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2.4 Separating lease and nonlease components
Publication date: 31 Jan 2023
us Leases guide 2.4
Lease contracts may contain nonlease components that should be accounted for using other accounting models (e.g., common area maintenance or services such as security). Only the components that are integral to the right to use an underlying asset are considered lease components. ASC 842 requires a reporting entity to allocate the contractual consideration between components of the arrangement. Distinguishing between lease and nonlease components is also important because it is not always appropriate to record assets and liabilities associated with the nonlease components.
Lessors and lessees follow different allocation methods among the components. For example, by granting a customer the right to use an asset, a supplier is performing a revenue generating activity and the recognition should be consistent with the framework in ASC 606. A customer using that asset would not follow revenue recognition guidance.
This section discusses:
● How to identify separate lease and nonlease components
● How to allocate consideration to the components for a lessor and a lessee
If two or more arrangements are entered into at the same time, ASC 842-10-25-19 provides guidance regarding whether those contracts should be considered together.
If contracts are combined based on the criteria in ASC 842-10-25-19, the conclusion regarding whether the arrangement is or contains a lease could be different than assessing each contract individually. Any component considered to be a lease element, regardless of whether it is in an individual or combined contract, should be classified, recognized, and measured in accordance with the guidance in ASC 842.
When analyzing a contract that contains multiple pieces of equipment, a customer should consider whether the arrangement contains one lease component or more than one. See LG 2.5 for information regarding the accounting for multiple units of account within a lease that are all deemed to be separate lease components.
2.4.1 Identifying lease and nonlease components
Contracts may involve payments for lease components, nonlease components, and items that are not considered contract components. The identification of these elements is important because consideration in the contract (as defined in ASC 842) is allocated only to the lease and nonlease components.
To be considered a component, an activity must transfer a good or service. The transfer of the right to use an asset in a leasing arrangement is considered a component similar to the delivery of an asset or providing services.
Lease components are elements of the arrangement that provide the customer with the right to use an identified asset. The right to use an underlying asset is a separate lease component if (1) the lessee can benefit from the right to use the underlying asset either on its own or together with other resources that are readily available, and (2) the right to use the underlying asset is neither highly dependent on nor highly interrelated with other rights to use other underlying assets in the arrangement.
Not all activities related to a lease are subject to the guidance in ASC 842. For example, a supplier may lease a truck and also operate the leased asset on behalf of a customer (i.e., provide a driver). The service of providing a driver is not related to securing the use of the truck and is not a lease component. Only items that contribute to securing the output of the asset are lease components. In this example, only the use of the truck is considered a lease component. Similarly, costs incurred by a supplier to provide maintenance on an underlying asset, as well as the materials and supplies consumed as a result of the use of the asset, are not lease components.
Nonlease components are distinct elements of a contract that are not related to securing the use of the leased asset. Arrangements that include both lease and nonlease components are common in real estate transactions. For example, if the landlord/lessor of a property provides common area maintenance (CAM) of leased office space, such as cleaning and landscape services, the CAM involves delivery of a separate service and is not considered a cost of securing the office building. As such, it is considered a nonlease component.
Nonlease services can be included in equipment leases as well. For example, as part of a lease of specialized equipment to a hospital, a medical device supplier may also provide operational or maintenance services. Even if the equipment is considered a lease, the operational or maintenance services are nonlease components presuming they are distinct (i.e., capable of generating an economic benefit separate from the lease of the equipment). See RR 3.3 for additional information.
Excerpt from ASC 842-10-15-30
Components of a contract include only those items or activities that transfer a good or service to the lessee. Consequently, the following are not components of a contract and do not receive an allocation of the consideration in the contract:
- Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee
- Reimbursement or payment of the lessor’s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset.
Costs related to property taxes and insurance do not involve the transfer of a good or service and accordingly are not contract components. As such, these costs do not represent payments for goods and services and are simply part of total consideration. Payments for property taxes that are levied based on legal ownership (i.e., regardless of which party uses the asset) and insurance when a lessor is the primary beneficiary of the insurance policy would be incurred by the lessor of the underlying asset whether or not the underlying asset is leased. Although these payments may be based on a specific underlying (e.g., real estate taxes), they do not represent components and instead simply reflect another form of consideration under the contract. Such amounts are allocated to their lease and nonlease components following the guidelines described in LG 2.4.2 and LG 2.4.3.
ASC 842 requires lessors to record gross revenues and expenses associated with activities or costs that do not transfer a good or service to the lessee (e.g., real estate taxes, insurance) when such amounts are paid by the lessor and subsequently reimbursed by the lessee, because the costs are the lessor's costs of owning the asset. This will result in many lessors recording higher gross revenues and expenses than they did under the previous leasing guidance.
ASC 842-10-15-39A requires lessors to exclude lessor costs from variable payments (and, therefore, from variable lease revenue), when the costs are required to be paid by a lessee directly to a third party.
The guidance also permit lessors, as an accounting policy election, to not evaluate whether certain sales taxes and other similar taxes are costs of the lessor or costs of the lessee. Instead, lessors should account for those amounts as if they were costs of the lessee and should exclude the amounts from contract consideration.
Figure LG 2-3 illustrates common examples of lease components, nonlease components, and items that would not be considered contract components. The nature of payment for each of the items may be fixed, variable (e.g., based on a third-party invoice), or a combination of fixed and variable (e.g., a fixed amount adjusted for future price changes). The nature of the payment does not dictate the determination of whether the item is a component.
