Lease accounting continues to be a subject that draws interest from investors, regulators and, again this year, standard setters. Here we look at the recent changes to both UK and International standards, an area of ongoing challenge and recent key messages from the FRC.
As a result of the economic impact of the global pandemic some lessees have been granted rent concessions e.g. one-off rent reductions, rent waivers or payment holidays. The International Accounting Standards Board (IASB) has issued Covid-19-Related Rent Concessions which amends IFRS 16 and simplifies how lessees account for such rent concessions. The simplification is to allow companies not to account for rent concessions as lease modifications, which would be potentially complex and, among other things, require the derivation of a new borrowing rate for each lease for which a rent concession had been received. This simplification or rather “practical expedient” may only be applied if certain conditions are met, as follows:
Whether or not to apply the practical expedient is an accounting policy choice. If the company chooses to apply it, the resulting accounting depends on the specific nature of the rent concession. For instance, if the concession is a one-off reduction in rent, it will be accounted for as a variable lease payment and be recognised in profit or loss in the period in which the release from the payments is granted, with a corresponding decrease in the lease liability. No practical expedient is provided for lessors.
The amendments are effective for periods beginning on or after 1 June 2020, with earlier application permitted and have been endorsed by the EU with effect from the same date.
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FRS 102 did not explicitly specify how to account for changes in lease payments resulting from rent concessions. The FRC recently issued an amendment to Section 20 of FRS 102 for Covid-19-related rent concessions applying only to temporary rent concessions occurring as a direct consequence of the pandemic and within a limited timeframe. The conditions for application are the same as those contained in the IFRS 16 amendment (as set out above).
The amendment requires entities to recognise changes in operating lease payments that arise from Covid-19-related rent concessions on a systematic basis over the periods that the change in lease payments is intended to compensate (rather than, for example, being spread over the entire lease term). Unlike the amendment to IFRS 16, this amendment is mandatory and applies to both lessees and lessors.
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Although establishing the term of a lease is nothing new, it takes on a new significance under IFRS 16 as it now has a direct effect on the assets and liabilities recognised in a company’s balance sheet, rather than just being an item that affects disclosures in the notes.
In considering a question about lease term, the IFRS Interpretations Committee (IFRIC) concluded that a company should always consider the broader economics of a contract, not just the narrow contractual terms, when determining the lease term.
For example, for cancellable leases that continue indefinitely until either party gives notice to terminate, the lease term is beyond the date on which the contract can legally be terminated if either party has an economic incentive not to terminate or exit the lease such that it would incur a penalty that is more than insignificant. Following IFRIC’s guidance, the assessment of whether or not any penalty is more than insignificant will not only include consideration of any specific penalties set out in the contract but also the broader economic effects that would be felt by the parties on termination. For example, for lessees the penalty might be more than insignificant if there is significant investment in leasehold improvements that would become redundant if the lease were terminated.
It will be important that companies reflect this guidance in any reassessments of lease term that are triggered as a result of the companies’ actions to address the occurrence of significant events or changes in circumstances arising from the recent economic conditions.
To find out more, read our publication:
In September 2020, the FRC published a review into the reporting of leases in the first year that IFRS 16 was applicable and identified several important areas where companies need to improve their reporting. Their main observations were companies relied too much on boilerplate language when explaining their accounting policy for leases and instead should tailor their descriptions to match their particular circumstances, that descriptions of significant judgements in the application of the policy were inadequate and few companies provided the broader disclosures required by the standard to assist readers in understanding the exposure to future cash outflows from leases e.g. variable lease payments and the impact of extension options not recognised in the lease liability. Their review was based on a sample of 20 companies in industries where they expected IFRS 16 to have the biggest impact.
The full FRC report can be found here.
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