COVID-19, IFRS 16 and lease accounting: the impairment question

By Shaun Steenkamp

This financial year was always going to be a challenge for the accounting profession as many companies prepared for the first-time implementation of IFRS 16 Leases.

However, no one anticipated that a global pandemic would bring about an unprecedented disruption to economies in its wake. The accounting profession has had to adapt in many ways, but COVID-19 and the consequential economic slowdown has presented a particular challenge for the first-time application of IFRS 16.

Every lease an entity enters into now creates a separate asset and liability in the financial statements.

The liability basically represents the entity’s future cash flow commitments (adjusted for the time value of money) under the lease. The corresponding asset represents the entity’s right to use the leased asset – hence its moniker, a “right-of-use asset”.

More broadly, the asset reflects a portion of the future economic benefits the entity expects to realise through its continued use in the business over the term of the lease. Therein lies the key challenge for the accounting profession in the current economic climate. What future economic benefits can the leased asset generate if the entity has been forced to pause operations or reduce its productivity?

Commercial real estate test case

The problem is clearer for entities that have a physical presence, with retail and hospitality being good examples to illustrate the key issues for the profession. 

In these sectors, forced lockdowns, social distancing and cleaning requirements have significantly reduced the operating capacities of many venues, with some now having to operate at sub-optimal capacity compared to their pre-COVID-19 situation. 

Although mandated rent concessions have helped, these are expected to be short-term and longer term rent obligations are likely to remain materially unchanged.

If the entity no longer expects to recover the cost of the lease through operation, or disposal, the right-of-use asset will be impaired. The impairment will essentially represent the difference between expected future cash inflows and the cash outflows associated with the lease as captured in the right-of-use asset. 

Such an impairment is recognised immediately in profit or loss and might further deteriorate an already stressed financial position.

Not a new accounting concept

It is important to remember that accounting standards have prescribed the above outcome for some time and that IFRS 16 does not introduce a new concept in this regard. The impairment recognised under IAS 36 Impairment of Assets is effectively similar to an “onerous contract provision” that would have been recognised under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

Switching from one accounting standard to another might appear benign but assessing a lease for impairment under IAS 36 introduces new considerations. When applying IAS 36, some key questions to ask include:

• Does the lease form part of a cash-generating unit (CGU)?
• Is the lease a “corporate asset”?
• What discount rate applies in impairment modelling?

The first two considerations are new for leases but are otherwise well-established for assets in general. 

IFRS 16 should not pose a particular challenge in this regard. However, for some industries the inclusion of a lease as part of a large cash generating unit (CGU) or treated as a corporate asset might stave off an impairment charge. 

This is despite the fact that in other industries the same set of facts applicable to the lease could instead result in the entity recognising an impairment loss. This outcome is appropriate as it reflects the importance of a leased asset to the revenue-generating ability of an entity. 

A corporate head office that cannot be fully occupied is less likely to be impaired because the cost of that asset is spread across multiple CGUs. On the other hand, a similarly sized hospitality or retail venue might be required to recognise an impairment due to the revenue generating nature of the asset and its cost being reflected in a single CGU.

The third point concerning discount rates, however, is worth exploring in some more detail for its ramifications on a per-lease basis as well as for an entity’s impairment model overall.

What’s in a discount rate?

Discount rates are prevalent throughout accounting standards. For the most part, they don’t cause concern in how they affect the application of accounting requirements to elements of the financial statements within the scope of different standards. 

However, for lease accounting one discount rate is relevant for the measurement of the right-of-use asset and another is relevant for assessing the right-of-use asset for impairment.

The discount rate applied to a lease may be either the entity’s incremental borrowing rate or a finance charge that is implicit in the cash flows of the lease. Often an entity will use its incremental borrowing rate. In contrast, the discount rate applied to a value-in-use impairment model is commonly based on a weighted average cost of capital.

For an entity that is entirely debt-funded there should be no difference in these rates. However, the vast majority of entities use a mixed funding model with capital provided by both debt and equity sources. This means an entity’s weighted average cost of capital under IAS 36 will differ from an incremental borrowing rate under IFRS 16. 

The interplay between these two discount rates can produce counter-intuitive outcomes at the best of times. In the current economic environment, the interplay could lead to an impairment loss being recorded even if the entity otherwise appears cashflow positive. This is more likely the case for entities that have been pushed to near break-even profitability due to social distancing and cleaning requirements.

Reassess all assumptions

Much like for everything in this economic environment, entities must reassess all their assumptions in their impairment models for COVID-19 and IFRS 16. Key questions that are worth asking include:

• Does the entity’s post-IFRS 16 leverage ratio change its weighted average cost of capital?
• Are the discount rates used for leases truly reflective of the entity’s borrowing costs?
• Do future cash inflows reflect a slower economy?
• Have leased assets been appropriately allocated to CGUs?
• Are corporate leased assets identified and treated appropriately?

Many of the above questions are hallmarks of the periodic impairment test. However, the economic effects of COVID-19 and the extension of impairment testing to leases under IFRS 16 make them more important to ask than ever before.