The international project on lease accounting: the view from Europe

Context of EFRAG’s outreach event

Leasing is one of the most heavily debated accounting topics over the last decade. Almost all companies regardless of their industry are impacted somehow, either by being lessor, lessee or both at the same time.

The replacement of IAS 17 ‘Leases’ started as a joint project between the IASB and the US standard-setter the Financial Accounting Standards Board (FASB). However, after several joint publications (a Discussion Paper in 2009, and Exposure Drafts (EDs) in 2010 and 2013) and subsequent deliberations, it seems that the Boards will arrive at different conclusions in the end. Further, the new Standard will only significantly change lessee accounting, while lessor accounting will most probably remain as it is with some additional disclosure requirements. One of the many reasons for this might be that there is no common understanding of what a lease actually is, including what its characteristics are, and how the revised Accounting Standard should consequently differentiate leases and service contracts, considering that the accounting outcomes for each will be significantly different. That was the surprising conclusion of an outreach event organised by the European Financial Reporting Advisory Group (EFRAG) on 15 September 2014 in Brussels.

Background to the outreach event

Following the publication of the 2013 ED, EFRAG and certain national Standard-setters in Europe conducted a field-test, which was followed by a consultation. Due to limited time both projects were small-scale, with common contributors (ACCA was one of the respondents to the consultation). As a result of these, EFRAG identified that the biggest unresolved issues of the lease project relate to the actual scope of the 2013 ED (what is a lease within the scope of the Standard, and what is a service contract) and the Type A / B lease distinction (reflecting the extent to which the asset’s benefits are consumed during the lease term).

Following the deliberation of responses to the 2013 ED, the IASB and the FASB diverged in their views, and tentatively decided to support different approaches for lessees. Although both agree that all leases should be recognised on the balance sheet, the IASB decided to go back to a single model (Type A, similar to the current finance lease model in IAS 17) while the FASB maintains the 2013 ED’s  dual approach. The FASB model distinguishes between arrangements that are in substance purchases of the underlying asset (and are written as leases) and those leases that are not in substance purchases of the underlying asset. The boards also differ, at least as at the time of writing, on small-ticket leases (e.g.: computer, cell phone, etc). The FASB does not agree with IASB’s planned general scoping out of these leases from a revised Standard.

It was due to these developments that EFRAG decided to seek further feedback during a public consultation. The result of this was shared during the public outreach event organised by EFRAG in September 2014. In order to limit the scope of the consultation, EFRAG focused on two questions. On the one hand the consultation asked the respondents, through a general question, for examples and views on the identification and separation of lease and service contracts. In addition, the consultation requested participants to state their preference as between the IASB’s and the FASB most recent proposals.

In addition, EFRAG presented ideas at the event on the question of what might constitute the difference between a service contract and a lease.

Views expressed during the public consultation and the outreach event

There were a limited number of respondents to the public consultation (44 respondents). The vast majority of these were European listed groups. The 42 responses received on the second question (IASB / FASB preference) were mixed, with 14 in favour of the IASB’s approach, 12 in favour of the FASB’s but a larger number (16) not supportive of either.

In responding to the first question, many respondents argued (similarly during both the field-test and consultation) that the distinction between a lease and a service contract is problematic. The respondents provided several examples of transactions that would qualify as leases under the 2013 ED proposals, but which in the constituents’ view, should not be recognised on a lessee’s balance sheet. Based on the summary prepared by EFRAG, the respondents provided the following justifications that such transactions should be accounted for as service contracts:

1. The client who takes on the contract (Customer) cannot prove that the asset provider (Supplier) will benefit from replacing the asset during the contract period.
2. The legal responsibility for the asset remains with the Supplier.
3. The Supplier is responsible for maintenance and repair.
4. The contractual restrictions on the use of the asset by the Customer prevent the Customer having control over the asset.
5. The Customer’s purpose in entering into the transaction is to obtain a service.
6. The service component predominates in the arrangement.

The above views were amplified by comments made during the outreach event, when participants provided their own positions on the question of identification / separation of lease and service contracts, such as the following:

1. In many cases it is unclear whether substantive control is provided to the lessee through the contract (eg a property company leasing out retail spaces in a shopping centre).
   
   
2. Some participants argued that as the definition of a lease (in 2013 ED) requires identifying whether (amongst other factors) the contract conveys the right to control the use of the identified asset, the concept of ‘control’ in the wording should refer to ‘control’ as defined by IFRS 10. Under that Standard, control requires having power, being exposed to or having rights to variable returns, and having the ability to use that power to affect investment returns. Such a requirement would obviously result in a significantly higher threshold for the existence of a lease agreement (for many transactions it would be even impossible). One participant illustrated the discussion with the case of a car leasing arrangement when the Customer does not directly use the asset (as the car is provided to its employee) and it will only control the car if the employee terminates their employment with the Customer before the end of the lease period. In the view of the participants, such a contract does not convey the right for the Customer to use the asset.
   
   
3. The 2013 ED focuses on the ability to swap the asset, and whether this would be of benefit to the lessor or the lessee. However, the focus on this notion of ‘substitutability’ is too narrow. In many industries (e.g., drilling rigs and passenger planes), industry standards have evolved which also provide obligations on the Supplier to include specific types of services in the leasing package. Even if the asset by itself represents substantial value, the additional services provided by the leasing Supplier are such that other entities, like financial institutions, would not be able to provide the same overall level of service to the Customer. The most common example is the so-called ‘wet’ lease of an aircraft, when the Supplier provides the asset but also the full crew and additional ancillary services to operate the aircraft.
   
