Leases II: remeasurement, sale-and-leaseback and lessors

Lesson 5 measured a simple lease at commencement and followed it to the end. Leases in practice change: rents rise with inflation, tenants extend or shrink their space, companies sell buildings and lease them back, and many companies are lessors as well as lessees. This lesson covers remeasurement and modifications of lessee leases, sale-and-leaseback transactions, subleases and the lessor's side, which both boards largely carried forward from the earlier standards. Northlake provides the examples: its warehouse lease is indexed to inflation, it sells and leases back its head office, and it leases monitoring stations to municipalities that prefer not to buy them.

Remeasuring the lease liability

After commencement, the lessee remeasures the lease liability when the lease payments change. The remeasurement is recognized as an adjustment to the right-of-use asset (or in profit or loss if the asset has been reduced to zero). The rate used depends on why the payments changed. If the change results from a reassessment of the lease term, of a purchase option or of a floating interest rate, the liability is remeasured using a revised discount rate at the reassessment date. If the change results from an index or rate, such as the consumer price index, or from a change in amounts expected under a residual value guarantee, the original discount rate is kept.

Under ASC 842, a lessee does not remeasure the liability merely because an index or rate changes; the changes are recognized as variable lease cost in the period incurred, unless the liability is remeasured for another reason, such as a change in lease term, at which point the updated index is used. This is a further IFRS–US GAAP difference.

Lease modifications

A lease modification is a change in the scope of a lease or its consideration that was not part of the original terms, such as adding or removing space, extending or shortening the term, or changing the rent. A modification is accounted for as a separate new lease if it increases the scope by adding the right to use one or more underlying assets and the consideration increases by an amount commensurate with the standalone price for that added scope. Otherwise, the lessee remeasures the existing lease liability using a revised discount rate at the modification date. For a modification that decreases scope, such as giving up a floor of a building, the lessee first reduces the right-of-use asset proportionately and recognizes a gain or loss, then adjusts for the remaining change in the liability.

During the COVID-19 pandemic, both boards offered temporary relief so that lessees did not have to assess whether rent concessions were modifications. That relief has expired, but the episode showed how often lease terms change in practice and how much work remeasurements require. Many companies now use lease accounting software that tracks each lease's payments, options and index provisions.

Sale-and-leaseback transactions

In a sale-and-leaseback, a company sells an asset, often real estate, and leases it back from the buyer. The seller-lessee raises cash while keeping the use of the asset. The first question in both frameworks is whether the transfer is a sale under the revenue standard (IFRS 15 or ASC 606): has control of the asset passed to the buyer-lessor? A leaseback alone does not prevent sale treatment, but a repurchase option at anything other than fair value usually does. If the transfer is not a sale, the seller keeps the asset on its books and treats the cash as a financial liability.

If the transfer is a sale and the leaseback is not a finance lease, ASC 842 recognizes the full gain on sale immediately, measured as the difference between the sale price (adjusted for off-market terms) and the carrying amount, and accounts for the leaseback as a new lease with the right-of-use asset measured at the present value of the leaseback payments. If the leaseback is a finance lease, the transfer is not a sale, and the seller treats it as a financing. IFRS 16 instead restricts the gain to the rights actually transferred.

Lessor accounting

Both boards decided that lessor accounting under the old standards worked well enough, so IFRS 16 and ASC 842 largely carried it forward. A lessor classifies each lease at inception. Under ASC 842, a lessor classifies a lease as a sales-type lease if it meets any of the five criteria used by lessees (lesson 5). If none is met, it is a direct financing lease if the present value of payments plus any residual value guaranteed by third parties is substantially all of the fair value and collection is probable; otherwise it is an operating lease.

For a finance (or sales-type) lease, the lessor derecognizes the underlying asset and recognizes a net investment in the lease, the present value of lease payments receivable plus any unguaranteed residual value. A manufacturer or dealer lessor, such as Northlake leasing its own stations, recognizes revenue at the lower of the asset's fair value and the present value of lease payments, cost of sales equal to the carrying amount less the present value of any unguaranteed residual, and therefore selling profit at commencement. Interest income is then recognized over the lease term on the net investment using the rate implicit in the lease. For an operating lease, the lessor keeps the asset, depreciates it and recognizes lease income on a straight-line basis.

# Net investment in a sales-type (finance) lease: five payments of 30,000 at 7%
payment, rate, years = 30_000, 0.07, 5
net_inv = sum(payment / (1 + rate) ** t for t in range(1, years + 1))
cost = 90_000
print(f"Revenue {net_inv:,.0f}; cost of sales {cost:,}; selling profit {net_inv - cost:,.0f}")
print(f"{'Year':>4} {'Payment':>8} {'Interest':>9} {'Principal':>10} {'Net investment':>15}")
total_interest = 0
for y in range(1, years + 1):
    interest = net_inv * rate
    principal = payment - interest
    net_inv -= principal
    total_interest += interest
    print(f"{y:>4} {payment:>8,} {interest:>9,.0f} {principal:>10,.0f} {max(net_inv, 0):>15,.0f}")
print(f"Total interest income {total_interest:,.0f}; total profit {total_interest + 123_006 - cost:,.0f}")

Revenue 123,006; cost of sales 90,000; selling profit 33,006
Year  Payment  Interest  Principal  Net investment
   1   30,000     8,610     21,390         101,616
   2   30,000     7,113     22,887          78,729
   3   30,000     5,511     24,489          54,241
   4   30,000     3,797     26,203          28,037
   5   30,000     1,963     28,037               0
Total interest income 26,994; total profit 60,000

Over the lease, Northlake earns $26,994 of interest income on top of the $33,006 selling profit, for total income of $60,000: the $150,000 of payments less the $90,000 cost. If the city had instead signed a two-year lease of the same station, the lease would be an operating lease: Northlake would keep the station in property, plant and equipment, depreciate it and recognize rental income straight-line.

Subleases and intermediate lessors

When a lessee subleases an asset, it becomes an intermediate lessor. Under ASC 842 it classifies the sublease by reference to the underlying asset, not the right-of-use asset, so a sublease is more often an operating lease than under IFRS. If it is an operating sublease, the intermediate lessor continues to account for the head lease as before and recognizes sublease income straight-line, testing the right-of-use asset for impairment if sublease income is lower than head-lease cost.

Disclosure and analysis

Lessees disclose the carrying amounts of right-of-use assets by class, depreciation, interest on lease liabilities, short-term and variable lease expense, total cash outflows for leases, additions, and a maturity analysis of lease liabilities. Lessors disclose selling profit, finance income on the net investment, operating lease income and a maturity analysis of payments receivable. Because lease liabilities are often among a company's largest obligations, these disclosures repay careful reading: a retailer's store leases, an airline's aircraft leases and a telecom company's tower leases can rival its bonded debt.