Onerous lease contracts and impairments, and investor issues
This article addresses the technical matter of onerous lease contracts and their impairment and then considers two types of approach to SBR exam questions:
(i) investors issues in SBR questions and
(ii) the application of knowledge to SBR question scenarios.
This article addresses the technical matter of onerous lease contracts and their impairment and then considers two types of approach to SBR exam questions:
(i) investors issues in SBR questions and
(ii) the application of knowledge to SBR question scenarios
Specifically, question 3 from the March 2020 exam is used to illustrate this point.
Onerous lease contracts and impairments
IFRS 16, Leases has brought significant change to the accounting treatment of leases, the most important of these changes being that lessees now have to recognise operating leases as a right-of-use (ROU) asset and a lease liability. As with other assets, this ROU asset may have to be tested for impairment. Since the ROU asset is a non-financial asset, the requirements of IAS 36 apply. However, there are two exemptions to the IAS 36 impairment model.
Firstly, when a lessee applies the fair value model in accordance with IAS 40 for its investment properties, it also applies the fair value model to the ROU asset. Secondly, if a ROU asset relates to a class of PPE to which the lessee applies the revaluation model, then the lessee can elect to apply the revaluation model to all of the ROU assets that relate to that class of PPE.
In accordance with IAS 36, the ROU asset is tested for impairment on a standalone basis unless it forms part of a cash-generating unit (CGU). If the ROU asset is tested for impairment as a part of the CGU then it should be included in the CGU’s carrying amount. IAS 36 requires entities to consider whether a buyer would be required to assume any liabilities, which could include the lessee’s lease liability. In such a case, the lease liability needs to be included in the recoverable amount of the CGU and in the carrying amount of CGU as well.
When considering onerous contracts, these are governed by IAS 37, Provisions, Contingent Liabilities and Contingent Assets and this IFRS standard is applied to any contract for which unavoidable costs of meeting the contract obligations exceed the economic benefits expected to be received under that contract. However, it is interesting to consider whether IAS 37 and IFRS 16 can co-exist.
The International Accounting Standards Board (the Board) decided not to specify any particular requirements in IFRS 16 for onerous contracts. The Board made this decision because:
(a) for leases that have already commenced, no requirements are necessary. After the commencement date, an entity can appropriately reflect an onerous lease contract by applying the requirements of IFRS 16. A lessee will determine and recognise any impairment of right-of-use assets applying IAS 36, Impairment of Assets.
(b) for leases that have not already commenced, the requirements for onerous contracts in IAS 37, Provisions, Contingent Liabilities and Contingent Assets are sufficient. The requirements in IAS 37 apply to any contract (and hence any lease contract) that meets the definition of an onerous contract in that standard.
The question also arises as to how to deal with onerous contracts when initially applying IFRS 16. A company can either:
- apply IAS 36 to its right-of-use assets, or
- not apply IAS 36 on the date of initial application, but instead rely on its assessment of whether any of its leases are onerous under IAS 37. Any onerous lease provision is derecognised and an equal amount is deducted from the carrying amount of the relevant right-of-use asset.
This choice can also be applied on a lease-by-lease basis.
Thus, candidates should carefully read the question before answering to determine whether IAS 36 or IAS 37 should be applied to the onerous leasing contract. If the examining team wants candidates to consider the matter under a specific IFRS standard (ie IAS 37 or IFRS 16), then that standard will be specifically referred to in the requirement. However, candidates should also appreciate that marks will be awarded for any discussion that is rational and logical, even though it doesn’t appear in the suggested solution.
Investors issues in SBR
Every SBR exam will include a question that tests an investor’s perspective. Although the nature of the question will vary, it will normally include 2 professional marks. The question may require candidates to comment upon the usefulness of certain types of information to investors and their needs. When answering a question on a specific IFRS standard, candidates should use their knowledge of that accounting standard to discuss how this could impact on the investment decisions of investors. For example, there may be a need for a clear explanation of deferred tax balances in financial statements and an analysis of the expected timing of reversals so that investors can see the time period over which deferred tax assets arising from losses might reverse.
As a general rule, the principles of good disclosure would be useful to investors. Thus, candidates can use these principles as a framework for answering generic questions which involve an investor perspective. The Board has received feedback from investors along the following lines:
- Investors are concerned about ineffective communication. In particular, they highlight the importance of proper application of materiality by entities when deciding what to disclose and how best to communicate that information.
- Investors consider comparability and entity-specific information to be particularly important but note that there is potential for conflict between these two principles.
- Many investors think that the inclusion of IFRS information outside the financial statements could be useful in some circumstances but have some concerns about understandability, assurance and the on-going availability of information.
- Many investors agree that the Board should not prohibit the inclusion of non-IFRS standard information in financial statements. However, investors have concerns about the risk of entities providing misleading information, or clouding IFRS standard information.
