Leases

As part of its continual deliberations surrounding the Exposure Draft Leases, the Boards considered the following topics:

• Distinguishing between a lease and a purchase or sale
• Accounting for purchase options

Summary

The Boards made a number of tentative decisions in the conduct of these deliberations; however, such tentative decisions were made in the context of further necessary outreach in the following areas:

• The definition of a lease, as distinguished from the definition of an instalment sale;
• Whether the reassessment for a bargain purchase option should be the same as the reassessment for renewal options, focussed most notably on the linkage of value of the underlying asset.
  • In this assessment, consideration is placed on whether, in a bargain purchase option, we have a significant incentive to extend and the impact of developments in the underlying asset value subsequent to entering into the lease
  • We note that the IASB preliminarily decided that no expected difference in the reassessment indicators would be expected between a bargain purchase option / significant economic incentive option and a renewal option, while the FASB preliminarily decided that a potential difference may be present between a bargain purchase option / significant economic incentive option and a renewal option based on the determination as to whether the option should be assessed on day 1 of the lease or reassessed throughout the lease term;

  Distinguishing between a lease and a purchase or sale

  The purpose of this discussion was to determine whether the leases standard should provide guidance for distinguishing a lease from a purchase or sale.

  As a result of the assessment performed by the staff, the staff recommended that guidance should not be provided in the leases standard for distinguishing a lease of an underlying asset from a purchase or sale of an underlying asset.

  As outlined within the Exposure Draft,

  An entity should not apply [the leases proposals] to the following contracts, which represent a purchase or sale of an underlying asset:

  1. a contract that results in an entity transferring control of the underlying asset and all but a trivial amount of the risks and benefits associated with the underlying asset to another entity; and
  2. a lease after the lessee has exercised a purchase option specified in the lease. A contract ceases to be a lease when such an option is exercised and becomes a purchase (by the lessee) or sale (by the lessor).

  The application guidance in the Exposure Draft further states that:

  • That determination is made at inception and is not subsequently reassessed.
  • An entity should consider all relevant facts and circumstances when determining whether control of the underlying asset is transferred at the end of the contract.
  • A contract normally transfers control of an underlying asset when the contract automatically transfers title to the underlying asset to the transferee at the end of the contract term.
  • A contract normally transfers control of an underlying asset when the contract includes a bargain purchase option. A bargain purchase option is an option to purchase the asset at a price that is expected to be significantly lower than the fair value of the asset at the date that the option becomes exercisable. If the exercise price is significantly lower than fair value, it would be reasonably certain at the inception of the lease that such options will be exercised. An entity that has a bargain purchase option is in an economically similar position to an entity that will automatically obtain title to the underlying asset at the end of the lease term. By exercising its bargain purchase option, the transferee would be able to direct the use of, and receive the benefits from, the whole of the underlying asset for the whole of its life.

  Using the above guidelines, and considering feedback received from outreach activities and related internal discussions amongst the staff, the staff noted a view that if the Boards appropriately define a lease in the leases project, then the proposed guidance on this issue would be unnecessary. In such a definition, it would be necessary to provide a clear principle for the definition of a lease, and clear guidance on when to apply the revenue recognition requirements in the revenue recognition project for lessors.

  The staff also noted that in the Exposure Draft, the Boards excluded from the scope of the leases standard transactions that include either automatic title transfer or a bargain purchase option. Likewise, the staff noted that the Boards introduced the Exposure Draft guidance to determine which leases are in-substance purchases or sales when the Boards were considering only a performance obligation approach to lessor accounting. Under the performance obligation model, an underlying asset is not derecognised and income is recognised over time, leading to an accounting approach that could be different from sale accounting. However, subsequently, the Boards discussed and proposed two accounting approaches for lessors in the Exposure Draft. To the extent that a derecognition model is retained, the boundary between leases and purchases or sales becomes less relevant. This is because, under the derecognition approach to lessor accounting, the accounting would be similar to the accounting for a sale of an asset (e.g. an underlying asset is derecognised and income may be recognised at the commencement of the lease).

