Determining the lease term under Ind AS 116 Leases can be a very
complex and judgemental exercise. For purposes of evaluating the lease term,
one needs to understand the interaction between the non-cancellable period in a
lease, the enforceable period of the lease and the lease term. Lease term is
determined at the inception of the contract. An entity shall revise the lease
term if there is a change in the non-cancellable period of a lease.
Note: The determination of lease term under Ind AS 116 is very crucial
because it impacts the determination of (1) whether a lease is a short-term
lease – if it is a short-term lease, practical expediency is available not to
apply the detailed recognition requirements of the standard applicable to a
non-short-term lease, (2) the lease term also determines the amount of the
right of use asset (ROU) and the lease liability on the balance sheet.
Subsequent depreciation and finance charges are also impacted by the amount
capitalised on account of the ROU asset and the lease liability.
The concepts are described in detail below under three broad steps.
STEP
1 – DETERMINE THE ENFORCEABLE PERIOD
A contract is defined as ‘An agreement between two or more parties that
creates enforceable rights and obligations.’
(Para B34) 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 both the lessee and the lessor have the right to terminate the lease without permission from the other
party with no more than an insignificant penalty.
IFRIC observed (see IFRIC update June, 2019, Agenda Paper 3, Lease
term and useful life of leasehold improvements IFRS 16 Leases and IAS 16
Property, Plant and Equipment) that, in applying paragraph B34 (above) of
IFRS 16 and determining the enforceable period of the lease, an entity
considers:
(a) the economics of the contract. For example, if either party has an
economic incentive not to terminate the lease and thus would incur a
penalty on termination that is more than insignificant, the contract is
enforceable beyond the date on which the contract can be terminated; and
(b) whether each of the parties has the right to terminate the
lease without permission from the other party with no more than an
insignificant penalty. If only one party has such a right, the contract is
enforceable beyond the date on which the contract can be terminated by that
party.
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. If an entity concludes that
the contract is enforceable beyond the notice period of a cancellable lease (or
the initial period of a renewable lease), it then applies paragraphs 19 and
B37-B40 of IFRS 16 to assess whether the lessee is reasonably certain not to
exercise the option to terminate the lease.
Author’s note: These
clarifications should equally apply to Ind AS, as IFRIC deliberations and
conclusions are global and robust.
Example – Enforceable
period
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 (but not beyond ten years) until the
lessee or the lessor elects to terminate it and includes stated consideration
required during any renewed periods (referred to as ‘cancellable leases’). 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. Can the lease term go beyond the date at which
both parties can terminate the lease (inclusive of any 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 (but not beyond ten
years), inclusive of the notice period. There is an agreement which meets the
definition of a contract (i.e., an agreement between two or more parties that
creates 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.’ The penalties
should be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.
In the above example, the enforceable period is ten years, i.e., if
either party has an economic incentive not to terminate the lease and
thus would incur a penalty on termination that is more than insignificant, the
contract is enforceable beyond the date on which the contract can be
terminated.
The fact pattern includes an automatic renewal up to a period of ten
years. The agreement could have been drafted as a one-year contract with a
fixed nine-year renewal period (setting out detailed terms and conditions of
renewal), which either party could have terminated. In either of these fact
patterns, if there is more than an insignificant penalty for either of the
parties for the period of ten years, the enforceable period will be ten years.
This assessment should be carried out at the inception of the contract.
STEP
2 – DETERMINE THE LEASE TERM
Extract of Ind AS 116:
18 An entity shall determine
the lease term as the non-cancellable period of a lease, 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.
19 In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to
exercise the option to extend the lease, or not to exercise the option to
terminate the lease, as described in paragraphs B37–B40.
B34 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.
B35 If only a
lessee has the right to terminate a lease, that right is considered to be an
option to terminate the lease available to the lessee that an entity considers
when determining the lease term. 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.
B37… entity
considers all relevant facts and circumstances that create an economic
incentive for the lessee to exercise, or not to exercise, the option (Ind AS
116.19, Ind AS 116.B37-B40):
* contractual terms and conditions for the optional periods compared
with market rates
* significant leasehold improvements
* costs relating to the termination of the lease
* the importance of that underlying asset to the lessee’s operations
* conditionality associated with exercising the option
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 that the lessor termination options
are generally disregarded. If only a lessor has the right to terminate a lease,
that is disregarded to determine the lease term, because the lessee does not
have an unconditional right to avoid its obligation to continue with the lease.
