IFRS 16: Lease Term & other considerations - Ep 4

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.

Joining me in the studio is Johan van-Huyssteen, a technical accounting partner specialising in the telecommunications industry in our PwC South African practice.

Welcome to the podcast studio Johan.

Johan: Hi Dipthi, it is nice to be with you in the studio and thanks for having me.

Dipthi: So in our last podcast on lease term, we discussed the considerations and challenges in determining the lease term under IFRS 16. The Interpretations Committee meeting held in November last year finalised an agenda decision relating to the impact of penalties in determining the lease term, which has been a much-debated issue. Could you perhaps give our audience some background?

Johan: Yes Dipthi, I can certainly do that. As you mentioned this is a topic that has been discussed at length. 

And the issue really addresses how to apply the term or notion of a penalty in IFRS 16, which states that a lease contract is no longer enforceable when the lessee or the lessor each have a right to terminate the lease with no more than an insignificant penalty. Ahe question was really, is the term penalty meant to apply narrowly to the payment of penalties stipulated in the lease contract or is it a concept expected to look at the broader economics, considering economic incentives and disincentives for both of the contracting parties. 

Now the IFRIC discussion in November also introduced the concept of  a cancellable lease and a renewable lease, which is where issues are over determining the enforceable period most often occur. A cancellable lease is one that does not specify a particular contractual term but continues indefinitely until either party to the contract gives notice to terminate and includes a notice period of, for example, less than 12 months and does not oblige either party to make a payment on termination. On the other hand, a renewable lease specifies an initial period, and renews indefinitely at the end of the initial lease period unless terminated by either of the parties to the contract. 

Dipthi: Thank you for that background Johan.Given this issue, where did the Interpretations Committee eventually get to on this decision?

Johan: Dipthi, I think the first important point is just to remind our listeners that IFRS 16 does not define ‘’penalty’’’ as such. The Interpretations Committee  concluded that in assessing the ‘’no more than an insignificant penalty’’ reference in the standard and in determining the enforceable period of the lease, an entity should consider the broader economics of the contract and not only the contractual termination payments. Now if either party will incur more than an insignificant penalty from terminating (including economic penalties), the contract is enforceable beyond the date on which the contract can be terminated by that party. Entities should consider whether each of the parties have a right to terminate the contract without permission from the other party with no more than an insignificant penalty. And in applying IFRS 16, a lease is no longer enforceable only when both parties have such a right. 

Now if an entity concludes that the contract is enforceable beyond the notice period of a cancellable lease (or the initial period of a renewable lease), and remember those are the two terms which i actually refer to a bit earlier, it would need to assess whether the lessee is reasonably certain not to exercise the option to terminate the lease.

And Dipthi, perhaps an additional point to mention is that the enforceable period sets the maximum lease term while the non-cancellable period is the minimum lease term. And sometimes,  more often than not,  judgement has to be applied in determining the lease term which may lie somewhere between these two points.

Dipthi: I understand that there was another question addressed by the IFRIC at the same time in the context of non-removable leasehold improvements. Could you perhaps explain the issue and the thought process around this?

Johan: Certainly Dipthi. There are two aspects that were discussed by the IFRIC, the first one being the useful life of non-removable leasehold improvements and the second one being the interaction between the lease term on one hand and the useful life of leasehold improvements on the other.

Now starting with the first aspect, an entity applies the property, plant and equipment standard or IAS 16 to determine the useful life of non-removable leasehold improvements. In determining the useful life of non-removable leasehold improvement. In determining the useful life, legal or similar limits on the use of the asset, such as expiry date of related leases should be considered. Now, if the lease term of the related lease is shorter than the economic life of those leasehold improvements, the entity considers whether it expects to use the leasehold improvements beyond that lease term. If the entity does not expect to use the leasehold improvements beyond the lease term of the related lease then,it concludes that the useful life of the non-removable leasehold improvements is the same as the lease term. 

And perhaps Dipthi, just to mention, the Committee observed that an entity might often reach this conclusion for leasehold improvements that the entity will use and benefit from only for as long as it uses the underlying asset in the lease.

Dipthi: That’s interesting. So how does this then interact with the lease term?

Johan:  As we discussed a bit earlier, when determining the lease term and the enforceable period of the lease, it is important to consider the broader economics and all relevant facts and circumstances that create an economic incentive of disincentive for the lessee, which includes significant leasehold improvements. Now there might be circumstances where the useful life of the non-removable leasehold improvement exceeds the assessed lease term (for example, where management for instance will dismantle and redeploy the leasehold improvement at the end of the lease terms). Therefore, it might be possible based on the specific facts for the leasehold improvements to have a useful life which is longer than the lease term.

Dipthi: Thanks Johan for that feedback on the November agenda decision. Another aspect of accounting which is commonly found in the Telcos space are asset retirement obligations. Before we get into  the accounting considerations, please could you elaborate on what asset retirement obligations are?

Johan: Dipthi, well I think simply put, is where an operator constructs or places, for example a cell tower on leased land, the operator  might have an obligation to remove the cell tower and restore the land to its original condition at the end of the lease.

Dipthi: So moving on to the accounting implications, what might that be for this restoration obligation. 

Johan: Dipthi, we are back in IFRS 16. And IFRS 16  states that the cost of restoring the underlying asset to its original condition at the end of the lease is in fact included in the cost of the right of use asset. This implies that the asset retirement obligation asset or ARO asset is recognised at the same time as the restoration provision, and forms part of the right of use asset for the leasehold land, with, importantly, its useful life being the same and not exceeding the lease term.

Dipthi: Considering IAS 16 which is the property, plant and equipment standard, does it not state that the cost of an item of property, plant and equipment includes an estimate of the costs of dismantling and restoring the site on which it is located? There seems to be quite a contrast there, as this suggests that the asset retirement obligation asset or ARO asset forms part of the cost of the equipment constructed on the leasehold land, and it should have the same useful life as that equipment?

Johan: Yes, that observation is right on the money. There is indeed a contrast between IFRS 16 and IAS 16 in this regard. And what is important in determining the treatment of the asset retirement obligation is really to consider what gave rise to this obligation, that is does it arise from the lease contract or does it actually arise from the underlying asset?

If the obligation arises as a result of the land lease, the asset retirement obligation should logically form part of the right of use asset. 

And on the other hand, if the obligation arises from laws or regulations, in fact, it actually has nothing to do with the lease and should attach to the cell tower itself. And these conclusions reached will really therefore depend on the facts and circumstances specific to each lease arrangement.

Dipthi: Thank you for joining us in this podcast for yet another interesting discussion on much-debated IFRS 16 issues. The new standard has clearly kept everyone on their toes even a year into implementation!

Johan: Yes Dipthi, indeed it has! Perhaps a couple of parting thoughts from my side. I think firstly it is fundamental that entities understand the issues and impact of these agenda decisions on their accounting as it is likely to have significant business implications. And then when we talk about specific issues such as the lease term and the useful life of improvements, more often than not, these are areas that require some judgement and entities should consider explaining these and how they have actually applied these as part of its critical judgments and estimates in their respective financial statements.

Dipthi: Definitely agree with you on that Johan and one important take away is to . stay up to date with updates from the IFRIC. 

Stay tuned for the next podcast which plans on covering the interaction between IFRS 16 and IAS 36 Impairments.