Service components/Executory costs; March 22 meeting

At the March 22 joint FASB/IASB board meeting (videoconference viewable here; background materials available here), the boards tackled leases that include a service component. This is what FAS 13 calls "executory costs"; the amounts are part of the future minimum rent commitments, but are excluded from capitalization, as they are considered a service contract that is simply expensed without a balance sheet impact. For operating leases, however, they were pretty unimportant to distinguish from other rent.

The boards agreed to keep the concept of separate service (executory) and lease components of the rent, with the service component not counted as part of the obligation/receivable but simply treated as an expense.

Both lessee and lessor need to evaluate whether the payments can be allocated in this way, in keeping with requirements of the Revenue Recognition project simultaneously underway. If the service component is not considered "distinct" from the lease component, they are not to be separated. Services would be considered distinct if, for example, they are available independently of the lessor, or the lessor sells them outside of leasing transactions.

If an entity is unable to determine an allocation between service and lease components, the entire rent is treated as lease. Since treating it as a service will generally be preferable financially, there's an incentive to get the numbers right.

If the total rents later change for a lease that has service and lease components, the entity should try to apportion the changes between the components. If unable to do so, they should divide the change in rents pro rata between the two components.

The new rules will apply immediately with the application of the new standard. For capital leases, it should be a non-issue; operating leases, however, will need to be analyzed to determine what portion should be considered service. (It's not clear whether the terminology is to be changed from "executory costs" to "service component.")