UNDER ASC 842 137
VARIABLE LEASE PAYMENTS THAT DEPEND ON AN INDEX OR A RATE
As discussed in the Lease Classification and Key Terms, variable lease payments that depend on an index or a rate are
included in the lease payments and are initially measured using the index or rate at the commencement date. Other
variable payments (for example, those based on sales of the lessee) typically are not included in the lease payments.
Subsequent changes in the index or rate do not represent the resolution of a contingency and, therefore, absent
another event requiring remeasurement of the lease payments, the amounts resulting from the difference between the
index or rate at commencement and subsequent changes are recognized as variable lease payments. Variable lease
payments based on an index or a rate are remeasured only when the lessee remeasures the lease payments for another
reason (for example, when there is a change in the lease term) and, if so, are remeasured using the index or rate at
the remeasurement date. The FASB considered, but rejected, an approach in IFRS 16, Leases in which the lessee
remeasures the lease payments when there is a change in the cash flows (when the adjustment to the lease payments
takes effect).
The following table summarizes the accounting for variable lease payments based on an index or a rate under ASC 842:
Accounting Under ASC 842
Variable lease payments based on an index or a rate are not
remeasured after the commencement date, and subsequent changes in
the index or rate are recognized as variable lease payments, unless the
lessee remeasures the lease payments for another reason.
When lease payments are remeasured for another reason (for example,
when there is a change in the lease term), a lessee remeasures variable
lease payments that depend on an index or a rate using the index or
rate at the remeasurement date.
A lessee updates the discount rate if the lease payments are
remeasured because of (a) a modification not accounted for as a
separate contract, or (b) a change in the lease term or the assessment
of a purchase option.
ACCOUNTING FOR LEASES UNDER ASC 842 138
Example 6.5 - Remeasurement of variable lease payments that depend on an index or a rate
FACTS
Assume Retailer Co. entered into another lease of retail space with the following terms:
•
The noncancellable period of the lease is five years, and Retailer Co. has an option to renew the
term for an additional five years.
•
At the commencement date, Retailer Co. determines it is not reasonably certain to exercise the
renewal option. Accordingly, the lease term at the commencement date is five years.
•
Annual lease payments are $100,000, payable at the beginning of each year.
•
Lease payments for each year will increase based on the increase in the Consumer Price Index
(CPI) for the preceding 12 months.
•
The lease is classified as an operating lease.
•
There are no nonlease components.
Retailer Co. paid $20,000 of initial direct costs and received at the commencement date a lease incentive
of $30,000.
The rate implicit in the lease is not readily determinable. Therefore, Retailer Co. uses its incremental
borrowing rate, which is 7% at the commencement date.
Assume that at the end of the first year of the lease, CPI has increased by 2%.
ANALYSIS
The initial measurement of the lease liability after the first payment is $338,721 (present value of four
payments of $100,000 due at the beginning of Years 2 to 5, discounted at $7%).
The initial measurement of the right-of-use asset is $428,721 (amount of lease liability of $338,721, plus
lease prepayment of $100,000, plus initial direct costs of $20,000, less lease incentive of $30,000).
In Year 1, Retailer Co. recognizes a single lease cost of $98,000 (the total lease payments of $470,000
[$500,000 – lease incentive of $30,000], plus initial direct costs of $20,000 equals total lease costs of
$490,000, which is divided by the lease term of five years).
If Retailer Co. is not required to remeasure the lease liability for another reason, Retailer Co. does not
make an adjustment to the lease liability to reflect the increase in payments due to the increase in CPI at
the end of the reporting period. In other words, the measurement of the lease liability continues to
reflect annual lease payments of $100,000.
For example, the Year 2 payment amount is $102,000. However, the $100,000 annual fixed payment
continues to be recognized as a reduction in the lease liability, while the $2,000 variable lease payment
will be recognized in profit or loss for Year 2 of the lease along with the single lease cost of $98,000. The
lease liability is not remeasured.
ACCOUNTING FOR LEASES UNDER ASC 842 139
MODIFICATIONS
A lease modification is 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 of the contract that adds or terminates the right to
use one or more underlying assets or extends or shortens the contractual lease term). Modifications only include
changes to the terms and conditions that did not exist in the original contract. For example, the exercise of an option
that was included in the original lease does not constitute a modification. Lessees are required to account for
modifications at the date that the lease modification is approved by the lessee and the lessor, which is the effective
date of the modification under ASC 842. ASC 842 differentiates between modifications that result in a separate
contract and which therefore do not affect the accounting for the original contract, and other modifications that
should be accounted for as part of the original contract. That determination can be made by using the following steps:
ASU 2020-04 provides optional expedients and exceptions for applying U.S. GAAP to contracts and
transactions affected by the reference rate reform (i.e. discontinuation of LIBOR as a reference rate or
other reference rate expected to be discontinued as a result of reference rate reform). Accordingly,
modifications to contracts within the scope of ASC 842 may be accounted for as a continuation of the
existing contract with no reassessment of lease classification and discount rate, and no remeasurement
of lease payments that otherwise would be required for modifications not accounted for as separate
contracts. Instead, the change in reference rate is treated as variable lease payments that were based
on the reference rate in the original lease. However, to qualify for the optional expedient, other terms
being concurrently modified, if any, need to be related to the replacement of a reference rate
because of reference rate reform. For example, changes to the contractual term of the lease,
additions or terminations of right-to-use underlying assets, changes to renewal, termination or
purchase options are deemed unrelated to the replacement of a reference rate and, therefore, are not
eligible for the expedient. See ASC 848-20-15-2 through 15-6 for additional information about scope of
the expedient, and ASC 848-20-35-11 through 35-13 for application of the expedient to leases.
ACCOUNTING FOR LEASES UNDER ASC 842 140
If a modification is not accounted for as a separate contract, the lessee accounts for the modification as follows at the
modification’s effective date:
Modification General Accounting Additional Guidance
Grants the lessee an
additional right-of-use not
included in the original
contract and the lease
payments are not
commensurate with
standalone price
Remeasure the
lease payments and
the consideration in
the contract,
Reallocate the
remaining
consideration to the
lease and nonlease
components (unless
the practical
expedient to not
separate is
elected),
Update the discount
rate for the lease,
Remeasure the
lease liability, and
Reassess lease
classification and
update the
subsequent
accounting for the
lease accordingly.
Recognize the remeasurement amount 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, the remaining amount is
generally recognized in profit or loss.
Extends or reduces the
term of an existing lease,
other than through
exercise of an option in
the original contract
Changes the consideration
in the contract only
Fully or partially
terminates an existing
lease (for example,
reduces the assets subject
to the lease)
Decrease the carrying amount of the ROU asset on a
basis proportionate to the full or partial termination.
Any difference between the reduction in lease liability
and proportionate reduction in ROU asset is recognized
as a gain or loss at the modification’s effective date.
ASC 842 provides two acceptable methods for
determining the proportional reduction in the ROU
asset (see illustration in Example 6.9).
The following is also important to note:
Initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a
modification to a lease should be accounted for in the same manner as those items would be accounted for
in connection with a new lease.
If a finance lease is modified and the modified lease is classified as an operating lease, any difference
between the adjusted carrying amount of the right-of-use asset and the carrying amount of the right-of-use
asset that would result from applying the initial operating right-of-use asset measurement guidance to the
modified lease should be accounted for like a rent prepayment or lease incentive (see Example 6.8B).
If a master lease agreement permits the lessee to gain control over the use of additional underlying assets
during the contract’s term but does not obligate the lessee to do so, the lessee taking control over the use of
an additional asset should be accounted for as a lease modification as described above (i.e., apply the
flowchart above, and if applicable, the accounting in the above table). In contrast, a master lease
agreement that specifies a minimum number of units or dollar value of equipment does not result in a lease
modification when the lessee obtains control over the use of those additional assets. Rather, there may be
separate lease components in the original contract, and potentially multiple commencement dates.
When a modification is not accounted for as a separate contract, the lessee remeasures the lease
liability for the modified, existing lease as of the modification’s effective date as if the modified lease
were a new lease that commenced on that date. Therefore, the lessee reassesses lease classification
and remeasures the right-of-use asset and the lease liability based on the changed terms and
conditions of the modified contract (including the changed lease payments).
ACCOUNTING FOR LEASES UNDER ASC 842 141
Example 6.6 - Modification is accounted for as a separate lease
FACTS
Assume the same facts as in Examples 6 and 6.2 apply, in which the lease of the retail space is an
operating lease. Also assume the following:
•
At the end of Year 5 of the lease, Retailer Co. and the lessor agree to modify the contract to
include an additional 9,000 square feet of retail space in an adjacent building for the remaining 5
years of the original 10-year lease term. No costs are incurred with the modification.
•
The additional space is made available for use by Retailer Co. at the beginning of Year 6.
•
The annual lease payments in Years 6-10 increase by $140,000, payable in arrears.
•
Retailer Co.’s incremental borrowing rate at the effective date of the modification is 7%.
ANALYSIS
Retailer Co. notes that the modification grants it an additional right-of-use not included in the original
contract. Retailer Co. also assesses the corresponding increase in lease payments and determines that the
increase is commensurate with the market lease rate for similar space at the modification date. Retailer
Co. therefore concludes that the modification should be accounted for as a separate contract.
This means that the accounting for the original 10-year lease of 10,000 square feet is not affected by the
modification (see Example 6.2 for the accounting).
Retailer Co. determines that the separate lease is an operating lease.
The accounting for the lease liability for the new 9,000 square feet of retail space lease is as follows:
PMT
Interest
(7%)
Principal
Amort.
Closing
balance
Year 1
-140,000
40,182
-99,818
474,210
Year 2
-140,000
33,195
-106,805
367,404
Year 3
-140,000
25,718
-114,282
253,123
Year 4
-140,000
17,719
-122,281
130,841
Year 5
-140,000
9,159
-130,841
0
PV(7%) =
574,028
Retailer Co. initially measures the ROU asset at the same amount as the lease liability (since there are no
initial direct costs, or lease incentives received, for the additional right-of-use).
$
$
Right-of-use asset
574,028
Lease liability
574,028
Retailer Co. accounts for the right-of-use asset as follows, assuming no impairment and remeasurements.
Opening
balance
Periodic
lease cost
Interest (7%)
Amortization
Closing
balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 1
574,028
-140,000
40,182
-99,818
474,210
Year 2
474,210
-140,000
33,195
-106,805
367,404
Year 3
367,404
-140,000
25,718
-114,282
253,123
Year 4
253,123
-140,000
17,719
-122,281
130,841
Year 5
130,841
-140,000
9,159
-130,841
0
ACCOUNTING FOR LEASES UNDER ASC 842 142
Example 6.7 - Modification is not accounted for as a separate lease - Lease classification unchanged
FACTS
Assume the same facts as in Examples 6 and 6.2 apply in which Retailer Co’s lease of retail space is
classified as an operating lease. Also assume the following:
•
At the beginning of Year 6, Retailer Co. and the lessor agree to extend the term of the lease by 5
years for fixed annual lease payments of $140,000.
•
At the beginning of Year 6, the carrying amount of the lease liability and right-of-use assets are
$590,767 and $509,436, respectively.
•
Retailer Co.’s incremental borrowing rate at the effective date of the modification is 7%.
ANALYSIS
The modification does not grant Retailer Co. an additional right of use. It merely changes an attribute of
the original lease by extending the period of use for the original ROU asset. That is, Retailer Co. still
controls only a single right of use it received at lease commencement.
Therefore, the modification cannot be accounted for as a separate contract.
At the effective date of the modification, Retailer Co. reassesses lease classification using the revised
lease term and lease payments, remaining economic life, current fair value and updated discount rate,
and concludes that it continues to be an operating lease.
Retailer Co. remeasures the lease liability based on the remaining 10-year lease term and 10 remaining
payments using its incremental borrowing rate at the modification date of 7%.
PMT
Interest
(7%)
Principal
Amort.
Closing
Balance
Year 6
-127,628
68,865
-58,763
925,022
Year 7
-134,010
64,752
-69,258
855,764
Year 8
-140,710
59,903
-80,807
774,957
Year 9
-147,746
54,247
-93,499
681,458
Year 10
-155,133
47,702
-107,431
574,028
Year 11
-140,000
40,182
-99,818
474,210
Year 12
-140,000
33,195
-106,805
367,404
Year 13
-140,000
25,718
-114,282
253,123
Year 14
-140,000
17,719
-122,281
130,841
Year 15
-140,000
9,159
-130,841
0
PV(7%)=
983,785
ACCOUNTING FOR LEASES UNDER ASC 842 143
Consequently, the modified lease liability equals $983,785 (or an increase of $393,017).
The increase to the lease liability is recorded as an adjustment to the right-of-use asset (that is, there is
no income or loss recognized at the modification date). The updated balance of the right-of-use asset is
$902,453 ($509,436 + $393,017).
Retailer Co. updates the periodic lease cost for the remainder of the lease (10 years):
Total lease payments (paid and not yet paid)*
$1,927,789
Plus, initial direct costs
20,000
Less, periodic lease cost recognized in prior periods**
(623,895)
Total remaining lease cost [A]
$1,323,894
Periodic lease cost [B] = [A] / 10y
$132,389
* This amount reflects the total revised lease payments. It includes those paid in Years 1 – 5, the revised lease payments
for the remaining lease term, less the lease incentive received at commencement date of $30,000.
** Represents period lease cost of $124,779 for 5 years.
Retailer Co. recognizes annual straight-line lease expense of $132,389 for the remainder of the lease
term.
The accounting for the ROU asset after the remeasurement is summarized in the following table,
assuming no impairment and remeasurements:
Opening
balance
Periodic
lease cost
Interest on
lease liability
Amortization
Ending
Balance
[A]
[B]
[C]
[D] = [B] +
[C]
[A] + [D]
Year 6
902,453
-132,389
68,865
-63,525
838,929
Year 7
838,929
-132,389
64,752
-67,638
771,291
Year 8
771,291
-132,389
59,903
-72,486
698,805
Year 9
698,805
-132,389
54,247
-78,142
620,662
Year 10
620,662
-132,389
47,702
-84,687
535,975
Year 11
535,975
-132,389
40,182
-92,208
443,767
Year 12
443,767
-132,389
33,195
-99,195
344,573
Year 13
344,573
-132,389
25,718
-106,671
237,901
Year 14
237,901
-132,389
17,719
-114,671
123,231
Year 15
123,231
-132,389
9,159
-123,231
0
ACCOUNTING FOR LEASES UNDER ASC 842 144
Example 6.8A - Modification is not accounted for as a separate lease – Lease classification changes from
operating to finance
FACTS
Assume the same facts as in Example 6.7 above apply, except that at the effective date of the
modification, Retailer Co. concludes that lease classification changes from operating to finance.
ANALYSIS
The assessment of the modification is the same as in Example 6.7, and therefore the modification cannot
be accounted for as a separate contract.
The remeasurement of the lease liability and adjustment to the ROU asset is also the same as in Example
6.7. That is, after the remeasurement, the carrying value of the lease liability and ROU asset are
$983,785 and $902,453, respectively.
However, unlike Example 6.7, Retailer Co. does not calculate the updated straight-line lease expense.
Instead, as of the effective date of the lease modification, the ROU asset is amortized on a straight-line
basis to the earlier of the end of the underlying asset’s useful life or lease term. However, If the lease
transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise a
purchase option, the lessee amortizes the right-of-use asset to the end of the asset’s useful life.
Example 6.8B - Modification is not accounted for as a separate lease – Lease classification changes from finance
to operating
FACTS
Assume the same facts as in Examples 6 and 6.1 apply, in which Retailer Co’s lease of manufacturing
equipment was a finance lease. Also assume the following:
•
At the beginning of Year 6, Retailer Co. and the lessor agree to modify the lease to reduce the
remaining lease term by two years and for revised annual lease payments of $130,000 for the
remaining three years of the lease.
•
At the beginning of Year 6, the carrying amount of the lease liability and right-of-use assets are
$590,767 and $447,169 (894,337*[5/10]), respectively.
•
Retailer Co.’s incremental borrowing rate at the effective date of the modification is 7%.
ACCOUNTING FOR LEASES UNDER ASC 842 145
ANALYSIS
The modification reduces the term of the lease, and the term is an attribute of the lease. Therefore, the
modification cannot be accounted for as a separate contract and Retailer applies ASC 842-10-25-11(b).
Retailer Co. remeasures the lease liability based on the remaining 3-year lease term, 3 remaining
payments using its incremental borrowing rate at the modification date of 7%.
PMT
Interest
(7%)
Principal
Amort.
Closing
Balance
Year 6
-130,000
23,881
-106,119
235,042
Year 7
-130,000
16,453
-113,547
121,495
Year 8
-130,000
8,505
-121,495
0
PV(7%)=
341,161
Consequently, the remeasured lease liability equals $341,161 (or a decrease of $249,606).
The decrease in lease liability is recorded as an adjustment to the ROU asset (that is, there is no income or
loss recognized at the modification date). The updated balance of the right-of-use asset is $197,562.
Retailer Co. accounts for the lease at the modification date as an operating lease; e.g. the revised lease
term is not for the major part of the remaining economic life of the underlying asset (3/7= 42.86%).
Accordingly, Retailer Co. will record a single lease cost over the remaining lease term (3 years).
In addition, in accordance with ASC 842-10-25-14, Retailer Co. accounts for the difference between the
updated carrying amount of the ROU asset and the carrying amount of the ROU asset that would result from
applying the initial measurement guidance for operating ROU assets, as either a rent prepayment or a lease
incentive. Retailer Co. calculates that amount as follows:
Updated ROU asset carrying amount
$197,562
ROU operating lease carrying amount*
341,161
Lease incentive
$(143,599)
* This amount represents the amount of the lease liability after remeasurement. There are no initial direct costs or
lease incentives for the modification and, therefore, no further adjustments under ASC 842-20-30-5.
Next, Retailer Co. calculates the remaining cost for the lease as follows*:
Sum of remaining lease payments**
$390,000
Less, lease incentive adjustment from above
(143,599)
Total remaining lease cost [A]
$246,401
Periodic lease cost [B] = [A] / 3y
$82,134
* Approach illustrated is based on application of ASC 842-10-25-14. Alternatively, Retailer Co. could determine the
remaining lease cost by applying ASC 842-20-25-8. In doing so, the lease incentive calculated above of $143,599 would
not be included under ASC 842-20-25-8(a) (it only relates to application of the method described in ASC 842-10-25-14),
and the periodic lease cost previously recognized under ASC 842-20-25-8(c) would be determined as the sum of periodic
interest and amortization of the ROU asset. Regardless of the approach selected, the total remaining lease cost should
be the same.
** This amount reflects the remaining (modified) lease payments ($130,000 x 3 years).
ACCOUNTING FOR LEASES UNDER ASC 842 146
Retailer Co. recognizes annual straight-line lease expense of $82,134 for the remainder of the lease term.
The accounting for the ROU asset after the remeasurement is summarized in the following table:
Opening
balance
Periodic
lease cost
Interest on
lease liability
Amortization
Ending
Balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 6
197,562
-82,134
23,881
-58,253
139,310
Year 7
139,310
-82,134
16,453
-65,681
73,629
Year 8
73,629
-82,134
8,505
-73,629
0
Example 6.9A - Modification is not accounted as a separate lease – Partial termination
FACTS
Assume the same facts as in Examples 6 and 6.2 apply, in which the lease is an operating lease. Also
assume the following:
•
At the beginning of Year 6 of the lease, Retailer Co. and the lessor agree to modify the original
lease for the remaining 5 years to immediately reduce the leased retail space to only 5,000
square feet. In addition, the annual lease payments in Years 6-10 are reduced to $65,000.
•
At the beginning of Year 6, the carrying amount of the lease liability and right-of-use assets are
$590,767 and $509,436, respectively.
•
Retailer Co.’s incremental borrowing rate at the effective date of the modification is 7%.
ANALYSIS
Retailer Co. concludes that the modification should not be accounted for as a separate contract, as it
does not grant Retailer Co. an additional right of use but rather decreases the original scope of the lease
(from 10,000 square feet to 5,000 square feet).
At the effective date of the modification, Retailer Co. reassesses lease classification and concludes that
the lease continues to be an operating lease.
Retailer Co. remeasures the lease liability based on the remaining 5-year lease term and discounts the
remaining payments using its incremental borrowing rate at that date.
PMT
Interest
(7%)
Principal
Amort.
Closing
Balance
Year 6
-65,000
18,656
-46,344
220,169
Year 7
-65,000
15,412
-49,588
170,581
Year 8
-65,000
11,941
-53,059
117,521
Year 9
-65,000
8,226
-56,774
60,748
Year 10
-65,000
4,252
-60,748
0
PV(7%)=
266,513
ACCOUNTING FOR LEASES UNDER ASC 842 147
The carrying amount of the right-of-use asset is determined using either of the following approaches:
Method A – Remeasuring the ROU asset based on the
change in lease liability
Method B – Remeasuring the ROU asset based on the
remaining right-of-use
Lease liability after modification 266,513
Lease liability before modification (590,767)
Remeasurement adjustment (324,254)
Percentage change in liability (54.89)%
Pre-modification ROU asset: 509,436
Percentage of change in liability (54.89)%
Reduction ROU asset (279,614)
$ $
Lease liability 324,254
Other income/gain 44,640
Right-of-use asset 279,614
The updated balance of the lease liability and of the
right-of-use asset after the above journal entry are
$266,513 and $229,822, respectively.
Reduction in ROU (5,000)/10,000SF = (50.00)%
Pre-modification ROU asset 509,436
Percentage of change in ROU (50.00)%
Reduction to ROU asset (254,718)
Pre-modification lease liability 590,767
Percentage of change in ROU (50.00)%
Reduction to lease liability (295,384)
$ $
Lease liability
295,384
Other income/gain 40,666
Right-of-use asset 254,718
The difference between the remeasurement of the
lease liability of $266,513 (reflecting the revised lease
payments and updated discount rate) and the
remaining lease liability of $295,383 (590,767 –
295,384) after the above journal entry is recorded as
an adjustment to the ROU asset:
$ $
Lease liability
28,870
Right-of-use asset 28,870
The updated balance of the lease liability and of the
right-of-use asset after the above journal entries are
$266,513 and $225,848, respectively.
ACCOUNTING FOR LEASES UNDER ASC 842 148
Retailer Co. then updates the periodic lease cost for the remainder of the lease (10 years):
If Method A (change in lease liability) was used
Total lease payments (paid and not yet paid)*
$560,744
Plus, initial direct costs**
9,023
Less, periodic lease cost recognized in prior periods***
(281,458)
Total remaining lease cost [A]
$288,309
Periodic lease cost [B] = [A] / 5y
$57,662
* This amount reflects the total revised lease payments. It includes the relative portion (100% - 54.89% reduction in ROU
= 45.11%) after remeasurement of the payments paid in Years 1–5 (552,563 * 45.11% = $249,278), plus the revised lease
payments for the remaining lease term ($325,000), less the relative balance of the lease incentive received at
commencement date of $13,534 ($30,000 x 45.11%).
** Represents the relative portion of the initial direct costs after remeasurement ($20,000 * 45.11%)
*** Represents the relative portion of the periodic lease cost recognized in Years 1-5 ($124,779 * 45.11% * 5).
Opening
balance
Periodic
lease cost
Interest on
lease liability
ROU
Amortization
Ending
Balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 6
229,822
-57,662
18,656
-39,006
190,816
Year 7
190,816
-57,662
15,412
-42,250
148,566
Year 8
148,566
-57,662
11,941
-45,721
102,845
Year 9
102,845
-57,662
8,226
-49,435
53,410
Year 10
53,410
-57,662
4,252
-53,410
0
58,487
Note: Retailer Co. could also have determined the remaining lease cost based on the updated ROU asset of
$229,822, plus the sum of periodic interest accretion in Years 6-10 of $58,487 (per above table), which
equals $288,309, or an annual lease cost of $57,662. This could be used as an independent recalculation of
the remaining lease cost for accuracy purposes.
If Method B (Percentage of the remaining right of use) was used
Total lease payments (paid and not yet paid)*
$586,282
Plus, initial direct costs**
10,000
Less, periodic lease cost recognized in prior periods***
(311,947)
Total remaining lease cost [A]
$284,335
Periodic lease cost [B] = [A] / 5y
$56,867
* This amount reflects the total revised lease payments. It includes the relative portion (100% - 50.00% reduction in ROU
= 50.00%) after remeasurement of the payments paid in Years 1–5 (552,563 * 50% = $276,282), plus the revised lease
payments for the remaining lease term ($325,000), less the relative balance of the lease incentive received at
commencement date of $15,000 ($30,000 * 50%).
** Represents the relative portion of the initial direct costs after remeasurement ($20,000 * 50%).
*** Represents the relative portion of the periodic lease cost recognized in Years 1-5 ($124,779 * 50% * 5).
ACCOUNTING FOR LEASES UNDER ASC 842 149
Opening
balance
Periodic
lease cost
Interest on
lease liability
ROU
Amortization
Ending
Balance
[A]
[B]
[C]
[D] = [B] + [C]
[A] + [D]
Year 6
225,848
-56,867
18,656
-38,211
187,637
Year 7
187,637
-56,867
15,412
-41,455
146,182
Year 8
146,182
-56,867
11,941
-44,926
101,255
Year 9
101,255
-56,867
8,226
-48,640
52,615
Year 10
52,615
-56,867
4,252
-52,615
0
58,487
Note: Retailer Co. could also have determined the remaining lease cost based on the updated ROU asset of
$225,848, plus the sum of periodic interest accretion in Years 6-10 of $58,487 (per above table), which
equals $284,335, or an annual lease cost of $56,867. This could be used as an independent recalculation of
the remaining lease cost for accuracy purposes.
Example 18 in ASC 842-10-55-177 through 55-185 provides two different methodologies for
determining the proportionate reduction in the right-of-use asset in a partial termination and for
calculating the gain or loss on partial termination. We illustrated this accounting in Example 6.9A
above. The FASB noted in paragraph BC177 of ASU 2016-02 that both approaches are acceptable to
the Board. Consistent with ASC 842-10-10-1, we believe an entity should apply an approach
consistently to lease modifications with similar characteristics and in similar circumstances.
ACCOUNTING FOR LEASES UNDER ASC 842 150
Example 6.9B - Modification is not accounted as a separate lease – Partial termination and extension of the
lease term
FACTS
Assume the same facts as in Examples 6 and 6.2 apply, in which the lease of the retail space is an
operating lease. Also assume the following:
•
At the beginning of Year 6 of the lease, Retailer Co. and the lessor agree to modify the original
lease such that the retail space Retailer Co. uses is reduced from 10,000 square feet to 5,000
square feet effective at the modification date, the term of the lease is extended by three years,
and lease payments are reset to $68,000 annually, with a 5% annual increase for the remainder of
the revised term.
•
At the beginning of Year 6, the carrying amount of the lease liability and right-of-use asset are
$590,767 and $509,436, respectively.
•
Retailer Co.’s incremental borrowing rate at the effective date of the modification is 7%.
ANALYSIS
Retailer Co. concludes that the modification cannot be accounted for as a separate contract, as it does
not grant Retailer Co. an additional right of use but rather decreases the original scope of the lease (from
10,000 square feet to 5,000 square feet) and also extends the lease term for the remaining right of use
(an attribute of the original lease).
Retailer Co. should account for the partial termination and the extension of the term, considering the
change in lease payments. To do so, we believe Retailer Co. can first account for the partial termination
(in the same manner as in Example 6.9A), and then account for the term extension.
Assume Retailer Co. applies Method B described in Example 6.9A (remeasuring the ROU asset based on
the remaining right of use).
Regardless of the method used to account for the reduction in the ROU asset, the remeasured lease
liability after accounting for the partial termination and term extension is the same, and is based on the
remaining lease term and payments, discounted using Retailer Co.’s incremental borrowing rate at the
modification date.
PMT
Interest
(7%)
Principal
Amort.
Closing
Balance
Year 6
-68,000
33,346
-34,654
441,711
Year 7
-71,400
30,920
-40,480
401,231
Year 8
-74,970
28,086
-46,884
354,347
Year 9
-78,719
24,804
-53,914
300,433
Year 10
-82,654
21,030
-61,624
238,809
Year 11
-86,787
16,717
-70,071
168,738
Year 12
-91,127
11,812
-79,315
89,423
Year 13
-95,683
6,260
-89,423
0
PV(7%)=
476,365
ACCOUNTING FOR LEASES UNDER ASC 842 151
Retailer Co. applies the following steps to account for the partial termination and term extension:
Worksheet for partial termination accounting:
Reduction in ROU (5,000)/10,000SF =
(50.00)%
Pre-modification ROU asset
509,436
Percentage change in ROU
(50.00)%
Reduction to ROU asset
(254,718)
Pre-modification lease liability
590,767
Percentage change in ROU
(50.00)%
Reduction to lease liability
(295,384)
$
$
Lease liability
295,384
Other income/gain
40,666
Right-of-use asset
254,718
Worksheet for term extension accounting:
Lease liability before modification
$590,767
Partial termination adjustment (journal entry above)
(295,384)
Lease liability balance after partial termination
295,383
[A]
Remeasured lease liability amount (see table above)
476,365
[B]
Remaining adjustment [B] – [A]
$180,982
The difference between the remeasured lease liability of $476,365 and the lease liability balance after the
partial termination entry of $295,383 is recorded as an adjustment to the ROU asset:
$
$
Right-of-use asset
180,982
Lease liability
180,982
Following the above entries, the carrying amounts of the lease liability and right-of-use asset are $476,365
and $435,700, respectively.
ACCOUNTING FOR LEASES UNDER ASC 842 152
IMPAIRMENT
IMPAIRMENT ASSESSMENT OVERVIEW
The FASB determined that a right-of-use asset is a long-lived nonfinancial asset and, therefore, should be within the
scope of the Impairment or Disposal of Long-Lived Assets Subsection of ASC 360. Therefore, right-of-use assets must be
monitored for impairment, like other long-lived nonfinancial assets, regardless of whether the lease is an operating
lease or a finance lease.
The impairment assessment is performed at the asset group level, which is the lowest level for which identifiable cash
flows are largely independent of the cash flows of other groups of assets and liabilities.
An asset group is tested for impairment when events or changes in circumstances indicate that the asset group may not
be recoverable. ASC 360-10-35-21 provides the following examples:
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
When impairment indicators exist, an asset (asset group) should be tested to determine whether there is an
impairment. The impairment test is a two-step process as follows:
Step 1 – Determine if the asset group is recoverable
. To do so, compare (a) the carrying value of the asset group
with (b) the undiscounted cash flows expected from the asset group’s direct use and eventual disposal. If (a) exceeds
(b), the asset group is not recoverable and the entity moves to Step 2.
Step 2 - Determine the impairment loss
. To do so, determine the asset group’s fair value and recognize an
impairment loss, if any, for the excess of the asset group’s carrying amount over its fair value.
The impairment loss reduces only the carrying amounts of a long-lived asset or assets of the group.
The impairment loss is allocated to the long-lived assets in the asset group (including ROU assets) on a pro
rata basis using the relative carrying amounts of those assets, except that individual long-lived assets cannot
be written down below their individual fair values whenever that fair value is determinable without undue
cost and effort.
The impairment model under ASC 360-10-35 is not new but the recognition of new right-of-use assets associated with
operating leases has resulted in questions about the application of ASC 360.
For finance leases, consistent with capital leases under ASC 840, lease liabilities are excluded when testing an asset
group for impairment. This is because debt related to financing of long-lived assets generally is excluded. Because the
finance lease liability is excluded from the asset group, the finance lease payments also are excluded when
determining the undiscounted cash flows of the asset group.
ACCOUNTING FOR LEASES UNDER ASC 842 153
IMPAIRMENT ASSESSMENT FOR OPERATING LEASES
Because ASC 842 and ASC 360 do not specify whether the related lease liability for operating leases should be included
in an asset group for impairment testing purposes, we believe there are multiple acceptable approaches which we
summarize in the following table.
Approach A Approach B Approach C
Step 1 – In determining
the carrying amount of
the asset group:
Exclude operating lease
liability
Include operating lease
liability
Include operating lease
liability
Step 1 – In determining
the undiscounted cash
flows:
a,b
Exclude lease payments
Include lease payments but
exclude the portion related
to interest accretion
Include lease payments,
with inclusion of the
portion related to interest
accretion
Step 2 – In determining
the fair value of the asset
group under a discounted
cash flow approach:
a,b,c
Same approach as Step 1
above
Same approach as Step 1,
but include total lease
payments (since the cash
flows will be discounted)
Same approach as Step 1
above
Note a - Use entity specific assumptions in Step 1, and market participant assumptions (highest and best use) in Step 2.
Note b – Cash flows include variable lease payments not included in the measurement of the lease liability.
Note c - In allocating the impairment loss to the long-lived assets in the asset group (i.e., the pro rata allocation subject to the
individual fair value limitation), consider the right-of-use asset without the lease liability.
We believe each of the above approaches is acceptable because:
For Approach A, the operating lease liability is akin to a financial liability and it is measured the same way as
finance lease liabilities. Therefore, under that view, the approach under ASC 360 should be the same
whether the lease is an operating lease or a finance lease.
For Approach B, the lease is classified as an operating lease, and the related liability may be viewed as an
operating liability, rather than debt (see paragraph BC14 of ASU 2016-02). Therefore, like other operating
liabilities, the operating lease liability is included in determining the carrying amount of the asset group.
However, the lease payments should exclude the portion related to interest accretion on the lease liability
as it relates to capitalization/ financing of the entity, not its operations.
For approach C, this is consistent with approach B, except that the lease payments included in the
undiscounted cash flows are the total operating lease payments (because the operating lease cost is
recognized as a single lease cost).
Because the different approaches are consistent in how they treat the liability and related cash flows (either both are
included or both are excluded), the approach selected generally should not significantly change whether an asset group
is impaired, and an entity should select an approach and apply it consistently.
ACCOUNTING FOR LEASES UNDER ASC 842 154
Additional Complexities Related to Application of ASC 360 to Right-of-use Assets – Abandonments and Subleases
As described above, ASC 842 requires an entity to apply the guidance on impairment of long-lived assets in ASC 360
to right-of-use assets. Now that operating leases are recognized on balance sheet, there are additional complexities
related to impairment and other standards that an entity will need to consider. For example, after a lease has
begun, an entity may consider subleasing or abandoning either the leased asset or a portion of the underlying asset.
These may be necessary business decisions, but they will result in additional accounting questions that need to be
addressed. Some of those questions include:
Did the entity appropriately identify its lease components (the unit of account under ASC 842)?
A lessee may have initially assumed that the unit of account under ASC 842 was a single lease component (for
example, one lease component for a lease of multiple floors in an office building). This may have been
because the accounting outcome under ASC 842 was the same whether the contract included a single lease
component or a lease component for each floor leased. However, entering into a sublease or deciding to
abandon a portion of a right-of-use asset raises a unit of account question.
Because of the sublease or
abandonment, the lessee should determine how many lease components the lease contract includes, as it may
for example affect asset groupings under ASC 360, and whether impairment triggers exist, among other aspects.
Does it affect asset groupings for impairment testing purposes?
ASC 360 requires an entity to group assets at the lowest level for which identifiable cash flows are largely
independent of the cash flows of other groups of assets and liabilities. There generally is judgment in
determining asset groupings, although entering into a sublease will usually result in that asset being deemed
its own asset group, as it will generate standalone cash flows from the sublease. A lessee should have
processes in place to evaluate whether, and if so, when, asset groupings would change due to sublease and
abandonment decisions.
Is the entity required to test the asset group for impairment?
Subleasing the underlying asset for the remainder of the lease term is not considered abandoning the asset
because the lessee continues to derive economic benefits from use of the asset (through the cash flows on
the sublease). However, ASC 842-20-35-14 provides that if a lessee enters into a sublease for which the lease
cost for the term of the sublease exceeds the anticipated sublease income for that same period, the original
lessee should 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.
The decision to abandon a right-of-use asset may also be an indicator that an impairment test is required for
the asset group, as it represents a significant adverse change in the extent or manner in which the asset is
being used. Whether an impairment test is performed will depend on how significant the asset to be
abandoned is to the asset group, which will require the use of professional judgment.
Should the entity revise the useful life of some of the long-lived assets, including the leased asset?
ASC 360-10-35-22 notes that when a long-lived asset is tested for recoverability, it also may be necessary to
review depreciation estimates and method as required by ASC 250 (see ASC 250-10-45-17 through 45-20 and
250-10-50-4). Any revision to the remaining useful life of a long-lived asset resulting from that review also
should be considered in developing future cash flow estimates when testing the asset (asset group) for
recoverability.
Also, if an entity commits to a plan to abandon a long-lived asset before the end of its previously estimated
useful life, ASC 360-10-35-47 notes that depreciation estimates should be revised to reflect the asset’s use
over its shortened useful life.
See also ASC 360-10-S99-2 (SAB Topic 5.CC, Impairments) for an example related to a mainframe computer to
be abandoned for additional considerations, including timing of revision of estimated useful lives, and below
for an SEC staff speech on this topic.
ACCOUNTING FOR LEASES UNDER ASC 842 155
Should the entity record additional liabilities under other standards, such as exit or disposal cost
obligations (ASC 420, Exit or Disposal Cost Obligations)?
While charges that are considered lease payments (whether fixed or variable) are excluded from the guidance
in ASC 420 on exit or disposal cost obligations, if the lease contract includes nonlease components and the
lessee elected to separate the lease and non-lease components, the lessee should accrue the portion of fixed
payments and estimated variable payments allocated to the non-lease components on the cease-use date of
an underlying asset subject to a lease. This is summarized in the following table:
Lessee elected non-
separation practical
expedient.
Payments for non-lease components or non-components (e.g.
taxes, insurance) are all lease payments (whether fixed or
variable), and therefore are outside the scope of ASC 420.
Lessee did not elect non-
separation practical
expedient.
The lessee should accrue the portion of the fixed payments and
estimated variable payments allocable to the nonlease component
(for example, common area maintenance).
Operating Lease Right-of-use Asset Not Impaired, But for Which Estimated Useful Life Is Shortened
If a right-of-use asset is determined to not be impaired under ASC 360, there is no basis to write down the carrying
amount of the right-of-use asset. However, as previously discussed, a lessee may have to revise (shorten) the
previously estimated useful life of the asset when a lessee anticipates abandoning it prior the end of the lease
term. When this occurs, the link between the economic benefits to be derived from the lease and the lease
payments is broken, similar to the FASB’s view described below in Accounting for Operating Leases Once Impaired.
In those situations, while not explicit in ASC 842, we believe it may be appropriate for the lessee to account for the
operating lease as if the right-of-use asset has been impaired. This is also consistent with the SEC staff speech
reproduced below.
The SEC staff discussed the accounting for abandonment of right-of-use assets under the leases
standard at the 2020 AICPA Conference on Current SEC and PCAOB Developments:
Geoff Griffin
Professional Accounting Fellow, Office of the Chief Accountant
“Right-of-use asset guidance
[…] 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;[9] 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-
ACCOUNTING FOR LEASES UNDER ASC 842 156
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.”
[9] See ASC 842-20-35-9.
ACCOUNTING FOR OPERATING LEASES ONCE IMPAIRED
After a right-of-use asset has been impaired, it is subsequently measured at its carrying amount immediately after the
impairment less any accumulated amortization, and is amortized from the impairment date to the earlier of the end of
its useful life or the end of the lease term. A previously recognized impairment loss cannot be reversed.
For an operating lease, this means that the updated single lease cost following an impairment is calculated as the sum
of the following:
Amortization of the remaining balance of the right-of-use asset after the impairment, generally 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 using the interest method, as before the impairment.
When an operating lease ROU asset is impaired, the FASB concluded in paragraph BC259 of ASU 2016-
02 “that the link that many perceive between the economic benefits to be derived from the lease and
the lease payments, and reference in support of a single, generally straight-line lease cost for
operating leases, is effectively “broken” after the right-of-use asset is impaired because the lessee will
no longer obtain future economic benefits from the lease equal to (or greater than) the payments it is
required to make to the lessor. In other words, the lease payments no longer have any direct
correlation to the economic benefits the lessee is able to derive from the lease but, instead, represent
a liability reflective of a past expectation of economic benefits that could be derived from the lease.”
Therefore, while a lessee will continue to recognize a single lease cost for an operating lease following
an impairment, it will no longer be recognized on a straight-line basis.
Operating Lease Right-of-use Asset Impaired and Subsequently Modified or Remeasured
After a right-of-use asset is impaired, the lease may be subsequently modified (and that modification is not
accounted for as a separate contract), or the lease may be remeasured (for example, because of a reassessment of
the lease term or purchase option). As discussed in Reassessments and Modifications, certain reassessment events
and modifications not accounted for as a separate contract result in accounting for the lease essentially in the same
way as a new lease. Even so, we believe the lessee should continue to apply the guidance on operating leases that
have been impaired. This is because the link between the economic benefits to be derived from the lease and the
lease payments continues to be “broken” even after a modification or reassessment. That is, the lessee continues
to no longer obtain future economic benefits from the lease equal to (or greater than) the revised lease payments.
