IFRS 16 Good Important Read – Lease payments

Lease payments – Lessee perspective

or what does a lessee include in its lease liability?

At the commencement date, a lessee measures the lease liability as the present value of lease payments that have not been paid at that date. In a simple lease that includes only fixed lease payments, this can be a simple calculation (IFRS 16.26).

Lease payments

Worked example – Fixed lease payments are included in lease liabilities
Lessee B enters into a five year lease of a photocopier. The lease payments are 10,000 per annum, paid at the end of each year.

Because the annual lease payments are fixed amounts, B includes the present value of the five annual payments in the initial measurement of the lease liability.

Using a discount rate (determined as B’s incremental borrowing rate) of 5%, the lease liability at the commencement date is calculated as follows:

Year

Lease payments

Discounted

1

10,000

9,524

2

10,000

9,070

3

10,000

8,638

4

10,000

8,227

5

10,000

7,835

Lease liability at commencement date

43,294

 

Categories of lease payment

The payments included in the measurement of the lease liability comprise (IFRS 16.27 ):

In contrast, the following payments are excluded from the lease liability:

Residual value guarantees

A residual value guarantee is a guarantee made to the lessor that the value (or part of the value) of an underlying asset will be at least a specified amount at the end of the lease. This guarantee is made by a party unrelated to the lessor (IFRS 16.A Definitions).

If a lessee provides a residual value guarantee, then it includes in the lease payments the amount that it expects to pay under the guarantee. If the amount expected to be payable under a residual value guarantee changes, then the lessee remeasures the lease liability using an unchanged discount rate ((IFRS 16.27(c), IFRS 16 42–43).

Worked example – Residual value guarantees

Lessee Z has entered into a lease contract with Lessor L to lease a car. The lease term is five years.

In addition, Z and L agree on a residual value guarantee – if the fair value of the car at the end of the lease term is below 400, then Z will pay to L an amount equal to the difference between 400 and the fair value of the car.

At commencement of the lease, Z expects the fair value of the car at the end of the lease term to be 400. Z therefore includes an amount of zero in the lease payments when calculating its lease liability.

Subsequently, Z monitors the expected fair value of the car at the end of the lease term. If the expected fair value of the car falls below 400, then Z will remeasure the lease liability to include the amount expected to be payable under the residual value guarantee, using an unchanged discount rate.

Has the accounting for residual guarantees changed?
Yes – there are two important differences compared with IAS 17.
  1. The amount that the lessee includes in the lease liability is different. Amounts potentially payable under residual value guarantees are included in a lessee’s minimum lease payments under IAS 17. However, the amount included under IAS 17 is the maximum exposure under the guarantee, not the expected amount payable, and
  2. A lessee remeasures the lease liability when there is a change in the amount that it expects to pay under a residual value guarantee. There is no such remeasurement under IAS 17, because the lessee’s lease liability always includes the maximum amount payable (IFRS 16.42(a)).

Taken together, these differences mean that amounts relating to residual value guarantees included in lease payments under the new standard are often lower than under IAS 17 – but the presence of a residual value guarantee creates new volatility in the gross assets and liabilities reported by the lessee. Using the fact pattern in ‘Worked example – Residual value guarantees above, under IAS 17 Lessee Z would disregard how much it expects to pay under the residual value guarantee, and include the full exposure of 400 in its minimum lease payments.

Lessees will need to carefully consider what additional processes are required to determine and document the estimate of the amount expected to be paid. They need to consider this at the commencement date and when performing subsequent remeasurements (when expectations change).

Is it always clear that a lease contains a residual value guarantee?

No – in some cases, a lessee will need to use judgement to identify whether a lease contains a residual value guarantee. This is because some features of a lease may function economically as residual value guarantees but be expressed in a different manner. Consider the two clauses in the following example.

Lessee Z leases new cars, typically for lease terms of five years. Z agrees to indemnify the lessors for excess wear and tear on the vehicles.

Lease A Lease B
Indemnification clause

Under this clause, Z will pay to the lessor the difference between the
actual sales price of the vehicle at the end of the lease term and
the ‘excellent condition’ value for the five-year-old vehicle in
accordance with a specific residual value benchmark.

Indemnification clause

Under this clause, Z will pay to the lessor a fixed amount per mile above the normal mileage according to a specific residual value benchmark for a five-year-old car.

Type of payment

The indemnification is a residual value guarantee because the amount that the lessee can be required to pay is the difference between the actual sales price and a value determined based on a benchmark.

