Applying IFRS 16 – Understanding the Termination and Extension Options
Issued by the IASB, IFRS 16, published in 2016, replaces its counter-regulation IAS 17 and will apply for all and any annual accounting periods from January 1st, 2019.
This new standard, just like IAS 17 before it deals with the accounting treatment of leases, but it is fair to say in a more proscriptive manner than just setting out guidelines to be interpreted – the FASB has issued a similar standard as FAS 13 ASC 842.
Key differences between the lease and outright purchase of assets exist and one of these is most apparent in the options available to each at the end of a particular period. What happens then?
A vanilla operating lease will expire, due notice having been served, at the end of the minimum or fixed term of the lease. At that point or shortly before arrangements can be mutually agreed between the lessor and lessee to either
- Return the asset or assets subject to the lease to the lessor or
- Continue the lease of the asset(s) at the underlying periodic rental on a period by period basis or
- Negotiate a secondary term at the same or more usually a reduced periodic rental payment
A non-vanilla operating lease will expire likewise but among other options may offer the lessee the opportunity to
- Terminate the lease early or
- Extend the lease for a further fixed term or terms at a pre-agreed rental or
- Though strictly speaking outside the remit of an operating lease give “purchase” options
As essentially lessees must treat all leases going forward from 1st January 2019 as though they were finance type leases – recording the asset value and associated committed liabilities on the balance sheet of the lessee – it is key to understand the implications for leases already contracted that may have extension or termination options and additionally the benefits of negotiating such options for future leases and the implications of contracting to them. Also, for consideration always is the “reasonable certainty” or otherwise of any such option being adopted by the lessee – put bluntly, is the lease a finance lease or purchase in disguise? The lessee may have complete freedom to exercise the option or through lack of choice may have little option but to exercise the extension. Further what of leases already in a secondary term with more than 12 months to run.
What is the Lease Term?
Set out in IFRS 16:18 the lease term is defined as “the non-cancellable period for which a lessee has the right to use an underlying asset, together with any:
- periods covered by an option to extend the lease if the lessee is ““reasonably certain”” to exercise that option and
• periods covered by an option to terminate the lease if the lessee is ““reasonably certain”” not to exercise that option.
This definition is an example of the standard being more regulatory then IAS 17.
Why Would a Lessee Opt for a Shorter Lease Term?
If off balance sheet finance of assets has been a mainstay of a business then in order to mitigate the impact of the new standards, IFRS 16 and ASC 842, a lessee may “contract” to leases of shorter periods thus reducing the committed liabilities and hopefully resulting in a more desirable financial outcome. Operationally, however, the shorter lease periods taken on their own may lead to more expense and wasted resource as assets need to be changed more frequently as the leases expire or result in increased costs through a necessity to extend them.
When does the Lease Term Begin and End?
IFRS 16 is quite explicit in stating that a lease term begins on the ‘commencement date’ of the lease. [IFRS 16:B36] This is defined as the date on which the lessor makes an underlying asset available for use by a lessee. [IFRS 16: Appendix A] and it is the date on which the lessee initially recognises and measures right-of-use assets and lease liabilities. Though payments may have been made by the lessee to the lessor prior to the commencement date, a lessee does not obtain and control its right to use the underlying asset until the commencement date, before which, the lessor has not yet performed under the contract though under IFRS 16:B44 any such payments must be treated as and included in total lease payments. The lease term of an operating lease contractually ends, assuming there has been no default during the term, at the end of a fixed term lease or on completion of the lessee’s obligations under a minimum term agreement.
What is the Length of the Lease Term
In assessing the length of a lease term the lessee must consider:
- The length and number of the rental periods
- Any “free” periods provided by the lessor to the lessee IFRS 16: B36
- Any extension options that the lessee might be ““reasonably certain”” to exercise through choice or obligation
- Whether any termination option that exists is either unlikely to be exercised or impracticable to exercise
- Whether any option is enforceable
With the above in mind under IFRS 16:BC128, the lessee must take into account any periods that are likely to be non-cancellable under either termination options or extension options. Under IFRS 16:18 the lessee will include any such non-cancellable periods as part of the lease term calculation.
How is “reasonable certainty” Assessed and Applied?
Reasonable certainty is a “measurement” that the lessee should apply under IFRS 16:B37 to whether they are likely to
- exercise an option to extend the lease; or
- exercise an option to purchase the underlying asset or
- not exercise an option to terminate the lease.
In making these assessments, all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option must be valued and that value taken into account – [IFRS 16:19 & B37].
