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Leases

Date recorded:

Definition of a lease

The IASB's Technical Manager introduced the paper with the Staff recommendations dealing with the definition of a lease. Staff recommended:

  • retaining the definition of a lease, but adding clarifications;
  • clarifying whether fulfilment of the contract depends on the use of an identified asset;
  • clarifying the right to control the use of an identified asset by focussing on the ability to affect the potential cash flows to be derived from using the asset;
  • adding guidance regarding which decisions most significantly affect the potential cash flows to be derived from use and removing guidance in the 2013 ED regarding assets that are incidental to the delivery of services;
  • retaining the majority of the application guidance in the 2013 ED;
  • clarifying that restrictions on the use of an asset were generally considered ‘protective rights’; and
  • not including a definition of a service in the final lease standard.

The Technical Manager pointed out that the 2013 ED and the modifications proposed were in alignment with the concept of control in the revenue recognition standard. She further clarified that the intention of including examples was to show the application of the principles in grey areas or areas that required more judgement based on comments received from the 2013 ED. The discussion was divided in (a) substitution rights and (b) the right to control an asset from the customer perspective.

 

Substitution rights

One IASB member raised a question regarding the example of rendering cloud services: An entity contracted a cloud service and needed a server, which would be used solely for providing cloud services to the entity. In this example, how would the customer determine whether a right of the lessor to substitute the server was substantive? The Technical Manager responded that, originally, the focus had indeed been on assessing substantiveness from the supplier’s perspective. However, given that it might be almost impossible for a customer to know what cost and benefits a supplier would incur when substitution, Staff were proposing a clarification that, if it was impractical for a customer to make such an assessment, it should conclude that substitution rights were not substantive and should continue with the assessment of the other requirements related to the definition of a lease.

Another IASB member pointed out that Example 4 in the agenda paper, which focuses on a contract for drilling services, showed that the approach was to move from focussing on the output to focussing on economic benefits. He asked whether economic benefits were only related to cash flow or something broader, to which the Technical Manager confirmed that looking at cash flows was their intention.

Some IASB members asked what type of evidence was necessary for a lessee to demonstrate whether substitution rights were substantive. Some FASB members expressed the same concern, particularly with regard to the U.S. auditing environment. The Technical Manager responded that in most cases it would be obvious whether the supplier benefited from the substitution; hence, in most cases it would not be necessary to go further as to what was written in the contract, the focus should be on cost and benefits, and judgement would be also required. The analysis would have to be made at inception and no reassessment would be required. One IASB member also requested that the wording be clarified such that substitution rights were not related to regular maintenance, since in case of malfunction, in most cases it would be stated in the contract that the supplier would have to replace the asset. Further, some FASB members asked whether a detailed calculation of the assessment would be required or whether a qualitative assessment would suffice. The FASB Project Manager clarified that the assessment would be primarily qualitative. In most cases, for example in a lease of a photocopier, the lessee would never allow a photocopier to be replaced with an older one and, consequently, replacing with a newer one would not be beneficial for the vendor. He also indicated that guidance for consolidation required qualitative analysis. One FASB member pointed out that the word "outweigh" seemed to require some calculation. If the Staff did not mean to require calculations, this should be made clear in the standard.

When called to a vote, both Boards approved the Staff recommendation regarding substitution rights.

 

Right to control the use of an identified asset

There was a substantive discussion on both Boards regarding the notion as to whether there could be "joint" decision making in a lease as it occurred with joint arrangements. Both the IASB’s Technical Manager and the Technical Principal clarified that they had never looked at whether the asset could be jointly controlled by the customer and the supplier; only one party would be assumed to have obtained more benefits, so one would look particularly at which party had the ability to make decisions that most significantly affect the economic benefits of the asset.

