The new IFRS accounting standard for leases, ‘IFRS 16’, that was announced in early 2016, includes several exemptions which a lessee has the option to apply when implementing the new guidelines. Having already discussed the low-value asset exemption in detail here, we’d now like to examine the short-term lease exemption.
The lease accounting exemption for short-term leases is included in IFRS 16 to ease the financial burden of the new standard. It’s an accounting policy choice which a lessee may elect to apply, but they can only have that option if the lease meets certain criteria.
In short, a lease agreement can be exempted from inclusion on balance sheet, should a lessee choose to do so, if it:
- Does not extend beyond 12 months in duration
- Does not contain any purchase options
- All leases of the same underlying assets receive the same treatment (in regards to exemption).
Also, all items of a similar class must be treated equally. For example, if a lessee applies the exemption to the lease of a franking machine, using the above criteria, it must apply the exemption to all other franking machinery the business has on lease.
But this being the case and the agreement being shorter than 12 months in duration is not always enough.
Beyond all this, the lessee will have to compare the lease contract against the new standard, paying particular attention to any lease extension options or break clauses.
If there are either of these, the lessee will have to apply the reasonably certain assessment criteria to judge whether the respective option to extend or terminate the lease will be taken up. And this is similar to what exists under current IAS 17 standards.
This means, a lessee could not treat a lease as exempt simply because it had a break clause option inside 12 months, if that option would not pass the reasonably certain assessment criteria to be activated. For example, a major civil engineering contractor involved in a five-year motorway contract could not keep their heavy plant exempt just because it had a break clause after 11 months. It is clear they will need the plant for longer than this, so it cannot be exempt.
Why There Are Exemptions
The board decided to include two exemptions within the new standard in order to appease concerns, expressed in the feedback, that implementing the new standard would be a big financial burden.
Due to a combination of the redefining of what constitutes a lease and the ever growing size of lease portfolios, the work involved with becoming compliant with the new standard is huge.
In The End Less Than 12 Months Is Short-Term
The final IFRS 16 treatment of short-term lease exemption was widened to include those of which is not “reasonably certain” that the term will be more than 12 months, when the likelihood of taking up options of extensions and the severity of termination clauses are considered.
As a result, a lessee is not required to recognise an asset or liability with a lease term of 12 months or less, as long as the extension options and termination rules in the agreement make it likely the agreement will not extend beyond a year.
This may be a subtle consideration but it allows some accounting flexibility for the lessee, whilst also helping to achieve the wider aim of IASB; getting a fairer representation of lease portfolios in front of those who assess a company’s financial state.
This is despite concerns raised during the drafting process that, by putting a definite line in the sand of “short-term” being defined as 12 months or less, the opportunity for understatement of a lessee’s assets and liabilities could still arise due to, what participants in offering feedback called, “structuring opportunities”.
Tactically Using Repeat Short-Term Agreements Is Not Allowed
In the end, the IASB staff deemed that a clear 12 month “bright line” in the sand found the right balance between offering some flexibility for those who benefit from being able to keep short-term agreements being reported on balance sheet and still keeping the period short enough to be truly “short-term”. The reasoning was that there is a huge economic difference between entering into a one year lease versus a five-year lease, compared to entering a three-year lease versus a five-year lease.
In short, one year is short-term and that’s that.
If companies choose to use “structuring” in their lease portfolio management, the savings and potential benefits will be negligible in comparison to the effort put into achieving them.
At the same time, any unscrupulously engineered, repeatable short term agreements - Fictional Airlines leasing Boeing planes for 11 months and 30 days, time after time, for example - should be painfully clear and be reprimanded appropriately.
Small Value Ticket Price Explained
Measured by looking at individual leased items, if a lease meets the “low value” criteria it can be exempt from the general considerations of IFRS 16. If you want to read in more depth about small value ticket item exemptions check out this blog post: IFRS 16 exemptions in relation to being small value lease assets are explained in more depth here: What is the IFRS 16 Exemption for Low-Value Assets? (With IFRS 16 Example).
However, as both the small value and short term asset exemptions are optional, a lessee may choose to ignore them and recognise all their assets and liabilities in line with the general requirements in IFRS 16.
Make Sure You Are Compliant And Take The Work Out Of Doing So
We have created a completely free and no obligation 7 step guide to becoming compliant with IFRS 16. Inside it, we run through the global changes in a little more detail, show you the 7 step walkthrough to becoming fully compliant and give you some options on how to do it. Press the button below to open your copy.
Download it below.