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Leases

Date recorded:

The FASB’s Lead Project Manager introduced the agenda paper on the definition of a lease. He indicated that the paper contained background information from the 2013 ED on the topic, feedback received, and tentative decisions made in the May 2014 joint meeting. The core section of the paper provided information on the staff proposal for how best to define that a customer obtained control of the use of an identified asset; it also discussed how to articulate the right to control the use of an asset with the requirement that a customer must obtain substantially all the economic benefits derived from the use of an asset. The staff also present to the Boards an option of including (alternative A) or not including (alternative B) an additional requirement on whether a customer must have the ability to derive the economic benefits from directing the use of the identified asset on its own or together with other assets, i.e. without the continuing involvement of the supplier.

Alternatives A and B proposed by the staff would not change the main concept that a customer must direct the use and obtain substantially all of the economic benefit of an identified asset during the applicable term. The Project Manager indicated that the key difference between both alternatives would be in respects to when the customer’s rights of use would resolve. Under alternative A that would be the case only when the customer was capable of deriving the future economic benefits from its right of use independently from the supplier’s continuing involvement. Conversely, alternative B would assert that any time the customer controlled the use of an identified asset so as to derive probable future economic benefits, a right of use exists. He indicated that in the vast majority of cases the staff expected that there would be no difference as to the outcome under either alternative A or B. Only in the specific circumstance when the equipment was of such specialized nature that the customer would be incapable of operating the asset on its own and without the supplier’s involvement or of deriving the benefits in another way, e.g. by subleasing the asset, then the arrangement might not be classified as a lease under alternative A.

The staff’s proposal was for alternative B. The Project Manager pointed out that the staff believed their proposed clarification on the notion of the right of use to be clearer and simpler to apply. Staff also believed that it would avoid unintended consequences. He also pointed out that the main objective was to identify whether a customer had a right of use to control an identified asset, and the definition should be applied regardless of the underlying asset; instead, the terms of the contract must define what was or was not a lease.

Several FASB members requested a clarification as regards protective rights. One FASB member said that he understood that the more protective rights were in a contract, the less economic benefits a customer would derive. The Project Manager said that this would be the case, generally; he also said that paragraph 36 of the agenda paper explained the staff’s rationale for protective rights. He said that the objective was to capture rights that were really to protect the supplier’s interest in the asset, its personnel, or related assets. He pointed out though that staff had found it difficult to identify a clear dividing line: In certain cases, those rights could be predetermined under the contract or mutually agreed; some rights could be solely protective, but at some point could become a situation of shared power. He also said that the notion of protective rights existed in other guidance. The FASB member replied that it would be important to add those considerations in the drafting of the final standard.

Another FASB member pointed out that the key aspect was the distinction between control of an asset vs controlling the right of use of an asset. Accordingly, protective rights might define what the right of use was in some respects. Some protective rights could be related to the physical asset (for example, an asset that could not be painted in a different colour), but would not mean that there was no control of the right of use of the asset. The Project Manager agreed andsaid that, for example, a customer could lease a plane but would not be allowed to flight to Iraq or Afghanistan. Such a restriction would not mean that the customer did not direct the right of use of the asset. Rather, that restriction would be a protective boundary around the right of use. Another Board member said that those cases would be just boundaries. For example, if in a lease of car there was a limit of 5,000 miles a year, then the lease would only relate to those 5,000 miles.

One FASB member expressed concern about how far the analysis should be made in terms of the identification of an asset in a contract. If a contract stated a specific equipment that came with an operator, and the operator performed specific tasks, such as ABCD for three years, that contract would not be a lease. However, if a customer would contract an equipment with an operator for three years and on site the customer would direct the operator to perform tasks ABCD, then that contract would be a lease. In the first case the use would be specified in the contract, in the other it would not be. The Project Manager agreed and said that paragraph 28 of the agenda paper was key to analysing the issue. He said that the key point was that the asset would be used for three years. If the contract stated that the tasks could only be changed by way of a new contract, then the contract would be classified as a service because it would not meet the ‘direct the use’ criterion; rather, the customer was only getting an output from the asset. Conversely, if during the three year period the customer had the right to direct and change how this asset was used, for example, from task A to task B and then to task C, the customer was in a position to direct the use of the asset and could change the economic benefits that could be derived from the use of the asset. The FASB member said that there was a fine line to distinguish, and it was difficult to deal with it.

Several FASB members expressed concerns about the distinction between alternatives A and B. One FASB member said that according to the staff, there would be a limited number of high dollar value leases that would lead to different accounting under alternatives A and B. He asked the staff to confirm this and also requested clarification as to what the unintended consequences under alternative A would be that the staff was eluding to. The Project Manager said that he was not sure as to whether the distinction should focus on high dollar value equipment, for example, a machine that was custom-designed and required specialised operation that would not be necessarily expensive. He said that what mattered was not the type of asset, but what could be determined that created a right of use of an asset for the customer. He said that in the framework analysed by the staff there would not be a huge number of differences. He reiterated that the differences would occur when there was specialised equipment involved that the customer was not able to operate on its own, and/or the customer was unable to sublease the equipment. He believed that the differences between A and B would be found in certain industries, but in general, there would not be differences. As regards unintended consequences, he said that he was not able to envision every possible interpretation of the standard; in addition, he said that practice would develop which would create other interpretations.

