Accounting for IFRS 16 Lease Concessions

Transcript

Shreeya 

Hello, and welcome back to our podcast series “On the top shelf”, which deals with topical issues in IFRS that impact clients operating in the retail and consumer industry. 

My name is Shreeya and I am a Senior Manager in PwC’s Accounting Consulting Services.

Today we’re going to be focusing on every retailer’s favourite IFRS standard… IFRS 16, leases. I’m joined, today, by Anton Hugo, a partner in the PwC Assurance practice. Anton is the PwC Africa Retail Industry Leader. Welcome to our podcast Anton! 

Anton

Thank you Shreeya. Great to be here.

Shreeya

Anton , I understand you have experienced an interesting retail trend along the lines of lessees. Could you perhaps tell us what you’ve been seeing on the ground?

Anton

Sure. It’s been several months since the civil unrest; however, we’ve been seeing retailers respond proactively and they have made substantial strides in bringing most of their stores back on line. But, interestingly, we’ve been seeing landlords waive or unconditionally forgive their lease payments in some instances for the period that stores were unable to trade. 

Shreeya

Even beyond the civil unrest, if there was - for example - a natural disaster that damaged the leased premises - the landlord could potentially provide lessees with some relief, right? 

Anton

Exactly, and it’s the IFRS 16 accounting impacts of these reliefs that come to mind, which has been quite topical for retailers. How do you account for these reliefs is the key question.

Shreeya 

I agree, and I guess it depends quite a lot on the origin of the relief. What is triggering that relief? Could you give us some examples of lessee reliefs that are out there in practice?

Anton

Sure, before we get into the accounting for the reliefs - we need to always consider the “background facts” as they’re called. 

Some lease contracts contain pre-existing clauses that might trigger when there’s a disaster event. These clauses could result in reduced lease payments for the period when the retail store cannot trade. In other words, the payments for those months are ultimately forgiven by the landlord in an unconditional manner. 

But, importantly  it depends on what each individual’s contract actually says. There may also be a concession granted that would reschedule payments instead of forgiving them. So, “don’t pay me this month - but pay me double the following month”.

Shreeya

I see. Getting an understanding of how the relief arises, and whether it is triggered by existing clauses in the contract, is critical to inform the accounting.

Anton

Yes, exactly.

Shreeya

Okay, let’s think about an example that illustrates the “forgiveness” of lease payments. If a lease agreement for a retail store provides for a payment holiday for the period when the store is closed as a result of a catastrophe event, referred to as a “force majeure” clause...

There, in that case, I think the payment holiday is recognised by the lessee over the period when the store remains closed. This is because the event triggering the payment holiday (that is, the store closure) occurs over time as the force majeure occurs.

Anton

Yes. To illustrate, where monthly lease payments are R100, the lessee would derecognise R100 of its lease liability during each month of the payment holiday, with a corresponding gain recognised in the income statement.

Shreeya

Okay, so the crux is: when there’s an unconditional forgiveness of lease payments, they’re treated as a ‘debt’ forgiveness and result in a reduction in the lease liability and a corresponding gain in the income statement similar to a variable lease payment.

What about when we have a deferral of lease payments? How do we treat those?

Anton

Hmmm, when it comes to the deferral of lease payment - some concessions might be in the form of the lease payments being rescheduled rather than reduced – such that, in nominal terms, the consideration for the lease has not changed.

An entity might judge that, where such a deferral is proportionate, it is not a lease modification, since there is no change in either the scope of the lease or the consideration for the lease.

However, unless additional interest is charged for the period of the deferral at the rate used to measure the lease liability or lease asset, there will be an effect on the present value of the lease payments.

Shreeya

Okay. In that case, I think this effect might be accounted for by adjusting the lease liability (for the lessee) and the recognition of a corresponding gain (for the lessee) at the time when the deferral is granted.

Anton

Yes, precisely.

Shreeya

What about cases where management tries to get a foot in the door and enter into renegotiations with the landlord? Beyond these reliefs ? 

Anton

That’s quite a different case I think. The outcomes there could be a bit broader.

Where the contractual clauses only allow the party suffering from the catastrophe event to enter into a negotiation, any changes to the lease payments that are made after such a negotiation will likely not be treated as variable lease payments. 

In these cases, lessees will need to consider whether the negotiated change is a forgiveness of some of the lease payments, which might be treated as:

a partial extinguishment by applying IFRS 9’s derecognition requirements as we just mentioned… or a proper, extensive lease modification in terms of IFRS 16. 

