Harbour Logistics: Lease Term, Incentives and a Mid-Term Sublease
Harbour Logistics Ltd (HLL), a Hong Kong company with a 31 December year-end, leased a warehouse on 1 January 20X5 for a non-cancellable term of five years, with an option to extend for a further three years at then-market rent. Annual rent is HK$1,200,000 payable in arrears. The lessor granted a six-month rent-free period at inception and paid HLL a lease incentive of HK$300,000. HLL incurred legal fees of HK$240,000 directly attributable to negotiating the lease. HLL also pays common area maintenance (CAM) charges of HK$60,000 per annum and a turnover rent of 2% of annual sales above HK$10,000,000; 20X5 sales were HK$12,000,000. HLL's incremental borrowing rate is 5%. HLL spent HK$600,000 on leasehold improvements with an estimated useful life of eight years. At 31 December 20X6, because of a regional downturn, HLL vacated the warehouse and subleased it to a third party for the remaining three years at HK$900,000 per annum.
1. Determine the lease term, and calculate the lease liability and right-of-use asset at commencement. Explain the extension option judgement.
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Lease term. The non-cancellable term is five years. The extension option is included only if HLL is reasonably certain to exercise it (HKFRS 16.18–20). Relevant factors include the extension rent being at market, the cost and disruption of relocating, the warehouse's location, and HLL's planned operations. There is no evidence of significant leasehold improvements or specialisation that lock HLL in, and the option is at market rent, so the default conclusion is that the extension is not reasonably certain and the term is five years. The judgement must be documented and reassessed if circumstances change.
Lease payments. Because of the six-month rent-free period, the actual payments are HK$600,000 at the end of year 1 and HK$1,200,000 at the end of years 2–5. The rent-free period is part of the negotiated payment schedule, not a separate transaction.
Discounting at 5%:
- Year 1: 600,000 / 1.05 = 571,429
- Year 2: 1,200,000 / 1.05² = 1,088,435
- Year 3: 1,200,000 / 1.05³ = 1,036,605
- Year 4: 1,200,000 / 1.05⁴ = 987,243
- Year 5: 1,200,000 / 1.05⁵ = 940,231
- Lease liability = HK$4,623,943
Right-of-use asset = lease liability 4,623,943 + initial direct costs 240,000 − lease incentive received 300,000 = HK$4,563,943. The incentive is deducted from the right-of-use asset rather than recognised as income.
2. Explain the treatment of the rent-free period, the lease incentive, the CAM charges, the turnover rent, and the depreciation period for the leasehold improvements.
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- Rent-free period: not recognised as a separate gain or as zero rent in year 1. It is embedded in the payment stream and captured through the initial measurement of the lease liability, producing a constant effective cost over the lease term.
- Lease incentive: a payment from the lessor that reduces the cost of the right-of-use asset (HKFRS 16.24(b)). It is not revenue and is not spread as a credit to profit or loss.
- CAM charges: these are non-lease components. HLL may elect the practical expedient in HKFRS 16.15 not to separate non-lease components and instead account for the lease and CAM as a single lease component. If the expedient is elected, the fixed CAM is included in the lease liability measurement. If not, the CAM is a service expense as incurred. The election must be applied consistently by class of underlying asset.
- Turnover rent: variable lease payments that do not depend on an index or rate are excluded from the lease liability and expensed when the triggering condition occurs (HKFRS 16.38). For 20X5, 2% × (12,000,000 − 10,000,000) = HK$40,000 expense.
- Leasehold improvements: depreciated over the shorter of the useful life (eight years) and the lease term (five years), because the improvements have no value to HLL at the end of the lease. Depreciation is HK$600,000 / 5 = HK$120,000 per year, unless a renewal becomes reasonably certain, in which case the longer period may be used.
3. At 31 December 20X6 HLL subleases the warehouse for the remaining three years. Classify the sublease and explain the accounting consequences, including whether an impairment test on the right-of-use asset is required.
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Head lease continues. HLL remains the lessee under the head lease, so the lease liability and the obligation for the head rent continue unchanged; the sublease does not extinguish them.
Classification of the sublease. The sublease is classified by reference to the right-of-use asset arising from the head lease, not by reference to the warehouse itself (HKFRS 16. B58). The sublease covers the whole of the remaining three-year lease term, so it transfers substantially all of the risks and rewards incidental to the right-of-use asset. It is therefore a finance lease, notwithstanding that the sublease rent of HK$900,000 is below the head rent of HK$1,200,000.
Accounting. HLL derecognises the right-of-use asset and recognises a net investment in the sublease measured at the present value of the sublease payments, discounted at the rate implicit in the sublease (or the head lease rate if the implicit rate is not readily determinable). Using 5%: 900,000/1.05 + 900,000/1.05² + 900,000/1.05³ = HK$2,450,970. The carrying amount of the right-of-use asset at that date is the initial HK$4,563,943 less two years' depreciation at HK$912,789 per year = HK$2,738,365. The difference of approximately HK$287,395 is a loss on the sublease, recognised in profit or loss. HLL continues to recognise interest on the head lease liability and finance income on the net investment.
Impairment. Because the right-of-use asset is derecognised in a finance sublease, no separate impairment test on it is needed. If the sublease had instead been classified as an operating lease (for example, if it covered only part of the remaining term), HLL would retain the right-of-use asset, recognise sublease income on a straight-line basis, and test the right-of-use asset for impairment under HKAS 36 because the lower sublease rent is an indicator that the asset may not be recoverable.