Audit Partner at RSM Poland
In this article, resuming the topic of IFRS 16, we will have a look at situations in which a lease contract has been modified. In the opening remarks it is worth recalling that any changes of the interest rate, being the basis for calculating the lessor’s interest, or any changes of the index (e.g. inflation level), being the basis for calculating lease payments, are already included in the variable payments and shall not be discussed here any further. Any such changes result only in the need to make adjustments to the outstanding liabilities and adjust the right-of-use assets accordingly.
Let us consider a short example:
As of the second year, lease payments are adjusted for the inflation rate. Assuming that the contract term is 5 years, with yearly payments of 100 units (we skip the discount) and 5% inflation after year 1, the payment for the second, third, fourth and fifth year shall amount to 105 units. As of the second year, any future payments (liabilities) and right-of-use assets shall be adjusted to keep up with the inflation rate. The discount rate shall remain unchanged.
However, the agreed contract terms often change, e.g. the contract term is extended, there is a change in the scope of the contract (e.g. increase/decrease of the leased space) or a change in the price/payment for the service. In such cases, Lessees must each and every time consider contract amendments in terms of:
- possible separate lease contract;
- adjustments to the accounting for the currently existing lease contract.
In the first step, we analyse the option of a separate lease potentially being created. Thus, it should be considered whether both following conditions are met (IFRS 16, paragraph 44):
- changes grant the lessee additional rights to use underlying assets, and these rights have not been provided for previously in the original contract and
- price change is commensurate with the stand-alone price of the additional right.
As you can see, in the case of reducing the scope of the contract, the risk of a separate lease should not occur.
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Let us discuss a situation where a contract of a 10-year lease for 200 square meters of office space is amended to include an additional 150 square meters of leased space, e.g. from the beginning of year 6.
In the case in which the price for the lease of an additional 150 sq m is commensurate with the current market rate, that the Lessee would otherwise pay if he entered into a separate lease contract, there is no adjustment of the original 10-year contract, and pursuant to IFRS 16 principles, a separate right to use additional assets should be created. This means that the lessee (user) will disclose the assets and liabilities for the right to use the assets in the form of 200 sq m of office space and 150 sq m separately in the balance sheet – from the perspective of IFRS, these will be two separate contracts.
While in a situation in which the price for additional space (150 sq m) is incommensurate with the market rate that the Lessee would otherwise pay if he entered into a separate lease contract, the additional right to use the assets shall result in the adjustment of the value of the existing right to use the original space of 200 sq m. Thus, we must remeasure the right to use a total of 350 sq m of space on the basis of outstanding liabilities at the date of contract modification, discounted using the discount rate at the date of contract modification. It should be remembered that double-entry bookkeeping is transferred to the right to use the assets.
Thus, we may face a change of the contract term or a change of the subject of the contract, but also changes of the guaranteed residual value or changes of interest rates/indexes; in the two latter cases, we use the original discount rate to determine the new lease liability.
As it has already been mentioned, the scope of the lease contract may be increased; although, there may also be a decrease in the scope. In such case we should:
- consider a percentage change of the scope of the contract and reduce the remaining right to use the underlying assets and outstanding liabilities accordingly at the date of contract modification;
- transfer the difference to the financial result.
In the second step, we should:
- determine actual liabilities, which might have been changed as well, on the basis of the outstanding liabilities discounted using the revised discount rate, and the difference between the previously defined liabilities and their revised value shall be accounted for in the adjustment of assets (rights to use underlying assets).
In the economic reality, the changes can be effected differently (e.g. amendment to the contract providing for an increase of the consideration or a decrease in the scope of the contract or a decrease in the scope of the contract with an extension of the contract term).
Every modification should be treated individually. We will be happy to help you out with all these intricacies.
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