Overview
Month-to-month, year-to-year, rolling, holdover and indefinite leases have no fixed end date. They continue until one party gives notice. IFRS 16 applies to them like any other lease, and they are not automatically short-term leases.
IFRS 16 determines the lease term in two steps:
- Determine the enforceable period - how long the contract creates enforceable rights and obligations (IFRS 16.B34).
- Determine the lease term within that period - the non-cancellable period plus optional periods the lessee is reasonably certain to use (IFRS 16.18).
Only if the resulting lease term is 12 months or less can the lessee apply the short-term recognition exemption. Otherwise, a lease liability and right-of-use asset are recognised.
This article forms part of our full IFRS 16 guide.
Step 1: The Enforceable Period
A lease is no longer enforceable when both the lessee and the lessor each have the right to terminate without the other's permission, with no more than an insignificant penalty (IFRS 16.B34). If either party would suffer more than an insignificant penalty, the contract remains enforceable beyond the notice date.
In November 2019, the IFRS Interpretations Committee confirmed that "penalty" is assessed on the broader economics of the contract, not only on contractual termination payments. Relevant penalties include:
- Abandoning or dismantling significant non-removable leasehold improvements,
- Relocation costs and disruption to operations,
- Loss of a strategic or hard-to-replace location,
- Below-market rentals that would be lost on exit.
Where termination rights are one-sided, IFRS 16.B35 applies:
| Who can terminate | Treatment |
|---|---|
| Both parties, no more than an insignificant penalty | Contract ends at the notice date; enforceable period is the notice period |
| Only the lessee | A lessee termination option, assessed for reasonable certainty |
| Only the lessor | Included in the non-cancellable period |
Step 2: The Lease Term
Within the enforceable period, the lessee includes periods it is reasonably certain to continue using the asset. "Reasonably certain" is a high threshold, assessed using the factors in IFRS 16.B37, including:
- Rentals for the continuing period compared with market rates,
- Significant leasehold improvements expected to provide economic benefit,
- Costs of terminating, relocating or finding a replacement asset,
- The importance of the asset to operations,
- Past practice with similar assets.
For a rolling lease, each renewal is in effect an option not to terminate. A lease term of one month is appropriate only where the lessee is not reasonably certain to stay beyond the notice period.
Leasehold improvements
The Committee also linked the lease term to IAS 16. If non-removable leasehold improvements are expected to be used beyond the lease term, the entity should consider whether that lease term is consistent with its own expectations.
Indefinite and Perpetual Leases
Some contracts have no end date at all, for example long-standing land arrangements or undocumented intercompany leases of group premises. The same two steps apply:
- If only the lessee can terminate, the enforceable period may be indefinite. The lease term is the period the lessee is reasonably certain to continue, estimated from the B37 factors, business plans and the useful life of improvements.
- If neither party can terminate, the lease term is the full contractual period. Where the contract in substance transfers control of the asset itself, rather than a right of use, it is a purchase and not a lease.
Year-to-year leases follow the same logic. A year-to-year lease with a lease term of exactly 12 months can qualify as short-term, but expected renewals often extend it beyond 12 months.
ASC 842
ASC 842 applies a similar enforceability concept: periods in which both parties can cancel with no more than an insignificant penalty fall outside the contract. See ASC 842 vs IFRS 16.
Practical Example
A distributor occupies a warehouse on a month-to-month agreement. Either party may terminate on one month's notice with no contractual penalty. Rent is 20,000 per month, payable in arrears.
At commencement, the distributor installs non-removable racking and cold-storage fittings costing 900,000 with a useful life of five years. Comparable premises are not available nearby.
Step 1: Enforceable period. The lessor can exit at no cost, but the lessee would abandon 900,000 of improvements and incur relocation costs. The lessee's penalty is more than insignificant, so the contract is enforceable beyond the one-month notice period.
Step 2: Lease term. The lessee is reasonably certain to remain for the five-year life of the improvements. The lease term is five years, so the short-term exemption is not available.
Measurement. Using an incremental borrowing rate of 11% per annum (0.9167% per month), the present value of 60 payments of 20,000 is 919,861.
| Journal | Dr | Cr |
|---|---|---|
| Commencement | ||
| Right-of-use asset | 919,861 | |
| Lease liability | 919,861 | |
| End of month 1 | ||
| Finance cost (919,861 × 0.9167%) | 8,432 | |
| Lease liability | 11,568 | |
| Bank | 20,000 | |
| Depreciation (919,861 ÷ 60) | 15,331 | |
| Accumulated depreciation | 15,331 |
The lease liability after month 1 is 908,293. See calculating the lease liability and right-of-use asset for the full mechanics.
Contrast. Had the distributor stored goods in a generic unit with no improvements and readily available alternatives, neither party would face a significant penalty. The lease term would be one month, and the 20,000 would be expensed monthly under the short-term exemption.
Reassessment
The lease term is reassessed on a significant event or change in circumstances within the lessee's control, such as installing major improvements (IFRS 16.20). The lease liability is then remeasured using a revised discount rate.
For a month-to-month lease initially accounted for as short-term, any change in the lease term makes it a new lease (IFRS 16.7). If the new lease term exceeds 12 months, the lessee recognises a lease liability and right-of-use asset from that date. A formal change to the contract is a lease modification.
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Conclusion
A lease without a fixed term is not a short-term lease by default. IFRS 16 requires the enforceable period to be determined first, considering the broader economics of exit for both parties, and the lease term to be set within it using the reasonably certain threshold. Where leasehold improvements, relocation costs or strategic locations make exit costly, a month-to-month agreement can carry a multi-year lease term and a material lease liability.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.