LEASES AND OTHER TRANSFERABLE CONTRACTS Introduction This paper looks at leases and other transferable contracts. It concentrates on examining the treatment of leases and other transferable contracts as one of the four existing categories within intangible non-produced assets in SNA93. 2 In preparing this paper a number of issues relating to the treatment of leases (licences) more broadly arose. This prompted us to prepare an additional paper Leases and Licences. That paper takes a top-down view of the treatment of these instruments. 3 The conclusions in this paper presupposes that there should be a category in SNA93 broadly along the lines of the current leases and other transferable contracts category. As such, the conclusions reached in this paper should be considered in this context. This presupposition is relaxed in the broader paper Leases and Licences. Because of this, some of the conclusions in that paper are different to those in this one. 1 The existing SNA93 treatment 4 "Leases and other transferable contracts" is one of the four categories of intangible non-produced assets listed in SNA93. 5 The Annex to Chapter XIII, SNA93 provides the following definition for this category of intangible non-produced assets: "Leases or contracts where the lessee has the right to convey the lease to a third party independently of the lessor. Examples include leases of land and buildings and other structures, concessions or exclusive rights to exploit mineral deposits or fishing grounds, transferable contracts with athletes and authors and options to buy tangible assets not yet produced. Leases on the rental of machinery are excluded from non-financial intangible assets." 6 This definition raises a number of issues in relation to leases and transferable contracts that are discussed below. When should an asset be recognised? 7 It has been argued that leases and transferable contracts do not have a value in their own right until there is a change in market prices for the asset (or labour service) that is the subject of the lease. For example, it could be argued that a long term lease 1 Most notably, as will be seen, this paper suggests that up-front payments for leases on economic assets should be treated as prepayments of rent/rental, and that a new liability category be created to recognise the market value of the lessor obligations under the lease. The paper Leases and Licences does not reach this conclusion.
on office premises which allows the rental to be determined in line with market conditions each year, would not qualify as an asset. However, if such a lease involved predetermined rentals for the whole period of the lease and market rentals for office accommodation subsequently increased, then the lease could be regarded as an asset for the lessee. Anne Harrison (2001) has suggested the following qualifying condition for a lease of this type to be regarded as an asset: "A lease or contract should be considered an asset for the lessee if it can be sold by the lessee to a third party for a sum greater than the sum payable under the terms of the lease or contract from the lessee to the lessor." Intangible assets of this type appear to have some unusual characteristics. First, the asset seems to arise because the lessee has locked in lower operating expenses (or lower rent payments) in future periods. Second, assuming that the lessee is engaged in an ongoing business, there would be no incentive for him to realise this "holding gain", since he would incur relocation costs if he was to sub-lease his existing office space and move to other similar accommodation. Third, if market rentals fall below the predetermined rentals in the lease agreement should the lease be regarded as a liability for the lessee? Fourth, from the lessee's point of view the asset (liability?) seems to be attributable solely to a type of holding gain (loss?). 8 It could be argued that if a lessor sold a building he would really be selling both the structure itself and any unexpired leases with existing tenants. The value of this latter component would be negative (positive) if the rentals on the premises were locked in at lower (higher) levels than the market was currently yielding. SNA93 discusses the difficulty of distinguishing the land and building components when buildings are sold, but it would appear that there is also a need for explicit guidelines on how to treat unexpired rental contracts on commercial buildings when the sale of a building occurs. 9 A further question is whether such leases (and transferable contracts) should be recognised (a) when first written, (b) when market conditions change, or (c) only when a partly expired lease is sold by the original lessee to another lessee. Under a section concerning the appearance of intangible non-produced assets, SNA93 (paragraph 12.21) states: "...They make their appearance in the System when entities are patented, transferable contracts are written, or enterprises are sold at prices that exceed the net worth of the enterprise in question, etc... The writing of transferable contracts consists of the coming into force of a binding agreement that provides some economic benefit that can be passed on to a third party independently of the provider of that benefit." 10 Despite this extract from SNA93, which seems to suggest that transferable contracts "appear" when the agreement comes into force, a number of authors including Harrison (2001), Magniez (2001) and Pitzer (2002) would appear to rule out option (a). They argue that it is only when market conditions change that an asset is created for the original lessee. It could be argued that the existence of a long-term lease for office accommodation is worth something to the original lessee, even without a change in market rentals - viz. a degree of certainty, convenience, etc. - however, such values would generally be relatively small and would not be recorded as assets in the balance 2
