Foreign Currency Leases Under IFRS 16: Accounting and Examples

Foreign Currency Leases Under IFRS 16

A foreign currency lease is one whose payments are denominated in a currency other than the lessee's functional currency. It is accounted for under two standards at once: IFRS 16 measures the lease, IAS 21 translates it.

That division produces the defining feature of these arrangements. The lease liability is a monetary item, so it is retranslated at every closing rate. The right-of-use asset is non-monetary, so it stays frozen at the commencement date rate. One side of the original entry moves with the currency and the other does not, and the gap between them is an exchange difference in profit or loss with no offsetting movement anywhere else.

Two facts make the rest of this article easier to follow:

1. Every measurement decision — lease term, discount rate, remeasurement, modification — is made in the currency of the lease, before any translation happens.
2. Over the full lease term the total charge to profit or loss always equals the functional currency cash actually paid. Currency movements change the timing and the line items, never the total.

Throughout, the reporting entity is a UK company whose functional currency is sterling (GBP), leasing under a contract denominated in US dollars (USD). Exchange rates are quoted as £ per $1, so a rate of 0.75 means $1 buys £0.75 and a rising rate means a strengthening dollar.

Two Standards, One Lease

IFRS 16 contains almost no foreign currency guidance. It does not need to: a lease liability is a financial liability and a right-of-use asset is a non-financial asset, and IAS 21 already tells you how to translate both. The work is therefore done in a fixed order.

Why the Liability and the Asset Diverge

IAS 21 classifies every balance as monetary or non-monetary, and the two sides of a lease fall on opposite sides of that line. This is not an anomaly to be corrected; it is the direct consequence of what each balance actually is.

The economic logic is that the entity's exposure is to the cash it must still hand over. Once the right of use has been obtained, its cost is spent and settled; no future currency movement can change what the entity paid for it. The unpaid rentals, by contrast, remain fully exposed until settled.

Measurement at Commencement

At the commencement date the lease is measured entirely in the lease currency and translated once.

• Lease liability — the present value of the lease payments not yet paid, discounted at the rate implicit in the lease or, if that cannot be readily determined, the lessee's incremental borrowing rate. Both the payments and the rate are expressed in the lease currency. See our article on the lease liability for the full mechanics.
• Right-of-use asset — the lease liability, plus initial direct costs, plus payments made at or before commencement, plus any restoration obligation, less lease incentives received.
• Translation — the spot rate on the commencement date converts the liability into the functional currency, and the right-of-use asset is recognised at the same converted amount.

Each component of the right-of-use asset is translated at the rate applying on the date it arises, which is usually the commencement date but need not be:

Subsequent Measurement: The Four Moving Parts

After commencement, four things happen each period, and only one of them uses the closing rate.

In practice the exchange difference is best derived as a balancing figure rather than calculated component by component. Roll the functional currency liability forward through interest and payments, then compare it with the lease currency closing balance translated at the closing rate. The difference is the exchange difference:

Opening liability + interest − payments = expected closing liability Actual closing liability (foreign currency balance × closing rate) − expected closing liability = exchange difference

This is more reliable than translating each movement separately, because it automatically captures the interaction between the rate used for interest, the rate used for payments and the closing rate.

Choosing the Discount Rate

The discount rate must match the currency of the cash flows it discounts. If a sterling entity discounts dollar rentals at its sterling borrowing rate, it is applying the interest rate environment of one currency to the cash flows of another, and the resulting liability is wrong in both currencies.

Where the rate implicit in the lease can be readily determined, that rate is used and the currency question resolves itself — it is derived from the lessor's cash flows, which are denominated in the lease currency. Where it cannot, the incremental borrowing rate must be the rate the lessee would pay to borrow, over a similar term and with similar security, the funds necessary to obtain a similar asset in the same currency as the lease payments.

For entities in higher-interest-rate economies leasing in a hard currency, the difference is not marginal. A South African group with a rand borrowing rate of 11% and a dollar borrowing rate of 6% will overstate its discounting — and understate its dollar lease liability — by a wide margin if it uses the rand rate.

Example 1: A Three-Year Dollar Lease

The full pattern in one lease.

• Commencement — 1 January X1
• Term — three years, no extension or termination options
• Payments — 100,000 dollars annually in arrears, each 31 December
• Discount rate — the incremental borrowing rate in dollars, 6%
• Year end — 31 December
• Rates (£ per $1) — commencement 0.750; average X1 0.765, closing X1 0.780; average X2 0.790, closing X2 0.800; average X3 0.810, closing X3 0.820

Step 1 — Measure the lease in dollars

The liability is the present value of three payments of 100,000 discounted at 6%, which is 267,301 dollars. That schedule is fixed at commencement and is unaffected by anything the exchange rate subsequently does.

