The Treatment of Contracts, Including Leases, in System of National Accounts 1993

John S. Pitzer[*]

Canberra II Group: On the Measurement of Non-Financial Assets

First Meeting, 15-17 April 2003, Voorburg, Netherlands

A.Introduction

B.Contracts as Intangible Nonproduced Assets

1.Basic Concepts of Intangible Nonproduced Assets

2.Economic Characteristics of Contracts

3.Economic Appearance of Contracts When They Are Signed

4.Economic Appearance of Contracts After They Are Signed

5.Conclusions and Recommendations

C.Treatment of Leases

1.Current Treatment in SNA 1993

2.Leases of Fixed Assets

3.Leases of Tangible Nonproduced Assets

4.Partitioning Assets

5.Combined Leases of Fixed Assets and Nonproduced Assets

6.The Treatment of Rent

7.Conclusions and Recommendations

D.Government-Issued Permits

E.Build—Own—Operate—Transfer (BOOT) Schemes

1

The Treatment of Contracts, Including Leases, in System of National Accounts 1993

A.Introduction

  1. The Canberra II Group was convened in 2002 to investigate several issues associated with the treatment of nonfinancial assets in System of National Accounts 1993 (SNA 1993). This paper deals primarily with one of the topics within the mandate of Sub Group I, Leases and Other Transferable Contracts. Licenses issued by general government are included in this topic. Of primary concern is the need for greater specificity regarding the conditions that require or permit a contract to be treated as an asset.
  2. Leases are a particularly troublesome type of contract. Three other topics in the mandate of Sub Group I deal with the treatment of leases in SNA 1993: (1) Borderline between rent(al) and sale, (2) Treatment of land, and (3) Treatment of Buy/Own/Operate/ Transfer (BOOT) schemes. These topics will also be discussed.

B.Contracts as Intangible Nonproduced Assets

1.Basic Concepts of Intangible Nonproduced Assets

  1. All nonproduced assets enter the accounting system of SNA 1993 (the system) by means of flows in the Other Changes in the Volume of Assets Account. Flows recorded in this account will be referred to here as “other volume changes.”An other volume change that marks the entrance to the system of an asset is frequently referred to as an “economic appearance.” Paragraphs 12.14 through 12.22 of SNA 1993 describe the various types of economic appearances of nonproduced assets that were foreseen when SNA 1993 was published.
  2. Nonproduced assets are either tangible or intangible. The categories of tangiblenonproduced assets identified in SNA 1993 are land, subsoil assets, non-cultivated biological resources, and water resources. All tangible nonproduced assets occur naturally in nature.[†]They may or may not be economic assets as defined in paragraph 10.2 of SNA 1993 (see box on following page). In order fora natural asset that is not an economic asset to become one, some event must take place to change its status and bring it into the system. Paragraphs 12.15 through 12.20ofSNA 1993indicate that tangible nonproduced assets enter the system (1) by being discovered, (2) by becoming economically exploitable as a result of changes in prices and/or technology, (3) by convertingland from a wild or waste state to a state in which ownership rights can be established and the land put to economic use, (4) by reclaiming land from the sea, or (5) by improving the quality of an existing asset through a change in its use.[‡]

Assets versus economic assets. Not all entities that might be referred to as assets are economic assets within the definition of paragraph 10.2 of SNA 1993. The requirement for ownership rights to exist excludes the atmosphere and the international oceans, although they clearly provide economic benefits. Undiscovered subsoil assets and land that has not been reclaimed from the sea obviously cannot be economic assets.The requirement for providing economic benefits excludes known assets whose current market price is zero, such as subsoil assets unexploitable given current prices and technology and land in a wild or waste state, because the economic benefits provided by the asset net of the cost of obtaining them is zero.Implicit in the definition of an economic asset is a requirement that it must be possible to estimate a reliable value. The existence of historic monuments and noncultivated biological resources may be well known, but without a valuation they cannot be included in the system. Finally, some assets have no value by definition. Forward-type financial derivatives are assets that have no value when created but may gain value at a later time as a result of price changes in the underlying items to which the derivatives are linked.

  1. Intangible nonproduced assets do not occur in nature. According to paragraph 12.21:

Non-financial intangible non-produced assets are constructs devised by society evidenced by legal or accounting actions. They make their appearance in the System when entities are patented, transferable contracts are written, or enterprises are sold at prices that exceed the net worth of the enterprise in question, etc. The patenting consists of the entity being granted legal protection by law or judicial decision. The writing of transferable contracts consists of the coming into force of a binding agreement that provides some economic benefit that can be passed on to a third party independently of the provider of that benefit.

