As part of its continuing deliberations surrounding the Exposure Draft Leases (Leases ED), the Boards deliberated on the topics of the lessor accounting model, accounting for variable lease payments and embedded derivatives.
The Boards made a number of tentative decisions during these deliberations, as follows:
Lessor accounting model:
Application of a single lessor accounting model (i.e., the receivable and residual approach) for all leases except those that are short-term (defined as a lease that, at the date of commencement of the lease, has a maximum possible lease term, including any options to renew or extend, of 12 months or less) or leases of investment property measured at fair value.
Under the 'receivable and residual' approach, the lessor would:
The Boards requested that the staff further explore the application of the 'reasonably assured' concept as it relates to recognising profit at lease commencement.
Accounting for variable lease payments:
Variable lease payments that depend on an index or a rate would be initially measured at the rate that exists at lease commencement. Lessees and lessors would reassess variable lease payments that depend on an index or rate when measuring the lessee's liability to make lease payments and the lessor's right to receive lease payments in subsequent periods. At reassessment, all changes to the lessee's liability and the lessor's receivable resulting from changes in variable lease payments that depend on an index or rate would be reflected as proposed in the Leases ED. However, the Boards asked the staff to bring back two specific topics regarding recognition at a future meeting.
Entities would be required to assess whether their lease contracts include embedded derivatives which would be accounted for in the scope of current guidance.
As part of the June 2011 Board meeting, the Boards asked the staff to explore possible lessor accounting approaches; specifically considering whether to apply a single lessor accounting model and, if so, what the model would be, or whether to retain the current operating and finance lessor accounting models while distinguishing between leases that transfer substantially all the risks and rewards of ownership. The Boards also provided the staff with informal votes on a number of key topics in relation to possible lessor accounting model approaches.
Lessor accounting model
Continuing from discussions as part of the May and June joint Board meetings, the Boards considered two approaches for the lessor accounting model: (1) a dual-model approach consisting of current operating lease accounting for 'other-than-finance' leases and the 'receivable and residual' approach for 'finance' leases (akin to current capital leases) ("dual-model approach") and (2) the 'receivable and residual' approach for all leases ("single-model approach").
The 'receivable and residual' approach would include the following elements:
- initially measure the lease receivable at the present value of lease payments discounted using the rate charged in the lease, and subsequently measure the lease receivable at amortised cost using the effective interest method
- initially measure the residual asset on an allocated cost basis (i.e., based on the proportion of the underlying asset's fair value that is the subject of the lease) and subsequently accrete the residual asset using the rate charged in the lease
- recognise profit at lease commencement for any difference between (i) the previous carrying amount of the underlying asset and (ii) the sum of the lease receivable and the residual asset recognised, subject to the profit being reasonably assured (see discussion of this concept below)
- recognise interest income on the receivable and residual asset over the lease term.
The staff provided feedback from constituent outreach, in which a clear majority of IFRS constituents preferred a single-model, while US GAAP constituents were relatively split between a single- or dual-model approach. The majority of the staff preferred the single-model approach given its consistency with the lessee single-model approach and the fact that the spectrum of lease contracts was not considered to be uniquely different so as to justify two unique model approaches. However, a minority of staff expressed a preference for a dual-model approach given the key economic differences of different lease transactions. These individuals reconciled having a single lessee model (as opposed to a dual-model for lessors) by acknowledging that there is a threshold difference for revenue recognition (lessor) as compared to liability recognition (lessee).
The Boards reviewed practical examples of both approaches and noted that the 'receivable and residual' approach, when compared to current operating lease accounting, provided for accounting which better reflected the pricing of the contract (e.g., constant rate of return on investments), provided users with better information about risks by separately recognising the receivable and residual asset and provided a more accurate depiction of the economics of the transaction within a company's statement of financial position.
As a result, the Boards tentatively agreed to apply a single-model approach for lessors.
