Best guide IFRS 16 Lessor modifications

Best guide IFRS 16 Lessor modifications

summarises the accounting for lessor modifications that depends on – and may change – the lease classification.

Unlike IAS 17 Leases, the new standard provides detailed guidance on the lessor accounting for lease modifications, with separate guidance for modifications to finance leases and operating leases.

However, additional complexities arise for modifications of a finance lease receivable not accounted for as a separate lease for which, under paragraph 80(b) of IFRS 16, the lessor applies the requirements of IFRS 9 Financial Instruments. A number of issues arise due to differences in the basic concepts between IFRS 16 and IFRS 9.

The following diagram summarises the accounting for lease modifications by a lessor.

Best guide IFRS 16 Lessor modifications

Separate lease Not a separate lease – Finance to operating Not a separate lease – Finance to finance Lessor modifications to operating expenses

* A lessee reassessment of whether it is reasonably certain to exercise an option to extend, or not to exercise a termination option, included in the original lease contract is not a lease modification

Discount rates

Generally, a lessor does not reassess the discount rate when accounting for leases. However, it will use a revised discount rate in some modification scenarios (IFRS 16.41).

In which modification scenarios does a lessor revise the discount rate?

Whether a lessor revises the discount rate on a lease modification depends on:

  • whether the modification is accounted for as a separate lease; and
  • the lease classification.

In addition, a lessor may not need to determine a discount rate for many modifications of operating leases.

Type of modification

Impact

The modification of a finance lease is accounted for as a separate lease.

The lessor determines the rate implicit in that separate lease. The lessor does not revise the discount rate of the original lease.

The modification of a finance lease is not accounted for as a separate lease and the lessor reassesses the lease classification as if the modified terms were in effect at inception.

The new standard is silent on whether the lessor uses the original discount rate or a new discount rate to assess classification in the context of a modification.

Therefore, the lessor needs to determine the appropriate discount rate when performing the classification test – i.e. to determine whether the lease would have been a finance lease or an operating lease had the modified terms been in effect at inception.

The modification of a finance lease is not accounted for as a separate lease and the lease would have been classified as a finance lease had the modified terms been in effect at inception.

The lessor accounts for the modification under IFRS 9.

If, under IFRS 9, the modification results in derecognition of the original finance lease receivable, then the discount rate for the new finance lease receivable is determined in accordance with IFRS 16.

For modifications that do not result in derecognition, it is less clear whether the lessor continues to use the original discount rate or uses the revised discount rate.

The modification of a finance lease is not accounted for as a separate lease and the lease would have been classified as an operating lease had the modified terms been in effect at inception.

The lessor accounts for the modification as a new lease from the effective date of the modification and measures the carrying amount of the underlying asset as the net investment in the lease immediately before that date.

The modification to an operating lease is accounted for as the termination of the original lease and the creation of a new lease.

If required*, the lessor determines the rate implicit in the new lease considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease.

* The lessor may be required to determine the interest rate implicit in the lease when determining the classification of the new lease and when measuring the net investment in the lease if that new lease is classified as a finance lease. However, the lessor may not need to determine a discount rate for many modifications of operating leases.

Lessor modifications to finance leases

A lessor’s accounting for a modification to a finance lease depends on whether the modification, in substance, represents the creation of a new lease that is separate from the original lease. Like the lessee, the lessor accounts for such a modification as a separate lease (IFRS 16.BC238–BC239).

Accounting for a modification to a finance lease that is not accounted for as a separate lease further depends on whether the lease classification would have been different had the modified terms been in effect at the inception date.

Separate lease

A lessor accounts for a lease modification as a separate lease if both of the following conditions exist:

  • the modification increases the scope of the lease by adding the right to use one or more underlying assets; and
  • the consideration for the lease increases by an amount equivalent to the stand- alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract (IFRS 16.79).

In this case, the lessor:

  • accounts for the separate lease in the same way as any new lease; and
  • makes no adjustment to the initial lease.

Worked example – Modification that is a separate lease

Lessor L enters into an eight-year lease of 40 lorries with Lessee M. The lease term approximates the lorries’ economic life and no other features indicate that the lease does not transfer substantially all of the risks and rewards incidental to ownership of the lorries. Therefore, L classifies the lease as a finance lease.

