QUERY
A lessee enters into a lease for an office
property. The lease has a non-cancellable term of 5 years and contains an
option for the lessee to extend the lease for a further 5 years. The rentals
for the period under the extension option (i.e., years 6-10) are at market
rates. Upon commencement of the lease term, the lessee incurs cost constructing
immoveable leasehold improvements specific to the property. The useful life of
the leasehold improvement is 7 years. At the commencement date of the lease,
the lessee expects, but is not reasonably certain, to exercise the extension
option. The economic penalty of abandoning the leasehold improvement at the end
of the non-cancellable term of the lease is not so significant as to make
exercise of the renewal option reasonably certain. Over what period does the
lessee depreciate leasehold improvements?
RESPONSE
View 1 – The
useful life of the leasehold improvements is 5 years
Appendix A to Ind
AS 116 defines lease term as: “The non-cancellable period for which a lessee
has the right to use an underlying asset, together with both:
u (a) periods covered by an
option to extend the lease if the lessee is reasonably certain to exercise that
option; and…”
In this case, since
the lessee is not reasonably certain to exercise the option to extend the
lease, the lease term is 5 years for the purpose of Ind AS 116.
Ind AS 16 (56)
states that:
“…all the following
factors are considered in determining the useful life of an asset:
u (a) expected usage of the
asset. Usage is assessed by reference to the asset’s expected capacity or
physical output.
u (b) expected physical wear
and tear, which depends on operational factors such as the number of shifts for
which the asset is to be used and the repair and maintenance programme, and the
care and maintenance of the asset while idle.
u (c) technical or commercial
obsolescence arising from changes or improvements in production, or from a
change in the market demand for the product or service output of the asset…
u (d) legal or similar limits
on the use of the asset, such as the expiry dates of related leases.” (emphasis
added.)
Keeping in mind the
legal limits, the useful life of the leasehold improvements is 5 years.
View 2 – The
useful life of the leasehold improvements is 7 years
The useful life of
the leasehold improvement is based on its expected utility to the entity [Ind
AS 16(57)]. To determine the expected utility, the lessee would consider all
the factors in paragraph 56 of Ind AS 16. While paragraph 56(d) of 16 should be
considered, the factor regarding “expected usage of the asset” in paragraph
56(a) of Ind AS 16 is equally relevant in determining the useful life. The
condition contained in paragraph 56(d) of Ind AS 16 reflects the necessity to
consider the existence of legal or other externally imposed limitations on an
asset’s useful life. The ability to extend the lease term is within the control
of the lessee and is at market rates so there are no significant costs or
impediments to renewal. The term
“expected usage of the asset” for the determination of useful life of an asset
indicates a lower threshold than the “reasonably certain” threshold for
including the extension period in the lease term for Ind AS 116 purposes.
In accordance with
Ind AS 16 (51), if the assessment of useful life changes (for example, the
lessee no longer expects to exercise the lease renewal option) the change shall
be accounted for as a change in an accounting estimate. In such circumstances,
the entity may also need consider whether there is an impairment.
AUTHOR’S VIEW
The author believes
that there is greater merit in View 1, because it results in harmony between the way lease term
and useful life of the leasehold improvements are determined.
