Mr. Hans Hoogervorst Chairman International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom 19 September 2013 Lease Exposure Draft ED/2013/6 Comments on the Exposure Draft Dear Sirs, The Hong Kong Shipowners Association is a trade association representing the interests of shipowners, ship managers and ship operators resident in Hong Kong, as well as the various companies supplying services to those companies. When FASB and IASB (the Boards ) first issued a Lease Exposure Draft in August 2010 (the First ED ), we submitted comments by letter on 14 December 2010 expressing our concerns on the impact of the proposed standards to the shipping industry. On 16 May 2013, the Boards issued a revised Leases Exposure Draft (the Revised ED ) and we are grateful to have the opportunity to make a submission in relation to the Revised ED. According to the Maritime Industry Foundation's Maritime Knowledge Center, over 90% of the world s trade by volume is transported by sea. While the shipping industry is not as well understood by public as other industries, e.g. real estate and airlines, nevertheless, it is of vital importance to the world economy. The Revised ED has addressed some of the concerns arising from the First ED, however, we consider that the business characteristics of shipping companies have not been thoroughly taken into consideration. The Revised ED introduces excessive complexity for the accounting requirements and reduces the understandability and usefulness of the information provided to users. Fundamentally, the Boards assume that leases of all chattels such as aircraft, cars, rolling stock and ships are financing transactions, whereas leases of (real) property are truly leases. In shipping, bareboat charters are usually financing transactions, but time charters are not financing transactions, except for those for whole of the expected useful life of the Vessel, but are based on the acquisition of operating capacity at the market rate prevailing on the day the contract is made, just as a lease of a floor of a building or a home in the market is based on the rental rates at the time of concluding the lease. 1
Our key comments include: There are insufficient guidelines and unclear principles for developing industry specific applications; The presumptions for the classification of dual models may not be appropriate to the shipping companies; The complexity of the accounting treatment will create great cost burdens on shipping companies. We will further discuss the above comments in the following sessions. Insufficient guidelines and unclear principles to develop industry specific application guidance We are concerned that the guidance included in the ED is not sufficient for shipping companies to apply the standards consistently. We understand during the deliberations in early 2011, the Boards included a time charter example in its staff paper for assessing a time charter arrangement and concluded it contained a lease. This example was not included in the Revised ED. While we do not believe time charters should be treated as leases under the revised ED (as further explained below), some people believe that the non-inclusion of such important and relevant example indicates the Board has not determined if time charters are leases. As a result, this could result in diversity of practice. Furthermore, we believe that the illustrative examples included in the Revised ED are not sufficiently clear on the notion of the substitution rights and the right to control the use of an asset. We believe the fact pattern in examples 1, 2 and 5 could be improved by giving further clarification on the key factors that influenced the conclusion of substitution rights and the rights to control the use of an asset. Such examples would be relevant for shipping companies to assess if a charter arrangement is a lease. Example 1B Contract for rail cars Our comments Paragraph 9 mentioned that a supplier's right to substitute an asset is not substantive, if customer consent is required. It is not clear what the level of consent would make the substitute right become not substantive. Often some form of consent will be required if a supplier wishes to replace an asset. The boards should clarify or provide additional guidance for evaluating when substitution rights are considered non substantive as a result of a barrier to exercise the substitution right. The guidance on substitution rights also suggests that both the purchaser/lessee will have visibility of the supplier/lessor s access to additional assets and finance, in reality this will likely not be the case. We recommend that the assessment should focus on the contractual terms rather than on the supplier s financial position, or its access to assets of the counterparties to an arrangement. 2
