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6 LEASES - A PROJECT UPDATE THE MAIN PROPOSALS The main objective of the project has been maintained, which is that for most leases with a term of one year or more lessees will record assets and liabilities. There will be two approaches to be followed to determine the amounts to be recorded in profit or loss; one will result in a higher overall charge in the early periods of a lease due to the effect of finance charges on the lease liability which will decline as the obligation declines over the lease term, while the other will normally result in an overall constant charge to profit or loss over the lease term. The model to be followed will depend on the extent of consumption of the leased asset over the lease term. For lessors, there will also be two approaches which will be based on the same classification criteria used by lessees. One approach will result in the recording of the sale of part or all of the leased asset, while the other will result in accounting that is similar to current guidance for operating leases. BDO comment We believe that clear application guidance will need to be included in the revised proposals, in particular in respect of the new concept of the ‘extent of consumption of the leased asset’, as the accounting result under each of the two approaches may be significantly different. DEFINITION OF A LEASE When would a contract contain a lease? An entity would determine whether a contract contains a lease on the basis of the substance of the contract, by assessing whether the fulfilment of the contract depends on the use of a specified asset (an asset that is explicitly or implicitly identifiable) and whether the contract conveys the right to control the use of that specified asset for a period of time. A right to control the use of an asset is conveyed if the lessee has the ability to direct the use, and receive the benefit from that use throughout the lease term. The requirement for the arrangement to cover a specified asset is an important distinction, as it means that it would be necessary to be able specifically to identify the asset (for example, an item of plant and machinery or a building). A physically distinct portion of a larger asset could also be a specified asset (for example, the first floor of a building, floors 10 to 15 of a 20 storey building or an indentified 100 square metre area of a 1,000 square metre commercial space). However, if a portion of an asset cannot be specifically identified (for example, a specified proportion of the capacity of a pipeline or of a fibre optic cable network) that portion is not a specified asset. What would be the lease term? The lease term would be the non-cancellable period for which the lessee has contracted with the lessor to lease the underlying asset, together with the effect of any options to extend or terminate the lease when there is a ‘significant economic incentive’ for an entity to exercise an option to extend the lease, or for an entity not to exercise an option to terminate the lease.
LEASES - A PROJECT UPDATE 7 What would be a ‘significant economic incentive’? In assessing whether there is a significant economic incentive to exercise an extension or termination option, a lessee and a lessor would consider contract-based terms (terms that are included in the lease contract), asset-based factors (for example significant leasehold improvements made by the lessee that might have material value when a lease extension option is due to be exercised and would be lost if the lessee exercised the termination option) and entity-based factors (for example management intent). All these factors would be considered together and the existence of only one factor would not necessarily, by itself, signify a significant economic incentive to exercise an option. The lease term would be reassessed only when there is a significant change in relevant factors, meaning that the lessee would either now have, or no longer have, a significant economic incentive to exercise an option. The thresholds for evaluating a lessee’s economic incentive to exercise options to extend or terminate a lease and options to purchase the underlying asset would be the same for both initial and subsequent assessment. However, changes in market rental rates after lease commencement would not be included in the analysis. BDO comment The Boards’ decision to exclude future changes in market rental rates from the analysis when reassessing whether there is a significant economic incentive to exercise options to extend or terminate a lease might initially seem odd. However, this was in response to comments received by the Boards that, if changes in market rental rates were included in the analysis, this could result in excessive complexity in financial reporting. This is because the effect could be excessive volatility in the carrying amounts of assets and liabilities, as part or all of the arrangements subsequently fell within or moved outside the recognition threshold. What is not yet entirely clear from the Boards’ discussion is the linkage between market rental rates and management intent, as the latter would be taken into account. The IASB Staff included the following example to support the decision to exclude changes in market rental rates (IASB Board paper, May 2011): Lessee A has a 10-year lease for its corporate headquarters in a large metropolitan area with annual payments of CU150,000. The lease has a 5-year renewal option at the same annual payment of CU150,000. During the 10 years, the following occurs to annual market rates for the lease of comparative real estate: (a) At the end of year 3, there is an increase in demand. The annual market rate increases to CU300,000. (b) At the end of year 6, a local recession drives the annual market rate to CU50,000 per year. (c) At the end of year 8, because of tax incentives instituted by the local jurisdiction to stimulate the economy, an increase in demand results in the market rate increasing to CU320,000 per year. (d) At the end of year 10, the market rate is still CU320,000. However, Lessee A has decided that it has changed its business model to lower costs by decentralizing its management. It now estimates that it needs a much smaller space for its corporate headquarters and does not exercise the option to extend the lease term. The example does illustrate that, if market rental rates were to be taken into account it would be possible for the assessment of whether the extension option would be exercised to change on a number of occasions. This would result in the five year extension period being included or excluded from the lease asset and liability at various points. However, it does not clearly address the potential for management to decide to relocate, and also exercise the lease extension option with the intention of subletting the existing premises at a profit.
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