Lease Term under Ind AS 116 - Lessee’s Perspective

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Introduction of Ind AS 116 has made significant changes in the accounting for leases in the books of the lessee. The recognition of the Right of use Asset and lease liability in the books of lessees (even for operating leases as per the erstwhile Ind AS 17) ushers in an era of more fair representation by bringing in the off-balance sheet resources used for business and financial liabilities of a lessee, into the balance sheet.

Determination of the lease term is one of the critical aspects of accounting for leases under Ind AS 116. In this article, we will dwell into the nitty gritty of determining the lease term.

The following are critical to determining the lease term under Ind AS 116:

1. Contracted term in the lease agreement

2. The extension clause in the lease agreement

3. The termination clause in the lease agreement

Let’s discuss the intricacy in determining the lease term in the commonly seen lease terms an entity enters into:

Scenario I:

Term of contract is 5 years

Extension clause: Contract can be extended for a period of three years if mutually agreed by lessor and lessee

Termination clause: Lessor has a unilateral right to terminate the contract. This right to terminate is other than a remedy for non-compliance of the terms of the contract by the lessee.

Analysis and conclusion of the lease term:

• Through the terms, the lessee and the lessor can enforce the contract for 5 years.

• The extension option will not be enforceable unilaterally as it can be invoked only if both the lessor and lessee agree.

• If a contract can be terminated only by lessor, then the non-cancellable period of the lease includes the period covered by the option to terminate the lease.

• Thus, the lease term is 5 years.

Paragraph reference in Ind AS 116: 18, B34 & B35

Scenario II:

The term of the Contract is 5 years

Extension clause: The contract can be extended for a period of three years if mutually agreed by the lessor and lessee

Termination clause: Lessee has a unilateral right to terminate the contract by giving three months’ notice. This right to terminate is other than a remedy for noncompliance of the terms of the contract by the lessor.

Analysis and conclusion of the lease term:

• The lease term does not include that period covered by an option to terminate the lease if the lessee is reasonably certain to exercise the option.

• The lessee is to consider all relevant facts and circumstances that create an economic incentive for it to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option.

• The shorter the non-cancellable period of a lease, the more likely a lessee is to exercise an option to extend the lease or not to exercise an option to terminate the lease. This is because the costs associated with obtaining a replacement asset are likely to be proportionately higher.

• A lessee’s past practice regarding the period over which it has typically used particular types of assets (whether leased or owned), and its economic reasons for doing so, may provide information that is helpful in assessing whether the lessee is reasonably certain to exercise, or not to exercise, an option.

• The extension option will not be enforceable unilaterally as it can be invoked only if both the lessor and lessee agree.

• Thus the lessee is to analyze the facts of the case (including the above mentioned points) and estimate whether it would exercise the option of termination.

• If it estimates that it will terminate the contract before the end of 5 years (term mentioned in the contract), then the lease term would be that specific period, if not it would be 5 years.

Paragraph reference in Ind AS 116: 18, B34, B37, B39 & B40

Scenario III:

The term of the contract is 5 years

Extension clause: The contract can be extended for a period of three years if mutually agreed by the lessor and lessee

Termination clause: After the lock-in period the lessor and lessee have the right to terminate the agreement by giving 3 months’ notice. This right to terminate is other than a remedy for non-compliance with the terms of the contract by the lessee or lessor

Analysis and conclusion of the lease term:

• In determining the lease term and assessing the length of the non-cancellable period of a lease, an entity shall apply the definition of a contract and determine the period for which the contract is enforceable.

• 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. The past facts of the case or trend cannot be cited to state that the contract will not be terminated by the lessor or lessee which makes the lease enforceable.

• The term insignificant penalty is to be interpreted to include any penalty for termination under the contract and other consequential penalties (including cost overruns or losses) to be incurred from terminating the lease contract. Examples of other consequential penalties would include paying higher rents for the same or similar leased asset, the amount invested in the leasehold improvements, additional travel costs to be incurred due to a change in location of the leased asset, loss of reputation for a change in location for a building in which the retail store exists, etc.

• The extension option will not be enforceable unilaterally as it can be invoked only if both the lessor and lessee agree.

• Thus given the facts of the case:

• if the penalty of termination is insignificant then the lease term would be three months (notice period to be given before termination). In this case, the short-term lease exemption under Ind AS 116 can be applied as the lease term is below 12 months and consequently no Right of Use asset and lease liability is to be accounted for in the books of the lessee.

• If the penalty of termination is not insignificant, then the lease term would be 5 years.

• If we add a three-year "lock-in" period into the facts of the case, i.e. the lessor and lessee can unilaterally terminate the contract only after the lock-in period of 3 three years, then the lease term would be three years plus the three months.

Paragraph reference in Ind AS 116: 18, 5, 6 & B34

Scenario IV:

Term of the contract is 5 years

Extension clause: The lessor has the right to provide the option of an extension of three years to the lessee.

Termination clause: The lessor and lessee have the right to terminate the agreement by giving 3 months’ notice. This right to terminate is other than a remedy for non-compliance by the lessee or lessor

Analysis and conclusion of the lease term:

• The contract terms allow a right only to the lessor to provide an option to negotiate for an extension of the contract. The lessee cannot extend the contract unilaterally.

• The extension clause in this scenario would not have any bearing on the lease term.

• For the analysis of the said termination clause, please refer to the analysis in Scenario III.

• Thus, when the penalty of termination is insignificant, the lease term would be 3 months (notice period to be given to terminate). If the penalty to terminate is not insignificant, then the lease term would be 5 years.

Paragraph reference in Ind AS 116: 18, B34 & B35

Scenario V:

Term of the contract is 5 years

Extension clause: Lessee has the option to enforce the extension of the term by three years.

Termination clause: After the lock-in period the lessor and lessee have the right to terminate the agreement by giving 3 months’ notice. This right to terminate is other than a remedy for non-compliance by the lessee or lessor

Analysis and conclusion of the lease term:

• The contract terms allow the lessee to enforce the extension. The lessee is to consider all relevant facts and circumstances that create an economic incentive for it to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option.

• For the analysis of the said termination clause, please refer to the analysis in Scenario III.

• Thus, when the penalty of termination is insignificant, the lease term would be 3 months (notice period to be given to terminate). If the penalty to terminate is not insignificant, then the lease term would be 5 years plus 3 years if the lessee is reasonably certain to exercise the extension option, if not it would be 5 years.

Paragraph reference in Ind AS 116: 18, B34, B37, B39 & B40

This article has been published in the Chartered Accountant Study Circle ("CASC") Bulletin.