We have already had a number of questions raised on our Technical Helpline about determining the lease term under the revised FRS102 Sept 2024 for leases that are on a “rolling basis” (sometimes referred to as “evergreen” or “perpetual” leases).   For some leases, the contractual terms will be such that it is clear that it is truly a month-to-month contract, however, there are a number of other situations, such as leases between related parties, where the situation may not be as clear.

 

It is important to know (especially regarding the related party point) that in order for there to be a lease, there does not have to be a written contract; the definition of a contract is simply “an agreement between two or more parties that creates enforceable rights and obligations.”

 

If it is determined that there is a lease, the lease term needs to be determined. For an evergreen / perpetual lease, this is determined in the same way as for any other lease, which means referring to paragraphs 38 and 39 of FRS102 Section 20, as an aggregate of :

 

• The non-cancellable period of a lease, plus
• Period covered by an option to extend (when “reasonably certain” to be exercised), less
• Period covered by an option to terminate (when “reasonably certain” to be exercised)

 

As per IFRS 16 para B35, the non-cancellable period of a lease is the period for which the lessee cannot cancel the lease (i.e. because the lessee is obliged to pay the rentals for this amount of time). Any right of the lessor to terminate the lease does not have an impact on the lessee’s determination of the non-cancellable period.

 

But regarding “short term leases” paragraph 20.5 provides the reporting entity with a choice to not apply the right of use model to these (just expense them as we would do now). FRS 102 defines a short-term lease as “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.” This applies to transition also re leases with less than 12 months left to run.

 

But, to reach the conclusion that the lease term is 12 months or less, the lessee needs to consider paragraphs 20.38 and 39.

 

An agreement between a small company and a serviced office provider such as Regus may be a rolling monthly contract. Assuming that the lessee is uncertain about how long they intend to stay in that property (e.g. due to a number of alternative options) and there is no more than an insignificant penalty for either party in exiting the contract at the end of a month then there are no enforceable obligations beyond the end of the month, and this would be considered a short-term lease.

 

However, in the scenario where the company rents a property from a director or fellow group company, without a formalised lease agreement, the substance of the arrangement will need to be considered.

 

Often, arrangements between related parties are on favourable terms (i.e. below market rates), and there is an expectation that they will continue for a long period. Consider the following example:

 

Subsidiary Co rents a property from its parent company on an initial 12-month contract, which then renews for a further 12 months unless cancelled by either party. Consideration is payable, but this is below market rates. Subsidiary Co has occupied the premise for 5 years already.

 

The property is a factory, and the Subsidiary Co has recently spent hundreds of thousands of pounds installing large plant and equipment which has an expected life of 15 years.

 

There is an economic incentive for Subsidiary Co to remain in the property given the below market rent and the significant costs that would be involved in removing the plant.

 

Subsidiary Co determines that a lease exists anticipate remaining in the property for the foreseeable future, not least because of the below market rent. In determining the length of the lease term, the subsidiary uses the estimated useful life of the equipment recently installed.

 

If there is no written lease agreement, there would need to be an assessment of whether there is a contract, and if so, whether it contains a lease. On the basis of a five year occupation, continual payment of rentals, and the penalties that would be incurred on cancellation, there would likely still be lease here.

 

So, in reality, the “substance” of what is going on must be thought about re each lease and whilst the example above deals with an obvious related party situation the same principals could apply to any outside party in terms of rolling leases where the incentive is there to stay (be it penalties not to stay or benefit from continuing to use) and the intention is to roll.