Another FASB member said that he understood that under alternative A the analysis was done from the customer’s perspective, because the customer obtained benefits independently from the supplier’s involvement, which in his opinion was the correct way of analysing it. Conversely, under alternative B it could be argued that even though an asset was not specified in the contract, but was highly specialised, then the asset was being taken out of circulation for the supplier to be used elsewhere, which would create an asset for the customer leading to there being a lease. He believed this to be the wrong (i.e. the supplier's) perspective to look at. He doubted that it would be the intention of the Board to characterise such arrangements as leases. The Project Manager said that this situation could be an unintended consequence; however, he believed that even when taking the asset out of circulation, it would still be necessary to analyse the notion of direct the use of an asset. The FASB member said that although lessees would try to keep leases out of the balance sheet, there could be unintended consequences from the enforcers where auditors and/or regulators might say that it was a lease.

Another FASB member said that the focus should be on whether the customer had control over the asset. He said that some stakeholders had suggested that in the presence of a service, a customer would be biased to characterise the entire contract as a service, which would not be the appropriate outcome. He said that some stakeholders were asking if there could be any contract that had an asset to deliver a service and the asset would be a service delivery device. They asked if the asset should be bifurcated. He said that in most instances when a customer contracts the output from an asset and even specifying the asset, the customer would be buying a service, because the supplier could choose how to perform the service. He asked whether there could be cases when a customer was buying the output of an asset and the asset was specified in the contract, because he believed that in most cases the supplier would choose the asset. He said that there could be very few cases where the asset was specified, and in those cases alternative A was the most appropriate path because it would require the analysis of whether the customer or the supplier can operate the asset. The Project Manager said that the concept of identifying an asset was not new; it would still be possible to have explicit or implicit identification of an asset. He referred to the agenda paper for the T-shirt factory exampleand said that if a customer was taking all the output of a factory, that consideration would not be enough to conclude that there was a lease; it would still be necessary to analyse whether or not the customer could direct the use of an asset. He also said that the contract described by the FASB member would fall out of the definition of a lease in either alternative A or B. The FASB member said for that reason he believed that alternative A was clearer, because if only the supplier could operate the asset, this would mean that the customer would not have control of the asset.

One FASB member said that he believed there was a very fine line and he agreed that it would have to be somewhere; however, he said that he would have preferred another alternative, which would be as follows: If the contract precluded a customer from using the asset, then it would a the service, even though the service could be commercially available somewhere else. He believed that it was a step too far requiring no ability to use the asset separately from the supplier. The Project Manager said that he agreed that the line had to be drawn somewhere; further, he said that the staff was proposing a line that could be objective, namely to assess whether the customer could direct what the asset could do.

The discussion then moved to the IASB. One IASB Board member asked about the unintended consequences described in alternative A. He specifically referred to paragraph 42(d) of the agenda paper and said that in the case presented, the consumables were needed to operate the asset and could only be obtained from the supplier. He asked what the impact would be if there was a restriction in the contract as to where the customer could buy the supplies. He asked if that situation would be a service contract. Further, he said that it would be easy to put such a restriction into a contract. The IASB's Technical Principal said that the intention was not to create a difference just for that aspect- She said that a customer would still have to consider the consumables as something separate and readily available. The FASB's Lead Project Manager pointed out that paragraph 47(a) of the agenda paper would answer that question: The notion of readily available would be similar to the revenue standard, in that a restriction would not be considered substantive if a customer could buy the consumable from somebody else. Accordingly, the restriction would not be substantive.

Another IASB member asked whether the scope of alternative A was whether there was a lease of an asset while the lessor provided labour service. The FASB's Lead Project Manager said that paragraph 50 of the agenda paper explained the differences between alternatives A and B. He said that the scenario considered by the staff would be when the supplier provided a specified asset that nobody else in the market could provide and the customer did not have the skill to operate the asset independently from the supplier, and also that the customer could not obtain benefits from sub-leasing the asset. In that regard, the FASB Chairman pointed out that the distinction would be whether nobody else had the ability to provide the asset, so it would be a very limited number of applicable situations. The IASB Chairman added that in that case it would not be necessary to complicate the standard. The IASB member then said that outsourcing of labour was a huge service. He asked whether the staff found any service that could not be found through outsourcing. The IASB Technical Principal said that it would depend how it would be interpreted in the market place. She confirmed that the staffhad not yet done any research, but she would not expect to find cases of services that could not be outsourced. The IASB member replied that if anything could be outsourced why alternative A was being considered. He also believed the term "readily available" to be highly problematic. Further, he said that it would not be appropriate to ignore something that was in the contract as suggested previously by the FASB's Lead Project Manager. The Project Manager reminded him that alternative A was considered but not recommended by the staff, and the term "readily available" as explained in paragraph 41 of the agenda paper was not meant to be an exact correlation of the revenue standard, but was still a term that users would understand.

