Leases: Implementation of a New Approach
Invitation to Comment and Questions for Respondents

Part I – Introduction and scope

The Group of 100 agrees with the fundamental principle of the paper that standard-setters should aim to develop a single methodology to account for leases so that like transactions are treated in a similar manner. A single methodology will also aid in the comparability of financial information as long as that methodology is consistent with the economic substance of lease transactions. It is not necessary to adopt the financial rights and obligations approach to achieve this outcome.

The "performance" criteria advocated in Chapter 2 is one approach to determining whether or not a lease asset and liability should be recognised. Another approach may be the concept of "passage of control" to the lessee which usually follows delivery of the asset. A control concept may also assist in distinguishing lease contracts form other types of executory contracts, which do not result in the transfer of control of an asset from the outset.

However, the discussion in this Chapter does not go far enough in considering the various types of arrangements that could give rise to assets and liabilities under the proposed methodology. The distinction between what falls within the scope of any revised accounting standards for leases, and what is outside scope is clearly fundamental and requires greater consideration than covered in Chapter 2.

A clear definition (and practical guidance) needs to be developed to ensure that reasonable certainty exists as to the classification of contracts. This would be particularly so for contracts involving intangible benefits (see below) and for contracts described as take or pay contracts in paragraphs 2.36 to 2.38 of the Invitation to Comment. The treatment of service contracts/part service contracts discussed in paragraphs 2.39 to 2.46 of the Invitation to Comment appears to be an area which would be open to wide interpretation.

Leases of intangible assets should not be excluded from the scope of revised standards. However, further consultation and consideration of the application/scope of any revised standard would be necessary because of the possibility that many practical problems would arise.

Application of these proposals would lead to the recognition of a number of intangible assets which may not have been recognised in the past. These would vary from industry to industry and further investigation would be necessary before any firm determinations can be made. Issues surrounding the valuation of recognised intangible assets, and ongoing assessments of carrying amounts would also need to be addressed.

If the proposed approach proceeds, the Group of 100 strongly recommends that the application of any revised standard on leasing, and on the various arrangements which are commonly undertaken on an industry by industry basis, be subject to extensive consultation.

Some further examples (not all necessarily intangibles) not mentioned in paragraph 2.47 of the Invitation to Comment include:

• use of brand/mastheads under contract from another party could lead to a mismatch between recognised and unrecognised intangible assets;
• a publisher may be required to recognise an asset and liability for mastheads/titles "leased" from another party while mastheads/titles which have been internally developed are not recognised;
• franchise arrangements;
• royalty arrangements;
• air rights, landing slots and terminal access rights in the aviation industry;
• contracts for the use of intellectual property, patents, copyrights;
• contracts for the provision of IT hardware, software and associated support services;
• radio and television license agreements;
• access rights to telecommunications, Internet facilities and cable channels;
• motor vehicle design specifications provided to other companies under service agreements;
• other distribution rights; and
• property access arrangements.

Failure to deal with conceptual and practical issues relating to these types of lease contracts could lead to confusion and inconsistent treatments which would undermine the application of the proposed approach to accounting for leases.

The Group of 100 acknowledges that the Invitation to Comment states in paragraph 2.51 that work in this area has not yet been fully explored. As such, the above comments are made to constructively assist in highlighting that this further work must be undertaken on a more specific industry basis.

The Group of 100 agrees that application should be based on the principle of materiality.

Leases of land and buildings, as accounted for by lessees, should not be excluded from the scope of revised standards. However, consideration needs to be given to various structures which may not be on a commercial footing, for example, peppercorn leases, perpetual leases, etc.

In addition, a question arises in respect of non-income producing property leases where it may not be appropriate to record an asset on the basis that conditions contained in the lease and attaching to the use of the property may significantly affect the rights which the lessee can enjoy. These may include, for example, minimum development requirements, make-good conditions, inability to sub-let, inability to redevelop or re-build. These conditions may mean that an asset does not meet the asset recognition criteria in that the lessee’s ability to generate or control any future economic benefits associated with recognition of an asset is restricted. Alternately, the lease asset may fail a recoverable amount test immediately after recognition, suggesting that an immediate write-off is required.

Part II – Lessee accounting

Q4 Do you agree with the Group’s recommendations related to lessee accounting in Chapter 3 that:

The Group of 100 agrees that assets and liabilities should be recognised where recognition criteria are satisfied.

The Group of 100 agrees with this approach, to the extent that the rights and obligations can be reliably measured.

The Group of 100 agrees with this approach.

The Group of 100 does not agree with this principle. Each lease should be considered on its merits and where it is clear that an option to renew will be exercised, the associated assets and liabilities should be recognised. This approach would more appropriately recognise the economic substance of the transaction and is more likely to reflect the reality of arrangements in respect of long-lived assets.

To adopt this approach would require definition of a test to enable the determination to be made as to whether or not the option is likely to be exercised. Possible alternatives include a "balance of probabilities test", a "beyond reasonable doubt test" or a test of "virtual certainty".

This approach allows for situations where renewal is considered "certain" as the asset in question is fundamental to the business. For example, a lease of a terminal at a major airport where option periods are common, leases of heavy equipment (aircraft, ships), trading name franchise agreements and the like. In such circumstances it would be appropriate to include future option periods in the initial valuation of the asset. This would also apply to circumstances where the lessee is not free to avoid renewal.

Further evidence to support the certainty of execution of the options would be the amount of capital expenditure undertaken by the lessee in respect of the leased asset, which may increase the financial penalty to the lessee (by way of depreciation or asset write-offs) if it fails to exercise the options.

In these circumstances, the depreciation period for leasehold improvements should include the option period/s.

b) Do you agree that, except in those circumstances where it can be demonstrated that an option has significant value (and assuming its value can be ascertained with sufficient reliability), the payments required by the lease should be deemed to relate to the right to use the property for the lease term?

The Group of 100 agrees with this approach.

The Group of 100 favours the alternative approach, since it is consistent with the minimum lease payments approach adopted in other circumstances and removes the difficulties of identifying/measuring "similar" leases without contingent rental provisions (something that could be extremely difficult for the more exotic/industry specific leases).

Difficulties also exist with reliability of measurement of contingent rentals. Where a lease includes contingent rentals, say based on performance (percentage of turnover/profit) of the lessee, the lessor has in effect become a stakeholder in the lessee’s business. It would seem appropriate in these cases that the contingent rentals are only recognised as expenses/revenues as underlying performance triggers are achieved.

For this reason, contingent rentals should be treated as period expenses in line with the arguments put forward in paragraph 4.69 of the Invitation to Comment. This approach appears consistent with the performance criteria espoused for recognition of lease assets and lease liabilities in Chapter 2 of the Invitation to Comment. Until such time as the contingent event has occurred (ie, performance), no right or obligation exists.

The Group of 100 agrees with the preferred view in the Invitation to Comment. Since price rises are outside the lessee’s control, they should be factored into the minimum lease payments. Obviously there is an issue involved in estimating inflation over the period of the lease. However the Group believes the level of judgment involved is not as significant as that required in paragraphs 65-77 of Chapter 4 of the Invitation to comment.

The Group’s view as reflected in the Paper is that an asset and liability should be recognised at the beginning of the lease term measured at the present value of the payments the lessee is required to make during the lease term and the fair value of guarantees or other residual value agreements (if it is practical to quantify them).

An alternative view is that in circumstances where in substance the lessee has exposure to risk on substantially all of the property’s value, it should record an asset and liability at the beginning of the lease reflecting the full fair value of the property, regardless of the cash flows that are specified in the lease contract. (Those who hold this view believe that Examples 4 and 5 in Chapter 5 are economically similar and therefore the accounting treatment should be similar).

Which of the two views do you support? If you support the alternative view, how would you define the circumstances in which gross asset and liability amounts should be reported?

The Group of 100 supports the alternative view. Where the lessee has exposure to risk on substantially all of the property’s value, it should record an asset and liability at the beginning of the lease reflecting the full fair value of the property, regardless of the cash flows that are specified in the lease contract. This again better reflects economic reality and ensures like assets, leased over the same lease term but with different residual cash flows are valued at the same amount.

Gross asset and gross liability amounts should be reported where the lessee bears the risk/benefit of changes in the residual value as opposed to a third party guarantor or the lessor.

The Group’s preferred view is that the carrying amount of both the lease liability and the lease asset should be increased or decreased (subject to the carrying amount of the asset not being increased above a value that would cause an impairment write-off), and that the asset’s revised carrying amount should be depreciated over the remainder of the lease term.

An alternative view is that the difference between the remeasured liability and its previous carrying amount should be recognised immediately as a loss or gain in income.

The Group of 100 does not agree with either view canvassed in the Invitation to Comment.

Adjusting the asset value due to subsequent changes in the value of the lessee’s obligations in relation to residual value guarantees is akin to revaluing the asset following initial recognition. This approach will lead to confusion where individual leased assets are adjusted (potentially upwards) without revaluing the class of assets to which they relate (as required by AASB1041), whereas the carrying values of other leased assets or owned assets can only be adjusted (upwards) by undertaking a revaluation of the relevant class of asset.

The alternative approach is also not acceptable on the basis that fluctuations in residual value guarantees would result in unrealised gains or losses being recognised through the profit and loss which may reverse in later periods, especially for long-lived assets. These fluctuations may not represent "firm" obligations (as they may reverse in later periods) and would distort period to period comparisons of profitability if brought to account.

Consistent with its position in respect of recognition of fair values in respect of financial instruments and agriculture the Group of 100 would support an approach of recognising changes in residual value guarantees as period adjustments and taken to equity and recycled to operating profit on realisation at the end of the lease period.

The Group of 100 does not agree with this principle for the reasons outlined in the answer to question 5 above. Each lease should be considered on its merits and where it is clear that an option to renew will be exercised (which may be more likely when a residual value guarantee also exists), the associated assets and liabilities should be recognised. This approach would more appropriately recognise the economic substance of the transaction and is more likely to reflect the reality of arrangements in respect of long-lived assets.

It may not always be practical to obtain an estimate of the lessee’s incremental borrowing rate for a loan with the same security as the lease for certain complex leasing structures used for industry specific assets, for example, aircraft, airport terminals, shopping centres, mining rights and shipping.

It would appear that the rate implicit in the lease is the best reflection of the risks relating to that particular financing and therefore should be the appropriate rate to use as the discount factor. Where the implicit rate cannot be determined, then the incremental borrowing rate for the entity should be used.

There is a marked inconsistency in the Invitation to Comment. On the one hand the Invitation to Comment states its objective is to recognise, at the beginning of the lease term, the fair value of the rights and obligations that are conveyed by the lease. Yet, in a sale and leaseback arrangement, the paper advocates that the value of the remaining lease asset is equal to the proportion of the historical cost of the asset retained by the lessee, on the basis that this portion of the original asset has not been disposed of.

Taking the example in paragraph 7.29 of the Invitation to Comment, this results in a leased asset being recognised which is lower in value than the associated lease liability. As such, the asset remaining is not stated at fair value on inception of the lease. This appears inconsistent.

If the fair value of the asset is higher on entering the lease, why then would the principles in Chapter 5 regarding the accounting treatment of subsequent changes in the value of the lessee’s obligations (in relation to residual value guarantees) not apply? If the preferred view in these situations is that the carrying amount of both the lease liability and the lease asset should be increased or decreased accordingly, under a sale and leaseback arrangement where the lease liability is at fair value it appears incongruous the asset remains at historical cost. Instead, the consistent argument would be to increment the asset for the increase in fair value and take the difference through the profit and loss. This would result in the total gain being recognised under the "one transaction" approach being the same as that recognised under the "two transaction" approach. It should be noted, however, that the timing of recognition of the gain under the "one transaction" approach and current accounting requirements would be different. Gains on sale/finance leaseback of assets are currently amortised to profit over the period of the lease, whereas the "one transaction" approach advocates immediate recognition of the gain associated with the "part" of the asset disposed of.

The "two transaction" approach may be more appropriate where long-lived assets have an active re-sale market and may be refinanced a number of times during their life to take advantage of increases in fair value. In addition, if the terms and conditions of the leaseback are different to the rights enjoyed through ownership of the asset, the leased asset retained may not be the same as the original asset, and should be fair valued accordingly.

In addition, it is clear that the value of assets which have been held for some time may have changed significantly from the original cost and the reason a sale/leaseback has been pursued is to take advantage of the improved value. In these circumstances, (and where the sale and leaseback has been negotiated on an arm’s length basis) to perpetuate recording the remaining asset at an historical cost which is not representative of the remaining value to the business does not appear appropriate.

Part III – Lessor accounting

Q13 Do you agree with the general principle (Chapter 8) that a gain should be recognised at the beginning of the lease term if (a) there is evidence that the value of the lessor’s assets (less its liabilities) has increased as a result of its performance in entering into the lease contract, and (b) the increase can be measured reliably?

The recognition of a gain at the beginning of the lease term is consistent with the concept that the lessee is acquiring an asset and the lessor disposing of an asset. The gain that arises would be due to the fact that the carrying value of the asset is below its fair value where the lease has been conducted on a commercial arm’s length basis.