Example – Lease term
Incremental facts to the previous example are that the mandatory
non-cancellable period is one year and notice period is two months. In this
example, it is possible that the lease term may exceed the one year and two
months period. The lease term is one year and two months plus 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. ten years. The lease
term therefore, will fall between one year two months and ten years.
STEP
3 – CONSIDER INTERACTION BETWEEN ENFORCEABLE PERIOD AND LEASE TERM
Consider the following lease contract:
# Lock-in period is one year
# Contract is for ten years and will be auto renewed for a year for next
nine years after lock-in period of one year
# The terms and conditions of the auto renewal are clearly spelt out in
the contract
# Either party can cancel the contract by giving two months’ notice
after lock-in period without paying any monetary penalty.
In the above example, the non-cancellable period is
one year. The enforceable period is dependent upon whether either party is
incurring more than an insignificant penalty. If neither party is incurring
more than an insignificant penalty, the enforceable period is one year
(non-cancellable period) and two months (notice period). However, if either
party is incurring more than an insignificant penalty, the enforceable period
is ten years (total contract period). The enforceable period could have been
greater than ten years if the contract had a further renewal clause and the
terms and conditions of the auto renewal are clearly spelt out in the contract.
The lease term will fall between the non-cancellable period and the enforceable
period. It cannot be greater than the enforceable period. For example, if the
lessee has made significant investment by way of leasehold improvement, and the
life of the improvement is eight years, the lease term may be eight years,
subject to other facts. If, however, the life of leasehold improvements is ten
years, then there may be significant disincentive for the lessee to walk away
from the lease earlier than ten years, and the lease term may be ten years,
subject to evaluation of other facts.
The above thought process is captured in the table below.
ILLUSTRATIVE
EXAMPLES
Query
3Z Co (lessee) enters into arrangements for lease of warehouses for a
period of one year. The lease agreement does not provide any purchase option in
respect of the leased asset, but 3Z has a right to renew for one additional
year. Consider two scenarios: (a) right of renewal does not require permission
of the lessor; (b) right of renewal requires permission of the lessor. Whether
the recognition exemption for short-term leases is available to 3Z?
Response
Whether the short-term lease exemption applies depends on what the lease
term is and if that term is one year or less. First, one should determine the
enforceable period. If either party has an economic incentive not to terminate
the lease and thus would incur a penalty on termination that is more than
insignificant, the contract is enforceable beyond the date on which the
contract can be terminated. Assuming that there is economic disincentive for
one of the parties (either lessee or lessor), the enforceable period is two
years in both the scenarios.
The next step is to determine the lease term. In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to exercise
the option to extend the lease, or not to exercise the option to terminate the
lease. If only the lessor has the right to terminate a lease, that is
disregarded to determine the lease term, because the lessee does not have an
unconditional right to avoid its obligation to continue with the lease.
Consequently, in both the scenarios the lease term could range between one and
two years. If the lease term is greater than one year, the lease would not
qualify for short-term exemption.
Query
Scenario 1
Lessee entered into a lease arrangement with lessor for an overhead line
facility with Indian Railways across their railway track for a period of ten
years. Lessee paid in advance the rentals for the entire period of ten years.
The arrangement does not grant lessee with tenancy or right or interest in the
land. Based on past experience, the lessor will renew the contract for another
ten years at the end of the contract period. The following are some of the
principal terms of agreement:
(i) Either
party can terminate the contract by giving one month’s notice and no monetary
penalty will apply.
(ii) Lessor
reserves full rights on the land below the overhead line facility.
(iii) If
lessor gives termination notice, lessee at its own cost shall remove the overhead
line and shall restore the railway land to its original condition. Lessor has
given notice to lessees to shift transmission lines from railway land only in a
few rare and unusual cases.
(iv) Lessee
is reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years since shifting of transmission lines will affect its
business adversely.