Therefore, the lessee continues to amortize the remeasured right-of-use asset on a straight-line basis.
ACCOUNTING FOR LEASES UNDER ASC 842 157
Example 6.10 - Impairment of right-of-use asset – Operating lease
FACTS
Assume the same facts as in Examples 6 and 6.2 apply, in which the lease of retail space is an operating
lease. Also assume the following:
•
For impairment testing purposes, the leased retail space is part of Asset Group A, which includes
the operating lease right-of-use asset, leasehold improvements, inventory and operating payables.
•
At the end of Year 2 of the lease, there is a significant adverse change in the business climate and
lower financial performance than initially anticipated, and Retailer Co. tests Asset Group A for
recoverability.
•
The asset group is comprised of the right-of-use asset with an ending balance of $750,556,
unamortized leasehold improvements of $100,000, and the carrying value of inventory and
operating payables offset each other. The ending balance of the lease liability is $805,114.
•
Retailer Co. elected to assess impairment by applying Approach C (explained below).
•
Based on that approach, assume that the undiscounted expected cash flows associated with Asset
Group A are determined to be $40,000 over the remaining lease term, and the fair value of Asset
Group A is $35,000.
ANALYSIS
Retailer Co. applies Approach C as follows:
Approach C
Step 1 – Determine the carrying amount of the
asset group by including the operating lease
liability
$45,442 (ROU asset of $750,556, less lease liability of
$805,114, plus unamortized leasehold improvements
of $100,000).
Step 1 – Determine the undiscounted expected
cash flows which include the entire amount of
the lease payments
$40,000.
The asset group is considered not recoverable as the
carrying value of the asset group of $45,442 is higher
than the undiscounted cash flows of $40,000. Retailer
Co. proceeds to Step 2.
Step 2 – Determine the impairment loss using a
fair value approach such as the DCF analysis.
$10,442 (carrying value of $45,442 less fair value of
$35,000).
Retailer Co. records an impairment charge of $10,442. The impairment loss is applied on a pro rata basis
only to the long-lived assets in the asset group, which in this Example are the operating lease right-of-use
asset and the leasehold improvements. The impairment loss does not reduce each long-lived asset’s carrying
value below their respective fair value and therefore Retailer Co. records a journal entry as follows:
$
$
Impairment loss
10,442
Right-of-use asset
9,215
= 10,442 * (750,556/850,556)
Leasehold improvements 1,227 = 10,442 * (100,000/850,556)
ACCOUNTING FOR LEASES UNDER ASC 842 158
The carrying amount of the right-of-use asset after impairment is $741,341.
Retailer Co. determines that amortizing the right-of-use asset over the remaining lease term remains
appropriate (that is, the useful life is not shortened).
Retailer Co. recognizes a single lease cost as determined under ASC 842-20-25-7. Therefore, the single
lease cost in each period following the impairment is calculated as the sum of (a) the straight-line
amortization of the remaining carrying amount of the right-of-use asset over the remaining lease term of 8
years, and (b) the interest accretion of the lease liability in each of the remaining years (which is
unchanged). This results in the single lease cost no longer being fixed at each of the remaining periods, as
illustrated in the following table.
Opening
balance
Amortization
Closing
balance
Interest on
liability
Periodic lease
cost
[A]
[B]
[A] + [B]
[C]
[B] + [C]
Year 3
741,341
-92,668
648,673
-48,307
-140,974
Year 4
648,673
-92,668
556,006
-44,590
-137,258
Year 5
556,006
-92,668
463,338
-40,320
-132,988
Year 6
463,338
-92,668
370,671
-35,446
-128,114
Year 7
370,671
-92,668
278,003
-29,915
-122,583
Year 8
278,003
-92,668
185,335
-23,669
-116,337
Year 9
185,335
-92,668
92,668
-16,647
-109,315
Year 10
92,668
-92,668
0
-8,781
-101,449
DERECOGNITION
ASC 842 provides specific derecognition requirements for the following events:
Accounting
Lease termination before
expiration of lease term
Derecognize right-of-use asset and lease liability
Recognize any difference in profit or loss
Purchase of the underlying asset
Adjust the carrying amount of the asset for any difference between
the purchase price and the carrying amount of the lease liability
immediately before the purchase.
This accounting does not apply for underlying assets acquired in a
business combination, which are initially measured at fair value in
accordance with ASC 805-20-30-1.
Sublease in which the original
lessee is relieved of primary
obligation under the original lease
Derecognize right-of-use asset and lease liability
Recognize any difference in profit or loss
Any consideration paid or received upon termination that was not
already included in the lease payments (for example, a termination
payment) is included in the determination of profit or loss to be
recognized.
If original lessee is secondarily liable, the lessee also recognizes a
guarantee obligation in accordance with ASC 405-20-40-2.
ACCOUNTING FOR LEASES UNDER ASC 842 159
Chapter 6 - Accounting for Leases – Lessors
OVERVIEW
This chapter addresses the accounting by lessors for leases classified as sales-type leases, direct financing leases, or
operating leases as discussed in Chapter 4, Lease Classification and Key Terms
.
The primary objective of ASC 842 was to improve accounting for leases by lessees. Accordingly, the accounting for
leases by lessors remains broadly consistent with previous GAAP and varies depending on lease classification. While ASC
842 did not significantly change the accounting for lessors, the previous accounting model was not retained in its
entirety. For example, some aspects of the new leases guidance were aligned between lessees and lessors.
Since leasing is fundamentally a revenue-generating activity for lessors, some of the changes in ASC 842 were also
required as a result of the issuance of ASU 2014-09, Revenue from Contracts with Customers (Topic 606), which
superseded all other previous GAAP on revenue recognition that formed the basis for some aspects of the previous
lessor accounting model, such as the accounting for sales of real estate. The changes were intended to maintain
cohesion between the revenue recognition (and related cost) guidance applicable to sellers of tangible goods under
ASC 606 and the guidance applicable to lessors of those same assets under ASC 842.
Some users of financial statements also criticized the level of information disclosed by lessors under previous GAAP and
asked for additional information about a lessor’s exposure to credit risk and residual-asset risk. Consequently, lessors
are now required to provide enhanced disclosures on these areas, including providing the carrying amounts of the
components in sales-type and direct financing leases (namely, the lease receivable, the unguaranteed residual asset,
and for direct financing leases, deferred selling profit), along with information about how a lessor manages its risks
associated with the residual value of underlying assets.
The accounting under ASC 842 for lessees and lessors is broadly symmetrical in the statement of comprehensive income
but not in the statement of financial position. While lessees are required to record a lease liability for all leases at
lease commencement (except for short-term leases if the election is made), lessors will not record a lease receivable
for operating leases. Lessors will also recognize the economic benefits associated with the underlying asset and the
lease in a single unit of account, namely a net investment in the lease for sales-type and direct financing leases.
Lessors will continue to recognize the underlying asset for operating leases.
For discussion on a lessor’s practical expedient to not separate lease and nonlease components in an operating lease,
see Chapter 3, Identifying and Separating Components
.
ACCOUNTING FOR LEASES UNDER ASC 842 160
LEASE CLASSIFICATION BY LESSORS
Consistent with previous GAAP and as discussed further in an Chapter 4, Lease Classification and Key Terms, the
lessor accounting model distinguishes between sales-type, direct financing, and operating leases as follows:
Sales-type or direct financing leases with variable lease payments that resulted in a day-1 loss
Under ASC 842, a lessor excludes from the consideration in the contract, and therefore from lease
payments, most variable payments related to the use of the asset (such as the volume of
electricity generated by a solar farm). Depending on the magnitude of those variable payments,
this may result in the recognition of a selling loss at the commencement date (a “day-one loss”)
for a sales-type or direct financing lease if the amount of the net investment in the lease
recognized is less than the carrying amount of the underlying asset derecognized. Those excluded
variable payments are then recognized entirely as lease income when the changes in facts and
circumstances on which those variable payments are based occur. However, in July 2021 the FASB
issued ASU 2021-05 to address this day-one loss issue and which is reflected in the above
flowchart. See Chapter 9, Adopting ASC 842, for the effective dates and transition requirements.
ACCOUNTING FOR LEASES UNDER ASC 842 161
SUMMARY ACCOUNTING REQUIREMENTS BASED ON LEASE CLASSIFICATION
Sales-Type Lease Direct Financing Lease Operating Lease
Balance
Sheet
If collectibility is probable,
derecognize the underlying
asset and recognize a net
investment in the lease at
the commencement date.
If collectibility is not
probable, continue to
recognize the underlying
asset and record any
payments received as a
deposit liability.
Derecognize the
underlying asset and
recognize a net
investment in the lease
at the commencement
date.
Selling profit, if any, is
deferred and included
in the net investment
in the lease.
Continue to recognize the
underlying asset.
Initial direct costs are
deferred.
If collectibility was probable
initially, subsequently
increase the net investment
in the lease to reflect
interest income and reduce
it as lease payments are
received. Also assess the net
investment in the lease for
impairment under ASC 310
(or ASC 326).
If collectibility was not
probable initially, monitor
collectibility and certain
other events (termination of
contract or repossession of
the underlying asset).
Subsequently, increase
the net investment in
the lease to reflect
interest income, and
reduce it as payments
are received.
Assess the net
investment in the lease
for impairment under
ASC 310 (or ASC 326).
The underlying asset is
subject to other GAAP (e.g.,
ASC 360 on PP&E, including
for impairment)
Initial direct costs are
amortized over the lease
term.
Income
Statement
Recognize selling profit or
loss at the commencement
date of the lease.
Initial direct costs – If the
fair value of the underlying
asset is different than its
carrying amount, expense
them. Otherwise, those are
deferred and included in the
net investment in the lease.
Recognize selling profit
over the lease term
through interest
income. If there is a
selling loss, recognize
at the commencement
date.
Initial direct costs are
deferred and included
in the net investment
in the lease.
If collectibility is probable,
recognize lease payments in
income over the lease term,
usually on a straight-line
basis. Otherwise, lease
income is limited generally to
lease payments collected.
Expense initial direct costs on
same basis as lease income
over the lease term.
Recognize variable lease
payments in the period in
which the changes in facts
and circumstances on which
they are based occur.
Recognize any impairment
charges of the underlying
asset under ASC 360.
Recognize variable lease payments not included in the net
investment in the lease in the period when changes in facts
and circumstances on which the payments are based occur.
Recognize interest income using the rate implicit in the
lease.
Recognize any impairment charges (or credit losses).
ACCOUNTING FOR LEASES UNDER ASC 842 162
Fair value of the underlying asset for lessors
A lessor should apply the guidance in ASC 820 on fair value measurement when determining the
fair value of an underlying asset. However, for lessors that are not manufacturers or dealers (i.e.,
generally financial institutions and captive finance companies), the fair value of the underlying
asset at lease commencement is defined as its cost, reflecting any volume or trade discounts that
apply. This exception applies only if there has not been a significant lapse of time between the
acquisition of the underlying asset and lease commencement. If there has been a significant lapse
of time, the lessor must apply the ASC 820 definition of fair value.
This fair value exception is consistent with the fair value exception that existed under ASC 840,
which the FASB added to ASC 842 with the issuance of ASU 2019-01 following feedback from lessors
previously qualifying for the exception in ASC 840.
A lessor may incur costs to ready the leased asset for its intended use, such as shipping,
mobilization, and similar costs. Costs for such activities are not initial direct costs because those
are not costs to obtain a lease contract. Therefore, a lessor cannot capitalize such costs by
applying the guidance on initial direct costs. However, questions arose as to whether such costs
should be expensed in all cases or could be capitalized by analogy to other GAAP.
The SEC staff addressed this question at the 2018 AICPA Conference on Current SEC and PCAOB
Developments:
Andrew W. Pidgeon
Professional Accounting Fellow, Office of the Chief Accountant
“Certain lessee and lessor costs
[…] we have received application questions related to the new leases standard, including questions
regarding lessee and lessor accounting for certain costs relating to a lease.
[…] The second lease cost consultation related to lessor accounting for costs incurred to fulfill its
obligations under a lease. 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,[11] 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.
I encourage lessees and lessors that elect to apply either of those accounting policies to apply the
policies consistently and include appropriate disclosure of those policies if material.”
[11] FASB ASC Topic No. 606, Revenue from Contracts with Customers (“Topic 606”).
Accordingly, we believe that either of the following approaches is acceptable as an accounting
policy election applied to all leases, and disclosed if material:
•
Expense the costs as incurred, or
•
Capitalize the costs by analogy to the guidance on contract fulfillment costs under ASC
340-40,
Other Assets and Deferred Costs – Contracts with Customers
, assuming the costs
meet the criteria for capitalization.
ACCOUNTING FOR LEASES UNDER ASC 842 163
SALES-TYPE LEASES – A DEEPER DIVE
COLLECTIBILITY IS PROBABLE AT COMMENCEMENT DATE
In a sales-type lease, the lessor is considered to transfer control of the underlying asset to the lessee at the
commencement date (See Lease Classification and Key Terms
). Therefore, assuming collectibility of the lease
payments, including any amount necessary to satisfy a lessee residual value guarantee is probable, a lessor recognizes
a net investment in the lease and derecognizes the underlying asset at lease commencement, with any selling profit or
loss arising from the lease recognized immediately. The net investment in a sales-type lease is the sum of the
following, discounted using the rate implicit in the lease (See
Lease Classification and Key Terms):
Because of the way the rate implicit in the lease is defined, the net investment in the lease recognized
typically will equal the fair value of the underlying asset plus any deferred initial direct costs (less prepaid
lease payments, if any).
At the commencement date, the selling profit or selling loss equals the following:
Initial direct costs are expensed if the fair value of the underlying asset at the commencement date is different than
its carrying amount. Otherwise, initial direct costs are deferred and included in the measurement of the net
investment in the lease and are reflected in the calculation of the rate implicit in the lease.
If a lessor concludes that collectibility is probable at commencement, it does not reassess that conclusion. Subsequent
changes in the credit risk of the lessee are accounted for in accordance with the impairment (or credit loss) guidance
applicable to the net investment in the lease. See Impairment Section in this chapter for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 164
After the commencement date, a lessor measures the net investment in the lease by:
Increasing the carrying amount to reflect interest income on the net investment in the lease, using the rate
implicit in the lease.
Reducing the carrying amount to reflect the lease payments collected during the period.
Also, the net investment in the lease is not remeasured after the commencement date except in a lease modification
that is not accounted for as a separate contract. See Modification Section in this chapter for additional discussion.
A lessor also recognizes the following in the statement of operations:
Interest income on the net investment in the lease using the rate implicit in the lease.
Variable lease payments that are not included in the net investment in the lease as income in the period
when the changes in facts and circumstances on which the variable lease payments are based occur.
Impairment (or credit losses) on the net investment in the lease.
COLLECTIBILITY IS NOT PROBABLE AT COMMENCEMENT DATE
If collectibility of the lease payments, plus any amount necessary to satisfy a lessee residual value guarantee is not
probable at lease commencement, a lessor does not derecognize the underlying asset. Instead, it recognizes any lease
payments received, including variable lease payments, as a deposit liability. The lessor then continues to monitor
collectibility for any changes in assessment. The deposit liability recorded for payments received is derecognized at
the earlier of the following events:
Collectibility of the lease payments and any amounts required to satisfy a lessee residual value guarantee
becomes probable.
The contract has been terminated, and the lease payments received from the lessee are nonrefundable.
The lessor has repossessed the underlying asset, has no further obligation under the contract to the lessee,
and the lease payments received from the lessee are nonrefundable.
Also, the accounting for derecognizing the deposit liability depends on which event above occurred.
On the date that collectibility of the lease payments plus any amount necessary to satisfy a lessee residual value
guarantee is assessed as probable, the lessor:
1.
Derecognizes the carrying amount of the underlying asset,
2.
Derecognizes the carrying amount of any deposit liability recognized,
3.
Recognizes a net investment in the lease based on the remaining lease payments and remaining lease
term, using the rate implicit in the lease determined at the commencement date, and
4.
Recognizes selling profit or selling loss calculated as:
a)
The lease receivable; plus
b)
The carrying amount of the deposit liability; minus
c)
The carrying amount of the underlying asset, net of the unguaranteed residual asset.
At the date the contract is terminated, or the asset is repossessed with no further obligation to the lessee, and
assuming in both cases that the lease payments received are nonrefundable, the lessor derecognizes the
carrying amount of any deposit liability with the corresponding amount recognized as lease income.
ACCOUNTING FOR LEASES UNDER ASC 842 165
The above treatment for sales-type leases when collectibility is not probable is consistent with the guidance in ASC 606
related to contracts with customers for which collectibility of the consideration is not probable. However, it represents
a change from prior guidance, which resulted in operating lease classification when collectibility was not probable.
In assessing collectibility, a lessor should consider all facts and circumstances regarding the lessee’s ability and intent
to pay, including the lessee’s credit quality, other income or assets with which the lessee could make the lease
payments if the business in which the asset is used is not successful, the economic climate of the business in which the
asset will be used (level of competition and risk, lessee experience in the industry, etc.), the lessor’s history of
collections and repossessions with similar lessees, and the lessor’s past practice of providing any concessions or waivers
to its lessees.
The topic of collectibility assessment by a lessor for sales-type leases was discussed by the SEC
staff at the
2019 AICPA Conference on Current SEC and PCAOB developments
:
Erin Bennet
Professional Accounting Fellow, Office of the Chief Accountant
“ASC 842 and Collectibility
[…] OCA staff recently considered a fact pattern where the registrant enters into sales-type leases
of equipment. The lessee is required to make a down payment and also make periodic lease
payments, generally over a four-year contractual period. The registrant has historically
experienced a high rate of payment delinquencies, leading to defaults that result in termination of
the contract and, in most cases, repossession of the equipment. Based on historical experience,
the registrant collects an average of 60% of the contractual lease payments. The registrant
continues to expect a high rate of defaults and structures its leases to compensate for the high
credit risk of its customers through a high rate implicit in the lease, a residual value guarantee,
and the intent and ability to repossess the equipment if the customer defaults.
The registrant concluded collectibility of the lease payments was probable at lease inception. The
registrant asserted that at the lease commencement date, the customer had the intent and ability
to pay as evidenced by a credit evaluation and a substantive down payment, among other factors.
[Footnote omitted] Further, the registrant asserted that the historical lessee defaults were
generally due to a change in the lessee’s circumstances subsequent to the lease inception.
The staff objected to the registrant’s view and concluded that there was not a sufficient basis to
assert that collectibility of the lease payments was probable at the lease commencement date. In
reaching this conclusion, the staff considered all factors including the registrant’s assessment of
the lessee’s credit quality and the registrant’s history of collections with similar lessees.”
ACCOUNTING FOR LEASES UNDER ASC 842 166
ACCOUNTING AT THE END OF THE LEASE TERM
At the end of the lease term, a lessor reclassifies the net investment in the lease to the appropriate category of asset
(for example, property, plant, and equipment) in accordance with other GAAP, measured at the carrying amount of the
net investment in the lease. The lessor then accounts for the underlying asset in accordance with other Topics, such as
ASC 360.
ACCOUNTING FOR LEASE TERMINATION
If a sales-type lease is terminated before the end of the lease term, a lessor:
Tests the net investment in the lease for impairment or credit losses under ASC 310 or ASC 326-20,
respectively,
Reclassifies the net investment in the lease to the appropriate category of asset in accordance with other
GAAP, measured as 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, and
Accounts for the underlying asset that was the subject of the lease in accordance with other GAAP, such as
ASC 360.
Examples 1A through 1C below illustrate the initial and subsequent measurement of a sales-type lease, under
different scenarios.
Please note that for the illustrations throughout this chapter, the tables presented in each Example are consistent
with how they would be displayed in a spreadsheet, with amounts shown with no decimals, and no rounding
function used.
Example 1A - Sales-type lease with lessee residual value guarantee – collectibility is probable
FACTS
J.R.E Inc. (“J.R.E”) enters into a 6-year lease of non-specialized equipment with Lessee.
Lease payments are $25,000 per year, due at the end of each year. Lessee provides a residual value
guarantee of $35,000.
At lease commencement, the equipment has a fair value of $170,000 and a carrying value of $150,000.
The equipment has a remaining economic life of 10 years, and J.R.E expects the residual value of the
equipment at the end of the 6-year lease term to be $55,000.
The lease does not transfer ownership of the equipment to Lessee nor grant it a purchase option.
J.R.E incurs $2,000 of initial direct costs.
There are no nonlease components in the agreement.
J.R.E concludes at the commencement date that it is probable it will collect the lease payments and the
amount necessary to satisfy the residual value guarantee provided by Lessee.
ACCOUNTING FOR LEASES UNDER ASC 842 167
ANALYSIS
Accounting on Day 1 (commencement date)
In order to determine whether the lease is a sales-type lease, J.R.E. calculates the rate implicit in the lease
as shown below. Since the fair value of the underlying asset is different than its carrying value, no initial
direct costs are deferred and they are not reflected in the calculation. Also note that there are no
investment tax credits. Accordingly, the rate implicit in the lease in this example is the rate that causes the
aggregate present value of the lease payments and of J.R.E’s expected residual value of the equipment at
the end of the lease term to equal the fair value of the underlying asset at commencement.
PMT
Year 1
(170,000)
Beginning of year (commencement date)
Year 1
25,000
End of year payment
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
80,000
(25,000 lease payment + 55,000 estimated residual value)
Undiscounted PMTs
205,000
Rate implicit in the lease
4.68%
J.R.E calculates the present value of the lease payments and of the lessee residual value guarantee at the
commencement date as follows, using the rate implicit in the lease determined above:
PMT
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
60,000
(25,000 lease payment + 35,000 lessee guaranteed residual value)
Undiscounted PMTs
185,000
PV (4.68%) =
154,800
J.R.E classifies the lease as a sales-type lease because (1) the present value of the lease payments and
lessee residual value guarantee amounts to substantially all of the fair value of the equipment at the
commencement date (154,800/170,000 = 91%), and (2) ASC 842-10-25-3A on variable lease payments not
based on an index or a rate does not apply.
The net investment in the lease is initially measured at $170,000 and represents the sum of the following:
•
Lease receivable of $154,800 (see calculation above), and
•
Unguaranteed residual asset of $15,200 (present value of $20,000 expected unguaranteed residual
value, discounted at 4.68%).
The net investment in the lease equals the fair value of the underlying asset because there are no
deferred initial direct costs nor prepaid lease payments.
ACCOUNTING FOR LEASES UNDER ASC 842 168
At the commencement date, J.R.E calculates the selling profit/loss as follows:
Lease receivable*, minus 154,800
Carrying value of the equipment, net of unguaranteed residual value**, minus 134,800
Deferred initial direct costs*** ---
Selling profit 20,000
* J.R.E uses the lease receivable as it is lower than the fair value of the underlying asset ($170,000)
** The unguaranteed residual value used for this calculation equals the PV of the difference between the amount the
lessor expects to receive at the end of the lease term ($55,000) and the lessee residual value guarantee ($35,000).
*** The initial direct costs are not eligible for deferral because the fair value of the underlying asset is different than its
carrying amount at the commencement date. Accordingly, these costs are expensed at the commencement date.
At the commencement date, J.R.E records the following journal entry:
$
$
Dr. Net investment in the lease 170,000
Dr. Operating expenses*
2,000
Cr. Cash* 2,000
Cr. Equipment – carrying value 150,000
Cr. Selling profit
20,000
* Assumes lease inception and lease commencement are at the same date.
To derecognize the underlying asset at its carrying value, and recognize the net investment in the lease and
selling profit.
Subsequent measurement (assuming no modifications)
J.R.E increases the carrying amount of the net investment in the lease for interest income using the rate
implicit in the lease of 4.68% and reduces it to reflect the lease payments collected. For example, J.R.E
records the following journal entry at the end of Year 1:
$ $
Dr. Cash
25,000
Cr. Net investment in the lease 17,044
Cr. Interest income* 7,956
* Net investment in the lease of $170,000 at 4.68%
In accordance with ASC 842-30-30-1, and for disclosure purposes, J.R.E calculates the components of the net
investment in the lease, which include the lease receivable and the unguaranteed residual asset.
ACCOUNTING FOR LEASES UNDER ASC 842 169
The following summarizes the accounting for the lease receivable throughout the lease term:
Beg.
Balance
Interest
Payment
End.
Balance
[A]
[B] = [A] x 4.68%
[C]
[D] = [A] + [B] + [C]
Year 1
154,800
7,245
(25,000)
137,045
Year 2
137,045
6,414
(25,000)
118,459
Year 3
118,459
5,544
(25,000)
99,003
Year 4
99,003
4,634
(25,000)
78,637
Year 5
78,637
3,680
(25,000)
57,317
Year 6
57,317
2,683
(25,000)
35,000
The following summarizes the accounting for the unguaranteed residual asset throughout the lease term,
along with the ending balance of each component and of the net investment in the lease:
Unguaranteed
Residual
Asset Beg.
Balance
Interest
Unguaranteed
Residual Asset
End. Balance
Lease
Receivable
End. Balance
Net Investment
in the Lease
End. Balance
[A]
[B] = [A] x 4.68%
[C] = [A] +[B]
[D] – see above
[E]= [C]+[D]
Year 1
15,200
711
15,911
137,045
152,956
Year 2
15,911
745
16,656
118,459
135,115
Year 3
16,656
780
17,436
99,003
116,439
Year 4
17,436
816
18,252
78,637
96,889
Year 5
18,252
854
19,106
57,317
76,423
Year 6
19,106
894
20,000
35,000
55,000
At the end of the lease term, the net investment in the lease equals the estimated residual value of
the asset of $55,000, the lease receivable equals the Lessee residual value guarantee of $35,000
and the unguaranteed residual asset is the difference between $55,000 and $35,000.
The following summarizes interest income recognized in profit or loss throughout the lease term:
Year 1
7,956
Year 2
7,159
Year 3
6,324
Year 4
5,450
Year 5
4,535
Year 6
3,577
Total
35,000
Total interest income recognized is $35,000, which represents the difference between (1) the
undiscounted lease payments plus the expected residual value of the asset at the end of the lease
term of $205,000, and (2) the fair value of the underlying asset at the commencement date of
$170,000.
At the end of Year 6, J.R.E reclassifies the net investment in the lease of $55,000 to property, plant and
equipment and then accounts for it under ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 170
Example 1B - Sales-type lease with no residual value guarantee – Collectibility is probable
FACTS
Heisenberg Co. enters into a 10-year lease with Lessee for a piece of non-specialized equipment.
Lease payments are $50,000 per year and due at the beginning of each year.
The lease does not transfer ownership of the equipment to Lessee nor grant it a purchase option.
At lease commencement, the equipment has a fair value of $425,000 and a carrying value of $395,400.
The equipment has a remaining economic life of 12 years, and Heisenberg Co. expects the residual value of
the equipment at the end of the lease term to be $20,000.
Heisenberg Co. incurs $5,000 of initial direct costs.
No residual value guarantees are provided by Lessee or any other third parties unrelated to Heisenberg Co.
There are no nonlease components in the agreement.
Heisenberg Co. concludes at the commencement date that it is probable it will collect the lease payments.
Heisenberg Co. uses the lease of the equipment as an alternative means of realizing value from goods it
otherwise sells in the ordinary course of business. See Chapter 8 for further information on presentation of
selling profit or loss.
ANALYSIS
Accounting on Day 1 (commencement date)
Because the lease term is for a major part (in this case 83%) of the remaining economic life of the
equipment, Heisenberg classifies the lease as a sales-type lease (note that in this example the lease
payments also represent substantially all of the fair value of the equipment). ASC 842-10-25-3A on variable
lease payments not based on an index or a rate does not apply.
Heisenberg Co. calculates the rate implicit in the lease as shown below. Since the fair value of the
underlying asset is different than its carrying value, no initial direct costs are deferred and they are not
reflected in the calculation. Also note that there are no investment tax credits.
PMT
Year 1
(375,000)
(425,000 fair value - 50,000 first lease payment)
Year 2
50,000
Year 3
50,000
Year 4
50,000
Year 5
50,000
Year 6
50,000
Year 7
50,000
Year 8
50,000
Year 9
50,000
Year 10
50,000
Beginning of year – lease payment
Year 10
20,000
End of year - estimated residual value
Rate implicit in the lease
4.58%
ACCOUNTING FOR LEASES UNDER ASC 842 171
Heisenberg Co. calculates the present value of lease payments during Years 2–10 at the commencement date
discounted at 4.58% plus the lease payment received at lease commencement, which amounts to $412,214
(or 97% of the fair value of the equipment).
Heisenberg Co. recognizes a net investment in the lease of $375,000 initially measured as the sum of the
following:
•
Lease receivable of $362,214 which is the present value of the remaining unpaid lease payments (or
$412,214 discussed above minus first payment of $50,000 received). Note that there are no residual
value guarantees provided by either the lessee or a third-party.
•
Unguaranteed residual asset of $12,786 (present value of $20,000 expected unguaranteed residual
value, discounted at 4.58%).
The net investment in the lease equals the fair value of the underlying asset of $425,000 less
$50,000 prepaid lease payment. There are no deferred initial direct costs.
At the commencement date, Heisenberg Co. records the following entries:
$
$
Dr. Cash (lease payment for Year 1) 50,000
Dr. Cost of goods sold
382,614*
Dr. Net investment in the lease 375,000
Cr. Equipment – carrying value 395,400
Cr. Sales-type lease – revenue
412,214**
To derecognize the underlying asset at its carrying value, and recognize the net investment in the lease
and selling profit.
* In accordance with ASC 842-30-45-4a, cost of goods sold is the carrying amount of the equipment ($395,400) minus the
unguaranteed residual asset ($12,786).
**In accordance with ASC 842-30-45-4a, revenue is recognized at the lesser of (1) the fair value of the underlying asset
($425,000), and (2) the sum of the lease receivable and any lease payments prepaid by the lessee ($412,214).
Heisenberg Co. also expenses the initial direct costs as follows:
$ $
Dr. Operating expenses*
5,000
Cr. Cash* 5,000
* Assumes lease inception and lease commencement are at the same date.
To recognize the initial direct costs as an expense.
Subsequent measurement (assuming no modifications)
Heisenberg Co. increases the carrying amount of the net investment in the lease for interest income using
the rate implicit in the lease of 4.58% and reduces it to reflect the lease payments collected. For example,
Heisenberg Co. records journal entry #1 at the end of Year 1 to recognize interest accrued and journal entry
#2 at the beginning of Year 2 to reflect the second lease payment:
$ $
Dr. Net investment in the lease
17,157
Cr. Interest income* 17,157
* Net investment in the lease of $375,000 multiplied by the rate implicit in the lease of 4.58%
To recognize interest income on net investment in the lease – Year 1
ACCOUNTING FOR LEASES UNDER ASC 842 172
$
$
Dr. Cash 50,000
Cr. Net investment in the lease
50,000
To recognize cash payment received beginning of Year 2
In accordance with ASC 842-30-30-1, and for disclosure purposes, Heisenberg Co. calculates the components
of the net investment in the lease, which include the lease receivable and the unguaranteed residual asset.
The following summarizes the accounting for the lease receivable throughout the lease term:
Beg.
Balance
PMT
Interest
End.
Balance
[A]
[B]
[C] = [A + B] x 4.58%
[D] = [A] + [B] + [C]
Year 1
362,214
-
16,572
378,785
Year 2
378,785
(50,000)
15,042
343,827
Year 3
343,827
(50,000)
13,443
307,270
Year 4
307,270
(50,000)
11,770
269,040
Year 5
269,040
(50,000)
10,021
229,062
Year 6
229,062
(50,000)
8,192
187,254
Year 7
187,254
(50,000)
6,279
143,533
Year 8
143,533
(50,000)
4,279
97,813
Year 9
97,813
(50,000)
2,187
50,000
Year 10
50,000
(50,000)
0
0
The following summarizes the accounting for the unguaranteed residual asset throughout the lease term,
along with the ending balance of each component and of the net investment in the lease:
Unguaranteed
Residual
Asset Beg.
Balance
Interest
Accretion
Unguaranteed
Residual
Asset End.
Balance
Lease
Receivable
End. Balance
Net Investment
in the Lease
End. Balance
[A]
[B] = [A] x 4.58%
[C] = [A] +[B]
[D] See above
[E]= [C]+[D]
Year 1
12,786
585
13,371
378,785
392,157
Year 2
13,371
612
13,983
343,827
357,810
Year 3
13,983
640
14,623
307,270
321,893
Year 4
14,623
669
15,292
269,040
284,332
Year 5
15,292
700
15,991
229,062
245,053
Year 6
15,991
732
16,723
187,254
203,977
Year 7
16,723
765
17,488
143,533
161,022
Year 8
17,488
800
18,288
97,813
116,101
Year 9
18,288
837
19,125
50,000
69,125
Year 10
19,125
875
20,000
0
20,000
At the end of the lease term, the net investment in the lease equals the estimated residual value of
the asset of $20,000.
ACCOUNTING FOR LEASES UNDER ASC 842 173
The following summarizes interest income recognized in profit or loss throughout the lease term:
Year 1
17,157
Year 2
15,654
Year 3
14,083
Year 4
12,439
Year 5
10,721
Year 6
8,924
Year 7
7,045
Year 8
5,079
Year 9
3,024
Year 10
875
Total
95,000
Total interest recognized is $95,000 and represents the difference between (1) the undiscounted
lease payments plus the expected residual value of the asset at the end of the lease term of
$520,000, and (2) the fair value of the underlying asset at the commencement date of $425,000.
At the end of Year 10, Heisenberg Co. reclassifies the net investment in the lease of $20,000 to the
appropriate category of asset in accordance with other GAAP.
Example 1C - Sales-type lease with lessee residual value guarantee – collectibility is not probable
FACTS
Assume the same facts as in Example 1A above, except that at the commencement date, J.R.E Inc.
concludes that collectibility of the lease payments plus the amount necessary to satisfy Lessee’s residual
value guarantee is not probable. In reaching this conclusion, J.R.E considers both Lessee’s ability and
intent to pay the required payments. Specifically, Lessee has limited credit history and no significant other
income or assets with which to make the payments if its operations were unsuccessful.
Also assume that at the end of Year 3, collectibility of the lease payments and the amount necessary to
satisfy Lessee’s residual value guarantee become probable, and that the contract has not been terminated
and the underlying asset has not been repossessed.
ANALYSIS
Accounting while collectibility is not probable
At the commencement date, because collectibility is not probable, J.R.E continues to recognize the
equipment. That is, it does not recognize a net investment in the lease nor any selling profit or selling loss.
Consistent with Example 1A, the initial direct costs are expensed at the commencement date.
J.R.E continues to reassess collectibility to determine whether the lease payments and the amount
necessary to satisfy Lessee’s residual value guarantee are probable of collection. For years 1 and 2,
collectibility is still not probable. Therefore, J.R.E accounts for the $25,000 Year 1 and Year 2 lease
payments received as a deposit liability.
ACCOUNTING FOR LEASES UNDER ASC 842 174
Also, since the underlying asset is not derecognized, J.R.E recognizes depreciation expense on the
equipment. In this example, assume annual depreciation is $15,800. The following journal entries are
recorded in each year:
$
$
Dr. Cash 25,000
Cr. Deposit liability
25,000
$ $
Dr. Depreciation expense 15,800
Cr. Equipment
15,800
Accounting once collectibility becomes probable
At the end of Year 3, Lessee makes the $25,000 payment due under the lease, which J.R.E. records as a
deposit liability. The updated balance of the deposit liability is therefore $75,000.
Depreciation expense of $15,800 is recorded on the equipment. Therefore, the updated carrying amount of
the equipment is $102,600 [$150,000 carrying value at the commencement date – ($15,800 x3)].
At the end of Year 3, J.R.E concludes that collectibility of the lease payments plus the amount necessary to
satisfy Lessee’s residual value guarantee is now probable based on Lessee’s payment history under the lease
(three lease payments made on time) and the fact that the business in which the leased asset is used has
proven to be successful and has significantly improved since the commencement date.
J.R.E does not reassess the classification of the lease. That is, it remains a sales-type lease.
Once collectibility is probable at the end of Year 3, J.R.E:
•
Derecognizes the carrying amount of the equipment (i.e., $102,600)
•
Derecognizes the carrying amount of the deposit liability (i.e., $75,000)
•
Recognizes a net investment in the lease based on the remaining lease payments and remaining
lease term, using the rate implicit in the lease determined at the commencement date (i.e.,
4.68%).
•
Recognizes a selling profit or loss (see below for calculation).
The net investment in the lease is calculated as follows:
PMT
Year 4
25,000
Year 5
25,000
Year 6
80,000
(25,000 lease payment + 55,000 estimated residual value)
Undiscounted PMTs
130,000
PV (4.68%) =
116,439
(rate implicit in the lease determined at commencement date)
The net investment in the lease of $116,439 consists of the following:
•
Lease receivable of $99,003 (present value of 3 lease payments of $25,000 and the amount of
Lessee’s residual value guarantee of $35,000 at the end of the lease term), and
•
Unguaranteed residual asset of $17,436 [($55,000 estimated residual value - $35,000 Lessee
guaranteed amount) * (1.0468)^-3].
ACCOUNTING FOR LEASES UNDER ASC 842 175
The above balances are same as the ending balances in Example 1A at the end of Year 3 since none
of the accounting assumptions (e.g., estimated residual value) have been updated.
J.R.E calculates the selling profit/loss as follows:
Lease receivable ($99,003) plus deposit liability balance ($75,000), minus 174,003
Carrying value of equipment ($102,600), net of unguaranteed residual asset ($17,436) 85,164
Selling profit 88,839
J.R.E records the following journal entry:
$
$
Dr. Net investment in the lease 116,439
Dr. Deposit liability
75,000
Cr. Equipment – carrying value 102,600
Cr. Sales-type lease – selling profit 88,839
J.R.E then accounts for the remaining three years of the lease as any other sales-type lease. The following
summarizes the accounting for the net investment in the lease for the remaining three years:
Beg.
Balance
Interest
Payment
End.
Balance
[A]
[B] = [A] x 4.68%
[C]
[D] = [A] + [B] + [C]
Year 4
116,439
5,450
(25,000)
96,889
Year 5
96,889
4,535
(25,000)
76,423
Year 6
76,423
3,577
(25,000)
55,000
At the end of the lease (Year 6), J.R.E reclassifies the net investment in the lease, then equal to the
estimated residual value of the asset of $55,000 to property, plant and equipment and accounts for it under
ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 176
DIRECT FINANCING LEASES – A DEEPER DIVE
RECOGNITION AND INITIAL MEASUREMENT
A lessor classifies a lease as a direct financing lease if none of the criteria for sales-type lease classification are met
and if both of the following criteria apply:
The present value of the sum of the lease payments and any residual value guaranteed by the lessee and/or
any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the
underlying asset.
It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual
value guarantee.
Even though the above two conditions may be met, a lessor will classify the lease as operating if the lease includes
variable lease payments that do not depend on an index or a rate and that would result in the recognition of a selling
loss at lease commencement if the lease were classified as a direct financing lease.
Also, if a lessor classifies a lease as an operating lease because collectibility is not probable, subsequent changes in
collectibility do not change lease classification (i.e., the lease continues to be classified as operating). However,
collectibility will affect the amount of lease income recognized in profit or loss. See Operating Leases Section in this
chapter for additional discussion.
For a lease classified as a direct financing lease, the lessor converts its risk in the underlying asset (asset risk) into
credit risk. Therefore, a lessor recognizes a net investment in the lease at the commencement date and derecognizes
the underlying asset. The net investment in a direct financing lease is calculated the same way as for a sales-type
lease, except that:
Any selling profit arising from the lease (see calculation in the Sales-Type Leases section above) is deferred
and recognized as part of the subsequent measurement of the net investment in the lease.
Initial direct costs incurred are deferred and included in the measurement of the net investment in the
lease, regardless of whether the fair value of the underlying asset at the commencement date equals its
carrying amount or not. The rate implicit in the lease is defined in such a way that initial direct costs
deferred are included automatically in the net investment in the lease.
The following summarizes the initial measurement of the net investment in a direct financing lease:
Because of the way the rate implicit in the lease is defined and because selling profit is deferred in a direct
financing lease, the net investment in a direct financing lease recognized typically will equal the carrying
value of the underlying asset plus any initial direct costs (less prepaid lease payments, if any).
Like sales-type leases, a lessor does not reassess whether collectibility is probable for leases that are classified as a
direct financing lease after the commencement date. Subsequent changes in the credit risk of the lessee are accounted
for in accordance with the impairment (or credit loss) guidance applicable to the net investment in the lease. See
Impairment Section in this chapter for additional discussion.
ACCOUNTING FOR LEASES UNDER ASC 842 177
SUBSEQUENT MEASUREMENT
After the commencement date, a lessor measures the net investment in the lease by:
Increasing the carrying amount to reflect interest income on the net investment in the lease using the rate
implicit in the lease (but unlike a sales-type lease, the rate implicit in the lease is determined using the carrying
amount of the underlying asset rather than its fair value since selling profit is deferred and recognized over the
lease term).
