Interpretation of “Period of time” under IFRS 16

What is a period of time under IFRS 16?

The term ‘period of time’ should not be interpreted too literally.

An amount of use of the underlying asset, such as the number of production units that an item of equipment will produce, can also describe a period of time as required by paragraph 9 of IFRS 16.

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 way would be to say 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 our 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.

Can perpetual lease contracts that contain termination options qualify as short-term leases?

Let’s see this example where entity A enters into a lease of small office space. The lease continues in perpetuity, but both the lessor and the lessee have termination options. The termination options are exercisable at any time, with a three-month notice period. The entity exercising the termination option will bear no more than an insignificant penalty. Does the contract qualify as a short-term lease for the lessee?

Analysis A: Short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less. The lease term is defined as the non-cancellable period of a lease, together with both periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option and periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

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, the enforceable period of the lease ends at the earliest point in time at which both parties can leave the contract and its contractual obligations. The enforceability of a lease contract does not require assessment of what is reasonably certain. In this example, both the lessee and the lessor have a termination right, with a three-month notice period, and the entity exercising it will bear no more than an insignificant penalty. Hence, the lease term is only three months, and so the lease qualifies as a short-term lease at the commencement date.

Now, what will happen when only the lessee has a termination option. Does the contract qualify as a short-term lease?

Analysis If only the lessee has a termination option, the lease term depends on whether, or for how long, the lessee is reasonably certain not to exercise the termination option. Depending on this analysis, the lease could qualify as a short-term lease if the lease term is 12 months or less. So if, for example, it is reasonably certain that the lessee will not exercise the termination option before the end of month 57 (effective at the end of month 60), the lease term is five years. If the lessee is reasonably certain not to exercise the termination option only within the first nine months, the contract qualifies as a short-term lease.

Now, if the Lessor has a termination right. What will happen? Furthermore, it is now assumed that the contractual term of the lease is 10 years. Does the contract qualify as a short-term lease?

Analysis: If only the lessor has the right to terminate the lease, the non-cancellable period of the lease includes the period covered by the option to terminate the lease.

Hence, the lease term is equal to the contractual term of the lease (that is, 10 years). The lease contract does not qualify as a short-term lease.

Thus, it can be seen that the lease term plays the most important role in the determination of the ROU value and the corresponding lease liability. It requires careful and detailed analysis which also mainly depends on the SUBSTANCE OVER FORM OF THE CONTRACT.