Do you think that you have no leases to account for under IFRS 16 Leases because you only have either undocumented arrangements between related entities in a group, or because you have leases that continue indefinitely after an initial non-cancellable period, and these arrangements can be terminated at any time by either party without penalty?
If so, this article explains why you should think again.
Except for certain low value and short-term leases, for years beginning on or after 1 January 2019, IFRS 16 requires lessees to capitalise all leases on their balance sheets by recognising a right-of-use asset and a related lease liability. The amount capitalised is derived from the lease liability, which is determined by discounting the future lease payments due over the ‘lease term’. It is therefore imperative that the ‘lease term’ is determined correctly.
The non-cancellable period is the period for which a lessee has the right to use an underlying asset, together with both:
Applying the definition above:
| Enforceable period (maximum lease term) | No enforceable rights and obligations – no contract | ||
| Non-cancellable period - (minimum lease term) | Periods covered by extension options where lessee is reasonably certain to exercise | Periods covered by termination options where lessee is reasonably certain NOT to exercise | |
Figure 1
Fact pattern 1
Lessee enters into a lease for office premises with Lessor for a non-cancellable period of five years.
The lease does not contain any options (either explicit or implicit) to extend or terminate the lease.
Assume that there are no provisions for ‘hold over’ terms, either contractually or under common law. (We note that in Australia it would be extremely rare to encounter leases with no ‘hold over’ clauses).
Where leases do not contain options for lessees to either extend the period of the lease, or to terminate the lease early, it is a simple process to determine the ‘lease term’ because it is merely the non-cancellable period of the lease. In this example, Lessee uses the non-cancellable period of the lease (five years) as the lease term when determining the lease liability.
Fact pattern 2
Lessee enters into a lease for office premises with Lessor for a non-cancellable period of five years.
Lessee has an option to extend the lease for an additional two years, but is not reasonably certain to exercise this option.
After considering factors in IFRS 16, paragraph B37, Lessee determines that it is not reasonably certain to exercise the extension option. Similar to Fact pattern 1 above, Lessee uses the non-cancellable period of the lease (five years) as the lease term when determining the lease liability.
Fact pattern 3
Lessee enters into a lease for office premises with Lessor for a period of five years.
Lessee has an option to terminate the lease at the end of Year 3 of the five-year lease.
After considering factors in IFRS 16, paragraph B37, if Lessee determines that it is reasonably certain to exercise the termination option at the end of Year 3, the lease has a non-cancellable period of three, rather than five, years. Lessee therefore uses the non-cancellable period of the lease (three years) as the lease term when determining the lease liability.
Determining the ‘lease term’ becomes more complicated for cancellable and renewable leases.
| Type of lease | Description |
| Cancellable leases (leases with ‘hold over’ provisions) | No specified contractual term. Continues indefinitely until either party to the contract gives notice to terminate. |
| Renewable leases (month to month lease) | Specifies an initial lease term. Renews indefinitely at the end of the initial period unless terminated by either party. |
The effect of both cancellable and renewable leases is that they continue to run for an indefinite period of time, the only difference being that renewable leases have an initial non-cancellable period, whereas cancellable leases do not. For both of these types of leases, after the initial non-cancellable period, either the lessee or lessor can terminate the lease at any time, usually with no financial penalty to be paid by either party on termination. Because of the absence of financial penalties stipulated in the contract, many preparers of financial statements quote IFRS 16, paragraph B34, and argue that the lease is not enforceable, and therefore there is no lease term to consider.
In determining the lease term and assessing the length of the non-cancellable period of a lease, an entity shall apply the definition of a contract and determine the period for which the contract is enforceable. 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.
IFRS 16, paragraph B34Reading paragraph B34 above, in order for the lease contract be unenforceable:
Paragraph B34 does not stipulate whether ‘penalty’ refers only to financial penalties (such as the lessee having to pay an amount to the lessor on termination, or vice versa) or whether it also refers to other types of penalties.
The question put to the IFRS Interpretations Committee (Committee) asked whether, when applying paragraph B34 of IFRS 16 to assess whether there is ‘no more than an insignificant penalty’, an entity considers the broader economics of the contract, and not only contractual termination payments.
In applying paragraph B34, the Committee observed that in addition to contractual termination payments, the broader economics of the contract are also considered in order to determine if there are any ‘penalties’.
Although not specifically laid out in the agenda decision, having to consider the broader economics of the contract results in a two-step process when considering the lease term of cancellable and renewable leases:
The Committee observed that, in applying paragraph B34, we must consider the broader economics of the contract, and not merely contractual termination payments. For example, if either party has an economic incentive not to terminate the lease because it would incur a penalty on termination that is more than insignificant, the contract is enforceable beyond the date on which the contract can be terminated.
Examples of economic incentives for a lessee not to terminate the lease could include, for example:
Examples of economic incentives for a lessor not to terminate the lease could include, for example:
Once it has been established that the lease is enforceable, regardless of whether it is the lessee or lessor that incurs the penalty, both parties would then determine the appropriate lease term by referring to paragraphs 19 and B37-B40 of IFRS 16.
Fact pattern
Lessee enters into a lease for office premises with Lessor for a non-cancellable period of five years.
At the end of the non-cancellable five-year period, the lease converts to a ‘month to month’ lease and Lessee and Lessor may each terminate the lease with one months’ notice and no contractual penalty owing.
