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Leases

Date recorded:

At the February 2012 joint meeting, the Boards received a summary from the Working Group Meeting held on January 24, 2012. The Boards also discussed:

  • three alternative approaches to subsequently measuring the right-of-use ('ROU') asset by the lessee, and whether there are any consequences for lessor accounting resulting from the outcome of the lessee accounting discussions; and
  • whether the Boards agree with their previous tentative decision to exclude leases of investment property from the scope of the receivable and residual approach and whether there are any consequences for lessee accounting arising from this tentative decision.

The Boards had previously discussed and reached tentative decisions regarding lessee accounting at their April and May 2011 joint board meetings. This was consistent with the 2010 Leases ED. Those decisions were that a lessee would recognise:

  • a liability to make lease payments ('lease liability'), initially measured at the present value of lease payments, and subsequently measured at amortised cost using the effective interest method.
  • a right-of-use ('ROU') asset, initially measured at an amount equal to the lease liability (plus any initial direct costs and prepaid lease payments) and subsequently measured at amortised cost (using a systematic basis that reflects the expected pattern of consumption of benefits from using the underlying asset).

Although many respondents to the 2010 ED accepted the recognition of an asset and liability by the lessee, and the initial measurement of the asset and liability at an amount equal to the discounted lease payments, some respondents expressed concern about the resulting accelerated expense profile. As a result of this concern, the Boards discussed during 2011 alternative ways to subsequently measure the ROU asset but tentatively decided to retain the initial and subsequent measurement proposals but to re-expose those proposals together with other proposed changes. However, the Boards continue to receive comments and objections from some constituents regarding the proposed lessee accounting, in particular, noting that the resulting lease expense recognition profile does not reflect the economics of all lease transactions.

In view of such comments received and due to the significance of the proposed changes to the existing lessee accounting model (i.e., accounting outcome and the costs involved), the Boards decided that they should re-discuss the lessee accounting proposals before publishing the re-exposure document.

At the February 2012 meeting, the Boards discussed three alternative amortisation approaches to subsequently measuring the ROU asset by the lessee:

  • Approach A — This is the current approach based on the Boards' tentative decisions to date which treats a lease contract as being equivalent to the purchase of an intangible asset (i.e., ROU asset), which is financed separately (i.e., lease liability). As the ROU asset is a non-financial asset, it is accounted for consistently with other non-financial assets. As the lease liability is a financial liability, it is accounted for consistently with other financial liabilities. The initial view was that it would enable constituents to apply one lessee accounting model and it would be unnecessary to distinguish between operating and finance/capital leases or leases and in-substance purchases. Also, this approach would result in more simple accounting, would enhance comparability and reduce structuring opportunities. Under this approach, the lessee's total lease expense for an individual lease would typically decrease over the lease term because: a) the interest expense is based on the liability balance, which decreases as the lessee makes payment and b) the ROU asset would be typically amortised on a straight-line basis. These components would be subsequently measured independently of each other.
  • Approach B — The 'interest-based amortisation' approach treats a lease contract differently from the purchase of a non-financial asset, which is financed separately. The rationale of this approach is that lease contracts give rise to ROU assets, which are a distinct class of non-financial assets and as such warrant a different method of amortisation than is conventionally applied in practice for purchases of PPE. Under this approach, the total lease expense would be recognised more evenly over the lease term as the lessee would take into account the time value of money when subsequently measuring both the ROU asset and the lease liability with the amortisation charge being lower in the earlier years than under Approach A, offsetting the higher interest expense on the lease liability in those years. For a typical lease where the lessee expects to consume the benefits evenly and pays even amounts over the period that the benefits are consumed, this would result in a straight-line total lease expense. The total lease expense in each period would equal the cash paid. If there were prepayments or rent free periods, then the total lease expense would not be straight-lined reflecting the financing effect.
  • Approach C — The 'underlying asset' approach treats a lease contract as being equivalent to the purchase of the underlying asset being leased (e.g., PP&E), which is financed separately for a period that corresponds to the lease term. The amortisation charge under this method would include: a) depreciation on the piece of the underlying asset expected to be consumed by the lessee over the lease term and b) unwinding of discount on the expected value of the underlying asset at the end of the lease term (at the interest rate used to initially measure the ROU asset). The lease expense profile would vary depending on the level of consumption of the underlying asset over the lease term. The rationale for this approach is based on how a lessor prices lease contracts and as such, on what the lessee is paying for (i.e., when making lease payments): a) payment for the piece of the asset that the lessee consumes over the lease term, b) finance charged on that part, and c) a required return on the residual value of the asset because the residual asset cannot be used by the lessor while under lease. This approach would provide a single approach to lessee accounting but would result in different expense recognition profiles depending on the consumption of the leased asset's value over the lease term.

