*Article updated on May 20, 2020.*
For lessees on your IFRS financial statements
The COVID-19 outbreak has significantly affected businesses. Companies have had to close their offices, stores, and retail locations to the public, resulting in either significantly reduced revenue and cash inflow, or in many cases, no revenue at all. As a result, companies are looking for ways to reduce costs where they can. For many companies, one of the most significant fixed costs is rent or lease payments for not only the physical premises but also for vehicles and equipment required to run the business.
As a strategy to reduce the costs associated with rent and lease payments businesses can either take advantage of concessions granted by the lessor, they can renegotiate, or terminate the lease altogether. If this strategy is being considered, there are financial reporting impacts under IFRS 16 Leases (“IFRS 16") that will need to be reflected by the lessee in the period that the lease or rent concessions are made.
Rent concessions- Enforceable rights
Rent concessions can take the form of waived or reduced rent for a period of time. Under IFRS 16, the accounting impact of rent concessions depends on whether or not the changes are based on enforceable rights that the lessee has under either the lease agreement or the law.
Enforceable rights may exist in the lease agreement itself, including in a “force majeure” clause. Under such a clause, the lessee may be entitled to rent concessions because of its inability to fulfil its obligations under the contract due to ‘acts of God’. If the contract does not explicitly include enforceable rights, local laws in the jurisdiction that governs the lease agreement may create an enforceable right. For instance, a law that forbids eviction due to non-payment during these difficult times may create an enforceable right. Whether or not there are enforceable rights explicitly in the contract or created by law is a legal issue, and companies should speak to their legal counsel when making this determination.
If rent concessions granted by the landlord are based on enforceable rights that existed at the time the lease was entered into, the concession is considered to be a variable payment. IFRS 16.38 requires variable payments that are not considered in the initial measurement of the lease liability to be accounted for in the period that it relates to, which will result in a reduction of the lease liability and a gain in profit or loss. Effectively, in times where payments are being waived or deferred, this will result in “negative rent” in profit or loss.
Rent concessions - not based on enforceable rights and other amendments
IFRS considers rent concessions that are not based on enforceable rights, or other changes to terms in the contract such as reducing the size of the leased space or termination, to be modifications. Modifications are either accounted for as separate agreements or continuation of existing agreements.
Modifications- Separate agreement
Where a lease is modified, IFRS 16.44 requires the determination of whether the changes result in the termination of the existing lease and entering into of a new one. This is determination is based on two criteria:
- Whether the lessee has been granted an additional right of use that is not included in the original lease contract such as an increase in leased space or an increase in lease term; and
- Whether the increase in the lease payment required under the modification is commensurate with the stand-alone price for the additional right of use.
Due to the negative impact of COVID-19 on most businesses we anticipate that it would be rare for a lease modification to meet the criteria above to be recognized as a separate lease.
Modifications- Continuation of an existing lease
Under IFRS, the impact of accounting for a modification of an existing lease depends on the nature of the modification.
In all cases IFRS 16.45 requires that the lease liability be remeasured using updated inputs, including the determination of a new incremental borrowing rate, revised lease payments and revised lease term. Given the recent changes to interest rates as well as expected changes to credit ratings, the change in incremental borrowing rate could result in a material impact to the lease liability.
The remeasurement is accounted for under IFRS 16.46 as follows:
- Where the modification relates to decreasing the scope of the lease, the right of use asset is adjusted and the difference between that and the portion of the lease liability associated with the scope change is recognized as a gain or loss in profit or loss; and
- For all other modifications, the adjustment is recorded against the right of use asset and there is no impact on profit or loss.
Accounting relief- Amendment to IFRS 16
On May 15th, 2020 the International Accounting Standards Board approved an amendment to IFRS 16 related to accounting for COVID-19 related rent concessions. The final amendment will be issued on or around May 28, 2020.
The practical expedient allows lessees that are party to a COVID-19-related concession to make an election not to assess whether the concession is a lease modification. This practical expedient saves lessees from assessing each individual contract to determine if there are enforceable rights and instead apply paragraph 38 and account for the rent concession as a variable lease payment.
This election is only applicable to concessions that meet the following criteria:
- The change in lease payments results in revised consideration for the lease that is substantially the same as, or less than, the consideration for the lease immediately before the change; and
- Any reduction in lease payments only affects payments originally due on or before June 30, 2021; and
- There is no substantive change to other terms and conditions of the lease.
It should be noted that for criteria b) above, a concession that reduces payments until June 30, 2021 and then increases payments in subsequent years would meet this condition.
If concessions do not meet the criteria to apply the practical expedient, or companies choose not to apply it, then modification accounting may be appropriate. The application as described in Modifications- Continuation of an existing lease, and the resulting calculations, can be complicated and judgmental under IFRS 16.
Deferred lease payments
Where there is no change in the amount of the lease payments, but a deferral has been granted (i.e. a change in the timing of when lease payments are due), there is no impact on the financial statements. Companies will continue to accrue interest on the lease liability, and then reduce the liability when payments are made in accordance with IFRS 16.36 (b).
Lessees that choose to apply the practical expedient are required to disclose that fact as well as the amount recognized in profit or loss to reflect changes in lease payments that arise from COVID-19 related rent concessions. However, lessees are not required to disclose the information required by paragraph 28(f) of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, which means lessees do not need to disclose the effect of applying an IFRS for the first-time in the current period.
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