Lease term when contract is for indefinite period
Question:
“We leased an office. The lease contract says that there is a three months’ notice period (for both us and our landlord) and no other specific lease term. We plan to stay in this office indefinitely, certainly for more than one year. Can we apply a short-term lease exemption in this case? There is no penalty on either side.”
Answer:
Frankly speaking – this question is a bit tricky, but in general, finance people seem to lean toward NOT applying the short-term lease exemption and instead, going for full lease accounting under IFRS 16.
Their main arguments:
- IFRS 16 requires management’s expectations and intentions to be considered. If the lessee expects to stay for longer than one year, then it is a NO for short-term exemption. This is especially if there are economic incentives to stay longer (e.g. leasehold improvements, high relocation costs, or negative incentive in form of significant penalties). Here, no such incentives were mentioned, but the expectation was still to stay long-term.
- Some auditors argue that the lessors are unlikely to terminate, because they prefer stable tenants, and as a result, the lessor’s right to terminate with three months’ notice is often ignored. That’s a NO for short-term exemption.
Sounds crystal clear, right?
Hmmm… wait a second.
Real-life example
Let me tell you a short story.
One of my clients had exactly the same lease contract: an indefinite period with three-months notice period for both parties, no penalties, and lessee’s intention to stay for more than one year.
So, they did not apply the short-term lease exemption, Based on management’s best estimate, they assumed that they would stay in the current office for two years and then relocate due to their growth.
And, their then-auditor suggested that the lessor would not likely exercise its termination right.
But business is business…
After four months, the lessor terminated the lease contract with three months’ notice. The reason was simple – a much larger company wanted to lease whole two floors, and our lessee occupied about one third of one floor.
So, the lessee needed to go after seven months (four months passed PLUS three months’ notice), to vacate the place for more lucrative customer.
OK, you might say it was not ethical or whatever, but that’s not the point of this post.
The point is that the poor lessee needed to move out and deal with the lease accounting in its financial statements.
Again – this is NOT all black or white. After all, the lessee could have been that lucrative customer for which the lessor would break his bones to get, and then the story would have turned out differently.
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