A new approach to lease accounting - determining what is part of the lease contract

IFRS news

Contracts may contain both lease components and non-lease components.  AASB 16 gives two options in these circumstances:

  • Account for the lease component(s) separately from non-lease components; or
  • A practical expedient allows the entire contract to be accounted for as a lease.

Where a non-lease component is identified, it is outside the scope of AASB 16, and is accounted for under the relevant accounting standard.

Example 4 – Commercial Machinery

A warehousing company rents a fork-lift truck for use in its operations for five years, at a cost of $10,000 per year.  The contract includes both the vehicle rental, and the maintenance of that vehicle.  The vendor of the truck provides similar maintenance contracts to customers that purchase trucks outright for $1,500 per year.

In this situation, the company would use the observable standalone price of the maintenance component to determine the allocation of the contract.  $8,500 per year would be allocated to the lease, and therefore recognised as a lease liability at inception (see below).  The remainder would be determined to be a service contract, and therefore recognised as an operating expense in each period.

Determining the Lease Term

The lease term is the duration of any non-cancellable period in the lease contract, but must be extended to include:

  • Any period for which the lessee has an option to extend the lease, if the lessee is reasonably certain to exercise that option
  • Any period for which the lessee has an option to terminate the lease, if the lessee is reasonably certain not to exercise that option

Determining whether a lessee is likely to exercise an option will require the application of judgment, and may include consideration of:

  • Whether the rent payable during an option period would be significantly different to market rates
  • The existence of any termination penalties or option fees, or conditions attached to the option.
  • Whether significant leasehold improvements have been made
  • The costs of termination to the lessee, and the availability of suitable alternatives

The likelihood of an option being exercised does not have to be reassessed at each financial reporting date, but must be reconsidered where there is a significant event, such as significant leasehold improvements being made, or a sublease being entered into.

Example 5 – An option to renew

A retailer enters into a 10 year lease for retail premises with an option to renew for a further 5 years.  At the inception of the lease, the retailer determines that they are not reasonably certain to exercise the option, and therefore the lease term is 10 years.

After four years, the retailer enters into a sub-lease for part of the premises for a period of 11 years.  This is considered a significant event, as it is now reasonably certain that the option will be exercised, since the retailer cannot otherwise honour their sublease contract.

The lease liability and associated right of use would be remeasured on this date, based on the option being exercised, meaning that the remaining lease term is now 11 years.

Learn more:

 Summary of the new standard AASB 1 6 >> 

 Determination of whether contracts contain a leasE >>

 Accounting for the lease >>

 download the full article as a PDF >>