IFRS16: Long-term capacity - Ep 1

Transcript

Dipthi: Welcome to the first podcast in this series focusing on topical issues in the telecommunications industry. I am Dipthi Govind, a manager in PwC South Africa's Accounting Consulting Services division and I will be your host. Our aim is to keep you up to date with key accounting issues and business issues within the Telecommunications industry. In this episode we will be covering the impact of IFRS 16 on long-term capacity arrangements.   

Whether it may be the leasing of cellular towers, which we often see on our daily commute, or if you happen to spot your service provider's logo on the car next to you in traffic, it is evident that telecommunications companies enter into a wide range of lease arrangements, both as lessors and lessees.

The new standard is definitely causing ripples in the Telco industry. IFRS 16 sees changes relating to lessee accounting, while lessor accounting remains largely unchanged.

In the studio today I am joined by Renitha Dwarika, a technical accounting partner specialising in the telecoms industry. Welcome to our first telecoms podcast Renitha.

Renitha: Thank you Dipthi. And I am very delighted to be part of this first episode of the podcast series!

Dipthi: Thank you for joining us today. For the communications space in particular, there are quite a few different types of arrangements, a common one being long-term capacity arrangements. So let's just dive straight into the detail, could you elaborate what a long-term capacity arrangement is?

Renitha: Yes certainly! Well, a long-term capacity arrangement is essentially a contract, which is longer term in nature. In practice I have seen these contracts span between 20 to 30 years and basically what it  does it gives one party, being the customer the right to use capacity on another party, being the suppliers telecommunication network. These contracts may be structured in many different ways.

However some of the common sort of capacity arrangements that I have seen typically involve wavelength, fibre and sometimes they are even structured as consortium-type arrangements.

Dipthi: So fibre seems to be the latest trend and I understand that the accounting is different depending on whether the arrangement includes dark fibre or lit fibre. Could you briefly touch on the difference between dark fibre and lit fibre?

Renitha: So sometimes dark fibre is also referred to as unlit fibre and basically what it is, is a fibre optic cable that has been laid under the ground which is not connected to any sort of telecommunication equipment, so it is available for use.

Lit fibre is then almost the opposite of dark fibre, so lit fibre is the same thing, it is a fibre optic cable that has been laid under the ground, however it has already been "lit" by for example an operator , so it is connected to a port on a piece of telecommunication equipment.

Dipthi: It's interesting that you say that as in the current technological environment, we see that leases of dark fibre are becoming increasingly common. So that background is quite helpful, so let's kick off with talking about these fibre arrangements that provide an operator with exclusive use of a fibre/s or multiple fibres within a suppliers' fibre cable. In my understanding, in these arrangements the customer may have an unforfeitable right of use for say 20 years, and is responsible for lighting the fibre. 

Am I correct in saying that the starting point would be to consider whether this arrangement contains a lease?

Renitha: Yes, so your starting point would be to identify if there is a lease. 

So one of the first questions that you would have to ask yourself is, is there an identified asset? And some of the things that you would want to think about in making this assessment is having a look at the contract and determining how specific the contract is about the fibre. So does it specify the exact fibre strands that the customer will use. it may even go as specific to saying that this fibre strand starts at point X and ending at point Y.

If it is that specific, then you are basically one step closer to saying that you have an identified asset.

Dipthi: And what if the contract is not that specific?

Renitha: So if the contract is not that specific, then it is likely that there is no identified asset unless you can demonstrate that the customer is able to use substantially all of the capacity of the entire fibre cable. So let's put this in an example, if you for example have a 20% capacity of a fibre cable, that is likely not an identified asset as it does not give the right to substantially all of the identified cable. 

If we move back to where the contract is quite specific, then before we conclude that we have an identified asset, another thing that we  will have to assess is does the supplier have any substantive substitution rights?

Dipthi: So before you continue there Renitha, I have a question - would it be correct to say that the right to substitute an asset in the event of repairs and maintenance is not deemed to be substantive?

Renitha: Yes, that would be right and that is something that is specifically mentioned in the standard. So what we will have to do is you'll have to look at the contract in detail and analyse all of the terms and clauses in the contract  that give rise to a substitution right. But once you identify the substitution rights, you can't just stop there. You need to assess whether those substitution rights are substantive. And here we look to the standard which has guidance and it says that for a right to be substantive, the supplier must be able  to substitute the asset with an alternative asset, so in our fibre example the supplier must be able to move the customer from one fibre strand onto another available fibre strand that is available and then, secondly, the supplier must also gain an economic benefit from doing that.

Dipthi: Okay, so are there any other considerations to bear in mind in identifying a lease arrangement?

Renitha: Yes, and I think I did mention earlier on, that we also need to ensure that the customer can obtain substantially all of the economic benefits from the use of the fibre, so in line with that we will have to think about whether there are any restrictions on the use of the fibre and potentially then the resale of the capacity.

