Lease modifications and contract combinations

The Practice Fellow on the IASB’s project team introduced agenda paper 3A on lease modifications and contract combinations, dealing specifically with the first part on how to identify and how to account for a lease modification.

Identifying a lease modification

According to the paper a lease modification would be defined as any change to the contractual terms and conditions of a lease that were not part of the original terms and conditions of the lease. She acknowledged that, based on the IASB’s educational session held on the previous day, the wording would be clarified to say "any change that affected the scope or the consideration paid for the lease".

Accounting for a lease modification – lessees

The staff recommendation was that a lessee should account for a lease modification as a new lease, i.e. separately from the original lease, when the following occurred:

1. A modification grants the lessee an additional right-of-use (RoU); and
2. The additional RoU is priced commensurate with its standalone price.

If a lease modification did not constitute a separate new lease, the staff provided two alternative approaches how to account for the lease modification:

• Approach 1 would distinguish between increases and decreases of the scope of the original lease (i.e. adding to or terminating the RoU or extending or shortening the lease term) and changes in the consideration to be paid without a concurring change in the scope of the lease. Increases of scope would be accounted for by remeasuring the lease liability and adjusting the carrying amount of the RoU asset correspondingly. Conversely, decreases in scope would be treated as an early termination of the lease and would lead to adjustments to the lease liability and RoU asset, whereby any difference between the two would be recognised in profit and loss.
• Approach 2 would require an assessment of whether the changes were substantial or non-substantial similar to the proposals on contract modification in the 2013 Exposure Draft. The accounting for substantial changes would be similar to contract modifications in IFRS 9 (using the so-called '10 per cent test'). Non-substantial modifications would be accounted for as a continuation of the original lease.

The staff recommended Approach 1.

Accounting for lease modifications – lessors

Lease modifications should be evaluated in a manner consistent with the evaluation of contract modifications in the forthcoming revenue recognition standard. A lessor should account for a lease modification as a new lease when:

1. The lease modification granted the lessee an additional RoU not included in the original lease; and
2. The additional RoU is priced commensurate with its standalone price.

If a lease modification did not represent a separate new lease, the staff suggested to account for it depending on the type of lease:

• For Type B leases, a lessor would account for a lease modification as a new lease from the effective date of the modification
• For Type A leases, a lessor would recognise a financial asset. A lessor should apply IFRS 9 (or the respective U.S. GAAP section on receivables) when accounting for the derecognition and impairment of these financial assets, including when assessing the effect of a lease modification. This would mean no substantive change for IFRS lessors with respect to lease modifications, but would represent a change to U.S.GAAP lessors.

Discussion

Lessor accounting: Some IASB members expressed concern about introducing modifications to lessor accounting when it was agreed at the March meeting that no changes would be made. One IASB member said that by adding guidance there was a risk of creating diversity in practice while currently there were no issues noted in the application of lessor accounting. Some FASB members indicated that they understood that paragraph 47 of the agenda paper clarified that there were no changes to lessor accounting and the new material added by the staff was only to conform changes and not aimed at changing practice. The U.S. Project Manager confirmed this understanding. The proposal was only to add guidance to support current practice, the main changes would only occur to U.S. GAAP lessor accounting in order to align it with IFRSs.

Use of Examples and guidance: Some IASB members indicated that the examples added confusion and were not helpful while others considered them to be useful. Several IASB members expressed support for addressing contract modifications because they occurred frequently, although did not prefer to explain the concept through examples. Some FASB members expressed support for the use of examples while requesting that they be made clearer (for example the table in paragraph 23 of the agenda paper). They also mentioned that they considered it very important to have guidance in this area.

The IASB’s Technical Principal for the leases project said that the fact that there were examples discussed in the paper id not necessarily mean that they would be included in the final standard. She believed that the concepts could be clearly explained in a few paragraphs, the objective of using examples was primarily for the Boards’ analysis.   

Comments on the lessee approaches: One IASB member expressed a preference for approach 2 because it was consistent with financial instruments accounting. In addition, she expressed a concern whether there could be cases where there was a reduction in scope that was not significant (for example 5%) while there was a significant change in the discount rate (comparing the discount rate used at inception of the lease vs. the discount rate applicable now). She wondered how this would this be accounted for. The Practice Fellow responded that the change in the lease liability should be separated in two components (1) the change in scope – a reduction – should have the corresponding impact in P&L and (2) the second component (which would be any change other than scope) would only have a corresponding impact in the ROU without any impact on profit or loss. Based on this response, the IASB member requested that the examples be made clearer to reflect this concept appropriately. The Practice Fellow responded that the examples were calculated in a simplified way but clarified that the concept was that only reductions in scope would affect profit or loss. One IASB member had a question regarding example 4 of the paper (modification that is a change in consideration only) and questioned whether this change did not affect profit or loss since it was the same asset for a reduced price for the remaining lease term. The Technical Principal responded that it would be possible to go either way, if the asset was initially measured at cost and the asset was the same, there would be an argument for not adjusting the RoU; however, the staff’s rationale was that most of the time changes would be related to changes in RoU, and on day one the asset was measured as the same amount as the liability, so it appeared more logical that when there was a change in the liability, there should be a change in the RoU asset, too.

