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Determining Whether an Arrangement Contains a Lease (Rights of Use of Assets)

Go To List of IFRIC Issues Should certain rights to use assets (for instance, in outsourcing arrangements) be accounted for as assets under a finance lease? Discussion at IFRIC Meeting February 2002: IFRIC asked its staff to develop materials for discussion at a future meeting. Discussion at IFRIC Meeting July 2002: Three key questions are: whether the asset in the arrangement must be explicitly specified in the agreement, or can it be implicit; must the right to use an asset be an exclusive right; and can the asset be a component of a larger asset. IFRIC will develop an interpretation. Discussion at IFRIC Meeting August 2002: IFRIC will develop an interpretation that will distinguish a lease from a service using examples that are clearly distinguishable. Rights of use that result in derivatives or intangibles would be excluded. IFRIC will also consider adding to its agenda, as separate projects, related issues such as (a) guarantees inherent in take-or-pay contracts, (b) asset componentisation, and (c) the distinction between a lease and a derivative. Discussion at IFRIC Meeting November 2002: The IFRIC continued its discussion of when a contract that gives an entity the right to use an asset should be accounted for as a lease. The draft Interpretation is being retitled "Determining Whether a Contract Contains a Lease". IFRIC members expressed diverse views about some of the more fundamental aspects of this project. Nevertheless, the staff proposed to send a pre-ballot draft to the members to be further discussed at the February 2003 IFRIC meeting. There was significant doubt among the members as to whether the draft to be circulated could be approved based on the fundamental disagreements on key issues as noted below. There was also concern that the interpretation was creating a rule, not interpreting or creating a principle. The draft interpretation states that a contract should be considered a lease if all three of the following criteria met: The arrangement is dependent upon a specific item of property, plant or equipment ('the asset') The entity obtains control over that asset; and The entity in substance pays for its right to use the asset and is obliged to pay whether or not it needs the asset. Discussion at IFRIC Meeting February 2003: The IFRIC continued its discussion of determining when a contract that gives an entity the right to use an asset should be accounted for as a lease. The staff proposed that in assessing whether a lease had arisen all of the following criteria should be present: The agreement is dependent upon a specific item or items ('the asset'); The entity obtains control over that asset for a specific period of time; and The entity is contractually, or in substance, required to make payments under the agreement for its right to use the asset rather than for its actual use. Previously it had been proposed that a lease would have been considered to exist when an entity that had rights to acquire substantially all of the output produced by an asset was deemed to have control over the asset (as specified by the above criteria), but only if the supplier obtained a return that was commensurate with that which would be obtained by an asset manager or operator. The requirement to consider the supplier's return was therefore eliminated as it was not considered to be important in assessing whether a lease existed but whether the lease would be an operating or finance lease. Some IFRIC members were concerned that this could result in an inappropriate definition of control arising and were more comfortable with the inclusion of conditions indicating that the payments were in respect of the right to use the asset and not for the actual use of the asset or its output. These members referred the staff to the current EITF proposals in this regard and requested the staff to liaise with the EITF to arrive at similar wording. The IFRIC supported that any agreement that fell within the ambit of the interpretation should be assessed at the inception of the contract and should only be reassessed if there was an amendment or significant modifications to the agreement. Thus the agreement would not be reassessed if there was only a change in circumstances. IFRIC agreed that the interpretation on issue should have retrospective application. One member of the IFRIC strongly disagreed, and it was agreed that this would be referred to in the Basis for Conclusions with a specific request to comment. IFRIC agreed that the staff would draft a proposed interpretation to be circulated to the IFRIC prior to the next meeting with a view to finalising the interpretation for exposure at the next meeting. Discussion at IFRIC Meeting April 2003: IFRIC considered a draft Interpretation that proposed that an agreement contains a lease, which should be accounted for under IAS 17, if all three of the following criteria are met: (a) Fulfillment of the agreement depends upon a specific item or items ("the asset"); (b) The purchaser controls the right to use the asset for a specific period of time; and (c) The purchaser's obligation to make payments to the supplier under the agreement is for the time that the asset is made available rather than for actual use of the asset. The draft Interpretation's second criterion ("controls the right to use") can be met in agreements in which a purchaser has rights to acquire substantially all of the output produced by an asset. IFRIC had previously agreed that in such agreements additional criteria were required to distinguish those agreements that convey a right of use from those that do not. This meant that the second criterion is not met (and thus an agreement did not contain a lease) if both: The price per unit of output is either fixed per unit of output or indexed to market prices, and The supplier is required to pay market-based liquidating damages if it fails to deliver. The IFRIC discussed whether the inclusion of contracts where substantially all of the output of an asset was acquired focused on ownership of the asset as opposed to control of the asset took place. Certain members believed that the Interpretation potentially changed the definition of control that has been used in Standards to date and focussed on ownership to indicate control. The IFRIC agreed that: The Interpretation should focus on the asset being the right to control the output and not the underlying asset. The IFRIC further agreed that the Interpretation should focus on the right to the capacity of the asset (possibly including an assessment of realistic future changes) and not a current fixed right of output from the asset. The Interpretation should clarify that a right to substitute assets in the contract did not change the assessment of the contract as a lease. There is a need for disclosure in the area of commitments, take or pay contracts and other executory contracts but that this should be addressed as a separate project. The staff will make the changes requested and prepare a final draft Interpretation for approval. Discussion at IFRIC Meeting September 2003 The IFRIC considered a draft Interpretation, Determining Whether an Arrangement Contains a Lease. The staff provided details of editorial changes made as a result of comments from IFRIC members. The IFRIC approved the draft proposal for exposure (9-2). Discussion at IFRIC Meeting December 2003 The Draft Interpretation was sent to the Board. One Board member expressed concerns on the three criteria, as they appear to be internally inconsistent. The staff has redrafted the Interpretation, and IFRIC generally agreed on the amendments. Some IFRIC members expressed concerns that the draft is still unclear as to whether the asset being accounted for is a right of use or the underlying asset. The staff was asked to redraft the Interpretation to address those concerns. Additionally, the staff should consider the relationship of this project to the one on concession agreements. January 2004 – IFRIC Draft Interpretation D3 In January 2004, IFRIC issued Draft Interpretation D3, Determining Whether an Arrangement Contains a Lease. D3 would require arrangements that do not take the legal form of leases, but that have the substance of leases, to be accounted for in accordance with IAS 17, Leases. The types of arrangements addressed include outsourcing arrangements; contracts to supply network capacity in the telecommunications industry; take-or-pay contracts (in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services; and service concession arrangements in which a supplier (usually a private entity) provides the use of an item of infrastructure to a purchaser (usually a government). The draft provides guidance on determining whether an arrangement is, or contains, a lease for the purpose of applying IAS 17, but it does not provide guidance on whether such leases should be classified as finance or operating leases. Discussion at the IFRIC Meeting May 2004 The IFRIC was provided with a summary of comment letters on D3. The IFRIC concluded that it should continue with the project, but that field tests should be conducted. Some IFRIC members noted their objection to the general model and would rather have a model based on control of the asset – not control over the output as required in D3. The IFRIC agreed to reconsider this model, noting the requirements in EITF Issue 01-8. The IFRIC discussed at length the issue of components and proportions of an asset. Some IFRIC members suggested remaining silent on these issues. Other members noted a model based on output is flawed if IFRIC does not answer 'output from what'. The IFRIC noted that a final interpretation should be effective for 2005 first-time adopters. Discussion at the July 2004 IFRIC Meeting Scope Concern was expressed that it was not clear where lease accounting ended and accounting for service concession arrangements begins. After discussion, IFRIC concluded that decisions had to be taken first on who controlled the assets, as this would determine the relevant accounting literature to look to. The differences between 'control' and 'right of use' were discussed, with members indicating that control was a more permanent notion compared to right of use. Members raised the concern as to how the holistic approach of examining service concession arrangements may potentially contradict the components approach in IAS 16 Property, Plant and Equipment. This concern was illustrated by considering an example where a road is layered with tar by an operator in line with a service concession agreement. Should the asset recognised by the operator only be that layer as the rest of the road potentially belongs to the grantor? This approach would be consistent with the components approach in IAS 16. Members agreed to continue the discussion of whether to 'draw a