It is common for a lessee and lessor to negotiate changes to the terms and conditions of a lease contract. Any resulting change in the scope or the consideration for a lease is accounted for as a lease modification. Here we respond to the common questions we are hearing on the impact of lease modifications on transition to AASB 16 Leases.
Let’s pose a scenario that Company Y entered into an operating lease of an office building that runs from 1 July 2010 to 30 June 2020 with no extension or early termination options. Two years before expiry, on 1 July 2018, Company Y and the lessor agree to amend the terms and conditions of the original contract to extend the lease for a further five years after the original expiry date (i.e. till 30 June 2025).
On 1 July 2019, the date of initial application of AASB 16, Company Y elected the modified retrospective method for transition, electing to apply the option where the right-of-use (ROU) asset is measured retrospectively as if the new standard had always been applied.
Question 1: Do previous lease modifications affect the measurement of the ROU asset on transition to AASB 16?
Interpretive response: Yes. As Company Y applies the modified retrospective method and elects the option to measure the ROU asset retrospectively, it measures the ROU asset taking into account all previous lease modifications between commencement and the date of initial application (DIA). It uses the incremental borrowing rate (IBR) at the DIA in performing this calculation.
Accordingly, Company Y measures the lease liability and the ROUA at commencement of the lease. To reconstruct the ROU asset, the increase in the lease liability at the effective date of the modification needs to be calculated. At the effective date of the modification, the lease liability is remeasured to include the lease payments for the extended period (2020 to 2025). Company Y uses the IBR at the DIA resulting in an increase to the lease liability of $291,000 from $267,000 to $558,000. The increase in liability of $291,000 is adjusted against the ROU asset, resulting in a ROU asset of $512,000. This adjustment to the ROU asset would have a flow-on impact on subsequent depreciation expense.
On the other hand, on adopting the standard, Company Y measures the lease liability at the present value of remaining lease payments discounted using its IBR at the DIA (i.e. $492,000). The difference between the reconstructed ROU asset and the lease liability is recognised in opening retained earnings at the DIA [i.e. $492,000 – $438,000 = $54,000]. The calculations are illustrated below.
|Lease Liability||ROU asset|
|Before modification (at 1 July 2018)||$267,000||$221,000|
|Increase in lease term – adjustment to the ROU asset||$291,000||$291,000|
|At modification (at 1 July 2018)||$558,000||$512,000|
|Depreciation of ROU asset||($74,000)|
|Balance at DIA (at 1 July 2019)||$492,000||$438,000|
Question 2: Can the Company use the practical expedient on hindsight to calculate the ROU asset retrospectively when applying the modified retrospective method?
Interpretive response: No. Company Y cannot measure the ROU asset retrospectively as if the lease term was 15 years at the commencement date. This is because the original contract does not contain the option to extend.
On transition, a lessee is permitted to adopt the standard retrospectively or follow a modified retrospective method [AASB 16:C5].
If a lessee applies the modified retrospective method, it recognises the cumulative effect of initially applying the standard as an adjustment to the opening balance of retained earnings at the date of initial application [AASB 16:C7].
Under the modified retrospective method, for leases previously classified as operating leases, a lessee is permitted to choose, on a lease-by-lease basis, how to measure the right-of-use asset using one of two methods:
Under the modified retrospective method, a lessee may use hindsight, such as in determining the lease term if the contract contains options to extend or terminate the lease [AASB 16:C10(e)].
If you would like to discuss the implementation of the new standard for your organisation, please contact us.