Leaseurope response to Exposure Draft ED/2013/6 Leases

Transcription

1 Hans Hoogervorst, Chairman International Accounting Standards Board Russell Golden, Chairman Financial Accounting Standards Board Brussels, 13 September 2013 Leaseurope response to Exposure Draft ED/2013/6 Leases Dear Mr Hoogervorst, Dear Mr Golden, Leaseurope, the trade body representing the European leasing and automotive rental industry, has been actively engaged in the IASB and FASB s (the Boards) project to revise the accounting for leases since its start in Over the years, we have tried to constructively contribute to this process and, while we are pleased to see that some of our concerns have been recognised, we are disappointed with the final outcome of the Boards proposals at they are set out in Exposure Draft ED/2013/6 Leases (the ED). We are unfortunately not able to find sufficient justification for supporting the new ED s approach and thus recommend that the existing leases standard, with additional disclosures and possible presentational improvements, be retained. The principle reasons for this are set out below. The conceptual basis for the Right of Use model remains unclear The Boards have still not adequately explained why there should be a difference in accounting for contracts that convey the right to use an item (arising when access to the item is granted) and contracts conveying the right to another type of performance by a counterparty (which arise when a contract has been signed). In the latter case, an entity has acquired a resource that it controls as the result of past events and from which future economic benefits are expected to flow. Hence, such rights also meet the IASB s definition of an asset and yet they are not being addressed. A more fundamental debate on an entity s rights, the kinds of assets they give rise to and how these rights should be accounted for is required before the Boards decide to introduce a major conceptual shift specifically for lease arrangements into their standards. This lack of debate and clear understanding is probably one of the root causes behind the difficulties of the leases project which has been on the Boards agenda since Page 1 of 24

2 This being said, we understand that the Boards motivation behind the leases project is to remedy a perceived flaw with existing lease accounting, and that they believe this should take precedence over a conceptual debate on an entity s rights and assets. However, although it may be possible to improve some aspects of IAS17, in our opinion and as explained below, such concerns have been significantly overstated. The IASB s justification for changing the accounting for leases and its portrayal of the use of leasing are misleading The IASB appears to suggest the preparers of accounts are omitting to account for leases. In reality, in Europe, when the lease client is subject to IFRS, these leases are recognised either on the face of the lessee s balance sheet as finance leases, or as operating leases, in which case with lease expenses recognised in the lessee s P&L and information on committed lease payments disclosed in the notes. European businesses are not omitting to account for leases, they are simply complying with current requirements. In 2012, the firms represented through Leaseurope s member associations granted more than 6 million individual lease contracts. Of these, 99% were equipment leases, with an average deal size of Contrary to non-ifrs jurisdictions where lease classification is based on numerical thresholds, a significant portion of these European transactions already qualify as IAS17 finance leases. In such cases, assets and liabilities are always recorded on the lessee s books, in the same way as liabilities that are used to purchase assets. Of those leases that are operating leases, they represent transactions where the lessee truly does not bear the risks and rewards associated with the leased asset. Given that IAS17 s principles-based approach ensures that decisions regarding lease classification are taken based on the economic substance of a contract, they are also not structured contracts. Instead, the vast majority of these operating leases are straightforward contracts for the use of small items such as cars, copiers or ITC equipment, together with significant service components and where the lessee is not exposed to asset risk 2. They differ fundamentally from other leases where the lessee is seeking to finance and secure the availability of a specific asset, and is willing to take on more asset risk. Moreover, these operating leases are not used to hide debt. They can instead best be described as a form of outsourcing that provides a service to businesses, involving flexible and temporary access to assets. This is done in combination with a wide variety of additional facilities designed to ensure that the client does not have to deal with the hassle and cost of asset management. These service products are becoming increasingly popular because they leave the client free to focus on its core operations. 1 When real estate leases are included, the average deal size increases to Operating leases for lessees can also include instances when the lessor has a finance lease but has passed on the asset risk of the leased item to a 3 rd party to the contract, such as an asset manufacturer. In the books of the lessee, the lease is classified as an operating lease as it does not have any asset risk. Page 2 of 24

3 In our view, although such contracts involve the use of assets, it is questionable as to whether they should effectively be considered to contain a financing component at all. They are no more or less financing contracts than any other type of contractual commitment. The time value of money is certainly integrated into such contracts, but this is the case for almost all contractual arrangements that involve periodic payments, without this leading to them being qualified as financing transactions. The introduction of Type B leases is indicative of the fact that the Right of Use model does not work in practice The assumptions behind the Right of Use model are that all leases give rise to a liability, as well as an asset for the lessee. This asset is referred to as the right of use asset. Consequently, if all leases give rise to the same assets and liabilities, all leases should be accounted for in the same way. Indeed one of the main selling points of the RoU approach was that it did not require different accounting for different classes of leases. The Board argued that this would increase comparability of financial statements and reduce the opportunity to structure transactions to achieve a desired accounting outcome 3. The new ED s introduction of different categories of leases, Type A and Type B leases, with different accounting for each type, using a distinction based on the consumption principle, goes against the long-stated objective of removing lease classification. As a result, the aim of the leases project is becoming increasingly difficult to understand. If all leases are supposed to convey the same types of assets and liabilities to a lessee, it does not appear to be logical to then introduce different measurement requirements for different leases. If different measurement is needed to reflect varying economic realities, the more exact conclusion may very well be that different leases do not convey the same types of assets and liabilities, or that some leases do not convey assets or liabilities at all. Yet, instead of questioning the Right of Use approach itself or whether all leases effectively should qualify for recognition, the model has just been adjusted to arrive at a desired outcome. The confusion is apparent in other areas. The Right of Use model also supposes that, for all leases, the lessee is financing its right of use asset with its lease liability, which is thus a financial liability. Under the new ED, with lessees not recognising interest on their Type B liabilities and including Type B lease payments in operating activities, one concludes that these contracts are not financing transactions. Yet, at the same time, Type B lessees have to disclose an interest component in the notes. This lack of consistency is likely to result in a complete misunderstanding as to the nature of leases. 3 August 2010 Exposure Draft Leases Snapshot Page 3 of 24

