FASB and IASB Board Members and Leases Working Group Members. Summary Report of the February 15, Leases Working Group Meeting

Transcription

1 SUMMARY International Accounting Standards Board To: FASB and IASB Board Members and Leases Working Group Members Date: April 6, 2007 From: Leases Team Hoyt (ext. 298) Subject: Summary Report of the February 15, 2007 Leases Working Group Meeting cc: Leisenring, Bielstein, L. Smith, MacDonald, Project Team, Lott, Carney, Allen, Gabriele, Sutay, FASB Intranet; FASAC: Chookaszian, Polley; IASB: Upton, Hickey, Knubley, Peerless Topic: Leases Working Group Meeting Basis for Discussion: Agenda Papers 1, 5-11 Length of Discussion: 10:00 a.m. to 5:30 p.m. (GMT) Attendance: Board members present: Staff in charge of topic: Other staff present: FASB: Linsmeier and Seidman IASB: Cope, Engström, Danjou, McGregor, O Malley, Smith, and Yamada FASB: Zeyher and Roberge IASB: Knubley, Peerless FASB: Bielstein, Hoyt (by phone), and Sledge (by phone) 1 of 15

2 SUMMARY Observers: Wietse Koster, International Organisation of Securities Commissions (IOSCO) Janet Luallen, International Organisation of Securities Commissions (IOSCO) Dominique Thouvenin, European Financial Reporting Action Group (EFRAG) Working Group Members: Ann Bordelon, Wal-Mart Bill Bosco, Leasing 101 David Maxwell, Classic Technology David Trainer, New Constructs (by phone) George Yungmann, NAREIT Ho Soh Khim, Singapore Aircraft Leasing Enterprise Iain Robertson, Canadian Pacific Railway Jan Buisman, PricewaterhouseCoopers Jed Wrigley, Fidelity (by phone, a.m.) John Bober, GE Kevin Davies, Anglogold Ashanti Mark Venus, BNP Paribas Lease Group Neri Bukspan, Standard and Poor s (by phone) Peter Kilgour, Swire Properties Limited Rich Jones, Ernst & Young (by phone) Richard Richards, Qantas (by phone) Thomas Gruber, Daimler Chrysler Financial Services AG Thomas Schröer, Leaseurope 2 of 15

3 Summary Report of the Leases Working Group Meeting 15 February 2007 London Purpose of Report 1. The purpose of this report is to summarize the views and discussions held during the working group meeting. This report does not attribute any of the views expressed to individuals nor does it attempt to assess the extent of support for each view. An audio of the full day s discussion is available on the IASB s website. The Need for Change 2. The working group was presented with a summary explaining why a fundamental revision of all aspects of lease accounting is needed. The need for change arises because: a. Rights and obligations that meet the definitions of assets and liabilities under the frameworks of both the IASB and the FASB may not be recognized in an entity s balance sheet under current guidance. b. Users of financial statements routinely make estimated adjustments to reported amounts in financial statements to take account of operating leases. c. The difficulty in defining the operating/finance lease split leads to economically similar transactions being accounted for differently. d. The difference in accounting between finance leases and operating leases leads to structuring of leases to achieve a predetermined accounting result. e. The magnitude of the complexity and volume of existing standards and interpretations (particularly in the United States). f. It provides an opportunity for convergence. 3 of 15

4 Working Group s Response to The Need for Change 3. Overall, working group members agreed that there is a need for change. However, working group members raised concerns about the following areas: a. The scope of the project (including whether one model will fit all leases) b. Accounting for non-core assets c. The complexity of lease transactions (including tax implications) d. The practicality of a fundamental revision e. Accounting for small and medium-sized enterprises (SMEs) f. The cost or benefit of any proposed changes. 4. In addition, many members stressed the need for a standard that is clear and easy to implement. Purpose of Meeting and the Role of the Working Group 5. It was explained that the working group s role is to provide expert advice on proposals, implementation issues, and practical considerations from different perspectives (lessors, lessees, users, auditors, and regulators). The working group will not be asked to reach a consensus view, make group recommendations, vote on any proposals, or discuss all issues. 6. The purpose of this meeting was to obtain the working group s views on the staff s conceptual analysis of a lease contract and to identify practical issues that arise from the models presented. At this stage in the project, measurement and scope are not being considered. The conclusions presented in the following papers are preliminary. 4 of 15

