Lease Incentives Explained - IFRS 16

Introduction

Lease incentives are benefits provided by a lessor to a lessee to encourage them to enter into a lease agreement. These incentives can take various forms and significantly impact the measurement of lease liabilities and right-of-use assets for lessees, as well as income recognition for lessors. This article explores the definition, accounting treatment, and implications of lease incentives under IFRS 16.

Definition of Lease Incentives

Lease incentives are payments made by a lessor to a lessee, or the reimbursement or assumption by a lessor of costs incurred by the lessee.

Lease payments under IFRS 16 explicitly state that lease incentives should be deducted when determining lease payments.

Examples of Lease Incentives:

• Rent-Free Periods: A lessor may offer an initial period where no lease payments are required.
• Cash Payments or Other Assets: A lessor may provide an upfront cash incentive to the lessee.
• Reimbursement or Assistance with Setup Costs: A lessor may cover expenses like moving costs, leasehold improvements, or customisation expenses.

Lessee Accounting Treatment

Timing of receipts

• Received after the Commencement Date: Lease incentives reduce the lease payments used to calculate the present value of the lease liability, thereby reducing the initial recognition of the right-of-use asset.
• Before or On the Commencement Date: Lease incentives directly reduce the initial balance of the right-of-use asset.

Straight-line Method

For entities applying a straight-line lease expense recognition method:

• Lease incentives are deducted from lease payments on a straight-line basis over the lease term.
• The lease incentive is initially recorded as an accrued lease expense (liability).
• Over time, this liability is amortised, offsetting the difference between the straight-line lease expense and the actual cash payments.

Example:

A lessee enters into a five-year lease with a total lease payment of R100,000 per year. The lessor provides a R20,000 cash incentive upfront. This incentive reduces the lease payments in the calculation of the lease liability and right-of-use asset, leading to a lower initial asset recognition. The straight-lined lease expense is therefore R96,000 (100,000 - 20,000 / 5).

Journal Entries for the Lessee:

• When the incentive is received:

  Dr Cash R20,000
  Cr Lease Incentive Liability R20,000

• As rent is paid (every year for 5 years):

  Dr Rental Expense R96,000
  Dr Lease Incentive Liability R4,000
  Cr Cash R100,000

Lessor Accounting Treatment

Finance Leases
Since lease incentives reduce the value of the lease payments, they also reduce the value of the lease receivable or net investment in the lease. The lease incentive is treated as an outflow when calculating the interest rate implicit in the lease.

Operating Leases
For operating leases, lease incentives are deducted from the lease payments recognised as income on a straight-line basis. Upfront lease incentives are recorded as an accrued income (asset) and amortised over the lease term. This results in a reduction in straight-line lease income, mirroring the simplified method used by lessees.

Example: A lessor provides a R30,000 lease incentive for a 10-year lease with annual lease payments of R120,000. The incentive is amortised over the lease term, reducing recognised lease income. The straight-lined lease income is therefore R117,000 (120,000 - 30,000 / 10).

Journal Entries for the Lessor:

• When the lease incentive is granted:

  Dr Lease Incentive Asset R30,000
  Cr Cash R30,000

• As rent is received (every year for 10 years):

  Dr Cash R120,000
  Cr Rental Income R117,000
  Cr Lease Incentive Asset R3,000

Leasehold Improvements and Lease Incentives

If the lessor controls the leasehold improvements, they are normally recognised as assets in the lessor’s statement of financial position and do not qualify as lease incentives. However, if the lessee controls the leasehold improvements, they are considered lease incentives and should be deducted from the lease payments when calculating the right-of-use asset.

Value-Added Tax (VAT) Considerations

Lease incentives typically attract VAT. Therefore, it is crucial for both the lessor and the lessee to account for VAT correctly, depending on whether the lessor can claim input VAT or not. This will determine whether VAT-inclusive or VAT-exclusive amounts should be used in the accounting treatment of lease incentives.

Conclusion

Lease incentives are an essential aspect of lease agreements under IFRS 16. They influence both lessees' and lessors' accounting treatments, from the calculation of lease liabilities and right-of-use assets to income recognition. Proper understanding and treatment of lease incentives ensure compliance with IFRS 16 and reflect the financial implications of lease agreements accurately.

For further clarification or guidance, feel free to reach out to insight@leash.co.za.