Earlier this year, I was facilitating a U.S. GAAP Update for a regional CPA firm and their clients. After the class, one of the clients asked me about a “lease” they had entered into involving fiber-optic cable as the lessor. I stated that within ASC 842 there were special considerations for leases of portions of assets, such as leases of capacity, specifically, whether or not the contract actually contains a lease and is within the scope of the new lease accounting standard, ASC 842 Leases.
The client provided me the agreement. It was titled “Fiber-Optic Lease Agreement.” The first thing to realize is that just because a contract contains the word “LEASE” does not mean that is a lease as defined by ASC 842.
As we discussed in this post,
A lease is a contract that 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.
Therefore, there are two conditions that must be met for a contract to be a lease:
- There is an identified asset; and
- The customer has the right to control the use of such asset.
We’ll dive into these two conditions in a moment, but first let’s set out the general terms of the contract I was given to review:
- Lessor is in the process of establishing a fiber-optic network for its own business use.
- Contract provides for the lease of designated fiber-optic strands and related facilities owned by the lessor to the lessee for and during the term of the contract.
- Each segment of fiber shall be described in separate exhibits. Each exhibit shall describe the geographic location of the fiber-optic cable and the lease payment for the specific segment of the fiber-optic cable.
- The lease term shall be for a period of ten (10) years, with automatic renewals at the end of the lease term (or any extension thereof) for a similar term unless either party provides notice of their intention to terminate the lease.
- Lessee shall pay to the lessor a fixed monthly payment during the first year of the contract. The lease payment may be adjusted by the lessor with about sixty (60) days’ written notice.
- Lessor is the owner of the leased strands and the lessee cannot convey legal title or assign to third parties rights in the leased strands other than the rights described in the contract. Furthermore, the lessee may not assign or sublease its rights or obligations under the contract to any third party without the express written consent of the lessor.
- Lessee shall be permitted to use the fiber-optic network to sublet leased fiber strands to third party entities and to provide communication services, including broadband internet, and for other lawful purposes, provided the lessee’s use of the lease strands does not interfere with lessor’s superior rights to full use and enjoyment of the network.
- Lessee is responsible for any repairs and maintenance.
We need to determine if the two conditions for a lease are met in our example:
According to ASC 842-10-15-16:
A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fiber-optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.
A capacity portion of an asset that is “physically distinct” would meet the definition of an identified asset. In our example, this condition would be met if the contract explicitly identified individual strands within the fiber-optic cable.
However, if a capacity portion of a larger asset is not physically distinct, the only way it’s an identified asset is if the portion represents “substantially all” of the asset’s capacity. This gives the customer the right to obtain substantially all of the economic benefits from use of the asset. In our example, if the contract does not explicitly identify the individual strands, the contract would only be a lease if the customer has the right to obtain substantially all of the overall fiber-optic cable’s capacity. Although ASC 842 does not define “substantially all,” most accounting firms have interpreted it as 90% or more.
Right to Control the Use
According to ASC 842-10-15-17:
To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (for example, by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party.
If there are any stipulations in the contract that would prevent the customer from obtaining substantially all of the economic benefits from use of the asset, the contract is not a lease. Examples would include substantive substitution rights held by the lessor or the lessor preventing the customer from subleasing the asset to another party.
Let’s take a look at few examples set out in ASC 842-10-55-55 through 55-62 to help clarify when a contract for the use of fiber-optic cable would and would not contain a lease.
Example 1 – Contract Contains a Lease
Customer (lessee) enters into a 15-year contract with a utilities company (supplier/lessor) for the right to use 3 specified, physically distinct dark fibers within a large cable connecting Hong Kong to Tokyo. Customer makes the decisions about the use of the fibers by connecting each end of the fibers to its electronic equipment (for example, the Customer “lights” the fibers and decides what data and how much data those fibers will transport). If the fibers are damaged, Supplier is responsible for the repairs and maintenance. Supplier owns extra fibers but can substitute those for the Customer’s fibers only for reasons of repairs, maintenance, or malfunction (and is obliged to substitute the fibers in these cases).
The contract contains a lease of dark fibers.
Customer has the right to use the 3 dark fibers for 15 years. The fibers are explicitly specified in the contract and are physically distinct from other fibers within the cable. The Supplier does have a substantive substitution right, as they can only substitute the fibers for reasons of repairs, maintenance, or malfunction.
Customer has the right to control the use of the fibers throughout the 15-year period because:
- Customer has the right to obtain substantially all of the economic benefits from use of the fibers over the 15-year period of use. Customer has exclusive use of the fibers throughout the period of use.
- Customer has the right to direct the use of the fibers. Customer makes the relevant decisions about how and for what purpose the fibers are used by deciding when and where to light the fibers and when and how much output the fibers will produce (that is, what data and how much data those fibers will transport). Customer has the right to change these decisions during the 15-year period of use.
Although the Supplier’s decisions about repairing and maintaining the fibers are essential to their efficient use, those decisions do not give Supplier the right to direct how and for what purpose the fibers are used. Consequently, Supplier does not control the use of the fibers during the period of use.
Example 2 – Contract Does Not Contain a Lease
Customer (lessee) enters into a 15-year contract with a utilities company (supplier/lessor) for the right to use a specified amount of capacity within a cable connecting Hong Kong to Tokyo. The specified amount is equivalent to Customer having the use of the full capacity of 3 strands within the cable (the cable contains 15 fibers with similar capacities). Supplier makes decisions about the transmission of data (that is, Supplier lights the fibers and makes decisions about which fibers are used to transmit Customer’s traffic and about the electronic equipment that Supplier owns and connects the fibers).
The contract does not contain a lease.
Supplier makes all decisions about the transmission of its customers’ data, which requires the use of only a portion of the capacity of the cable for each customer. The capacity portion that will be provided to Customer is not physically distinct from the remaining capacity of the cable and does not represent substantially all of the capacity of the cable. Customer does not have the right to use an identified asset.
Determining whether or not a contract of a larger portion of an asset meets the definition of a lease requires judgment. Just remember to document the two conditions set out in ASC 842 as discussed in this post! If you get stuck, we’re here to help!
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