The Boards were asked to consider whether the 'receivable and residual' approach could be used in all leasing environments. Specifically, the Boards were asked to consider the following possible scope exceptions:
- Investment property measured at fair value: Leases ED, as issued by the IASB, proposed that a lessor should apply IAS 40 Investment Property to leases of investment properties that are measured at fair value. Given the unique aspects of investment property modelling including the fact that investment properties typically take the form of an appreciating asset, significant constituent support was provided for this scope exception, as many constituents noted a more appropriate reflection of an investment property lessor's business is for the lessor to measure the entire investment property at fair value and recognise lease income over the lease term on a straight-line (or more systematic) basis. Likewise, constituents noted the practical difficulties in applying the 'receivable and residual' approach to investment properties given multi-tenant properties limiting the availability of fair value information for individual units within one building. For this reason, the staff recommended retaining the Leases ED scope exclusion such that leases of investment property measured at fair value (either in accordance with IAS 40 or the final FASB Investment Properties standard once completed) would be excluded from the scope of the lessor accounting approach. For those leases, the lessor would recognise lease income over the lease-term on a straight-line (or other more appropriate systematic) basis. One Board member suggested that the scope of the exception be extended beyond those investment properties applying IAS 40 to include other assets that are measured at fair value, but there was little support for this proposal from other Board members. With little deliberation, the Boards agreed with the staff recommendation
- Short-term leases (defined as a lease that, at the date of commencement of the lease, has a maximum possible lease term, including any options to renew or extend, of 12 months or less): Following a similar scope exception confirmed for the lessee accounting model as part of the 13-15 June 2011 joint Board meeting, the Boards decided that the proposed guidance in the Leases ED would be retained such that short-term leases would not require recognition under the 'receivable and residual' approach (i.e. could be accounted for consistent with the current requirements for operating leases). This scope exception would be elective by asset class. Disclosure surrounding short-term leases will be discussed separately
- Impractical to determine the carrying amount of a leased portion of an asset: The staff highlighted that application of the 'receivable and residual' model requires information about the carrying amount of the asset that is the subject of the lease (and fair value of that asset if profit is to be recognised at lease commencement). If the lessor has entered into numerous lease contracts for physically-distinct portions of a single larger asset, the staff noted that it might be impractical for the lessor to allocate a portion of the total carrying amount of the asset to each leased portion (in addition, it is likely to be difficult to fair value each leased portion of the larger asset). Thus, the staff proposed a scope exception from applying the 'receivable and residual' model if it is impractical to determine the carrying amount of a leased portion of an asset. Many Board members expressed concern with this proposal, as they noted it allows for significant management judgement so as to impair comparability. These Board members also questioned the practical difficulties in obtaining necessary information to apply the 'receivable and residual' approach. As a result, the Boards tentatively decided not to allow for a scope exception to the 'receivable and residual' approach based on practicality.
Profit recognition under a 'receivable and residual' approach
The Boards were asked, in applying the 'receivable and residual' approach (discussed above), if a lessor should recognise profit on the right-of-use asset transferred to the lessee at lease commencement (i.e. the difference between the fair value of the underlying asset and the carrying amount at lease commencement), or defer profit recognition over the lease term unless the lease agreement transfers substantially all of the risks and rewards of ownership of the underlying asset.
The staff proposed that profit should be recognised to the extent that profit is reasonably assured in an attempt to limit variability in profit or loss when the lessor has not transferred substantially all of the risks and rewards of ownership of the underlying asset to the lease or the estimate of the residual value of the underlying asset is not a reliable prediction of what the underlying asset will be worth at the end of the lease term. Reasonably assured would be designed to be generally consistent with the use of the term in the revenue recognition project.
The staff noted the appropriateness of initial profit recognition in that, at lease commencement, the lessor has performed by making the underlying asset available for use by the lessee and, in exchange, has a lease receivable. Likewise, the staff noted that recognition of any manufacturing / dealer profit at lease commencement is derived from services performed in advance of entering into the lease.
