Lease accounting: Lessor contributions for fit-outs
Lease accounting: Lessor contributions for fit-outs
Lease incentives are defined in NZ IFRS 16 Leases as payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of a lessee’s costs.
The general rule of thumb is that cash changes hands between the lessor and the lessee, or the lessor assumes an obligation of the lessee owing to another party.
Examples of lease incentives include:
The cost includes:
By reducing the carrying amount of a ROU asset, the lessee is recognising that it is economically ‘better off’ because of the payment (i.e., the cost of the lease as reflected in its financial statements over the lease term has been reduced).
However, if the economic substance is that the lessee is economically no better or worse off as a consequence of a payment by the lessor to the lessee because the lessor will ultimately be compensated for the payment as part of the future lease payments, crediting (or deducting) the payment from the ROU asset (as shown in the above diagram) will not reflect the economic substance of the payment.
Lessor contributions towards a property’s fit out that the lessee controls for accounting purposes (see below) provide the lessee with more economic benefits than they would otherwise enjoy from merely using the ROU asset (leased premises).
For example, the lessee may be able to remove the improvements after the lease ends.
In these circumstances, lessor contributions towards the fit out would be considered lease incentives under NZ IFRS 16.
However, lessor contributions that merely reimburse the lessee for property fit out costs incurred, where it is instead the lessor substantively retaining control of the fit out, are not lease incentives (because the lease is presumably priced in such a way that the total payments will compensate the lessor for the fit out payment, less the expected residual value in the fit out, at the end of the lease term).
The accounting entries for lessor payments to lessees will therefore vary, depending on whether the lessor or lessee retains substantive control of the lease fit out (for accounting purposes).
For more on the above, please contact your local BDO representative.
This article has been based on one that originally appeared on BDO Australia, read the original article here.
The general rule of thumb is that cash changes hands between the lessor and the lessee, or the lessor assumes an obligation of the lessee owing to another party.
Examples of lease incentives include:
- Cash payments by a lessor to a lessee as an inducement for the lessee to enter into the lease
- Compensation paid by the lessor to the lessee for costs incurred by the lessee to enter into the lease, and
- The lessor extinguishing a liability of the lessee arising as a consequence of entering into the lease, e.g. a penalty for early termination of an existing lease.
How to account for lease incentives?
The lessee is required to recognise the cost of the right-of-use (ROU) asset at the lease commencement date.The cost includes:
- The amount of the initial measurement of the lease liability.
- Any lease payments made at or before the commencement date, less any lease incentives received.
- Any initial direct costs incurred by the lessee.
- An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or because of having used the underlying asset during a particular period.
Lease incentives are therefore deducted from the cost of the ROU asset when they are received.
Are lessor contributions for property fit outs (leasehold improvements) a lease incentive?
It depends. Although the definition of lease incentives refers to ‘payments made by a lessor to a lessee associated with a lease…’, not all payments by a lessor to a lessee necessarily represent an economic inducement to the lessee to enter the lease.By reducing the carrying amount of a ROU asset, the lessee is recognising that it is economically ‘better off’ because of the payment (i.e., the cost of the lease as reflected in its financial statements over the lease term has been reduced).
However, if the economic substance is that the lessee is economically no better or worse off as a consequence of a payment by the lessor to the lessee because the lessor will ultimately be compensated for the payment as part of the future lease payments, crediting (or deducting) the payment from the ROU asset (as shown in the above diagram) will not reflect the economic substance of the payment.
Lessor contributions towards a property’s fit out that the lessee controls for accounting purposes (see below) provide the lessee with more economic benefits than they would otherwise enjoy from merely using the ROU asset (leased premises).
For example, the lessee may be able to remove the improvements after the lease ends.
In these circumstances, lessor contributions towards the fit out would be considered lease incentives under NZ IFRS 16.
However, lessor contributions that merely reimburse the lessee for property fit out costs incurred, where it is instead the lessor substantively retaining control of the fit out, are not lease incentives (because the lease is presumably priced in such a way that the total payments will compensate the lessor for the fit out payment, less the expected residual value in the fit out, at the end of the lease term).
The accounting entries for lessor payments to lessees will therefore vary, depending on whether the lessor or lessee retains substantive control of the lease fit out (for accounting purposes).
- Lessee substantively controls the lease fit out (for accounting purposes):
- Fit out contributions are a lease incentive and credited to the ROU asset when received
- Lessor substantively controls the lease fit out (for accounting purposes):
- Fit out contributions are not a lease incentive.
- Payments to the lessee are merely a reimbursement of costs, so there is no impact on the measurement of the ROU asset.
How to assess whether the lessee or lessor controls the lease fit out?
Entities should ask the following questions when deciding whether the lessor or lessee controls the leasehold improvement (fit out):- Is the lessee contractually required to construct or install the leasehold improvements?
- Can the lessee continue to use or benefit from the improvement independently after the lease term ends?
- Are the leasehold improvements unique to the lessee’s intended use of the leased asset, and not available to the lessor in a lease to other parties?
- Can the lessee remove or replace the leasehold improvements without prior consent from the lessor, or without adequately compensating the lessor?
- Is the expected economic useful life of the (individual components of the) fit-out less than, or substantially equal to, the reasonably expected lease term that has been determined?
- Did the lessee incur costs exceeding the reimbursement amount committed by the lessor i.e., any expenditure by the lessee above the agreed reimbursement will be considered as being under the lessee’s control.
Answering ‘yes’ to one or more to questions 1-5 could indicate that the lessee controls the lease fit out, and answering ‘no’ could indicate that the lessor controls the lease fit out. In addition, answering ‘yes’ to question 6 is another factor that may indicate that the lessor controls the lease fit out.
Need help
Please contact our Financial Reporting Advisory team for assistance in your entity’s lease accounting application issues. For more information on lease accounting including BDO’s Managed Lease Services offering, please click here.For more on the above, please contact your local BDO representative.
This article has been based on one that originally appeared on BDO Australia, read the original article here.