- Investors think that the Board should require an entity to clearly identify, label, explain and reconcile any non-IFRS standard information presented in the financial statements.
- Many investors feel that the Board should define performance measures. Many investors have encouraged the Board to define one or more of the following: EBIT, EBITDA and other performance measures such as operating profit.
- Most investors support the suggestion to develop definitions of, and requirements for the presentation of, unusual or infrequently occurring items. Investors think that this would help to avoid misleading or inconsistent use of those terms.
- Investors think that useful accounting policy disclosures are those that relate to material items, transactions or events or provide insight into how an entity has exercised judgement in selecting and applying accounting policies.
The above principles could be used when SBR candidates answer several types of investor related questions but would only gain marks if applied to the scenario.
The application of SBR knowledge to question scenarios
It is important to explore this latter point further. The SBR exam requires candidates to answer questions using the application of knowledge to a question scenario. However, in SBR, candidates often fail to gain valuable marks through not using the scenario in their answer.
The verb used in the question requirement and the number of marks allocated to it gives the candidate an idea about the nature and degree of detail required. A purely discursive answer will lose marks if computations are required and no marks will be awarded to calculations that have not been asked for. Simply repeating facts from the scenario or an accounting standard without any further explanation or application of that knowledge is insufficient. This is because markers are looking for evidence of analysis and professional judgment.
There is some evidence that some candidates practice poor time management. Often, these candidates do not attempt all of the questions with the result that relatively easy marks, particularly in the final parts of question 4 are lost. Some candidates spend a disproportionate amount of time addressing the issues in question 1 with the result that there is little time left to answer question 4. There needs to be a balance between the time spent on all of questions and an understanding that spending too much time on any one question will affect performance.
If candidates forget the principles in a particular accounting standard, a good strategy is to refer to the Conceptual Framework. If candidates feel that they cannot answer part of a question, then the principles in the Conceptual Framework, applied correctly, will always gain some marks. This is the case even if the Conceptual Framework is not mentioned in the suggested solution. Candidates are advised to structure and present their answer in a way that assists the marking process and so it is not advisable to merge many parts of an answer into one.
SBR consciously includes challenging and contemporary question scenarios. Candidates will be awarded marks for discussion of issues which do not appear in the suggested solution but are relevant to the scenario. Additionally, extra marks may be gained if a candidate discusses a point particularly well.
A good example of this approach can be seen in question 3 March 2020, which you can find here.
The question required candidates to discuss how to account for contingent performance conditions where individual football players are paid bonuses which represent additional contract costs. Candidates needed to be able to discuss when the bonuses would be recognised. There is no existing IFRS standard to refer to in this question, therefore candidates were required to use accounting principles. There is diversity in practice where accounting for contingent performance conditions is concerned.
So, how should SBR candidates have answered this question?
There are several ways in which this question could have been answered and candidates could either refer to the Conceptual Framework or other existing accounting standards. For example, candidates could use the definition of a liability in the Conceptual Framework to help: 'a liability is a present obligation of the entity to transfer an economic resource as a result of past event'. So, the entity should have an obligation. When a player’s contract is signed, management should make an assessment of the likely outcome of performance conditions in order to determine if there is an obligation.
Secondly, there needs to be an obligation to transfer an economic resource. The economic resource being transferred will be a cash amount.
Thirdly, the obligation needs to be a present obligation that exists as a result of past event. Hence, any contingent amounts will only be recognised from the date management believes that the performance conditions will be met. Before this date, an obligation will not exist and the past event can be argued as the signing of the contract.
Alternatively, the definition of a provision in IAS 37 could be used to answer the question. A provision is a present obligation that has arisen as a result of a past event, payment is probable, and the amount can be estimated reliably.
Leicester City Football Club states in its financial statements that ‘Contractual obligations are recognised when they become payable with prepayments/accruals recognised at each period end. However, Manchester United Football Club states the following re bonus payments to players – 'Any performance bonuses are recognised when the Company considers that it is probable that the condition related to the payment will be achieved.' The suggested solution to Q3 March 2020 is written in accordance with this accounting policy.
However, there is an argument that there is a possible financial liability which should be recognised at the acquisition of the player. The examining team do not necessarily agree with this view as players can leave the football club or become injured and not trigger the payments. However, if candidates argued this point coherently, then marks would have been awarded accordingly.
It is worth remembering that the examining team give credit for answers that are not included in the suggested solution at every exam. This is because corporate reporting is not an exact science! It requires judgement and is subjective… it is your judgement and opinions that employers want to see and so these are the skills that the SBR examining team is attempting to develop. Therefore, SBR candidates should be prepared to apply their corporate reporting knowledge to many different business contexts and contemporary SBR questions.