As part of continual deliberations surrounding the Exposure Draft Leases published 17 August 2010, the Boards considered the accounting for options to extend or terminate a lease, in which the Exposure Draft proposed that an entity should account for options to extend or terminate a lease by defining the lease term as the longest possible term that is more likely than not to occur (see paragraphs B16-B20 of the Exposure Draft), in a definition applicable to both the lessee and the lessor.
In outlining feedback including comment letters and other outreach, the staff noted:
- Many respondents agreed with the Boards that options to extend and terminate leases affect the economics of lease contracts and supported a consistent approach for applying the lease term definition to both lessees and lessors
- Many respondents acknowledged the boards' concerns relating to the structuring risks associated with options to extend and terminate leases
- Many respondents and workshop participants questioned the practical application of the proposals, questioning how the lease term would be determined in situations in which a lease contract includes, for example, month-to-month extension terms/open-ended/'pay-as-you-go' contracts, a right of first refusal, or terms permitting termination by either the lessee and/or the lessor.
Generally, respondents encouraged the Boards to consider whether the objective of the lease term definition is to focus on (1) contractual future lease cash flows, (2) estimating all future lease cash flows or (3) in-substance contractual future lease cash flows.
Based on feedback received from interested parties, the Boards were asked to consider the following topics:
- Initial measurement of options to extend or terminate a lease
- Reassessment requirements associated with options to extend or terminate a lease
- Symmetry between lessee and lessor accounting
The staff proposed three alternatives to the initial accounting for lease term options:
A majority of the staff recommended Approach C; citing that factors such as past practice and management intent would not influence the determination of a reasonably certain lease term at inception. The staff believed this approach was more objective because it does not depend on the assessment of future business conditions or management intent, which could easily be altered by external economic circumstances. Other staff members external to the above majority cited approval for Approach B, because including all factors that may affect the potential lease term, such as past practice and management intent, would more closely reflect the expected future cash flows associated with the lease, and thus, be more responsive to the needs of the users of the financial statements.
In deliberations on the above three initial measurement approaches, the majority of the Boards (absent three members of the Boards) tentatively approved Approach C, with clarification of the wording applied thereto, as summarised below:
- The use of the reasonably certain threshold applied in Approach C. Multiple members of the Boards debated the use of the term, 'reasonably certain' as a threshold outlined in Approach C; questioning whether this term suggested too high a threshold, and likewise, how this threshold should be viewed in industry practice.
While certain members of the Boards supported the use of the 'reasonably certain' criterion, as it deters judgement on the part of management to manipulate a company's financial position, the majority of the Boards tentatively concluded that any future amendments should consider revised wording to more appropriately define the level of certainty required in recognition of an initial option to extend or terminate. A proposed wording, as agreed by the majority of the Boards, stated that the term 'reasonably certain' should be replaced by the phrase, 'clear economic incentive to exercise the options.' The staff agreed to review such wording at a future meeting.
The tentative decision of application of Approach C was reached after considering:
- Approach C provides more objectivity, as it does not depend on the assessment of future business conditions or management intent
- Approach C is responsive to concerns that it may be misleading to include amounts in the lessee's liability that the lessee has genuine flexibility to avoid because there is no economic incentive to renew
- Approach C would result in more consistent reporting and less volatile financial reporting.
The Exposure Draft proposed that lessees and lessors should adjust the lease liability/asset after initial recognition if facts or circumstances indicate that there would be a significant change in the lessee's liability to make lease payments or in the lessor's right to receive lease payments. When such indications exist, the lessee and lessor are required to reassess the length of the lease term.
After receiving respondent feedback that the reassessment is overly complex and burdensome, the staff identified two approaches to subsequent measurement relating to the lease term:
The staff supported Approach A, requiring a reassessment of the lease term on a basis consistent with the initial determination of lease term.
In deliberations amongst the Boards, the Boards tentatively concluded with the view of the staff. One member of the Boards expressed concern that the current language in the Exposure Draft suggests continual reassessment, and as such, it was suggested that the staff provides further clarity that continual reassessment without changes in underlying circumstances in not required.
The tentative decision was reached after consideration by the Boards that requiring reassessment of the lease term provides useful information to users because the lease term is determined on a consistent basis over the duration of the lease contract.
The Exposure Draft does not make a distinction between a lessee and a lessor in the way term options are accounted for. However, because the lessee and the lessor may have different information on whether the lessee will extend or terminate the lease, the lessee and the lessor may not determine the same lease term.
In this regard, the Boards considered whether the definition of lease term should be consistent between the lessee and the lessor.
As part of this assessment, the staff highlighted the following reasons that support differences in the accounting for options to extend or terminate a lease between a lessee and a lessor:
- The information known to the two parties of the lease will be asymmetrical
- The lessee is usually the party that holds the option and exercise of the option is usually within the control of the lessee, but outside of the control of the lessor
- For a lessor applying the derecognition approach, reassessment of the lease term results in the recognising revenue and/or reversals of revenue based on a subjective determination by the lessor. Because there is an impact on revenue resulting from a reassessment, the recognition principle for a lessor applying the derecognition approach may need to be more restrictive.
In contrast, the staff highlighted the following reasons that do not support differences in the accounting for options to extend or terminate a lease between a lessee and a lessor:
- Less complex to apply and understand, which may be helpful to users of financial statements
- Easier to account for subleases and related party leases.
Consistent with the tentative decision of Approach C, above, within the initial measurement of options to extend or terminate a lease, the Boards cited that under Approach C, the accounting for the lease term requires both parties to assess the lease term based on the lease contract and the leased asset, rather than business and other factors, and as such, there would usually be symmetrical information available to both parties. As both parties are assessing the same contract at the same time (lease inception) to determine the lease term, it is more likely that the lessee and lessor would determine the same lease term.
As a result, the Boards had unanimously decided that it is appropriate to have a consistent definition of lease term between the lessee and the lessor.
Topics to be discussed at future meetings
The staff intend to discuss the following related topics in a future meeting:
- Accounting for purchase options
- Presentation impact of changes from a reassessment of lease term
- Disclosures regarding options to extend or terminate a lease.