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Initial recognition and subsequent measurement – financial statements of lessees and lessor: operating leases
Initial Recognition and subsequent measurement
Extract from FRS 102 – Section 20.15-20.15B
20.15 A lessee shall recognise lease payments under operating leases (excluding costs for services such as insurance and maintenance) as an expense over the lease term on a straight-line basis unless either:
(a) another systematic basis is representative of the time pattern of the user’s benefit, even if the payments are not on that basis;
OR
(b) the payments to the lessor are structured to increase in line with expected general inflation (based on published indexes or statistics) to compensate for the lessor’s expected inflationary cost increases. If payments to the lessor vary because of factors other than general inflation, then this condition (b) is not met.
Example of applying paragraph 20.15(b):
X operates in a jurisdiction in which the consensus forecast by local banks is that the general price level index, as published by the government, will increase by an average of 10 per cent annually over the next five years. X leases some office space from Y for five years under an operating lease. The lease payments are structured to reflect the expected 10 per cent annual general inflation over the five-year term of the lease as follows:
|
Year 1 |
CU100,000 |
|
Year 2 |
CU110,000 |
|
Year 3 |
CU121,000 |
|
Year 4 |
CU133,000 |
|
Year 5 |
CU146,000 |
X recognises annual rent expense equal to the amounts owed to the lessor as shown above. If the escalating payments are not clearly structured to compensate the lessor for expected inflationary cost increases based on published indexes or statistics, then X recognises annual rent expense on a straight-line basis: CU122,000 each year (sum of the amounts payable under the lease divided by five years)
20.15A A lessee shall recognise the aggregate benefit of lease incentives as a reduction to the expense recognised in accordance with paragraph 20.15 over the lease term, on a straight-line basis unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset. Any costs incurred by the lessee (for example costs for termination of a pre-existing lease, relocation or leasehold improvements) shall be accounted for in accordance with the applicable section of this FRS.
20.15B Where an operating lease becomes an onerous contract an entity shall also apply Section 21 Provisions and Contingencies
OmniPro comment
The entity recognises an expense from the date when the lease commences rather than the inception date. Where for example, an entity has taken out a lease but the retailer is not ready to open, the standard requires that this cost be expensed during the period, it cannot be deferred on the balance sheet.
Where costs are incurred which are directly attributable to negotiating and arranging a lease, these should be capitalised and expensed over the life of the lease on a straight line basis. If it is not related to that lease then it is expensed. A termination penalty for an old premises so that the entity could move into a new premises cannot be capitalised as this is a separate trasnsaction and is not an asset.
As can be seen from the example included in Section 20.15 above, only lease increases specifically linked to a general inflationary index which is published can be expensed as incurred. If they do not then they are expensed on a straight line basis over the life of the lease.
Example 4: Operating lease with inflationary increases
Company A enters into a lease on a building for 5 years for an annual fee of CU20,000. Under the lease agreement rents will increase in line with the general increase/decrease in published inflation. However, it also stipulates that the minimum inflation rate that will be charged is 2% even where the published rate is lower. As the lease agreement is no longer linked to a general inflation rate and is capped, it does not meet the conditions in Section 20.15(b) so therefore the amount that should be expensed each year is as follows:
CU20,000+(CU20,000*1.02) + (CU20,000*1.04)+ (CU20,000*1.06)+ (CU20,000*1.08)= Total cost over the 5 years = CU104,080 /5year = CU20,816
Anything above the CU20,816 in any year is expensed as incurred.
Lease incentives
It is not unusual for landlords to provide tenants with incentives to enter into a lease agreement, especially for land and buildings. In order to encourage a key tenant to take on a lease, landlords may offer a cash sum, a specific length of time rent free or provide a contribution towards the cost of fitting out the premises. Section 20 requires such incentives to be deferred and credited into the profit and loss account over the life of the lease.
Example 5: Rent free period
Company A entered into a lease with a landlord for 10 years with a rent review after year 5. The rent payable on the lease per annum is CU200,000. As part of the agreement, the landlord agreed to provide the first 3 months rent free (CU200,000/12mths*3mths=CU50,000). Under Section 20, the lease incentive needs to be written off over the life of the lease. Assume the lease agreement commenced on 1 October and Company A’s year end is 31 December. The journals required to be posted in Company A’s TB at the 31 December are
|
|
CU |
CU |
|
Dr Rental Expense in P&L (CU16,250* X 3 months) |
48,750 |
|
|
Cr Lease Incentive Accrual BS |
|
48,750 |
Being journal to recognise the expense for the first 3 months in year one
From year 2 on, the CU48,750 is written back to the profit and loss and set against the rental expense i.e. at the end of year 2 the accrual would be reduced to CU43,750 (CU48,750-CU5,000) to show the net cost of CU195,000 per annum.
If in the above example the landlord provided a contribution of CU50,000 towards the cost of fixed assets or towards the cost of relocating, the treatment would be the same.
* Calculate the actual total rental payments over the 10 years i.e. actual rent payments are only paid for 9 years and 9 months = CU200,000 *9.75 years= CU1,950,000. Therefore the total amount of rent to be charged over the life of the lease is = CU1,950,000/10 years = CU195,000 per annum or CU16,250 per month. Therefore for the first 3 months an accrual is required as no payment is made. However, this accrual is then reduced over the life of the lease such that the cost shown each year is CU195,000.
NOTE: the date of the rent review is ignored.
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