In business, leases usually represent a significant fixed cost that needs to be paid regularly. The COVID-19 epidemic stopped or restricted the business activities of many lessees who thus lost their income but their obligation to pay rent continued.
Certain lessees were able to pay their rents from reserves they had made in prior periods, others used the government’s support and some assessed the situation and decided to reduce the area of leased premises or move their activities to cheaper premises and leave the existing ones. In this article, we would like to outline the accounting impacts of business decisions relating to lease relationships, including both the decision to continue on the current premises using the state support and the decision to partly or entirely terminate the existing lease contract.
Subsidies for the lease of business premises
The government support provided to entrepreneurs whose business activities were demonstrably limited due to reasons relating to the COVID-19 epidemic is governed by Act No. 210/2020 Coll., on Certain Measures to Mitigate the Impacts of the SARS CoV-2 Coronavirus Epidemic on Lessees of Business Premises (hereinafter the “Act to Mitigate Impacts on Lessees”).
This Act regulates the option to postpone rent payments for business premises for the period from 12 March to 30 June 2020 until the end of 2020 without entrepreneurs being exposed to the risk of unilateral termination of the contract by the lessor on the grounds of their failure to pay rent.
The ban on termination of a contract for the lease of premises applies from the effective date of the Act to 31 December 2020 (so called “protective period”). If the lessee fails to pay the rent owed by 31 December 2020, the lessor is entitled to terminate the lease of business premises with a five-day notice period.
The Act to Mitigate Impacts on Lessees is not accompanied by any changes in accounting regulations, i.e. its impacts do not change the regular accounting treatment of rents and their inclusion in expenses (the lessee) and income (the lessor).
Agreed postponement of rent maturity
Any agreed postponement of rent maturity has no impact on the reporting of expenses by lessees or income by lessors. The lease continues and as such, it is recognised in the reporting period in which it is provided, the rent deferment will only have effect on the lessee’s and the lessor’s cash flow. The relief consisting in the maturity postponement will have an impact on the move of provisioning for receivables, both statutory and accounting.
Under the Act to Mitigate Impacts on Lessees, provision of a rent discount is a precondition to receive the state subsidy and therefore, we assume that this alternative will be the most frequent. Discount provision will be reflected in the reduction of the lessor’s income. The lessee’s rent will be recognised net of the lessor’s discount and once a subsidy arising from the above-mentioned government support is granted, the support will be reported in a regular manner as part of Other operating income pursuant to Section 25 of Regulation No. 500/2002 Coll., for entities maintaining double entry accounting records (hereinafter the “Regulation”) and Czech Accounting Standard No. 017.
Early termination or notice of termination of a lease contract
Czech accounting regulations do not explicitly stipulate whether or how to recognise a loss arising from a lease contract for premises that the lessee discontinued using for business, or what the treatment is if the lessee moves to other premises under more favourable conditions and terminates the original contract in part or as a whole and there are two parallel contracts in place – the new and the original one. In addition, the lessee may be subject to sanctions for early termination of the lease contract.
For similar situations, International Financial Reporting Standards (IFRS) use the term “onerous contracts” and create reserves (provisions under IFRS terminology) for loss arising therefrom. IAS 37 defines an onerous contract as a contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. The unavoidable costs under a contract reflect the least net cost of exiting from the contract, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfil it. In May 2020, Amendments to IAS 37 were issued specifying the ”costs of fulfilling a contract”. The amendments are effective from 1 January 2022.
1. May onerous contracts be recognised under Czech Accounting Standards?
Entities are obliged to maintain accounting books and records so that the financial statements prepared based on them provides a true and fair view of the subject matter of accounting and the financial situation of the entity (Section 7 (1) of Act No. 563/1991 Coll., on Accounting, hereinafter the “Accounting Act”).
We believe that Czech entities also have to create reserves for onerous contracts. In our opinion, this results from the general principle of a true and fair view, the prudence concept (Section 25 (3) of the Accounting Act) and Directive 2013/34/EU of the European Parliament and of the Council of 26 June 2013 on the annual financial statements (hereinafter the “Directive”), which provides, inter alia, a more detailed definition of reserves than the wording transposed to the Accounting Act. The Accounting Act implemented the Directive as of 1 January 2016 (Section 1 (1) of the Accounting Act), therefore, provisions of the Directive are applicable to the Czech accounting framework.
The financial statements user must be informed of the amount of liabilities which the entity is committed to pay, and the portion of profit to be used to settle the existing liability should be “protected” through reserves.
The EU Directive stipulates in Article 12 that provisions (i.e. reserves under CAS terminology) shall cover liabilities the nature of which is clearly defined and which at the balance sheet date are either likely to be incurred or certain to be incurred, but uncertain as to their amount or as to the date on which they will arise. At the balance sheet date, a provision shall represent the best estimate of the expenses likely to be incurred or, in the case of a liability, of the amount required to meet that liability.
