US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 5

Chapter 5: Leases

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Accounting for leases – Lessee section

5-1 Identifying a lease - Scenario 1

Background

Company A, a biotech company, enters into an arrangement with Company B, a contract manufacturing organization, to produce medical equipment and disposables (“the Products”) that Company A then sells to outside customers. Company B has multiple production lines that it uses to fulfill orders for multiple customers. The arrangement allows Company B to choose the production line used to fulfill Company A’s orders. Even after the production of the Products commences on a product line, Company B can easily change to a different production line with minimal transfer costs. Company A submits legally-binding purchase orders quarterly to Company B and is contractually required to provide an annual non-binding production forecast. The products are generic, can easily be stored and Company B has full discretion over the operating process, including the selection of materials to use in production.

Question: Does this arrangement contain a lease?

Solution

This arrangement likely does not contain a lease under ASC 842. While the use of an asset, the production line, is implicit in the contract, there is likely no identified asset because substantive substitution rights exist. Also, there is likely not a lease because Company B has the right to change the operating process and decide when the output is produced.

Relevant guidance

The right to control the use of an asset may not necessarily be documented, in form, as a lease agreement. Often, the right to use an identified asset is embedded in an arrangement that may appear to be a supply arrangement or service contract. Therefore, a reporting entity should consider all of the terms of an arrangement to determine whether it contains a lease.

ASC 842-10-15-3: A contract is or contains a lease if the contract 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).

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

5-2 Identifying a lease - Scenario 2

Background

Company A, a biotech company, enters into an arrangement with Company B, a contract manufacturing organization, to produce medical equipment and disposables (“the Products”) that Company A then sells to outside customers. The Products are highly specialized, there is a dedicated production line for the Products and Company B is contractually restricted from using any other production line to fulfill its obligations under the arrangement. Purchase orders are very frequent and key operating decisions are predetermined by Company A and any changes are subject to approval by Company A.

Question #1: Does this arrangement contain a lease?

Question #2: How should Company A account for this embedded lease under ASC 842?

Solution

Question #1: Does this arrangement contain a lease?

There is an identified asset explicit in the contract (that is, the production line) and there are no substitution rights.

Company A has the right to obtain substantially all of the economic benefit from the use of the identified asset. Company A also directs the use of the identified asset because Company B does not have the right to change the operating instructions, including types of  materials/components, overall production process, and other decisions related to the output, without prior authorization by Company A. Further, Company A is also directing the use of the production line through frequent purchase orders, which, consequently, determine whether and when the equipment is used.

Company A controls the use of the identified asset because Company A (1) has the right to obtain substantially all of the economic benefit from the use of the identified asset and (2) has the right to direct the use of the identified asset and therefore, this arrangement is likely to contain a lease under ASC 842.

Question #2: How should Company A account for this embedded lease under ASC 842?

Company A should allocate the expected consideration between the leased production line (lease component) and the services to produce the drug product (non-lease component) based on their relative standalone selling prices at contract inception. If the arrangement contains fixed consideration, (or if Company A is required to purchase minimum volumes, which would establish fixed minimum consideration) then Company A would record a lease liability on its balance sheet at the present value of the amount of fixed consideration allocated to the lease, and a corresponding right-of-use (ROU) asset.

If the contract contains no minimum monthly volume, the arrangement would continue to contain an embedded lease; however, the consideration would be 100% variable. Because variable consideration is excluded from the measurement of the lease liability, there would be no initial accounting for this agreement. Instead, Company A would allocate and record a portion of each payment as variable lease expense for the embedded lease component and a portion as the cost of the contract manufacturing. Alternatively, under ASC 842, Company A can elect not to separate lease components from non-lease components and instead disclose the consideration in the arrangement entirely as lease expense.

Relevant guidance

ASC 842-10-15-3: A contract is or contains a lease if the contract 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).

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

ASC 842-10-15-4: To determine whether a contract conveys the right to control the use of an identified asset (see paragraphs 842-10-15-17 through 15-26) for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

a. The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs 842-10-15-17 through 15-19)

b. The right to direct the use of the identified asset (see paragraphs 842-10-15-20 through 15-26).

If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use.

5-3 Identifying components in an arrangement

Background

Company A, a biotech company leases a biotech lab facility, including the land on which the building is situated, and laboratory equipment, from Company B, the lessor. Company B does not lease or sell the equipment separately, but other suppliers do. The laboratory equipment can be used in other facilities. The monthly payment to the lessor includes (a) fixed rent for the building, land, and laboratory equipment; (b) a fixed amount for property taxes and insurance; (c) a fixed amount for maintenance related to the laboratory equipment; and (d) a fixed amount related to the maintenance of building and land. The accounting effect of treating the right to use land as a separate lease component is insignificant because doing so would not have an impact on the classification of any lease component.

Question: What are the lease components in this arrangement?

Solution

The lease components in the arrangement are the building (including land) and laboratory equipment. The nonlease components are the maintenance services for the building (including land) and maintenance services for the laboratory equipment. The lease of the laboratory equipment is considered a separate component from the lease of the building and land as it is neither dependent on, nor highly interrelated with the building or land since the equipment could be sourced from other providers and be used in other facilities.