2 Contract for coffee services We are not clear why a customer does not have the ability to derive the benefits from the use of the coffee machines on its own just because the consumables need to be supplied by supplier. If it is the case, we will believe that the vessel with ship master and crews provided by the shipowner (i.e. time charter) is not a lease because the charterer has no right whatsoever to replace the ship master and crew under a time charter arrangement. 5 Contract for energy/power We are not clear from the illustration and analysis who is the party controlling the asset and when the contract should be accounted for as a lease. In reality, it is not always the case that the activities involved in an agreement are solely carried out by the purchaser or the suppler. We believe more guidance on when these activities are shared by both the purchaser and supplier with various level of decision making rights in different situations (e.g. under a charter) would be helpful. The Revised ED places more emphasis on the identified asset and the right to control the use of the identified asset. Taking the analogy of those examples mentioned above in the Revised ED, we do not consider that time charters represent leases under the definition of leases under the Revised ED. Besides, it should be noted that vessel chartering and aircraft leasing are quite different. In practice, aircraft are leased under arrangements which are similar to finance leases. The control of the aircraft is passed to the airline operators for services in which the aircraft is used. However, the control of the vessel remains with the shipowner under time charter arrangements, so that as navigation, maintenance, repair, insurance, crewing, victualling, supplying, etc remain the responsibility of and are controlled by, the shipowner; the vessel is operated by the ship s master and crews who are employees of the shipowner. Therefore, we believe time charters are akin to service contracts which require the use of a vessel for a service provided for a period of time. We would suggest the Boards provide a clear clarification on the definition of the leases under the Revised ED, if such interpretation is not consistent with the Boards view. (See appendix 1 on our analysis of time charter arrangement and further discussion on this area) Dual model of the lease We agree with the Boards that different types of lease should be presented differently and therefore there cannot be a single right-of-use model to fit all types of lease arrangements. One of the key changes in the Revised ED is that the Boards now propose two different expense recognition patterns for different types of lease depending on whether the lessee acquires or consumes more than an insignificant portion of the underlying asset. We agree that there are two types of leases (i.e. Type A leases and Type B leases). However, we consider that the Boards presumption that most leases of assets other than property are financing in nature and to be classified as Type A lease is not appropriate. In addition, there is a risk of inconsistent interpretations on the terms of insignificant, substantially all and major part and arbitrary accounting 3
applications among different shipping companies. For example, vessels which have comparable economic lives to property and priced in a manner similar to a property lease should not be treated as Type A leases by both lessors and lessees solely because they are not real property. It should be noted that there are a broad range of leasing arrangements in the shipping industry. It is not common for shipping companies to enter into leases solely for the purposes of financing and achieving off-balance sheet presentations. The shipping industry is a capital intensive industry and its operating assets are the vessels. In order to provide marine transportation services, shipping companies build up their fleet of vessels and capacity through owning vessels and/or chartering vessels from other shipowners. The main purpose of entering into short to medium terms charter contracts is to manage its fleet capacity in a flexible way to meet the market demands of marine transportation services or in out-sourcing or subcontracting part of its business operations to other parties if its own capacity is full. Shipping industry players are concerned more with the volatility of charterhire rates, and the technical specifications of vessels for delivering transportation services. We are of the view that the business characteristic of a time charter is similar to (real) property and it is NOT a financing transaction. Time charterhire rates are transparent to the industry and reflect the market demand/supply of shipment in a specific period, with little or no adjustments to take account of the individual credit risk of the counterparty and cost of returns on the vessels under contract. The pricing of a charterhire is similar to a lease of property. While we strongly believe that a time charter does not meet the new definition of lease, if the Boards still consider a time charter is a lease, we believe it should be treated similarly to property, i.e. Type B (if it is in the scope of lease). A classification based on business nature rather than asset nature would better reflect the economics. In addition, the classification assessment is further complicated by the high volatility in charterhire rates and inactive second hand vessel price. For example, the time charter rate of a capsize dry bulk vessel in last 5 years has moved from US$111,500 per day in 2008, US$33,000 per day in 2010 to US$12,360 per day in 2013. As a result, two medium charter period arrangements with the same terms could fall into Type A or B for a different period because of significant differences in charter rates and/or vessel price. This therefore reduces comparability between transactions for different periods and different shipping companies. Complexity of accounting treatment create burdens for shipping companies As explained above, the business model for certain shipowners is to build up their vessel fleet and capacity through owning vessels and/or chartering vessels to provide transportation service using time charters or voyage charters. There are many charter-in and charter-out contracts and their periods are vary from months to years. Time charter arrangements, if they fall into the scope of leases, need to be accounted for under two standards which have different recognition and presentation requirements. As a lessor, the service component is going to be accounted for under the new revenue model, while the lease component is required to be accounted for under the new lease model. Such a complex accounting treatment creates a great burden for shipping companies, because of the large volumes of chartering transactions. 4