  At the 17 February 2011 meeting, the Boards discussed two types of leases for both lessees and lessors and a principle for identifying two types of leases. One indicator the Boards are considering for distinguishing between the two types of leases is potential ownership transfer, the same criteria to distinguish a lease from a purchase or sale in the Exposure Draft. Therefore, if the Boards ultimately decide to introduce two approaches to lessee accounting, the accounting by a lessee for finance type leases would be similar to purchase accounting. Therefore, the staff think that there is no fundamental difference in the accounting for an arrangement accounted for as a purchase or as a finance lease for a lessee.

  Consequently, the staff think that criteria to distinguish between a lease and a purchase or sale are not necessary, as a result of the following:

  • the final Leases standard would appropriately define a lease;
  • the final Revenue Recognition standard would appropriately provide guidance on when to recognise revenue;
  • the accounting for a purchase of an underlying asset would be similar to the accounting by a lessee under the accounting for a finance lease (if there are two types of leases for lessees) when applying the final Leases standard; and
  • the accounting for a sale of an underlying asset would be similar to the accounting by a lessor under the accounting for a finance lease (if there are two types of leases for lessors) when applying the final Leases standard.

  In consideration of the staff's recommendation, the Boards collectively recognised the importance of defining a lease from that of a instalment purchase (sale), as multiple members of both Boards expressed concern with:

  • The current definition of leases in the context of accounting for term options, purchase options or other variables in contracts, whereby it is not considered particularly clear whether such variables would ultimate fall within the scope of leases or revenue recognition. Further, if included in the scope of the definition, multiple members of the Boards questioned the significance assessment which should be used in evaluating term options, whereby only significant economic incentives should be included in the relevant assessment. Likewise, members of the Boards questioned whether continual reassessment of significant economic incentives would be required, and to this extent, whether general market movements would result in changed conclusions on whether an incentive is economically significant on a quarterly basis.
  • Whether the definition of a lease should be considered as a point-in-time assessment, as opposed to a forward-looking assessment, whereby leasehold improvements, for example, performed during the lease term would require a reassessment of the accounting for a lease. The staff noted an intention that only material changes would result in a reassessment.
  • While the revenue recognition model currently present provides for a residual definition, whereby items external to the lease accounting would be expected to fall into the scope of the revenue recognition guidance, concern was expressed around 'failed sales' or other environments which may result in an underlying transaction being accounted for external to both the lease and revenue recognition models.

  Noting the above, there was a general concern that the current lease definition did not appropriately consider the right to use aspect of a contract, in conjunction with the control of the underlying component to a contract.

  While considering the above, and in conjunction with further discussions regarding the accounting for purchase options, below, the Boards tentatively confirmed the staff's recommendation that the guidance to distinguish between a lease and a purchase should not be carried forward into the final standard. A lease contract should be accounted for in accordance with the leases standard and contracts that represent a purchase or sale of an underlying asset should be accounted for in accordance with other applicable standards (e.g. revenue recognition by lessors, property, plant and equipment by lessees). The Boards recommended that further consideration be placed on the definition of a lease, however, while outreach activities should include the related definition of a lease. Further, outreach should be conducted around evaluation of the lease assessment as a point-in-time assessment, as opposed to a forward-looking assessment.

  Accounting for purchase options

  The purpose of this discussion, in the context of the above discussion regarding distinguishing between a lease and a purchase or sale, was to deliberate on the accounting by lessees and lessors for purchase options included in a lease contract. In this context, the deliberation considered including both options that the lessee has a significant economic incentive to exercise (which would usually include bargain purchase options) and options that the lessee does not have a significant economic incentive to exercise (which would usually include non-bargain purchase options).

  Ultimately, the staff expressed mixed views as to whether a purchase option should be accounted for as an ultimate renewal option, or whether a purchase option should only be accounted for upon exercise, with the following distinct views present:

  • A majority of staff members think that purchase options are the ultimate renewal option. These staff members note the economic similarities between an option to purchase an underlying asset and an option to extend the lease of an underlying asset. The exercise price of the option should be included in the lessee's liability to make lease payments and the lessor's right to receive lease payments when there is a significant economic incentive to exercise a purchase option ("Approach A" for application purposes herein).
  • Other staff members think that purchase options should be accounted for as a termination of the lease contract and the purchase of the underlying asset. The result of this view is that all purchase options would be accounted for only upon exercise, consistent with the proposals in the Exposure Draft. Therefore, lease payments would exclude the exercise price of all purchase options. These staff members highlighted that an option to purchase the underlying asset is a termination of the lease agreement, and results in the purchase/sale of the underlying asset when the option is exercised ("Approach B" for application purposes herein).