5 Agenda Paper 5 Identification of Assets and Liabilities Arising in a Simple Lease 7. The questions asked in this paper and the responses received are summarized below. Has the staff correctly identified the promises exchanged and the rights and obligations arising in this simple lease contract? 8. Overall, working group members agreed with the rights and obligations identified in the paper but had questions about when obligations arise (at signature or delivery), differences between a right of use and the economic benefits derivable from use, and how legal and tax treatments factor into the example provided in the paper. 9. One working group member, however, disagreed with the lessee s obligations as stated. That member believes the obligation of the lessee should be for the full cost of the item being leased. Does the lessee s right to use the leased item meet the definition of an asset? 10. One working group member asked how long a right of use needs to exist before one can call it an asset. For example, if a lease contract provides for the use of an item for one day, does that meet the definition of an asset and should it be recognized on the balance sheet? The staff indicated that this would be considered as part of the scope of the project. 11. Others raised concerns about whether right of use might be better explained as the economic benefit derivable from the use of the asset. That is, it is the outcome from the use of the item that offers economic benefit as opposed to the item itself. 5 of 15

6 Does the lessee s obligation to make payments under the lease represent a liability? 12. Based on all comments, all working group members agreed. However, questions were raised as to whether a lease contract should be looked at as a whole or in part based on the individual promises exchanged. Another member asked whether delivery means making the asset available the date it is delivered to the lessee or making it available throughout the duration of the contract, raising the concept of executory contracts. Does the working group agree that the lessee s obligation to return the leased item does not meet the definition of a liability? 13. One working group member disagreed. That member regards the lessee s obligation to return the asset as similar to the obligation to repay the principal on a loan made by the lessor to the lessee. 14. The inconsistency between the significance of delivery at the beginning of the lease contract and delivery at the end of the lease contract was noted; that is, assets for the right to use begin after the item has been delivered, but the obligation to deliver the item back to the lessor at the end of the lease term does not appear to meet the definition of a liability. Does the working group agree that the lessor s obligation to permit the use of the machinery by the lessee does not meet the definition of a liability? 15. A member asked whether, based on the working definitions, the reduction in cash flows available from the machinery would meet the definition of a liability. A member of the IASB noted that it might need to be clarified that a liability (in terms of the working definition) is a reduction in cash flows that is not the result of an increase in another asset. 6 of 15

7 Agenda Paper 6 Analysis of Different Accounting Models for a Simple Lease 16. The questions asked in this paper and the responses received are summarized below. Suggestions for any other accounting models that the staff should consider? 17. Certain working group members suggested that the staff consider combining models to find a solution. The model selected would depend upon the type of lease transaction. Another noted that once one starts dividing up the rights and obligations in a lease contract as opposed to looking at the lease contract in totality, it becomes very difficult to differentiate between an executory contract, a service contract, and a lease. What practical/operational issues might be encountered with the right-of-use model? And what effect might the adoption of this model have on the structuring of leases? 18. Several members suggested that lease terms may be shortened and complex options introduced in an attempt to minimize the lessee s recognized assets and liabilities. However, a number of members noted that shorter lease terms would have an effect on the pricing of a lease. The consensus among members was that lessors are going to protect themselves from risk either by either turning to original equipment manufacturers (guarantees from the OEM to the lessor) or by passing on costs to the lessee through penalties, breakage charges, or higher lease payments. Lessors would not accept a lease term that exposed them to risk that they could not pass on to the lessee or to a third party in some way. 19. One member stated that contracts may start to include a requirement for continuous delivery, availability, or functionality of the equipment in an attempt to demonstrate that the contracts are executory contracts rather than contracts that convey a right of use. 7 of 15

8 Do you agree with the staff s conclusion that the whole asset approach fails to faithfully represent the contractual positions of the lessor and lessee? 20. One member supported the whole asset model under circumstances in which the leased item may not be able to be returned. In those cases, there always is an obligation to make the lessor whole in some way, whether by returning the asset or paying cash. Another member supports the whole asset approach for all lease of core, non real-estate assets regardless of whether they can be returned. Do you agree with the staff s conclusion that the executory contract model fails to represent the contractual position of the lessee and lessor? 21. Some members believed that executory contract treatment is appropriate for shortterm or immaterial leases. Are members arguing that the accounting treatment for some of these less material items should be under an executory contract model? Or are members arguing that until delivery of the leased item, these transactions are, in fact, executory? 22. One member noted that in certain lease agreements, the lessee pays the lessor up front; therefore, the right to use the asset is conditional on payment and represents an executory contract. Another member suggested that delivery is a necessary requirement, but not a sufficient requirement; therefore, a combination approach may be most meaningful. 8 of 15