4 Moreover, looking at how the revised lessee and lessor requirements sit together, it is also difficult to understand how, in a Right of Use context, a Type B lessor could have granted a right to use an asset, and yet still have retained the full value of the underlying on its books. The conceptual premise of the Right of Use model that an asset is a bundle of rights that can be separated and sold no longer seems to hold in this instance. Instead, the accounting creates multiple assets out of a single underlying asset in a situation where it is difficult to understand exactly why a lessee should be recognising an asset in the first place. In conclusion, we consider that the introduction of Type A and Type B leases shows that the Right of Use model is not sufficiently robust to be applied in practice to the population of contracts referred to as leases. The new classification criteria are a poor outcome of the re-deliberations Classification is subjective by nature, hence one of the reasons for the Boards wanting to change existing lease accounting. However, in comparison to IAS 17 where there was one main distinction, i.e. between finance and operating leases, the new ED now has two important dividing lines, one between leases that consume the benefits of the underlying asset and those that do not, and another one that separates leases from services. While a lease/service line exists theoretically under IAS 17, the existing standard does not come under stress at this end of the spectrum because of the similar accounting for operating leases and service contracts. On the other hand, both of the new ED s lines will be placed under pressure and this undoubtedly contributes to the complexity of the proposals. Basing the classification of leases on the nature of the underlying asset seems counterintuitive when the requirements for an entity that owns those different types of assets outright is the same. Additionally, whatever the consumption patterns of different underlying assets may be, the lessee s asset is the right to use the asset, and not the asset itself, according to the Right of Use model. This right of use asset will always be consumed entirely over the contract. Moreover, the Boards practical expedient to the consumption principle, i.e. the differentiation between equipment and property leases, with asymmetrical thresholds for exceptions, means that equipment leases with the same economics as the population of Type B real estate leases, will not be reflected in the same way. Page 4 of 24

5 Given that the bulk of leases that originally came under fire for not being recognised as on-balance sheet financing contracts are property leases (different sources confirm this to be at least 80% of all of today s operating leases 4 ), treating only this subset of contracts as non-financial arrangements where the benefits are consumed as they are paid for is difficult to justify. Concretely, the new proposals will always treat equipment leases as financing contracts, with the front-loaded lease expense that that the related accounting implies, whereas the financing component of such contracts can very well be negligible, or at the very least entirely comparable to that contained in a property lease. A time value of money component is present in all these contracts unless they are paid for upfront. Up until now, the Boards have continuously rejected the notion of linked measurement for leases on the grounds that it would introduce a method of amortisation typically not used for owned assets. It therefore seems contradictory to now introduce some form of this into the standard, particularly on the basis of a conceptually weak distinction between different leases. This being said, if the Boards ultimately do arrive at the conclusion that Type B P&L impacts are a desirable outcome, it would, in our view, be more correct to apply annuity amortisation to the entire population of lease contracts, without classification or categorisation, on the grounds that all right of use assets are a new, specific category of assets that warrant specific measurement. The new proposals do not provide better information for users Feedback provided by the relatively few user representatives who comment on this project shows that not all users consider all "leases" to be the same type of instruments. They do not think that leases always give rise to the same economic effects, nor to assets and liabilities in every circumstance. Additionally, depending on their analysis perspective, users look to understand different aspects of a lessee s business, and thus find different kinds of information to be more or less relevant 5. Those who focus on expected cash flows want to understand an entity s contractual commitments under leases as well as under all kinds of other executory (service) contracts. Others seek to understand an entity s return on assets employed and would prefer to see leased assets reflected under a model where the full value of the underlying asset is recognised on the lessee s books. There are also those who view some leases as being equivalent to financing a purchase and other leases as straightforward operating expenses. It is impossible to find a practical solution to the Right of Use model that would reconcile these perspectives and information needs. 4 For instance, the US Equipment Leasing and Finance Association has estimated that approximately 80% of the total undiscounted dollar amount of committed operating lease payments in the US, which is in the region of 1.25 trillion USD, is for leases of property. A survey of European preparers Are you ready for the new leases standard? Preparers Views on new Lease Accounting: European Impact Survey 2010,by PWC Accounting & Valuation Advisory Services reveals that the situation is similar at European level, with 82% of the operating lease commitments reported by respondents being for leases of property. Another survey of preparers, The potential impact of the right-of-use model for lease accounting on a sample of UK companies, by the Winchester Business School confirms the predominance of real estate in operating leases in the UK. 5 These user views are taken from the IASB staff s summary of feedback received during their informal outreach undertaken in April and May 2012 (IASB staff paper presented at the May 2012 Board meeting). Page 5 of 24

