IFRS16: Lease term- Ep 3

Transcript

Dipthi: Welcome to the third episode of the Telco Talks podcast series focusing on topical issues in the telecommunications industry. I’m Dipthi Govind, a technical accounting manager in the PwC South African practice and I will be your host. Our aim is to keep you up to date on key accounting issues in the telecommunications industry.

In past podcasts we have covered long term capacity arrangements as well as the unit of account under IFRS 16 Leases. So continuing with IFRS 16 in this episode, we are going to be discussing the considerations and challenges in determining the lease term under IFRS 16.

Joining me in this episode is Ranvir Sawak, a technical accounting manager specialising in the telecommunications industry in our PwC South African practice.

Welcome to this podcast Ranvir.

Ranvir: Hi Dipthi, thanks for having me.

Dipthi: So to get the ball rolling, can you explain what is meant by the lease term in terms of IFRS 16?

Ranvir: Sure, the lease term is defined in IFRS 16 as being the non-cancellable period to which the lessee has the right to use an underlying asset. This period includes renewal or extension options where the lessee is reasonably certain to exercise the option and termination options where the lessee is reasonably certain not to exercise the termination option.

Dipthi: Could you perhaps give us an example? 

Ranvir: Let’s assume we have a lease with a 5 year term, with an option to terminate the lease after 3 years. The leasee also has an option to extend the lease to 7 years meaning we have an extension option for 2 years. If the lessee is reasonably certain to extend, the lease term would be 7 years. If the lessee is reasonably certain to exercise your termination option, the lease term would be 3 years. The lease term would be 5 years where the lessee is not reasonably certain to extend the lease and is not reasonably certain to exercise the termination option. In summary, the principle is that where an option exists, the lease term is the shorter period unless the lessee is reasonably certain to use the underlying asset for longer.

Dipthi: I understand that the determination of the lease term under IFRS 16 could require significant judgement. Could you expand on why the lease term is so pivotal in the telecommunications space?

Ranvir: Sure Dipthi. The lease term is pivotal when calculating the value of the lease liability which is a function of the lease payments over the lease term discounted by an appropriate discount rate. This dictates the amount recorded for the entity’s lease obligation and related right of use asset - the longer the lease term, the larger the lease liability and related right of use asset. The determination of lease term becomes challenging when you have multiple extension options or terminations options. Lease term is also tricky when you have month to month leases. In our experience, IFRS 16 has a significant impact for clients in the telecommunication industry due to the nature of business being so capital intensive as well as the number of leases in place.

Dipthi: You mentioned that the lessee needs to be reasonably certain in deciding whether to include renewal or termination options in the determination of the lease term. 

Is there any guidance that could assist our listeners to determine what is considered to be reasonably certain?

Ranvir: Certainly. IFRS 16 has guidance on the matter and in most instances this will be fact and circumstances specific.

In the Telco environment one could look at the contractual terms and conditions for the option period in relation to the market rentals. It is more likely that a lessee will not exercise a renewal option if the lease payments are expected to be higher than the market related lease payments.

One could also consider whether there are any significant leasehold improvements.

Another consideration is the importance of the leased asset to the lessee’s operation. If the asset is seen to be highly specialized or a strategic asset to the lessee’s operation, the lessee is more likely to exercise a renewal option. For example, if one has to consider a telco operator, certain masts or cellphone towers would be expected to be a strategic asset in the operator’s business for example, the location of the mast is very important.  Therefore if there is a renewal option in the lease of a cellphone tower, it may be reasonably expected that a lessee will exercise a renewal option because this asset is of strategic importance to the lessee.

These are a few examples to illustrate the considerations on renewal options under IFRS 16.

Dipthi: That’s quite helpful Ranvir. So, the lease term, including the renewal and termination options are determined at the inception of the lease. 

Ranvir: Yes, the parties should first consider the formal written agreement and determine the legally enforceable lease term based on the agreement.

Dipthi: On that same topic, wasn’t there a recent IFRIC discussion on this point?

Ranvir: Yes there was a recent IFRIC discussion and the IFRIC noted that one needs to look at the broader economics of the transaction. If the terms of the formal written agreement do not align with the economics of the transaction, the parties should consider whether the lessee has rights or economic incentives beyond the written agreement to determine the lease term.

Dipthi: The IFRIC discussions also mention that when looking at the criteria of an insignificant penalty one needs to consider the broader economics of the contracts and not only the termination penalties that are noted in the contract.

Can you elaborate on what is meant by this?

Ranvir: Well, where contracts contain termination clauses for example if the lessee  cancels the lease before the end of the original term, the lessee needs to pay an amount that is equivalent to 3 months rental.

In this example, one might be inclined to say that the only penalty is the 3 months rental that needs to be paid as noted in the contract and only this should be looked at when determining if either party can cancel with no more than an insignificant penalty. However, it’s not always that straight forward.

One should  start by looking at the contractual termination penalties, in this case it would be an amount equivalent to 3 months rental. It then needs to be determined if this amount is more than an insignificant penalty.

Dipthi: I recall that the IFRIC clarified that the definition of termination penalties is broader than what is stated in the contract.

Ranvir: Yes, for example, let us assume in this case, an Operator is leasing a space on a tower and has installed its equipment on the tower. The tower is in a location that is optimal to maximize network coverage and quality. In this case we can see that the tower is a strategic asset and losing it will have a broader consequences than the financial penalty that is stated in the contract. 

Dipthi: That puts it into perspective nicely. We have noted that in some instances lease arrangements, for example where an operator is leasing a tower for which the  contract has a month to month renewal option. How would one go about assessing the term in this case?

Ranvir: Well that’s quite interesting because this scenario could create a case where the lease term is indefinite or evergreen. However, remember that the over aching principle is that one needs to be reasonably certain as to whether or not they will exercise a renewal or termination option which will require judgement..

In practice some operators that tend to consider their business plan or forecast period to determine the term over which they expect to make business decisions.

Dipthi: Would the considerations that you have now mentioned change if the original contract has ended and there is no renewal clauses in the contract but the lessor is still allowing the lessee to use the asset and the lessee is continuing to make lease payments?

Ranvir: Firstly we consider whether the contract is enforceable 

The IFRIC has noted that a contract is no longer enforceable when either party has the right to terminate the contract with no more than an insignificant penalty. However, the broader economics of the transactions need to be kept in mind when looking at this as previously discussed.

Dipthi: I see that the IFRIC has been quite busy!  We have touched on the challenges and considerations around the lease term, could you shed some light on the reassessment of the lease term?

Ranvir: Sure, as mentioned before the lease term is determined at the inception of the lease. The standard notes that the lease term should be reassessed when there is a significant event or change in circumstances that affects whether the lessee is reasonably certain to exercise an extension or termination option. 

Dipthi: What might be seen as a significant event or change in circumstances which would trigger a reassessment?

Ranvir: Well,significant events or changes in circumstances can differ depending on the circumstances for  an entity. 

Let’s consider our month to month lease scenario. When we looked at the lease term, we factored in the business plan of an operator. If this has changed this may result in a change of the lease term.

There could also be a business decision made by the lessee that could directly impact on whether they are reasonably certain to exercise an option such as moving from 4G to 5G. 

This change in business decision could be seen as a significant event that would warrant the lessee to reassess the lease term.

We recommend that operators clearly define what they view as a significant event that would result in a reassessment of the lease term. The definition would be fact and circumstances specific. In our case, where we have used the business plan, one could justify that a change in the business plan is a significant event and hence would result in a reassessment of the lease term.

Dipthi: This has been quite insightful and interesting. Thank you for joining us in the podcast studio Ranvir.

And for our listeners, it is quite clear that lease term is a judgemental and topical area. With this in mind, operators should consider disclosing this judgement in their financial statements. Stayed tuned for the next podcast which will cover other considerations linked to lease term under IFRS16.