IRR How to calculate

IRR How to calculate

The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.

When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0).

Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision).

In reality, there are many other quantitative and qualitative factors that are considered in an investment decision). If the IRR is lower than the hurdle rate, then it would be rejected, if IRR is the only investment consideration.

Under IFRS 16 ‘Leases’, a similar calculation is used to calculate discount rates are used to determine the present value of the lease payments used to measure a lessee’s lease liability. Discount rates are also used to determine lease classification for a lessor and to measure a lessor’s net investment in a lease.

For lessees, the lease payments are required to be discounted using:

For lessors, the discount rate will always be the interest rate implicit in the lease.

The interest rate implicit in the lease is defined in IFRS 16 as ‘the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.’

The lessee’s incremental borrowing rate is defined in IFRS 16 as ‘the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment’.

The incremental borrowing rate is determined on the commencement date of the lease. As a result, it will incorporate the impact of significant economic events and other changes in circumstances arising between lease inception and commencement.

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Lease calculation – IFRS 16 Structured best approach

Lease calculation

Lease calculation provides a logical model to understand the calculations that have to be made in accounting for IFRS 16 Leases. In addition a lease contract calculation Excel model is provided to do the work. IFRS 16 Structured best approach

The 5-step lease calculations model

Use the 5-step lease calculations model to systematically document your lease calculations.

Step 1. Identification of a lease contract

a) When should this assessment be made?

An entity is required to assess whether a contract is, or contains a lease at the inception of the contract.

There is a difference between the inception date of the contract and the commencement date of the lease as follows:

Inception Date of the Contract

Commencement Date of the Lease

Is the earlier of the date of:

  • A lease agreement; and
  • A commitment by the parties to the principal terms and conditions of the lease.

The date on which a lessor makes an underlying asset available for use by a lessee.

b) When Does a Lease Exist?

A lease exists where the contract grants the right to control the use of an identified asset for a period of time in exchange for consideration.

Control over the use of an identified asset for a period of time is conveyed when, the customer has both of the following throughout the period of use (IFRS 16.B9):

  1. The right to obtain substantially all of the economic benefits from use of the identified asset; and
  2. The right to direct the use of the identified asset. IFRS 16 Structured best approach

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Sale and leaseback accounting under IFRS 16

Sale and leaseback accounting

A sale and lease back transaction is a popular way for entities to secure long-term financing from substantial property, plant and equipment assets such as land and buildings. IFRS 16 made significant changes to sale and lease back accounting in comparison with IAS 17. A sale and leaseback transaction is one where an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) for consideration and leases that asset back from the buyer-lessor.

The IFRS 16 guidance on ‘failed sales’ means that some sale-and-lease back transactions are accounted for as pure financing transactions by both lessors and lessees.

In a sale-and-lease back transaction, a company (the seller-lessee) transfers an underlying asset … Read more

Sub-leases of real estate – IFRS 16 Best short read

Sub-leases of real estate

New classification guidance means that more sub-leases are finance leases under IFRS 16 than previously, impacting the financial position and financial performance of intermediate landlords.

A sub-lease is a transaction in which a lessee (or ‘intermediate lessor’) grants a right to use the underlying asset to a third party, and the lease (or ‘head lease’) between the original lessor and lessee remains in effect. (IFRS 16.3)

A company applies IFRS 16 to all leases of right-of-use assets in a sub-lease. The intermediate lessor accounts for the head lease and the sub-lease as two different contracts.

Sub-leases of real estate

An intermediate lessor classifies the sub-lease as a finance lease or as an operating lease with reference to the right-of-use asset arising from the head lease. That is, the intermediate lessor treats the right-of-use asset as the underlying asset in the sub-lease, not the item of property, plant or equipment that it leases from the head lessor. (IFRS 16.B58)

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Landlord Lease modifications

Landlord Lease modifications / Rental modifications

Accounting for lease modifications has become a hot topic due to the COVID-19 pandemic, with many tenants seeking rent concessions and other changes to lease agreements.

Unlike IAS 17, IFRS 16 provides detailed guidance on the lessor accounting for lease modifications, with separate guidance for modifications to finance leases and operating leases.

A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of its original terms and conditions. Common examples are:

  • decreasing the scope of the lease by removing the right to use one or more underlying assets;
  • decreasing the scope of the lease by shortening the contractual lease term; and
  • changing the consideration in the lease by increasing or decreasing the lease payments.

Changes that result from renegotiations of the original contract are lease modifications.

The exercise of an option included in the original lease contract is not a modification. There is no lease modification when a lessor reassesses the lease term if:

  • the lessee exercises an option not previously included in the lessor’s determination of the lease term;
  • the lessee does not exercise an option previously included in the lessor’s determination of the lease term;
  • an event occurs that contractually obliges the lessee to exercise an option not previously included by the lessor; or
  • an event occurs that contractually prohibits the lessee from exercising an option previously included by the lessor (see Changes in the lease term).

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

Original lease is a finance lease

Change to contractual terms and conditions

Original lease is an operating lease

Increase in scope of lease by adding right of use for one or more underlying assets and at stand-alone price for increase

All other contract modifications.