When making these assessments, IFRS 16:B37 advises that factors to include among others are
- contractual terms and conditions for the optional periods compared with market rates, such as:
– the value of rentals for the lease in any optional period;
– the amount of any variable payments for the lease or other contingent payments, such as payments resulting from termination penalties and residual value guarantees; and
– the terms and conditions of any options that are exercisable after initial optional periods (e.g. any purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates);
- 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 or “repair” costs;
– relocation and return costs;
– costs of identifying another underlying asset suitable for the lessee’s needs;
– costs of integrating a new asset into the lessee’s operations; and
– termination penalties and similar costs, including costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location;
- the importance of that underlying asset to the lessee’s operations (considering, for example, whether the underlying asset is a specialised asset, the location of the underlying asset and the availability of suitable alternatives); and conditionality associated with exercising the option (i.e. when the option can be exercised only if one or more conditions are met), and the likelihood that those conditions will exist.
A contractual option to extend or terminate a lease may be combined with one or more other obligations (e.g. a residual value guarantee) such that the lessee guarantees the lessor a minimum or fixed cash return that is “substantially” the same regardless of whether the option is exercised. In such cases, there can be assumed a “reasonable certainty” that the termination option will not be exercised and the extension option will be – IFRS 16:B38.
We have already looked at why shorter-term leases might be considered but 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. Among other considerations this is because the costs associated with obtaining a replacement asset, locating it, installing it and retraining staff are likely to be proportionately higher the shorter the non-cancellable period – IFRS 16:B39.
Similarly, an assessment can be made on “reasonable certainty” of adoption of an option by taking account of the behaviour of the lessee in the past with regard to selection and use of assets and the leasing of such assets.
Reassessment of Lease Term
With all of the above in mind as IFRS 16 or ASC 842 is adopted, the lessee needs to reassess its existing lease portfolio with particular regard to the identified “reasonable certainties” and accept and account for the revised lease terms. With leases going forward, the lease term needs to be assessed at outset from the “commencement date” thru any contractually “non-cancellable” lease periods and to further include any lease periods where there is “reasonable certainty” that they will eventually materialise – whether through a significant event, historical habit, compelling economics or enforceability issues.
Reassessment is an ongoing event and a lease should be revisited as to its term on the occurrence of any significant event – IFRS 16:20. Such an event may be any of the following:
- significant leasehold improvements not anticipated at the commencement date 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;
- a significant modification to, or customisation of, the underlying asset that was not anticipated at the commencement date;
- the inception of a sublease of the underlying asset for a period beyond the end of the previously determined lease term; and
- a business decision of the lessee that is directly relevant to exercising, or not exercising, an option (e.g. a decision to extend the lease of a complementary asset, to dispose of an alternative asset or to dispose of a business unit within which the right-of-use asset is employed).
Revision of Lease Term
Having reassessed the lease term then it is necessary of course to revise the lease term and to account for it going forward with regard to such revision. Such revision is required under IFRS 16:21 whenever
- the lessee exercises an option not previously included in the entity’s determination of the lease term;
- the lessee does not exercise an option previously included in the entity’s determination of the lease term;
- an event occurs that contractually obliges the lessee to exercise an option not previously included in the entity’s determination of the lease term; or
- an event occurs that contractually prohibits the lessee from exercising an option previously included in the entity’s determination of the lease term.
- on the change of assessment of “reasonable certainty” of adoption of an option after a lease has begun
How do you Revise?
This is a period of uncertainty with regard to work involved and impact of adoption of IFRS 16/ASC 842. Resource needs to be applied and LOIS Lease Accounting, the web-based software solution from Innervision has been developed with just this in mind. Not only will it manage your existing portfolio but from you implementing it then it will assess each lease (new or old), generate the journals for your general ledger to reflect the revised lease terms whenever an option is taken, not taken or its “reasonable certainty” changes. Amortisation, balance sheet, depreciation and committed liabilities are all recalculated and accounted for. Visit www.innervision.co.uk for a demo.
If you’re looking for further guidance on how to effectively transition to the new standard, or if you have any other questions around how it could impact your organisation, download our free guide, ‘The 7 Steps to Lease Accounting Compliance’ – just follow the link below to access your copy.
Disclaimer: this article contains general information about the new lease accounting standards only and should NOT be viewed in any way as professional advice or service. The Publisher will not be responsible for any losses or damages of any kind incurred by the reader whether directly or indirectly arising from the use of the information found within this article.