Figure LG 2-3
Examples of components and non-components
Examples of components and non-components
Examples of lease components |
|
Examples of nonlease components |
|
Examples of non-components |
|
*See LG 2.5 for evaluation of contracts that relate to buildings and land.
2.4.2 Determining contract consideration
Once lease and nonlease components have been identified, the next step is to determine contract consideration to be allocated to the identified components. Not all payments will be included in contract consideration. ASC 842-10-15 provides guidance for determining what to include in contract consideration for both lessors and lessees.
The consideration in the contract for a lessee includes all of the payments described in paragraph 842-10-30-5, as well as the following payments that will be made during the lease term:
a. Any fixed payments (for example, monthly service charges) or in substance fixed payments, less any incentives paid or payable to the lessee, other than those included in paragraph 842-10-30-5
b. Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.
The consideration in the contract for a lessor includes all of the amounts described in paragraph 842-10-15-35 and any other variable payment amounts that would be included in the transaction price in accordance with the guidance on variable consideration in Topic 606 on revenue from contracts with customers that specifically relates to either of the following:
a. The lessor’s efforts to transfer one or more goods or services that are not leases
b. An outcome from transferring one or more goods or services that are not leases.
2.4.3 Allocating consideration to lease and nonlease components
Once contract consideration has been determined, it needs to be allocated to the lease and nonlease components. ASC 842-10-15-28 through ASC 842-10-15-42 provide guidance for lessees and lessors on how to allocate contract consideration once all contract components have been identified.
Figure LG 2-4 and Figure LG 2-5 summarize how certain payments are treated in determining contract consideration and allocating it to lease and nonlease components for lessors and lessees.
Figure LG 2-4
Determining and allocating contract consideration - lessor
Determining and allocating contract consideration - lessor
Payment type |
Include in consideration |
Allocation to components |
Fixed payment |
Yes |
Allocate to lease and nonlease components, generally based on relative standalone price |
Variable payment that depends on a rate or index, based on the rate or index at commencement date |
Yes |
Allocate to lease and nonlease components, generally based on relative standalone price |
Variable payment not based on rate or index that relates exclusively to nonlease components (see LG 2.4.6.1 for details) |
Determine amount of variable payments to include using the guidance in ASC 606 |
Allocate to specific nonlease components, if doing so results in an allocation that is consistent with the allocation objective in ASC 606. Otherwise, allocate to all components based on relative standalone price |
Variable payments not based on rate or index that relate to lease component, either in part or in full (see LG 2.4.6.1 for details), and changes in variable payments based on a rate or index, that occur after lease commencement |
Not included in consideration at lease commencement for initial measurement |
When variability is eliminated (i.e., payment amount is known), allocate on the same basis as the initial allocation of consideration |
See LG 2.4.4 and LG 2.4.6.1 for further details on how lessors should apply this guidance.
Figure LG 2-5
Determining and allocating contract consideration - lessee
Determining and allocating contract consideration - lessee
Payment type |
Include in consideration |
Allocation to components |
Fixed payments |
Yes |
Allocate to lease and nonlease components, generally based on relative standalone price |
Variable payments that depend on an index or rate |
Yes, using the index or rate at the inception date |
Allocate to lease and nonlease components, generally based on relative standalone price |
Other variable payments |
Not included in consideration at lease inception for initial measurement |
When variability is eliminated (i.e., payment amount is known), allocate on the same basis as the initial allocation of consideration |
See LG 2.4.5 and LG 2.4.6.2 for further details on how lessees should apply this guidance.
2.4.4 Lessor allocation of contract consideration
By satisfying a contract that contains lease and nonlease components, lessors generate revenue. Therefore, once the contract components have been identified, it is appropriate for lessors to follow the relevant guidance in ASC 606 to determine how to allocate contractual consideration between the components. See RR 5 for guidance on this allocation method.
If an arrangement includes variable consideration, the amount of total consideration allocated to the lease and nonlease components may vary based on the nature of the variable payments and the components to which they relate. See LG 2.4.6.1 for information.
2.4.4.1 Component practical expedient for lessors
The guidance in ASC 842-10-15-42A allows lessors to elect to aggregate nonlease components that otherwise would have been accounted for under the revenue recognition standard with the associated lease component, if the following conditions are met:
- The timing and pattern of transfer for the nonlease component and the associated lease component are the same
- The stand-alone lease component would be classified as an operating lease if accounted for separately
A lessor recognizes revenues under an operating lease over the lease term, generally on a straight-line basis. Therefore, the first condition noted above only applies when the performance obligation for the nonlease component is also satisfied over time. Refer to RR 6.3 for more information on performance obligations satisfied over time. Also, that condition would only apply if the lease and nonlease components would be recognized over identical time periods, i.e., the condition would not apply when providing the components begins, or ends, at different dates. For example, we do not believe a lessor can apply this expedient to a three-year lease of equipment which includes a one-year maintenance component (whereas they may be able to apply this expedient if the maintenance contract was also for three years).
If this practical expedient is elected, and the nonlease component is aggregated with the associated lease component, the lessor would account for the combined component as follows:
- If the nonlease components are the predominant characteristic, account for the combined component under the revenue standard. In doing so, the lessor would (a) recognize revenue consistent with the method assessed when applying the “timing and pattern of transfer” criterion to use the expedient and (b) account for all variable payments, including those related to the lease, under the revenue guidance.
- If the nonlease components are not the predominant characteristic, account for the combined component as an operating lease under the leases standard. All variable payments, including those related to any good or service, would be accounted for as variable lease payments.