6 At the same time, users obviously welcome simple, consistent and transparent information 6. Given that the new ED proposals not only introduce different types of leases the nature of which is difficult to understand, expenses and cash flow components related to Type A and Type B leases are required to being shown in different line items of the P&L and cash flow statement respectively. Consequently, it is likely to be significantly more complex for users to identify information on leases than it is today. These aspects alone make it highly unlikely that the financial information under the new proposals will be an improvement on the existing model. In fact, the IASB recognises that users will continue to make adjustments going forward. In our opinion, given the weak conceptual background of the proposals, users will not be able to fully understand the information that preparers will be required to provide. As a result, we do not see any meaningful benefits of changing existing lease accounting along the lines that the Boards are proposing. Indeed, a key group of user representatives in the US has recently signalled their intention to formally object to the proposals because they are too complex and not an improvement over current accounting 7. Moreover, we consider that the costs of change will be substantial for preparers of accounts. Cost and complexity appear to be inherent to the Right of Use model Leaseurope and many other stakeholders have repeatedly expressed significant concerns regarding the cost and complexity of the proposals. We recognise that the Boards have taken steps to reduce the complexity associated with certain aspects of the original ED, particularly by changing the treatment of optional periods, contingent rentals and short term leases. These are all welcome steps in the right direction. However, the inherent complexity of the Right of Use model has not gone away. Our analysis of the types of complexity and ensuing costs that entities would have to deal with has not fundamentally changed since the first ED. For instance, entities would still have to be able to consistently understand and apply a new definition of a lease. Identifying a potentially enormous number of contracts that meet the new lease definition and collating the related information throughout an organisation will still be an immense task. Contrary to what is stated in the Basis for Conclusions, the vast majority of lessees do not have systems in place to track and account for lease agreements in the level of detail required by the ED. Indeed, such systems will have to be largely developed from scratch, something that can only be done after completion of the project. Moreover, those entities who use lease documentation to outsource their asset usage requirements will find even the simplest aspects of right of use accounting significantly more complex than dealing with such contracts as operating expenses. These entities precisely do not want to worry about allocating rental payments between service and lease amounts, maintaining right of use asset registers, etc. They are simply seeking the convenience of a single, regular expense instead. Moreover, new concepts such as a significant economic incentive will likely also be difficult to interpret and apply. Reassessments, although perhaps less frequently required than under the first ED, will remain an additional burden. 6 Idem 7 FASB Investors Technical Advisory Committee (ITAC) 27 August 2013 Page 6 of 24

7 The new classification requirements will further complicate the accounting process, as will the proposed disclosure requirements. In our opinion, the Boards analysis of the costs associated with the proposals is oversimplified and vastly understates the costs preparers will have to incur. The proposed disclosure requirements go far beyond existing requirements and appear to have been included in an effort to remedy potential flaws of the model. In our view, disclosures should instead complement the more high-level information presented in the other statements. However, on top of extremely burdensome reconciliation requirements, that are similar to but go beyond those for owned assets, the new disclosures also require a description of how entities have decided whether or not they have a lease and how they have split service and lease components. A standard that is sufficiently robust should have provided clear principles on which entities base their decisions and should not need additional disclosures to explain to users how these principles have been interpreted and applied. Lastly, we have repeatedly warned against attempts to completely overhaul the conceptual basis for lease contracts without taking into account the potential longer-term, economic impacts of such a change. The European Commission examines the economic consequences of every planned initiative before it becomes part of EU legislation. If a new lease accounting standard is to become part of EU legislation in the future, it should be subject to the same, rigorous impact assessment. The types of economic impacts we have identified include, notably, the knock-on effects that will inevitably occur on the accounting standards used by SMEs. Around 40% of European SMEs are users of leasing. The progressive introduction of complex right of use concepts into their accounting would very likely to lead to a reduction in their use of leasing, leaving them with little or no alternatives to access assets, other than outright purchases of equipment. In many cases and particularly in the current environment where access to funding is an important issue for SMEs, this may very well prove to be impossible. Similarly, the effects on public accounting standards should not be ignored. Moreover, with references being made to IFRS leasing concepts in many areas of European tax and financial legislation, as well as in European case law, the consequences for businesses using and granting leases will be significant and yet have been entirely ignored. For instance, lessees such as banks operating in regulated markets, will see impacts on most of their Basel 3 requirements (including their capital requirements for credit and operational risks and leverage ratios), even though their risk profile will not have changed in practice. Finally, complex accounting requirements that would create barriers preventing businesses access to productive assets would be especially unwelcome in a European environment where policy makers are precisely seeking to kick start economic growth by promoting business investment Page 7 of 24

8 IAS17, its classification principles with complementary, high quality disclosures, must be the way forward for global lease accounting In light of the above, Leaseurope considers that the Right of Use model is not practicable, does not have clear or sufficiently mature concepts, does not provide high quality financial information, is too complex and will be excessively costly to implement and apply. Until these issues can be addressed, and for the reasons given above, we recommend that the Boards do not adopt a new leases standard on the basis of a Right of Use approach. However, as the Boards develop their asset and liability definitions in the context of their project on the Conceptual Framework, we recommend that they also analyse the most appropriate accounting for all types of contractual rights and obligations. At this stage, we think that retaining IAS17 and its classification principles, properly enforced and uniformly and unambiguously applied across all jurisdictions, is the way forward. With the Boards leases project having drawn attention to leasing arrangements, preparers, auditors and users will also place greater emphasis on high quality disclosures for leases. In this context, we think that the current disclosure requirements for IAS 17 operating leases can usefully be complemented in a way that will effectively cater to the wide-ranging needs of users. Improvements to IAS 17 disclosures can also be completed fairly rapidly as new requirements can draw heavily on the work that has been done on the leases project so far. In our opinion, there are numerous advantages to an approach that retains an IAS 17 principlesbased categorisation of leases with improved disclosures and presentation. First of all, by retaining a theoretical framework that is well understood with meaningful disclosures, users would have the necessary information and flexibility to gain a full understanding of an entity s use of leasing and determine the metrics they consider to be the most useful in their analysis of a company. Improved presentation within lessee accounts that clearly allows users to identify leased assets from owned assets would also be helpful in this respect. Secondly, the cost of change for users and preparers has been cited as one of the major difficulties with the Boards proposals. If designed carefully, costs would be much more limited under an approach that aims to improve lease disclosures without overhauling completely the conceptual framework for these contracts. Lastly, the other longer-term, economic impacts of the Right of Use model listed above and that have not yet been analysed by the Boards would be avoided. Page 8 of 24

