The IFRS^® Accounting Standards Discussion Group’s purpose is to act in an advisory capacity to assist the Accounting Standards Board (AcSB) in supporting the application in Canada of IFRS^® Accounting Standards. The Group maintains a public forum at which issues arising from the current application, or future application, of issued IFRS Accounting Standards are discussed and makes suggestions to the AcSB to refer particular issues to the International Accounting Standards Board (IASB) or IFRS^® Interpretations Committee. In addition, the Group provides advice to the AcSB on potential changes to IFRS Accounting Standards and such discussions are generally held in private.

The Group comprises members with various backgrounds who participate as individuals in the discussion. Any views expressed in the public meeting do not necessarily represent the views of the organization to which a member belongs or the views of the AcSB.

The discussions of the Group do not constitute official pronouncements or authoritative guidance. This document has been prepared by the staff of the AcSB and is based on discussions during the Group’s meeting.

Comments made in relation to the application of IFRS Accounting Standards do not purport to be conclusions about acceptable or unacceptable application of IFRS Accounting Standards. Only the IASB or the IFRS Interpretations Committee can make such a determination.

ITEMS PRESENTED AND DISCUSSED AT THE SEPTEMBER 19, 2023, MEETING

Accounting for the Development of Carbon Credits by a Renewable Energy Generator

Background

At its May 2023 meeting, the IFRS Accounting Standards Discussion Group discussed the accounting for the development of carbon credits that will ultimately be sold. The Group discussed one example of a voluntary scheme and a specific activity that generates carbon credits in that scheme. The Group noted that carbon credits can be generated in many ways and recommended that this topic be brought back for further discussion.

Accordingly, the Group discussed the accounting for renewable energy certificates/credits (RECs) by an entity that owns and operates a solar energy facility. The discussion focused on the recognition and measurement of the RECs when there is a time lag between the generation of electricity and the transfer (or use) of RECs.

Fact Pattern 1

Company S (“the Company”) has a solar energy facility that generates electricity. When the electricity is generated, the Company sells it into the spot energy market.
The Company has a virtual power purchase agreement (VPPA) for the next 10 years, which includes the sale of the associated RECs. For purposes of this discussion, a REC refers to the environmental attributes of the generation of one megawatt hour (MWh) of energy produced by the solar energy facility.
The RECs are transferred to the customer not at the time of electricity generation, but rather up to one year after the electricity is generated and sold. The RECs must first be verified and certified by the government so they can be used by the customer in provincial emission regulatory schemes.
The RECs are a separate unit of account from the electricity, and they meet the definition of an asset.
The Company classifies the RECs as inventory.
The fair value of the RECs is material.
The Company has determined that the REC component of the VPPA meets the own-use exemption in IFRS 9 Financial Instruments.¹ That is, it would be scoped out of IFRS 9 based on the guidance in paragraph 2.4. It is accounted for as an executory sales contract of RECs with a separable embedded derivative (electricity price swap).
The sale of the RECs is part of the Company’s ordinary activities and is determined to be a performance obligation under IFRS 15 Revenue from Contracts with Customers. Revenue for the sale of RECs is recognized when control of each REC is transferred to the customer after verification and certification.

Fact Pattern 2

In contrast to Fact Pattern 1:

The Company does not have a VPPA. Rather, it holds the RECs for its own use to settle compliance obligations arising from emission regulations.
There may be a difference in the classification of the RECs because entities that hold the RECs to satisfy an obligation may classify them as either inventory² or intangible assets.³

Similar to Fact Pattern 1:

The RECs are a separate unit of account from the electricity, and they meet the definition of an asset.
The fair value of the RECs is material.

Issue 1: Can the RECs be considered an output, or are they a government grant?

Analysis

RECs may arise as a result of the power generation process. RECs are also often a construct of government programs. Therefore, a key question arises: Are RECs effectively an output of the energy facility or a transfer of value from the government to an entity? These views may result in differences in the initial measurement of the RECs.

View 1A – RECs are ONLY an output

Proponents of this view think that the RECs are an output of the solar energy facility because the RECs are created and are dependent on the operation of the asset. They think that the Company may classify the RECs as inventory because the RECs are outputs that are part of the Company’s ordinary activities. They think this view may also apply to Fact Pattern 2 when the Company classifies the RECs as intangible assets. Although it may seem unusual to think about intangible assets as “outputs,” this does occur in other industries such as software, media, and pharmaceuticals.

View 1B – RECs are ONLY a government grant

Proponents of this view think that the RECs are a government grant because they represent a transfer of an economic benefit from the government. This is because the Company receives verified and certified RECs for complying with conditions of the government program, being the production of renewable electricity.

Proponents of this view think that the RECs would be accounted for as a non-monetary asset under IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. Applying paragraph 23 of IAS 20, the Company could measure the RECs at their fair value or at a nominal amount.

View 1C – RECs can be an output OR a government grant

Proponents of this view think that both View 1A and View 1B are supportable, and hence that it may not be possible to rule out either. Therefore, they think the Company should determine an accounting policy in Fact Patterns 1 and 2 that is applied consistently to similar transactions.

The Group’s Discussion

The Group agreed with the analysis of factors an entity might consider when determining whether the RECs would be an output or a government grant. Group members discussed that an important factor for consideration is whether the RECs have value as soon as the related electricity is generated, or only after the RECs are certified. They noted that this could depend on the government’s role and the nature of the market for the RECs (e.g., voluntary or compliance market). A Group member explained that an entity may purchase RECs in a voluntary market to meet its own emissions targets. In contrast, an entity may purchase RECs in a compliance market to meet compliance obligations arising from emission regulations.

Several Group members supported View 1A in the case of a voluntary market in which the government is not creating a requirement to offset emissions with RECs. However, they supported View 1C in the case of a compliance market as discussed further below.

Other Group members who supported View 1A discussed why they did not support View 1B. For example, two Group members commented that in Fact Patterns 1 and 2, the government appears to be simply performing an administrative service. They noted that this is similar to how an engineer performs a final inspection before a building can be used or occupied. Another Group member noted that government grants are generally not transferrable to other parties, whereas RECs are transferable. Two Group members commented that the sole fact that the government is involved in a given situation does not automatically imply that there is a government grant (or conversely, a tax).

One Group member commented that they typically see scenarios where the government initiates a transaction because it wants a certain outcome. To achieve that outcome, the government may transfer some form of economic benefit to an entity. The Group member noted that in Fact Patterns 1 and 2, the government does not appear to be seeking a certain outcome. Thus, they thought the RECs would not be a government grant and would instead be an output.

In contrast, some Group members agreed with View 1C or otherwise thought that Views 1A and 1B could each be supported in different scenarios. Several Group members noted that there is not always a clear answer in practice given the variety of fact patterns and the complexity of regimes. Many Group members thought the answer would depend on the facts and circumstances. For example, they thought the RECs could be a government grant if the government is considered to be transferring an economic benefit to the Company, particularly in a compliance market. One Group member noted that in a compliance market, the government may effectively create a need for RECs through emissions regulations. Two Group members remarked that if the Company has compliance obligations arising from emission regulations, the government may transfer an economic benefit to the Company either by certifying RECs that would settle the obligation or by giving up the right to charge penalties for noncompliance.

Some Group members suggested that the RECs may have value by virtue of the government’s process of verifying and certifying the RECs. One Group member noted that this may not be the case if the government’s process is mostly administrative, which they think it would be in Fact Patterns 1 and 2. They commented that the RECs may alternatively have value because a market exists for them, which could suggest that the RECs are an output. The Group member thought it would also be important to consider government policy risks that could impact whether such a market would continue to exist in the future.

One Group member considered whether the RECs exist because they are a by-product of generating the electricity, or because the government created a program tied to sustainability-related objectives. They commented that by-products are generally secondary products generated through the production or processing of a primary product. For example, they noted that the production of butter results in the creation of skim milk as a by-product. They think it is debatable whether the RECs are truly a by-product of the electricity as the electricity is generated irrespective of the RECs.

The Group discussed some clarifications regarding Fact Patterns 1 and 2, and how facts and circumstances could differ. Importantly, it was clarified that in Fact Patterns 1 and 2, there is no question as to whether the government will verify or certify the RECs; rather, it is only a matter of time. In addition, revenue from the sale of the RECs is not recognized until after the RECs are verified and certified. Group members noted that revenue recognition may occur earlier depending on the particular facts and circumstances, such as the specifics of the contract and the certification process. For example, when certification is considered administrative or perfunctory in nature, control of the RECs might transfer to the customer before the RECs are certified. Group members commented that this is an evolving space and government involvement varies by jurisdiction.

It was also clarified that RECs often transfer to the customer at the same time the electricity is sold into the grid. However, in this example and others there is a timing difference between when the electricity is sold and the RECs transfer. This timing difference creates accounting implications, which were the focus of the Group’s discussions.
Some Group members further noted that renewable energy generators that produce RECs may not have compliance obligations under emissions regulations. However, other entities that have compliance obligations may purchase RECs to help meet those obligations. It was also noted that a conglomerate could own a renewable energy facility in one part of the business and have compliance obligations in other parts of the business.

