QUESTION: Entity X (lessee) enters into a lease with Entity Y (lessor) for two assets namely, Asset A and Asset B, with 10 months non-cancellable term with an option to extend the lease for 5 months. The lease does not have a purchase option. At the lease commencement date, for Asset A, Entity X is reasonably certain to exercise the extension option and for Asset B, Entity X is not reasonably certain to exercise the extension option. Entity X classifies both the leases as short-term lease and availed the recognition exemptions provided in Ind AS 116.
During the audit, it was discovered that the recognition of leases is not as per the Ind AS 116, what would be the correct recognition?
LEASE TERM (PARAGRAPHS B34-B41) OF IND AS 116
PARA 18 - An entity shall determine the lease term as the non-cancellable period of a lease, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
PARA 19 - In assessing whether a lessee is reasonably certain to exercise an option to extend a lease, or not to exercise an option to terminate a lease, an entity shall consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option to extend the lease, or not to exercise the option to terminate the lease, as described in paragraphs B37- B40.
PARA 20 - A lessee shall reassess whether it is reasonably certain to exercise an extension option, or not to exercise a termination option, upon the occurrence of either a significant event or a significant change in circumstances that:
(a) is within the control of the lessee; and
(b) affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or not to exercise an option previously included in its determination of the lease term (as described in paragraph B41).
PARA 21 - An entity shall revise the lease term if there is a change in the noncancellable period of a lease. For example, the non-cancellable period of a lease will change if:
(a) the lessee exercises an option not previously included in the entity's determination of the lease term;
(b) the lessee does not exercise an option previously included in the entity's determination of the lease term;
(c) an event occurs that contractually obliges the lessee to exercise an option not previously included in the entity's determination of the lease term; or
(d) an event occurs that contractually prohibits the lessee from exercising an option previously included in the entity's determination of the lease term.
SOLUTION: Firstly, the auditor verified whether the entity X (lessee) on commencement date is reasonably certain to exercise an option to extend a lease or not considering all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option to extend the lease as described in paragraphs B37- B40. After assessment, the auditor concluded that the lessee is reasonably certain to exercise the extension option in case of Asset A and not to exercise in case of Asset B.
In Appendix A of Ind AS 116, the following are defined:
Short-term lease: A lease that, at the commencement date, has a lease term of 12 months or less. A lease that contains a purchase option is not a short-term lease.
Lease term: The non-cancellable period for which a lessee has the right to use an underlying asset, together with both:
(a) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
(b) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
So, to determine whether the lease is short-term lease or not, firstly lease term needs to be calculated. In the stated case, considering the above definition, the following is the lease terms:
Lease term of Asset A: 10 months + 5 months = 15 months
Lease term of Asset B: 10 months (since not reasonably certain to exercise the extension option)
Now, as per the definition, a lease is to be classified as short-term lease if the lease term is of 12 months or less. Therefore, Asset A cannot be classified under short-term lease and Asset B is classified under short-term lease.
Entity X was incorrect in classifying Asset A under short-term lease.
As per Para 22 of Ind AS 116, "at the commencement date, a lessee shall recognize a right-of-use asset and a lease liability".
However, as per Para 5 of Ind AS 116, "a lessee may elect not to apply the requirements in Para 22 to 49 (Recognition, Measurement and Presentation by Lessee)to:
(a) short-term leases;
(b) leases for which the underlying asset is of low value".
In the stated case, following Para 5, assuming both assets are not low value assets as no information given in this regard. Entity X may avail recognition exemption for Asset B only and cannot avail exemption for Asset A since it does not meet the criteria of classifying lease as short term lease. Therefore, Entity X was incorrect in availing exemption with respect to Asset A.
As per Para 6 of Ind AS 116, "If a lessee elects not to apply the requirements in paragraphs 22-49 to either short-term leases or leases for which the underlying asset is of low value, the lessee shall recognize the lease payments associated with those leases as an expense on either a straight-line basis over the lease term or another systematic basis. The lessee shall apply another systematic basis if that basis if that basis is more representative of the pattern of the lessee's benefit."
In the given case, Entity X can avails recognition exemption for Asset B, therefore lease payments for the same shall be recognized as an expense either on SLM basis or another systematic basis.
For Asset A, Entity X should recognize the right-of-use asset and a lease liability as per Para 22.
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