M’s business has expanded and M now requires additional lorries. At the beginning of Year 5, L and M amend the contract to grant M the right to use 20 additional lorries of the same type for the remaining contractual period – i.e. for four years. The lease payments for these additional lorries are 5% higher than originally, due to an increase in their purchase price.

The lease of the additional lorries was not part of the original terms and conditions of the contract. Therefore, this is a lease modification.

L accounts for this modification as a separate lease at the effective date of the lease modification because:

  • the modification increases the scope of the lease by adding the right to use additional underlying assets – i.e. 20 additional lorries; and
  • the lease payments for the additional lorries are commensurate with their stand-alone rentals. Even though the lease payments for the new lorries are 5% higher than the prices in the original lease, this change reflects the increase in purchase prices.

L does not modify the accounting for the original lease of 40 lorries. L classifies the lease of 20 additional lorries as an operating lease because the lease term for those additional lorries is not for the major part of their economic life and no other features indicate that the lease transfers substantially all of the risks and rewards incidental to ownership of the lorries. (In practice, this scenario might involve a master lease agreement.

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Not a separate lease – Finance to operating

When a modification to a finance lease is not a separate lease, the lessor first assesses whether the classification of the lease would have been different if the modified terms had been in effect at the inception date (IFRS 16.80(a)).

If a modification to a finance lease is not a separate lease and the lease would have been classified as an operating lease if the modified terms had been in effect at the inception date, then the lessor:

  • accounts for the lease modification as the termination of the original lease and the creation of a new lease from the effective date of the modification; and
  • measures the carrying amount of the underlying asset as the net investment in the original lease immediately before the effective date of the lease modification.

Worked example – Modification that is not a separate lease and lease would have been classified as an operating lease

Modifying the above example, at the end of Year 2 Lessee M decides to cease one of its activities in two years and therefore needs to terminate the lease of 40 lorries early. At the beginning of Year 3, L and M amend the contract so that it now terminates after Year 4.

Early termination was not part of the original terms and conditions of the lease and is therefore a lease modification. The modification does not grant M an additional right to use and therefore cannot be accounted for as a separate lease.

L determines that had the modified terms been in effect at the inception date, the lease term would not have been for the major part of the lorries’ economic life. Furthermore, there are no other indicators that the lease would have transferred substantially all of the risks and rewards incidental to ownership of the lorries. Consequently, the lease would have been classified as an operating lease.

At the beginning of Year 3, L accounts for the modified lease as a new operating lease. Consequently, L:

  • derecognises the finance lease receivable and recognises the underlying assets in its statement of financial position according to the nature of the underlying asset – i.e. as property, plant and equipment in this case; and
  • measures the aggregate carrying amount of the underlying assets as the amount of the net investment in the lease immediately before the effective date of the lease modification.

Not a separate lease – Finance to finance

If a modification to a finance lease is not a separate lease and the lease would have been classified as a finance lease if the modification had been in effect at the inception date, then the lessor accounts for it under the requirements of IFRS 9 (IFRS 16.80(b)).

The following flowchart summarises the accounting in this case (the three lowest boxes are discussed beneath the flowchart).

modification to a finance lease

Determining whether the modification is substantial

IFRS 9 requires derecognition of a financial asset when the contractual rights to its cash flows expire. However, there is no comprehensive guidance on how this criterion should be applied to modifications of financial assets. IFRS 9 states that in some circumstances the renegotiation or modification of the contractual cash flows of a financial asset can lead to its derecognition.

In general, the holder of the financial asset should perform a quantitative and qualitative evaluation of whether the modification is substantial – i.e. whether the cash flows of the original financial asset and the modified or replacement financial asset are substantially different.

If the cash flows are substantially different, then we believe that the contractual rights to cash flows from the original financial asset should be deemed to have expired.

In general, in making this evaluation an entity needs to develop its own policies and methods. In doing so it may, but is not required to, analogise to the guidance on the derecognition of a financial liability (IFRS 9.3.2.3, B5.5.25).

Accounting for a substantial modification

A substantial modification results in derecognition of the financial asset. The following guidance applies under IFRS 9.

