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IFRS 16: Determining the lease term
as announced in our January newsletter, we are addressing issues surrounding IFRS 16 Leasing in a short newsletter series. The previous newsletters have dealt with the following topics:
– January 2021: “Has the plane landed – Introduction to our IFRS 16 series”
– February 2021: “IFRS 16: Scope and Exemptions”
– March 2021: “IFRS 16: Identifying a lease”
In today´s newsletter, we focus on the determination of the lease term.
From our practical experience in IFRS 16 transition projects, we can assure you that determining the lease term is one of the key issues and one that is frequently anything but trivial.
To illustrate the problems involved, consider the following real-life example from one of our projects:
A business lease agreement between Meier GmbH as lessor and Müller AG as lessee (tenant) of Müller AG’s office and factory building contains the following stipulations under Section 2, Lease Term: “The lease begins on 01 Jan 01 and runs for a fixed term until 31 Dec 16. Both parties have an option to terminate for the first time as of 31 Dec 07 and then as of 31 Dec 10 and 31 Dec 13. Notice of termination must be served in writing at least one year in advance of the respective special termination date.”
What do you think? What is the lease term? 16 years, 7 years, or maybe even 10 years or 13? As you can see from this example, problems arise in practice whenever there are (special) rights (or options) to terminate or extend.
The standard’s answer to such questions can be found in IFRS 16.18 et seq. in conjunction with B34-B41. IFRS 16.18 (please read) stipulates on this point as follows:
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.
Whether (and when) the lessee is reasonably certain to exercise the option to extend or not to exercise the option to terminate has to be assessed according to the stipulations in IFRS 16.19 in conjunction with B37-B40 (please briefly skim over).
As you can see, all that is set out in those passages makes eminent sense. Nonetheless, it makes the test time-consuming and the outcome still involves judgement in case of doubt.
As you see once again, depending on the interpretation and line of argument followed, the impacts on the accounting (see under 5. below) and on the presentation of the financial position, financial performance and cash flows would be quite substantial. So let’s hope that the accounting and auditing practitioners converge around a ‘uniform’ solution in the near future.
Should you ever lose track of the big picture, my colleagues and I will be happy to help and guide you safely through the IFRS accounting jungle. Contact me by email at email@example.com