During this ‘month to month’ period, lease payments are based on the last month’s lease payment from the non-cancellable period, indexed for inflation.
At the commencement date of the lease, Lessee installed leasehold improvements with a useful life of 12 years. These improvements are not capable of being transferred to a different property.
As in Example 1 above, the non-cancellable lease period is five years but the enforceable period is less clear. Although there is no contractual penalty owing on termination, applying the agenda decision, and considering the broader economics of the contract, Lessee is likely to incur a penalty to terminate the lease that is more than insignificant by having to scrap leasehold improvements that are not capable of being transferred to another property. Therefore the contract is enforceable.
This economic penalty could exist anytime from the beginning of year 6 to the end of year 12 and judgement is required. Therefore the maximum lease term is 12 years (end of useful life of leasehold improvements), but it could be less. For example, the maximum lease term could end when the remaining written down value of the improvements becomes insignificant.
| Enforceable period (maximum lease term) – 12 years | No enforceable rights and obligations – no contract | ||
| Non-cancellable period - (minimum lease term) | Periods covered by extension options where lessee is reasonably certain to exercise | Periods covered by termination options where lessee is reasonably certain NOT to exercise | |
| 5 years | N/A – converts to indefinite ‘month to month’ lease after initial period | Requires judgement – Up to an additional 7 years or until the economic penalty of writing off the remaining leasehold improvements becomes insignificant | |
Fact pattern
Sub uses an office building that is owned by Parent.
Sub and Parent have no documented lease agreement, however, Sub pays Parent $5,000 per month for use of the office space.
Sub has used the office space for a number of years and has an established head office at that location.
In this example, there is no documented lease agreement, but a lack of a written contract does not necessarily mean that a lease does not exist. IFRS 16 defines a contract in the same way as IFRS 15 Revenue from Contracts with Customers, i.e. a contract is ‘an agreement between two or more parties that creates enforceable rights and obligations.’
In this example, Sub is habitually utilising space provided by Parent with a set monthly payment, so a contract appears to exist.
To determine the lease term, we follow a similar process to that outlined in Example 2. Sub is required to consider the broader economics of its arrangement with Parent, including both contractual and economic penalties for both Sub and Parent if Sub were to vacate the premises. The fact that the lessor is the parent does not modify the requirements of IFRS 16.
It is likely that Sub would suffer economic penalties if forced to vacate the office space because it has established its head office on these premises. Therefore the lease term could be for a substantial period of time (many years, possibly for the remaining useful life of the office building). Judgement is required in determining the appropriate lease term.
| Enforceable period (maximum lease term) – Up to remaining useful life of building | No enforceable rights and obligations – no contract | ||
| Non-cancellable period - (minimum lease term) | Periods covered by extension options where lessee is reasonably certain to exercise | Periods covered by termination options where lessee is reasonably certain NOT to exercise | |
| NIL | N/A – indefinite | Requires judgement – Up to useful life of the office building | |
The agenda decision establishes that when determining the enforceable period of the lease and the lease term, entities must consider broad economic circumstances beyond purely contractual terms. Contractual terms are not limited to written or verbal contracts – they could be implied. This is in contrast to other IFRS Standards such as IAS 32 Financial Instruments: Presentation where it has been long established that economic compulsion does not affect the classification of a financial instrument.
The agenda decision is also consistent with the Basis for Conclusions to IFRS 16, BC156 which emphasises that ‘the lease term should reflect an entity’s reasonable expectation of the period during which the underlying asset will be used’.
Preparers of financial statements need to rethink how this agenda decision will impact their financial statements, in particular, the separate financial statements prepared for group entities as these may contain the types of undocumented leases referred to in our article.
Group financial statements could also be impacted where leases with unrelated parties have completed their non-cancellable period and are in the ‘month to month’ phase.
Please contact your engagement partner or BDO IFRS Advisory if you require assistance implementing these changes.
IFRIC agenda decisions do not have effective dates or transitional provisions, however, many regulators consider them to be mandatory requirements, and therefore should be implemented as soon as possible.
Nevertheless, entities should have ‘sufficient time’ in order to assess the impact of these agenda decisions, and to implement their effects on an entity’s selection and application of accounting policies.
The Committee finalised this agenda decision on 26 November 2019, shortly before 31 December 2019, which is the first annual reporting period under IFRS 16 for entities with calendar year-ends. Given the short period of time available to implement the effect of the final agenda decision, preparers are reminded of article published by the IASB and written by Sue Lloyd, Vice-Chair of the IASB and Chair of the IFRS Interpretations Committee, which is available here.
The question of what constitutes ‘sufficient time’ will depend on the extent of change, and level of complexity, that arises from an agenda decision. However, it is necessary for preparers to deal with any required changes as quickly as practicable. ‘Sufficient time’ does not permit an entity to delay its work in making the changes that are required.
For entities with a relatively small number of leases, they will have sufficient time to implement the effects of this agenda decision before the finalisation of their 31 December 2019 financial statements.
For entities with large numbers of leases (say, hundreds or thousands), this may not be feasible, however, the period of time before implementation should be completed is generally limited (i.e. to the next interim reporting period).
In situations where an entity is not able to implement the effects of an agenda decision before the financial statements are finalised, clear disclosure should be made of this fact, along with any quantitative information that is available (e.g. the potential impact expressed as a range or a maximum).
The following resources contain more information regarding the agenda decision: