Lease contracts with “Inflation- Index”, “Contingent rentals” or “Variable Intt.” – Embedded Derivatives as per Ind-As/ IFRS
In continuation of previous articles on “ Double-double test, Caps & Floor, Call/Put/ Prepayments, Foreign Currency Bonds & Credit derivatives– Embedded Derivatives as per Ind-As/ IFRS”, Lease contracts which are having clauses related to the price adjustments based on Inflation Index, Contingent rentals based on sale or Variable Interest rates are to be assessed whether these embedded derivatives require separation or to be consider it as closely related.
Leased Assets are being given to earn rentals and all future rentals normally should be agreed in a way where it can actually beat inflation amount to keep that earning relevant for owner of assets. Hence many countries including India, an Inflation Index related price adjustment clause is being mentioned in such lease agreement which comes under the definition of Derivatives. Similarly some of the lease agreements cover a clause which states that the lease rental will be based on some basic price PLUS an additional percentage on sales. And some others would include a clause where the lease prices will change based on changes in Variable interest rates.
Standard has provided specific guidance on these issues and reader would be able to note these kind of specific topics where standards specifically given a certain accounting treatment about such embedded derivatives.
Let’s have a quick reference of the standard which talks about such Lease related options and related guidances if separation is required-
Ind-As 109 – “Financial Instruments”
Para -B-4.3.8 (f)- An embedded derivative in a host lease contract is closely related to the host
contract if the embedded derivative is
(i) an inflation-related index such as an index of lease payments to a consumer price index (provided that the lease is not leveraged and the index relates to inflation in the entity’s own economic environment),
(ii) contingent rentals based on related sales or
(iii) contingent rentals based on variable interest rates.
Let’s have a clarity about the concept first before we get into an example. Inflation related Index (or any other index which can relate to Inflation) of any country specifies the amount of changes related to the Inflation of that period and it would be prudent to provide an option in leases agreements where future period rentals will be adjusted based on this index and hence this derivative should be treated as closely related. Now, Careful to note here- Inflation Index must be of the place where LEASED ASSET situated and should not related to any other region in order to make it eligible as closely related. Further there are some situation where such reference Inflation Index is being used over and above the normal inflation rate e.g. 1.2 times of index or 1.5 times of index(might be Inflation index or consumer price index etc), these are called leveraged conditions and standards specifically exclude these leveraged clauses in order to be eligible as closely related. Rest two clauses are contingent rentals based on sales which has specifically described as closely related. Another one is variable Interest rates which is again should be in line with the objectives mentioned above i.e. Variable Interest rate should be of that Leased asset economic environment only and should not be leveraged.
Let’s take an example to understand the overall objective of the standards and its related guidances –
An Entity (operates in Singapore) provides a Leased Asset (located in India) to entity A (operates in India). Lease agreement has basic lease rentals of INR 1 Million for next 5 years and rentals will be subject to the below clauses –
1) Lease rentals will be based on Inflation price Index of Singapore? Or
2) Lease rentals will be based on Inflation price Index of India where the leased asset situated? Or
3) Lease rentals as per point 2 will be multiplied by 1.5 X of index price? Or
4) Lease rentals will be based on basic price PLUS 2% of sales of Entity A as contingent rentals? Or
5) Lease rentals will be based on Variable rate as per MIBOR (Where leased asset situated)?
Specify which embedded derivative will require separation from its host lease agreement?
Suggested approach –
1) Since leased asset is situated in India , hence inflation index reference from any other economic environment will not be treated as closely related. Hence separation is required.
2) Since Inflation price Index is using as reference of economic environment in which a leased asset situated, hence it will be closely related. No separation required.
3) Inflation related reference rate should be in line of normal inflation prices and anything over and above will be classified as LEVERAGED (as per para 4.3.8 (f)) and hence separation is required.
4) All contingent rentals which are based on sales of a lease will be treated as closely related as per the para 4.3.8 (f) of Ind-As 109 and hence no separation is required.
5) Variable Interest rate reference of the economic environment in which leased asset operates i.e. India will be treated as closely related subject to the conditions that it is not leveraged. In this example MIBOR which is Mumbai Interbank rates will be construed as closely related and hence no separation is required.
Readers will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as an Independent IFRS Advisor & Corporate Trainer. He can be reached via email at firstname.lastname@example.org or Whatsapp +91-9634706933)