sheet of a business. SNA93 should make it clear which of these three options is applicable. 11 If an asset is created at the time a lease contract for office accommodation at a fixed rental is signed, it would appear to have a zero value at that time (assuming that the fixed rental stream is based on expected market rates). Its value at any future point in time would depend on changes in market rents and the time remaining until the contract expired. 12 If there is an up-front payment associated with the inception of the lease, should the lease be recognized as an asset at the time of inception? Furthermore, should the up-front payments be treated as part of the value of the lease or something else (eg a rental prepayment)? These issues are explored further below. Leases on sub-soil assets 13 SNA93 paragraph 10.129 recommends that the sale of a lease on subsoil assets (where the lease involves a series of payments to the owner of the subsoil assets that are usually referred to as royalties) by the lessee to a third party should be treated as the sale of an intangible non-produced asset in the capital account. This treatment does not seem to depend on there being any change in market prices for the subsoil asset. Does this imply that a corresponding intangible non-produced asset should be recorded in the balance sheet of the purchaser and that the seller should have already recorded an intangible non-produced asset in its balance sheet when the lease was first granted or only later when the sale occurred? (SNA93 paragraph 10.129 also indicates that sales of leases on land or buildings should be treated similarly.) In the situation where there had been no change in market prices it would appear that the sale price of the lease would simply be equal to any prepaid royalties. However, there would seem to be no justification for recording an intangible non-produced asset on the balance sheet of the lessee as the prepaid royalties should have been treated as a financial asset of the lessee (which would be matched by a corresponding liability for the owner of the subsoil asset - prepaid royalties received). 14 A variation on the situation discussed in the previous paragraph is where an upfront fee is paid for a lease (licence) to exploit a subsoil asset over a number of years and the lessee has the right to transfer the lease to a third party. In this case the lessee may consider that he has an asset that he could sell at some future time. In the absence of any changes in market prices for the subsoil asset, the value of the nonproduced intangible asset would appear to equal prepaid rent on the subsoil asset (assuming that the original payment to the owner was at a realistic market price). It could be argued that by selling the lease the original lessee is simply converting a financial asset (prepaid rent) into another financial asset (cash), so that if an intangible non-produced asset had been created its value would have to be zero. 15 Another possibility is that the original lease could be regarded as involving the sale of a tangible non-produced asset rather than payments of rent, but there would be 3
no reason to record an intangible asset in this case and the subsequent sale of the lease would also be recorded as the sale of a tangible non-produced asset. 2 What value should be recorded in the balance sheet? 16 If the view taken by Harrison (2001), Magniez (2001) and Pitzer (2002) that these assets only arise when market conditions change was accepted, it would imply that only the capital gain element should be recorded as an intangible non-produced asset. A further implication is that any lease payments that are made in advance should be recorded as financial assets for the lessee and financial liabilities for the lessor. When a lessee sells a lease, the sale would involve both the sale of the intangible non-produced asset (the capital gain element) and the conversion of one financial asset (prepaid lease payments) into another financial assets (cash). However, it is not clear how SNA93 paragraph 10.129 should be interpreted. Should the actual sale price be recorded in the capital account or only the capital gain element? SNA93 paragraph 10.130 appears to recommend showing the full sale value (including ownership transfer costs for the purchaser and after deducting ownership transfer costs for the seller). SNA93 paragraphs 10.129 and 10.130 should perhaps be amended to clarify that only the capital gain element (adjusted for ownership transfer costs) is to be recorded in order to ensure consistency with how the transaction should be recorded in the financial account and the balance sheet. 