IASB Exposure Draft ED/2013/6 - Leases

Our Ref: PSD/ED18/2013

Sunday, 16 December 2018

Hans Hoogervorst

Chairman IASB

30 Cannon Street

London EC4M 6XH

United Kingdom

Dear Hans,

IASB Exposure Draft ED/2013/6 - Leases

The Institute of Certified Public Accountants of Kenya (ICPAK) welcomes the opportunity to comment on the Exposure Draft (ED/2013/6) – Leases; issued by the International Accounting Standards Board (IASB).

We commend the IASB’s and FASB’s commitment to achieving the goal of convergence between the two sets of standards and encourage both Boards to continue their efforts to achieve a single set of accounting requirements. However, although we fully support the Boards’ goal to improve lease accounting, we are not fully convinced that the Board should proceed with finalization of the ED in its current form at this time. We recognise that the IASB has emphasised in its communications that the project was intended to recognise financial liabilities that are currently not included in the statement of financial position (balance sheet) and we feel this narrowed the focus of this ED in the development of the right-of-use model. We are concerned by the lack of concepts on “right-of-use” model and this might add to complexities in implementing the standard.

We note that by focusing largely on the right to use tangible assets, the model creates a distinction between contractual rights to use tangible assets, intangible assets and service assets. This would create opportunities to skew transactions to obtain a particular accounting result. The focus on rights of use also poses a complexity challenge which may significantly impact on the relevance of financial information as it requires preparers to separate lease arrangements into relevant (lease) and irrelevant (non-lease) elements for purposes of recognition. Various aspects of accounting for a right of use asset by the lessee are also problematic. For example, we are not convinced that the Boards’ existing guidance on impairment, or the application of the revaluation model in IAS 16 Property, Plant and Equipment, are appropriate for a right of use asset.

We are also not convinced that the IASB could have got it“wrong” on “operating leases” for such a long time and believe that the aspect of “...substantially all” and “less than substantially all” provided a clearer distinction than the proposal to have “insignificant” and “more than insignificant” in recognition, measurement and presentation of leases.

We have included our responses to each of the questions set forth in this ED, in an appendix to this letter.

If you would like to discuss these comments further, please contact the undersigned on r the undersigned at .

Yours Faithfully,

Nixon Omindi

Manager, Professional Standard

For Professional Standards Committee

Appendix – ICPAK’s Submission on the IASB Exposure Draft ED/2013/6Leases

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Question 1: Identifying a lease

Do you agree with the definition of a lease and the proposed requirements in paragraphs 6–19 for how an entity would determine whether a contract contains a lease? Why or why not? If not, how would you define a lease? Please supply specific fact patterns, if any, to which you think the proposed definition of a lease is difficult to apply or leads to a conclusion that does not reflect the economics of the transaction.

ICPAK agrees with the proposed definition of a lease and welcomes the changes introduced since it tends to align with the concept of control as defined in IFRS 10 - Consolidated Financial Statements and the Exposure Draft Revenue from Contracts with Customers (ED Revenue). It is also an improvement to the definition and criteria as provided for in IFRIC 4 Determining whether an Arrangement contains a Lease.

Question 2: Lessee accounting

Do you agree that the recognition, measurement and presentation of expenses and cash flows arising from a lease should differ for different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why?

ICPAK prefers the differentiation in IAS 17, where the distinction is between ‘substantially all’ and ‘less than substantially all’ rather than between ‘insignificant’ and ‘more than insignificant’. As noted in paragraph 5 of the Alternative View (AV), we are concerned about the application of the proposed classification model without providing additional guidance on the key concepts. We encourage the IASB to develop more guidance on the concept of “substantially all”, “major part” and “insignificant” to ensure correct application of the same.

Question 3: Lessor accounting

Do you agree that a lessor should apply a different accounting approach to different leases, depending on whether the lessee is expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset? Why or why not? If not, what alternative approach would you propose and why?

As stated above, we do not agree with classifying leases from the perspective of the lessor based on transfer of more than an “insignificant portion” of the economic benefits to the lessee. ICPAK notes that this is not consistent with the criteria in the forthcoming revenue recognition standard for transfer of the significant risks and rewards of ownership of the asset. The proposed model poses a potential risk of different accounting treatments for economically similar transactions.

Also see our additional comments under Question 13 below.

Question 4: classification of leases

Do you agree that the principle on the lessee’s expected consumption of the economic benefits embedded in the underlying asset should be applied using the requirements set out in paragraphs 28–34, which differ depending on whether the underlying asset is property? Why or why not? If not, what alternative approach would you propose and why?

