Recent clarifications of the new leases standard

Should subsurface rights (e.g. a right to place an oil pipeline in underground space in exchange for consideration) be accounted for as leases?

Based on the fact pattern in the request, the IFRS IC concluded that none of the scope exceptions in IFRS 16 apply, the defined underground space is a tangible identified asset and the contract contains a lease.

Under US GAAP there are presently mixed views about whether a lease exists in a similar arrangement. In the absence of further guidance from the FASB or the SEC staff, we believe an entity may apply either of the following views:

• View 1: subsurface land is identifiable and can be leased (similar to the IFRS IC conclusion)
• View 2: subsurface rights can be analogized to air rights, which are defined as an intangible asset under US GAAP, and hence accounted for as outside the scope of the lease standard (ASC 842).

We have observed most companies apply View 2 under US GAAP, which is not permissible under IFRS Standards based on the conclusion of the IFRS IC.

Should the lessee’s incremental borrowing rate (IBR) reflect the interest rate the lessee would pay for a loan with a payment profile similar to that of the lease?

Leases typically repay the principal of the lease over the lease term – i.e. the payment profile is that of an amortizing loan. In contrast, many loans and other debt instruments make interest only payments during the term of the debt and repay the principal only at maturity (i.e. bullet loan).

IFRS 16 defines the lessee’s IBR as the rate of interest that a lessee would have to pay to borrow over a similar term and with a similar security to obtain an asset of similar value to the right-of-use asset in a similar economic environment. It is therefore a lease-specific rate that takes into account the terms and conditions of the lease. The IFRS IC observed that it would be consistent with the definition of the IBR for a lessee to refer as a starting point in determining the IBR to a readily observable rate for a loan (or other debt) with a similar payment profile to that of the lease.

However, the IFRS IC noted that IFRS 16 does not explicitly require a lessee to determine its IBR to reflect the interest rate in a loan with a similar payment profile to that of the lease. Further, if a rate for a loan with a similar payment profile to that of the lease is not readily observable or available, the IFRS IC’s decision does not discuss whether the lessee is required to adjust for the payment profile difference between the lease and the reference borrowing.

In contrast, we believe US GAAP requires the lessee to adjust for payment profile differences between the lease and the reference borrowing. Therefore, in some circumstances, this Agenda Decision might permit divergence in the application of IFRS Standards and US GAAP on a part of leases requirements that was previously considered to be substantially converged.

Does an entity consider economic costs other than contractual termination payments when determining the enforceable period of the lease? Should the useful life of any related non-removable leasehold improvements be limited to the lease term determined under IFRS 16?

Penalties when determining the enforceable period

The IFRS IC noted that the lease term under IFRS 16 cannot be less than the non-cancellable period of the lease or exceed the period for which the contract is enforceable. IFRS 16 states that a lease is no longer enforceable when both parties have the right to terminate the lease without incurring a more than insignificant penalty. IFRS 16 however does not define ‘penalty’.

The IFRS IC observed that when determining the enforceable period of the lease, the entity should consider the broader economics of the contract, meaning economic incentives to renew (or not terminate) the lease. That is, ‘penalty’ is a broad economic concept that includes more than contractual termination payments. Examples include the costs of abandoning or dismantling non-removable leasehold improvements, and costs to transport or replace the underlying asset with another comparable asset.

If an entity concludes that a lease is enforceable beyond the non-cancellable period of the lease, it then must assess whether the lessee is reasonably certain to exercise its option(s) to renew (or not to terminate) the lease.

The IFRS IC’s conclusion is consistent with the explicit definition of ‘penalty’ in ASC 842. Therefore, we would generally expect consistent outcomes between ASC 842 and IFRS 16 when determining the enforceable period of a lease.

Useful life of non-removable leasehold improvements

The economic life of non-removable leasehold improvements will frequently affect the lease term. If a lessee will forfeit significant economic value in its leasehold improvements by not renewing (or by terminating) the lease, it may be ‘reasonably certain’ to continue the lease to avoid that outcome.

Put differently, the more significant the economic value of the leasehold improvements that would be forfeited by the lessee by terminating (or not renewing) the lease, the more likely the lease term will include periods after an optional renewal (or termination) date.

The useful life of leasehold improvements is determined under IAS 16, similar to other property, plant and equipment, and may exceed the lease term. The IFRS IC observed than an entity will often conclude that the useful life of non-removable leasehold improvements is the same as the lease term. However, this will not always be the case.

Unlike IFRS Standards, US GAAP prohibits amortizing leasehold improvements over a period longer than the lease term. While this difference exists, because of the relationship between the lease term and the presence of significant leasehold improvements, we do not expect entities will frequently reach different leasehold improvement useful life conclusions between US GAAP and IFRS Standards in practice. 

A customer enters into a contract for the use of a ship for five years. Certain relevant decisions about how and for what purpose the ship can be used during the period of use are predetermined in the contract. However, not all relevant decisions are predetermined. Instead, the customer retains relevant decision-making rights about where and when the ship sails, and those decisions substantively affect the economic benefits to be derived from the ship’s use. The supplier operates and maintains the ship throughout the five-year term. Does the contract contain a lease under IFRS 16?

Based on the fact pattern in the request, the IFRS IC tentatively concluded that the customer has the right to direct the use of the ship throughout the lease term. This is because, while some decisions about how and for what purpose the ship will be used are predetermined, other relevant how and for what purpose decisions are not predetermined – i.e. are available to be made during the period of use – and the customer controls those decisions. Consequently, the contract contains a lease assuming the other parts of the lease definition are met.

We believe that the same conclusion would be reached under US GAAP.  

New - November 2019

How does a seller-lessee measure the right-of-use asset and the gain or loss arising from a sale-leaseback transaction where the leaseback payments are entirely or mostly variable?

In the fact pattern submitted to the IFRS IC, a seller-lessee transfers an asset to a buyer-lessor and leases it back for 10 years. However, the lease payments are entirely variable, based on the lessee’s revenue. Such payments are generally excluded from a lessee’s lease liability. The submission notes that if the right-of-use asset is measured in accordance with IFRS 16.24 (i.e. based on the lease liability), then it would also be measured at zero. Consequently, the seller-lessee would recognize the entire gain or loss on the sale of the asset (difference between the cash received and the carrying amount of the asset) when it is transferred to the buyer-lessor even though the seller-lessee retains the right to use the asset for 10 years.

Conversely, it could be argued that this outcome would be inconsistent with the principle in IFRS 16.100(a). This is because, despite the variable nature of the leaseback payments, the seller-lessee retains a significant right to use the asset.

The IFRS IC is still discussing this issue.

Because the sale-leaseback guidance under US GAAP is significantly different from that in IFRS 16, this question does not arise under US GAAP.