Pros and Cons of Separating Lease and Non-Lease Components
One practical expedient that’s receiving mixed reviews is the expedient that allows companies to choose, by asset class, to not separate lease and non-lease components.
Electing this expedient would certainly reduce the burden of separating the lease and non-lease components, which can be extensive. While at first glance it may seem simple to allocate the costs listed in the contract to the separate components, in actuality it’s more complex. Under the new standard, allocation is not based on the cash paid for a component, but rather on the standalone observable price. Tracking down the standalone observable price is expected to be challenging, and for some asset classes, it may not be worth the effort. In those cases, there’s a strong argument for electing the expedient.
However, electing the expedient also comes with some drawbacks, including:
Capitalizing More on the Balance Sheet
The value of both the lease components and the non-lease components will need to be reported on-balance sheet, so companies will see their assets and liabilities increase more than they already would have under the new standard.
Potentially Triggering a Finance Lease
One of the criteria for a finance lease is that the present value of the lease (plus guaranteed residual value) is greater than “substantially all of the fair market value” of the asset on lease. Including non-lease components in the calculation of present value could push the lease over the threshold. If the classification changes from operating to finance, the income statement may also be impacted.
Potentially Triggering an Impairment
If the value of the right-of-use asset recorded on the balance sheet is greater than the market value of the right-of-use asset, it could trigger an impairment. Including non-lease components on the balance sheet may be enough to push the recorded value of the asset over its market value.
Many companies will likely choose to take this expedient for some of their asset classes, but not all. Those companies will need to track down the standalone observable price for the asset classes where the expedient is not applied. A good place to start the search is with the lessors who keep detailed information for their leases, and might know the true value of the components.