Both Boards generally agreed with the staff's recommendation; however, such agreement was based on the ability to adequately define the term reasonably assured. Specifically, the Boards considered examples outlined by the staff, including uncertainties in: estimating the residual value at the end of the lease term; allocating payments made by the lessee into lease and non-lease components; and determining the fair value of the underlying asset at lease commitment. The staff identified all three of these environments as areas in which the right-of-use asset transferred would not be reasonably assured.
Board members expressed concerns related to the consistency of the 'reasonably assured' concept to that outlined in the revenue recognition model and the confusion of the concepts of reasonably estimated and reasonably assured.
While these concerns are inter-related, specific concerns expressed by Board members included:
- Reasonably assured, as applied in the revenue recognition project, outlined three specific criteria in determining recognition timing. The nature of these criteria were more akin to a revenue recognition model as opposed to a leasing model, in the view of particular Board members, and thus, consistent application of the concept across projects did not seem like an appropriate response. However, other Board members noted the importance of retaining consistent terminology across projects to avoid confusing constituents
- Examples outlined by the staff in applying the reasonably assured concept suggested that any uncertainties (e.g., estimates) triggered deferral of profit recognition. Certain Board members cited guidance in paragraph IN16 of the Revenue from Contracts with Customers exposure draft, which notes that would not be required to defer revenue recognition if revenue is determined to be reasonably estimated (i.e., the entity has experience with similar types of contracts and the entity's experience is relevant to the contract because the entity does not expect significant changes in circumstances). Thus, the Boards saw the staff as being overly conservative in applying the reasonably assured concept when compared to the revenue project. The staff noted its intention was to allow for profit recognition at lease commencement if profit is reasonably estimated.
After debate, the Boards tentatively agreed with the staff recommendation that at lease commencement, a lessor should recognise profit on the right-of-use asset transferred to the lessee if that profit is reasonably assured. If the profit on the right-of-use asset transferred is not reasonably assured, a lessor would apply the 'receivable and residual' approach outlined above except that the lessor would initially measure the residual asset as the difference between the carrying amount of the underlying asset and the lease receivable. The lessor would subsequently accrete the residual asset using a constant rate of return to an amount equivalent to the underlying asset's carrying amount at the end of the lease term as if it had been subject to depreciation.
However, in the above decision, the Boards asked the staff to provide draft wording for application of reasonably assured in advance of final drafting of the standard. Many Board members preferred that the application guidance consider the definition of reasonably assured outlined in the revenue recognition project (i.e., consistent principle), but provide criteria which were appropriate for a leasing environment, while also applying the reasonably estimated concept.
Accounting for variable lease payments
In April and June 2011, the Boards tentatively decided that variable lease payments should not be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable unless those payments represent:
- variable lease payments that are structured in such a way that they are in-substance fixed lease payments (commonly referred to as "disguised minimum lease payments")
- the portion of a residual value guarantee expected to be paid by the lessee, or
- an index or rate derived payment, in which case indices or the prevailing (spot) rate at lease commencement would be used for calculating the variable lease payments.
As part of this Board meeting, the Boards were asked to discuss the measurement of variable lease payments that depend on an index or a rate within the lessee's liability to make lease payments and the lessor's right to receive lease payments. This discussion was derived from clarification requested by constituents as to how to apply a spot rate to the initial measurement of variable lease payments that depend on an index or a rate; specifically considering an environment in which a daily spot rate does not exist (e.g. when the lease payments are linked to an annual rate of inflation) or the index is a scale rate (e.g. lease payments are linked to a consumer price index (CPI) formula — such as a rate of 125 at the lease commencement date). In these environments, constituents were questioning whether the spot rate was indicative of: an annual rate of inflation of zero or CPI rate of 125, respectively; a rate based on the most recent annual rate of inflation; or a rate based on a historical average.
