What Qualifies as a Lease Under ASC 842?

The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 842 to change how organizations account for leases. This standard requires most leases to be recognized on the balance sheet, providing greater transparency into a company’s financial obligations. Applying ASC 842 begins with identifying whether a contract, or part of a contract, qualifies as a lease. This determination dictates whether the arrangement is recorded on a company’s balance sheet as a right-of-use (ROU) asset and a corresponding lease liability.

Core Elements of a Lease

A contract qualifies as a lease under ASC 842 if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition emphasizes two criteria: the presence of an identified asset and the customer’s right to control the use of that asset.

Identified Asset

An identified asset is a specific asset, such as property, plant, or equipment, that is either explicitly or implicitly specified in a contract. An asset is explicitly identified when the contract clearly states the specific asset, perhaps by serial number, address, or other unique identifier. An asset can be implicitly identified if, at the time the asset is made available for use by the customer, the supplier only has one asset available to fulfill the contract.

A supplier’s substantive substitution right can prevent an asset from being identified. A substitution right is substantive only if the supplier has both the practical ability to substitute alternative assets throughout the period of use and would benefit economically from exercising that right. For example, if a supplier can replace a truck with another vehicle that is less powerful and benefits financially from this change, the substitution right is substantive. If the supplier’s right to substitute is only for repairs, maintenance, or if the asset malfunctions, it is not considered a substantive right. If an asset is located at the customer’s premises, the cost of substitution is higher, which may indicate that the supplier would not economically benefit from substitution.

A capacity portion of an asset, such as a segment of a fiber optic cable, is not considered an identified asset unless it represents substantially all of the asset’s capacity. This “substantially all” refers to 90% or more of the asset’s capacity. For example, leasing a specific floor of a building is an identified asset because it is physically distinct.

Right to Control the Use

Control over the use of an identified asset exists if the customer has both the right to obtain substantially all of the economic benefits from the asset’s use and the right to direct the use of the identified asset throughout the period of use. Both conditions must be met for control to be established.

Right to Obtain Substantially All Economic Benefits

The customer must have the right to obtain substantially all of the economic benefits from using the identified asset. Economic benefits include the output and by-products generated from the asset, as well as any cash flows or other benefits that could be realized from commercial transactions with a third party. For example, if a company leases a power plant, the right to substantially all economic benefits would include the power produced and any associated renewable energy credits.

The concept of “substantially all” translates to 90% or more of the economic benefits. This assessment considers the economic benefits within the defined scope of the customer’s right to use the asset. For example, if a contract allows a customer to use a truck for a maximum of 50,000 miles, the economic benefits assessment focuses only on the benefits derived from those 50,000 miles, not the truck’s entire economic life.

Right to Direct the Use

The customer has the right to direct the use of an identified asset if they can direct how and for what purpose the asset is used throughout the period of use. This involves making relevant decisions about the asset’s utilization.

This right can be demonstrated in two ways. First, the customer can direct how and for what purpose the asset is used. This includes the ability to change the type of output produced by the asset, such as deciding whether a shipping container is used for transport or storage. Second, if the relevant decisions about how and for what purpose the asset is used are predetermined, the customer can still direct use if they have the right to operate the asset (or direct others to operate it) without the supplier changing those operating instructions. This also applies if the customer designed the asset in a way that predetermines its use.

For example, a company leasing a corporate jet may have restrictions on flight hours or airspace. Despite these protective rights of the supplier, the customer still directs the use by deciding when and where the jet flies within the contract’s scope.

Separating Components Within a Contract

Contracts often contain multiple elements, some of which may be leases and others that are not. ASC 842 requires entities to identify and separate these distinct components. A distinct lease component is the right to use an identified asset that is neither highly dependent on nor highly interrelated with other identified assets in the contract. This means the customer could benefit from the right of use on its own or with other readily available resources. For example, if a contract includes the lease of a building and separate maintenance services, the building lease is a distinct lease component, while the maintenance is a non-lease component.

Entities must allocate the contract consideration to each identified lease and non-lease component based on their relative standalone prices. This requires estimating standalone prices if observable market prices are not readily available. Activities that do not transfer a good or service to the customer, such as administrative tasks or reimbursement for a lessor’s costs like property taxes, are considered non-components and are not allocated consideration.

A practical expedient is available for lessees, to elect not to separate non-lease components from associated lease components. If this expedient is elected, the combined unit is accounted for as a single lease component under ASC 842. This election must be applied as an accounting policy choice by class of underlying asset. While this simplifies accounting by avoiding complex allocations, it results in a larger ROU asset and lease liability on the balance sheet. For example, a lease for equipment that includes maintenance services could be treated as one combined lease component if this expedient is applied.

Reassessing Lease Identification

Lease identification under ASC 842 is reassessed only when there is a change in the terms and conditions of the contract. Specific triggering events necessitate a reassessment of whether a contract continues to qualify as a lease. One such trigger is a change in the contract’s terms or conditions, which might alter the scope of the lease or the consideration involved. For example, if a contract is amended to significantly change the leased asset or the payment structure, a reassessment is required.

Another trigger is an event or change in circumstances within the lessee’s control that affects the lessee’s certainty to exercise or not exercise an option to extend, terminate, or purchase the underlying asset. An example includes the construction of significant leasehold improvements by the lessee, which might make it economically certain for them to exercise a renewal option they previously considered unlikely.

If a contract contains a condition that obliges the lessee to exercise or not exercise an option, this also triggers a reassessment. If the lessee elects to exercise an option they previously considered unlikely, or vice versa, a reassessment is needed. The implications of such a reassessment can include re-evaluating the lease classification and remeasuring the lease liability and ROU asset.