Even minor amendments to leases under IFRS 16 create significant work for lessees

IFRS 16 Leases, which comes into effect for financial reporting periods beginning on or after 1 January 2019, will fundamentally change the manner in which lessees account for leases by requiring them to recognise lease liabilities and associated right-of-use assets for the leases that they enter into (with some very limited exemptions).

In the August 2018 edition of Accounting News we worked through an example of a simple building lease to demonstrate just how significant that change will be.

This month, we examine how to account for two very common lease modifications:

  • An increase in lease payments due to the change in an index, and
  • A reduction in the amount of floor space leased.   

Increase in lease payments due to the change in an index (Based on IFRS 16, Illustrative Example 14)

Where a lease includes variable lease payments that depend on an index or a rate, the measurement of the lease liability at inception uses the index or rate as at the commencement date of the lease.  When that index or rate changes (which results in amended lease payments), the lease liability in relation to the remaining lease payments must be remeasured. 

Example

Background

Company A is the lessee in a 10-year lease of property, with annual lease payments of $50,000, payable at the beginning of each year.

The lease agreement specifies that lease payments will increase every two years on the basis of the increase in the Consumer Price Index (CPI) for the preceding 24 months.

The CPI at the commencement date is 125.  At the beginning of the third year of the lease, the CPI is 135.

As the interest rate implicit in the lease is not readily determinable, Company A's incremental borrowing rate of 5% is used as the discount rate. This reflects the rate at which Company A could borrow an amount similar to the value of the right-of-use asset, for a 10-year term, with similar collateral.

At the commencement date, Company A makes the lease payment for the first year and measures the lease liability at the present value of the remaining nine payments of $50,000, payable annually in advance, discounted at the interest rate of 5%, which is $355,391. 

Commencement of the lease

The right-of-use asset is then calculated as follows:

Component of initial measurement  
Initial measurement of the lease liability $355,391
Plus: Lease payments made at or before commencement date $50,000
Plus: Initial direct costs incurred by the lessee Nil
Plus: Estimated restoration costs Nil
Less: Lease incentives received Nil
Total $405,391

 The journal entry at the date of commencement of the lease is:

  Dr Cr
Right-of-use asset $405,391  
Lease liability   $355,391
Cash (lease payment for first year)   $50,000

Years 1 to 10

Assuming there is no change to CPI over the period of the lease, each year, Company A will make a cash payment of $50,000 (at the beginning of the year).  The lease liability will then decrease over the period of the lease as follows:

Year Opening Payment Post payment Interest (5% x post payment) Closing (post payment + interest)
1     $355,391 $17,770 $373,161
2 $373,161 $50,000 $323,161 $16,158 $339,319
3 $339,319 $50,000 $289,319 $14,466 $303,785
4 $303,785 $50,000 $253,785 $12,689 $266,474
5 $266,474 $50,000 $216,474 $10,824 $227,298
6 $227,298 $50,000 $177,298 $8,865 $186,162
7 $186,162 $50,000 $136,162 $6,808 $142,971
8 $142,971 $50,000 $92,971 $4,649 $97,619
9 $97,619 $50,000 $47,619 $2,381 $50,000
10 $50,000 $50,000 Nil Nil Nil

Change in CPI at the end of Year 2

At the end of Year 2 of the lease:

  • A cash payment of $50,000 has been made (at the beginning of year 2)
  • The right-of-use asset has been depreciated (on a straight line basis over the 10-year lease term) by $81,078 ([$405,391/10 = $40,539] x 2)
  • Interest expense has been incurred = $33,928 ($17,770 in Year 1 + $16,158 in Year 2).

The journal entries for Years 1 and 2 are as follows:

End of Year 1 Dr Cr
Depreciation expense $40,539  
Right-of-use asset   $40,539
Recognise depreciation expense for Year 1 in profit or loss
End of Year 1 Dr Cr
Interest expense $17,770  
Lease liability   $17,770
Recognise interest expense for Year 1 in profit or loss
Beginning of Year 2 Dr Cr
Lease liability $50,000  
Cash   $50,000

Recognise lease payment at beginning of Year 2

End of Year 2 Dr Cr
Depreciation expense $40,539  
Right-of-use asset   $40,539
Recognise depreciation expense for Year 2 in profit or loss
End of Year 2 Dr Cr
Interest expense $16,158  
Lease liability   $16,158
Recognise interest expense for Year 2 in profit or loss

Change in CPI at beginning of Year 3

At the beginning of Year 3, before accounting for the change in future lease payments resulting from the change in the CPI and making the lease payment for Year 3, the lease liability is $339,319 ($355,391 - $16,072, as can be seen in the lease liability table above).

At the beginning of Year 3, the CPI is 135. Lease payments are therefore adjusted to $54,000 to take account of the CPI impact, i.e. $50,000 × (135/125).

As there is a change in the future lease payments resulting from a change in the CPI used to determine those payments, Company A must remeasure the lease liability to reflect those revised lease payments.

At the beginning of Year 3 of the lease, the lease liability will be the present value of eight payments of $54,000, payable annually in advance, discounted at 5%, which is $366,464.  