Type of payment

The indemnification is a variable lease payment because it is not a guarantee of value but a payment based on use.

Accounting impact

Because the indemnification is a residual value guarantee, Z includes the expected amount payable in its lease liability.

Z remeasures the lease liability if its expectation of the amount payable changes

Accounting impact

Because the indemnification is a variable lease payment based on usage (see Section 4.1), Z does not include the amount payable in the
lease liability.

Instead, Z recognises the amount payable as an expense in the periods in which the liability is incurred.

 

Something else -   Expected cash flow

Renewal, termination and purchase options

At the commencement date, a lessee determines whether it is reasonably certain to exercise an option to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease early. Lessees make this determination by considering all relevant facts and circumstances that create an economic incentive to exercise an option, or not to do so (IFRS 16.18–20, IFRS 16 B37–B40).

The lessee determines the lease payments in a manner consistent with this assessment, as follows.

  • Renewal options: If the lessee is reasonably certain to exercise a renewal option, then it includes in the lease liability the relevant lease payments payable in the period covered by the renewal option.
  • Termination option: Unless the lessee is reasonably certain not to terminate the lease early, it reflects the early termination in the lease term and includes the termination penalty in the measurement of the lease liability.
  • Purchase option: If the lessee is reasonably certain to exercise an option to purchase the underlying asset, then it includes the exercise price of the purchase option in the lease payments (IFRS 16.18, IFRS 16 27(d)–(e)).

A lessee remeasures the lease liability, using a revised discount rate, if it changes its assessment of whether it is reasonably certain to exercise a renewal or purchase option, or not to exercise an option to terminate the lease early (IFRS 16.36(c), IFRS 16 40). (See Reassessment of renewal, termination and purchase options for further discussion of this reassessment.)

Worked example – Lessee purchase option: Assessing if reasonably certain to be exercised at commencement date

Lessee E enters into a non-cancellable five-year lease with Lessor R to use a piece of equipment in an evolving area of the technology sector. There is no renewal option, but E has the option to purchase the equipment at the end of the lease for 500.

Because this piece of equipment is used in an evolving area of the technology sector, which is subject to rapid change, the fair value of the equipment at the end of the lease is subject to significant volatility – estimates range from 400 to 900. The duration of the non-cancellable period of five years is significant in this context. This reflects, for example, that newer and/or better alternative assets may be introduced during the five-year lease term.

E makes an overall assessment of whether it has an economic incentive to exercise the purchase option at the end of the lease and concludes that it is not reasonably certain to do so. This includes E’s assessment of the significant volatility in the future fair value of the equipment at the end of the lease and the probability that better alternative assets may be introduced during that period.

Assessing whether E is reasonably certain to exercise the option can involve significant judgement. A shorter term (e.g. one or two years) or a different environment (e.g. lease of real estate in a historically highly predictable real estate market) could lead to a different conclusion.

Worked example – Lessee termination option: Assessing if reasonably certain not to be exercised

Lessee B enters into a 10-year lease of a floor of an office building.

There is no renewal option, but B has the option to terminate the lease early after Year 5 with a penalty equal to three months’ rent.

The annual lease payments are fixed at 100,000 per annum.

At the commencement date, the building is brand new and is technologically advanced for office buildings in the surrounding business parks, and the lease payments are consistent with the market rental rate.

Initial assessment at commencement

At the commencement date, B concludes that it is reasonably certain not to exercise the option to terminate the lease early, and therefore excludes the termination penalty from its lease liability and determines the lease term as 10 years.

Subsequent reassessment of certainty that option will be exercised

During Year 4, B sells a significant component of its business and reduces its headcount by 50%.

At the end of Year 4, similar office buildings in the area that meet B’s needs for a smaller workforce are available for lease from Year 6 for annual payments of 55,000. B estimates that the cost to move its workforce would be 40,000.

B concludes that the change in circumstance is significant, is within its control and affects whether it is still reasonably certain not to exercise the termination option (IFRS 16.20–21).

To evaluate whether it is still reasonably certain that it will not terminate the lease early, B compares the future cash outflows as follows.

Lease payments

B makes an overall assessment of whether it now has an economic incentive to terminate the lease early, including consideration of the cost saving of moving to a smaller office space.