Reducing the carrying amount to reflect the lease payments collected during the period.
Accounting for components of the net investment in a direct financing lease
As discussed above, total periodic interest income recognized on a direct financing lease is
determined based on the carrying amount of the net investment in the lease multiplied by the rate
implicit in the lease (which is determined using the carrying amount of the underlying asset).
However, a lessor uses the rate implicit in the lease (using the fair value of the underlying asset at
the commencement date) to accrete interest income on the lease receivable and unguaranteed
residual asset. Therefore, the portion of the deferred selling profit that is amortized each period
equals the difference between total periodic interest income recognized on the net investment in
the lease less the periodic interest income earned on the lease receivable and unguaranteed
residual asset. See Example 2 for illustration.
After the commencement date, a lessor recognizes the following in the statement of operations:
Interest income on the net investment in the lease using the rate implicit in the lease (as discussed above).
Variable lease payments that are not included in the net investment in the lease as income in the period when
the changes in facts and circumstances on which the variable lease payments are based occur.
Impairment (or credit losses) on the net investment in the lease.
The net investment in the lease is not remeasured after the commencement date except in a lease modification that is
not accounted for as a separate contract. See Modification Section in this chapter for additional discussion.
ACCOUNTING AT THE END OF THE LEASE TERM
At the end of the lease term, a lessor reclassifies the net investment in the lease to the appropriate category of asset
(for example, property, plant, and equipment) in accordance with other GAAP, measured at the carrying amount of the
net investment in the lease. The lessor then accounts for the underlying asset that was the subject of a lease in
accordance with other Topics, such ASC 360.
ACCOUNTING FOR LEASE TERMINATION
If a direct financing lease is terminated before the end of the lease term, a lessor:
Tests the net investment in the lease for impairment or credit losses under ASC 310 or ASC 326-20, as applicable.
Reclassifies the net investment in the lease to the appropriate category of asset in accordance with other GAAP,
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.
Accounts for the underlying asset that was the subject of the lease in accordance with other GAAP, such as ASC
360.
ACCOUNTING FOR LEASES UNDER ASC 842 178
Example 2 - Direct financing lease
FACTS
Assume the same facts as in Example 1A above, except that the $35,000 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 are probable.
ANALYSIS
Accounting at the commencement date
For this Example, the following interest rate information will be needed to (1) assess classification of the lease
as a sales-type lease, (2) if not a sales-type lease, to assess classification as a direct financing lease, and (3) if
classified as a direct financing lease, to account for the net investment in the direct financing lease:
Step 1: Calculate rate
implicit in the lease as
defined
Step 2: Add initial direct
costs to the fair value of
the underlying asset
Step 3: Replace fair value
of the underlying asset by
its carrying amount
PMT
PMT
PMT
Year 0
(170,000)
(172,000)
(152,000)
Year 1
25,000
25,000
25,000
Year 2
25,000
25,000
25,000
Year 3
25,000
25,000
25,000
Year 4
25,000
25,000
25,000
Year 5
25,000
25,000
25,000
Year 6
80,000
80,000
80,000
Undiscounted PMTs
205,000
205,000
205,000
Rate implicit in the
lease
4.68%
“Sales-Type
Classification Rate”*
4.38%
“DFL Classification
Rate”**
7.68%
“Direct Financing
Rate”***
* The Sales-Type Classification Rate is the rate that is used to assess whether the lease qualifies as a sales-type lease under
ASC 842-10-25-2(d). It is the same rate as calculated in Example 1A based on the fair value of the underlying asset at the
commencement date, the lease payments to be received over the lease term, and the expected amount of the residual
asset at the end of the lease term. Initial direct costs are excluded since the fair value of the underlying asset is different
than its carrying value.
** The Direct Financing Lease (“DFL”) Classification Rate is the rate that is used to assess whether the lease qualifies as a
direct financing lease under ASC 842-10-25-3(b)(1). It is calculated like the Sales-Type Rate, except that initial direct costs
are deferred (i.e., added to the fair value of the underlying asset). This rate will also be used to initially and subsequently
measure the lease receivable and the unguaranteed residual asset.
*** The Direct Financing Rate is the rate used for initial and subsequent measurement of the net investment in the lease. It
is calculated like the DFL Classification Rate, except that the carrying amount of the asset is used, rather than fair value,
since the selling profit is deferred and recognized as part of the subsequent measurement of the net investment in the
lease.
ACCOUNTING FOR LEASES UNDER ASC 842 179
To determine if the lease qualifies as a sales-type lease, J.R.E calculates the present value of the lease
payments at the commencement date using the Sales-Type Classification Rate. The lease payments include
only the annual payments of $25,000 made by Lessee. Because the residual value guarantee is provided by a
third party, it is not considered in the sales-type lease classification test.
PMT
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
25,000
Undiscounted PMTs
150,000
PV (4.68%) =
128,200
J.R.E concludes that none of the criteria for classifying the lease as a sales-type lease are met because:
•
The lease does not transfer ownership of the equipment to Lessee nor grant it a purchase option.
•
The lease term is not for the major part of the remaining economic life of the underlying asset (6/10
= 60%).
•
The present value of the lease payments does not amount to substantially all of the fair value of the
equipment (128,200/170,000 = 75%). Note: this calculation does not consider the residual value
guarantee provided by the
third party
.
•
The underlying asset is not of a specialized nature and it will have alternative uses to the lessor at
the end of the lease term.
J.R.E then assesses classification of the lease as a direct financing lease, using the DFL Classification Rate:
PMT
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
60,000
(25,000 lease payment + 35,000 3
rd
party residual value guarantee)
Undiscounted PMTs
185,000
PV (4.38%) =
156,532
J.R.E 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 third-party residual
value guarantee amounts to substantially all of the fair value of the equipment (156,532/170,000 =
92%).
•
It is probable J.R.E will collect the lease payments and any amount necessary to satisfy the third-
party residual value guarantee.
•
ASC 842-10-25-3A on variable lease payments not based on an index or a rate does not apply.
ACCOUNTING FOR LEASES UNDER ASC 842 180
Therefore, at the commencement date, J.R.E derecognizes the equipment for $150,000 and recognizes a net
investment in the lease of $152,000 measured using the Direct Financing Rate:
PMT
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
80,000
(25,000 lease payment + 55,000 estimated residual value)
Undiscounted PMTs
205,000
PV (7.68%) =
152,000
The net investment in the lease equals the carrying value of the underlying asset of $150,000 plus the
initial direct costs of $2,000. There are no prepaid lease payments.
The net investment in the lease includes the following components:
•
Lease receivable of $156,532 (which is the present value of the lease payments and the third-party
residual value guarantee, discounted using the
DFL Classification Rate of 4.38%
),
•
Unguaranteed residual asset of $15,468 (which is the difference between the estimated residual
value of $55,000 and the third-party residual value guarantee of $35,000, also discounted at 4.38%)
•
Deferred selling profit of $20,000, which is calculated as follows:
Lease receivable, minus 156,532
Carrying value of the equipment, net of unguaranteed residual value, minus (134,532)
Deferred initial direct costs (2,000)
Deferred selling profit 20,000
The sum of the lease receivable, unguaranteed residual asset, and deferred selling profit equals the
carrying amount of the net investment in the lease of $152,000.
J.R.E records the following journal entry at the commencement date:
$
$
Dr. Net investment in the lease
152,000
Cr. Equipment – carrying value
150,000
Cr. Cash (or prepaid asset)
2,000
To derecognize the underlying asset and recognize a net investment in the direct financing lease.
ACCOUNTING FOR LEASES UNDER ASC 842 181
Subsequent measurement (assuming no modification)
J.R.E increases the carrying amount of the net investment in the lease for interest income using the Direct
Financing Rate of 7.68% and reduces it to reflect the lease payments collected. For example, J.R.E records the
following journal entry at the end of Year 1:
$
$
Dr. Cash 25,000
Cr. Net investment in the lease
13,331
Cr. Interest income*
11,669
* Net investment in the lease of $152,000 multiplied by the Direct Financing Rate of 7.68%
J.R.E subsequently measures the net investment in the lease using the Direct Financing Rate of 7.68%,
assuming no modifications throughout the lease term:
Beg.
Balance
Interest
(7.68%)
PMT
Ending
Balance
Year 1
152,000
11,669
(25,000)
138,669
Year 2
138,669
10,646
(25,000)
124,315
Year 3
124,315
9,544
(25,000)
108,859
Year 4
108,859
8,357
(25,000)
92,217
Year 5
92,217
7,080
(25,000)
74,296
Year 6
74,296
5,704
(25,000)
55,000
In accordance with ASC 842-30-30-1, and for disclosure purposes, J.R.E calculates the separate components of
the net investment in the lease as follows:
Lease receivable (using the DFL Classification Rate):
Beg.
Balance
Interest
(4.38%)
PMT
Ending
Balance
Year 1
156,532
6,850
(25,000)
138,382
Year 2
138,382
6,056
(25,000)
119,438
Year 3
119,438
5,227
(25,000)
99,665
Year 4
99,665
4,361
(25,000)
79,026
Year 5
79,026
3,458
(25,000)
57,484
Year 6
57,484
2,516
(25,000)
35,000
Unguaranteed residual value (using the DFL Classification Rate):
Beg.
Balance
Interest
(4.38%)
Ending
Balance
Year 1
15,468
677
16,145
Year 2
16,145
706
16,851
Year 3
16,851
737
17,588
Year 4
17,588
770
18,358
Year 5
18,358
803
19,161
Year 6
19,161
839
20,000
ACCOUNTING FOR LEASES UNDER ASC 842 182
Deferred selling profit:
Beg.
Balance
Profit Earned*
Ending
Balance
Year 1
(20,000)
4,142
(15,858)
Year 2
(15,858)
3,884
(11,974)
Year 3
(11,974)
3,580
(8,394)
Year 4
(8,394)
3,226
(5,168)
Year 5
(5,168)
2,818
(2,350)
Year 6
(2,350)
2,350
0
* The portion of the deferred selling profit recognized in the income statement each period equals the difference between
the interest income recognized on the net investment in the lease during the period and the sum of the interest income
earned on the lease receivable and the unguaranteed residual asset during that same period.
For example, in Year 1:
Interest income on the net investment in the lease is $11,669 (initial net investment in the lease of $152,000 x
Direct Financing Rate of 7.68%)
Amortization of deferred selling profit is $4,142 and is equal to interest income of $11,669 minus interest
recognized on the lease receivable of $6,850 minus interest recognized on the unguaranteed residual asset of $677.
At the end of the lease term, the net investment in the lease equals the estimated residual value of
the asset of $55,000, the lease receivable equals the third party residual value guarantee of $35,000,
the unguaranteed residual asset is the difference between $55,000 and $35,000, and the deferred
selling profit balance is zero (i.e., all selling profit has been recognized over the lease term).
The following summarizes interest income recognized in profit or loss throughout the lease term:
Year 1
11,669
Year 2
10,646
Year 3
9,544
Year 4
8,357
Year 5
7,080
Year 6
5,704
Total
53,000
Total interest income recognized is $53,000 and represents the difference between (1) the
undiscounted lease payments plus the expected residual value of the asset at the end of the lease
term of $205,000, and (2) the carrying value of the underlying asset at the commencement date of
$150,000 plus initial direct costs of $2,000.
At the end of the lease term, J.R.E reclassifies the net investment in the lease of $55,000 to property, plant and
equipment and then accounts for it under ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 183
OPERATING LEASES
RECOGNITION AND INITIAL MEASUREMENT
The accounting by a lessor for operating leases under ASC 842 is the same as the accounting under ASC 840. A lessor
does not derecognize the underlying asset at the commencement date, and it defers any initial direct costs as a
separate asset.
SUBSEQUENT MEASUREMENT
After the commencement date, a lessor continues to measure the underlying asset subject to an operating lease,
including testing it for impairment, in accordance with other Topics, such as ASC 360 on property, plant and
equipment.
A lessor recognizes the following lease income in profit or loss, depending on whether collectibility of the lease
payments plus any amount necessary to satisfy a residual value guarantee provided by either the lessee or a third party
is probable:
Collectibility is probable Collectibility is not probable
Recognize the following:
The lease payments as income over the lease term
typically 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 (see
below for additional discussion).
Variable lease payments in the period in which the
changes in facts and circumstances on which these
payments are based occur.
Lease income is limited to the lesser of:
The amounts described in the left column, and
The lease payments, including variable lease
payments, that have been collected from the
lessee (i.e., a cash basis).
Initial direct costs are recognized as an expense over the lease term on the same basis as the lease income.
Pattern of benefits expected from use of the underlying asset
ASC 842 considers the right to control the use of the underlying asset as the equivalent of physical
use. That is, if the lessee controls the use of the underlying asset, recognition of lease income is
not affected by the extent of the lessee’s use of the underlying asset.
The lessor should also reassess changes in collectibility after the commencement date. If collectibility of the remaining
lease payments plus amounts necessary to satisfy a residual value guarantee becomes probable, then, any difference
between the cumulative lease income that would have been recognized on an accrual basis and cumulative lease
income that has been recognized on a cash basis is recognized as a current-period adjustment to lease income.
See Example 1, Case D at ASC 842-30-55-40 through 55-42 for an illustration of a lease classified as an operating lease
when collectibility of the lease payments and amounts to satisfy a residual value guarantee is not probable at the
commencement date.
See also Impairment Section in this chapter for additional discussion on collectibility and impairment considerations for
operating leases.
ACCOUNTING FOR LEASES UNDER ASC 842 184
Example 3 - Operating lease
FACTS
Assume the same facts as in Example 1A above, except that no residual value guarantee is provided either
by Lessee or an unrelated third party.
Collectibility of the lease payments is considered probable at the commencement date and throughout the
lease term.
ANALYSIS
In order to determine whether to classify the lease as a sales-type lease, J.R.E calculates the present value
of the lease payments at the commencement date, using the rate implicit in the lease of 4.68% (see Example
1A for calculation):
PMT
Year 1
25,000
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
25,000
Undiscounted PMTs
150,000
PV (4.68%) =
128,200
J.R.E concludes that none of the criteria for classifying the lease as a sales-type lease are met because:
•
The lease does not transfer ownership of the equipment to Lessee nor grant it a purchase option.
•
The lease term is not for a major part of the remaining economic life of the underlying asset (6/10
= 60%).
•
The present value of the lease payments does not amount to substantially all of the fair value of
the equipment (128,200/170,000 = 75%).
•
The underlying asset is not of a specialized nature and will have alternative uses to the lessor at
the end of the lease term.
In addition, the lease does not qualify as a direct financing lease since there is no third-party residual value
guarantee. Accordingly, the lease is classified as an operating lease.
J.R.E initially recognizes the amount of initial direct costs ($2,000) as a separate asset.
J.R.E continues to measure the equipment in accordance with ASC 360, Property, Plant and Equipment.
At the end of Years 1-6, J.R.E records the following entries (assuming the lease is not modified or
terminated and the assessment of collectibility as probable does not change) to reflect the periodic lease
income and amortization of the deferred initial direct costs:
$
$
Dr. Cash
25,000
Cr. Lease income
25,000
Dr. Operating expenses
333
Cr. Other assets – initial direct costs
333
ACCOUNTING FOR LEASES UNDER ASC 842 185
MODIFICATIONS
A lease modification is a change to the terms and conditions of the contract that results in a change in the scope of, or
the consideration for, the lease. For example, a lease could be modified to add or terminate the right to use one or
more underlying assets, it could be modified to extend or shorten the contractual lease term, and so forth.
A lessor is required to account for the modification at the date that the lease modification is approved by both the
lessee and the lessor (the effective date of the modification under ASC 842).
A lessor also accounts for the following events as modifications:
When the lessee exercises a renewal or purchase option included in the original contract that the lessor
previously determined was not reasonably certain of exercise,
When the lessee exercises a termination option included in the original contract that the lessor had determined
the lessee was not reasonably certain to exercise,
When the lessee takes control over the use of an additional underlying asset under a master lease agreement
that permits (i.e., does not require) the lessee to gain control over the use of additional underlying assets
during the term of the agreement.
In accounting for lease modifications, ASC 842 differentiates between modifications that result in a separate contract
and which therefore do not affect the accounting for the original contract, and other modifications that should be
accounted for as part of the original contract. That determination can be made by using the following steps:
ACCOUNTING FOR LEASES UNDER ASC 842 186
Modifications of contracts with LIBOR based rates
ASU 2020-04 provides optional expedients and exceptions for applying U.S. GAAP to contracts and
transactions affected by the reference rate reform (i.e., discontinuation of LIBOR as a reference rate or
other reference rate expected to be discontinued as a result of reference rate reform).
Accordingly, modifications to contracts within the scope of ASC 842 that change the reference rate may
be accounted for as a continuation of the existing contract with no reassessment of lease classification
and discount rate, and no remeasurement of lease payments that otherwise would be required for
modifications not accounted for as separate contracts. Instead, the change in reference rate is treated
as variable lease payments that were based on the reference rate in the original lease.
However, to qualify for the optional expedient, other terms being concurrently modified, if any, must be
related to the replacement of a reference rate because of reference rate reform. For example, the
following changes are not eligible for the expedient because they are deemed unrelated to the
replacement of a reference rate:
-
Changes to the contractual term of the lease,
-
Additions or terminations of right-to-use underlying assets,
-
Changes to renewal, termination, or purchase options.
See ASC 848-20-15-2 through 15-6 for additional information about scope of the expedient, and ASC 848-
20-35-11 and 35-12 for application of the expedient to leases by lessors.
If a modification is not accounted for as a separate contract, a lessor:
Reassesses the lease term and any purchase option. See Chapter 4,
Lease Classification and Key Terms,
for
additional details on assessing whether renewal options, purchase options and termination options are
reasonably certain to be exercised.
Remeasures and reallocates the remaining consideration in the contract. See
Lease Classification and Key
Terms
for additional details on measuring lease payments, and Chapter 3 on
Identifying and Separating
Components
for additional details on allocating consideration.
Reassesses lease classification based on the facts and circumstances (and the modified terms and conditions)
as of the effective date of the modification (for example, using the fair value and remaining economic life of
the underlying asset at that date). See
Lease Classification and Key Terms
for additional details on
determining lease classification.
Also, initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a
modification to a lease should be accounted for in the same manner as those items would be accounted for in
connection with a new lease.
ACCOUNTING FOR LEASES UNDER ASC 842 187
The accounting for modifications that are not accounted for as a separate contract is summarized in the following
table depending on how classification changes (and assuming there continues to be a lease after the modification):
Type of Modification Accounting Considerations
Operating lease to
operating lease
Account for the modification as a termination of the existing lease and creation
of a new lease that commences on the effective date of the modification.
Consider any prepaid or accrued lease rentals related to the original lease as
part of the lease payments for the modified lease.
See Example 20 at ASC 842-10-55-190 through 55-193 for illustration.
Operating lease to
sales-type or direct
financing lease
Account for the modification as a termination of the existing lease and creation
of a new lease that commences on the effective date of the modification.
Recognize a net investment in the modified lease and derecognize both the
underlying asset and any deferred rent liability or accrued rent asset (which
adjusts the selling profit or loss).
•
If the modified lease is classified as a sales-type lease, the selling profit
or loss is recognized in profit or loss at the effective date of the
modification. See Example 21, Case A at ASC 842-10-55-194 through 55-
197 for an illustration.
•
If the modified lease is classified as a direct financing lease, any selling
loss is recognized in profit or loss at the effective date of the
modification. However, any selling profit is deferred and included in the
measurement of the net investment in the lease. See Example 21, Case B
at ASC 842-10-55-198 through 55-200 for an illustration.
After the effective date of the modification, a lessor accounts for the modified
lease in the same manner as any other sales-type or direct financing lease.
Direct financing lease to
direct financing lease
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.
See Example 22, Case A at ASC 842-10-55-201 through 55-205
for an illustration.
Sales-type lease to
sales-type or direct
financing lease
Direct financing lease to
sales-type lease
Account for the modified lease under the guidance for sales-type leases. The
effective date of the modification is the commencement date of the modified
lease.
Calculate the selling profit or selling loss on the lease as the difference between
the fair value of the underlying asset at the effective date of the modification
and the carrying amount of the net investment in the original lease immediately
before that date.
See Example 22, Case B at ASC 842-10-55-206 and 55-207
for an illustration. See
also Example 4 below.
Direct financing or
sales-type lease to
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.
See Example 22, Case C at ASC 842-10-55-208 and 55-209
for an illustration. See
also Example 5 below.
ACCOUNTING FOR LEASES UNDER ASC 842 188
Example 4 - Modification of a direct financing lease to a sales-type lease
FACTS
Assume the same facts as in Example 2 apply, in which J.R.E entered into a lease of non-specialized
equipment with Lessee for 6 years, with annual lease payments of $25,000 payable at the end of each year,
and with a third-party residual value guarantee of $35,000. The lease was classified as a direct financing
lease at the commencement date. Also assume the following:
At the end of Year 1 of the lease, J.R.E and Lessee agree to extend the lease term by two years.
The annual lease payments in each of Years 7-8 are $30,000.
The fair value of the equipment at the effective date of the modification is $162,000.
The carrying amount of the net investment in the lease immediately before the modification is $138,669.
The estimated residual value of the equipment at the end of the modified lease is $20,000, of which $8,000
is guaranteed by a third-party unrelated to Lessee or J.R.E.
At the effective date of the modification, the remaining economic life of the equipment is 9 years.
There are no initial direct costs related to the modification.
ANALYSIS
The modification does not grant Lessee an additional right of use but rather alters Lessee’s already obtained
right to use the equipment. Therefore, the modification is not accounted for as a separate contract.
Because the lease term is for a major part (in this case 78%) of the remaining economic life of the equipment
at the effective date of the modification, J.R.E classifies the lease as a sales-type lease (note that in this
example the lease payments are also substantially all of the fair value of the equipment). ASC 842-10-25-3A
on variable lease payments not based on an index or a rate does not apply.
The rate implicit in the modified lease is calculated as shown below:
End of
PMT
Year 1
(162,000)
Year 2
25,000
Year 3
25,000
Year 4
25,000
Year 5
25,000
Year 6
25,000
Year 7
30,000
Year 8
50,000
(30,000 lease payment + 20,000 estimated residual value)
Rate implicit in the
lease
5.64%
ACCOUNTING FOR LEASES UNDER ASC 842 189
At the effective date of the modification, J.R.E recognizes a net investment in the sales-type lease of
$162,000 (the fair value of the underlying equipment at that date). In addition, it derecognizes the
outstanding balance of the net investment in the direct financing lease of $138,669. The difference is
recognized as a selling profit.
$
$
Dr. Net investment in sales-type lease
162,000
Cr. Net investment in direct financing lease
138,669
Cr. Selling profit
23,331
The net investment in the lease consists of a lease receivable of $153,826 (present value of lease payments
and third-party residual value guarantee) and unguaranteed residual asset of $8,174, all discounted at 5.64%.
Following the modification, J.R.E accounts for the sales-type lease in the same manner as any other sales-
type lease, as illustrated in Examples 1A and 1B.
ACCOUNTING FOR LEASES UNDER ASC 842 190
Example 5 - Modification of a sales-type lease to an operating lease
FACTS
Assume the same facts as in Example 1A apply, in which J.R.E entered into a lease of non-specialized
equipment with Lessee for 6 years, with annual lease payments of $25,000 payable at the end of each year,
and in which Lessee provided a residual value guarantee of $35,000. The lease was classified as a sale-type
lease at the commencement date. Also assume the following:
At the end of Year 1 of the lease, J.R.E and Lessee agree to shorten the lease term by two years.
The annual lease payments in each of Years 2-4 increase to $30,000 due at the end of each year.
The fair value of the equipment at the effective date of the modification is $162,000.
The carrying amount of the net investment in the lease immediately before the modification is $152,956.
J.R.E expects that the residual value of the equipment at the end of the remaining 3-year lease term will be
$90,000, of which $25,000 is guaranteed by Lessee.
At the effective date of the modification, the remaining economic life of the equipment is 9 years.
There are no initial direct costs related to the modification.
ANALYSIS
As the modification does not grant Lessee an additional right-of-use, it is not accounted for as a separate
contract.
The rate implicit in the modified lease is calculated as shown below:
End of
PMT
Year 1
(162,000)
Year 2
30,000
Year 3
30,000
Year 4
120,000
(30,000 lease payment + 90,000 estimated residual value)
Rate Implicit in the lease
4.33%
J.R.E concludes that none of the criteria for classifying the lease as a sales-type lease are met because:
•
The lease does not transfer ownership of the equipment to Lessee nor grant it a purchase option.
•
The lease term is not for a major part of the remaining economic life of the underlying asset (3/9 =
33%).
•
The present value of the lease payments plus Lessee’s residual value guarantee, discounted at
4.33%, does not amount to substantially all of the fair value of the equipment at the effective date
of the modification (104,756/162,000 = 65%).
•
The underlying asset is not of a specialized nature and will have alternative uses to the lessor at
the end of the lease term.
As there is no residual value guarantee provided by a third-party, J.R.E classifies the modified lease as an
operating lease in accordance with ASC 842-10-25-3(b).
ACCOUNTING FOR LEASES UNDER ASC 842 191
J.R.E therefore recognizes the equipment at the carrying amount of the net investment in the lease
immediately before the modification:
$
$
Dr. Equipment 152,956
Cr. Net investment in sales-type lease
152,956
If collectibility of the lease payments plus Lessee’s residual value guarantee is considered probable, J.R.E
will recognize the lease payments of $90,000 ($30,000 × 3 years) on a straight-line basis over the 3-year
modified lease term, as well as depreciation on the equipment over its remaining useful life.
IMPAIRMENT
NET INVESTMENT IN SALES-TYPE AND DIRECT FINANCING LEASES
A lessor determines the impairment (or loss allowance) related to net investment in sales-type and direct financing
leases and records any impairment (or loss allowance) in accordance with ASC 310 on receivables (as described in
paragraphs 310-10-35-16 through 35-30), or ASC 326-20 on financial instruments measured at amortized cost when
adopted. In determining the loss allowance for a net investment in the lease, a lessor considers the collateral relating
to the net investment in the lease, which 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.
In some cases, the contractual term over which the expected credit losses are measured in accordance with ASC 326-
20-30-6 may differ from the lease term determined in accordance with ASC 842-10-30-1, due to certain requirements in
both standards that may shorten or extend the contractual term. For example, consideration of lease extension options
under ASC 842 may not be reflected in the contractual term used for purposes of ASC 326 unless certain conditions are
met. In order to address any potential differences between the lease term and the contractual term under both
standards, the FASB issued ASU 2020-03, Codification Improvements to Financial Instruments to clarify that lessors
should use the lease term determined under ASC 842 as the contractual term for the net investment in leases for
purposes of measuring credit losses under ASC 326.
OPERATING LEASES
Because lessors do not derecognize the underlying asset associated with an operating lease, there is no net investment
in the lease to be assessed for impairment. Instead, the underlying asset continues to be assessed for impairment in
accordance with the guidance in ASC 360-10-35.
Also, ASC 842-30-25-12 and 25-13 provide guidance for lessors on the impairment of operating lease receivables. That
guidance establishes a collectibility constraint whereby lease income for operating leases is recognized on a straight-
line basis (or other systematic basis) only when collectibility of the lease payments and any amounts due under residual
value guarantees is probable. ASC 842-30 is silent as to whether a lessor can (or should) apply other GAAP for the
impairment of its operating lease receivables. Before adoption of ASC 842, many lessors applied the guidance in ASC
310 on receivables and in ASC 450-20 on loss contingencies and recognized reserves on operating lease receivables.
Operating lease receivables are outside the scope of ASC 326-20 on credit losses, but ASC 326-20 superseded the
guidance in ASC 310.
Accordingly, questions arose as to whether the guidance in ASC 842-30 on lessor accounting is the complete set of
accounting guidance that should be applied to operating lease receivables, or whether a lessor can (or should) continue
to recognize reserves on operating lease receivables under other GAAP.
ACCOUNTING FOR LEASES UNDER ASC 842 192
At a FASB meeting in July 2019, the FASB staff clarified that the following two approaches are acceptable and that
lessors should provide appropriate disclosures to the extent material:
Approach 1: Apply ASC 842-30 only
Under this approach, a lessor applies ASC 842-30-25-12 and 25-13 only. At the lease commencement date and
throughout the lease term, a lessor evaluates its operating leases for collectibility on an individual lease basis. The
accounting under this approach is summarized in the following table.
Collectibility of lease payments plus any
amount necessary to satisfy a residual value
guarantee is:
Lessor recognizes lease income:
Probable
On a straight-line basis (or other systematic basis), plus variable
lease payments in the period in which the changes in facts and
circumstances on which these payments are based occur
(i.e., on an accrual basis)
Not probable
At the lesser of:
Straight-line lease income (or other systematic basis), plus
variable lease payments (i.e., the accrual basis described
above)
Lease payments, including variable lease payments,
collected (i.e., a cash basis)
When the assessment of collectibility changes during the lease term, a lessor recognizes on a cumulative basis as a
current period adjustment to lease income the difference between (1) the accrual basis and (2) the cash basis,
typically as either a credit to lease income (if collectibility becomes probable) or as a debit to lease income (if
collectibility becomes not probable). The lessor would continue to assess collectibility throughout the remainder of the
lease term and make further adjustments when the assessment of collectibility subsequently changes, also on a
cumulative basis as a current period adjustment to lease income.
When collectibility is not probable, the lessor recognizes lease income subject to the constraint described above,
which means that any lease receivable, if recognized, is fully reserved.
Approach 2: Apply ASC 842-30 first, then apply ASC 450-20
Under this method (like Method 1 above), a lessor assesses its operating lease receivables at the individual lease level
under ASC 842-30 to determine whether collectibility of the lease payments (plus any amount necessary to satisfy a
residual value guarantee) is probable. If collectibility is not probable, the lessor recognizes revenue subject to the cash
basis constraint described in Method 1, which means that any lease receivable, if recognized, is fully reserved.
Once the collectibility assessment under ASC 842-30 is performed, a lessor then applies ASC 450-20. For operating
leases that were considered probable of collection under ASC 842-30 and for which receivables are recognized, the
lessor establishes and maintains a general allowance (reserve) in accordance with ASC 450-20, reflecting the lessor’s
expectation that a portion of the operating lease receivables will be uncollectible.
ACCOUNTING FOR LEASES UNDER ASC 842 193
The following flowchart summarizes the initial considerations when applying Method 1 and Method 2 (note that the
flowchart does not address changes in the assessment of collectibility):
ACCOUNTING FOR LEASES UNDER ASC 842 194
The application of ASC 450-20 in addition to ASC 842-30 (i.e., Approach 2) has also resulted in additional practice
issues, which are summarized in the following table.
Issue Considerations
Should reserves recognized under ASC
450-20 be established through a
reduction of lease income or through
bad debt expense?
Based on discussions with the FASB staff, either approach is acceptable.
If reserves under ASC 450-20 are
established through bad debt
expense, how should a lessor account
for a change in assessment of
collectibility going from probable to
not probable?
Broadly speaking, the FASB staff noted at a July 2019 FASB meeting that it
is acceptable for the reserve accounting for operating lease receivables to
be consistent with that currently applied for trade receivables (before
ASC 326-20 becomes effective), as long as the lessor ceases recognizing
lease income on a straight-line basis for an individual lease when
collectibility no longer is probable for that lease.
Specifically, we believe multiple approaches may be acceptable
depending on the lessor’s methodology for establishing and maintaining
reserves under ASC 450-20, including:
Writing off the gross receivable for the individual lease as an
adjustment to lease income and separately adjusting the ASC 450-
20 reserve as a bad debt expense adjustment (i.e., adjustments are
made on a gross basis),
Writing off the portion of the ASC 450-20 reserve attributable to the
individual lease against the gross receivable for that lease and
writing off the remaining balance of the lease receivable as an
adjustment to lease income (i.e., adjustments are made on a net
basis). This approach assumes that a lessor can identify on a
systematic and rational basis the portion of the ASC 450-20 reserve
attributable to individual leases.
Other approaches may be acceptable depending on the reserve
methodology the lessor applied. In those circumstances, entities are
encouraged to discuss with their accounting advisor or auditor the
appropriateness of their methodology for recapturing amounts from the
general reserve.
ACCOUNTING FOR LEASES UNDER ASC 842 195
OTHER TRANSACTIONS
SALES OF LEASE RECEIVABLES
Transfers of lease receivables from sales-type and direct financing leases (which include the lease payments and
amounts under residual value guarantees provided by either the lessee or a third-party) are subject to the
requirements of ASC 860 on transfers and servicing. Unguaranteed residual assets however do not meet the definition
of financial assets. 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, it no longer accretes the unguaranteed
residual asset to its estimated value over the remaining lease term. Instead, any remaining unguaranteed residual asset
is reported at its carrying amount at the date of the sale and is subsequently evaluated for impairment using the
guidance in ASC 360.
Future lease payments in an operating lease are executory in nature and do not qualify as a recognized financial asset
in the balance sheet, unlike lease receivables stemming from sales-type or direct-financing leases discussed above.
Accordingly, these lease payments are in the scope of ASC 860 only when they are due. A lessor’s sale or assignment of
future lease payments under an operating lease is accounted for as a secured borrowing under ASC 470 because the
lessor’s economic interest in an operating lease represents the sale of future revenues in an executory contract rather
than a receivable. Therefore, the lessor continues to record lease income on the operating lease in addition to
recognizing interest expense on the borrowing. As the lessee makes payments under the lease, the lessor reduces the
amount of borrowing based on the portion of the lease payments that represent principal reductions rather than
interest expense. Lessors should not offset the lease income and the interest expense on the borrowing (i.e., gross
presentation in the income statement is required) since the secured borrowing transaction is separate from the
operating lease.
SALE AND LEASEBACK TRANSACTIONS
For guidance on sale and leaseback transactions refer to Chapter 7, Other Topics.
OTHER TRANSACTIONS
There are other transactions which we have not addressed in this chapter. Those include:
Sale of equipment with guaranteed minimum resale amount: see ASC 842-30-55-1 through 55-15,
Guarantee payments received: see ASC 842-30-55-16.
ACCOUNTING FOR LEASES UNDER ASC 842 196
Chapter 7 - Other Topics
OVERVIEW
In chapters 5 and 6, we discussed the accounting for leases by lessees and lessors, respectively.
In this chapter, we discuss other transactions and topics that are affected by the requirements under ASC 842. Those
include:
Sale and leaseback transactions,
Business combinations,
Subleases, and
Income taxes.
ACCOUNTING FOR LEASES UNDER ASC 842 197
SALE AND LEASEBACK TRANSACTIONS
OVERVIEW
In a sale and leaseback transaction, one entity (seller-lessee) transfers an asset that it owns to another entity (buyer-
lessor) and leases that asset back from the buyer-lessor for a period of time in exchange for consideration.
For transactions within the scope of the sale and leaseback guidance, the seller-lessee and the buyer-lessor apply the
following requirements to determine whether to account for the transaction as a sale and a leaseback, or as a
financing arrangement.
Evaluate under ASC 606
whether a contract
exists and whether the
buyer-lessor obtains
control of the asset
ASC 842-40 relies on the guidance in ASC 606 in substantially the same way as does the
guidance in ASC 610-20, which applies to sales of nonfinancial assets to parties other
than customers. If under ASC 606 a contract does not exist or the buyer-lessor does not
obtain control of the asset, no sale has occurred, and the transaction is accounted for
as a financing. If a contract exists and the buyer-lessor obtains control of the asset, the
entity applies the other requirements below.
Determine whether the
leaseback is classified as
a sales-type lease
(buyer-lessor) or finance
lease (seller-lessee)
The existence of a leaseback does not by itself prevent the buyer-lessor from obtaining
control of the asset. However, if the leaseback is classified as a finance lease by the
seller-lessee or a sales-type lease by the buyer-lessor, the buyer-lessor does not obtain
control of the asset and the transaction is a financing. This is because the seller-lessee
directs the use of, and obtains substantially all of the remaining benefits from, the
underlying asset before and after the transaction.
Identify whether the
seller-lessee has a
repurchase option, and if
so, evaluate whether
such repurchase option
precludes sale
accounting
ASC 606 notes that a customer does not obtain control of an asset if the seller has the
obligation or the right to repurchase the asset. However, for sale and leaseback
transactions, a seller-lessee repurchase option does not preclude sale accounting if:
The exercise price is the asset’s fair value at the time of exercise, and
There are alternative assets, substantially the same as the transferred asset,
readily available in the marketplace (in other words, the buyer-lessor could use
the proceeds from the repurchase to acquire an asset that is substantially the
same in the marketplace).
If either of those two conditions is not met or the transferred asset is real estate
(because it is considered unique), the transaction is accounted for as a financing.
ACCOUNTING FOR LEASES UNDER ASC 842 198
The following flowchart summarizes the decision steps to evaluate the accounting for sale and leaseback transactions:
We will analyze and explain the above steps in further details in the following sections.
ACCOUNTING FOR LEASES UNDER ASC 842 199
SCOPE CONSIDERATIONS
Properly identifying transactions that must be evaluated under the sale and leaseback guidance is a critical step as it
may result in accounting for the transaction very differently (for example, the buyer accounting for the transaction as
a financing rather than a purchase of the asset). The following section discusses scope considerations.
APPLICATION BY SELLER-LESSEE AND BUYER-LESSOR
The guidance in ASC 842-40 applies to both the seller-lessee and the buyer-lessor (that is, it is intended to be
symmetrical). This represents a significant change from ASC 840-40, which only applied to seller-lessees. This is also
different from ASC 606 which applies to only the seller, not the customer. Buyer-lessors in sale-leaseback transactions
must now determine whether they have a ‘successful purchase’ under ASC 842-40. This symmetrical treatment also
applies in situations in which the lessee is considered the accounting owner of an asset before lease commencement,
as further discussed below.
CONTROL OF UNDERLYING ASSET BEFORE COMMENCEMENT DATE
The sale and leaseback guidance applies when the lessee controls the underlying asset before lease commencement. As
such, the guidance potentially applies to the following situations depending on the facts and circumstances:
Lessee obtains
legal title to the
underlying asset
before that title is
transferred to the
lessor and the
asset is leased to
the lessee.
In those situations, the entity assesses whether the lessee controls the underlying
asset before the asset transfers to the lessor (that is, whether the lessee directs
the use of, and obtains substantially all of the remaining benefits from, the asset
before it transfers to the lessor).
If
the
lessee controls the asset before the commencement date, the
transaction is in the scope of the sale and leaseback guidance.
Otherwise
, the transaction is accounted as a purchase of the asset by the
lessor and a lease between the parties.
This could occur for example in transactions between a manufacturer, a lessor and
a lessee for the purchase of an asset by the lessor from the manufacturer, in which
the lessee obtains legal title momentarily for tax or other reasons. If the lessee
obtains legal title to the asset but does not obtain control of the underlying asset
before it is transferred to the lessor, the transaction is not a sale and leaseback
transaction.
The evaluation of control should be based on the specific facts and circumstances
of the transaction, including whether the lessee obtains physical possession of the
asset, has the significant risks and rewards of ownership, and accepts the asset
before the asset is transferred to the lessor.
ACCOUNTING FOR LEASES UNDER ASC 842 200
Entity negotiates a
lease before the
underlying asset is
available for use
by the lessee, also
referred to as
build-to-suit
transactions (e.g.,
the underlying
asset must be
constructed or
redesigned).
In those situations, the entity assesses whether the lessee controls the underlying
asset being constructed before the commencement date by applying the guidance
in ASC 842-40-55-5 (discussed on the next page).
If the lessee controls the asset being constructed before lease commencement, the
transaction is in the scope of the sale and leaseback guidance.
If the lessee does not control the underlying asset under construction, the lessee
may still incur costs relating to the construction or design of the underlying asset
before the commencement date (for example, architectural services in developing
the building specifications, specific leasehold improvements, etc.). In those
situations, the lessee accounts for those costs as follows:
Under other GAAP, such as ASC 360 or ASC 330, for lessee-owned assets (for
example, leasehold improvements that the lessee pays for during the
construction period and that will benefit the lessee in future periods) and
for goods or services (other than the lease) provided to the lessee.
As lease payments (i.e., prepaid rent), regardless of the timing or form of
those payments such as contribution of construction materials, if the
payments are made for the right to use the lessor-owned assets.
ACCOUNTING FOR LEASES UNDER ASC 842 201
The following flowchart summarizes the decision steps to determine if the lessee controls the underlying asset under
construction:
In the assessment of the first question above, we believe that a purchase option exercisable solely with the passage of
time results in the lessee controlling the asset under construction from inception of the arrangement. However, if a
purchase option becomes exercisable only after a contingent event, we believe the analysis will require judgment and
the conclusion will depend on the specific facts and circumstances of the transaction, including whether the lessee or
the lessor controls the occurrence of the contingent event. Also, if the lessor has a put option, we believe the analysis
should be consistent with the guidance under ASC 606 (that is, whether the lessor has a significant economic incentive
to put the asset back to the lessee).