Lessors will need to apply judgment to determine the predominant characteristic of the combined component. The lessor should consider whether the lessee would ascribe more value to the non-lease component in the arrangement. We believe that often, the predominant characteristic will be readily discernable and could be determined qualitatively. When that is not the case, a lessor may need to evaluate the arrangement quantitatively to conclude that the nonlease component is predominant.
If elected, the practical expedient will need to be applied to all contracts that qualify for the practical expedient as of the date of the election.
2.4.5 Lessee allocation of contract consideration
ASC 842 provides guidance for lessees to allocate contractual consideration between multiple components. Consistent with other allocation models, such as the revenue recognition model in ASC 606, this guidance emphasizes maximizing the use of observable inputs.
A lessee shall allocate (that is, unless the lessee makes the accounting policy election described in paragraph 842-10-15-37) the consideration in the contract to the separate lease components determined in accordance with paragraphs ASC 842-10-15-28 through 15-31 and the nonlease components as follows:
a. The lessee shall determine the relative standalone price of the separate lease components and the nonlease components on the basis of their observable standalone prices. If observable standalone prices are not readily available, the lessee shall estimate the standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain.
b. The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the nonlease components of the contract.
Initial direct costs should be allocated to the separate lease components on the same basis as the lease payments.
Estimating standalone prices will require judgment when identical goods or services are not readily available in the marketplace. Assets do not need to be identical for their inputs to be considered observable. Inputs are not required to be supplier specific or identical; similar leased products in the market can be useful observable data points provided the information is both consistent and comparable. For example, a lessee may be able to estimate market rents for a new lease from similar, though not identical, lease arrangements, by estimating the impact of the differences between the two arrangements. A good or service that is unique to a supplier may not have market comparisons. In this circumstance, a lessee should gather as much information from the supplier regarding their basis for establishing the price in the arrangement. While knowing an asset’s sale price may provide the lessee helpful information, the allocation of consideration should be based on the standalone price of the right-of-use asset, not the standalone price of the underlying asset.
A lessee should maximize the use of observable data and utilize the best available information to determine its allocation. Estimates are permitted when necessary, but only if observable standalone pricing or observable inputs are not available. Estimates must be applied consistently across similar arrangements and like assets. If an arrangement includes variable consideration, whether the variable consideration is included in total contract consideration and allocated to the lease and nonlease components depends on the nature of the variable payments. See LG 2.4.6 for information.
Question LG 2-3 addresses how a lessee should allocate payments for property taxes and insurance.
Question LG 2-3
Should a lessee that pays property taxes and insurance for an underlying asset directly to the billing authority include those payments in its computation of contract consideration to be allocated to components of the contract?
Should a lessee that pays property taxes and insurance for an underlying asset directly to the billing authority include those payments in its computation of contract consideration to be allocated to components of the contract?
PwC response
Including payments made by a lessee for property taxes and insurance in contract consideration will depend on whether the lessee is required to pay a fixed or variable amount.
If a lessee is required to pay a fixed amount of property taxes and insurance related to the leased asset, such payments should be included in contract consideration and allocated to the lease and nonlease components. If a lessee is required to pay the actual amounts for property taxes and insurance (i.e., a variable amount rather than fixed payments) such payments should be excluded from contract consideration and instead recorded as incurred by the lessee. When recorded, the variable amounts would be allocated to the lease and nonlease components on the same basis as the initial allocation of contract consideration.
If a lessee is required to pay for property taxes and insurance, it does not matter whether the lessee directly pays a third party on the lessor’s behalf or reimburses the lessor. Insurance and property taxes on the underlying asset are not separate lease or non-lease components. The lessee should account for such payments as additional consideration in the arrangement, subject to allocation, and not as insurance or property tax expense. See LG 2.5 for additional information.
2.4.5.1 Component practical expedient for lessees
A lessee may elect an accounting policy, by asset class, to include both the lease and nonlease components as a single component and account for it as a lease. Making this election relieves the lessee of the obligation to allocate contract consideration to the lease and nonlease components, although it may increase the total lease liability to be recorded on its balance sheet. Refer to LG 10 for further discussion of applying this practical expedient during transition.
In describing the rationale for this practical expedient, paragraphs BC149 and BC150 of the Basis for Conclusions to ASU 2016-02 indicate that the Board focused on whether lessees should separate services from lease components. It is unclear whether the Board intended to allow lessees to combine purchases of other goods that are not services (e.g., inventory), with lease components. We believe a lessee applying this practical expedient should combine the nonlease component only when it would otherwise recognize the cost associated with both the lease and nonlease components in a similar fashion (i.e., either when both are capitalized or when both are expensed). For example, in a contract manufacturing arrangement, a lessee could combine the procurement of raw materials and the lease of production equipment when both components are included in the lessee’s inventory costing system and capitalized into the measurement of inventory costs. However, we do not believe a lessee should combine, for example, chemicals purchased for resale into the lease of a pipeline from the chemical supplier, as doing so would distort the lessee’s reporting of inventory and cost of sales.
2.4.5.2 Accounting effects of a lessee electing the component practical expedient
Electing the practical expedient to combine lease and associated nonlease components as a single lease component has additional accounting effects for the lessee. This election will increase payments allocated to the lease components but it does not change the fair value used for classifying the underlying asset. As such, the election increases the possibility that the lease would be classified as a finance lease under the lease payments criterion.
