Many leases (particularly property leases) include renewal and termination options that permit the lessee (and/or lessor) to vary the term (length) of the lease.
In such cases, NZ IFRS 16 requires an entity to initially determine, and then subsequently reassess, what it expects the reasonably certain lease term to be, given all relevant facts and circumstances as at the beginning of the lease.
Making the assessment of what is reasonably certain requires consideration of various factors, including whether the options are held by the lessee, lessor, or both.
For more detailed guidance on this issue, refer to Chapter 4.2 and 5.6 of BDO’s comprehensive IFRS in Practice – IFRS 16 Leases publication.
Accounting for a change
When an entity revises its use or non-use of renewal and termination options within its existing lease agreement (thereby changing the lease term for accounting purposes), the present value of the remaining lease payments over the revised lease term is recalculated.
This includes updating the lease payments to be made if, for example, the use of a termination option requires a termination fee to be paid to the lessor.
The discount rate used to perform this recalculation is NOT the original discount rate that was determined when the lease was originally recognised.
Instead, the applicable current discount rate based on all facts and circumstances as at the date of adjustment is required to be used.
There are various reasons as to why the current discount rate at the date of the adjustment may now be different from the original discount rate that was originally determined at the beginning of the lease, including (but not limited to):
- Changes in the interest rate environment over the intervening period (i.e. changes to the base rate of lending, such as changes to the Official Cash Rate (OCR)).
- Changes in the credit risk of the entity over the intervening period (noting that the discount rate used for NZ IFRS 16 is entity specific)
- The revised term of the lease (i.e. longer (shorter) lease terms typically attract higher (lower) interest rates), and/or
- The revised total remaining lease payments (i.e. the larger (smaller) the total remaining lease payments the higher (lower) the interest rate).
For more details on discount rates to be applied under NZ IFRS 16, refer to BDO’s previous Cheat Sheet publication Applying Discount Rates under the New Lease Standard (NZ IFRS 16).
The difference between the previous carrying amount of the lease liability and the revised present value is made as equal and opposite adjustment to the lease liability and right-of-use asset, meaning that no gain or loss is recognised in profit or loss as a result of the change.
This is unless (i) the lease term has decreased, and (ii) the difference is greater than the carrying amount of the right-of-use asset.
In this case, the right-of-use asset is reduced to nil, and any residual amount of the difference is recognised in profit or loss.