As part of its continuing deliberations surrounding the Exposure Draft Leases (Leases ED), the Boards discussed: (1) consequential amendments to IFRS 3 Business Combinations / Topic 805 Business Combinations in the FASB Accounting Standards Codification, (2) transition requirements related to IFRS 3 Business Combinations and Topic 805, (3) consequential amendments to IAS 23 Borrowing Costs / Topic 835 Interest and (4) transition accounting for secured borrowings.
In addition to the above discussion topics, the staff noted that it intends to bring staff papers to the December 2011 meeting. However, it currently anticipates completion of redeliberations on the project as part of that meeting.
Consequential amendments for business combinations
The staff discussed the measurement of lease assets and lease liabilities recognised in a business combination. Considering proposals in the Leases ED that lease assets and lease liabilities would be exempt from the fair value measurement requirements in the business combinations guidance (and instead, measured in accordance with the new leases standard), and respondent feedback to the Leases ED that ensued, the staff considered two alternatives of measuring lease assets and liabilities in a business combination (context of lessees); measure the right-of-use asset and liability to make lease payments at the present value of the remaining lease payments, with an adjustment made to the right-of-use asset for any off-market terms (the approach proposed in the Leases ED), or measure both the right-of-use asset and the liability to make lease payments at fair value (consistent with the measurement principle for business combinations).
In presenting its analysis, the staff noted certain advantages to the Leases ED model, including:
- the benefits of fair value measurement are achieved without the related costs of fair value measurement by arriving at a net carrying amount for acquired lease contracts that closely approximates the fair value of that contract without undergoing the costs of obtaining a fair value for the individual right-of-use asset and liability to make lease payments.
- it is consistent with the lessee model in the leases standard.
However, this approach was also known to have disadvantages in that the business combination literature in IFRSs and US GAAP is based on the premise that fair value provides the most relevant information in the case of business combinations, and thus, the Leases ED proposal contradicts this premise.
Several IASB members questioned the need to establish an exception to IFRS 3; noting that leases are not inherently more complex to value that other items requiring fair valuation in a business combination. Other Board members built on this concern and noted that they did not believe that the Leases ED achieved a relative fair value approach; citing the difference in the measurement basis between initial recognition of leases (in which the significant economic incentive criteria is not considered) as compared to evaluation of renewal options in subsequent periods as example of a valuation difference.
Board members also expressed concern with applying adjustments to the right-of-use asset for 'off-market terms' under the Leases ED approach. Specifically, they noted uncertainty as to the offsetting entry to an adjustment to off-market terms, and questioned the scope of assessing off-market terms. The staff responded that it anticipated the debit / credit to a right-of-use asset adjustment for off-market terms to be applied against goodwill. The staff also clarified that off-market terms would be measured as the difference between the present value of the remaining lease payments at the acquisition date and the present value of the lease payments that the acquirer would expect to pay if, at the acquisition date, it entered into an identical lease for the remaining period.
Based on the above deliberations, both Boards tentatively decided:
- If the acquiree is a lessee, the acquirer should recognise a liability to make lease payments and a right-of-use asset. The acquirer should measure: (i) the liability to make lease payments at the present value of future lease payments in accordance with the proposed leases guidance, as if the associated lease contract is a new lease at the acquisition date, and (ii) the right-of-use asset equal to the liability to make lease payments, adjusted for any off-market terms in the lease contract.
- If the acquiree is a lessor applying the receivable and residual approach, the acquirer should recognise a lease receivable and a residual asset. The acquirer should measure: (i) the lease receivable at the present value of the future lease payments in accordance with the proposed lease guidance, as if the lease was a new lease at the acquisition date; and (ii) the residual asset as the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable.
- If the acquiree is a lessor of investment property or if the acquiree has short-term leases (or acquires a lease which has a remaining lease term at the acquisition date which is considered a short-term lease under the proposed lease standard), the acquirer should apply the guidance in IFRS 3 and Topic 805 relating to acquired operating leases.
The staff noted that respondents to the Leases ED requested that the leases standard contain transition guidance for previously recognised intangible assets or liabilities relating to favourable or unfavourable terms in an operating lease.
