As part of its continuing deliberations surrounding the Exposure Draft Leases (Leases ED), the Boards discussed whether there should be different lease expense recognition patterns for different lease contracts in the context of lessee accounting and whether any changes should be made to the lessor accounting proposals as a consequence of the lessee accounting discussions.
The Boards made a number of tentative decisions during these deliberations, as follows:
- The Boards reversed their previous tentative decision and tentatively decided that there should be different lease expense recognition patterns for different lease contracts. A lessee would apply an approach consistent with the Boards’ previous tentative decision (resulting in accelerated expense recognition) to some leases and apply a whole contract approach (resulting in straight-line expense recognition) to other leases (excluding short-term leases). A right-of-use asset and lease liability would be recorded under both approaches.
- A lessee should distinguish between those different leases based on whether the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term. That principle should be applied by using a practical expedient based on the nature of the underlying asset.
- The underlying principle used to distinguish whether the lessor receivable and residual approach applies would be symmetrical with the principle used in distinguishing between the type of lease under the lessee model.
Lease expense recognition patterns
During its May 2012 meeting, the IASB and FASB staff presented to the Boards a summary of the feedback received as part of its outreach regarding the pattern of lease expense recognition resulting from the lessee accounting model. After discussing relevant outreach feedback, Board members directed the staffs to further develop three approaches for discussion during the June 2012 meeting. Those approaches, focused on the subsequent measurement of the right-of-use asset, were as follows:
- Approach A: an approach consistent with the Boards’ previous tentative decision that treats a lease contract as being equivalent to the purchase of an intangible asset that is financed separately thereby resulting in a pattern of accelerated expense recognition;
- Approach B: a “whole contract” approach which considers the right-of-use asset and the lease liability that arise from a lease contract to be one unit of account when initially and subsequently measuring those balances, and thus, requires recognition of the total lease payments evenly over the lease term (i.e., straight-line expense recognition). The lessee would present the total expense each period as lease expense and there would be no separate interest component or amortisation component in the income statement
- A combination approach which applies Approach A to some leases and Approach B to other leases.
At this meeting, the staffs provided an overview of each approach; summarising the rationale, reasons to support the approach and relevant concerns.
In deliberations, individual preferences quickly resolved themselves into board preferences, as a significant majority of IASB members expressed support for application of Approach A to all leases while FASB members generally expressed support for a combination approach which applied Approach A to some leases and Approach B to other leases. No support was expressed for applying Approach B to all leases.
Reasons for supporting a particular approach varied. Specifically, Board members supporting Approach A often noted that it was the most conceptually sound and offered the least complexity since it could be applied to all leases without the need to distinguish between lease types. In expanding on these ideas, Board members noted:
- The expense recognition pattern is conceptually consistent with a right-of-use model, whereby the lessee recognises a right-of-use asset and a lease liability separately. The subsequent measurement of the right-of-use asset, a non-financial asset, and lease liability, a financial liability, is consistent with the subsequent measurement of other non-financial assets and financial liabilities. Board members also noted that application of Approach B to certain leases fails to reflect interest expense for the time value of money and results in an amortisation profile for the right-of-use asset which does not have a conceptual basis.
- Approach A is a coherent model for all leases which reduces complexity and cost for users, preparers and auditors. Further, user feedback during outreach activities expressed a preference for one approach to lessee accounting.
- Development of a principle for determining which expense pattern to apply to each contract will be subject to criticism given a diversity of views amongst constituents.
However, other Board members noted that constituent outreach has indicated that the economics of lease contracts differ. Consequently, these Board members supported a two-model approach that would apply Approach A to some leases and Approach B to others based on the underlying economics of the lease. These Board members acknowledged that constituents may question why, when applying Approach B, the asset and liability is not presented on a net basis given that Approach B links the right-of-use asset and the lease liability. Thus, they indicated that a robust basis for conclusions would be necessary to provide the Boards’ rationale as to why Approach B is appropriate but net presentation on the statement of financial position is not.
Board members were asked to vote on their first preference of applying either Approach A to all leases or a combination of Approaches A and B to all leases. All but one FASB member supported a combination of Approaches A and B, while all but one IASB member expressed support for applying Approach A to all leases (with two IASB members abstaining). As many IASB members expressed a willingness to entertain a combination of Approaches A and B for purposes of convergence, the FASB Chair asked if the IASB would object to applying a combination approach. No objections were raised, with two IASB members abstaining. Therefore, the Boards tentatively decided that there should be different lease expense recognition patterns for different lease contracts (Approach A would apply to some leases and Approach B to others).
Determination of a dividing line for different types of leases
Given the above tentative decision to apply a different pattern of expense recognition to some leases, Board members discussed the line to be used in distinguishing between leases accounted for under Approach A and Approach B. The staffs presented several alternatives for drawing a line, including:
- Option 1: Determination based on the transfer of substantially all of the risks and rewards of ownership (using the principle outlined in IAS 17 Leases)
- Option 2: Determination based on whether the right-of-use asset represents the acquisition of a more than insignificant portion of the underlying asset
- Option 3: Determination based on the nature of the underlying asset (e.g., leases of property versus leases of assets other than property)
- Option 4: Determination based on the lessee’s business purpose for entering into the lease arrangement.