Because the list of circumstances discussed in ASC 842-40-55-5 is not all inclusive, there could be other circumstances
that result in the lessee controlling the underlying asset under construction before the commencement date.
Therefore, in evaluating the last question of the flowchart above, judgment will be required to identify such
circumstances, if any. In concept, the FASB noted that the evaluation above is similar to the evaluation under ASC 606-
10-25-27 when determining if a performance obligation is satisfied over time.
See ASC 842-40-55 Example 3 for an illustration of the application of the above guidance by both the seller-lessee and
the buyer-lessor.
ACCOUNTING FOR LEASES UNDER ASC 842 202
If the lessee controls the asset under construction, it should recognize that asset just as it would recognize any other
asset it controls, along with a liability for any amounts funded by the lessor. The lessor recognizes a receivable rather
than construction in progress. Also, both entities should apply the guidance in Section “Determining whether the
transfer of the asset is a sale” to determine if and when to recognize a sale. As discussed in that section, an entity
typically cannot conclude that there is a sale until the commencement date of the leaseback.
Example 1A - Lessee Is the Accounting Owner During Asset Construction
FACTS
Rx Hospital owns vacant land adjacent to its hospital. It plans to use the land to expand its operations to
include additional medical facilities that will complement its current services provided to patients.
Rx Hospital leases the vacant land to MJ Developer before construction begins and for a 40-year term with
two 5-year extension options. The completed building is expected to have an economic life of 40 years.
Rx Hospital will lease the completed building for an initial 20-year term with two 10-year extension options.
Rx Hospital has a purchase option on the asset exercisable at any time throughout the construction period.
ANALYSIS
RX Hospital entered into a lease of the land before construction begins and for a term including renewals
that permit MJ Developer to lease the land for substantially all the property improvements’ economic life.
However, Rx Hospital has a purchase option exercisable at any time during construction. It is therefore the
accounting owner during construction, and the transaction is in the scope of sale and leaseback guidance.
Rx Hospital recognizes the construction in progress in accordance with ASC 360. Any amounts funded by MJ
Developer are recognized as a financial liability.
Because the accounting is symmetrical under ASC 842-40, MJ Developer recognizes a receivable for
construction costs incurred (rather than construction in progress) during the construction period.
At the end of the construction period (commencement date of the lease), Rx Hospital and MJ Developer will
assess whether the transaction qualifies as a sale and a leaseback.
Example 1B - Lessee Is Not the Accounting Owner During Asset Construction
FACTS
Assume the same facts as in Example 1A, except that Rx Hospital does not have a purchase option. There are
no other circumstances resulting in Rx Hospital being the accounting owner of the asset being constructed.
Rx Hospital provides various materials during construction of the additional building.
ANALYSIS
The transaction is not in the scope of the sale and leaseback guidance because Rx Hospital is not the
accounting owner of the asset being constructed under ASC 842-40-55-5.
Rx Hospital should account for the various materials provided during construction based on their nature. If
the costs relate to leasehold improvements, Rx Hospital accounts for those under ASC 360. If the costs do
not relate to leasehold improvements or other goods or services (other than the lease) provided to Rx
Hospital, but rather are payments for the right to use the building once constructed, Rx Hospital accounts
for those as lease payments (i.e., prepaid lease payments).
ACCOUNTING FOR LEASES UNDER ASC 842 203
Example 2 - Lessor Partially Constructed the Asset Before Lease Inception
FACTS
Lessee is in the luxury cruise line industry, and it enters into a lease with Developer for a new cruise ship
that Developer partially constructed at lease inception.
The fair value of the partially constructed ship at
lease inception is $25 million, and total expected costs to complete it are approximately $600 million.
Lessee has an option to purchase the partially constructed asset at any point during construction.
ANALYSIS
Because of the purchase option, Lessee controls the luxury cruise ship under construction and the
transaction is in the scope of the sale and leaseback guidance. Lessee therefore recognizes construction in
progress at its fair value and a financing obligation at lease inception.
Because the accounting is symmetrical under ASC 842-40, Developer derecognizes the construction in
progress and recognizes a receivable. The amount of the receivable recognized, along with any selling profit,
depends on the facts and circumstances. For example, if Developer has an obligation to complete the
construction of the cruise ship, we believe Developer should recognize a receivable at cost plus an
appropriate margin based on the percentage of completion method.
SALE OF A PARTIALLY CONSTRUCTED ASSET WITH A CONTEMPORANEOUS LEASE ONCE CONSTRUCTION IS
COMPLETED
In some transactions, the owner of a partially constructed asset may sell the asset “as-is” to a developer (lessor) who
commits to complete construction of the asset and to lease the completed asset back to the seller at the end of the
construction period. The asset sold may be in different stages of construction (for example, only soft costs incurred,
hard costs incurred in varying degrees, and so forth). These transactions are not specifically addressed in ASC 842, and
therefore there may be multiple approaches to determine whether such transactions are in the scope of the sale and
leaseback guidance. For example, the following approaches may be acceptable if applied consistently by an entity as
an accounting policy:
All sales of construction-in-progress assets, irrespective of the dollar amounts incurred or the stage of
construction, with a commitment to lease the asset back once construction is completed are in the scope of
the sale and leaseback guidance.
Only transactions for which the construction-in-progress asset is substantially similar to the completed asset
are in the scope of the sale and leaseback guidance.
However, because ASC 842 is not clear, other approaches between the two approaches described above may also be
acceptable, such as establishing a threshold at which construction-in-progress assets with a commitment to lease the
asset back once construction is completed are in the scope of the sale and leaseback guidance.
ACCOUNTING FOR LEASES UNDER ASC 842 204
Example 3A - Sale of a Partially Constructed Asset
FACTS
Lessee is in the logistics industry and has started construction of a new plane that it owns. So far it has
incurred $75,000 in construction costs and total costs are expected to be approximately $350,000.
Lessee sells the partially constructed plane to Aircraft Builder who agrees to complete construction of the
plane and to lease the completed plane back to Lessee at the end of the construction period.
Lessee is not the accounting owner of the asset during the remainder of the construction period (i.e., none
of the conditions in ASC 842-40-55-5 are met after lease inception).
ANALYSIS
Lessee has made an accounting policy to account for such transactions under the sale and leaseback
guidance only if the partially constructed asset is substantially similar to the completed asset.
Lessee considers the facts and circumstances of the transaction, including costs incurred to date compared
to total expected costs, and concludes that the transaction is not in the scope of the sale and leaseback
guidance because the partially constructed asset is not substantially similar to the completed asset.
Lessee applies other GAAP (e.g., ASC 610-20) to determine whether and when to recognize the sale.
Example 3B - Sale of a Partially Constructed Asset With a Repurchase Option
FACTS
Assume the same facts as above, except that the sale contract with Aircraft Builder provides Lessee with an
option to purchase the partially constructed plane at any time during the construction period.
ANALYSIS
The purchase option results in Lessee being the accounting owner of the asset under construction in
accordance with ASC 842-40-55-5(a). Therefore, Lessee does not derecognize the partially constructed plane
and accounts for the proceeds from the sale as a financial liability. Lessee will recognize any additional
amounts funded by Aircraft Builder for the construction of the plane as increases to value of the
construction in progress asset and the financial liability.
Because sale-leaseback accounting is symmetrical, Aircraft Builder accounts for the cash paid and any
additional amounts funded for the construction of the plane as a receivable rather than construction in
progress.
Lessee and Airplane Builder should wait until the commencement date of the leaseback to determine
whether sale and leaseback is achieved. This is because ASC 842-40 precludes sale accounting when the
leaseback is classified as a finance lease by the seller-lessee or sales-type lease by the buyer-lessor, and
classification of the leaseback cannot be assessed prior to the commencement date.
ACCOUNTING FOR LEASES UNDER ASC 842 205
SALE OR TRANSFER OF A PURCHASE OPTION TO A THIRD-PARTY WITH LEASEBACK OF THE ASSET
An entity may sell or transfer a purchase option on an asset to a third-party with a commitment from the third-party to
exercise the option and lease the asset back to the entity. For example, a lessee may have a purchase option under an
existing lease of a building (or equipment) which the lessee assigns to a third-party. In turn, the third-party commits to
exercise the option to purchase the building (or equipment) and to lease the asset back to the lessee once the asset is
purchased. Terms and conditions in such transactions may vary, such as the price at which the purchase option is
exercisable (fair value vs. fixed price), whether the purchase option is currently exercisable, and so forth. Care should
be given in these situations based on the specific facts and circumstances of the transaction to determine whether the
sale and leaseback guidance applies. However, consistent with the concepts underlying the guidance in ASC 842-40-25-
3 on repurchase options, we believe that if there are alternative assets substantially the same as the asset subject to
the transaction and the strike price is fair value, the transaction may not be within the scope of the sale and leaseback
guidance. This is because the lessee could have negotiated with a third-party (e.g., bank) for the direct purchase and
lease of a different (but substantially similar) asset, which would not be subject to the sale and leaseback guidance.
However, for assets like real estate, we believe such transactions will be in the scope of the sale and leaseback
guidance because no two real estate assets are the same.
Example 4 - Assignment and Exercise of a Purchase Option in a Real Estate Lease
FACTS
Distributor is the lessee of a warehouse that has a noncancelable term of ten years and for which the
expiration is approaching. The lease includes two fixed price extension options for ten years each, and a fair
market value purchase option exercisable at the end of the initial ten-year term.
Distributor assigns the purchase option to Real Estate Co which commits to exercise the purchase option and
to purchase the warehouse subject to due diligence procedures. Upon closing, Real Estate Co agrees to lease
the warehouse to Distributor for a noncancelable period of ten years. The lease includes two fixed price
extension options and a fair value purchase option.
Following the due diligence procedures being satisfactory to Real Estate Co, the transaction closes and the
lease between Distributor and Real Estate Co commences.
ANALYSIS
In this example,
Distributor
and Real Estate Co evaluate the transaction and determine, based on the facts
and circumstances of the transaction (including that the purchase option is on a real estate asset, which is
considered unique) that Distributor is considered to control the warehouse before Real Estate Co’s
purchase, even though Distributor does not legally own the warehouse. Therefore, the transaction is in the
scope of the sale and leaseback guidance.
Because the lease between Distributor and Real Estate Co also includes a purchase option, the transaction is
accounted for as a financing by Distributor and Real Estate Co.
ACCOUNTING FOR LEASES UNDER ASC 842 206
SALE-LEASEBACK TRANSACTIONS WITH VARIABLE INTEREST ENTITY BUYER-LESSORS
Certain sale-leaseback transactions may be structured with a legal entity that the buyer-lessor specifically created for
tax, legal or other reasons to hold assets related to one or more sale and leaseback transactions. In those situations, an
entity should carefully consider whether other GAAP guidance applies to the transaction, specifically the variable
interest entity (VIE) subsections of ASC 810-10 on consolidation. If for example the lease includes a repurchase option
or residual value guarantee that represents a variable interest in the buyer-lessor entity, the VIE subsections of ASC
810-10 would apply unless a scope exception is met. If the VIE subsections apply, the seller-lessee should determine
whether it has a controlling financial interest in the buyer-lessor entity that holds the nonfinancial asset(s). If the
seller-lessee is the primary beneficiary of the buyer-lessor entity, the seller-lessee would apply ASC 810-10 and
consolidate the buyer-lessor entity rather than apply ASC 842-40 on sale and leaseback transactions. For further
discussion on the application of the VIE guidance in ASC 810-10, see our publication BDO Knows: Variable Interest
Entities available here. See also this link
for a consultation the SEC staff discussed at the 2019 AICPA Conference on
Current SEC and PCAOB Developments related to a sale-leaseback transaction involving a variable interest entity.
Because transactions may be structured in a variety of ways, an entity with a complex structure may consider
discussing the appropriate accounting with their accounting advisors.
LESSEE INDEMNITY FOR PREEXISTING ENVIRONMENTAL CONTAMINATION
A lessee may be required to indemnify the lessor for preexisting environmental contamination. However, this provision
alone does not mean that the lessee controlled the underlying asset prior to the lease commencing. This is regardless
of the likelihood of a loss resulting from the indemnity. Therefore, the presence of such a provision does not mean the
transaction is in the scope of the sale and leaseback guidance.
SALE-LEASEBACK-SUBLEASE TRANSACTIONS
An entity may enter into a sale-leaseback transaction for which the asset is subject to an operating lease or is
subleased (or intended to be subleased) by the seller-lessee to another party under an operating lease. A sale-
leaseback-sublease transaction is within the scope of the sale and leaseback guidance. However, the existence of the
operating sublease does not by itself prevent the buyer-lessor from obtaining control of the asset nor does it prevent
the seller-lessee from controlling the asset before the transfer. All facts and circumstances should be considered in
determining whether the buyer-lessor obtains control of the underlying asset in a sale-leaseback-sublease transaction.
SALE SUBJECT TO A PREEXISTING LEASE
An entity may obtain an ownership interest in an underlying asset and at or near the same time enter into an operating
lease as a lessee for all or a portion of the underlying asset. For example, this could occur when an entity has an
investment in a partnership or subsidiary that owns the underlying asset. The entity subsequently sells its interest in
the partnership, 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.
If the scope or price of the preexisting lease is modified in connection with the sale, the transaction is in the
scope of the sale and leaseback guidance. Otherwise, the sale should be accounted for under other Topics.
However, a lease between parties under common control should not be considered a preexisting lease.
Accordingly, the sale and leaseback guidance should be applied to transactions that include nonfinancial assets
within the scope of ASC 842-40, except if ASC 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.
TRANSFER OF TAX BENEFITS
Refer to ASC 842-40-55-11 through 55-17 for additional guidance.
ACCOUNTING FOR LEASES UNDER ASC 842 207
DETERMINING WHETHER THE TRANSFER OF THE ASSET IS A SALE
If a transaction is in the scope of the sale and leaseback guidance, the entity (seller-lessee and buyer-lessor) must
determine whether the transfer of the asset is a sale. To do so, the entity:
Evaluates under ASC 606:
•
Whether a contract exists, and
•
Whether the buyer-lessor obtains control of the asset,
Assesses classification of the leaseback to determine whether the leaseback is classified as a finance lease
(seller-lessee) or sales-type lease (buyer-lessor), and
Identifies repurchase options and determines if such repurchase options preclude sale accounting.
IS THERE A CONTRACT?
In accordance with ASC 606-10-25-1, all of the following conditions must be met for a contract to exist:
The parties to the contract have approved the contract and are committed to perform their
respective obligations. The contract may be in writing, orally, or in accordance with other customer
business practices.
The entity can identify each party’s rights regarding the goods or services to be transferred. That is,
the legal rights regarding the transfer of the goods/ property are identifiable for the seller-lessee
and the buyer-lessor.
The entity can identify the payment terms for the goods or services to be transferred.
The contract has commercial substance. In other words, the risk, timing, or amount of the entity’s
future cash flows is expected to change as a result of the contract.
It is probable the entity (the seller-lessee) will collect substantially all the consideration to which it
will be entitled in exchange for the goods or services that will be transferred to the customer (the
buyer-lessor).
The application of this step generally does not create application issues. This is because sale and leaseback
transactions typically include at least a purchase and sale agreement and a lease agreement, for which the rights and
obligations of each party are clearly identified, including payment terms. Also, in many sale-leaseback transactions,
the transaction has economic substance because the buyer-lessor pays the consideration upfront and takes on risks
associated with the asset, including risks of changes in fair market rent, changes in the fair value of the asset, credit
risk and so forth.
Once the entity concludes that a contract exists, the next step is to determine whether the buyer-lessor has obtained
control of the asset.
ACCOUNTING FOR LEASES UNDER ASC 842 208
DOES THE BUYER-LESSOR OBTAIN CONTROL OF THE ASSET?
The following control indicators in ASC 606-10-25-30 are used to evaluate whether the buyer-lessor has obtained
control of the asset:
The seller-lessee has a present right to payment for the asset.
The buyer-lessor has legal title to the asset.
The seller-lessee has transferred physical possession of the asset. However, in sale and leaseback
transactions, the buyer-lessor generally does not receive physical possession of the asset until the
end of the lease and therefore this indicator will typically not be present.
The buyer-lessor has the significant risks and rewards of ownership; for example, when the buyer-
lessor has the ability to sell the asset if the property value increases and also absorbs any losses if
the property value declines.
The buyer-lessor has accepted the asset. However, this indicator may not be applicable in sale and
leaseback transactions that do not include agreed-upon specifications for the asset.
The assessment of most indicators above will be objective in nature (for example, the seller-lessee’s present right to
payment or the buyer-lessor having legal title). But the analysis of the risks and rewards indicator may be subjective
and there may be limitations on risks that the buyer-lessor takes. For example, a seller-lessee may guarantee the
residual value of the asset at the end of the lease term. Such guarantee does not in isolation preclude accounting for
the transaction as a sale and leaseback. Instead, the guarantee is considered in the entity’s overall consideration of
the risks and rewards indicator. The analysis may therefore require the use of professional judgment and the entity
should consider in its overall assessment the principle of transfer of control in ASC 606-10-25-25, which is that the
customer (in this case, the buyer-lessor) has the right to direct the use of, and obtain substantially all of the remaining
economic benefits from, the asset. The lessee residual value guarantee should also be included in the determination of
lease classification discussed below.
ACCOUNTING FOR LEASES UNDER ASC 842 209
CLASSIFICATION OF THE LEASE AS A FINANCE OR SALES-TYPE LEASE
The existence of the leaseback does not by itself prevent the buyer-lessor from obtaining control of the asset. Because
the lease payments received by the buyer-lessor during the lease term, plus the benefits that the buyer-lessor can
generate from the residual asset after the lease term, represent substantially all of the remaining benefits to be
derived from the asset immediately before the asset is leased to the seller-lessee, the buyer-lessor obtains control of
the asset.
However, when a lease is classified as a finance lease by the seller-lessee or a sales-type lease by the buyer-lessor, the
seller-lessee controls the underlying asset as a result of the leaseback; that is, the seller-lessee directs the use of, and
obtains substantially all the remaining benefits from, the underlying asset. The FASB determined that no sale should
occur because a finance lease is economically similar to purchasing the asset, and it would be inappropriate for a
seller-lessee to account for a concurrent sale and, in effect, repurchase of the same asset. In an operating lease, the
seller-lessee does not obtain substantially all of the remaining benefits from the underlying asset, and thus an
operating leaseback does not preclude accounting for the transaction as a sale.
In performing this step, an entity assesses classification at the leaseback commencement date and at the lease
component level. Accordingly, if there are multiple assets, the lease components must be identified first. See chapter
3 for additional details on identifying the components of a contract
.
Example Lease Components
Right to use real estate, such as a retail store
in a mall, or a floor in an office building.
Right to use computer equipment.
Right to use a vehicle, such as a truck.
Accounting When Leaseback Has Not Yet Commenced
In some sale and leaseback transactions, the leaseback does not commence until a future period
(for example, until a building or warehouse is constructed or renovated). In those situations, the
entity cannot recognize a sale (or purchase) until the leaseback commences. This is because ASC
842-40-25-2 requires an assessment of the classification of the leaseback, which is done at lease
commencement. Therefore, even if there is a high likelihood that the lease will be classified as an
operating lease by the seller-lessee, or a direct financing or operating lease by the buyer-lessor, an
entity cannot determine that a sale exists until the leaseback commences.
Example 5 - Sale of Land With Leaseback Following Construction of a Building
FACTS
Rx Hospital owns vacant land adjacent to its hospital and it plans to expand its operations to include
additional medical facilities that complement its current services provided to patients.
To that effect, Rx Hospital sells the vacant land to MJ Developer who will construct the building.
Once construction is completed, Rx Hospital agrees to lease the completed building for a noncancelable
term of 20 years, with two 10-year extension options.
ACCOUNTING FOR LEASES UNDER ASC 842 210
ANALYSIS
The leaseback of the medical office building once construction is completed includes an implicit lease of
land (see chapter 2 on definition of a lease). Therefore, the sale of the land is in the scope of the sale and
leaseback guidance.
Rx Hospital and MJ Developer cannot conclude that a sale has occurred until leaseback commencement.
Therefore, Rx Hospital (not MJ Developer) recognizes the land during the construction period.
Both entities should also determine whether Rx Hospital is the accounting owner of the building under
construction (See Scope section above for additional discussion).
Sale of an Asset With Leaseback For a Portion of the Asset Sold
In some sale and leaseback transactions, a seller-lessee may not have business needs for a
leaseback of the entire asset sold and therefore may lease back only a portion of it. For example, a
seller-lessee may sell a multi-story office building in which it leases back one or more, but not all
of the floors in the building. Depending on the terms and conditions of the leaseback and the facts
and circumstances of the transaction, the portion that is leased back may be classified as a finance
lease by the seller-lessee, or a sales-type lease by the buyer-lessor. In those situations, we
generally believe that whether the transaction is accounted for as a financing transaction will
depend on whether the portion leased back is legally distinct. If it is, the finance/sales-type
leaseback will not preclude sale accounting for the other legally distinct portions of the asset (e.g.,
the other floors not leased back by the seller-lessee), assuming the other requirements for sale
accounting are met. If the portion leased back is not legally distinct, consistent with the principle
of transfer of control in ASC 606-10-25-25, including that the customer (in this case the buyer-
lessor) obtains substantially all of the remaining economic benefits from the underlying asset, we
believe that sale accounting would be precluded unless the leaseback is for a minor portion of the
asset sold. If sale accounting is precluded based on the facts and circumstances of the transaction,
additional complexity in the accounting may arise. For example, while the seller-lessee accounts
for the transaction as a financing, it should consider accounting for imputed leases for the portions
of the asset that are not leased back.
REPURCHASE OPTIONS
Under ASC 606, a customer does not obtain control of an asset if the seller has the obligation or the right to repurchase
the asset. However, the FASB decided that certain repurchase options do not preclude sale accounting. The FASB noted
in paragraph BC352 of ASU 2016-02 that “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.”
The FASB also noted in paragraph BC352(c) that “Board members generally observed that real estate assets would not
meet criterion (2). 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’.” Therefore, a repurchase
option in a sale-leaseback transaction involving real estate (including integral equipment as defined in ASC 978) will
always preclude sale accounting, even if the repurchase option is at fair value.
ACCOUNTING FOR LEASES UNDER ASC 842 211
The following flowchart summarizes the decision steps under ASC 842 to determine whether an unconditional
repurchase option precludes sale and leaseback accounting (see discussion below of contingent repurchase options,
rights of first offer and rights of first refusal).
ACCOUNTING FOR LEASES UNDER ASC 842 212
Also, sale and leaseback transactions may include terms, such as extension options for substantially all of the
remaining economic life of the asset, or residual value guarantees, that have resulted in practice issues in the
application of ASC 842-40-25-3.
Renewal Clauses
Some lease arrangements may provide for fixed price or fair value renewal options for all or substantially all of the
remaining economic life of the underlying asset. In paragraph BC218 of ASU 2016-02, 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.”
Accordingly, we believe that care should be given in determining whether renewal options are economically the
same as repurchase rights, and whether such renewals preclude sale accounting (e.g., whether the renewal options
are at a fixed price versus at fair market rent, the nature of the underlying asset). Entities are encouraged to discuss
such transactions with their accounting advisor or auditor.
Residual Value Guarantees in a Sale-Leaseback
In some equipment sale and leaseback transactions, a seller-lessee may guarantee the residual value of the asset
and may also have a fair value repurchase option exercisable at the end of the lease term. Accordingly, the amount
the buyer-lessor will receive upon exercise of the repurchase option depends on the fair value at the exercise date
compared to the residual value guarantee (RVG) amount. If the fair value of the asset is equal to or greater than the
RVG, no payment under the RVG is triggered and the buyer-lessor receives an amount equal to fair value. If the fair
value of the asset is less than the RVG and the seller-lessee exercises its repurchase right, the buyer-lessor would
receive the RVG amount (that is, an amount in excess of fair value). Therefore, the repurchase option is not solely at
fair value. However, if all other conditions for sale accounting are met (that is, the conditions in ASC 842-40-25-1
and 25-2 are met), the transaction may still meet the conditions in ASC 842-40-25-3 on repurchase options if there
are alternative assets, substantially the same as the equipment, that are readily available in the marketplace. This is
because the buyer-lessor will always receive an amount that is at least equal to fair value, which it could use to
acquire an equivalent asset at fair value in the marketplace.
ACCOUNTING FOR LEASES UNDER ASC 842 213
Lastly, transactions involving the sale and leaseback of real estate often include various forms of repurchase rights.
Those rights may include conditional (or contingent) repurchase rights, rights of first refusal, and rights of first offer.
We discuss those below along with considerations as to whether such clauses preclude sale accounting.
Contingent Repurchase Options in Real Estate Sale and Leaseback Transactions
Lease agreements may include repurchase rights that can only be exercised if a specified event has occurred; for
example, if there is a change of control of the buyer-lessor or seller-lessee. ASC 842-40 does not specifically address
contingent repurchase options. However, paragraph BC 352(c) in the Basis of Conclusions of ASU 2016-02 makes clear
that the guidance on repurchase options is based on the guidance on repurchase rights in ASC 606. Under ASC 606,
contingent repurchase options do not automatically preclude sale accounting. Rather, such repurchase options are
evaluated based on the specific facts and circumstances of the transaction. For example, if a repurchase option is
exercisable based on a contingent event that is within the entity’s (seller’s) control, this generally implies that the
customer has not obtained control of the asset and, therefore, sale accounting is precluded. In contrast, if the
contingency is within the customer’s control, this may imply that the customer has the ability to determine whether
the repurchase option is exercisable and, therefore, the customer is not limited in its ability to direct the use of,
and obtain substantially all of the remaining benefits from, the asset.
Therefore, similar to contracts with contingent repurchase options within the scope of ASC 606, we believe that for
real estate:
A sale-leaseback transaction that includes a contingent repurchase option for which the contingency is
within the seller-lessee’s control would preclude sale-leaseback accounting.
A sale-leaseback transaction that includes a contingent repurchase option for which the contingency is
within the buyer-lessor’s control may not preclude sale-leaseback accounting, even if the underlying asset
is real estate. The evaluation would be similar to the evaluation of buyer put rights under ASC 606 (that is,
whether the buyer-lessor has a significant economic incentive to exercise the put).
If the contingency is outside the control of both the seller-lessee and buyer-lessor, whether sale-leaseback
accounting is achieved depends on the specific facts and circumstances of the transaction. For example, if
the contingent event was put in place as a protective measure and the likelihood at the transaction date
that the event will occur is remote, this may imply that the buyer-lessor has obtained control of the asset,
even if the underlying asset is real estate. In contrast, if the contingent event was put in place in
contemplation of a transaction or event potentially occurring in the near future and at the transaction
date that contingent event is likely to occur, this may imply that the buyer-lessor has not obtained control
of the asset because the buyer-lessor is limited in its ability to direct the use of, and obtain substantially
all of the remaining benefits from, the asset (because there is a contingency that is outside of its control
and the contingent event is likely to occur).
Right of First Refusal in Real Estate Sale and Leaseback Transactions
A right of first refusal (ROFR) is most commonly structured as an option that grants the seller-lessee the right to
repurchase the property subject to the sale-leaseback transaction if the buyer-lessor obtains a bona fide offer from
a third-party to purchase the property. A ROFR will generally only allow the seller-lessee the right to match that
third-party offer. If the seller-lessee elects to exercise the ROFR, the buyer-lessor must sell the property to the
seller-lessee, rather than to the third-party.
A provision that allows the seller-lessee the option to repurchase the property only if the buyer-lessor has decided to
sell the property and has obtained an offer from a third-party ordinarily will not result in a failed sale/purchase
(assuming the other conditions outlined in ASC 842-40-25-1 and 25-2 are also met). In that scenario, the buyer-lessor
controls the property through retaining the right to decide whether and when to sell the property.
ACCOUNTING FOR LEASES UNDER ASC 842 214
Right of First Offer in Real Estate Sale and Leaseback Transactions
A right of first offer (ROFO) is most commonly structured as an option that grants the seller-lessee the right to offer
to repurchase the property from the buyer-lessor. ROFOs may have varying terms and may be exercisable only after
a period of time or at a specified time, and only for a fixed or determinable amount, based on a formula, or at
market rates.
Whether a ROFO in a sale-leaseback transaction results in a failed sale/purchase will depend on the specific terms
and conditions. Generally, if the buyer-lessor has the ability to reject the seller-lessee’s offer with no significant
negative economic consequences, then the existence of the ROFO will not preclude sale accounting (assuming the
other conditions outlined in ASC 842-40-25-1 and 25-2 are also met). However, if the buyer-lessor would be
compelled economically or contractually to accept the offer, the ROFO is equivalent to a repurchase option and
would thus result in a failed sale/purchase for real estate transactions. In addition, if the seller-lessee is
economically or contractually compelled to make an offer, a ROFO may be the equivalent to an obligation to
repurchase the property (i.e., a forward) if the buyer-lessor is compelled to accept the offer, which also will result
in a failed sale/purchase. The buyer-lessor and seller-lessee should consider all relevant factors when determining
whether the buyer-lessor or the seller-lessee would be compelled to accept the offer, or make an offer,
respectively. The factors outlined in ASC 842-10-55-26 typically will be useful in evaluating the existence of
economic compulsion.
ACCOUNTING WHEN TRANSFER OF THE ASSET IS A SALE
RECOGNITION
If after analyzing the terms as noted in the previous sections it is determined that the transfer of the asset is a sale,
the sale of the asset and subsequent leaseback are accounted for independently, with the leaseback accounted for as
any other lease under ASC 842 by each party.
When the transaction is at market terms, the following occurs at the date the buyer-lessor obtains control of the asset:
The seller-lessee The buyer-lessor
Derecognizes the carrying amount of the
underlying asset,
Recognizes the transaction price in
accordance with ASC 606-10-32-2 through
32-27,
Recognizes a gain or loss for the difference
between the transaction price and carrying
amount of the asset,
Accounts for the leaseback in accordance
with ASC 842-20 on lessee accounting (see
Accounting for Leases - Lessees
).
Accounts for the purchase of the asset in
accordance with other GAAP (typically
ASC 360),
Accounts for the leaseback in accordance
with ASC 842-30 on lessor accounting (see
Accounting for Leases – Lessors
).
ACCOUNTING FOR LEASES UNDER ASC 842 215
The following Examples illustrate the accounting for various sale and leaseback transactions under different
scenarios. Please note that for the illustrations throughout this chapter, the tables presented in each Example are
consistent with how they would be displayed in a spreadsheet, with amounts shown with no decimals, and no
rounding function used.
Example 6A: Sale-Leaseback Transaction When Transfer of Asset Is a Sale
FACTS
Seller-Lessee sells an airplane to an unrelated Buyer-Lessor for $3.0 million, which is its fair value.
The carrying amount of the airplane is $2.7 million and it has a remaining useful life of 15 years.
At the same time, Seller-Lessee enters into a contract with Buyer-Lessor for the right to use the airplane for
5 years, with annual payments of $300,000 payable in arrears and escalating 2% annually.
The leaseback does not transfer ownership to Seller-Lessee at the end of the lease term and does not include
a purchase option. There are no initial direct costs.
Assume that the requirements in ASC 606 on contract existence and transfer of control are met and that
the leaseback is classified as an operating lease by both Seller-Lessee and Buyer-Lessor.
Seller-Lessee’s incremental borrowing rate is 4%. The rate implicit in the lease is not readily determinable.
ANALYSIS
Assessing whether the transfer of the asset is a sale
Seller-Lessee and Buyer-Lessor determine that the transfer of the asset is a sale. This is because:
•
The requirements in ASC 606 on contract existence and transfer of control are met,
•
The leaseback is classified as an operating lease,
•
There is no repurchase option.
Accounting by Seller-Lessee
At the commencement date, Seller-Lessee records the following journal entry:
$
$
Dr. Cash
3,000,000
Cr. Property, plant or equipment
2,700,000
Cr. Gain on sale
300,000
Seller-Lessee also recognizes a lease liability for the leaseback at the present value of the lease payments,
discounted using its incremental borrowing rate of 4%, which results in an initial lease liability of
$1,387,891 calculated as follows:
PMT
Year 1
300,000
Year 2
306,000
Year 3
312,120
Year 4
318,362
Year 5
324,730
Undiscounted PMTs
1,561,212
PV(4%) =
1,387,891
The initial measurement of the right-of-use asset is the same as the lease liability since there are no
prepayments, lease incentives, or initial direct costs.
ACCOUNTING FOR LEASES UNDER ASC 842 216
Seller-Lessee calculates the total lease cost to be recognized over the lease term:
Total lease payments (paid and not yet paid)
$1,561,212
Plus, initial direct costs
0
Total lease cost [A]
$1,561,212
Periodic lease cost [B] = [A] / 5
$312,242
The following table summarizes the accounting for the lease liability, assuming no modifications.
Beg.
Balance
Interest
(4%)
PMT
Closing
Balance
Year 1
1,387,891
55,516
(300,000)
1,143,407
Year 2
1,143,407
45,736
(306,000)
883,143
Year 3
883,143
35,326
(312,120)
606,349
Year 4
606,349
24,254
(318,362)
312,240
Year 5
312,240
12,490
(324,730)
-
The following table summarizes the accounting for the right-of-use asset, assuming no modifications and
impairments. See Accounting for Lease - Lessees for additional details and explanations.
Opening
Balance
Periodic
Lease Cost
Interest
(4%)
Amortization
Closing
Balance
[A]
[B]
[C] – see above
[D] = [B] + [C]
[A] + [D]
Year 1
1,387,891
(312,242)
55,516
(256,727)
1,131,164
Year 2
1,131,164
(312,242)
45,736
(266,506)
864,658
Year 3
864,658
(312,242)
35,326
(276,917)
587,741
Year 4
587,741
(312,242)
24,254
(287,988)
299,753
Year 5
299,753
(312,242)
12,490
(299,753)
-
Seller-Lessee recognizes straight-line lease expense of $312,242 on an annual basis throughout the lease
term.
Accounting by Buyer-Lessor
Buyer-Lessor recognizes the airplane at cost for $3.0 million. Buyer-Lessor subsequently accounts for the
asset under ASC 360.
Because the lease is classified as an operating lease, Buyer-Lessor recognizes lease income of $312,242
annually, assuming collectibility of the lease payments is probable throughout the lease term. See
Accounting for Leases – Lessors
for additional details on collectibility considerations for operating leases.
ACCOUNTING FOR LEASES UNDER ASC 842 217
OFF-MARKET TERMS
The sale price and lease payments in a sale and leaseback transaction are interdependent since they are negotiated as
a package. For example, the sale price might be more than the fair value of the asset because the leaseback payments
are above market; or vice versa. Because this could misstate the amounts recorded by the seller-lessee and buyer-
lessor, both in the day-1 accounting (the sale) and day-2 accounting (the leaseback), the FASB decided that an entity
should adjust the sale (purchase) price of the asset if the sale and leaseback occurs at other than a market rate.
Related party sale and leaseback transactions
The above guidance on adjustments for off-market terms does not apply if the transaction is
between related parties. Instead, the related party lessee and lessor should make appropriate
disclosures. This is consistent with the FASB’s decision that an entity should account for a related
party lease in accordance with the enforceable terms and conditions of that lease.
The entity determines whether the transaction is at market by comparing the difference between either of the
following, whichever is more readily determinable, maximizing the use of observable prices and observable
information:
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.
Accordingly, an entity does not have to determine the fair value of both the underlying asset and the market rental
payments. The FASB decided that such a requirement would likely be unnecessary given that any overpayment for the
underlying asset by the buyer-lessor would often be accompanied by above market rental payments, and vice versa.
Variable payment off-market terms
The FASB noted in ASC 842-40-30-3 and in paragraph BC365 of ASU 2016-02 that variable payments
are a part of the negotiated exchange between the parties and therefore should be considered in
determining whether the transaction is at a market rate. In doing so, the entity should consider
those variable payments it reasonably expects to be entitled to (or to make) based on all the
information (historical, current, and forecast) that is reasonably available to the entity. For a
seller-lessee, this includes estimating any variable consideration to which it expects to be entitled
in accordance with ASC 606-10-32-5 through 32-9. However, variable payments considered in this
evaluation should not be recognized as part of the transaction price for the seller-lessee, the cost
of the asset to the buyer-lessor, or included in the seller-lessee’s measurement of the lease
liability, except in accordance with the guidance in ASC 842 or other Topics such as ASC 606 or ASC
360.
If there are off-market terms, the entity accounts for those as follows:
If the sale price is below fair value, as prepaid rent because the underpayment is no different, in substance,
from a prepayment of rent by the seller-lessee. The prepaid rent is recognized by the buyer-lessor as deferred
rent (recognized over the lease term typically on a straight-line basis), and the lessee includes the amount as
part of the initial measurement of the right-of-use asset (recognized over the lease term as part of the
amortization of the right-of-use asset).
If the sale price is above fair value, as additional financing provided by the buyer-lessor to the seller-lessee in
accordance with other Topics because the overpayment is no different than the buyer-lessor granting the
seller-lessee a loan in addition to purchasing the seller-lessee’s asset. The buyer-lessor and seller-lessee
recognize a financial receivable and financial liability, respectively, and allocate the payments under the
contract between the lease and financing components.
ACCOUNTING FOR LEASES UNDER ASC 842 218
See ASC 842-40-55 Example 1 for an illustration of the accounting by both the seller-lessee and buyer-lessor for off-
market terms. See also Examples 6B and 6C below.
Example 6B - Sale-Leaseback Transaction With Off Market Terms – Sale Price Exceeds Fair Value
FACTS
Assume the same facts as in Example 6A, except that Seller-Lessee sells the airplane to Buyer-Lessor for $3.5
million. The observable fair value of the airplane is $3.0 million. Because the fair value of the airplane is
observable, Seller-Lessee and Buyer-Lessor use that benchmark to evaluate whether the sale is at market
terms.
The leaseback includes annual payments of $310,000 payable in arrears.
ANALYSIS
Assessing whether the transfer of the asset is a sale
Consistent with Example 6A, the Seller-Lessee and Buyer-Lessor determine that the transfer of the asset is a
sale. The changes in sale price and contractual lease payments did not change the conclusion.
Accounting by Seller-Lessee
At the commencement date, Seller-Lessee records the following journal entry:
$
$
Dr. Cash 3,500,000
Cr. Property, plant or equipment
2,700,000
Cr. Gain on sale 300,000
Cr. Financial liability 500,000
Seller-Lessee then determines the contractual payments attributable to repayment of the additional
financing; that is, the amount of each annual payment that must be attributed to repayment of the
financial liability for that liability to reduce to zero at the end of the lease term.
Seller-Lessee could calculate that amount using either of the following approaches, which should result in
the same amounts allocated:
•
Using the PMT function in Excel based on the payment terms and conditions of the lease, which in
this example results in $112,314 annual payments attributed to the financial obligation, or
•
Allocating the payments based on the relative basis of the initial lease liability and financial
liability recognized. In doing so, Seller-Lessee would calculate the lease liability as the present
value of five payments of $310,000 discounted at 4% (which amounts to $1,380,065) less the initial
amount of the financial liability of $500,000, resulting in a lease liability of $880,065. Seller-Lessee
would allocate the contractual payments as follows:
Measurement
Percentage
Allocation
Lease liability
880,065
63.77%
197,686
Financial liability
500,000
36.23%
112,314
Total
1,380,065
310,000
ACCOUNTING FOR LEASES UNDER ASC 842 219
The following table summarizes the accounting for the financial liability throughout the lease term.
Beg.
Balance
Interest
(4%)
PMT
Closing
Balance
Year 1
500,000
20,000
(112,314)
407,686
Year 2
407,686
16,307
(112,314)
311,680
Year 3
311,680
12,467
(112,314)
211,834
Year 4
211,834
8,473
(112,314)
107,994
Year 5
107,994
4,320
(112,314)
-
Seller-Lessee also recognizes a lease liability for the leaseback at the present value of the contractual
payments attributable to the lease of $197,686 ($310,000 annual payment less $112,314 attributed to the
financial liability). The following table summarize the accounting for the lease liability, assuming no
modifications.
Beg.
Balance
Interest
(4%)
PMT
Closing
Balance
Year 1
880,065
35,203
(197,686)
717,581
Year 2
717,581
28,703
(197,686)
548,598
Year 3
548,598
21,944
(197,686)
372,855
Year 4
372,855
14,914
(197,686)
190,083
Year 5
190,083
7,603
(197,686)
-
The following table summarizes the accounting for the right-of-use asset, assuming no modifications and
impairments. See
Accounting for Leases - Lessees
for additional details and explanations.
