Lease Components

When a lease contract contain one or more lease and non-lease components, the lessee and the lessor allocates the consideration to the components based on their stand-alone selling prices.

While two ore more lease components in a single contract must always be separated and the consideration allocated to them, US GAAP provides a policy choice to both lessees and lessors to not separate any non-lease component from relevant lease component and IFRS 16 allows such a choice only to lessees.

Separating lease and non-lease components

The following example illustrates how to separate lease component from non-lease components of a payment.

You work at Valhalla Foods, Inc., a large food manufacturer. You have leased 20 buses and 5 cars from Transiti, Inc to offer transportation to your work force. The lease is for a period of 5 years. Transiti is responsible for operations and maintenance of the bus fleet while you operate and maintain the car fleet. Total lease payments are $20,000 per month.

This contract has two lease components, namely bus fleet and car fleet, and one non-lease component. First, you need to allocate the total consideration to the lease components and the non-lease components. This allocation must be based on the relative stand-alone prices of the lease components and the non-lease components. For example, you can access the pricing model you used in negotiating the rentals to find out what was the contribution of the bus fleet, the car fleet and the operations and maintenance requirement towards total contract price.

Let's say $12,000 per month represents charge for buses, $5,000 per month represents charge for cars, and $3,000 is the operations and maintenance charge, you must capitalize buses and cars separately. If the implicit interest rates in case of buses and cars are 10% and 12% respectively, you can determine you right of use assets and lease liability at the commencement date using present value of an annuity formula as follows:

$$ \text{ROU}\ (\text{Buses})\\= \text{\$12,000}\ \times \frac{\text{1}-(\text{1}+\frac{\text{10%}}{\text{12}})^{-\text{12}\times \text{5}}}{\frac{\text{10%}}{\text{12}}}\\=\text{\$564,785} $$

Similarly, the right of use asset in respect of cars and associated lease liability can be calculated using Excel PV function as follows:

$$ \text{ROU}\ (\text{Cars}) \\=\text{PV}(\text{12%}/\text{12,60} \text{,} -\text{\$5,000})\\=\text{\$224,775} $$

This can be journalized as follows:

Right of use asset - Buses 564,784
Right of use asset - Cars 224,775
Lease liability 789,560

The amount due on account of the non-lease component is not capitalized but is expensed out when the associated operations and maintenance services are received.

Exception

However, since IFRS 16 and ASC 842 allows a practical expedient which allows lessees to not separate a non-lease component from lease component. If your company elects to adopt this policy choice, it can recognize right of use assets in respect of buses by including the operations and maintenance related charges in the lease payments. This would result in increase in right of use asset and lease liability by $141,196. However, this would also increase your finance cost (because liability is higher) and depreciation expense (because your right of use asset balance is high).

IFRS requires lessors to always segregate lease and non-lease components but US GAAP offers a policy choice not to do such segregation.

by Obaidullah Jan, ACA, CFA and last modified on
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