9 Do you agree with the staff that the model adopted in current standards fails to represent the true economics of lease transactions? 23. No members commented (see comments presented in paragraphs 3 and 4, above, when the need for change to the existing standards was discussed). Agenda Paper 7 Characteristics and Terms of Common Lease Contracts 24. Working group members were asked if the summaries presented in this paper captured the general terms of the lease examples presented and if anyone would like to provide additional examples of lease transactions that the staff should consider. 25. Working group members suggested including the following examples: a. Intangible asset leases b. Investment property leases c. Leases in which the lessor has the right to change the assets during the contract d. Power purchase arrangements with respect to utilities e. Leases in which the lessor has the option of putting assets to the lessee f. Full-service leases g. Sale and leaseback transactions. 26. One member listed a number of common terms of lease contracts, some that were not documented in the examples of AP7. Also, an example of a sale-leaseback was mentioned. 27. One member suggested that the interplay between any new accounting for leases and existing standards, (for example, IAS 40 Investment Property), should be considered. 9 of 15

10 28. It was mentioned that the above examples will be considered as the staff further analyzes the right-to-use model to see how the terms fit into the model, how measurement comes into play, and so forth. In addition, these examples will be used as a basis for applying the model in the Preliminary Views. Agenda Paper 8 Initial Recognition of Assets and Liabilities in Lease Contracts 29. The questions asked in this paper and the responses received are summarized below. When should assets and liabilities be initially recognized in the financial statements? Upon (a) the signing of the contract, (b) the delivery of the property, or (c) some other event? 30. Comments from members were mixed. Some members stated that the only practical time to recognize is upon the signing of the contract. Others mentioned that it is more prevalent to recognize upon delivery, as with aircraft leasing. Some suggested measurement at signing and then recognition upon delivery. One member mentioned the danger of getting too prescriptive; that is, if the framework is right, the timing of recognition should fall out of that. 31. There were comments that there could be events occurring with significant implications between signature date and delivery date, or that delivery could take place prior to the beginning of the lease term. Finally, another member commented that the timing of recognition may result from the specific facts and circumstances of the lease contract. Is there experience with assets that take a long time to construct or that may be constructed specifically for the lessee? What issues arise from those arrangements? 10 of 15

11 32. Members mentioned build-to-suit contracts that could take a year or even longer for the asset to be constructed and discussed when lessee commitments under leases of this type should be recognized as liabilities. Agenda Paper 9 Identification of Assets and Liabilities Arising in a Lease with a Lessee Option to Renew 33. The questions asked in this paper and the responses received are summarized below. Has the staff correctly identified the promises exchanged and the rights and obligations arising in this lease contract? 34. One member presented an example in which an asset with a 20-year useful life is leased. The lessee pays 40 percent of the value of the asset the first year, 30 percent the second year, and so forth ending with 100 percent at the end of the lease. The lease contract contains an option to renew or to terminate at the end of the first year. The member believed that by paying a sizeable portion of the lease payments in the first year, economic compulsion exists and that in all probability, the lessee will renew the lease at the end of year 1 and probably on an ongoing basis. 35. The purpose of the above example was to illustrate that under the right-to-use model, only a certain percentage of a right-to-use asset, along with a potential asset for the option to renew, would be recognized at the end of year 1. If expected renewals are not taken into account, the assets and liabilities recognized may well be less than those recognized under current guidance. 36. One member disagreed with the analysis that there is a conditional obligation of the lessee to either return the equipment at the end of the primary period or at the end of the secondary period. That member believes that the lessee has an 11 of 15

