Article:

IFRS 16: Initial recognition of the lease liability by lessees

11 July 2017

Under IFRS 16, initial measurement of the lease liability by lessees could be different to the liability determined under IAS 17, for example, where a lease contract has variable lease payments linked to an index or a rate or where payments are in-substance fixed payments. IFRS 16 includes specific requirements in respect of these matters.
 

How do you measure the lease liability?

The basic concept within IFRS 16 is that at the commencement date of a lease, a lessee recognises a right-of-use asset and a lease liability (unless the lessee elects to use the short term lease or low value exemptions discussed in previous articles).

The lease liability is measured as the

“present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate”

Therefore, the next question is – What lease payments do we include? A simple formula for this is as follows:

Fixed payments + Variable lease payments + Payments under a residual value guarantee + Purchase and termination options
 

What do each of these components mean?
 

Fixed payments - represents the set payments as outlined in the contract LESS any lease incentives receivable from the lessor. The standard also notes that this includes “in-substance” fixed payments. These are items that appear to be variable but in practice are unavoidable.
 

Variable lease payments – payments that can vary are only included as part of the initial lease liability calculation if they “depend on an index or a rate”. Examples of this would include variable payments linked to items such as inflation, LIBOR and the consumer price index. This could also include payments that vary to reflect changes in market rental rates. When measuring the initial liability, such payments should be measured using the index or rate as at the commencement date and should not include estimates of changes in the rates in future. An example is included below. 

If there are other variable payments that either are not dependent on an index or a rate, or are not “in substance” fixed payments then these are NOT included in the initial measurement of the lease and are instead recognised in profit or loss when the event or condition that triggers the payment is met.
 

Example – Lease payment linked to CPI
 

Year One – Beginning of Lease

Lessee enters into a 10-year lease of property with annual lease payments of CU 50,000 payable at the beginning of each year. The contract specifies that lease payments will increase every two years in line with the increase in the Consumer Price Index for the preceding 24 months. The Consumer Price Index at the commencement date is 125.

The lessee has determined the appropriate rate to discount lease payments is 5% (see Section 6.2 for a discussion on how to determine the appropriate discount rate.)

At the commencement date, the lessee makes the lease payment for the first year and measures the lease liability at the present value of the remaining nine payments of CU 50,000, discounted at the interest rate of 5% per annum, which is CU 355,391.
 

Assessment

Lessee initially recognises assets and liabilities in relation to the lease as follows:

Dr Right-of-use asset            CU 405,391

Cr Lease liability                  CU 355,391

Cr Cash                                 CU 50,000 (lease payment for the first year)
 

In measuring the lease liability, the lessee does not make any estimate of how future changes in CPI will impact future lease payments. Rather it assumes the initial lease payment will remain constant during the lease term.
 

Residual value guarantee – this represents a guarantee made to the lessor that the value of the underlying asset at the end of the lease will be at least a specified amount. These terms are generally included as an incentive for a lessee to maintain the asset and provide regular maintenance. These payments cannot be avoided and as such any amounts that the lessee expects to pay will be included in the initial lease liability.

Purchase and termination options – these payments will only be included in the initial lease liability if either the lessee is reasonably certain that they will purchase the underlying asset or if the lease term reflects the lessee exercising an option to terminate the lease. This will require some judgement and may significantly impact the value of the lease liability and asset recognised.
 

Don’t forget to discount!

Once you have determined all the payments as detailed above, the total must be discounted to reflect the expected timing of the payments. The rate used is either the:

  • Rate implicit in the lease – this is the rate that would cause the present value of the lease payments and unguaranteed residual value to equal the sum of the fair value of the underlying assets and any initial direct costs incurred. 
  • Incremental borrowing rate if the rate implicit in the lease cannot readily be determined - this should reflect the incremental rate of borrowing for a lessee in the same currency, with similar terms and for a similar period of time. 
     

Read more on accounting for leases:

IFRS 16: a closer look at short-term leases

IFRS 16 - a closer look at separating lease components

IFRS 16 - Definition of a lease

IFRS 16 – a closer look at ‘low value’
 

For help and advice on IFRS16 please get in touch with your usual BDO contact or Richard Matthews.

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