Interaction between IFRS 16 Leases and IAS 36 Impairment of Assets - Ep 5

Transcript

Interviewer (Dipthi): Welcome to this 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 Renitha Dwarika, a technical accounting partner specialising in the telecommunications industry in our PwC South African practice.

Renitha: Hi Dipthi, it’s great to be back.

Dipthi: IFRS 16 Leases remains a hot topic. In today’s episode, we are going to speak about IFRS 16 and its interaction with an existing standard being IAS 36, Impairment of Assets. One of the aspects of the transition to the new leasing standard that has proven to be quite challenging in practice, is the consideration of the impact that IFRS 16 has on an entity’s impairment model. 

So Renitha, to start off could you tell us what impact does IFRS 16 have on IAS 36?

Renitha: Hopefully by now we all know that IFRS 16 has had the biggest impact on lessees which has resulted in most lessees recognising a right of use asset and lease liability on the balance sheet. The right of use asset is subject to impairment testing under IAS 36 and here some challenges do arise for discounted cash flow modelling.

Dipthi: Based on IAS 36 and my understanding of impairment as is the case with all non-financial assets, is that it needs to be determined at what level the testing of the assets should be performed.

Renitha: Yes.  IAS 36 applies a “bottom up” approach to impairment testing. It is a two step process. The first step is to test the individual asset or alternatively cash-generating unit or CGU if the recoverable amount for the individual asset cannot be determined. The second step is to test the CGU or group of CGUs including any goodwill.

Typically a right of use asset does not generate cash flows that are largely independent from other assets, and in those circumstances the ROU asset should be grouped within the CGU to which it belongs for purposes of impairment testing.

Dipthi: That’s a great start. Before we get into the detail of the interaction between the two standards, could you give us an overview of the impairment model and broadly what should be considered?

Renitha: There are 2 methods to calculate recoverable amounts under IAS 36: the first approach is the fair value less costs of disposal approach and the other one is the value in use approach. The fair value less cost of disposal model is an external market participant approach whereas the value in use approach is based on an internal management perspective. Generally, fair value less cost of disposal of an asset or CGU  does not change due to the introduction of IFRS 16 as one would not expect the CGU to be worth more or less to a market participant simply because there is now a  ROU asset or lease liability now included on the balance sheet. The biggest impact is rather in relation to the VIU model.

Dipthi: We will focus the rest of the podcast on the VIU then. Could you perhaps walk us through the IFRS 16/IAS 36 interaction considerations by way of an example?

Renitha:  Yes sure Dipthi. Examples always work best! Let assume  we have Operator , who generates revenue from providing network services, and has a large network asset base including base stations, property, plant and equipment and even goodwill. The operator also leases its towers, for which a right of use and a lease liability is recognised on the balance sheet. 

It could be argued that the smallest group of assets that generate independent revenue streams for Operator D is the integrated network, and therefore that is the entire operation of Operator D is a single CGU.

Dipthi: So, the CGU has been identified, which includes the right of use asset. Let’s start with the value in use model.

Renitha: Post IFRS 16, the carrying amount of the CGU tested will be different to pre-IFRS 16 carrying amount as the right of use asset is now included in the CGU. Furthermore, the related lease liabilities are excluded from the carrying amount of the CGU as these are a form of financing and the VIU model requires cash flows from financing activities to be excluded from the carrying amount of the CGU. 

Dipthi: Are there any other considerations for the value in use calculation?

Renitha: There certainly are. IAS 36 requires that we compare “Like with Like”.  This means that the same principles we used to determine the carrying amount of the CGU should be used to calculate the recoverable amount. The first thing we need to remember is that any lease payments should be ignored in calculating the value in use as we have ignored the lease liability in the carrying amount of the CGU. However, cash flows for future variable lease payments and short-term and low value leases that are not included in the lease liability should be reflected in the cash flows.

The second thing is that the ROU asset included in the carrying amount of the CGU captures the lease payments over the lease term and therefore in calculating the VIU we need to determine the cash outflows required to replace the ROU asset at the end of the lease term and the implications on the terminal value,  and this is similar to what we would have historically done for maintenance capex outflows.

