The standard AASB 16 Leases is now in its second year of operation for public sector entities. In this article, we cover a brief update on some specific accounting issues that you may not have dealt with on transition.
Rent escalation clauses that depend on a future index or rate (for example, consumer price index (CPI) or market review) are considered variable lease payments and are not included in the initial recognition of the lease liability and right-of-use asset. Entities should not attempt to estimate or predict future variable increases, and instead should assume no change until the future change happens.
So what happens when rental payments change under these clauses? For example, if rent increases on 1 July each year following a CPI adjustment or market rent review, the entity should adjust the lease liability and right-of-use asset on 1 July when the change in rent payments takes effect. At 30 June of the previous financial year, the lease liability does not take into account this increase or any estimate of future changes. There is no post-balance-date adjustment to the 30 June financial statements, even if the amounts become known before management approves the financial statements.
The entity should remeasure the lease liability on 1 July using the new rental payments for the remainder of the lease term, and make the corresponding adjustment to the right-of-use asset. As the value of the right-of-use asset has changed, this will change the amount of depreciation expensed each year. The interest rate used to discount the future rentals is not adjusted.
Renegotiating a lease
Renegotiating lease payments (other than concessions relating to COVID-19) represents a change in consideration. Renegotiating results in a modification of the lease liability against the right-of-use asset from the date the lease was modified. This modification adjustment includes the effect of revising the discount rate by using the entity’s incremental borrowing rate as at the date of the lease modification. Similar to lease rental changes, the amount of depreciation expensed each year will also change.
In June 2020, the Australian Accounting Standards Board (AASB) issued an amending standard to provide practical expedients to lessees in respect of COVID-19-related rent concessions. The amendments allow a lessee to elect to not assess whether a COVID-19-related rent concession is a lease modification, and instead recognise a reduction, waiver or forgiveness of rental payments as a variable lease payment in the profit and loss statement. This relief was recently extended for COVID-19-related rent concessions entered into before 30 June 2022.
Reduction in space
The modifications resulting from a change in scope of the lessee’s leased asset can result in more complex accounting. An example is where a floor, or part of a floor or building, is no longer being leased. In this case, the lessee needs to reduce the liability for future rentals that will no longer be paid and reduce the right-of-use asset representing the floor space no longer leased.
The accounting is a proportional reduction (for example, based on original floor space versus reduced floor space) of both the lease liability and the right-of-use asset. Entities should recognise any difference between the two balance sheet amounts in the profit and loss statement. To remeasure the lease liability, the lessee should then revise the discount rate using the lessee’s incremental borrowing rate at the date of the modification, with the adjustment taken to the right-of-use asset. Again, the amount of depreciation expensed each year will change because the right-of-use asset has changed.
Not extending with an option that was included in the original lease term
The lease term, used to calculate the lease liability and the right-of-use asset, is based on the non-cancellable term and any periods where it is reasonably certain that the lessee will exercise an extension option. Lessees do not need to reassess the reasonably certain judgement every year. Instead, they should reassess the lease term when a significant event or a significant change in circumstances occurs that is within their control. If their assessment of the exercise of options changes, then they should account for the effect of the change in the lease term using the reassessment mechanism, not the modification mechanisms, in AASB 16.
For example, if a lessee previously decided that it was reasonably certain it would exercise an option, the extension period would have been included in the lease term (say a five year minimum, and five year extension period, equalling a 10 year lease term). If the lessee is no longer reasonably certain it will exercise the option, then the lease term is reduced.
This downward revision would result in adjustments to the lease liability to reflect the reduced remaining lease payments. The lessee remeasures the lease liability with a revised discount rate using the entity’s incremental borrowing rate at the date of reassessment. The adjustment is recognised as a reduction in the right-of-use asset, with a consequent change to the remaining depreciation period. If the reduction in the lease liability exceeds the carrying amount of the right-of-use asset, then the lessee would record a gain in the profit and loss statement.
Entities will need to assess other changes against the requirements of AASB 16, and the applicable reassessment and modifications mechanisms.