FASB and IASB Reconsider Approaches to Key Topics in ED on Leases
At their meeting on February 16 and 17, the FASB and IASB (the “boards”) reached a number of tentative decisions related to the leases project. All such decisions are subject to change before any standard becomes final.
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Editor’s Note: The boards’ staffs emphasized that the tentative decisions will be subject to field testing and extensive outreach with constituents over the next several months. The staffs indicated they will attempt to bring many of the decisions back to the boards in April for final decisions. |
Since the comment letter period ended, the boards have focused primarily on four topics: (1) lease term — accounting for renewal options, (2) contingent rentals, (3) definition of a lease — distinguishing a service contract from a lease contract, and (4) lease profit and loss recognition pattern.
Lease Term — Accounting for Renewal Options
The boards’ exposure draft (ED) on leases proposed that the lease term be measured as the longest possible term that is more likely than not to occur, including options to renew. Comment letters noted almost unanimous opposition to this measurement method. The boards agreed with many of the concerns raised in the comment letters and have tentatively decided on the use of a higher threshold to define the lease term. The proposed language would require inclusion of renewal options in the lease term if there is a significant economic incentive for an entity to exercise an option to extend the lease. The criteria entities would use to determine significant economic incentive are generally similar to current guidance on identifying when renewal periods should be included (e.g., bargain renewal options, penalties such as loss of leasehold improvements). The boards also tentatively decided to require reassessment of the lease term when the relevant factors change so significantly that a lessee would have, or no longer have, a significant economic incentive to renew.
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Editor’s Note: The boards’ tentative decision replaces the ED’s much maligned “FIN 48–like” approach to assessing the lease term. However, the boards’ ongoing discussions on this matter should be followed closely because several members stated that they did not intend that the revised definition represent the same “reasonably assured” threshold that exists in current GAAP. In other words, some board members felt the tentative decision represents a lower threshold than that under current GAAP. In addition, while the boards’ higher threshold (relative to the ED) for including renewal options might provide some relief, the requirement to reassess the lease term will continue to represent a challenge for many companies. Although a higher threshold reduces some of the burden of reassessment, it still puts the onus on preparers to either perform a continual reassessment or establish a robust list of “renewal indicators.” |
Contingent Rentals
The ED proposed that entities measure lease payments by using an expected outcome approach. Most comment letters received by the boards opposed this measurement approach, in particular the requirement to include contingent payments in the measurement. Almost all board members agreed that variable payments should be recognized for those based on an index and payments when the variability lacks commercial substance (e.g., the lease contains disguised minimum lease payments). The boards also tentatively decided that variable lease payments that meet a high recognition threshold — such as “probable” or “reasonably certain” — should be measured and included in the initial measurement. How the variable payments will be measured will be discussed at a future meeting. In addition, the boards tentatively agreed that entities should use the spot rate to measure variable payments related to an index rather than a forward rate.
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Editor’s Note: One board member observed that the revised proposals related to contingent rentals might be considered “dead on arrival” by the boards’ constituents because they could still require highly subjective estimates to be made for certain arrangements (e.g., leases in which rentals fluctuate on the basis of sales). Lessees and lessors with significant contingent rent features should monitor these ongoing discussions because their outcome will determine whether the revised proposals represent a significantly less complex approach than that discussed in the ED. |
Definition of a Lease — Distinguishing a Service Contract From a Lease Contract
In trying to define what a lease is, the boards have focused their discussions on two main concepts under the ED and in current guidance: (1) a specified asset and (2) the right to control the use of a specified asset. The boards have also discussed providing an exception for assets that are incidental to the delivery of a service, and they have debated whether a portion of a larger asset could be the subject of a lease.
Specified Asset
The boards’ debate has centered on whether a specified asset means a uniquely identified asset (e.g., a specific serial number) or an asset of a particular specification (e.g., a pool of similar vehicles) and whether a lessor’s right to substitute assets would affect this analysis. The boards tentatively decided on the broader view — that is, an asset of a particular specification. However, both views will be discussed as part of the staffs’ additional outreach and field testing.
