How does the short-term lease exemption work in IFRS 16?
IFRS 16 Leases provides a recognition exemption whereby lessees can choose not to capitalise ‘short-term leases’ on the balance sheet, and instead recognise lease payments as an expense, either on a straight-line basis, or another systematic basis, if that basis is more representative of the pattern of the lessee’s benefit. The short-term lease exemption must be applied consistently to all underlying assets in the same class.
What is a short-term lease?
A short-term lease is one that, at commencement date, has a lease term of 12 months or less. A short-term lease cannot include a purchase option.
What is the lease term?
The lease term starts on the lease commencement date and includes:
- The non-cancellable period of the lease
- Periods covered by an option held by the lessee to extend the lease if the lessee is reasonably certain to exercise that option, and
- Periods covered by an option held by the lessee to terminate the lease if the lessee is reasonably certain NOT to exercise that option.
Where the non-cancellable period of the lease is greater than 12 months, the short-term lease exemption cannot apply. However, the existence of a lessee extension option beyond 12 months does not necessarily mean that the short-term lease exemption cannot be applied because ‘lease term’ depends on the lessee being reasonably certain to exercise extension options.
How are short-term leases accounted for?
Lessees will recognise lease payments for a short-term lease as an expense on either a straight-line basis over the lease term or another systematic basis if that basis is more representative of the pattern of the lessee’s benefit. This makes short-term lease accounting an attractive option because it saves lessees time in preparing lease accounting journal entries, and it also keeps any associated lease liability off the balance sheet.
As tempting as it may seem for lessees to try and structure leases as short-term leases, in practice it is likely not to be a viable proposition for lessors, except in cases of assets that are usually subject to short-term rental periods such as a pop up store.
Once a short-term lease, always a short-term lease?
This is not the case. When facts and circumstances surrounding the lease change, lessees must consider whether they still have a short-term lease.
Leases are classified as ‘short-term’ if, at commencement date, they have a lease term of less than 12 months. However, this does not mean that we apply a ‘set and forget’ approach to classifying leases as short-term. Lessees must consider a short-term lease to be a new lease if there is a:
- Lease modification, or
- A change to the lease term (for example, if the lessee exercises an option to extend the lease beyond 12 months which it was previously not reasonably certain to exercise).
The following examples demonstrate how the accounting for short-term leases works in practice. In all examples, assume that the lessor has no substitution rights over the retail space occupied by PopUpStore. The agreement therefore meets the definition of a ‘lease’ because PopUpStore has the right to control the use of the identified asset (retail store) for a period of time in exchange for consideration.
Example 1 – Not reasonably certain to exercise extension option beyond 12 months
PopUpStore, which has a 30 June year-end, enters into a non-cancellable six-month lease with Shopping Centre on 1 October 2019 to sell its goods over the Christmas period. PopUpStore also has an option to extend the lease for a further 12 months. Monthly rental is $1,000, payable in arrears.
As this is the first time PopUpStore has occupied a store in this area, on 1 October 2019, it determines that it is not reasonably certain to exercise the extension option.
PopUpStore therefore concludes that it has a short-term lease because the total lease term is less than 12 months.
For the year ended 30 June 2020, PopUpStore recognises the following journal entry for the short-term lease:
Dr Rental expense $6,000
Cr Bank $6,000
Example 1A – Not reasonably certain to exercise extension option beyond 12 months, then reassess extension option on 1 April 2020 as being reasonably certain
Same facts as Example 1 above. PopUpStore sells face masks, and but due to the COVID-19 health crisis, business is booming and it determines on 1 February 2020 that it is now reasonably certain to exercise the extension option, extending the lease term to 31 March 2021. The incremental borrowing rate of PopUpStore on 1 February 2020 is 5%.
IFRS 16, paragraph 7(b) requires that a short-term lease is treated as a new lease if there is a change in the lease term. As PopUpStore has reassessed the likelihood of it exercising its 12-month extension option, it accounts for the lease as a new lease. Because the lease term at commencement of this new lease is greater than 12 months (i.e. 2 months plus 12-month extension option), it cannot be accounted for as a short-term lease and is instead capitalised on the balance sheet.
PopUpStore will therefore capitalise the lease on its balance sheet on 1 February 2020 as a new lease as follows:
Dr Right-of-use (ROU) asset $13,572
Cr Lease liability $13,572
From 1 February 2020 to 30 June 2020 (year-end), PopUpStore recognises the following journal entries:
Dr Interest expense $243
Dr Lease liability $4,757
Cr Bank $5,000
To recognise reduction in lease liability for lease payments made and related interest expense
Dr Amortisation of ROU asset $4,847
Cr Accumulated amortisation – ROU asset $4,847
To recognise amortisation on ROU asset for 5 months from 1 February 2020 to 30 June 2020
Actual modifications to leases which result in a change in the lease term will be accounted for in a similar manner to reassessments of extension or termination options because IFRS 16, paragraph 7 requires both of these to be accounted for as new leases.
