As we’ve discussed on many past occasions, the IASB has issued IFRS 16 Leases, effective for annual reporting periods beginning on or after January 1, 2019.
We looked here 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; significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract; costs relating to terminating the lease; the importance of the underlying asset to the lessee’s operations; and whether the option can be exercised only if one or more conditions are met, and if so the likelihood that those conditions will exist. The standard 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.
CPA Canada’s IFRS Discussion Group recently fleshed out these concepts by considering some specific examples, for instance:
- Retailer A has leased a store in a preferred high-density location for an initial non-cancellable term of five years, with an option to extend the lease by another five years at a premium rate compared to market rate at the end of the initial term. Past practice has demonstrated that, on average, Retailer A generally remains in a leased location for over 10 years.
Of course, one often wishes such fictional scenarios came with more detail, but the example as it stands is still useful in illustrating the kinds of judgments that will sometimes be necessary. On the one hand, there might be a potential cost saving to the lessee from moving on after five years and avoiding the premium rate increase. On the other hand, its past practice might suggest this won’t be the determining factor, although the group noted the importance of putting such past practice in context and carefully considering its predictive value – for instance “Retailer A’s business objective may change over the years and technological advancements or changes in customer shopping behaviour may affect its future decision to continue leasing a physical location.” The group might have cited other considerations too, such as the entity’s plans for lease improvements and its budgeted period for recovering their cost. Overall, it didn’t arrive at a clear answer for what the lease term would be. One can imagine other scenarios though in which the lease term would more likely be limited to the non-cancellable period, when an above-market rate increase gets imposed at the end of that period; for example, in a situation involving back-office space which can be readily vacated and replaced.
Here’s another scenario the group considered:
- Security Co. is in the business of providing corporate security monitoring services to customers. Security Co. enters into a service contract with its customer to provide security monitoring services for 12 months. At the same time, it also enters into a lease contract with the customer to provide security equipment for 12 months. The security equipment must be returned at the end of the term. Both contracts have been combined and accounted for as a single contract.
- Both contracts automatically renew for 12 months if the customer does not terminate them two months before the 12-month contract term expires. Security Co. cannot terminate the contract after 12 months. Past practice shows that 90 per cent of Security Co.’s customers do not terminate the contract before 12 months; after 24 months, 70 per cent of the customers remain under contract; and after 36 months, only 20 per cent of the customers remain under the contract.
The premise here is that any renewal would be at market rate, so no financial incentive exists one way or the other. Other factors apply though, such as the time, effort and inconvenience to the customer to change service providers (e.g., returning the previous equipment and having new equipment installed) – the group labels these as “non-monetary” factors, although the discussion also points out that they do have cost implications (time is money). The group concluded such factors are relevant in assessing the likelihood of the lessee extending the contract. It also noted: “it is inherently more difficult for a lessor to assess a lessee’s action when considering if the lessee is reasonably certain to exercise an extension term. The lessor should also assess whether the population of leases are homogenous to ensure it is reasonable to apply termination percentages based on past practice.” Once again, one can fairly easily imagine how adding further facts to the scenario might tilt the assessment one way or the other.
The group considered a few other examples too. In one case, it even reached a specific, unconditional answer on what the length of the lease term should be. Go read it for yourself!
The opinions expressed are solely those of the author