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Editor’s Note: We believe that if the boards proceed with the broader definition of a specified asset, this will significantly increase the number of arrangements subject to lease accounting. This revised definition would result in the need for lessees and lessors to apply lease accounting to a group of assets rather than to a specified asset, which represents a significant change from current GAAP. Some board members observed that this could potentially require the use of a “portfolio approach” to lease accounting. |
Right to Control the Use of a Specified Asset
The boards received numerous comments that the conditions entities would use to determine whether an arrangement conveys the right to control the use of an asset — which were for the most part carried forward from EITF Issue 01-81 and IFRIC 42 — were difficult to apply and resulted in diversity in practice. Much of the criticism was directed toward the condition in paragraph B4(c) of the ED, under which an arrangement would be accounted for as a lease when a purchaser obtained all but an insignificant amount of the output of an asset.
The boards deliberated two options to address these concerns. Option 1 would preserve the existing guidance but revised wording would be used in an attempt to clarify the principle of paragraph B4(c). Option 1 would replace the concept of “output” that is used in current guidance with “potential cash flows from use of the asset” and would also remove the exceptions related to the pricing of the output. Under Option 2, the concept of control would be consistent with that in the revenue recognition project, which incorporates a “power” element (the ability to direct the use of the asset) along with the “benefit” element (the ability to receive the benefits from use of an asset).
The boards tentatively voted for Option 2. However, both views will be discussed as part of the staffs’ additional outreach and field testing.
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Editor’s Note: The boards’ final decisions on this topic could significantly change the number of arrangements accounted for as a lease. While Option 1 would potentially reduce the number of take-or-pay and supply contracts subject to lease accounting by replacing “output” with the (seemingly) broader notion of “potential cash flows from use of the asset,” it would also eliminate the exceptions from lease accounting for arrangements in which a purchaser pays a fixed or market price per unit of output. Entities that have relied on these exceptions historically should closely monitor the boards’ ongoing deliberations on this topic. We believe Option 2 could significantly reduce the number of take-or-pay and supply contracts subject to lease accounting because it would essentially remove the notion that an arrangement contains a lease simply because the supplier obtains all but an insignificant amount of the output of an asset. |
Other Topics
The boards expressed support for an exception from the scope of lease accounting for arrangements in which an asset is incidental to the delivery of services. The boards also indicated they will continue to seek input on whether a portion of a larger asset can be a specified asset (and thus, subject to lease accounting). The boards decided to perform outreach on two approaches: (1) clarifying that both physical and nonphysical portions of a larger asset can be specified assets (an example of a nonphysical asset discussed by the boards was 50 percent of the data capability of a fiber-optic cable) or (2) clarifying only that physically distinct portions of a larger asset could be considered a specified asset. The staff noted that the first approach would also require a revised definition of the right to control the use of an asset (otherwise, it would significantly expand the scope of transactions subject to lease accounting).
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Editor’s Note: The scope exception for assets incidental to the delivery of services was discussed in the context of both (1) a cable service provider that also provides a cable box to a customer and (2) professional seat licenses. These two examples were cited as arrangements that several board members thought should be outside the scope of the lease accounting guidance. |
Lease Profit and Loss Recognition Pattern
A concern raised in both the comment letters and roundtables was the front-end loaded profit and loss impact of the ED’s proposals. The boards have been sympathetic to this argument and have explored the concept that there may be different types of leases. The boards reconfirmed that all leases should be on the balance sheet; however, they decided that there could be different types of leases and will pursue an alternative expense/income recognition pattern (such as straight-line expense recognition) for leases designated as “other than financing” (i.e., operating leases). The boards discussed indicators (e.g., length of lease term, residual asset risk) that would help entities distinguish between a financing lease and an “other than financing” lease; however, no firm decisions were made. The boards directed the staffs to develop additional indicators and to perform focused outreach to receive feedback on them.
[1] EITF Issue No. 01-8, “Determining Whether an Arrangement Contains a Lease.”
[2] IFRIC 4, Determining Whether an Arrangement Contains a Lease.