Because the cost saving of moving to a smaller office space far exceeds the penalty for early termination, at the end of Year 4 B concludes that it is no longer reasonably certain not to exercise the option to terminate early at the end of Year 5. Note that in practice B would consider the time value of money when making this assessment.

B includes the termination penalty (25,000) in its lease payments and also determines that the remaining lease term has been reduced to one year.

B remeasures its lease liability using a revised discount rate. Any net remeasurement of the lease liability is adjusted against the right-of-use asset.

How have the accounting consequences of the ‘reasonably certain’ threshold changed?

IFRS 16 retained the ‘reasonably certain’ threshold when assessing renewal, termination and purchase options. This threshold is familiar from IAS 17, though there is additional guidance on how to apply it.

More importantly, the accounting consequences of concluding that a lessee is reasonably certain to exercise such an option are different. Under IAS 17, this conclusion typically impacts the assessment of lease classification:

  • if a lessee is reasonably certain to exercise a renewal option, then this increases the lease term, making it more likely that the lease is a finance lease; and
  • if a lessee is reasonably certain to exercise a purchase option, then this is itself an indicator that the lease is a finance lease.

Under the new standard, this conclusion generally impacts the measurement of the lease liability, because the lease payments are determined in a manner consistent with the conclusion on whether the lessee is reasonably certain to exercise the option.

Another key difference is that under IAS 17 a lessee does not reassess the likelihood that it would exercise an option unless there is a change in the terms and conditions in the lease. Under the new standard, a lessee reassesses whether it is reasonably certain to exercise an option after the occurrence of a significant event or a significant change in circumstance that would impact the assessment and is within the lessee’s control.

The new requirement to remeasure the lease liability introduces new financial statement volatility in gross assets and liabilities. Lessees will need to develop new processes to keep these options under review and to document their assessment at each reporting date.

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Lease payments – Lessor perspective

or what does a lessor include in its lease liability?

Unlike lessees, who now apply a single lease accounting model under the new  standard, lessors continue to classify their leases using the dual model that exists under IAS 17 – as either a financing or an operating lease. The lease classification test for lessors is essentially unchanged.

On commencement of a finance lease, a lessor derecognises the underlying asset and recognises a finance lease receivable. The finance lease receivable
is measured at the present value of the future lease payments plus any unguaranteed residual value accruing to the lessor.

However, lease payments are defined differently for lessees and lessors.

The key differences in how lessees and lessors identify lease payments are as follows.

IFRS 16 15, IFRS 16 20–21, IFRS 16 27(c)–(e), IFRS 16 40, IFRS 16 70(c)–(e)

Lessee Lessor
Residual value guarantee Includes in lease payments amounts expected to be payable under residual value guarantees that it provides to the lessor. Includes in lease payments residual value guarantees provided by the lessee, a party related to the lessee or a third party unrelated
to the lessor that is financially capable of discharging the obligations under the guarantee.
Non-lease components If a lessee uses the practical expedient in paragraph 15 of the new standard not to separate non-lease components, then it includes in the lease payments the associated payments allocated to non-lease components. Excludes payments allocated to non-lease components from the lease payments
Reassessment of  initial assessment

Both use the same guidance for assessing whether  they are reasonably certain to exercise options to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease.

However, unlike lessees, lessors do not reassess their initial assessment of lease term and purchase options.

The IASB has noted that most constituents did not consider symmetry between lessee and lessor accounting to be a high priority. The inconsistencies noted above were acknowledged by the IASB as it finalised the standard. The risk is that these inconsistencies may give rise to structuring opportunities in more complex arrangements

Payments that depend on an index or rate

Initial measurement of the lease liability

Variable lease payments that depend on an index or rate are initially included in the lease liability using the index or rate as at the commencement date of the lease (IFRS 16.27(b)).

This approach applies to, for example, payments linked to a consumer price index (CPI), payments linked to a benchmark interest rate (e.g. LIBOR) or payments that are adjusted to reflect changes in market rental rates (IFRS 16.28).

Reassessment of the lease liability

After the commencement date, lessees are required to remeasure the lease liability to reflect changes to the lease payments arising from changes in the index or rate. Any remeasurement is generally adjusted against the right-of-use asset (IFRS 16.36(c), IFRS 16.39).

Lessees reassess the lease liability by discounting the revised lease payments in the following scenarios (IFRS 16.42(b), IFRS 16.43, IFRS 16.B42).

Lessee remeasures lease liability using revised lease payments and…

an unchanged discount rate when:

  • future lease payments change to reflect market rates (e.g. based on a market rent review) or a change in an index or rate used to1

  • determine the lease payments; or–the variability of payments is resolved so that they become in-substance fixed payments.

a revised discount rate when:

  • future lease payments change as a result of a change in floating interest rates.

IFRS 16’s approach to accounting for payments that depend on an index or a rate is a change in practice for most companies. Under IAS 17, the usual practice is to treat these payments as contingent rents, recognised in the period in which they are incurred.

The new approach is simple to apply, insofar as lease payments are always based on current information. For example, a lessee is never required to forecast the future amount of an index or a rate. However, remeasuring the lease liability for changes in the value of an index or rate introduces new balance sheet volatility in gross assets and liabilities, and system challenges.

Payments that depend on an index

On lease commencement, variable lease payments that depend on an index are measured using the index as at the commencement date of the lease (IFRS 16.27(b)).

When the change in future lease payments is a result of a change in an index (or rate), the lessee remeasures the liability using an unchanged discount rate (IFRS 16.42(b), IFRS 16.43).

Worked example – Payments that depend on an index

IFRS 16.27–28, IFRS 16 39, IFRS 16.42(b), IFRS 16.43, IFRS 16 IE6

Company Y rents an office building. The lease term is five years and the initial annual rental payment is 2.5 million. Payments are made at the end of each year. The rent will be reviewed every year and increased by the change in the CPI. The discount rate is 5%.

Initial measurement of the lease liability

To measure the lease liability on commencement, Y assumes an annual rental of 2.5 million.

Lease payments

Subsequent reassessment of lease liability

During Year 1, the CPI increases from 100 to 105 (i.e. the rate of inflation over the preceding 12 months is 5%).

Because there is a change in the future lease payments resulting from a change in the CPI, which is used to determine those lease payments, Y needs to remeasure the lease liability.

At the end of Year 1, Y calculates the lease payment for Year 2 as 2.6 million (2.5 million x (105 / 100)).

Accordingly, Y remeasures the lease liability as follows. The subsequent remeasurement of the lease liability is adjusted against the right-of-use asset.

Lease payments

Worked example – Amortisation of lease liability and change in payment linked to an index

Lessee Y enters into a lease for a five-year term with Lessor L for a retail building, commencing on 1 January. Y pays 155 per year, at the end of each year.

Y’s incremental borrowing rate is 5.9%. Additionally, the lease contract states that the lease payments for each year will increase on the basis of the increase in the CPI for the preceding year.

At the commencement date, the CPI for the previous year is 120 and the lease liability is 655, based on annual payments of 155 discounted at 5.9%.

Assume that initial direct costs are zero and there are no lease incentives, prepayments or restoration costs. Y records the following entries for Year 1.

Lease payments

To recognise lease at commencement date

Lease payments

To recognise payment and expense for Year 1

Subsequent reassessment of lease liability at end of Year 1

At the end of Year 1, the CPI increases to 125. Y calculates the revised payments for Year 2 and beyond, adjusted for the change in CPI as 161 (155 x 125 / 120).

Because the lease payments are variable payments that depend on an index, Y adjusts the lease liability to reflect the change based on an unchanged discount rate.

The adjustment is calculated as the difference between the original lease payments (155) and the reassessed payment (161) over the remaining four-year lease term, discounted at the original discount rate of 5.9%.

Lease payments

To recognise remeasurement at end of Year 1

What common types of indices do lease payments depend on?

In practice, it is common for lease agreements to include periodic rent review clauses that depend on a published index. These clauses adjust contracted lease payments to reflect changes in inflation measures and other factors.

Common indices used include the following.

  • Consumer price index (CPI).
  • Producer price indices (PPIs).
  • Retail prices indices (RPIs).
  • House price indices.
  • Average earnings indices.

When does the guidance apply?

The guidance described above applies only when the lease payments depend on the future – i.e. uncertain – level of an index. It does not apply to fixed uplifts designed to reflect expected changes in an index.

Consider two different rent adjustment clauses, as follows.

Lease A Lease B
Rent adjustment clause

The rent for Year 1 is 100. At the end of each year, the rent is adjusted to reflect the change in RPI over the preceding months. Average annual
inflation over the previous three years has been 5%.

Rent adjustment clause

The rent for the first year is 100. Rents increase by 5% in each subsequent year. This increase is designed to compensate the lessor for expected changes in RPI, because average annual inflation over the previous three years has been 5%.