  • When the modification results in derecognition, the modified asset is recognised as a new financial asset and initially measured at its fair value plus eligible transaction costs.
  • Ignoring any other fees and costs, derecognition effectively results in an overall gain or loss equal to the difference between:
    • the amortised cost of the old asset; and
    • the fair value of the new asset minus the amount of expected credit losses recognised as an impairment allowance on the new asset.
  • IFRS 9 is not explicit about the accounting for modification costs and fees incurred when the new financial asset is not classified as at fair value through profit or loss – i.e. whether they are:
    • eligible for capitalisation as incremental transaction costs that are directly attributable to the acquisition of the new asset; or
    • expensed immediately as relating to the derecognition of the old asset.
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Consequently, it appears that an entity should apply judgement in developing its accounting policy for determining whether and which transaction costs are eligible for capitalisation (IFRS 9.B5.5.25–B5.5.26).

Accounting for a modification that is not substantial

IFRS 9 contains guidance on the following aspects of modifications of financial assets that do not result in derecognition of the asset, irrespective of the reason for the modification:

  • measuring the gross carrying amount of financial assets; and
  • recognising the resulting gains or losses (IFRS 9.5.4.3, BC5.231–BC5.236).

Under IFRS 9, for modifications that do not result in derecognition the gross carrying amount of the asset is generally recalculated by discounting the modified contractual cash flows using the original effective interest rate. Any difference between this recalculated amount and the existing gross carrying amount is recognised in profit or loss as a modification gain or loss (IFRS 9.5.4.3, A).

When a finance lease receivable is modified and not accounted for as a separate lease, under paragraph 80(b) of IFRS 16, the lessor applies the requirements of IFRS 9. However, a number of issues arise due to differences in the basic concepts between IFRS 16 and IFRS 9.

How does this apply to a modification to a finance lease that is not a separate lease and that would have been classified as a finance lease if the modification had been in effect at inception?

When a modified finance lease is not accounted for as a separate lease and would have been classified as a financial lease had the modification been in effect at inception date, the standards requires the lessor to apply IFRS 9. However, a number of issues arise due to conceptual differences between the two standards. It is unclear how to apply that guidance in practice. These differences include the following (the list is not exhaustive).

Under IFRS 16

Under IFRS 9

Measurement on initial recognition

A finance lease receivable is measured at an amount equal to the net investment in the lease.

A new financial asset is measured at an amount equal to fair value plus directly attributable transaction costs.

Discount rate

A finance lease receivable is measured using the interest rate implicit in the lease.

A financial asset in the scope of IFRS 9 that is classified as measured at amortised cost is accounted for using an effective interest rate.

This is the rate that, on initial recognition, equalises the fair value of the financial asset plus transaction costs to the future cash flows.

Cash flows

Only certain types of cash flows are considered when determining the net investment in the lease. Many of the variable cash flows (e.g. variable lease payments not depending on indexes or rates) are ignored. Reassessment of cash flows is made only in certain circumstances (e.g. if there is a change in the non-cancellable period of a lease).

Cash flows are determined based on the estimated amounts by considering all contractual terms and include the estimate of all variability in cash flows. Estimated cash flows are revised when there is a change in the underlying facts and circumstances of cash flows.

Unguaranteed residual value

Unguaranteed residual value is included in the measurement of the finance lease receivable.

No equivalent is included in the measurement of a financial asset in the scope of IFRS 9.

Lessor modifications to operating leases

A lessor accounts for a modification to an operating lease as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease (IFRS 16.87).

Worked example – Lessor modifications to operating leases

Lessor Y enters into a 10-year lease of office space with Lessee X. Y classifies this lease as an operating lease because it does not transfer substantially all of the risks and rewards incidental to ownership of the office space.

The lease agreement specifies a starting rent of 100,000 payable in arrears and requires the lease payments to be increased by 2% per annum – i.e. 1,094,972 for the whole 10-year period. X does not provide any residual value guarantee. There are no initial direct costs, lease incentives or other payments between X and Y.

The accounting for the lease payments on a straight-line basis is performed by first determining the annual rental income of 109,497 (1,094,972 / 10), which takes into account the annual indexation.