17 It does not seem logical to record the actual lease payments (whether these are made up-front or periodically) as an intangible non-produced asset for the lessee. Consider the situation where a lease relating to a commercial building is signed and involves an up-front payment covering rentals for a number of years. If the actual lease payment were to be recorded as an intangible non-produced asset, there would also need to be an explicit decision not to record prepaid rentals as a financial asset, in order to avoid double counting in the balance sheet of the lessee. However, this method of accounting appears to be invalid and would not be consistent with how the lessor would account for the transaction. The lessor would not record the full lease income in his profit and loss account in the year in which the lease was signed; rather he would record only that part relating to the rental for that accounting period, the rest would be recorded as a financial liability (prepaid rentals) in his closing balance sheet for the accounting period. Is there a corresponding liability? 18 In SNA93 liabilities are only recognised in relation to financial instruments. In the context of the balance sheets SNA93 appears to give a very one-sided view of leases and other transferable contracts. It seems reasonable to argue that if the lessee has an asset when market conditions change in his favour, then the lessor has an equivalent liability. SNA93 also does not discuss the situation where market conditions move against the lessee - should a negative asset (ie a liability?) be recognised in this case? 2 This is the line taken in the paper Leases and Licences, but for all economic assets and not just sub-soil assets. 4
Consequently, it could be argued that there is a case for recognising a special category of assets and liabilities (distinct from financial assets and liabilities) relating to leases and other transferable contracts, for which assets match liabilities across the whole economy (ignoring for the present the possible existence of such leases between residents and non-residents). Given that many leases and other transferable contracts would be between institutional units in the same sector it could be argued that this item is not of major importance at the national or institutional sector level - although obviously it could be quite important for an individual institutional unit. Amortisation and other changes in value 19 SNA93 paragraph 12.34 states: "Just as the appearance of intangible non-produced assets is recorded in the other change in the volume of assets account, so is their write-off, termination or exhaustion. For purchased goodwill, amortisation should be recorded over a period of time after the purchase of an enterprise, following country accounting standards; exhaustion of patent protection should be recorded over the duration of the patent." Although leases and other transferable contracts are covered by the first sentence of this extract, no additional comment is included in relation to leases. Consequently, it would appear that it was intended that once recognised in the System that leases and other transferable contracts be written off in subsequent periods via an entry in the other change in volume of assets account. In the absence of further changes in market conditions, the write-off would arise because each accounting period there would be one less accounting period before the value of the asset would be extinguished on expiry of the lease. There is also a question concerning how to record changes in the value of the intangible asset arising from further changes in market conditions. It does not seem logical to record the appearance of a lease as an intangible asset (that arose in the first place because of a change in market prices) in the other change in volume of assets account, but then to treat further changes in the value of the intangible asset, arising from further changes in the relevant market prices, as revaluations of that intangible asset in the revaluation account. Exclusion of leases relating to machinery 20 At a theoretical level there does not seem to be a logical reason to exclude leases on the rental of machinery from this category of intangible assets when leases on the rental of buildings and other structures are included. Possibly, this exclusion was based on the belief that leases relating to the rental of machinery were generally for periods of less than one year or because leases relating to items of machinery were generally not transferable. (Are long term leases for oil tankers and other vessels transferable?) 5
Leases that are not transferable 21 When market conditions change similar holding gains and losses to those discussed above (for both the lessor and the lessee) could arise in relation to lease contracts that are not transferable. However, SNA93 does not seem to provide a mechanism to record them. The question therefore is whether the condition of transferability is sufficient to justify a different treatment for leases depending on whether or not they can be transferred by the lessee to a third party. Special categories for mobile phone licences and other government licences/rights etc? 22 The ISWGNA recommended that mobile phone licences (when they qualify as assets) are to be included as intangible non-produced assets. Anne Harrison (2001) has argued that there are conceivably two elements to the balance sheet value for mobile phone licences. First, they could have a capital gain (or loss) element that qualifies as a transferable lease in the sense discussed above. Second, there is the value of the licence that arises from using the underlying natural asset that is authorised by the licence. Consequently, if it were thought desirable to restrict the category of leases and other transferable contracts to the type of capital gain or loss discussed above, one option would be to record the first element as an intangible non-produced asset. 