How will the new leases standard impact business combinations?

IFRS 3 Business Combinations contains various exceptions to the general recognition and measurement principles of measuring identifiable assets and liabilities of the acquiree at fair value on acquisition date. One of these exceptions (special rules) relates to accounting by the acquirer where the acquiree has entered into lease arrangements as lessee.

For business combinations occurring after the effective date of IFRS 16, the acquiree (lessee) will already be recognising a right-of-use (ROU) asset and a lease liability on its balance sheet. This article outlines the special rules to be applied by the acquirer to leases when completing its business combination accounting at acquisition date.

Exception for short-term and low value leases

Regardless of whether the acquiree has applied the recognition and measurement exceptions contained in IFRS 16, paragraph 5 at commencement date to its leases, under IFRS 3, paragraph 28A, the acquirer is not required the capitalise a ROU asset and lease liability for the following leases:

Short-term leases, i.e. the lease term ends within 12 months of acquisition date, and
Low value leases.

We expect most lessees to apply the low value exception at commencement of a lease, so it is unlikely acquirers would need to use that exception for business combination entries at acquisition date. However, the above exception for short-term leases is a convenient short cut for long-term leases of the acquiree that have less than a year to run at acquisition date.

Remeasuring the lease liability at acquisition date

IFRS 3, paragraph 28B outlines special rules for recalculating the lease liability at acquisition date.

The acquirer shall measure the lease liability at the present value of the remaining lease payments (as defined in IFRS 16) as if the acquired lease were a new lease at the acquisition date.

Extract of IFRS 3, paragraph 28B

Key to recalculating the lease liability is using revised payments and the appropriate discount rate at acquisition date. Note that the discount rate used must be an updated rate at acquisition date, taking into account various economic factors, including credit risk. The table below shows how we determine the discount rate (incremental borrowing rate, or IBR) at acquisition date.

Determining the incremental borrowing rate at acquisition date

Acquisition of business assets, and not a separate legal entity

If leases are acquired through the acquisition of business assets, the lease contract will need to be assigned to the acquirer, who becomes the new lessee. This results in a new lease contract at acquisition date, and the discount rate (assuming use of incremental borrowing rate) will be that of the acquirer as the new lessee.

Use discount rate of acquirer at acquisition date.

Acquisition of business – purchase of separate legal entity – no restructure of lease

If leases are acquired through the acquisition of a separate legal entity, leases entered into by the acquiree generally continue until the lease terminates (assuming the lease is not restructured). This means that the lease remains in the name of the acquiree, and the discount rate to be applied to the revised lease payments is the incremental borrowing rate of the acquiree (lessee).

This is consistent with the Basis for Conclusions to IFRS 16, BC160 which says:

‘The IASB’s objective in specifying the discount rate to apply to a lease is to specify a rate that reflects how the contract is priced.’

Even though this is a new lease from the perspective of the acquirer, initial recognition is still driven by the guidance in IFRS 16. Therefore the ‘lessee’ remains the acquiree and the subsidiary cannot default to using the parent’s incremental borrowing rate in its own financial statements, and nor can the group in its consolidated financial statements.

Use discount rate of acquiree (lessee) at acquisition date.

Acquisition of business – purchase of separate legal entity – restructure of lease at acquisition date to include acquirer guarantees

In cases where the lease is simultaneously restructured at the time of the business combination to take account of credit enhancements provided by the acquirer (e.g. guarantees to lessor), the acquirer’s incremental borrowing rate may be relevant in determining the incremental borrowing rate of the lessee (acquiree) at acquisition date.

Use discount rate of acquiree (lessee) at acquisition date, including impact of credit enhancement.

Measuring the ROU asset at acquisition date

IFRS 3, paragraph 28B also outlines special rules for determining the amount of the ROU asset at acquisition date.

The acquirer shall measure the right-of-use asset at the same amount as the lease liability, adjusted to reflect favourable or unfavourable terms of the lease when compared with market terms.

Extract of IFRS 3, paragraph 28B

Prior to IFRS 16, IFRS 3 required the following to be recognised by the acquirer at acquisition date:

An intangible asset for favourable lease terms on operating leases compared to market, and
A liability for unfavourable lease terms on operating leases compared to market.

These intangibles and liabilities will no longer be recognised separately, but instead are added or deducted from the balance on the ROU asset.

Differences between acquiree and consolidated financial statements

It is important to note that the same lease will be shown in the financial statements of the acquiree and the group at different amounts. This is best illustrated using this basic example below.

Initial lease information

Small Co entered into a 10-year lease for office premises on 1 January 20X1.

Annual rent, payable in arrears is $1,000.

The incremental borrowing rate of Small Co on 1 January 20X1 is 6.5%.

There are no extension or termination options in this lease.

The right-of-use asset is amortised on a straight-line basis over 10 years.

Business combination

On 1 January 20X3, Small Co is acquired by the Big Co Group. At acquisition date, it is determined that the incremental borrowing rate of Small Co reduces to 5%. There is no change to the useful life of the ROU asset (i.e. amortisation continues on a straight-line basis over the remaining eight years of the lease).

Assume that the lease payments are still considered to be at market rates, therefore no adjustment is required to the ROU asset by the group for the unfavourable or favourable element compared to market rates.

The following table illustrates how amounts recognised in the separate financial statements of Small Co, and the consolidated financial statements of the Big Co Group at 1 January 20X3 (acquisition date) and 31 December 20X3 are different. The business combination therefore results in ongoing adjustments made in the group accounts until the end of the lease.

	Small Co $	Big Co Group $
1 January 20X3 – Balance sheet
ROU asset	5,751	6,463
Lease liability	6,089	6,463
31 December 20X3 – Profit or loss
Amortisation of ROU asset	719	808
Interest expense	396	323
31 December 20X3 – Balance sheet
ROU asset	5,032	5,655
Lease liability	5,485	5,786

Summary

When undertaking business combinations, acquirers need to be aware of these special rules when accounting for leases, and the fact that leases of the acquiree are treated as if the acquirer has entered into a new lease at acquisition date.

Acquirers therefore need to maintain separate books and records for all leases acquired as part of a business combination, and this is where BDO Lead and BDO Lease Management Services can assist. Please contact a member of BDO’s IFRS Advisory team if you require assistance.