Landlord Lease term – IFRS 16 Best complete read

Landlord Lease term

New guidance on lease term could impact the period over which operating lease incentives are recognised in profit or loss, particularly for renewable and cancellable leases.

1 Overview of landlord lease term

Determining the lease term is a critical estimate that is significant for the lessor. The lease term may affect the lease classification. For operating leases, it impacts the period over which lease incentives are recognised.

The lease term is the non-cancellable period of the lease, together with:

  • optional renewable periods if the lessee is reasonably certain to extend; and
  • periods after an optional termination date if the lessee is reasonably certain not to terminate early. (IFRS 16.18)

To determine the lease term, a lessor first determines the length of the non-cancellable period of a lease and the period for which the contract is enforceable. It can then determine – between those two limits – the length of the lease term.

The lessor determines the lease term at the commencement date.

The lease term starts when the lessor makes the underlying asset available for use by the lessee. It includes any rent-free periods. (IFRS 16 Definition, IFRS 16.B36)

When the ‘period of use’ includes any non-consecutive periods of time, the lease term is evaluated on the basis of the aggregate period of use – i.e. the sum of the non-consecutive periods. (IFRS 16 Definition)

IFRS 16 provides guidance on when a lessee should reassess the lease term and remeasure the lease liability and right-of-use asset. However, it is silent for lessors. (IFRS 16.20)

Food for thought – How do landlords recognise operating lease income in a lease with non-consecutive periods of use?

In most commercial real estate leases, the benefit conveyed by the landlord to the tenant is the right to use the underlying property over the lease term. Therefore, operating lease income is recognised only during the periods the Landlord lease termlessee has the right to use the underlying asset.

For example, a landlord leases a retail store space in a shopping mall to a tenant during the holiday season (15 October to 15 January) each year for three years. The lease is classified as an operating lease. In this case, the landlord recognises operating lease income, including variable lease income, only during the period from 15 October to 15 January each year. No lease income is recognised outside that time window.

See Changes to operating leases that are not lease modifications in Lease modifications for a discussion on revenue recognition when the tenant’s business is impacted by COVID-19 or government restrictions.

2 Non-cancellable period

The ‘non-cancellable period’ is the period during which the lessee cannot terminate the contract. The lease term cannot be shorter than the non-cancellable period. (IFRS 16.B35, IFRS 16.BC127–BC128)

Food for thought – If a lessor can cancel the lease, then does this affect the non-cancellable period?

No. If only the lessor has the right to terminate a lease, then the non-cancellable period of the lease includes the period covered by the lessor’s option to terminate the lease. In this situation, the lessee has an unconditional obligation to pay for the right to use the asset for the period of the lease, unless and until the lessor decides to terminate the lease. (IFRS 16.B35, IFRS 16.BC128)

Any non-cancellable period or notice period in a lease would meet the definition of a contract and be included as part of the lease term.

Food for thought – How does a company determine the non-cancellable period when it is not fixed at lease commencement?

In some lease arrangements, at commencement the non-cancellable period is not fixed, and becomes fixed only after the lease commencement date. For example, a company may lease an asset to use on a specific project and the lease will state that the period of use is for the duration of the project, with no termination or renewal options.

The standard does not specifically address situations in which the non-cancellable period of the lease is not fixed at lease commencement.

In these cases, it appears that a company should estimate the non-cancellable period at the commencement date. Subsequently, the company should reassess the lease term when the non-cancellable period becomes fixed (see Changes in the lease term).

3 The enforceable period

To determine the lease term, a lessor determines the period for which the lease is enforceable using the definition of a contract. For this purpose, the contract comprises the written agreement and applicable laws and regulations in the local jurisdiction that stipulate and govern the parties’ rights and obligations. (IFRS 16.2, IFRS 16.B34, IFRS 16.BC127)

Enforceability is a matter of law in the relevant jurisdiction and each contract will need to be evaluated based on its terms and conditions. This includes considering the guidance on enforceability in paragraph B34 of IFRS 16, including the role of penalties in assessing the enforceable period.

The key steps to determining the enforceable period are as follows.

Landlord Lease term

Renewal and termination options are considered in the assessment of the lease term if they are enforceable. The ‘enforceable period’ is the period for which enforceable rights and obligations exist between the lessee and lessor. This is the maximum potential length of the lease term. (IFRS 16.B34, IFRS 16.BC127)

Although the standard does not define ‘enforceability’, paragraph B34 describes when a contract is (and is no longer) enforceable under the standard. A lease is no longer enforceable beyond the point at which both the lessee and the lessor have the unilateral right to terminate the lease without permission from the other party, and with no more than an insignificant penalty. (IFRS 16.B34, IFRS 16.BC127)

Consequently, a contract is enforceable beyond the date on which it can be terminated if:

  • both parties have the right to terminate but one party, or both, would incur a penalty on termination that is more than insignificant; or
  • only one party has the right to terminate the lease without the permission of the other party.

