Leases - Distinguishing between leases and services
As part of continual deliberations surrounding the Exposure Draft Leases published 17 August 2010, the Boards considered the following topics given feedback received as part of comment letter and outreach activities:
- Distinguishing between leases and services, including:
Following outreach activities discussed during the January 2011 joint Board meeting, the staff highlighted consideration as to whether there should be more than one lease model for both lessees and lessors, and specifically, the profit or loss effects of the proposed right-of-use model for both lessees and lessors. In this context, the following overriding questions were raised to the Boards:
- Are there different types of leases; a concept unique from the current Exposure Draft which suggests one type of lease?
- If there are different types of leases, should all leases have the same profit or loss recognition pattern or should there be differences in profit or loss recognition?
- If there are different types of leases, what are the indicators that distinguish one type from another?
The staff recommendations as part of this meeting included:
- Tentative acknowledgement that there are two different types of leases, with a plan to establish a targeted approach for outreach on underlying topics derived from this tentative acknowledgement.
- If there are different types of leases, that each type have a different profit or loss recognition pattern for both the lessee and lessor. Specifically, there is a lease that is:
- A finance lease that is akin to an instalment purchase / sale in which the financing element is significant and should be reflected in the pattern of profit or loss recognition of both lessees and lessors. The profit or loss of a finance lease has a profit or loss pattern consistent with the proposals in the Exposure Draft and includes interest expense / income (using the effective interest method), and would usually reflect the lessee consuming the right-of-use asset on a straight-line basis, or
- An 'other-than-finance lease' that is a lease transaction in which the financing element is not considered significant. The profit or loss pattern of an other-than-finance lease is characterised by straight-line recognition consistent with today's US GAAP / IFRS operating lease accounting
- Indicators to make a determination between the two proposed types of leases, including (a) residual asset, (b) potential ownership transfer, (c) length of lease term, (d) rent characteristics, (e) underlying asset, (f) embedded or integral services and (g) variable rent.
The concept of the appropriate presentation for leases will be subject to deliberation at a future meeting.
The Boards, in deliberation of the concept of two different types of leases in the Boards' right-to-use model, tentatively confirmed the staffs' conclusions, including that of targeted outreach activities, highlighting:
- Certain types of leases provide for a financing element which is not significant as the lessee enters into a rental transaction to use the asset rather than a transaction that is similar to financing the acquisition of the asset; in substance, a lease not entered into for the purpose of financing, but rather, to create flexibility, mitigate the risk of ownership and /or outsource activities related to maintenance and administration
- Certain types of leases have varying levels of ancillary services combined in the arrangement which may differentiate the form of a lease
- The distinction of two types of leases is not inconsistent with the Boards' stated purpose of providing users of financial statements with a complete and understandable picture of an entity's leasing activities.
In reaching the above tentative confirmation, the Boards also tentatively confirmed the staffs' views regarding a different profit or loss recognition pattern for both the lessee and lessors, citing:
- Different entities engage in lease transaction for different reasons, including those of a financing nature and other of an other-than-financing nature, as described above.
Multiple members of the Boards suggested further development and discussion regarding the profit and loss recognition patters applied in an effort to provide linkage between the assets and liabilities derived under lease transactions.
In contemplation of the distinction of leases noted above, the Boards considered what indicators should be used to distinguish one type of lease from another; generally concluding that new indicators should be identified independent of those outlined in current standards, although the indicators recommended by the staff, as specified above, consider current guidance in IAS 17 and ASC 840, as well as feedback received from comment letters and outreach activities.
Certain members of the Boards expressed concerns regarding the indicators expressed by the staff including:
- Defining a 'by-exception' model for finance lease classification, whereby indicators outlined herein may be viewed in isolation. Specifically, multiple members of the Boards expressed reservation that the applicability of one of the indicators for finance lease distinction should not be viewed as conclusive evidence of the appropriateness of a finance lease distinction. Further, multiple members of the Boards deliberated as to whether two indicator lists should be produced to distinguish indicators to be considered in finance lease distinction, independent of indicators for other-than-finance lease distinction, as well as if a hierarchical approach to the indicators should be provided.
- Inconsistencies in application of the right to acquire 'substantially all' the risks and rewards incidental to ownership. Current guidance expresses finance lease determination based on the transfer of substantially all the risks and rewards incidental to ownership; however, no certain members of the Boards felt no clear indicators exists in defining the significance of risk and reward distinction among the two lease types (akin to the "90% test" outlined in paragraph 10(d) of IAS 17 and ASC 840-10-25-1(d).
Future deliberation on the above topic will continue at a future meeting.
In application of the definition of a lease expressed within the Exposure Draft, as generally consistent with current IFRS and US GAAP literature, and considering feedback from comment letter and outreach sessions, the staff focused its proposals to the Boards on the concepts of specificity of assets and the right to control; considering the following:
- Specificity of an asset
- Should the definition of a lease refer to a specific or specified asset (e.g., uniquely identified asset or an asset of a particular specification)?
- Should the final standard clarify whether an asset can be a portion of a larger asset?
- Should the final standard address assets that are incidental to the delivery of specified services?
- Right to control
- Should the concept of control apply the principles already in IFRIC 4 and ASC Topic 840, but change to the wording of paragraph B4(c) to clarify the principle underlying those words?
- Should the concept of control be consistent with the concept of control included in the revenue recognition Exposure Draft?