Step 2 — Translate at commencement

The liability of 267,301 dollars is translated at 0.750, giving 200,476. With no initial direct costs, prepayments or restoration obligation, the right-of-use asset is recognised at the same amount.

Step 3 — Roll the liability forward in sterling

Interest is translated at the average rate for the year and each payment at the spot rate on 31 December. The closing liability is the dollar balance at the closing rate, and the exchange difference is the balancing figure.

Taking year X1 line by line:

• Interest — $16,038 × 0.765 = 12,269
• Payment — $100,000 × 0.780 = 78,000
• Closing liability — $183,339 × 0.780 = 143,004
• Exchange loss — 143,004 − (200,476 + 12,269 − 78,000) = 143,004 − 134,745 = 8,259

Step 4 — Journals for year X1

Step 5 — What the three years add up to

The total charge equals the total cash paid, exactly. That is the control that proves a foreign currency lease schedule: depreciation plus interest plus exchange differences must equal the functional currency cash outflow over the life of the lease. If it does not, a rate has been misapplied somewhere.

What the currency movement changes is the shape of the charge. Depreciation is flat because the asset is frozen at 0.750. Interest falls as the liability amortises. The exchange losses front-load the pain, because the exposure is largest when the outstanding balance is largest — the same 3-cent move costs 8,259 in year one and 1,944 in year three.

Remeasurements and Modifications

When the lease changes, the sequence is unchanged: recalculate in the lease currency under IFRS 16, then translate the adjustment at the spot rate on the date of the change.

Two consequences follow, and both surprise people.

The right-of-use asset becomes a layer cake. Each remeasurement adds a slice translated at a different rate, and each slice is then frozen. The asset's carrying amount is a blend of historical rates that no single exchange rate will ever reconcile to. This is correct, and it is why the asset should be tracked in the functional currency after commencement — attempting to maintain a foreign currency carrying amount for the right-of-use asset and translating it at reporting dates reintroduces exactly the retranslation IAS 21 prohibits.

A revised discount rate must still be a rate in the lease currency. Where a reassessment requires a revised rate, it is the entity's incremental borrowing rate in the lease currency at the date of reassessment — not the original rate, and not a functional currency rate.

Example 2: Remeasuring for a Rent Review

Continuing Example 1. On 1 January X2 a contractual rent review linked to an index increases the two remaining annual payments from 100,000 to 110,000 dollars. Because the change arises from an index, the original discount rate of 6% is retained.

Step 1 — remeasure in dollars. The present value of two payments of 110,000 at 6% is 201,673 dollars, against a carrying amount of 183,339 dollars. The increase is 18,334 dollars.

Step 2 — translate at the remeasurement date rate. The spot rate on 1 January X2 is 0.780. The adjustment is 18,334 × 0.780 = 14,301.

Step 3 — note the two layers. The right-of-use asset now carries 200,476 at 0.750 and 14,301 at 0.780. Its carrying amount immediately after the remeasurement is 133,651 (cost less one year's depreciation) plus 14,301 = 147,952, which is depreciated over the remaining two years at 73,976 per year. Neither layer will ever be retranslated.

Step 4 — carry on. The liability continues to be retranslated as before, now on a larger balance.

The rent review raised the liability by 14,301 and the exchange loss for X2 by 377 relative to Example 1 — because a bigger dollar balance carries a bigger dollar exposure. The depreciation charge rose too, but only by the amount of the new layer spread over the remaining term. Currency and scope changes stack; they do not interact.

Variable Payments and Third Currencies

Two situations regularly cause difficulty.

Payments that vary with an index or rate. These are included in the liability at the index level ruling at commencement, and remeasured when the index changes — in the lease currency first, then translated at the remeasurement date rate as in Example 2. Payments that vary with usage or sales are excluded from the liability entirely and expensed as incurred, translated at the spot rate when the obligation arises. Our article on variable lease payments covers the distinction in full.

Payments settled in a currency other than the currency of the contract. The currency of the lease is the currency in which the payments are contractually fixed, not necessarily the currency in which cash happens to move. A contract that fixes rent in dollars but permits settlement in rand is a dollar lease: the liability is measured and retranslated in dollars, and the conversion into rand on each payment date is simply the spot transaction that settles it.

Foreign Currency Leases vs Leases of a Foreign Operation

These are different problems and they are constantly confused. The test is whose functional currency you are comparing the lease against.

The counter-intuitive point is the last row of the asset line. A right-of-use asset that is never retranslated in the subsidiary's own accounts is retranslated on consolidation, because translating a foreign operation into the presentation currency applies the closing rate to all assets and liabilities regardless of their monetary status. The difference goes to other comprehensive income rather than profit or loss, so it never touches earnings.

A group can face both problems at once, and then the layers apply in order: first the subsidiary translates the foreign currency lease into its own functional currency under the transaction rules, then the group translates the subsidiary into the presentation currency.

Example 3: A Dollar Lease Inside a Euro Subsidiary

The same three-year dollar lease from Example 1, now held by a subsidiary whose functional currency is the euro, in a group that presents in sterling. Rates: at commencement €0.90 per $1 and £0.85 per €1; at the first year end €0.95 per $1 and £0.82 per €1.

Layer 1 — the subsidiary translates the dollar lease into euros. This is the foreign currency transaction problem, and it behaves exactly as in Example 1.

The exchange loss on the liability is recognised in the subsidiary's profit or loss, and it flows into consolidated profit unchanged.

Layer 2 — the group translates the subsidiary into sterling. Every asset and liability is translated at the closing rate of £0.82 per €1, the right-of-use asset included.

The right-of-use asset was frozen at €240,571 and will stay there for the whole lease. In sterling it moves every year, because the closing rate moves. That sterling movement is a translation difference recognised in other comprehensive income and accumulated in the foreign currency translation reserve — it is not an exchange difference under the transaction rules, and it never reaches profit or loss unless the foreign operation is disposed of.

Income statement items are translated at the rate on the transaction date, in practice an average rate for the period. The subsidiary's depreciation of €80,190 and its dollar exchange loss are both translated at the X1 average euro/sterling rate, not the closing rate.

Hedging the Currency Exposure

A lease liability is a recognised financial liability, so it can be a hedged item under IFRS 9. This matters because the exposure is often large, long-dated and highly predictable — a better hedging candidate than most trade balances.

Where the FX risk on the recognised lease liability is designated in a cash flow hedge, the effective portion of the derivative's gain or loss goes to other comprehensive income and is reclassified to profit or loss in the periods in which the hedged exchange differences affect profit or loss — offsetting the IAS 21 retranslation. Designating a fair value hedge of the currency risk instead takes the derivative movement straight to profit or loss, where it meets the retranslation directly.

Without hedge accounting, a forward contract taken out over the lease payments is still measured at fair value through profit or loss under IFRS 9. The two effects largely offset in aggregate, but they will not match period by period, because the derivative is measured on forward rates while the liability is retranslated at spot rates.

Presentation, Cash Flows and Disclosure

Income statement. The exchange difference arises on a financing liability, so it is ordinarily presented within finance costs or as a separate exchange line, not in operating expenses. It should not be netted against interest on the lease: they are different items with different drivers, and combining them obscures both. The policy must be applied consistently and disclosed where the amounts are material.

Cash flow statement. Three separate points, all of which get missed:

• Cash payments are translated at the spot rate on the payment date. The principal element is a financing outflow; the interest element follows the entity's chosen policy for interest paid.
• The unrealised exchange difference on the outstanding liability is a non-cash item and is eliminated in the reconciliation from profit. It is not a cash flow of any category.
• It is also not part of the "effect of exchange rate changes on cash and cash equivalents", which relates only to foreign currency cash balances. Presenting the lease retranslation there is a common and material error. Our article on foreign exchange in the cash flow statement works through the reconciliation in detail.

Disclosure. Beyond the standard IFRS 16 disclosures — depreciation by class, interest expense, total cash outflow for leases and the maturity analysis of lease liabilities — a foreign currency lease portfolio attracts additional attention:

Our article on IFRS 16 disclosures sets out the full lessee disclosure package.

Common Mistakes

Quick Reference Summary

Conclusion

A foreign currency lease is not a special kind of lease. It is an ordinary IFRS 16 lease measured in the currency of its payments, translated by IAS 21 like any other transaction.

Everything distinctive about it follows from a single classification: the liability is monetary and moves with the closing rate, the right-of-use asset is non-monetary and does not move at all. Interest and payments are translated at the rates ruling when they occur, remeasurements enter the asset at the rate on the day they happen, and the exchange difference on the liability is recognised in profit or loss.

Over the lease term the total charge always reconciles to the functional currency cash paid — which is the check worth running before anything is filed.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.