Therefore, Y accounts for the lease payments over the first half of the lease term (i.e. Years 1–5) as follows.

the first half of the lease term

Due to high vacancy rates in the real estate market, Y would like to encourage X to commit to staying in the office space for longer. At the beginning of Year 6, Y and X enter into negotiations and agree to:

  • extend the original lease of the floor of office space by an additional five years after Year 10; and
  • fix the annual payments for the original lease at 110,000 payable in arrears for the remaining 10 years (i.e. five remaining years of the original lease term plus a five-year extension).

The change in consideration and the extension of the lease term were not part of the original terms and conditions of the lease and are therefore a lease modification. Y accounts for this modification as a new operating lease from the effective date of the modification. This takes into account accrued lease payments relating to the original lease as follows.

the revised second half of the lease term

Table end Note

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Termination or break of a lease

Occasionally a lessee terminates a lease earlier than the term contemplated in the original agreement and pays the lessor a termination penalty (IFRS 16.79, 80(a), 87).

Lease payments include penalties for terminating the lease. However, unlike a termination penalty considered in the initial measurement and determination of the lease term, some termination payments result from negotiation between the lessee and the lessor when they reach a modified agreement. It appears that if the lease modification is accounted for under the new standard, then these termination penalties should be considered part of the revised lease payments.

The following example illustrates the lessor accounting in a typical scenario.

Worked example – Termination/break of the lease not included in original contract

Lessee L enters into a 10-year contract with Lessor M to lease a building. There are no termination or break clauses in the original contract.

M classifies the lease as an operating lease.

During Year 5, L begins experiencing financial difficulties and wants to end the lease earlier than originally planned. At the end of Year 5, L and M enter into negotiations and agree to terminate or break the lease at the end of Year 7 (i.e. in two years’ time, three years earlier than the original expiry of the lease).

L agrees to pay M a termination or break fee. L and M also agree to reduce the lease payments for the remaining term until the end of Year 7.

The original terms and conditions of the lease did not include an option to terminate or break the lease, reduce the lease term or reduce lease payments. Therefore, M treats this as a modification to an operating lease. That is, M treats the modification as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease.

In this case, the lease contains only a single lease component; therefore, the termination or break fee forms part of the revised lease payments.

The following example illustrates how above example compares with a scenario in which the termination penalty clause was included in the original terms of the contract.

Worked example – Termination/break of the lease was included in original contract

Assume the same facts as above example, except that the original lease agreement included an option for L to terminate the lease at the end of Year 7, subject to a termination penalty. Therefore, when L exercises its termination option there is no lease modification.

At commencement of the original lease, L and M assessed whether it was reasonably certain that L would not exercise the termination or break option. This was included in the determination of the lease term.

  • If it was not reasonably certain that L would continue the lease after Year 7 (i.e. not reasonably certain that L would not exercise the termination option), then at the commencement date, in the absence of other factors affecting the lease term, the lease term would have been assessed to be seven years and the break fee would have been included in the lease payments used in the initial measurement of the lease.

  • If it was reasonably certain that L would continue the lease after Year 7 (i.e. reasonably certain that L would not exercise the termination option), then at the commencement date, in the absence of other factors affecting the lease term, the lease term would have been assessed to be 10 years and the break fee would not have been included in the lease payments included in the initial measurement of the lease liability.

At the end of Year 5, L exercises its termination option, which was not included in the original determination of the lease term. This changes the non-cancellable period of the lease and causes M to revise the lease term. M does not reassess the lease classification because this is not a lease modification – i.e. the lease remains classified as an operating lease.

The new standard does not address the lessor’s accounting for reassessment. Therefore, there is no guidance on the accounting for a break fee included in the original contract that was not originally included in the lease payments from operating leases but subsequently becomes payable because the option to terminate the lease is exercised.

When the termination option is exercised by L and M revises the lease term because of the change in the non-cancellable period of the lease, M should include the break fee in the revised lease payments. In this case, M will recognise the fees as income, generally on a straight-line basis over the remaining term of the lease.

The accounting for the amounts received by the lessor in connection with the modification may be different if the lease modification is accounted for in accordance with IFRS 9 (IFRS 16.80(b)).

See also: IFRS Community – Lessor accounting

Best guide IFRS 16 Lessor modifications

Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications Best guide IFRS 16 Lessor modifications

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