The staff recommendations as part of this meeting included:
- No definitive recommendation as to whether an asset should refer to a specific or specified asset. The staff recommended targeted outreach in this area
- No definitive recommendation as to clarifying whether an asset can be a portion of a larger asset, but highlighting two likely approaches: (a) applying current IFRIC 4 and ASC Topic 840 guidance without additional amendment, which clarifies that a physically distinct portion of a larger asset can be a specified asset or (b) clarifying whether a physical or non-physical (e.g., capacity) portion of a larger asset can be a specified asset. The staff recommended targeted outreach in this area
- The inclusion of working regarding assets that are incidental to the delivery of specified services, which is generally consistent with paragraph B1 of the Exposure Draft that 'an entity shall determine whether the contract is, or contains, a lease on the basis of the substance of the contract...'.
Specificity of an asset
The Boards, in response to whether the definition of a lease refers to a specific or specified asset, expressed a relatively split view, with the majority of the Boards supporting that a 'specified asset' should be viewed more broadly as an asset of a particular specification (e.g., copier machines under a leasing arrangement can be substituted with consistent models, assuming no disruption of service). Deliberations underlying this tentative decision considered that a more broad views considers that a customer has received the same benefits and functionality throughout the lease term, while the opposing view highlights that a broad view may result in variances in accounting between the lessor and lessee, whereby a lessor must identify a specific asset to enable practical application of the derecognition model within the Exposure Draft.
The Boards agreed to tentatively confirm the broad 'specific asset' application while taking both approaches for targeted outreach.
In evaluating the concept of whether assets can be a portion of a larger asset, the majority of the Boards confirmed that any amendments should clarify whether a physical or non-physical (e.g., capacity) portion of a larger asset can be a specified asset.
Focusing on the concept of non-physical asset distinction as a lease, the majority of members of the Boards noted that a non-physical portion of a larger asset could be a specified asset, as this was conceptually consistent with the right-of-use model proposed in the Exposure Draft and an approach of viewing an underlying asset as a bundle of rights. The staff expressed concerns about the implications and possible unknown consequences of expanding the application of the definition of a lease to non-physical portions of a larger asset and acknowledged that, for cost / benefit reasons, it may be appropriate to clarify that non-physical portions of a larger asset would unusually not meet the definition of a specified asset. Therefore, the staff recommended that the Boards seek input through targeted outreach on both of the likely approaches set forth by the staff.
The Board confirmed the recommendation of the staff.
In evaluating the concept of assets incidental to the delivery of specified services, such as season tickets to a sporting venue or a cable box provided when a customer contracts to have viewing rights to particular television channels, the Exposure Draft was silent on such examples. The staff provided preliminary draft wording to the definition of a lease to capture assets that are incidental to the delivery of specified services, noting consideration as to the 'incidental' nature of the asset.
Under preliminary draft wording provided by the staff, an asset was considered likely to be incidental to the provision of a service when (a) specification of the asset is determined by the supplier as a mechanism for providing a specified service requested by the customer in the contract; or (b) the asset component of the contract is insignificant in terms of its benefit to the customer when compared to the service components of the contract.
The majority of the Boards agreed with this definition amendment, but noted that the term 'insignificant' should be clarified as whether such an assessment underlies economics or other benefits. A minority of members of the Boards considered whether time should be a component of the definition (e.g., a time charter of one day versus five years), but no consensus was reached.
Right to control
The current definition of a lease within the Exposure Draft raises the concept of a right to control, whereby a contract is said to convey the right to use an asset if it conveys to an entity the right to control the use of the underlying asset during the lease term. Control, in the context of a lease, is considered to provide for either (a) the active ability to operate or control physical access to an asset as well as the right to obtain some output or other utility of the asset; or (b) having the right to obtain all but an insignificant amount of the output or other utility of the asset as long as the pricing is such that the customer is paying for the right to use the asset, rather than for actual use or output.
Comments from respondents around the control provision questioned the following key concepts: (a) how should the 'ability or right to operate' concept be applied when a customer relies on personnel employed by the supplier to receive benefits from use of the specified asset; (b) what does 'output', 'insignificant', 'contractually fixed per unit' and 'current market price' mean within paragraph B4(c) of the Exposure Draft; (c) why would the concept of control applied when a customer obtains the right to control the use of an asset be different from the concept of control applied when a customer obtains control of a good?
In response to the main comments raised, the staff expressed two possible approaches:
- Retain the concept of control already in IFRIC 4 and ASC Topic 840 regarding the right to control the use of a specified asset, but change to the wording of paragraph B4(c) to clarify the principle underlying those words
- Revise the description of control in the lease standard to be consistent with the concept of control included in the revenue recognition Exposure Draft.
The staff recommend a targeted outreach of the above approaches, while also further deliberating any potential unintended consequences of applying the revenue recognition concept to the leasing environment. Certain members of the Board expressed the need for consistency in the use of the term 'control,' while a minority noted the unique nature of the revenue environment to that of the leasing environment.
The proposal provided by the staff provided preliminary draft wording relating to the definition of a lease in this area, including application of the revenue recognition Exposure Draft to the leasing environment.
Relevant deliberations included determination as to whether the entity has the ability or right to operate the asset or direct others to operate the asset in a manner that it determines while obtaining or controlling more than an insignificant amount of the potential cash flows from use of the asset, the ability or right to control physical access to the underlying asset while obtaining or controlling more than an insignificant amount of the potential cash flows from use of the asset, and rights to obtain substantially all the potential cash flows from use of the asset throughout the term of the lease.
The Boards expressed concern that use of the term, 'cash flows' should be broadened to include any benefit derived from use of the assets. The staff will consider revised wording in a future meeting.
The Boards confirmed the staffs' recommendation to field test the above approaches, with a majority preference of consistency between control defined within the revenue Exposure Draft and that of the leasing proposal. The Boards also asked the staff to consider unintended consequences of a consistent modelling within revenue and leasing in this area.