Leases (ifrs 16) - Lease term, discount rate, and remeasurem...

Learning Outcomes

This article explains how to determine the lease term, select the appropriate discount rate, and handle the remeasurement of lease liabilities under IFRS 16. By the end, you will know how to assess lease extension and termination options, apply the correct discount rate, and recalculate lease liabilities when contract terms change, ensuring compliance for ACCA SBR exam scenarios.

ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand and apply IFRS 16 to lease accounting, with a practical focus on accurately measuring lease liabilities. Be ready to:

• Assess the full lease term, including extension and termination options, and evaluate when options are likely to be exercised
• Determine and apply the correct discount rate to lease payments
• Apply requirements for initial and subsequent measurement of the lease liability
• Remeasure the lease liability when lease terms or expected payments change
• Explain and justify the accounting for remeasurements in financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which periods are included in the "lease term" under IFRS 16?
   1. Only the non-cancellable period
   2. Non-cancellable period plus all optional extension periods
   3. Non-cancellable period plus extension periods if exercise is reasonably certain
   4. Only periods with purchase options
2. What discount rate should a lessee normally use to measure its lease liability?
   1. Lessee’s incremental borrowing rate
   2. Lessor’s cost of capital
   3. Risk-free rate
   4. Weighted average cost of capital

3. True or false? A change in expected lease payments that depends on an index triggers remeasurement of the lease liability.

4. When a lessee revises the lease term to include an extension option previously not included, what other amount must typically be adjusted?
   1. The right-of-use asset
   2. Interest expense
   3. Lease deposit
   4. Variable lease payments

Introduction

IFRS 16 Leases requires lessees to recognise most leases on the balance sheet through a right-of-use asset and a lease liability. Three technical areas are critical for both calculation and judgement: (1) determining the correct lease term, (2) applying the appropriate discount rate, and (3) remeasuring the lease liability when relevant changes occur after inception. Errors in these steps may distort financial statements and are heavily tested in the ACCA SBR exam.

Key Term: Lease term
The non-cancellable period of a lease, plus periods covered by extension or termination options when exercise is reasonably certain.

Determining Lease Term

The lease term establishes the period over which lease payments are discounted and expensed. The assessment must go beyond the contractual minimum period.

Components of the Lease Term

• Non-cancellable period: The minimum period the contract cannot be terminated.
• Extension options: Periods covered by a lessee’s or lessor’s option to extend are included if it is "reasonably certain" that the option will be exercised.
• Termination options: Periods covered by an option to terminate are excluded if it is "reasonably certain" the option will not be exercised.

Judgement is needed for “reasonably certain”—consider financial incentives, significant leasehold improvements, local market conditions, and historical behaviour.

Key Term: Reasonably certain
A high threshold of probability that an option will or will not be exercised, considering all economic factors.

Worked Example 1.1

Spin plc leases equipment for 4 years, with a 2-year extension option. Historically, Spin renews similar leases if a major client contract is won. At commencement, Spin has not won the client contract. Should the extension be included in the lease term?

Answer:
No. Unless Spin is already "reasonably certain" (based on current facts) to exercise the option, the lease term is 4 years. If the client contract is won later, and this changes the likelihood that extension is now reasonably certain, a reassessment and possible remeasurement are needed.

Selecting the Discount Rate

The lease liability is initially measured at the present value of lease payments, using a specific discount rate.

Lessee: Which Rate?

IFRS 16 states the lessee should use the "interest rate implicit in the lease," if readily determinable. Otherwise, use the "incremental borrowing rate."

Key Term: Incremental borrowing rate
The rate a lessee would have to pay to borrow the funds needed to obtain an asset of similar value and term from a comparable lender.

Key Term: Interest rate implicit in the lease
The rate causing the present value of lease payments and unguaranteed residual value to equal the fair value of the leased asset plus costs to the lessor.

If neither rate can be determined, use the incremental borrowing rate, ensuring it reflects the term, security, and asset value.

Worked Example 1.2

Tree Ltd enters a 5-year property lease. The lessor does not disclose asset fair value or residual value. Tree Ltd's incremental borrowing rate is 7%. Which rate is used?

Answer:
Tree Ltd should use its incremental borrowing rate of 7% to discount future lease payments, as the implicit rate cannot be calculated.

Remeasurement of Lease Liability

During the lease, certain changes require a lessee to "remeasure" (recalculate) the lease liability.

Remeasurement Triggers

Remeasure the lease liability when:

• The lease term changes (e.g., lessee now “reasonably certain” to extend or shorten the lease)
• The expectation of a purchase option changes
• Lease payments change due to index or rate changes, or contractual reassessments (e.g., new CPI)
• Residual value guarantees change

After recalculating the lease liability, a corresponding adjustment is posted to the right-of-use asset.

Matched Discount Rate

• Use a new discount rate when the lease term or purchase option changes.
• Use the original rate for changes caused by floating payments (indexed), unless modification changes the scope of the lease.

Worked Example 1.3

River plc leases office space for 6 years with a break option after 3 years. At commencement, River is not reasonably certain to continue beyond Year 3. After two years, River commits to expansion, and now it is reasonably certain the break option will not be used. What is required?

Answer:
River must increase the lease term to 6 years. The lease liability is remeasured using a revised discount rate at the reassessment date. The adjustment is recognised against the right-of-use asset.

Exam Warning

In exam scenarios, always specify whether the discount rate is updated. For lease term changes, a revised (current) discount rate must be applied.

Revision Tip

Prepare a table summarising when you revise the discount rate and when you retain the original, for quick reference in exam calculations.

Summary

IFRS 16 requires lessees to carefully assess lease term (including options), apply the correct discount rate, and remeasure lease liabilities when terms or expectations change. Misjudging these will misstate both assets and liabilities and is a frequent SBR exam risk.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and determine the lease term under IFRS 16, considering extension and termination options
• Identify and select the correct discount rate for initial lease measurement
• List and describe scenarios that require remeasurement of the lease liability
• Recognise which rate to use when remeasuring the liability in each scenario
• Record and present the remeasurement adjustment in financial statements

Key Terms and Concepts

• Lease term
• Reasonably certain
• Incremental borrowing rate
• Interest rate implicit in the lease