Lease incentives for fit outs under the lessee’s control
Lease incentives for fit outs under the lessee’s control
Lease incentives are defined in IFRS 16 Leases as payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of a lessee’s costs. The general rule of thumb is that cash changes hands between the lessor and the lessee, or the lessor assumes an obligation of the lessee owing to another party. Examples of lease incentives include:
- Cash payments by a lessor to a lessee as an inducement for the lessee to enter into the lease
- Compensation paid by the lessor to the lessee for costs incurred by the lessee to enter into the lease, and
- The lessor extinguishing a liability of the lessee arising as a consequence of entering into the lease, e.g. a penalty for early termination of an existing lease.
How to account for lease incentives?
The lessee is required to recognise the cost of the right-of-use (ROU) asset at the lease commencement date. The cost includes:
- The amount of the initial measurement of the lease liability
- Any lease payments made at or before the commencement date, less any lease incentives received
- Any initial direct costs incurred by the lessee
- An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or because of having used the underlying asset during a particular period.
Lease incentives are therefore deducted from the cost of the ROU asset when they are received.
Are lessor contributions for property fit outs (leasehold improvements) a lease incentive?
It depends. Although the definition of lease incentives refers to ‘payments made by a lessor to a lessee associated with a lease…’, not all payments by a lessor to a lessee necessarily represent an economic inducement to the lessee to enter the lease. By reducing the carrying amount of a ROU asset, the lessee is recognising that it is economically ‘better off’ because of the payment (i.e., the cost of the lease as reflected in its financial statements over the lease term has been reduced). However, if the economic substance is that the lessee is economically no better or worse off as a consequence of a payment by the lessor to the lessee because the lessor will ultimately be compensated for the payment as part of the future lease payments, crediting (or deducting) the payment from the ROU asset (as shown in the above diagram) will not reflect the economic substance of the payment.
Lessor contributions towards a property’s fit out that the lessee controls provide the lessee with more economic benefits than they would otherwise enjoy from merely using the ROU asset (leased premises). For example, the lessee may be able to remove the improvements after the lease ends. In these circumstances, lessor contributions towards the fit out would be considered lease incentives under IFRS 16.
However, lessor contributions that merely reimburse the lessee for property fit out costs incurred, with the lessor retaining control of the fit out, are not lease incentives because the lease is presumably priced in such a way that the total payments will compensate the lessor for the fit out payment, less the expected residual value in the fit out, at the end of the lease term.
The accounting entries for lessor payments to lessees will therefore vary, depending on whether the lessor or lessee retains control of the lease fit out.
- Lessee controls the lease fit out: Fit out contributions are a lease incentive and credited to the ROU asset when received
- Lessor controls the lease fit out: Fit out contributions are not a lease incentive. Payments to the lessee are merely a reimbursement of costs, so there is no impact on the measurement of the ROU asset.
How to assess whether the lessee or lessor controls the lease fit out?
Entities should ask the following questions when deciding whether the lessor or lessee controls the leasehold improvement (fit out):
- Is the lessee contractually required to construct or install the leasehold improvements?
- Can the lessee continue to use or benefit from the improvement independently after the lease term ends?
- Are the leasehold improvements unique to the lessee’s intended use of the leased asset, and not available to the lessor in a lease to other parties?
- Can the lessee remove or replace the leasehold improvements without prior consent from the lessor, or without adequately compensating the lessor?
Answering ‘yes’ to one or more of the above questions could indicate that the lessee controls the lease fit out, and answering ‘no’ could indicate that the lessor controls the lease fit out. In addition, answering ‘yes’ to question 5. below is another factor that may indicate that the lessor controls the lease fit out.
- Did the lessee incur costs exceeding the reimbursement amount committed by the lessor i.e., any expenditure by the lessee above the agreed reimbursement will be considered as being under the lessee’s control.
This article illustrates the accounting for lease fit out contributions, where it is concluded that the lessee controls the lease fit out.
Example 1 – Fixed lease payments
Lessee X agrees to enter into a property lease arrangement with Lessor Y. The lease term is five years, with fixed annual payments in arrears of $50,000 from Year 1 to Year 5.
