Leases

​Memorandum

IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases. IFRS 16 requires an entity to consider the terms and conditions of contracts and all relevant facts and circumstances, and to apply the standard consistently to contracts with similar characteristics and in similar circumstances. [IFRS 16.2]. A lessee can elect not to apply the recognition requirements to: Short term leases - [IFRS 16.5]. A lease term is defined as the non-cancellable period for which a lessee has the right to use an underlying asset, together with both: Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option. [IFRS 16 Appendix A].

At the inception of a contract, an entity assesses whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for a consideration. [IFRS 16.9]. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce). [IFRS 16.10]. To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity assesses whether, throughout the period of use, the customer has both of the following: the right to obtain substantially all of the economic benefits from use of the identified asset; and the right to direct the use of the identified asset. [IFRS 16.B9]. If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term. [IFRS 16.B10]. In determining the lease term and assessing the length of the non-cancellable period of a lease, an entity applies the definition of a contract and determines 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. [IFRS 16.B34]. IFRS 16 also applies to contracts that are referred to as ‘cancellable,’ ‘month-to-month,’ ‘at-will,’ ‘evergreen,’ ‘perpetual’ or ‘rolling’ if they create enforceable rights and obligations. These types of lease generally allow for the contract to continue beyond a non-cancellable period until one party gives notice to terminate the contract (e.g. the contract will roll monthly until the lessee or the lessor elect to terminate the contract). If both the lessee and the lessor can terminate the contract without more than an insignificant penalty at any time at or after the end of the non-cancellable term, then there are no enforceable rights and obligations beyond the non- cancellable term (i.e. the lease term is limited to the non-cancellable term).

Example:

A lease contract has an initial non-cancellable period of one year and an extension for an additional year if both the lessee and the lessor agree. There is no penalty for either party if they do not agree to extend for the additional year. The initial one-year non-cancellable period meets the definition of a contract because it creates enforceable rights and obligations. However, the one year extension period does not meet the definition of a contract because both the lessee and the lessor could unilaterally elect to not extend the arrangement without a more than insignificant penalty. That is, at lease commencement, neither party has enforceable rights and obligations beyond the initial non-cancellable period.

At the epicentre of IFRS 16 is the lease contract, one that conveys the right to use an asset for a period of time in exchange for consideration.

IFRS 16 offers an optional simplified approach to lessees involved in short-term leases, which it refers to a recognition exemption. When determining whether a lease qualifies as a short-term lease, a lessee evaluates the lease term in the same manner as all other leases. That is, the lease term includes the non-cancellable term of the lease, periods covered by an option to extend the lease if the lessee is reasonably certain t Yexercise that option and periods covered by an option to terminate the lease if the lessee is reasonably  certain not to exercise that option.

As the determination is made at commencement date, a lease cannot be classified as short-term if the lease term is subsequently reduced to less than 12 months. In addition, to qualify as a short-term lease, the lease cannot include an option to purchase the underlying asset.

Example:

Scenario A

A lessee enters into a lease with a nine-month non-cancellable term with an option to extend the lease for four months. The lease does not have a purchase option. At the lease commencement date, the lessee concludes that it is reasonably certain to exercise the extension option because the monthly lease payments during the extension period are significantly below market rates. The lease term is greater than 12 months i.e. 13 months. Therefore, the lessee may not account for the lease as a short-term lease.

Scenario B

Assume the same facts as Scenario A except, at the lease commencement date, the lessee concludes that it is not reasonably certain to exercise the extension option because the monthly lease payments during the optional extension period are at what the lessee expects to be market rates and there are no other factors that would make exercise of the renewal option reasonably certain. The lease term is 12 months or less, i.e. nine months. Therefore, the lessee may (subject to its accounting policy, by class of underlying asset) account for the lease under the short-term lease exemption, i.e. it recognises lease payments as an expense on either a straight-line basis over the lease term or another systematic basis and does not recognise a lease liability or right-of-use asset on its balance sheet, similar to an operating lease under IAS 17.