The categories of intangible nonproduced assets identified in SNA 1993 are patented entities, leases and other transferable contracts, purchased goodwill, and other intangible nonproduced assets. As indicated in the following box, it is hard to discern a unifying concept for the types of assets that should be classified as intangible nonproduced assets. Instead, the types of assets and the means by which they appear in the system must be deduced from the examples cited in SNA 1993.

Major types of economic assets. As defined in SNA 1993, an asset is an entity that is expected to provide economic benefits over an extended period. When assets are classified by how they are created, most major types are straight forward. Assets can be produced deliberately, can exist naturally, or can result from one unit advancing funds to another unit. If an asset is not produced, does not occur naturally, and is not financial, then it must be created by human activity but not as the result of a production process. From the specified categories of intangible nonproduced assets, it appears that most are in fact produced, but are not the primary output of a production process. Customer lists and brand names may be deliberately created by an enterprise but as secondary outputs of several production processes or as part of the overall management of the enterprise. Creating such assets is usually done deliberately and with considerable resource consumption, but the costs of production are recorded as intermediate consumption and subsumed under general administrative expenses. Moreover, it may not be possible to identify the assets as separable entities once they have been produced. Some are inseparable from the enterprise itself and, therefore, cannot be sold.

  1. Although the category of leases and other transferable contracts is the subject of this section, the other categories of intangible nonproduced assets are examined first to determine the meaning of the terms involved in the definition of an intangible nonproduced asset, including “constructs devised by society,” “legal or accounting actions,” “coming into force,”and “economic benefit that can be passed on to a third party.”To have an economic asset in SNA 1993, there must be an entity over which ownership rights are enforced and from which economic benefits may be derived by the owner(s) over time. Patented entities are inventions of technical novelty, which, like other collections of knowledge, do not lend themselves to enforceable ownership rights without legal protection. They become economic assets only when a government provides legal protection by granting a patent, thereby allowing ownership rights over the invention to be established and the benefits to be captured by the owners.The patent is a construct devised by society, and granting the patent is a legal action creating an economic asset. The patented entity, however, must already exist.[§]Granting the patent is not an interaction between two units by mutual agreement and, therefore, is not a transaction. Rather, the government chooses as a matter of social and economic policy to grant the protection.
  2. Goodwill is a catch-all category that covers a wide variety of assets, such as customer lists, trade secrets, trademarks, copyrights, and brand names. Some, such as trademarks and copyrights, are constructs devised by society to provide legal protection for an existing asset or an asset in process of being created. In concept,the resulting assets could be treated similarly to patents. Even after the legal actions occur, however, there usually are no transactions, such as royalty payments, or other information on which a value can be estimated.Othergoodwill assets, such as customer lists or superior management techniques, come about through production activities, but are not separately identifiable or are exceptionally difficult to value. No construct has been devised by society to give their owners legal protection, but the assets do exist and contribute to the operating surpluses of the enterprises possessing them.
  3. Almost all private enterprises possess some assets that would be classified as goodwill in SNA 1993. If an enterprise does possess goodwill, then its market value will be greater than the net value of its other assets and liabilities. Summary evidence of the existence of goodwill for enterprises with publicly traded equity securitiescan be found in the prices of those securities. SNA 1993makes allowance only for purchased goodwill as an economic asset, probably for the practical reason that a reliable valuation usually is possible only when the goodwill is purchased. This restriction is one of several instances in which SNA 1993 suggests that the identification of a nonproduced asset, or an acceptable valuation of it,will be possible only when a transaction involving that assettakesplace. For example, a contract to initiate commercial logging in an uncultivated forest may be the first moment that sufficient information exists to estimate the economic value of the forest, but its existence was previously quite well known [See paragraph 12.19].
  4. In the case of goodwill, the transaction that provides an acceptable valuation is the purchase of the entire enterprise for an amount greater than the value of the enterprise’s already recorded net assets. Creating an asset called purchased goodwill is a construct devised by society to acknowledge the existence of a collection of assets from which economic benefits are being received. To accomplish the economic appearance of purchased goodwill, an accounting action is taken, which increasesthe net worth of the enterprise to match the purchase price. The purchase of the enterprise is a transaction that reveals the value of the goodwill, but clearly the goodwill existed well before the sale of the enterprise. Its economic appearance is separate from the sales transaction.In concept, all goodwill should be permitted if information exists on which a reliable value could be estimated.
  5. Based on the preceding analysis, a legal action evidencing a nonproduced asset is an action that permits an institutional unit to gain legal ownership of existing economic benefits that would otherwise be available to any unit, and an accounting action evidencing a nonproduced asset is an action recognizing that certain economic assets havepreviously been created and the enterprise has been gaining economic benefits from them. Legal and accounting actions can be combined. Registering a trademark or copyright is a legal action that establishes ownership rights over economic benefits and creates an economic asset, but the valuation of that asset may not be possible until other events take place, at which time an accounting action recognizes the existence of the asset.
  6. With this analysis of the meanings of constructs devised by society and of legal and accounting actions for patented entities and purchased goodwill as background, the meaning of legal and/or accounting actions for leases and other transferable contracts can be examined. First, it is noted that while the title of this asset category draws attention to leases, the category actually refers to contracts. The inclusion of leases in the title is an observation that they are likely in practice to be the most important type of contract included. Nevertheless, it is the character of a contract that is to be analyzed, not the character of a lease or of the differences between types of leases. This point is underlined by the list of types of contracts that might be assets given in the annex to Chapter XIII: “Examples include leases of land and buildings and other structures, concessions or exclusive rights to exploit mineral deposits or fishing grounds, transferable contracts with athletes and authors and options to buy tangible assets not yet produced. Leases on the rental of machinery are excluded from non-financial intangible assets.”
  7. Contracts are constructs devised by society to facilitate commercial operations and many other types of relationships between people and/or organizations, and they obviously result from legal actions. The definition of a legal action deduced in paragraph 10 is quite restrictive as far as which legal actions constitute actions that evidence intangible nonproduced assets. Some questions to consider here are whether a contract becomes an asset as a result of an accounting action or a legal action, whether a different definition of a legal or accounting action is necessary for contracts, andwhether a contract becomes an economic asset when it is signed or later.
  8. There is little in SNA 1993 to resolve these questions directly.Thus far in the literature, two positions have emerged. Dippelsman and Mæhle (2001) and ISWGNA (2002) suggest that a contract can become an economic asset when it is signed.[**]Harrison (2001), Magniez (2001), Eurostat (2002), and Pitzer (2002) suggest that a contract can become an asset as a result of an accounting action after it has been signed.These two positions are independent. After some background about contracts in general, these two positions will be considered.