With the adoption of ASC 842, the guidance in ASC 420-10, Exit or Disposal Cost Obligations, was modified to remove leases from its scope. While ASC 420-10 continues to apply to costs to terminate a contract that is not a lease, it would not apply to nonlease components that the lessee has elected to combine with lease components under the lessor expedient. See PPE 6.4.3 and PPE 6.4.3A for more information on the application of ASC 420 on contract termination costs related to leases.
2.4.6 Allocation of variable consideration
The allocation models for variable consideration are intended to incorporate the allocation concepts in ASC 606 while preserving the accounting model applicable to variable lease payments in ASC 842. The key difference between the two models is that variable payments, other than those that depend on an index or rate, are recognized under ASC 842 only as they are earned. In contrast, variable consideration under ASC 606 is estimated (subject to a constraint) and included in the initial allocation of consideration. The discussion below highlights how to deal with this difference when an arrangement includes lease and nonlease components.
As discussed in LG 2.4.1, before determining how to allocate consideration, it is important for lessees and lessors to identify the contract components. Variable consideration for costs that are not contract components (e.g., real estate taxes, insurance) are excluded from total consideration and would be recorded as incurred by the lessee. ASC 842-10-15-40A clarifies the accounting by lessors for variable payments that relate to both a lease and a nonlease component. The amendment requires lessors to allocate certain variable payments to the lease and nonlease components when the changes in facts and circumstances on which the variable payment is based occur. After the allocation, the amount of variable payments allocated to the lease component would be recognized in profit or loss in accordance with the leases guidance, and the amount of variable payments allocated to nonlease components would be recognized in accordance with other guidance, such as the revenue recognition guidance.
2.4.6.1 Allocating variable consideration for lessors
Figure LG 2-4 summarizes the allocation of consideration for lessors. When determining contract consideration for lease and nonlease components, variable payments not based on an index or a rate should only be considered provided they relate solely to nonlease goods and services. If they do, the variable payments should be estimated and, provided they meet the transaction price allocation objective specified in ASC 606, allocated to the nonlease components.
If, however, the variable payments relate even partially to the lease component, they are recognized when the underlying variability is resolved and are allocated to the lease and nonlease components on the same basis as the initial allocation of consideration. A lessor would recognize the amount allocated to lease components in accordance with the guidance in ASC 842, and the amount allocated to nonlease components in accordance with other applicable literature (typically ASC 606). ASC 842-10-15-39 through ASC 842-10-15-40A provide guidance on allocating variable payments to nonlease components.
The consideration in the contract for a lessor includes all of the amounts described in paragraph 842-10-15-35 and any other variable payment amounts that would be included in the transaction price in accordance with the guidance on variable consideration in Topic 606 on revenue from contracts with customers that specifically relates to either of the following:
a. The lessor’s efforts to transfer one or more goods or services that are not leases
b. An outcome from transferring one or more goods or services that are not leases.
Any variable payment amounts accounted for as consideration in the contract shall be allocated entirely to the nonlease component(s) to which the variable payment specifically relates if doing so would be consistent with the transaction price allocation objective in paragraph ASC 606-10-32-28.
A lessor may make an accounting policy election to exclude from the consideration in the contract and from variable payments not included in the consideration in the contract all taxes assessed by a governmental authority that are both imposed on and concurrent with a specific lease revenue-producing transaction and collected by the lessor from a lessee (for example, sales, use, value added, and some excise taxes). Taxes assessed on a lessor’s total gross receipts or on the lessor as owner of the underlying asset shall be excluded from the scope of this election. A lessor that makes this election shall exclude from the consideration in the contract and from variable payments not included in the consideration in the contract all taxes within the scope of the election and shall comply with the disclosure requirements in paragraph 842-30-50-14.
If the terms of a variable payment amount other than those in paragraph 842-10-15-35 relate to a lease component, even partially, the lessor shall not recognize those payments before the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee's sales on which the amount of the variable payment depends occur). When the changes in facts and circumstances on which the variable payment is based occur, the lessor shall allocate those payments to the lease and nonlease components of the contract. The allocation shall be on the same basis as the initial allocation of the consideration in the contract or the most recent modification not accounted for as a separate contract unless the variable payment meets the criteria in paragraph 606-10-32-40 to be allocated only to the nonlease component(s). Variable payment amounts allocated to the lease component(s) shall be recognized as income in profit or loss in accordance with this Topic, while variable payment amounts allocated to nonlease component(s) shall be recognized in accordance with other Topics (for example, Topic 606 on revenue from contracts with customers).
The guidance in paragraph 842-10-15-40 notwithstanding, a lessor shall exclude from variable payments lessor costs paid by a lessee directly to a third party. However, costs excluded from the consideration in the contract that are paid by a lessor directly to a third party and are reimbursed by a lessee are considered lessor costs that shall be accounted for by the lessor as variable payments (this requirement does not preclude a lessor from making the accounting policy election in paragraph 842-10-15-39A).
In light of the different models applicable to lease- and nonlease-related variable consideration, the first step in accounting for variable lease payments is to determine whether the payments relate, even partially, to a lease element. To do this, we believe it would be appropriate to analyze the factors that drive the variability of the payments. To practically analyze this, the factors that determine the amount and whether the variable payment is made should be understood. These factors could be physical factors, such as machine hours, equipment usage time, or number of items sold. They could also be based on economic factors, such as sales revenues and profits.
If it is determined the variable payments relate partially or fully to the lease component, the variable payments are excluded from the allocation for initial measurement. They are instead subsequently allocated between the lease and nonlease components when the underlying event occurs and then recognized in accordance with ASC 842-10-15-40. Variable payments that are exclusively related to the nonlease component are included in the allocation for initial measurement.
