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.
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.
The lease term starts on the lease commencement date and includes:
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.
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.
This is not the case. When facts and circumstances surrounding the lease change, lessees must consider whether they still have a short-term lease.
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.
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
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%.
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
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 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:
Assume the following on 1 February 2020:
The difference in the carrying amount of the lease liability before and after the reassessment is determined as follows:
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.
‘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.