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«Leases Project Subsequent measurement of leases with options and contingent rentals under amortised cost Topic Introduction Purpose 1. At the ...»

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IASB agenda

IASB Meeting 20 January 2010 9B

reference

FASB

- Education Session January 13 FASB memo

reference

Leases

Project

Subsequent measurement of leases with options and contingent

rentals under amortised cost

Topic

Introduction

Purpose

1. At the November 2009 joint meeting, the boards tentatively decided that the

subsequent measurement of the lessee’s obligation and the lessor’s receivable

should be at amortised cost using the effective interest method.

2. The purpose of this paper is to address how to apply the mechanics of amortised cost using the effective interest method to the subsequent measurement of the lessee’s obligation and the lessor’s receivable where there are reassessments of the expected lease term and contingent rentals.

3. This paper addresses the following issues:

(a) whether the incremental borrowing rate used to calculate the lessee’s

obligation to pay rentals should be revised under the amortised costbased approach where there are subsequent reassessments of:

(i) the expected lease term; and (ii) contingent rentals; and (b) whether the interest rate implicit in the lease used to calculate the lessor’s receivable should be revised under the amortised cost-based

approach where there are subsequent reassessments of:

(i) the expected lease term; and (ii) contingent rentals.

4. This paper is structured as follows:

Page 1 of 25 (a) discussion on the definition and mechanics of amortised cost using the effective interest method under IFRS and US GAAP;

(b) discussions on lessee accounting as follows:

(i) the implication of the boards’ tentative decision to subsequently measure the obligation to pay rentals at amortised cost; and (ii) for the issues outlined in paragraph 3(a) above:

 discussion of possible approaches; and  staff recommendations and questions; and (c) discussions on lessor accounting as follows:

(i) the implication of the boards’ tentative decision to subsequently measure the lessor’s receivable at amortised

–  –  –

(a) for the lessee’s obligation to make rental payments, the incremental borrowing rate should not be revised under the amortised cost-based

approach where there are subsequent reassessments of:

–  –  –

(b) for the lessor’s right to receive rentals, the interest rate implicit in the lease should not be revised under the amortised cost-based approach

where there are subsequent reassessments of:

–  –  –

(a) the required accounting for the obligation to pay rentals would be specified within the leases standard rather than by cross-referring to existing requirements for similar obligations;

(b) the initial measurement of the lessee’s obligation to pay rentals would be at the present value of the lease payments, discounted using the lessee's incremental borrowing rate;

(c) the subsequent measurement of the lessee’s obligation to pay rentals would be at amortised cost using the effective interest method; and (d) in a simple lease, the obligation to pay rentals would not be revised for any changes in the lessee’s incremental borrowing rate.

7. The boards asked the staff to consider whether the lessee’s incremental borrowing rate should be revised when the lessee’s expectations about the lease term change.

8. The boards also made the following tentative decisions on lessor accounting:

(a) the required accounting for the right to receive rental payments would be specified within the leases standard rather than by cross-referring to existing requirements for similar assets;

(b) the initial measurement of the lessor’s receivable would be at the present value of the lease payments discounted using the interest rate implicit in the lease plus any initial direct costs incurred by the lessor;

and (c) the subsequent measurement of the lessor’s receivable would be at amortised cost using the effective interest method.

Amortised cost and the effective interest method under IFRS and

US GAAP

9. Under IAS 39 Financial Instruments: Recognition and Measurement amortised

cost is defined as:

–  –  –

11. The principles of amortised cost under the IASB’s exposure draft on Financial Instruments: Amortised Cost and Impairment (ED) are the same as those under IAS 39. Amortised cost is the present value of a series of cash flows calculated

using the following inputs:

–  –  –

13. The FASB is reconsidering the definition of amortised cost in its financial

instruments project. The FASB has tentatively decided that:

–  –  –

14. The FASB has not yet, but will be addressing in the financial instruments project how the effective interest rate interacts with the amortised cost definition.

Paragraph 6 of IASB’s exposure draft on Financial Instruments: Amortised Cost and Impairment

–  –  –





16. In summary, amortised cost under IFRS is a cost-based measurement. The discount rate is not updated for subsequent revisions to the expected cash flows (unless part or all of the interest rate is contractually reset to current conditions eg floating rate instruments with a LIBOR reset).

17. On the other hand, it is debatable whether amortised cost could be considered a cost-based subsequent measurement under US GAAP in all circumstances. That is because in some instances US GAAP requires the discount rate to be recalculated for subsequent revisions to expected cash flows or expected terms of the financial instruments and in other cases the discount rate is not recalculated.

Lessee accounting

18. At their November 2009 joint meeting the boards tentatively decided to measure the lessee’s obligations to pay rentals at amortised cost using the lessee’s incremental borrowing rate.

19. If the boards had decided to require lessees to account for the obligation to pay rentals in accordance with existing requirements for financial liabilities, some obligations to pay rentals under more complex lease contracts might not have qualified for amortised cost measurement in their entirety. This would have reduced comparability between different types of lease transactions.

Leases with options - subsequent changes in the lease term

20. At their November 2009 joint meeting, the boards tentatively decided that for

lease contracts that grant the lessee the right to extend or terminate the lease:

–  –  –

(a) approach 1: no reassessment of the incremental borrowing rate;

(b) approach 2: reassess by updating for the current incremental borrowing rate for the remaining of the expected lease term; and (c) approach 3: reassess the incremental borrowing rate with the corresponding rate at initial recognition for the revised expected lease term.