Shreeya

So, thus far we’ve thought about cases where relief from the landlord was in terms of the contract. What about voluntary forgiveness of lease payments?

Lessors might agree to forgive some payments that become contractually due under the lease contract, without changing the scope of the lease or other terms (for example, if a lessee is in financial difficulty). 

How should such a forgiveness of lease payments be accounted for by the lessee where such reductions are not required by the contract or by laws or regulation?

Anton

Aha, there we have more of a policy choice. IFRS 9 and IFRS 16 contain different guidance for the treatment of such voluntary forgiveness of lease payments. Therefore, we believe that a policy choice exists for such reductions, which I’ll explain now.

A lessee could consider the rent reduction to be a partial extinguishment of the lease liability. 

If 100% of the obligation to pay the lessor as specified in the contract is cancelled, the forgiveness would be recognised as a gain in the income statement, with a corresponding reduction in the lease liability in the period in which the reduction is contractually agreed.

Alternatively, a lessee could consider that the rent reduction is a lease modification, because there is a change in the consideration for the lease (that is, the reduction was not part of the original terms of the lease), and it could apply paragraphs 44–46 of IFRS 16. 

In this case, the lessee would remeasure the present value of the remaining payments required under the lease using a revised discount rate at the date of the modification, and any difference from the previous carrying value would adjust the right-of-use asset.

Shreeya

Thanks for explaining that, Anton. As a reminder, when it comes to policy choices… entities should choose their treatment as an accounting policy and apply it consistently to amendments to contracts with similar characteristics and in similar circumstances. 

Anton

I agree with you. The missing piece in our conversation, however, has been when the lessee enters into significant renegotiations with the lessor and begins to change aspects like the scope and fixed consideration for the lease going forward.

Shreeya

That sounds like a modification to me….

Anton

Yes - I think that’s something to watch out for. Remember, the definition of a modification is CHANGE in the SCOPE of a lease, or the consideration of the lease.

Shreeya

Hmmm, yes, some examples of modification include adding or terminating the right to use one or more underlying assets - like downsizing the leased retail store size, or extending / shortening the contractual lease term. 

This is not to be confused with a lease re-assessment, though!

Anton

Yes, a reassessment is different. That is quite rule-specific within the standard. 

Shreeya

Exactly. So what the standard says is that a lessee shall reassess whether they are reasonably certain to exercise an extension option, or not to exercise a termination option. 

However, this reassessment can only happen when an event or change in circumstances happens that is within the control of the lessee. The nature of that event needs to have actually affected whether the lessee is reasonably certain to change some of its previous judgements. 

A common example of an event that could trigger a reassessment is a significant modification or customisation of the underlying asset that was not anticipated at the commencement date.

Anton

Shreeya, when you’re changing the lease term through changing your judgements with regards to options for renewal and NOT the baseline non-cancellable contractual term - is that a re-assessment?

Shreeya

Yes. That is accounted for by reflecting the revised lease payments using a revised discount rate for the remainder of the lease term. 

You can use the interest rate implicit in the lease if readily determined - otherwise the incremental borrowing rate at the date of re-assessment.

This is more of a balance sheet journal entry. 

Anton

I think people tend to be confused by modifications versus re-assessment with regards to changes in the lease term.

Shreeya

Yes, it can be quite tricky. In a nutshell… 

A re-assessment of the lease liability takes place if the cash flows change based on the original terms and conditions of the lease, for example if the lease term changes due to judgements regarding the extension options.

Changes that were not part of the original terms and conditions of the lease are lease modifications

Anton

We’ve covered quite a bit in this session!

Shreeya

Yes - let’s maybe recap. We’ve discussed how to account for reliefs for a lessee from the landlord. We’ve discussed the implications for when the relief comes from the contract itself and when the relief is voluntarily granted by the landlord - and we’ve also touched a bit on modifications versus re-assessments.

Anton

IFRS 16 - accounting for leases - can be quite complex, but I think once you have the facts at hand - it’s just about being systematic in your approach. I’m going to need some ‘relief’ from the standard, itself, soon! 

Shreeya

Haha, maybe I’ll “relieve” you of your time on the podcast for today by wrapping up the podcast now. Thanks for joining us, Anton!

Anton

Haha. Thanks for having me. It was great joining in on the podcast and I hope to be back in the aisle soon - looking up at the Top Shelf!

Shreeya 

“This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors”