Ask the Expert: Leases with cancellation clauses

David Holland, Moore Stephens National Head of Technical Accounting, offers his advice on technical and compliance issues that impact businesses.
 
Issue
An entity operates a soup kitchen from premises attached to a local church.   They have a MOU with the church regarding the lease of the premises which states either party can cancel the agreement without cause or compensation with 1 year’s notice.
 
How will AASB 16 and 1058 apply to this situation?
 
Conclusion
Since this lease can be cancelled without penalty with one years notice by the lessor then the lease term would be one year.
 
Given the lease term is one year then the exemption under AASB 16 can be applied (short term lease) which results in the lease payments typically being expensed on a straight-line basis (and no recognition of a right-of-use asset).
 
If the client adopts this approach then it won’t result in a recognition of an asset so AASB 1058 (FV of leases) won’t apply either.
 
Additionally, any leasehold improvements (which don’t revert back to the lessee in the event of a cancellation) should be expensed as they can’t be controlled beyond one year.
 
Background - AASB 16
The lease term is 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.
 
In determining the lease term and assessing the length of the non-cancellable period of a lease, an entity shall apply the definition of a contract and determine the period for which the contract is enforceable. A lease is no longer enforceable when the lessee and the lessor each has the right to terminate the lease without permission from the other party with no more than an insignificant penalty.
 
Short-term lease is 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.
 
5 A lessee may elect not to apply the requirements in paragraphs 22–49 to:

(a) short-term leases; and

(b) leases for which the underlying asset is of low value (as described in paragraphs B3–B8).
 
6 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 recognise 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 is more representative of the pattern of the lessee’s benefit.
 
AASB 1058

9 On initial recognition of an asset, an entity shall recognise any related contributions by owners, increases in liabilities, decreases in assets, and revenue (‘related amounts’) in accordance with other Australian Accounting Standards.