Issue 2: If the RECs are accounted for as an output (View 1A or View 1C), how should the RECs be measured initially?

Analysis

If the RECs are accounted for as an output and classified as inventory, it appears that IAS 2 Inventories would apply and a portion of the costs to generate the output should be allocated to the RECs.⁴ Note that any costs allocated to the RECs before they are verified and certified may be classified as “work in progress” inventory.

If the Company classifies the RECs as intangible assets under Fact Pattern 2, the views under this issue may also be relevant by analogy in determining the directly attributable costs (paragraphs 65-67 of IAS 38 Intangible Assets) of the RECs.⁴ This is because only a portion of the directly attributable costs related to the production of electricity should be attributed to the RECs.

The following additional facts are considered in analyzing each view:

The only outputs of the solar energy facility are electricity and RECs.
The total cost of generating the electricity and RECs is $125.
The selling price of the electricity is $150.
The selling price of RECs generated is $50.

View 2A – Based on the “relative sales value” of each product (paragraph 14 of IAS 2)

Proponents of this view think that costs would be allocated based on the guidance in paragraph 14 of IAS 2 for by-products. This would be based on the “relative sales value” for each product, which can be interpreted as the stand-alone selling price or fair value of each product.

Proponents of this view think that the total cost of $125 would be allocated as follows:

RECs: ($125 x $50/$200) = $31
Electricity: ($125 x $150/$200) = $94

View 2B – Based on the net realizable value (NRV), if the RECs are the by-product and immaterial (paragraph 14 of IAS 2)

This view assumes that:

RECs generated are incidental to providing the main service — the electricity; and
the NRV of the RECs is the same as their selling price.

Proponents of this view think that the total cost of $125 would be allocated as follows:

RECs: $50 (NRV)
Electricity: $125 − $50 = $75 (total cost less NRV of RECs)

View 2C – Measured at zero (or a nominal amount)

Proponents of this view think that the RECs would be measured at a cost of zero or a nominal amount. There appears to be little support for this view under IAS 2 unless the RECs are truly immaterial in value.

However, proponents of this view think that it may be required in Fact Pattern 2 if the Company classifies the RECs as intangible assets. This is because paragraph 65 of IAS 38 does not permit costs to be allocated to an internally generated intangible asset before it first meets the recognition criteria. The RECs may not meet the intangible asset recognition criteria until the verified and certified RECs are received, which is up to one year after the electricity is generated.

The Group’s Discussion

The Group agreed with the analysis of factors an entity might consider when initially measuring the RECs.

Under Fact Pattern 1, many Group members thought it would be difficult to support View 2C, which assumes that the value of the RECs is immaterial, especially given the growing market for RECs purchased to meet climate-related targets. Nevertheless, they acknowledged that there might be other fact patterns in which the value of the RECs could be immaterial.

Many Group members commented that the decision between View 2A and 2B would depend on the facts and circumstances and what is considered qualitatively and quantitatively material. One Group member noted that this could also depend on corporate strategy, which would determine whether the RECs are truly by-products or perhaps “co-products” of the electricity. They noted that by-products are often unavoidably created as a result of producing a primary product, whereas co-products may be purposely created as part of a strategic initiative. They thought a product could also be a co-product if it happens to be of such value that it provides a material revenue stream. The Group member added that these scenarios are not mutually exclusive, and they re-emphasized the importance of understanding the facts and circumstances.

Several Group members agreed with View 2A, often commenting that they thought the value of the RECs would not be immaterial in Fact Pattern 1. A few Group members thought that allocating costs based on relative sales values would best reflect the economics of the transaction, as the RECs and electricity are created together through the same process. One Group member added that, in some cases, the facility or entity may not be as viable or profitable without the RECs revenue stream. A few Group members suggested that under View 2C, the Company’s gross margin may be inconsistent from period to period and might not reflect the fact that the electricity and RECs are both significant revenue streams (potentially co-products). They explained that this is because all the costs associated with generating RECs would be recognized in gross margin in the first year when the electricity is sold, while the revenue from the RECs would be recognized the following year (after the RECs are verified/certified) without any related costs.

A Group member raised a related issue about comparability of margins across entities. They questioned how an entity that produces RECs could be compared to an entity that does not produce RECs. Under View 2A and 2B, an entity that produces RECs would report lower costs to produce electricity compared to an entity that does not produce RECs. This is because the first entity’s production costs would be split between electricity and RECs, whereas the second entity’s production costs would all be allocated to electricity. Another Group member commented that this is still an emerging area, so it may be too soon to see comparable information across jurisdictions.

A few Group members highlighted that there may be significant judgment involved in deciding between View 2A and 2B as well as in applying the selected View, which could lead to very different results. For example, one Group member noted that determining the relative sales value under View 2A could be particularly challenging in a voluntary market scenario where RECs are not actively traded. Another Group member added that some judgment may also be involved in determining what sales value to use for the electricity (e.g., spot price or VPPA price, and potential differences in price if the power purchase agreement were physical rather than virtual). One Group member noted that there could also be judgment in determining if/when the RECs would ultimately be certified, and how that would impact the presentation of margins under View 2A if the RECs are not certified when expected. Given the level of judgment involved, they stressed the importance of providing clear disclosures to enable financial statement users to compare entities and to understand the measurement approach and any risks around not obtaining certification in a timely manner.

Some Group members who agreed with View 2A noted that they would consider View 2B if the value of the RECs were immaterial. Two Group members thought that the RECs could be considered by-products under either View 2A or 2B, but that View 2B would apply when the value of the RECs is immaterial. A Group member commented that View 2A focuses on the first part of paragraph 14 of IAS 2, whereas View 2B focuses on the second part of that paragraph, which states that most by‑products are immaterial by their nature.

One Group member questioned the assumption in View 2B that the NRV and selling price of the RECs would be equal. It was clarified that this was a simplifying assumption for the purposes of the discussion, but that an entity would consider any costs necessary to sell the RECs in line with the IFRS Interpretations Committee’s June 2021 agenda decision, Costs Necessary to Sell Inventories—IAS 2.

Under Fact Pattern 2, a few Group members questioned View 2C if the Company were to classify the RECs as intangible assets. They thought the Company may be able to start capitalizing costs related to the RECs before the RECs are verified and certified because verification/certification is reasonably assured in this fact pattern. This is similar to the Group’s discussions on the timing of revenue recognition as summarized under Issue 1.

Issue 3: How should RECs that are classified as inventory be measured subsequently?

View 3A – At the lower of cost and the NRV (paragraph 28 of IAS 2)

IAS 2 generally requires inventory to be measured at the lower of cost (determined in Issue 2) and the NRV. Paragraph 5 of IAS 2 provides an exception to this for commodity broker-traders. Proponents of this view think that as a producer of RECs, the Company cannot meet the definition of a commodity broker-trader. Thus, they think this exception would not apply.

View 3B – At fair value less costs to sell since the RECs may be considered to be a commodity

Proponents of this view think that the RECs can be viewed as a commodity, and thus that the Company can apply the measurement exception in paragraph 5 of IAS 2.

The Group’s Discussion

The Group agreed with the analysis and generally supported View 3A. A few Group members commented that a generator business model is unlikely to qualify as a commodity broker-trader business model. One Group member clarified that this does not mean an entity cannot engage in both types of activities.

Two Group members noted that the terms “commodity” and “broker-trader” are not defined in IAS 2. However, paragraph 5 of IAS 2 states, "Broker-traders are those who buy or sell commodities for others or on their own account.” Group members discussed that regardless of whether RECs could be considered commodities, the Company in this fact pattern does not buy RECs but rather produces them. Hence, they thought the Company would not qualify as a broker-trader.

Overall, the Group’s discussion raised awareness of how a renewable energy generator accounts for the development of RECs. This is a rapidly emerging area and views are still developing. The Group may discuss similar issues in the future as other fact patterns emerge. The Group recommended that the AcSB consider the need for educational material in this area as part of its research activities.

¹ Material that links to the CPA Canada Handbook is available to subscribers only. However, all information needed to understand the content is provided in this document.
² The RECs could be classified as inventory if they are determined to be materials or supplies consumed in the production process or in the rendering of services (paragraph 6(c) of IAS 2 Inventories).
³ For the purposes of the discussion, assume all criteria for recognizing an intangible asset are met, including the ability to measure the cost of the asset reliably.
⁴ The question of cost allocation may be less relevant if the RECs are transferred to the customer at the same time as the electricity is generated.

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Unit of Account for Lease Modification Accounting

The Group then discussed whether lease modifications should be assessed at the contract level or at the separate lease component level.

Background

With remote and hybrid work arrangements becoming more common, many entities are reducing their leased office space. Some entities are reducing office space by, for example, reducing the amount of square footage leased on one floor of an office building, or by terminating the lease of an entire floor in an office lease that relates to multiple floors in the same building. If an entity reduces the scope of their lease and the reduction in scope was not part of the original terms and conditions of the lease, this would meet the definition of a lease modification in IFRS 16 Leases.

Lease modifications

An entity applies the guidance in paragraphs 44-46B of IFRS 16 to account for lease modifications. Paragraph 44 states that:

A lessee shall account for a lease modification as a separate lease if both:

(a) the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
(b) the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate
adjustments to that stand-alone price to reflect the circumstances of the particular contract.