A lease is no longer ‘enforceable’ when both the lessee and lessor have the right to terminate it without agreement from the other party with no more than an insignificant penalty. If only the lessee has the right to terminate a lease, then that right is considered to be an option available to the lessee to terminate the lease that a company considers when determining the lease term.

Termination options held by the lessor only are not considered when determining the lease term because, in this situation, the lessee has an unconditional obligation to pay for the right to use the asset for the period of the lease, unless the lessor decides to terminate the lease. (IFRS 16.B34–B35, IFRS 16 BC127)

The following summarises the impact of penalties and termination rights on the determination of the enforceable period. (IFRS 16.B34–B35, IFRS 16 BC127)

Landlord Lease term

IFRS 16 does not define the term ‘penalty’. Therefore, questions have arisen in practice about whether a company considers the broader economics of the contract or only contractual termination payments when applying IFRS 16.B34. The IFRS Interpretations Committee discussed this issue and noted that when determining the effect of termination rights under IFRS 16.B34, a company considers the broader economics of the contract and not only contractual termination payments.

Case – Impact of termination rights on enforceable period

Scenario 1

Tenant B leases a retail store from Landlord C under the following terms.

  • The written contract is for a stated maximum term of five years.
  • B and C each have the unilateral right to terminate the lease at the end of Year 2 with no more than an Landlord lease terminsignificant penalty.
  • Relevant laws and regulations that govern the transaction do not stipulate any other rights and obligations of the parties in addition to those in the written contract.

On lease commencement, the enforceable period is two years, regardless of how likely it is that both parties will decide to extend the lease beyond the end of Year 2.

Scenario 2

Tenant D leases a warehouse from Landlord E under the following terms.

  • The written contract is for a stated maximum term of five years.
  • After Year 1, D and E each have the unilateral right to terminate the lease, but a one-month notice period is required – i.e. the lease terminates one month after the termination notice is given. Notice cannot be given before the end of Year 1. If the lease is terminated in this way, then neither party will suffer a more-than-insignificant penalty.
  • Relevant laws and regulations that govern the transaction do not stipulate any other rights and obligations of the parties in addition to those in the written contract.

On lease commencement, the enforceable period is 13 months.

Food for thought – Can a lease be enforceable even if some terms and conditions remain open to negotiation between the parties?

It depends. Judgement is required to establish whether the combined effect of the written contract and applicable laws and regulations establishes terms and conditions under which the lease will continue after the date on which both parties can terminate the lease. For example, laws and regulations may establish some but not all of the terms and conditions under which a lease may continue after the date on which both parties can terminate the lease.

This is often the case for laws relating to real estate leases under which the tenant has certain statutory rights to remain in occupation. In some cases, a tenant may also have an enforceable right to renew a lease but the rent in the renewal period will be subject to negotiation within broadly defined parameters.

For example, the future rent may depend on market rent or changes in market property values, or be subject to independent arbitration if it is not mutually agreed.

Depending on the facts and circumstances, this type of arrangement may be considered akin to a renewal option subject to a market rent review. When this is the case, the future rents are variable payments that depend on an index or a rate. For more discussion on how to account for these variable payments, see Fixed and in-substance fixed payments.

Food for thought – What is the enforceable period when both the lessee and lessor have termination rights, but only one party would suffer a more-than-insignificant penalty?

The existence of a penalty affects the enforceable period in different ways, depending on which party would suffer a more-than-insignificant penalty. (IFRS 16.B34–B35, IFRS 16.BC127)

In the following scenarios, relevant laws and regulations that govern the transaction do not stipulate any other rights and obligations of the parties in addition to those in the written contract.

Scenario 1 – Both parties have termination rights without the permission of the other, but only the lessor’s right gives rise to a more-than-insignificant penalty

In this case, the enforceable period ends when the lessor’s exercise of its termination option no longer gives rise to a more-than-insignificant penalty – i.e. when both the lessee and the lessor have the unilateral right to terminate the lease with no more than an insignificant penalty.

In contrast, if the lessor’s termination right will no longer result in a more-than-insignificant penalty before the lessee’s termination option becomes exercisable, then the lessor’s termination option is disregarded for accounting purposes until the lessee’s termination option becomes exercisable.

