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):

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

The following diagram provides an overview of the thought process used by an entity when assessing whether a contract contains a lease or not.

IFRS16.B13-B20

Lease calculation

Substantive right to subsitute…

Lease calculation

Substantially all the benefits…

IFRS 16.B21-B23

Lease calculation

IFRS16.B25-B30

IFRS 16 Structured best approach

Examples of decision-making rights that allows the customer to direct how and for what purpose the asset is used, include the rights to change:

the type of output that is produced by the asset (e.g. using a shipping container to transport goods or for storage);
when the output is produced (e.g. when an item of machinery will be used);
where the output is produced (e.g. where an item of equipment is used); and
whether the output is produced, and the quantity of that output (e.g. whether to produce energy from a power plant and how much energy to produce from that power plant)

Examples of decision-making rights that do not grant the right to change how and for what purpose the asset is used, include the rights that limit decisions to operating and maintaining the asset. Therefore, such rights can be held by the customer or supplier. However, rights to operate an asset may grant the customer the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined.

The data used in a lease contract database are basic things like:

date of input in system
person making the input
date of contract (inception date)
date of commencement of the lease
lease classification ¹
identified asset description ²
identified asset identification³
asset qualifications ⁴
leasecontract number
lessor identification⁵
contractual end date
expected ending date (if different)
lease term amount
lease term payment frequency (month, quarter, year)
lease currency

Step 2 Lease term

Before establishing the lease term in the contract it is useful to separate any non-lease components, in short the decision model is as follows:

The standard defines lease term as the non-cancellable period for which a lessee has the right to use an underlying asset, together with both:

Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
Periods after an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

The lease would start on the date on which a lessor makes an underlying asset available for use by a lessee, including any rent free periods.

When the entity assesses the non-cancellable period of a lease, the entity should determine the period for which the contract is enforceable. A lease is no longer enforceable when both the lessee and the lessor can exercise its right to terminate the lease without permission and by paying an insignificant penalty.

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Lease Options to Extend or Terminate

As noted above, appropriate consideration of how likely a lessee is to exercise its right to extend or terminate a lease is crucial in determining the correct lease term.

The analysis should consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option, or vice versa. This includes considering any expected changes in facts and circumstances from the start of the lease until the exercise date of the option.

A lessee is more likely to exercise an extension option or not exercise a termination option the shorter the non-cancellable period is. This is due to the higher cost associated with obtaining a replacement asset for the shorter non-cancellable period.

In addition, a lessee is likely to exercise an extension option or not exercise a termination option when the extension or termination option is combined with one or more other contractual features (e.g. a residual value guarantee) where the lessee guarantees the lessor a return that is substantially the same regardless of whether the option is exercised.

The following sample questions will assist the entity in their assessment:

Are terms and conditions favourable or unfavourable to the lessee for the optional periods compared to market rates (amount of fixed, variable and/or contingent payments in optional periods; any penalties; etc.)?
Will the lessee need to make significant leasehold improvements to the underlying asset over the lease term?
Are there significant costs related to the termination of the lease? (e.g. negotiation, relocation, identifying another underlying asset suitable for the lessee’s needs, integrating a new asset into the lessee’s operations, or termination penalties and similar costs);
How important is the underlying asset to the lessee’s operations? (is it specialized?, what is the availability of suitable alternatives?); and
Are there conditions that must be met in order for the option to be exercised? If so, what is the likelihood that those conditions will be met?
Does the lessee have a past practice of exercising extension options or not exercising termination options and the economic reasons relating to past practice is still relevant?

Reassessment of Lease Term

A lease term may change because of a change in the likelihood that a lessee will exercise their extension or termination option. Therefore, a lessee must reassess whether it is reasonably certain to exercise or not exercise an extension or termination option upon the occurrence of either a significant event or a significant change in circumstances that:

Is within the control of the lessee; and
Affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or vice versa (e.g. significant leasehold improvements, modifications, or customizations to the underlying asset that were not initially expected when the lease commenced or business decisions such as the disposal of a business unit).

If the lease term subsequently changes as a result of this reassessment, the lessee is required to remeasure the lease liability. The lessee will use a revised discount rate at the date of reassessment.

Lessors on the other hand are not required to reassess the lease term after the lease commences.