The above-mentioned definition indicates that the amount needed to settle a clearly defined liability arising from an onerous contract existing as of the balance sheet date should be reported through a reserve.
Premises no longer used do not bring any economic benefit to the entity; however, the company has a liability arising from the lease contract that is likely to be settled through a cash outflow the amount of which may be reliably estimated.
In other words, unavoidable costs of the lease contract to satisfy the liability stipulated in the contract are higher than the economic benefits that are expected to be received based on the contract.
Such a contract thus has features of a loss-making, onerous contract and a reserve should be created to cover the costs relating to the future cash outflow.
2. How to calculate the amount of reserve?
The amount of reserve should be calculated as the lower of:
- The difference between the sum of all rent payments until the termination of the lease contract and any possible income from sub-lease, or
- Sanction for early termination of the contract.
Any possible income from the sub-lease should be certain enough as of the date of the financial statements (reserve calculation), preferably stipulated in a contract; otherwise, its use in the calculation is hard to justify (pursuant to Section 25 (3) of the Accounting Act – refer to Section 5 below).
In philosophical terms, a manager acting with due care selects the procedure leading to a lower loss.
What about discounting?
If the lease relationship is long-term (the remaining contract term is more than 12 months from the balance sheet date), the issue of cash flow discounting to determine the amount of reserve should be taken into consideration. Although the Accounting Act does not specifically anticipate this method of valuation of liabilities, or reserves (it anticipates e.g. using the fair value for technical reserve valuation in the insurance business), we believe that in order to meet the requirement of providing a true and fair view, reserve calculation should reflect the time value of money and discounting should be applied. In order to meet the requirements of tax regulations, it is appropriate to use specific sub-ledger accounts for the reserve and the profit and loss accounts relating to the recognition and update of the reserve to include the time value of money.
3. Where to recognise a reserve for loss-making contracts?
The reserve for loss-making contracts is recognised in the balance sheet in line “B.4. Other reserves” and in the profit and loss account in line “F.4. Reserves relating to operating activities and complex deferred expenses”.
We recommend describing the content of the reserve and method of its creation in the notes to the financial statements.
4. Updating recognised reserves
A reserve recognised in year X should be updated in the following years. Especially changes in the time value of money, the updated residual value of loss arising from the loss-making contract and any possible change in income reducing the amount of loss from sub-lease, etc. should be reflected.
Rents are often agreed in foreign currencies, typically in euros. A reserve is a liability that is subject to the revaluation using the CNB’s exchange rate as of the balance sheet date and the update will thus include the effect of possible exchange rate movements.
5. Technical improvements of unused premises
The Accounting Act stipulates the prudence principle in Section 25 (3). It requires that entities only include profit generated as of the balance sheet date in its valuation as of this date, taking into account all foreseeable risks and possible losses relating to assets and liabilities and known to them as of the financial statements date as well as all impairment irrespective of the fact whether the entity generated profit or incurred loss in the reporting period.
The Regulation also stipulates how to apply the prudence principle to bookkeeping. In terms of fixed asset valuation, the Regulation requires an entity whose fixed asset valuation is subject to change to recognise a temporary adjustment to the value through provisions and a permanent adjustment through depreciation.
If the unused premises, as well as technical improvements made to the premises, no longer bring any economic benefit to the reporting entity, the entity should consider whether there is a permanent or temporary impairment of the technical improvement, estimate the impairment value and recognise the impairment in line with the prudence principle in the company’s balance sheet.
6. Where to report impairment of technical improvement?
Permanent or temporary decrease in the value (impairment) of technical improvement is reported in the profit and loss account in line “E. Adjustments to values in operating activities” (Section 24a of the Regulation).
The balance sheet for the current period includes the amount of technical improvement not adjusted for provisions and accumulated depreciation (gross), the amount of related provisions and accumulated depreciation (adjustment) and the amount of technical improvement reduced by provisions and accumulated depreciation (net).
7. Reserve for restoration of the leased premises to the original condition
If the contractual relationship includes the lessee’s obligation to restore the premises to the original condition and the lessee creates (depending on materiality) a reserve for this item, the situation in which a lease contract becomes onerous as specified in Section 1 and a reserve is considered as described in Section 3 above may mean, for example, that:
- Reserve creation will continue over the remaining lease term, or
- Reserve creation will be accelerated if the contract is terminated early and subject to penalty.
This context should be taken into consideration. A reserve for restoration of the leased premises to the original condition also represents management’s estimate that needs to be updated at least as of the balance sheet date.