A lessee's lease payments are structured so that annual rent increases each year in line with a published consumer price index. Two years into the lease, the index rises significantly, increasing the cash rent due for the following year. Under IFRS 16, how should the lessee account for this change?
- Recognize the additional rent as an expense in profit or loss only in the year it is actually paid, with no adjustment to the lease liability or the right-of-use asset
- Treat the change as a lease modification, which requires the lessee to remeasure the lease using a newly revised discount rate as of the date the index changes
- Ignore the change entirely for accounting purposes, because payments linked to a published index are treated as fully variable, off-balance-sheet payments under IFRS 16 in the same way as payments linked to sales or usage
- Remeasure the lease liability to reflect the revised future lease payments, discounted using the discount rate applied at lease commencement (left unchanged), with the corresponding adjustment made to the right-of-use asset
Why D? And why not the others?
Correct answer: D. Remeasure the lease liability to reflect the revised future lease payments, discounted using the discount rate applied at lease commencement (left unchanged), with the corresponding adjustment made to the right-of-use asset
IFRS 16 paragraphs 27(b) and 42(b) require variable lease payments that depend on an index or a rate to be included in the initial measurement of lease payments using the index or rate at commencement, and then remeasured when there is a change in the future lease payments resulting from a change in that index or rate (typically when the adjustment to the cash payments takes effect). This remeasurement uses the discount rate applied at commencement, left unchanged, because a change in an index or rate is not a lease modification, and the offsetting entry adjusts the right-of-use asset rather than profit or loss. The option expensing the extra rent as incurred with no balance-sheet adjustment is wrong because index-linked variable payments are explicitly brought into the lease liability, unlike payments that are truly variable with no index or rate basis (for example, payments based purely on sales or usage), which are expensed as incurred and never enter the liability. The option treating the change as a lease modification requiring a revised discount rate is wrong because IFRS 16 distinguishes remeasurement triggered by an index or rate change (unchanged discount rate) from an actual lease modification, such as a change in the scope or consideration of the lease that was not part of its original terms (which can require a revised discount rate). The option ignoring the change entirely because it is 'fully variable' conflates index/rate-linked payments, which are on-balance-sheet and subject to remeasurement, with genuinely usage- or sales-based variable payments, which are the ones IFRS 16 keeps off the lease liability.
Source: IFRS 16 Leases, paragraphs 27(b) and 42(b) (variable lease payments that depend on an index or a rate)