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Leases

Date recorded:

In a subsequent deliberation session held on 17 February 2011 surrounding the Exposure Draft Leases, the Boards considered the following topics given feedback received as part of comment letter and outreach activities:

Accounting for variable lease payments

The Exposure Draft Leases identified that in some leases, the amount of each contractual lease payment is variable rather than fixed. That variability can arise because of features such as, but not limited to, residual value guarantees, penalties for failure to renew, and contingent rentals. The Exposure Draft Leases proposes that at the date of commencement of a lease, a lessee should recognise a liability to make lease payments and a lessor should recognise a right to receive lease payments (lease receivable) in the statement of financial position. Payments arising under a lease include fixed payments as well as all variable payments. The Exposure Draft proposes that an entity should measure the liability to make lease payments and the lease receivable using an expected outcome technique. Expected outcome is the probability-weighted average of the cash flows for a reasonable number of possible outcomes. In addition, the Exposure Draft proposes that a lessor should include variable lease payments in the measurement of the lease receivable only if those payments can be reliably measured.

In assessing feedback from comment letters and outreach activities, users had mixed views on the treatment of variable lease payments, whereby most supported additional information relating to variable lease payments, but views on the appropriate recognition pattern within the financial statements varied. Such views included concern as to judgement applied in measurement of variable lease payments that depend on future performance or usage, as well as the volatility and challenge of measuring reliably variable lease payments using an expected outcome technique.

In consideration of the above, the staff recommendations as part of this meeting included:

  • The majority of the staff recommended that variable lease payments should be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable only if those variable lease payments depend on an index or a rate.
  • The minority of the staff recommended that all variable lease payments that are "probable" or "reasonably assured/certain" should be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable.
  • Disclosures would be required for variable lease payments; however, relevant disclosures will be subject to a future meeting.
  • A reliability threshold should be included in the proposal for the measurement of variable lease payments for both lessees and lessors.

Taking each in hand, in evaluating which variable lease payments should be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable, the majority of the staff detailed inclusion only if those variable lease payments depend on an index or a rate; noting the following key advantages:

  • May avoid concerns relating to the accuracy or provision of measurement;
  • More consistent accounting between the lessor and lessee in cases in which the lessor would otherwise be unable to estimate variable lease payments reliably;
  • May better reflect the fact that variable lease payments based on usage or performance provide lessees with flexibility and reduce their business risk.

A minority of the Boards noted that in such an application, the lessee's measurement of the liability and lessor's measurement of lease receivables would not reflect the amounts that an entity has the ability to avoid, whereby such accounting may depict understated lessee obligations and lessor receivables when future cash flows are highly likely to occur. Further, certain members of the Boards were concerned that such an appropriate would create structuring opportunities.

Support from the Boards regarding the above approach cited that such an approach promotes consistency in application and reduces judgement and variability. Further, the approach was believed to capture residual value guarantees and term option penalties (or obligations to retire the leased asset), which is consistent with the definition of minimum lease payments under IAS 17 and ASC Topic 840.

In application of a principle that all variable lease payments that are "probable" or "reasonably assured/certain" should be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable noted the following key advantages:

  • May give a more faithful depiction of the rights received by the lessor and the obligations incurred as it may be more reflective of actual cash flows.

A majority of the Boards questioned whether such an approach would lead to highly subjective estimates, and likewise, concerns were expressed over the definition of "probable" or "reasonably assured/certain" as applied in the recommendation. One member of the Boards deliberated as to whether the concept of the "foreseeable future" should be considered in modelling, whereby assessment of probability is limited to the period management considers being "foreseeable" based on budgets and forecast modelling.

Support from the Boards regarding the above approach cited that such an approach addresses the operational and reliability concerns expressed by preparers, while providing more useful information to financial statement users to assess amounts, timing and uncertainty of cash flows.