In considering this environment, the staff recommended clarifying the previous tentative decision by stating that variable lease payments that depend on an index or rate should initially be measured based on the index or rate that exists at the date of commencement of the lease (as opposed to stating measurement in accordance with the spot rate since a spot rate does not always exist). As an example, for a lease tied to CPI, a CPI of 100 at lease commencement would result in applying a CPI of 100 throughout the remaining lease term. The measurement of the lessee's liability would exclude any estimation of future rates / indices.
A minority of the Boards expressed a desire to apply a more reliable rate if one is available (i.e. a rate that more appropriately reflected the economics of the transaction). Specifically, these Board members noted that the spot rate is likely not indicative of a future rate prediction, and thus, for example, if a forward rate existed, they preferred the use of the forward rate. However, multiple Board members expressed concern with applying with applying any methodology other than that proposed by the staff, as these Board members felt that the staff proposed a practical expedient that limited structuring opportunities. Further, these Board members noted the complexity that may be added in applying a methodology other than that proposed by the staff. As such, the Boards tentatively agreed that variable lease payments that depend on an index or rate should initially be measured based on the index or rate that exists at the date of commencement of the lease.
The Boards then considered whether reassessment and subsequent measurement of variable lease payments that depend on an index or rate is necessary.
While a minority of the Boards noted the added complexity / time burden of reassessing each lease each period, other Board members did not identify this as an overly complex or time intensive task. They noted the benefits of requiring reassessment, including timely delivery of more relevant information to users of financial statements given that it reflects current economic decisions and consistency with the requirement to reassess options to extend or renew a lease and the accounting for foreign exchange differences.
As such, the Boards tentatively agreed to require reassessment of variable lease payments that depend on an index or rate.
Finally, as a result of the above decision, the staff asked the Boards how to account for changes in the expected amount of such payments; recommending the following:
- For lessees:
- recognise in profit or loss to the extent that such changes relate to the current period
- recognise as an adjustment to the right-of-use asset to the extent that those changes relate to future periods
- For lessors:
- recognise as an adjustment in the expected amount of the right to receive lease payments in profit or loss.
Many Board members, while agreeing with the framework, were unclear as to how to distinguish current and future period adjustments in the lessee accounting model. The staff noted that they will bring this issue back in a future discussion.
Another Board member cited concern with the lessee approach in an environment in which profit is deferred based on the reasonably assured concept outlined above. This Board member requested the staff to consider an environment in which profit is constrained in amending the above application proposal (i.e. can you always say take to profit or loss). The staff will bring this issue back in a future discussion.
The Boards were asked to consider whether entities would be required to assess whether their lease contracts include embedded derivatives which would be bifurcated and accounted for in accordance with the guidance on financial instruments, as is currently required under both IFRSs and US GAAP.
The staff outlined little constituent feedback in this area given that the Leases ED did not provide guidance on embedded derivatives in lease contracts nor did it request feedback from constituents in this area. Staff analysis highlighted that retaining the embedded derivative assessment requirement would provide users with timely information regarding risks related to embedded derivatives, limit structuring opportunities and provide fair value information in relation to lease payments.
The Boards strongly supported retaining current guidance requiring assessment as to whether host lease contracts contain embedded derivatives in providing fair value measurement of assets and liabilities relating to lease contracts. They expressed that:
- guidance on embedded derivatives and the closely related criteria were originally introduced to prevent abuse, and this risk remains unchanged. More specifically, one Board member noted that it is needed to prevent structuring opportunities in structuring a derivative as a lease
- variances would exist between the measurement approach (proposed above) and fair value measurement.
While the Boards supported requiring assessment as to whether host lease contracts contain embedded derivatives, one Board member expressed a desire to provide clarity in any final standard as to the appropriate accounting guidance to apply in accounting for embedded derivatives considering the scope of IFRS 9 Financial Instruments and IAS 39 Financial Instruments: Recognition and Measurement is limited to financial instruments as opposed to a lease liability.