Additional concerns were raised by other Board members. One IASB member asked whether the geographical location was important in the analysis. The FASB's Lead Project Manager said that it would need to be sourced in a reasonable period of time. He confessed that he did not know exactly how it would be interpreted, but he believed that the staff had created some boundaries in their analysis. The IASB member responded that this was then a very fine line. He believed that the point already raised by a fellow Board member about identifying the asset and control were more objective irrespective of the customer's location, as otherwise there could be identical assets that would lead to different classifications, depending on the customer’s location and access to other suppliers. He said that for this reason he was supporting alternative B. The FASB's Lead Project Manager said that it had not been their intention to have differences depending on location; however, he acknowledged that it could be interpreted in that way. One FASB member asked whether, if a customer would buy 100% production of a plant, that would be considered a lease. He believed that under alternative B, there would be a lease. The IASB member pointed out that still would be necessary to control the use of the asset. The IASB's Technical Principal pointed out that this was the proposed change made in the ED in respect to IFRIC 4, as today that contract could be a lease; with the proposed amendments though, a customer must also direct the use of the asset, in addition to obtaining the benefits. The FASB member asked the staff to indicate where the wording was in the agenda paper that would lead to that conclusion, to which the FASB's Lead Project Manager said it was in paragraph 28 of the agenda paper.

Another IASB member said he did not find any benefits in pursuing alternative A, and did not support adding additional guidance proposed under this alternative. He said that the main objective was to account for rights to use an asset; if there were other conditions, there could be remote scenarios which would be contrary to the main objective.

In relation to the term "readily available", a fellow IASB member said that users provided narrow descriptions that were not consistent with paragraphs 42 and 43. He described a situation in which an entity would supply a specialised asset with new technology and train people that only the supplier could operate. In one situation, the supplier would issue one invoice per month; in another alternative, the supplier would issue one invoice for the asset and another invoice for the services provided. He asked whether there would be a different interpretation for each case The FASB's Lead Project Manager said that it would still be one contract, and the entity would have to apply the contract combination guidance. The IASB member then said that in another example, the entity’s business model was to lease specialised assets. If a customer wanted to buy the asset, the entity would sell it and supply the service. Given that scenario, he asked whether the entity would have to reconsider the initial lease classification, as now the supplier would provide the services separately. The FASB’s Lead Project Manager said they had not considered this situation in the paper. The IASB member said that whether the service was provided separately or not by the supplier should not affect the accounting of the customer.

Another IASB member had a question on the T-shirt example in the paper, focusing on the capability of the customer to operate the asset: If a customer rented a car and the insurance said that the customer was the only person allowed to drive the car, but the customer did not know how to drive the car, she believed that the customer had still leased a car. She said that the correct focus should be the right to direct the use and obtain the benefits from it, rather than focusing on the ability of the customer to operate the asset; for that reason, she would prefer alternative B.

Another IASB member said that adding additional guidance would not help distinguishing between services and leases. He raised an example in which an entity contracts medical equipment that could be operated only by the supplier for a five year term. He said that even if the entity did not use the equipment during the period (i.e. did not obtain the economic benefits), the contract would be a lease. He asked whether under alternative A that would be a service. The IASB's Technical Principal said that there should not be a difference between alternatives A or B. The contract was for the right to use an asset, so it would be a lease under alternatives A or B regardless of the actual use. In the example, the customer took all the risks related of the asset. The differences between alternatives A and B would not be related to the amount of use. The IASB member expressed concerns that this would create structuring opportunities.

Another IASB member said that, based on responses from the staff, it seemed to him that the rare circumstances, as discussed in paragraph 42 of the agenda paper, are probably not as rare as the staff thought that many items would come off, such as airplanes, heavy equipment, IT etc. He asked what kind of structuring opportunities alternative A could lead to. The IASB's Technical Principal said that it would not be possible to completely avoid them, and staff would not be able to write standards to totally ring-fence.

The FASB Chairman  asked whether the distinction between alternatives A or B should be about the legal or regulatory requirement that only the supplier could provide the services. That being said, he was not sure whether this situation existed though.

The IASB Chairman said that he had mixed feelings, as the discussion had demonstrated that the issue could be very complicated. He expressed sympathy for the proposal but still he had concerns, particularly about the term "readily available". He said that currently, everything was available. He also said that there were a limited number of cases in which alternative A would be applicable. He felt that items that were currently capital leases, such as capital-intensive assets in the oil and gas industry, could be scoped out under alternative A. He said that in order to scope out a contract, the service component would have to be the most significant part of the contract.

The FASB and IASB Chairmen concluded that their Boards agreed with the answer to question 1) as regards the definition of a lease, in particular the meaning of additional guidance to conclude whether a customer could direct the use of an asset. However, they concluded that the staff should keep working on question 2) to address the concerns raised by the Boards. The Boards would discuss the topic again at a future joint meeting.

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