   
4. Some participants at the outreach event commented that nowadays many composite contracts are entered into, which are not solely ‘in-substance’ purchases. For example, a leasing company expressed the view that if it were to offer solely financing arrangements, then most of their customers would not be interested. The lease has to be bundled with other services. In the end, it becomes very difficult to distinguish the lease and the services.

Arguments were expressed that the revised leasing Standard should focus on whether the leasing or service component predominates in the contract, but most of the participants agreed that this would be too subjective, and would leave scope to structure agreements to achieve a desired result.

EFRAG’s analysis of the difference between a service and a lease

As indicated above, EFRAG presented ideas to assist in attempting to identify the key distinguishing factors between leases and service contracts. Two different issues were looked at:

A lease is a financing arrangement

The lease project has included a statement that ‘leases provide a source of financing’. However, this concept is not really reflected in the current definitions (both in IAS 17 and the proposals for a revised Standard). A more thorough analysis of the concept can conclude that in order to determine that a lease is a financing arrangement, the contract and the Supplier should have specific characteristics.

Firstly, the contract would require repayments of the principal amount ‘lent’, together with interest compensating the lessor for the risks and time value of money, as is standard for a loan contract. In the context of a lease contract, the lease agreement would furthermore:

1. Not provide for variable payments, according to the usage of the leased asset.
2. Not require the delivery of other goods or services to provide a guaranteed level of service.
3. Contain penalty provisions, mainly in the form of additional interest chargeable to the lessee in case of late payment.

Secondly, for financing arrangements, the Supplier would also display specific characteristics in connection with its business model. These would include:

1. The Supplier is a financial institution or its subsidiary.
2. The Supplier is a manufacturer that both sells and leases assets, without providing more complex solutions based on the delivery of additional services related to the assets.
3. The Supplier’s risks are limited to financial market interest rate risk, the Customer’s credit risk, and the market risk of the asset’s residual value.

Unbundling of lease and service components

This second issue concerns whether indicators can be identified that the contract is more than financing, and in fact delivers complex solutions based on the provision of an asset and services, which can or should be unbundled into lease and service components for accounting purposes.

An example to illustrate this issue involves the parties to time charter contracts for shipping vessels. A typical time charter requires the ship owner (ie, the Supplier) to provide services to the merchant (Customer) which ensure proper loading, unloading, efficient and secure navigation, etc. These services require the involvement of highly-skilled crew using dedicated equipment owned by the Supplier. Such an example could indicate that the provision of the additional services combined with the delivery of the asset constrains (or prevents) control over the use of the asset by the Customer, because it prevents separability of the delivered asset’s right of use from the provision of the related operating services.

The above is an example of a transaction where the Customer is in a different position during the contract term from the owner of a purchased asset who is able to outsource the services (or can otherwise separate out the services) relating to the asset.

The following characteristics give an indication that the transaction forms an inseparable bundle, and is in substance a service:

1. The benefits from the use of the asset cannot be delivered to the Customer on a continuous basis separately from the related services and other goods delivered by the Supplier.
2. The Supplier continues to be significantly and actively involved in the asset after the contract commencement date, such as through having an obligation to operate and maintain the asset throughout the period of the contract.
3. Operating risks remain with the Supplier and are not transferred to the Customer.
4. The risks around availability of the asset remain with the Supplier.

Conversely, the following indicators show an ‘in-substance’ purchase with services that are incidental:

1. The Supplier also sells the related services separately.
2. There is no significant continuing involvement needed from the Supplier after the date of commencement of the contract, except for managing the credit risk of collecting the lease payments.

If based on the identification of the lease and service components, it cannot be concluded that the contract falls within the scope of the proposed guidance for leases, then the contract represents another type of agreement, ie it is not a lease. In this case, IFRS 15 Revenue from Contracts with Customers might be relevant.

On the other hand, where there are indications that a contract contains a lease but it cannot be concluded that this is the sole element, then in order to separate the lease and service component, once again IFRS 15 might be relevant in order to identify the distinct goods or services. Both the leasing and revenue models are based on the notion of a transfer of control and consequently, the guidance for the recognition of revenue and recognition of an asset and liability for leases should be consistent. However, there are differences between the criteria for identifying distinct goods or services under IFRS 15, and the 2013 ED’s right-of-use asset separability criteria when assessing the ability to derive benefits from use. The main difference relates to the requirements of para 27(b) of IFRS 15, which requires that the entity’s promise to transfer the goods or service to the Customer is separately identifiable from other promises in the contract. By contrast, the 2013 ED does not require that the service components should be separately identifiable.

Conclusion

The conclusion which might be reached to date, following EFRAG’s public consultation and the outreach event, is that despite the time spent so far on the leasing project, there is still a lack of clarity, the resolution of which is fundamental to producing an appropriate revised Standard on leasing. After several years spent on the project, it is still unclear when the lessor (Supplier) conveys the right to control the use of the asset, and what characteristics should be displayed by an asset-backed financing arrangement in order for it to meet the definition of a ‘lease’.

In the past, mainly in its comment letters on the IASB’s exposure drafts, ACCA has expressed concerns regarding the ‘right of use’ model proposed by the IASB for the accounting for lease agreements, and the scope in the proposals for uncertain judgements. The question therefore arises as to what steps the IASB should take next, and whether at this stage, it is in a position to take them.