Subleases

The IASB’s Practice Fellow introduced the paper containing the Staff recommendations dealing with subleases. She pointed out that the issue would only be looked at from the perspective of the intermediate lessor; the ultimate lessor and the sublessee would apply the guidance in the normal way, so there was no perceived need to address their accounting. The Practice Fellow said that she would divide the topic into two parts, namely the accounting for subleases and their presentation.

The Staff recommendations were as follows:

• An intermediate lessor should account for a head lease and a sublease as two separate contracts following the general principles each, unless those contracts meet the contract combinations guidance adopted by the Boards at the April 2014 joint Board meeting;
• Classification of the sublease would depend on the accounting regime:
  • For entities applying the U.S. GAAP model, Staff recommended to base the classification of the sublease with reference to the underlying asset, rather than the Right-of-Use (ROU) asset arising from the head lease;
  • For entities applying the IFRS guidance, Staff was split as to whether classification of the sublease should be done with reference to the ROU asset or the underlying asset.

The Practice Fellow handed over to the Boards for discussion.

With regard to the application of subleases under IFRSs the IASB’s Vice Chairman asked whether his understanding was correct that there would be no need to write anything on subleases in the (IASB’s) final standard. The Practice Fellow responded that this would depend on which route the IASB decided to follow. In case the Board decided to base classification of the sublease with reference to the ROU asset, then there would be no need to add further guidance. The Technical Principal added that the scope paragraphs, both under U.S. GAAP and IFRSs, would have to be amended to clearly state that the final standard would apply to all leases including ROU assets borne from subleases. Another IASB member said that he would prefer the IASB to add guidance since this was a difficult area. There was room for confusion, so should the Board decide to base sublease classification on the ROU asset, then this should be clearly stated. A fellow Board member said that he became convinced that markets would be helped most, if the information presented in the financial statements was consistent throughout all leases. Hence, his preference was clearly to align head lease and sublease accounting, even if this meant that the presentation of interest income under the sublease and interest expense under the head lease was different. Therefore, he agreed with those on the Staff who favoured a classification for the sublease that was based on the ROU. Other Board members agreed with these comments. One IASB member pointed out that it would be necessary to have guidance related to derecognition.

The FASB Chairman sought clarification as to what precisely was meant by “reference to the ROU asset arising from the head lease” under the IASB’s literature: He gave the example where a company leased seven floors in a building in a head lease and then subleased only one floor over the same term as the head lease – was the ROU asset seven or one floors? The IASB’s Practice Fellow responded that it would be the one floor only (which would then lead to a partial derecognition).

The FASB’s Vice Chairman said he agreed with the Staff’s recommendation suggested for U.S. GAAP applying entities (i.e. in classifying subleases, reference would be made to the underlying asset). He also felt that, generally, there should be no issues when an entity made an in-substance purchase (or entered into a type A lease) and either a corresponding in-substance sale or a Type B lease in the sublease arrangement. The one point where he felt not entirely clear was the example provided in the agenda paper where an entity would enter into a type B head lease to then sublease the asset under a type A lease; how could one lease out more than one already had? The FASB’s Project Manager responded that, whilst those cases might be extremely rare, it would be necessary to look at all the facts and circumstances. The FASB Chairman pointed out situation he had seen in practice where market prices had spiked dramatically some time after entering into the head lease, so that situation was possible. He therefore recommended including some guidance. A fellow FASB member said he was uncomfortable with where the Boards seemed to be going. With reference to the IASB’s decision, he believed that the ROU asset should have been seven floors, as this was the right that the entity had obtained under the head lease. Only a portion of that ROU had then been subleased. In his view, the sublease should not be accounted for as an in-substance sale as the entity would not qualify for type A lessor accounting.

When called to a vote, both the FASB and the IASB approved the staff recommendation that an intermediate lessor should account for a head lease and sublease as a separate two contracts. A majority of five FASB members approved that an intermediate lessor should classify a sublease in reference to the underlying asset, whereas the other two members voted for classifying a sublease in reference to remaining right of use asset. On the IASB, Board members agreed unanimously that an intermediate lessor should classify a sublease in reference to the right of use asset.

The IASB’s Practice Fellow went on to present the Staff’s recommendation for presentation of subleases. They suggested that an intermediate lessor should not offset lease assets and lease liabilities unless they met the offsetting requirements under IFRS and U.S. GAAP, respectively. Equally, intermediate lessors should not offset lease income and lease expense, unless it recognised sublease income as revenue and acted as an agent.

One IASB member asked whether it was relevant to assess whether an intermediate lessor was acting as an agent, as, if that was the case, there would be no lease. The Technical Principal agreed. Another IASB member pointed out that the requirements should be no different from IAS 32. The FASB Vice Chair also agreed with the comment made previously by the IASB member that there should be no guidance for a principal vs agent situation as there was no lease in that case. One FASB Board member pointed out that offsetting was generally not appropriate, because if, in a sublease, the lessee defaulted, the intermediate lessor would still be liable for the head lease.

Both the FASB and IASB approved the staff recommendations unanimously. The technical principal confirmed that the final standard would not include any wording related to principal vs agent considerations.

