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Difference Between Leases and Service Contracts Becomes Clearer

May 27, 2014

The FASB and IASB agreed to clarify the difference between a lease and a service contract but have yet to write the precise wording. Having a clear definition for a lease contract is a crucial part of the effort to overhaul lease accounting, which under current financial reporting standards lets companies keep lease liabilities off their balance sheets.

The FASB and IASB on May 22, 2014, attempted to clarify the difference between leases and service contracts.

The difference is an important element of the boards’ planned lease accounting standard because service arrangements won’t be covered by the standard. Businesses that use buildings and equipment under lease contracts will have to report the lease costs and record the contract’s value as an outstanding liability on their balance sheets. The requirement is a sea change from accounting practices businesses have employed for years.

The FASB’s Proposed Accounting Standards Update (ASU) No. 2013-270, Leases (Topic 842), and the IASB’s Exposure Draft (ED) No. 2013-6, Leases, defined a lease as “a contract that conveys the right to use an asset for a period of time in exchange for consideration.” The boards don’t plan to fundamentally change the definition.

The draft standards also say a contract contains a lease if the customer controls use of the asset. Control would be determined by assessing whether the customer can direct the asset’s use and will receive the sales and earnings it generates. In contrast, when a supplier controls the use of the underlying asset, the contract is for a service.

In most cases, identifying whether a contract contains a lease is a straightforward exercise. But gray areas emerge for contracts such as charter arrangements in the shipping, oil, and gas industries, power purchase agreements, and subcontracted manufacturing service arrangements, FASB and IASB staff members told the boards.

Many businesses told the boards that the examples in their proposals were overly simplistic or confusing. Some FASB and IASB members agreed, with FASB member Daryl Buck saying he disagreed with conclusion of one of the proposed examples that described a three-year contract for offshore oil drilling.

After debating for more than an hour, the boards agreed on the general direction for clarifying the distinction between leases and service contracts but didn’t decide on the wording. They agreed to give the research staffs “leeway” in drafting new examples that take into account the comments submitted by businesses and board members’ concerns.

Coming up with a universal definition of a lease is crucial to the FASB and IASB’s effort to revamp existing lease accounting standards, which allow companies to keep lease liabilities off their balance sheets. Critics have complained about this long-standing practice for years, and said companies mask significant liabilities by not having to record the cost to rent things like office parks, airplanes, or heavy equipment.

The standard-setters are divided on some of the project’s major components, but setting a consistent definition in IFRS and U.S. GAAP will at least help minimize differences between the two boards. The definition will help the boards determine which contracts have to follow the forthcoming guidance and which will be exempt.

In addition to the lease definition, the FASB and IASB also discussed how to separate lease and non-lease components in a contract, agreeing to largely confirm what was proposed in the 2013 exposure drafts. Determining how to separate and account for a contract’s components is important for businesses that use leases to rent several bundled assets, such as a manufacturing plant, which could include a factory, the land on which the building sits, and the equipment installed in it.

The boards agreed that lessors should apply the guidance in the forthcoming revenue recognition standard to determine the transaction price for a contract’s separate pieces.

The boards also agreed to a slight change to the 2013 proposals and decided that lessees would have the option of separating a contract’s lease and nonlease components, and allocating the component’s costs based on their prices.

Lessees could choose to not separate the contract’s components and treat the entire contract as a single lease.

Finally, the boards decided that lessors will have to record the start-up costs for a lease contract—such as sales commissions and payments to tenants to renew their leases—if the costs wouldn’t have been incurred without the lease.

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