Opening
Balance
Periodic
Lease Cost
Interest
(4%)
Amortization
Closing
Balance
[A]
[B]
[C] – see above
[D] = [B] + [C]
[A] + [D]
Year 1
880,065
(197,686)
35,203
(162,484)
717,581
Year 2
717,581
(197,686)
28,703
(168,983)
548,598
Year 3
548,598
(197,686)
21,944
(175,743)
372,855
Year 4
372,855
(197,686)
14,914
(182,772)
190,083
Year 5
190,083
(197,686)
7,603
(190,083)
-
Seller-Lessee recognizes straight-line lease expense of $197,686 along with interest expense on the
financial liability (for example, $20,000 in Year 1) throughout the lease term.
Accounting by Buyer-Lessor
Buyer-Lessor recognizes the airplane at a cost of $3.0 million. Buyer-Lessor subsequently accounts for the
asset under ASC 360.
Buyer-Lessor recognizes a financial asset for the additional financing provided to Seller-Lessee in the
amount of $500,000.
Buyer-Lessor determines an interest rate in accordance with ASC 835-30-25-12 and 25-13 and allocates the
contractual payments between the leaseback and financial asset. The contractual payments attributable
to repayment of the additional financing is the amount of each annual payment that must be attributed to
the financial asset for that asset to reduce to zero at the end of the lease term (consistent with how it was
calculated for Seller-Lessee above).
Buyer-Lessor will also recognize lease income and interest income based on the amounts attributed to the
leaseback and financial asset.
ACCOUNTING FOR LEASES UNDER ASC 842 220
Example 6C - Sale-Leaseback Transaction With Off Market Terms – Sale Price Is Less Than Fair Value
FACTS
Assume the same facts as in Example 6A, except that Seller-Lessee sells the airplane to Buyer-Lessor for
$2.5 million. The observable fair value of the airplane is $3.0 million. Because the fair value of the
airplane is observable, Seller-Lessee and Buyer-Lessor use that benchmark in evaluating whether the sale
is at market terms.
The leaseback includes annual payments of $290,000 payable in arrears.
ANALYSIS
Assessing whether the transfer of the asset is a sale
Consistent with Example 6A, the Seller-Lessee and Buyer-Lessor determine that the transfer of the asset is
a sale. The changes in sale price and contractual lease payments did not change the conclusion.
Accounting by the Seller-Lessee
Because the sale price is less than the fair value of the plane, Seller-Lessee accounts for the difference of
$500,000 as a prepayment of rent.
Seller-Lessee recognizes a lease liability for the leaseback at the present value of the unpaid lease
payments, discounted using its incremental borrowing rate of 4%, which results in an initial lease liability
of $1,291,028 calculated as follows:
PMT
Year 1
290,000
Year 2
290,000
Year 3
290,000
Year 4
290,000
Year 5
290,000
Undiscounted PMTs
1,450,000
PV(4%) =
1,291,028
The initial measurement of the right-of-use asset is the same as the lease liability plus the prepayment of
$500,000. There are no lease incentives, nor initial direct costs, and therefore the initial amount of the
right-of-use asset is $1,791,028 (1,291,028 + 500,000).
At the commencement date, Seller-Lessee records the following journal entry:
$ $
Dr. Cash
2,500,000
Dr. Right-of-use asset 1,791,028
Cr. Property, plant or equipment 2,700,000
Cr. Lease liability
1,291,028
Cr. Gain on sale 300,000
ACCOUNTING FOR LEASES UNDER ASC 842 221
Seller-Lessee calculates the total lease cost to be recognized over the lease term:
Total lease payments (not yet paid)
$1,450,000
Prepayment of rent (i.e., off market terms) 500,000
Plus, initial direct costs
0
Total lease cost [A]
$1,950,000
Periodic lease cost [B] = [A] / 5
$390,000
The following table summarizes the accounting for the lease liability, assuming no modifications.
Beg.
Balance
Interest
(4%)
PMT
Closing
Balance
Year 1
1,291,028
51,641
(290,000)
1,052,670
Year 2
1,052,670
42,107
(290,000)
804,776
Year 3
804,776
32,191
(290,000)
546,967
Year 4
546,967
21,879
(290,000)
278,846
Year 5
278,846
11,154
(290,000)
-
The following table summarizes the accounting for the right-of-use asset, assuming no modifications and
impairments.
Opening
Balance
Periodic
Lease Cost
Interest
(4%)
Amortization
Closing
Balance
[A]
[B]
[C] – see above
[D] = [B] + [C]
[A] + [D]
Year 1
1,791,028
(390,000)
51,641
(338,359)
1,452,670
Year 2
1,452,670
(390,000)
42,107
(347,893)
1,104,776
Year 3
1,104,776
(390,000)
32,191
(357,809)
746,967
Year 4
746,967
(390,000)
21,879
(368,121)
378,846
Year 5
378,846
(390,000)
11,154
(378,846)
-
Seller-Lessee recognizes straight-line lease expense of $390,000 on an annual basis throughout the lease
term.
Accounting by the Buyer-Lessor
Buyer-Lessor recognizes the airplane at cost for $3.0 million. Buyer-Lessor subsequently accounts for the
asset under ASC 360.
Buyer-Lessor recognizes deferred rent in the amount of $500,000 at the commencement date.
Because the lease is classified as an operating lease, Buyer-Lessor recognizes lease income of $390,000
annually (the sum of the unpaid lease payments and the prepayment, divided by five), assuming
collectibility of the lease payments is probable throughout the lease term. See
Accounting for Leases -
Lessors
for additional details on collectibility considerations for operating leases.
ACCOUNTING FOR LEASES UNDER ASC 842 222
ACCOUNTING WHEN TRANSFER OF THE ASSET IS NOT A SALE
RECOGNITION
If the transfer is not a sale, the transaction is accounted for as a financing by both the seller-lessee and buyer-lessor.
The Seller-Lessee The Buyer-Lessor
Continues to recognize the transferred asset,
and to apply ASC 360 (depreciation,
impairment, etc.),
Accounts for amounts received as a financial
liability in accordance with other Topics,
Allocates rent payments made between interest
expense and principal amortization.
Does not recognize the transferred asset
under ASC 360,
Accounts for amounts paid as a receivable
in
accordance with other Topics,
Allocates rent payments received between
interest income and principal amortization.
SELLER-LESSEE ADJUSTMENTS TO INTEREST RATE ON FINANCIAL LIABILITY
A seller-lessee (but not a buyer-lessor) should adjust the interest rate on the financial liability as necessary to avoid
negative amortization of the financial liability and a built-in-loss when the asset is derecognized. This is achieved by
determining that both:
Interest on the financial liability is not greater than the payments over the shorter of the lease term and the
term of the financing. The term of the financing could be shorter, for example, when a repurchase option
that precluded sale accounting expires before the end of the lease term. In considering this requirement, we
believe it applies over the
entire
lease term or term of the financing rather than to individual periods.
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 and the date at which control of the asset transfers to the buyer-lessor. That is,
there is no built-in loss at the earlier of the end of the lease term or the term of the financing.
We believe the above requirements apply only to situations in which control of the asset is
expected to transfer to the buyer-lessor at some point. If for example the leaseback includes a
lessee option to repurchase the asset at the end of the lease term that is reasonably certain of
exercise, we believe the seller-lessee should impute interest at a rate that amortizes the financial
liability at the end of the lease term to the price of the repurchase option. That is, there should be
no gain or loss recognized at the end of the leaseback term because control of the asset is not
expected to transfer to the buyer-lessor at any point. See Example 7D for illustration.
ACCOUNTING AT THE DATE THE BUYER-LESSOR OBTAINS CONTROL
At the end of the leaseback period (or at the date the buyer-lessor obtains control of the underlying asset), the seller-
lessee recognizes any remaining balance of the financial liability as proceeds from the sale of the asset. The gain, if
any, that is recognized reflects any difference between those proceeds and the carrying amount of the asset at that
date. The buyer-lessor derecognizes the carrying amount of its financial asset and recognizes the transferred asset at
that same amount. This accounting is consistent with Example 2 in ASC 842-40-55.
As discussed earlier, in a failed sale and leaseback transaction the buyer-lessor may obtain control of the underlying
asset before the end of the leaseback (for example, when a repurchase option that precluded sale accounting expires
before the end of the leaseback term). Example 2 in ASC 842-40-55 illustrates the accounting both initially and once
the purchase option expires. However, this example has led to a number of questions, including whether lease
classification should be reassessed once the repurchase option expires. Accordingly, care should be given in those
situations, and entities are encouraged to discuss these situations with their accounting advisor or auditor.
ACCOUNTING FOR LEASES UNDER ASC 842 223
Example 7A - Accounting for Failed Sale-Leaseback
FACTS
Seller-Lessee sells an airplane to an unrelated Buyer-Lessor for $3 million, which is its fair value.
The carrying amount of the airplane is $2.7 million and it has a remaining useful life of 15 years.
At the same time, Seller-Lessee enters into a contract with Buyer-Lessor for the right to use the airplane for
5 years, with annual payments of $300,000 payable in arrears and escalating 2% annually.
Seller-Lessee has a fixed price repurchase option at the end of year 5 for $1.8 million, which Seller-Lessee is
not reasonably certain to exercise.
Absent the repurchase option, there are no other terms or conditions that would preclude sale accounting.
Seller-Lessee’s incremental borrowing rate is 4%.
ANALYSIS
The exercise price of the repurchase option is fixed and therefore precludes accounting for the transaction
as a sale.
Seller-Lessee therefore accounts for the $3 million of proceeds received as a financial liability, and it utilizes
its incremental borrowing rate of 4% to recognize interest expense.
Seller-Lessee also continues to recognize the asset and continues to depreciate it over the remainder of its
useful life (assume depreciation expense is $180,000 annually).
Seller-Lessee’s accounting for the financial liability and asset are determined as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A] [B] = [A] x 4.00% [C] [D] = [A] + [B] + [C]
Year 1
3,000,000
120,000
(300,000)
2,820,000
2,520,000
Year 2
2,820,000
112,800
(306,000)
2,626,800
2,340,000
Year 3
2,626,800
105,072
(312,120)
2,419,752
2,160,000
Year 4
2,419,752
96,790
(318,362)
2,198,180
1,980,000
Year 5
2,198,180
87,927
(324,730)
1,961,377
1,800,000
Seller-Lessee determines that there is no negative amortization of the financial liability and no
built-in-loss at the end of the lease term (financing term). Therefore, no further adjustments to
the interest rate are required.
Buyer-Lessor also accounts for the transaction as a financing and determines an appropriate interest rate in
accordance with ASC 835-30-25-12 and 25-13.
If at the end of Year 5 the repurchase option is not exercised and expires, Seller-Lessee recognizes the sale
of the asset by derecognizing the underlying asset for $1.8 million, derecognizing the carrying amount of the
financial liability of $1.96 million, and recognizing a gain of $161,377. Buyer-Lessor recognizes the
underlying asset at the amount of its financial receivable at that date.
ACCOUNTING FOR LEASES UNDER ASC 842 224
Example 7B - Accounting for Failed Sale-Leaseback by Seller-Lessee – Negative Amortization
FACTS
Assume the same facts as Example 7A above, except that the payments are $105,000 annually, payable in
arrears.
ANALYSIS
As stated in Example 7A, this transaction is considered a financing transaction.
Seller-Lessee’s accounting for the financial liability and asset are determined as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A]
[B] = [A] x 4.00%
[C]
[D] = [A] + [B] + [C]
Year 1
3,000,000
120,000
(105,000)
3,015,000
2,520,000
Year 2
3,015,000
120,600
(105,000)
3,030,600
2,340,000
Year 3
3,030,600
121,224
(105,000)
3,046,824
2,160,000
Year 4
3,046,824
121,873
(105,000)
3,063,697
1,980,000
Year 5
3,063,697
122,548
(105,000)
3,081,245
1,800,000
Seller-Lessee determines that there is no built-in-loss at the end of the lease term (financing
term). However, there is negative amortization of the financial liability (the aggregate interest
expense over the 5-year period exceeds the aggregate payments made). Therefore, Seller-Lessee
is required to adjust the interest rate.
Seller-Lessee therefore determines an adjusted interest rate that does not result in negative amortization of
the financial liability. In this case, it is 3.50% (i.e., $105,000 annual payment divided by the initial financial
liability of $3,000,000). The updated balances are as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A]
[B] = [A] x 3.50%
[C]
[D] = [A] + [B] + [C]
Year 1
3,000,000
105,000
(105,000)
3,000,000
2,520,000
Year 2
3,000,000
105,000
(105,000)
3,000,000
2,340,000
Year 3
3,000,000
105,000
(105,000)
3,000,000
2,160,000
Year 4
3,000,000
105,000
(105,000)
3,000,000
1,980,000
Year 5
3,000,000
105,000
(105,000)
3,000,000
1,800,000
If at the end of Year 5 the repurchase option is not exercised and expires, Seller-Lessee recognizes the sale
of the asset by derecognizing the underlying asset for $1.8 million, derecognizing the carrying amount of the
financial liability of $3.0 million, and recognizing a gain of $1.2 million.
ACCOUNTING FOR LEASES UNDER ASC 842 225
Example 7C - Accounting for Failed Sale-Leaseback by Seller-Lessee – Built-in-loss
FACTS
Assume the same facts as Example 7A above, except that the payments are $375,000 annually, payable in
arrears.
ANALYSIS
As stated in Example 7A, this transaction is considered a financing transaction.
Seller-Lessee’s accounting for the financial liability and asset are determined as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A]
[B] = [A] x 4.00%
[C]
[D] = [A] + [B] + [C]
Year 1
3,000,000
120,000
(375,000)
2,745,000
2,520,000
Year 2
2,745,000
109,800
(375,000)
2,479,800
2,340,000
Year 3
2,479,800
99,192
(375,000)
2,203,992
2,160,000
Year 4
2,203,992
88,160
(375,000)
1,917,152
1,980,000
Year 5
1,917,152
76,686
(375,000)
1,618,838
1,800,000
Seller-Lessee determines that there is no negative amortization of the financial liability but there
is a built-in-loss at the end of Year 5 (i.e., the carrying amount of the asset exceeds the carrying
amount of the financial liability). Therefore, Seller-Lessee is required to adjust the interest rate.
Seller-Lessee therefore determines an adjusted interest rate that does not result in a built-in-loss at the end
of Year 5. In this case, it is approximately 5.305% (calculated so that the financial liability equals the
carrying amount of the asset at the end of the lease term).
The updated balances are as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A]
[B] = [A] x
5.305%
[C]
[D] = [A] + [B] + [C]
Year 1
3,000,000
159,149
(375,000)
2,784,149
2,520,000
Year 2
2,784,149
147,698
(375,000)
2,556,847
2,340,000
Year 3
2,556,847
135,640
(375,000)
2,317,487
2,160,000
Year 4
2,317,487
122,942
(375,000)
2,065,429
1,980,000
Year 5
2,065,429
109,570
(375,000)
1,800,000
1,800,000
If at the end of Year 5 the repurchase option is not exercised and expires, Seller-Lessee recognizes the sale
of the asset by derecognizing the underlying asset for $1.8 million, derecognizing the carrying amount of the
financial liability of $1.8 million, and recognizing no gain or loss.
ACCOUNTING FOR LEASES UNDER ASC 842 226
Example 7D - Accounting for Failed Sale-Leaseback by Seller-Lessee – Repurchase Option Reasonably Certain of
Exercise
FACTS
Assume the same facts as Example 7A above, except that the repurchase option at $1.8 million is reasonably
certain of exercise.
ANALYSIS
As stated in Example 7A, this transaction is considered a financing transaction.
Because control of the asset is not expected to transfer to Buyer-Lessor at any point, there should be no gain
or loss recognized by Seller-Lessee at the end of the leaseback term. Accordingly, Seller-Lessee should
adjust the interest rate so that the financial liability at the end of Year 5 equals the exercise price of the
purchase option. In this case, this results in an interest rate of approximately 2.838%.
Seller-Lessee’s accounting for the financial liability and asset are determined as follows:
Beg. Liability
Balance
Interest
PMT
End. Liability
Balance
End. Asset
Balance
[A]
[B] = [A] x
2.838%
[C]
[D] = [A] + [B] + [C]
Year 1
3,000,000
85,138
(300,000)
2,785,138
2,520,000
Year 2
2,785,138
79,040
(306,000)
2,558,178
2,340,000
Year 3
2,558,178
72,599
(312,120)
2,318,657
2,160,000
Year 4
2,318,657
65,802
(318,362)
2,066,096
1,980,000
Year 5
2,066,096
58,634
(324,730)
1,800,000
1,800,000
At the end of Year 5 the repurchase option is exercised. Seller-Lessee derecognizes the carrying amount of
the financial liability of $1.8 million, and credits cash for the payment made to Buyer-Lessor.
ACCOUNTING FOR LEASES UNDER ASC 842 227
BUSINESS COMBINATIONS (OR ACQUISITIONS BY NOT-FOR-PROFIT ENTITIES)
There are several areas for which the accounting for leases acquired in a business combination or an acquisition by a
not-for-profit entity (herein referred to as business combinations) differs from the accounting for a new lease. For
some of these areas ASC 805 and ASC 842 provide clear accounting guidance. For other areas the guidance, including
the interaction of ASC 805 and 842, is not clear. Additionally, the guidance sometimes differs depending on whether
the acquiree is a lessee or a lessor.
LEASE CLASSIFICATION
ASC 842-10-55-11 notes that the acquirer of a lease in a business combination should retain the acquiree’s previous
lease classification, unless the lease is modified and that modification is not accounted for as a separate contract.
This guidance applies whether the acquired entity is a lessee or a lessor. If there is a modification and the
modification is not accounted for as a separate contract, the acquirer should reassess classification. See
Lease
Classifications and Key Terms for lease classification guidance. In some cases, an acquired lease may be amended to
change only the name of the parties specified in the lease. We believe such changes are administrative in nature and
are not a modification because they do not change the scope of or the consideration for the lease.
Classification of an Acquired Lease in an Asset Acquisition
ASC 842 does not specify whether classification of an acquired lease in an asset acquisition should
be reassessed or retained like in business combinations. However, an acquired lease is typically
measured as if it were a new lease of the acquirer; and for a new lease, one of the steps an entity
performs is assessing classification. The only explicit exception that exists is for acquired leases in a
business combination. Therefore, for asset acquisitions we believe the acquiring entity should
generally reassess lease classification. However, there may be differing views on this question, and
entities are encouraged to discuss classification of leases acquired in an asset acquisition with their
accounting consultants and auditors.
LEASE IDENTIFICATION
While ASC 842 discusses lease classification in a business combination, it does not provide guidance on whether an
acquirer should reassess an acquiree’s conclusions about whether a contract is or contains a lease. However, consistent
with the guidance in paragraph 842-10-15-6, which states that an entity reassesses whether a contract is or contains a
lease only if the terms and conditions of the contract are changed, we believe that an acquirer should not reassess the
acquiree’s previous lease identification conclusion determined under ASC 842 unless the contract is modified in
connection with the transaction and such modification is not accounted for as a separate contract. Reassessing lease
identification may also result in a conclusion that the contract does not contain a lease at the acquisition date, thereby
directly conflicting with the specific requirement to retain lease classification of the acquiree in a business
combination. However, there could be additional complexity when the acquirer and acquiree have adopted ASC 842 at
different dates and/or have used different transition practical expedients. Entities are encouraged to discuss those
situations with their accounting consultants and auditors.
RECOGNITION AND MEASUREMENT (ACQUIREE IS THE LESSEE)
The acquirer recognizes assets and liabilities arising from leases in which the acquiree is a lessee in accordance with
ASC 842. That is, the acquirer recognizes a lease liability and right-of-use asset on the balance sheet. However, ASC
805-20-25-28B provides an accounting policy election in which the acquirer may elect not to recognize assets or
liabilities for leases that, at the acquisition date, have a remaining lease term of 12 months or less. This includes not
recognizing an intangible asset or liability for favorable or unfavorable market terms. The election to not recognize
leases on balance sheet at the acquisition date is made by asset class and applies to all of an entity’s acquisitions.
ACCOUNTING FOR LEASES UNDER ASC 842 228
If the acquirer does not make the election for leases with a remaining lease term of 12 months or less above, or if the
lease is more than 12 months, the acquirer must measure the acquired lease as follows:
Notwithstanding that the classification of a lease acquired in a business combination is not reassessed
(absent a modification), the acquirer must measure the lease liability at the present value of the remaining
lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date.
6
The FASB
explained in paragraph BC415 of ASU 2016-02 that measuring the acquired lease as if it were a new lease
encompasses reassessing the following assumptions: the lease term, any lessee purchase options, lease
payments (such as amounts probable of being owed under a residual value guarantee), and the discount rate.
The acquirer measures the right-of-use asset at the amount of the lease liability, adjusted for any favorable
or unfavorable terms (i.e., off-market terms) present in the lease. In other words, the acquirer is required to
value off-market terms as before adoption of ASC 842, except that those off-market terms are now
recognized as part of the initial measurement of the right-of-use asset rather than as separate intangibles.
The acquirer must also separately recognize the following, if applicable:
Identifiable intangible assets associated with the lease, usually called an in-place lease intangible,
representing market participants’ willingness to pay a price for the lease, even if the lease is at market, such
as the lease of gates at an airport or of prime location retail space.
Leasehold improvements owned by the acquiree (see discussion below on subsequent measurement).
The following table summarizes the potential assets and liabilities that may be recognized for leases acquired in a
business combination when the acquiree is the lessee:
Operating Lease / Finance Lease
Assets
Right-of-use asset (equal to lease liability adjusted for above/below market terms)
In-place lease intangible (fair value)
Leasehold improvements owned by the acquiree (fair value)
Liabilities
Lease liability (present value of the remaining lease payments, as if the lease were a new
lease of the acquirer at the acquisition date)
6
The measurement of an acquired lease in a business combination represents an exception to the fair value measurement principle
that is generally required for acquired assets and liabilities. The FASB determined that the benefit of measuring acquired leases at
fair value would not justify the costs of collecting the data needed to apply a fair value measurement.
ACCOUNTING FOR LEASES UNDER ASC 842 229
Accounting for Acquired Operating Leases When Acquirer Is Reasonably Certain to Exercise a Purchase Option
As previously noted, ASC 842 is clear that in a business combination the acquirer measures an acquired lease as if it
were a new lease of the acquirer at the acquisition date. The acquirer therefore reassesses the lease term, purchase
options, lease payments and discount rate. In doing so, the acquirer may determine at the acquisition date that it is
reasonably certain to exercise a purchase option included in the acquired lease, which would result in the lease
being classified as a finance lease. The acquiree may have previously determined otherwise and classified the lease
as an operating lease. Also, ASC 842 is clear that the acquirer should retain the acquiree’s lease classification.
Therefore, even if the acquirer’s assumptions (as compared to the previous assumptions used by the acquiree) would
result in a change in lease classification if assessed at the acquisition date, the acquiree’s lease classification should
be retained (unless the lease is modified and that modification is not accounted for as a separate contract). In those
situations, the measurement of the lease liability should include the payment related to exercise of the purchase
option. Additional complexities may arise in the day-2 accounting, including the period and method for amortizing
the right-of-use asset and, therefore, entities are encouraged to discuss those situations with their accounting
consultants and auditors.
Recognition and Measurement of Acquired Leases When Acquiree’s and Acquirer’s Policy on Nonseparation Differ
As discussed in Identifying and Separating Components, a lessee may elect a practical expedient by asset class not
to separate nonlease component(s) from the associated lease component. Electing the practical expedient may in
some situations change classification from operating to finance when performing the present value test in ASC 842-
10-25-2(d). Also, an acquiree and acquirer may have made different elections regarding nonseparation of lease and
non-lease components. For example, the acquirer may have elected the nonseparation practical expedient while the
acquiree did not, or vice versa, potentially resulting in different conclusions on classification of the acquiree’s leases
if the acquirer’s policy had been applied. Therefore, questions have arisen as to how the acquirer should classify
and measure acquired leases when conforming the acquiree’s accounting policies to those of the acquirer.
As discussed previously, ASC 842-10-55-11 is clear that lease classification is retained in a business combination, with
the only exception being for modifications not accounted for as a separate contract. Therefore, we believe the
acquirer should retain the acquiree-lessee’s previous classification, even if the accounting policy between the
acquiree and acquirer on nonseparation is different. However, we believe that the acquirer should conform the
acquiree’s policies to its own and measure the acquired lease consistent with the acquirer’s own policy. Specifically:
If the acquirer elected the nonseparation practical expedient while the acquiree did not, the acquirer
should combine the acquiree’s nonlease components with the associated lease component when initially
measuring the acquiree’s leases in its business combination accounting.
If the acquirer did not elect the nonseparation practical expedient while the acquiree did, the acquirer
should separate the acquiree’s nonlease components from the associated lease component when initially
measuring the acquiree’s leases in its business combination accounting. One acceptable approach to
separate the components would be to use standalone prices at the business combination date.
ACCOUNTING FOR LEASES UNDER ASC 842 230
Measurement of Related Party Leases With Off-Market Terms Acquired in a Business Combination
ASC 842-10-55-12 requires leases between related parties to be accounted for based on their legally enforceable
terms and conditions. ASC 842-40-30-4 also notes that for sale and leaseback transactions between related parties,
the entity does not adjust the sale price for off-market terms. As a result, entities typically do not adjust their lease
accounting for off-market terms in related party leases. However, we believe an exception may apply for acquired
related party leases in a business combination. Specifically, the acquirer in a business combination applies ASC 805-
20-25-12 (applicable to acquired operating leases) and ASC 805-20-30-24 (applicable to all leases of an acquiree-
lessee) to account for all leases. Those paragraphs indicate that the acquirer should measure the right-of-use asset
at the same amount as the lease liability, adjusted to reflect favorable or unfavorable terms of the lease when
compared with market terms.
ACCOUNTING FOR LEASES UNDER ASC 842 231
RECOGNITION AND MEASUREMENT (ACQUIREE IS THE LESSOR)
The recognition and measurement of assets and liabilities related to an acquired lease in which the acquiree is the
lessor depends on lease classification.
For a sales-type or direct financing lease, the acquirer measures the net investment in the lease at the sum
of the following:
Lease receivable
at the present value, discounted using the rate
implicit in the lease, of the following as if the acquired lease were a
new lease at the acquisition date:
The remaining lease payments,
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
Unguaranteed residual asset
, as the difference between the fair value
of the underlying asset at the acquisition date and the carrying amount
of the lease receivable
The net investment in the lease is therefore equal to the fair value of the underlying asset at the acquisition
date. In calculating the acquisition-date fair value of an underlying asset that is subject to a sales-type lease
or a direct financing lease by the acquiree-lessor, the acquirer should take into account the terms and
conditions of the lease.
For an operating lease, the underlying asset is recognized and measured at fair value. The fair value of the
underlying asset is not affected by the lease (that is, the fair value would be the same whether or not there
is an operating lease in place). Also, if the contract terms are favorable or unfavorable as compared to
market terms, the acquirer should recognize an intangible asset or liability, respectively, for those off-
market terms.
Additionally, for all types of acquired leases for an acquiree-lessor, it may be appropriate to recognize
identifiable intangible assets such as in-place leases or customer relationships. Any such intangible assets
are recognized at fair value following the principles of ASC 805.
The following table summarizes the potential assets and liabilities that may be recognized for leases acquired in a
business combination when the acquiree is the lessor:
Sales-type or Direct Finance Lease Operating Lease
Assets
Net investment in the lease (lease
receivable + unguaranteed residual
asset)
In-place lease intangible (fair value)
Customer relationship intangible (fair
value)
Underlying asset (fair value)
Favorable lease terms (fair value)
In-place lease intangible (fair value)
Customer relationship intangible (fair value)
Liabilities
Not applicable
Unfavorable lease terms (fair value)
ACCOUNTING FOR LEASES UNDER ASC 842 232
LEASEHOLD IMPROVEMENTS ACQUIRED IN A BUSINESS COMBINATION
The acquirer should recognize the fair value of leasehold improvements acquired in the business combination.
Additionally, ASC 842-20-35-13 requires leasehold improvements acquired in a business combination to be amortized
over the shorter of the useful life of the assets and the remaining lease term at the date of acquisition. However, as
discussed in ASC 805-20-35-6, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is
reasonably certain to exercise a purchase option, the lessee should amortize the leasehold improvements to the end of
their useful life.
ACCOUNTING FOR LEASES UNDER ASC 842 233
SUBLEASES
OVERVIEW
A sublease is a transaction in which an underlying asset is re-leased by the lessee (intermediate lessor or sublessor) to a
third-party (sublessee) and the original (or head) lease between the lessor and the lessee remains in effect. In the
FASB’s view, leases of right-of-use assets (i.e., subleases) should be accounted for in the same way as other leases.
Accordingly, subleases are within the scope of ASC 842.
The following summarizes the accounting by each party under the original lease and/or sublease.
Disclosures related to subleases are discussed in upcoming, Presentation and Disclosures
.
ORIGINAL LESSOR ACCOUNTING
The accounting by the original lessor depends on the nature of the transaction.
Original lessee subleases
the asset or sells/ transfers
the original lease
agreement to a third party
Original lessor continues to account for the lease as it did before.
Original lease agreement is
replaced by a new
agreement with a new
lessee
Lessor accounts for the transaction as a termination of the original
lease.
Lessor classifies and accounts for the new lease as a separate
transaction like any other leases (see
Accounting for Leases -
Lessors for additional guidance on lessor accounting).
SUBLESSEE ACCOUNTING
A sublessee classifies and accounts for the sublease like any other leases as a lessee (see Accounting for Leases –
Lessees for detailed guidance). The sublessee assesses classification of the sublease by reference to the underlying
asset rather than by reference to the right-of-use asset. For example, in classifying the sublease the sublessee
evaluates whether the sublease term is for a major part of the remaining economic life of the underlying asset, rather
than the remaining term of the head lease.
ACCOUNTING FOR LEASES UNDER ASC 842 234
SUBLESSOR ACCOUNTING
A sublessor should account for a head lease and a sublease as two separate contracts (i.e., two separate units of
account) unless those contracts meet the contract combination guidance in ASC 842-10-25-19 (which we believe will be
infrequent because the counterparty to the sublease is typically a different entity from the counterparty to the head
lease).
The accounting by the original lessee (sublessor) depends on whether it retains the primary obligation under the
original lease.
ORIGINAL LESSEE IS RELIEVED OF ITS PRIMARY OBLIGATION UNDER ORIGINAL LEASE
The Original Lessee:
Derecognizes the right-of-use asset and lease liability.
Recognizes any difference in profit or loss.
Includes any consideration paid or received upon termination that was not already
included in the lease payments (for example, a termination payment) in the
determination of profit or loss to be recognized.
Recognizes a guarantee obligation in accordance with ASC 405-20-40-2 if the original
lessee is secondarily liable. In this case, the guarantee obligation is initially measured at
fair value and that amount reduces the determination of profit or loss to be recognized.
ORIGINAL LESSEE RETAINS PRIMARY OBLIGATION UNDER ORIGINAL LEASE
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) accounts for the original lease in one of the following ways:
Original Lease
Classification
Sublease
Classification The Original Lessee (Sublessor):
Operating or
finance lease
Operating lease
Continues to account for the original lease as before the
sublease commencement.
Recognizes sublease income over the lease term (See
A
ccounting for Leases – Lessors).
If the lease cost of the original lease for the term of the sublease
exceeds the anticipated sublease income for the same period,
that circumstance is an indicator that the carrying amount of the
original lease right-of-use asset may not be recoverable in
accordance with ASC 360-10-35-21.
Refer to
A
ccounting for Leases – Lessees f
or additional
complexities on application of ASC 360 to right-of-use assets
when a lessee plans or enters into a sublease.
Operating or
finance lease
Sales-type or direct
financing lease
Derecognizes the original lease right of use asset.
Continues to account for the original lease liability as before
the sublease commencement.
Recognizes a net investment in the sublease and any selling
profit or loss consistent with the classification of the sublease
(see
A
ccounting for Leases – Lessors
).
Evaluates the net investment in the sublease for impairment like
any other lessors (see
A
ccounting for Leases – Lessors).
ACCOUNTING FOR LEASES UNDER ASC 842 235
The sublessor assesses classification of the sublease by reference to the underlying asset rather than by reference to
the right-of-use asset. For example, in classifying the sublease the sublessor evaluates whether the sublease term is for
a major part of the remaining economic life of the underlying asset, rather than the remaining term of the head lease.
The original lessee as sublessor should also use the “rate implicit in the lease” (as defined) 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 (head)
lease.
Impact of Entering into a Sublease on Head Lease Term
The sublessor should also consider the reassessment requirements applicable to the head lease
upon entering into the sublease in accordance with ASC 842-10-35-1(a) and ASC 842-10-55-28(d).
The original lessee may enter into a sublease that includes extension options that, if exercised by
the sublessee, would force the original lessee to also exercise one or more extension options in the
original lease. We observe that ASC 842-10-30-1 on lease term notes that periods covered by an
option to extend (or not terminate) the lease in which exercise of the option is controlled by the
lessor are included in the lease term. However, the FASB noted at a Board meeting that this
requirement does not extend to options held by third parties (such as a sublessee). Accordingly,
whether sublease options are included in the assessment of the head lease term depends on the
facts and circumstances. Generally, the head lessee would be required to reassess and update the
head lease term when the sublease term (determined in accordance with ASC 842-10-30-1) exceeds
the remaining lease term of the head lease. See
A
ccounting for Leases – Lessees for additional
details about reassessment events and impact on accounting for lessees.
Example 8A - Sublease With a Term That Exceeds Remaining Lease Term of the Original Lease
FACTS
Dessert Co. enters into a retail store lease in a shopping mall for an initial period of four years, with two 2-
year extension periods.
At lease commencement, Dessert Co. determined that it was not reasonably certain to exercise the
extension options, and therefore the lease term was four years.
The original lease was classified as an operating lease.
After one year into the lease, Dessert Co. enters into an agreement with Mikey’s Cookie Company to
sublease the entire retail store for a noncancelable term of five years.
Dessert Co. is not relieved of the primary obligation under the original lease.
The sublease is determined to be an operating lease.
ANALYSIS
Because Dessert Co. is still the primary obligor under the original lease, the sublease does not represent a
termination of the original lease.
Since the sublease term of 5 years exceeds the remaining lease term of the original lease of 3 years, Dessert
Co. is required to reassess and update the lease term to be at least 5 years (i.e., 3 years remaining in the
initial lease term plus at least one 2-year extension period). See
A
ccounting for Leases – Lessees for
additional guidance and impact on accounting for lessees.
ACCOUNTING FOR LEASES UNDER ASC 842 236
Example 8B - Sublease With Extension Options That Are Not Reasonably Certain of Exercise
FACTS
Assume the same facts as in Example 8A, except that the sublease with Mikey’s Cookie Company has a three-
year noncancelable term with two 2-year extension options.
Dessert Co. as sublessor assessed the lease term of the sublease and determined that it is three years (i.e.,
Mikey’s Cookie Company is not reasonably certain to exercise its extension options).
ANALYSIS
The lease term for the sublease is three years, which is the remaining lease term of the original lease.
Even though Dessert Co. would be forced to exercise its extension option(s) in the original lease if Mikey’s
Cookie Company were to exercise its extension option(s) in the sublease (that is, exercise of the extension
options in the original lease is now outside Dessert Co.’s control), Dessert Co. determined that Mikey’s
Cookie Company is not reasonably certain to exercise its extension options and therefore Dessert Co. would
not update the lease term of the original lease solely as a result of entering into the sublease.
Example 8C - Sublease With Extension Options That Are Reasonably Certain of Exercise
FACTS
Assume the same facts as in Example 8B, except that Mikey’s Cookie Company is reasonably certain to
exercise its first extension option.
ANALYSIS
In this case, like in Example 8A the sublease term exceeds the remaining lease term of the original lease.
Therefore, Dessert Co. is required to reassess and update the lease term to be at least 5 years (i.e., 3 years
remaining in the initial lease term plus at least one 2-year extension period). See
A
ccounting for Leases –
Lessees for additional guidance and impact on accounting for lessees.
ACCOUNTING FOR LEASES UNDER ASC 842 237
In a sublease arrangement, the original lessee may require the sublessee to pay directly to the original lessor or a
third-party either or both the rent payments and other costs such as property taxes and insurance otherwise due under
the original lease.
ASC 842-10-15-40A requires a lessor to 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 should be accounted for by the lessor as variable
payments.
This requirement also applies to a sublessor for lessor costs paid by the sublessee directly to a third-party, including
the head lessor. Therefore, the accounting by the sublessor can be summarized as follows:
Sublessee pays lessor costs directly to a
third-party, including the head lessor
Sublessor pays costs and is reimbursed by
sublessee
Exclude from variable payments.
In other words, treat like a sublessee
cost, which does not affect the
accounting for the lease.
Account for costs excluded from
consideration in the contract as lessor
costs (i.e., as variable payments).
In other words, recognize on a gross
basis.
Importantly however, the above requirements do not apply to payments (whether fixed or variable)
for the right to use the underlying asset that are paid by the sublessee directly to the original
lessor. Accordingly, if the sublease requires the sublessee to make such payments directly to the
original lessor, the original lessee (sublessor) should still present those amounts gross in profit or
loss.
ACCOUNTING FOR LEASES UNDER ASC 842 238
ACCOUNTING FOR INCOME TAXES
OVERVIEW
A leasing arrangement generally provides a financing party (the lessor) with the right to claim tax benefits from the
ownership of an asset intended to be used by another party (the lessee) so that the tax benefits can be “shared” with
the lessee through lower rent or lease payments. The basic tax benefit is tax deferral – i.e., accelerated tax deductions
in early years to reduce income from the leasing arrangement and from other sources in exchange for more taxable
income in later years when tax depreciation deductions from the leased asset are less than in early years. Additional
tax benefits might include investment tax credits.
ASC 740 provides for two basic principles related to the accounting for income taxes:
To recognize the estimated taxes payable or
refundable on tax returns for the current year as
a tax liability or asset.
For example, in a “true lease” for federal income tax
purposes, a lessor would determine taxable income
based on, among other things, rental income (as
earned), depreciation on the asset under the Modified
Accelerated Cost Recovery System, and deductible
interest expense using the interest method.
To recognize deferred tax liabilities and assets for
the future tax consequences of events that have
been recognized in an entity’s financial
statements or tax returns (i.e., timing differences
and carryforwards).
See below for further discussion.
Tax Classification of Leases
The U.S. federal income treatment or classification of leases range from a “true lease” which means the lessor is
considered the tax owner of the leased property (the lessee does not own an asset for tax purposes), a conditional
sale (the lessor is a conditional seller and the lessee is a conditional buyer), a lending transaction (the lessor is a
creditor and the lessee is a debtor and the owner of a mortgaged asset), or other type of participation. Therefore,
depending on the terms of the arrangement, the classification of a lease arrangement for federal income tax
purposes could differ from the classification for financial reporting purposes.
For a true tax lease, the lessor is considered the tax owner of the leased property. As such, the lessor is entitled to
tax deductions related to the ownership of the property, including depreciation and interest expense as note above,
while recognizing rental income. The primary focus of the U.S. federal tax classification analysis is whether the
lessor retains sufficient risks and rewards from ownership, including consideration of whether the lessor has made a
substantial equity investment and retains a meaningful interest in the residual value of the asset (i.e., whether the
lessor has upside and downside residual risk in the leased property).
While U.S. federal tax law does not contain a comprehensive articulation of “true leases,” certain principles have
been developed through IRS administrative guidance and case law that define a “true lease” including:
Minimum unconditional “at risk” investment (i.e., equity investment and remaining useful life beyond lease
terms),
No bargain purchase options (i.e., less than fair market value when option is exercised) or put option to
lessee,
No economic compulsion to purchase the asset at the end of the term or at a fixed purchase option,
No investment by lessee beyond certain improvements or additions,
No lessee loans or guarantees,
1
2
ACCOUNTING FOR LEASES UNDER ASC 842 239
Profit (beyond tax benefits) and positive cash flow requirements,
No limited use property,
Commercially feasible that another party can use the asset after lease expiration, considering remaining
useful life and residual value,
Other considerations and facts and circumstances.
DEFERRED INCOME TAXES
The following terminologies are important for the understanding and accounting for deferred taxes:
Temporary Differences Deferred Tax Assets Deferred Tax Liabilities
Relate to the difference between
the tax basis of an asset or liability
and its reported amount in the
financial statements that will result
in taxable or deductible amounts in
future years when the reported
amount is recovered or settled.
Result from deductible temporary
differences that exist at the end of
a period and are measured using
enacted tax rates and provisions of
the enacted tax law.
Result from taxable temporary
differences that exist at the end of
a period and are measured using
enacted tax rates and provisions of
the enacted tax law.
The issuance of ASC 842 did not change the principles for income tax accounting for leases. As such, the requirement
to recognize deferred taxes for timing differences remains the same.
For some leases, there will be no significant changes to the accounting for income taxes. For example, ASC
842 does not have a significant impact on the accounting requirements for lessors or lessees for finance
leases. As such, there is not a significant change in the accounting for income taxes related to these leases.
For other leases, there will be a greater impact. Most notably, since ASC 842 now requires lessees to
recognize lease liabilities and right-of-use assets on the balance sheet for operating leases, the adoption of
ASC 842 will, in most cases, require lessees to record new deferred tax assets and liabilities.