Many Board members expressed a view that Option 4 was not operational. They noted that this underlying principle in this option is based on the intention of the lessee in determining whether the lease transaction was primarily entered into as a financing arrangement or not which may create comparability issues for users. Therefore, no support was expressed for this alternative.
Two FASB members expressed support for Option 1 on the basis that it incorporates a residual risk consideration when applied under the lessor model and promotes a smoother transition between current accounting and the proposed lease model (given that the IAS 17 criteria are well known in practice). However, other Board members expressed concerns that the IAS 17 criteria were developed for a different purpose than use under a right-of-use model, and given the nature of the criteria, it may inappropriately result in a significant number of leases being classified under Approach B (above).
Many Board members were unclear as to the distinguishing characteristics between Options 2 and 3. The staffs acknowledged that Option 3 was considered a practical expedient of Option 2 where the staffs considered that conclusions would generally be consistent applying either option. Under Option 2, for leases in which the right-of-use asset represents the acquisition of more than an insignificant portion of the underlying asset, a lessee would apply the accounting treatment in Approach A above.
However, for leases in which the lessee is not consuming a more than insignificant portion of the underlying asset, a lessee would apply Approach B. Under Option 3, the line would be based on the type of underlying asset. Leases of property would generally be accounted for using Approach B above unless the lease term is for the major part of the economic life of the underlying asset or the present value of fixed lease payments accounts for substantially all of the fair value of the underlying asset.
Leases of assets other than property would be accounted for under Approach A above unless the lease term is an insignificant portion of the economic life of the underlying asset or the present value of the fixed lease payments is insignificant relative to the fair value of the underlying asset. According to the staffs’ agenda papers, most property leases would be accounted for using Approach B while most leases of assets other than property would be accounted for under Approach A.
While some Board members supported Option 2, they expressed concerns with the introduction of a new concept (i.e., consumption). Other Board members expressed concern that Option 3 simplified the economics too significantly. However, many Board members saw Option 3 as effectively introducing a rebuttable presumption to Option 2. Therefore, they preferred that Options 2 and 3 be combined in some capacity.
When put to a vote, the IASB had a clear majority of 10 votes for Option 3. However, the FASB had a split vote (two members supported Option 1, two members supported Option 2 and three members supported Option 3). The IASB Chair asked if either Board would object to developing a principle based on consumption (consistent with Option 2) (i.e., whether the lessee acquires and consumes more than an insignificant portion of the underlying asset over the lease term) but providing a practical expedient based on the nature of the underlying asset(Option 3). No objections were raised.
Consequences of lessee decisions on lessor accounting
Given the above tentative decisions, the Boards discussed whether there should be consequences for lessor accounting resulting from the lessee accounting discussions.
Board members supported changing previous tentative decisions on the lessor model as a result of tentative decisions taken on the lessee model.
The staffs presented three possible approaches to progressing the lessor model following tentative decisions taken on the lessee model:
- applying a symmetrical model between lessees and lessors where the dividing line used to distinguish leases in the lessee model should also be applied in distinguishing use of the lessor model
- developing a new dividing line for lessors which is based on the lessor business model
- developing a new dividing line for lessors which is based on the IAS 17 principle of an in-substance sale. Ultimately, such a dividing line would be used to determine which leases would be within the scope of the lessor receivable and residual approach.
Many Board members thought the lessee and lessor accounting models should be linked and generally symmetrical, with any instances of asymmetry clearly explained in the basis for conclusions.
Other Board members noted that lessees and lessors have fundamentally different reasons for entering into leases, and thus, were satisfied with asymmetry between the lessee and lessor accounting models (although one IASB member questioned whether a decision to abandon symmetry between the lessee and lessor model could open up the possibility of excluding lessors from the leases project altogether given that constituents have not historically expressed a view that the IAS 17 model for lessors was broken).
A few Board members expressed a preference that the lessor model be aligned with the revenue recognition proposals as opposed to the lessee model. They noted that the lessor model should consider residual risk, akin to revenue recognition proposals, in determining whether any day 1 profit should be constrained and recognised over time. Therefore, these Board members expressed a preference that the lessor model include a constraint on profit which considers residual risk. However, the staffs noted that the incorporation of a constraint was considered in July 2011 in applying a ‘reasonably assured’ criteria but was rejected by the Boards.
When put to a vote, the Boards (with 4 votes from the FASB and 11 votes from the IASB) tentatively decided that a symmetrical model should be applied between lessees and lessors where the dividing line used to distinguish leases in the lessee model would also be applied in distinguishing use of the lessor receivable and residual model. Thus, for leases in which the lessor is deemed to have sold (lessee consumed) a more than insignificant portion of the underlying asset to the lessee, the lessor would reflect the accounting under the receivable and residual approach. However, for leases in which the lessor is not deemed to have sold a more than insignificant portion of the underlying asset to the lessee, the lease would not be within the scope of the receivable and residual approach and would apply an approach similar to operating lease accounting.