Since neither of the above conditions would be met when an entity reduces their leased office space, the lessee would not account for the lease modification as a separate lease. For a lease modification that is not accounted for as a separate lease, paragraph 45 of IFRS 16 requires a lessee to:

(a) allocate the consideration in the modified contract applying paragraphs 13-16;
(b) determine the lease term of the modified lease applying paragraphs 18-19; and
(c) remeasure the lease liability by discounting the revised lease payments using a revised discount rate. The revised discount rate is determined as the
interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee's incremental borrowing rate at
the effective date of the modification, if the interest rate implicit in the lease cannot be readily determined.

For a lease modification that fully or partially decreases the scope of the lease, paragraph 46 of IFRS 16 requires the lessee to decrease the carrying amount of
the right-of-use asset to reflect partial or full termination of the lease. Paragraph 46 also requires the lessee to recognize in profit or loss any gain or loss relating
to the partial or full termination of the lease.

Separating components of a contract

For a contract that is, or contains, a lease, paragraph B32 of IFRS 16 requires that an entity account for each lease component within the contract as a separate lease component if both of the following criteria are met:

(a) the lessee can benefit from use of the underlying asset either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee has already obtained (from the lessor or from other transactions or events); and
(b) the underlying asset is neither highly dependent on, nor highly interrelated with, the other underlying assets in the contract. For example, the fact that a
lessee could decide not to lease the underlying asset without significantly affecting its rights to use other underlying assets in the contract might indicate
that the underlying asset is not highly dependent on, or highly interrelated with, those other underlying assets.

The Group discussed whether an entity applies the requirements for lease modifications in paragraphs 44-46B of IFRS 16 to the contract as a whole or to each separate lease component.

Fact Pattern 1

Company X has entered into a lease contract for one floor of a multi-floor office building for a term of 10 years.
There was no early termination right within the original lease contract.
In Year 3 Company X determined that they will no longer need a portion of the overall leased space (20 per cent of the floor being leased) beyond Year 5.
Company X enters into an amendment to the lease agreement with the lessor to terminate the lease on that portion of the floor at the end of Year 5.
The rental payment for the remaining office space in Years 6 to 10 is reduced proportionately to the reduction in leased space.
Company X has determined that the lease of one floor of office space represents one lease component.
The incremental borrowing rate (IBR) was 4 per cent at the inception of the lease and 6 per cent at the date of modification.

Issue 1: How should Company X account for the partial termination of one leased floor?

Analysis

The change in leased floor space is a reduction in the scope of the lease. Since this reduction in scope was not part of the original terms and conditions of the lease, this meets the definition of a lease modification. Since this lease modification reduces the scope of the lease, Company X would not account for the modification as a separate lease; that is, paragraph 44 of IFRS 16 does not apply.

In accordance with the requirements in paragraphs 45-46 of IFRS 16 and following Illustrative Example 17, “Modification that decreases the scope of the lease,” Company X would first reduce the right-of-use asset and lease liability to reflect partial termination of the lease and recognize any difference in profit or loss. Then it would adjust the lease liability to its modified carrying amount based on the revised discount rate of 6 per cent at the effective date of the modification, with a corresponding adjustment to the right-of-use asset.

The Group’s Discussion

The Group agreed with the analysis. Some Group members indicated it would be unlikely for a lessor to reduce the lease payments proportionately to the reduction in leased space and accept no termination penalty because the fair value per square foot of leased space normally fluctuates throughout the lease term. A lessee would also normally consider their ability to re-lease the space to another lessee in their negotiation of the modified lease payments and any termination penalty assessed. Therefore, although the Group agreed that the analysis is technically accurate, it thought that this fact pattern (or a similar fact pattern) might be unlikely to occur.

Fact Pattern 2

Company X has entered into a lease contract for five floors of a multi-floor office building for a term of 10 years.
The stand-alone selling price on a per-square-foot basis is the same for each floor throughout the 10-year lease.
There was no early termination right within the original lease contract.
In Year 3, Company X determined that they will no longer need a portion of the overall leased space (one floor) beyond Year 5.
Company X enters into an amendment to the lease agreement with the lessor to terminate the lease of one floor at the end of Year 5.
As part of the amended agreement, Company X does not need to pay a termination penalty.
The rental payment for the remaining office space in Years 6 to 10 is reduced proportionately to the reduction in leased space.
Company X has determined that each floor in the office building represents a separate lease component.
There are no non-lease components in the contract.
The IBR was 4 per cent at the inception of the lease and 6 per cent at the date of modification.

Issue 2: How should Company X account for the termination of an entire floor in a multi-floor lease?

Analysis

View 2A – The unit of account for lease modifications is at the contract level and Company X should remeasure the entire contract (i.e., all floors)

Proponents of this view think that the definitions of a lease and a lease modification in Appendix A of IFRS 16 indicate that lease modifications should be applied at the contract level and not at the separate lease component level because they refer to the contract as a whole, and not the component that has been modified. Appendix A defines a “lease” as, “A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.”

Appendix A defines a “lease modification” as: “A change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease (for example, adding or terminating the right to use one or more underlying assets, or extending or shortening the contractual lease term).”

They note that the guidance in the standard on separating components of a lease refers only to the separation of lease components and the allocation of consideration between the various components. It does not indicate that each component constitutes a separate lease. Furthermore, paragraph 45(a) of IFRS 16 requires the lessee to allocate the consideration in the modified contract applying paragraphs 13-16. Proponents of this view think that these paragraphs require an allocation of consideration to non-lease components and lease components, which supports the view that lease modifications should be accounted for at the contract level.

If Company X accounts for the lease modification at the contract level, they would first reduce the carrying amount of the right-of-use asset and lease liability to reflect partial termination of the lease, recognizing any difference in profit or loss. Then they would adjust the lease liability to its modified carrying amount based on the revised discount rate (i.e., the IBR of 6 per cent) at the effective date of the modification, with a corresponding adjustment to the right-of-use asset.

Proponents of this view note that the accounting outcome under this approach would be consistent with the accounting outcome under Issue 1. They think that the accounting outcomes under Issue 1 and Issue 2 should be similar because the lease modifications under both fact patterns are economically similar.

View 2B – The unit of account is at the separate lease component level and Company X should remeasure only the amended lease component of the contract (i.e., the amended floor)

Entities often account for a lease of assets constituting separate lease components as one lease because the inputs used (e.g., lease term, lease payments, discount rates) are the same for each of the lease components. However, the requirements in paragraphs 12, B12 and B32 of IFRS 16 imply that the accounting for leases should be performed at the separate component level. Therefore, proponents of this view think that entities would not be precluded from applying lease modification accounting at the separate lease component level, even when the entity accounts for the separate lease components as one lease, and especially when the unmodified lease components are not impacted by the lease modification.

In this fact pattern, the lease payments are reduced proportionately to the reduction in overall leased space and the allocation of lease payments to the space that will continue to be leased will remain unchanged. Since the individual floors in the office space are assessed and accounted for separately, terminating the right to use one floor is a reduction in the scope of one lease component. There is, however, no change in consideration related to the remaining four floors. Since these lease components have not been modified, an entity would not apply the requirements in paragraph 45 of IFRS 16 to them.

If Company X accounts for the lease modification at the separate lease component level, they would first reduce the carrying amount of the right-of-use asset and lease liability attributable to the modified lease component to reflect the early termination of that component, recognizing any difference in profit or loss. Then they would adjust the lease liability attributable to the modified lease component to its modified carrying amount based on the revised discount rate (i.e., the IBR of 6 per cent) at the effective date of the modification, with a corresponding adjustment to the right-of-use asset.

Proponents of this view note that Company X would not be required to remeasure the lease liability for the unmodified lease components using the revised discount rate. Since the revised discount rate would need to be applied to the contract as a whole under Issue 1 and Issue 2 – View 2A, this approach would result in a different accounting outcome.

View 2C – There is an accounting policy choice to be made as to whether lease modification accounting is at the “contract” level or “separate lease component” level

Proponents of this view think that Views 2A and 2B both have merit. In the absence of specific guidance on this matter, they think it is reasonable for entities to apply the requirements in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and establish an accounting policy choice.

The Group was also asked if their views on Issue 2 would change if, as a result of the lease amendment, there was a termination payment that was payable up front or over time.

The Group’s Discussion

Several Group members indicated that Fact Pattern 2 depicts facts and circumstances that they do not normally observe. They noted that in this fact pattern, Company X negotiated the termination of one floor in isolation. The Group members indicated that contract modifications normally involve renegotiations of the entire contract. The modified lease payments in the renegotiated contract and any termination penalty charged might depend on several factors, including current market conditions, the floors included in the modified lease and the lessor’s ability to lease the vacated floor(s) to other tenants at a more or less favourable rate. They also noted that in many offices the fair value per square foot of leased space is different on each floor, and the relative value of each floor often fluctuates throughout the lease term. These factors would all need to be considered as part of the renegotiation of the lease.

