Key Takeaways
- Lease liability is a monetary item - retranslate at the closing rate with forex differences in profit or loss
- Right-of-use asset is a non-monetary item - keep at the historical rate with no ongoing translation adjustments
- Translation from functional to presentation currency creates a Foreign Currency Translation Reserve (FCTR)
- Interest expense uses the average rate; depreciation uses the historical asset rate
- Exchange rate volatility can create significant income statement impacts on large lease portfolios
Understanding Translation Currencies
When leases are denominated in a currency other than the entity's functional currency, IFRS 16 must be applied in conjunction with IAS 21 (The Effects of Changes in Foreign Exchange Rates). Understanding the different currency concepts is essential.
Denominated Currency
The currency in which lease payments are made - commonly called the "lease currency". For example, a UK subsidiary paying rent in USD has a USD-denominated lease.
Functional Currency
The currency of the primary economic environment in which the entity operates - typically the currency in which it primarily generates and expends cash.
Presentation Currency
The currency used to present the entity's financial statements. This can be any currency and may differ from the functional currency for group reporting purposes.
Translation to Functional Currency
When a lease is denominated in a foreign currency, it must first be translated to the entity's functional currency. IAS 21 provides the general translation rules:
Monetary Items
Use the closing rate
Monetary items are settled in cash. The lease liability is monetary because it represents an obligation to pay a fixed amount of foreign currency.
Non-Monetary Items
Use the historical rate
Non-monetary items carried at historical cost use the exchange rate at the transaction date. The right-of-use asset is non-monetary.
IFRS 16 Items and Exchange Rates
| IFRS 16 Item | Classification | Rate to Use |
|---|---|---|
| Lease liability | Monetary | Closing rate |
| Right-of-use asset | Non-monetary | Historical rate (commencement date) |
| Lease payments | Transaction | Spot rate at payment date |
| Interest expense | Income/expense | Average rate (or spot rate at transaction date) |
| Depreciation | Income/expense | Historical rate (same as ROU asset) |
Key Insight
Because the lease liability uses the closing rate and the ROU asset uses the historical rate, the two will diverge over time due to exchange rate movements - unlike leases in the functional currency where they unwind symmetrically.
Exchange Rate Differences on Lease Liabilities
Exchange rate movements between the lease liability's carrying amount and its translation at the closing rate create foreign exchange differences. These are recognised in profit or loss.
Example: Foreign Currency Lease Liability
A EUR functional currency entity has a USD-denominated lease:
- Lease liability at commencement: $100,000 at spot rate 0.90 EUR/USD = €90,000
- After Year 1 interest and payment, liability in USD: $82,000
- Year-end closing rate: 0.95 EUR/USD
- Lease liability at closing rate: $82,000 × 0.95 = €77,900
The movement in the liability includes:
- Interest expense (using average rate)
- Lease payment (using spot rate on payment date)
- Foreign exchange difference (balance to reach closing rate)
Income Statement Volatility
Large foreign currency lease portfolios can introduce significant exchange rate volatility into the income statement. This is often an unexpected consequence of IFRS 16 adoption for multinational groups with cross-border leases.
Depreciation of Foreign Currency ROU Assets
The right-of-use asset is a non-monetary item measured at historical cost. It is not retranslated - depreciation is calculated based on the historical rate at which the asset was initially recorded.
Example: ROU Asset Depreciation
- ROU asset cost: $100,000 at commencement spot rate 0.90 EUR/USD = €90,000
- Lease term: 5 years, straight-line depreciation
- Annual depreciation: €90,000 ÷ 5 = €18,000 per year
The depreciation charge remains €18,000 regardless of subsequent exchange rate movements. The asset carrying value at year 1 end is €72,000 (€90,000 - €18,000).
No forex on ROU asset: In the functional currency, the right-of-use asset is non-monetary, so no foreign exchange differences arise on the asset itself. All forex impacts flow through the lease liability.
Translation to Presentation Currency
When an entity's presentation currency differs from its functional currency, a second level of translation is required for group reporting. IAS 21 provides the rules for non-hyperinflationary economies:
| Item | Translation Rule |
|---|---|
| Assets and liabilities | Closing rate at reporting date |
| Income and expenses | Average rate for the period |
| Resulting difference | Other comprehensive income (FCTR) |
Foreign Currency Translation Reserve (FCTR)
When translating to presentation currency, a difference arises between the movements during the year (using average rates) and the closing balance (using closing rates). This difference is recognised in Other Comprehensive Income as part of the Foreign Currency Translation Reserve.
Example: Translation to Presentation Currency
A EUR subsidiary reports to a GBP parent. Exchange rates:
- Opening EUR:GBP = 0.89
- Average EUR:GBP = 0.87
- Closing EUR:GBP = 0.85
| ROU Asset Movement | Rate | EUR | GBP |
|---|---|---|---|
| Opening balance | Opening (0.89) | €90,000 | £80,100 |
| Depreciation | Average (0.87) | (€18,000) | (£15,660) |
| FCTR adjustment | N/A | - | (£3,240) |
| Closing balance | Closing (0.85) | €72,000 | £61,200 |
The £3,240 FCTR adjustment represents the exchange difference on translation to presentation currency.
Practical Considerations
Managing Forex Complexity
Foreign currency leases create ongoing complexity that requires careful management:
When the Discount Rate Currency Matters
The incremental borrowing rate should reflect the currency of the lease payments. A USD-denominated lease should use a USD borrowing rate, not a rate converted from the entity's functional currency.
Simplification
Consider whether hedging the lease payments might reduce income statement volatility. While not required, some entities use forward contracts or other instruments to manage forex exposure on significant foreign currency leases.
Summary: Exchange Rate Application
| Stage | Item | Rate | Forex Impact Location |
|---|---|---|---|
| To Functional Currency | Initial ROU asset | Spot at commencement | None (frozen) |
| Initial lease liability | Spot at commencement | None (at recognition) | |
| Lease liability (ongoing) | Closing rate | Profit or loss | |
| Interest expense | Average rate | N/A | |
| Depreciation | Historical rate | N/A | |
| To Presentation Currency | All assets/liabilities | Closing rate | OCI (FCTR) |
| All income/expenses | Average rate | OCI (FCTR) |
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.