A question arises in relation to property trusts, where the rental income to the trust over any particular period is its only revenue stream. It may not be appropriate to recognise gains upfront (and only treat the interest component of each rental receipt as income) as this approach will significantly affect the timing and evenness of profit recognition. It may also lead to a significant profit at inception of the lease, in advance of the physical cash being received. This raises issues regarding the trust's ability to repatriate funds to unitholders via distributions, where the trust does not have the cash on hand. This issue should be specifically addressed through industry consultation.

As noted above, the recognition of a gain at the beginning of the lease term would only occur in circumstances where the carrying amount of the asset subject to the lease is less than its fair value, and the lease is conducted on an arms-length commercial basis.

Consequently, it is difficult to see how a gain would arise in circumstances other than those described in para 8.18 where the lease has been negotiated on an arms-length commercial basis. This requirement should be clearly spelt out in any revised proposals.

Questions arise in relation to property trusts, where the non-financial assets may in fact be classified as investments and not bricks and mortar. Is it possible to dispose of part of an interest in an investment (property)? Is the remaining investment (property) asset a non-financial asset? This issue should be considered in an industry by industry review of the application of any revised accounting standard.

The practicality of estimating accurately the risk-adjusted interest rates applicable to the rent receivable and the residual value on every lease in a broad portfolio is unrealistic and should not be pursued in any revised proposals. A high degree of judgement and consequent risk of error (and inability to audit) may result, especially for complex leases with numerous immeasurable risks including cross-default clauses, indemnities, performance guarantees and the like.

For these reasons, the rate implicit in the lease should be used which would theoretically be an easier calculation. Whilst this may not fully represent the risks associated with the two distinct assets, it is more likely to ensure a consistent treatment between leases and comparability between organisations. Where the implicit rate cannot be determined, then the incremental investment rate for the entity should be used.

The Group of 100 supports the alternative view for the same reasons noted in Question 6 above in respect of lessees.

An alternative view (corresponding to the alternative view of the appropriate lessee accounting noted in Question 7) is that only the existing level of rentals should be reflected in the receivable asset that is recognised by the lessor at the beginning of the lease.

Which of the alternative approaches do you support, and why?

The Group of 100 supports the alternative view for the same reasons noted in Question 7 above in respect of lessees.

The discounting approach advocated in the Invitation to Comment and the proposed treatment of unwinding the discount needs further consideration. This approach will result in the asset being "revalued" upwards on an annual basis as the discount is unwound and a "profit" being recognised in the profit and loss account representing the increase in value of the asset due to the passage of time.

This approach would be inconsistent with the treatment of other long-term assets which are carried at depreciated historic cost or depreciated revalued amount. The Group of 100 believes further consideration should be given to Option B where the discount is not unwound meaning that the residual asset is initially recorded at its fair value, as is then only revalued in line with current accounting requirements on revaluations.

Part IV –Other issues

Q19 Do you agree with the recommendation in Chapter 13 that lessors of land and buildings should report as separate assets in their balance sheets the amount of their investment that represents lease receivables, and that which represents their interest in the residual value of the property, and that the finance income for the lease receivables and changes in the interest in the residual value should be reported separately? If not, what alternative treatment would you favour and why?

Where a property lessor is required to record a separate asset representing lease receivables, a gain or loss would result which would be recognised on inception of the lease. This gain or loss would be the difference between the fair value of the (part) of the property asset given up, and net present value of the lease income (the lease receivable). Following this point, the interest component of each rental payment would be taken to income along with any changes in the value of the lessor’s residual interest in the asset. This approach pre-supposes that lessors fair value their assets each year and take the differences to income.

At present, this is not the normal approach in Australia. Property assets for lease are normally recorded as investments, subject to independent valuation with increments being taken to revaluation reserves. Rental income is taken to profit on an accruals basis. The change advocated in the Invitation to Comment may have significant impacts on both the timing and quantum of profits recorded by property lessors and may result in permanent changes in the measurement of performance. It may also impact the ability to effectively make distributions to unit holders as noted in the response to question 13.

Whilst the approach advocated may be conceptually attractive, it may have severe consequences on financial performance and on investor sentiment. Before any position can be agreed in this area, specific consultation should be undertaken to more fully evaluate the effect of alternative treatments.

The Group of 100 agrees in principle that information on fair values should be preserved.

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