Lease term, CPI remeasurement and restoration obligation under IFRS 16
On 1 January 20X5, Harbour Ltd signed a 10-year lease of a warehouse. Annual rent is $240,000, payable in advance. The lease includes an option to extend for a further five years at the then market rent. Harbour incurred $60,000 of legal and initial direct costs and estimates refurbishment costs of $180,000 at the end of the lease term, as required by the contract. The incremental borrowing rate is 6%. Harbour is likely to extend because the warehouse is central to its distribution network and relocation costs would be significant. In 20X6, the consumer price index increased by 4%, and the lease payments are indexed to CPI. The annuity factor at 6% for 10 years is 7.36 and for 15 years is 9.71 (rent payable in advance); the 15-year discount factor is 0.417.
1. Determine the lease term and calculate the initial lease liability and right-of-use asset at 1 January 20X5.
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Lease term: 15 years. IFRS 16 includes extension periods when extension is reasonably certain. Harbour is likely to extend: the warehouse is central to distribution and relocation costs are significant. The extension rent is at market, but the current market rent is $240,000 and the 15-year factor is given. Including the extension reflects the enforceable right and the economic incentive.
Initial lease liability: 15 payments of $240,000 in advance at 6%: $240,000 × 9.71 = $2,330,400.
Initial ROU asset:
- Lease liability: $2,330,400
- Initial direct costs: $60,000
- Refurbishment obligation: $180,000 × 0.417 = $75,060
- Total ROU asset: $2,465,460
The refurbishment obligation is recognised as a provision under IAS 37 because the obligation exists at commencement; IFRS 16 requires the present value to be included in the cost of the ROU asset. The credit entry is the provision, not the lease liability.
2. Explain how the CPI increase in 20X6 and the refurbishment obligation should be accounted for over the lease term.
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In 20X6 the CPI increase changes the lease payments because the rent is indexed to CPI. IFRS 16 requires remeasurement of the lease liability using the revised payments ($240,000 × 1.04 = $249,600 a year) over the remaining 13 years, discounted at the original 6% rate. The adjustment is made against the ROU asset; there is no gain or loss. Depreciation is adjusted prospectively over the remaining lease term. The discount rate is not revised because the change is due to an index, not a change in the interest rate.
The refurbishment provision is unwound over the lease term: interest expense increases the provision and the carrying amount of the ROU asset is depreciated. At the end of the lease, the provision should equal the $180,000 cost. The CPI remeasurement does not affect the refurbishment provision, which is a separate IAS 37 obligation.