The COVID-19 coronavirus pandemic is significantly affecting economic activity and sentiment around the world, with disruption to business operations, supply chains and production lines.
Companies are making business decisions that affect their lease contracts in response to uncertainty caused by COVID-19. As a result, lease contracts containing renewal and termination clauses may need to be reassessed to determine whether there is any change to the lease term. Any changes in the lease term could have a significant impact on the carrying amount of lease assets and liabilities.
Further, lease contracts with purchase options may need to be reassessed if the lessee concluded initially that exercise of the purchase option was reasonably certain.
Companies may need to remeasure lease assets and liabilities due to changes in economic incentives to exercise options in their lease contracts.
Reassessment of options
IFRS 16 Leases requires a lessee to determine whether it is reasonably certain:
In doing so, lessees consider all relevant facts and circumstances that create an economic incentive for them to exercise an option or not. [IFRS 16.19]
A lessee remeasures its lease liability when a significant event or a significant change in circumstances within its control changes any of its assessments about what is reasonably certain – i.e. to exercise a renewal or purchase option or not to exercise an option to terminate the lease early. [Insights 5.1.330.10]
A lessee applies judgement when identifying significant events or significant changes in circumstances that trigger reassessment of these options. The lessee then considers the effect of current economic incentives to determine whether it is reasonably certain to exercise, or not to exercise, each option.
For example, a retailer concludes that revised commercial plans developed in response to the COVID-19 outbreak trigger a reassessment of renewal options in its store leases. In assessing whether it is reasonably certain to exercise the renewal options, the retailer considers the economic incentives existing at the date of the reassessment.
Accounting for reassessments
If a lessee changes its assessment of whether it is reasonably certain to exercise a renewal or purchase option, or not to exercise an option to terminate the lease early, then it remeasures its lease liability using a revised discount rate. The lessee adjusts the carrying amount of the right-of-use asset for the remeasurement of the lease liability. If the carrying amount of the right-of-use asset is reduced to zero, then any further reductions are recognised in profit or loss. [IFRS 16.39, 40(a)–(b)]
As a result, reassessment can have a significant impact on the carrying amount of lease assets and liabilities at the date of the reassessment. In turn, this may affect the amount and profile of depreciation and interest expense recognised subsequently.
For example, suppose a company that leases a vehicle initially assessed that it was reasonably certain to exercise an option to purchase the vehicle at the end of the lease term. As a result, it included the exercise price of the purchase option in the initial carrying amount of its right-of-use asset and lease liability, and depreciated the right-of-use asset over the useful life of the vehicle. Subsequently, the company concludes that it is not reasonably certain to exercise the purchase option. It therefore remeasures the right-of-use asset and lease liability, and depreciates the right-of-use asset over the lease term.
What about lessors?
Lessees and lessors use the same guidance for assessing whether they are reasonably certain to exercise options on lease commencement. However, unlike lessees, lessors do not generally reassess their initial assessment of the lease term and purchase options.
Changes in the non-cancellable period of a lease
Decisions that companies make during this uncertain time may also affect how the non-cancellable period of a lease is determined. For example, the non-cancellable period of a lease will change if:
IFRS 16 requires a lessee to revise the lease term and remeasure the lease liability using a revised discount rate when there is a change in the non-cancellable period of a lease.
The International Accounting Standards Board is proposing relief to lessees on rent concessions directly related to COVID-19. Read our web article.
References to ‘Insights’ mean our publication Insights into IFRS
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