Determining the Lease Term Under IFRS 16
IFRS 16, Leases, prescribes a single lessee accounting model requiring lessees to recognize most leases on the balance sheet by recognizing their right to use an asset for a period of time and an associated liability for their obligation to make lease payments. Check out our overview course on IFRS 16 for more information on the general requirements for lease accounting.
The IFRS Interpretations Committee (IFRIC) continues to receive questions on various aspects of applying IFRS 16. In this post, we take a look at an issue posed to the IFRIC Committee related to the lease term.
Lease term
IFRS 16 states that the lease term is determined at the lease commencement date (i.e., the date the underlying asset is available to the lessee) based on the non-cancellable period for which the lessee has the right to use the underlying asset, together with:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Note that to determine the lease term, one must determine what is “reasonably certain.”
Reasonably certain
When would a lessee be reasonably certain to exercise or not exercise an extension or termination option?
The answer is: If they have an economic incentive to do so.
A practice issue was brought to the IFRIC committee regarding the determination of the lease term for a renewable lease. Let’s walk through the issue via an example:
Mac Co. enters into a contract to lease an office building from Cheese Inc. The contract does not specify a particular contractual term. It states that after 18 months, the contract renews indefinitely unless terminated by either party to the contract. To terminate, either party only needs to give 2 months’ notice to the other party. The contract does not oblige either party to make a payment on termination.
How should the lease term be determined for this renewable lease?
Remember, the lease term is the non-cancellable period of a lease, together with the periods covered by an option to extend the lease if the lessee is reasonably certain to exercise the option, and periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
In the application guidance to IFRS 16 and in particular, paragraph B34, it indicates that in determining the lease term and assessing the length of the non-cancellable period of a lease, an entity should, in addition to applying the definition of a contract, determine the period for which the contract is enforceable.
That same paragraph specifies that a lease is no longer enforceable when the lessee and the lessor each has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.
Additionally, in the Basis for Conclusions of IFRS 16, it indicates that in the IASB’s view, the lease term should reflect an entity’s reasonable expectation of the period during which the underlying asset will be used because that approach provides the most useful information.
No more than an insignificant penalty
A similar scenario with a question was also posed to the IFRIC:
When applying paragraph B34 of IFRS 16 and assessing the “no more than an insignificant penalty” guidance, should an entity consider the broader economics of the contract and not only the contractual termination payments? Such consideration might include, for example, the cost of abandoning or dismantling leasehold improvements.
The IFRIC Committee observed that in the scenario provided to them to review, the broad economics of the contract (and NOT only contractual termination penalties) should be considered as well as whether each of the parties has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.
Remember, paragraph B34 states that a lease is no longer enforceable only when both parties have such a right.
In summary
This is just one of many issues received (and reviewed) by the IFRIC. If you are interested in other practice issues reviewed by the IFRIC, as well as staying up to date on recently issued IFRS standards and amendments, consider taking our IFRS Update course, which you can find on our learning library.
You can also check out our Leases technical topic page where we discuss other accounting considerations, compare IFRS 16 to ASC 842, and provide links to all of our lease courses and other helpful resources!
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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.
