(Second of two parts)
In the first part of this two-part series, we discussed how to assess whether changes in lease contracts are lease modifications, and covered lease concessions that are treated as variable rent, lease modifications, and accounted for as government grants.
We continue our discussion by reassessing lease terms, including the exercise of purchase, renewal or termination options, as well as the impairment of lease-related assets and a recent amendment issued on May 28 to IFRS 16 on pandemic-related rent concessions.
REASSESSMENT OF LEASE TERM INCLUDING THE EXERCISE OF PURCHASE, RENEWAL OR TERMINATION OPTIONS
In view of the adverse effects brought about by the COVID-19 outbreak, lessees and lessors should revisit the lease terms of their existing contracts. In particular, they must revisit whether or not the lessees are reasonably certain to exercise their options to extend or terminate the leases, and even their rights to purchase the leased assets at the end of the lease term. PFRS 16 requires that lease terms should be reassessed upon the occurrence of either a significant event or a change in circumstances that will affect the lessee’s assessment as to whether or not it is reasonably certain to exercise those options.
A change in the lease term brought about by a reassessment — as to whether or not a lessee is reasonably certain to exercise a renewal or purchase option, or not to exercise an option to terminate the lease — constitutes a lease modification. This will trigger lease modification accounting as discussed in the preceding part of this article.
IMPAIRMENT OF LEASE-RELATED ASSETS
The pandemic also has a possible effect on the impairment of the lessee’s right-of-use (ROU) asset and the lessor’s leased asset or lease receivable. PAS 36, Impairment of Assets, requires that both the lessee and lessor should assess if there are indicators that their respective lease-related assets may be impaired, and could therefore trigger an impairment test in accordance with PAS 36. In the case of a lessee, the adverse effect of the pandemic on their business might make it difficult to recover the value of their ROU asset, particularly if they are not able to negotiate for a lease concession from the lessor.
In the case of a lessor in an operating lease, the lessor might have to deal with the same impairment issue as they might encounter difficulties in recovering the value of their leased asset. Similarly, in the case of a lessor in a finance lease, the lessor should factor the impact of the outbreak on the collectability of their lease receivable in estimating credit losses in accordance with PFRS 9. Lease renegotiations are thus expected to result in balancing the interests of both parties to ensure the least amount of impairment if it cannot be avoided.
AMENDMENT TO IFRS 16 ON PANDEMIC-RELATED RENT CONCESSIONS
As discussed previously, the guidance under PFRS 16 in accounting for pandemic-related lease concessions can be difficult, especially if there are many contracts to deal with and the rent concessions qualify as lease modifications. In order to help ease the accounting burden, the International Accounting Standards Board issued on May 28 an amendment to IFRS 16 that provides an option to lessees not to account for qualified pandemic-related lease concessions as lease modifications. A lessee shall apply the amendment for annual reporting periods beginning on or after June 1. Earlier application is permitted, including financial statements not authorized for issue by 28 May 2020.
In order to apply this option, the following criteria must be satisfied:
1.The concession must be a direct consequence of the pandemic;
2.The concession results in a revised consideration that is substantially the same or lower than that immediately preceding the grant of the concession;
3.The reduction in lease payments affects only payments originally due on or before 30 June 2021; and
4.There is no substantive change in other terms and conditions of the lease.
While the amendment aims to provide relief, it also poses some challenges even to lessees. First, the amendment does not prescribe an accounting treatment for lease concessions if the expedient is invoked. However, the basis for conclusion to the amendment provides that if a qualified lease concession is not accounted for as a lease modification, then a lessee will generally account for it as a variable lease payment with a charge to profit and loss for the period. Absent one accounting treatment for the same type of concession, it can result in diversity in practice among lessees.
It is also noteworthy that while lessees that elect to apply the expedient do not need to assess whether a concession constitutes a modification, lessees still need to evaluate the appropriate accounting for each concession as the terms of the concession granted may vary.
Second, since the amendment provides an option, a lessee that avails of it may produce financial results that may be incomparable to those produced by one that does not. Treating lease concessions as variable lease payments, for example, will likely result in a higher net income for a period; however, this will also result in an unadjusted or higher ROU asset which can trigger impairment concerns.
Third, in order to qualify for the expedient, the concession should only affect lease payments originally due on or before June 30. While there are currently only a few lease concessions in the Philippines that extend beyond this date, the uncertainties surrounding the pandemic pose possible issues in respect of future concessions that may not qualify for the expedient.
Finally, while the amendment provides relief to lessees, lessors do not enjoy the same. They may therefore need to account for lease concessions in accordance with PFRS 16 as discussed above.
CONSENSUS IN CONCESSIONS
The pandemic significantly impacted our economy, with many businesses left with no choice but to rationalize operations for fear of not being able to pay their rents on time. For both lessors and lessees, there is the question of the continuing impact on their existing lease agreements if the pandemic continues.
Perhaps the best and most sustainable approach is for both parties to develop a joint strategy to compensate any rental loss suffered during the outbreak. Parties can seek help from their legal counsels to better understand their contracts in the hope that both will be able to arrive at a mutually beneficial solution. In most cases, agreements based on mutual trust and consent produce the best economic results, especially during these challenging times. After all, consensus is the foundation of contracts and the economic successes of both lessor and lessee are not separate but rather shared.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Jerome B. Ching is a Senior Manager from the Assurance Service Line of SGV & Co.