The lease term must also be adjusted for changes in the non-cancellable period of a lease. Examples include:

Depending on whether a particular extension/termination option was previously included in the determination of the lease term or not, the lessee exercising or not exercising of that extension or termination option
An event occurs that contractually:
- Obliges the lessee to exercise an option not previously included in the entity’s determination of the lease term; or
- Prohibits the lessee from exercising an option previously included in the entity’s determination of the lease term.

Step 3 Initial measurement of the lease liabilty

On lease commencement, the lessee recognizes and measures a lease liability.

Lease liability = present value of future lease payments (the monthly/quarterly/yearly lease payments plus the expected end payment (if any) discounted at the interest rate implicit in the lease.

The interest rate implicit in the lease is 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.

If the discount rate implicit in the lease is not readily determinable, the lessee may use its incremental borrowing rate (IFRS 16.26).

IFRS 16.27 lists the following payments will be included in the lease liability:

Fixed payments (including in-substance fixed payments), less any lease incentives receivable;
Variable lease payments that depend on an index or a rate (e.g. payments linked to an inflation index or a benchmark interest rate, such as the Bank of Canada’s prime rate, or payments that vary to reflect changes in market rental rates);
Amounts expected to be payable by the lessee under residual value guarantees;
The exercise price of a purchase option that the lessee is reasonably certain to exercise; and
Payments of penalties for terminating the lease, if the lease term reflects early termination.

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Right-of-Use Asset

On the commencement date, the lessee recognizes and measures the right-of-use asset at cost. Cost is comprised of the following:

* The definition of initial direct costs is consistent with the definition of incremental costs of obtaining a contract contained in IFRS 15. These are costs incurred to obtain a lease that would not have been incurred otherwise. These costs typically consist of commissions, legal fees (e.g. costs of originating the lease contract), administrative fees with negotiating the terms and conditions of the lease contract. General overhead or costs associated with obtaining offers for leases are typically not direct costs.

**The asset retirement obligation includes an estimate of costs to the lessee for:
– Dismantling and removing the underlying asset;
– Restoring the site where the underlying asset is located; or
– Restoring the underlying asset to a condition specified by the terms and conditions of the lease (unless those costs are incurred to produce inventories).

Subsequent Measurement of Lease Liability

The lease liability is subsequently measured like financial liabilities in IFRS 9 using the effective interest method so that the carrying amount of the lease liability is measured on an amortized cost basis and the interest expense is allocated over the lease term.

Additionally, after the commencement date the lease liability would be remeasured for any lease modifications (refer to Lease Modifications) or to reflect any changes to lease payments (e.g. in-substance fixed payments).

IFRS 16 does not allow a lessee to measure lease liabilities at fair value after initial measurement.

Step 4 Historical reporting

At implementation of IFRS 16 a lessee has a choice of whether to apply the standard to its leases:

Retrospectively to each prior reporting period presented (“Full retrospective application”); or
Retrospectively with a cumulative effect of initial application recognized at the date of initial application as an adjustment to the opening balance of retained earnings (or other component of equity, as appropriate). The comparative information under this option is not restated. (“Modified retrospective application”)

When modified retrospective application is selected by the entity, the standard contains specific transition requirements and practical expedients depending on whether the lease was previously classified as operating or finance lease.

Modified retrospective application

Recognize a lease liability → measured at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate.

Recognize a right-of-use asset* → measured at either (accounting policy choice):

Carrying amount as if IFRS 16 was applied (discount at incremental borrowing rate); or
An amount equal to the lease liability adjusted for prepaid or accrued lease payments in the statement of financial position directly before the date of initial application.

* The right-of-use asset should be evaluated for impairment on the date of initial application using IAS 36, unless the practical expedient ‘Impairment review on date of initial application’ as discussed in the practical expedient table below is applied.

Step 5 Historical changes to the asset or lease contract

Significant leasehold improvements, modifications, or customizations to the underlying asset, made in the past, that were not initially expected when the lease commenced have to be taken into account.

The case – Rent of a piece of land and building

The lessor is contractually obliged to build a building based on technical specifications provided by the lessee. The lease contract contains a non-canceable lease term of 10 years. The contract date is 1 January 2016.

The buildings consist of a warehouse, offices, integrated workplaces and outside parking. The initial investment at inception of the contract is estimated at 3,900,000.

The annual lease payment is 470,000 and is payable at the end of the year. There is no pricing index included.

Changes to the initial design of the building are for the account of the lessee. Changes to the design may not exceed 250,000. The lessee is obliged to pay such changes at the beginning of the lease period. Such a payment has to be included as a special first lease payment. In this case it is presumed that the threshold will not be exceeded.