Most Group members agreed with View 2A because they thought this approach better reflects the economics of a transaction when the entire lease is renegotiated upon the termination of one floor. Other Group members agreed with View 2A because they thought the wording of the lease modification guidance implies that the lessee should allocate the consideration in the modified contract to the modified lease components (in accordance with paragraphs 13-16 of IFRS 16) after the entity determines that a contract modification has occurred (i.e., the standard does not say to allocate consideration to lease components first, and then assess whether a lease component has been modified). They noted that IFRS 16 does not provide specific guidance on whether a lessee should allocate the modified consideration at the contract level or separate lease component level when a contract is modified. However, they thought this view is consistent with the application of paragraph 13 of IFRS 16. They noted that they supported this view whether or not the lessor charged a termination penalty. Some Group members thought that Company X should apply the lease modification guidance to the contract as a whole regardless of whether all the lease components are identical. They thought that this would result in a more consistent application of the standards to different facts and circumstances. One Group member noted that paragraph 44 of IFRS 16 indicates that an entity shall treat a lease modification as a separate lease only when the modification represents an increase in the scope of the lease and the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope. Since Company X decreased the scope of their lease, this transaction is not in scope of paragraph 44. Therefore, they thought that Company X should remeasure the lease liability for the entire contract. They also thought that, in most situations, remeasuring the entire lease liability based on the revised discount rate would not be onerous, as following View 2B, there is already a requirement to determine an updated incremental borrowing rate for the modified component. One Group member thought that the accounting outcome for Fact Patterns 1 and 2 should be the same because these fact patterns are economically similar.

Some Group members supported View 2B. They thought that lease modifications should be accounted for at the separate lease component level because this is the level at which the contract is accounted for. One Group member noted that the standard does not require an adjustment to the incremental borrowing rate on the existing lease components when the modification increases the scope of a lease and the consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope. Therefore, they thought that it would be more consistent if entities did not adjust the discount rate on unmodified lease components when the scope of the lease decreases. However, other Group members noted that the guidance in paragraph 45 and Illustrative Example 17 of IFRS 16 demonstrate that an entity is required to adjust the discount rate when the scope of the lease decreases. One meeting participant raised an alternative fact pattern when Company X enters into five separate but identical leases at the same time and then subsequently terminates only one of those leases. They thought that in this alternative fact pattern the lessee would apply the lease modification guidance to the terminated lease only. They thought the accounting outcome should be the same when a lessee terminates one lease or one lease component. One Group member noted that paragraph B2 of IFRS 16 provides application guidance on the combination of contracts that are entered into at or near the same time with the same counterparty. They indicated that the five contracts in this alternative fact pattern would be accounted for as a single contract if one of the criteria in paragraph B2 is met.

Some Group members thought that Views 2A and 2B both have merit, depending on the facts and circumstances, and that an entity should apply judgment to determine which method best reflects the economics of the transaction (i.e., this is not an accounting policy choice as indicated in View 2C). They noted that an entity would be required to disclose this accounting policy if it is material to the entity, and that this disclosure should specify that the lease and non-lease components are identified at the inception of the lease, and not at the point of lease modification. Some Group members thought that accounting for the lease modification at the separate lease component level would only be appropriate if each of the lease components is identical, which is unlikely to be the case. One Group member who agreed with View 2B indicated that they would agree with View 2A if the lessor charged a termination penalty to Company X. However, they noted that the lessor may not charge a termination penalty if the lease payments on the remaining floors are at a favourable rate. One Group member noted that paragraphs 4.48-.55 of the Conceptual Framework for Financial Reporting provides guidance on how to identify the unit of account for a transaction. They thought that entities should refer to this guidance when determining the unit of account for a lease modification. However, one Group member noted that paragraphs SP1.1-1.3 specify that the Conceptual Framework is not a Standard, and that nothing in the Conceptual Framework overrides any requirement in a Standard.

Overall, the Group’s discussion raised awareness of views on the unit of account for lease modification accounting. The Group acknowledged that there are diverse views on this matter. However, some Group members noted that, in many cases, the impact of applying the lease modification requirements to the modified component or to the contract as a whole may be immaterial because the difference is an offset to the right of use asset. Therefore, no immediate actions were recommended to the AcSB as a result of this discussion. The Group recommended that the Board consider highlighting observations from this discussion in its response to the IASB’s Request for Information, “Post-implementation Review of IFRS 16,” when it is issued.

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Accounting for Equity Instruments in a Shares-for-Debt Transaction

Background

Financial liabilities are most commonly extinguished by repayment with cash. In certain transactions (such as private placements), financial liabilities may instead be extinguished through the issuance of common shares or a combination of common shares and share purchase warrants. Shares-for-debt transactions with shareholder-creditors continue to be observed in public markets in Canada. In the present interest rate environment, more of these transactions could be contemplated where financial liabilities are extinguished other than by cash repayment.
The Group discussed matters related to the accounting for equity instruments in a shares-for-debt transaction. This included the factors an entity might consider when determining whether a shareholder-creditor is acting in the capacity of a shareholder, the accounting for equity instruments issued, and the recognition of any resulting extinguishment differences.

Current guidance

IFRIC 19 Extinguishing Financial Liabilities with Equity Instruments provides guidance when a debtor and creditor renegotiate the terms of a financial liability with the result that the debtor extinguishes the liability fully or partially by issuing equity instruments to the creditor. IFRIC 19 addresses the measurement of any difference between the carrying amount of a financial liability (or part of a financial liability) extinguished and the consideration paid. It also requires that this difference be recognized in profit or loss (paragraph 9 of IFRIC 19).

IFRIC 19 does not apply in situations when the creditor is also a direct or indirect shareholder, and it is determined that the creditor is acting in its capacity as a shareholder (paragraph 3(a) of IFRIC 19). Paragraph BC7 of the Basis for Conclusions for IFRIC 19 states that determining whether the issuance of equity instruments to extinguish a financial liability is considered a transaction with an owner in its capacity as an owner would be a matter of judgment depending on the facts and circumstances.

In providing guidance for transactions accounted for as changes in equity during the period, paragraph 109 of IAS 1 Presentation of Financial Statements includes transactions with owners in their capacity as owners.

In summary, IFRS Accounting Standards provide guidance on shares-for-debt transactions when the shareholder-creditor is not acting as a shareholder. However, judgment is required when the shareholder-creditor is acting as a shareholder. Judgment is required in areas such as determining whether the shareholder-creditor is acting as a shareholder, and in measuring the shares-for-debt transaction in that case. When the shareholder-creditor is acting in the capacity of a shareholder in the shares-for-debt transaction, the difference between the carrying amount of the extinguished debt and the equity instruments issued may be recognized within equity. For example:

If the equity instruments issued to extinguish the debt are recognized at the fair value of the equity instruments issued, then the difference between that and the carrying amount of the liability would be recognized in equity.
If the equity instruments issued are recognized at the carrying amount of the financial liability, then there is no extinguishment difference.

Issue 1: What factors might the entity consider when determining whether a shareholder-creditor is acting in the capacity of a shareholder?

Analysis

The following are examples of factors an entity might consider:

(a) Comparison of the terms of the transaction with shares-for-debt transactions completed with non-shareholder-creditors

Stock exchanges in Canada have listing policies that specify terms such as the quantity and the deemed price of instruments to be issued in a
private placement.

When a shares-for-debt transaction is completed with a tranche of creditors under identical terms regardless of the nature of the creditor (shareholder or non-shareholder), this may indicate that any shareholder-creditor is acting in the capacity of a creditor.
When a shares-for-debt transaction is completed with one tranche of non-shareholder-creditors under certain terms and another tranche of shareholder-creditors under different terms (e.g., trading prices over different trading periods), this may indicate that the shareholder-creditor is acting in the capacity of a shareholder.

(b) Other transactions with or relationships to the entity

In addition to holding debt instruments and common shares, a shareholder-creditor may have engaged in other transactions or relationships
with the entity, such as:

holding trade payables or convertible instruments;
agreeing to waive significant interest and/or penalties on the debt instruments;
agreeing to amendments to repayment or maturity dates for the debt instruments; or
acting as a guarantor for other liabilities of the entity.

The magnitude of these transactions or relationships may be relevant to determining the shareholder-creditor’s capacity in the
shares-for-debt transaction.

Note that these other transactions may also be outside the scope of IFRIC 19 if the shareholder-creditor and the entity are controlled by the same
party or parties before and after the transaction, and the substance of the transaction includes an equity distribution by or contribution to the entity.

The nature of past transactions or relationships between the shareholder-creditor and the entity may indicate that the shareholder-creditor is presently
acting as more than a lender. If there were no past transactions or relationships and no other determining facts and circumstances, the sole matter of
the existence of a shareholder-creditor relationship may not preclude an entity from applying IFRIC 19.

(d) Involvement in the entity’s decision-making

The extent of the shareholder-creditor’s involvement in the entity’s operations, decision-making processes, or governance structures may provide
indications as to the shareholder-creditor’s capacity in the shares-for-debt transaction. For example, a shares-for-debt tranche may include a
creditor who is a director-shareholder and a creditor who is a management entity shareholder. Consider the following scenarios:

The debt with the director-shareholder was originally a loan advanced in cash. The loan terms have subsequently been extended or modified over
multiple fiscal periods for the entity to maintain or improve ongoing financial flexibility. This may indicate shareholder capacity.
The debt with the management entity shareholder was an unpaid invoice for management services provided in the immediately preceding period.
This may indicate creditor capacity.

