Understanding lease incentives

By Zilla Efrat

The accounting standard IFRS 16/AASB 16 on leasing, which took effect on 1 January 2019, is regarded as a significant improvement on its predecessor IAS 17 Leases.

However, as the standard is being adopted, users have raised questions about the treatment of lease incentives when applying the new requirements.

IFRS 16 removes the distinction between finance and operating leases for lessee accounting, requiring almost all leases to be recognised on the balance sheet.

According to the International Accounting Standards Board (IASB), it will affect an estimated US$2 trillion in the leased assets of listed companies using International Financial Reporting Standards (IFRS) or US GAAP (Generally Accepted Accounting Principles). It is also likely to have an impact on operational aspects of some companies, including loan covenants, credit ratings and borrowing costs.

CPA Australia’s policy adviser on reporting, Ram Subramanian, says there are concerns around the standard’s treatment of lease incentives – that is, payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of costs of a lessee.

Commercially, lease incentives can take various forms, including rent-free periods, reduced rentals and fit-outs, or relocation costs paid for by the landlord either directly or through reimbursing the lessee. It should be noted that rent-free periods, reduced rentals and similar arrangements that do not involve a payment by the landlord do not meet the new definition of lease incentive.

Subramanian notes that IAS 17 was released with guidance in the form of SIC-15 (Australian Accounting Standards Board (AASB) Interpretation 115). Guidance on how to account for lease incentives under IFRS 16 is currently limited to Illustrative Example IE 13 – Measurement by a lessee and accounting for a change in the lease term (IE 13).

According to CPA Australia, IE 13 has caused some confusion in the industry, and the IASB has announced proposals to amend it.

A CPA Australia submission to the IASB calls for formal guidance and illustrative examples on how lease incentives should be dealt with under IFRS 16 (AASB 16).

It would also like to see some inconsistencies in the terminology of the new standard ironed out.

Confusion

However, in a submission to an exposure draft on annual improvements to IFRS standards in August 2019, CPA Australia raises concerns that the proposed amendment will only add to the confusion, and suggests ways in which guidance could be developed to address its concerns around lease incentives.

These suggestions are based on Subramanian’s discussions with the IASB’s technical staff once concerns were first raised in May 2019.

“They have said to me, ‘Look, at the end of the day, the standard tells you what to do and you have to be able to exercise your own judgement and interpretation to apply the requirements in these circumstances’,” he says. A technical inconsistency that needs to be cleared up is the terminology used in the definition of lease payments. It suggests that lease payments already exclude lease incentives, while the requirements for calculating the right-of-use asset and lease liability imply otherwise.

“We say that may be well and good, but if people interpret it differently, you will have different outcomes and you will lose comparability and consistency. Therefore, you need some guidance to support what the interpretation should be.”

Subramanian says some of IFRS 16’s requirements lack clarity – for example, it’s unclear whether the definition of lease incentives includes costs incurred by the lessee associated with leasehold improvements that are reimbursed by the lessor.

While SIC-15 includes these costs as examples of lease incentives and IASB technical staff indicate that there are no plans to change the previous approach, a paragraph in IE 13 states that these payments do not meet the definition of lease incentives in IFRS 16 because, for example, they could be for improvements made to the lessor’s asset.

Defining incentives

CPA Australia believes many of these costs do meet the definition of lease incentives, and has asked the IASB to amend IE 13 to ensure clear guidance is provided.

It has also asked for formal guidance on other areas, such as the accounting treatment for lease incentive balances brought forward at the date of transition to IFRS 16 or received after a lease’s commencement date.

Subramanian says a technical inconsistency that needs to be cleared up is the terminology that is used in the definition of lease payments. It suggests that lease payments already exclude lease incentives, while the requirements for calculating the right-of-use asset and lease liability imply otherwise.

In its submission to IFRS’s exposure draft in August 2019, business advisory and accounting group Nexia Australia and New Zealand also raises the lack of guidance on lease incentives and cautions that some of IFRS 16’s wording could lead to different interpretations and treatments of the standard.

Nexia’s accounting and audit technical director, Martin Olde, notes: “Neither IFRS 16 itself, the Application Guidance contained in Appendix B of that standard, nor the Basis of Conclusion to IFRS 16 contain any further discussion or guidance on the treatment of lease incentives.

“As a result, we are aware of diversity in views on the application and treatment of lease incentives under IFRS 16.”

While the issues around lease incentives have been raised in Australia, Subramanian anticipates that similar issues will emerge in other jurisdictions that have adopted IFRS 16.