Dataline A look at current financial reporting issues - PwC

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lessee. Clearly both parties are entering into the lease with an expectation of payments being made, so should some amount of the contingent payment be considered an "in-substance" fixed lease payment? If so, what amount? Some factors to consider may be whether this arrangement is consistent with usual business terms offered by the lessor, whether a minimum level of sales or output is required under the contract, how the arrangement terms compare with standard industry practice, and why the contract pricing terms have been structured in this manner. It is not clear whether this issue will be addressed in the revised ED or will be discussed as part of redeliberations that take place after comments are received on the revised ED. .46 "Term option penalties" would be included or excluded in the measurement of lease assets and lease liabilities in a manner that is consistent with the accounting for options to extend or terminate a lease. For example, if a lessee would be required to pay a termination penalty if it does not renew the lease and the renewal period is excluded from the lease term, then that penalty should be included in the recognized lease payments. .47 Variable lease payments will require reassessment as rates and indices change, which may be as often as each reporting period. Reassessing lease payments based on a rate or index will require lessees to re-measure their right-of-use asset and lease obligation each time rates and indices change. Lessees would account for this change in the income statement when it relates to a past or current accounting period and as an adjustment to the right-of-use asset when it relates to a future period. Lessors would account for all changes in the right to receive lease payments due to changes in a rate or an index immediately in the income statement. PwC observation: The requirement for lessors to immediately account for in the income statement all changes in the right to receive lease payments due to movements in a rate or an index represents a significant change from the current models — irrespective of whether the lessor is using an approach similar to existing operating lease accounting or the receivable and residual approach. For example, in a 20-year real estate lease with rents that increase with changes in the Consumer Price Index annually over the base year, a change in the index after year 1 impacts years 2-20 and the present value of the differential hits the income statement in one lump sum. This is not symmetrical to lessee accounting and could result in significant volatility in, and front loading of, earnings relative to the contract rents. Definition of a lease .48 The initial ED carried forward the definition of a lease in existing guidance, subject to some relatively minor amendments. Perhaps the most surprising issue to the boards that came out of the comment letters was the level of concern raised about carrying this forward into the proposals and the extent of application issues in applying the current lease definition that respondents identified. .49 The boards acknowledged during redeliberations that there may be many more multiple-element arrangements that contain an embedded lease than originally expected, which could have substantially increased the complexity and cost of applying the initial ED. Some common agreements that may contain an embedded lease are: National Professional Services Group | CFOdirect Network – www.cfodirect.pwc.com Dataline 18
Time-charter contract: A time charterer enters into a contract with a ship owner for the use of a named cargo ship for 5 years. Under the time charter, cleaning services relating to the cargo space or other relevant services, such as overseeing the loading and unloading of cargo and management of cargo at sea, are the responsibility of the ship owner in addition to maintenance and overhaul. Food and water for the captain and crew are also provided by the owner. The charterer may be chartering the ship either to carry its cargo or cargo owned by third-parties. The charterer pays a daily or monthly hire rate, based on the market price at the date of the contract, for the use of the ship (including the captain) and also pays for the costs of all fuel consumed by the ship and all port fees. Additionally, the time charterer pays all cargo loading and unloading charges. Analysis — An assessment of whether this arrangement is a contract for transportation services or includes an embedded lease of the cargo ship is required. The conclusion will depend on whether the instructions provided in the time charter contract are deemed to convey the right to control the ship to the time charterer even though the captain and crew are provided by the ship owner. Parts supply contract: Purchaser P and Supplier S enter into a parts supply agreement for the lifetime of the finished product concerned. S uses equipment (that is owned by S) that can only be used to manufacture the parts required by P. The equipment is identified in the agreement and S could not use an alternative asset to manufacture the parts. The estimated capacity of the equipment is 500,000 units, which corresponds to the total estimated production of units over the equipment's life cycle. P takes all of the output produced by S using the equipment. Analysis — An assessment of whether this arrangement is a contract for the supply of parts or includes an embedded lease of the equipment used to manufacture the parts is required. The conclusion will depend on whether P has the right to control the equipment based upon the extent of P's involvement in the design of, operation of, and sourcing of the raw materials needed for, the equipment used to manufacture the parts. .50 Under current guidance, a conclusion that a contract for services contains a lease would not have a significant accounting impact for lessees or lessors if the lease is classified as an operating lease. However, this would have changed significantly under the initial ED. The judgment about whether a lease exists and the allocation of contract consideration between the lease and non-lease elements would be much more important for these so-called "embedded leases." PwC observation: Under current guidance, any embedded lease within an arrangement would often be considered an operating lease. However, many lessees do not separate the embedded lease because the accounting for an operating lease and a service/supply arrangement is generally the same (i.e., there is no recognition on the balance sheet and straightline expense is recognized over the contract period). This practice will change with the proposal to recognize leases on the balance sheet. Accordingly, there is likely to be a greater focus on identifying whether a component of an arrangement meets the definition of a lease. .51 During redeliberations, the boards affirmed the proposal in the initial ED to define a lease as “a contract in which the right to use a specified asset (the underlying asset) is conveyed, for a period of time, in exchange for consideration.” National Professional Services Group | CFOdirect Network – www.cfodirect.pwc.com Dataline 19
Page 1 and 2: Dataline A look at current financia
Page 3 and 4: .4 In June 2005, the Securities and
Page 5 and 6: .9 In early 2011, the boards began
Page 7 and 8: .14 Although the project proposes c
Page 9 and 10: Potential outcomes for lessees Star
Page 11 and 12: loss and cash flows. After much bac
Page 13 and 14: The revised dual lessor accounting
Page 15 and 16: Financial Instruments project. Howe
Page 17: PwC observation: Judgment will be r
Page 21 and 22: index or rate that was applicable f
Page 23 and 24: The path forward .61 The boards are
Page 25 and 26: Topic Initial ED Revised ED PwC obs

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