While for the lease component, an entity could apply the exceptions to leave accounting for the short term contracts (i.e. < 1 year) using existing IAS 17 accounting treatment, while long term contracts (i.e. >5 years) are likely to be treated as Type A leases and some medium term contracts (i.e. <3 years) are likely to be treated as Type B leases under the new lease model. Time charter agreements with same charter periods, because of different charterhire rates, will have different accounting treatments. The information regarding revenue generating activity is going to be disaggregated and scattered into different account captions in the income statement (e.g. service income vs interest income, depreciation vs amortization vs interest cost), statement of cash flow (operating, investing, financing) and statement of financial position and have different recognition patterns (a mix of front-loading and straightline income/expense recognition). Furthermore, for shipping companies which charter-in and then charter-out vessels, their balance sheets will be grossed up for those charter-in contracts, even though they may successfully charter-out all the committed periods. Unlike other vehicle leasing which has a stable rental price, the charterhire rates for vessels are highly volatile over time. The high volatility of charterhire rates creates difficulties for shipowners to determine the classification of the lease and to estimate the carrying value of the residual assets for each charterhire contract. Moreover, income generated from time charter arrangements is considered as service income and not subject to tax by certain jurisdictions. With the implementation of this new model, it may trigger those tax authorities to follow the accounting presentation and to tax the shipowners for those interest income. This potentially creates an extra cost burden to the shipping companies. We do not believe the new ED enables any meaningful presentation of the operation of the shipping companies or enhances comparability of performance among shipping companies, but increase costs of implementing this accounting model and keeping track of all charter contracts. SUMMARY The Revised ED includes some new changes and more guidance on the proposed lease accounting method, however, these new changes are not helpful and not practical for application to shipping companies. It is a key characteristic of many shipping companies that there are many vessel chartering contracts entered into by shipping companies, to ensure they have sufficient operational capacity for their business. These vessel chartering contracts may be subject to new lease accounting rules. Even though the shipping industry is an important business sector that will be greatly impacted by the proposed standard on leases, there is no clear guidance or no clear illustrative examples that are applicable for the shipping industry in the Revised ED. The high volatility of the charterhire rates adds complexity to the application of the lease model by the shipping industry (e.g. determining the residual value, assessing the type of lease) and that also involves subjective judgement. This will cause difficulties and likely 5
inconsistencies as the shipping companies try to understand and adopt the proposed standard. Moreover, we would like to emphasise that vessel chartering is NOT undertaken for financing purposes and its pricing is similar property. It is not reasonable to have a general presumption that all leases apart from those in relation to property are classified as Type A leases. The Boards should consider the business and operational nature of shipping industry from a more comprehensive angle. The Association would be grateful if the Boards would take this submission and the recommendations of the Association into account in the development of the proposed standard. Yours sincerely, Arthur Bowring Managing Director Hong Kong Shipowners Association 6