If allocating the variable consideration entirely to the nonlease component is consistent with the transaction price allocation objective in ASC 606, the variable payment should be allocated entirely to the nonlease component. The transaction price allocation objective is explained in ASC 606-10-32-28 through ASC 606-10-32-29, and ASC 606-10-32-40.
The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer.
To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).
An entity shall allocate a variable amount (and subsequent changes to that amount) entirely to a performance obligation or to a distinct good or service that forms part of a single performance obligation in accordance with paragraph 606-10-25-14(b) if both of the following criteria are met:
a. The terms of a variable payment relate specifically to the entity’s efforts to satisfy the performance obligation or transfer the distinct good or service (or to a specific outcome from satisfying the performance obligation or transferring the distinct good or service).
b. Allocating the variable amount of consideration entirely to the performance obligation or the distinct good or service is consistent with the allocation objective in paragraph 606-10-32-28 when considering all of the performance obligations and payment terms in the contract.
If the transaction price allocation objective is not met, the variable payment should be included in the initial contract consideration and allocated to the lease and nonlease components based on their relative standalone selling prices.
It is common for suppliers in certain industries to structure transactions with significant variable payments. Suppliers in these industries are willing to accept variability in payments because they believe such arrangements will be profitable overall, and variable payments can make an arrangement attractive to the customer. In certain instances, transactions with significant variable payments may qualify as a transfer of control under ASC 606 and may also meet the classification criteria as a sales-type lease in accordance with ASC 842-10-25-2 through ASC 842-10-25-3 (see LG 3.3 for lease classification criteria). In these instances, the leases standard should be applied. Under ASC 842, variable payments that do not depend on an index or rate and are at least partially related to the lease asset, are not considered until the contingency is resolved. This may lead to the recognition of an initial loss by the lessor (even if the overall arrangement is expected to be profitable). The discount rate used to record a lease receivable cannot be less than zero. As such, a lessor would not be permitted to use a rate less than zero to avoid recognition of an initial loss. In response to concerns raised in the post implementation review, the FASB published ASU 2021-05, which upon adoption requires a lessor to classify a lease with variable lease payments (that do not depend on an index or a rate) as an operating lease at the lease commencement date if classifying the lease as a sales-type lease (or direct financing lease) would result in recognition of a selling loss. See LG 10.10 for the effective date and transition requirements of ASU 2021-05.
Figure LG 2-6 illustrates the decision process for the allocation of variable consideration for lessors.
Figure LG 2-6
Lessor allocation of variable consideration
Lessor allocation of variable consideration
Example LG 2-14, Example LG 2-15 and Example LG 2-16 illustrate how to allocate variable consideration between lease and nonlease components. Figure LG 2-7 summarizes the key distinctions between the facts and conclusions in each example.
EXAMPLE LG 2-14
Variable consideration is excluded from allocation – contract for sale of medical equipment and consulting services (sales-type lease)
Customer Co, a medical facility, contracts with Supplier Corp to lease specialized medical equipment over a five-year period. Prior to leasing the specialized medical equipment from Supplier Corp, Customer Co treated 5,000 patients per year using an older version of the equipment. Supplier Corp asserts that the new medical equipment is more efficient than the older version and will allow Customer Co to treat additional patients.
Supplier Corp will also provide consulting services to assist Customer Co with optimizing operations and reducing inefficiencies at its medical facility. Supplier Corp believes that the consulting services will both reduce costs and further increase the number of patients Customer Co can treat using the new equipment. The number of hours Supplier Corp will provide each year as part of these consulting services is fixed at inception of the contract.
The parties agree that Customer Co will make fixed annual payments of $400,000 and will make an incremental payment based on the number of patients treated using the new equipment. Specifically, for each patient treated in excess of an established threshold of 6,000 per year, Customer Co will make an incremental payment to Supplier Corp of $100 per patient.
Supplier Corp believes that Customer Co will treat 7,000 patients each year, and therefore will be required to make an incremental payment of $100,000 (1,000 patients in excess of threshold × $100 per patient) per year. Total expected annual payments are $500,000 ($400,000 fixed + $100,000 variable).
Supplier Corp expects that even without the consulting services, Customer Co would realize a significant increase in the number of patients it could treat as a result of the new, more efficient equipment and would be required to make at least part of the incremental payment.
The medical equipment has a useful life of five years and is not expected to have a residual value at the end of the lease term. The lease of the medical equipment has met the classification criteria as a sales-type lease since the lease term is for a major part of the useful life of the asset.
The standalone selling price of the equipment is $2,000,000 (cost basis of $1,900,000) and the standalone selling price for the consulting services is estimated to be $26,000 per year.
In the first year of the arrangement, Customer Co treats 7,000 patients using the new equipment.
Supplier Corp has adopted ASU 2021-05.
Supplier Corp has elected not to aggregate lease and nonlease components in accordance with ASC 842-10-15-42A.
How should Supplier Corp account for this arrangement at lease commencement and in the first year?
Analysis
The equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments do not depend on an index or rate. In addition, Supplier Corp believes that it will be entitled to at least part of the variable payments regardless of whether the consulting services are provided. Therefore, the variable payments relate, at least partially, to the lease component. Consequently, the variable consideration should be excluded from the allocation of consideration used for initial measurement, and will be allocated to both the lease and nonlease components when the underlying event occurs.