Even though ICPAK agrees that consumption of the underlying asset is one of the indicators of whether control of the underlying asset has transferred to the customer; we do not believe that it is the only factor that should be considered in making that determination. The general approach is that all Type A leases have a ‘financing’ element, the ED does not recognise a ‘pure’ finance lease (such as hire purchase) where title automatically passes at the end of the lease period. We believe that assets acquired under such leases should be recognised ab initio as property, plant and equipment [IAS 16] and not as right-of-use assets, recognising that the substance of the transaction is the purchase of an asset (on deferred payment terms). Failing this, the ED should clarify the accounting treatment for a right-of-use asset when title transfers to the lessee. Logically the asset would be reclassified at this point to property, plant and equipment at its existing carrying amount (IE 9-Lessee accounting for purchase options). We suggest that the IASB amend paragraph 31 to read “… a lease is classified as a Type A lease if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term [borrowed from IAS 17.10] or if the lessee has a significant economic incentive to exercise an option to purchase the underlying asset”. And the same captured in Paragraph 48 to ensure that this is explicitly stated.

The ED does not seem to allow a lease of land and buildings to be split (contrary to IAS 17.16, which requires that a lease of land and buildings be split). Paragraph 20 talks about identifying each separate lease component, but an asset within a lease component containing more than one asset is separated only if the underlying asset is neither dependent on, nor highly interrelated with, the other underlying assets. There is need for more guidance on “dependent or highly interrelated”. For a lease of land and buildings the two, or more, underlying assets would be regarded as highly interrelated. Paragraph 32 states that the economic life of the ‘primary’ asset shall be regarded as the economic life of the underlying asset, in determining the classification of the lease. Paragraph 48 then requires the lessee to amortise the right-of-use asset (singular) to the earlier of the end of the useful life of the right-of-use asset (again singular) or the end of the lease term. Unlike paragraph 32, paragraph 48 is silent on which of the underlying assets should be regarded as the primary asset for the purposes of amortisation.

For illustrative purposes, if an entity purchases a 99 year lease of farm land, with just a barn on it with a remaining useful life of 20 years, the two components are highly interrelated so cannot be separated. Paragraph 33 requires that the life of the building (barn in this case) will be the life of the underlying asset when applying the classification criteria, it is not clear what would be the useful life of the underlying asset in determining amortisation in accordance with paragraph 48?

Question 5: Lease term

Do you agree with the proposals on lease term, including the reassessment of the lease term if there is a change in relevant factors? Why or why not? If not, how do you propose that a lessee and a lessor should determine the lease term and why?

ICPAKagrees that the ED will more faithfully reflect the reasonably expected effective duration of a lease, and consequently the rights and obligations that arise from lease agreement

Question 6: Variable lease payments

Do you agree with the proposals on the measurement of variable lease payments, including reassessment if there is a change in an index or a rate used to determine lease payments? Why or why not? If not, how do you propose that a lessee and a lessor should account for variable lease payments and why?

We agreed. However, we foresee a likely spate of leases dressed up as having variable lease payments by entities that want to avoid recognising a lease liability and a right of use asset. We note that the ED tries to address this in paragraph 39(c) by including “variable lease payments that are in-substance fixed payments”, but drafters of leases will no doubt be very creative in trying to disguise the substance of the lease payments, in the way that finance leases were dressed up to look like operating leases under IAS 17. Wetherefore encourage the IASB to clarify how to determine whether variable lease payments are “…in-substance fixed payments”, as we believe the principle in the ED and the Illustrative Examples may not be sufficient to capture all possible types of variable payments that might qualify as “in-substance fixed payments”.

Question 7: Transition

Paragraphs C2–C22 state that a lessee and a lessor would recognise and measure leases at the beginning of the earliest period presented using either a modified retrospective approach or a full retrospective approach. Do you agree with those proposals? Why or why not? If not, what transition requirements do you propose and why?

Are there any additional transition issues the boards should consider? If yes, what are they and why?

ICPAK prefers full retrospective applicationbecause it increases comparability between entities and transactions. We agree with granting practical reliefs that lead to the reduction of implementation costs and the proposal to carry forward the amounts recognised before the transition date for leases previously classified as finance leases as it will avoid recognition for a second time after adopting the new standard of expenses already charged in the lessee’s profit and loss.

Question 8: Disclosure

Paragraphs 58–67 and 98–109 set out the disclosure requirements for a lessee and a lessor. Those proposals include maturity analyses of undiscounted lease payments; reconciliations of amounts recognised in the statement of financial position; and narrative disclosures about leases (including information about variable lease payments and options). Do you agree with those proposals? Why or why not? If not, what changes do you propose and why?

ICPAK supports the ED proposals on disclosures and welcomes the introduction of disclosure objectives as part of those requirements. We believe that this will help to ensure that the most relevant information is provided to users of financial statements. Indeed, requirements related to the disclosure of significant assumptions and judgements made by entities allow users to understand better the analysis performed by an entity on lease contracts.

(Questions 9-11 FASB-only)

Question 12: Consequential amendments to IAS 40

Do you agree that a right-of-use asset should be within the scope of IAS 40 if the leased property meets the definition of investment property? If not, what alternative would you propose and why?

