As part of its continual deliberations surrounding the Exposure Draft Leases (Leases ED), the Boards deliberated on the following topics:
- Defining a lease
- Accounting for variable lease payments.
The Boards made a number of tentative decisions in the conduct of these deliberations, as summarised below:
Defining a lease
Accounting for variable lease payments
Defining a lease
Following discussion at a joint meeting of the Boards on 17 February 2011 in which the definition of a lease and the application guidance in the Leases ED relating to that definition were discussed, the staff presented feedback received from targeted outreach in relation to previous decisions of the Boards.
Specific discussion points of this targeted outreach considered (1) whether the definition of a lease should refer to a specific or specified asset, or to an asset of a particular specification, (2) whether both a physically distinct portion (e.g., a floor of a building) and a non-physically distinct portion (e.g., capacity portion of a pipeline) of a larger asset can be the subject of a lease and (3) when does a customer have the right to control the use of a specified asset, among other areas.
Feedback from outreach activities noted that participants generally did not support the widening of the definition of 'specified asset' (beyond that of a uniquely identified asset), with many participants agreeing that the right to substitute an asset is an important aspect of assessment. If a supplier has the substantive right to substitute an asset, a customer, in the view of many respondents, would not control the use of that asset.
Several Board members raised concerns that application of the term, 'specified asset,' as used in the ED to defined leases, to one particular asset, without consideration of substitutability to an asset of consistent specification, would be too specific and would ignore the broad principle of including assets of a particular specification in the definition of a lease given the financing nature of underlying arrangements. Other Board members noted that if a customer recognised a right to use an asset, as discussed in the Leases ED, the asset should be identifiable, and similarly, if a supplier derecognises a right to use an asset, the asset being derecognised needs to be identifiable. As a result, it was considered that the concept of substitutability, as applied in any final standard, should consider the existence of substitutability rights of a supplier, whereby a supplier's ability to substitute assets under an arrangement as a result of practicality and economic feasibility, without requiring the customer's consent, would not result in lease accounting treatment according to the specified asset criterion alone. As a result, the Boards tentatively decided that a 'specified asset,' as defined in the Leases ED, should be defined as an identifiable asset as opposed to an asset of a certain specification. A "specified asset" would be an identifiable asset that is explicitly or implicitly identified in the contract. An asset would be implicitly identified if it would not be practical and economically feasible for the owner to substitute alternative assets in place of the underlying asset during the lease term.
Portions of a larger asset
Regarding contracts which represent a portion of a larger asset, the staff provided a recommendation that a physically-distinct portion of a larger asset (e.g., a floor of a building) can be a specified asset, but a capacity portion of a larger asset that is not physically-distinct (e.g., access to a portion of the capacity of a pipeline) cannot. Several Board members noted the significance of the control concept (e.g., access control) in the determination of whether a portion of a larger asset is representative of a lease, but the Boards tentatively concurred with the staff's recommendation.
Right to control
The Boards discussed two alternative views:
- whether the control concept applied within the definition of a lease should be considered with the forthcoming revenue recognition standard, whereby a customer has the right to control the use of a specified asset if it has the ability to direct the use, and receive benefits from use, of that asset (Approach A)
- whether the control concept proposed in the Leases ED should be retained in which the right to control the use of a specified asset is conveyed if the customer has the ability to direct the use, receive the benefits from use and pays for the right to use the asset, rather than paying a per unit price for the output (Approach B).
The majority of the members of the Boards supported Approach A as a result of considerations to (1) consistency in standard setting, (2) concern that Approach B creates structural opportunities in pricing and (3) the significance of the control principles applied in the revenue recognition proposal as would be applied consistently in the Leases ED. Respective members of the Board discussed the necessity of appropriate draft wording in any final standard issuance to consider all available evidence in the determination as to whether a customer has the ability to direct the use and receive the benefits from use of a specified asset, including control of physical access, involvement in the design of the specified asset and rights to obtain substantially all of the economic benefits.
In circumstances in which the supplier directs the use of the asset used to perform services requested by the customer (similar to the 'separate performance obligations' concept in the revenue recognition project), under the proposal in Approach A, the customers and suppliers would be required to assess whether the use of the asset is an inseparable part of the services requested by the customer (if inseparable, the entire contract would be accounted for as a service contract because the customer has not obtained the right to control the use of the asset) or a separable part of the services provided. Those supporting the concept of separating components in the definition of a lease cited that if an asset is separable from other services provided in a contract, the contract contains at least two separate components; the right to use an asset at the date of commencement of the contract and the other services over the term of the contract, and consequently, recognition principles should be applied accordingly.
Certain members of the Boards expressed concerns regarding the separable decisions outlined above, noting concerns with the identification of appropriate indicators to determine separable components and the potential impact of a large number of service contracts arising out of incidental services which are not determined to be separable. Examples raised by members of the Boards included a copier which includes a service contract, in which separation of elements is not able to be established, or the accounting for time charters. The staff were asked to re-consider draft verbiage provided in any final standard around the "separability" concept, including distinction of unique application environments such as common-area maintenance in the real estate sector.
Ultimately, the majority of the Boards tentatively decided that the description of 'control,' as defined in the Leases ED, should be revised to be consistent with the revenue recognition project while including guidance on separable assets, whereby a contract would convey the right to control the use of the underlying asset if the customer has the ability to direct the use, and receive the benefit from use, of a specified asset throughout the lease term.
Accounting for variable lease payments
The Boards were presented with staff recommendations and outreach feedback regarding the identification of lease payments that are in-substance fixed lease payments but are structured as variable payments in form (e.g., disguised minimum lease payments), following the Boards' tentative decision in February 2011 to require that the lessee's liability and the lessor's receivable include an estimate of disguised minimum lease payments.
- recognise no underlying aspect of variable lease payment contracts in the financial statements but disclose the underlying nature of such contracts
- recognise only the fixed portion of such contracts (e.g., the disguised fixed payments underlying a variable lease payment contract, such as a lease contract which prescribes a floor with potential increasing variability would result in recognition of the fixed floor to the contract), with associated disclosure of variability, or
- recognise a "reasonably assured" estimate of the associated obligation or benefit (e.g., for a contract which requires lessee payment to a lessor based on sales, a review of historic sales that can be projected for the foreseeable future should be used to assess the obligation).
Board members discussed:
- Consistency in recognition of estimates amongst this proposed standard and that of current projects surrounding insurance, impairment and revenue recognition
- Concerns regarding determination of a minimum lease amount in contracts which are completely comprised of variable lease payments, where a lack of substantive support exists for estimating prospective payments
- Concerns regarding the recognition of underlying lease assets or liabilities which extend beyond the foreseeable future of a company's projections lending to significant variability in the balance sheet each year
- Consideration of a recognition model which reflects only unavoidable amounts.
As a result of this assessment, the majority of the Boards tentatively decided that the asset and liability recognised under a lease contract should exclude variable lease payments except for those that are considered disguised minimum lease payments.
Disguised minimum lease payments are those payments in a lease contract that are structured such that the variable payments are in-substance fixed. Many Board members acknowledged that the exclusion of variable lease payments (except disguised minimum lease payments) is a practical expedient because contingent rentals represent an unconditional obligation at lease commencement. These Board members noted the practical concerns with recognition of a 'reasonably assured' estimate of potential variable cash flows.
This tentative decision reverses the Boards' previous tentative decision that included a high threshold for all variable payments. The Boards asked the staff to consider any practical guidance available from accounting firms in the identification of disguised fixed minimum lease payments for purposes of practical guidance to provide in any final standard issuance.