Not-for-profit entities (NFPs) to recognise peppercorn leases on the balance sheet

In February 2017 Accounting News we highlighted the requirements of the new income recognition standard for NFPs, AASB 1058 Income of Not-for-Profit Entities.

One of the big impacts of the AASB 1058 requirements is that assets subject to peppercorn leases, i.e. those with below-market payments, will be capitalised on the balance sheet, with a credit to income.

Scope

AASB 1058 applies to transactions where the consideration to acquire an asset is significantly less than fair value, principally to enable the not-for-profit (NFP) entity to further its objectives.

How does this apply to peppercorn leases?

Peppercorn leases are leases where the lease payments do not reflect the fair value of the property being leased. In other words, the consideration paid by the lessee is significantly less than the fair value.

These arrangements typically occur in the NFP space, where philanthropists may grant an NFP the right to use premises at peppercorn (nominal) rentals. This results in the financial statements not reflecting the true value of economic resources available to the NFP.

What types of entities would have peppercorn lease arrangements?

The following types of NFPs may have peppercorn lease arrangements:

Schools leasing Crown land
Schools leasing land owed by a religious order
Sporting clubs from local councils
Boat and yachting clubs from local councils
Surf Lifesavers clubs, etc.

What does AASB 1058 require?

The standard sets out recognition and measurement requirements for both the debit and credit side of transactions.

Debit entry

Assets (debit side) are recognised by applying other applicable Australian Accounting Standards such as:

AASB 9 Financial Instruments (e.g. for cash received)
AASB 116 Property, Plant and Equipment (for PPE)
AASB 138 Intangible Assets, and
AASB 16 Leases.

Consequential amendments have been made to the respective standards above so that assets are measured initially at fair value in accordance with AASB 13 Fair Value Measurement where the consideration for the asset is significantly less than fair value principally to enable the entity to further its objectives.

AASB 16 has also been amended to explicitly require that if an NFP is the lessee in a lease with significantly below-market terms and conditions, principally to enable the entity to further its objectives, the right-of-use asset is measured at fair value in accordance with AASB 13 Fair Value Measurement.

Credit entry

Once assets have been recognised at fair value, the corresponding credit entry could be made to:

A contribution by owners
Revenue (AASB 15 Revenue from Contracts with Customers)
Lease liability (AASB 16 Leases)
Financial instrument (AASB 9 Financial Instruments), or
Provisions (AASB 137 Provisions, Contingent Liabilities and Contingent Assets).

Any excess of the fair value of the asset recognised, over the credit entry above is recognised immediately in profit or loss.

How does this impact the recognition and measurement of peppercorn leases?

Currently, peppercorn leases for premises are usually classified as operating leases under AASB 117 Leases and expensed as incurred at the amount of the nominal lease payments.

AASB 1058 will require peppercorn leases to be recognised and measured as follows:

The right-of-use asset will be recognised and measured at fair value under AASB 13
A lease liability for the nominal peppercorn payments will be recognised under AASB 16, and
The difference between 1 and 2 above will be recognised immediately in profit or loss as income.

Action points

Valuations will need to be performed to establish the fair value at transition date for the right-of-use asset subject to the peppercorn lease.

However, the Basis for Conclusions to AASB 1058 notes that:

Fair value is only required at initial recognition or transition to measure the right-of-use asset and is not required on an ongoing basis (i.e. the right-of-use asset can continue to be recognised using the cost model), and
Valuations do not need to be performed by a professional valuation expert.

Example 1 - Peppercorn leases – recognition after the effective date of AASB 1058

Extracted and adapted from AASB 1058 Example 14

Background

School A, a not-for-profit school, was built on land leased to it by Church B.

On 1 July 2020, Church B (the lessor) leases the land to School A (the lessee) for a payment of $10 per year for 99 years (i.e. a peppercorn lease).

On 1 July 2020:

Present value of the remaining lease payments is $100
Fair value of the right of use of the land is $2 million.

