Audit Manager at RSM Poland
In the previous part of our considerations, we raised the issue of simplifications in the application of IFRS 16, when assets and liabilities are not recognized. Entities benefitting from the simplifications charge payments directly into costs - usually, on a straight-line basis over the period of the lease. Operating leases are settled in a similar manner (in accordance with the IAS 17 regulations, still in effect). For the record, below please find a handful of information.
IFRS 16 provides for exemptions for two types of contracts:
- involving low-value assets (we explained this concept in our previous publication LINK);
- and the so-called short-term lease contracts concluded for 12 months or less;
In order to be able to benefit from the second option, the entity should first estimate the term of the lease correctly.
IFRS 16 requires the entity to estimate the period during which it is sure (it has reasonable assurance) that it will benefit from a lease contract (the so-called non-cancellable period of a lease - a non-terminable period during which the lessee has the right to use a given asset). The lease term is, therefore, the duration of the contract. When estimating the lease term, many factors should be taken into account, including any possible periods for which the contract may be extended (if the lessee is sure that they will exercise the extension option) and terminated (applies only to the lessee's option to terminate the lease) if the lessee has reasonable assurance that they will not execute the termination option. The most important factor is for this estimation to be based on the entity’s previous practice and be consistent with its plans for the following years. The entity should, therefore, consider all relevant information and circumstances that may support the extension/early termination of the contract or not. IFRS 16 gives examples of factors to be considered (as at the day the lease commences) when conducting this analysis. These include, among others:
- the nature of the leased asset,
- the possibility of using alternative solutions,
- the amount of rent after exercising the option to extend the contract (market price or lower than the market price),
- conditional payments,
- costs related to the termination of the contract.
For example - a lease contract was concluded for 6 years but the lessee can terminate the contract without incurring any costs, as well as without the consent of the lessor after only 3 years. Then, as at the so-called commencement date, the probability that the option of early termination of the contract after 3 years will be implemented is assessed. The irrevocable lease term, the so-called non-cancellable period of a lease will be set at 3 or 6 years, depending on the result of the aforementioned analysis.
Attention should also be paid to the proper determination of the date the lease commences. This date is not always in line with the date specified in the contract. For example, if an asset is placed at the disposal of the lessee before it is actually put by them to use, (e.g. in order to adjust it to the needs of the lessee), then the date on which the asset was transferred to the lessee for use should be assumed as the lease commencement date.
The issue of the correct determination of the lease term is particularly important in the case of the so-called short-term leases, as taking the possible option to extend the contract into account will determine whether the asset/assets will be included in the balance sheet or not.
Let us assume that company X has rented commercial premises from company Y. The lease contract was concluded for one year with the possibility of it being renewed on a yearly basis. As at the date of signing the contract, company X does not intend to extend the contract (this is not indicated by their current practice or the entity's plans regarding the premises). The lease term is, therefore, one year (the company may exercise the right of exemption under the short-term lease measure). However, if for example, it would turn out that in order to adapt the premises to its needs, company X would incur significant initial investments the economic useful life of which is three years, it should be considered whether this is not a prerequisite for extending the lease term for another year (or two years) and set the lease term for 2-3 years - then the assets and liabilities should be included in the balance sheet.
The issue of asset identification and their initial recognition will be the subject of our blog soon.