Maintenance services for the building (including land) and equipment involve the provision of separate services to Company A and are considered separate nonlease components.

Real estate taxes and insurance do not represent separate goods or services and therefore are not contract components. Any payments related to those amounts would be included in the overall contract consideration to be allocated to the identified contract components.

Relevant guidance

ASC 842-10-15-28: After determining that a contract contains a lease in accordance with paragraphs 842-10-15-2 through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met:

a. The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. 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).

b. The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee’s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other.

5-4 Build-to-suit

Background

Company A, a pharmaceutical company, enters into an arrangement with a real estate company, Company B (landlord), for the lease of a building that will house biotech labs once constructed. Company B hires a construction company to build the building. Company A is required to provide the design for the building and to reimburse Company B for the construction to modify rooms to create labs and for Company B’s purchase of the related equipment. The equipment will remain in the building at the end of the lease term, can be utilized by a subsequent tenant, and are considered Company B’s assets. Company B holds legal title to the land on which the building will be built as well as the legal title to the building under construction. Company B does not have an enforceable right to payment for its performance to date. Company A does not have the right to buy the partially-constructed building at any point during the construction period.

Question: How should Company A account for the above construction?

Solution

Company A does not control the building under construction because (a) the building is legally owned by Company B; (b) Company B does not have an enforceable right to payment for its performance to date; (c) Company B owns the land on which the building will be constructed and Company A does not control or lease the land; and (d) Company A does not have the right to buy the partially constructed building at any point during the construction period. Company A would record the costs incurred relating to the design of the building, the construction of the labs, and purchase of the related equipment as lease payments because they are costs incurred in connection with the completion of lessor assets and do not represent payment for goods or services provided to Company A. Company A would recognize such costs as prepaid rent (and reclassify the prepaid rent to the right-of-use asset upon commencement of the lease).

Relevant guidance

ASC 842-40-55-5: If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date:

a. The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor).

b. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph 842-10-55-7) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased.

c. The lessee legally owns either:

1. Both the land and the property improvements (for example, a building) that are under construction.

2. The non-real-estate asset (for example, a ship or an airplane) that is under construction.

d. The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs 842-40-25-1 through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements.

e. The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements.

The list of circumstances in ASC 842-40-55-5 indicting a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date.

5-5 Accounting for modification – separate lease

Background

Company A, a life sciences company, enters into a 5-year lease for 2,000 square feet of warehouse space with Company B, a landlord, for $10,000 per month.

At the end of year one, Company A and Company B agree to amend their lease contract to include an additional 1,000 square feet of warehouse space in the same building for the remaining four years of the lease. Company A pays an additional $6,000 per month for the additional space. The additional $6,000 is in line with the current market rate to lease 1,000 square feet of warehouse space in that particular building at the date that the modification is agreed to. Company A will make monthly payments of $16,000 per month after the modification.

Question: How should Company A account for this lease modification?

Solution

Company A should account for the lease modification as a separate lease because the modification granted Company A an additional right of use at a price that is commensurate with the standalone price for the additional space. Therefore, on the new lease commencement date, Company A would have two separate leases:

  • The original lease for 2,000 square feet for five years

  • A new lease for the additional 1,000 square feet for four years

The accounting for the original lease is not impacted by the modification.

Relevant guidance

ASC 842-10-25-8: An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present:

a. The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset).

b. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract.  For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee.

5-6 Accounting for a sub-lease

Background

Company A, a biotech company, enters into a building lease with a 25 year term. The building has a depreciable life of 40 years. At the end of year 3, Company A enters into an agreement with Company B to sublease the building to Company B for the remaining 22 years. Company A is not relieved of its obligations under the original head lease.

Question: How should Company A account for its sublease with Company B?

Solution

Company A would account for the sublease to Company B as an operating lease because the term of the sublease is not for a major part of the remaining life of the underlying asset of the sublease (i.e., the sublease term of 22 years represents only 59% of the remaining 37-year life of the building) and Company A has concluded that no other classification criteria in ASC 842-10-25-2 would result in a sales-type lease.

Relevant guidance

In a sublease, an entity is both a lessee and a lessor for the same underlying asset. In a sublease, a lessee subleases the underlying asset to a sublessee; the entity is then referred to as the intermediate lessor (or sublessor). In a sublease transaction, the lease between the original lessee and lessor (referred to as the head lease) remains in effect.

ASC 842-10-25-2: A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a.  The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b.  The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c.  The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d.  The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e.  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.

ASC 842-10-25-6: When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset.

Accounting for leases – Lessor section

5-7 Substitution rights

Background

Company A, a medical device company,  enters into an arrangement with Company B, a hospital, to provide a medical imaging scanner and supply medical imaging consumables (cartridges) for five years. Upon executing the arrangement, Company A installs a medical imaging scanner at Company B’s premises that requires the use of Company A’s consumables. The scanner has been customized to run Company B’s proprietary software. Company A provides the scanner free of charge to Company B; however, Company A expects to recover the scanner cost through Company B’s purchase of consumables. Legal title to the scanner remains with Company A. The contract permits Company A to substitute the scanner. However, due to the potential disruption substitution would have on Company B’s activities, the contract includes a significant penalty in the event of downtime above a specified threshold. Therefore, it is expected that Company A will not substitute the equipment, except in the case of malfunction. Company A also provides maintenance services.