Type of payment

The rents depend on an index – i.e. on the future amount of RPI. On lease commencement, the lessee includes in the lease liability the annual lease payments of 100. At the end of Year 1, the lessee remeasures the lease liability to include future lease payments based on the then level of RPI.

Type of payment

The rents are fixed; they do not depend on the future value of RPI. On lease commencement, the lessee includes in the lease liability the annual lease payments that increase by the fixed factor of 5% – that is, 100, 105, 110, 116 etc. There are no future changes in lease payments that require the lessee to remeasure the lease liability.

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What if a rent review mechanism contains an embedded derivative?

Under IFRS, derivatives embedded in a lease that are considered not closely related to the lease host have to be separated and accounted for under IFRS 9 Financial Instruments. This is because although IFRS 16 includes requirements for features of a lease that may meet the definition of a derivative (e.g. options), the new standard was not developed with accounting for derivatives in mind (IFRS 16.BC81).

As an example, a lease agreement with variable lease payments adjusted for two times the change in CPI needs to be separated and accounted for under IFRS 9 because the feature is considered leveraged.

Conversely, an inflation-indexed embedded derivative in a lease contract may be considered closely related to the lease if:

  • the index relates to inflation in the country in which the leased asset is operated; and
  • the feature is not leveraged.

In this case, the feature is not separated and, instead, the whole payment is accounted for under IFRS 16.

Payments that depend on a rate

Consistent with payments that depend on an index, variable lease payments that depend on a rate are initially measured using the rate as at the commencement date of the lease (IFRS 16.27(b), IFRS 16.39, IFRS 16.42(b)).

The lease liability is subsequently remeasured if the variable lease payments change as a result of a change in the relevant rate (e.g. LIBOR).

The lessee remeasures the liability using an unchanged discount rate when the change in future lease payments results from a change in a rate, with the exception of floating interest rates (IFRS 16.42(b), IFRS 16.43).

In the case of a floating interest rate, the lessee revises the discount rate for the change in the interest rate.

Worked example – Payments that depend on a rate: Initial measurement and subsequent remeasurement
Lessee C enters into a five-year lease of a car. The lease payments are paid at the beginning of each year and are determined as follows.
  • The discount rate is 5%.
  • On commencement, LIBOR is 2%.
  • The initial fair value of the asset is 10,000.
  • Annual lease payments in Years 1–4 are determined as LIBOR x 10,000,based on LIBOR at the date of payment.
  • The payment in Year 5 is determined as (LIBOR x 10,000) + 10,000.

Initial measurement of the lease liability

On commencement, C determines the lease liability as follows.

  • The payment of 10,000 in Year 5 is fixed, and therefore is included.
  • The payments in Years 1–5 determined as LIBOR x 10,000 represent variable lease payments that depend on a rate, and therefore are also included.

At commencement, C makes the payment for Year 1 and then measures the lease liability and right-of-use asset as follows.

Lease payments

At commencement, C records the following entry.

Lease payments

To recognise lease at commencement date

At the end of Year 1, C records the following entries.

Lease payments

To recognise depreciation and interest expense for Year 1


At the beginning of Year 2, LIBOR increases to 2.5%. Using a revised discount rate of 4.5%, B remeasures the lease liability and right-of-use asset, and then makes payment for Year 2.

Lease payments

* The right-of-use asset is measured as the balance on commencement (9,136) less depreciation in Year 1 (1,827) plus the adjustment for remeasurement of the lease liability (317).

Subsequent reassessment of the lease liability – Year 2

Because the lease payments are determined using LIBOR at the date of payment, the lease payment for Year 2 is 250 (10,000 x 2.5%). C records the following entries during Year 2.

Lease payments

To recognise remeasurement of lease liability at beginning of year 2

Lease payments

To recognise payment and depreciation for  Year 2

Subsequent reassessment of the lease liability – Year 3

At the start of Year 3, LIBOR decreases to 2.4% and C’s discount rate is revised to 5.1%. C remeasures its lease liability and right-of-use asset, and then makes payment for Year 3.

Lease payments

During Year 3, C records the following entries.

Lease payments

To recognise remeasurement of lease liability at beginning of year 3

Lease payments

To recognise payment and expense for Year 3

Lessor considerations

There are no differences in the identification of lease payments for lessees and lessors regarding lease payments that depend on an index or a rate, though the accounting consequences may be different due to the different accounting models for lessees and lessors.

 

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