Notwithstanding, transitioning to ASC 842 will not impact how leases are classified for federal income tax
purposes.
New Deferred Taxes for Lessee Operating Leases Under ASC 842
For book purposes under ASC 842, a lessee in an operating lease recognizes a lease liability and a right-of-use asset
at the commencement date, except for short-term leases. However, for tax purposes, if the lease is considered a
true lease, there will be zero tax basis for the lease liability and right-of use asset. This creates two separate
temporary differences for which deferred taxes must be recognized. Specifically, a lessee in an operating lease
recognizes:
A deferred tax liability (measured at the applicable tax rate) for the right-of-use asset since future
recovery of the book basis (i.e., generating cash inflows from the use of the leased asset) will not have a
corresponding depreciable tax basis, thereby resulting in more taxable income to the lessee.
A deferred tax asset (measured at the applicable tax rate) for the lease liability because the future
settlement of the lease liability (i.e., paying down the carrying value or principal) will result in a tax
deduction through deductible rents.
Also, the subsequent measurement of the lease liability and right-of-use asset will often diverge, and thus the
respective deferred taxes will not entirely offset.
These temporary differences must be tracked separately for disclosure purposes (as gross deferred tax assets and
liabilities must be separately disclosed) and, because the reversal pattern for the deferred tax liabilities will likely
ACCOUNTING FOR LEASES UNDER ASC 842 240
be different than the reversal pattern for the deferred tax assets, this could impact the measurement of valuation
allowances.
A deferred tax asset is assessed, together with all other deferred tax assets within a jurisdiction or a taxpaying
entity, for realizability. However, the deferred tax liability for the right-of-use asset would generally be considered
a source of income to support realization of the deferred tax asset.
The magnitude of the deferred taxes recognized initially will depend on several factors, including the length of the
lease term, significance of lease payments, and the lessee’s accounting policy election related to not separating
non-lease components (such as maintenance services) from the related lease component, as discussed in Identifying
and Separating Components. For example, a lessee that elected for its equipment asset class to not separate the
non-lease components (maintenance) from the related equipment lease component will include the maintenance
payments in the measurement of the lease liability and right-of-use asset that would otherwise be allocated to the
maintenance component. For tax purposes, the standalone value of the non-lease component (the maintenance
service) would not be capitalized as part of the cost basis of leased property; rather, any prepayment of non-lease
components could be capitalized as a separate asset and amortized over time. However, in some cases, non-lease
components could also be deducted as incurred depending on the terms of the agreement and the taxpayer’s
method of accounting for such items. As such, the measurement of deferred taxes must consider all these factors.
INITIAL DIRECT COSTS
For book purposes, lease origination costs that qualify as initial direct costs under ASC 842 are capitalized and
recognized as an expense over the lease term. For lessees, initial direct costs are part of the right-of-use asset,
irrespective of lease classification, and thus affect the measurement of the deferred taxes associated with the right-of-
use asset. For lessors with operating leases, initial direct costs are capitalized as a separate asset and amortized over
the lease term. As such, they will give rise to a separate temporary difference. For lessors with sales-type or direct-
financing leases, initial direct costs that are deferred are automatically included in the net investment in the lease
based on how the rate implicit in the lease is calculated. As such, they do not give rise to a separate temporary
difference; rather they affect any deferred taxes associated with the net investment in the lease.
The definition of initial direct costs under ASC 842 is narrower than under ASC 840. Under ASC 842, initial direct costs
include incremental costs of a lease that would not have been incurred if the lease had not been obtained (See
Lease
Classifications and Key Terms for additional details). Consequently, certain origination costs that previously were
capitalized under ASC 840 now will be expensed under ASC 842. Also, for sales-type leases, lessors are required to
expense initial direct costs for leases in which the fair value of the underlying asset differs from its carrying amount at
lease commencement. For income tax purposes lease origination costs are still required to be capitalized (and
amortized), thereby creating additional temporary differences and associated deferred income taxes, although federal
tax law allows for an immediate deduction of de minimis costs incurred to acquire an asset (up to $5,000 of the entire
cost for taxpayers with applicable financial statements). This tax deduction allowance might be suitable for small value
leases (e.g., certain office equipment and computers).
SALE-LEASEBACK TRANSACTIONS
The accounting for sale-leaseback transactions under ASC 842 may result in temporary differences. As discussed earlier
in this chapter, ASC 842 requires the application of ASC 606 (existence of a contract and transfer of control), the lease
classification guidance under ASC 842, and specific repurchase option guidance to determine whether the transaction
qualifies for sale accounting. If a sale-leaseback transaction fails sale accounting, the consideration paid by the buyer-
lessor for the asset is accounted for as a financing by both the seller-lessee and the buyer-lessor.
Some sale-leaseback transactions that meet the current tax law requirements for sales for seller-lessees and purchases
for buyer-lessors may fail the accounting requirements above on sale accounting, creating temporary differences. For
example, a seller-lessee would recognize current taxable income but would recognize a deferred tax asset for the
future inclusion of book income. Conversely, certain sale-leaseback transactions involving real estate which did not
qualify as sales under ASC 840 may result in sale accounting under ASC 842, also impacting deferred income taxes.
ACCOUNTING FOR LEASES UNDER ASC 842 241
OTHER CONSIDERATIONS
There might be current tax implications as a result of the adoption of ASC 842, such as a redetermination of state and
local income taxes due to changes in apportionment factors used to allocate income to states and local jurisdictions.
Additionally, the adoption of ASC 842 could cause an entity to re-evaluate its tax accounting method for leases.
Currently, Section 6.03 of Rev. Proc. 2019-43 provides an automatic change procedure for taxpayers to change the
classification of sale, lease or financing transactions for tax purposes.
TRANSFER PRICING
Intercompany transactions between related parties should meet the so-called ‘arms- length’ standard, which generally
requires that such transactions be priced similar to how such transactions would be priced with unrelated parties.
Typically, certain financial indicators are used to determine whether such transactions are at arms- length. Such
indicators include return on sales, return on assets and other measures. Most often, these ratios are computed on a US
GAAP basis. Due to the adoption of ASC 842, the US GAAP ratios may change, which may impact the intercompany
pricing between related parties. Companies with intercompany transactions should carefully analyze the impact the
new leasing standard may have on its US GAAP measures used to set its intercompany pricing.
ACCOUNTING FOR LEASES UNDER ASC 842 242
Chapter 8 - Presentation and Disclosures
OVERVIEW
During the project leading to the new lease standard, many users indicated that the disclosure requirements in the
legacy lease guidance did not provide them with enough information to understand an entity’s leasing activities. As a
result, ASC 842 includes enhanced disclosure requirements, including an overall disclosure objective together with
expanded disclosure requirements for leases.
Consistent with the disclosure requirements in ASC 606 on revenue from contracts with customers, the FASB did not
provide explicit materiality requirements. An entity will consider the disclosure objective, which is to enable users of
financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases, and determine the
level of details and emphasis needed on various disclosure requirements to satisfy the disclosure objective. The more
extensive the entity’s leasing activities, the more comprehensive the disclosures are expected to be.
For lessees, the FASB viewed differences in risks between leased assets and owned assets, between lease liabilities and
other financial liabilities, and economic differences between operating and finance leases. Those differences drove
some of the new presentation and disclosure requirements in ASC 842. Presentation of lease expense for operating
leases, and amortization and interest expense for finance leases in the statement of comprehensive income is generally
consistent with prior GAAP; and the presentation of cash flows arising from leases in the statement of cash flows will
be driven by the presentation of lease expense in the income statement.
Meanwhile the FASB decided to retain most aspects of the lessor accounting model in previous GAAP. Therefore,
lessors’ presentation of leases in the statement of financial position, statement of comprehensive income, and
statement of cash flows generally will not change. But many users indicated they needed more information about a
lessor’s leasing activities and associated risks, including credit risk related to lease receivables, and residual asset risk
for the unguaranteed residual assets. ASC 842 therefore includes expanded disclosures about lessors’ leasing activities.
ACCOUNTING FOR LEASES UNDER ASC 842 243
PRESENTATION
SUMMARY OF LESSEE PRESENTATION REQUIREMENTS
Lessee Presentation Requirements
Statement of
Financial
Position
Present in the statement of financial position separately from each other and from other
assets or liabilities:
•
Finance lease right-of-use assets
•
Operating lease right-of use assets
•
Finance lease liabilities
•
Operating lease liabilities
If not presented separately, disclose which line items in the statement of financial position
include the right-of-use assets and lease liabilities
If not presented separately, a lessee is precluded from presenting:
•
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
Classify right-of-use assets consistent with how other depreciating assets such as PP&E are
classified (i.e., as noncurrent based on ASC 210-10-45-4(f)); and classify lease liabilities as
current or noncurrent consistent with the way other financial liabilities are classified
Statement of
Comprehensive
Income
For finance leases, present interest expense on the lease liability and amortization of the
right-of-use asset in a manner consistent with how the entity presents other interest
expense and depreciation or amortization of similar assets, respectively
ASC 842 does not provide specific guidance on presentation of variable lease payments for
finance leases. We believe that presentation as either lease expense or interest expense
may be appropriate
For operating leases, lease expense is included in income from continuing operations
consistent with the presentation of other operating expenses, and should be classified
within cost of sales; selling, general, and administrative expense; or another expense line
item depending on the nature of the lease
Statement of
Cash Flows
For finance leases:
•
Classify repayments of the principal portion of the lease liability within financing
activities
•
Classify interest on the lease liability in accordance with requirements relating to
interest paid in ASC 230 on cash flows (typically in operating activities)
For operating leases, classify payments within operating activities, except if 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
For all leases, classify variable lease payments and short-term lease payments not included
in the lease liability within operating activities
The establishment of ROU assets and lease liabilities at lease commencement (or that
change as a result of lease modifications or reassessment events) should be disclosed as
noncash investing and financing activities in accordance with ASC 210-10-50-4
ACCOUNTING FOR LEASES UNDER ASC 842 244
LESSEE PRESENTATION REQUIREMENTS EXPLAINED
STATEMENT OF FINANCIAL POSITION
The FASB did not mandate separate presentation of lease amounts in the statement of financial position. However, the
FASB determined that providing the carrying amount of a lessee’s right-of-use assets and lease liabilities separately for
finance and operating leases, and separate from other assets and liabilities will provide users with important
information about an entity’s use of lease arrangements in its business activities and about the relationship between
the lessee’s lease liabilities and right-of-use assets. Based on its outreach activities and deliberations during the
project, the FASB noted that:
There are differences between leased assets and owned nonfinancial assets (for example, there is typically
no residual asset risk for a lease but there are risks associated with replacing the lease at the end of its term
based on market conditions),
A lease liability is a unique class of liability that is linked to a corresponding asset and has features, such as
options and variable lease payments, that may differ from other liabilities,
Right-of-use assets for operating and finance leases are measured differently after the commencement date
(see chapter 5 on
Accounting for Leases - Lessees
), and lease costs for operating and finance leases differ
in terms of recognition and presentation in the statement of comprehensive income. Therefore, separate
presentation of lease liabilities for operating and finance leases will help users understand the liability
balance to which the lease costs relate, and
Presenting assets and liabilities arising from finance and operating leases in the same line item in the
balance sheet would be misleading because of the differences in underlying economics of each lease type.
For example, finance lease liabilities are the equivalent of debt, while operating lease liabilities are not
debt-like but are operating in nature and are generally treated differently in bankruptcy.
While the FASB did not prescribe where right-of-use assets must be presented (when they are not presented
separately), paragraph BC265 of ASU 2016-02 notes that in some Board members’ view, “presenting operating lease
assets together with owned property, plant, and equipment may be inappropriate given the Board’s conclusion that
operating leases convey rights and carry risks substantially different from those of owned property, plant, and
equipment.”
STATEMENT OF COMPREHENSIVE INCOME
The FASB’s decisions on presentation of lease cost in the statement of comprehensive income are linked to the Board’s
rationale for the lessee accounting model discussed in
the chapter 5 on
Accounting for Leases - Lessees
.
The FASB noted that finance leases are economically similar to the financed acquisition of other nonfinancial
assets, and therefore a lessee should present amortization of the right-of-use asset and the interest on the
lease liability in separate line items, similar to how an entity presents depreciation or amortization of similar
assets and other interest expense.
In some Board members’ views, operating leases grant different rights to, and impose different obligations
on, the lessee such that they are not economically equivalent to other acquisitions of nonfinancial assets.
Also, for operating leases, a lessee should recognize a single lease cost based on the pattern in which the
benefits conveyed by the lease are consumed, which is generally on a straight-line basis over the lease term.
To the extent not capitalized as part of the cost of another asset, the single lease cost is included in the
lessee’s income from continuing operations, like under previous GAAP.
STATEMENT OF CASH FLOWS
The requirements for presenting cash outflows in the statement of cash flows are linked to the presentation of
expenses arising from a lease in the statement of comprehensive income and are generally consistent with prior GAAP.
ACCOUNTING FOR LEASES UNDER ASC 842 245
Example 1 - Statement of cash flow presentation - Lessees
FACTS
Ironside Co. leases heavy machinery for its operations with a lease term of 10 years. Payments start at
$100,000 in the first year and increase by 5% annually. There are no initial direct costs, lease incentives,
or prepaid lease payments.
Ironside Co. accounts for the lease as an operating lease and recognizes straight-line lease expense of
$125,779 annually
[A]
.
The rate implicit in the lease is not readily determinable and therefore Ironside Co. uses its incremental
borrowing rate, which is 6%.
ANALYSIS
Ironside Co. accounts for the lease as follows throughout the lease term, assuming no modifications,
reassessments, or impairments. See chapter 5 on
Accounting for Leases - Lessees
for additional
guidance.
Lease Liability Right-of-use Asset
Beg.
Balance
Interest
(6%)
PMT
Closing
Balance
Amort. of
Liability
Beg.
Balance
Amort.
Closing
Balance
[B]
[C]
[B] + [C]
[A] – [B]
Year 1
904,337
54,260
-100,000
858,598
(45,740)
904,337
(71,519)
832,819
Year 2
858,598
51,516
-105,000
805,114
(53,484)
832,819
(74,263)
758,556
Year 3
805,114 48,307 -110,250 743,170 (61,943) 758,556 (77,472) 681,084
Year 4
743,170
44,590
-115,763
671,998
(71,172)
681,084
(81,189)
599,895
Year 5
671,998
40,320
-121,551
590,767
(81,231)
599,895
(85,459)
514,436
Year 6
590,767
35,446
-127,628
498,585
(92,182)
514,436
(90,333)
424,103
Year 7
498,585
29,915
-134,010
394,491
(104,094)
424,103
(95,864)
328,239
Year 8
394,491 23,669 -140,710 277,450 (117,041) 328,239 (102,109) 226,130
Year 9
277,450
16,647
-147,746
146,352
(131,099)
226,130
(109,132)
116,998
Year 10
146,352
8,781
-155,133
0
(146,352)
116,998
(116,998)
0
Ironside Co. uses the above information to prepare its statement of cash flows. One acceptable
presentation is for Ironside Co. to (1) add back the amortization of the right-of-use asset as a noncash
rent expense and (2) to separately present the change in lease liability. However, other presentations
may be acceptable (for example, presentation as a single net line item consistent with presentation of
the single operating lease expense in the income statement). In this example, other line items are
omitted, and we assume Ironside Co. has only one lease.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Net income XX XX XX XX XX XX XX XX XX XX
Noncash rent
expense
71,519 74,263 77,472 81,189 85,459 90,333 95,864 102,109 109,132 116,998
Change in
lease liability
(45,740) (53,484) (61,943) (71,172) (81,231) (92,182) (104,094) (117,041) (131,099) (146,352)
Net cash from
operations
XX XX XX XX XX XX XX XX XX XX
ACCOUNTING FOR LEASES UNDER ASC 842 246
SUMMARY OF LESSOR PRESENTATION REQUIREMENTS
Lessor Presentation Requirements
Statement of
Financial
Position
Sales-type and direct financing leases
•
Present lease assets (i.e., the aggregate of the lessor’s net investment in sales-type
and direct financing leases) separately from other assets
•
Classify lease assets as current or noncurrent consistent with the way similar assets
are classified
Operating leases
•
Present the underlying asset subject to an operating lease and any lease receivable
in accordance with other topics (for example, ASC 310 on Receivables or ASC 360 on
PP&E)
Statement of
Comprehensive
Income
For all leases, present income arising from leases separately, or disclose which line items
in the statement of comprehensive income include lease income
For sales-type and direct financing leases, present profit or loss recognized at the
commencement date in a manner that best reflects the lessor’s business model, for
example:
•
Present revenue and cost of goods sold in separate line items if the lessor uses
leases as an alternative means of realizing value from goods it would otherwise sell
(e.g., manufacturers and dealers), so that income and expenses from sold and
leased items are presented consistently. Note that revenue recognized is the lesser
of (1) the fair value of the underlying asset at the commencement date and (2) the
sum of the lease receivable and any prepaid lease payments. Cost of goods sold is
the carrying amount of the underlying asset at the commencement date minus the
unguaranteed residual asset
•
Present profit or loss in a single line item if the lessor uses leases for purposes of
providing finance (e.g., financial institutions)
Statement of
Cash Flows
Classify cash receipts from leases within operating activities, regardless of lease
classification
However, lessors within the scope of ASC 942, Financial Services – Depository and Lending,
should classify principal payments received under sales-type and direct financing leases
within investing activities consistent with paragraph 942-230-45-4
Some leases, such as real estate leases, require the lessee to reimburse the lessor for costs
incurred related to property taxes, insurance, and maintenance services (e.g., common area
maintenance). As discussed in chapter 3, Identifying and Separating Components, lessor costs
such as property taxes and insurance that protects the lessor’s asset are not a component of the
contract, while maintenance services represent a nonlease component. A lessor accounts for
lessor costs paid by the lessor and reimbursed by the lessee on a gross basis, and such
reimbursements are allocated between the lease and nonlease components consistent with the
initial (or most recent) allocation of the consideration in the contract unless the variable
payments can be allocated only to the lease component. If the lessor elected the practical
expedient not to separate under ASC 842-10-15-42A, and assuming the lease component is
predominant, the tenant reimbursements should be presented within lease income (unless one
or more nonlease components do not meet the conditions to be combined). Additional
disclosures factually discussing the reimbursements may be appropriate in the notes.
ACCOUNTING FOR LEASES UNDER ASC 842 247
LESSOR PRESENTATION REQUIREMENTS EXPLAINED
STATEMENT OF FINANCIAL POSITION
The net investment in the lease is comprised of the following components: the lease receivable, the unguaranteed
residual asset and, for direct financing leases, any deferred selling profit. In considering presentation of sales-type and
direct financing leases on the balance sheet, the FASB decided against requiring a lessor to separately present the
components of the net investment in the lease. Accordingly, a lessor is required to present a single net investment in
sales-type and direct financing leases separately from other assets. However, certain disclosures of the lessor’s
investments in leases are required to provide users with information about the lessor’s exposure to credit risk (for the
lease receivable) and asset risk (relating to the unguaranteed residual asset). Refer to the disclosure section for
additional discussion. Lease assets are financial assets that are subject to current and noncurrent presentation
requirements in a classified balance sheet.
For operating leases, the assets underlying those leases and related depreciation are presented in accordance with
other accounting guidance (for example, ASC 360). Also, in accordance with ASC 842-30-50-13, assets subject to
operating leases should be presented separately from owned assets that are held and used by the lessor as they are
subject to different risks. Any rent receivable, deferred rent revenue (that results from the requirement to recognize
rents on a straight-line basis), and prepaid initial direct costs are also subject to current and noncurrent presentation
requirements.
STATEMENT OF COMPREHENSIVE INCOME
ASC 842 provides guidance on presentation in the statement of comprehensive income only for sales-type and direct
financing leases. No guidance is provided for operating leases.
For sales-type and direct financing leases, the FASB noted that lessors’ business models vary. For example, some like
banks and other financial institutions use leasing as a means to provide financing to lessees. Others like manufacturer
or dealer lessors use leasing as an alternative means of realizing value from assets they would otherwise sell (for
example, medical equipment manufacturers). Accordingly, ASC 842 permits presentation of the profit recognized at
the commencement date as either gross or net based on the lessor’s business model.
ASC 842 does not provide specific guidance on the presentation of variable lease payments received for direct financing
or sales type leases. We believe that presentation as either lease income or interest income may be appropriate.
STATEMENT OF CASH FLOWS
When ASU 2016-02 was initially issued, all lessors were required to classify all cash receipts from leases as operating
activities in the statement of cash flows, regardless of whether the lease was an operating lease, sales-type lease, or
direct financing lease. In the FASB’s view, this is because leasing is generally part of a lessor’s revenue-generating
activities.
However, the FASB received feedback from lessor stakeholders within the scope of ASC 942, Financial Services—
Depository and Lending, that they historically have presented principal payments received under leases within
investing activities based on an illustrative example in ASC 942 that was not eliminated with the issuance of ASC 842.
Following that feedback, the FASB issued ASU 2019-01, Codification Improvements in March 2019 to clarify that lessors
that are depository and lending institutions within the scope of ASC 942 should present all “principal payments
received under leases” within investing activities. See chapter 9, Adopting ASC 842
, for effective dates and transition
of ASU 2019-01.
ACCOUNTING FOR LEASES UNDER ASC 842 248
DISCLOSURE REQUIREMENTS
DISCLOSURE OBJECTIVE APPLICABLE TO LESSEES AND LESSORS
ASC 842-20-50-1 (applicable to lessees) and ASC 842-30-50-1 (applicable to lessors) provide that “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.” ASC 842-20-50-2 (applicable to lessees) and ASC 842-30-50-2 (applicable to lessors)
further indicate that “a lessee [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 lessee [lessor] shall aggregate or disaggregate
disclosures so that useful information is not obscured by either the inclusion of a large amount of insignificant detail or
by aggregating items that have different characteristics.”
With that objective in mind, judgment will be required to determine the level of disclosures necessary for an entity.
However, as a guiding principle, paragraph BC 276 in the Basis for Conclusions of ASU 2016-02 indicates that “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….” For example, although ASC 842 does not provide specific quantitative or
qualitative disaggregation requirements such as those required under ASC 606, for entities for which leasing is a
significant portion of their business, such disaggregation might be appropriate.
Therefore, an entity may consider the following steps in preparing its notes to the financial statements:
Entities must make appropriate disclosures for each annual reporting period for which a statement of comprehensive
income (statement of activities) is presented and in each year-end statement of financial position. Entities are not
required to repeat disclosures if the information is already presented in the financial statements as required by other
accounting standards.
Although the majority of the disclosures required by ASC 842 only affect an entity’s annual financial statements, the
standard requires that lessors provide a table disclosing lease income for each interim and annual reporting period.
Entities otherwise should look to ASC 270 on interim disclosure requirements as applicable for additional guidance.
Additionally, in the year of adoption, the Securities and Exchange Commission (SEC) requires public companies to
include all required annual disclosures in any interim financial statements that are prepared until the next annual
financial statements are filed – even if the disclosure requirements are only applicable for annual periods. Refer to the
next chapter, Adopting ASC 842
, for additional disclosure requirements in transition.
Unlike other recent standards, ASC 842 does not distinguish between public entities and all other entities. The
disclosure principle and related requirements apply to all entities.
Consider information relevant
to users’ understanding of the
amount, timing and uncertainty
of cash flows from leases
Consider the level of
detail necessary based on
the significance of the
entity’s leasing activities
Provide the required disclosures
about the entity’s leases in
sufficient detail in order to
meet the disclosure objective
ACCOUNTING FOR LEASES UNDER ASC 842 249
LESSEE DISCLOSURE REQUIREMENTS
Lessee Disclosure Requirements
Qualitative
Disclosures
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 above
disclosures, as applicable)
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
Information about significant assumptions and judgments made, including:
•
The determination of whether a contract contains a lease
•
The allocation of consideration in a contract between lease and nonlease
components
•
The determination of the discount rate for the lease
Quantitative
Disclosures
For each period presented, disclose amounts related to a lessee’s total lease cost (i.e.,
including amounts recognized in income and capitalized) and the cash flows arising from
lease transactions:
•
Finance lease cost, segregated between amortization of right-of use assets and
interest on lease liabilities
•
Operating lease cost
•
Short-term lease cost, excluding expenses relating to leases with a lease term of one
month or less
•
Variable lease cost
•
Sublease income, disclosed on a gross basis, separate from finance or operating lease
expense
•
Net gain or loss recognized from sale and leaseback transactions
•
Amounts segregated between those for finance and operating leases for:
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, based on the remaining lease term
and the lease liability balance for each lease as of the reporting date
Weighted-average discount rate, based on the discount rate for the lease
used to calculate the lease liability balance for each lease, and remaining
balance of lease payments for each lease, as of the reporting date
(See ASC 842-20-55-53 for an example of these disclosures)
ACCOUNTING FOR LEASES UNDER ASC 842 250
Lessee Disclosure Requirements
•
Disclose maturity analysis of undiscounted lease liabilities (commonly referred to as
the 5-year table) separately for finance leases and operating leases, with a
reconciliation of undiscounted cash flows to the finance lease liabilities and
operating lease liabilities recognized in the statement of financial position
While the FASB included an example lessee disclosure of quantitative disclosures in ASC 842-
30-55-53 (Example 6) for which the information is provided in a tabular format, the
disclosure requirements in ASC 842-20-50 do not specifically require such a format
Policy
Elections and
Practical
Expedients
Disclose policy election for short-term leases, if elected
•
If the short-term lease expense does not reasonably reflect the lessee’s short-term
lease commitments, disclose that fact and the amount of short-term lease
commitments
Disclose practical expedient for not separating lease components from non-lease
components, if elected, and which asset classes to which the election applies
Disclose accounting policy on using the risk-free discount rate for the lease, if elected,and
which class or classes of underlying assets to which the election applies
Related Party
Leases
Disclose lease transactions between related parties in accordance with paragraphs 850-10-
50-1 through 50-6
Sale and
Leaseback
Transactions
If a seller-lessee enters into a sale and leaseback transaction, it provides the disclosures
required for lessees for the leaseback
A seller-lessee must also disclose the main terms and conditions of the sale and leaseback
transaction and any gains or losses arising from the transaction separately from gains or
losses on disposal of other assets
Noncash Changes in Right-of-Use Assets to Disclose
ASC 842-20-50-4(g)(2) requires disclosure of “[s]upplemental noncash information on lease
liabilities arising from obtaining right-of-use assets.” In addition, ASC 230-10-50-3 requires
disclosure of information about all investing and financing activities of an entity during a period
that affects recognized assets or liabilities but that do not result in cash receipts or cash payments
in the period. Therefore, we believe that all material noncash changes to right-of-use assets, both
increases and decreases, should be disclosed, either on the face of the statement of cash flows or
in the related notes. The initial recognition of a right-of-use asset should therefore be included in
this disclosure, along with the following:
- Any lease modification that grants an additional right-of-use asset or removes a right-of-use
asset,
- Any other remeasurement that results in increases or decreases (debits or credits) to the
right-of-use asset, such as changes in the assessment of the lease term.
See chapter 5, Accounting for Leases – Lessees, for additional information on modifications and
remeasurement events.
ACCOUNTING FOR LEASES UNDER ASC 842 251
Example 2 - Lessee disclosure example
For purposes of this example, we have assumed that Susie’s Stitch-n-Sew (“Susie’s”) is a national retailer of fabrics
and other craft materials which primarily leases its retail locations. We have not presented a statement of financial
position, but have assumed that Susie’s has presented the following captions:
Operating lease ROU assets
Fixed assets, net
Current portion of operating lease liabilities
Long-term operating lease liabilities
Current portion of long-term debt
Long-term debt
We have also not presented a statement of comprehensive income but have assumed that Susie’s has presented Cost
of sales, SG&A expense, Depreciation and amortization expense, and Interest expense.
This example assumes that the guidance in ASC 842 has been in effect for all periods presented, and that all amounts
are in millions.
Note X. Leases
Susie’s has historically entered into a number of lease arrangements under which we are the lessee. Specifically, of
our 250 retail locations, 240 are subject to operating leases and 5 are subject to finance leases. In addition, we
lease our corporate headquarters facility, as well as various warehouses and regional offices. We are also a party to
an additional 12 leases in which we previously operated a retail location, but which are now subleased to third
parties. In addition, we have elected the short-term lease practical expedient related to leases of various
equipment used in our retail locations.
As of December 31, 20X9, we have entered into eight leases for additional retail locations and one lease for an
additional warehouse which have not yet commenced. Although certain of the retail locations are currently under
construction, we do not control the building during construction, and are thus not deemed to be the owner during
construction.
All of our retail leases include multiple optional renewal periods. Upon opening a new retail location, we typically
install brand-specific leasehold improvements with a useful life of approximately eight years. To the extent that the
initial term of the related lease is less than the useful life of the leasehold improvements, we conclude that it is
reasonably certain that a renewal option will be exercised, and thus that renewal period is included in the lease
term, and the related payments are reflected in the ROU asset and lease liability. Generally, we do not consider
any additional renewal periods to be reasonably certain of being exercised, as comparable locations could generally
be identified within the same trade areas for comparable lease rates.
All of our leases include fixed rental payments, but many of our leases also include variable rental payments.
Specifically, a number of our leases in certain markets require rent payments that are calculated as a percentage of
sales in that location. In addition, we also commonly enter into leases under which the lease payments increase at
pre-determined dates based on the change in the consumer price index. While the majority of our leases are gross
leases, we also have a number of leases in which we make separate payments to the lessor based on the lessor’s
property and casualty insurance costs and the property taxes assessed on the property, as well as a portion of the
common area maintenance associated with the property. We have elected the practical expedient not to separate
lease and nonlease components for all of our building leases.
ACCOUNTING FOR LEASES UNDER ASC 842 252
During 20X9, 20X8 and 20X7, we recognized rent expense associated with our leases as follows:
20x9
20x8
20x7
Operating lease cost:
Fixed rent expense
$23.7
$22.6
$20.5
Variable rent expense
3.8
3.6
3.4
Finance lease cost:
Amortization of ROU assets
2.5
2.4
2.2
Interest expense
2.0
2.1
2.0
Short-term lease cost
0.2
0.2
0.3
Sublease income
(1.3)
(1.1)
(1.2)
Net lease cost
$30.9
$29.8
$27.2
Lease cost – Cost of sales
$4.2
$4.0
$4.1
Lease cost – SG&A
22.2
21.3
18.9
Lease cost – Depreciation and amortization
2.5
2.4
2.2
Lease cost – Interest expense
2.0
2.1
2.0
Net lease cost
$30.9
$29.8
$27.2
Amounts recognized as right-of-use assets related to finance leases are included in fixed assets, net in the
accompanying statement of financial position, while related lease liabilities are included in Current portion of long-
term debt and Long-term debt. As of December 31, 20x9 and 20x8, right-of-use assets and lease liabilities related to
finance leases were as follows:
20x9
20x8
Finance lease ROU assets
$17.6
$17.0
Finance lease liabilities:
Current portion of long-term debt
2.2
2.2
Long-term debt
15.3
15.1
ACCOUNTING FOR LEASES UNDER ASC 842 253
During the years ended December 31, 20x9, 20x8 and 20x7, we had the following cash and non-cash activities
associated with our leases:
20x9
20x8
20x7
Cash paid for amounts included in the
measurement of lease liabilities:
Operating cash flows from operating leases
$26.0
$25.7
$24.8
Operating cash flows from finance leases
2.0
2.1
2.0
Financing cash flows from finance leases
2.0
1.9
1.9
Non-cash investing and financing activities:
Additions to ROU assets obtained from:
New operating lease liabilities
$18.7
$20.3
$16.2
New finance lease liabilities
-
3.4
-
The future payments due under operating and finance leases as of December 31, 20x9 is as follows:
Operating
Finance
Due in 20x0 $ 22.6 $ 2.2
20x1 23.9 3.8
20x2
24.7
3.6
20x3 25.3 3.6
20X4 24.0 3.6
All years thereafter 8.3 2.1
128.8 18.9
Less effects of discounting (35.9) (3.6)
Lease liabilities recognized
$ 92.9
$ 15.3
As of December 31, 20x9 and 20x8, the weighted-average remaining lease term for our operating leases is 4.8 years
and 4.9 years, respectively, while the weighted-average remaining lease term for our finance leases is 5.3 years and
5.6 years, respectively.
Because we generally do not have access to the rate implicit in the lease, we utilize our incremental borrowing rate
as the discount rate. The weighted average discount rate associated with operating leases as of December 31, 20x9
and 20x8 is 4.2% and 4.0%, respectively, while the weighted-average discount rate associated with finance leases is
3.9% and 3.8%, respectively.
The incremental borrowing rate is the rate of interest that we 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. In determining that
rate, the Company considers prevailing economic conditions at the commencement date and factors such as
company-specific credit risk, term of the lease and options, and the effect of collateralization based on the nature
and quality of the underlying asset.
ACCOUNTING FOR LEASES UNDER ASC 842 254
LESSOR DISCLOSURE REQUIREMENTS
Considering the disclosure objective previously discussed, and to help entities achieve that objective, ASC 842 requires
that a lessor disclose quantitative and qualitative information about:
Its leases,
The significant judgments made in applying ASC 842, and
The amounts recognized in the financial statements for those leases.
The following table summarizes those disclosure requirements:
Lessor Disclosure Requirements
Qualitative
Disclosures
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
Information about significant assumptions and judgments made, including:
•
The determination of whether a contract contains a lease
•
The allocation of consideration in a contract between lease and nonlease
components (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 determination of the amount the lessor expects to derive from the underlying
asset following the end of the lease term
Information about how the lessor manages its risk associated with the residual value of its
leased assets
•
Risk management strategy for residual assets
•
Carrying amount of residual assets covered by residual value guarantees
•
Any other means by which the lessor reduces its residual asset risk, for example
buyback agreements and variable lease payments for use in excess of specified limits
Quantitative
Disclosures
For each annual
and interim
reporting
period, disclose
in a tabular format
:
•
Sales-type leases and direct financing leases:
Profit or loss recognized at the commencement date (disclosed on a gross or
net basis as discussed in the Presentation section above)
Interest income (either in aggregate or separated by components of the net
investment in the lease)
•
Operating leases: Lease income relating to lease payments
•
Lease income relating to variable lease payments not included in the measurement of
the lease receivable
Disclose the components of the lessor’s aggregate net investment in sales-type and direct
financing leases (that is, the carrying amount of lease receivables, unguaranteed residual
assets, and any deferred selling profit on direct financing leases)
Sales-Type and Direct Financing Leases
•
Explain significant changes in the balance of unguaranteed residual assets and
deferred selling profit on direct financing leases
ACCOUNTING FOR LEASES UNDER ASC 842 255
Lessor Disclosure Requirements
•
Disclose maturity analysis (commonly referred to as the 5-year table) of undiscounted
lease receivables, with a reconciliation of undiscounted cash flows to lease
receivables
Operating Leases
•
Disclose maturity analysis (commonly referred to as the 5-year table) of undiscounted
lease payments to be received. The maturity analysis for operating leases must be
presented separately from the maturity analysis for sales-type and direct financing
leases
•
Provide disclosures required by ASC 360 on property, plant, and equipment
separately for underlying assets under operating leases from owned assets
Policy
Elections and
Practical
Expedients
An entity that elects the practical expedient to not separate nonlease components from
associated lease components (including an entity that accounts for the combined component
entirely in ASC 606 on revenue from contracts with customers) should disclose the following
by class of underlying asset:
•
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 uses to account for the combined component (ASC 842 or ASC
606)
A lessor that elects 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 the lessee shall disclose its
election and comply with the disclosure requirements in ASC 235-10-50-1 through 50-6
Related Party
Leases
Disclose any lease transactions between related parties in accordance with ASC 850 on
related party disclosures
Sale and
Leaseback
Transactions
The buyer-lessor provides the disclosures applicable to lessors for the leaseback
Leveraged
Leases
Although ASC 842 removed leveraged lease accounting, leases that met the definition of a
leveraged lease under ASC 840 that commenced before ASC 842’s effective date are
grandfathered in. As such, entities that continue to have leveraged leases must continue to
provide disclosures as required by ASC 842-50, which carries forward existing guidance from
ASC 840.
ACCOUNTING FOR LEASES UNDER ASC 842 256
Chapter 9 - Adopting ASC 842
OVERVIEW
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), to increase transparency and comparability among
entities by requiring:
Lessees to recognize leases on balance sheet, and
Lessees and lessors to provide more information about their leasing arrangements so that users can better
assess the amount, timing, and uncertainty of cash flows from leases.
Under its core principle, a lessee recognizes a right-of-use asset and a lease liability on the balance sheet for most
leases. The pattern of expense recognition in the income statement depends on a lease’s classification. Lessor
accounting remains largely consistent with previous U.S. GAAP but was updated for consistency with the new lessee
accounting model and with ASC 606 on revenue from contracts with customers.
ASC 842 was effective for public business entities and certain other entities for fiscal years beginning after December
15, 2018 (January 1, 2019 for calendar year-end public companies), and for interim periods within those fiscal years.
For other entities, ASC 842 is now effective for fiscal years beginning after December 15, 2021 and interim periods
beginning the following year considering deferrals in effective date the FASB provided to those entities. Early adoption
is permitted for all entities.
ASC 842 provides for two transition methods, to which we refer in this chapter as the modified retrospective approach
and the transition alternative. These methods are discussed in detail throughout this chapter. Regardless of the
transition method elected, ASC 842 initially applies to all existing leases. Generally, one key objective the FASB had in
mind when developing the transition provisions was to allow entities to “run-off” the accounting for their existing
leases, with the exception for lessees to recognize their existing operating leases on balance sheet. The run-off
approach means that, for example, the initial measurement of existing operating leases by lessees is based on the
minimum rental payments, as the entity applied it under ASC 840, and for an existing capital lease that is classified as
a finance lease under ASC 842, the initial amount reported under ASC 842 is the carrying amount of the capital lease
asset and obligation under ASC 840. This also means that, when leases are initially reported using ASC 840 data
(minimum rental payments) or carrying amounts, the entity will not reallocate the consideration in the contract if the
contract includes nonlease elements (components). However, this run-off approach ceases, and the lease is accounted
for under ASC 842, if the lease is modified on or after ASC 842’s effective date and that modification is not accounted
for as a separate contract and, for a lessee, if it is required to remeasure the lease payments and the lease liability.
At first, transition to the new leasing standard may seem relatively straight-forward. However, applying the transition
requirements can be complex with important nuances that should be considered. After issuing ASU 2016-02, the FASB
also issued several additional ASUs that affect certain aspects of transition. Both the FASB and SEC staffs have also on a
ACCOUNTING FOR LEASES UNDER ASC 842 257
number of occasions provided interpretive views about specific aspects of the new standard. Accordingly, having a
clear understanding of the transition provisions as amended, and as interpreted, will be key to successfully adopt ASC
842.
This chapter summarizes the transition requirements of the new standard. It includes insights into certain aspects of
the transition requirements and practical examples to assist entities in their implementation of ASC 842. As the icon at
the beginning of this chapter suggests, implementing ASC 842 typically will require cross-functional teamwork.
As entities ready themselves to adopt ASC 842 and obtain an understanding of the transition requirements, they should
consider the new processes (or updates to existing processes) and controls they need for a robust adoption,
implementation, and ongoing application of the new standard. Entities should consider the following as they adopt ASC
842:
Determine System Needs
Many entities that adopted ASC 842 found that they needed to implement software solutions. Unless an
entity has a very low number of leases, a software solution may result in a more efficient application
of ASC 842 considering its requirements, from initial recognition through ongoing accounting and
reporting, including remeasurement of leases on balance sheet for specific events, and the number of
disclosures to provide.
Know the Lease Population
One of the key challenges in adopting the new standard is ensuring that the lease population is
complete, including leases for which payments are fully variable and embedded leases. There are usual
suspects, of course, like real estate lease contracts, which are relatively easy to identify and generally
are already tracked. But an entity's contracts are not always labeled as "leases." Leases may be
embedded in other contracts such as service contracts, IT contracts, and transportation contracts, to
name just a few.
If a contract includes the right to use an asset (i.e., a lease), it should be tracked and accounted for as
part of adopting ASC 842. This is true even if one elects the package of practical expedients, which
includes the ability to not reassess existing contracts. Historically, entities may not have thoroughly
assessed service contracts for the existence of embedded leases, given the similarities between
operating lease accounting and service expense accounting. However, that assessment was technically
required under ASC 840, and the package of practical expedients does not grandfather errors.
This completeness assessment will be a critical and potentially time-consuming step. This also typically
won't be an accounting department exercise only — it may involve people from various departments
across the entity, including procurement, treasury, IT, and legal, and potentially from foreign
locations.
Assess Efforts Related to Lease Data Input
Another time-consuming step in the implementation process involves gathering the lease data so that
lease assets and liabilities are accurately calculated and reported in the financial statements after
adoption. As previously noted, many entities have found that they need a software solution in order to
manage compliance with the new lease standard. Use of manual processes such as calculating right-of-
use asset and lease liability values on Excel spreadsheets may be less efficient.