An allocation of the fixed payment over the term of the lease would be made as follows:
Standalone price (A) |
Relative % (A/$2,130,000) (B) |
Fixed Payments ($400,000 × 5 years) (C) |
Allocated payment (B × C) |
|
Medical equipment |
$2,000,000 |
93.9% |
$2,000,000 |
$1,877,934 |
Consulting services (5 years) |
130,000 |
6.1% |
$2,000,000 |
122,066 |
Total |
$2,130,000 |
100% |
$2,000,000 |
At the lease commencement date, because the variable payments that do not depend on an index or rate should be excluded from the allocation of consideration used for initial measurement, Supplier Corp would incur a net loss since allocated payments are lower than the cost basis of the equipment (allocated payment of $1,877,934 is less than the cost basis of $1,900,000). In light of the day-one loss, Supplier Corp would classify and account for the lease as an operating lease in accordance with ASU 2021-05.
In the first year of the arrangement, Supplier Corp would allocate the fixed and variable payments of $500,000 ($400,000 fixed and $100,000 variable) based on the relative standalone selling price of the lease and nonlease components at lease inception, as shown below.
Relative % |
Fixed payment allocated |
Variable payment allocated |
Total allocated payment |
|
Medical equipment |
93.9% |
$375,587 |
$93,897 |
$469,484 |
Consulting services (5 years) |
6.1% |
24,413 |
6,103 |
30,516 |
Total |
$400,000 |
$100,000 |
$500,000 |
Fixed payments allocated to the medical equipment lease would be recognized in accordance with ASC 842, typically on a straight-line basis. Since the lease is classified as operating lease, the annual straight-line lease income attributable to the medical equipment lease is $375,587 ($1,877,934/5). Fixed payments allocated to the consulting services would be recognized using the guidance in ASC 606. Variable payments would be recognized pursuant to the guidance in ASC 842-10-15-40 when the variability is resolved.
EXAMPLE LG 2-15
Variable consideration is included in the allocation – contract for sale of medical equipment and consulting services (sales-type lease)
Variable consideration is included in the allocation – contract for sale of medical equipment and consulting services (sales-type lease)
Customer Co, a medical facility, contracts with Supplier Corp to lease specialized medical equipment over a five-year period. Prior to leasing the specialized medical equipment from Supplier Corp, Customer Co treated 5,000 patients per year using an older version of the equipment. Supplier Corp believes that the new equipment will provide for better patient care, but it is not expected to significantly impact the number of patients that Customer Co can treat.
Supplier Corp will also provide consulting services to assist Customer Co with optimizing operations and reducing inefficiencies at its medical facility. Supplier Corp believes that the consulting services will both reduce costs and further increase the number of patients Customer Co can treat using the new equipment. The number of hours Supplier Corp will provide each year as part of these consulting services is fixed at inception of the contract.
The parties agree that Customer Co will make fixed annual payments of $400,000 and will make an incremental payment based on the number of patients treated using the new equipment. Specifically, for each patient treated in excess of an established threshold of 6,000 per year, Customer Co will make an incremental payment to Supplier Corp of $100 per patient. Increases in the number of patients Customer Co can treat will result primarily from the optimization of processes as a result of the consulting services. Absent those services, it is unlikely that the 6,000 patient threshold would be met.
Supplier Corp believes that Customer Co will treat 7,000 patients each year, and therefore will be required to make an incremental payment of $100,000 (1,000 patients in excess of threshold × $100 per patient) per year. Total expected annual payments are $500,000 ($400,000 fixed + $100,000 variable).
The medical equipment has a useful life of five years and is not expected to have a residual value at the end of the lease term. The lease of the medical equipment has met the classification criteria as a sales-type lease since the lease term is for a major part of the useful life of the asset.
The standalone selling price of the equipment is $2,000,000 (cost basis of $1,900,000) and the standalone selling price for the consulting services is estimated to be $26,000 per year.
In the first year of the arrangement, Customer Co treats 7,000 patients using the new equipment.
The Company has adopted ASU 2021-05.
How should Supplier Corp account for this arrangement at lease commencement and in the first year?
Analysis
The equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments relate exclusively to the nonlease component.
In this example, Supplier Corp concludes that the variable payments relate specifically to an outcome from Supplier Corp’s performance of its consulting services. Therefore, Supplier Corp evaluates the payments in accordance with ASC 606-10-32-5 through ASC 606-10-32-13. Supplier Corp estimates, using the most likely amount method, that (a) it will be entitled to receive the $500,000 in variable payments and (b) it is probable that including this amount in the transaction price will not result in a significant revenue reversal, the $500,000 would be included in consideration in the contract. Supplier Corp allocates the variable payments to the lease and nonlease components based on relative standalone selling price, as the transaction price allocation objective is not met (please refer to Example LG 2-16 for an example of how to allocate consideration when the transaction price allocation objective in ASC 606-10-32-28 is met). See RR 5 for information on allocating variable consideration.
Standalone price (A) |
Relative % (A/$2,130,000) (B) |
Fixed Payments ($400,000 x 5 years) (C) |
Variable Payments ($100,000 x 5 years) (D) |
Total Allocated payment B x (C + D) |
|
Medical equipment |
$2,000,000 |
93.9% |
$2,000,000 |
$500,000 |
$2,347,500 |
Consulting services (5 years) |
130,000 |
6.1% |
$2,000,000 |
$500,000 |
$152,500 |
Total |
$2,130,000 |
100% |
$2,500,000 |
The total allocated lease payments are $2,347,500. The annual payments attributable to the lease component are $469,500 ($2,347,500/5). For simplicity, it is presumed that all annual lease payments, including the expected variable consideration, are received at the beginning of each year of the lease. The rate implicit in the lease was determined to be 8.72% and the lease receivable is $2,000,000.
