Informed and reasoned consideration of the ideas and issues raised in the discussion paper:
In regards to scope, there are two issues being raised in this discussion paper.
Issue# 1)Whether the scope of proposed new lease accounting standard should be based on the scope of the existing lease accounting standard.
The first approach considered was to base the scope of the proposed new standard on that of the existing lease accounting standards.(SFAS 13 and IAS 17). In case of scope, the IAS 17 and SFAS 13 differ from each other. i.e. SFAS 13 applies to contracts of Property, plant and equipment but IAS 17 defines a lease as a right to use an asset (including Intangible assets) but before issuing anew standard, the board needs to reconcile these issues.
There are some disadvantages of the first approach mentioned in paragraph 2.6.
- Inappropriate classification into leases.
- Similar contracts with similar characteristics may not be accounted for consistently. e.g. Executory contracts and lease contracts.
- People will try to structure arrangements in the form of contract for services rather than contract for the right to use.
- This approach will also require additional guidance on distinguishing between payment for services from the payment of right to use an asset.
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The second approach considered was to undertake a fundamental reconsideration of what constitutes a lease. This approach would potentially change the scope of any propsed new leases accounting standard.
Even there are arguments against the first approach, the board decided that the scope of the proposed lease accounting standard should be based on the existing standard and listed the following reasons for this decision.(paragraph 2.10)
- Scope approach in existing standard is familiar to constituents.
- It is easy to find out that whether a lease contract falls under the existing standard.
- The board prefer focusing on the main aspects of a new accounting approach for leases before determining whether any changes in scope are needed.
Issue#2) The second issue in scope is should the proposed new standard exclude non-core asset leases or short-term leases?
The boards discussed whether non-core-asset leases (i.e. leases of assets not essential to an entity's operations) and short-term leases (i.e. leases typically of less than one year) should be excluded from the scope but did not come to any preliminary views on either of those issues.
Non-Core Assets & Short term Leases:
Constituents consider that the costs associated with recognising and measuring assets and liabilities in case of non-core assets and short-term leases outweigh the benefits and they are of little interest to users. So they think that such assets should be accounted for as operating leases and thus excluded from the scope of leases. However there are problems associated with this approach as stated in paragraphs 2.17 and 2.19 as such lease contracts may give rise to material assets and liabilities, problems with defining a short-term lease and all assets are essential to the operation of the business.
Approach to lessee accounting:
Issue: Do you agree with the boards' analysis of the rights and obligations, and assets and liabilities arising in a simple lease contract? And the board's decision to adopt an approach to lessee accounting that would require the lessee to recognise: (a) an asset representing its right to use the leased item for the lease term (the right-of-use asset) and (b) a liability for its obligation to pay rentals instead of a component approach to lease contracts.
The boards tentatively decided to develop a new approach to accounting for all leases including operating leases. Rather than classifying leases as finance leases (purchase of an item) and operating leases (executory contracts), under this approach, the lessee would recognise in all lease contracts:
- an asset representing its right to use the leased item for the lease term (the right-of-use asset)
- a liability for its obligation to pay rentals.
The board also concluded that obligation to return the leased item at the end of lease term is not a liability as it does not result in an economic outflow.
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They based their decision on the inconsistency of existing lease accounting model with asset and liability definitions in the Framework and CON 6 and also stated the criticisms of the existing accounting model, which the proposed approach can address in paragraph 3.28 as application of same accounting rules to all lease contracts, reducing unrecognised financing and consistency with board's conceptual frameworks.
Components approach in complex leases:
Lease contracts can convey various rights and obligations to the lessee e.g. options to extend or terminate and lease and obligations to pay contingent rentals,etc because all of these components meet the definition of assets and liabilities as embodied in Frameworks. The boards discussed the components approach (whether each component of the lease should be recognised and measured as a separate asset and liability) but the boards finally decided not to adopt component approach. Instead the board concluded that the lessee should only recognise:
- a single right-of-use asset that includes rights acquired under options
- a single obligation to pay rentals that includes obligations arising under contingent rental arrangements and residual value guarantees.
This decision was due to following problems associated with adopting components approach:
- Difficulty for preparers to apply an accounting standard for the recognition and measurement of each separate lease component. are often interrelated.
- The components of a lease contract are often interrelated. E.g. The lessee's probability to exercise an option to extend the lease would not provide useful information to the users in recognising a liability of residual value guarantee.
- Unless all components of the lease are measured on the same basis (eg fair value), it may be possible to arrange leases in such a way as to reduce the amount recognised for an obligation pay rentals.
- The fair value of options to extend or terminate a lease is difficult to measure. This is because there is no market for options of this type and they are not normally priced separately from the lease contract. Measurement is complicated by the fact that, unlike many financial options, the assets underlying options to extend or terminate a lease are often specialised and may not be exercisable until a long way in the future (eg 20 years in some real estate leases).
- A components approach may not provide users with complete information about the economic position of the lessee. That is because options to extend a lease that are seemingly out of the money may nevertheless be exercised for entity-specific reasons. For example, an entity that leases a production line may choose to exercise an option to extend the lease, thereby avoiding disruption to its activities, even though the exercise price of the option is greater than the market rate.