ICPAK agrees with the requirement to include the right-of-use arising from a lease of a property within the scope of IAS 40, provided that the leased property meets the definition of an investment property.

Question 13: Additional Comments

We encourage the IASB to further consult on the issues mentioned under BC 3 especially:-

BC 3(a) says “...many users often adjust the financial statements to capitalise a lessee’s operating leases”. We are puzzled by this conclusion since we are yet to come across such users or a case where management of an entity capitalising operating leases in their management accounts to help them with their decision making. The IASB should provide statistical assessment of these “many users”.
BC 3(b) complains that under IAS 17 “...transactions that are economically similar can be accounted for very differently”. We opine that misses the whole point of IAS 17, which is that not all leases are “economically similar”, and that the accounting treatment should reflect the economic substance of the lease. Ironically, under the ED, “economically similar” transactions would be accounted for in 3 different ways (short term, Type A and Type B) instead of the 2 alternatives in IAS 17.

We are puzzled that an operating lease meets the criteria for recognition as an asset and a liability on commencement of the lease and are wondering why it has taken the IASB to figure out this anomaly (if so). If leases were not excluded from the scope of IAS 38, the contract itself would qualify as an intangible asset, but its value would be determined by whether the lease payments represented market values, or whether the lease was on favourable or unfavourable terms. BC 15(a) states that “the lessee has a present obligation to make lease payments once the underlying asset has been delivered (or made available) to the lessee”. If the lessee enters into a lease of a building for 5 years requiring monthly payments of rent, in my view the underlying asset is “delivered” progressively over that period, not all on the commencement of the lease, reflected in the fact that the lease payments fall due progressively over the same period. In this situation we believe it is counter-intuitive to claim that there is a present obligation (as opposed to a future obligation) for the whole “lease liability” on commencement, and that it is somehow a financing transaction.

The ED seems to presume that any lease of an asset, other than property, for more than 12 months is a device to finance the business. Assuming an entity hires a truck for 18 months, say, paying CU 1,000 per month, expecting to earn revenue of CU 1,500 per month from the use of that truck, we think it has to be wrong to recognise the net present value of the future cash outflow initially, and then unwind the discount over the 18 month period, ending up with an expense pattern as illustrated in BC 447, and that it is difficult to understand what the interest cost represents (in terms of economic substance). We might end up with a situation where “many users”, including management, have to adjust the financial statements to arrive at the ‘real’ position (in this case – that they are making a profit of CU 500 each month). On the contrary, for a Type B lease where the whole cost is paid up-front, in our view that should be regarded as the net present value of the monthly rents that would have been paid over the period of the lease, and therefore should not be expensed on a straight line basis.

We appreciate that the IAS Board is not concerned with the tax accounting issues that might arise from IFRS, but they should take them into account when considering the cost/benefit aspects of the ED. In our jurisdiction (and likewise a number of jurisdictions), it will be difficult to persuade the Revenue Authority to grant capital allowances on a ‘right-of-use’ asset, or to allow the unwinding of the discount as an interest expense when no money has been borrowed. We already have a situation in Kenya where, if you rent an office paying, say, a monthly rent, the rent is tax deductible, but if you pay up-front for, say, a 30 year lease of an office, the amortisation of the ‘pre-paid operating lease rental’ is not tax deductible, and the pre-paid operating lease rental recognised initially does not qualify for capital allowances. It took about 10 years to persuade the Kenyan government to amend the Income Tax Act to allow computer software capitalised as an intangible asset to qualify for capital allowances! We foresee a tussle in many countries, all the accounting for, in particular, Type A leases under this ED would have to be reversed in the tax computation and substituted by the ‘real’ rental payments leading to some complexity and cost implications.

Paragraphs 54 and 55: I assume the requirements of IAS 1.60 apply to the presentation of lease liabilities, but it might be helpful if the ED stated this explicitly. We also assume that the right of use asset would be presented as non-current, unless the lessee has not made the election under paragraph 118, in which case the right-of-use asset related to short term leases would be presented under current assets. Again it would be helpful if the ED was explicit on this.

We suggest that the IASB provide some guidance in the determination of the discount rate by a lessor for, say, an 18 month rental of a truck. The lessor will not charge the lessee a rate, and we cannot see how one could determine the “rate implicit in the lease”.

Paragraph 4(c): this excludes leases of biological assets from the scope of the ED, but then says “see IAS 41 Agriculture”. There is no reference in IAS 41 to leases of biological assets, so saying “see IAS 41” does not help very much. Under IAS 8.11, management would have to refer to this ED anyway, so it might be better to leave leases of biological assets within the scope of the ED. Leases of biological assets, particularly livestock, are relatively rare, there exist cases of bearer plan leases such as leases of coffee plantations, which include the coffee bushes as a component.