FASB members indicated support for the staff approach on the basis that approach 1 was more direct. There were currently complexities in applying the model suggested in approach 2 (specifically related to the '10 per cent test'). Further, they expressed their concern that the concept of "substantial" and "non-substantial" would require significant judgement. An additional issue could be the existence of several non-substantial changes that in aggregate were substantial.  Lastly, they felt that approach 1 permitted a better linkage between assets and liabilities. 

One IASB member was concerned about changes in the discount rate. He thought that if a change was not substantial the discount rate should not be changed. Further, he asked whether the proposal was to choose either approach 1 or 2 or whether the two could be combined. The Technical Principal responded that it would be possible, for example, to add as a first step whether the change was substantial or not, and to then analyse the change in terms of scope and considerations. However, the staff decided not to add more complexities in the paper. The Board member responded that he actually believed that it would reduce complexity and add simplification. Another IASB member also supported this approach because the wording in approach 1 as to "any change" would imply a significant number of transactions in scope. Another IASB member questioned whether combining both approaches would require more guidance to define what was substantial and what was not. For that reason he would prefer approach one. One FASB member expressed support for this potential combination approach; however, he indicated that it could create potential structuring opportunities.

Other Comments: One IASB Member asked whether the analysis had to be done on a portfolio basis or on a contract-by-contract basis. The Technical Principal responded that it should be done on a contract basis.

As regards applying the financial instruments guidance on derecognition to leases, the IASB project manager said that this would not be new under IFRSs, whilst the FASB Project Manager clarified that U.S. GAAP did neither refer the lessor or lessee to the financial instrument guidance to determine whether a change was substantial or not.

Decision: Both FASB and IASB Board members approved the staff proposal included in questions 1 to 4 in the paper.

Contract combinations

The Technical Associate on the IASB’s project team introduced the paper. The 2013 ED did not include guidance on contract combinations. The staff proposed that an entity would combine two or more contracts entered into at or near the same time with the same counterparty (or related parties) and consider the contracts as a single transaction if either of the following criteria were met:

1. The contracts were negotiated as a package with a single commercial objective; or
2. The amount of consideration to be paid in one contract depended on the price or performance of the other contract.

Discussion: There was no significant discussion on this paper. One IASB member asked whether if you had a lease contract for two completely different assets and get a discount for signing both contracts, the discount would have to be allocated or whether the contracts should be combined. The U.S. project manager responded that allocating a discount would be discussed in future sessions on definitions of a lease and separating lease/non-lease components.

Decision: Both the FASB (unanimous) and the IASB (12 member in favour) approved the staff proposal to include contract combination guidance.

Variable lease payments

Initial measurement

A member of the FASB Project Team introduced agenda paper 13B on variable lease payments. The staff proposed that the initial measurement of variable lease payments included in lease assets and lease liabilities would include only variable lease payments that depend on an index or a rate, measured using the index or rate at lease commencement (thereby confirming the proposals in the 2013 ED). Constituents had different views on whether variable payments that did not depend on an index or rate (such as those linked to performance) met the definition of assets or liabilities. The staff did not propose to discuss this issue further.

Discussion: One FASB member indicated that he supported the staff proposal considering that the rationale is cost-benefit and not on whether variable lease payments that did not depend on an index or rate were assets or liabilities (which he believed they were). He further recommended that the basis of conclusion should be drafted on that basis, i.e. making cost-benefit considerations the argument. Other members of the FASB agreed with this suggestion. In addition, one IASB member asked how staff would discuss this issue in the Basis for Conclusions, i.e. whether staff would merely describe the views raised by constituents or stating the Boards’ view on it. He also said that one needed to be cautious with the cost-benefit argument, as something could be costly today (in relation to measuring lease payments that did not based on an index or rate) but not in the future. The Technical Principal said that the Basis for Conclusions would reflect the Boards’ discussions.