12 unconditional obligation to return the equipment at a certain point in time. The issue is when that point in time is, as it is unknown whether the lessee will renew the lease. Do you believe that an option to renew at market terms is worth anything to the lessee or even an option at all? 37. One member commented that market terms can be situational in many instances. Another commented that there may be value to the option merely because the lessee has security of supply. Another questioned whether an option would meet the definition of a probable future economic benefit for reasons of probability of outcome and whether the option provides an economic resource throughout the period it is available to the lessee. Do you agree that the lessee s right to call for the use of the machinery in the secondary period meets the definition of an asset? 38. A number of working group members stated that the lessee s right to call for the use of the machinery is an asset. The practical challenge that was underscored numerous times by members is how to measure these options. Valuation of options of this type is dependent on more than just financial considerations. Lessee behavior (for example) will affect the measurement of the options. Do you agree that the lessor s unconditional obligation to stand-ready to grant a right of use to the lessee in the secondary period meets the definition of a liability? And what practical issues need to be considered if this liability is to be recognised? 39. Several members did not agree that this was a liability of the lessor, stating that this was merely a reduction in the residual value of the leased item (a credit). Several reiterated that the lessor is going to price these leases to mitigate its own risk whether or not the lessee decides to renew. Determining whether the lessor 12 of 15

13 has a liability or an asset becomes situational. Another member pointed out that, at least with equipment leases, chances are that lessors are not pricing in the alternative uses of the equipment because they do not intend to get the equipment back. Agenda Paper 10 Analysis of Different Accounting Models for a Lease with a Lessee Option to Renew 40. The questions asked in this paper and the responses received are summarized below. Any comments on the different approaches for treating options embedded in lease contracts and any preferences for one approach over another? 41. Some members mentioned a control approach that involves valuing the right to use over the period the lessee has control of the leased item (normally, through an option). However, other members were concerned with booking liabilities for renewal periods not yet exercised by the lessee and noted the inconsistency of this approach with the accounting treatment of options in the financial instruments world. That is, many members asserted that lease options are not financial options that can be readily settled for cash. Lessee behavior must be considered and lessee behavior may not follow the financial value of the option. A couple of people have made the point that many of these options are exercised for other than financial reasons, in other words, the difference between the lease and fair market rates. Can we get more discussion on that? 42. Members suggested that renewals occur for the sake of avoiding the nuisance of originating a new lease or purely for location. One member mentioned that with respect to equipment leasing, options to buy are more typical than options to renew. Another member suggested that with car leases there is often negotiation 13 of 15

14 near the end of the lease term. Many members stated that the decisions to renew are financial in nature but depend upon different factors location, practicality, or availability and not necessarily the price of the lease. Agenda Paper 11 Options to Terminate a Lease 43. The questions asked in this paper and the responses received are summarized below. Any comments on whether options to terminate are economically similar to options to renew? 44. The views among members were mixed. One member mentioned that it depends on how the lessor has financed the leased item short term or long term. Some conceded that, theoretically, the two options could be seen as the same. But to make them economically the same, the lessor has to be willing to accept a significant amount of residual risk at the point of renewal/termination. Nearly all agreed that, whatever the terms, the lessor is going to price the lease to factor in residual value risk such that the lessor earns a reasonable return on the leased item during the term of the lease and is covered in terms of risk at the end of the lease. If options to terminate are the same as options to extend in economic terms, should they be accounted for in the same way? 45. A comment was made that termination penalties would adjust in each situation to make sure the lessor is made whole (a sliding scale of penalty payment). Auditing firms would never allow a one-month lease treatment. They would look at factors that compel the lessee to a certain lease term. Another member commented that a lease is essentially a variable cost for using the asset over a variable time frame with an unconditional obligation to make the lessor whole. 14 of 15

15 In the case where you have to pay more to get out of the lease than you would have had to pay to stay in the lease, would you then still have an asset if you are paying more to get out of a lease than to stay in a lease? 46. Some suggested you might have an up-front loss, but it may depend whether or not you actually have an asset factors such as the ability to sublease or location come into play. Closing Comments Is there anything else that we discussed today that is important in your mind that you would like to have us think about as we take this project forward? Is there any additional advice that you d like to give us? 47. One member mentioned that he sees a lot of opportunity for asset impairment testing and that it is important that we consider all the complexities of that standard in this one. A question was raised as to who (the lessee or lessor) is responsible for depreciation of the asset under the right-to-use model. The answer is that the model has not addressed that yet. 15 of 15