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Issue Consider the following example involving change in terms of an operating lease. Entity Z is the lessee in an operating lease. The lease term is 10 years. Annual rent is Rs.200, with a fixed escalation of 5% each year. This results in a straight-lined annual lease expense of Rs.252. At the end of year 5, Entity Z and the landlord agree to modify the lease terms. The fixed escalation of 5% is replaced with CPI-linked escalation. The base rent for this purpose is the escalated rent at year 5 under the original terms (Rs.243). At the end of year 5, Entity Z has accrued rent of Rs.153 in its balance sheet as a consequence of straight-lining (prior to any adjustment to reflect the new terms). Entity Z’s accounting policy for contingent rents on operating leases is to expense them in the period to which they relate. The CPI-based escalation clause is considered to be a closely-related embedded derivative and is therefore not separated from the host contract. How is the modification recognised?
Alternative views
AS-19 has no specific guidance on the measurement implications of amending the terms of a lease. Therefore several views are possible, each of which have their own advantages and disadvantages. Also see appendix for the calculations.
View 1: Cancellation and new lease
View 1 treats the modification to the lease contract as a cancellation of the existing lease along with a new lease. AS-19.10 states that “Lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 5 to 9 had the changed terms been in effect at the inception of the lease, the revised agreement is considered as a new agreement over its revised term. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased asset) or changes in circumstances (for example, default by the lessee), however, do not give rise to a new classification of a lease for accounting purposes.” The wording of AS- 19.10 and its reference to a ‘new agreement’ might be viewed as providing support for this approach (albeit acknowledging that this paragraph addresses reassessment of lease classification and is therefore not directly on point).
As a consequence:
- the accrued rent of Rs.153 arising out of straight-lining is released to profit & loss in its entirety at the end of year 5
- a new minimum lease payment (MLP) is determined prospectively as Rs.243 per annum. This amount is straight-lined as the non-contingent portion of the annual lease expense in years 6-10
- the effect of the CPI adjustment is recognised in each annual period, being the cumulative effect of CPI from year 6 onwards.
One argument against this approach is that it is questionable that it results in a pattern of lease expense that reflects the time pattern of the lessee’s benefits in accordance with AS-19.23 which states that “Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss on a straight line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.”
Moreover, it is also questionable that the revision to the lease terms is in substance a cancellation of an existing lease.
View 2: Continuation of lease — revise SLM expense based on adjusted MLPs
View 2 treats the revised lease terms in years 6-10 as a continuation of the original lease. However, the MLPs are now different and the straight-line calculation should reflect this. One method is to determine the new total MLPs for the entire lease (i.e., years 1-10) under the revised terms. A straightline expense is determined for the fixed portion based on that amount.
As a consequence:
- a revised straight-line (non-contingent) annual lease expense of Rs.232 per annum is determined based on the revised total MLPs
- the accrued rent at the end of year 5 is adjusted. The revised accrual is the difference between the cumulative expense based on Rs.232 and the actual payments up to year 5. This results in Rs.96 being released to P&L instead of the entire Rs.152 under view 1
- the effect of the annual CPI adjustment is recognised in each annual period as per view 1.
View 3: Continuation of lease — use original SLM and adjust for variation between original rent and revised rent each period
Like view 2, view 3 treats the revised lease terms in years 6-10 as a continuation of the original lease. However, under view 3 the contingent adjustment is characterised as the variation between the original payment each year and the revised payment. This might be argued to be a better representation of the substance of the revision, which swaps fixed escalation for index-based escalation.
As a consequence:
- the accrued rent at year 5 is not adjusted
- the original straight-lined annual lease expense of Rs.252 continues to be recognised as the non-contingent portion
- the contingent portion in years 6-10 is the difference between the original cash rent for that year based on 5% escalation and the revised cash rent based on CPI.
Conclusion
Each of the above views is essentially unsupported in the standard, and have their own merits and drawbacks. Nevertheless View 3 appears to be the most logical as it results in a better reflection of substance of the change in the operating lease arrangement and is a better representative of the time pattern of the user’s benefit. Appendix
Original Lease Term & Expense Profile
|
Year
|
MLP’s
|
SL
|
Accrual
|
Cumulative
|
|
|
|
expenses
|
|
accrued
|
|
|
|
|
|
|
|
1
|
200.00
|
251.56
|
-51.56
|
-51.56
|
|
|
|
|
|
|
|
2
|
210.00
|
251.56
|
-41.56
|
-93.12
|
|
|
|
|
|
|
|
3
|
220.50
|
251.56
|
-31.06
|
-124.17
|
|
|
|
|
|
|
|
4
|
231.53
|
251.56
|
-20.03
|
-144.21
|
|
|
|
|
|
|
|
5
|
243.10
|
251.56
|
-8.46
|
-152.66
|
|
|
|
|
|
|
|
6
|
255.26
|
251.56
|
3.70
|
-148.96
|
|
|
|
|
|
|
|
7
|
268.02
|
251.56
|
16.46
|
-132.50
|
|
|
|
|
|
|
|
8
|
281.42
|
251.56
|
29.86
|
-102.64
|
|
|
|
|
|
|
|
9
|
295.49
|
251.56
|
43.93
|
-58.71
|
|
|
|
|
|
|
|
10
|
310.27
|
251.56
|
58.71
|
0.00
|
|
|
|
|
|
|
|
Total
|
2515.58
|
2515.58
|
0.00
|
|
|
|
|
|
|
|
Revised Lease Term &
Expense Profile
|
Year
|
|
MLP’s
|
CPI
|
Cash
|
View
1
|
View
2
|
View
3
|
|
|
|
|
|
|
|
rent
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1
|
|
200.00
|
|
200.00
|
251.56
|
251.56
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
2
|
|
210.00
|
|
210.00
|
251.56
|
251.56
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
3
|
|
220.50
|
|
220.50
|
251.56
|
251.56
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
4
|
|
231.53
|
|
231.53
|
251.56
|
251.56
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
5
|
|
243.10
|
|
243.10
|
98.89
|
154.08
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
6
|
|
243.10
|
1.05
|
255.26
|
255.26
|
244.22
|
251.56
|
|
|
|
|
|
|
|
|
|
|
|
|
7
|
|
243.10
|
1.06
|
270.57
|
270.57
|
259.53
|
254.11
|
|
|
|
|
|
|
|
|
|
|
|
|
8
|
|
243.10
|
1.07
|
289.51
|
289.51
|
278.47
|
259.65
|
|
|
|
|
|
|
|
|
|
|
|
|
9
|
|
243.10
|
1.06
|
306.88
|
306.88
|
295.84
|
262.95
|
|
|
|
|
|
|
|
|
|
|
|
|
10
|
|
243.10
|
1.05
|
322.23
|
322.23
|
311.19
|
263.52
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
2320.63
|
|
2549.57
|
2549.57
|
2549.57
|
2549.57
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