Question

Point to Point Ltd provides a service, transporting passengers from Hosea Kutako International Airport to hotels in Windhoek City and the surrounding areas.

It enters a contract with Bust Ltd for the lease of five, 25-seater buses for a period of 3 years. The lease payments are constant over the lease term. The market for airport transfer is constantly changing and Point to Point Ltd may need to use similar 25-seater buses or large 40-seater buses, depending on whether other models of transport become available or not. As such the contract allows Point to Point Ltd to cancel the lease at the end of the 1st year or at the end of the 2nd year without any penalty.

Required:

Discuss with reference to IFRS 16 Leases: how Point to Point Ltd should account 10 for this lease contract .

Answer 1

The question deals with the termination of the lease contract .

It should be noted that there are various options of extension or termination of the lease contract . Some cases of the leases, where the lessee has a termination option and the analysis is entirely about the duration of the lessee will chose. As per Paragraph B34 ,IFRS 16 both the lessee and the lessor have termination options . The Paragraph states that a lease is not enforceable when the lessee and the lessor each have the right to terminate the lease without seeking the permission from the other person with incurring an ‘insignificant penalty’. However ,if there is an insignificant penalty the analysis needs to include both what is explicitly in the contract alongwith the other kinds of economic penalties which aren't included in the contract. So, the definition of ‘penalty’ is to be considered more broadly instead of the plain "a contractual penalty", but should also include other economic factors, such as those discussed below.

In the first instance, the lessee only has a termination option, for estimating the lease term the lessee shall assess the likelihood of the exercising or failing such an optifon. Few things which should be considered in this assessment are enumerated below :

1) Terms and conditions of the contract for the periods compared with market rates, such as:

i. The terms and conditions of the options which may be exercisable after periods covered by another option

ii. Variable payments for the lease or other contingent payments;

iii. Payments for the lease in any optional period;

(2) Significance of an underlying asset to the lessee’s operations.

(3) Major improvements alongwith the other improvements incurred on the underlying assets which are expected to have a significant residual benefit to the lessee when options become exercisable;

(4) Termination Costs of the lease

(5) Association with the exercising option and the likelihood that those conditions will be met.

Leases of similar assets, may also be given consideration in determining the likelihood of options being exercised. The reason for exercising such options may not be apparent from any single criterion, but may relate to synergies and a weighting of several reasons that must be considered in aggregate.

Therefore ,if there are two lessees which might determine different lease terms on identical lease contracts because the facts and circumstances under which they operate would mean that one lessee concluding that its reasonably certain to exercise one or more options, while the next option might be resulting that it's not reasonably certain any of them will be exercised.