(First of two parts)
Almost every part of the country has been, and remains, under community quarantine to help curb the COVID-19 pandemic. Business owners were forced to announce the temporary closure of non-essential establishments such as shopping centers, schools and office buildings, supermarkets, drugstores and other essential businesses which saw changes in operating hours and on-site operations, while food providers such as restaurants were only allowed to provide take away and food delivery services. As a result, commercial tenants found themselves in a dramatic situation where they lost all their revenue overnight while their obligations under their lease agreements continue to apply.
Although some lease contracts have provisions relating to force majeure events, most, if not all of these contracts do not include clauses on rent concessions specific to pandemics. In view of the situation, some lessors have announced that they are giving concessions to their lessees in the form of rent holidays or rent reductions during the lockdown, interest-free delays in rental payments, and even the restructuring of the amount and timing of rental payments until the end of the lease term. In lease contracts without force majeure clauses, lessors technically retain the discretion on whether to grant these reliefs, the extent of the relief to be provided, and over who they consider is entitled. Meanwhile, some lessees also proactively seek rent concessions (e.g., deferral of lease payments) or even amendments to the lease contracts to cushion their economic burden until the end of lease term, given that the full adverse effect of the pandemic remains unknown to this day.
Considering the voluntary nature of these concessions in this instance, many are curious as to how the lessors and lessees should account for these under PFRS 16, Leases.
ASSESSING WHETHER CHANGES IN CONTRACT ARE LEASE MODIFICATIONS
When changes are made to the terms of lease contracts (e.g., in lease payments or lease terms), the accounting for those changes will depend on whether they meet the definition of a lease modification under PFRS 16, which is defined as “a change in the scope of or consideration for a lease that was not part of the original terms and conditions of the lease.”
In assessing whether there has been a change in the scope of a lease, an entity considers whether there has been a change in the right of use granted to the lessee, which can be manifested in adding or terminating the right to use one or more underlying assets or extending or shortening the lease term. For example, a lessee may decide to rationalize operations and agree with the lessor to decrease the leased area from 1,000 square meters to 500 square meters. Another example would be a lessee negotiating with the lessor to extend or reduce the lease term.
On the other hand, when assessing whether there was a change in the consideration for a lease, the lessee and lessor should consider the overall effect of the change in the lease payments due under the contract. For example, there is a change in consideration when the lessor decides to provide a rental waiver during periods of the pandemic or when the lessor and lessee agree to change the lease payments from fixed to variable.
If there is no change in either the scope of or the consideration for the lease, then there is no lease modification. Even if there are such changes, but those would have resulted from clauses in the original lease contract or in the law or regulation covering the said contract, those changes are considered part of the original terms and conditions of the lease, hence there would still be no lease modification even if the effect of those clauses was not previously contemplated.
In considering whether changes in the scope or consideration are part of the original terms and conditions of a lease contract, an entity should consider all relevant facts and circumstances which may include the lease contract itself, or the law or regulation applicable to the lease contract. A paper by the International Accounting Standards Board (IASB) mentioned that for a change to be part of the original terms and conditions of the contract, there should be a clause present in either the contract itself or in the law or regulation governing the lease contract that provides an automatic adjustment of lease payments if a particular event occurs or circumstance arises. In some instances, it can be demonstrated by the presence of a force majeure clause in the contract, which allows for possible renegotiations or revisions when a specific situation occurs, such as when lease payments are suspended in cases of a prolonged market instability.
The presence of force majeure clauses in contracts would not automatically make the changes part of the original terms and conditions of those contracts. Oftentimes, these clauses are broadly written and do not specify what contractual rights and obligations are consequential to the occurrence of a force majeure event, much less what events would constitute force majeure. Therefore, the lessor and lessee may need to revisit the lease contract and agree on the coverage of the force majeure clause. In many cases, the parties may need to involve expert legal interpretation.
LEASE CONCESSIONS TREATED AS VARIABLE RENT
When it is established that a change in scope or lease consideration is not a lease modification, said change will generally be accounted for as a variable lease payment. Accordingly, each party should continue to account for the lease under the original lease contract, with the rent concession accounted for as an adjustment to lease income or expense in the period in which the concession arises.
LEASE CONCESSIONS TREATED AS LEASE MODIFICATIONS
When the change in lease payments is considered a lease modification, both the lessee and lessor should apply the guidelines for lease modifications under PFRS 16. The lessee in this case will remeasure the lease liability by discounting the revised lease payments using a revised discount rate, with a corresponding adjustment to the right-of-use (ROU) asset. This accounting treatment has an effect of recognizing the impact of the concession over the remaining lease term.
Since the modification requires the remeasurement of lease liability using a revised discount rate, it is necessary for the lessee to determine an incremental borrowing rate at the date of modification. The problem, however, is that the outbreak has driven market volatility, which could pose difficulties in estimating the revised incremental borrowing rate.
On the other hand, lessors will need to check whether the modification triggers a change in lease classification. For finance leases, if the modification changes the lease classification to an operating lease, then the lessor at the time of modification will derecognize the finance lease receivable and recognize the underlying assets according to their nature (i.e., property and equipment or investment property) at an amount equal to the investment in the lease immediately before the effective date of the modification. If the modification does not change the lease classification, the lessor shall recalculate on the modification date the present value of the renegotiated cash flows discounted at the lease receivable’s original effective interest rate, and recognize a gain or loss applying the concepts in PFRS 9, Financial Instruments.
For operating leases, the lessor treats the modification prospectively by recalculating the straight-line lease income, considering the effects of the concession and any prepaid or accrued rent at the time of modification over the remainder of the lease term.
LEASE CONCESSIONS ACCOUNTED FOR AS GOVERNMENT GRANTS
We observed that in some countries, governments roll out financial relief measures to support local businesses impacted by the pandemic. For example, in countries where most land properties are government-owned, the government provides relief to the lessees of these properties such as a waiver of rent, one-time property tax rebates and cash assistance during the outbreak. These government measures are not yet observed here at this point, although we may expect the same from the Philippine government to help drive the economy should the pandemic continue for a longer period. These actions by the government are outside the scope of PFRS 16 and may qualify as government grants to be accounted for in accordance with PAS 20, Accounting for Government Grants and Disclosure of Government Assistance.
LEASE TERM REASSESSMENT AND THE IMPAIRMENT OF LEASE-RELATED ASSETS
In the second part of this article, we will discuss the reassessment of 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 28 May 2020 to IFRS 16 on pandemic-related rent concessions.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion 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.