Accounting for Lessee COVID-19 rent concessions

In order to try to contain the spread of the COVID-19 virus, many governments across the world enforced national lockdowns significantly impacting economic activity.  Many businesses have been affected by these lockdowns and as a result governments, landlords and other economic participants have provided some relief to try to alleviate economic hardship of these lockdowns.  As part of this effort, many lessors have provided rent concessions to lessees due to this direct impact of COVID-19 on them.  Most rent concessions or payment holidays received by lessees take the form of either a decrease in rental payments  or a deferral of rentals (payment holiday).  How should the lessees account for these different rent concessions?

This is essentially a change in the lease agreement, therefore we start by looking at the lease modification guidance in IFRS 16 Leases (‘IFRS 16’).  A lease modification is defined as either a change in scope or payments of a lease that was not part of the original lease conditions. 

The International Accounting Standards Board (‘IASB’) issued amendments to IFRS 16 in May 2020 to address the impact of rent concessions received as a direct result of COVID-19. The IASB noted that applying lease modification guidance could become complex and cumbersome for lessees, especially where large volumes of leases are affected.

This amendment applies only to lessees and not to lessors. It allows lessees to account for COVID-19 related rent concessions as variable lease payments instead of as a lease modification affecting the asset. The  variable lease payment is to be recognised through profit or loss in the period in which the event or condition that triggers those payments occurs.  This amendment is a voluntary practical expedient, however, there are three conditions that must be met before a lessee can apply it, namely:

1. the amendment to the lease payments results in a revised consideration being less than or equal to the consideration before the lease revision;
2. the reduction in lease payments is only for periods up to 30 June 2022¹; and
3. there is no substantive change to any other term and conditions of the lease. [IFRS 16.46B]

Rent concessions that substantially increase the lease consideration would not meet the requirements of the first condition of the practical expedient above.  If the increase reflects time value of money, the consideration is considered to be substantially the same and the rent concession could potentially meet the first condition of the practical expedient. Where, for example, the rental space is reduced, together with the concession, the third condition is not met.

¹ The IASB has recently issued a revision to their original practical expedient to extend the reduction in lease payments from 30 June 2021 to 30 June 2022. This could result in unintended consequences to those preparers that alread elected the practical expedient, or elected not to – not discussed in this article.

Different rent concessions received by lessees

As mentioned, lessees can receive rent concessions that take the form of a reduction of lease payments or a lease payment deferral. It is important to understand what these entail and what the accounting implications are.

1.     Reduction of lease payments

Reduction of lease payments by way of a reduction in the rental amounts, rent free periods or payment holidays are payments where the lessor provides a rent free or reduced rental period to the lessee without expecting the lessee to repay those lease payments.

A lessee who has applied the practical expedient will account for a reduction in lease payments as a variable lease payment reducing the lease payments in profit or loss with the corresponding adjustment against the lease liability (applying paragraph 38 of IFRS 16).  The lessee no longer has the full obligation as originally agreed on with the lessor and thus has to reflect the ‘revised’ contractual obligation after taking the rent concession into account.

Example 1.1: Reduction of lease payments with unconditional non-repayment

Retailer ABC entered a 5-year lease agreement on 1 January 2019.  The monthly payments are R 500 per month.  COVID-19 hit in April and May 2020 with hard lock down being imposed a month earlier. 

Retailer ABC is significantly impacted by COVID-19 and the lessor has provided a rental concession on 1 June 2020 as a relief measure.  

The terms and conditons offered by the lessor is to reduce Retailer ABC’s lease payments by forgiving six months’ rental unconditionally, i.e. Retailer ABC is not required to repay the reduced/forgiven lease payments.  Retailer ABC accrues interest using its incremental borrowing rate of 4 %.

Amended lease liability calculation to include reduction of lease payments (extracted and summarised)

Analysis:

Retailer ABC determines that it can apply the practical expedient in the period that the rent concession has been given as:

• the revised consideration for the lease is less than the consideration for the lease immediately preceding the change,
• the six months reduction in lease payments affects lease payments due before 30 June 2022, and 
• there have not been any other changes to the terms and conditions of the lease agreement.

As the lease concession forgives the lease payments unconditionally, it is accounted for in its entirety on 1 June 2020 as this is the date that triggers the concession. 

Retailer ABC will pass the following journal:

Dr.  Lease liability (R500 x 6)    R3 000

  Cr. Gain on rent concession Received (P&L)  R3 000

[Recognition of portion of Lease Liability payments reduced unconditionally from 1 June 2020]

As part of the lease liability is being extinguished, paragraph 3.3.3 of IFRS 9 Financial Instruments (‘IFRS 9’) is applied and requires that the resulting gain to be recognised in profit or loss (‘P&L') when a liability is extinguished.

Retailer ABC will continue to recognise the interest expense on the lease liability using an unchanged discount rate. The lessee must at all times reflect the present value of future lease payments as its obligation that is owed to the lessor in its statement of financial position (‘SOFP').

The lessee will continue to recognise depreciation of the right-of-use asset over the remaining lease term as well as test the right-of-use asset for impairment.

Example 1.2: Reduction of lease payments with conditions

The same fact pattern from Example 1.1 applies, except that the concession is conditional on whether the country is still in lockdown on or after 1 June 2020. 

Analysis:

The lessee will account for the rental concession on a monthly basis until the condition is fulfilled.  Therefore, at 1 June 

2020 Retailer ABC will pass the same journal, but monthly:

Dr.  Lease liability (SOFP)         R 500

  Cr. Gain on rent concession received (P&L)     R 500

[Recognition of portion of lease liability forgiven for June 2020]

Retailer ABC will recalculate the interest using its original discount rate for each month the concession is received.

