How does the acquirer in a business combination account for the acquiree’s lease restoration provisions?

This article was originally published in September 2023. It was updated in December 2024 to reflect alternative views.

When one business acquires another as part of a business combination accounted for under IFRS 3 Business Combinations, the acquirer must determine the appropriate accounting for the acquiree’s leases. The acquiree continues to recognise its leases as usual, but the acquirer, in its group financial statements, has to make various adjustments in the group’s consolidated financial statements.

Accounting for the right-of-use (ROU) asset and lease liability at acquisition date

The acquirer in a business combination measures the identifiable assets acquired and identifiable liabilities assumed at their acquisition-date fair values. However, there is an exemption for leased assets of the acquiree.

Accounting for restoration provisions

Lease restoration obligations are recognised separately from the lease liability as a provision under IAS 37 Provisions, Contingent Liabilities and Contingent Assets. At the acquisition date, the acquirer recognises the restoration provision at its fair value.

Accounting for the debit side

IFRS 16 requires a lessee to include in the cost of its ROU asset, an estimate of restoration costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located, or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories.

However, as noted above, when an acquirer accounts for a lease as part of a business combination, the ROU asset is measured at the same amount as the lease liability. So, where is the debit side of the restoration provision recognised? Despite IFRS 3, paragraph 28B, can it be included in the cost of the ROU asset recognised by the acquirer, or is it simply recognised as part of goodwill?

Example

Entity B has a lease for its office premises. At the end of the lease, Entity B has an obligation to ‘make good’ the property, i.e. to restore it to its original condition. Entity B therefore recognised a restoration provision upon commencement of the lease, and included a corresponding amount in the cost of the ROU asset.

Entity B is subsequently acquired by Entity A in a business combination for $2.5 million. The following information is relevant regarding the identifiable assets and liabilities of Entity B at acquisition date:

	$
Fair value of identifiable assets (excluding ROU assets)	12,500,000
Fair value of identifiable liabilities (excluding lease liabilities and restoration provisions)	10,000,000
Fair value of restoration provision	50,000
Present value of remaining lease payments for office premises	250,000

At acquisition date, Entity A recognises a lease liability and equivalent ROU asset for $250,000 in its consolidated financial statements (IFRS 3, paragraph 28B). No further adjustment is required to the ROU asset because Entity B’s lease payments were at market rates at commencement of the lease, as well as at the business combination acquisition date.

There are two possible ways for Entity A to account for the debit side of the fair value of Entity B’s lease restoration provision on the acquisition date:

• Method 1 – the measurement of the ROU asset does not reflect the effect of the restoration provision – recognise as part of goodwill
• Method 2 (BDO’s preferred method) – the measurement of the ROU asset reflects the effect of the restoration provision.

Rationale for Method 1 – Restoration provision recognised as part of goodwill

Because the ROU asset equals the lease liability, Entity A does not make any further adjustments to the ROU asset at acquisition date (IFRS 3, paragraph 28B). That is, the costs associated with the restoration provision cannot be included as part of the cost of the ROU in the consolidated financial statements, and is included as part of goodwill.

Entity A calculates goodwill for its acquisition of Entity B in its consolidated financial statements as follows:

	$	$
Cash		2,500,000
Identifiable assets	12,500,000
ROU assets	250,000
	12,750,000
Identifiable liabilities	(10,000,000)
Lease liabilities	(250,000)
Restoration provision	(50,000)
	(10,300,000)
Net assets acquired		2,450,000
Goodwill		50,000

Rationale for Method 2 – Restoration provision recognised as part of the ROU asset

IFRS 3.28B requires that the acquirer measures the ROU asset at the same amount as the lease liability at the acquisition date, adjusted to reflect favourable or unfavourable terms of the lease when compared with market terms. While IFRS 3.28B does not include an explicit reference to any restoration provision being a part of the ROU asset when the acquirer acquires the property lease, it requires the measurement of the ROU asset to be adjusted to reflect favourable or unfavourable terms when compared with market terms.

The terms of the lease payments, which are at market, contemplate the fact that the lessee will be obligated to restore the property at the end of the lease term, for example, by painting it. If this obligation were not present in the lease contract, the lease payments would (all other things being equal) be higher. Therefore, the ROU asset should be adjusted to reflect the fact that the contractual lease payments are ‘off market’ compared to a lease contract that is only for the right to use the underlying asset, with no associated restoration provision.

Entity A, therefore, includes the debit side of the restoration provision when measuring the ROU asset at the acquisition date. Entity A calculates goodwill for its acquisition of Entity B in its consolidated financial statements as follows:

	$	$
Cash		2,500,000
Identifiable assets	12,500,000
ROU assets	300,000
	12,800,000
Identifiable liabilities	(10,000,000)
Lease liabilities	(250,000)
Restoration provision	(50,000)
	10,300,000
Net assets acquired		2,500,000
Goodwill		Nil

Need assistance?

Our website contains information about how BDO can help you with your lease accounting. We have a cloud-based lease management system called ‘BDO Lead’ to help you manage the complexities around implementing IFRS 16 in practice. We also provide outsourced leased management services where we manage lease accounting on your behalf using BDO Lead.

Please contact BDO’s IFRS & Corporate Reporting team if you require assistance with your lease accounting.