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Journal entry — Leases — FASB and IASB continue redeliberations

Published on: Oct 23, 2014

At their joint meeting yesterday, the FASB and IASB continued redeliberating their revisions to lease accounting, primarily focusing on the definition of a lease.

Background

The boards’ May 2013 proposal defines a lease as “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.” To determine whether a contract contains a lease, an entity would need to evaluate whether:

  • “Fulfillment of the contract depends on the use of an identified asset.”
  • “The contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.”

At their May 2014 joint meeting, the boards made tentative decisions related to the definition of a lease.1 However, the boards directed their staffs to perform additional analysis of the application of the lease definition guidance. In response, at yesterday’s meeting, the staffs provided recommendations on how the boards could clarify the assessment of whether an entity has the right to control the asset. Specifically, the staffs recommended guidance that would clarify the evaluation of a customer’s right to (1) direct the use of the identified asset and (2) obtain substantially all of the economic benefits from directing the use of the asset.

Right to Direct the Use of an Identified Asset

The boards tentatively decided that in evaluating its right to direct the use of an identified asset, a customer should focus on its ability to direct “how and for what purpose” the asset is used. In performing this evaluation, the customer would consider its ability to control certain key aspects of the identified asset, including the purpose, time frame, and location associated with the asset’s use or deployment.

The boards also clarified that if the contract explicitly defines, or the customer and supplier mutually agree on, how and for what purpose the asset is used, the customer would still have the right to direct the use of the identified asset if it (1) has the ability to direct how the asset is used (i.e., the supplier has no right to change the operating instructions) or (2) designed the underlying asset “in a way that predetermines . . . [h]ow and for what purpose the asset will be used”2 or operated.

Moreover, the boards tentatively decided that a supplier’s protective right (e.g., a contract that specifies the maximum use of an asset or requires prudent operating practices) would not, in itself, prevent the customer from directing the use of the identified asset.

Right (or Ability) to Obtain Substantially All of the Economic Benefits From Directing the Use of the Identified Asset

The staffs proposed two different approaches for evaluating whether a customer has obtained, or has the ability to obtain, substantially all of the economic benefits from directing the use of the underlying asset.

Under the first approach (Alternative A in the FASB’s agenda paper), a customer would need to have the ability “to derive the economic benefits from directing the use of the identified asset on its own or together with other resources that are readily available to the customer.”3 To have this ability, the customer would need to have the means or skill to use the identified asset on an ongoing basis.

Under the second approach (Alternative B in the FASB’s agenda paper), the FASB would retain the approach from the May 2013 exposure draft. This approach would also focus on the customer’s ability to obtain substantially all of the economic benefits from directing the use of the leased asset during the lease term; however, a customer would not be required to assess whether it needs other readily available resources to obtain these benefits.

The following example, which has been reprinted from the FASB’s agenda paper, illustrates the difference between the two approaches:

Example 4: Specialized Equipment

Customer enters into a five-year contract with Supplier for the use of Equipment B.

Equipment B is explicitly specified in the contract. Supplier cannot substitute another piece of equipment for Equipment B unless Equipment B is not working.

Equipment B is a specialized piece of equipment that is operated by Supplier. Nonetheless, the contract gives Customer the right to decide whether, when, and where Equipment B is used, as well as what tasks it performs (for example, what it produces or what it transports), throughout the five-year contract term. . . .

The contract contains a lease.

The contract involves an identified asset. Equipment B is explicitly identified in the contract and Supplier has no right to substitute the asset unless it is not working.

Customer has the right to direct the use of the asset. This is because Customer makes the decisions about how and for what purpose Equipment B is used. Customer decides whether, when, and where Equipment B is used, as well as what tasks it performs, throughout the period of use. These decision-making rights give Customer the right to direct the use of the identified asset, regardless of the fact that Supplier operates the asset under the terms of the contract. Customer also has the right to obtain substantially all of the economic benefits from directing the use of the identified asset. No other party can use the equipment throughout the contract term.

Customer would account for the lease component of the contract separately from the service component (the operating services provided by Supplier), recognizing lease assets and liabilities only for the payments made for the lease.

Additional Analysis — Ability to Derive Economic Benefits (Alternative A)

A lease would not exist if the following conditions were met:

a)     Customer is not capable of operating the specialized asset on its own or together with other readily available resources. Supplier has specialized knowledge with respect to its equipment that is not readily available in the marketplace (that is, the operating services are not provided separately by Supplier or another third party, and could not be sourced in a reasonable period of time).

b)     Customer cannot otherwise derive a substantial portion of the economic benefits from directing the use of the identified asset (for example, there is no market for subleasing the asset separate from the operations services provided by the supplier).

After discussing the two alternatives as well as concerns that this issue is expected to apply only to a relatively small number of leases, the boards decided to defer making a decision. Rather, the staffs were directed to refine their proposed recommendations so that the boards can agree on a converged approach in the future. The boards plan to revisit this issue at their November meeting.

Next Steps

The boards also expect to discuss various other aspects of their proposed leases guidance at future meetings, including the following:

  • Lessee disclosures.
  • Transition.
  • Effective date.
  • Cost-benefit analysis.
  • Small-ticket lease exceptions.
  • Other items, including consequential amendments and sweep issues.
____________________

1 For more information, see Deloitte’s May 23, 2014, journal entry.

2 See paragraph 34(b) of the FASB’s agenda paper.

3 “Readily available resources,” as that term is defined in the FASB’s agenda paper, would generally include (1) “[s]ervices sold separately by the supplier or a third party” to operate the identified or a complementary asset, (2) trained personnel that the supplier or a third party can directly hire or “that are readily available in the marketplace,” and (3) “[c]onsumables or other supplies sold separately by the supplier or a third party.” 

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