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Leases

Date recorded:

As a result of feedback received to the Boards’ tentative proposals on the Leases project, as well as issues identified by the staffs in drafting a revised exposure draft on leases, the staffs brought the following topics to the Boards for consideration:

  • Application of the proposed revenue recognition guidance to sale and leaseback transactions;
  • Two issues regarding how a lessee would account for leases under the single lease expense (SLE) approach (that being, the approach which results in straight-line recognition in the statement of comprehensive income); and
  • Two issues related to the classification of leases.

Before presenting these topics, the staffs noted that the FASB intends to discuss private company issues associated with the leasing proposal in a FASB only meeting next week. As a result of this discussion, as well as a desire to have an extended period for a fatal flaw review, the release of both the IASB and FASB’s revised exposure drafts on the Leases project is now expected to occur during the first quarter of 2013 (previously the fourth quarter of 2012).

Sale and leaseback transactions

In March 2011, the Boards discussed sale and leaseback accounting and tentatively decided:

  • If a sale has occurred, the transaction is accounted for as a sale and then a leaseback of the entire underlying asset. If a sale has not occurred, the entire transaction would be accounted for as a financing arrangement.
  • An entity should apply the control criteria proposed in the Revenue recognition project to determine whether a sale has occurred.
  • When the consideration for the sale is at fair value, the gain or loss arising from the transaction should be recognised when the sale occurs.
  • When the consideration is not at fair value, the assets, liabilities, and gain or loss recognised should be adjusted to reflect current market rentals.

The staffs reported that constituents have raised the following questions relating to previous Board tentative decisions on applying the control criteria in the Revenue recognition project to sale and leaseback transactions:

  • Are the control criteria in the revenue recognition guidance applied to the entire sale and leaseback transaction or only to the sales portion of the transaction?
  • If applied only to the sales portion of the transaction, would all transactions be accounted for as sale and leaseback transactions?
  • If applied to the entire transaction, would all sale and leaseback transactions be accounted for as financing arrangements?
  • How is a sale and leaseback transaction accounted for if it includes an unconditional right for the seller/lessee to repurchase the asset (i.e., a call option) with an exercise price below the original selling price of the underlying asset?

As a result of analysis performed, the staffs recommended clarifying the following in the revised Leases exposure draft:

  • When determining whether a sale has occurred in a sale and leaseback transaction, an entity should apply the guidance developed in the Revenue recognition project to the entire transaction.
  • The existence of the leaseback does not, in isolation, prevent the transaction from being accounted for as a sale and a leaseback.
  • However, if the leaseback is such that the seller/lessee has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset, a sale has not occurred. The seller/lessee is assumed to have the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset if: the lease term is for the major part of the economic life of the underlying asset; or the present value of the minimum lease payments accounts for substantially all of the fair value of the underlying asset.
  • If there are multiple lease components in the transaction, the assessment is performed for each lease component separately.
  • If an entity concludes that a sale has not occurred in accordance with the Revenue recognition project, the entire transaction is accounted for as a financing arrangement.
  • Minor amendments to the wording of paragraph B40(a) of the 2011 Revenue recognition exposure draft should be made (as underlined below). Those amendments would clarify that if an entity has an unconditional obligation or unconditional right to repurchase the asset, the entity should account for the contract as a lease in accordance with the leases standard, if the entity can repurchase the asset for an amount that is less than the original selling price of the asset, unless the contract is part of a sale and leaseback transaction. In that case, the entity should account for the contract as a financing arrangement.

No fundamental objections were raised to the staffs’ recommendations. However, a few clarification requests were outlined. Specifically:

  • One IASB member noted that the proposed amendments to the Revenue recognition exposure draft were directed at call options and did not address put options embedded in a sale and leaseback. Hearing the Board member’s request for clarification, the staffs acknowledged that both an unconditional right to repurchase the asset in the original contract (a call) and an unconditional obligation to repurchase the asset at the customer’s request (a written put) should be clarified in the revenue recognition proposals. Therefore, the staffs recommended that an amendment should be made to paragraph B43 of the 2011 Revenue recognition exposure draft to effectively state if a customer has the ability to require the entity to repurchase the asset (a put), and that put is priced such that the customer has a significant economic incentive to exercise that right, the entity should account for the transaction as a lease.
  • One IASB member questioned whether there were any inconsistencies between the above proposals and those for bill and hold transactions in the Revenue recognition project. The staffs noted that they would be working with the Revenue recognition project team to ensure that the proposals were consistent in this area.
  • One FASB member questioned whether, as a result of the staffs’ proposals, Emerging Issues Task Force (EITF) Issue 97-10, The Effect of Lessee Involvement in Asset Construction (now codified in FASB Accounting Standards Codification 840-40, Leases – Sale-Leaseback), would be retained in US GAAP subsequent to the issuance of a final leasing standard. EITF Issue 97-10 considers how an entity (lessee) that is involved with the construction of an asset that it will lease when construction is completed should determine whether it should be considered the owner of that asset during the construction period. The FASB staff noted that it would consider this issue.

With no further debate, the Boards tentatively agreed with the staff recommendations, inclusive of clarification of sale and leaseback accounting that includes a written put option.