The last thing that I would like to mention is, we also need to think about the customer's ability to direct the use of the asset, and that is quite a critical question. So that would typically involve the decision-making around how and for what purpose the asset is used. For a fibre example, a crucial question is, who is responsible for lighting that fibre?

Dipthi: So, on that not of decisions, our listeners can find a useful decision tree included in Appendix B of IFRS 16 to determine whether a contract contains a lease.

Dipthi: So we have touched on dark fibre arrangements, could you explain how this arrangement would differ from a lit fibre arrangement?

Renitha: Sure, so in a lit fibre arrangement, typically, a customer would only be entitled to, for example, only 4 fibre strands out of, let's say a cable which has a total of 12 fibre strands and those 4 fibre strands are in most cases not specific. In that case, the contract will not contain an identified asset, assuming also that the 4 fibre strands do not represent substantially all of the capacity of that 12-strand cable. And then we know, if there is no identified asset, then there is no lease arrangement.

Dipthi: So in that instance if there is no lease arrangement, what would be the accounting for this type of arrangements.

Renitha: So we see these arrangements being accounted for as service arrangements where the supplier is providing capacity rather than the use of an identified asset.

Dipthi: So that's been quite insightful. In the time that I've had the opportunity to engage with telecom clients, I've noticed that it's not uncommon for operators to contract with other third parties in consortium-type arrangements to construct, let's say infrastructure or systems, in which these parties share in the capital and operating costs as well as share in the capacity of the infrastructure and systems. These types of arrangements therefore can prove to be quite beneficial for telcos. What are your thoughts on this?

Renitha: Definitely. Consortium arrangements do have a lot of  benefits, and some of the benefits that come to mind is the reduction in the internal burden of asset management. And because you've reduced this burden, management can focus on other areas of development. And then also something you mentioned is the shared cost structure which helps in reducing costs.

Dipthi: So, that doesn't sound like your typical lease arrangement, therefore what impact is the new standard likely to have on these types of arrangements?

Renitha: So we still need to consider whether the arrangement contains a lease. So let's turn this around - I am going to ask the questions now, so we can test your knowledge. Okay, so let's take a typical consortium arrangement:

• We have two parties who come together to let's say build a subsea cable system so they share equally in the costs of building that system
• They then hold joint legal title over the assets.
• And decision-making around the development and then the operation of the system requires unanimous consent.
• Once the system is up and running, they share equally in the capacity of the system, and let us assume that there is no sort of restrictions on how they use the capacity.

So now just based on that and everything we've discussed now about IFRS 16 would you say the arrangement contains a lease?

Dipthi: So, given that fact pattern and the points that we have touched on thus far, I would not think so, as each party shares in the planned capacity equally, therefore this doesn't represent substantially all of the capacity of the asset. Hopefully I am on the right track there.

Renitha: Great, so clearly you have been listening so well done. So here what we would say is, because the parties require unanimous consent regarding the development and operation of the cable system, the arrangement is likely to give both of those parties joint control over the collection of the assets that make up the sub-sea cable.

As a result, we would expect that this type of arrangement is a joint arrangement that  would be scoped into IFRS 11 rather than our leasing standard being IFRS 16.

Dipthi: So, based on that example and the points that we've touched on thus far, it is clear that all factors need to be considered as identifying a lease arrangement is not as straightforward as it may appear to be. On that note, Renitha, do you have any other topics or considerations that you would like to share with our audience on long term capacity arrangements?

Renitha: Yes, there is a lot that I would like to speak about, but time is limited. So I will just briefly touch on another type of arrangement which is quite common and that would be the lease of wavelengths or spectrum. So, a  wavelength is basically a beam of light that does not have any physical attributes. And because it lacks this physical attribute, it is not tangible in nature and when we look at these arrangements, we therefore think about intangible assets and sometimes even a lease arrangement under IFRS 16.

Dipthi: In which case, from my knowledge of the standard the lessee has a policy choice as to whether to apply IFRS 16 to leases of intangible assets.

Renitha: Yes, so the scope of IFRS 16 does allow an entity a policy choice for the lease of intangible assets and it does have a few specific cases that is not included in the scope exemption. If an entity chooses not to apply IFRS 16, then it must consider whether the arrangement includes either the acquisition of an intangible asset or it constitutes solely a service contract. And in practice today, what we typically see is that these arrangements are treated as service contracts.

Dipthi: Thank you for joining us Renitha, really appreciate your insights. It has been an interesting discussion on long-term capacity arrangements.We look forward to having more topical discussions in future podcasts within the communications space.

Please join us for our next podcast where we will discuss the determination of the unit of account under IFRS 16.

Renitha: Yes, that has been a very topical issue so I really look forward to that one!