008: What is the lease term of cancellable property rental contracts under IFRS 16?
IFRS question 008: Lease term of cancellable property rentals under IFRS 16
A company has opened a branch at a building, by signing a rental agreement with the landlord of the building on which branch is situated.
The initial agreement will be for 10 years and either party can terminate the agreement at any time by giving two month’s notice.
The tenure of the agreement can be extended at both parties consent. The company has no intention to discontinue the branch operations in near future. However, loss-making branches may be subject to relocation or closure in the future.
What is the lease term in this case? And, how to account for this lease?
IFRS answer 008
This is a great question, because similar contracts are very common.
In many rental contracts there are provisions about terminating the leases by any party, either by the lessee or by the lessor and exactly these provisions can deeply affect how you are going to account for the leases.
The new lease standard IFRS 16 was issued in 2016 and it’s mandatory to apply it for the periods starting on or after 1 January 2019.
It introduced the revolutionary change in accounting for operating lease contracts by the lessees.
Under IAS 17, as long as the lease is operating, you just book the rental costs as an expense in profit or loss and that’s it.
Under IFRS 16, you as a lessee do not classify the lease anymore, but instead you recognize all the leases in the same way:
- You recognize the right-to-use asset and lease liability in the statement of financial position, and
- Each rental payment is then split to the reduction of the lease liability and finance cost,
- Plus, you amortize the right-to-use asset.
If you really need to know it well, then I recommend checking out my IFRS Kit that teaches you IFRS 16 and other standards in a very easy way, step by step, with lots of practical examples in Excel.
There are few exemptions when you do not have to account for the right-of –use asset:
- The lease is either short-term, that is for 12 months and less with no purchase option, or
- You are leasing the asset that has low value when new, like computer or furniture, just as an example.
These are optional exemptions, so you can take them, but you don’t have to.
Let’s get back to the question – do we have the short-term lease here? Or not?
Well, IFRS 16 says that the lease term is non-cancellable period of the lease. Non-cancellable period means that the contract is enforceable during that period.
If any part can terminate the lease unilaterally, or without the consent of the other party, and there are no significant penalties, then the contract is no longer enforceable.
The question said that the lease was for 10 years, but any party could terminate the lease anytime with 2 months notice.
What does it tell you?
Is the lease non-cancellable?
No, it is not. In fact, it is cancellable within 2 months and there’s no mention about the penalties.
In fact, the lease is non-cancellable just for the period of 2 months, not 10 years.
Here, you can’t take into account the assumption that the company does not plan to relocate within the near future.
It does not matter, because also the lessor can cancel the lease without any penalty.
The situation would be different if the right to terminate the lease on a short-term notice has just one party:
- If the right to terminate the lease with 2 months notice has just the lessee and the lessor must keep the lease term at 10 years as agreed, then the right to terminate is the same as the option to terminate.In this case, lessee would assess how long would he want to stay in the property based on many factors.
- If the right to terminate the lease has just the lessor, not the lessee, then the non-cancellable period includes the period covered by the option to terminate the lease (just 2 months in the question). However, please be careful here, because a lessor’s right to terminate is often ignored when determining the lease term, because the lessee must pay for ROU for the period of lease (until the lessor terminates). Thus it would be 10 years if the lessor’s right to terminate is ignored.
Finally, how to account for such a lease?
Well, as soon as you understand that the lease is non-cancellable only for 2 months in this case, it is a short-term lease and you have 2 options:
- Either you can apply the exemption for short-term leases and book the rental payments as expenses in profit or loss. Just be careful, because you should apply this exemption to all class, not on one-by-one basis.So, let’s say you’re a bank and you regularly rent the offices for your branches with similar terms, you have to apply the exemption to all of them, not selectively.
- The second option is not to apply exemption, but account for the lease as for any other lease, that is – right-of-use asset, lease liability, etc.But, in this case, I would not recommend it because it would be highly impractical for various reasons.
If you want to learn more about the new lease standard IFRS 16, then I strongly recommend checking out my IFRS Kit – it fully covers new IFRS 16 in step-by-step videos together with highly practical examples solved in excel.
Hereby I would like to thank Mr. Bostjan Pecnik for the interesting conversation related to this topic and for additional guidance he provided.
Please, share your thoughts, questions or comments below these show notes. Thank you!
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