Subsequent changes in leases (NZ IFRS 16)

Background

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.

Comment

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.

Background

Many leases (particularly property leases) include clauses that subsequently change (typically increase) the lease payments to be paid by the lessor, by typically either undertaking a market rent review, and/or pegging the lease payments to an inflation-linked index (such as CPI), at predetermined intervals (i.e. annually, bi-annually, at renewal date etc.)

Such clauses result in what NZ IFRS 16 terms as variable lease payments.

The impacts of variable lease payments are not estimated and then built into the lease payment stream when an entity determines the present value of the remaining lease payments.

For more detailed guidance on this issue, refer to Chapter 5.1 and 5.6 of BDO’s comprehensive IFRS in Practice – IFRS 16 Leases publication.

Accounting for a change

As and when lease payments change as a result of market rent reviews and/or inflation (CPI) clauses in the original lease agreement, the present value of the revised lease payments over the remaining lease term is recalculated.

The discount rate used to perform this recalculation is the original discount rate that was determined when the lease was originally recognised (i.e. the discount rate is not updated).

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.

Background

As a result of COVID-19, many lessors and lessees entered into agreements (or were required by law) to amend lease payments due to the disruption that COVID was causing in practice (i.e. enforced shut-downs, and/or restricted business operating practices).

Where such and event was not contemplated within the original terms a lease agreement, NZ IFRS 16 as originally written would have required such changes to be accounted for as modifications (refer to 4. below) which would have required (amongst other things) a new current discount rate to be determined.

Realising the immense impracticality of requiring every affected (NZ)IFRS reporting entity around the world to comply with such a requirement, an amendment to (NZ)IFRS 16 was fast-tracked and released in May 2020.

The amendment provides an alternative (simplified) approach to addressing changes to lease payments as a result of COVID-19, so long as certain criteria are met.

Accounting for a change

As and when lease payments are renegotiated as a result of COVID-19, the present value of the revised lease payments over the remaining lease term is recalculated.

The discount rate used to perform this recalculation is the original discount rate that was determined when the lease was originally recognised.

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 profit or loss.

The exact mechanics of the recalculation will depend on the specific nature of the renegotiated lease payments, which could include (for example):

1. A deferral of lease payments.
2. A deferral of lease payments with proportionate increase at end of lease term.
3. An unconditional forgiveness of rent.
4. A conditional forgiveness of rent.
5. A conversion of fixed lease payments to variable lease payments.
6. A forgiveness of accrued and unpaid rent.

For more detailed guidance on this issue, and worked examples of the above, refer to BDO’s comprehensive IFR Bulletin – Accounting for Rent Concessions: Lessee FAQs publication, as well as BDO’s previous Cheat Sheet publication COVID-19 related lease payment changes (NZ IFRS 16).

Background

During the course of a lease, the lessee and lessor may formally amend the terms of the lease for various reasons.

These changes may increase (or decrease) the quantum of what is being leased (scope), and/or revise the remaining term of the (and associated renewal and/or termination options).

NZ IFRS 16 refers to such amendments as modifications.

Accounting for a change

The accounting treatment to be applied depends on the exact nature of the modification.

Scenario 1 – The scope of the lease has increased, and the lease payments have increased by a consummate amount (i.e. representing the fair, stand-alone market price of the additional quantum now being leased)

1. In this case, the modification is treated as a separate, stand-alone lease.
2. Accordingly, the usual accounting treatment requirements of NZ IFRS 16 are applied to the new, modified terms.

Scenario 2 – The scope of the lease has decreased

1. In this case, the modification is not treated as a separate, stand-alone lease.
2. The modification is accounted for in two steps:
   1. The right-of-use asset and lease liability are decreased by their relative amounts compared to the original lease, taking the difference to profit or loss.
   2. The lease liability is then remeasured using the current discount rate that applies as at the date of adjustment. 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.

Scenario 3 – All other scenarios (including if the scope is increased, but the lease payments have not increased by a consummate amount)

1. In this case, the modification is not treated as a separate, stand-alone lease.
2. The lease liability is then remeasured using the current discount rate that applies as at the date of adjustment. 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.

For more detailed guidance on this issue, refer to Chapter 5.7 of BDO’s comprehensive IFRS in Practice – IFRS 16 Leases publication, including worked examples of:

• Lease Modification that is a Separate Lease
• Lease Modification that Increases the Lease Term
• Lease Modification that Decreases Scope
• Lease Modifications that Reduce the Lease Term Only

From the discussion above, it should be clear that the initial adoption of NZ IFRS 16 does not result in a “set-and -forget” scenario for leases.

That is, there are a number of potential scenarios that will require subsequent accounting adjustments to be quantified and recognised in terms of lease accounting.

Accordingly, entities will need to revisit the robustness and functionality of their existing lease accounting treatment program, whether this is being managed either in:

1. Spreadsheets
   1. And if so, ensuring that there are adequate safeguards to ensure that the manual update of the spreadsheets can incorporate, and correctly process, all manner of various subsequent changes that may occur.
2. Dedicated lease software
   1. And if so, ensuring (with the software provider) that the software has sufficient functionality to incorporate, and correctly process, all manner of various subsequent changes that may occur.

Current and potential users of BDO’s very own lease software product, BDO LEAD (whether by direct licence, of via BDO’s unique, cost effective, outsourced Managed Lease Services arrangement) can rest assured that BDO LEAD has sufficient functionality to incorporate, and correctly process, all manner of various subsequent changes that may occur (one of the benefits of using lease software that is designed by accountants, for accountants).

For entities that have previously decided to manage the accounting treatment of their leases on spreadsheets, but who have now decided consider a step-up to a dedicated lease software solution (or has had this step-up strongly recommended by their Auditor, Directors, and/or Audit Committees), we would be more than happy to discuss how BDO LEAD would be a powerful option to consider.