9 Our answers to the questions posed in the revised Exposure Draft are set out below in Appendix 1. These comments are intended to provide constructive input into the Boards re-deliberation process but should not be interpreted as sign of support for the Right of Use model. We provide an example of disclosures that could be required to complement IAS 17 with the information necessary to address user needs in Appendix 2. We thank you for taking the time to consider our response to the Leases ED and remain at your disposal to discuss any of the issues raised herein further. Please do not hesitate to contact us or Leaseurope s Director of Asset Finance and Research, Jacqueline Mills (mailto:j.mills@leaseurope.org, ) for any additional information you may require. Yours sincerely, Tanguy van de Werve LEASEUROPE DIRECTOR GENERAL Mark Venus CHAIR, LEASEUROPE ACCOUNTING COMMITTEE About Leaseurope Leaseurope brings together 44 member associations representing the leasing, long term and/or short term automotive rental industries in the 33 European countries in which they are present. The scope of products covered by Leaseurope members ranges from hire purchase and finance leases to operating leases of all asset categories (automotive, equipment and real estate). It also includes the short term rental of cars, vans and trucks. It is estimated that Leaseurope represents approximately 92% of the European leasing market and in 2012, total new leasing volumes worth billion were granted by the firms represented through Leaseurope s members. More info at Page 9 of 24

10 Appendix 1. Leaseurope s Responses to the Leases ED Questions Question 1: Identifying a lease While we welcome the steps the Boards have taken to improve the definition of a lease in a Right of Use context, we still have significant concerns that the line being drawn between leases and service is arbitrary and will be extremely difficult to apply in practice. Moreover, the definition of a lease requires a level of judgement that is so significant that it is unlikely to be interpreted or applied consistently, resulting in a potential lack of comparability of financial information for leases. Fulfilment of the contract depends on the use of an identified asset We consider that this part of the definition of a lease has been usefully clarified since the original ED. For instance, many outsourcing contracts may very well specify assets by serial or registration number. This is simply a precaution on the part of the supplier to be able to ensure clear identification of the assets it owns, it does not imply that the client is seeking to use or finance a specific asset. We therefore agree that the supplier s ability to substitute the asset indicates that the client does not wish to finance a particular item. We think that while ED 8-9 (description of when an asset is identified and conditions for when a supplier s right is considered to substantive) reflects this notion appropriately, the Basis for Conclusions provides a certain cause for concern. Indeed BC 105(b) may be interpreted in such a way that asset substitution would effectively have to be demonstrated in order for a contract to qualify as a service contract. Instead, it must be the supplier s ability to substitute the asset that determines whether or not this criteria is met, not whether substitution has (or will) take place in practice. We therefore recommend that the wording related to substitution clauses be removed from BC 105(b) to avoid any confusion. Contract conveys the right to control the use of an identified asset While we appreciate that the Boards have tried to align the notion of control used in the Leases ED with that from the Revenue Recognition standard, we still have reservations as to whether the proposed guidance will effectively lead to the appropriate conclusions regarding whether a contract is or is not a lease. As the proposals stand, contracts with the same economic effects for a lessee will alternatively be classed as leases or service contracts depending on who supplies the consumables to be used with the asset. For instance, examples 2 and 3 from the Illustrative Examples create the exact same rights and obligations for the client, with the client being contractually obliged to use consumables from the supplier in both cases. However, the Boards conclude that example 2 is not a lease whereas example 3 is a lease because other parties provide consumables that can be used with the underlying asset. Clearly, the existence of other providers of consumables, parts or supplies cannot be used as a factor that determines when an entity is able to direct the use of the underlying asset. Page 10 of 24

11 In our opinion, examples such as these show that the new line the Boards is trying to draw between contracts that fall under the Leases guidance and those that do not is still very arbitrary and in some cases counter-intuitive. It is also not at all clear that different parties (preparers, users, auditors) will interpret the guidance consistently. The level of judgment required may be too important to yield consistent conclusions and thus comparable information between entities. Consequently, we do not consider the definition of a lease is sufficiently robust for use in a final standard at this point. Moreover, entities will have to assess thousands of contracts, including all of their outsourcing arrangements, against these complex requirements. There is no indication that such a costly effort on the part of preparers would effectively bring useful information to users of accounts overall. Separating the components of a contract One of the advantages of outsourcing asset-needs to a leasing company is that the lessor can take care of the wide variety of service components that are necessary for the client to be able to benefit from the asset s use. In some cases, the use of assets can actually be secondary to the service that the entity wishes to obtain. This form of bundling provides operational simplicity to clients, because their asset and service related payments are grouped into one operating expense. Such contracts are becoming increasingly popular as firms choose to focus on their core activities and tend to outsource those asset needs that are ancillary to their business. While some of these contracts may be excluded from the scope of this standard, ED 19 (incidental assets) is too restrictive to cater for the majority of these contracts. If they qualify as leases, it will be extremely burdensome for preparers to identify and separate service and lease components, if not impossible. Even the simple aspects of accounting for the service and right of use components separately, such as creating asset registers, recognising depreciation, etc. may lead to part of the economic rationale for opting for these contracts falling away. This is still a significant source of the complexity of the Boards proposals that has not been substantially improved. We consider that this creates an unacceptable level of new work for preparers that could jeopardise the business model of outsourcing asset management. Entities would then have no choice but to enter into separate asset management contracts and asset purchases, which would represent a significant step backwards in modern business practice. This being said, should the Boards proceed with the model set out in the ED, we would encourage them to consider the following issues: Lessors separating service components Leaseurope has repeatedly made the point that, by definition, lessors/suppliers have the necessary information to be able to split out individual components. Page 11 of 24