Regardless of the method chosen, an entity will need to plan for sufficient time to input the data into
the relevant system or program for each lease so that each is accurately reported and disclosed.
ACCOUNTING FOR LEASES UNDER ASC 842 258
EFFECTIVE DATES
For calendar-year public business entities (PBEs), certain not-for-profit organizations (NFPs) and certain employee
benefit plans (EBPs), ASC 842 took effect in 2019 and interim periods within that year. For other calendar-year
entities, ASC 842 was initially required to take effect in 2020, and interim periods in 2021. However, in November
2019, the FASB issued ASU 2019-10 which initially deferred the effective date of ASC 842 by one year. Also, because of
the disruption caused by the Coronavirus Disease 2019 (COVID-19), including resource constraints, dislocation, and
other priorities that entities faced with the COVID-19 pandemic, the FASB decided to further defer the effective date
of ASC 842 by another year for private companies and certain NFPs.
The following table summarizes the final effective dates of ASC 842:
Effective Dates
Public business entities, NFPs
that have issued or are conduit
bond obligors for securities
traded, listed or quoted on an
exchange or over-the-counter
market, and EBPs that file or
furnish financial statements
with or to the U.S. Securities
and Exchange Commission (SEC)
Except for NFPs discussed below: Fiscal years beginning after December 15,
2018 and interim periods within those fiscal years.
NFPs that have not yet issued financial statements or made financial
statements available for issuance as of June 3, 2020: Fiscal years beginning
after December 15, 2019 and interim periods within those fiscal years.
Early application is permitted.
All other entities Fiscal years beginning after December 15, 2021 and interim periods within
fiscal years beginning after December 15, 2022.
Early application is permitted.
At the December 2019 AICPA National Conference on Current SEC and PCAOB Developments, the
SEC staff announced that it would not object to a public business entity that otherwise would not
meet the definition of a public business entity except for a requirement to include or the inclusion
of its financial statements or financial information in another entity’s filing with the SEC adopting
ASC 842 for fiscal years beginning after December 15, 2020, and interim periods within fiscal years
beginning after December 15, 2021. Those dates were consistent with the effective dates for ASC
842 as amended in ASU 2019-10. Refer to paragraph 842-10-S65-1.
Also, the CAQ SEC Regulations Committee published its July 2020 highlights which noted “Given
that the FASB has deferred the effective dates of certain accounting standards in light of COVID-
19, the SEC staff will extend its prior relief related to the adoptions of ASC 842 and ASC 606 to
entities that meet the definition of a PBE only because their financial statements or financial
information is included in other entities’ filings with the SEC to satisfy the requirements of Rules
3-05, 3-09 or 4-08(g) of Regulation S-X.”
With the new effective dates, a calendar year-end private company is required to adopt ASC 842
on January 1, 2022 for its annual financial statements. While the 2022 annual financial statements
may not be issued until sometime in 2023, that calendar-year-end private company is required to
recognize its operating leases on the balance sheet on January 1, 2022 and from that date to apply
ASC 842 and other GAAP requirements to its existing leases and new leases. Private companies
should therefore consider those requirements in their implementation plan.
ACCOUNTING FOR LEASES UNDER ASC 842 259
EFFECTIVE DATES OF ADDITIONAL ACCOUNTING STANDARDS UPDATES
As part of its monitoring of ASC 842 implementation by companies, the FASB made a number of amendments to ASC
842 to address stakeholder concerns. The following table summarizes those ASUs and their effective dates, as further
amended by FASB’s deferral of effective dates in ASU 2020-05. Note that early application generally is also permitted.
ASU Key Amendments
Effective Dates for
PBEs, Certain NFPs/EBPs
Effective Dates for All
Other Entities
2018-01
Land easement practical expedient for
transition
Fiscal years (FYs)
and interim periods
beginning after
12/15/2018.
NFPs that have not
yet issued financial
statements or made
financial statements
available for
issuance as of
6/3/2020: FYs and
interim periods
beginning after
12/15/2019.
Fiscal years (FYs)
beginning after
12/15/2021 and
interim periods
beginning after
12/15/2022.
2018-10
Various codification improvements
2018-11
7
Lessor practical expedient to not separate
nonlease components in a lease contract
Alternative transition method
2018-20
8
Lessor accounting policy for sales taxes and
other similar taxes
Lessor costs paid by lessees directly to
third parties
Lessor recognition of variable payments in
lease contracts with nonlease components
2019-01
Determining fair value of the underlying
asset by lessors that are not manufacturers
or dealers
Presentation by lessor on statement of cash
flows for certain leases
FYs and interim
periods beginning
after 12/15/2019.
FYs beginning
after 12/15/2021
and interim
periods after
12/15/2022.
2020-04
Optional expedient for modifications of
lease contracts that reference LIBOR
Effective for all entities as of 3/12/2020
through 12/31/2022.
2021-05
9
Accounting by lessors for certain leases
with variable lease payments
FYs and interim periods beginning after
12/15/2021.
FYs beginning after 12/15/2021 and interim
periods after 12/15/2022.
2021-09
10
Discount rate for lessees that are not
public business entities
7
Effective dates presented are for entities that did not adopt ASC 842 by the issuance date of ASU 2018-11. For entities that had
adopted ASC 842, refer to paragraph 842-10-65-2 for additional effective date and transition guidance.
8
Effective dates presented are for entities that did not adopt ASC 842 by the issuance date of ASU 2018-20. For entities that had
adopted ASC 842, refer to paragraph 842-10-65-3 for additional effective date and transition guidance.
9
For entities that had adopted ASC 842 by the issuance date of this ASU, refer to paragraph 842-10-65-5 for additional effective
date and transition guidance.
10
NFPs (including a conduit bond obligor) and EBPs are not public business entities (according to the definition in the Master
Glossary) and, therefore, are permitted to make the risk-free rate election. Also, for entities that adopted ASC 842 before issuance
date of this ASU, refer to paragraph 842-10-65-6 for additional effective date and transition guidance.
ACCOUNTING FOR LEASES UNDER ASC 842 260
TRANSITION METHODS
MODIFIED RETROSPECTIVE APPROACH
ASU 2016-02 initially included a single transition method with which to adopt ASC 842, which we refer to in this
chapter as the modified retrospective approach. Under that transition method, an entity applies ASC 842
retrospectively to each prior reporting period, subject to specific practical expedients and transition requirements.
An entity that is a lessee must recognize operating leases on balance sheet at the later of:
The beginning of the earliest comparative period presented in the financial statements, and
The commencement date of the lease.
The later of the two dates above represents the “application date” under this transition method; that is, the date at
which the ASC 842 transition requirements are applied to the lease.
The recognition requirement applies to all existing operating leases, including leases that expired before the effective
date (adoption date) but subsequent to the application date. However, if a lessee elects the accounting policy related
to short-term leases for an asset class, the lessee does not apply the approach discussed in this chapter to those short-
term leases. A short-term lease is 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. See
Accounting for Leases - Lessees
for additional guidance on short-term leases. Note that under this transition a lessee
should determine whether a lease qualifies as a short-term lease based on the lease term at lease commencement
rather than based on the remaining term at the application date. Also, any lease that commences after ASC 842’s
effective date is accounted for under ASC 842.
The effect of adopting ASC 842, if any, is recognized as a cumulative effect adjustment to retained earnings at the
beginning of the earliest comparative period presented.
An entity (lessee or lessor) must also provide the new and enhanced disclosures under ASC 842 in all periods presented,
including the prior periods. See chapter 8, Presentation and Disclosures
, for additional guidance.
TRANSITION ALTERNATIVE
In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842) – Targeted Improvements, which provides entities with
an additional (and optional) transition method with which to adopt ASC 842, which we refer to in this chapter as the
transition alternative. Under this transition method, an entity initially applies ASC 842 to all leases existing at the
effective date (adoption date) and recognizes a cumulative effect adjustment to the opening balance of retained
earnings, if any, as of that date. The adoption date therefore represents the “application date” under this transition
method.
As discussed above, if a lessee elects the accounting policy related to short-term leases for an asset class, the lessee
does not apply the approach discussed in this chapter to those short-term leases. Note that under this transition
alternative, a lessee should determine whether a lease qualifies as a short-term lease based on the lease term at lease
commencement rather than based on the remaining term at the adoption date. Also, any lease that commences after
ASC 842’s effective date is accounted for under ASC 842.
The comparative periods presented in the financial statements remain under the legacy leases guidance (ASC 840). If
an entity elects this transition alternative, it is required to provide the ASC 840 disclosures for all prior periods
presented that remain under the legacy leases guidance. This transition requirement does not change the existing
disclosure requirements in ASC 840 (for example, it does not create interim disclosure requirements that entities
previously were not required to provide).
The FASB provided this additional transition method to reduce costs and complexity for preparers in implementing ASC
842. Given the significant cost relief provided by this transition alternative, we expect many entities will adopt ASC
842 using that transition method rather than the modified retrospective approach.
ACCOUNTING FOR LEASES UNDER ASC 842 261
WHAT’S DIFFERENT BETWEEN THE TWO TRANSITION METHODS?
To illustrate the main differences between the two transition methods, assume a calendar year-end public business
entity that adopted ASC 842 on January 1, 2019 and that presents three years of income statements (current period
and two comparative periods). In that situation, the beginning of the earliest comparative period presented for that
entity is January 1, 2017, and its adoption date is January 1, 2019. For that entity, the main differences between the
two transition methods are summarized in the following table:
Modified Retrospective Approach Transition Alternative
Application
Date
The later of (1) January 1, 2017 and (2) lease
commencement date. For example:
For a lease that commenced before
January 1, 2017, the application date for
that lease is January 1, 2017. Therefore, the
entity applies the ASC 842 transition
requirements to that lease on January 1,
2017.
For a lease that commenced after
January 1, 2017 such as June 15, 2017, the
application date is its lease commencement
date of June 15, 2017.
January 1, 2019 for all existing leases.
Therefore, the entity applies the ASC 842
transition requirements to all of its existing
leases on January 1, 2019.
Recognition Recognize all existing leases at the application
date (the “later of date” above).
Record a cumulative effect adjustment to
retained earnings, if any, as of January 1, 2017
and adjust the income statement for prior
periods as necessary (e.g., write off costs
incurred after January 1, 2017 that do not meet
the definition of initial direct costs under ASC
842, if applicable – see package of practical
expedients discussion below).
Recognize all existing leases as of January 1,
2019.
Record a cumulative effect adjustment to
retained earnings, if any, as of January 1, 2019
for any effects of adoption (e.g., write off of
unamortized initial direct costs under ASC 840
that do not meet the definition of initial direct
costs under ASC 842, if applicable – see
package of practical expedients discussion
below).
Discount Rate
for Operating
Leases
(Lessees)
Determined at the application date (i.e., the
“later of date” discussed above).
Determined as of January 1, 2019 for all
existing operating leases.
Operating
Leases
Denominated
in a Foreign
Currency
(Lessees)
Apply ASC 830 for leases denominated in a
foreign currency. This means that foreign
currency exchange rates should be tracked, and
transaction gains and losses recognized, during
the comparative periods for those operating
leases now recognized on balance sheet.
Comparative periods are not affected since
they remain under ASC 840 (i.e., operating
leases are not recognized on balance sheet).
Starting on January 1, 2019 (when all existing
operating leases are recognized on balance
sheet), apply ASC 830.
Disclosures Provide all ASC 842 disclosures for the current
and all comparative periods.
Provide ASC 842 disclosures for the current
period and provide ASC 840 disclosures for the
comparative periods.
ACCOUNTING FOR LEASES UNDER ASC 842 262
WHAT STAYS THE SAME BETWEEN THE TWO TRANSITION METHODS?
As illustrated in the table above, the transition alternative generally changes when an entity initially applies ASC 842
(e.g., when a lessee recognizes operating leases on balance sheet) but it does not change how an entity initially
applies it. For example, the guidance about how an entity initially measures existing operating leases is the same
regardless of whether the modified transition approach or the transition alternative is elected.
Example 1 - Transition Approach and Application Date
FACTS
Susie’s Stitch-n-Sew (Susie’s) entered into a five-year noncancelable arrangement on 1/1/2018 with a mall
operator that meets the definition of a lease under ASC 840.
Susie’s classified the lease as an operating lease.
Assume 1/1/2018 is both the inception date and commencement date of the lease.
On 1/1/2019, Susie’s adopts ASC 842. Susie’s initial application of ASC 842 depends on the transition
method it elects.
SCENARIO 1: Susie’s adopts ASC 842 using the transition alternative
Susie’s recognizes the above operating lease (along with any other existing operating leases) on balance
sheet on 1/1/2019 (adoption date), which is Susie’s application date under the transition alternative.
The prior period balance sheet (i.e., for the year ended 12/31/2018) remains under ASC 840 which means it
does not include recognition of an ROU asset or lease liability for the above lease.
Susie’s is required to provide the ASC 840 disclosures for all prior periods still under ASC 840, which
includes the 2018 balance sheet. Therefore, Susie’s provides all disclosures required under ASC 840,
including the disclosure about future minimum rental payments required as of 12/31/2018 in accordance
with paragraph 840-20-50-2. This information will enable users to compare both balance sheets, for
example, through constructive capitalization of the 2018 balance sheet using the footnote disclosure of
future minimum rental payments remaining at 12/31/2018.
Susie’s should also provide the ASC 842 disclosures for the period of adoption (i.e., for 2019).
SCENARIO 2: Susie’s adopts ASC 842 using the modified retrospective approach
Susie’s recognizes the above operating lease (along with any other existing leases) at the application date,
which for this operating lease is 1/1/2018 (i.e., the later of 1/1/2017 if Susie’s presented three periods of
income statement, and the lease commencement date of 1/1/2018).
Susie’s should provide the ASC 842 disclosures for all periods presented, including the comparative periods.
ACCOUNTING FOR LEASES UNDER ASC 842 263
TRANSITION DISCLOSURES
An entity provides transition disclosures required by ASC 250 on accounting changes and error corrections, except for:
The requirements in paragraph 250-10-50-1(b)(2) on the effect of the change on income from continuing
operations, net income (or other appropriate captions), any other affected financial statement line item, and
any affected per-share amounts for the current period and any prior periods retrospectively adjusted, and
The requirements in paragraph 250-10-50-3 for the effects discussed above on financial information reported
for interim periods.
An entity that elects the transition alternative should 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.
Also, as discussed later in this chapter if an entity elects one or more practical expedients, it should disclose that fact.
PUBLIC COMPANY DISCLOSURE CONSIDERATIONS
SAB 74 DISCLOSURES. In periods prior to ASC 842’s adoption, registrants are required to make disclosures under the
SEC’s Staff Accounting Bulletin No. 74 (codified in SAB Topic 11.M), Disclosure Of The Impact That Recently Issued
Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period
(“SAB 74”). SAB 74 requires that when a recently issued accounting standard has not yet been adopted, a registrant
disclose the potential effects of the future adoption in its interim and annual SEC filings. SAB 74 disclosures should be
both qualitative and quantitative. According to Center for Audit Quality (CAQ) Alert 2017-03,
SAB Topic 11.M – A
Focus on Disclosures for New Accounting Standards, the SEC staff expects that SAB 74 disclosures will become more
robust and quantitative as the new accounting standard’s effective date approaches. As such, the following types of
SAB 74 disclosures are expected in a registrant’s financial statements in the periods before new accounting standards
are effective:
A comparison of accounting policies
. Registrants should compare their current accounting policies to the
expected accounting policies under the new accounting standard(s).
Status of implementation
. The status of the process should be disclosed, including significant
implementation matters not yet addressed or if the process is lagging.
Consideration of the effect of new footnote disclosure requirements in addition to the effect on the balance
sheet and income statement.
A new accounting standard may not be expected to materially affect the
primary financial statements; however, it may require new significant disclosures that require significant
judgments.
Disclosure of the quantitative impact of the new accounting standard if it can be reasonably estimated, or
disclosure that the expected financial statement impact of the new accounting standard cannot be
reasonably estimated.
Qualitative disclosures
. When the expected financial statement impact is not yet known by a registrant, a
qualitative description of the effect of the new accounting standard on the registrant’s accounting policies
should be disclosed.
SELECTED FINANCIAL DATA – 5 YEAR TABLE. Some SEC registrants questioned whether they must recast all periods
reflected in the 5-year “Summary of Selected Financial Data” to be in accordance with ASC 842. However, registrants
are only required to adjust the periods in the financial data table that correspond to the periods adjusted in the
registrant’s financial statements. For example, for an entity that adopted ASC 842 as of the effective date (i.e.,
without restating prior comparative periods), the four prior years in the selected financial data table would not be
adjusted. However, registrants are required to provide the disclosures required by Instruction 2 to S-K Item 301
regarding comparability of the data presented.
ACCOUNTING FOR LEASES UNDER ASC 842 264
TRANSITION PRACTICAL EXPEDIENTS
The FASB provided several transition practical expedients to reduce an entity’s cost of adopting ASC 842. The package
of practical expedients and the practical expedient to use hindsight were provided in ASU 2016-02. Another practical
expedient was added subsequently to address specific concerns raised by certain stakeholders relating to diversity in
practice that existed in the accounting for land easements and the costs associated with implementing ASC 842 to
those arrangements.
PACKAGE OF PRACTICAL EXPEDIENTS
ASC 842 provides three practical expedients that, if elected must be applied as a package consistently to all of an
entity’s leases (as a lessee and as a lessor) that commenced before the effective date.
Considering the significant benefits associated with the package of practical expedients, we expect that most entities
will elect it. Nonetheless, there are important considerations which we will discuss separately for each practical
expedient included in this package.
NOT REASSESSING EXPIRED OR EXISTING CONTRACTS
ASC 842 is generally consistent with prior guidance and limits its application to leases of property, plant or equipment.
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.”
A contract is or contains a lease under ASC 842 when:
While the definitions of a lease under ASC 840 and ASC 842 are similar, there are nuances that could result in a
different conclusion. For example, under ASC 840 a customer could have the right to control the use of an asset solely
based on obtaining substantially all the output from that asset, assuming the contract is priced in a certain way (e.g.,
some power purchase agreements). However, those same arrangements may not be leases under ASC 842 if the
customer does not direct the use of the underlying asset (i.e., power criterion). See chapter 2, Identifying a Lease
, for
additional guidance.
However, if an entity elects the package of practical expedients, it does not reevaluate its existing contracts under
ASC 842. Instead, the entity carries forward its previous conclusions reached under ASC 840 when adopting ASC 842.
For example, if an entity evaluated a contract under ASC 840 and correctly determined that the contract contained a
lease, the entity carries forward that conclusion when applying the transition requirements of ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 265
Errors and Omissions of Assessment under ASC 840 Not Grandfathered
The FASB provided this practical expedient because the Board expected that most leases under ASC 840 would be
leases under ASC 842 and therefore the costs of applying the new definition of a lease to all existing contracts
generally would exceed the related benefits. However, electing the package of practical expedients does not
grandfather errors or omissions of assessment. For example, if the entity did not previously evaluate a contract
under ASC 840 (e.g., a potential embedded lease in a service contract) and that contract would meet the
definition of a lease, or if it evaluated a contract but reached an incorrect accounting conclusion, those errors are
not grandfathered by the election of the package of practical expedients. In those situations, if the entity still
plans on electing the package of practical expedients, it must evaluate those contracts under ASC 840 (i.e., not
under ASC 842) to be able to benefit from the package of practical expedients.
NOT REASSESSING LEASE CLASSIFICATION
Based on the lease classification guidance in ASC 842 (as amended by ASU 2021-05):
When none of the above criteria are met, a lessee classifies the lease as an operating lease, and a lessor classifies the
lease as either an operating lease or a direct financing lease based on additional requirements. See chapter 4,
Lease
Classification and Key Terms, for additional guidance. The following applies in transition depending on whether the
entity elects the package of practical expedients:
Entity Elects Package Entity Does Not Elect Package
The entity does not reassess classification of its
expired or existing leases under ASC 842 but carries
forward its previous conclusions reached under ASC 840
when adopting ASC 842. For example, if an entity
determined that a lease was classified as an operating
lease under ASC 840, the entity carries forward that
classification when applying the transition
requirements of ASC 842.
The entity must reassess lease classification under ASC
842 at the later of the commencement date of the lease
or the most recent lease modification that required the
entity to reassess lease classification. If the
classification changes, there are specific recognition and
measurement requirements that generally result in the
entity revaluing the lease.
Lease Classification Not Expected to Change Significantly
The FASB provided this practical expedient as it concluded that the costs of applying the new lease classification
tests to all existing leases generally would exceed the related benefits (for example, the Board expected that most
operating leases under ASC 840 would also be classified as operating leases under ASC 842). However, there are
situations in which lease classification could change between ASC 840 and ASC 842 (for example, there is no longer
prescriptive lease classification guidance for real estate under ASC 842), and entities impacted may want to
consider the information ultimately provided to their users in determining whether to elect the package of
practical expedients or not.
ACCOUNTING FOR LEASES UNDER ASC 842 266
NOT REASSESSING INITIAL DIRECT COSTS
Under ASC 842, initial direct costs are defined as the incremental costs of a lease that would not have been incurred if
the lease had not been obtained. This means that lease commissions and payments made to an existing tenant to
incentivize that tenant to terminate its lease meet the definition of initial direct costs under ASC 842. But other costs,
such as costs to negotiate or arrange the lease that would have been incurred regardless of whether the lease was
obtained are not initial direct costs. Examples of such costs include fixed employee salaries, general overheads, costs
incurred by the lessor to solicit potential lessees through advertising, and other costs related to activities that occur
before a lease is obtained (such as costs to negotiate the lease, to obtain legal or tax advice, or to evaluate a potential
lessee’s financial condition). This is because the potential lessee could have walked away at the last minute and these
costs would still be due to attorneys, employees, etc. See chapter 4, Lease Classification and Key Terms
for
additional guidance.
The following applies in transition depending on whether the entity elects the package of practical expedients:
Entity Elects Package Entity Does Not Elect Package
The entity does not reassess capitalized initial direct
costs of existing leases under ASC 842. Instead, the
entity includes existing unamortized initial direct costs
under ASC 840 in the initial measurement of the lease.
For example, assume an entity (lessee) deferred initial
direct costs related to an operating lease under ASC
840, and the unamortized balance of such initial direct
costs is $5,000 at the application date. If the entity
elects the package of practical expedients, the entity
includes that $5,000 balance in the initial measurement
of the right-of-use asset for that operating lease.
The entity should reassess all existing capitalized initial
direct costs under ASC 842.
The entity should write off those that do not meet the
definition of initial direct costs under ASC 842 as an
adjustment to retained earnings, unless the entity
elects the modified retrospective approach and the
costs were incurred after the beginning of the earliest
period presented, in which case those costs should be
written off as an adjustment to earnings in the period in
which they are incurred.
Definition of Initial Direct Costs Narrower Under ASC 842 Compared to ASC 840
The definition of initial direct costs under ASC 842 is substantially narrower than the definition under ASC 840 and
aligns with the definition of incremental costs to obtain a contract under ASC 340-40. This may represent a
significant change for certain entities; for example, those with active leasing programs that currently capitalize
external legal and other consulting fees, internal legal fees and costs associated with an internal leasing
department. Under ASC 842, those costs will generally be expensed as incurred.
An entity expecting to be significantly impacted by this change in definition should consider the aggregate effect
of electing the package of practical expedients before reaching a decision. For example, if an entity capitalized a
significant amount of initial direct costs under ASC 840 for existing leases and expects to capitalize a significantly
lower amount for new leases, expenses on the income statement for the periods under ASC 842 will reflect both
(a) amounts of lease origination costs for new leases incurred during the period that do not meet the definition of
initial direct costs under ASC 842, and (b) amortization of initial direct costs previously capitalized under ASC 840.
However, not electing the package of practical expedients means the entity will not be able to benefit from the
other two expedients included in the package (not reassessing whether a contract is or contains a lease, and not
reassessing lease classification). While the outcome of these two reassessments may be expected to be
substantially the same as under ASC 840, the time and effort to perform and document the reassessment may be
significant. Accordingly, an entity should consider its specific facts and circumstances in determining whether to
elect the package of practical expedients or not (e.g., usefulness of information in the financial statements, time
needed to reassess existing contracts, etc.).
ACCOUNTING FOR LEASES UNDER ASC 842 267
Example 2 - Transition Approach and Package of Practical Expedients
FACTS
In Example 1, we introduced Susie’s lease of retail space commencing on 1/1/2018 for a five-year
noncancelable period. Also assume that there are three five-year renewal options and the following
additional details about Susie’s lease.
Payment terms
. Rent payments started on 1/1/2018 and are $50,000 per month payable in advance plus
one percent of sales during the initial five-year term. Base rent increases by 10% in each five-year
renewal period (for example, rent is $55,000 per month for the first renewal period).
Leasehold improvements
. Susie’s incurred costs to construct leasehold improvements to customize the
space to its brand requirements with an estimated useful life of eight years. The unamortized leasehold
improvements balance at the end of the noncancelable period are significant to Susie’s.
Initial direct costs
. Susie’s incurred initial direct costs of $22,000, which includes $15,000 of legal fees
for the review and negotiations of the lease, and $7,000 in broker commissions.
There were no modifications to the lease agreement.
ACCOUNTING UNDER ASC 840
Susie’s concluded that the contract was a lease under ASC 840.
Susie’s determined that the lease term was ten years (the initial five-year term plus one five-year
renewal period). This is because the unamortized leasehold improvements at the end of the
noncancelable period were significant to Susie’s, and therefore Susie’s concluded it was reasonably
assured to exercise the first renewal option.
Susie’s determined that the lease was an operating lease and therefore Susie’s did not recognize this
lease on balance sheet under ASC 840.
Susie’s recognized straight-line lease expense of $630,000 during 2018 (the sum of the lease payments
over the 10-year lease term, divided by 10), which resulted in an accrued rent balance of $30,000 as of
12/31/2018 on balance sheet.
Unamortized initial direct costs at 12/31/2018 are $19,800 ($22,000 / 10 years X 9 years remaining) and
are comprised of $13,500 unamortized legal fees and of $6,300 unamortized broker commission.
In its financial statements for the year ended 12/31/2018, Susie’s provided all required ASC 840
disclosures, including disclosure of rental expense with separate amounts for minimum rentals and
contingent rent. Susie’s also disclosed future minimum rental payments of $5,700,000 for the above lease
(four remaining years at $50,000 per month plus five years at $55,000 per month).
ADOPTION OF ASC 842
On 1/1/2019, Susie’s adopts ASC 842.
Susie’s did not elect the practical expedient to use hindsight.
Susie’s initial application of ASC 842 depends on which transition method it elects and whether it elects
the package of practical expedients.
ACCOUNTING FOR LEASES UNDER ASC 842 268
Susie’s Adopts ASC 842 Using the Transition Alternative
Susie’s recognizes the above operating lease on balance sheet on 1/1/2019, as illustrated in Example 1.
And Elects the Package of Practical Expedients
(Which It Must Do for All Its Leases)
And Does Not Elect the Package of Practical
Expedients
Accordingly, Susie’s does not reassess: Accordingly, Susie’s reassesses:
Whether this contract is a lease (i.e., it is a
lease for purposes of adopting ASC 842),
Whether this contract is a lease. In this case,
Susie’s concludes the contract is also a lease
under ASC 842,
Lease classification (i.e., it is an operating
lease for purposes of adopting ASC 842),
Lease classification. In this case, Susie’s
determines the lease is also classified as an
operating lease at 1/1/2018 under ASC 842,
Initial direct costs capitalized (i.e., the
$22,000 continue to be capitalized).
Therefore, the amount of unamortized initial
direct costs of $19,800 at 12/31/2018 is
included in the initial measurement of the
right-of-use asset on 1/1/2019.
Initial direct costs capitalized. In this case,
Susie’s determines that a portion of initial direct
costs (legal fees) capitalized under ASC 840 does
not meet the definition of initial direct costs
under ASC 842. Therefore, the unamortized
portion of these costs ($13,500 at 12/31/2018) is
written off as an adjustment to retained earnings
on 1/1/2019. The remaining unamortized portion
of initial direct costs ($6,300 unamortized
commission) is added to the initial measurement
of the right-of-use asset on 1/1/2019.
Susie’s Adopts ASC 842 Using the Modified Retrospective Approach
Susie’s recognizes the above operating lease on balance sheet on 1/1/2018, as illustrated in Example 1.
And Elects the Package of Practical Expedients
(Which It Must Do for All Its Leases)
And Does Not Elect the Package of Practical
Expedients
Accordingly, Susie’s does not reassess: Accordingly, Susie’s reassesses:
Whether this contract is a lease (i.e., it is a
lease for purposes of adopting ASC 842),
Whether this contract is a lease. In this case,
Susie’s concludes the contract is also a lease
under ASC 842,
Lease classification (i.e., it is an operating
lease for purposes of adopting ASC 842),
Lease classification. In this case, Susie’s
determines the lease is also classified as an
operating lease at 1/1/2018 under ASC 842,
Initial direct costs capitalized (i.e., the
$22,000 continue to be capitalized).
Therefore, the entire amount of initial
direct costs of $22,000 is included in the
initial measurement of the right-of-use asset
on 1/1/2018.
Initial direct costs capitalized. In this case, Susie’s
determines that a portion of initial direct costs
(legal fees) capitalized under ASC 840 do not meet
the definition of initial direct costs under ASC
842. As such, the $15,000 must be written off as
an expense (rather than retained earnings) when
incurred because those costs were incurred during
a period for which an income statement is
presented. The remaining costs ($7,000
commission) is added to the initial measurement
of the right-of-use asset on 1/1/2018.
ACCOUNTING FOR LEASES UNDER ASC 842 269
HINDSIGHT PRACTICAL EXPEDIENT
An entity may use hindsight in determining the lease term (when considering lessee options to renew or terminate and
to purchase the underlying asset) and in assessing impairment of right-of-use assets. This expedient:
If elected, must be applied by the entity to all of its leases (for example, the entity cannot choose to apply it
only to leases under which it is a lessor and not to leases under which it is a lessee),
May be elected separately or in conjunction with either or both the package of practical expedients and the
land easements practical expedient.
If an entity elects the hindsight practical expedient, the entity performs the reassessment of lease term and purchase
options at the adoption date (for example, January 1, 2019 for a calendar year-end public business entity) irrespective
of the transition method elected. The entity also should consider all economic factors relevant to that assessment,
including those that are contract-based, asset-based, market-based and entity-based consistent with paragraph 842-10-
55-26. An entity cannot simply look at renewals or purchase options it knows have been exercised.
Considerations for Electing Hindsight Practical Expedient
The hindsight practical expedient was initially intended to provide relief when the modified retrospective approach
was the only transition method available. Specifically, it was intended to allow an entity to avoid reassessing lease
term and impairment of right-of-use assets during each of the prior periods presented. However, electing the
hindsight practical expedient may be time consuming depending on the volume of leases that an entity has and may
result in additional complexity in applying the transition requirements (for example, if the entity elects the
package of practical expedients and therefore retains the same lease classification, but the lease term changes
based on the use of hindsight). Also, the hindsight assessment should be performed at the date of adoption (for
example, January 1, 2022 for a calendar year-end private company). It cannot be performed at an earlier date
without adjusting the evaluation for significant changes in economic factors between the date of evaluation and
date of adoption. Considering the level of work generally needed for this practical expedient, and the lack of
benefits when a company elects the transition alternative, many entities have not or do not plan to elect it.
LAND EASEMENTS PRACTICAL EXPEDIENT
Land easements (also commonly referred to as rights of way) represent the right to use, access, or cross another
entity’s land for a specified purpose. Easements are used in various industries, such as in the energy, utilities,
transportation and telecom industries. For example:
A midstream energy company may acquire a land easement for the right to pass a pipeline over, under, or
through an existing area of land while allowing the landowner continued use of the land for other purposes
(farming, hunting, etc.) if the landowner does not interfere with the rights of the midstream energy entity.
An electric utility might acquire a series of contiguous easements so that it can construct and maintain its
electric transmission system on land owned by others.
Terms of land easements can vary greatly between agreements. For example, a land easement may be perpetual or
term based, may provide for exclusive or nonexclusive use of the land, and may be prepaid or paid over a defined
term. The grantor (landowner) also may retain rights associated with access and use of the land area, or it may be
restricted in its ability to access and use the land area.
Diversity has historically existed in U.S. GAAP in the accounting for land easements before the introduction of ASC 842.
For example:
Some entities have accounted for their land easements as intangible assets based on the guidance in Example
10 of ASC 350-30,
Intangibles—Goodwill and Other—General Intangibles Other than Goodwill
, which refers to
land easements in that example as intangible assets.
Some entities have applied ASC 360 and considered the prepaid land easement as a cost to bring property,
plant or equipment (for example, a pipeline) to the condition and location necessary for its intended use.
ACCOUNTING FOR LEASES UNDER ASC 842 270
Some entities have applied ASC 840 (for example, a cell tower company entering into a land easement for
the right to erect a communication tower).
Because of that diversity, in January 2018, the FASB issued ASU 2018-01, Land Easement Practical Expedient for
Transition to Topic 842, to clarify that land easements are in the scope of ASC 842. However, considering the existing
diversity in accounting, ASU 2018-01 allows entities that previously did not account for land easements as leases under
ASC 840 to elect a transition practical expedient to not assess those land easements under ASC 842 when adopting the
new standard. This approach is intended to reduce the cost and complexity associated with assessing whether existing
and expired land easements meet the definition of a lease for entities transitioning to ASC 842. Instead, entities will
continue to account for those land easements under other GAAP unless the land easement is modified on or after ASC
842’s adoption date. An entity that currently accounts for land easements as leases under ASC 840 cannot elect this
practical expedient for those easements.
An entity must apply this expedient consistently to all its existing and expired land easements that were not accounted
for as leases under ASC 840, and it may be elected separately or in conjunction with either or both the package of
practical expedients and the hindsight practical expedient.
Also, because the Board clarified in ASU 2018-01 that land easements are in the scope of ASC 842, once an entity
adopts the new lease standard, it must apply that guidance prospectively to all new or modified land easements to
determine whether those arrangements meet the definition of a lease under ASC 842.
Example 3 - Land Easements in Transition
Electric Company obtained a series of easements years before its adoption of ASC 842. The easements were obtained
so that Electric Company could install poles to which its power lines would be attached. In addition to installing its
poles, Electric Company has the right to access the poles via a corridor leading from the nearest road to the pole.
Electric Company will make payments over time under the easement agreement in return for long-term access
rights. Electric Company historically accounted for those land easements along with its poles as property, plant and
equipment under ASC 360.
Because Electric Company did not account for those land easements as leases under ASC 840, it can elect the land
easement practical expedient. This means that Electric Company will continue to account for those land easements
under ASC 360 unless the agreement is modified on or after ASC 842’s adoption date, in which case Electric Company
will need to assess whether those easements meet the definition of a lease under ASC 842. If elected, the practical
expedient must be applied to all of Electric Company’s land easements not accounted for as leases under ASC 840.
Alternatively, if Electric Company does not elect the land easements practical expedient, it should evaluate all of its
existing land easements when adopting the new standard to determine whether those easements meet the definition
of a lease under ASC 842.
Practical Expedient Provided for Cost-Benefit Reasons
Through outreach with stakeholders in industries most involved with land easements, the FASB learned that many
land easements are perpetual (and therefore would not meet the definition of a lease under ASC 842 because they
are not “for a period of time”) and that many land easements are prepaid (and therefore already recognized on
balance sheet). The Board therefore did not want entities to incur significant time and effort (considering the
volume of land easements and age of those agreements) to evaluate them under ASC 842, especially considering that
adoption of ASC 842 was generally not expected to have a material impact for these existing land easements.
While diversity in practice in accounting for land easements exists before ASC 842, it generally would be
inappropriate for an entity to change its accounting policy prior to adopting ASC 842 from accounting for those as
leases under ASC 840 to accounting for those under ASC 350 or ASC 360.
ACCOUNTING FOR LEASES UNDER ASC 842 271
TRANSITION – LESSEES
We previously explained when entities should recognize leases on balance sheet and noted that the date at which a
lease is recognized on balance sheet is the application date, which depends on the transition method selected. We will
now explore how the entity measures those leases on balance sheet.
The initial measurement generally depends on whether lease classification changes between ASC 840 and ASC 842.
If an entity elects the package of practical expedients, the entity applies the guidance for leases that do not
change lease classification.
If an entity does not elect the package of practical expedients, the entity must first reassess lease
classification under ASC 842 before determining which transition guidance to apply.
MEASUREMENT OF EXISTING OPERATING LEASES UNDER ASC 840 AND ASC 842
If an entity elects the package of practical expedients, or the entity does not elect it but lease classification does not
change, and the lease is an operating lease, the initial measurement of the lease at the application date is summarized
as follows:
A lessee initially measures the lease liability (LL) for a lease classified as an operating lease
under ASC 840 and 842 at the present value of:
The
remaining minimum rental payments
as determined under
ASC 840
, and
Any amounts probable of being owed under a residual value guarantee.
This present value calculation is performed using the discount rate for the lease determined
at the application date. An entity that is not a public business entity may use the risk-free
rate. See chapter 4, Lease Classification and Key Terms
for additional details on the
discount rate for the lease and the risk-free rate accounting policy.
The right-of-use asset (ROU) is initially measured at the amount of the initial measurement of
the lease liability, adjusted for the following:
Any prepaid or accrued rent payments,
Any unamortized lease incentives,
Any unamortized initial direct costs, and
The carrying amount of any liability recognized in accordance with ASC 420 on exit
or disposal cost obligations for the lease.
Unless the entity elects the package of practical expedients, any unamortized initial direct
costs (IDCs) that do not meet the definition of initial direct costs under ASC 842 should be
written off as an adjustment to equity, unless the entity elects the modified retrospective
approach and the costs were incurred after the beginning of the earliest period presented, in
which case those costs should be written off as an adjustment to earnings when incurred.
The lease liability then continues to be measured each period like the initial measurement described above. The ROU
asset also continues to be measured like the initial measurement described above, except if the carrying amount was
adjusted for the carrying amount of an ASC 420 liability, in which case the lessee applies the recognition and
subsequent measurement guidance when the ROU asset has been impaired.
ACCOUNTING FOR LEASES UNDER ASC 842 272
The following provides additional subsequent measurement guidance for operating leases:
Initial measurement of
ROU asset includes an
ASC 420 liability
In those situations, the transition guidance requires a lessee to
account for the lease under the subsequent accounting
guidance for impaired ROU assets. As a result, the lease will no
longer receive straight-line expense treatment in the income
statement. Instead, the entity will subsequently amortize the
ROU asset on typically a straight-line basis consistent with
finance leases and accrete interest on the lease liability. While
the pattern of recognition in the income statement will no
longer be straight line, the total cost is still presented as a
single lease cost in operating expenses.
ROU asset is impaired
under ASC 360 on or
after adoption date
Starting on or after ASC 842’s effective date, ROU assets are
subject to the impairment guidance under ASC 360.
Like ROU assets that initially include an ASC 420 liability, if the
ROU asset is impaired under ASC 360, the lease will no longer
receive straight-line treatment in the income statement post
impairment date.
Contract is modified on
or after adoption date,
and the modification
does not result in a
separate contract (see
paragraph 842-10-25-8)
In those situations, the lessee must follow the requirements of
ASC 842 from the effective date of the modification. This
means that, for example, the lessee no longer can use
minimum rental payments as applied in ASC 840; rather the
lessee should use the lease payments as defined in ASC 842.
See Accounting for Leases - Lessees
for a discussion of the
modification guidance for lessees.
The lessee is required to
remeasure the lease
liability in accordance
with paragraphs 842-20-
35-4 and 35-5
The same applies as for modifications not accounted for as
separate contracts.
See Accounting for Leases - Lessees
for a discussion of the
remeasurement guidance for lessees.
See also Accounting for Leases - Lessees
for comprehensive guidance on lessee accounting.
ACCOUNTING FOR LEASES UNDER ASC 842 273
Example 4 – Initial Measurement of Existing Operating Lease Under Both ASC 840 and ASC 842
Let’s continue Susie’s lease of retail space in Example 2.
Assume that Susie’s adopts ASC 842 on 1/1/2019 using the transition alternative. Susie’s application date
is therefore 1/1/2019, which is its adoption date.
Susie’s elects the package of practical expedients but not the hindsight practical expedient.
Susie’s discount rate for the retail space lease is 6% at 1/1/2019.
Susie’s lease details relevant to the initial recognition of this lease were as follows:
•
Lease term
. Originally, ten years (five-year noncancelable period plus first five-year renewal
period). The remaining lease term at the application date is nine years.
•
Payment terms
. Rent payments were $50,000 per month plus one percent of sales during the
initial five-year term. Payments then increase to $55,000 per month. Future minimum rental
payments were $5,700,000 at 12/31/2018. Accrued rent resulting from straight-line recognition at
12/31/2018 was $30,000. The rent payments based on percentage of sales are contingent rents
and therefore are not included in the initial measurement of the lease.
