As we discussed here, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.
We’ve already discussed some of the issues attaching to the first step in the new standard’s lease accounting model, to identify at inception of a contract whether that contract is a lease, or contains a lease, and the standard’s major scope exemption. Let’s look now at some matters relating to determining the lease term. This is:
- the non-cancellable period of a lease, together with both:
- (a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
- (b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.
In making the determination, the entity considers all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option to extend the lease, or not to exercise the option to terminate the lease. These include:
- contractual terms and conditions for the optional periods compared with market rates, such as fixed or variable payments or option payments;
- significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable;
- costs relating to the termination of the lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee’s needs, costs of integrating a new asset into the lessee’s operations, or termination penalties and similar costs;
- the importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset, the location of the underlying asset and the availability of suitable alternatives; and
- conditionality associated with exercising the option (ie when the option can be exercised only if one or more conditions are met), and the likelihood that those conditions will exist.
The standard notes: “The shorter the non-cancellable period of a lease, the more likely a lessee is to exercise an option to extend the lease or not to exercise an option to terminate the lease. This is because the costs associated with obtaining a replacement asset are likely to be proportionately higher the shorter the non-cancellable period.” It also observes that the lessee’s past practice (for example, whether it has typically used particular types of assets for particular periods of time) may be helpful in assessing whether the lessee is reasonably certain to exercise, or not to exercise, an option.
All of this might in some cases generate a different analysis of the lease term from the current definition in IAS 17: “the non-cancellable period for which the lessee has contracted to lease the asset together with any further terms for which the lessee has the option to continue to lease the asset, with or without further payment, when at the inception of the lease it is reasonably certain that the lessee will exercise the option.” The term “reasonably certain” is the same between the new and the old standards, but the greater supporting guidance in IFRS 16 might generate a different analysis in some cases.
In the basis for conclusions to the standard, the IASB notes other possible approaches to this issue that it considered and rejected. Additional periods could in theory have been reflected using a components approach, in which options in a lease are recognized and measured as separate components of the lease; a disclosure approach, in which an entity recognizes a lease liability or a lease receivable for the non-cancellable period and discloses the existence of any options to extend the term; or a measurement approach, in which options in a lease are included in the measurement of lease assets and lease liabilities using a particular method – such as a probability-weighted method. Some stakeholders argued to the IASB that payments to be made during future optional periods don’t meet the definition of a liability for the lessee (or an asset for the lessor) until those options are exercised. They argued that an entity with a five-year non-cancellable lease is in a different economic position from an entity with a three-year lease with an option to extend for two years that may or may not be exercised. Scanning these rejected arguments and approaches can be useful in focusing on and applying the principles behind what the IASB did decide.
Anyway, an entity revises the lease term if a change occurs in the non-cancellable period of a lease. For example, this will change if the lessee exercises an option it didn’t previously include in its determination of the lease term, or if it doesn’t exercise an option it did previously include in its determination of the lease term.
More to come on other aspects of IFRS 16…
The opinions expressed are solely those of the author