(e) Size of ownership interest

Under Canadian securities legislation, shareholders that own or control 10 per cent or more of an issuer’s securities are required to submit insider
reports. The ownership interest must be disclosed therein. The ownership percentage held by the shareholder-creditor, particularly if it is at or
above an insider level, could indicate influence over the entity. That level of influence may not be present in a creditor-only relationship.

(f) Duration of ownership interest

When a shareholder-creditor holds its equity interest in the entity for a longer period, that might indicate a strategic intention (net asset growth)
typical of a shareholder over a profit intention (yield) typical of a creditor.

(g) Business rationale

When the shareholder-creditor’s reasons for accepting equity instruments as settlement of the financial liability are known and determined to be
strategic (e.g., to influence the entity’s operations or direction), this may indicate the shareholder-creditor is acting in a shareholder capacity.
When the shareholder-creditor instead seeks or announces an immediate exit of their equity position following the shares-for-debt transaction,
this may indicate the shareholder-creditor is acting in a creditor capacity.

(h) Objective of the counterparty

Stand-alone arm’s length transactions between lenders and borrowers occur at fair value. That is, the lender would not be compelled to complete
a transaction that does not maximize their return. A lender will seek to maximize their return even when they are willing to accept alternatives to
cash as repayment of debt (such as when the debtor is under duress).

In contrast, shareholders do not necessarily transact at fair value. When information is available as to arm’s length extinguishment terms for the
subject debt that are more favourable to the creditor, that may indicate the shareholder-creditor is acting in a shareholder capacity. That is, a
shareholder-creditor acting in a shareholder capacity may be willing to accept less-favourable terms than a party acting in a creditor capacity.

(i) Participation in shareholder meetings

The extent of the shareholder-creditor’s participation in shareholder meetings could provide context as to the shareholder-creditor’s capacity in a
shares-for-debt transaction. Context could also be provided based on how the shareholder-creditor exercises their voting rights in matters such as
significant transactions.

Fact Pattern 1

Entity A is a medium-sized technology company listed on a Canadian stock exchange.
Entity A has a diverse group of creditors, including both institutional and individual lenders.
One creditor, Debt Ventures Inc. (DVI), also holds a 4.9 per cent equity interest in Entity A.
DVI has a significant loan with a maturity date that was extended once and is now about to mature.
Entity A has encountered financial difficulty and is unable to repay the loan in cash on the amended maturity date. Entity A and DVI enter into an agreement
to settle the loan by the issuance of Entity A’s common shares.
The loan terms are similar to loans Entity A has entered into with creditors when there is no equity position.
DVI has not been involved in the day-to-day decision-making of Entity A. DVI does not have a representative on the board of directors nor any executive influence within Entity A.
DVI has not actively participated in shareholder meetings in the past. In addition, DVI has not exercised voting rights or shown interest in Entity A’s governance.
DVI's ownership interest of 4.9 per cent is not considered a significant equity interest. DVI does not have significant influence or control over Entity A’s operations.
DVI has held the loans for a relatively short time. The investment horizon aligns with similar creditors seeking financial returns.
DVI initially issued the loan to Entity A with the expectation of receiving interest payments and the return of principal upon maturity. DVI has arranged with a third party for acquisition of the shares DVI received in the shares-for-debt agreement immediately following its completion.

Entity A concludes that DVI is acting in its capacity as a creditor seeking repayment of the loan.

Fact Pattern 2

Risk Ventures Inc. (RVI) is a venture capital firm that invests in early-stage technology companies. One of their portfolio companies, Entity B, is a public entity experiencing financial difficulties.
RVI is a significant shareholder with a 20 per cent equity interest in Entity B.
RVI has also issued a loan to Entity B with a maturity date that has been extended once and is now about to mature. Entity B is unable to repay the loan in cash. Entity B and RVI enter into an agreement to settle the loan by the issuance of Entity B’s common shares.
RVI typically provides financing to its portfolio companies in the form of equity investments. This approach is consistent with their investment strategy.
RVI has a representative on Entity B’s board of directors and actively participates in strategic decision-making.
RVI regularly attends and actively participates in Entity B’s shareholder meetings. RVI exercises its voting rights and engages in discussions related to Entity B’s direction and plans.
RVI’s 20 per cent equity interest in Entity B represents a significant investment in Entity B. This ownership interest gives RVI significant influence over Entity B’s operations and strategic decisions.
RVI has been a shareholder in Entity B since its early seed rounds and has maintained a long-term investment horizon. Its commitment to Entity B aligns with buy-and-hold shareholder expectations.
RVI has a strong relationship with Entity B’s management, characterized by its role as a strategic investor rather than a traditional creditor. RVI has provided loan guarantees to other creditors of Entity B.
RVI’s primary motivation is to support Entity B’s growth and success. While RVI is concerned about the repayment of the loan, its actions are driven by a broader objective to ensure Entity B’s viability.

Entity B concludes that RVI is acting in its capacity as a shareholder. This is because RVI’s involvement and intentions go beyond the typical
characteristics of a creditor.

Fact Pattern 3

Entity C is a publicly traded technology company based in Canada. Entity C has a complex capital structure with traditional and hybrid debt instruments and common and preferred shares.
One of Entity C’s largest shareholder-creditors is Holdcredit Ventures Inc. (HVI). HVI holds a 20 per cent equity interest and has issued a term loan to Entity C comprising 20 per cent of Entity C’s total term debt.
The HVI term loan is due for repayment, and Entity C is facing financial challenges. Entity C and HVI enter into an agreement to settle the loan by the issuance of Entity C’s common shares.
HVI has engaged in a mix of financing transactions with Entity C. These include equity investments and debt instruments, which is not uncommon for HVI. However, HVI has also entered into traditional debt-only lending relationships with other non-technology companies in the past.
HVI has a representative on Entity C’s board of directors and participates in key decisions. HVI actively engages in strategic discussions, indicating a degree of influence.
HVI occasionally attends shareholder meetings, and its participation is not consistent. HVI votes in some meetings but not in others.
HVI’s 20 per cent equity interest in Entity C gives them significant influence. HVI’s term loan also represents a significant financial claim.
HVI has been a shareholder in Entity C for a considerable period and maintains a long-term investment horizon with all its investees. The HVI term loan with Entity C had a slightly shorter duration than term debt issued to other investees.
HVI’s actions in this case are somewhat inconsistent with historical behaviour. HVI has previously acted as both a creditor and a shareholder, but its agreement to accept shares to extinguish the term loan rather than undertaking other repayment (or collection) action would be the first of its kind for HVI.
Concurrent with the negotiations with HVI for a shares-for-debt settlement, Entity C engaged a prospective new lead banker to undertake a comprehensive review of its debt portfolio. This review indicated that there is no evidence that the terms agreed to with HVI are off-market.
HVI has expressed concern about Entity C’s financial health but also considers the long-term potential of Entity C.

HVI’s role is not readily categorized as solely that of a creditor or a shareholder because their history, involvement, and motivations reflect elements of both roles.

Facets that indicate acting in the capacity of a creditor include entering into debt-only lending relationships with other companies, and no evidence of arm’s length terms that are more favourable. Facets that indicate acting in the capacity of a shareholder include participating in key decisions, engaging in
strategic discussions, attending shareholder meetings, and voting.

The Group’s Discussion

The Group agreed with the analysis of factors an entity might consider in determining whether a shareholder-creditor is acting in its capacity as a shareholder or creditor in a shares-for-debt transaction. The Group members noted that the analysis will involve judgment, and the factors discussed may not necessarily be found in the IFRS Accounting Standards. Rather, these factors may be useful considerations to help entities apply judgment in such situations.

Group members discussed the importance of understanding the economics of the transaction, such as how the negotiations are done and the entity’s interactions with other shareholders and creditors. They also noted that the balance of factors is important (e.g., an insider-level ownership interest is not a bright line indicator), but that some factors may carry more weight than others. For example, several Group members commented that transacting at fair value as described in factor (h) would be a particularly strong indicator that a shareholder-creditor is acting in a creditor capacity. If that is known, they think other factors may be less relevant. One Group member also noted that fair value may not be known in some circumstances (e.g., in a cease trade scenario). In the absence of a precise fair value measure, judgment may be required, and it may become more important to consider other factors.

One Group member questioned the importance of factor (i), which suggests that participating in shareholder meetings and exercising voting rights could indicate a shareholder-creditor is acting in a shareholder capacity. For example, they thought if a shareholder-creditor is on the entity’s board of directors and votes regularly, but there are not many items of significance to vote on, this may not indicate that the shareholder-creditor is acting in a shareholder capacity. Another Group member commented that judgment would need to be applied, including considering how the shareholder-creditor votes and exercises their rights and with what degree of influence.

A Group member commented that in assessing factor (g) on business rationale, they would consider the difference in value between the debt and shares. The magnitude and direction of this difference could help indicate the shareholder-creditor’s intentions. The Group member thought this would become particularly important if the shares were categorized as a Level 1 fair value measurement in accordance with IFRS 13 Fair Value Measurement, as this would mean there is an active market for the shares. If there is an active market for the shares, it is more likely that the shareholder-creditor could immediately exit their equity position following the shares-for-debt transaction.

Group members also discussed incremental factors that an entity might consider, such as:

Extent and diversity of other creditors – If the shareholder-creditor is the only party willing to lend, that could indicate they are acting in a shareholder capacity.
Magnitude of the debt – A shareholder-creditor that holds significant debt may be compelled to act in ways that appear as if they are acting in a shareholder capacity. However, they may simply be trying to recover what little they can because recovering a small amount is better than recovering nothing.
Reasons for settling the debt through the issuance of equity instruments – The transaction may be occurring for reasons other than financial difficulties of the entity, which could inform the assessment.
Nature of the equity instruments issued – The equity instruments may not always be common shares. For example, they could be another type of share with different rights, which may be relevant to the assessment.

Group members also discussed the three fact patterns presented:

On Fact Pattern 1, Group members generally thought that the shareholder-creditor was acting in a creditor capacity based on the facts presented. Nevertheless, one Group member noted that it is important to look at other factors, including the economics of the transaction and whether the shareholder-creditor’s debt was extinguished at fair value. For example, they noted that the shareholder-creditor might have needed cash for their own purposes, and this transaction combined with the immediate sale of the shares to another party would have been an easy way to get that cash. The Group member noted that it may be relevant to look at any termination clauses that other creditors may have been subject to, and whether there would have been a discount if those creditors tried to cash in early.
On Fact Pattern 2, Group members noted that it was unclear whether the shareholder-creditor was transacting at fair value. They thought this information was important to gather before making a conclusion.
On Fact Pattern 3, some Group members thought the shareholder-creditor was acting in a creditor capacity. They noted that a strong indicator of this was that there was no evidence that the terms agreed to were off-market per the banker’s review, meaning the transaction would have been at fair value. One Group member commented that the shareholder-creditor’s 20 per cent equity interest, long-term investment and participation in board meetings may be indicators of acting in a shareholder capacity.

Issue 2: In situations when the shareholder-creditor is acting in its capacity as a shareholder, what is the accounting for equity instruments issued and for recognizing any resulting extinguishment differences?

Consideration paid in shares-for-debt transactions may consist of common shares only, or it may consist of equity units (common shares and common share purchase warrants).⁵ Relevant considerations may be noted from discussions at the Group meeting on November 29, 2016, on the settlement of a shareholder loan. Circumstances where consideration is paid in the form of equity-classified units are illustrated below.

Fact Pattern

A creditor has agreed to lend $5 million to Entity Y. The creditor is also a shareholder of Entity Y.
Subsequently, Entity Y and the shareholder-creditor enter into another agreement to settle the entire loan with the issuance of equity-classified units of Entity Y. These consist of one common share and one common share purchase warrant exercisable for a period of two years.
At the date of extinguishment:

The carrying amount of the loan is $3.5 million.
The fair value of the common shares at their quoted price is $3.5 million.
The fair value of the share purchase warrants using an option pricing model is $500,000.
There is no concurrent financing of units issued for cash proceeds.

Entity Y has determined that the shareholder-creditor is acting in its capacity as a shareholder in the shares-for-debt transaction.
Entity Y applies the guidance in paragraph 109 of IAS 1, where transactions with owners in their capacity as owners are equity transactions and are not recognized in profit or loss for the period.

View 2A – Entity Y measures the equity instruments issued at fair value, and the difference between the carrying amount of the financial liability and the fair value of the equity instruments is recognized in equity

Proponents of this view think:

Entity Y would remove the financial liability at the carrying amount of $3.5 million from its statement of financial position when it is extinguished in accordance with paragraph 3.3.1 of IFRS 9.
The equity instruments issued would be measured at their fair value of $4 million.
This would result in a difference of $500,000 between the carrying amount of the financial liability and the fair value of the consideration paid. This would be recognized in Entity Y’s equity at the date of extinguishment.

View 2B – Entity Y measures the equity instruments issued at the carrying amount of the financial liability extinguished, resulting in no difference

Proponents of this view think that:

The equity instruments issued would be measured at the carrying amount of the financial liability of $3.5 million.
Entity Y would remove the financial liability at the carrying amount of $3.5 million from its statement of financial position when it is extinguished in accordance with paragraph 3.3.1 of IFRS 9.
This would result in no difference.

View 2C – An accounting policy choice exists

Proponents of this view note that the IFRS Accounting Standards do not specially consider this transaction. They think the standards allow for judgment depending on the facts and circumstances, and thus that Entity Y has an accounting policy choice.

The Group’s Discussion

Several Group members agreed with View 2C. Two Group members highlighted that the Basis for Conclusions on IFRIC 19 notes that the IFRS Accounting Standards do not contain specific guidance on the initial measurement of an entity’s issued equity-classified instruments. As such, they think either View 2A or 2B would be possible.

One Group member agreed with View 2B. They thought it may not be appropriate to increase equity as in View 2A given the level of measurement uncertainty inherent in the valuation of share purchase warrants. The fair value of the shares may also not be observable in some situations (e.g., if the company is private).

Overall, the Group’s discussion raised awareness of how an entity accounts for equity instruments in a shares-for-debt transaction, including factors an entity may consider in determining whether a shareholder-creditor is acting in a shareholder or creditor capacity in such a transaction. No further actions were recommended to the AcSB.

⁵ For the purposes of this discussion, it is assumed that the common share purchase warrants are classified as equity in accordance with IAS 32 Financial Instruments: Presentation. If they were not, there may be additional considerations.

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IAS 1: Classification of Liabilities with Covenants when an Entity is Granted a Waiver or Grace Period

The Group then discussed various scenarios and examples of the application of the 2022 amendments to IAS 1 on non-current liabilities with covenants when an entity is granted a waiver or grace period.

Background

In October 2022, the IASB issued Non-current Liabilities with Covenants (Amendments to IAS 1) (the “October 2022 amendments”). The October 2022 amendments aimed to improve the information an entity provides when its right to defer settlement of a liability is subject to compliance with covenants within 12 months after the reporting period. These amendments are effective for annual reporting periods beginning on or after January 1, 2024, with earlier application permitted.

Pursuant to the October 2022 amendments, an entity classifies a liability as current if it does not have the right, at the end of the reporting period, to defer its settlement for at least 12 months after the end of the reporting period. A liability is also classified as current when it is not scheduled for repayment within 12 months of the end of the reporting period but can be called by the lender at any time without cause.

Lenders often include conditions in loan arrangements (hereafter referred to as “covenants”). Covenants that an entity must comply with only after the reporting date would not affect the classification of a liability as current or non-current at the reporting date. However, those covenants that an entity is required to comply with on or before the reporting date would affect their classification as current or non-current, even if the covenant is only assessed after the entity’s reporting date.

The October 2022 amendments also introduced a new disclosure requirement for liabilities arising from loan arrangements that are classified as non-current when the entity’s right to defer settlement of those liabilities is subject to the entity complying with covenants within 12 months after the reporting period. In such situations, an entity shall disclose information in the notes that enables users of financial statements to understand the risk that the liabilities could become repayable within 12 months after the reporting period. These disclosures include:

(a) information about the covenants (including the nature of the covenants, when the entity is required to comply with them, and the carrying amount of the liability); and
(b) facts and circumstances, if any, that indicate the entity may have difficulty complying with the covenants. Such facts and circumstances could also
include the fact that the entity would not have complied with the covenants based on its circumstances at the end of the reporting period.

Fact Pattern 1

An entity enters into a loan arrangement with a covenant requiring the entity to maintain a total debt-to-shareholders’ equity ratio of less than 75 per cent at each quarter end.
If the entity expects that they are at risk of violating the debt covenant, they may ask the lender to waive the covenant reporting requirements before the testing date, or to provide them with a period of grace.
The loan has a remaining maturity of three years at the reporting date.

Issue 1A: How should the entity classify the related borrowings when the lender has provided a waiver before the testing date?

Analysis

Since the lender granted a waiver to the entity before the testing date, this has amended the loan agreement and removed the covenant requirement for that reporting period. The lender does not have an enforceable right to call the loan even if the entity would have been in breach of the covenant on the reporting date. The entity would classify the loan as non-current at the end of the reporting period.

The Group’s Discussion

The Group agreed with the analysis.

Issue 1B: How should the entity classify the related borrowings when the lender has provided a period of grace before the testing date?

Analysis

Since the lender did not grant a waiver to the entity before the testing date, the entity breached the loan covenant on the testing date. Since the entity breached the loan covenant, the lender has an enforceable right to repayment of the loan at the end of the period of grace. Therefore, the classification of the loan as current or non-current depends on the length of the period of grace granted to the entity. If the period of grace is greater than 12 months after the balance sheet date, the entity would present the loan as non-current. If the period of grace is less than 12 months after the balance sheet date, the entity would present the loan as current.

The Group’s Discussion

The Group agreed with the analysis.