The two Boards had a lengthy discussion about the appropriate discount rate. One IASB member expressed a concern with regard to indexes related to inflation. He wondered whether one should use a real or nominal discount rate. If lease payments were linked to inflation, it would be necessary to apply a real discount rate, otherwise by not including inflation in the lease payments and discounting at a nominal rate, the liability would be understated. He was also concerned about the subsequent accounting given that he observed in the manuals of at least two accounting firms that suggested two different approaches. The Technical Principal responded that the objective was to try to reflect the rate on the contract. The IASB member responded that there was a real and nominal discount rate and the guidance had to be explicit. Also, by applying a real discount rate, no reassessment would be needed. There was an extensive debate on this matter. One FASB member expressed agreement with the concern raised by the IASB member while saying he believed the guidance would lead to the approach suggested by the IASB member. He suggested the staff add guidance to indicate that if cash flows included inflation, then the discount rate had to include inflation.

Decision: A majority of both Boards (5 for the FASB, 13 for the IASB) agreed with the staff’s suggestion.

Subsequent measurement

The Project manager on the FASB side continued with laying out the staff’s proposal for subsequent measurement, which included the following three approaches:

• Approach 1 – Require reassessment at each reporting period as proposed in the 2013 ED.
• Approach 2 – A lessee would reassess variable lease payments that depend on an index or a rate only when there as a contractual change in the cash flows.
• Approach 3 – Require reassessment of these payments only when the lease liability is reassessed for other reasons (that is, reassessment of the lease term or whether the lessee is, or is not, reasonably certain to exercise an option to purchase the underlying asset). As the Boards had tentatively decided not to require lessors to reassess the lease term, the approach would not require a lessor to reassess its lease receivable for changes to an index or a rate used to determine lease payments.

 The staff recommended Approach 3 for cost-benefits reasons.

Discussion: One FASB member indicated that he disagreed with the proposal because it was inconsistent with previous decision on contract modifications. He would support Approach 2 as he believed that if there were significant changes in scope or price, the lessor should be required to reassess. The project manager clarified that the proposal was for situations where there was no change in the contract; it was only dealing with escalator provisions that already existed in the contract. Other FASB members indicated support for the staff proposal on cost-benefits grounds. It was mentioned that changing the information from period to period would not necessarily provide useful information. Other arguments raised in favour included the point that, as long as the cash flow and discount rate were aligned, it would not be necessary to have a periodic reassessment as in Approach 2. One IASB member indicated that she disagreed with the staff proposal because they had already given several concessions for cost-benefit reasons. A company would know the indexes and should be able to update the calculations; for that reason she would support Approach 2. Other IASB members also expressed support for Approach 2. One IASB member particularly indicated that in many jurisdictions inflation was high and that it would be inappropriate not to update the indexes when those changes were trigger in the contract. Another IASB member indicated that the portfolio approach would help to alleviate the costs, so Approach 2 seemed to provide the right balance. Another IASB member reiterated his comment regarding the need to match cash flow and discount rate for inflation-linked leases. Hence, a reassessment would not be needed. If that was not possible, he would support Approach 2.

Decisions: A majority of five FASB members was in favour of Approach 3 (with the remaining two showing a preference for Approach 2), whereas 15 IASB Board members voted in favour of Approach 2. Given the divergence, the FASB Chairman suggested come back again on this topic after the Board had discussed discount rates to see whether they could converge. However, the results were the same and no FASB member was willing to agree to Approach 2 for the sake of convergence. The FASB Chairman therefore suggested putting this issue on the list of non-converged items and potentially returning to it at a later stage.

In-substance fixed payments

A member of the FASB staff introduced the agenda paper on in-substance fixed payments. He pointed out that neither U.S. GAAP nor IAS 17 contained guidance as to when variable lease payments that are in-substance fixed would have to be included in calculating minimum lease payments (though, in practice, these payments were generally included when determining minimum lease payments). The staff recommendation was to

1. retain the 2013 ED’s principle that variable lease payments that are in-substance fixed be included in the definition of lease payments;
2. note in the Basis for Conclusions that the notion of variable lease payments that are in-substance fixed existed under current practice; and
3. include additional illustrative examples to help clarify the guidance.

Discussion: FASB Board members indicated support for the staff proposal, though some said that the examples would need to be clarified. In general, however, they agreed to use examples to explain the concept. On the other hand, IASB Board members expressed concern about the use of examples. Some said that the examples did not genuinely demonstrate the concept, which is why they preferred using words instead of examples.

Decision: Both FASB and IASB members approved staff proposals (1) and (2). However, neither the FASB nor the IASB members approved the inclusion of examples as suggested in proposal (3).

Discount rate

Another member of the FASB’s project team introduced the agenda paper, which dealt with the determination and reassessment of the discount rate.

