Here’s the background to an issue recently discussed by CPA Canada’s IFRS Discussion Group:
- Under IFRS 16 Leases, a contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Paragraph B9 of IFRS 16 further requires two criteria to be met to demonstrate the right to control the use of an identified asset: 1. the right to obtain substantially all of the economic benefits from use of the identified asset; and 2. the right to direct the use of the identified asset.
- (The standard also specifies: “A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fibre optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset.”)
- In the oil and gas industry, companies commonly structure arrangements where a customer has a right to both a fixed committed volume of the capacity of an identified asset (e.g., processing facility or pipeline) and a right of first refusal/offer (ROFR) over the remaining capacity. The Group discussed whether the fact that a customer has a right to obtain additional capacity through a ROFR gives that customer the right to substantially all of the economic benefits of the asset.
Here’s the fact pattern they discussed:
- Company A enters into a 10-year contract with Company B for 70 percent of the capacity of a specific gas pipeline. Company A also has a right of first refusal over the remaining 30 percent of the capacity of the pipeline, such that Company B can only sell additional capacity to other customers if Company A agrees not to purchase the remaining capacity. The pricing of the contract is at market terms. Assume there are other potential customers in the vicinity that could use the additional capacity.
In these circumstances, does Company A have the right to obtain substantially all of the economic benefits from the use of the pipeline? It may seem that it straightforwardly does – it has the ability to prevent Company B from selling the additional capacity to anyone other than itself. But on the other hand, various reasons may exist why Company A’s right isn’t substantive. Similar to the factors set out in IFRS 10 in assessing rights held by an investor over an investee, these might include penalties or terms and conditions that would deter the company from exercising its rights, or relevant legal and regulatory roadblocks, among other things. The group’s discussion added some industry-specific examples:
- (a) The production forecast does not economically justify purchasing additional capacity.
- (b) The ability to share the operating costs with new customers creates an economic incentive to not exercise the ROFR.
- (c) The ROFR is included as a price protection for the lessee to prevent a lower price being offered to a new customer.
- (d) Existence of the right for the asset owner to expand the capacity to include a second customer once the ROFR is exercised.
For another reference point, in determining the lease term, IFRS 16 requires that an entity assess at the commencement date, considering all relevant facts and circumstances, whether the lessee is reasonably certain to exercise an option to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease. This might introduce such considerations as the importance of the underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset, its location and the availability of suitable alternatives. In this particular case, the fact pattern specifies that the pricing of the contract is at market, but if it wasn’t, then other considerations would come into play as well.
You might think, as an aside, that if the IFRS 16 model is for the greater good, then value would exist in recognizing a right of use asset and related liability for identified rights to portions of assets, regardless of whether other parties also have rights to significant portions of those assets. In the standard’s basis for conclusions, the IASB noted: “Widening the notion of an identified asset to possibly capture portions of a larger asset that are not physically distinct might have forced entities to consider whether they lease assets used to fulfil any contract for services, only to conclude that they do not. Consequently, the IASB concluded that widening the definition to include capacity portions of a larger asset would increase complexity for little benefit.”
Anyway, given the diversity of views, the group referred the issue to the Accounting Standards Board for further discussion at its July 2019 meeting. The Board subsequently decided not to raise the issue with IFRIC at present, but “to continue monitoring future developments in IFRS 16 Leases, specifically in the oil and gas industry, to assess whether this issue should be raised in the future.” So there you go.
The opinions expressed are solely those of the author