There was also a substantive discussion on both Boards in relation to the examples included in the agenda paper. Although the Board members agreed with the principle, they mentioned difficulties in understanding the thought process to get to the conclusion. One FASB member suggested to add a "hierarchy" of decisions that needed to be made to reach a conclusion, like, for example, the U.S. GAAP guidance to analyse variable interest entities, and indicated that it would be necessary to have a decision rule. The IASB’s Technical Manager and the FASB’s Project Fellow clarified that the intention was that when a customer was allowed to make the majority of decisions, then it was a lease; conversely, if there were "mixed rights", it would be necessary to apply the framework pertaining to consolidation, particularly the concepts of power and benefits. Several Board members requested more examples and that the Staff clearly demonstrated the thought process in reaching each conclusion. Some Board members requested a flow chart that could help understand the principle. By providing an example one FASB member explained the difficulty in reaching a conclusion to distinguish between a lease and a service. He felt that in the case where he rented a car, it would clearly be a lease; however, if somebody else drove the car, it could be a service. Modifying the example further, he suggested that if route was fixed, it could be a service, but if he requested changes to the route, it could be a lease.

One FASB member asked whether the main principle was to determine how and for what purpose the asset would be used. Staff had reached different conclusions in examples 1 (on time charter) and 2 (on voyage charter), although, in both cases, the customer determined the route of the ship. A fellow FASB member responded that the difference was that in the first example, the customer determined the routes during the term of the contract, whilst in the second example, all decisions had already been made upfront and no decisions were left to the customer after the contract commenced; accordingly, the examples needed to be articulated better. Another FASB member indicated that, based on this rationale, it would be easy to structure the contract to reach a particular conclusion. Some Board members asked whether the focus should be on who operated the asset. However, this notion was not supported; for example, one IASB member said that a ship’s captain would always "operate" the vessel (i.e. make critical decisions regarding to the route, safety, etc.), but that did not mean that somebody else was in control of the asset. The FASB Chairman concluded that the examples needed to be improved by clarifying how the principle was to be applied. The IASB Chairman asked the Staff whether the examples would need to be brought back for discussion. The IASB’s Technical Principal replied that this would not be necessary. He also pointed out that the examples would be for their own analysis and would not necessarily be included in the final standard.

There was also a substantive discussion in relation to whether or not to tie the concept of economic benefits to potential cash flows. One IASB member had a question with regard to paragraph 66 of the agenda paper, which required focusing the assessment on the ability to affect "potential cash flows". It seemed to him that there was a broader context in the paper, because in other sections Staff would use the term “economic benefits”, which could include other activities. The IASB’s Technical Principal indicated that it would be possible not to define economic benefits explicitly as connected to cash flows in the final standard. The rationale for this guidance was impairment, hence, the analysis focussed on cash flows to determine whether an asset was recoverable. One FASB member indicated that the concept of cash flows conflicted with the list of items presented in the Staff memo that could lead to economic benefits. He pointed out that there could be cases whether benefits were beyond the cash flows of the identified asset, for example, when the asset was used to enhance the value of another asset; accordingly, he suggested that the standard refer only to economic benefits. Another FASB member also expressed concerns with the notion of cash flows as, in his view, the concept of economic benefits was well understood. It would be difficult to connect the notion of cash flows to, for example, leasing office furniture.

Both Boards agreed:

  • to retain the concept of economic benefit without tying it only to cash flows;
  • to work in a small group from both Boards with the Staff to develop additional examples that could help clarify the principle. If the group could not agree on the examples, then the issue would be brought back for further discussion. It was also clarified that the examples would not necessarily be included in the final standard.

 

Separating lease and non-lease components

The FASB’s Project Fellow introduced the paper covering two topics. The Boards were asked to

  1. consider the lowest appropriate unit of account for application of the final leases standard; and
  2. consider when lease components should be separated from non-lease components and how to allocate the consideration in the contract between the separate components.

On the first issue, the Staff did not propose any changes to the 2013 ED. On the second issue, though, Staff suggested a change from the 2013 ED for lessees, such that when separating lease and non-lease components in the absence of observable information, the lessee would be allowed to use estimates. The discussion was divided in separating lease components (Question 1) and separating and allocating consideration to lease and non-lease components (Questions 2-4).

 

Separating lease components

One FASB member raised a question about the interaction between the separation requirements and the portfolio approach, which had been approved by both Boards. The FASB Project Manager responded that this topic was discussed paragraph 11 of agenda paper 3B. The objective of the separation requirement was to determine the lowest level and not a ceiling at which an entity could disaggregate. There had been no intention to override the guidance on the portfolio approach.