Issues relating to the single lease expense approach

Accounting after impairment of the right-of-use asset

The staffs sought the Boards view on the accounting after impairment of the right-of-use asset under the SLE approach. In summarising multiple approaches and issues, the staffs recommended that when the right-of-use asset in a lease is impaired, the revised Leases ED should include guidance on how to recognise the remaining lease expense. That guidance should indicate:

  • When the right-of-use asset is fully impaired, the lessee should recognise the remaining lease expense in each period in an amount equal to the periodic unwinding of the discount on the lease liability. This recommendation was based on the fact that continued application of the SLE approach would often require the lessee to recognise another asset (‘an artificial asset’) to facilitate the recognition of a straight-line expense pattern in each period for the remaining lease term.
  • When the right-of-use asset is partially impaired, the lessee should recognise the remaining lease expense in each period in an amount equal to (a) the periodic unwinding of the discount on the lease liability plus (b) an even allocation of the remaining right-of-use asset balance over the remaining lease term.
  • In both of those circumstances, the lessee should present lease expenses recognised in the remaining periods in accordance with the SLE approach.

While many Board members originally appeared supportive of the proposals, one concern was raised. That specific concern was that for leases to which the SLE approach applied, an insignificant impairment of the right-of-use asset forces a lessee to revert to an alternative accounting approach for that lease more akin to the accelerated expense leasing approach (referred to as the Interest and Amortisation approach). The Board member raising this concern remarked that an accounting change is triggered even though the economics of the lease had not changed, and likewise, the basis of the proposed accounting after impairment of the right-of-use asset was inconsistent with that of the reason for originally classifying the lease under the SLE approach.

This was further supported by concerns raised by other Board members, including:

  • How would a lessee recognise the remaining lease expense subsequent to impairment of the right-of-use asset if the impairment charge was subsequently reversed (IFRS only consideration)?
  • For consistency with the accounting when no impairment of the right-of-use asset is recorded, should the proposal instead recommend the continued application of a SLE profile except in cases where it artificially creates an asset (i.e., apply the SLE profile with the inclusion of an expense floor where expenses cannot fall below the periodic unwinding of the discount on the liability)?
  • Will the staffs’ proposals create an incentive for lessees not to recognise impairment charges so as to avoid an accelerated lease expense profile?

The FASB tentatively expressed support for the staffs’ recommendation. However, the IASB tentatively supported the alternative approach outlined above. That being, a lessee would continue to apply the SLE approach subsequent to impairment of the right-of-use asset. However, the total lease expense recognised in any period should not be lower than the amount of the periodic unwinding of the discount on the liability. When the right-of-use is fully impaired, this would result in the lessee recognising the remaining lease expense in an amount equal to the periodic unwinding of the discount on the lease liability (i.e., the remaining lease expense would no longer be recognised on a straight-line basis). The lessee would present lease expense recognised in the remaining periods in accordance with the decisions reached under the SLE approach.

As a result of the IASB’s tentative decision, the FASB decided to reconsider its previous vote and tentatively decided to support the alternative approach supported by the IASB for a converged solution.

Lease expense recognition pattern

The staffs sought the Boards view on whether the intent under the SLE approach is for the total expense to be recognised on a straight-line basis in all cases or whether another systematic basis should also be allowed. As a result of its analysis, and in remaining consistent with the wording of current IFRS and US GAAP standards in relation to operating lease accounting, the staffs recommended that a lessee with leases accounted for under the SLE approach be required to recognise total expense using a straight-line basis, unless another systematic basis is more representative of the pattern in which use is expected to be derived from the underlying asset (underlined text refers to the staffs’ proposed amendment to the Boards’ previous tentative decision).

One IASB member expressed a strong objection to the staffs’ recommendation. He noted that the staffs’ proposal was inconsistent with the basis of the SLE approach. Specifically, he believed that the SLE approach was originally developed as the best presentation of the benefits being received from the lease; not the benefits being received from the underlying asset. He noted that the original basis for the SLE approach was that it was substantially different than the purchase of an asset, and therefore, looking to the underlying asset to determine an appropriate pattern of expense recognition appeared inconsistent with this basis.

Hearing this feedback, both Boards tentatively rejected the staffs’ recommendation. A lessee with leases accounted for under the SLE approach would be required to recognise total expense using a straight-line basis.

Issues relating to the classification of leases

Date of assessment

The staffs requested feedback from the Boards on the timing of the lease classification test; specifically, whether the intent was that this test would be performed at lease commencement only. Highlighting its analysis, the staffs recommended that an entity should determine lease classification at lease commencement only (primarily on the basis of cost and complexity).

One FASB member noted that lessees are required to reassess the lease term when certain relevant factors change so significantly that a lessee would have, or no longer have, a significant economic incentive to renew a lease. This Board member believed that reassessment of the classification of the lease should be required whenever there is a reassessment of the lease term. However, other Board members expressed support for the staffs’ recommendations based primarily on the perceived complexities in reassessing. With little additional feedback, both Boards tentatively supported the staffs’ proposal.

Underlying asset in a sublease

The staffs requested feedback from the Boards as to whether the lease classification test for subleases should be based on the right-of-use asset or the asset that is leased. Highlighting its analysis, the staffs recommended, for the purpose of lease classification test in a sublease, an entity should consider the underlying asset to be the asset that is leased as opposed to the right-of-use asset. This was based primarily on a view of providing decision-useful information to users of financial statements.

One IASB member believed a consequence of the right-of-use leases model is that the underlying asset in a sublease is the right-of-use asset and this should not be different when classifying leases. Therefore, she believed that for purposes of lease classification, an entity should consider the right-of-use asset to be the asset that is leased as opposed to the underlying asset.

However, with little additional debate, both Boards supported the staffs’ recommendation.

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