Lessee balance sheet presentation

The next issue discussed was devoted to presentation of the ROU asset and the lease liability under type A and type B leases. A member of the FASB’s project team introduced the agenda paper and presented the Staff recommendation regarding presentation of the ROU asset: A lessee should either present type A ROU assets as a separate line item on the balance sheet or disclose them in the notes. In case of the latter, a lessee should (a) present type A ROU assets within the same line item as the corresponding underlying assets would be presented if they were owned and (b) disclose in the notes which line items in the balance sheet included the type A ROU assets.

Member of both the FASB and the IASB indicated general agreement with the Staff recommendation. A FASB member said he did not like the labelling of type A ROU assets in the U.S. context, as under the proposed U.S. GAAP model, there would only be in-substance purchases (and, hence, owned assets) and (type B) leases. Other Board members agreed. Some IASB members pointed out that disclosure would be important so that the leasing activity could be identified from the financial statements. In the end, both the FASB and the IASB approved the staff recommendation. On the FASB, there was substantive discussion related to FASB-only questions. The Board members agreed to require separate presentation of type A and type B lease assets.

The FASB’s project team member then continued with outlining the Staff recommendation regarding the presentation of the lease liability. Following that recommendation, a lessee should either present type A lease liabilities as a separate line item on the balance sheet or disclose in the notes. Again, in the latter case, a lessee should disclose in the notes which line items in the balance sheet included type A lease liabilities. The staff did not recommend specifying how a lessee should present lease liabilities on the balance sheet.

The IASB’s Technical Principal clarified that under IFRSs, users should apply IAS 1 to determine the appropriate classification of lease liabilities. Staff would make clear that lease liabilities met the definition of financial liabilities. An IASB member raised the concern whether saying nothing and just pointing to IAS 1 was sufficient, as the inclusion of lease liabilities into ‘debt’ could have a significant impact on ratios. The Technical Director responded that he had seen users including the lease liabilities, so he was not overly concerned. Another IASB member agreed with the point raised by the previous member and felt that he got a point there. She thought that classification on the liabilities side of the balance sheet was more by nature rather than by function and said that it was not entirely clear as to what someone would do under IAS 1. A fellow IASB member agreed with these comments.

Cash flow presentation

The last item in this session was devoted to the presentation of leases in the statement of cash flows. The Technical Manager provided an overview of the agenda paper before presenting the staff recommendation. Staff suggested that:

• Lessors should classify cash receipts from leases within operating activities (i.e. retaining the 2013 ED’s proposal).
• FASB only (retained from the 2013 ED) – Lessees should present:
  • cash payments for the principal portion of the lease liability arising from type A leases within financing activities;
  • cash payments for the interest portion of the lease liability arising from type A leases within operating activities; and
  • cash payments arising from Type B leases within operating activities.
• IASB only – Lessees would be required to:
  • classify all lease cash payments within operating activities (which would constitute a change from today’s practice, under which the principal portion would currently be presented within financing and the interest element as either financing or operating as per an accounting policy choice); and
  • separately disclose the lease payments within cash flows from operating activities (similar to the existing requirements of IAS 7 relating to interest and taxes).

With regard to the IASB-only recommendation, the Technical Manager pointed out concerns with the current presentation by lessees under IFRSs, as some operating and investing cash flows (used by users when calculating ‘free cash flow’) did not include cash outflows in respect of the principal element of lease payments. Depending on the lessee’s accounting policy choice, it was possible that did not include interest payments either. This meant that a lessee could be generating operating cash inflows from the use of assets for which the related capital expenditure had never been included within operating or investing cash flows. This capital expenditure ‘blind spot’ was something that has been raised by some users as an adjustment they would need to make to reported figures in their analyses.

One IASB member indicated that given that current practice today in IFRS is approach 1, he did not see any benefit of changing to approach 2. Another IASB member indicated that he could accept approach 2 because the nature of the lease was a financing operation but its function was operating. Further, users would find information more useful if payments were classified as operating cash flows.

The Technical Principal indicated that the cash flow statement was clearly problematic and beyond leases. One IASB member indicated that it would not be beneficial trying to fix IAS 7 as part of the leasing standard, there should be a separate project to address IAS 7. Another IASB member expressed agreement and also pointed out that it was necessary to enhance the visibility of non-cash items. The Technical Principal responded that IAS 7 currently required disclosure of non-cash items elsewhere in the financial statements, and it would be contradictory to add a specific requirement in IAS 17. There was considerable discussion regarding the ‘blind spots’ presented in the paper. One IASB member indicated that this issue could be addressed as part as the Disclosure Initiative project. Another IASB member indicated that when IAS 7 was written, there was fewer leasing activity than today; nowadays, most leases would be classified as capital leases. Some IASB members expressed support for approach 2 as they believed it to be easier to apply.

When called to a vote, both Boards unanimously approved the Staff recommendation regarding cash flow classification by the lessor. Further, the FASB voted unanimously in favour of the Staff recommendation as regards the lessee’s classification of cash flows. In contrast, a majority of eleven IASB members voted in favour of retaining the status quo regarding lessee classification of lease payments and therefore turned down the Staff recommendation. The IASB agreed unanimously with the proposal to separately present lease payments though.