(v) There
are no renewal options beyond ten years and a new agreement will need to be
entered into between the lessor and the lessee, and the terms and conditions
with respect to the new agreement will have to be agreed upon by both parties
at that point in time.
Will the lease qualify as a short-term lease?
Scenario 2
Consider the same fact pattern as above, with some
changes. Beyond the ten-year period, the contract includes an automatic renewal
option whereby the contract will automatically continue for an additional term
of 20 years, unless either party terminates the contract. What will be the
lease term in this fact pattern?
Response
Scenario 1
If one or both parties would incur a more than
insignificant penalty by exercising its right to terminate – the contract
continues to be enforceable over the ten-year period. The penalties should be
interpreted broadly to include more than simply cash payments in the contract.
The wider interpretation considers economic disincentives. The following
factors prima facie suggest that at the commencement date, the lessee is
not likely to have an economic incentive to exercise the termination option:
(a) Lessee
expects to operate the transmission line beyond ten years.
(b) It is
unlikely that the lessee will be able to locate an alternative location that
fulfils its requirements. Such open spaces will generally be available only
with Indian Railways. If at all an alternative location is available, it may
involve a considerable increase in the length of the transmission line and may
therefore involve considerable additional cost.
(c) If at
all relocation is possible, the relocation may entail significant additional
costs and the benefit of obtaining alternative location at lower lease rentals
may not be worth it.
(d) In case
premature termination by the lessee results in the lessor forfeiting a significant
part of the advance lease rental payment, this would be an additional factor
providing economic incentive to the lessee to not terminate the lease
prematurely.
The enforceable period will therefore be ten years,
irrespective of whether the lessor will incur more than an insignificant
penalty or not by terminating the contract. The next step is to determine the
lease term. An entity shall determine the lease term as the non-cancellable
period of a lease, together with the periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option.
Interestingly, under Ind AS 116, the legal enforceability of the option from
the perspective of the lessor is not relevant. In other words, the lessor may
refuse to extend the lease and may cancel the lease during the ten-year period,
or at least has the ability to cancel the lease at any time during the ten-year
period. However, in determining the lease term, the lessor’s rights are not
relevant. Consequently, based on the facts in the given case, the lease term
will be ten years and will not qualify for short-term exemption.
Scenario 2
In the second scenario, the same assessment as in
Scenario 1 is relevant. However, in this scenario the contract will be
automatically renewed for another 20 years unless either of the party walks
away from the contract. As mentioned above, in determining the lease term, the
lessor’s rights are not relevant. An entity will consider the factors described
in B37. From the available information it appears that the lessee will continue
for 30 years, beyond which there are no additional renewal or automatic renewal
clauses. The lease term could therefore be 30 years, subject to further
analysis of detailed facts.
Query
A part of the transmission line of El Co passes through private land
(not owned by Indian Railways). El enters into a lease agreement with the
private land owner for a period of 12 months for overhead facility. The
following are some of the principal terms of agreement:
(i) There
are no renewal or automatic renewal clauses and the lease can be renewed or
cancelled with the mutual consent of both the parties.
(ii) Either
party shall be at liberty to put an end to the arrangement by giving one-month
previous notice in writing to that effect and in the event of such a notice
neither of the party shall have any claim for any compensation whatsoever.
It is likely that the contract will be renewed for another one year at
the expiry of its current term. The lease agreement does not provide any
purchase option in respect of the leased asset to the lessee. The lessee is
reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years, since shifting of transmission lines will affect its
business adversely. Whether the short-term lease exemption will apply?
Response
The lease agreement to allow overhead transmission lines is for a period
of 12 months. The agreement does not grant a renewal, auto-renewal or extension
or purchase option to the lessee. Accordingly, the lease qualifies as a
‘short-term lease’, notwithstanding the fact that upon expiry of each 12-month
period there is high degree of certainty that the lease will be renewed for a
further period of 12 months by mutual consent between the lessor and the lessee
at that point in time. The lessee can, therefore, avail the exemption of not
applying the lessee accounting model of the standard to the lease and instead
account for the lease as per paragraph 6 of Ind AS 116. As per paragraph 6, the
lessee recognises the lease payments as an expense on a straight-line basis
over the lease term or another systematic basis.
