IASB Exposure Draft ED/2020/4 Lease Liability in a Sale and Leaseback – Proposed amendment to IFRS 16

Page 1 of 8Our Ref.: C/FRSCSent electronically through the IASB Website (www.ifrs.org)

24 March 2021Mr Hans HoogervorstInternational Accounting Standards BoardColumbus Building7 Westferry CircusCanary WharfLondon E14 4HDUnited KingdomDear Hans,IASB Exposure Draft ED/2020/4Lease Liability in a Sale and Leaseback – Proposed amendment to IFRS 16The Hong Kong Institute of Certified Public Accountants (HKICPA) is the only bodyauthorised by law to set and promulgate standards relating to financial reporting, auditing,and ethics for professional accountants, in Hong Kong. We are grateful for the opportunityto provide you with our comments on this Exposure Draft (ED).The HKICPA appreciates the IASB’s initiative to improve the accounting requirements forsale and leaseback transactions, and acknowledges the difficulties encountered by theIASB to improve these requirements without making significant changes to IFRS 16 Leasesat this stage.Nevertheless, we disagree with the proposals for the primary reasons that there is a lack inconceptual basis to account for a lease liability arising from a sale and leasebacktransaction (leaseback liability) differently from a normal lease liability and we find theproposals complex to apply.The HKICPA has carefully reviewed the ED and performed outreach with local stakeholdersto broaden awareness of the proposals and collect feedback. We provide responses to thequestions raised in this ED in the Appendix, with our primary concerns being as follows:

There is lack of conceptual basis to account for a leaseback liability differently from anormal lease liability.It is debatable whether all variable lease payments meet the definition of a leaseliability as indicated in paragraph BC168 of IFRS 16. The cost-benefits and otherconsiderations detailed in paragraph BC169 of IFRS 16 are equally applicable in asale and leaseback transaction.The proposed hybrid measurement model for the leaseback liability (see appendixfor details) does not provide relevant information regarding the financial position,profit or loss, or the cash flows of the seller-lessee; nor does it provide a holistic viewof the economics of the sale and leaseback transaction.The proposals would introduce significant practical challenges with regard to theestimation of future variable lease payments both from a preparer’s and an auditor’sperspective.Entities might have to incur significant costs to reconfigure their existing accountingsystems to cater for the new measurement requirements for leaseback liabilities.Page 2 of 8The ED introduces a new undefined term “shortfalls” which raises further questions.Additional disclosures should be required for users to get a holistic view of theeconomics of the sale and leaseback transaction, particularly regarding the impact inprofit or loss and the statement of cash flows if the proposals were to be pursued.Instead of recognising a lease liability as per paragraph 100(a)(ii) of the ED, ourstakeholders provided possible alternatives including recognising a full gain (similar toparagraphs AV1-AV4 of the ED) or a deferred gain on the date of the sale and leasebacktransaction.In terms of the deferred gain approach, the seller-lessee would (i) measure the right-of-use(RoU) asset and the gain/loss on the sale and leaseback transaction in accordance withthe existing guidance in paragraph 100(a) of IFRS 16; (ii) measure the leaseback liabilityon the same basis as a normal lease liability; and (iii) recognise any resulting difference(net of selling price) as a deferred gain. The deferred gain would be amortised over thelease term to profit or loss on a straight line or other systematic basis.We acknowledge there might be limited conceptual basis to these alternatives; however,they are simpler to apply than the proposals in the ED (which in our view also lack inconceptual basis) and they do not introduce significant changes to the existing principles inIFRS 16.In addition to the above, we would suggest the IASB consider allowing other alternatives indetermining the proportion of the asset retained depending on facts and circumstances andnot restrict its determination to the present value of the expected future lease payments asa proportion of the fair value of the asset sold as proposed in paragraph 100(a)(i) of the ED.Given the inherent conflict between the requirements for a sale and leaseback transactionand those for a normal lease in IFRS 16, we believe the IASB should revisit these issuesholistically in the post-implementation review of IFRS 16.If you have any questions regarding the matters raised in this letter, please contact me(ceciliakwei@hkicpa.org.hk) or Joni Kan, Associate Director of the Standard SettingDepartment (jonikan@hkicpa.org.hk).Sincerely,Cecilia KweiDirector, Standard Setting DepartmentPage 3 of 8Work undertaken by HKICPA in forming its views:

The HKICPA:

(a) issued an Invitation to Comment on the ED on 11 December 2020 to our stakeholders;

(b) sought input from its Leases Advisory Panel comprising technical and industry expertsand auditors from accounting firms; and(c) developed its views through its Financial Reporting Standards Committee, havingreflected on its stakeholders’ feedback. The Committee comprises academics, preparerrepresentatives from various industry sectors, investors, regulators, and technical andindustry experts from small, medium and large accounting firms.This submission outlines the HKICPA's views and summarises our stakeholders' commentson the ED/2020/4.Detailed comments on IASB ED/2020/4Question 1 – Measurement of the right-of-use asset and lease liability arising from asale and leaseback transactionStakeholders’ viewsLack of conceptual basis to account for a leaseback liability differently from a normal leaseliability1)

Stakeholders are generally concerned that the IASB is proposing a fundamentalchange to how an entity accounts for a lease liability arising from a sale and leasebacktransaction (leaseback liability). They find that paragraphs BC9-BC15 of the ED donot provide any conceptual basis for recognising a leaseback liability for expectedvariable lease payments. Instead, the IASB acknowledges at paragraph BC11 of theED that the measurement of the leaseback liability is a function of how the right-of-use (RoU) asset and the gain/loss on the sale and leaseback transaction is initiallymeasured, effectively relegating the leaseback liability to a ‘residual’ construct withoutconceptual basis.2)

The absence of a robust conceptual basis to rationalise the internal conflict betweenthe measurement of a leaseback liability and a normal lease liability creates a risk ofunintended consequences, and detracts from the quality and usefulness of thefinancial information produced.3)

Some stakeholders recommended the IASB should conduct a more fundamental andthorough analysis of what principles should prevail at the initial recognition of a saleand leaseback transaction, including fixed and/or variable lease payments.4)

Several practitioners shared that, as noted in paragraph BC168 of IFRS 16 Leases,there are divergent views as to whether variable lease payments linked to the futureperformance or use of an underlying asset meet the definition of a liability. Hence, itis questionable whether the proposals in paragraphs 100(a)(ii) and 100A(b) of the EDregarding a lease liability are conceptually sound.5)

These practitioners believed that the existing principles in paragraph 100(a) of IFRS16 can be applied to a sale and leaseback transaction involving variable leasepayments not based on an index or a rate by simply measuring the leaseback liabilityusing the normal principles of IFRS 16 and recognising any difference as a deferredgain (instead of recognising it as a leaseback liability as per proposed paragraphAppendixPage 4 of 8100(a)(ii) of the ED). The deferred gain would then be amortised to profit or loss overthe leaseback term on a straight-line or other systematic basis.6)

A few practitioners are of the view that the gain/loss on the sale of the asset shouldbe recognised in full at the date of the transaction as rationalised by arguments similarto those explained in paragraphs AV1-AV4 of the ED, and that the leasebackarrangement should be accounted for as a new normal lease arrangement.7)

On the other hand, a practitioner disagreed with the deferred gain and full gainconcepts because in his view, since the RoU asset represents the portion of the fullasset that has not been sold, no gain could arise on that portion as no sale has takenplace for that portion of the asset. As such, there is no gain to be deferred in the firstplace. Hence, in his view, neither the full gain nor the deferred gain alternative isconceptually sound.8)