The main objective is for the lessee to reflect the present value of its future lease payments owed to the lessor. 

As mentioned in Example 1.1, Retailer ABC will continue to recognise depreciation on the right-of-use asset and test the right-of-use asset for impairment, especially as a portion of the lease liabiity has been extinguished.

2.    Deferral of lease payments

A deferral of lease payments occurs when the lessor has decreased the lease payment for a certain period of time and the lessee then pays an increased lease payment at a later stage to catch up the payments. 

These type of rent concessions are not accounted for as variable lease payments as they are not forgiven and do not extinguish a portion of the lessee’s lease liability. 

These rent concessions are accounted for as a remeasurement to the lease liability.  The lessee will continue to recognise interest as well as an adjustment for the time value of money. This is in line with the principle that the lessee reflects the present value of future lease payments at all times.

That being said, the lessee will present the revised lease payment schedule using its original discount rate when the concession becomes effective as the lessee is not applying lease modification accounting by using the practical expedient.

The impact of the remeasurment is recognised in profit or loss when the rent concession becomes effective.

With regards to the right-of-use asset, the lessee will continue to depreciate its right-of-use asset over the lease term (and possibly the extended lease term if applicable) and the lessee will also consider any impairments on the right-of-use asset in accordance with IAS 36 Impairment of Assets (‘IAS 36’).

Example 2.1: Accounting for deferral of lease payments where the lease term is not extended

Using the same fact pattern for Retailer ABC, except with the following changes to the terms of the rent concession:

The terms of the rent concession is that the lessee can defer payments for six months (i.e. June 2020 to November 2020). Retailer ABC will repay these months by paying R1000 per month over December 2020 to May 2021.

Extracted and summarised from Original schedule of lease payments

Extracted and summarised from Remeasured present value schedule of lease payments

Analysis:

Retailer ABC remeasures its lease liability based on the new lease payments schedule on the date the concession becomes effective, using its unchanged discount rate. Retailer ABC recognises the impact of the lease liability remeasurement in profit or loss.  After the six months deferral period, the payments increase to R1 000 till May 2021.

1 June 2020:

Dr.  Lease liability (SOFP)      R 58,62

  Cr. Gain on rent concession received (P&L)   R 58,62

[Impact of the remeasurement of lease liability at 1 June 2020 to reflect the present value of the remaining lease obligation after taking the rent deferral into account]

Dr.  Interest (P&L)                 R 66.47

  Cr. Lease liability (SOFP)        R66.47     

[Interest on Lease Liability for the month of June 2020]

<recurring monthly journals continue for interest>

1 December 2020:

Dr. Lease Liability (SOFP)     R1 000

Cr. Bank (SOFP)                      R1 000

[New Lease payment as at 1 December 2020]

Dr.  Interest (P&L)                 R 66.81

  Cr. Lease liability (SOFP)        R66.81     

[Interest on Lease Liability for the month of December 2020]

Example 2.2:  Accounting for deferral of lease payments where the lease term is  extended

Using the same fact pattern for Retailer ABC, except with the following changes to the terms of the rent concession:

Retailer ABC is afforded a six month rent holiday which is followed by six additional months added on to the lease term.  The lease term changes to 66 months.

Analysis:

When a rent concession is provided that results in an change to the lease term, Retailer ABC should consider whether the change in lease term is substantially the same or less than the extended deferral period provided by the lessor. 

Retailer ABC does not account for the additional lease payments as a change in lease term in terms of paragraph 40(a) of IFRS 16 as they are applying the practical expedient. 

A change in lease term (as described in paragraph 40(a) and 21 of IFRS 16) includes exercising termination or extension options which the lessee was not reasonably certain to exercise at the commencement of the lease or any renegotiations between a lessor and lessee.

Where the lessee applies the practical expedient, the lessee is not required to use a revised discount rate, as opposed to a change in lease term brought about by paragraph 40(a) of IFRS 16 which requires the use of a revised discount rate. 

Retailer ABC will use its original discount rate when it remeasures the lease liability to reflect the present value of future remaining lease payments.

With regards to the right-of-use asset, Retailer ABC does not adjust the right-of-use asset with the remeasurement, but instead they will depreciate the right-of-use asset over the new longer lease term.  The right-of-use asset will also need to be tested for impairment if any indicators arise in terms of IAS 36.

Other considerations

Lessees should always consider whether there are any indicators that the right-of-use asset could be impaired in terms of IAS 36, especially in these uncertain times and with Covid-19 being considered an indicator by most regulators. The uncertainty in recoverable amounts and fair value is greatly increased as a buyer would most likely not pay the same price for an asset at the start of the pandemic versus a date further down in the pandemic.  It is important to keep monitoring for any impairment triggers.

In terms of disclosure around the application of the practical expedient, lessees are required to disclose the fact that they have applied the practical expedient.  This is in addition to stating  whether the practical expedient was applied to all rent concessions that met the requirements of paragraph 46B of IFRS 16.  If the practical expedient was not applied to all rent concessions, the lessee must disclose information about the nature of the contracts to which the lessee has applied the practical expedient.  The amount recognised in profit or loss for the reporting period to reflect changes in lease payments must also be included in the related COVID-19 rent concession disclosures.

Lessees should consider the tax impacts of applying the practical expedient and how it can impact current and deferred tax. 

If your company has received a rent reduction or deferral due to Covid-19, it is important that you understand the implications and the options available to you. You will need to decide if you can, as well as if you will, use the practical expedient, and how to utilise it.