When it comes to contracts with lease and non-lease components, entities have a couple of accounting options. One of them—a practical expedient afforded in Accounting Standards Codification (ASC) 842—provides a simplified means of accounting for contracts with multiple components.
The Financial Accounting Standards Board (FASB) first released guidance on leases in a 2016 Accounting Standards Update. After multiple delays, most entities have either adopted ASC 842 or are in the process of implementation. One of the more challenging aspects of implementation is determining the lease and non-lease components of a contract. Here, we will focus on these components and provide some examples to help identify and account for them from the lessee’s perspective.
After determining that a contract is or includes a lease, an entity must then attempt to separate the “lease components” from the “non-lease components” and “non-components.”
Lease Components
ASC 842 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 lease contract may encompass the right to use multiple assets, such as land, buildings, and equipment. The entity must evaluate and decide whether to account for these assets separately or as one under ASC 842. To account for them separately, they must meet two criteria:
- The lessee can benefit from the right to use the asset either on its own or with other “readily available” resources.
- The right of use (ROU) of the underlying asset is neither highly dependent on nor highly interrelated with the ROU of other underlying assets in the contract.
If the two criteria for separation are not met, the individual ROU must be combined with another so the combined ROU meets both and can be accounted for as a single lease component. Additionally, ASC 842 states that an entity leasing land and other assets must account for the ROU of the land as a separate lease component unless doing so would have an insignificant effect on the accounting.
Non-Lease Components
ASC 842 indicates that a non-lease component transfers to the lessee a good or service that is separate from the ROU of the underlying asset. Examples include service contracts, maintenance, and repair costs that are commonly embedded in the periodic payments the lessee makes. These types of contractual arrangements are considered non-lease components, are not capitalized as part of the ROU asset, and are separated from the lease payments. The segregation of lease and non-lease components could have a significant financial reporting impact.
Warranties must also be evaluated. If the lessor’s commitment is more extensive than a typical warranty, it might be considered as the lessor providing a service to the lessee, and therefore should be accounted for as a non-lease component.
Non-Components
To be considered components of a contract, items or activities need to transfer goods or services to the lessee. Otherwise, they are considered non-components and no contract consideration is allocated to them. Some examples include real estate or property taxes related to the leased assets; insurance that covers the lessor’s interest in the leased asset; reimbursement or payment of the lessor’s costs; and shipping, delivery, and installation of the underlying leased asset.
Accounting for Contracts With Lease and Non-Lease Components
In a contract with lease and non-lease components, there are two options:
- Separate the lease components from the non-lease components, which can be a time-consuming, tedious process.
- Employ ASC 842’s practical expedient that allows an entity to make an accounting policy election by class of underlying asset, choosing not to separate the lease and non-lease components. Instead, each separate component associated with that lease component will be accounted for as a single lease component. Electing this practical expedient will result in the recognition of larger ROU assets and lease liabilities.
ASC 842 indicates that payments included in a contract should be allocated to the lease and non-lease components based on their respective stand-alone prices. If observable prices are available, they should be utilized in the allocation. Observable prices are those the lessor or vendor would have been able to charge for the components, had they been sold separately.
This is best defined through the lessor’s or vendor’s actual sales information for the sale of similar goods or services. If there is a high degree of uncertainty or variability related to the price of a component, the residual estimation approach can be used. Under this approach, the stand-alone price of a component is determined by taking the total transaction price and reducing it by the observable stand-alone prices of the other components.
Illustrative Example
Facts and Circumstances: An entity leases a facility, which includes a building, land, and three pieces of equipment. The building, land, and all three pieces of equipment are considered separate lease components because they meet the above criteria to be treated and accounted for separately. As part of the agreement, the lessor is to provide maintenance services for each piece of equipment throughout the lease term (the fixed non-lease component), and the lessee is required to pay an annual fee of $1,500 at the end of the year for each piece of equipment if it is operated at a minimum number of hours for the year (the variable non-lease component).
The remainder of the example will focus on the lease, maintenance services, and variable payment for one of the pieces of equipment.
For fixed payments, the contract requires $20,000 annual payments for 10 years, or $200,000 total. The lessee determines the stand-alone prices of the equipment lease and maintenance services to be $190,000 and $15,000, respectively. Thus, $185,4001 of the fixed payments would be the basis for the lease liability (before discounting), and the remaining $14,6002 would be allocated to the maintenance services.
- $200,000 x 92.7% ($190,000/($190,000 + $15,000))
- $200,000 x 7.3% ($15,000/($190,000 + $15,000))
These amounts will be recognized on a straight-line basis over the 10-year term of the lease. As such, $18,540 of the annual fixed payment will be recognized as a lease cost, and $1,460 will be recognized as maintenance expense.
For the variable payments, we assume that in the first year the equipment exceeded the minimum number of hours, and the lessee now owes $1,500. ASC 842 requires that variable payments be allocated to the lease and non-lease components in the period the obligation to make those payments is met, and requires that the allocation be based on the same percentages used in allocating the fixed payments. Thus, the lessee will allocate the $1,500 as follows: 92.7% ($1,390.50) to lease cost and 7.3% ($109.50) to maintenance expense.
So, in total for the first year, the lessee would allocate $19,930.50 ($18,540 + $1,390.50) to lease cost and $1,569.50 ($1,460 + $109.50) to maintenance expense.
Simplified Example Using the Practical Expedient
Assuming the same facts, if the lessee chooses the practical expedient, all fixed and variable payments would be treated as lease payments. As a result, all fixed payments associated with a contract would be treated as a lease component, which would increase the lease liability due to the non-separation of non-lease components. The practical expedient would also require the lessee to treat variable payments as a lease expense in the period the obligation to make the payment is satisfied.
In our previous example, the $200,000 would be the basis for the lease liability instead of the $185,400, and the entire $1,500 variable payment would be recognized as lease expense. The practical expedient certainly simplifies the accounting for contracts with multiple components. An entity’s decision to employ the practical expedient will likely be influenced by its number of leases and its sensitivity to reporting increased debt on its books.
How PYA Can Help
If you have questions about accounting for lease agreements, separation of lease and non-lease components, identification of non-components, or the application of the practical expedient in ASC 842, contact one of our PYA executives below at (800) 270-9629.