A few practitioners understood that the IASB would like to add additional guidance onhow to determine the proportion of the asset retained given the current lack ofguidance. However, they find the proposals requiring a determination of the presentvalue of the expected future lease payments, including reference to the fair value ofthe asset sold, complex and potentially not practicable in certain circumstances.Additionally, other methods may be appropriate depending on facts andcircumstances, e.g. to compare the leaseback period with the remaining useful life ofthe asset sold. Accordingly, they suggest that the IASB not restrict the method ofdetermination to that proposed in the ED.9)

Several stakeholders also commented that the introduction of the ED’s proposalswould be disruptive to preparers. This is because substantial system changes maybe necessary to cater for the proposed different measurement bases for sale andleaseback transactions and normal lease arrangements.The proposed hybrid measurement model for the leaseback liability does not providerelevant information for the transaction10)

Some stakeholders considered that the prohibition of remeasuring the leasebackliability to reflect a change in future variable lease payments (except for a change inlease term or a lease modification) per paragraph 102B(c) of the ED indirectlyintroduces a “hybrid measurement model”. Under such a hybrid measurement model,the initial estimates are recognised as a leaseback liability and any differencebetween those initial estimates (barring any modifications or changes in lease term)

and actual payments is recognised in profit or loss as they arise. This hybridmeasurement model was not contemplated when the IASB developed IFRS 16 andthe current presentation and disclosure requirements do not provide meaningfulinformation to users of financial statements (see paragraph 11).11)

As noted in paragraph BC3 of the ED, sale and leaseback transactions often involvehigh-value assets with a long economic life. If the IASB’s observation in BC19 of theED is indeed appropriate that an entity could reasonably estimate variable leasepayments for sale and leaseback transactions, the majority of our stakeholders areof the view that the prohibition of remeasuring the leaseback liability for changes inexpected variable lease payments (other than for a change in lease term or a leasemodification) would significantly undermine the usefulness of financial information.This is because the estimates made on initial recognition would become less relevantgiven changes in facts and circumstances over a potentially long period of time. Inparticular:

Page 5 of 8the balance sheet may no longer faithfully represent the current liquidity positionof the seller-lessee;

the profit and loss split between depreciation, interest expense and the gainsor losses arising from the differences between the actual and expected leasepayments may become meaningless as they are computed based on outdatedexpectations; andthe statement of cash flows split between operating cash flows (differencebetween actual and expected lease payments) and financing cash flows(principal portions of the expected lease payments) may not fairly represent theentity’s approach to cash management as it is based on outdated information.12)

Stakeholders understood and appreciated that the prohibition on revising estimatesis made on cost and benefit grounds, and it was noted that paragraph BC30 of theED states that IFRS 16 already includes various simplifications for variable leasepayments (which was used to support the ED’s proposal). However, those othersimplifications would not result in the anomalies noted in paragraph 11 above. Thisis because under the existing model:

no lease liability is recognised for variable lease payments that are notdependent on an index or a rate. Such lease payments are expensed asincurred; andthe lease liability is remeasured when there is a change to the cash flows forvariable lease payments that are dependent on an index or rate (paragraph42(b) of IFRS 16). In other words, the lease liability is based on relatively currentinformation, and apart from depreciation and interest expense, no gains orlosses arising from the differences between the actual and expected leasepayments are recognised in profit or loss.13)

Some stakeholders suggested the IASB should consider analogising to paragraph42(b) of IFRS 16 to require a remeasurement of the leaseback liability in relation tovariable lease payments that are dependent on an index or a rate when there is achange to future cash flows. However, to be consistent with the initial measurementof the leaseback liability as per paragraphs 100(a)(ii) and 100A of the ED, suchsubsequent remeasurement should include expected future changes in the index orrate, and not be based on the index or rate on the date of remeasurement. Such asuggestion is obviously subject to cost/benefits considerations.14)