Appendix 1 VESSEL CHARTERING There are three common types of charters: 1) bare-boat charters; 2) time charters; and 3) voyage charters. The operational characteristics of these three types of vessel chartering are summarized in Appendix 1a. Definition of leases When analyzing the operational characteristics of the three types of vessel chartering, we consider that bare boat charters will fall under the definition of a lease under paragraphs 6 7 of the Revised ED, while a voyage charter would be a service contract. For time charter, we believe that it is not a lease under the definition of leases under the Revised ED, and instead it is a service contract. We have further elaborated our thoughts below. Whether time charter contains a lease? When we determine whether time charter contains a lease, we have to assess the following: Is there an identifiable asset? A time charter is a charter arrangement by which a vessel of specific type/size is secured for transporting cargoes for a period of time. Usually a named vessel with the required type/size for the services is specified in the time charter contract. The time of delivery can be changed and modified. The charterer will issue shipping instructions to the shipowner to advise when the Charterer s cargoes are available for shipment. Since most ships are of a standard size and configuration, it is possible for a similar or even a sister ship to be substituted with the consent of the charterer. A charterer who enters into time charter arrangement is not only focusing on the model of the ship but also who is the shipowner managing that ship, as it would determine the quality of the service provided. Therefore, the consent, based on our experience, would generally not be unduly withheld by the charterer and is more akin to a protective right. However, under a literal reading of paragraph 9 of the Revised ED, it seems that the shipowner is considered to have no substantive right to substitute the asset merely because it requires consent by the charterer. We do not believe such narrow interpretation would be appropriate, in particular when the consent could be just a form/a protective clause to charterer and there is no economic or operational barrier to replace the ship for the shipowner. Is there a right to control the use of the identified asset? Under a time charter arrangement, the vessel is controlled and managed by the shipowner. The responsibilities for navigation, maintenance, repair, insurance, crewing, victualling, supplying, etc of the ship remain with the shipowner. The ship master and crew, who are responsible for the navigation and safety of the vessels are hired by, and are employees of, the shipowner. Ship management services are separately available in the market, but the charterer has no right to arrange another ship manager to operate that ship under a time charter arrangement. Although a charter contact terms states that the ship master shall throughout the charter period be under the orders and directions of charterer, practically the charterer is only able to provide instructions for the ports to be visited for loading or discharging the cargoes and to order normal 7
consumption/speed of vessel as specified in the contract. That means the charterer can only specify the output, but not control the process. The shipowner has the absolute right to change the route if it is necessary (for example if there is a war or there are pirates in certain geographical locations) and it may also reject the cargo, if it is not suitable for the vessel. All the rights held by the shipowner mentioned above do not just protect the shipowner s residual interest in the vessel but also effectively control the use of the vessel (e.g. how much cargo is loaded and how the cargo is stowed) during the service period. Taking the analogy in examples 2 and 5B in the Revised ED, the charterer has the ability to specify the output but without a decision-making authority, it cannot derive the benefits from use of the vessel on its own, by replacing the ship master and the crew, and the ship master and the crew (who represent the shipowner) retain the decision-making authority on how to manage the vessel during the service period. Without the crew, the vessel has no use or value to the charterer under a time charter. The vessel is incidental to the delivery of the transportation service and the charterer who selects a time charter arrangement (instead of a bareboat charter) receives a bundle of goods or services that combine to deliver an overall transportation service. Summary of operational characteristics of the three types of vessel chartering Bare Boat Charter Time Charter Voyage Charter Hire Charge at market daily rate Charge at market daily rate Charge at rate per ton or a lumpsum Charter period A number of years (normally in long term) Various from months to years (normally 3-5 years) The length of the voyage dictates the period. Off hire period No off hire No hire during off hire periods (e.g. drydocking, machinery breakdowns, medical diversions, etc.) Cost borne by shipowner Capital cost of vessel (e.g. depreciation) Capital costs of vessel (e.g. depreciation); and fixed costs (e.g. crew costs, repair and maintenance, insurance etc.) which will still be absorbed by the shipowner even if such costs increase or change during the charter period Not applicable Capital costs of vessel (e.g. depreciation); fixed costs (e.g. crew costs, repair and maintenance, insurance etc.) t; and voyage costs (e.g. bunkers, port charges etc.) 8
Bare Boat Charter Time Charter Voyage Charter Possession of Charterer Shipowner Shipowner vessel Control of vessel Charterer Shipowner (while Shipowner under instructions from the charterer as to the ports to sail to and from and the cargo to be loaded) Responsibility of Charterer Shipowner Shipowner navigation and safety of the vessel Manning Charterer Shipowner Shipowner Insurance Charterer Shipowner Shipowner Maintenance Charterer Shipowner Shipowner Responsibility for carriage of cargo if it is lost or damaged on a voyage Charterer Shipowner Shipowner 9