Another FASB member asked the Staff whether the separation of land and buildings that was currently required by GAAP would still be required. The FASB Project Fellow responded that the decisions already made for lessee and lessor accounting would require separating land and buildings whenever necessary. He further indicated that the separation of land and buildings was not necessarily a good example of this guidance because it focused primarily on different elements or pieces. One IASB member indicated that he did not see any benefit in separating land and buildings, although in certain cases it would be necessary, for example, to assess impairment. However, he would not require entities to carry out a systematic separation of the lease components, but would require entities in an impairment situation to “consider” separation of land and buildings instead.

Another IASB member indicated disagreement with the requirement, particularly as regards adding the guidance stated in paragraph 15 and 16 of the agenda paper. He was concerned that adding guidance would create more diversity in practice.

Both the FASB and the IASB members approved the Staff proposal to retain separate lease component guidance in the final leases standard with 7 and 12 votes, respectively.

 

Separating and allocating consideration to lease and non-lease components

One FASB member asked how this guidance would be applied if, for example, an entity leased an entire building or a portion of a building. Specifically, he wondered whether non-lease components would be identified in the same way in both scenarios. The FASB Project Manager responded that he would not view them differently. The FASB member responded that this conclusion should be clear in the standard.

In relation to paragraph 49 one IASB member asked the Staff what the meaning of stand-alone prices was, since different companies could get different prices. The IASB’s Technical Principal referred to IFRIC 4, which already required the use of estimates and, consequently, there were no fundamental changes being introduced. The IASB member also asked if the residual method would work for the lease and non-lease component in the same way. The Technical Principal confirmed that it would work for either component.

Another IASB member voiced his concern that, in many cases, prices would be difficult to estimate, as mentioned in paragraph 33 of the agenda paper, particularly for industries that are highly volatile (such as the utilities sector). He suggested adding a concession, namely, if the majority of the contract was for service, then the whole contract should be considered a service. The Technical Principal responded that this would override the decision already made regarding the definition of a lease.

Both the FASB and the IASB members approved the Staff proposals included in question 2, 3, and 4 as follows.

Recommendations FASB IASB
2: Separation of contracts into lease and non-lease components and allocation of consideration to them – lessors: retain guidance similar to that proposed in the 2013 ED 7 16
3: Separation of contracts into lease and non-lease components and allocation of consideration to them – leases: change the 2013 ED proposals to mandate separation and allocation 7 15
4: Permit lessees to elect, as an accounting policy by class of underlying asset, not to separate lease and non-lease components and account for the contract as a single lease contract 4 10

 

Initial direct costs

The Technical Associate briefly introduced the paper addressing which initial direct cost should be considered. She reported that only a few constituents had commented on the issue. The Staff proposed two views: Approach 1 would use an incremental cost notion similar to that contained in the upcoming standard on revenue recognition and Approach 2 would retain the notion currently contained in IAS 17 and be potentially a bit wider than Approach 1. Lastly, as regards the accounting for initial direct costs, Staff proposed that

  • Lessees include initial direct costs in the initial measurement of the right-of-use (ROU) asset and amortise those costs over the lease term;
  • Lessors in a Type A lease (except those who recognise selling profit at lease commencement) would include initial direct costs in the initial measurement of the lease receivable by taking account of these costs in determining the rate implicit in the lease. If the lessor recognised selling profit at lease commencement, it should recognise initial direct costs associated with a Type A lease as an expense at lease commencement; and
  • Lessors in a Type B lease should recognise initial direct costs as an expense over the lease term on the same basis as lease income.

There were no comments from either FASB or IASB members. The Boards approved the Staff recommendations as follows:

Recommendations FASB IASB
1: Initial direct cost should only include cost that are incremental 7 15
2: Definition of incremental cost - Approach 1
    Definition of incremental cost - Approach 2
7

10

3: Lessees and lessors should apply the same definition of initial direct costs 7 15
4: Accounting for initial direct cost as outlined above 7 15

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