Lessee X’s incremental borrowing rate (IBR) is 3%.
At the start of the lease, Lessor Y also agrees to pay for the extra fit out of fixtures and furniture amounting to $20,000. These do not need to be returned to Lessor Y and can remain with Lessee X after the end of the lease term.
The lease payment schedule is as follows:
| Year |
Cash flow ($) |
|
1 |
50,000 |
|
2 |
50,000 |
|
3 |
50,000 |
|
4 |
50,000 |
|
5 |
50,000 |
The total lease payments of $250,000 are discounted at 3%, resulting in a present value of $228,985.
The journal entries for this fact pattern are as follows:
At lease commencement:
Dr ROU asset $228,985
Cr Lease liability $228,985
When Lessee X incurs the $20,000 fit out costs:
Dr PPE asset $20,000
Cr Cash $20,000
When Lessee X receives reimbursement from Lessor Y for fit out costs:
Dr Cash $20,000
Cr ROU asset $20,000
Example 2 - Variable lease payments
Lessee A agrees to enter into a property lease arrangement with Lessor B. The lease term is five years, with variable lease payments equalling x% of the retail property’s turnover from Year 1 to Year 5.
Lessee A’s IBR is 3%.
At the start of the lease, Lessor B also agrees to pay for the extra fit out of fixtures and furniture amounting to $20,000. These do not need to be returned to Lessor B and can remain with Lessee A after the end of the lease term.
The lease payment schedule is as follows:
| Year |
Cash flow ($) |
|
1 |
0 |
|
2 |
0 |
|
3 |
0 |
|
4 |
0 |
|
5 |
0 |
Note that there are no fixed lease payments, as all payments are contingent upon Lessee A generating turnover during the lease term. Actual variable lease payments made are recognised as an expense when incurred. As such, no ROU asset or lease liability is recognised at lease commencement.
The journal entries for this fact pattern are as follows:
At lease commencement:
Dr ROU asset Nil
Cr Lease liability Nil
When Lessee A incurs the $20,000 fit out costs:
Dr PPE asset $20,000
Cr Cash $20,000
When Lessee A receives reimbursement from Lessor Y for fit out costs:
Dr Cash $20,000
Cr ROU asset $20,000
What to do about this negative ROU asset?
Strict application of the requirements in paragraphs 23-25 of IFRS 16 results in a negative ROU asset for the lease incentive receipt. However, it would be inappropriate to recognise this negative asset as a gain in profit or loss.
Instead, applying the subsequent measurement guidance in paragraph 32 of IFRS 16, the negative ROU asset is amortised over the shorter of the lease term and the ROU asset’s useful life.
Example 3 - Fit out costs exceed contribution by lessor
Lessee G agrees to enter into a property lease arrangement with Lessor H. The lease term is five years, with fixed annual payments in arrears of $50,000 from Year 1 to Year 5.
Lessee G’s IBR is 3%.
At the start of the lease, Lessor H also agrees to pay for the extra fit out of fixtures and furniture amounting to $20,000, which will be reimbursed as progress bills are submitted.
These fit outs do not need to be returned to Lessor H and can remain with Lessee G after the end of the lease term.
Lessee G ultimately spends $25,000 on the fit outs, with the excess $5,000 not reimbursed by Lessor H because it was not part of the committed amount and therefore incurred by Lessee G.
The lease payment schedule is as follows:
| Year |
Cash flow ($) |
|
1 |
50,000 |
|
2 |
50,000 |
|
3 |
50,000 |
|
4 |
50,000 |
|
5 |
50,000 |
The total lease payments of $250,000 are discounted at 3%, resulting in a present value of $228,985.
The journal entries for this fact pattern are as follows:
At lease commencement:
Dr ROU asset $228,985
Cr Lease liability $228,985
When Lessee G incurs the $25,000 fit out costs:
Dr PPE asset $25,000
Cr Cash $25,000
When Lessee G receives reimbursement from Lessor H for $20,000 of the fit out costs:
Dr Cash $20,000
Cr ROU asset $20,000
More information
Our IFRS in Practice publication contains in-depth discussion and examples to help you apply other aspects of IFRS 16 to your organisation.
Need help?
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