One issue that came up repeatedly for me at this weekend’s FASB-IASB reporting issues conference was that of the apparent clash between the objective to provide relevant information through financial reports and the objective to maintain consistency with the conceptual framework’s definitions of assets and liabilities.

An example illustrates the nature of the problem: consider a contract between two parties to provide services or goods that has a fixed term but also a renewal option at the end of the initial term.  At inception, if the provider feels that it is highly likely (and predictable with reasonable accuracy) that there will be a renewal of the contract, at what amount should the provider record the right to receive payments?  The initial period?  Or a period that includes possible renewals?

If we were trying to determine the value to the firm of the contract, we would likely include assessments of probability of various different contract terms and compute the expected value of the payments that would occur (and discount those payments for time value as appropriate).  However, does that computed amount meet the definition of an asset to the provider?

The FASB Conceptual Framework definition of assets (paragraph 25 of Concepts Statement 6) says, “Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”  If the signing of the agreement is the past transaction or event, clearly that contract conveys to the provider the right to a stream of future payments (probable future economic benefits) during the initial contract term.  But what about payments that might occur during a renewal period, when that renewal is at the option of the customer and has not yet happened?  Information about those payments and their probability of occurrence is likely relevant to financial statement users, but would recording such payments presently violate the definition of an asset?

An alternative view is that this is a measurement issue, not an issue about the definition of an asset.  From that view, the contract conveys to the provider the right to receive a stream of future payments, both during the contract term and probabilistically thereafter.  Anticipating whether or not the customer will choose to renew the contract is done in order to measure the magnitude of the probable future economic benefits, not to evaluate whether the provider has a present economic right to such payments.

At present, I have yet to resolve in my mind whether this is indeed a challenge to the definition of an asset or a measurement issue.  However, resolving this issue is crucial to several of the projects standard-setting projects currently under joint discussion by the FASB and IASB.  In particular, this scenario is representative of revenue recognition in a number of different settings, including lessor’s accounting for leases and accounting for insurance contracts.  The “provider” in the example above could well be a lessor, an insurer, or other seller of goods and/or services.

In some discussions of these issues, the Boards have considered a ‘look-through’ approach where, for example, lessees are directed to determine the effective lease term in the presence of renewal options.  Is looking through the renewal option a tool to estimate/measure uncertain cash flows, or does it represent a potential inconsistency with the definition of an asset?  Or, is it a means of estimating the stand-alone value of options that are embedded in contracts?

I welcome additional thoughts about this to help me resolve this issue for my own edification.