Background

The Committee received a submission about application of lease term requirements under IFRS 16 to a cancellable lease or a renewable lease with a particular fact pattern:

• Cancellable lease: an entity enters into a lease contract that does not specify a particular contractual term and continues indefinitely until either party gives notice to terminate. When either the lessee or lessor gives notice, the lease continues for a period of less than 12 months (‘notice period’) until termination. Neither party is obliged to make a contractual payment on termination.
• Renewable lease: an entity enters into a lease contract with a specified initial period, which renews indefinitely unless terminated by either the lessee or lessor.

The submitter asks 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 the useful life of any non-removable leasehold improvements is limited to the lease term of the related lease (Question 2).

Staff analysis — Question 1

IFRS 16:B34 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. Accordingly, the staff analyse that if only one party has such a right, the contract is enforceable beyond the notice period (or the initial period).

In addition, the staff observe the economics of a contract shall be taken into account to determine the lease term and the core principle is that the lease term should reflect an entity's reasonable expectation of the period during which the underlying asset will be used. Following such analysis, the significance of economic incentive to exercise the termination right by the other party of the lease is a factor to consider. The staff analyse that if on top of the fact pattern of cancellable lease set out in the submission, the underlying asset is both specialised so the lessor would be unable to lease the asset to another lessee on equivalent terms and critical to the lessee's business, the contract continues to be enforceable beyond the notice period even if there is no contractual payment on termination.

Staff analysis — Question 2

In responding the question, the staff analyse the different terms used in IAS 16 Property, Plant and Equipment, namely 'economic life' which means the period of use that would consume all of the future economic benefits embodied in the asset; and 'useful life' which means the period over which an asset is expected to be available for use by an entity.

The staff further analyse one of the factors in determining whether a lessee is reasonably certain to exercise an extension option or not to exercise a termination option (for determining the lease term) is that the significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable. One of the views on useful life is that the level of certainty in assessing optional periods ('reasonably certain' applying IFRS 16) and in determining useful life ('expected to be available' applying IAS 16) are different and a lessee might conclude that the useful life can be longer than the lease term. The staff acknowledge that this is theoretically possible but view that it would be a rare outcome considering the limits on the use of the asset and the period of expected utility, and hence a lessee would conclude that the useful life of the non-removable leasehold improvements is the same as, or shorter than, the lease term of the related lease.

Staff recommendation

The staff recommended that a tentative agenda decision be published stating that the Committee concluded that the principles and requirements in IFSR 16 provide an adequate basis for an entity to determinethe lease term of cancellable and renewable leases. The Agenda Decision would also state that the Committee concluded that the requirements in IAS 16 and IFRS 16 provide an adequate basis for an entity to determine the useful life of any non-removable leasehold improvements relating to such a lease.

Discussion

In respect of Question 1, most Committee members agreed with the staff analysis that the entity needs to look at the economics of the lease contract, as implied by IFRS 16:B34, rather than just the legal form of the contract. In particular, some Committee members agreed with the staff analysis that penalty is broader than payment and so economic consequences should be considered when determining the enforceable period of a lease.

However, they are puzzled about whether the lease is still enforceable in the situation that the lessor can terminate while the lessee has no termination option. IFRS 16 introduced the control notion and accordingly, when a lessor has a termination option, the lessee does not control the right-of-use asset during that period subject to the lessor's termination option. IFRS 16 does not comment on this specifically. The staff responded that IFRS 16:B34 only applies to situations 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:B35 deals with scenarios when only one party to the lease contract has a termination option. The Committee members commented that there is lack of clarity on how to read the words in IFRS 16:B34 and how to implement it in practice and this could be looked at in a Post Implementation Review. At the same time, they suggested the Board to issue education material with examples illustrating the application of IFRS 16:B34.

In respect of Question 2, a Committee member said the tentative agenda decision analyses that the lease term determines the useful life of the leasehold improvement and the useful life determines the lease term at the same time. He was worried that this will lead to a rule-based implementation of IFRS 16. He suggested instead that the lease term should be determined first before effectively linking up between lease term and useful life. Another Committee member said IAS 16 does not cap the useful life to the lease term and questioned whether there is sufficient basis to support the agenda decision.

The general comments about the tentative agenda decision from the Committee members suggested that the tentative agenda decision is written carefully and not as strong as the staff paper. Specifically, the tentative agenda decision has not included the context of paragraphs 53 and 59 of the staff paper (which point out the staff's expectation that in majority of cases the lease term to be at least as long as the economic life of the leasehold improvement, and in rare circumstances the useful life of the leasehold improvement is longer than the lease term). Those reading the tentative agenda decision might not reach the same conclusions as those in the staff paper.

The staff responded that the intention of the tentative agenda decision is to cover all cases, and reiterated that they already considered the impact of many scenarios when preparing the tentative agenda decision. As mentioned in the tentative agenda decision, an entity needs to look at the economics of the contract, which means it does not rule out any rare cases. The staff considered the tentative agenda decision can at least can give a reasonable relationship between IAS 16 and IFRS 16.

Another Committee member said the tentative agenda decision has not addressed whether the useful life of the leasehold improvement could be greater than the enforceable period of the lease. The staff responded that it is not addressing the question in the tentative agenda decision. Further if the entity has no control over asset, the entity could not depreciate the asset.

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