When the lessee’s termination option becomes exercisable, both the lessee and the lessor have the unilateral right to terminate the lease with no more than an insignificant penalty, and the enforceable period does not extend beyond that point.

Scenario 2 – Both parties have termination rights without the permission of the other, but only the lessee’s right gives rise to a more-than-insignificant penalty

In this case, the enforceable period ends when the lessee’s exercise of its termination option no longer gives rise to a more-than-insignificant penalty.

Food for thought – If the lessor has the right to refuse a request from the lessee to extend the lease, then does this prevent the contract from being enforceable?

Not necessarily. (IFRS 16.B34–B35, IFRS 16.BC127)

Some leases include a clause stating that the lessee may request a renewal of the lease, subject to agreement with the lessor.

The IFRS Interpretations Committee discussed this issue and observed that paragraph B34 of IFRS 16 applies because, in effect, the lessee’s option not to request a renewal and the lessor’s option to refuse the lessee’s request are substantially equivalent to termination options.

When discussing this, the Committee noted that the description of ’enforceable’ in paragraph B34 is not strictly a legal concept, and includes reference to whether exercise of a termination option carries ‘no more than an insignificant penalty’.

Therefore, in these cases a company considers whether the lessee or lessor would suffer a more-than-insignificant penalty to determine the enforceable period.

4 Reasonably certain threshold

The concept of ‘reasonably certain’ is integral to determining the lease term. IFRS 16 does not define ‘reasonably certain’ and there is no bright line when making the assessment. A lessor considers all of the relevant facts and circumstances that create an economic incentive for the lessee to exercise a renewal option or not to exercise a termination option.

Termination options held solely by landlords are considered in determining the lease term because, in this situation, the lessee has an unconditional obligation to pay for the right to use the asset for the period of the lease, unless the lessor decides to terminate the lease. (IFRS 16.19, IFRS 16.B35, IFRS 16.BC157)

The standard provides examples of factors to consider when assessing whether it is reasonably certain that a lessee would exercise an option to renew or not exercise an option to terminate the lease. The assessment of the degree of certainty is based on the facts and circumstances at commencement of the lease, rather than on the lessee’s intentions.

The following table provides examples of factors that create an economic incentive either to exercise or not to exercise options to renew or terminate early. (IFRS 16.B37, IFRS 16.B40)

Examples of relevant facts and circumstances

Contractual/Market

  • Level of rentals in any secondary period compared with market rates
  • Contingent payments
  • Renewal and purchase options
  • Costs relating to the termination of the lease and the signing of a new replacement lease
  • Costs to return the underlying asset

Asset

  • Nature of item (specialised)
  • Location
  • Availability of suitable alternatives
  • Existence of significant leasehold improvements

Food for thought – Does the existence of non-removable significant leasehold improvements impact the lease term?

Yes. The IFRS Interpretations Committee considered the interaction between determining the lease term and the useful life of non-removable significant leasehold improvements in the context of its discussion on cancellable and renewable leases. (IFRS 16.B37)

When assessing whether it is reasonably certain to extend (or not to terminate) a lease, a company considers all relevant facts and circumstances that create an economic incentive for the lessee. This includes significant leasehold improvements (made or planned to be made) over the term of the contract that are expected to have significant economic benefit when the option to extend (or terminate) becomes exercisable.

Food for thought – Can lessees and lessors reach different conclusions about whether it is reasonably certain that an option will be exercised?

Yes. Lessees and lessors may reach different conclusions about whether the lessee is reasonably certain to exercise an option to renew or not to exercise an option to terminate early.

Lessees and lessors may also reach different conclusions about lease term because of information asymmetry and the judgemental nature of the assessment. The assessment of reasonably certain is based on judgements (e.g. about the importance of an underlying asset to the lessee) and estimates (e.g. of the fair value of the underlying asset in the future). In addition, lessors will not necessarily be familiar with the lessee’s specific facts and circumstances, which may result in a different conclusion.

5 Renewable and cancellable leases – Application issues

In some cases, a real estate lease contract may continue indefinitely until either party gives notice to terminate it (i.e. cancellable lease), or may renew indefinitely unless it is terminated by either party (i.e. renewable lease). For example, evergreen leases are leases that automatically renew on a day-to-day, week-to-week or month-to-month basis – i.e. they are cancellable leases. A question arises over how to determine the non-cancellable and enforceable period of such leases.

