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IFRS Question 019: Capitalization of the rental expenses

We run the school and we plan to build the new school building on the leased land. We leased a land from the government for 40 years with an option to renew for another period. The rentals are at market conditions.

The construction is going to take about 3 years. Can we capitalize the rental payments during construction into the cost of the new school building?

Another question is that a part of the older school building undergoes major refurbishment and we had to lease a building to continue with classes. Can we capitalize these rentals into the cost of the new building?
 

IFRS Answer 019

The short answer is – NO, I would not do it, in both cases.

Let me explain you why.
 

Capitalization of land rental expenses

I know that many companies do capitalize the rental expenses in pre-opening period or during the construction because they consider it as expenses directly attributable to bringing the asset to the location and condition to operate as intended by the management.

But, let me tell you that the rental expenses in this case are NOT attributable to the construction itself, but they are attributable to the leased property – land.

The paragraph 58 of IAS 16 specifically says that the land and buildings are separable assets and are accounted for separately when they are acquired together.

So, yes, it is true that without this rental expense the school would not be able to construct the new school building, but under IAS 16, the company still must distinguish the land and building.

In this case, the rental expense relates to the land, not the building – so no capitalization.

Also, let me point you to the paragraph 19 of IAS 16.

It deals with expenses during the pre-opening period – it’s clearly said that no, you cannot capitalize the similar expenses.
 

What to do instead?

Well, we are in 2018 and currently, there are two lease standards: IAS 17 and IFRS 16.

I’m sure you are aware of the main difference:

  • Under older IAS 17, the school would have to book the rental expenses for the land in profit or loss because it’s clearly operating lease. IAS 17 says that the land of the lease is operating.
  • Under the new IFRS 16, you need to book the right-of-use asset resulting from the operating lease.

It means that you need to discount all the future rentals by the interest rate implicit in the lease to the present value and this would be your right-of-use asset.

That’s the debit side, and the credit is the lease liability.

So, under IFRS 16, you are effectively capitalizing the operating lease of land anyway, in the form of right-of-use asset.

And, as it is 2018, I strongly recommend applying IFRS 16 now and not wait, because it is applicable since 1 January 2019, the next year and you would have to do that anyway, just later.
 

Capitalization of rental expenses to continue business

The school refurbishes the old building and moves classes to another leased building while the new one is constructed or the older one is refurbished.

Can the school capitalize the rental expenses of the alternative building?

No, it cannot.

The reason is that these expenses are not directly attributable to the construction of the new building or to the refurbishment of the old one – I think that the school can do both without renting out the alternative building.

These expenses are attributable to continuing the business, they are simply related to the revenue-generating activities and thus they need to be expensed.

Of course, here’s IFRS 16, so if you apply this standard and the lease is for more than 12 months, then you would probably need to account for certain right-of-use asset, too.

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