•
Initial direct costs
. Susie’s incurred initial direct costs of $22,000, which includes $15,000 of legal
fees for the review and negotiations of the lease and $7,000 broker commission. The unamortized
costs at 12/31/2018 are $19,800. Because Susie’s elected the package of practical expedients, it
includes the entire unamortized balance of $19,800 in the initial measurement of the ROU asset.
Based on the above information, Susie’s initially measures the operating lease as follows:
It measures the lease liability at the present value of the unpaid minimum rental
payments at 1/1/2019, discounted at 6%. There is no residual value guarantee
provided by Susie’s.
Based on the present value calculation, Susie’s determines the initial measurement of
the lease liability is $4,390,078. On the same date, Susie’s makes the rent payment of
$50,000 and therefore the lease liability is reduced to $4,340,078.
and
It measures the ROU asset at the following:
Initial amount of the lease liability
$4,390,078
Prepaid (accrued) rent (30,000)
Less unamortized lease incentives
N/A
Plus unamortized initial direct costs 19,800
Less carrying amount of ASC 420 liability N/A
Initial measurement of the ROU asset
$4,379,878
There is no adjustment to retained earnings for this lease considering the initial measurement
requirements and the fact that Susie’s elected the package of practical expedients.
Susie’s will continue to measure the lease liability and ROU asset in the same way as described above,
and Susie’s will recognize monthly straight-line lease expense of $52,683 (consistent with the amount
recognized under ASC 840) unless the ROU asset is impaired on or after ASC 842’s effective date.
Also, if on or after 1/1/2019 Susie’s modifies the lease and it is not accounted for as a separate contract,
or Susie’s is required to remeasure the lease liability under paragraphs 842-20-35-4 and 35-5, Susie’s will
follow the requirements in ASC 842 from the effective date of modification or remeasurement date.
ACCOUNTING FOR LEASES UNDER ASC 842 274
EXECUTORY COSTS FOR EXISTING OPERATING LEASES
As previously explained, a lessee is required to use the minimum rental payments as determined under ASC 840 when
initially measuring existing operating leases in transition. However, because ASC 840 is not clear on whether executory
costs (that is, taxes, insurance and maintenance) should be included or excluded as part of minimum rental payments,
diversity in practice developed under ASC 840. Some lessees accounted for the entire rental payment as a minimum
lease payment while others excluded from the minimum lease payment the portion representing executory costs of the
leased asset. Therefore, questions arose about how a lessee should recognize existing operating leases in transition.
The SEC staff addressed those questions at the 2017 AICPA Conference on Current SEC and PCAOB Developments
and, more recently, at the 2018 AICPA Conference on Current SEC and PCAOB Developments:
Andrew W. Pidgeon - Professional Accounting Fellow, Office of the Chief Accountant
Lessee transition – minimum rental payment composition policies
The first consultation I am going to share builds upon a topic discussed last year at this conference
by one of my colleagues related to lessee measurement of leases at transition to Topic 842.[2]
Topic 842 requires lessees to measure leases at transition based on Topic 840[3] “remaining
minimum rental payments.”[4] My colleague noted that diversity in practice exists related to
executory costs, and their inclusion in, or exclusion from, Topic 840 minimum rental
payments. He further noted that the staff 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 to Topic 842.
Earlier this year, we received a consultation regarding a registrant’s ability to change its policies
related to the composition of minimum rental payments, including a change at transition to Topic
842. For example, to change from excluding executory costs from, to including executory costs in,
minimum rental payments. We observed that Topic 250[5] permits a registrant to change from one
generally accepted accounting principle to another generally accepted accounting principle when
there are at least two generally accepted principles if the change is preferable.[6] In response to
the consultation, we communicated that the staff did not object to a registrant’s application of
Topic 250 to change its policy relative to the composition of Topic 840 minimum rental payments,
including a change at transition to Topic 842.[7]
[2] Michael P. Berrigan, Professional Accounting Fellow, Office of the Chief Accountant, U.S. Securities and
Exchange Commission, Remarks before the 2017 AICPA Conference on Current SEC and PCAOB Developments
(December 4, 2017), at: https://www.sec.gov/news/speech/berrigan-aicpa-2017-conference-sec-pcaob-
developments.
[3] FASB ASC Topic No. 840, Leases (“Topic 840”).
[4] ASC 842-10-65-1(l).
[5] FASB ASC Topic No. 250, Accounting Changes and Error Corrections (“Topic 250”).
[6] ASC 250-10-45-2(b).
[7] Registrant requirements related to accounting policy changes are identified in Rule 10-01(b)(6) of
Regulation S-X; see also, ASC 250-10-S99-4 and the related guidance in SAB Topic 6.G.2.b, Reporting
Requirements for Accounting Changes
While discussed in the context of public companies, we believe the above guidance equally applies to private
companies.
ACCOUNTING FOR LEASES UNDER ASC 842 275
PAYMENTS BASED ON AN INDEX OR A RATE FOR EXISTING OPERATING LEASES
Another question that arose on the application of minimum rental payments relates to those based on an index or a
rate, and whether existing operating leases should be initially measured using the index or rate at lease inception or
using the current value at the application date.
The SEC staff addressed that question at the 2018 AICPA Conference on Current SEC and PCAOB Developments
.
Andrew W. Pidgeon - Professional Accounting Fellow, Office of the Chief Accountant
Lessee transition – minimum rental payment measurement policies
More recently, we received another consultation regarding minimum rental payments and lessee
transition to Topic 842. That consultation, submitted by a group of registrants, related to the
measurement of minimum rental payments that are based on an index or a rate (“indexed
payments”). Specifically, the inquiry related to whether at transition to Topic 842 leases with
indexed payments should be measured based on the index or rate value from lease inception, or
the then current index or rate value.
Topic 840 requires lessees to disclose “future minimum rental payments.”[8] We understand that
in order to meet that disclosure requirement, some lessees disclose future minimum rental
payments related to indexed payments based on the index or rate value at lease inception, and
other lessees disclose those payments based on the current rate or index value. Similar to the
consultation shared during last year’s conference regarding the composition of minimum rental
payments, we observed that Topic 840 does not provide specific guidance with regard to the
measurement of future minimum rental payments for disclosure of indexed payments. Therefore,
the staff did not object to a registrant consistently applying their Topic 840 accounting policy
regarding the measurement of future minimum rental payments for disclosure when concluding
whether remaining minimum rental payments should be calculated based on the lease inception or
current index or rate values for purposes of measuring leases at transition to Topic 842.
Additionally, the consultation discussed a registrant changing its policy relative to the
measurement of future minimum rental payments for indexed payments, including at transition to
Topic 842. Specifically, the consultation discussed a change from using lease inception index or
rate values, to using current index or rate values to measure future minimum rental
payments. The consultation concluded that the change was a change in accounting policy subject
to Topic 250. The staff did not object to that conclusion. The staff further communicated that
when evaluating whether that policy change is preferable, 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.
[8] ASC 840-20-50-2(a).
As previously noted, lessees will generally use future minimum rental payments determined in accordance with ASC 840
to calculate the lease liability and right-of-use asset to be recognized upon adoption of ASC 842. Therefore, how one
determined future minimum rental payments when the payments are based on an index or rate for purposes of
disclosures under ASC 840 should be consistent with how those payments are determined for purposes of adopting ASC
842.
While discussed in the context of public companies, we believe the above guidance equally applies to private
companies.
ACCOUNTING FOR LEASES UNDER ASC 842 276
DISCOUNT RATE USED TO INITIALLY MEASURE EXISTING OPERATING LEASES
As previously explained, the transition guidance in ASC 842 provides that existing operating leases should be initially
measured using the discount rate for the lease at the application date. The guidance however does not specify whether
the discount rate should be determined based on (1) the remaining lease term and remaining minimum rental
payments, or (2) the total lease term and total minimum rental payments. The SEC staff addressed that question at the
2017 AICPA Conference on Current SEC and PCAOB Developments
, which we believe also applies to private
companies.
Michael P. Berrigan - Professional Accounting Fellow, Office of the Chief Accountant
Lease Transition — Incremental Borrowing Rate
Another transition topic addressed by the staff relates to the incremental borrowing rate a lessee
should apply when measuring the lease liability in transition. […] registrants observed that the
transition guidance does not specify whether the discount rate selected should be based on the
original lease term or the remaining lease term.[7]
Some registrants concluded that the lessee should select a discount rate based on the original
lease term as they believe that rate better reflects the borrowing rate embedded within the
contract when the lessee entered into the arrangement. Other registrants concluded the lessee
should select a rate based on the remaining lease term as they believe the rate more accurately
reflects the rate applicable to the remaining lease liability recognized in transition. The staff
observed that the transition guidance does not specify the lease term that should be used to
determine the discount rate and further observed that either rate used in transition may
significantly differ from the rate that would have been determined at commencement of the lease
(i.e. the original commencement date of the lease). The staff concluded 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 ultimately did not object to a registrant’s consistent application of
either approach to determine the lessee’s lease liabilities in transition.
[7] To illustrate, assume an entity previously entered into a 20 year lease with total payments of $20 million
and that the remaining lease term as of the earliest date presented in the financial statements upon adoption
of ASC 842 is five years with remaining payments of $5 million. The question raised is whether it is
appropriate for the entity to select the discount rate applicable as of the date of the first period presented in
the financial statements based on an original lease term (for example, the rate applicable for a 20 year
borrowing with payments of $20 million) or the remaining lease term (for example, the rate applicable for a
five year borrowing with payments of $5 million).
ACCOUNTING FOR LEASES UNDER ASC 842 277
Example 5 – Determining the Discount Rate for Existing Operating Leases
In Example 4, Susie’s adopted ASC 842 on 1/1/2019 and elected the transition alternative. Its retail space
lease commenced on 1/1/2018 and Susie’s initially determined that the lease term under ASC 840 was ten
years (and therefore nine years remain at 1/1/2019). Susie’s total fixed lease payments under the lease
were $6,300,000 and payments remaining at 12/31/2018 are $5,700,000 as disclosed in its footnotes.
In determining the discount rate for all of its existing operating leases, including the retail space lease
just described, Susie’s is permitted to use either of the following two approaches. The approach Susie’s
selects must be applied consistently to all of its existing operating leases when transitioning to ASC 842,
and Susie’s should disclose which approach it applied.
•
Approach A: Use Remaining Lease Term and Remaining Minimum Rental Payments.
For its
lease of retail space above, Susie’s would determine the discount rate based on (1) a remaining
lease term of nine years, and (2) remaining lease payments of $5,700,000.
•
Approach B: Use the Total Lease Term and Total Minimum Rental Payments
.
For its lease of
retail space above, Susie’s would determine the discount rate based on (1) a total lease term of
ten years, and (2) total lease payments of $6,300,000.
LESSEE PRACTICAL EXPEDIENT NOT TO SEPARATE DURING TRANSITION
ASC 842 provides a practical expedient for lessees not to separate the nonlease components of a contract (for
example, maintenance or operation of the underlying asset) from the associated lease component. The practical
expedient must be elected by asset class. While the transition guidance specifically addresses certain practical
expedients (for example, the short-term lease exemption), it does not address the lessee practical expedient not to
separate. However, while not addressed in transition, we believe an entity may elect, by asset class, the lessee
practical expedient to not separate during transition.
If elected in transition, we believe the entity should apply the lessee practical expedient also to new leases
within that asset class that commence on or after the effective date.
If not elected in transition (and since it is not discussed in transition), the entity may still elect the lessee
practical expedient to new leases within that asset class that commence on or after the effective date.
IMPAIRMENT CONSIDERATIONS
Prior to adopting ASC 842, an entity may have recognized an impairment loss on its asset group(s). In that situation,
the impairment loss was allocated to the recognized long-lived assets in the asset group. Because operating leases
were not recognized on balance sheet before ASC 842, operating leases did not receive any allocation of the
impairment loss at that time. Accordingly, stakeholders questioned whether upon adoption of ASC 842 an entity is
required to reallocate prior impairment losses because of the new asset recognized for an existing operating lease.
The FASB specifically addressed this question at a public Board meeting in November 2016 in which it clarified that it
was not its intent to require entities to reallocate prior impairment losses. The FASB also observed that reallocating
prior impairment losses would result in writing up some of the other long-lived assets in the asset group, which is not
permitted under U.S. GAAP. Accordingly, the impairment guidance in ASC 360 applies to right-of-use assets starting
only at the effective date. See Accounting for Leases - Lessees
for guidance on impairment of right-of-use assets.
Also, prior to adopting ASC 842, an entity may have recognized an impairment loss for its asset groups that resulted in
the complete write-off of the recognized long-lived assets in the asset group (or a write-off limited to the fair value of
the individual long-lived assets), with a remaining and “unused” impairment loss. Had an operating lease in the asset
group been recognized on balance sheet at the date of impairment, some or all of the unused impairment losses may
have been recognized. Accordingly, stakeholders questioned whether on adoption of ASC 842 an entity is required or
permitted to recognize some or all of the prior unused impairment losses.
ACCOUNTING FOR LEASES UNDER ASC 842 278
In those situations, we believe an entity may reduce the amount of the right-of-use asset initially recognized for
unused impairment losses with a corresponding adjustment to retained earnings, assuming the asset group to which the
operating lease pertains continues to be impaired. We also believe it would be acceptable for the entity to recognize
the impairment in earnings on adoption rather than revisiting prior impairments to determine whether unused
impairment losses existed. If the entity elects the modified retrospective transition and the impairment occurred
during the comparative periods, the adjustment should be recognized in earnings of the relevant period.
SUBLEASE LIABILITIES EXISTING AT ADOPTION DATE
As previously discussed, ASC 842 provides explicit transition guidance for leases with existing ASC 420 liabilities.
However, ASC 842 is silent about existing sublease liabilities recognized under ASC 840-20-25-15 when costs expected
to be incurred under an operating sublease exceed anticipated revenue on the operating sublease. Because of the lack
of guidance, there may be multiple approaches in transition depending on the facts and circumstances, including
netting the existing sublease liability against the right-of-use asset (like the treatment of ASC 420 liabilities in
transition, in which case the entity applies the guidance on right-of-use assets that are impaired), or writing off the
existing sublease liability through retained earnings as part of the cumulative effect adjustment at transition (and
evaluating the right-of-use asset for potential impairment).
ACCOUNTING FOR LEASES UNDER ASC 842 279
MEASUREMENT OF EXISTING CAPITAL LEASES UNDER ASC 840 THAT ARE FINANCE LEASES UNDER
ASC 842
If an entity elects the package of practical expedients, or the entity does not elect it but lease classification does not
change (that is, the lease is a capital lease under ASC 840 and a finance lease under ASC 842), the initial measurement
of the lease at the application date is summarized as follows:
A lessee initially measures the lease liability for a lease classified as a capital lease
under ASC 840 and classified as a finance lease under ASC 842 at the carrying amount of
the capital lease obligation under ASC 840.
The ROU asset is initially measured at the carrying amount of the capital lease asset
under ASC 840, plus any unamortized initial direct costs that meet the definition of
initial direct costs under ASC 842, or all unamortized initial direct costs if the entity
elects the package of practical expedients.
Unless the entity elects the package of practical expedients, any unamortized initial
direct costs that do not meet the definition of initial direct costs under ASC 842 and that
are not included in the measurement of the capital lease asset under ASC 840 should be
written off as an adjustment to retained earnings, unless the entity elects the modified
retrospective approach and the costs were incurred after the beginning of the earliest
period presented, in which case those costs should be written off as an adjustment to
earnings when incurred.
In short, other than the change in description of the capital lease asset to right-of-use asset and the capital lease
obligation to lease liability, the transition guidance for existing capital leases under ASC 840 that are classified as
finance leases under ASC 842 results in the carryforward of the existing asset and liability under ASC 840.
After initial recognition:
If the entity elected the modified retrospective transition, the lessee follows the general subsequent
measurement guidance in ASC 840 before the effective date, and
Irrespective of the transition method elected, the lessee applies ASC 842 on and after the effective date. As
an exception, when applying the subsequent measurement guidance in ASC 842 after adoption, a lessee does
not remeasure the lease payments for changes in amounts probable of being owed under residual value
guarantees. This is because the capital lease obligation under ASC 840 already included the full amount of
the residual value guarantee.
The entity also classifies the assets and liabilities held under capital leases as right-of-use assets and lease liabilities
arising from finance leases for presentation and disclosure purposes.
If the entity modifies the contractual terms and conditions of the lease on or after the effective date and the
modification does not result in a separate contract, or the lessee is required to remeasure the lease liability (see
Accounting for Leases - Lessees
for additional guidance), the lessee follows the guidance in ASC 842 from the
effective date of the modification or the remeasurement date.
ACCOUNTING FOR LEASES UNDER ASC 842 280
MEASUREMENT FOR LEASES THAT CHANGE CLASSIFICATION
If an entity does not elect to apply the package of practical expedients during transition, then it must reassess lease
classification under ASC 842, which may or may not result in changes:
If lease classification does not change, the lessee applies the guidance described in the preceding two
sections to the lease.
If classification changes, a lessee should initially recognize those leases at the application date as further
described below. However, we believe that changes in classification should be infrequent for most entities
considering the similarities in classification guidance between ASC 840 and ASC 842.
LEASES CLASSIFIED AS OPERATING LEASES UNDER ASC 840 AND CLASSIFIED AS FINANCE LEASES UNDER ASC 842
A lessee initially measures a lease classified as an operating lease under ASC 840 and classified as a finance lease under
ASC 842 as follows:
The lease liability is measured at the present value of:
The remaining
minimum rental payments
as determined under ASC 840, and
Any amounts probable of being owed under a residual value guarantee.
This present value calculation is performed using the discount rate for the lease
determined at the application date. An entity that is not a public business entity may use
the risk-free rate. See Lease Classification and Key Terms for additional details on the
discount rate for the lease and the risk-free rate accounting policy.
The ROU asset is first calculated as the applicable proportion of the lease liability at the
commencement date. The applicable proportion of the lease liability is the remaining
lease term at the application date relative to the total lease term.
The ROU recognized is then adjusted by the carrying amount of any prepaid or accrued
lease payments and the carrying amount of any liability recognized in accordance with ASC
420.
Because the entity did not elect the package of practical expedients, any unamortized
initial direct costs that do not meet the definition of initial direct costs under ASC 842
should be written off as an adjustment to retained earnings, unless the entity elects the
modified retrospective approach and the costs were incurred after the beginning of the
earliest period presented, in which case those costs should be written off as an adjustment
to earnings when incurred.
Also, if the entity modifies the contractual terms and conditions of the lease on or after the effective date and the
modification does not result in a separate contract, or the lessee is required to remeasure the lease liability for any
reason (see Accounting for Leases - Lessees
for additional guidance), the lessee should follow the guidance in ASC 842
from the effective date of the modification or the remeasurement date. This means that the lessee will no longer use
the minimum rental payments as applied under ASC 840 to account for the lease but rather will use the lease payments
as defined in ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 281
LEASES CLASSIFIED AS CAPITAL LEASES UNDER ASC 840 AND CLASSIFIED AS OPERATING LEASES UNDER ASC 842
A lessee initially measures a lease classified as a capital lease under ASC 840 and classified as an operating lease under
ASC 842 as follows:
The initial measurement of the lease liability is the present value of the lease
payments not yet paid as defined under ASC 842 (not the minimum rental payments
determined under ASC 840) discounted using the discount rate for the lease
determined at the application date.
The ROU asset is initially measured using the amount of the initial measurement of the
lease liability and is then adjusted for the following, as applicable, depending on the
transition method elected:
Any prepaid (accrued) lease payments,
Any (unamortized) lease incentives,
Any (unamortized) initial direct costs, and
Any difference between the carrying amount of the capital lease asset and
capital lease obligation under ASC 840 that are derecognized at the
application date (which are accounted for in the same manner as prepaid or
accrued rent).
Because the entity did not elect the package of practical expedients, any unamortized
initial direct costs that do not meet the definition of initial direct costs under ASC 842
should be written off as an adjustment to retained earnings, unless the entity elects
the modified retrospective approach and the costs were incurred after the beginning
of the earliest period presented, in which case those costs should be written off as an
adjustment to earnings when incurred.
The lease is then accounted for under ASC 842 like any new lease would be.
If the entity modifies the contractual terms and conditions of the lease on or after the effective date, and the
modification does not result in a separate contract, or the lessee is required to remeasure the lease liability for any
reason (see Accounting for Leases - Lessees
for additional guidance), the lessee applies ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 282
TRANSITION - LESSORS
MEASUREMENT
Like lessees, the measurement of existing leases generally depends on whether classification changes between ASC 840
and ASC 842.
If an entity elects the package of practical expedients, the entity applies the guidance for leases that do not
change classification.
If an entity does not elect the package of practical expedients, the entity must first reassess lease
classification under ASC 842 before determining which transition guidance applies.
The following tables summarize the transition provisions for each lease classification scenario:
Existing lease is an
operating lease under
ASC 840 and ASC 842
Continue to recognize at the application date the underlying asset
along with any related assets or liabilities, such as rent
receivables.
Account for previous securitized receivables as secured
borrowings in accordance with other Topics.
If the entity does not elect the package of practical expedients,
any unamortized initial direct costs that do not meet the
definition of initial direct costs under ASC 842 should be written
off as an adjustment to retained earnings, unless the entity elects
the modified retrospective approach and the costs were incurred
after the beginning of the earliest period presented, in which
case those costs should be written off as an adjustment to
earnings when incurred.
Existing lease is a sales-
type lease or direct
financing lease under
ASC 840 and ASC 842
Continue to recognize at the application date the carrying amount
of the net investment in the lease. This includes any unamortized
initial direct costs capitalized as part of the net investment in the
lease for a direct financing lease under ASC 840, regardless of
whether the package of practical expedients is elected.
If the entity elected the modified retrospective transition, the
lessor accounts for the lease under ASC 840 before the effective
date of ASC 842.
Regardless of the transition method elected, beginning on the
effective date of ASC 842 the lessor applies the recognition,
subsequent measurement, presentation, and disclosure guidance
in ASC 842.
Beginning on the effective date, if the lessor modifies the lease
and the modification is not accounted for as a separate contract,
the accounting depends on the classification of the modified
lease. See
Accounting for Leases - Lessors
for additional
guidance.
A lessor does 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.
ACCOUNTING FOR LEASES UNDER ASC 842 283
Existing lease is an
operating lease under
ASC 840 and a sales-type
lease or direct financing
lease under ASC 842
The objective is to account for the lease, beginning on the application
date, as if it had always been accounted for as a sales-type lease or
direct financing lease under ASC 842. Accordingly, the lessor:
Derecognizes the carrying amount of the underlying asset at the
application date,
Recognizes a net investment in the lease at the application date
as if the lease had been accounted for as a sales-type lease or
direct financing lease under ASC 842-30 since lease
commencement,
Records any difference between the two amounts above as an
adjustment to:
•
Retained earnings, if the entity elected the transition
alternative or the modified retrospective approach (and
the lease commenced before the beginning of the earliest
period presented, or if the lease was acquired as part of a
business combination).
•
Earnings, if the entity elected the modified retrospective
approach and the lease commenced on or after the
beginning of the earliest period presented.
•
See also guidance below for operating leases acquired as
part of a business combination for potential offsetting
entries related to favorable and unfavorable terms of the
lease.
Then, the lessor accounts for the lease under ASC 842.
Existing lease is a sales-
type lease or direct
financing lease under
ASC 840 and an
operating lease under
ASC 842
The objective is to account for the lease, beginning on the application
date, as if it had always been accounted for as an operating lease under
ASC 842. Accordingly, the lessor:
Recognizes the underlying asset at the application date at what
the carrying amount would have been had the lease been
classified as an operating lease under ASC 840,
Derecognizes the carrying amount of the net investment in the
lease,
Records any difference between the two amounts above as an
adjustment to:
•
Retained earnings, if the entity elected the transition
alternative or the modified retrospective approach (and
the lease commenced before the beginning of the earliest
period presented, or if the lease was acquired as part of a
business combination).
•
Earnings, if the entity elected the modified retrospective
approach and the lease commenced on or after the
beginning of the earliest period presented.
Then, the lessor accounts for the lease under ASC 842 and the
underlying asset under other Topics (e.g., ASC 360).
ACCOUNTING FOR LEASES UNDER ASC 842 284
LEVERAGED LEASES
Unlike the legacy leases guidance, a lessor can no longer classify a lease as a leveraged lease under ASC 842. However,
existing leveraged leases that commenced before the effective date of ASC 842 are grandfathered and continue to be
accounted for by the lessor like under ASC 840 until they expire or are modified (see ASC 842-50). If a leveraged lease
is modified on or after the effective date, it must be accounted for as a new lease as of the effective date of the
modification in accordance with ASC 842. A lessor also applies the legacy leases guidance to a leveraged lease that
commenced before the effective date and that is acquired in a business combination or an acquisition by a not-for-
profit entity, unless that lease is modified.
PRACTICAL EXPEDIENT NOT TO SEPARATE FOR OPERATING LEASES
ASU 2018-11, Leases (Topic 842) – Targeted Improvements, provided lessors with an accounting policy by asset class to
combine nonlease components with the associated lease component when certain criteria are met. When those criteria
are met, the accounting for the combined component is dictated by the predominant component(s) (that is, ASC 606 or
ASC 842). Once the practical expedient is elected for an asset class, the lessor is required to apply it to all future lease
contracts within that asset class that meet the criteria for combination. See Lease Classification and Key Terms
for
additional guidance.
This lessor practical expedient must be elected at the effective date and must be applied to all new and existing
leases. As a result, the election of the practical expedient may change presentation for some lessor entities. For
example, lessor entities that previously presented taxes, insurance and maintenance recoveries separately from rental
income can longer present those recoveries separately in the income statement if they elect the lessor practical
expedient not to separate (see Presentation and Disclosures
for additional details).
For entities that adopted ASC 842 before the issuance of ASU 2018-11, refer to paragraph 842-10-65-2 for additional
effective dates and transition guidance.
NARROW SCOPE IMPROVEMENTS FOR LESSORS
ASU 2018-20, Leases (Topic 842): Narrow-Scope Improvements for Lessors, simplifies lessor’s accounting for sales taxes
and certain lessor costs, and clarifies the recognition of certain variable payments for contracts with lease and
nonlease components.
Sales Taxes and Similar Taxes
. A lessor can make an accounting policy election to exclude from the
consideration in the contract and from variable payments not included in the consideration 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. This includes for example sales, use, value
added, and some excise taxes. However, taxes assessed on a lessor’s total gross receipts or on the lessor as
owner of the underlying asset (for example, property taxes) are excluded from the scope of this election.
When the lessor makes this election, it should comply with the disclosure requirements in paragraph 842-30-
50-14.
Recognition and Presentation for Lessor Costs in Net Leases
. A lessor may incur various costs in its role as
a lessor or as owner of the underlying asset (lessor costs), such as property taxes and certain insurance costs.
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. ASC 842 initially required
a lessor to report those amounts as revenue and expenses (that is, on a gross basis) whether the lessee
reimburses the lessor or pays such costs on lessor’s behalf to a third-party. However, stakeholders raised
concerns with this requirement, including challenges with estimating those costs when the lessee pays the
amounts directly to third parties, and noted limited benefits because the amounts in the income statement
would net to zero. In response to those concerns, the FASB issued ASU 2018-20 which made the following
amendments for this issue.
ACCOUNTING FOR LEASES UNDER ASC 842 285
Lessor costs are paid by
the lessee directly to
third parties
The lessor excludes those payment amounts from variable
payments and therefore from revenue. That is, there is
nothing for the lessor to report in the income statement.
Costs are paid by the
lessor and reimbursed by
the lessee
The lessor accounts for the reimbursements as variable
payments. That is, a lessor is required to present those on a
gross basis in the income statement.
Accounting for Variable Payments in Contracts with Lease and Nonlease Components
. The ASU clarified
the requirements in paragraph 842-10-15-40 for lease contracts in which the terms of the variable payment
amount (other than those that depend on an index or a rate) relate to a lease component (even partially)
when the changes in facts and circumstances on which the variable payment is based occur.
See chapter 3, Identifying and Separating Components, for additional details. While the effective date and transition
approach differs for entities that did not early adopt ASC 842 as compared to those that did, the new guidance
nevertheless must be applied to all new and existing leases. For entities that adopted ASC 842 before the issuance of
ASU 2018-20, refer to paragraph 842-10-65-3 for additional effective dates and transition guidance.
CODIFICATION IMPROVEMENTS
ASU 2019-01, Leases (Topic 842) – Codification Improvements, clarifies the application of certain aspects of ASC 842
primarily for financial institutions.
Determining Fair Value of the Underlying Asset
. ASC 842 initially did not include an exception that existed
under ASC 840 for determining fair value for lessors who are not manufacturers or dealers (generally
financial institutions and captive finance companies). In response to feedback from lessors previously
qualifying for the exception in ASC 840, the FASB added a similar exception under ASC 842. As a result, for
lessors that are not manufacturers or dealers, the fair value of the underlying asset at lease commencement
is defined as its cost, reflecting any volume or trade discounts that apply. This exception applies only if
there has not been a significant lapse of time between the acquisition of the underlying asset and lease
commencement. If there has been a significant lapse of time, the lessor applies the ASC 820 definition of
fair value like any other lessor.
Cash Flow Classification for Sales-Type and Direct Financing Leases
. ASC 842 initially required lessors to
classify all cash receipts from leases as operating activities, regardless of whether the lease was an operating
lease, sales-type lease, or direct financing lease. However, the FASB received feedback from lessor
stakeholders within the scope of ASC 942,
Financial Services—Depository and Lending
, that they historically
have presented principal payments received under leases within investing. Following that feedback, the FASB
clarified that lessors that are depository and lending institutions within the scope of ASC 942 should present
all “principal payments received under leases” within investing activities.
Refer to paragraph 842-10-65-2 for effective dates and transition guidance.
CERTAIN LEASES WITH VARIABLE LEASE PAYMENTS
ASU 2021-05, Leases (Topic 842) – Lessors—Certain Leases with Variable Lease Payments, addressed the recognition of
a selling loss at the commencement date (a “day-one loss”) for sales-type or direct financing leases because of variable
lease payments that do not depend on an index or a rate. The ASU addressed this issue by requiring lessors to classify
such leases as an operating lease when the lease includes variable lease payments that do not depend on an index or a
rate and that would result in the recognition of a selling loss at lease commencement if the lease were classified as a
sales-type lease or direct financing lease. See Lease Classification and Key Terms
for additional details. Also refer to
paragraph 842-10-65-5 for effective dates and transition guidance.
ACCOUNTING FOR LEASES UNDER ASC 842 286
OTHER TRANSITION REQUIREMENTS
In addition to the above transition provisions applicable to lessees and lessors, ASC 842 includes other transition
provisions, including prior sale and leaseback transactions, existing build-to-suit lease arrangements and amounts
previously recognized as part of business combinations.
SALE AND LEASEBACK TRANSACTIONS BEFORE THE EFFECTIVE DATE
Previous sale and
leaseback transaction
was accounted for as a
failed sale and leaseback
under ASC 840 and
remains a failed sale at
the adoption date
Reassess whether a sale would have occurred under ASC 842 as follows:
If the entity elected the modified retrospective approach
. The
seller-lessee reassesses whether a sale would have occurred under
paragraphs 842-40-25-1 through 25-3 (see
Other Topics
) at any
point on or after the beginning of the earliest period presented. If
any such reassessment results in sale accounting, the entity
accounts for the sale and leaseback transaction on a modified
retrospective basis from the date sale accounting is achieved.
If the entity elected the transition alternative
. The seller-lessee
reassesses whether a sale would have occurred under paragraphs
842-40-25-1 through 25-3 (see
Other Topics
) at the beginning of
the period of adoption. If that reassessment results in sale
accounting, the seller-lessee recognizes the sale as an adjustment
to retained earnings. The entity then accounts for the leaseback
under ASC 842.
Classification of the leaseback
. The transition provisions do not
address how a lessee should classify the leaseback. However, we
believe that if the entity elected the package of practical
expedients, the lessee may perform the classification assessment
under either ASC 840 at lease inception or under ASC 842 at lease
commencement.
Previous sale and
leaseback transaction
was accounted for as a
sale and leaseback under
ASC 840
The entity does not reassess the transaction. That is, it remains a
successful sale and leaseback transaction. We believe this also
applies to buyer-lessors that did not apply ASC 840-40 and
accounted for the transaction as a successful purchase.
The entity accounts for the leaseback in accordance with the
lessee and lessor transition requirements applicable to existing
leases (see previous sections).
The seller-lessee may also need to make other adjustments
depending on the classification of the leaseback and the transition
method elected, as further discussed below.
ACCOUNTING FOR LEASES UNDER ASC 842 287
DEFERRED GAINS OR LOSSES ON EXISTING SALE AND LEASEBACK TRANSACTIONS
As discussed above, a previous sale and leaseback transaction that was accounted for as a sale and leaseback under
ASC 840 is not reassessed under ASC 842. However, there may be deferred gains or losses recognized on those
transactions. The transition provisions require that certain adjustments be made depending on the classification of the
leaseback and the transition method elected.
Previous sale and capital
leaseback
The seller-lessee continues to recognize any deferred gains or
losses that exist at:
•
The later of the beginning of the earliest comparative
period presented and the date of sale of the underlying
asset (if the entity elected the modified retrospective
approach),
•
The adoption date (if the entity elected the transition
alternative).
The seller-lessee amortizes the deferred gains or losses starting
from the date determined above 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, in proportion to the amortization of the
right-of-use asset,
•
If the underlying asset is not land only and the leaseback is
an operating lease, in proportion to the recognition of
total lease cost in the income statement.
Previous sale and
operating leaseback
The seller-lessee writes off any deferred gains or losses that do
not result from off-market terms as an adjustment to retained
earnings, unless the entity elects the modified retrospective
transition and the date of sale is after the beginning of the
earliest period presented (in which case the adjustment is
recognized in earnings at the date of sale).
The seller-lessee recognizes any deferred gains or losses resulting
from off-market terms (that is, when the consideration for the
sale is not at fair value or the lease payments are not at market
rates) as a financial liability or as an adjustment to the leaseback
right-of-use asset, respectively.
•
The adjustment is recorded at the later of the beginning of
the earliest comparative period presented and the date of
sale of the underlying asset if the entity elected the
modified retrospective approach.
•
The adjustment is recorded at the adoption date if the
entity elected the transition alternative.
ACCOUNTING FOR LEASES UNDER ASC 842 288
Example 6 – Deferred Gain on Existing Sale and Leaseback Transaction
Susie’s has a number of retail stores that it leases, like the one we illustrated earlier. Susie’s also has one such retail
store that it leases as a result of a past sale and leaseback transaction in which Susie’s sold the retail store it owned
and then leased it back for some period of time. The terms of the transaction were at market. The transaction was
properly accounted for as a sale under ASC 840 (i.e., not as a failed sale) and the leaseback was determined to be an
operating lease. Further, the profit on sale did not exceed the present value of the minimum lease payments under
ASC 840. Therefore, the entire gain was deferred over the leaseback term.
In accordance with ASC 842’s transition requirements, Susie’s does not reassess whether the sale and leaseback
transaction would have qualified for sale accounting under ASC 842. Also, because there were no off-market terms,
Susie’s should recognize the deferred gain balance on the sale-leaseback transaction as a cumulative-effect
adjustment to retained earnings at the adoption date if it elects the transition alternative. If Susie’s elects the
modified retrospective approach, the adjustment also would be recorded in retained earnings unless the date of sale
is after the beginning of the earliest period presented, in which case the adjustment would be to earnings in the
relevant period.
BUILD-TO-SUIT ARRANGEMENTS
An entity (as lessee) may be deemed the accounting owner of a construction project solely because of the transaction’s
build-to-suit designation under ASC 840. In that situation, the entity recognized the asset (for example, for the
construction costs the lessee or lessor incurred) and a corresponding liability.
The transition provisions generally require the lessee to derecognize those assets and liabilities on a modified
retrospective basis unless the construction is still in progress at the adoption date and the lessee is determined to be
the accounting owner under ASC 842. See paragraph 842-40-55-5 and chapter 7 on Other Topics
for additional
guidance on determining whether a lessee controls the asset under construction under ASC 842 and therefore is
considered the accounting owner.
The date at which the lessee derecognizes the build-to-suit assets and liabilities depends on the transition method the
entity elects.
The entity elects the modified retrospective approach
. The lessee derecognizes those build-to-suit assets
and liabilities with an adjustment to retained earnings, if any, at the later of (1) the beginning of the earliest
comparative period presented and (2) the date the lessee is determined to be the accounting owner under
ASC 840.
The entity elects the transition alternative
. The lessee derecognizes those build-to-suit assets and
liabilities with an adjustment to retained earnings, if any, at the adoption date.
The lessee then applies the lessee transition requirements to the lease as discussed in the earlier sections. The
transition provisions do not address how a lessee classifies the lease in that situation. However, we believe that if the
entity elected the package of practical expedients, the lessee may perform the classification assessment under either
ASC 840 at lease inception or under ASC 842 at lease commencement.
Also note that if the construction period of the build-to-suit lease concluded before the beginning of the earliest period
presented (if the entity elects the modified retrospective approach) or the effective date (if the entity elects the
transition alternative) and the transaction qualified as a sale and leaseback transaction under ASC 840, the lessee does
not apply the transition provisions for build-to-suit arrangements discussed above but instead applies the general
lessee transition requirements for the lease. However, if the transaction did not qualify as a sale and leaseback
transaction under ASC 840, the entity applies the build-to-suit transition provisions and derecognizes the asset and
related liability. The company does not apply the sale and leaseback transition provisions, and does not assess
whether the transaction would qualify as a sale under ASC 842.
ACCOUNTING FOR LEASES UNDER ASC 842 289
Write Off of Assets and Liabilities in a Built-to-Suit Arrangement
The transition provisions of ASC 842 require the write-off of assets and liabilities recognized solely because of a
transaction’s build-to-suit designation under ASC 840. As such, an entity should carefully analyze the composition of
those assets and liabilities in determining whether the full amount of the asset and liability should be written off. For
example, the asset recognized may include lease prepayments (e.g., the lessee paid construction costs of the lessor)
or leasehold improvements that the lessee paid for themselves, or the liability may include lessor lease incentives
received related to leasehold improvements, items which are not solely related to the build-to-suit designation. In
those situations, we believe those amounts retain their characteristics (e.g., as prepaid lease payments, leasehold
improvement assets or lease incentives) and, accordingly, they should not be written off but instead included in the
initial measurement of the right-of-use asset or as leasehold improvements.
BUSINESS COMBINATIONS
The transition provisions of ASC 842 require entities to derecognize assets or liabilities recognized under ASC 805 on
business combinations related to favorable or unfavorable terms for acquired operating leases. The transition
requirements depend on whether the entity is the lessee or the lessor, and for the lessor, whether lease classification
changes from operating lease to sales-type or direct financing lease (when the lessor entity does not elect the package
of practical expedients).
Entity is a lessee
Derecognize any favorable lease asset or unfavorable lease
liability with the corresponding adjustment to the carrying
amount of the right-of-use asset.
Entity is a lessor and
lease classification
changes from operating
to sales-type or direct-
financing lease
Derecognize any asset or liability with the corresponding
adjustment to retained earnings. Also apply other transition
requirements applicable to existing operating leases that
are sales-type or direct-financing leases under ASC 842
(which require the lessor to account for the lease as if it
had always been a sales-type or direct financing lease).
Entity is a lessor and the
lease remains an
operating lease
No adjustments needed. Continue to recognize and account
for the favorable or unfavorable terms as the entity did
before adopting ASC 842.
APPLICATION OF THE PORTFOLIO APPROACH IN TRANSITION
ASC 842 permits an entity to apply the leases guidance on a portfolio basis. Specifically, paragraph 120 in the Basis for
Conclusions to ASU 2016-02 indicates that the standard permits both a lessee and a lessor to apply the leases guidance
at a portfolio level for leases with similar characteristics as long as the use of the portfolio approach would not differ
materially from the application of ASC 842 to the individual leases in the portfolio. Paragraphs 842-20-55-18 through
55-20 provide an example in which the portfolio approach is utilized in determining the discount rate for the lease.
We believe the application of the portfolio approach may be particularly beneficial during transition for the recognition
of existing operating leases on balance sheet. For example, an entity (lessee) may decide to group existing operating
leases into portfolios of leases with similar characteristics (for example, in terms of lease payments, lease term, and so
forth) to determine the discount rate to initially measure those leases.
Contacts
Oran Asher Professional Practice Manager oasher@bdo.com
Lisa Edelman Professional Practice Senior Manager ledelman@bdo.com
Thomas Faineteau
Professional Practice Partner
Jin Koo Professional Practice Partner [email protected]
Angela Newell Professional Practice Partner [email protected]
ACCOUNTING FOR LEASES UNDER ASC 842 291
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