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Leases – lessor accounting

Date recorded:

Overview

As part of its continuing deliberations surrounding the Exposure Draft Leases (Leases ED), the Boards deliberated on the topic of the lessor accounting model.

The Chairman of the IASB decided that it would be best to assume, for purposes of discussing further the lessor accounting model, application of the derecognition approach as prescribed in the Leases ED. The Chairman of the IASB asked the Boards to take an informal vote on various issues to assist the staff in developing future staff papers on lessor accounting under a derecognition model. The Boards generally supported recognition of the residual asset as an allocation of the underlying asset's previous carrying amount (i.e., allocation based on the proportion of the underlying asset's fair value that is the subject of the lease).

The Boards supported the staff exploring the following topics in relation to the above model:

  • accretion of the residual asset over the lease term
  • recognition of profit or loss upon transfer of the right-of-use asset
  • derecognition of a portion of the underlying asset.

 

Introduction

As part of the May 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.

In deliberations, prior to a formal vote as to a preference for a single lessor accounting model or two lessor accounting models (i.e., derecognition model for a lease that transfers substantially all the risks and rewards of ownership and the current operating lease model when a lease does not transfer substantially all risks and rewards), the Boards decided that it would be best to assume, for purposes of discussing further the lessor accounting model, application of the derecognition approach. Under such an approach, noting the lessor's two rights arising from a lease contract take the form of the lease receivable and the residual asset, the Boards agreed, as generally consistent with other financial assets of a similar nature, that the lease receivable should be initially measured at the present value of the lease payments, discounted using the rate charged in the lease, and subsequently measured at amortised cost using the effective interest method.

However, in considering the above model, the Boards expressed a few key concerns, including:

  • whether to recognise the residual asset as an allocation of the underlying asset's previous carrying amount or whether to measure the residual asset at the present value of the estimated residual value of the underlying asset at the end of the lease term
  • whether to recognise profit or loss upon transfer of the right-of-use asset
  • what is the appropriate methodology for subsequent measurement of the residual (i.e., accrete to rate defined in lease or accrete to estimated residual value)
  • how to account for the lease of a portion of an underlying asset.

Initial measurement of the residual asset

In initially measurement of the residual asset, the majority of the Boards expressed a view consistent with that of the Leases ED that measurement should be an allocation of the previous carrying amount of the underlying asset, as calculated based on a proportion of the underlying asset's fair value that is the subject of the lease (e.g., cost of underlying — [(cost x lease receivable) / fair value of underlying]). These Board members expressed a preference of avoiding subjectivity in measurement of the residual (and potential variability in the financial statements) which would be present if preparers were asked to estimate the future fair value of the residual. However, other Board members expressed concern that the above allocation measurement provides an "artificial" number (i.e., undefined number). These Board members contend that the valuation of the residual asset, representative of the right to an underlying asset at some point in the future, should initially be measured at the present value of the estimated residual value of the underlying asset at the end of the lease term. By way of an informal vote, Board members supported application of an allocated residual valuation model, but in doing so, expressed concerns in profit and loss recognition at lease commencement.

Initial profit recognition

In modelling of the above derecognition model, Board members expressed concern over recognition of "day 1 profit", if applicable (e.g., the difference between the fair value of the underlying asset and the carrying amount at lease commencement), 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 (which could create variability in profit and loss in future periods).

In relation to this concern, multiple alternatives were suggested by individual Board members including:

  • recognition of profit only when substantially all the risks and rewards of ownership of the underlying asset have transferred, in which recognition of profit would be confined to the recognised residual asset until such point that substantially all the risks and rewards of ownership have transferred; or
  • recognition of profit only to the degree prescribed by the concept of transfer outlined in the revenue recognition project (e.g., recognition of the residual should be limited to circumstances in which the underlying asset is reliably predictable).

Other Board members expressed a preference to recognise profit or loss as the right-of-use asset is transferred given that the lessor has performed by making the underlying asset available to the lessee and the lessee controls the right-of-use asset. These Board members note that the lessor is generally able to obtain or calculate reliable residual value estimates as this valuation is considered in the underlying pricing of the lease agreement. Further, these Board members note that the risk of reporting excessive profits at lease commencement would generally be limited to situations in which the residual value is expected to fall below the amount initially allocated to the residual asset (based on the above informal decision) or the lessor concludes at lease commencement that the lessee has a significant economic incentive to exercise a purchase or extension option which eventually is not exercised.

Based on the above discussions, the Boards requested the staff to explore further the recognition of profit at lease commencement as compared to deferral alternatives noted above.

Subsequent measurement of the residual asset

Following constituent feedback to the Leases ED, in which the Leases ED proposed that the allocated carrying amount of the residual asset would not be remeasured or adjusted apart from impairment, the Boards considered whether the residual asset should be accreted over the lease term. While Board members generally supported accretion of the residual in order to avoid volatility in profit and loss over the lease term, many Board members supported accreting the residual asset to estimated fair value at the end of the lease term, while the staff proposed that the residual asset be accreted over the lease term using the rate charged in the lease. The Boards asked the staff to reconsider the accretion methodology for discussion in a future meeting.

Lease of a portion of the underlying asset

As highlighted above, the Boards expressed concerns with recognition of profit at lease commencement when the underlying or residual asset is not reliably predictable. The Boards noted that unreliable predictions of fair value may often be present when the underlying asset to be leased is a portion of a larger asset (e.g., lease of individual stores in a shopping mall or lease of a floor of a building).

Board members deliberated possible alternatives to applying the lessor accounting model when the fair value of the underlying asset is unreliable, including applying current operating lease accounting, applying a modified receivable and residual approach (i.e., application of the derecognition model as set forth above in which the residual asset would be initially measured as the difference between the present value of the lease receivable and the carrying amount of the underlying asset, with no day 1 profit, if applicable, and the residual asset would be subsequently accreted on a constant effective yield basis) or applying the receivable and residual approach set forth for the lease of an entire underlying asset as set out above.

Multiple Board members highlighted a preference to retain consistency in the lessor model (for both leases of an entire asset or a portion of an asset), whereby application of a derecognition model would be applied (either under a modified or 'standard' receivable and residual approach) for both. While many agreed with this view, some Board members were concerned with the measurement of a residual asset in a componentised environment. Specifically, these Board members noted the challenges in bifurcating residual assets if a derecognition model is used (especially when considering common area environments; for example, in the lease of individual stores in a shopping mall, how would a preparer bifurcate the residual asset component of the air conditioning unit to all lessees in the mall), and therefore, preferred application of the current operating lease accounting in these environments. In an informal vote, the majority of the Boards supported application of the modified derecognition approach set out above for leases where the fair value of the underlying asset is not reliably measurable (e.g., when the underlying asset is a portion of a larger asset).

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