The IFRS Interpretations Committee discussed this issue and noted that in doing so a company considers the broader economics of the contract and not only contractual termination payments. If only one party has the right to terminate the lease without permission from the other party and with no more than an insignificant penalty, then the contract is enforceable beyond the date on which the contract can be terminated by that party. (IFRS 16.B34)

If a company concludes that the contract is enforceable beyond the notice period of a cancellable lease (or the initial period of a renewable lease), then it applies the reasonably certain threshold assessment to determine the lease term. (IFRS 16.19, IFRS 16.B37–B40)

A penalty may expire or, over a period of time, the effect of a penalty that is initially more than insignificant may become insignificant. For example, a termination penalty that is more than insignificant if it is incurred after only one year of a lease may be insignificant if it is incurred after four or five years when considered in the context of the broader economics of the contract.

Case – Termination rights: No more than an insignificant penalty

Tenant L enters into a five-year lease of a warehouse with Landlord M. (IFRS 16.B34)

L designs and sells furniture internationally online and is testing use of the warehouse as a showroom. The cost to fit out the warehouse space to serve as a showroom is not significant. If the showroom is unsuccessful, then L does not plan to use the space as a warehouse.

Under the lease agreement, L and M each have the right to terminate the lease without a contractual penalty on each anniversary of the lease commencement date.

M considers the following when evaluating whether L will incur a more-than-insignificant penalty if it terminates the lease.

  • The leasehold improvements are minor. Therefore, L’s loss of economic value if the contract is terminated before the end of their economic life is not significant.
  • The cost to dismantle the leasehold improvements is not significant.
  • The cost to restore the warehouse to its original condition is not significant.
  • The potential impact of early termination on customer relationships is low. L mostly interacts with its customers through its website, with a small number expected to visit the showroom in person.

M determines that it can easily find a new tenant considering that the demand for a warehouse is high for this location.

Enforceable period and lease term

Based on its analysis of the facts and circumstances, M determines that both parties can terminate the lease with no more than an insignificant penalty after one year. In this case, the enforceable period and the non-cancellable period of the lease are both one year.

This is because – after both parties’ termination rights become exercisable at the end of Year 1 – neither party has enforceable rights (i.e. L to use the warehouse or M to receive lease payments) or obligations (i.e. L to make lease payments or M to permit continued use of the warehouse).

Because both the enforceable period and the non-cancellable period of the lease are one year, the lease term is also one year.

Case – Renewable lease: More than an insignificant penalty

Tenant K leases a property from Landlord M under the following terms. (IFRS 16.B34)

  • The written contract is for five years and does not contain any extension or termination options.
  • There is a local law that states that if K remains in occupation after the end of Year 5, then the terms of the original contract will continue to apply. However, it remains the case that both parties have the unilateral right to terminate the contract at the end of Year 5 (i.e. because the written contract that is for five years expires). This will be the case as long as K continues to make the lease payments and complies with its other obligations under the original contract with M.
  • At the end of Year 5, because of the existence of significant economic incentives for each party to continue the lease for longer, K continues to occupy the property and make the lease payments. M accepts the payments and does not seek to evict K.

The significant economic incentives for M and K include the following.

  • At the commencement date, K undertakes significant, non-removable leasehold improvements. If the contract were terminated before the end of their economic life, then this would create a significant loss of economic value (which would exceed the benefits that K might receive from terminating this lease with above-market payments; see last bullet below) that would remain significant in the future beyond the end of Year 5.
  • The property location is ideal for K’s business (i.e. for strategic relationships with suppliers and customers) and cannot be replaced in the near term.
  • The lease rentals that K will continue to pay are above current market rates: i.e. M may be unable to lease the property to another tenant on equivalent terms.

Enforceable period

Under IFRS 16.B34, M and K determine the enforceable period based on the broader economics of the contract. Considering the existence and significance of identified penalties, M and K determine at the commencement date that the enforceable period extends beyond five years and will extend as long as the termination penalties remain more than insignificant.

M and K apply their own judgement separately when making these assessments. They may need to consider additional factors in more complex arrangements.

Case – No stated terms

Landlord R leases a retail space to Tenant E. There is no stated duration for the lease in the contract. E can terminate the lease at the end of any month by leaving the premises. For each month that the asset is used by E, E will pay a fixed fee to R for the right to use that asset. (IFRS 16.B37, IFRS 16.B39)

The non-cancellable period of the lease is one month because E could elect to leave the premises before the start of Month 2. If E has an ongoing need to use an asset similar to the underlying asset in its business, then the costs to E of terminating the lease (e.g. cost of non-removable leasehold improvements) and entering into a new lease (e.g. identifying another asset, entering into a different contract and moving costs) may provide a compelling economic reason for E to continue to use the space for a period that is longer than the non-cancellable period – i.e. the lease term may be more than one month.

Food for thought – How does the assessment of reasonably certain differ for evergreen leases?