Classification at inception if modification had been in effect then as:

Operating lease

Finance lease

Separate lease

Not a separate lease

Apply IFRS 9

Modifications to operating leases

Food for thought – When does a lessor account for a lease modification?

Similar to a lessee, a lessor accounts for modifications to operating and finance leases on the effective date of the modification. This is the date when both parties agree to the lease modification. (IFRS 16.79–80, IFRS 16.87)

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Landlord Lease payments

Landlord Lease payments

Distinguishing between fixed and variable lease payments will impact the profile of a landlord’s earnings.

1. Overview

At commencement, a lessor identifies the lease payments, which include: (IFRS 16.70)

  • fixed payments, including in-substance fixed payments, less any lease incentives;Landlord Lease payments
  • variable lease payments that depend on an index or a rate;
  • the exercise price of a purchase option if the lessee is reasonably certain to exercise that option;
  • payments of penalties for terminating the lease, if the lease term reflects the assessment that the lessee will exercise an option to terminate the lease; and
  • the full amount (regardless of the likelihood that payment will be due) of any residual value guarantees provided to the lessor by the lessee, by a party related to the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Real estate leases will often include some or all of the following:

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Landlord lease definition

Landlord lease definition

Identifying a lease of real estate is usually straightforward – but some scenarios will require judgement.

1 Overview

A lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. (IFRS 16.B9)

The key factors to consider when applying the lease definition are as follows.

Landlord lease definition

2 Applying the definition to real estate

Types of properties common in real estate leases include:

  • land and buildings;
  • office space: e.g. a floor of a building;
  • retail space;
  • specified spots in a car park; and
  • residential property.

When applying the lease definition to real estate arrangements, it will usually be clear whether the arrangement meets the lease definition criteria.

Key factors to consider when applying the lease definition are as follows.

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Sale-and-leaseback of real estate – IFRS 16 Best complete read

Sale-and-leaseback of real estate

New guidance on ‘failed sales’ means that some sale-and-leaseback transactions are accounted for as pure financing transactions by both landlords and tenants.

In a sale-and-leaseback transaction, a company (the seller-tenant) transfers an underlying asset to another company (the buyer-landlord) and leases that asset back from the buyer-landlord. (IFRS 16.98–103)

Sale-and-leaseback

To determine how to account for a sale-and-leaseback transaction, a company first considers whether the initial transfer of the underlying asset from the seller-tenant to the buyer-landlord is a sale. The company applies IFRS 15 to determine whether a sale has taken place. This assessment determines the accounting by both the buyer-landlord and the seller-tenant.

Buyer-landlord

Transfer to buyer-landlord is a sale

* Adjustments are required if the sale is not at fair value or the lease payments are off-market. A company is not required to assess both, however – only whichever one is more ‘readily determinable’.

Transfer to buyer-landlord is not a sale

Seller-tenant

Transfer to buyer-landlord is a sale

* Adjustments are required if the sale is not at fair value or the lease payments are off-market. A company is not required to assess both, however – only whichever one is more ‘readily determinable’.

Transfer to buyer-landlord is not a sale

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Leased investment property

Leased investment property

It is mandatory rather than optional for landlords to apply IAS 40 to account for leased investment property, requiring landlords to disclose fair value information for all leased investment property.

A company applies IAS 40 to account for a right-of-use asset if the underlying asset would otherwise meet the definition of investment property. (IAS 40.2, IAS 40.30, IFRS 16.48, IFRS 16.56)

Under IAS 40, a company chooses as its accounting policy either the fair value model or the cost model for measuring its investment property. The company applies the policy to all of its investment property – i.e. it applies the same policy to owned and leased investment property. However, in either case the company complies with the disclosure requirements of IAS 40 – including disclosures of the fair value of the investment property. (IFRS 16.34, IFRS 16.56, IAS 40.30)

Leased investment propertyIf a lessor enters into an operating lease of investment property, then it continues to recognise the investment property. In contrast, if a lessor enters into a finance lease of investment property, then it derecognises the investment property and instead recognises a net investment in the lease, which is accounted for under IFRS 16.

An intermediate lessor classifies a sub-lease as a finance lease or an operating lease with reference to its right-of-use asset under the head lease rather than the underlying asset – see Sub-lease. (IFRS 16.B58)

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Separate lease and non-lease components for real estate under IFRS 16

Separate lease and non-lease components

Many real estate leases contain multiple lease and non-lease components, which landlords need to identify and account for separately.

1 Overview

IFRS 16 requires a landlord to separate the lease and non-lease components of a contract. (IFRS 16.12, IFRS 16.BC135(b))

In practice, real estate contracts may contain:

  • one or more lease components: e.g. the right to use land and/or a building; and
  • one or more non-lease components: e.g. maintenance, cleaning and provision of utilities.

For lessors, identifying components and allocating consideration will determine the split of lease income vs revenue from contracts with customers. These amounts are often presented and have to be disclosed separately. For example, a real estate company will need to distinguish lease income from revenue for other property related services – e.g. common area maintenance (CAM). (IFRS 15.110, IFRS 15.114, IFRS 16.90)

The key steps in accounting for the components of a contract are as follows.

Identify separate lease components (go here)

Identify non-lease components (go here)

Allocate consideration (go here)

Reallocate consideration on lease modification (go here)

2 Typical lease components in real estate contracts

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