Determining the lease term
Contributed by Zampa Debattista
24 February, 2020
The term of the lease plays an important part in the accounting treatment of a particular lease. Under IFRS 16, it impacts the measurement of the right of use asset and lease liability in the lessee's books. It also determines whether the exemption for short term leases may be applied or not, in which case the lease may be expensed rather than capitalised.
How is the lease term determined?
The lease term is the non-cancellable period of a lease, together with periods covered by an option to extend given that there is reasonable certainty that such an option shall be exercised. In situations including an early termination option, the optional period forms part of the lease term only if there is reasonable certainty that the option to terminate shall not be exercised.
Contract 1: non-cancellable 7-year lease with an option by the lessee to extend to year 10.
If lessee reasonably certain to extend - 10 years
If lessee not reasonably certain to extend - 7 years
Contract 2: non-cancellable 7-year lease with an option by the lessee to terminate as from year 4.
If lessee reasonably certain not to terminate - 7 years
If lease not reasonably certain not to terminate - 4 years
The assessment of reasonable certainty may require some degree of judgement. This judgement rotates around the economic incentives of the lessee to exercise the option.
Economic incentives can include monetary factors such as:
- Prospective lease payments for a secondary lease period compared to expected market rates
- Termination penalties
- Improvements by the lessee, thus incentivising extension or non-termination
- Lessee costs in case of termination and non-extension
One would need to also consider non-monetary factors such as:
- Lessee dependency on the asset (e.g. premises location)
- The inconvenience and the time needed to change the lessor and enter into a new contract
In reality, there will be circumstances that will change over the years, and in such cases the lease term would need to be revised.
Over the duration of the determined lease term it is necessary that the contract is enforceable. If both the lessor and the lessee have the right to terminate the lease at their own will and without incurring a significant penalty, the lease contract is not enforceable.
For instance, if a contract states that both parties can terminate with 3 months' notice and no contractual penalties apply, the lease term is 3 months.
It needs to be stressed that the term 'penalty' needs to be interpreted in a broader way than a contractual penalty. In fact, the term is interpreted as covering also an economic disincentive to terminate.
Sometimes only one of the parties has the right to terminate a lease. If it is the lessee who has the right to terminate without significant penalty, this is considered as an option to terminate when determining the lease term. If only the lessor has the right to terminate without significant penalty, the non-cancellable period of the lease includes the period covered by the option. The reasoning behind this is that the lessee has the unconditional obligation to pay for the right to use the asset for the period of the lease, unless the lessor decides to terminate the lease.
The lease term for non-consecutive periods of use is calculated by only adding up the periods for which there is a lease.
Last but not least, the lease term includes any rent-free periods provided to the lessee.
Changes in the lease term affect the measurement of the lease liability. In fact, when there is a change in the lease term, the lessee would need to remeasure the lease liability. This is a type of contract modification.
One would need to make further considerations in more complex situations, or in situations that require more judgement.
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