The FASB has recently issued a new practical expedient allowing lessors to make an accounting policy election to combine lease and nonlease components if certain criteria are met. If combined, entities will have to evaluate whether the combined components should be accounted for in accordance with the new revenue or leases standards.
Hello! I’m Justin Frenzel, a Senior Manager at PwC.
In previous videos in our leases series, we discussed several practical expedients available to help ease the transition to the new leases standard. Today, we're continuing our leases series with a discussion of another practical expedient that allows lessors to avoid separating lease and associated nonlease components within a contract if certain criteria are met.
Currently under the new standard, entities must separate lease and nonlease components in a contract. For lessors, consideration in the contract is allocated to the lease and nonlease components in accordance with the allocation guidance in the new revenue standard. Consideration allocated to the lease component is then accounted for under the new leases standard, while consideration allocated to the nonlease components is accounted for under other topics, such as the new revenue standard.
A recently issued practical expedient for lessors will alleviate the burden of separating the components in the contract. It will allow lessors to make an accounting policy election, by class of underlying asset, to not separate nonlease components. Said differently, lessors may account for lease and nonlease components as a single combined component. However, the lessor practical expedient is limited to circumstances in which the nonlease component would otherwise be accounted for under the new revenue standard and the following two criteria are met:
First - the timing and pattern of transfer for the nonlease component and the associated lease component are the same; and
Second - the stand-alone lease component would be classified as an operating lease if accounted for separately. Once lease and nonlease components are combined under this practical expedient, a lessor must then determine how to account for the combined component. This determination is based on whether the lease or nonlease components are the predominant characteristic of the combined component.
If the nonlease components are predominant, a lessor should account for the combined component as a single performance obligation under the new revenue standard. However, if the lease component is predominant, a lessor should account for the combined component in accordance with the new leases standard.
Evaluating predominance will require judgment, but generally a lessor should be able to reasonably determine whether the combined component is predominantly a lease or a revenue arrangement without having to perform a detailed quantitative or theoretical analysis.
Let's demonstrate these principles with an example. Assume the following:
In this example, the lease of the office building represents a lease component because it provides the lessee with the right to use the office building. On the other hand, the provision of common area maintenance services represents a nonlease component because it is not considered a cost of securing the right to use the office building.
So now that we've established that a lease and nonlease component exist, let's see if the components can be combined as a single component for accounting purposes. To begin, let's discuss the first criterion. In this case, because the lessor is providing both the right to use the office building and the common area maintenance services continuously over a five year period, the timing and pattern of transfer of both components is the same. The first criterion is therefore met.
The second criterion is similarly met because the lease component, when evaluated exclusive of the nonlease component, would be classified as an operating lease. Accordingly, the lessor would combine both components into a single component consistent with the lessor's accounting policy.
Additionally, let's assume that the lessor determines the lease component is the predominant characteristic of the combined components. As such, the lessor would account for the combined components under the new leases standard.
So let’s wrap up. With the effective date of the new leases standard quickly approaching, companies have a lot of work ahead of them getting ready for the new guidance. But the good news is, is there are many resources available to help. For more information, please refer to the Leases page on CFOdirect.com. Thank you.