IFRS 16 Leases – Q&A’s

Q&A. 1: Is a perpetual period a ‘period of time’?

In order to qualify as a lease, an arrangement must convey a right to use an identified asset for a ‘period of time’. However, some contracts such as certain land easements have no limitation on the time period (that is, they are for a perpetual time period). Since IFRS 16 does not define the term ‘period of time’, it is not clear whether perpetual use rights are covered by that term.

One approach would be to argue that truly perpetual use rights are not over a (specified) ‘period of time’, and so they do not meet the definition of a lease in accordance with paragraph 9 of IFRS 16. However, an entity must consider the substance of the contract in determining whether it is truly perpetual. For example, if the contract provides for ongoing payments, and the arrangement can be terminated by merely stopping the payments, the term would not be truly perpetual.

Similarly, long-term leases of land (for example, 999-year leases) should not be considered to be perpetual. Truly perpetual use rights would need to be analyzed to determine whether an asset should be recognized under another standard, such as IAS 16 or IAS 38.

An alternative approach would be to argue that, even though there is no limit on the time period, a ‘perpetual term’ is still a ‘period of time’. Under this approach, a perpetual use right would meet the definition of a lease, provided that all other parts of the lease definition are met.

In ACT’s view, in the absence of specific guidance in IFRS 16, both approaches would be acceptable, and so the entity has an accounting policy choice. The policy chosen should be consistently applied and disclosed. If this choice represents a critical accounting judgment, the entity should consider the IAS 1 disclosure requirements.

Q&A. 2:  Which decisions should be considered when assessing which party has the right to direct the use of an asset?

The table below provides some questions to consider when evaluating which party has the relevant decision-making rights:

Q&A. 3: How do termination options affect the length of the lease term?

Three scenarios are possible for termination options: Only the lessee has a termination option: the period covered by the termination option is included in the lease term only if the lessee is reasonably certain not to exercise the termination option. Only the lessor has a termination option: the period covered by the termination option is part of the non-cancellable lease period.

Each party has the right to terminate the lease: the period covered by the termination options is not part of the lease term, provided that each party has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.

Q&A 3A. How is ‘penalty’ interpreted in the context of paragraph B34 of IFRS 16?

A lessee enters into a lease contract with a lessor to lease a building on 1 January 20X1. The contract is concluded for an indefinite time. The lessee and the lessor each have a right to terminate the contract at the end of each calendar year, with a six-month termination notice. In case of termination, there is no contractual penalty payment payable between the parties.

However, the lessee has a significant economic disincentive to terminate the contract before the end of year 10. Examples of these economic disincentives might be:

• Significant leasehold improvements which are integral to the building and which involve a loss in economic value for the lessee if the contract is terminated before the end of their economic life.
• Costs relating to the termination of the contract (such as cost of finding a replacement lease, negotiating or relocating).
• The importance of the underlying asset to the lessee’s operations.

Should an economic disincentive to exercise a termination option be considered to be a penalty in terms of paragraph B34 of IFRS 16?

Based on paragraph B34 of IFRS 16, 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.

IFRS 16 does not specifically define the term ‘penalty.

The IASB staff released a webcast (Lease Term Q&A, October 2017) in which an IASB staff member and an IASB Board member discussed this topic. In that webcast, the IASB Board member stated that “a termination payment is clearly one kind of penalty, but a penalty could arise in other ways. For example, if either the lessee or the lessor will suffer some other kind of economic outflow as a consequence of terminating; so things like costs of relocating, or finding new tenants, or dealing with leasehold improvements, then there is a penalty even if it’s not explicitly in the contract” and “when the Board developed the requirements in B34 we were thinking of a broader definition of a penalty than just, say, a termination payment in the contract”.

The broad interpretation of the term ‘penalty suggested by the IASB staff webcast is consistent with the US GAAP guidance on leasing, ASC 842, which defines a penalty as follows:

“Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following:

1. Disburse cash
2. Incur or assume a liability
3. Perform services
4. Surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit or suffer an economic detriment. Factors to consider in determining whether an economic detriment may be incurred include, but are not limited to, all the following:
5. The uniqueness of purpose or location of the underlying asset
6. The availability of a comparable replacement asset
7. The relative importance or significance of the underlying asset to the continuation of the lessee’s line of business or service to its customers
8. The existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the underlying asset
9. Adverse tax consequences
10. The ability or willingness of the lessee to bear the cost associated with relocation or replacement of the underlying asset at market rental rates or to tolerate other parties using the underlying asset.”