Paragraph 102B(c) of the ED requires a seller-lessee to remeasure the leasebackliability as specified in paragraph 36(c) of IFRS 16, except in the circumstancesdescribed in paragraph 42(b) of IFRS 16. This means a remeasurement is requiredin the following circumstances:

change in lease term;

change in assessment of whether to exercise a purchase option (not applicablehere as the presence of a purchase option would have precluded thetransaction to qualify as a sale in the first place in terms of paragraph B66 ofIFRS 15 Revenue from Contracts with Customers);

change in expected residual value guarantee (RVG);

change in in-substance fixed lease payments; orlease modifications.Page 6 of 8However, the second and the last sentences of paragraph 102B(c) of the ED refersto a change in lease term and lease modification only. We recommend that the IASBinclude references to changes in RVG and in-substance fixed lease payments inthese sentences to ensure consistent application.15)

With regard to applying paragraph 102B(c) of the ED in remeasuring the leasebackliability, stakeholders had split views on whether the corresponding adjustment shouldbe recognised in profit or loss or be recognised against the RoU asset. Somestakeholders supported recognition in profit or loss given the RoU asset arising froma leaseback transaction is initially measured differently from that of a normal leasearrangement. Hence, the principles in paragraph 39 of IFRS 16 do not apply. Incontrast, other stakeholders considered the impact should adjust the RoU assetsimilar to the normal principle for remeasurement as stated in paragraph 39 of IFRS16, to avoid structuring opportunities for gains in future periods.16)

A majority of our stakeholders suggested that the IASB reconsider the drafting ofparagraph 102B(c) of the ED as they find the current wording difficult to understand.Measurement uncertainty of variable lease payments17)

Stakeholders generally considered that estimating performance-based variable leasepayments and future changes in indices or rates is subject to the same high level ofmeasurement uncertainty for a sale and leaseback transaction as that for a normallease arrangement.18)

Many stakeholders considered that the IASB’s concerns regarding variable leasepayments when developing IFRS 16 (as noted in paragraphs BC163-169 of IFRS 16)

remain valid with regard to a sale and leaseback transaction. Future changes inindices and rates are outside the control of an entity, and estimation does notnecessarily become more certain under a sale and leaseback transaction. As forperformance-based variable lease payments, having owned the asset before doesnot necessarily make the estimation of future performance more reliable than in anormal lease arrangement, as one would expect the entity to have carried out properfinancial due diligence before entering into a normal lease arrangement subject toperformance-based variable lease payments. These stakeholders questionedwhether the observation in paragraph BC19(a) of the ED that ‘the Board expects thatseller-lessees would be able to reasonably estimate the expected lease payments’ isjustified.A new undefined term “shortfalls”

19)

Paragraph 102B(d) of the ED states “If there are shortfalls in the actual paymentsmade (i.e. payments made are less than the payments due) or recoveries ofshortfalls…”. The term “shortfalls” is not defined in the proposal, nor is it an existingconcept in IFRS 16. The reference to the lessee’s paying less than what is due impliesthere has been a credit loss event, and the proposals require the leaseback liabilityto be reduced with a corresponding entry to profit or loss; however, it is not clearwhether the seller-lessee has been legally released from the obligation to pay.20)

Some stakeholders recommended the IASB revisit the wording of paragraph 102B(d)

of the ED and clarify what is meant by “shortfalls”, with examples illustrating thejournal entries to ensure consistent application.Page 7 of 8Additional disclosure requirements21)

The current disclosure requirements in paragraphs 53(a), (b) and (e) of IFRS 16 donot cater for variable lease payments that are recognised as lease liabilities. As such,the value of information provided by these paragraphs, if unchanged, would be dilutedas users would not be able to ascertain what the full variable lease payments wereduring the year, which is split into depreciation, interest expense and other variablegains/losses under the proposals.22)

Paragraph 59(b)(i) of IFRS 16 is limited to future cash outflows not included in thelease liability and does not require disclosure of future cash savings that could ariseunder the proposals (e.g. the actual performance-based lease payments are less thanthe initial expected performance-based lease payments).23)

Overall, stakeholders believe that the IASB should consider requiring separatedisclosures for sale and leaseback transactions and normal lease transactions onboth initial recognition and subsequent measurement given the inherent differencesin accounting between these transactions under the proposals.Other drafting issues24)

