Subsequent Measurement and Reassessment of Lease Liabilities and Assets
Explore the intricacies of subsequent measurement and reassessment of lease liabilities and assets, focusing on Canadian accounting standards and practical applications.
7.5 Subsequent Measurement and Reassessment
In the realm of lease accounting, the subsequent measurement and reassessment of lease liabilities and assets play a crucial role in ensuring that financial statements accurately reflect the economic realities of lease transactions. This section delves into the intricacies of how lease assets and liabilities are measured over time, including the remeasurement due to changes in lease terms, focusing on Canadian accounting standards and practical applications.
Understanding Subsequent Measurement
Subsequent measurement refers to the process of updating the carrying amounts of lease liabilities and right-of-use (ROU) assets after initial recognition. This involves adjusting for factors such as interest accrual, lease payments, and any changes in lease terms or conditions. The goal is to ensure that the financial statements provide a true and fair view of the entity’s financial position and performance.
Lease Liabilities
Lease liabilities are initially recognized at the present value of future lease payments. Over the lease term, these liabilities are subsequently measured using the effective interest method. This involves:
- Interest Accrual: Interest expense is recognized on the lease liability, calculated using the discount rate determined at the lease commencement date. This interest is added to the carrying amount of the lease liability.
- Lease Payments: Lease payments reduce the carrying amount of the lease liability. Payments are allocated between a reduction of the liability and interest expense.
Right-of-Use Assets
The ROU asset is initially measured at cost, which includes the initial measurement of the lease liability, any lease payments made at or before the commencement date, initial direct costs, and an estimate of costs to dismantle or restore the leased asset. Subsequent measurement of the ROU asset can follow either the cost model or the revaluation model, depending on the entity’s accounting policy.
- Cost Model: Under the cost model, the ROU asset is measured at cost less accumulated depreciation and any accumulated impairment losses.
- Revaluation Model: If the ROU asset relates to a class of property, plant, and equipment that is revalued, the revaluation model may be applied. This involves measuring the ROU asset at fair value less any subsequent accumulated depreciation and impairment losses.
Reassessment of Lease Liabilities
Reassessment of lease liabilities occurs when there is a change in the lease term, a change in the assessment of an option to purchase the underlying asset, or a change in the amounts expected to be payable under a residual value guarantee. The reassessment process involves:
- Revising the Discount Rate: If there is a change in the lease term or a change in the assessment of an option to purchase, the discount rate is revised. The revised discount rate is the rate at the date of reassessment.
- Remeasuring the Lease Liability: The lease liability is remeasured by discounting the revised lease payments using the revised discount rate. The adjustment to the lease liability is recognized as an adjustment to the ROU asset.
Practical Examples and Scenarios
Example 1: Change in Lease Term
Consider a company that initially recognizes a lease liability of $100,000 with a lease term of 5 years and a discount rate of 5%. After 2 years, the company renegotiates the lease, extending the term by an additional 3 years. The discount rate at the date of reassessment is 4%.
- Initial Lease Liability: $100,000
- Interest Expense (Year 1): $5,000
- Lease Payment (Year 1): $20,000
- Carrying Amount (End of Year 1): $85,000
- Interest Expense (Year 2): $4,250
- Lease Payment (Year 2): $20,000
- Carrying Amount (End of Year 2): $69,250
Upon reassessment, the lease liability is remeasured using the revised discount rate of 4% and the revised lease payments over the new lease term of 6 years.
Example 2: Change in Residual Value Guarantee
A company leases a piece of equipment with a residual value guarantee of $10,000. Initially, the company expects to pay $5,000 under the guarantee. After 3 years, the company reassesses and now expects to pay $8,000.
- Initial Estimate: $5,000
- Revised Estimate: $8,000
The lease liability is remeasured to reflect the change in the expected payment under the residual value guarantee, with the adjustment recognized in the ROU asset.
Regulatory Framework and Compliance
In Canada, lease accounting is governed by IFRS 16, which aligns closely with ASC 842 in the United States. Both standards emphasize the importance of subsequent measurement and reassessment to ensure that financial statements accurately reflect the economic realities of lease transactions.
Key Points of IFRS 16
- Lease Modifications: IFRS 16 requires lessees to reassess lease liabilities when there is a change in the lease term, a change in the assessment of an option to purchase, or a change in the amounts expected to be payable under a residual value guarantee.
- Discount Rate Revisions: The standard mandates the use of a revised discount rate when there is a change in the lease term or a change in the assessment of an option to purchase.
- Disclosure Requirements: Entities must disclose information about the nature and effect of lease modifications, including the impact on financial statements.
Challenges and Best Practices
Common Challenges
- Complex Calculations: The process of remeasuring lease liabilities and ROU assets can be complex, particularly when dealing with multiple leases or significant changes in lease terms.
- Judgment and Estimates: Reassessment often involves significant judgment and estimates, particularly in determining the revised discount rate and expected payments under residual value guarantees.
Best Practices
- Regular Monitoring: Entities should regularly monitor lease agreements for changes that may trigger reassessment.
- Robust Systems: Implementing robust systems and processes can help ensure accurate and timely reassessment of lease liabilities and assets.
- Professional Judgment: Leveraging professional judgment and expertise can aid in navigating the complexities of lease reassessment.
Real-World Applications
In practice, subsequent measurement and reassessment of lease liabilities and assets are critical for entities with significant lease portfolios. For example, retail companies with numerous store leases must regularly reassess lease terms and conditions to ensure accurate financial reporting.
Conclusion
Subsequent measurement and reassessment of lease liabilities and assets are essential components of lease accounting. By understanding the principles and processes involved, entities can ensure that their financial statements accurately reflect the economic realities of lease transactions, providing valuable insights to stakeholders.
References
- IFRS 16 Leases: International Financial Reporting Standards as adopted in Canada.
- CPA Canada Handbook: Guidance on lease accounting and financial reporting standards.
- ASC 842 Leases: Accounting Standards Codification for lease accounting in the United States.
