Over what period does a lessee depreciate leasehold improvements that it makes to a property under an operating lease that contains an option for the lessee to extend the lease?
Fact pattern
A lessee enters into an operating lease for an office property. The lease has a 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 CU100,000 constructing immoveable leasehold improvements specific to the property. The economic life of the leasehold improvements is 7 years. At commencement of the lease, the lessee expects to exercise the extension option, but is not reasonably certain it will do so.
Conclusion View 1: The useful life of the leasehold improvements is the shorter of the lease term or the assets’ economic life.
The lessee depreciates the leasehold improvements over the lease term of 5 years.
Reasons for View 1
AS-19.3 states:
“The lease term is the non-cancellable period for which the lessee has agreed to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which at the inception of the lease it is reasonably certain that the lessee will exercise.”
In this fact pattern, at the inception of the lease, the lessee is not ‘reasonably certain’ that it will exercise the lease option, although renewal may be expected. For the purpose of AS-19, the lease term is thus 5 years. AS-6.20 requires “the depreciable amount of a depreciable asset shall be allocated on a systematic basis to each accounting period during the useful life of the asset”.
AS-6.3.3 defines ‘useful life’ as either: “
(a) The period over which a depreciable asset is expected to be used by the enterprise; or
(b) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.”
In addition, AS-6.7 states that:
“The useful life of a depreciable asset is shorter than its physical life and is:
(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.
(ii) ……………. ” In the fact pattern, one of the factors in determining the useful life of the leasehold improvements is the expiry date of the related lease. The expected utility of the leasehold improvements should be consistent with the reasonably certain lease term as defined in AS-19. Therefore, the useful life of the leasehold improvements is 5 years.
View 2: The expected economic life of the leasehold improvements is used as the useful life.
In the fact pattern, the lessee depreciates the leasehold improvements over 7 years, since it expects to extend the lease to 10 years and utilise the leasehold improvements for 7 years.
Reasons for view 2
AS-6.20 requires “the depreciable amount of an asset shall be allocated on a systematic basis over its useful life”.
AS-6.3.3 defines ‘useful life’ as either:
(a) The period over which a depreciable asset is expected to be used by the enterprise; or
In addition, AS-6.7 states that:
“The useful life of a depreciable asset is shorter than its physical life and is:
(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.”
The useful life of the leasehold improvements is based on the ‘expected utility’ (AS-6.3.3). To determine the expected utility, the lessee would consider ‘all the factors’ in AS-6.7. While 6.7 should be considered, the factor regarding ‘expected usage of the asset’ in AS-6.3.3 is equally relevant in determining the useful life. The condition contained in AS-6.7 reflects the necessity to consider the existence of legal or other externally imposed limitations on an asset’s useful life. However, in the fact pattern, 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 lease term as defined in AS-19 does not include the extension period because the lessee is not ‘reasonably certain’ of extending the lease. However, a different threshold is used in AS-6 for the determination of the useful life, which is the period over which the lessee expects to use the leasehold improvements. The term ‘expected usage of the asset’ for the determination of useful life of an asset indicates a lower threshold than the ‘reasonably certain’ of extending the lease threshold for including the extension period in the lease term for accounting purposes. As a result, although the accounting lease term is 5 years, the leasehold improvements is depreciated over the period over which the lessee expects to use the assets (as it expects to extend the lease to 10 years), which is 7 years.
In accordance with AS-6.23, if the assessment of useful life changes as a result of the lessee not expecting to exercise the lease renewal option, the unamortised depreciable amount should be charged over the revised remaining useful life.
The author believes that view 1 is conservative and fits into the concept of prudence enshrined in Indian GAAP framework. On the other hand view 2 is also justified on the basis of AS-6.