Interpreting the word ‘penalty’ in paragraph B34 of IFRS 16 might represent a critical accounting judgment, in which case the entity should consider the IAS 1 disclosure requirements.

Q&A 4: How is the lease term impacted by break clauses?

If a lease contains a break clause (that is, a right of the lessee to terminate the lease after a certain point in time), the length of the lease depends on whether the lessee is reasonably certain not to exercise the option.

Where the lessee has a break clause without penalty or another economic incentive, it is more likely that the lessee will exercise the option to terminate. Unless a lessee is reasonably certain not to exercise a termination option, the lease term will be the period between the commencement of the lease and the earliest effective date of the break option.

Where the lessee has a break clause that requires the lessee to make a termination payment to compensate the lessor (sometimes referred to as the ‘stipulated loss value’), such that the recovery of the lessor’s remaining investment in the lease was assured, it is less likely that the lessee will exercise the termination clause. If the lessee is reasonably certain not to exercise the termination option, the lease term will include the period covered by the termination option.

Q&A 5: Does the assessment of whether a lessee is ‘reasonably certain to exercise an option include non-monetary economic incentives?

An entity considers all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, an extension or a termination option when determining the lease term. Does an economic incentive have to be monetary (which can be either contractual or non-contractual), or are non-monetary aspects also taken into account?

Non-monetary aspects are included in the analysis, provided that they reflect economic incentives and not irrational behavior. Examples of nonmonetary aspects include time needed to change the lessor and enter into a new contract; and the inconvenience resulting from changing the lessor and entering into a new contract.

A lessee’s past practice might provide information that is helpful in assessing whether the lessee is reasonably certain to exercise, or not to exercise, an option. It is, however, key to understand the economic reasons for that past practice. Those economic reasons, if any, must be considered in the lease term assessment. [IFRS 16 para B40].

Q&A 6: How does IFRS 16 define the term ‘low value’?

The standard does not define the term ‘low value’, but the Basis for Conclusions explains that the IASB had in mind assets of a value of US$5,000 or less when new. The amount of US$5,000 is, however, not a quantitative threshold but an example that the IASB has used to illustrate a general principle.

In order to assess whether a leased asset qualifies for the low-value asset exemption, an entity should focus on the nature of the asset. Examples of assets of low value can include IT equipment (tablets and personal computers), office furniture, or telephones. Cars would not qualify as low-value assets, because a new car would typically not be of low value. The types of assets that qualify for the low-value asset exemption might change over time if, due to technological or market developments, the price of a particular type of asset changes. A change in the US dollar foreign currency exchange rate or the inflation rate does not, by itself, affect whether an asset is within the scope of the exemption.

Q&A 7: What factors should a lessee consider when determining an incremental borrowing rate?

The incremental borrowing rate is the rate of interest that a lessee would have to pay to borrow, over a similar term and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment. Given the definition in Appendix A to IFRS 16 as well as in paragraphs BC160 to BC162 of IFRS 16, when calculating the incremental borrowing rate, a lessee should consider the following factors:

• The rate calculated should be the rate at which the entity could borrow. The rate should not reflect the cost of equity finance and, as such, it would be inappropriate to use a WACC (or any other rate including a component ‘cost of capital’ alongside the cost of debt).
• The rate should reflect the amount that the entity could borrow over the term of the lease. It should be the rate at which an entity would borrow to acquire an asset of similar value to the right-of-use asset, rather than to acquire the entire underlying asset. An exception would be where the lease term is for substantially all of the life of the underlying asset.
• The rate should reflect that of a secured borrowing for a similar asset (being the right-of-use asset, not the underlying asset), rather than an unsecured borrowing or general line of credit.
• The rate should reflect the credit standing of the entity and the rate at which it would borrow in a similar economic environment. For example, if a company has GBP functional currency and typically borrows in GBP, but it enters into a US dollar lease, the incremental borrowing rate will reflect the cost of borrowing US dollars.

Q&A 8: How is the term ‘index or rate’ interpreted?

In accordance with IFRS 16, variable lease payments are included in the measurement of the lease liability if they depend on an index or rate. [IFRS 16 para 27(c)]. Paragraph 28 of IFRS 16 provides three examples of an index or rate: a consumer price index, a benchmark interest rate (such as LIBOR), and market rental rates.