IFRS 16, the new leases standard, Part III

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Athens, January 2019

Chris Ragkavas, BA, MA, FCCA, CGMA
IFRS technical expert, financial consultant.

What’s the risk of misestimating the lease period?

In order to calculate the lease liability, the lessee needs to consider the most likely number of years representing the lease period. In commercial lease agreements, it is very common to come across fascinating clauses as the one below:

“The non-cancelable lease period is agreed to be 7 years, with an option to extend for another 5 years, to be followed by two more options to extend, each for 3 years”.

So how are we to decide whether we should consider the lease period to be 7, 12, 15, or 18 years?

Let’s use the example of Part I, where Burberry entered into a lease agreement as follows:

  • Commencement date of the lease: 1/1/2020.
  • Annual lease payments in arrears:  GBP 100,000.
  • Lease term: 10 years.
  • No end-of-lease-term purchase options.
  • Burberry can extend for another 5 years, to be followed by a last option to extend, for another 5 years.

For starters, we are not expected to be prophets.. No-one can know for sure at the commencement of the lease, what the total period will be. However, the standard does provide a range of criteria to be considered, in order to make an appropriate estimate which is surely more trustworthy than an unfounded guess.

For example:

  1. Will Burberry enjoy special terms and conditions if they decide to extend the lease, as compared to current market terms?
  2. Have Burberry undertaken material leasehold improvements in the property, so that it is safe to assume on 1/1/2020 that it is rather unlikely they would opt to move out only 10 years later?
  3. How expensive do we estimate to be for Burberry to relocate to a comparable property at the end of the 10th year, and not much later, say at the end of the 15th or 20th year?
  4. How important is this property for Burberry’s operations, for achieving commercial goals and objectives?

Depending on our understanding of these issues, we will apply professional judgement and decide on 1/1/2020 on the number of years to take into consideration when calculating the lease liability and the corresponding equal amount of the right-of-use asset.

Queries, comments, are welcome at [email protected]

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