It does not differ. The lease term for evergreen leases is determined in the same manner as for all other leases, which means considering whether the lessee is reasonably certain to exercise one or more available renewal options. (IFRS 16.B37, IFRS 16.B39)

Determining whether a lessee is reasonably certain to exercise a renewal option in an evergreen lease may involve significant judgement. In general, the shorter the non-cancellable period of a lease, the more likely it is that a lessee is reasonably certain to exercise one or more renewal options. This is because, in many cases, it may be prohibitive to continually substitute leased assets.

For example, if a lessee leases a retail or warehouse space on a monthly basis and expects to need a substantially similar space for the next 18–24 months, then there may be a significant economic incentive (e.g. to avoid moving costs or customers having to find the lessee’s new location) to renew the lease rather than continually move to a similar space throughout the period.

6 Changes in the lease term

After the commencement date, the lessor reassesses the lease term when there is a change in the non-cancellable period of a lease. This requirement applies to both lessees and lessors. For example, the non-cancellable period of a lease will change if: (IFRS 16.21)

  • the lessee exercises an option not previously included in the lessor’s determination of the lease term;
  • the lessee does not exercise an option previously included in the lessor’s determination of the lease term;
  • an event occurs that contractually obliges the lessee to exercise an option not previously included by the lessor; or
  • an event occurs that contractually prohibits the lessee from exercising an option previously included by the lessor.

For example, a lessor determined at commencement that the lease term was the non-cancellable period of five years, considering that it was not reasonably certain that the tenant would exercise a renewal option for an additional five years.

However, if at the end of Year 4 the tenant exercises the renewal option for the additional five years by giving formal notification to the lessor, then the lessor revises the remaining lease term to six years to reflect the new non-cancellable period.

Case – Date of the change in the non-cancellable period

Tenant L leases a retail store from Landlord R. The lease is non-cancellable for 10 years and includes a five-year renewal option. L is required to notify R if it intends to exercise the renewal option by the end of Year 9. At lease commencement, R concludes that L is not reasonably certain to exercise the renewal option and, therefore, the lease term is 10 years. (IFRS 16.21)

The retail location performs better than expected for reasons not anticipated at lease commencement. In Year 7, L decides that it will exercise the renewal option. However, L decides not to notify R until it is required to do so – i.e. at the end of Year 9.

In this case, the better-than-expected trading performance is a market-based factor, which does not in isolation trigger a reassessment of the lease term. Therefore, both R and L reassess the lease term only when L formally notifies R that it will renew the lease – i.e. at the end of Year 9.

Food for thought – Is a lessor required to reassess the lease term when the lessee reassesses whether it is reasonably certain to exercise an option?

No. Lessors reassess the lease term and remeasure the lease payments only when there is a change in the non-cancellable period of the lease, as described in IFRS 16.21. In contrast, paragraph 20 requires reassessment in additional circumstances, but this applies only to lessees. (IFRS 16.20–21)

The Board intended to minimise changes to lessor accounting under IAS 17, under which lessors generally determined the lease term at commencement and did not reassess unless there was a change in the contract. IFRS 16 provides detailed guidance on the lessor accounting for lease modifications (see Lease modifications).

Food for thought – If the non-cancellable period becomes fixed only after lease commencement, then should a company reassess the lease term?

Yes, if the fixed period is different from the initial estimate. (IFRS 16.21, IFRS 16.BC184, IFRS 16.BC187)

If the non-cancellable period of the lease is not fixed at lease commencement, then the company should estimate the non-cancellable period. In this case, it appears that a company should reassess the lease term when the non-cancellable period of the lease becomes fixed and differs from the initial estimate.

We believe that not updating the lease term could result in counter-intuitive accounting results. For example, the lessor might recognise lease income (or lease expense for the lessee) over a period that is unrelated to the non-cancellable period of the lease.

Food for thought – How should a lessor account for the remeasurement of the net investment in a finance lease when there is a change in the non-cancellable period?

IFRS 16 is silent on how a lessor accounts for the remeasurement of the net investment in a finance lease when it revises the lease term. It appears that the lessor should choose an accounting policy, to be applied consistently, to remeasure the net investment in the lease by applying by analogy the guidance in: (IFRS 16.21)

  • IFRS 9 on accounting for a change in expected cash flows, using the original discount rate determined at inception; or
  • IFRS 16 on remeasurement of a lease liability by the lessee, using a revised discount rate.

It appears that when the lessor changes its assessment of the lease term, it should also update the unguaranteed residual value to reflect the revised date on which the lease term ends and the landlord obtains possession of the real estate property.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Landlord Lease term

Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term

Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term

Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term Landlord Lease term

Leave a comment