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IFRS 16 — Lease term and useful life of leasehold improvements

Date recorded:

Agenda Paper 4

Background

In its June 2019 meeting, the Committee discussed a submission about application of lease term requirements under IFRS 16 to a cancellable lease or a renewable lease. The submitter asked whether a lease contract is enforceable beyond the notice period of a cancellable lease or the initial period of a renewable lease (Question 1); and whether the useful life of any non-removable leasehold improvements is limited to the lease term of the related lease (Question 2).

In respect of Question 1, the Committee agreed with the staff that the economics of a contract shall be taken into account to determine the lease term, rather than just legal form of the contract. They also analysed the meaning of 'penalty' and considered economic consequences should be taken into account when determining the enforceable period of a lease. This has implications for the application of IFRS 16:B34 which states that a lease is no longer enforceable when the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty. If only one party has the right to terminate the lease without permission from the other party with no more than an insignificant penalty, the contract is enforceable beyond the date on which the contract can be terminated by that party.

In response to Question 2, the Committee agreed with the staff analysis of the different terms used in IAS 16, that 'useful life' means the period over which an asset is expected to be available for use by an entity (economic life). If the lease term of the related lease is shorter than the economic life of those leasehold improvements, the entity considers whether it expects to use the leasehold improvements beyond that lease term. Applying IFRS 16:B34, the entity considers whether the contract is enforceable (lease term) for at least the period of expected utility of the leasehold improvements.

The Committee decided, by a majority of votes, not to add the matter to the standard-setting and to publish the tentative agenda decision.

Comment letters received show that most of the respondents (i) disagreed with one or more aspects of the Committee's technical analysis and conclusions for Question 1, and (ii) did not comment specifically on Question 2. In respect of Question 1, they have concerns on the application of the word 'penalty' in IFRS 16:B34. They also disagreed with the Committee's technical conclusions on contract enforceability as they consider: (i) the other areas of IFRS Standards treat contract enforceability as a legal concept, (ii) in order for a lease to no longer be enforceable, each of the parties to the lease must have the right to terminate the lease without permission from the other party with no more than an insignificant penalty and (iii) rationale in the tentative agenda decision in effect requires a lessee to assess contract enforceability from the lessor's perspective.

Staff analysis

In respect of Question 1, the staff have further analysed the term 'penalty' and considered other paragraphs and the Basis for Conclusions of IFRS 16 which lead to the conclusions that (i) 'penalty' refers to an economic penalty and (ii) it is important to consider contract economics and not only legal form in explaining the concept of enforceability. In relation to the respondents' concerns on lessor's perspective, the staff analysed IFRS 16:B34 and consider the existence of a penalty on termination is different from an intention not to terminate. There are no practical circumstances where the lessor's perspective can affect lease term because IFRS 16:B34 is clear that each party's rights have to be considered and IFRS 16:B37 states the economic incentive is an important consideration in determining 'reasonable certainty' of the extension option or termination option. Many respondents recommended standard-setting as an alternative to publishing an agenda decision. These respondents say it is not possible to reach the conclusion in the tentative agenda decision applying the existing requirements in IFRS 16. However, the staff continue to hold their view that the principles and requirements of IFRS 16 provide an adequate basis for an entity to determine the lease term of cancellable and renewable leases.

Staff recommendation

Given the number of comments received about standard-setting, the staff recommended either finalising the agenda decision subject to certain editorial changes or propose a minor clarifying narrow-scope amendment to IFRS 16:B34 as part of the next Annual Improvements to IFRS Standards. Any proposed amendment to IFRS 16:B34 to clarify the application of the word ‘penalty’ would meet the AIP criteria.

Discussion

The discussion lasted around 1 hour 45 minutes. A recording of the discussion is available on the IFRS Foundation website (as are recordings of all IFRS Interpretations Committee meetings). The recordings are on the IFRS Interpretations Committee meetings page, which you can access by clicking on the Agenda papers link (above).  

There was a lively debate in the meeting in respect of the determination of the lease term. Some Committee members agreed with the technical analysis of the staff paper about the meaning of "penalty" and impact on the lease term. They highlighted that the diagram in paragraph 3 of the staff paper is helpful in distinguishing the lease term from what is the enforceable period. From the context in IFRS 16:B34, they agreed that a substantive termination penalty provides evidence of whether there are enforceable rights and obligations and so a penalty has a direct implication on enforceability and "penalty" should be seen as wider than only contractual penalty.

On the other hand, some Committee members disagreed with the technical analysis and conclusion on a few aspects. One Committee member considered that the term "enforceable" is clearly defined in IFRS 15:10 and so enforceability is strictly referred to on a legal view, which is exactly the opposite of the view presented in the staff analysis. "Enforceability" disconnects with the contractual agreement if economic terms are also being considered. A few of the Committee members even commented that users may misunderstand this wider economic view of "penalty" and a lot of judgement areas are created that make IFRS 16 even less understandable for stakeholders. Some Committee members disagreed with this view and thought the concept of enforceability in IFRS 16 is clearly different from IFRS 15 and therefore a user who is interpreting IFRS 16 should not refer to IFRS 15. A few Committee members thought the staff analysis is not clear in expressing the meaning of "penalty" and more importantly, IFRS 16:BC127 contradicts with the principles expressed in IFRS 16:B34. 

There was no new substantive discussion about the useful economic life (i.e. Question 2) among the Committee members.

Some Committee members did consider that the large amount of comment letters actually reflects the fact that the concepts that are key to Question 1 are not well-explained in IFRS 16 leading to different users reaching different interpretations. Therefore, even though many Committee members agreed personally with the view in the tentative agenda decision, they nonetheless considered that a more prudent follow up action (such as proposing an amendment to IFRS 16 or developing an Interpretation), is appropriate in this case.  Some of them had a strong view that the appropriate due process was the standard-setting route and that publishing an agenda decision as an inappropriate shortcut. Other Committee members had concerns about the timing and need to provide guidance for the current reporting season. They supported finalising the agenda decision, because that would give timely guidance to people in the year of adoption, which brings many benefits. They noted that alternatives such as standard-setting or an annual improvement would not be timely enough. Other members were less concerned about timing because it was important to respect that entities need “sufficient time” to implement any changes resulting from an agenda decision and that it was likely to be too late for December year-end for many entities. Developing an Annual Improvement could be just as timely in terms of implementing change and could provide transition guidance. The Chair noted that she thought this “could be a very real case where people need sufficient time.”

The Committee decided, by a majority of votes (7 votes to 6), not to add the matter to the standard-setting and to finalise the agenda decision.

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