Peppercorn leases: the lowdown on AASB 16 and AASB 1058

In December 2018, the Australian Accounting Standards Board (AASB) issued an amending standard that provides a temporary exemption for not-for-profit (NFP) entities from the requirement to fair-value the right-of-use assets arising from peppercorn lease contracts.

The exemption is optional, allowing entities to measure and recognise right-of-use assets arising from peppercorn leases at fair value if they choose to do so, or at cost (based on actual payments).

The term “peppercorn lease” is generally used to describe a lease that has nil or nominal lease payments. For the purposes of the standard, the term also includes leases with lease payments that are more than nominal but significantly below market value, principally to enable an NFP to further its objectives.

Peppercorn lease arrangements are a common feature in private sector NFPs, where philanthropic-minded asset owners provide significantly discounted access to leased property and other assets to assist NFP entities in furthering their not-for-profit objectives. Similarly, in the public sector, quite often subsidised access to assets is provided as part of funding arrangements to entities.

The requirement to measure and recognise a right-of-use asset arising from a peppercorn lease contract was established through AASB 1058 Income of Not-for-profit Entities and AASB 16 Leases, which require almost all leases to be recognised in the balance sheet as a right-of-use asset and a corresponding lease liability.

Both standards are effective from 1 January 2019. The recent AASB exemption also takes effect from the same date. For NFP entities with June year-ends, the new requirements and temporary exemption will first apply for the year to 30 June 2020.

Practical challenges facing NFPs

Since the issuance of AASB 1058 in 2016, many entities have had difficulties in determining the fair value of right-of-use assets arising under peppercorn leases. Difficulties include significant lessor restrictions on the leased asset, specialised assets and leased assets that are accompanied by significant maintenance costs and operating obligations.

In all these cases, it has been challenging to estimate an equivalent fair-value rent. Some NFP entities have raised concerns with the image of financial health portrayed by a “day one” gain recognised in the income statement, when no cash inflows are associated with such a gain.

David Hardidge, a financial reporting expert and director at the Queensland Audit Office, highlights some of the practical challenges NFP entities might face.

“What is the fair-value rental to a not-for-profit entity? I have seen examples where entities are looking at comparable commercial rent paid by for-profit entities. Yet they would not be able to afford to pay such a rental and still be able to provide the agreed services. So, is a commercial rent really fair value?

“Another issue is lease term. You can have a 99-year lease, where the agreement gives both parties an option to terminate on two years’ notice. Do you assume a 99-year lease term or a two-year lease term, or something in the middle?” says Hardidge.

Having considered stakeholder feedback, the AASB decided to grant a temporary exemption for peppercorn lease accounting while it considers its next steps. In arriving at its decision, the AASB notes that the current review of the Australian Charities and Not-for-profits Commission (ACNC) legislation includes a proposal to raise thresholds for financial reporting by ACNC-registered charities.

If these proposals are adopted, fewer charities may have a statutory requirement to prepare financial reports and therefore may not be impacted by the peppercorn lease accounting issue. Similarly, the AASB’s project to develop additional fair-value guidance for public sector NFP entities is progressing, and the AASB expects the outcomes to better inform its direction on accounting for peppercorn leases. An Exposure Draft setting out the AASB’s proposed fair value guidance is expected in Q3 of 2019.

The way forward

Although the AASB has provided an exemption from fair-valuing peppercorn leases, additional disclosures are required that enable an assessment of the entity’s dependence on peppercorn leases and the nature and terms of such leases.

CPA Australia supported the AASB’s proposal to provide a temporary exemption for NFP entities from the fair-value requirements surrounding peppercorn leases. Member feedback indicates that in many cases, the valuation of peppercorn leases can be subjective and arbitrary, and provide little or no value to users of financial statements. Agreeing on an appropriate value can often require the involvement of external independent valuers, at a cost that would reduce funds available for services.

It can also prove challenging for external audits and likely increase those costs. Given the undue cost and effort associated with the requirement, we have suggested the AASB consider a permanent exemption option for all peppercorn leases.

The AASB did consider whether the exemption could be limited to existing leases prior to the application of AASB 16, in light of the difficulties that may arise when seeking to estimate the fair value of a right-of-use asset, particularly if the lease was entered into some years back and/or there is insufficient documentation to clearly establish the terms and conditions of the lease.

The AASB also considered whether to grant a temporary exemption to NFP private sector entities only, and not to the public sector. These options may continue to feature in the AASB’s future deliberations when deciding the way forward.

Impact of potential changes outside Australia

While the changes primarily affect Australian NFP entities, the impact may extend further.

Ian Thomson, consulting financial officer at Crossroads Foundation Hong Kong, feels that potential changes to peppercorn lease accounting could impact organisations in Hong Kong.

“For those with significant philanthropic support from Australia, like Crossroads for example, it is possible that they may be asked by their Australian funders to provide financial information that complies with Australian Accounting Standards,” Thomson says.

“Although this is not an issue today,” says Thomson, “with increasingly stringent requirements being placed on NFPs by donors from foreign jurisdictions, certainly at Crossroads we see the need to remain aware of compliance changes and how that may affect operations such as ours in Hong Kong.”

It is important for entities preparing for the significant changes to lease accounting heralded by AASB 16 to be aware of specific issues such as those relating to accounting for peppercorn leases, and how this might affect their future financial reporting obligations.

Plugging in the numbers

An example of the accounting implications of AASB 1058/AASB 16 without the exemption.

Lease term: 5 years
Nominal peppercorn rent: A$1 per annum
Estimated fair value rent: A$50,000 per annum
Discount rate: 5 per cent 
Right-of-use asset to be recognised in the balance sheet: A$216,475
Lease liability to be recognised in the balance sheet: A$5
Day one gain recognised in the income statement: A$216,470
Additional depreciation expense recognised in the income statement: A$43,295 per annum