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 with  a lease term of 12 months or less at the commencement date. It 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. Nevertheless, if a lessee exercises an extension option available in a lease that was appropriately classified at its original commencement date as qualifying for the short-term exemption, the lessee is required to treat the extended lease as a new lease, and therefore reevaluate whether the extended term of the lease meets the necessary criteria for the short-term exemption.  

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, this 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.

A lease is classified as ‘short-term’ if, at the commencement date, it has 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 treat a short-term lease as 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).

This means lessees cannot simply assume leases that initially meet the necessary criteria for the short-term exemption will continue to qualify for the exemption, irrespective of what happens to them.

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 the 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 2024 to sell its goods over the Christmas period. PopUpStore also has an option to extend the lease for a further 12 months.

This option can be exercised anytime up to 15 February 2025. 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 2024, 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 2025, 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 exercise extension option on 1 February 2025

Same facts as Example 1 above. PopUpStore sells loaded donuts and milkshakes , premium treats that have become  the latest teenage craze. With business booming, on 1 February 2025 PopUpStore exercises the 12-month extension option, extending the lease term to 31 March 2026. The incremental borrowing rate of PopUpStore on 1 February 2025 is 5%.

IFRS 16, paragraph 7(b) requires that a short-term lease be treated as a new lease if there is a change in the lease term. As PopUpStore has exercised its 12-month extension option, there is a change in the lease term, and 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 2025 as a new lease as follows:

Dr         Right-of-use (ROU) asset                        $13,572
Cr         Lease liability                                                    $13,572

From 1 February 2025 to 30 June 2025 (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 five months from 1 February 2025 to 30 June 2025

Actual modifications to short-term leases that result in a change in the lease term will be accounted for in a similar manner. This is because IFRS 16, paragraph 7, requires both modifications and changes in the lease term for short-term leases to be accounted for as new leases.

If the extension option were only for, say, a six-month period instead of twelve, the new lease term would be eight months (two plus six months), and the lease could be accounted for as a short-term lease under IFRS 16, paragraph 6.

Example 2 – Reasonably certain to exercise the 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 2024 to sell its goods over the Christmas period. PopUpStore also has an option to extend the lease for a further 12 months. This option can be exercised anytime up to 15 February 2025. Monthly rental is $1,000, payable in arrears. PopUpStore’s incremental borrowing rate on 1 October 2024 is 5%.

PopUpStore signed a similar six-month lease for the December 2023 Christmas period, and due to the ongoing demand for its goods, determined on 1 October 2024 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 2024 as follows:

Dr         ROU asset                      $17,307
Cr         Lease liability                                                    $17,307

From 1 October 2024 to 31 January 2025, 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 four months to 31 January 2025

Change in assessment of extension option (reduction in lease term to less than 12 months)

Due to the cost-of-living crisis, on 1 February 2025, PopUpStore determines that it is no longer reasonably certain to extend the lease beyond 31 March 2025, and notifies the lessor of its intention not to exercise the renewal option which was included in its initial assessment of the lease term. Therefore, there are two 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 2025 for the remaining two months of the lease using a revised incremental borrowing rate on 1 February 2025, 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 2025:

  • 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 two 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 2025:

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 2025.

Cancellable leases are not automatically short-term leases

‘Cancellable’ leases  typically have no contractual term but continue indefinitely until either the landlord or the tenant gives 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 (written or verbal) 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 previous 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 therefore, ‘short-term’ leases, to be expensed monthly rather than 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, cancellable 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 considerably longer than 12 months, making it impossible for them to be classified as ‘short-term’.

Need assistance?

Lease accounting is complex, particularly where reassessment and modifications are involved. Please contact BDO’s IFRS & Corporate Reporting if you require assistance implementing IFRS 16.