The Board members focused their discussion on approaches B and C. During the meeting, the IASB and FASB expressed divergent views on the alternative approaches based on conceptual differences and concerns on the operationality of the various approaches. Several of the IASB members supported approach C on the basis that they felt it would provide decision useful information to users of financial statement because it better reflects the economics of a lease contract. Additionally, this approach could be applied to all leases without the need to distinguish between different types of leases. However, many Board members noted that this approach has not been tested and that it would be the most complex to apply from the lessee's perspective because it would require the lessee to estimate the percentage consumption of the underlying asset.

Many FASB members felt that approach C would likely not be operational because a lessee would not always have the necessary information to determine the percentage of consumption and were uncomfortable with the subjectivity and reliability of the estimates that would be used in the model under approach C. The staff indicated that approach C was insensitive to estimation errors but the Boards asked for further evidence to support this. Additionally, many FASB members thought this approach would be difficult to apply to some property leases. Furthermore, some FASB and IASB members expressed concern with approach C because it would not address the accelerated expense profile except for leases where there is a small percentage of consumption.

Several FASB members preferred approach B on the basis that it was operational and would address the straight-line expense issue. However, a number of Board members acknowledged that constituents may question why the asset and liability is not presented on a net basis because approach B links the asset and liability. These Board members indicated that a robust basis for conclusions will be necessary to provide the Boards' rationale as to why approach B is appropriate but net presentation is not. An IASB Board member also expressed concerns that approach B is inconsistent with the amortisation approaches used for PPE and intangible assets which may give rise to future requests to consider alternative amortisation approaches. In addition, many IASB members were concerned about approach B because it would require a line to be drawn to distinguish between leases and in-substance purchases.

The Boards also briefly discussed whether there were any consequences for lessor accounting resulting from the lessee accounting discussions. Some of the Board members noted that they were satisfied with the current lessor lease accounting model while some Board members expressed concerns that the lessee and lessor accounting models should be linked and be preferably symmetrical.

Many Board members expressed concerns on the previous decision to exclude leases of investment property from the scope of the receivable and residual approach for lessors. Several Board members noted that their rationale for previously voting for the exclusion was to provide practical relief and as such, there should be no consequences for the lessee model whereas some Board members noted that they supported the exclusion to both provide a practical relief and because the receivable and residual approach did not appropriately reflect the economics of leases of multi-tenant property.

Due to the divergent views expressed by the Boards and in order to determine the next steps to take, the Boards were asked a series of questions on their preferences. The Boards were first asked that if the staff were to conduct further analyses and outreach on approach C and it was determined to be operational and provide useful information, whether they would consider approach C as a first preference. Thirteen IASB members voted in preference of approach C whereas only one FASB member voted in preference of approach C. The FASB members were asked to consider two alternative preferences: applying approach B to all leases or applying approach A to leases of a "capital" nature and approach B to leases of an "operating" nature, assuming that a line was drawn to distinguish these two types of leases. One FASB member preferred approach B while six FASB members preferred a combination of approaches A and B to different types of leases. The IASB Board members were also asked that if approach C was taken off the table, to consider two alternatives: applying approach A to all leases or applying approach A to leases of a "capital" nature and approach B to leases of an "operating" nature, assuming that a line was drawn to distinguish the two types of leases. Seven IASB members preferred approach A whereas six IASB members preferred a combination of approaches A and B to different types of leases. Five members of the FASB supported using the concept of transfer of risks and rewards in IAS 17 as a starting point to drawing the line to distinguish leases of a capital nature versus operating nature. Based on the above expressed preferences and with a view to form a consensus, the Boards directed the staff to perform further outreach to constituents and analyses on approaches B and C to determine their operationality and whether they provide decision useful information. This analysis is expected to be discussed at the April meeting.

 

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