Ask the Expert: Lease payments linked to CPI and AASB 16

David Holland, Moore Stephens National Head of Technical Accounting, offers his advice on technical and compliance issues that impact businesses.

Issue
A business has a 30-year lease (starting at $1,000 per month) which increases at the end of every 3rd year based on the CPI (assume the CPI index started at 100 and was 102, 105 and 107 at the end of the 1st, 2nd and 3rd years).
 
How is this dealt with under AASB 16?
 
Conclusion
The initial lease liability and ROU asset (on commencement of the lease) will be measured using $1,000 per month (discounted using an appropriate discount rate).  The lease liability will not be updated at the end of the 1st or the 2nd year since the change in the CPI index has not resulted in a change in the cash flows (see BC190 below).  Only at the end of the 3rd year when the cash flows change from $1,000 per month to $1,070 per month will the lease liability need to be re-measured based on payments of $1,070 per month and using an unchanged discount rate (paragraph 43 below).  The adjustment to the lease liability will result to a Dr to the ROU asset of the same amount.
 
It is important to note that AASB 16 doesn’t require a forecast CPI index to be used in order to estimate future cash flows (BC166).
 
Background - AASB 16
27 At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the underlying asset during the lease term that are not paid at the commencement date:

(a) fixed payments (including in-substance fixed payments as described in paragraph B42), less any lease incentives receivable;

(b) variable lease payments that depend on an index or a rate, initially measured using the index or rate as at the commencement date (as described in paragraph 28);

(c) amounts expected to be payable by the lessee under residual value guarantees;

(d) the exercise price of a purchase option if the lessee is reasonably certain to exercise that option (assessed considering the factors described in paragraphs B37–B40); and

(e) payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

28 Variable lease payments that depend on an index or a rate described in paragraph 27(b) include, for example, payments linked to a consumer price index, payments linked to a benchmark interest rate (such as LIBOR) or payments that vary to reflect changes in market rental rates.

42 A lessee shall remeasure the lease liability by discounting the revised lease payments, if either:

(a) there is a change in the amounts expected to be payable under a residual value guarantee. A lessee shall determine the revised lease payments to reflect the change in amounts expected to be payable under the residual value guarantee.

(b) there is a change in future lease payments resulting from a change in an index or a rate used to determine those payments, including for example a change to reflect changes in market rental rates following a market rent review. The lessee shall remeasure the lease liability to reflect those revised lease payments only when there is a change in the cash flows (ie when the adjustment to the lease payments takes effect). A lessee shall determine the revised lease payments for the remainder of the lease term based on the revised contractual payments.

43 In applying paragraph 42, a lessee shall use an unchanged discount rate, unless the change in lease payments results from a change in floating interest rates. In that case, the lessee shall use a revised discount rate that reflects changes in the interest rate.
 
BC165 For similar reasons, the IASB decided to include variable lease payments that depend on an index or a rate in the measurement of lease liabilities. Those payments meet the definition of liabilities for the lessee because they are unavoidable and do not depend on any future activity of the lessee. Any uncertainty, therefore, relates to the measurement of the liability that arises from those payments and not to the existence of that liability.

BC166 In the IASB’s view, forecasting techniques could be used to determine the expected effect of changes in an index or a rate on the measurement of lease liabilities. However, forecasting changes in an index or a rate requires macroeconomic information that may not be readily available to all entities, and may result in measurement uncertainty. The IASB noted that the usefulness of the enhanced information obtained using such a forecast often might not justify the costs of obtaining it, particularly for those lessees with a high volume of leases. The IASB considered requiring a lessee to use forward rates when measuring lease liabilities if those rates are readily available. However, it decided not to do so because this would reduce comparability between those using forward rates and those not doing so. Consequently, at initial recognition, IFRS 16 requires a lessee to measure payments that depend on an index or a rate using the index or rate at the commencement date (ie a lessee does not estimate future inflation but, instead, measures lease liabilities using lease payments that assume no inflation over the remainder of the lease term).

BC167 Subsequent measurement of variable lease payments that depend on an index or a rate is discussed in paragraphs BC188–BC190.

Reassessment of variable lease payments that depend on an index or a rate (paragraph 42(b)).

BC188 In principle the IASB is of the view that users of financial statements receive more relevant information about a lessee’s lease liabilities if the lessee updates the measurement of its liabilities to reflect a change in an index or a rate used to determine lease payments (including, for example, a change to reflect changes in market rental rates following a market rent review). For example, without such remeasurement, the measurement of the lease liability for a 20-year property lease, for which lease payments are linked to an inflation index, is unlikely to provide users of financial statements with useful information about the entity’s future cash outflows relating to that lease throughout the lease term.

BC189 Some stakeholders expressed concerns about the cost of performing reassessments each time a rate or an index changes, and questioned whether the benefits for users of financial statements would outweigh the costs for lessees. For example, some stakeholders noted that the total expenses related to leases recognised in profit or loss by a lessee would be substantially the same, regardless of whether the lessee remeasures the lease liability for changes in an index or a rate.

BC190 In the light of this feedback, the IASB decided that a lessee should reassess variable lease payments that are determined by reference to an index or a rate only when there is a change in the cash flows resulting from a change in the reference index or rate (ie when the adjustment to the lease payments takes effect). The IASB noted that this approach is less complex and costly to apply than requiring a lessee to reassess variable lease payments at each reporting date. This is because a lessee would typically be expected to report its financial results more frequently than the occurrence of a contractual change in the cash flows of a lease with payments that depend on an index or a rate.