To offer relief for the significant effort levels the implementation of a new standard can place on an organization, the FASB often includes practical expedients where appropriate in the new guidance. A practical expedient is an option provided by standard setters to mitigate the burden of applying specific sections of the accounting guidance.

For the prescribed updates to lease accounting, the FASB issued several practical options to ease the adoption of ASC 842. Companies can apply these relief efforts as an accounting policy election either by class of asset or to the entire lease portfolio depending on the type of practical expedient. Identifying the appropriate practical expedients for your company will save time, but if not interpreted properly, companies run the risk of errors in their financial statements.

One expedient which offers significant resource savings to lessee financial statement preparers is the expedient permitting the combination of lease and nonlease components into a single lease component:

842-10-15-37: As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component.

As further clarification, this expedient must be applied as an accounting policy election at the asset class level. Therefore the lessee is not required to expend resources determining the fair value of each individual component and allocating contract payments between components.

*This practical expedient is offered to both lessees and lessors. However this article will focus on the application and implication of the expedient to lessees only.

Identifying components

Lease, nonlease, and noncomponents

Once a contract has been identified as a lease, the lessee must determine the separate components within the contract terms and conditions. Contract components are the various specified pieces or parts of a contract for which consideration is exchanged. Under ASC 842, components only include items and activities that transfer a good or service to the lessee. Contracts can also contain noncomponents, which are payments for activities that transfer no goods or services to the lessee. The parts of a lease agreement can be labeled:

  • Lease component
  • Nonlease component
  • Noncomponent

Lease components

Lease components directly transfer the right to use the underlying asset to the lessee. The nature of the payment, fixed or variable, does not dictate the determination of whether it is a lease component.

ASC 842 provides criteria that indicate the right to use each asset in a contract is considered a separate lease component. If both of the following conditions are met, the lease component is considered a separate component per ASC 842-10-15-28:

(1) the lessee can benefit from the right of use [of the underlying asset] either on its own or together with other resources that are readily available to the lessee, and

(2) the right of use [of the underlying asset] is neither highly dependent on or highly interrelated with other right(s) to use underlying assets in the contract.

One area that may involve additional consideration by lessees as it relates to lease components is leases of land and buildings. When a lessee leases an entire building, they are inherently also leasing the land underneath the building. Per ASC 842, lessees must account for land as a separate lease component from the rights to use the other underlying assets in a contract, unless the effect of separating the land from the additional components is insignificant. The FASB doesn’t define what would be significant, so lessees will need to use judgment in this determination. Additionally, the board explained land must be assessed separately because it has an indefinite economic useful life and therefore differs significantly from other asset types. This judgment centered approach to separating land from other lease components differs significantly from the rules based approach under ASC 840.

Nonlease components

A nonlease component is still a component of a contract because it transfers a separate good or service to the lessee. However, it is not directly related to securing the use of the underlying asset. Frequent examples of nonlease components include the cost of common area maintenance (CAM) provided by the landlord for a real estate lease, or charges for maintenance, landscaping, janitorial, or other services related to the lease.

Noncomponents

For a component to be a lease or nonlease component, some sort of good or service must be transferred to the lessee. Some contracts contain payments that do not contribute directly to the right to use the underlying asset and do not transfer any value to the lessee. These are called noncomponents. Lessees do not allocate consideration from the contract to noncomponents.

Common examples of noncomponents include:

  • 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, such as property taxes or insurance, regardless of whether directly paid to a third party or as a reimbursement to the lessor

Table: component types

Below is a chart of some of the common items found in real estate or other lease agreements and their classification:

Consideration Type Reasoning Examples
Fixed payments for use of the asset Lease component Rent payments directly transfer the right to use the underlying asset Base rent to use space in a building or to use a piece of equipment
Variable payments for use of the asset Lease component Rent payments directly transfer the right to use the underlying asset Usage or mileage-based payments on a vehicle or piece of equipment
Common Area Maintenance (CAM) Nonlease component Transfers a good or service to the lessee but does not relate directly to the underlying asset Building HVAC, public space lighting, parking lot maintenance
Other services Nonlease component Transfers a good or service to the lessee but does not relate directly to the underlying asset Security, janitorial services, administrative services
Reimbursement of lessor expenses Noncomponent Landlord is required to pay but the lessee does not directly receive a good or service Property taxes or insurance
Administrative tasks to initiate the lease Noncomponent Lessor is not receiving a good or service Legal fees, contracting costs

Implications of the expedient

Implications of not electing the expedient

Companies choosing not to apply the practical expedient to combine lease and nonlease components into a single component will be required to allocate the contract consideration to each of the individual lease and nonlease components on a relative standalone price basis. This requires lessees to find observable standalone prices for each component or estimate the standalone prices using the available market information if they are not readily available. The standalone price is the amount the component would be purchased for on its own. Standalone prices are not always readily available and can require significant evaluation effort.

Companies not electing the expedient will need to develop a methodology for allocating the contract consideration, document this method and review it with their auditors. Lessees will need to repeat this process for each lease within the underlying asset classes where the lessee opts to not apply the lease vs. nonlease component practical expedient.

Not electing the practical expedient can ultimately be costly and time consuming. The FASB provided this election to reduce the cost of implementing and maintaining compliance with the new lease accounting standard, ASC 842. It is expected most companies will take advantage of this expedient because of the resources required to evaluate standalone prices for each component of a lease and to determine a method for allocating consideration to each contract component.

Implications of electing the expedient

Grossed up balance sheet

Electing to apply the practical expedient to not separate the lease and nonlease components of a contract will ultimately result in a higher amount of total lease payments. being included within the present value calculation of the lease liability. This in turn also results in a higher ROU asset. Because of the potential balance sheet inflation, some companies are choosing not to apply the expedient to their higher dollar value leases such as real estate leases or more material equipment leases. However, the election must be applied by class of underlying asset.

Increased potential for asset impairment

An impairment loss occurs when the cash flows expected to be generated from an asset over its useful life no longer support the carrying value of the asset. ROU assets are subject to the annual impairment analysis described in ASC 360 Property, Plant, and Equipment.

As previously mentioned, applying the single lease component practical expedient can give companies a potentially inflated lease liability and ROU asset value. If the book value of a company’s ROU asset exceeds its market value, an asset impairment and subsequent impairment loss may be required.

Lease classification change

When evaluating a lease’s classification as either finance or operating, the lease is analyzed against five criteria. Under ASC 842, one of those criteria relates to the value of the lease. If the present value of the lease payments and any guaranteed residual value is greater than or equal to substantially all of the fair value of the asset, the lease is classified as a finance lease. Electing the expedient to include nonlease components in the measurement of a lease increases the likelihood of that lease being classified as a finance lease.

Summary

To provide relief for the adoption of ASC 842, the guidance provides an election to treat the lease and nonlease components of a lease agreement as a single component. This practical expedient has the potential to reduce the resources necessary to comply with ASC 842 for many entities, but it also can produce unfavorable outcomes for some entities.

Using a lease accounting software solution like LeaseQuery can be invaluable to help organizations track their lease portfolio along with the associated nonlease and lease components. Regardless of whether an organization chooses to combine nonlease and lease components, a software solution is a much better choice than Excel for the transition to ASC 842.

Related articles