Rattling around in the murky corners of IFRS 16…
Here’s another issue discussed in the past by Canada’s IFRS Discussion Group:
- In many cases, a lessee will enter into a lease agreement to rent space from a lessor. The lease agreement specifies that the lessee has an obligation at the end of the lease term, to remove the item of property, plant and equipment which the lessee installs on the premises (e.g., leasehold improvements or immovable equipment).
- Under IAS 17 Leases, operating leases are not recognized in the Statement of Financial Position. Therefore, entities have in practice, recognized the corresponding costs associated with the asset retirement obligation as part of the item of property, plant and equipment in accordance with paragraph 16(c) of IAS 16 Property, Plant and Equipment.
The group discussed a fact pattern where an entity enters into a 10-year lease agreement for the lease of land and installs equipment on that land. The terms and conditions of the lease agreement require the lessee to remove the equipment and restore the land back to its original condition at the end of the lease term. The entity recognizes a liability (under IAS 37) for that obligation at the time when it incurs the obligation (i.e. when the equipment is installed or attached to the land).
The group discussed whether the entity should treat the costs of removing the equipment and restoring the leased land as part of the cost of the right-of-use asset arising from the lease, or rather as part of the cost of the equipment. The issue doesn’t affect the measurement of the liability, which will follow IAS 37 either way. However the impact on depreciation expense might differ between the two, and the balance sheet classification would differ (of course, one imagines these impacts would often be immaterial).
Treatment as part of the right-of-use asset might be supported by IFRS 16.24, stating that the right of use asset includes: “an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories.” The problem though is that this passage refers to the asset underlying the lease, not to other assets not specifically covered by the lease (albeit that without its access to the lease land, the entity wouldn’t have installed the equipment). This might suggest that the appropriate treatment would continue to fall under IAS 16.
The group didn’t reach a clear consensus on the issue, with some members holding the opinion that neither view can be entirely rejected, and that an accounting policy choice therefore exists. One member set out a tweak to the fact pattern, where an entity removes something from the underlying leased premises and thereby assumes an obligation to restore the premises before the end of the lease term. In this situation, it may be clearer that the restoration obligation does attach directly to the right-of-use asset.
Here’s another issue discussed at the same meeting:
- When a lease includes both land and building elements, a lessee is required to apply the guidance in paragraph 12 of IFRS 16 to determine whether the right-to-use the land and building are a single lease component or separate lease components. Paragraph B32 of IFRS 16 provides the criteria for determining whether the right to use an underlying asset is a separate lease component.
- The criteria are:
- 1) the lessee can benefit from the use of the underlying asset on its own or together with other readily available resources; and
- 2) the underlying asset is neither highly dependent on, nor highly interrelated with, other underlying assets in the contract.
The group discussed a scenario where an entity enters into a lease of real property comprising a building, in which it operates a retail store, and the underlying land. Given the interdependency of the land and building in this situation, the group concluded that the building and the land aren’t considered separate lease components (it noted that US GAAP might take a different view though). It then extended the scenario so that the lease also includes an adjacent parking lot for the exclusive use of the entity’s customers. Clearly a high degree of interrelation still exists between the store and the parking lot, but perhaps not quite as high (if, for instance, customers can use the store without using the parking lot). Group members expressed different views on this, noting that the judgment would change to reflect different facts and circumstances (for example, whether the parking lot generates its own revenue stream). Again of course, if the depreciation periods are the same for both, then it won’t matter much either way.
The group also addressed various transitional issues for both these items.
The opinions expressed are solely those of the author