Stakeholders have asked the IASB to clarify the following drafting issues:

The first sentence of paragraph 102B(d) of the ED – it is not clear why the IASBexcludes above-market terms only and not below-market terms as well.Paragraph 102(b) of the ED – suggest rewording as ‘the difference between thepresent value of the contractual expected lease payments and the presentvalue of the payments for the lease at market rates’. This is because the key isto compare contractual rates (e.g. 2% of turnover) with market rates (e.g. 5%of turnover) in order to work out the off-market portion. However, the currentwording refers to ‘contractual payments’ and ‘expected lease payments’ withoutany reference to market rates which is the same thing (both at 2% of turnoverusing the above numbers).HKICPA analysis and recommendation25)

The HKICPA shares similar concerns as expressed by our stakeholders on theproposed amendments in the ED. There is a lack of conceptual basis for introducinga different measurement model for the leaseback liability compared to a normal leaseliability. Additionally, the proposed hybrid measurement model for a leaseback liability,with no remeasurement thereof when there is a change in the expected futurevariable lease payments (barring a change in lease term or a lease modification),would not provide relevant information to users with regard to the financial position,financial performance or cash flows of the seller-lessee in relation to the sale andleaseback transaction. Moreover, the proposals are complex and preparers’ existingaccounting systems may not be able to cater for the proposed requirements. All thesefactors will increase costs and complexity for entities when applying the Standard.26)

We acknowledge that the IASB explains in paragraph BC19 of the ED that seller-lessees would be able to reasonably estimate the expected lease payments becauseseller-lessees are in a different position from normal lessees. However, stakeholdersgenerally believe that estimating future variable lease payments for sale andleaseback transactions (performance-based or based on index/rate) are subject tothe same high level of estimation uncertainty as with normal lease arrangementsPage 8 of 8because the lease payments depend on factors that are outside the seller-lessee’scontrol.27)

In light of the above, we recommend that the IASB conduct a thorough analysis ofwhat principles should prevail at the initial recognition of a sale and leasebacktransaction involving variable lease payments.28)

In order to provide a short-term solution that is simple to apply with minimal changesto IFRS 16, we suggest that the IASB consider the alternatives suggested by ourstakeholders; namely recognising a full gain or a deferred gain on the date of the saleand leaseback transaction. Though these alternatives may not be conceptually ideal(noting that in our view there is a similar lack of conceptual basis for the proposals inthe ED), they are simple to apply without significant amendments to the existingStandard.29)

If the Board decides to go ahead with the proposals, we would recommend the Board:

Consider alternatives to determining the proportion of the asset retained underparagraph 100(a)(i) of the ED and not limit the determination to the presentvalue of the expected lease payments as a proportion of the fair value of theasset sold;

Consider analogising to paragraph 42(b) of IFRS 16 to require aremeasurement of the leaseback liability in relation to index-based variablelease payments when there is a change to the cash flows. However, to beconsistent with the leaseback liability’s initial measurement, such aremeasurement should include expected future changes in the index/rate, andnot be based on the index/rate on the date of remeasurement. A similarremeasurement should be required in the circumstances described inparagraph B42(a)(ii) of IFRS 16 in relation to in-substance fixed lease payments;

Clarify the drafting of paragraphs 102(b), 102B(c) and (d) of the ED to addressour stakeholders’ concerns;

Introduce additional disclosure requirements to address sale and leasebacktransactions involving variable lease payments regardless of whether theydepend on an index or a rate; andRe-assess the sale and leaseback accounting in the post-implementationreview of IFRS 16.Question 2 – TransitionStakeholders’ views30)

Stakeholders generally agreed with and did not have major comments on theproposed transition requirements in paragraph C20E of the ED.HKICPA analysis and recommendation31)

If the IASB decides to go ahead with the proposals, we agree with the proposedtransition requirements, particularly the requirements in paragraph C20E of the ED toavoid the use of hindsight and to ensure consistent application as explained inparagraph BC34 of the ED.