Since the lease with variable payments meets the classification criteria as a sales-type lease and does not result in day-one loss, Supplier Corp would classify and account for this lease as a sales-type lease. The adoption of ASU 2021-05 does not impact the accounting model since the arrangement does not give rise to a day-one loss. Supplier Corp would remove the asset from its balance sheet and record a receivable equal to the present value of the lease payments calculated using the rate implicit in the lease.
Supplier Corp would record the following journal entry on the lease commencement date.
Dr. Lease receivable |
$2,000,000 |
|
Dr. Cost of sales |
$1,900,000 |
|
Cr. Revenue |
$2,000,000 |
|
Cr. Medical equipment asset |
$1,900,000 |
In the first year of the arrangement, Supplier Corp would allocate the total $500,000 payment based on the relative standalone selling price of the lease and nonlease components at lease inception.
Relative % (A) |
Payment (B) |
Allocated lease payment (A x B) |
|
Medical equipment |
93.9% |
$500,000 |
$469,500 |
Consulting services (5 years) |
6.1% |
$500,000 |
30,500 |
Total |
100% |
$500,000 |
At the beginning of the first year of the arrangement, Supplier Corp would record the following entry to record receipt of the fixed medical equipment lease payment and variable incremental patient payment based on expected patient volume.
Dr. Cash |
$500,000 |
|
Cr. Lease receivable |
$469,500 |
|
Cr. Deferred service revenue |
$30,500 |
Interest paid to Supplier Corp at the beginning of year 2 would be accrued during year 1 (via a debit to the lease receivable and credit to interest income). At the beginning of the second year of the arrangement, Supplier Corp would record the following entry to record receipt of the fixed medical equipment lease payment, variable incremental patient payment based on expected patient volume, and interest on the lease receivable.
Dr. Cash |
$500,000 |
|
Dr. Lease receivable |
$133,460 |
|
Cr. Lease receivable |
$469,500 |
|
Cr. Deferred service revenue |
$30,500 |
|
Cr. Interest income |
$133,460 |
EXAMPLE LG 2-16
Allocating variable consideration – contract for sale of medical equipment and consulting services (sales-type lease)
Customer Co, a medical facility, contracts with Supplier Corp to lease specialized medical equipment over a five-year period. Prior to leasing the specialized medical equipment from Supplier Corp, Customer Co treated 5,000 patients per year using an older version of the equipment. Supplier Corp believes that the new equipment will provide for better patient care, but it is not expected to significantly impact the number of patients that Customer Co can treat.
Supplier Corp will also provide consulting services to assist Customer Co with optimizing operations and reducing inefficiencies at its medical facility. Supplier Corp believes that the consulting services will both reduce costs and further increase the number of patients Customer Co can treat using the new equipment. The number of hours Supplier Corp will provide each year as part of these consulting services is fixed at inception of the contract.
The parties agree that Customer Co will make fixed annual payments of $400,000 and will make an incremental payment based on the number of patients treated using the new equipment. Specifically, for each patient treated in excess of an established threshold of 6,000 per year, Customer Co will make an incremental payment to Supplier Corp of $100 per patient. Increases in the number of patients Customer Co can treat will result primarily from the optimization of processes as a result of the consulting services. Absent those services, it is unlikely that the 6,000 patient threshold would be met.
Supplier Corp believes that Customer Co will treat 7,000 patients each year, and therefore will be required to make an incremental payment of $100,000 (1,000 patients in excess of threshold × $100 per patient) per year. Total expected annual payments are $500,000 ($400,000 fixed + $100,000 variable).
The medical equipment has a useful life of five years and is not expected to have a residual value at the end of the lease term. The lease of the medical equipment has met the classification criteria as a sales-type lease since the lease term is for a major part of the useful life of the asset.
The standalone selling price of the equipment is $2,000,000 (cost basis of $1,900,000) and the standalone selling price for the consulting services is estimated to be $100,000 per year ($500,000 over the term of the contract).
In the first year of the arrangement, Customer Co treats 7,000 patients using the new equipment.
The Company has adopted ASU 2021-05.
How should Supplier Corp account for this arrangement at lease commencement and in the first year?
Analysis
The equipment lease and consulting services are separate lease and nonlease components, respectively. The variable payments relate exclusively to the nonlease component (consulting services).
Supplier Corp determined that it should allocate the variable payments entirely to the nonlease component (consulting services) and the fixed payments entirely to lease component (the equipment lease) because doing so would be consistent with the transaction price allocation objective in ASC 606-10-32-28.
The fixed payments of $2,000,000 ($400,000 × 5 years) would be allocated to the lease component. Since the lease meets the classification criteria as a sales-type lease, Supplier Corp would classify and account for this lease as a sales-type lease. The adoption of ASU 2021-05 does not impact the accounting model. Supplier Corp would remove the asset from its balance sheet and record a receivable equal to the present value of those fixed lease payments.
Supplier Corp would record the following journal entry on the lease commencement date.
Dr. Lease receivable |
$2,000,000 |
|
Dr. Cost of sales |
$1,900,000 |
|
Cr. Revenue |
$2,000,000 |
|
Cr. Medical equipment asset |
$1,900,000 |
In the first year of the arrangement, Supplier Corp would allocate the $400,000 fixed lease payment entirely to the medical equipment lease and the $100,000 variable payment to the consulting services; the revenue from services provided would be recognized using the guidance in ASC 606.
