IFRS 16, which entered into force from 1. januar 2019, introduced a comprehensive accounting standard for leases that replaced the previous standard IAS 17. One of the central aspects of IFRS 16 is the determination of the length of the lease period, which has significant implications for the companies’ accounting and financial reporting.
IFRS 16 leases – length of the lease period
Assessment of the rental period:
IFRS 16 requires that the lease period in a lease agreement be carefully assessed. This includes not only the initial lease period, but also any extension options and termination options that may affect the total duration of the lease. Extension options and termination options must be assessed individually and included in the calculation if they are likely to be exercised by the tenant.
Extension options and termination options
An extension option in a lease agreement gives the lessee the right to extend the lease agreement beyond the initial agreement period. This means that when the initial lease period expires, the tenant has the option of choosing to extend the lease for a further period, usually of a specified length and at a predetermined price. Extension options give the lessee the flexibility to continue using the leased asset after the original agreement has expired, without having to enter into an entirely new agreement.
On the other hand, termination options give the lessee the right to end the lease before the original lease term is complete. This means that the tenant has the option to terminate the lease before the agreed expiry date without being obliged to continue the lease for the remaining period of the agreement. Termination options give the tenant the flexibility to end the lease early if there are changes in the needs of the business or other circumstances that make it appropriate to terminate the lease early.
Extension options of an IFRS 16 lease have in most cases been assessed individually in cases where they may be significant. We have the impression that the companies have been quite restrictive in including extension options more than about five years into the future, but that individual assessments have meant that some extension options that may lie further into the future have been taken into account.
We believe it would be an advantage to have systems for following up on options. A system must be able to enter alerts and register options. Users can then get a better overview and it also provides better data for analyzes and budgets.
– Terje Glesaaen and Serge Fjærvoll in “IFRS 16 – experiences and the way forward”. Revisjon og Regnskap, utgave nr.8, 2019.
Both extension and termination options are important elements in lease agreements that give the tenant the opportunity to adapt to changing conditions and needs over time. These options must be carefully assessed when entering into lease agreements and included in the calculations when assessing the length of the lease period in accordance with accounting standards such as IFRS 16.
Lease period according to IFRS 16
When assessing the rental period, there are several factors that should be taken into account. These include the characteristics of the leased asset, its location, the need for associated facilities or services, as well as any unique conditions that may affect the duration of the lease. The companies must also take into account relevant legislation and contractual obligations that may affect the duration of the lease.
Accounting implications
The length of the lease period has a direct impact on the accounting of the lease agreement in accordance with IFRS 16. For example, if the lease has a term of 12 months or less with no options to extend, the lease may be classified as a short-term lease and lease payments may be recorded as operating expenses in the income statement.
On the other hand, if the lease has a duration exceeding 12 months or contains extension options that are likely to be exercised, the lease must be recognized on the lessee’s balance sheet as a right and a liability equal to the present value of the future lease payments. This can have significant impacts on the company’s financial key figures, such as the debt ratio and equity ratio.
Implementation of effective systems and processes
In order to ensure the correct accounting and handling of lease agreements in accordance with IFRS 16, it is important for companies to implement effective systems and processes for the follow-up and administration of lease agreements. This may include establishing systems to monitor and record extension and termination options, as well as establishing internal policies and controls to ensure that all relevant leases are identified and correctly accounted for.
Read also: Implementation of IFRS 16 before listing
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