COVID 19: Accounting for lease modifications

The COVID-19 pandemic is requiring those responsible for the preparation of financial statements to reconsider whether assumptions and assessments previously made are still valid and appropriate which in turn is creating an additional burden on entities all over the world. In particular, IFRS 16 has become an area of focus for entities and the International Accounting Standards Board (IASB).

The IASB has therefore added a practical expedient to provide relief for lessees from lease modification accounting for rent concessions related to COVID-19. We explain the current accounting requirements, the practical expedient and how to apply it.

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Lessors are providing lessees with rent concessions. These can be in the form of rent holidays or rent reductions for an agreed timeframe (possibly followed by increased rentals in future periods). In some jurisdictions, governments are making rent concessions a requirement. In others they are merely encouraging them. These concessions will have major impact for some lessees, particularly in the retail and hospitality industries which in many cases have been forced to temporarily close their premises.

IFRS 16 contains specific requirements on accounting for lease modifications. Rent concessions that change the overall consideration for the lease are in the scope of these requirements. Lessees are currently required to assess whether rent concessions are lease modifications and, if they are, apply specific accounting guidance. This can be burdensome, especially for large portfolios of leases with different features and different types of concessions. Entities already have significant pressures upon them as a result of this pandemic and what is set out in IFRS 16 just adds to the burden.

Lessor modifications

Finance leases

Lessor accounting for modification of finance leases is detailed in IFRS 16.79 to 80. Similar to lessee accounting, when the scope of a lease increases and the consideration changes commensurately, a separate lease exists. Where this is not the case, the lessor must:

• reassess the accounting for the lease and determine if the lease would have been considered an operating lease if the modification had been known; and, if so:
  • create a new lease from the effective date of the modification; and
  • reclassify the lease receivable balance at the date of modification to property, plant and equipment
• where the lease remains a finance lease, the lease receivable is remeasured by the application of IFRS 9. In such a case, assuming that that the receivable is classified as amortised cost, the change in future cash flows is a remeasurement event resulting in a gain or loss within profit or loss applying the catch-up guidance (ie discounting the revised contractual cash flows using the original discount rate).

Operating leases

IFRS 16 provides only limited guidance on modification of operating leases from a lessor’s perspective. It requires that any modification be considered a new lease, and that any remaining prepayments and accruals are included in the accounting for this new lease. IFRS 16 does not state whether balances arising from the lessor’s straight-lining calculation are considered to be accruals or prepayments but our view, consistent with the approach when applying IAS 17, is that they are.

In such an instance, if the new lease continues to be classified as operating, the future cash flows are recognised on a straight line (or other systematic) basis, adjusted for any prepayments or accruals. The expense recognition pattern should ensure the balance is written down to zero at the end of the lease. Another systematic basis could be that, for example, the pattern of recognition of the lease income reflects the lease payments. So if there was a three-month rent-free period, no lease income would be recognised for that three-month period.

Impairment
Due to the decrease in estimated future cash flows, impairment indicators may exist such that impairment of the individual assets should be considered.

Lessee modifications

Reasssessment vs modification

Lease modification and reassessment of the lease liability are two different concepts with potentially different accounting outcomes. Generally, a reassessment takes place when there are changes in lease payments based on contractual clauses included in the original contract – such as changes in CPI, a market price adjustment, a change in any price guarantee arrangement that might appear in the lease contract (IFRS 16.42). In such an instance, future cash flows are reforecast and present-valued utilising the discount rate set in the initial measurement of the lease (IFRS 16.43).

A lease modification (as considered in this document – does not address changes in leased asset, such as decreases in leased space) arises when the lease contract is altered such that future cash flows and/or the scope of the lease change. Where an increase in scope occurs, and the payment for this increase in scope is commensurate, a separate lease is accounted for (IFRS 16.44).

Otherwise, the original lease is remeasured by:

• identifying a revised discount rate appropriate to the revised lease term, underlying asset and the lessee
• determining the net present value of future cash outflows using that revised discount rate
• adjusting the remaining right-of-use asset for the increase or decrease in the lease liability. If the adjustment exceeds the carrying value of the right-of-use asset this excess is recognised as a gain in profit or loss.