2.Economic Characteristics of Contracts

  1. The previously cited reference to contracts from paragraph 12.21 suggests they become assets when they become legal documents: “The writing of transferable contracts consists of the coming into force of a binding agreement that provides some economic benefit that can be passed on to a third party independently of the provider of that benefit.” The phrase coming into force appears to refer to a contract being signed, butthe qualifications added suggest other interpretations are possible.The fact that few commercial contracts are ever recorded as assets in SNA 1993 suggests that the contracts that do become assets have some unusual, unspecified characteristics.
  2. A typical contract is signed by twoparties and provides for each party to perform some action in the future. Generally, the action performed by one party benefits the other party and the two parties perceive the values of the offsetting actions to be equal. For example, a contract may consist of a promise to deliver a newly produced machine in exchange for a promise to pay a specified amount of money.One party is obligated to fulfill its promise (the payment) only when the other party has fulfilled its promise (delivery of the machine), although the contract may establish a monetary penalty to be paid by one or both parties if they do not fulfill their promise.
  3. Thus, “coming into force” is not likely to mean when the contract is signed because that event signifies only that promises have been exchanged. If it means when one party performs its promise and creates an obligation for the other party, then a transaction is used to represent the action taken and the obligation created. Continuing the previous example, when the machine is delivered, the purchaser records an increase in gross fixed capital formation and an increase in accounts payable and the seller records a reduction in inventories and an increase in accounts receivable.At this point, the accounts receivable is the seller’s asset and the machine is the purchaser’s asset. Neither would consider the contract to be an asset, although the contract is the legal basis for the existence of each asset. A similar result is obtained with the expression “provides some economic benefit that can be passed on to a third party.” When the contract is signed it consists of equal valued obligations. At that point, there is no value that can be conveyed to a third party, assuming the contract was negotiated at current market prices. Assuming further that there is no change in prices or other factors affecting the contract, when one party performs its obligations, that party has conveyed something of value but now has imposed an enforceable obligation of equal value on the second party. Again, there is no value in the contract itself to be conveyed to a third party.
  4. In summary, if a contract is negotiated at market prices and those prices do not change, then a third party would not pay anything to obtain the rights and obligations of either of the original parties to the contract. If one of the original parties owes money or anything else of value to the other original party, then any sale of the contract to a third party would, of course, take into account the value of such an obligation. That is, if there is an accounts receivable, then a third party obviously would have to pay to acquire the accounts receivable.