IFRS 16 - Lease Term

Transcript

Shreeya: Hello, and welcome to the second podcast in our series “On the top shelf” which deals with topical issues in IFRS that impacts clients that operate in the Retail & Consumer Industry.

My name is Shreeya and I am a Manager at PwC’s Accounting Consulting Services and I am joined today by Saaleha Moolla, who is part of the PwC South African Accounting Consulting Services Retail Industry Team. Welcome!

Saaleha: Thank you Shreeya . Good to be here

Shreeya: Saaleha, I understand that IFRS 16 has had a tremendous impact on Retail & Consumer corporates. We also touched on that topic in our last podcast.

Saaleha: Yes, exactly. IFRS 16 has had a material impact on a number of clients in this industry. Particularly, what we have been seeing, is that the determination of the lease term is such a crucial input into this calculation. This is because the lease term drives the value of the lease liability and consequently the Right of Use asset that results from it.

Shreeya: I agree, as the Right of Use Asset is initially measured at cost, and is driven by the amount of the initial measurement of the corresponding lease liability.

Big picture, I understand that the lease term is determined by the non-cancellable period of a lease, together with the lease’s renewal periods (if the lessee is reasonably certain to exercise) and termination options (if the lessee is reasonably certain not to exercise).

Saaleha, what are some practical decisions or indicators that we have seen that then feed into the determination of the lease term?

Saaleha: That is a good question. Typically the approach is to group leases into portfolios and then apply indicators to the portfolio. Consider, for example, a group of loss-making stores. If stores are loss-making, they’re likely to be closed down once a termination option comes up - so in that case, we’d exclude the option to renew the lease and keep the lease term to the non-cancellable period of the contract.

On the other hand, if we have an anchor store, and have spent a lot of money to enhance the anchor store through leasehold improvements, and make it a real landmark for the brand - it would make sense to factor in the contractual rights to renew our lease contract at that site - and we end up with a longer lease term.

Where it gets tricky is, given the downturn in the economy, you might have retailers that previously factored in options to extend the lease…. But have now had second-thoughts and have now decided to close the store down!

We also find that in some instances the initial non-cancellable lease term ends up resulting in rates that exceed market rates for that location and the age of the mall or business centre. In those instances a retailer might decide to rather negotiate a new lease than to extend the old lease by exercising the renewal options.

Shreeya: Great points Saaleha. I want to pick up on that point you just mentioned about closing stores down... Where you’re thinking of closing down the store because of reasons that are entirely within the control of the lessee, an entity is prompted to re-assess whether it’s reasonably certain to take up an option to extend the lease, or not.

The timing of the decision, i.e. when the decision is made to close down, is also crucial from a financial year-end perspective! This is because questions around IFRS 5 - discontinued or abandoned operations can arise!

Saaleha, when should a lessee revise the lease term?

Saaleha: Good question. Remember, the lessee shall revise the lease term if there’s a change in the non-cancellable period of the lease, for example, by deciding not to exercise a renewal option that was previously included in the determination of the lease term.

In that instance, the lease is modified. The lease liability is discounted using the revised lease payments and a revised discount rate for the remainder of the shorter lease term. In that instance, you’d have a shorter lease term than previously - because the retailer decided to close the store in the new year.

There’s a lot to think about when it comes to the lease term...

Shreeya: Yes, there’s a lot to...come to ‘terms’ with! Hahaha 😄

Saaleha, I also understand there’s been an extension of the IFRS 16 lease concessions amendment due to COVID?

Saaleha: Yes, there has been an extension of the period which lessees can take advantage of the amendment. But, I think, for our listeners out there - let’s take it a few steps back and think about what the original lease concessions meant in the first place!

Shreeya: Sure, good point there.

In May 2020, the IASB published an amendment to IFRS 16 that provided an optional practical expedient for lessees. Lessees are not required to assess whether a rent concession related to COVID-19 with a reduction in lease payments due on or before 30 June 2021, was a lease modification.

Saaleha: In other words - a lessee didn’t have to go through the onerous exercise of analysing whether or not a rent concession relating to COVID constituted a lease modification or not… they could just elect to apply the practical expedient.

Shreeya: Yes! It would be really ironic if you received commercial, or in some territories, regulated relief from your landlord, but the accounting was a burden, right?

Can you tell us a bit about the scope of the amendment, so, what criteria does a lessee need to fall into in order to apply this?

Saaleha: There are three things to keep in mind about the scope:

Firstly - the change in lease payments resulted in revised consideration for the lease that was substantially the same as, or less than, the consideration for the lease immediately preceding the change.

Secondly - any reduction in lease payments affected only payments due on or before 30 June 2021. This date has, as we’ve previously mentioned, been extended to 30 June 2022.

Lastly - there was no substantive change to other terms and conditions of the lease.

Shreeya: Thanks for sharing a bit about the scoping of the amendment. Can you maybe also tell us what the crux of the rent concessions amendment is - why is it so attractive for retailers to apply?

Saaleha: So, essentially, lessees could elect to account for COVID rent concessions as if they were not lease modifications.

For example, some lease contracts contained pre-existing force majeure or similar clauses. Where such a clause applied to COVID-19 and resulted in reduced payments, the substance might have been appropriately accounted for as negative variable lease payments that are not dependent on an index or a rate.

Shreeya: This generally sounds a bit easier overall than having to account for a modification and having to go ahead and redetermine an Incremental Borrowing Rate as part of modification accounting.

Saaleha: Yes! But it’s not as simple as electing the amendment.
There is a catch to this extended amendment.

If a lessee already applied the practical expedient in the May 2020 amendment, it is required to continue to apply the practical expedient consistently, to all lease contracts with similar characteristics and in similar circumstances, using the March 2021 amendment.

If a lessee did not apply the practical expedient in the May 2020 amendment to eligible lease concessions, it is prohibited from applying the practical expedient in the March 2021 amendment.

Shreeya: Saaleha thank you so much for joining us on the podcast.

In today’s session, we came to ‘terms’ with the lease term and thought about practical aspects that inform our lease term accounting, such as anchor stores where one would be more likely to include extension options into the lease term.

We also discussed the IFRS 16 Rent Concessions Extension, where the IASB published a further amendment to extend the date of the practical expedient from 30 June 2021 to 30 June 2022.

Saaleha: Thanks for having me on the podcast Shreeya, and I’m looking forward to joining you again soon, in the aisle - 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.”