In final deliberations, the majority of the Boards confirmed, in relation to which variable lease payments should be included in the measurement of a lessee's liability to make lease payments and a lessor's lease receivable, the following items for inclusion:

  • Variable lease payments that depend on an index or a rate;
  • Variable lease payments that are "reasonably assured/certain," in which such a term will be defined in a later meeting;
  • "In-substance" / "phoney" leases which are provided at off-market terms;
  • Elevated disclosure within the notes of contingent rate leasing arrangements, which will be discussed in a later meeting.

In assessing a reliability threshold for inclusion in the proposal for the measurement of variable lease payments for both lessees and lessors, the staff recommended that the initial measurement of the variable lease payments that depend on an index or rate to be based on a prevailing rate (or spot rate), with subsequent update of this rate at each reporting period. This approach was considered to be a practical approach to avoid incomparability between entities.

The majority of the Boards tentatively confirmed the recommendation of the staff, noting the simplicity of the model as compared to use of forward rates and indices. Further, members of the Boards questioned whether forwards rates would result in incomparability and misleading information. Such a conclusion contradicts the Exposure Draft Leases proposal that when determining the present value of lease payments payable, variable lease payments that depend on an index or rate should be determined using readily available forward rates or indices.

Other variable lease payment consideration

The following topics were considered in relation to the recognition and measurement of the lessee's liability to make lease payments and a lessor's lease receivable for other lease payment considerations, absent those general considerations set forth above:

  • Residual value guarantees ("RVGs")
  • Third party RVGs
  • Term option penalties

RVGs

Given a lack of clarity as to whether RVGs should be included in lessee's liability to make lease payments and a lessor's lease receivable, the staff believed it important to clarify that RVGs (that are not from an unrelated party) should be included in the measurement of a lessee's liability to make lease payments and the lessor's lease receivable, similar to current guidance. The full amount of the RVGs would be included in this measurement.

The Boards confirmed such a recommendation, as considered against the variable lease payment definition outlined above, as a RVGs is viewed equivalent to a contingent payment at the end of the lease term, whereby they are linked to the value of the underlying asset and could be misleading to recognise such guarantees separately.

The Boards also tentatively decided that RVGs provided by the lessee (not unrelated third parties) should be included in the measurement of a lessee's liability to make lease payments at the amount that represents the difference between the residual value of the asset and the level of the guarantee. The amount of the residual value guarantee included in the liability to make lease payments will be reassessed. The staff will reach out to constituents to gather feedback on these tentative decisions.

Third party RVGs

The Exposure Draft proposes that the present value of lease payments should not include an estimate of amounts payable under RVGs that are provided by an unrelated third party, which has been objected by a minority as part of comment letter responses received and outreach activities performed. The conclusion expressed in the Exposure Draft Leases is reached because RVGs that are provided by an unrelated third party are not lease payments and are outside of the lease contract. Further, the staff believes that since such third party RVGs solely affect the value of the underlying lease asset and are not arrangements between the lessee and lessor, these should be accounted for as other guarantees.

Given the above, the staff recommended that the Boards confirm the tentative decision reflected in the Exposure Draft Leases that the lessee's liability to make lease payments and the lessor's lease receivable should not include an estimate of amounts payable under RVGs provided by an unrelated third party.

The Boards confirmed such a recommendation.

Term option penalties

Consistent with the proposals for variable lease payments, the Exposure Draft Leases proposes that the present value of lease payments should include an estimate of expected payments to the lessor under term option penalties.

While very few respondents providing feedback on the Exposure Draft Leases commented specifically on term option penalties, of those who responded to this particular proposal, many requested clarification of the term, while others disagreed with use of term option penalties in the measurement of the lessee's liability to make lease payments and a lessor's lease receivable.

Given the above, the staff recommended that if there are term option penalties for non-renewal and the renewal period is not included in the lease term, then those term option penalties should be included in the measurement of the lessee's liability to make lease payments and the lessor's lease receivable (e.g., term option penalties should be included to the extent that it is reasonably certain that the lessee will not extend the lease).

The Boards confirmed such a recommendation on the basis that such a conclusion is consistent with the accounting for options to extend or terminate a lease.

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