Question: Does the arrangement contain a lease?

Solution

Yes, the arrangement contains a lease. Although the contract does not explicitly specify the scanner, it is on site and customized for Company B. As a result, it is implicitly identified. While Company A has the legal right of substitution, this right is not substantive due to the significant disruption and potential downtime penalty if the equipment was to be substituted (substitution for maintenance or malfunction is not considered a substantive right to substitute). Therefore, the arrangement contains an identified asset, i.e., the scanner.

Company B has the right to control the use of the equipment throughout the period of use because:

a. Company B has the right to obtain substantially all of the economic benefits from the use of the identified equipment based on its exclusive access and use of the equipment during the five-year term; and

b. Company B makes the relevant decisions about how and when the equipment is operated by the hospital staff in their practice of medicine throughout the period of use.

Relevant guidance

ASC 842-10-15-4: To determine whether a contract conveys the right to control the use of an identified asset … for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

a. The right to obtain substantially all of the economic benefits from use of the identified asset ...

b. The right to direct the use of the identified asset ...

ASC 842-10-15-10: Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive if both of the following conditions exist:

a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time).

b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset).

5-8 Lease classification

Background

Company A, a medical device manufacturer, leases specialized medical imaging equipment to Company B, a hospital, designed and customized to work with Company B’s proprietary software. Given the age and customization of the equipment for Company B, Company A would incur significant costs to modify the equipment for use with another lessee or to facilitate its sale. The costs exceed the expected benefit resulting from any such sale. The arrangement is a lease of the equipment with the following additional facts:

Question: How should Company A classify the lease?

Solution

Since the equipment is of such a specialized nature that it is expected to have no alternative use to Company A at the end of the lease term, Company A would classify the lease as a sales-type lease. In this example, Company B has effectively obtained control of the underlying asset, which is economically similar to Company A selling the asset to Company B. Therefore, upfront profit recognition would be appropriate assuming collectibility of the lease payments is probable.

Relevant guidance

ASC 842-10-25-2: A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement:

a.  The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.

b.  The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.

c.  The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease.

d.  The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph 842-10-30-5(f) equals or exceeds substantially all of the fair value of the underlying asset.

e.  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.

5-9 Allocation of consideration to components of lease contract

Background

Company A, a medical device manufacturer, enters into an arrangement to lease medical equipment to Company B, a hospital, for a five-year period and to sell 4,500 disposable units per year to be used in the operation of the equipment. Disposables used for other medical equipment owned by Company B can be used in the medical equipment leased from Company A. Similarly, disposables purchased from Company A can be used in operating either the leased medical equipment or other medical equipment owned by Company B; therefore, the amount of disposables purchased by Company B is unrelated to the usage of the leased medical equipment. In addition, under the terms of the arrangement, Company A will provide maintenance services (similar maintenance services are sold separately by Company A for $10,000) and training (sold separately by Company A for $5,000) for no additional consideration. Company B will pay Company A $4.00 per disposable purchased.

The medical equipment has a useful life of five years and is not expected to have any residual value at the end of the lease term. Company A’s cost of the medical equipment is $14,000. At the lease commencement date, the standalone selling price of the equipment lease component is $15,000 and the standalone selling price of each disposable is $3.50.

Company A determines that the arrangement has one lease component - the lease of medical equipment, and three nonlease components - disposables, maintenance, and training. Total contract consideration is $90,000 (4,500 disposable units per year x 5 years x $4.00/unit). Any purchases above 4,500 units are considered optional purchases and therefore the right to purchase excess units is not considered a separate component. Company A has not elected to utilize the practical expedient described in ASC 842-10-15-42A, which would allow lease and nonlease components to be accounted for as a single component if certain criteria are met.

Question: How should Company A allocate contract consideration among the various lease and nonlease components at lease commencement?

Solution

The lease and nonlease components represent separate performance obligations under the revenue guidance in ASC 606. The $90,000 contract consideration would be allocated to lease and nonlease components based on their relative standalone selling price at lease commencement as follows:

At the commencement date, Company A would classify the lease as a sales-type lease because the lease term (5 years) is for the major part of the remaining economic life of the medical equipment (5 years) and collectibility of lease payments is probable at commencement date. Based on the allocation of transaction consideration, Company A would record $12,600 in revenue and net investment in the lease. It would also remove the equipment (carrying value $14,000) from its balance sheet; and record $14,000 cost of goods sold, resulting in a day-1 loss of $1,400 at the commencement date.*4,500 disposable units per year x 5 years x $3.50 standalone price/unit

Note - This example ignores any initial direct costs as well as the effect of discounting. ASC 842 requires lessors to discount lease payments using the rate implicit in the lease.

Relevant guidance

ASC 842-10-15-38: A lessor shall allocate the consideration in the contract to the separate lease components and the nonlease components using the requirements in ASC 606-10-32-28 through 32-41...

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Laura Robinette

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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