FACT PATTERN
A lease contract of a
retail outlet in a shopping mall allows for the lease to continue until either
party gives notice to terminate the contract. The contract will continue
indefinitely until the lessee or the lessor elects to terminate it and includes
stated consideration required during any renewed periods (referred to as
“cancellable leases” in the rest of the document). Neither the lessor nor the
lessee will incur any contractual cash payment or penalty upon exercising the
termination right. The lessee constructs leasehold improvements, which cannot
be moved to another premise. Upon termination of the lease, these leasehold
improvements will need to be abandoned, or dismantled if the lessor so
requests.
QUESTION
Can the lease term go
beyond the date at which both parties can terminate the lease (inclusive of any notice period)?
TECHNICAL DISCUSSION
View 1:
No. The lease term cannot go beyond the date where the lessee can enforce a
right to use the underlying asset, i.e. the end of the notice period. The
existence of economic penalties (eg; cost of shifting) does not create
enforceable rights and obligations.
The definition of “lease
term” in Ind AS 116 refers to lessee’s rights and reads as follows:
The
non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:
a) Periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option; and
b) Periods covered by an option to
terminate the lease if the lessee is reasonably certain not to exercise that
option.
B34 of Ind AS 116 contains
further guidance and states:
In
determining the lease term and assessing the length of the non-cancellable
period of a lease, an entity shall apply the definition of a contract and
determine the period for which the contract is enforceable. A lease is no
longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.
Appendix A of Ind AS 116
clarifies that the word “contract” is defined in other standards and
used in Ind AS 116 with the same meaning, i.e. “an agreement between two or
more parties that creates enforceable rights and obligations”.
For example, paragraphs 10
and 11 of Ind AS 115 include the following more detailed guidance about “contracts”:
10. A contract is an
agreement between two or more parties that creates enforceable rights and
obligations. Enforceability of the rights and obligations in a contract is a
matter of law. Contracts can be written, oral or implied by an entity’s
customary business practices. The practices and processes for establishing
contracts with customers vary across legal jurisdictions, industries and
entities. In addition, they may vary within an entity (for example, they may
depend on the class of customer or the nature of the promised goods or
services). An entity shall consider those practices and processes in
determining whether and when an agreement with a customer creates enforceable
rights and obligations.
11. Some
contracts with customers may have no fixed duration and can be terminated or
modified by either party at any time. Other contracts may automatically renew
on a periodic basis that is specified in the contract. An entity shall apply
this Standard to the duration of the contract (ie the contractual period) in
which the parties to the contract have present enforceable rights and
obligations.
Both B34 and the definition
of a contract in Appendix A of Ind AS 116 is cross-referenced to BC127 in the
Basis of Conclusions of IFRS 16, specifically deals with “cancellable leases”
as follows:
Cancellable
leases
For the
purposes of defining the scope of IFRS 16, the IASB decided that a contract
would be considered to exist only when it creates rights and obligations that
are enforceable. Any non-cancellable period or
notice period in a lease would meet the definition of a contract and, thus,
would be included as part of the lease term. To be part of a contract, any
options to extend or terminate the lease that are included in the lease term
must also be enforceable; for example the lessee must be able to enforce its
right to extend the lease beyond the non-cancellable period. If optional
periods are not enforceable, for example, if the lessee cannot enforce the
extension of the lease without the agreement of the lessor, the lessee does not
have the right to use the asset beyond the non-cancellable period.
Consequently, by definition, there is no contract beyond the non-cancellable
period (plus any notice period) if there are no enforceable rights and
obligations existing between the lessee and lessor beyond that term. In
assessing the enforceability of a contract, an entity should consider whether
the lessor can refuse to agree to a request from the lessee to extend the
lease.
This conclusion is entirely
consistent with a “right-of-use model” based on recognising and measuring the
rights that the lessee controls and has had transferred to it by the lessor.
