IFRS 16: understanding the principles of lease terms

While they might look straightforward at first, all new IFRS® Standards require a certain level of interpretation and judgement that give way to challenges and questions. IFRS 16 is no exception and its lease term assessment is a great example.

Of course, as you might already suspect, simple contractual arrangements are not always the best answer when it comes to IFRS Standards. The same applies to assessing lease terms under IFRS 16.

To help you out, let’s delve into the main principles.

A lease term is the noncancelable period of the lease combined with the lessee’s option to extend the lease term or to not terminate it early.

This means that the lease term equals the shortest period over which the lessee knows he or she will be legally obliged to make lease payments, taking into account the options to extend or terminate that are reasonably certain to be exercised. An assessment of the option’s exercisability considers broader economic incentives based on the relevant facts and circumstances that exist upon commencement of the lease – e.g. market rent, nature of the leased asset, cost of returning or improving the asset, or availability of an alternative asset.

In determining the noncancelable period, the entity only considers the period during which the lease is enforceable. In other words, the lessee must be able to exercise his or her option to terminate or extend – e.g. if the option to extend cannot be exercised without the lessor’s agreement, then it cannot be counted in the lease term.

On the other hand, enforceability can exceed the contractual lease term – for example, when the economics of the transaction do not align with the contractual term (typical for related party transactions or when the lessee invests in significant leasehold improvements with a useful life longer than the lease term). In such cases, the parties carefully assess the existence of any non-contractual enforceable rights and the possibility of including them in the lease term.

Any option to terminate held by the lessee is assessed as described above, e.g. inclusion in or exclusion from the noncancelable period must be enforceable, and the lessee must be reasonably certain to exercise it or not.

If the option to terminate belongs to the lessor, however, it is disregarded. For example, if the lease term is three years and the lessor has the option to terminate after one year, the noncancelable lease term is still three years. This is because the lessee has an unconditional obligation to pay for the period of the lease unless and until the lessor decides to terminate the lease, which is out of the lessee’s control.

It gets trickier when both parties have the right to terminate or to not renew. Such a lease is no longer enforceable if both parties can terminate without permission from the other and with no more than an insignificant penalty.

When assessing insignificant penalties in this case, broader economic substance, not only contractual cash flows, will be considered: cost of relocation/replacement, significance of the asset, etc. In other words, the termination clause must have real economic substance. Without any economic significance such a clause does not prevent the contract from being enforceable.

Secondly, if only one party has a right to terminate without permission from the other, the enforceable option needs to be evaluated based on the principles explained above.

If at any time during the lease term the noncancelable period changes, the entity needs to revise the lease term and recalculate the lease liability and right-of-use asset. The calculation must occur at the time of the change using a revised discount rate. This can happen, for example, because of significant changes in circumstances that are within the lessee’s control. Notably, the result of these changes affects the lessee’s decision on whether or not to extend or terminate the lease. Additionally, it contractually obliges lessees to exercise an option or prohibits them from exercising an option not previously included in the determination of the lease term.

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This article has been written by Katerina Buresova.