Fact Pattern 2

An entity enters into a term loan arrangement that includes a provision they must sell a foreign branch of their operations by December 31, 20X0.
The terms of the loan agreement state that the entity is permitted an additional two months to complete the sale if it is not able to sell the branch by the specified date.
As of December 31, 20X0, the entity has not sold the branch.
If the entity is unable to complete the sale by February 28, 20X1, the lender can demand repayment of the loan.
The entity has a December 31 reporting date.
The loan has a remaining maturity of three years at the reporting date.

Issue 2: How should the entity classify the term loan?

Analysis

The classification of the loan as current or non-current depends on whether the entity was granted a period of grace. Since IAS 1 does not define “period of grace,” an entity must apply judgment to determine if a period of grace was provided.

In this fact pattern, the original contractual provisions allow the sale of the foreign branch to be completed by February 28, 20X1. Therefore, a period of grace was not required on December 31 to avoid a covenant breach. The entity can continue to classify the loan as non-current at the reporting date because the covenant does not affect the entity’s right to defer payment of the liability at the end of the reporting period.

If, however, the contractual provisions had required the entity to sell the foreign branch by December 31, or obtain written approval from the lender to defer this requirement until February 28, this would be considered a period of grace. In this case, the entity would be required to classify the term loan as current at the balance sheet date because the period of grace would have been less than 12 months after the balance sheet date.

The Group’s Discussion

Some Group members thought that the condition in the loan agreement for the borrower to sell their foreign branch by December 31, 20X0, is not a substantive requirement. They noted that the lender did not have a contractual right to call the loan as at December 31, 20X0, based on the fact pattern presented in the paper and that the testing date for the loan condition was really February 28, 20X1. Therefore, they thought that the loan should be presented as non-current at the balance sheet date.

One Group member noted that they often see similar fact patterns involving loan agreements with financial covenants, and that these types of arrangements are more common than the one presented in this agenda paper. In these loan agreements, the borrower is typically required to comply with a financial covenant at year-end, and the loan agreement provides a pre-negotiated period of grace for the entity to rectify a breached covenant. The year-end financial covenant in these arrangements is normally considered substantive, and the borrower is required to test the covenant for a breach at the balance sheet date. The loan would need to be presented as current if the covenant is breached and the pre-negotiated period of grace is less than 12 months after the balance sheet date. This Group member indicated that entities should consider the nuances in their loan agreements to determine if a substantive covenant exists at year-end. They noted that a pre-negotiated period of grace in the loan agreement does not normally indicate that a year-end loan covenant is not substantive.

Fact Pattern 3

An entity enters into a term loan arrangement that includes a provision that the borrower must repay the loan if a specified revenue target is not attained by the end of each quarter.
The entity’s sales are reported to the lender in annual and interim financial statements.
The entity obtained a waiver from the lender before the end of the fourth quarter of 20X0 because they did not expect to meet the specified revenue target. This waiver only covers the fourth quarter of 20X0.
The entity also expects that it will not meet the revenue target for the first quarter of 20X1.
The loan has a remaining maturity of three years at the reporting date.
The loan balance is material to the entity and early repayment would significantly affect the borrower’s liquidity position.

Issue 3A: How should the entity classify the related loan as at December 31?

Analysis

Since IAS 1 does not define the term “covenant”, an entity must apply judgment to determine if a condition in a loan agreement is a loan covenant. A covenant is typically intended to protect a lender by granting it a right to call a loan earlier than the contractual maturity date when the borrower does not meet certain conditions. These conditions typically relate to the borrower’s financial condition or performance, and early repayment is triggered when there has been a deterioration in the conditions. In this fact pattern, the minimum revenue target would likely be considered a loan covenant.

When an entity is required to comply with a loan covenant on or before the reporting date, this requirement affects the classification of the loan as current or non-current, even if the covenant is assessed only after the entity’s reporting date. In this fact pattern, the entity breached the loan covenant on December 31, 20X0, because they did not meet the specified revenue target by the end of the quarter. However, the entity obtained a waiver from the lender before the end of 20X0 and, therefore, the lender agreed not to demand repayment of the loan as a result of the breach. The entity should classify the loan as non-current as at the reporting date.

The Group’s Discussion

The Group agreed that an entity must apply judgment to determine if a condition in a loan agreement is a loan covenant. The Group also noted that in some circumstances an entity must apply judgment to determine whether an agreement to defer the application of a loan covenant means there was:

(a) no breach of the covenant;
(b) a breach of the covenant and a waiver thereof was obtained before the balance sheet date; or
(c) a breach of the covenant and a period of grace to rectify it was obtained before the balance sheet date.

An entity’s assessment of which of the above scenarios applies might impact the analysis. The Group clarified that in Fact Pattern 3 there was either no covenant breach or a covenant breach and a waiver thereof before the balance sheet date, but no new covenants were inserted. The entity is then required to test the same loan covenant at the end of the first quarter to meet the recurring covenant requirements in the loan agreement. Some Group members thought that this arrangement is economically similar to one where there was a covenant breach, and an entity is granted a three-month period of grace to rectify that breach because the requirement to comply with the future covenant is intrinsically linked to the entity’s waived covenant at year-end. However, most Group members thought that, in Fact Pattern 3, the pre-existing loan covenant at the end of the first quarter is a future covenant that should not impact the classification of the loan as current or non-current at year-end.

One member questioned whether Group members’ views would change if the entity breached the year-end covenant, but then the lender waived the application of this covenant and imposed a new covenant that the entity must comply with at the end of the first quarter. They noted this arrangement is different than the one in Fact Pattern 3 because the covenant requirement at the end of the first quarter in this case was not part of the original loan agreement. Most Group members agreed that there is ambiguity as to whether this arrangement is a three-month period of grace or a waiver with the imposition of a new future covenant. If this arrangement is viewed as a three-month period of grace, the Group noted that the loan would need to be classified as current because the entity does not have the right to defer its settlement for at least 12 months. However, if it is viewed as a waiver with the imposition of a new future covenant, the Group noted that the loan would be classified as non-current because the lender does not have an enforceable right to call the loan unless the entity breaches the covenant in the following quarter. Therefore, some Group members thought that economically similar arrangements may lead to different accounting outcomes.

Issue 3B: What are the disclosure considerations following the October 2022 amendments?

Paragraph 76ZA of IAS 1 introduced new disclosure requirements for debt with covenants. When an entity classifies a liability arising from a loan arrangement as non-current, and that liability is subject to covenants that an entity is required to comply with within 12 months of the reporting date, the entity shall disclose information in the notes that enables users of financial statements to understand the risk that the liability could become repayable within 12 months of the reporting period. To comply with the new disclosure requirements, the entity might need to disclose:

(a) the carrying amount of the loan subject to the covenant;
(b) details of the covenant;
(c) the fact that the entity requested and has received a waiver from the lender for the fourth quarter revenue target to avoid a potential breach;
(d) the fact that, without the waiver obtained, the borrower would not have complied with the covenant if it were to be assessed for compliance based on
the borrower’s circumstances at the end of the reporting period; and
(e) circumstances that indicate the borrower may have difficulty complying with the covenant for the first quarter of the following year and the risk that
the loan could become repayable within 12 months after the reporting period.

The Group’s Discussion

The Group agreed with the disclosures that an entity would need to provide to comply with the October 2022 amendments when an entity classifies a liability as non-current, and that liability is subject to covenants that an entity is required to comply with within 12 months of the reporting date. One Group member noted that the disclosure requirements in paragraph 76ZA(b) of IAS 1 might require an entity to disclose sensitive information about their revenue forecasts and the probability that they will comply with the future covenant requirements. Some Group members noted that entities might also need to consider the disclosure requirements in other standards when there is a risk that their lender will call a loan. For example, they might need to consider the liquidity risk disclosures in IFRS 7, or the disclosure of significant doubt upon the entity’s ability to continue as a going concern in IAS 1.

Fact Pattern 4

An entity enters into a term loan arrangement with repayment terms based on a percentage of revenue for each fiscal year.
The entity’s sales are reported to the lender in annual and interim financial statements.

Issue 4: How should the entity classify the related loan as at December 31?

Analysis

Loan arrangements might include various conditions that specify when debt repayments are due. Since IAS 1 does not define the term “covenant”, an entity must apply judgment to determine whether a loan condition is a covenant. If the repayment conditions are considered covenants, an entity applies the guidance in paragraph 72B of IAS 1 to determine whether the loan should be classified as current or non-current. If the repayment conditions are not considered covenants, paragraph 72B of IAS 1 does not apply.

View 4A – The entire loan balance should be classified as current

Although the term “covenant” is not defined in IAS 1, loan covenants are typically included in loan arrangements to protect the lender from increased credit risks of the entity. In this fact pattern, the conditions specified in the loan arrangement do not appear to be mechanisms designed to protect the lender from increased credit risk. Conversely, increased revenue by the entity will accelerate loan repayments, even though the entity’s credit risk has not increased. Therefore, the relationship between revenue and loan repayments in this fact pattern does not appear to be a covenant and paragraph 72B of IAS 1 does not apply.