The staff recommended that upon transition, a lessee with any previously recognised assets or liabilities related to favourable or unfavourable terms in acquired operating leases derecognise those assets or liabilities and adjust the carrying amount of the right-of-use asset by the amount of any asset or liability derecognised. The recommendation was based on the premise that it is not appropriate to continue to recognise an intangible asset or liability relating to a favourable or unfavourable contract when there is an asset (the right-of-use asset under the Boards' lease proposals) whose value is directly affected by that asset or liability.
One Board member questioned whether the adjustment should go to retained earnings as opposed to the right-of-use asset. However, other Board members preferred the staff's recommendation as providing an answer which is more consistent with full-retrospective application. Without further debate, both Boards tentatively agreed with the recommendation of the staff.
The FASB staff then presented a FASB-only issued related to transition. Under US GAAP, an acquirer of any assets subject to operating leases in which the acquiree is the lessor is required to measure the acquisition date fair value of such acquired assets separately from the lease contract and to record a separate asset or liability for favourable or unfavourable lease terms. The staff did not think it was appropriate that such assets or liabilities related to favourable or unfavourable lease terms continue to be separately recognised as those assets and liabilities would effectively be recognised as a part of the lease receivable under the proposed receivable and residual approach. Therefore, the staff recommended that such assets or liabilities be treated as adjustments to retained earnings on transition. Without debate, the FASB tentatively agreed with the staff recommendation.
The Leases ED proposed removing finance charges in respect of finance leases from the scope of IAS 23. However, constituent outreach questioned if interest expense incurred under a lease could be capitalised, if appropriate, under IAS 23 and Topic 835.
The proposed removal of finance lease charges from the scope of IAS 23 was originally based on the Board's notion that a right-of-use asset itself would never be a qualifying asset. However, constituent outreach revealed examples in which a right-of-use asset would be a qualifying asset (e.g., in the case of leasing a specialised piece of equipment solely to construct a building, the right-of-use asset may be used to construct a qualifying asset). Therefore, the staff recommended that interest expense incurred in a lease be included in the scope of IAS 23 and Topic 835. Without debate, the Boards tentatively agreed with the staff's recommendation.
The staff presented information regarding transition accounting for secured borrowings. This issue is considered particularly relevant given that under existing IFRSs and US GAAP, a lessor would not recognise lease receivables associated with current operating leases, and therefore, could not account for the subsequent transfer of such operating lease receivables as sales. Instead, those transactions would be accounted for as secured borrowings. However, under current proposals, a lessor would recognise lease receivables at transition and present them as lease receivables pledged to lenders, and therefore, could conceivably determine that such pledged receivables meet the sale criteria.
The staff noted that if existing IFRSs and US GAAP for transfers were amended such that a lessor would be required to evaluate, as of the date of transfer, whether the sale criteria were met, the lessor would derecognise the lease receivables at transition. Any resulting gain or loss from derecognition would be recognised in opening retained earnings if the transaction occurred before the earliest comparative period. The staff recommended that a reconsideration of whether the sale criteria were met not be required because it may increase transition complexity and costs. However, the staff supported permitting a lessor to evaluate, as of the date of transfer, whether the sale criteria were met given that it was seen to improve comparability between periods if an entity elected application of transfer accounting retrospectively.
In considering this issue, many Board members expressed concern with allowing entities an 'election' to evaluate whether the sale criteria were met. Specifically, these Board members noted that the election does not promote comparability between reporting entities. Further, they noted the structuring opportunities associated with an election. Specifically, these Board members believed that entity elections would correspond to the favourability of the election on financial results, whereby entities would seek to project gains or bury losses wherever possible.
When put to a vote, 11 IASB members supported the staff's recommendation to permit reconsideration of whether or not the sale recognition criteria were met at the date of transfer, but no FASB members supported the staff's recommendation. Instead, one FASB member suggested that the evaluation of whether or not the sale recognition criteria are met should be considered on a prospective basis. Other FASB members supported this proposal. The IASB was asked to reconsider its previous vote in consideration of the FASB's proposal. In a vote, the IASB tentatively agreed with the proposal set forth by the FASB.