line' as to where the holistic view to be taken in the scope paragraph ends. The need to define 'service concession arrangements' was discussed and staff would look into this. Members indicated that this may require that staff consider the multiple elements revenue recognition issues as well. Control vs. risks and rewards, and consistency with IFRSs IFRIC members generally agreed that the significance of the residual interest in the assets should be a factor in establishing who controls the assets. IFRIC discussed other factors that indicate control, including whether the asset was constructed by the operator, estimated useful lives and concession periods, replacement assets expected to be purchased or constructed in the future (whether obliged or not), and the passing on of ownership. This debate was in the context of the different models used in IAS 18 Revenue and IAS 17 Leases in establishing when risk and rewards are passed and therefore, who controls the assets. Members requested that staff prepare examples for consideration by the IFRIC at the next meeting. The IFRIC noted a decision taken previously that an interpretation was to be developed regarding a sale and leaseback arrangement with a repurchase agreement. It was noted that such an interpretation would complete the suite of guidance regarding such issues. IFRIC discussed whether such guidance would be issued in the form of an interpretation or as an amendment to IAS 17, but no decisions were made. Receivables model and intangible asset model IFRIC debated when each model should be used. The staff requested guidance on the issue of what type of asset arises when either the grantor pays the operator or when the end user makes payment. The IFRIC suggested looking into the segmentation of concession contracts, which would help identify an asset construction phase (if any) and then a service phase that would cover the operation of the asset or provision of specified services. The importance of this segmentation proposal was underscored by the fact that certain arrangements may dictate that the operator will only be compensated for the construction phase based on the maintenance of the asset (for instance, the road constructed must be kept in good condition). In such a case, where the first phase receivable depends on the second phase performance, such segmentation may not be required. IFRIC also discussed whether a different treatment would result if two operators were engaged separately for each phase. In terms of the receivables model, a discussion ensued regarding the type of receivable: whether it is an IAS 11 Construction Contracts type receivable similar to 'gross amount due from customers for contract work' or an IAS 39 Financial Instruments: Recognition and Measurement type financial asset. There was concern that such a receivable would not necessarily meet the definition of a financial asset. Staff will explore this issue further. The issue of whether a receivable still existed if the amount was dependent on demand risk (level of activity in the service phase, such as number of cars using the road) was raised. The IFRIC appeared to be in general agreement that a receivable existed under IAS 11 but this was not the case in terms of IAS 39. Staff were again asked to explore the disconnect between the two standards. It was expressed that a receivable might exist that was based on part performance (that is, not an executory contract) but absent any demand risk. This scenario was effectively where the grantor had 'guaranteed' a minimum amount based on work done but subject to completion of construction. Regarding the demand risk discussion, staff asked the IFRIC to consider whether an intangible asset existed, instead of a financial asset. A debate ensued but no decisions were made. Revenue and profit or loss treatment of services provided in exchange for an intangible asset A general discussion took place regarding the exchange notion contained in IAS 16 and IAS 38 Intangible Assets. Specifically, IFRIC discussed any changes to the cash configuration as a principle that is used in existing literature. A conclusion was not reached as to whether cash flows changed in a service concession arrangement. Members noted that for an exchange to take place there must be an asset given up, whereas in the context of the discussion on service concession arrangements, it was not yet clear whether the assets in question were controlled by the operator. The debate was postponed as this issue had not yet been finalised. Discussion at the October 2004 IASB Board Meeting The point was made that the transition requirements would not be consistent with EITF 01-8, with Staff reiterating the point that IFRIC's position on this issue had been swayed by the potential loss of comparability if prospective application was required. Concern was raised regarding the wording in the interpretation that referred to 'portions' which emanates from legacy differences in the underlying Standards (SFAS 13 and IAS 17). The Staff were asked to include in the basis for conclusions, explicit statements around the areas that had been converged and differences that remained between this Interpretation and EITF 01-8 as a result of such legacy differences. The Board approved the Interpretation subject to the amendments discussed. December 2004: IFRIC Interpretation 4 Issued On 2 December 2004, the IFRIC issued Interpretation 4 Determining Whether an Arrangement Contains a Lease.