What is the lease term of an evergreen lease?
Some leases are structured so that there is an initial period of one month, for example, after which the lease automatically renews for the same duration unless terminated by one of the parties.
In this case, the non-cancellable period is one month. However, the enforceable period and hence the lease term may be longer. The lessee may have compelling economic reasons for continuing to use the asset for a period of time and will allow the lease to renew over that period. Note that lessor termination options are not considered in this assessment.
Evergreen leases may, therefore, not qualify for the short-term lease exemption because the lease term may exceed 12 months even when the non-cancellable period does not.
The same assessment would apply if the lessee may request a renewal of the agreement from the lessor. The lessor’s ability to refuse such a request is equivalent to a lessor termination option, which is not taken into account in determining the lease term.
What is the lease term of an undocumented intra-group lease?
It is not uncommon for leases between group companies to be undocumented. A contract may exist through customary practices. If, for example, a subsidiary has used an office owned by its parent and has paid a monthly amount to the parent for this usage, this may be enough to evidence the existence of a lease.
In such a scenario, either party may be able to terminate the arrangement at any time, meaning the non-cancellable period is zero years. However, the lessee should also consider whether it has an implied right to extend the lease and whether it is reasonably certain to use this right for a certain period of time, based on the factors set out in FRS 102 20.41, i.e.
(a) the contractual terms and conditions compared with market rates (b) significant leasehold improvements expected to have significant economic benefit when the option becomes exercisable (c) the costs relating to the termination of the lease (d) the importance of the underlying asset to the lessee’s operations (e) conditionality associated with exercising the option
Lessor termination options are not relevant in determining the lease term.
What is the effect of law on lease terms?
Local law may mean that the lessee has a statutory right to remain in leased premises after the lease’s contractual termination date. In this case, the lease is still enforceable beyond its contractual end date because of the operation of law, which is taken into account in the notion of enforceability.
This situation can arise under the UK Landlord and Tenant Acts.
Is the short-term lease exemption ever reassessed?
The definition of a short-term lease is based on the lease term at commencement date. This means that if a lease is initially assessed as not short-term, it cannot meet this definition later. This can change if there is a lease modification that qualifies for recognition as a new lease.
For example, if a lease is for nine months with a 6-month extension option that the lessee assesses is reasonably certain to be taken, then the lease term is assessed to be 15 months. This means it is not short-term. If the lessee later decides that the extension option will not be taken, it cannot then start applying the exemption.
However, paragraph 20.8 of amended FRS 102 states that if an entity is already applying the short-term lease exemption, any lease modification or change in the lease term is treated as a new lease. This means that in the example above, if the extension option was initially not included in the lease term but the lessee later decided it was reasonably certain to be exercised, the exemption would stop being applied from that point because the deemed new lease had a 15-month term from commencement.