Lastly we need to think about the discount rate. The projected VIU cash flows should be discounted at a pre-tax discount rate reflecting a market assessment of the capital structure, and risks specific to the asset or CGU.

Dipthi: A number of things to consider! What does one need to consider in terms of cash flows to replace the ROU asset?

Renitha: Basically in order to preserve the economic value of the CGU one needs to include cashflows which cater for replacement with equivalent lease assets. Therefore, payments for anticipated new leases should be considered as replacement investments (cash outflows) and therefore it is important that the "reinvestments" in “lease assets" are adequately forecasted for and as a result additional data collection will be required in this respect.

Dipthi: It is clear that replacement cashflows and the impact on the terminal value will require extra consideration! Are there any further considerations in relation to the discount rate?

Renitha: In terms of the discount rate - as I mentioned IAS 36 requires one to use a pre-tax rate (as it is a VIU model) that reflects the risk specific to the entity. Most entities starting point is their weighted average cost of capital which is made up of the cost of debt and cost of equity. Post IFRS 16, while the cost of debt and cost of equity has not changed,  the capital structure has indeed changed with the lease liability on the balance sheet and therefore the cost of the leasing debt and its weighting need to be considered in deriving an appropriate discount rate.

Dipthi: That is very helpful. Moving back to our example, in the event of the calculation resulting in an impairment of the CGU, that impairment needs to be allocated to the assets within the CGU. 

Any insights on this for our listeners?

Renitha: Sure Dipthi. What should be kept in mind is that the impairment is not directly allocated to the right of use asset, but rather IAS 36 follows a waterfall approach. In our example, the first step is to allocate the impairment to write down the goodwill within the CGU (which cannot be subsequently reversed). If, after allocating the impairment to goodwill, there is still an amount of the impairment remaining, the impairment should be allocated to the other individual assets, being the PPE, base stations, including the right of use asset  in the CGU on a pro-rata basis, based on the carrying amount of each asset in the CGU.

In doing this allocation, each individual asset should only be reduced to the higher of its fair value less costs of disposal, if measurable, it’s value in use or zero.

Dipthi: So from what you are saying Renitha, if a particular CGU has an impairment, it is likely that the entire impairment amount will not be taken against the right of use asset.

Renitha: Yes, that’s spot on Dipthi. But what should be kept in mind is that if an impairment loss  is not fully allocated because the assets do not have sufficient value to absorb the charge entirely then a liability will be raised for the unrecognised impairment loss to the extent the definition of a liability is met which is rare in practice.

Dipthi: Okay, so we’ve touched on the value in use calculation and the allocation of impairment. Is there anything else that needs to be considered when thinking about impairment losses?

Renitha: Yes, there are a couple of things to consider when an asset has been impaired. Firstly, after being written down to its recoverable amount, the asset continues to be depreciated. Linked to this, consideration should be given as to whether the useful life of the asset needs to be revisited -. So in short, entities should consider the economic useful life of assets when there has been an impairment.

Dipthi: It is quite clear that the adoption of IFRS 16 needs to be considered carefully with other standards, specifically IAS 36! Thank you for sharing these very useful points with our listeners.

Any final thoughts, tips or messages for our listeners Renitha?

Renitha: My parting thoughts would be that firstly the adoption of IFRS 16 has overall been a huge change for entities from an accounting perspective as well as a data collection perspective. The IAS 36 element also requires collation of information, both market and non-market related. 

Secondly, this requires entities to make more estimates and judgements than they have done in the past.

And this leads back to disclosures which is now are expected to be more robust incorporating more sensitivities, disclosure on assumptions used as well as estimates.

Dipthi: Fantastic, thank you very much for joining us Renitha and sharing some very useful information for our listeners.

Listen out for our next podcast where we will be discussing the latest IASB amendment to IFRS 16 on rent concessions.

Renitha: Thank you for having me!