Rent-free periods and rent abatements are not lease incentives under IFRS 16
Rent-free periods and rent abatements are not lease incentives under IFRS 16
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.
Is a rent-free period accounted for as a lease incentive?
No. Rent-free periods in a lease do not meet the definition of a lease incentive because no cash changes hands. Instead, the lessor waives rental payments without making payments to the lessee or reimbursing or assuming their costs. Rent-free periods are therefore not accounted for as lease incentives, and are not deducted from the cost of the ROU asset at the commencement of the lease. However, the reduced leased payments impact (reduces) the initially measured amount of the lease liability, and therefore also the associated ROU assets as illustrated below.
Example - Rent-free periods
Lessee A agrees to enter into a lease arrangement with Lessor B.
Lessor B offers a rent-free period for the first 12 months as an incentive to enter into the lease.
The lease term is five years, with fixed annual payments of $50,000 from Year 2 to Year 5, payable in arrears.
Lessee A’s incremental borrowing rate (IBR) is 3%.
The lease payment schedule is as follows:
|
Year |
Cashflow ($) |
|
Year 1 |
0 |
|
Year 2 |
50,000 |
|
Year 3 |
50,000 |
|
Year 4 |
50,000 |
|
Year 5 |
50,000 |
Under IFRS 16, the 12-month rent-free period is included in the lease liability calculation using a discounted cash flow model. The total lease payments of $200,000 (from Year 2 to Year 5) are discounted at 3%, resulting in a present value of $185,854.
At lease commencement, the lessee recognises a ROU asset and a lease liability of $185,854 with the journal entry:
Dr ROU asset $185,854
Cr Lease liability $185,854
Is a rent abatement accounted for as a lease incentive?
No. Similar to rent-free periods above, rent abatements also do not meet the definition of a lease incentive because no cash changes hands. Instead, the lessor waives rental payments without making payments to the lessee or reimbursing or assuming their costs. Rent abatements are therefore not accounted for as lease incentives, and are not deducted from the cost of the ROU asset at the commencement of the lease. However, the reduced leased payments impact (reduces) the initially measured amount of the lease liability, and therefore also the associated ROU assets, as illustrated below.
Example – Rent abatements
Lessee D agrees to enter into a five-year lease arrangement with Lessor E. Lease payments would ordinarily be $50,000 per year.
Lessor E agrees to a 12-month rent-free period as an incentive to the lessee for entering into the new lease. However, this will be spread over the lease term rather than being a rent-free period in Year 1.
This changes the annual rental payments for the lease term from $50,000 down to $40,000.
Lessee D’s incremental borrowing rate (IBR) is 3%.
The lease payment schedule is as follows:
|
Year |
Cashflow ($) |
|
Year 1 |
40,000 |
|
Year 2 |
40,000 |
|
Year 3 |
40,000 |
|
Year 4 |
40,000 |
|
Year 5 |
40,000 |
Under IFRS 16, the 12-month rent abatements are included in the lease liability calculation using a discounted cash flow model. The total lease payments of $200,000 (from Year 1 to Year 5) are spread evenly across the lease term, resulting in annual payments of $40,000. These are discounted at 3%, resulting in a present value of $183,188.
At lease commencement, the lessee recognises a ROU asset and a lease liability of $183,188 with the journal entry:
Dr ROU asset $183,188
Cr Lease liability $183,188
Example – Rent abatements awarded subsequent to the commencement date of the lease (lease modification)
Lessee X agrees to enter a property lease arrangement with Lessor Y.
The lease term is five years, with fixed annual payments of $120,000 from Year 1 to Year 5.
Lessee X’s incremental borrowing rate (IBR) is 3% at the commencement of the lease.
During Year 2, Lessee X identifies an issue with the property that was not disclosed by Lessor Y to Lessee X at the time of signing the lease contract. To compensate Lessee X for this issue, Lessor Y agrees to waive rent for three months in Year 2 of the lease. Currently, Lessee X’s incremental borrowing rate (IBR) is 4%.
After the rent abatement, the lease payment schedule is as follows:
|
Year |
Cashflow ($) |
|
Year 1 |
120,000 |
|
Year 2 |
90,000 |
|
Year 3 |
120,000 |
|
Year 4 |
120,000 |
|
Year 5 |
120,000 |
At the commencement of the lease, the lease liability and the ROU asset are calculated based on $120,000 per annum in lease payments.
Because the rent abatement was not contemplated in the original lease agreement between Lessee X and Lessor Y, under IFRS 16, the three-month rent-free period in Year 2 will be treated as a lease modification. Lessee X recalculates its lease liability using the above revised cash flows on the date when the waiver is granted, and Lessee X’s revised IBR of 4% is used to discount the cash flows to present value.
This will reduce the present value of the lease liability and also the associated ROU asset on the date of waiver, as well as the future depreciation and interest expense recognised over the remainder of the lease term.
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?
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 each year for rental adjustments.
For assistance, please contact BDO’s IFRS & Corporate Reporting team.