Lease Term, Turnover Rent and Fit-Out Incentive under IFRS 16
Riverton Retail Ltd leases a retail unit under a five-year lease starting 1 January 20X5. Annual payments are £120,000, paid in arrears, and increase by 3% each year. Riverton also pays turnover rent of 2% of sales above £2 million; 20X5 sales are expected to be £2.5 million. The lease includes an option to extend for three years at then-market rent. Riverton has not previously extended leases, but it will spend £250,000 on fit-out that has a seven-year useful life. Initial direct costs of £50,000 are incurred, and the lessor reimburses £30,000 of fit-out costs. Riverton’s incremental borrowing rate is 6%. The present value factors at 6% for years 1–5 are 0.9434, 0.8900, 0.8396, 0.7921 and 0.7473. Riverton applies IFRS 16 and has a 31 December year end.
1. Calculate the initial lease liability and right-of-use asset, stating which payments are included and excluded.
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Lease liability. Include fixed payments, in-substance fixed payments and variable payments that depend on an index or rate. The annual payments escalate by 3%, so they are fixed in substance once the base is set. Exclude turnover rent based on sales because it is a variable payment that does not depend on an index or rate.
Payments: year 1 £120,000; year 2 £123,600; year 3 £127,308; year 4 £131,127; year 5 £135,061.
Present value = £120,000 × 0.9434 + £123,600 × 0.8900 + £127,308 × 0.8396 + £131,127 × 0.7921 + £135,061 × 0.7473 = £113,208 + £110,004 + £106,889 + £103,868 + £100,931 = £534,900 approximately.
Right-of-use asset. Start with the lease liability £534,900, add initial direct costs £50,000, and deduct the lease incentive received from the lessor £30,000. The fit-out itself is a separate asset, not part of the right-of-use asset unless it is a leasehold improvement capitalised separately. Right-of-use asset = £534,900 + £50,000 − £30,000 = £554,900.
Recognise a lease liability and right-of-use asset of approximately £534,900 and £554,900 respectively at commencement.
2. How should Riverton judge whether to include the three-year extension option in the lease term?
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IFRS 16 requires the lease term to include optional extension periods only when the lessee is reasonably certain to exercise the option. This is a judgement based on all relevant facts and circumstances that create an economic incentive.
Factors pointing against extension: Riverton has no past practice of extending leases, the extension is at then-market rent so there is no bargain purchase or below-market benefit, and the unit could be vacated. Factors pointing towards extension: the £250,000 fit-out has a seven-year useful life, which is longer than the five-year initial term, and the fit-out is likely to be location-specific and costly to replicate. If the fit-out would have little value elsewhere, Riverton may be economically compelled to stay.
If Riverton concludes it is reasonably certain to extend, include the three-year extension period and estimate the extension payments using current market rent expectations, then discount them. If not, use five years and reassess at each reporting date. A change in the assessment is accounted for as a change in lease term, remeasuring the liability using a revised discount rate.
3. Compute the 20X5 finance charge, closing lease liability and depreciation, and explain the treatment of turnover rent.
Read the worked answer
Finance charge. Opening liability £534,900 × 6% = £32,094.
Closing liability. £534,900 + £32,094 − £120,000 paid = £446,994, approximately £447,000.
Depreciation. If the five-year term is used and no extension is reasonably certain, depreciate the right-of-use asset of £554,900 over five years: £554,900/5 = £110,980. If extension is reasonably certain, depreciate over the longer lease term, which reduces the annual charge.
Turnover rent. The 2% turnover rent is variable and based on sales, not on an index or rate. It is therefore not included in the lease liability. For 20X5, turnover rent = 2% × (£2.5m − £2.0m) = £10,000, expensed in profit or loss as incurred. It is not added to the right-of-use asset. The total 20X5 lease-related expense is therefore depreciation £110,980 + finance charge £32,094 + turnover rent £10,000, subject to any remeasurement for the extension option.