Including a renewal which the lessee cannot enforce without the agreement of
the lessor would unduly recognise in the right of use optional periods that do
not meet the definition of an asset. Even if the lessee has a significant economic
incentive to continue the lease, this does not turn a period subject to the
lessor’s approval into an asset because the lessee does not control the
lessor’s decision, unless the lessor’s termination right lacks substance. This
is a very high hurdle, which would be expected to be extremely rare and require
objective evidence.
View 2:
Yes, the lease term go beyond the date at which both parties can terminate the
lease.
Supporters of view 2
believe that an entity should evaluate the relevant guidance in the standard.
In considering the guidance in the standard, View 1 believes Ind AS 116 is
clear the lease term cannot be longer than the period in which the contract is
enforceable. However, Ind AS 116 is equally clear that a contract is
enforceable until both parties could terminate the contract with no more than
an insignificant penalty – which may be a period beyond the termination notice
period.
In the fact pattern above,
while the lease can be terminated early by either party after serving the
notice period, the enforceable rights in the contract (including the pricing
and terms and conditions) contemplate the contract can continue beyond the
stated termination date, inclusive of the notice period. In the fact pattern
above, there is an agreement which meets the definition of a contract (i.e., an
agreement between two or more parties that create enforceable rights and
obligations). However, the mere existence of mutual termination options does
not mean that the contract is automatically unenforceable at a point in time
when a potential termination could take effect.
Ind AS 116.B34 provides
explicit guidance on when a contract is no longer enforceable:
“A lease
is no longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.”
Therefore, when either
party has the right to terminate the contract with no more than insignificant
penalty there is no longer an enforceable contract. However, when one or both
parties would incur a more than insignificant penalty by exercising its right
to terminate – the contract continues to be enforceable. The penalties should
be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.
While the IFRS16.BC127 does
not discuss the notion of “no more than insignificant penalty”, supporters of
View 2 believe that Ind AS116.B34 should be evaluated based on the wording in
the standard (i.e., taking into account the economic disincentives for the
parties). To the extent that the lessee has a more than insignificant economic
disincentives (e.g., significant leasehold investments) to early terminate the
lease, the 2nd sentence in B34 will not be applicable. However, on
the other hand, if one or both parties have only insignificant economic
disincentives to terminate, say, after five years, the lease is not considered
enforceable after five years and hence the lease term cannot exceed five years.
Ind AS116.B34 does not directly provide guidance as to how long the lease term
should be. Rather, it provides guidance as to when a contract is no longer
enforceable and thus no longer exists.
While Ind AS 116.B34 and
B35 provide guidance on evaluating the period in which a contract continues to
be enforceable and how to evaluate lessee and lessor termination options, they
do not address how to evaluate the lease term once the enforceable period of
the contract has been determined (i.e., at least until both parties no longer
have a more than insignificant penalty if they were to terminate the contract).
To determine the lease term, the parties would apply Ind AS 116.18-19 and
B37-40 (i.e., the reasonably certain threshold). “Reasonably certain” is a high
threshold and the assessment requires judgement. It also acknowledges the
guidance in Ind AS 116.B35 which indicates lessor termination options are
generally disregarded (“If only a lessor has the right to terminate a lease,
the non-cancellable period of the lease includes the period covered by the
option to terminate the lease.”)
Thus, in this fact pattern
above, it is possible that the lease term may exceed the notice period. The
lease term is the non-cancellable (notice) period together with the period
covered by the termination option that it is reasonably certain the lessee will
not exercise such termination option.
However, the lease term
cannot be no longer than the period the contract is enforceable (i.e., the
point in time in which either party may terminate the lease without permission
from the other with no more than an insignificant economic disincentive,
inclusive of any notice period).
If the facts were different
and the contract had an end date but contemplates the lease might be extended
if both the lessee and lessor agree to new terms and conditions (including new
pricing) there may be no enforceable contract but rather an invitation to enter
into new negotiations.
In light of the compelling
arguments in both views, the author recommends that the Ind AS Transition
Facilitation Group (ITFG) should address this issue in consultation with the
IASB staff or IFRIC.
