IFRIC recently received a submission from the European Securities and Markets Authority (ESMA), cited in this blog in the past (most recently here) for its periodic publications of extracts from its database of enforcement decisions. Here’s the fact pattern behind the resulting tentative agenda decision issued by IFRIC:
- an entity manufactures cars and leases them to its customers. The lease term is usually three years, which is significantly shorter than the cars’ economic lives. The entity sells the leased cars at the end of the lease term.
- the entity classifies the lease contracts as operating leases and recognises the leased cars as property, plant and equipment. The entity measures the leased cars using the cost model in IAS 16 and depreciates them on a straight-line basis over the lease term.
The entity determines residual value of a car by estimating the entity’s disposal proceeds from its future sale of the car, on a car-by-car basis. ESMA asked whether the entity is required to reflect other expected future developments (such as expected future price or market trends, or inflation and other macroeconomic factors) in its estimate of the leased cars’ residual value. The submission opined that: “given the wide use of residual values in industries such as the automotive, shipping and airline industries, it is likely that the issue raised is widespread and has material effect on those affected.” It noted: “Even though current prices often largely account for expected future developments, including regulatory changes and consumer demand shifts, ESMA observes that estimations of future prices used under certain circumstances significantly differ from expected disposal proceeds at the balance sheet date.”
Paragraph 6 of IAS 16 defines an asset’s residual value of an asset as ‘the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.’ The submission set out a potential argument that using disposal proceeds observable today when accounting for property, plant and equipment wouldn’t provide relevant information for users of financial statements and would conflict with the spirit and purpose of IAS 16 (for example, if lower future residual values are almost certain due to policy changes, such as an already enacted future ban on combustion engines, tax increases etc.). It also argued, rather imaginatively, that because IAS 16.6 as cited above refers to an “estimated amount,” the requirement can’t be satisfied by using a current price which can be directly observed rather than estimated. Of the fifteen respondents to IFRIC’s information request, eight said they’d either observed such approaches in practice, or been informed of them by stakeholders.
The underlying staff paper didn’t particularly consider the conceptual merit of those arguments, finding it sufficient to focus on that term “currently obtain,” emphasizing that it reflects other expected future developments only to the extent such developments affect the amount the entity would currently obtain from disposing of the asset; for example, expected future technological changes that might make an asset obsolete. The concept doesn’t reflect other expected future developments to the extent they affect only future prices. As such, the Committee tentatively concluded that the principles and requirements in IAS 16 provide an adequate basis for analyzing the issue, and that a standard-setting project isn’t needed to address the request; the decision is open for comment until November 30, 2026.
That may be fair enough as a technical conclusion, but it’s hard from the facts provided to think that the rejected approach is particularly offensive on its own terms. The issue reminded me of the paranoia in Canada, during the early days of the conversion to IFRS, about “componentization” of property, plant and equipment, raising the fear that endless analysis of ancient machinery and buildings would be required, regardless that it would only result in a meaningless adjustment to the impenetrable depreciation numbers. Fortunately, it didn’t turn out to be quite the nightmare that some anticipated (or that some service providers might have self-servingly hoped for it to be) and as far as I know, Canadian regulators never made much of the issue. Given the often vast amount of estimation involved not only in identifying significant components but also in determining a useful life and the most appropriate depreciation pattern over that life, and given ample user awareness of the limitations of the resulting charge, I’m not sure much is gained from rejecting well-reasoned alternative approaches to residual value, especially if, as IFRIC’s information gathering suggests, they’re fairly commonly evidenced in practice. One hopes then that the agenda decision, if finalized in its current form, won’t result in too many companies having to incur major time and effort to haul their practices into compliance.
The opinions expressed are solely those of the author.