Example 2 – Reasonably certain to exercise extension option beyond 12 months
PopUpStore, which has a 30 June year-end, enters into a non-cancellable six-month lease with Shopping Centre on 1 October 2019 to sell its goods over the Christmas period. PopUpStore also has an option to extend the lease for a further 12 months. Monthly rental is $1,000, payable in arrears. PopUpStore’s incremental borrowing rate on 1 October 2019 is 5%.
PopUpStore signed a similar six-month lease for the December 2018 Christmas period, and due to the ongoing demand for its goods, determines on 1 October 2019 that it is reasonably certain that it will exercise the extension option at the end of the six-month non-cancellable period.
PopUpStore therefore concludes that this is not a short-term lease because the lease term is longer than 12 months.
PopUpStore will therefore capitalise the lease on its balance sheet on 1 October 2019 as follows:
Dr ROU asset $17,307
Cr Lease liability $17,307
From 1 October 2019 to 31 January 2020, PopUpStore recognises the following journal entries:
Dr Interest expense $265
Dr Lease liability $3,735
Cr Bank $4,000
To recognise reduction in lease liability for lease payments made and related interest expense
Dr Amortisation of ROU asset $3,846
Cr Accumulated amortisation – ROU asset $3,846
To recognise amortisation on ROU asset for 4 months to 31 January 2020
Change in assessment of extension option (reduction in lease term to less than 12 months)
Due to the impacts of COVID-19 and reduced tourist traffic from China, on 1 February 2020, PopUpStore determines that it is no longer reasonably certain to extend the lease beyond 31 March 2020. Therefore there are 2 months remaining on the lease.
It is important to note that this is not accounted for as a new lease under IFRS 16, paragraph 7(b) because it was not classified as a short-term lease from the start. PopUpStore accounts for this as a normal reassessment of the lease term and accounts for this under IFRS 16, paragraphs 39 and 40 by:
- Recalculating the lease liability on 1 February 2020 for the remaining 2 months of the lease using a revised incremental borrowing rate on 1 February 2020, and
- Adjusting the balance on the ROU asset for the difference in the carrying amount of the liability prior to the reassessment, and the recalculated amount above.
Assume the following on 1 February 2020:
- The incremental borrowing rate is 6%
- The carrying amount of the ROU asset is $13,461
- The carrying amount of the lease liability, prior to reassessing the lease term, is $13,572, and
- The carrying amount of the lease liability after reassessing the lease term, assuming 2 months remaining on the lease and a 6% incremental borrowing rate is $1,985.
The difference in the carrying amount of the lease liability before and after the reassessment is determined as follows:
- Before reassessment $13,572
- After reassessment $1,985
- Difference $11,587
PopUpStore will therefore recognise this difference as an adjustment against the balance on the ROU asset on 1 February 2020:
Dr Lease liability $11,587
Cr ROU asset $11,587
The balance of the lease liability and ROU asset will be amortised over the remaining two-month lease term, i.e. February and March 2020.
Hold over leases not automatically short-term leases
‘Cancellable’ leases, sometimes referred to as ‘hold over’ leases, typically have no contractual term but continue indefinitely until either the landlord or the tenant give notice to terminate the arrangement. These arrangements typically exist between related parties (for example, between a parent entity and a subsidiary).
In some cases, such agreements are not even documented and many argue that there is no lease to account for under IFRS 16. However, provided that there is an agreement (contract) that conveys the right to use a specified asset for a period of time in exchange for consideration, there is a lease to be accounted for under IFRS 16. Please refer to our February 2020 Accounting News article, Think you don’t have a lease – Think again – Implications of the IFRIC agenda decision – Determining the ‘lease term’ for cancellable and renewable leases for further discussion.
Lessees also argue that because such leases can be terminated at any time by either party, they are effectively ‘one month’ leases, and are therefore ‘short-term’ leases, to be expensed monthly, rather than being capitalised on the balance sheet.
In most cases, this is not a correct assumption. Example 3 of the above article illustrates how the lease term is determined for these related party, ‘hold over’ leases. Due to economic penalties that often exist if the lessee were to terminate such an arrangement, IFRS 16, paragraph B34 would render the lease enforceable by the lessee for essentially as long as it is economically beneficial for the lessee to continue to occupy the premises. For example, the lessee could have installed leasehold improvements worth a significant amount of money, or the premises could be in a location from which it is economically advantageous to operate, and therefore the lease term could be considerable longer than 12 months, making it impossible for them to be classified as ‘short-term’.
Lease accounting is complex, particularly where reassessment and modifications are involved. Please contact BDO’s IFRS Advisory Team if you require assistance implementing IFRS 16.