New leases standard – measuring the lease liability, part two

As we discussed here, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.

Last time we discussed some of the issues relating to initially measuring the lease liability. This is what it says about subsequent measurement:

  • After the commencement date, a lessee shall measure the lease liability by:
  • (a) increasing the carrying amount to reflect interest on the lease liability;
  • (b) reducing the carrying amount to reflect the lease payments made; and
  • (c) remeasuring the carrying amount to reflect any reassessment or lease modifications…, or to reflect revised in-substance fixed lease payments….

IFRS 16 doesn’t require or permit a lessee to measure lease liabilities at fair value after initial measurement. The IASB took the view that such an approach would have been inconsistent with the subsequent measurement of many other non-derivative financial liabilities, thus decreasing comparability, and would have been more complex and costly to apply than a cost-based approach.

Interest on the lease liability in each period during the lease term is the amount that produces a constant periodic rate of interest on the remaining balance of the lease liability. The periodic rate of interest is the discount rate applied in initially measuring the liability, except in situations where the liability is reassessed. This might be necessary a change occurs in the lease term, or in the assessment of an option to purchase the underlying asset, both assessed in the ways described in previous articles. In these cases, the lessee determines the revised lease payments on the basis of, respectively, the revised lease term, or to reflect the change in amounts payable under the purchase option.

In both these situations, the lessee determines the revised discount rate as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or otherwise using its incremental borrowing rate at the date of reassessment.

The lessee also remeasures the lease liability, by discounting the revised lease payments, if a change occurs in the amounts expected to be payable under a residual value guarantee, or if a change occurs in future lease payments resulting from a change in an index or a rate used to determine those payments (for example, to reflect changes in market rental rates following a market rent review). In these cases though the lessee uses an unchanged discount rate (unless the change in lease payments actually results from a change in floating interest rates), reflecting the IASB’s view that these situations don’t reflect a change in the economics of the lease, in the same way as those above do.

In all these cases, the lessee recognizes the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. If the carrying amount has already been reduced to zero, then it recognizes any additional remeasurement in profit or loss. The IASB considered whether some changes to the measurement of the lease liability should always be recognized in profit or loss because, for example, the reassessment of an option or a change in an index or a rate could be viewed as an event relating to the current period. However, it concluded that a change in the assessment of extension, termination or purchase options reflects a determination by the lessee that it’s acquired more or less of the right to use the underlying asset than it had before, and so is appropriately reflected as an adjustment to its cost; a change in the estimate of the future lease payments is a revision to the initial estimate of the cost of the right-of-use asset, which should be accounted for in the same way as the initial estimated cost; and the requirement to update the cost of the right-of-use asset is similar to the requirements in IFRIC 1.

In its basis for conclusions document, the IASB notes that IFRS 16 doesn’t provide specific requirements on how a lessee accounts for the effects of foreign currency exchange differences relating to lease liabilities denominated in a foreign currency. It notes: “Consistently with other financial liabilities, a lessee’s lease liability is a monetary item and consequently, if denominated in a foreign currency, is required to be remeasured using closing exchange rates at the end of each reporting period.” Some stakeholders suggested that a lessee should recognize any foreign currency exchange differences as an adjustment to the carrying amount of the right-of-use asset, on the basis that in effect they’re another form of variable lease payment. But the IASB concluded among other things that recognizing the amounts in profit or loss is consistent with the requirements for foreign exchange differences arising from other financial liabilities, and faithfully represents the economic effect of the lessee’s currency exposure to the foreign exchange risk.

More to come…

The opinions expressed are solely those of the author

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