12 Our remaining concern is that, in spite of having this information, the reference to the notion of distinct performance obligations taken from the Revenue Recognition standard may not always lead to the conclusion that the lessor should separate its various components. For instance, the goods and services in a bundle can be highly interrelated, integrated and customised to suit the customer. Some may consider this to be the case for instance in full service leasing contracts such as vehicle contract hire. In such a situation, Revenue Recognition would not qualify the bundle as being composed of distinct performance obligations. To avoid uncertainty and misinterpretations, we recommend that the Boards modify ED 22 to read as follows: 22. After identifying the lease components in a contract in accordance with paragraph 20, a lessor shall allocate the consideration in the contract using its information on lease and service components originally used to build the contract requirements in paragraphs of [draft] IFRS X Revenue from Contracts with Customers. Lessees separating service components For those contracts that do qualify as leases, lessees should separate out service components when information is available. In this context, the new ED s requirements are broadly an improvement over the original ED. However, we do not think that the absence of observable prices for certain components should automatically lead to the recognition of a single lease component which would include services. For instance, the fact that there may not be an observable price could actually indicate that the contract is not a lease. Instead of accounting for a single lease component in such cases, lessees should be permitted to make a reasonable estimate of service and lease components, accounting only for the latter under the Leases guidance. We understand that this would be consistent with Revenue Recognition guidance. Question 2: Lessee accounting We do not agree with the proposal. As explained in our introductory remarks, the underlying principles of the Right of Use model are that all leases give rise to the same assets and liabilities. If one accepts this premise, then all leases should be accounted for in the same way. If different leases have different economic effects as the Boards argue in the Basis for Conclusions, then the logical conclusion is that a Right of Use model cannot be applied to all of these contracts. The Boards proposals amount to considering all equipment leases to be financing transactions. This completely ignores the fact that a significant portion of equipment leases are entered into to avoid the inflexibilities and risks associated with ownership and/or to outsource activities related to the asset and are not financing transactions. The Boards argue that Type B leases are being entered into primarily to obtain the use of an asset (BC42) and, in such a case, that a straight line lease expense represents better information. We think that all leases involve the use of assets and that there are many more contracts where the economics are better represented by the recognition of an operating expense than what is suggested by the current proposals. Page 12 of 24

13 In our view, IAS 17 much better reflects, both from a balance sheet and P&L perspective, the real economic difference between lease contracts where the entity uses leasing in a manner that is similar to an outright purchase of the underlying asset compared to cases where an entity uses lease documentation to obtain a service involving the use of assets and avoid the taking of asset risk. We view the proposed accounting for Type B leases as being a poor compromise, designed solely to make the Right of Use model palatable to certain groups of constituents. As they stand, the proposals introduce confusion as to what the nature of Type B leases are (are they financings or not). The P&L and cash flow statement information suggests that they are not. However, the Boards still view all lease liabilities as financial liabilities (BC33) and require disclosure of the interest component on Type B leases in the notes to the accounts. It is also unclear why assets and liabilities should be recognised at all for Type B leases if they do not represent financing transactions. Type B leases could very well be presented net (as the asset value is plugged so as to equal the liability), in which case the model would effectively amount to current operating lease accounting. Moreover, Type B lease accounting will distort users analysis, for instance when they attempt to calculate ratios such as net debt or interest coverage. Lastly, the solution described in the ED of course does not address the negative impacts of frontloading lease expenses for Type A lessees. The Boards appear to have not taken such effects into account, and yet they could be equally as important as for Type B leases. The front-loading of expenses for Type A leases leads to the following: 1) A lack of comparability between lessee accounts. Lessees with identical rights and obligations would not have the same accounting, for instance when one enters into a 3 year lease of an asset that is at inception and the other has entered into a 6 year lease of the same asset that is 3 years into the contract (all else being equal). The first lessee would appear to be more profitable. 2) An increase in lease costs. As pointed out in the Basis for Conclusions, the increase in lease costs depends on the lessee s lease portfolio. However, in cases of businesses with more incoming leases than expiring leases, there will be no portfolio-level compensation of the front-loaded expense pattern but rather a permanent loss for the lessee. 3) A mismatch between lease costs and cash rentals paid. In many jurisdictions this will result in book/tax timing differences that will not help improve the clarity of nor facilitate the comparability between lessee financial statements. 4) A misrepresentation of the economics of the deal. In taking out a lease, a lessee often seeks to match its lease expenses and revenues. These economics are not reflected by front loaded expenses. We have significant concerns that these purely accounting effects could influence businesses economic reasons for choosing to lease whereas accounting should not be driving such decisions. Page 13 of 24