Since paragraph 72B does not apply, other paragraphs of IAS 1, as amended, will apply. Paragraph 69(d) of IAS 1 indicates that an entity classifies a liability as current when it does not have the right at the end of the reporting period to defer settlement of the liability for at least 12 months after the reporting period. Furthermore, paragraph 72A of IAS 1 indicates that an entity’s right to defer settlement of a liability for at least 12 months after the reporting period must have substance. In this fact pattern, the entity’s right to defer payment of the loan for at least 12 months from the end of the reporting period does not have substance. If it is assumed that the entity is a going concern, the entity would be expected to make future sales and might have committed sales contracts in place. The fact that the lender agreed to a repayment schedule based on a percentage of revenue as opposed to a fixed repayment schedule does not mean that the entity has a substantial right to defer settlement for at least 12 months after the end of the reporting period.

One might consider whether paragraph 75A of IAS 1 applies to this fact pattern. Paragraph 75A states that a liability is classified as non-current even if management intends or expects to settle the liability within 12 months after the reporting period. However, proponents of this view think that the guidance in paragraph 75A pertains to voluntary repayments only. In this fact pattern, the entity’s deferral of repayment beyond 12 months is not voluntary, but rather it is based on the contractual terms of the loan. Therefore, they think that paragraph 75A does not apply to this fact pattern.

Proponents of this view also note that the entity’s requirement to make loan repayments over the next 12 months is known. However, the amount that the entity will be required to repay is not known. Since the entity is unable to measure the amount of the loan for which they have a right to defer settlement for at least 12 months after the reporting period, the balance should be classified as current.

View 4B – A portion of the loan balance should be classified as current

For the same reasons outlined in View 4A above, the loan agreement does not include a covenant, and paragraph 72B of IAS 1 does not apply.

Proponents of this view think that presenting the entire loan balance as current would not accurately depict the borrower’s repayment obligation over the next 12 months. Instead, they think that the entity should classify a portion of the loan as current based on management’s estimate of sales within 12 months of the reporting period. The remaining balance would be presented as non-current. Additional disclosures may be required if there is significant measurement uncertainty associated with determining the current balance of the loan.

View 4C – The entire loan balance should be classified as non-current

Proponents of this view note that paragraph 72B of IAS 1 refers to conditions that give rise to an entity’s right to defer settlement of a liability arising from a loan arrangement for at least 12 months after the reporting period. They think that these conditions can be broader than mechanisms designed to protect the lender in case of an increase in the entity’s credit risk. For example, the entity’s right to defer repayment of the loan until it records revenue would be considered a condition specified in the loan agreement within the scope of paragraph 72B.

Proponents of this view also note that paragraph 75A of IAS 1 specifies that the classification of a liability as current should be unaffected by the likelihood that the entity will exercise its right to defer settlement of the liability for at least 12 months after the reporting period. A liability that meets the definition of non-current is classified as non-current even if management intends or expects the entity to settle the liability within 12 months after the reporting period (i.e., the current portion of debt should not be “estimated”).

As at the balance sheet date, future revenue is a condition that has not yet arisen. Therefore, proponents of this view think that the entity should record the entire loan balance as non-current until loan repayments are triggered when the entity records revenue. They think that any current liability recognized at the balance sheet date should be only in relation to revenue recognized prior to the end of the reporting period.

View 4D – Policy choice

Proponents of this view note that IAS 1 does not clearly define what is considered a covenant within the scope of paragraph 72B. Instead, paragraph 72B refers to “conditions”, which may be interpreted quite broadly. They think that an entity would need to develop an accounting policy for how they apply the requirements in paragraph 72B and apply this policy consistently to similar facts and circumstances. The entity would also need to disclose this accounting policy choice if it is a significant accounting policy for the entity.

The Group’s Discussion

The presenter of the paper clarified that in this fact pattern, the entity makes loan repayments on a quarterly basis based on sales reported in the prior quarter. For example, revenue reported in the fourth quarter triggers a loan repayment in the first quarter of the following year. Group members expressed diverse views on how the entity should classify the loan, and several Group members thought that each of the views had merit. The Group thought that any loan repayment obligations that were triggered as a result of past sales should be presented as current. However, the Group members discussed how the entity should classify the remaining loan balance when repayment obligations will be triggered by future sales.

Some Group members agreed with View 4A because they thought a liability should be classified as current unless there is evidence that the entity has the right to defer its settlement for at least 12 months. They noted that the entity is unable to prove that they have the right to defer settlement of the liability for at least 12 months because future sales are unknown to the entity until they occur. However, several Group members thought that presenting the entire loan as current is not useful to financial statement users unless management expects to fully repay the loan within 12 months. One Group member thought that the entity’s right to defer settlement of a portion of the loan for at least 12 months might have substance if management does not have a realistic expectation that the entity will earn enough revenue to trigger a full repayment of the loan within that time.

Some Group members agreed with View 4C because the entity is only required to make loan repayments within the next 12 months once sales revenue is recorded. However, several Group members also thought that presenting the entire loan as non-current is not useful to financial statement users unless management does not expect to make any sales within the next 12 months. They noted that the entity will almost certainly be required to make some loan repayments within the next 12 months if it is an operating entity with a revenue stream.

Several Group members thought that View 4B results in information that is most useful to financial statement users. They also thought that presenting a portion of the loan as current based on management’s estimate of sales over the next 12 months would most accurately depict the borrower’s repayment obligation in the following year. However, one Group member noted that paragraph 75A of IAS 1 (as amended) and BC48C(b) in the Basis for Conclusions indicate that classification of the loan as current or non-current is unaffected by management intentions or expectations. One meeting participant noted that the application guidance in paragraph B5.4.6 in IFRS 9 requires an entity to adjust the amortized cost of a financial liability to reflect revised estimated contractual cash flows when an entity revises its estimates of payments. Since entities are required to factor expected future payments into the measurement of their financial liabilities, he questioned whether the same principle should apply to their classification as current or non-current. However, a group member noted that loans classified as current under IAS 1 due to a covenant breach are not necessarily remeasured under IFRS 9 as IFRS 9’s amortized cost model considers the expected timing of the payments whereas the IAS 1 classification model is based on rights at the end of the reporting period to defer settlement for at least twelve months.

Overall, the Group’s discussion raised awareness of views on the application of the October 2022 amendments to IAS 1 on non-current liabilities with covenants when an entity is granted a waiver or grace period. The Group noted that there are diverse views on how to apply these amendments to different fact patterns, and how to determine whether an arrangement is considered a waiver, a period of grace, or a waiver with a new future covenant. The Group recommended that this topic be included on the December 2023 agenda so that the Group can discuss whether any consensus has emerged on these matters. The Group noted that the IASB might not have contemplated Issue 4 when they issued the October 2022 amendments to IAS 1. Therefore, the Group recommended that the AcSB staff discuss this Issue with the IASB staff to determine how the IASB intends the guidance in IAS 1 to be in applied in similar fact patterns.

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OTHER MATTERS

Annual Improvements to IFRS Accounting Standards – Volume 11

The IASB issued the Exposure Draft, “Annual Improvements to IFRS Accounting Standards – Volume 11.” The Exposure Draft proposes narrow-scope amendments to IFRS Accounting Standards and accompanying guidance as part of its periodic maintenance of the standards.

Canadians are encouraged to submit their comments to the IASB by December 11, 2023.

Post-implementation Reviews

The IASB issued the following Requests for Information:

Post-implementation reviews are part of the IASB’s due process and help the IASB assess the effects of requirements on financial statements users, preparers and auditors. The comment period deadline was September 27, 2023, for the Post-implementation Review of IFRS 9 and October 27, 2023, for the Post-implementation Review of IFRS 15.

Recent Amendments Made to IFRS Accounting Standards

International Tax Reform—Pillar Two Model Rules (Amendments to IAS 12)

The amendments to IAS 12 Income Taxes give companies temporary relief from accounting for deferred taxes arising from the Organisation for Economic Co-Operation and Development’s (OECD) international tax reform. The amendments also introduce targeted disclosure requirements for affected entities. The temporary relief from the accounting for deferred taxes arising from the OECD international tax reform is effective immediately upon issue.

Supplier Finance Arrangements (Amendments to IAS 7 and IFRS 7)

The amendments to IAS 7 Statement of Cash Flows and IFRS 7 Financial Instruments: Disclosures introduce new disclosure requirements to enhance the transparency of supplier finance arrangements. The amendments are effective January 1, 2024, with early application permitted.

Lack of Exchangeability (Amendments to IAS 21)

The amendments to IAS 21 The Effects of Changes in Foreign Exchange rates require entities to provide more useful information in their financial statements when a currency cannot be exchanged into another currency. The amendments are effective January 1, 2025, with early application permitted.

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PRIVATE SESSION

The Group’s mandate includes assisting the AcSB in influencing the development of IFRS Accounting Standards (e.g., providing advice on potential changes to the standards). The Group’s discussion of these matters supports the Board in undertaking various activities that ensure Canadian perspectives are considered internationally. Since these discussions do not relate to assisting interested and affected parties in applying issued IFRS Accounting Standards, this portion of the Group’s meeting is generally conducted in private (consistent with the Board’s other advisory committees).

At its September 2023 meeting, the Group provided input on the following document for comment to assist in the development of the AcSB’s response letter:

IASB’s Exposure Draft, “Annual Improvements to IFRS Accounting Standards – Volume 11”

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