  In discussing the above approaches, support for Approach A was seen in the following context:

  • Provides for the accounting of a purchase option consistent with the accounting for options to extend a lease.
  • Acknowledges that the pricing of a purchase option is interrelated with the pricing of other terms in the lease contract; a lease with a bargain purchase option would require larger periodic payments during the lease term. In other words, the pricing of the lease is such that a portion of the periodic lease payments (excluding the exercise price of a purchase option) relate to prepaying for the ownership of the asset.
  • The pattern of the lessee's expense would reflect the lessee's expectation that the asset will be purchased and used through the end of its economic life.
  • It is consistent with the Boards' decision on lease term option penalties.
  • It is consistent with the Boards' tentative decision that lease payments should include amounts expected to be payable under residual value guarantees.

  Discussion amongst members of the Boards highlighted the following primary disadvantages to such application, however, as follows:

  • Approach A includes an amount that is not part of the ongoing lease payments in the lessee's right-of-use asset and liability for lease payments.
  • The purchase price, which is included in the measurement of the lessee's right-of-use asset, would be amortised over the life of the underlying asset. If the purchase option is eventually not exercised, the amortisation of the asset may not reflect the economics of the usage of the right-of-use asset.

  Multiple members of the Boards also discussed examples where the lessor applies the performance obligation approach to a lease with a bargain purchase option (for instance, when the option is not a bargain at inception but becomes a bargain subsequently). This could potentially lead to the following disadvantages of Approach A for lessors applying a performance obligation approach:

  • It may be inappropriate for a lessor to determine whether the lessee is likely to exercise an option to purchase the underlying asset until the purchase option is exercised. That is, the lessor may not have information to determine that a lessee will exercise a purchase option.
  • It is unclear if a lessor applying the performance obligation approach would recognise revenue over the economic life of the asset or the term over which lease payments are made.
  • The underlying asset (and its residual value asset) would not be recognised by the lessor if, at the beginning of the lease, it was determined that it there is a significant economic incentive for a purchase option to be exercised. This could lead to the possibility of changes in presentation between periods as dependent upon the definition of significant economic incentive and related market influences on a period-by-period basis.

  In discussing the above approaches, support for Approach B was seen in the following context:

  • It does not include the exercise price of a purchase option that can be avoided. Therefore, Approach B avoids grossing up the lessee's right-of-use asset and liability for the exercise price of a purchase option that may, or may not, be exercised.
  • It avoids the need to "unwind" the accounting if it is later determined that the purchase option is not exercised.

  Discussion amongst members of the Boards highlighted the following primary disadvantages to Approach B:

  • It excludes the exercise price of a purchase option that the lessee may intend to exercise in the lessee's assets and liabilities. Therefore, Approach B potentially understates the expected cash flows of the lease.
  • Under Approach B, a lessee's amortisation expense is front-loaded because it does not reflect that the asset will be purchased and used for the remainder of its economic life.

  In deliberation of the above Approaches, the majority of the Boards tentatively confirmed application of Approach A, which applies a consistent modelling to that of renewal options. In reaching such a tentative conclusion, the Boards recommended outreach activities by the staff in the following areas:

  • The definition of a lease, as distinguished from the definition of an instalment sale;
  • Whether the reassessment for a bargain purchase option should be the same as the reassessment for renewal options, focussed most notably on the linkage of value of the underlying asset.
    • In this assessment, consideration is placed on whether, in a bargain purchase option, we have a significant incentive to extend and the impact of developments in the underlying asset value subsequent to entering into the lease.
    • We note that the IASB preliminarily decided that no expected difference in the reassessment indicators would be expected between a bargain purchase option / significant economic incentive option and a renewal option, while the FASB preliminarily decided that a potential difference may be present between a bargain purchase option / significant economic incentive option and a renewal option based on the determination as to whether the option should be assessed on day 1 of the lease or reassessed throughout the lease term;