3 Alternatively, a mobile phone licence asset could be treated as a single asset and classified to a single category within intangible non-produced assets. 4 23 Governments frequently grant rights to individuals or groups of individuals relating to the use of environmental assets, either permitting them to harvest naturally occurring biological resources or to use the environment to accommodate waste products. The rights may be granted outright, sold at a predetermined price or offered for tender or auction. These rights are commonly referred to as property rights, and according to the SEEA manual (approved but not yet published), should be treated as non-produced intangible assets under SNA93. Examples include fishing rights (these involve an annual quota for each producer limiting the allowable catch of a particular species from a particular area) and emission permits. Should these property rights be treated as non-produced intangible assets, and if so, should they be classified within the category leases and other transferable contracts or given their own category under nonproduced intangible assets in SNA93? The right to exploit subsoil assets should not be included in this category as such rights (whether described as rights, leases, or permits etc) would involve either the sale of the subsoil asset or rent payments for the right to use the subsoil asset. SNA93 paragraph 7.133 recommends that payments for the right to explore for minerals on an owner's land be treated as rent, rather than gross fixed capital formation on the intangible produced asset of mineral exploration. 3 The second element could be recorded as prepaid rent, or maybe even as a sale of part of the underlying asset. 4 Another option, which is discussed in the Leases and Licences paper, would be to record the entire lease within the category of the underlying asset. 6
24 Governments also grant rights in the form of licences to undertake particular economic activities such as casino operations, taxi services, and mobile phone services. These licences involve either granting monopoly status to a particular operator or limiting the number of operators in a particular market. The critical question is whether the associated licence fees are taxes or payments to purchase an intangible non-produced asset. This is considered further in the Leases and Licences paper. Distinction between intangible assets and financial assets relating to leases and other transferable contracts 25 The treatment of payments in relation to leases both between the lessor and the lessee and, if a lessee sells the lease to a third party, between the original and subsequent lessees, needs to be clarified. Amounts that represent prepayments of rent on a non-produced tangible asset or rentals on buildings and other structures should be recorded as financial assets by the lessee and financial liabilities by the lessor. When a lessee sells the lease to a third party for more than the value of prepayments of rent or rentals it is only the excess amount over and above the value of prepayments that should be recorded as an intangible non-produced asset in the balance sheet, since the part representing prepayments of rent or rentals should be recorded as a financial asset. Options to buy tangible assets not yet produced 26 SNA93 also includes options to purchase tangible assets not yet produced in the leases and transferable contracts category within non-produced intangible assets. Options to purchase tangible assets not yet produced may be sold to a potential customer by the manufacturer, usually in association with a definite order to purchase a number of tangible assets from the manufacturer during a particular time period. 27 It is not clear to us why these options should be treated differently to other forms of options, which are generally treated as financial instruments. 28 If there is a reason why such options are not considered as a financial instrument, an issue is whether the cost of the options should be regarded as part of the purchase price of the assets that the enterprise eventually acquires, or whether it is a separate non-produced intangible asset. Given that installation costs and ownership transfer costs are regarded as part of the cost of acquiring a tangible produced asset, why should options to purchase be treated differently, especially in the case where they are not sold to another enterprise? 29 A related issue is how the tangible asset manufacturer would account for the receipts from the sale of options to purchase tangible assets not yet produced. If the manufacturer treated this as part of his output, but the purchaser treated it as a nonproduced intangible asset, this would seem to create an inconsistency in the accounts. It does not seem likely that the tangible asset manufacturer would record income from the sale of options as the sale of non-produced intangible assets. Consequently, in the case where the options are not sold to another enterprise it would appear that a more 7