Determination of the discount rate

The 2013 ED contained a requirement according to which lessees would discount lease liabilities at the rate the lessor charges the lessee if that rate is available; else, they would use the incremental borrowing rate. Given that the Boards had previously agreed to allow a portfolio approach, the staff felt that the guidance was in need of clarification. Therefore, the staff proposed to:

• (a) Describe the rate the lessor charges the lessee as the rate implicit in the lease;
• (b) Include initial direct costs of the lessor in the definition of the rate implicit in the lease;
• (c) Clarify in the implementation guidance what ‘value’ refers to in the definition of the lessee’s incremental borrowing rate;
• (d) Include at least one example illustrating how to determine the lessee’s incremental borrowing rate; and
• (e) Provide guidance as to when a subsidiary might use the parent entity or group’s incremental borrowing rate as the discount rate applied to its leases.

Discussion: IASB members expressed general support for the staff recommendation. However, there was substantial debate regarding the staff proposal to add guidance as to when a subsidiary might use the parent’s discount rate. One IASB member indicated that guidance is necessary, while the majority disagreed and preferred that the standard remain silent in this topic. They indicated that there were different economic environments, currencies, and interest rates and that it would be difficult to address all of them in one example. These members believed that the guidance was clear and that examples would not add value. The project manager commented that guidance on the subsidiary’s discount rate was added based on the feedback received from constituents and because it was also based on current U.S. practice (where many subsidiaries defaulted to the parent’s discount rate if they did not have their own treasury function); nevertheless, the principle was that the rate should approximate the rate charged by the lessor. If that principle was met, it could still be possible for a subsidiary to use the parent’s discount rate.

Several FASB members raised concerns regarding the interaction with the subsequent measurement of variable lease payments where a majority of the FASB had supported Approach 3 (i.e., require reassessment of variable lease payments). If that were the case, it would be inconsistent not to reassess the discount rate. It was also mentioned that the discount rate should consider the characteristics of the cash flows, such as currency, timing, and variability of the cash flows. The project manager clarified that the staff recommendation concerning discount rate reassessment was based on approach 3 for variable lease payments. One FASB member highlighted that, hence, there would be multiple reassessment situations. Another FASB member said that when a contract was modified, both the cash flows and the discount rate would have to be reassessed.

Decision: The IASB Chairman concluded that the IASB members were in agreement with the staff recommendation on topics (a), (b) and (c) but were hesitant as regards topics (d) and (e). The FASB Chairman suggested discussing the next topic (reassessment of the discount rate) first before calling a vote. After that discussion, FASB members unanimously approved proposals (a), (b) and (c) and rejected (d) and (e). There was further debate by the FASB members on the use of examples. The project manager explained that they could add how the rate should be determined conceptually. The FASB Chairman asked the staff to continue working on the examples.

Reassessment

The project manager continued with the next issue being reassessment. The staff recommended that a lessee would be required to reassess the discount rate only when a significant event or significant change in circumstances within the control of the lessee resulted in a change to the lease term or the assessment of purchase options (question 3). Lessors would not reassess the discount rate because they would not reassess the lease term or whether or not it was reasonably certain that the lessee would exercise an option to purchase the underlying asset (question 2).

Discussion: There was extensive debate on reassessment. One FASB Board member reiterated his point that by updating the cash flows it would be necessary to update the discount rate, too, and he noted the inconsistency with the previous memo on variable lease payments as regards reassessment. The IASB project manager clarified that this paper did not discuss contract modifications. If a contract was modified, the discount rate would be updated. This discussion was to explore whether the discount rate should ever be updated, given the fact that the liability was measured on a cost basis.

One IASB member mentioned that she agreed with the concept. As regards the issue of reassessment where the IASB had voted in favour of Approach 2, she believed that there was no inconsistency because the changes in variable lease payments were known in the contract and should therefore be taken into account when determining the appropriate discount rate at inception; hence, there would be no need to reassess the discount rate. The IASB’s Technical Director clarified that this was also consistent with the forthcoming revenue recognition standard, which would distinguish between a contract modification and variability. A change in the terms was different from a change in the cash flows. One IASB member asked why there would be a need to update the discount rate if there was no change in the contract. The IASB’s Technical Principal clarified that it was their understanding that under a change in the lease term (if there was an option in the contract to renew) it would be appropriate to update the discount rate. Other IASB members agreed with this concept.  

Decision: When called to a vote, the FASB members voted unanimously on both questions 2 and 3. The IASB approved the staff recommendations with 15 (question 2) and 16 votes (question 3), respectively.