In the first year of the arrangement, Supplier Corp would record the following entry to record receipt of the fixed medical equipment lease payment and variable incremental patient payment.
Dr. Cash |
$500,000 |
|
Cr. Lease receivable |
$400,000 |
|
Cr. Service revenue |
$100,000 |
|
To record receipt of the fixed medical equipment lease payment and variable incremental patient payment |
||
This example depicts one fact pattern when the transaction price allocation objective under ASC 606 would be considered met (i.e., stand-alone selling price for the consulting services is equal to the expected variable payment for the services provided under the contract). We believe there are other fact patterns when the objective would also be met. Consider a circumstance when the fixed payments are $2,250,000 and the expected variable payments are $250,000. Allocating 100% of the variable payments and $250,000 of the fixed payments to the consulting services would also meet the allocation objective under ASC 606 because the payments allocated to both components of the contract would be consistent with their stand-alone selling prices.
Figure LG 2-7
A comparison of examples LG 2-14 through LG 2-16
A comparison of examples LG 2-14 through LG 2-16
Example |
Variable payment depend on a rate or index? |
Variable payment relate at least partially to lease component? |
Allocation of fixed payment to lease component and variable payment to nonlease component meet transaction price allocation objective? |
Fixed payment allocated to |
Variable payment allocated to |
Example LG 2-14 |
No |
Yes |
N/A |
Both lease and nonlease |
Both lease and nonlease, but only upon occurrence of the underlying event |
Example LG 2-15 |
No |
No |
No |
Both lease and nonlease |
Both lease and nonlease, at contract inception |
Example LG 2-16 |
No |
No |
Yes |
Lease |
Nonlease |
2.4.6.2 Allocating variable consideration for lessees
A lessee allocates consideration in a contract to lease and nonlease components based on their relative standalone prices. Only consideration that is discussed in ASC 842-10-15-35 is included in the allocable consideration.
The consideration in the contract for a lessee includes all of the lease payments described in paragraph 842-10-30-5, as well as all of the following payments that will be made during the lease term:
- Any fixed payments (for example, monthly service charges) or in substance fixed payments, less any incentives paid or payable to the lessee, other than those included in paragraph 842-10-30-5
- Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date.
Variable payments that do not depend on an index or rate should be excluded from lease payments at lease commencement for initial measurement. Subsequent to initial measurement, these variable payments are recognized when the event determining the amount of variable consideration to be paid occurs. However, variable payments that are based on achieving a specified target would be recognized at the time the achievement of the target is considered probable in accordance with ASC 842-20-55-1.
These payments, when recognized, will be allocated to the lease and nonlease components based on their relative standalone prices at lease inception. This concept is illustrated in ASC 842-10-55-140. Variable payments that depend on an index or a rate are included in the allocable consideration and allocated based on the relative standalone prices of the lease and nonlease components.
The lessor-specific guidance in ASC 842-10-15-39, under which a lessor ascribes certain variable payments solely to a nonlease component, as illustrated in Example LG 2-16, does not apply to lessees. A lessee must allocate all payments to all lease and nonlease components based on their relative standalone prices unless they elect the lessee component practical expedient described in LG 2.4.5.1.
2.4.7 Lessor accounting for an arrangement that includes a “free” lease
Suppliers often sell goods to customers in arrangements that require payment only when items are purchased, for example, on a per unit basis. Those suppliers may also provide related equipment to the customer at no additional charge. Examples include the following:
- A supplier of corn flour provides a tortilla maker to its customers for no contractual charge. The customer pays the supplier only for flour purchased without a minimum purchase obligation, and there are no other fees in the arrangement.
- A medical device manufacturer supplies a hospital with medical equipment for no contractual consideration. The equipment can only be used with disposables that the customer must purchase from the supplier, but the contract contains no minimum purchases.
In many such cases, the arrangement contains a lease of the free equipment as evaluated under the guidance in ASC 842-10-15. Nonetheless, suppliers have asked whether they are required to allocate consideration to the “free” lease component. Some have pointed to the definition of lease in the ASC 842 glossary to support the notion that a “free” lease does not meet the definition of a lease as there is ostensibly no consideration.
ASC 842-10 Glossary
Lease
A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. [emphasis added]
We believe that a supplier-lessor should generally allocate consideration to all lease and nonlease components within an arrangement. The component practical expedient for lessors (refer to LG 2.4.4.1) would typically not apply since the pattern of transfer for the equipment would be at a point in time and the services are performed over time. Notwithstanding this view, we believe it may be acceptable to allocate consideration solely to the nonlease component when an arrangement meets all of the following conditions:
- The contract only includes variable payments not based on an index or rate; that is, the contract contains no fixed payments (including fixed payments for other services), and no in-substance fixed payments (e.g., minimum purchase requirements, take-or-pay provisions)
- The consumables are priced at (or below) their stand-alone selling price
- The consumable price would be no different if the equipment were not provided
- The “free” equipment is insignificant
Determining whether “free” equipment is insignificant will require careful consideration of the rights and obligations in the arrangement. For example, a contract that permits the lessor to repossess the equipment (e.g., if a customer defaults or fails to meet supplier purchase or usage expectations) may be in conflict with an assertion that the equipment is insignificant. If a supplier concludes that the “free” lease is insignificant, it would be accounted for as an abandoned asset and written off through earnings when control transfers to the customer. Deferring and amortizing the cost of the equipment over time would be inconsistent with the supplier’s assertion that the equipment is insignificant.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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