Accounting for leases denominated in a foreign currency

Foreign currency leases are accounted for by applying both IFRS 16 Leases and IAS 21 The Effects of Changes in Foreign Exchange Rates. This is because the lease liability and the right-of-use (ROU) asset are treated differently for foreign currency translation purposes. Applying both standards creates complexity for preparers because lease liability amortisation must be updated as foreign exchange rates change.

Initial recognition

At the commencement date of the lease, the lessee:

  • Measures the lease liability in the lease currency using IFRS 16
  • Translates the lease liability into the entity's functional currency using the spot exchange rate at the commencement date, and
  • Measures the ROU asset based on the initial lease liability (plus any other amounts required by IFRS 16) using the same exchange rate used to convert the lease liability.

Subsequent measurement

Under IFRS 16 and IAS 21, a foreign-currency lease liability is treated as a monetary item and retranslated at each reporting date with exchange differences recognised in profit or loss. However, the associated ROU asset is a non-monetary asset carried at historical cost and is not subsequently retranslated.

This is often one of the most significant practical issues for multinational groups or entities with material foreign currency leases, because foreign currency volatility can create material profit or loss movements, even when the corresponding ROU asset does not change.

Example

Entity ABC is an Australian entity and has Australian dollars (AUD) as its functional and presentation currency.

Entity ABC enters into a five-year lease for property, plant and equipment. The lease is denominated in US dollars (USD).

At the commencement date:

  • The lease liability is USD 1,000,000
  • The spot rate is USD 1: AUD 1.50
  • Lease payments are made annually in arrears (USD 230,974)
  • Assume that there are no initial direct costs incurred by the lessee
  • Assume that the lessee has no obligation under the terms of the lease to dismantle, restore or remove the ROU asset.

Initial recognition

Entity ABC recognises the following journal entry on initial recognition of the lease (in Australian dollars):

Dr ROU asset                                1,500,000

Cr Lease liability                                                  1,500,000

USD 1,000,000 translated at 1:1.5

Subsequent measurement

Here we consider the ROU asset and the lease liability separately because one is a monetary item and the other is not.

Right-of-use asset

The ROU asset is a non-monetary asset carried at cost. Therefore:

  • It remains translated at the historical exchange rate used at the commencement date ($1,500,000)
  • It is not retranslated at subsequent reporting dates, and
  • Depreciation is recognised based on the asset's carrying amount in functional currency (AUD).

The journal entry at the end of the first year is as follows (in Australian dollars):

Dr Amortisation – ROU asset                                                  300,000

Cr Accumulated amortisation – ROU asset                                                         300,000

$1,500,000 / 5 years

Lease liability

As noted above, the lease liability is treated as a monetary item and retranslated at each reporting date with exchange differences recognised in profit or loss. Therefore, the lessee remeasures the lease liability in the foreign currency (USD) at the end of each reporting period by:

  • Accruing interest under IFRS 16 in the foreign currency (this increases the lease liability)
  • Reducing the lease liability for lease payments made in foreign currency
  • Translating the closing foreign currency lease liability using the closing exchange rate
  • Recognising any foreign exchange gain or loss in profit or loss.

The spot rate at the end of Year 1 is USD 1: AUD 1.60

One challenging aspect of this accounting is determining the exchange rate applicable to the interest expense, which, in this case, accrues over the whole year until the annual lease payment is made in arrears. For other leases, payments may be monthly, in which case the interest expense accrues monthly as well.

IAS 21 requires that foreign currency transactions be recognised using the spot exchange rate at the date of the transaction. In our example, this will be USD 1: AUD 1.60 for both the interest expense and the lease payment (which will be the actual amount paid).

Where there are monthly lease payments, actual foreign exchange rates will be used for the lease payments, and interest expense can either be converted at that same rate or, for practical reasons, by using a monthly average (see paragraph 21 of IAS 21 below).

A foreign currency transaction shall be recorded, on initial recognition in the functional currency, by applying to the foreign currency amount the spot exchange rate between the functional currency and the foreign currency at the date of the transaction.

IAS 21, paragraph 21

The date of a transaction is the date on which the transaction first qualifies for recognition in accordance with Australian Accounting Standards. For practical reasons, a rate that approximates the actual rate at the date of the transaction is often used, for example, an average rate for a week or a month might be used for all transactions in each foreign currency occurring during that period. However, if exchange rates fluctuate significantly, the use of the average rate for a period is inappropriate.

IAS 21, paragraph 22

The journal entries at the end of Year 1 are as follows (in Australian dollars):

Dr Interest expense                                          80,000

Cr Lease liability                                                                           80,000

USD 1,000,000 X 5% = 50,000 X FX rate of 1.6

 

Dr Lease liability                                                369,558

Cr Cash                                                                                         369,558

Lease payment of USD 230,974 X FX rate of 1.6

 

Dr Foreign exchange loss                                 100,000

Cr Lease liability                                                                           100,000

Opening lease liability of AUD 1,500,000 + 80,000 – 369,558 = AUD 1,210,442 compared to Closing USD liability of 819,026 X 1.6 = AUD 1,310,816

Similar entries will follow in the same way for Years 2 to 5 when the exchange rates are known.

The mismatch

As is evident from the above example, foreign exchange rate movements create a mismatch:

Item

IAS 21 classification

Exchange rate used after commencement

ROU asset (cost model)

Non-monetary

Historical rate

Lease liability

Monetary

Closing rate

Interest expense

Derived from the lease liability

Based on the translated liability

Depreciation

Derived from the ROU asset

Based on the historical carrying amount
 

So, if the foreign currency strengthens:

  • The lease liability increases
  • The foreign exchange loss is recognised in profit or loss
  • There is no impact on the ROU asset carrying amount.

And if the foreign currency weakens:

  • The lease liability decreases
  • The foreign exchange gain is recognised in profit or loss
  • There is no impact on the ROU asset carrying amount.

Lease modifications and remeasurements

When a lease is remeasured under IFRS 16 (for example, due to a change in lease payments due to inflation):

  • The lease liability is remeasured applying the IFRS 16 requirements and the exchange rate applicable on the remeasurement or modification date
  • The associated adjustment to the ROU asset is translated using the exchange rate applicable on the remeasurement date
  • Amortisation of the ROU asset will increase and be based on the adjusted carrying amount of the ROU asset, and
  • Future foreign exchange movements continue to affect only the lease liability because it remains a monetary item.

Similar adjustments are required when there is a lease modification, such as a negotiated extension of the lease term beyond its initial contract term.

Group reporting

Subsidiaries that enter into leases denominated in their own functional currency apply the usual IFRS 16 principles for lease accounting and are unaffected by the discussion above. On consolidation, the parent entity will apply the normal principles in IAS 21 to convert the assets, liabilities, income, and expenses of a foreign operation into the presentation currency for group reporting.

However, if a subsidiary itself enters into a foreign currency lease (a lease denominated in a currency different to its functional currency), it will have to adjust its lease liability at each reporting date and recognise a foreign exchange difference in profit or loss, as described in this article.

Need help?

BDO offers comprehensive support for your lease accounting needs. Our cloud-based system, BDO Lead simplifies the complexities of implementing IFRS 16. We also provide outsourced leased management services, handling your lease accounting using BDO Lead. These products are particularly helpful when lease liabilities need to be remeasured annually to reflect rental adjustments.

For assistance, please contact BDO’s IFRS & Corporate Reporting team.