Company A must increase the lease liability by $27,145 ($366,464 - $339,319).  The journal entry is:

  Dr Cr
Right-of-use asset 27,145  
Lease liability   27,145

At the beginning of the third year, Company A also makes the lease payment for the third year.  The journal entry is:

  Dr Cr
Lease liability 54,000  
Cash   54,000

Journal entries made at the end of Year 3 will need to reflect the increased carrying values of the lease liability and right-of-use asset. 

Reduction in the amount of floor space leased (Based on IFRS 16, Illustrative Example 17)

Where there is a change in the area leased, the lessee must adjust the lease liability and the right-of-use asset for the proportionate decrease in the leased area and also recognise any other changes to the lease liability. This involves the following steps by the lessee:

  1. Reduce the carrying amount of the right-of-use asset and the lease liability for the proportionate decrease in the leased area, recognising the difference as a gain/loss in profit or loss for the full or partial termination of the lease, and
  2. Remeasure the lease liability using a revised discount rate at the date the lease is amended. The resulting increase or decrease to the lease liability from the amount recognised in 1. above is adjusted against the right-of-use asset to reflect the revised lease payments and discount rate.

Example

Background

Company B is the lessee in a 10-year lease for 5,000 square metres of office space.

The annual lease payments of $50,000 are payable at the end of each year. 

As the interest rate implicit in the lease is not readily determinable, Company B’s incremental borrowing rate of 6% is used as the discount rate.

There are no lease payments made at or before commencement date, no initial direct costs incurred by the lessee, no estimated restoration costs and no lease incentives received. 

At the beginning of Year 6 of the lease, Company B and the lessor agree to amend the original lease to reduce the space to 2,500 square metres for an annual rent of $30,000.  At the beginning of Year 6, Company B’s incremental borrowing rate is 5%. 

Commencement of the lease

At the beginning of the lease, the lease liability is $368,004 (the present value of ten annual payments of $50,000 in arrears, at a discount rate of 6%). As there are no lease payments made at or before commencement date, no initial direct costs incurred by the lessee, no estimated restoration costs and no lease incentives received, the right-of-use asset at the inception of the lease is also $368,004.

The journal entry at the date of commencement of the lease is:

  Dr Cr
Right-of-use asset 368,004  
Lease liability   368,004

Years 1 to 10

Assuming there is no change to the original lease, each year, Company B will make a cash payment of $50,000 and the lease liability will decrease over the period of the lease as follows:

Year Opening value Interest expense (6% x opening value) Cash paid Closing value (opening value + interest – cash paid)
1 $368,004 $22,080 $50,000 $340,085
2 $340,085 $20,405 $50,000 $310,490
3 $310,490 $18,629 $50,000                     $279,119
4 $279,119 $16,747 $50,000 $245,866
5 $245,866 $14,752 $50,000 $210,618
6 $210,618 $12,637 $50,000 $173,255
7 $173,255 $10,395 $50,000 $133,651
8

$133,651

$8,019

$50,000

$91,670

9

$91,670

$5,500

$50,000

$47,170

10

$47,170

$2,830

$50,000

Nil

Reduction in leased space at beginning of Year 6

When the lease is amended at the beginning of Year 6:

  • The lease liability is $210,618 (from the table above)
  • The right-of-use asset is $184,002 (depreciated on a straight line basis - $368,004 x [5 years / 10-year useful life])
  • The new lease liability is $129,884 (the present value of five $30,000 annual payments in arrears at a 5% discount rate, which is Company B’s incremental borrowing rate at the beginning of Year 6).   

At the effective date of the lease modification (the beginning of Year 6), Company B must determine the proportionate decrease in the carrying amount of the right-of-use asset. This is calculated as a 50% decrease (2,500 square metres under the modified lease / 5,000 square metres originally leased).  The lease liability and right-of-use asset must then be decreased by that proportionate amount.  The journal entry is:

  Dr Cr
Lease liability (50% X $210,618) 105,309  
Right-of-use asset (50% x $184,002)   92,001
Profit or loss   13,308

The lease liability and right-of-use asset must then be adjusted by the change in the lease liability.  The journal entry is:

  Dr Cr
Right-of-use asset 24,575  
Lease liability   24,575
Calculated as $129,884 (amended lease liability) - $105,309 (50% of the old lease liability)

Concluding thoughts

As can be seen from the examples above, even simple amendments to leases under IFRS 16 result in complex calculations for lessees.  For lessees that enter into large numbers of leases that are likely to be amended (as is common, for example, with building leases), the introduction of IFRS 16 will result in time-consuming calculations needing to be performed at each reporting date.

BDO Lead

BDO has developed a web-based tool, BDO Lead, to assist with the new complexities of lease accounting.  BDO Lead has extensive functionality and opportunity for customisation, including the ability to account for changes to lease terms (which can be significant, particularly for property leases), a built in audit trail that provides details of all changes made within the tool, and the provision of a centralised repository for information on lease arrangements.  More information on BDO Lead is available here including a video explaining its functionalities.

Due to independence issues, BDO Lead cannot be licensed to audit clients of BDO.