Lease agreements can be complex, often including multiple renewal and termination clauses. Although determining the lease term is nothing new, it takes on a new significance under IFRS 16 Leases.
Lease term is now a critical estimate – affecting the size of the lease liability for a lessee and the lease classification for a lessor. It also determines whether a lease is eligible for the recognition exemption for ‘short-term’ leases for lessees.
Our publication Lease term – How long is the lease? (PDF 1.7 MB) contains practical guidance and examples showing how to determine the lease term when the lease commences and when to reassess it.
The lease term is the non-cancellable period of the lease, together with optional renewable periods if the lessee is reasonably certain to extend, and periods after an optional termination date if the lessee is reasonably certain not to terminate early.
To determine the lease term, a company first determines the length of the non-cancellable period of a lease and the period for which the contract is enforceable. It can then determine – between those two limits – the length of the lease term.
The new guidance on lease term has proved controversial. In 2019, after many companies had published opening statements of financial positions including new lease assets and liabilities, the IFRS Interpretations Committee was asked to consider the lease term. In December 2019, the Committee published its conclusion that when determining the lease term a company always considers the broader economics of the contract – not just the narrow contractual terms. For some companies, this view could drive a change in accounting policy.
The standard requires a substantial effort for companies to identify all leases with payments that should be included in the measurement of assets and liabilities and to determine the lease term based on the combined effects of the contractual arrangements and the relevant laws and regulations.
The standard introduces new estimates and judgements that affect the determination of the lease term – e.g. determining the enforceable period and whether a lessee is reasonably certain either to exercise a renewal option or not to exercise a termination option.
A company determines the lease term at the commencement date. A lessee is required to reassess the lease term on the occurrence of a significant event or change in circumstances that is within its control and directly affects whether it is reasonably certain to exercise (or not to exercise) an option included in the original contract. Both lessees and lessors revise the lease term if there is a change in the non-cancellable period. This requires ongoing monitoring and increases financial statement volatility.
Because of this requirement to reassess the lease term in some circumstances, volatility in assets and liabilities for lessees may increase. This may impact a company’s ability to accurately predict and forecast results and requires ongoing monitoring.
This could be a key practical issue at present, as companies take action to respond to the COVID-19 pandemic.
To minimize the impact of the standard, some companies may reconsider certain contract terms and business practices – e.g. changes in the structuring or pricing of a lease agreement, including the type of variability of lease payments and the inclusion and type of options in the contract. Therefore, the standard is likely to affect departments beyond financial reporting – including treasury, tax, legal, procurement, real estate, budgeting, sales, internal audit and IT.
Companies should have adequate systems and processes in place that allow them to identify the commencement date of new leases (which will not always be a stated date), determine the lease term on lease commencement and identify events or circumstances that require subsequent reassessment of the lease term. This becomes even more important when leasing and related actions that could trigger a lease term reassessment are decentralized and undertaken by non-accountants.
Companies will need to document the judgements, assumptions and estimates applied in determining the lease term at the commencement date and on reassessment. Appropriate disclosure is required in the financial statements, including disclosure of key judgements, accounting policies and changes in their application.
Read our full publication for practical guidance and examples, as well as a discussion on how to navigate the links between written contracts, laws and regulations and penalties, and some practical application issues and key disclosures.