14 If the Boards want to address concerns surrounding the front-loading of lease expenses and still maintain a Right of Use model, there is only one way in which this can be done that would be conceptually coherent. This would be to apply annuity amortisation to all leases that fall under the scope of the standard, without introducing classification, and requiring the separation of the interest and amortisation components of a lease in the P&L. The Boards dismissed the annuity amortisation approach on the grounds that it is not used for owned assets. However, it reflects the fact that, in a lease, the asset and liability side form an inseparable package, originating from the same contract, contrary to say a purchase of an asset financed by a loan where the loan and the purchase have distinct contractual origins. In a lease, the lessee cannot sell the liability without selling the asset or vice versa. It is also consistent with the fact that the asset and liability side in a lease both unwind to zero by the end of the contract. Additionally, we think that if the Boards introduce a new type of asset, the Right of Use asset, it could be appropriate to introduce new, specific measurement requirements for these assets. Other reasons for dismissing annuity amortisation included concerns around system changes, but this applies equally to Type B leases under the revised proposals. If the Boards are unwilling to go down the route of introducing a new amortisation pattern for all Right of Use assets, it is the Right of Use model itself that should be called into question. Short term leases We welcome the revised measurement proposals for short term leases, which represent a simplification over the previous ED. We are however concerned that the Boards have not included the notion of significant economic incentive into the definition of short term leases. As the proposals stand, an entity that would have an option to extend an 11 month contract for 6 months would be precluded from the exemption. Nevertheless, that entity could conclude that it does not have a significant economic incentive to extend the lease, and would end up having to apply the full guidance to a lease of 11 months. We do not think that the information benefits for users in such a case would outweigh the costs for preparers. The ED is also unclear as to precisely what disclosures are required for short-term leases. For instance, ED sets out the requirements for short term leases, and says that lessees may elect not to apply the requirements in ED and However, the disclosure requirements are given in ED and short-term lessees are not excluded from those. This is probably an oversight as requiring the same level of disclosures for short term leases (including by Type A and Type B leases) as for other leases would effectively cancel out any form of relief for preparers. The same concern arises for short term lessors. Lastly, short term lessees are exempt from ED 57, yet ED 57 specifically mentions short term leases. Page 14 of 24

15 Question 3: Lessor accounting For the Right of Use model to be theoretically coherent, we consider that the receivable and residual model should be the general model for all lessors, except for investment property leases where the fair value option is applied. This being said, we recognise that there are other types of lessors, such as those who lease a part of an otherwise owner-occupied building, other property lessors, certain equipment full-service lessors, etc. that would prefer to continue to use operating lease accounting. However, applying operating lease accounting to lessors fundamentally contradicts the Right of Use model. It is impossible to justify the fact that a lessor has transferred a valuable right to a lessee when the lessor retains the entire value of the underlying asset on its books. This is why the accounting for Type B leases from the lessor s point of view is inconsistent with the Type B lessees recognising an asset. Again, we therefore consider that instead of introducing fixes into the lease standard in attempt to make the Right of Use model work, the Boards should instead question the validity and applicability of the model. Receivable and residual model This being said, we think that the Boards have improved the receivable and residual model compared to the first ED. One significant improvement is the introduction of accretion for residual assets. This approach appropriately reflects the economics of the transaction and the lessor s level of return (the lessor is seeking to earn a return on its entire investment in the lease, i.e. on the receivable and the residual). Another aspect of the model that has been improved is sales profit recognition for manufacturer/dealer lessors. Nevertheless, while we view proportionate sales income as being consistent with the notion that the lessor has sold a part of the underlying asset (i.e. the Right of Use), we are concerned that the proposals may restrict the market by forcing manufacturer/dealer lessors that grant finance leases today to enter into agreements with third parties. Impairment for lessors At first glance, it seems logical that the proposals (ED 84) require the lease receivable to be tested for impairment in accordance with IAS39 (or the future credit losses standard) and the residual according to IAS36. However, because the definition of a lease receivable in the Leases ED is different to that of IAS17 8, the impairment rules will apply to a different unit of account than they do today. While the proposed requirements apply to the lessor s receivable and residual assets separately, today a lessor tests its net investment in the lease for impairment (i.e. the receivable and residual, referred to as lease assets in the new ED). If under the future Leases standard it is not allowed to the same, this will result in the lessor being forced to recognise impairment losses that it actually does not have when the value of the leased asset covers any credit loss. 8 Under IAS17, the lessor s receivable is the net investment in the lease which is the aggregate of minimum lease payments and any unguaranteed residual value discounted at the rate implicit in the lease. However, under the ED, residuals are not included in the lessor s receivable. Page 15 of 24

16 In practice, where there is any indication of impairment/expected loss, lessors look to the underlying asset. Indeed, lessors will take possession of the leased asset immediately on default of the lessee and seek to realise the asset in cash as soon as possible - in this way the lessor will recover its investment in the lease wholly or partly, and in some cases, can even achieve proceeds on asset disposal over and above the carrying value of the net investment in the lease. This practice does not have any regard to the distinction between how much of the investment in the lease relates to outstanding receivables and how much relates to the interest in the residual asset. Any allocation between the two parts would be entirely arbitrary. We note that the Boards have recognised that the lessor is seeking to achieve a return on its entire investment in the lease hence their decision to accrete the residual asset over the lease term and to require presentation of these lease assets as a total. We think that this reasoning should also be carried through to the impairment requirements for lessors. We understand nevertheless from contacts with the Boards that it is not their intention to require separate and independent impairment of the receivable and residual. If this is the case, the wording of the ED should be changed to make this clear in any future standard. This would involve changing ED 84 and 85 so that impairment is assessed by comparing the fair value of the underlying asset to the carrying value of the lease assets (or net investment in the lease). Moreover, the scope of either the existing impairment rules in IAS39 or the new impairment standard will need to be revised so as to refer to lease assets (or net investment in the lease) instead of lease receivable. In addition to credit loss impairment issues, the ED also gives rise to a number of concerns for residual asset impairment. Today, those lessors who have operating leases apply IAS36 to their leased assets. The Boards have translated this requirement into the Leases ED by requiring lessors to assess the residual asset for impairment in accordance with IAS36. However, while IAS36 works well when assessing current physical assets, a direct transposition does not work in the context of residual assets, which represent future physical assets (that the lessor will obtain at the end of the lease and the full sets of its rights are reunited). Of course, lessors must consider whether the expected value of the leased assets at the end of the lease may change. For instance, there may be an event that provokes a downward movement in second hand asset prices which would mean that the originally projected value of the residual asset at the end of the lease would be overstated, albeit the investment in the lease could very well still be recoverable. Equally, second hand asset values could also move upwards. We suggest therefore that in the context of the Leases ED it is more appropriate for lessors to reflect these movements in prices by adjusting their periodic accretion of the residual asset to their latest forecast of the final value of the residual (i.e. to the expected value of the asset at the end of the lease). Particularly if done on a portfolio basis, this would be consistent with lessor business models and is the equivalent of applying the prospective depreciation and impairment rules of IAS16 and IAS36 respectively (in an operating lease context) to a Right of Use model. Moreover, accounting for movements in the lessor's estimates of future asset prices provides much more meaningful information to users of accounts who want to understand the effects that these movements would have on a lessor (i.e. the extent of their exposure to asset risk). Page 16 of 24

17 Lessor presentation balance sheet We recommend that the following presentation be used in order to implement the above impairment requirements: Includes impairments relating to both asset and credit risk Residual Receivable Lease assets (Impairment) Net lease assets With guaranteed and non-guaranteed residuals presented separately (in primary statements or notes) Additionally, guaranteed residual exposures should form part of the lessor s receivable (as in such cases the lessor is no longer exposed to asset risk) or, at the very least, guaranteed and unguaranteed residual exposures should be presented separately in order to provide users with a more precise view of the types of risk a lessor is facing. Question 4: Classification If the Boards wish to maintain a Right of Use model, we disagree that classification should be introduced into the standard, notably as this goes against the original project objectives. Classification also introduces complexity and the possibility that similar transactions are accounted for differently. We recall that, as the Leases standard is currently proposed, there will be two important classification lines, i.e. Type A/Type B leases and leases/services. We also do not think that consumption of the economic benefits is necessarily an appropriate classification principle for driving subsequent measurement. This is because it looks at the underlying asset, rather than the actual asset that the lessee has obtained, i.e. the Right of Use asset, which is supposed to be the same asset under Type A and Type B leases and will always be consumed entirely over its life. This seems difficult to reconcile with a model that is supposed to look at an entity s rights. While we agree that there are economic differences between different types of leases, we do not think that the pattern of consumption of an underlying asset can be used to drive how a lease liability is accounted for. We understand that the Boards have introduced a practical expedient (ED 28-35), rather than the classification principle itself, into the standard. As the Boards recognise this expedient is not always consistent with the principle, we question why the principle itself has not been included into the body of the standard. Page 17 of 24

18 Moreover, the practical expedient has little conceptual merit in that it appears to have been designed to allow Type B accounting for those leases that the Boards have simply decided should qualify for this type of treatment. For example, a 4 year lease of a rail car with a 50-year economic life would qualify as a Type B lease (BC 125 b)) but according to the illustrative example number 12, a 2 year lease of an item of equipment with an economic life for 12 years would be a Type A lease. The Boards interpretation of insignificant does not seem to be consistent. Examples of inconsistencies in the practical expedient include the following: Skewed classification thresholds for equipment leases compared to property leases (e.g. equipment leases would only qualify as Type B leases if they are for an insignificant part of the total economic life of the underlying asset rather than for not a major part of the total economic life), due to the assumption that all equipment leases must be financing transactions, which ignores the economics of many such contracts. An underestimation of the number of cases where a lessee will consume more than an insignificant part of the economic benefits associated with property, i.e. this occurs more often than simply in cases where the duration of the lease term is for most of the economic life of the property. A departure from the asset consumption principle where Type A classification is based on a comparison of the lease term with the asset s total economic life, rather than the remaining economic life. This is also inconsistent with the second criterion which compares the present value of lease payments to the full fair value of the underlying asset. Entities may be able to achieve a desired P&L profile depending on the assessment of their lease term (i.e. depending on whether or not they conclude they have a significant economic incentive to exercise an option). In our view, if there is any form of classification, it should be based on IAS 17 principles and it should drive recognition rather than measurement. Question 5: Lease term We welcome the fact that Boards have moved away from the complex notion of longest term more likely than not to occur as this would have consistently resulted in lessees recognising assets and liabilities that they did not effectively have while having to perform extremely burdensome and unnecessary calculations at the same time. Although we understand that the newly proposed threshold of the lessee having a significant economic incentive to exercise an option is intended to be higher than the original proposal, we have concerns regarding the application of this notion in practice. We also consider that a lessee that has a 4 year lease and another lessee that has a 2 year lease with the significant economic incentive to renew this lease for a further 2 years are not in the same position and that this should be reflected in their accounts. In our view, any approach to determining a likely term goes beyond the true obligations of a lessee. Our conclusion therefore remains that only lease payments required to be made during the initial contractual lease term should be recognised, together with amounts that would be required to be paid to obtain optional flexibility. Page 18 of 24

