In a lease contract, the activities that transfer goods and services are described as “components” and are classified as either lease components or nonlease components. Lease components are those that convey the right to use an identified asset, such as the right to use a portion of a building. Nonlease components are those that are associated with the use of the asset but are not integral to its use, such as common area maintenance (CAM) for a building.
The guidance in ASC 842 provides practical expedients related to accounting for lease and nonlease components for both lessees and lessors. A practical expedient is an accounting policy election allowed by the Financial Accounting Standards Board (FASB) to provide relief from the burden of applying the requirements of an accounting standard. Let’s discuss:
Under ASC 842, it’s required to allocate the total consideration in a lease contract to each lease and nonlease component based on their relative standalone prices. However, as a practical expedient, lessees can make an accounting policy election to treat each lease component and its associated nonlease component(s) as a single lease component. Accordingly, lessees that elect the practical expedient do not have to allocate consideration in a contract between the lease and nonlease components. This policy election needs to be made by class of underlying asset (a lessee is not allowed to apply it on an asset-by-asset basis) and be applied consistently to all leases.
Example of Use
Using the example of a building lease that includes charges for CAM, a lessee that does not elect to apply the practical expedient would need to allocate the total contract consideration between the lease component (use of the building) and the nonlease component (CAM). This results in the lease being classified and measured using only the portion of the contract consideration allocated to the use of the building. Alternatively, a lessee that does elect to apply this practical expedient would consider the use of the building and the CAM to be a single lease component and would not allocate the contract consideration. This results in the lease being classified and measured using the total contract consideration. While the use of this practical expedient results in higher balances for lease liabilities and right-of-use (ROU) assets, it simplifies the underlying accounting.
However, a lessee cannot choose to combine only certain nonlease components when there are multiple nonlease components in the contract. Consider a building lease that includes charges for both CAM and security services. The lessee cannot choose to combine only the use of the building and the CAM while treating the security services as a separate nonlease component. To apply the practical expedient, the lessee must combine the use of the building and all its related nonlease components (both the CAM and security services) as a single lease component.
Please note, the standards do not prohibit a lessee from combining a relatively insignificant lease component with relatively significant associated nonlease component(s).
A similar policy election is also allowed for lessors under ASC 842. Lessors may elect to aggregate nonlease components that would otherwise be accounted for under the revenue recognition standard (ASC 606) with the associated lease component, if the following conditions are met:
- The timing and pattern of transfer of the nonlease component and the associated lease component are the same
- The standalone lease component would be classified as an operating lease if accounted for separately
If the nonlease component or components are the predominant component(s), the combined component should be accounted for as a single performance obligation in accordance with ASC 606, Revenue from Contracts with Customers. Otherwise, the lessor should account for the combined component as an operating lease in accordance with ASC 842.
Is this practical expedient right for your company?
In determining whether the application of this practical expedients are appropriate for your company, you should consider the impact on both the balance sheet and other financial measures, such as EBITDA.
For lessees, application of this practical expedient will result in recording higher balances for lease liabilities and ROU assets on the balance sheet, increasing the potential for leases to be classified as finance leases. This may impact certain financial ratios and debt covenant calculations. While GAAP basis earnings will remain unchanged, the use of this practical expedient could increase EBITDA depending on how that measure is defined and calculated. For finance leases, entities would have increased interest and amortization expenses as a result of the higher balances for lease liabilities and ROU assets, thus increasing the amounts added back to earnings. This may also be true for operating leases that report a single lease expense in the financial statements if the definition of EBITDA includes the interest and amortization amounts that make up the reported single lease expense.
Our experts understand the new accounting standards and can support your company in implementing them and making the right decision when it comes to the practical expedient. To talk to one of our professionals, please contact us.