Example: Leases under IFRS 16 during COVID-19
The pandemics of coronavirus, or COVID-19 has been here for a while and after the first shock of its quick spread and effect on people’s health, we are all seeing its economic consequences.
In order to stop the spread, governments in many countries ordered complete lockdown.
Many businesses had to stop their operations and thus their vital force – sales to the customers and resulting cash flow – was interrupted.
This situation can trigger perhaps the biggest depression we have ever seen.
However, my goal is not to rant about macroeconomics here – there are many other better economic forecasters out there than I am.
To smooth the economic hammer of the preventive measures, the governments and other parties promised certain reliefs or concessions.
One of them is providing some relief from payments of rent.
How the lessors provide rent concessions
My three children visit the school that rented its building with all the classes from the local municipality.
However, due to lockdown, all children were forced to stay at home and the school charged much lower fees to the parents for the scholarship.
But, most of the school’s costs are fixed – salaries of teachers and rent of office represent about 90% of all school’s expenses.
We don’t have to be mathematical geniuses to see that the school suffered a loss and desperately needed some relief from its expenses.
The municipality therefore agreed to provide temporary rent concession in two forms:
- To postpone the rental payment for the 2nd and 3rd quarter of 2020 for 6 months; and at the same time –
- To decrease the amount of quarterly rental payment for the next two payments.
I am sure that our school is not an exception and lessors provide similar rent reliefs elsewhere to support their customers during difficult times.
And, frankly speaking, I received a lot of questions from my subscribers:
How to account for rent concessions under IFRS 16?
Looking to IFRS 16, I gave one and the same answer: lease modification (in most cases).
According to IFRS 16, lease modification is a change in either scope or payments for the lease that was not part of the original conditions.
I teach accounting for the lease modifications in the IFRS Kit and believe me, it is not an easy thing, especially if the lessee has many leases.
It requires recalculation and adjustment of the lease liability – not a pleasant thing to do, especially if many lessees have adopted IFRS 16 in the previous year and already invested a lot of time, effort and money in all the recalculations.
So, I thought, they could start all over, especially when they received significant rent reliefs from the lessors.
The good news is – this is not true anymore.
New amendment of IFRS 16 to reflect COVID-19
Apparently, my thought process related to this topic was not so insane and far from reality, because IASB reacted to this situation.
In May 2020, IASB issued amendment of IFRS 16 Leases to tackle exactly the rent concessions provided to lessees as a response to the COVID-19 pandemics.
The title of the new amendment is Covid-19-related rent concession and you can download the full text of that on the official website of IFRS Foundation here.
The main message of this amendment is that you do not have to account for the rent concession as for the lease modification.
It is a practical expedient and it is voluntary.
However, you need to meet three conditions:
- Revised consideration must be either the same or less than the consideration before the change;
- The discount on rentals must not go beyond 30 June 2021. Therefore, if your lease term ends in December 2021 and the lessor gives you a discount on ALL payments until December 2021, then you CANNOT apply this expedient on ALL the lease.
- No other significant change in terms and conditions of the lease.
OK, but what does that practically mean?
If the lessor decreased or forgave the lease payments, then you simply treat them as a variable lease payments not included in the measurement of the lease liability.
In other words – straight in profit or loss, with the corresponding decrease in the lease liability.
If the lessor decreased the payment in one period, but then proportionally increased it in the subsequent period, then you simply need to continue recognizing the lease liability reduction and the interest as before – at least this is what Basis for conclusion says.
However, I would add that when the timing of the lease payment changes, then there is some remeasurement of the lease liability involved exactly due to different interest accruing over time.
I teach remeasurements and their mechanics in the IFRS Kit, so check that out if interested, but for now, let’s not overcomplicate the things and see the illustration on the example.
Example: Rent concession under IFRS 16
Let’s say that ABC rented an office in January 2019 for 3 years. Quarterly payment is CU 10 000. ABC’s annual incremental borrowing rate is 3% and payments are made at the end of each quarter.
First, we need to see how that lease is initially recognized.
We need to calculate the present value of the lease payments using incremental borrowing rate.
Here’s the trick: we have the annual incremental borrowing rate, but all we need is quarterly rate, because the payments are paid quarterly.
We can use the following formula to derive quarterly rate from the annual rate:
Thus, quarterly rate = 1,03 to the power of ¼ (as the quarter is ¼ of a year) less one = 0,74%.
Now, you can use PV function in excel to calculate the present value of series of 12 payments, 10 000 each, payable at the end of each quarter, at the rate of 0,74% per quarter.
It gives us CU 114 409. Hence at the lease commencement, in January 2019, ABC made the following journal entry:
- Debit Right-of-use asset: CU 114 409
- Credit Lease liability: CU 114 409.
Subsequently, ABC recognizes interest expense and the reduction of the lease liability in line with the following table:
OK. Everything went smoothly and then BOOM! Pandemics hit and ABC lost a lot of revenue.
So, ABC’s lessor provided a discount on the next 2 payments, for 2nd and 3rd quarter of 2020, amounting to CU 7 000 per payment.
ABC decided to apply the practical expedient as permitted by the newest IFRS 16 amendment and not account for the discount as for the lease modification, as it apparently met all three conditions to do so.
Therefore, the lease payment amounting to CU 3 000 for the 2nd quarter will be accounted for as:
- Debit Interest expense in profit or loss: CU 504 (as shown in the table above – see the yellow line)
- Debit Reduction of the lease liability: CU 9 496 (as shown in the table above)
- Credit Cash paid: CU 3 000 (Original payment of 10 000 less discount of 7 000)
- Credit Profit or loss – Rent Concession: CU 7 000
The payment for the third quarter will be recognized accordingly.
Many accountants indeed appreciate IASB’s quick action and response to the current situation – their amendment indeed eases the life of all people dealing with similar reliefs and concessions.
Please remember that this treatment relates solely to the relief provided as a result of COVID-19 pandemics, not to all concessions.
You can apply this expedient in your financial statements for the period starting on or after 1 June 2020, but even earlier than that if your financial statements have not been authorized for an issue before 28 May 2020.
Also, one more remark – please make sure you perform the impairment test on your right-of-use asset resulting from the leases.
It is quite probable that there might be some impairment, because the declining revenues as a result of pandemics and the related measures adopted by the governments are very strong indicator of this situation.
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