Accounting for IAS 17 to IFRS 16 leases

Now an operational lease accounted for under IAS 17 will be accounted for under IFRS 16. These lease payments were accounted for in profit or loss in the period they related to.

Assesment of the implicit discount rate

The discount rate implicit in the lease is calculated as follows:

3.900.000 –	470.000	–	470.000	–	470.000	–	……	–	470.000	=	0
	(1 + i)^1		(1 + i)^2		(1 + i)^3		…..		(1 + i)^10

It seems the discount rate implicit in the lease is 3,545%. Here is a table to do the fact check:

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The initial recognition at 1 January year 1 should be as follows (see below):

Right-of-use asset	3.900.000
Lease liability		3.900.000

The right-of-use asset is depreciated in a straight-line over 10 years: 390.000 per year. In respect of the lease liability interest has to be added (and charged as lease interest expense) were the 470,000 lease payment is an annuity payment as follows:

Because the depreciation charge is on a straight-line basis and the lease expense is not the IFRS 16 timing of total net profit impact is that cost will be more in the first year, balancing to zero in year 10. This shows from the following table:

Adjustments for IFRS 16 full retrospective approach

IAS 17 has been applied until year 2, so year 3 is the year IFRS 16 is implemented. The full retrospective approach starts in year 1.

As shown above the initial recognition at 1 January year 1 is as follows:

Right-of-use asset	3.900.000
Lease liability		3.900.000

The lease payment was recorded as an expense in year 1 this should be corrected, as follows:

Suspense account implementation IFRS 16 year 1	470.000
Lease expense account year 1		470.000

The clearing of the suspense account will show in the next entry, the adjusted recording of the year 1 lease payment:

Lease liability repayment year 1	331.754,19
Lease interest year 1	138.254,81
Suspense account implementation IFRS 16 year 1		470.000,00
Depreciation year 1	390.000,00
Depreciation right-of-use assets year 1		390.000,00

For year 2 the entries are:

ayment was recorded as an expense in year 2 this should be corrected, as follows:

Suspense account implementation IFRS 16 year 2	470.000
Lease expense account year 2		470.000

The clearing of the suspense account will show in the next entry, the adjusted recording of the year 1 lease payment:

Lease liability repayment year 2	343.505,36
Lease interest year 2	126.494,64
Suspense account implementation IFRS 16 year 2		470.000,00
Depreciation year 2	390.000,00
Depreciation right-of-use assets year 2		390.000,00

In year 3 these adjustments have to be made in the opening balance of 01 January year 3:

The lease payments recorded as lease expense in year 1 and year 2 have to be adjusted in the opening balance at as 01 January year 3:

Opening balance adjustment – implementation IFRS 16	940.000,00
Lease expense account year 1		470.000,00
Lease expense account year 1		470.000,00

Then the carrying amounts of the right-of-use assets and the lease liability have to be recorded at as 01 January year 3:

Opening balance adjustment – implementation IFRS 16	104.750,00
Right-of-use assets – 01 January year 3	3.120.000,00
Lease liability – 01 January year 3		3.224.750,00
Check	3.224.750,00	3.224.750,00

And the right of use asset depreciation and accretion of interest for year 1 and 2 have to be recorded in opening equity:

Opening balance adjustment – implementation IFRS 16		1.044.749,64
Depreciation year 1	390.000,00
Depreciation year 2	390.000,00
Accretion of interest year 1	138.255,00
Accretion of interest year 2	126.494,64

As a result the opening balance adjustment – implementation IFRS 16 balances (remaining are roundings).

Adjustments for the IFRS 16 modified retrospective approach

Opening balance 01 January year 3 the initial recognition at 1 January year 1 is as follows:

Right-of-use asset	3.900.000
Lease liability		3.900.000

Adjusting the 2 lease payments:

Suspense account – implementation IFRS 16	940.000,00
Opening balance adjustment – implementation IFRS 16		940.000,00

Adjusting the lease payments and depreciation for year 1 and 2

Suspense account – implementation IFRS 16		940.000,00
Lease liability – Lease payments year 1 + 2	675.250,36
Opening balance adjustment – implementation IFRS 16 – Accretion of interest year 1 + 2	264.749,64
Depreciation year 1 + 2		780.000,00
Opening balance adjustment – implementation IFRS 16 – Depreciation year 1 + 2	780.000,00

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