22. The following example illustrates the three approaches:

–  –  –

Approach 1: no reassessment to the incremental borrowing rate

23. Under the principles and measurement objectives of the requirements of IAS 39 and the proposals in the IASB’s Exposure Draft (ED) Amortised Cost and

–  –  –

24. Approach 1 is the most consistent with the principles of amortised cost under IFRS because the discount rate will not be reset because of reassessment of the lease term.

25. Lease term options are in a way similar to additional draw downs of a multidraw loan commitment facility, where options to extend constitute additional installments of the facility. For these multi-draw facilities, the interest rate to be charged is set at inception. The rate set at inception should already reflect the possibility of further draw-downs or of not using part of the facility. Similarly, for a lease with an option to extend, the incremental borrowing rate used at the inception should already reflect that the lease contains an option to extend.

26. The staff note that in practice it may be difficult to determine a discount rate that exactly matches the terms of the lease including the option to extend. However, the staff also note that if the interest rate implicit in the lease is used as the discount rate, the interest rate implicit in the lease would reflect the option to extend.

27. Also note that under approach 1, credit risk will not be remeasured. In June 2009, the IASB issued a discussion paper Credit Risk in Liability Measurement that requested constituents’ view on how (and whether) credit risk should be incorporated into liability measurement. Respondents to that paper generally think that credit risk should not be subsequently remeasured for financial liabilities at other than fair value. Comment letter analysis on the IASB’s discussion paper was presented to the IASB (October 2009, Agenda paper 6).

Copies of that analysis are available to board members on request.

28. Approach 1 is also the least complex and costly for preparers to apply.

Refer to paragraph 16 of this paper.

–  –  –

Approach 2: reassessment by updating for the current incremental borrowing rate for the remaining expected lease term

30. Some staff argue that by exercising the option to extend the lease, the lessee has effectively entered into a new lease agreement and hence the incremental borrowing rate should be updated to reflect this. However, other staff believe that the option to extend is an integral part of the lease agreement at inception.

That is, the lessee has not signed up to a new lease when it exercises the option to extend, because the terms of the lease at inception already contain the option to extend, so the pricing of the lease should already reflect the various terms of the lease including the extension option. Furthermore, it is inconsistent with the boards’ decision not to adopt a components approach.

31. The staff note that under this approach the credit risk of the lessee will be remeasured.

–  –  –

Approach 3: reassess the incremental borrowing rate with the corresponding rate at initial recognition for the revised expected leased term.

33. Under approach 3, the entity retrospectively revises its discount rate from lease inception when it reassesses the longest possible lease term that it is more likely than not to occur.

34. The disadvantages of approach 3 are as follows:

–  –  –

35. For the reasons stated in paragraphs 23 to 29 above, some staff recommend approach 1. They do not recommend approach 2 because it is inconsistent with the principles and measurement objectives of amortised cost under IAS 39 and the IASB ED. However, some staff support approach 2 for the reasons set out in paragraph 30. The staff do not recommend approach 3.

–  –  –

Subsequent reassessments of contingent rentals

36. This section of the paper discusses whether the lessee should be required to revise the incremental borrowing rate where there are changes in amounts payable under contingent rental arrangements.

37. There are five possible approaches to deal with this issue:

(a) approach 1: no reassessment of the incremental borrowing rate;

(b) approach 2: no reassessment of the incremental borrowing rate unless the rentals are contingent upon variable reference interest rates;

–  –  –

(d) approach 4: recalculate the effective interest rate based on revised future contingent rentals ; and (e) approach 5: recalculate the effective interest rate based on actual contingent rentals to date and revised future contingent rentals.

38. Appendix C sets out examples to illustrate these five possible approaches.

–  –  –

39. Approach 1 is consistent with amortised cost measurement under IFRS to the extent that contingent rentals are not linked to variable reference interest rates.

Under approach 1, the lessee’s incremental borrowing rate is not reassessed irrespective of whether contingent rentals are linked to variable reference interest rates.

40. Paragraph B2 of the IASB ED states:

If an entity revises its estimates of payments or receipts, the entity shall adjust the carrying amount of the financial asset or financial liability…to reflect actual cash flows and the revised estimated of expected cash flows… The entity recalculates the carrying amount by computing the present value of expected cash flows (on the basis of the revised estimate) using the financial instrument’s effective interest rate…

41. The following table summarises the advantages and disadvantages of

approach 1:

–  –  –

42. Under the principles and measurement objectives of the IASB’s ED Amortised Cost and Impairment3, the effective interest rate is not adjusted unless all or part of the rate is contractually reset to current conditions eg the LIBOR component of a variable rate financial instrument. (Refer to example C2 of Appendix C).

43. This approach is the most consistent with strict application of the measurement principles of amortised cost under IFRS4. For example, for contingent rentals linked to variable reference interest rates such as LIBOR, the reassessment of contingent rentals would require revising the incremental borrowing rate to take into account market changes in variable interest rates.

44. By not reassessing the discount rate, (unless the rentals are contingent on variable reference interest rates) it reflects conditions at lease inception, which is consistent with the notion of cost-based measurement. This approach is less complex and costly for preparers to apply and the staff think that it provides more relevant information than approaches 4 and 5.



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