School A has a 30 June year end.

As there is a significantly below-market lease at inception of the lease, School A identifies that the transaction is within the scope of AASB 1058.

School A determines that the peppercorn lease does not give rise to a contribution by owners, a contract with customer under AASB 15, a provision under AASB 137, or a financial instrument under AASB 9.

How should School A account for this peppercorn lease?

School A accounts for the peppercorn lease by recognising on 1 July 2020:

A right-of-use asset for the land of $2 million
A lease liability under AASB 16 of $100, and
The difference between the fair value of the right-of-use asset ($2 million) and the lease liability ($100) as income.

Accounting treatment

The journal entry for the accounting on commencement date of the lease (1 July 2020) is:

Dr		Right-of-use asset – land	$2,000,000
Cr		Lease liability		$100
	Cr	Income		$1,999,900

Example 2 - Peppercorn leases – accounting on transition – first time adoption of AASB 1058

Extracted and adapted from AASB 1058 Example 14

Background

School A, a not-for-profit school, was built on land leased to it by Church B.

Church B (the lessor) leases the land to School A (the lessee) for a payment of $10 per year for 99 years (i.e. a peppercorn lease).

The following information is relevant:

On 1 July 2018:

The present value of the remaining lease payments is $110.
The fair value of the right of use of the land is $2.1 million.

On 1 July 2019:

The present value of the remaining lease payments is $100.
The fair value of the right of use of the land is $2 million at 1 July 2019.

School A has a 30 June year end.

Prior to applying AASB 1058, School A had not previously recognised a right-of-use asset for land or a lease liability.

Modified retrospective approach on transition

If School A elects to apply the modified retrospective approach permitted on transition to AASB 1058, it does not restate comparatives in first year of adoption, but makes adjustments on 1 July 2019 via opening balances of its accumulated surplus.

How should School A account for the peppercorn lease on transition to AASB 1058 in its 30 June 2020 financial statements?

School A accounts for the peppercorn lease in accordance with the transition requirements of AASB 1058 by recognising:

The right-of-use asset for the land as at 1 July 2019 at the fair value of $2 million
The lease liability under AASB 16 of $100 (this accounting treatment is unaffected by AASB 1058), and
The difference between the fair value of the right-of-use asset ($2 million) and the lease liability ($100) as an adjustment to the opening balance of School A’s accumulated surplus as at 1 July 2019.

Accounting treatment

The journal entry for the accounting on transition date (1 July 2019) is:

Dr		Right-of-use asset – land	$2,000,000
Cr		Lease liability		$100
	Cr	Opening accumulated surplus		$1,999,900

Full retrospective approach on transition (applying AASB 108)

If School A elects to apply the full retrospective approach on transition to AASB 1058, it must restate comparatives in the first year of adoption.

How should School A account for the peppercorn lease on transition to AASB 1058 in its 30 June 2020 financial statements?

School A accounts for the peppercorn lease in accordance with the transition requirements of AASB 1058 by recognising:

The right-of-use asset for the land as at 1 July 2018 at the fair value of $2.1 million
The lease liability under AASB 16 of $110 (this accounting treatment is unaffected by AASB 1058), and
The difference between the fair value of the right-of-use asset ($2.1 million) and the lease liability ($110) as an adjustment to the opening balance of School A’s accumulated surplus as at 1 July 2018.

Accounting treatment

The journal entry for the accounting on transition date (1 July 2018) is:

Dr		Right-of-use asset – land	$2,100,000
Cr		Lease liability		$110
	Cr	Opening accumulated surplus		$2,099,890

Comparatives for the year ending 30 June 2019 will then be restated as follows:

Lease liability – to reflect the $10 peppercorn lease payment
Profit or loss – to reflect the amortisation of the right-of-use asset over 99 years (1 year’s amortisation expense) as well as interest expense on the lease liability (although not material in this case).