19 We question whether constituents will effectively understand how high the significant economic incentive threshold is supposed to be as guidance relating to the level of the threshold itself is not given in the ED, nor in the Basis for Conclusions. If the Boards really intend to make this a high hurdle for recognition, this should be explicitly stated in the standard. Similarly, while we understand that the Boards expect reassessments to be less frequent than under the initial ED, we remain unconvinced that this would effectively be the case in practice. We recall that the frequency of reassessment was cited as being one of the major unnecessary complexities with the initial proposals. The Boards should clarify within the ED itself that reassessments would only occur in exceptional cases. Moreover, as the significant economic incentive concept is highly subjective and ill-defined, we doubt that preparers, users and auditors will apply it with sufficient consistency to make the resulting accounting information comparable between companies. Lastly, the criterion has to be assessed from a lessee s point of view, even for the lessor s assessment of its receivable. It is unlikely that lessors will be able to determine lessee s behaviour in this way. This may already prove to be difficult upon initial recognition but the difficulty is likely to increase when it comes to determining whether or not the lessor should make a reassessment. As we have pointed out before, this is a crucial consideration as the outcome of this assessment could lead lessors to recognising assets they do not control. Therefore, our suggested approach, if the Right of Use model is to be retained, is that lessees recognise only their contractually committed (enforceable) payments, representing their effective liability. This would include any amounts that are required to be paid by the lessee either to obtain the ability to extend the lease term beyond the initial contractual term or to obtain the ability to purchase the asset at the end of the contract in addition to any amounts the lessee is required to pay if the lease contains a renewal or purchase option but where the lessee does not renew the lease or purchase the asset. The relevant amount payable under a residual value guarantee provided by a lessee to the lessor should also be included in the payments that are recognised. The concepts should be similar from the lessor s point of view. We consider that this approach mitigates the flaws associated with determining a likely lease term, whilst at the same time effectively recognising the commitments and risks that a lessee has under a lease. As already pointed out in our response to the original ED, this is because renewal options in reality either have no intrinsic value, or are already priced into the lease payments, or will lead to the lessor showing a higher residual exposure. In any of these situations, our approach will always appropriately reflect the true risks and commitments of both parties. This is detailed below, with the same reasoning applying to purchase options and termination options: 1) Renewal options allowing the lessee to extend the lease after the initial lease term at the then market rate (or an equivalent one-off payment.) Such an option has no intrinsic value as the lessee could simply obtain a new lease at the end of the initial lease. 2) Renewal options allowing the lessee to extend the lease after the initial lease term at a rate lower than the then market rate rentals (or an equivalent payment). Renewal options at lower than market rentals (or an equivalent payment) will either have been priced into the level of rentals of the initial lease term (which will be higher than if there is no such option) Page 19 of 24

20 or will be granted in conjunction with a residual value guarantee designed to protect the lessor from the shortfall between the secondary period rentals and market rentals. In the first case, the value of the option reflected in the higher rentals will already have been taken into account into the lessee s obligation to make rental payments and its right of use asset. In the second case, the relevant amount payable under a residual value guarantee is included in minimum lease payments. Consequently, the value of the option is appropriately taken in to account. 3) Renewal options allowing the lessee to extend the lease after the initial lease term at a rate higher than the then market rate rentals (or an equivalent payment). Renewals could also be granted at an above market rental. In such situations, if the rentals in the initial lease period are lower than they would be otherwise, the lessor is exposing itself to a significant risk that the lessee will not renew the lease (indeed, the lessee has no obligation to renew). The lessor accounting will reflect this situation clearly, by showing a large residual asset that will be clearly visible to users. Lessors will therefore only grant such leases if they are effectively comfortable with taking on such risk. In practice, it is unlikely that they will do so to any great extent but even if such contracts are granted, the accounting model will always appropriately reflect the true risks and commitments of both parties. Lastly, if the Boards do decide to maintain an approach whereby they try to approximate a likely lease term, it may be more appropriate for them to refer to the reasonably certain threshold that is used in current guidance for the recognition of bargain purchase options instead of significant economic incentive. As the Boards themselves point out, this threshold is considered to work sufficiently well in practice. It therefore seems reasonable to maintain that wording rather than introducing a new concept that could significantly alter practice, particularly given the risk that entities would apply it differently. Question 6: Lease payments We welcome the Boards decision to limit the recognition of lease payments to contractual fixed payments and contingent rentals based on usage or a performance factors to in-substance fixed leased payments. With respect to variable payments that depend on an index or rate, we think that the decision to allow the use of the spot rate is more appropriate than the requirements of the initial ED. However, we think that lease liabilities linked to a rate should simply be treated like other floating rate liabilities. That is to say that changes in amounts payable arising from variations in an underlying rate or index should be recognised in profit or loss in the period in which they occur to be consistent with the treatment of other financial liabilities. The recognition of such changes as an adjustment to the carrying amount of the right-of-use asset just brings about more complexity for lessees with no additional benefit, particularly as the proposals also require the adjustment of the discount rate. Indeed, reassessment on the basis of an adjusted discount rate effectively would produce the same measurement outcome for the majority of leases as the revised lease payments would be discounted at a new discount rate. At the very least, the approach adopted for such leases should be equivalent to that adopted for financial liabilities carried at amortised cost under IAS39. Page 20 of 24