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Calculation of lease liability after reduction of agreed-upon lease space: Ind AS 116
Question
Lucky Limited (hereinafter referred to as the Company) is a retail company. To expand its business, the company entered into a lease agreement on 1 April 20X1 with Royal Limited for 5,000 square meters of office space. The key elements of the lease agreement are as follows.
(a) The annual lease of Rs. 2,00,000 at the end of each year.
(b) The lease term is 5 years
(c) The lease can be amended and extended with the consent of both the party.
The interest rate implicit in the lease is 6% p.a. On 31 March 20X3, the company and Royal Limited mutually decided to reduce the area of office space to 3000 square meters by decreasing the yearly lease payment to 1,20,000. The company's interest rate implicit on the modification date is 5%. Such modification shall be effective from April 1, 20X3.
State, how such modification in the company books shall be recognised.
Relevant provision
Para 22 at the commencement date, a lessee shall recognize a right-of-use asset and a lease liability.
Para 23 at the commencement date, a lessee shall measure the right-of-use asset at cost.
Para 24 the cost of the right-of-use asset shall comprise:
(a) The amount of the initial measurement of the lease liability, as described in paragraph 26;
(b) Any lease payments made at or before the commencement date, less any lease incentives received;
(c) Any initial direct costs incurred by the lessee; and
(d) an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.
Para 26 at the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee's incremental borrowing rate.
Para 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 is 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.
Para 40 A lessee shall re-measure the lease liability by discounting the revised lease payments using a revised discount rate, if either:
(a) There is a change in the lease term, as described in paragraphs 20-21. A lessee shall determine the revised lease payments on the basis of the revised lease term; or
(b) There is a change in the assessment of an option to purchase the underlying asset, assessed considering the events and circumstances described in paragraphs 20-21 in the context of a purchase option. A lessee shall determine the revised lease payments to reflect the change in amounts payable under the purchase option.
Para 41 In applying paragraph 40, a lessee shall determine the revised discount rate as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee's incremental borrowing rate at the date of reassessment, if the interest rate implicit in the lease cannot be readily determined.
Para 44 In applying paragraph 40, a lessee shall determine the revised discount rate as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee's incremental borrowing rate at the date of reassessment, if the interest rate implicit in the lease cannot be readily determined.
Para 45 for a lease modification that is not accounted for as a separate lease, at the effective date of the lease modification a lessee shall:
(a) Allocate the consideration in the modified contract applying paragraphs 13-16;
(b) Determine the lease term of the modified lease applying paragraphs 18-19; and
(c) Re-measure the lease liability by discounting the revised lease payments using a revised discount rate. The revised discount rate is determined as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee's incremental borrowing rate at the effective date of the modification, if the interest rate implicit in the lease cannot be readily determined.
Para 46 for a lease modification that is not accounted for as a separate lease, the lessee shall account for the re-measurement of the lease liability by:
(a) Decreasing the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease for lease modifications that decrease the scope of the lease. The lessee shall recognize in profit or loss any gain or loss relating to the partial or full termination of the lease.
(b) Making a corresponding adjustment to the right-of-use asset for all other lease modifications.
Analysis of the case
1. According to Para 22 at the commencement date (1st April, 20X1) the company shall recognize the right-of-use asset and a lease liability. The cost of cost of the right-of-use asset shall comprise the amount of the initial measurement of the lease liability.
2. According to Para 26 the company shall measure the lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease.
3. Statement showing the calculation of lease liability at the commencement date:
4. Calculation of lease liability immediately before modification date i.e. 31st March, 2023:
Journal Entry at commencement date
5. Statement showing the calculation of modified lease liability if the lease space is reduced to 3000 square meters by decreasing the yearly lease payment to 1,20,000 and the company's implicit interest rate on the modification date is 5%.
calculation of modified lease liability
6. In scenario 3 the company shall recognize the lease liability on 1st April, 20X3 (i.e. on the modification date) of Rs. 5,44,400 Therefore the difference between lease liability immediately before the modification date and lease liability on modification of Rs. 2,09,892 (3,26,640 - 5,36,532) shall be adjusted to the Right of use asset according to Para 46 of Ind AS 116.
Conclusion
The company shall decrease the lease liability by Rs. 2,09,892 and the same shall be adjusted to the Right of Use asset (ROU).
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