satisfactory treatment would be to include the cost of the options in the gross fixed capital formation of the purchaser. This treatment would be similar to the situation where a purchaser pays a premium to a tangible asset manufacturer to obtain early delivery of a tangible asset even though no option to purchase exists. It would also amount to treating the payment to purchase the option as a prepayment (a financial asset) for the purchase of a tangible asset. 30 In the case where an option holder sells his option to purchase tangible assets not yet produced, the transaction could be treated as a financial transaction, with the seller converting a prepayment for a tangible asset into cash and vice versa for the new purchaser of the option. Where an option holder does not exercise his options or sell them to a third party, the cost of the options could be included with the cost of those tangible assets that were acquired. If an option to purchase a tangible asset not yet produced was not associated with any definite orders to purchase tangible assets and was not exercised or sold, it could presumably be written off as intermediate consumption. 31 It could be argued that options to buy tangible assets not yet produced could change in value because of changes in market conditions. Consequently, capital gains or losses could apply to such options in the same sense as discussed above for leases and other transferable contracts. Circumstances would need to change in two respects before any capital gain or loss could be realised. First, the enterprise with the option to purchase would have to decide not to proceed with the purchase and, second, another enterprise would have to be prepared to pay to purchase the options. 32 Given all of the above, the treatment of options to buy tangible assets not produced as non-produced intangible assets raises a number of concerns for which satisfactory answers are not readily apparent. Accordingly, we are of the view that these options should be treated as financial instruments, consistent with the treatment of other types of options in the system. Summary of issues 1. Should amounts paid at the inception of leases be treated as prepaid rentals (or rent), with a corresponding asset and liability being recorded in the financial accounts of the lessee and lessor respectively? 2. Should a leases or other transferable contracts be recognised as a non-produced intangible assets if it could be sold by the lessee to a third party for a sum greater than residual rental/rent payment under the lease? If this were so, when a lessee sells a lease to a third party the transaction would be recorded in the capital account. However, only the value of the intangible non-produced asset as recorded in the balance sheet (ie the capital gain element) would be recorded in the capital account. Any component of the sale price relating to prepaid rentals (or rent) should be recorded only in the financial accounts of the seller and purchaser. SNA93 paragraphs 10.129 and 10.130 would need to be amended to 8
clarify that only the capital gain element is to be recorded as the value of the transaction in non-produced intangible assets in the capital account. 3. Should a new category of liabilities distinct from financial liabilities be created to record the types of capital gains and losses associated with leases and transferable contracts for the lessor? 4. Should the changes in values for these assets and liabilities (other than those associated with the amortisation) be recorded in the revaluation account? In which case, should the appearance of these assets and liabilities (which come about through capital gains/losses) also be recorded in the revaluation account rather than the other changes in volume account? 5. Should capital gains and losses also be recorded in relation to leases that are not transferable? 6. Should the existing exclusion of leases on machinery and equipment from this category of assets be maintained? 7. Should property rights, such as fishing rights and emission permits, be treated as non-produced intangible assets, and if so, should they be classified within the category leases and other transferable contracts or given their own category under non-produced intangible assets? 8. If the ISWGNA treatment of mobile phone licences is reaffirmed should these licences be classified to their own separate category under non-produced intangible assets, classified to the existing category for leases and other transferable contracts, or possibly split between the two? 9. Should explicit guidelines be included in the SNA to indicate how to treat unexpired rental contracts relating to a commercial building when a sale of the building occurs? 10. Should options to buy tangible assets not yet produced be treated (along with other options) as financial instruments and therefore not included in the category leases and other transferable contracts? Australian Bureau of Statistics April 2003 9
References Australian Bureau of Statistics (2003), Leases and Licences, paper prepared for the Voorburg Meeting of the Canberra Group on Non-Financial Assets, April 2003. Donaghue, Brian (2002), Statistical Treatment of 'Build-Operate-Transfer' Schemes, IMF Working Paper (forthcoming) (Washington: International Monetary Fund). Harrison, Anne (2001), Characteristics of Assets and the Consequences for the National Accounts, paper presented at the OECD Meeting of National Accounts Experts, October 2001 (STD/NA(2001)38. Magniez, Jacques (2001), For a careful use of the intangible concept: Back to the issue of mobile phone licences; paper presented at the OECD Meeting of National Accounts Experts, October 2001 (STD/NA(2001)37. Pitzer, John S. (2002) Government Assets and Liabilities: Licenses, Leases, and Other Issues, paper prepared for the 27th General Conference of the International Association for Research in Income and Wealth, Stockholm, Sweden, August 2002. 10