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Lease Term IFRS 16 : Cancellable Property Rental Contracts

A business in Dubai opens a second office in a building and signs a rental contract with the landlord. The duration of the contract is 5 years, and either party can end the contract at any given time by giving a 60-day notice.

Both parties can adjust the contract duration if they all agree or be nullified if the business does not intend to conduct operations at the second office soon.

So, where do we see lease term in this context? And how can auditing firms in Dubai account for this lease?

Most rental agreements have clauses on ending leases by parties: the lessor and the lessee. These provisions may affect how Dubai audit specialists account for leases.

The IFRS 16, issued in 2016, required internal audit in Dubai & UAE to implement it as of January 1st, 2019. The standard revolutionized how audit services accounting for lease contracts by lessees.

Read More : How Audit Firms in Dubai De-risk Lease Accounting Modifications in IFRS 16.

According to IAS 17,  individuals can easily record rental costs as costs in profit and loss so long as lease works well.  With IFRS 16, the lessee cannot record the lease but categorizes it in the same approach.

Based on IAS 17, it is easy to book rental costs as an expense in profit/loss as long as the lease operates.  In IFRS 16, the lessee no longer categorizes the lease but recognizes all the leases in a similar approach.

Audit firm specialists classify the right to use asset and lease liability in the statement of financial position. Moreover, rental payments are divided into reducing the finance cost and lease liability—also, the amortization of the right to use assets.

There are several occasions where internal audit professionals don't need to account for the right of use asset. Typically, the duration of the lease is 12 months or less (short-term) with no purchase option, or a low-value asset is being leased when new, for example, furniture or computer

Do we consider the short-term lease or not?

According to lease term IFRS 16, the lease term is the non-cancellable period of the lease, meaning the agreement is enforceable during that period. Suppose one part opts to end the lease of the other or unilaterally, and there are no penalties.

In that case, the agreement is not enforceable anymore. Note that the contract duration is 5 years, but any part could end the contract as long as there is a 60-day notice.

Read More : Accounting Entries How to Book Profit Sharing Under IFRS 16.

What this means:

The lease is not non-cancellable because it has been terminated within 60 days. There are no penalties stipulated in the contract. Here, we can assume the Dubai company is not planning to relocate soon.

In addition, the lessor is allow to cancel the lease with no consequences. A different circumstance would come through if the right to cancel the lease on short notice was entitled only to one party.

There are many factors that the lessee will consider to figure out how long they wish to stay on the property. Moreover, they may choose to end the contract by giving a two months’ notice. Regardless, the lessor should adhere to a 10 year lease term. But they still can terminate the lease.

The lessee is not entitled to terminate the lease. Therefore, the non-cancellable period begins at the date the option was granted to terminate the lease (only 2 months). The lessee will have to cater for the ROU for the term of the lease.

This is why the right of the lessor to terminate the lease is often overlooked in determining the lease term. In other words, 10 years would be lost if the lessor did not exercise his right to terminate.

How Audit Services in Dubai & UAE Should Account For Such Leases

You have 2 options once you understand that the lease is non-cancellable for only 2 months in this case:

Suppose you are leasing for a short-term period. In that case, you can either apply for the exemption or book rental payments as expenses in your profit or loss. It is important to remember that you should apply for the exemption equally to all classes, not one by one. For example, suppose you are a bank and regularly rent your branches offices with similar terms. In that case, the exemption should apply to all branches, not selected ones.

If the lease is not exempt, one may account for it as other leases such as an asset right of use, lease liability. However, in this scenario, using this method would be highly impractical for various reasons.

You can learn more about the new lease standard IFRS 16 by reading different blogs about IFRS on our website. We have a lot of content that explain the new IFRS 16 step-by-step.

If you are a company located in Dubai & UAE looking for reliable audit firm in UAE to help you with rental contracts and complying with IFRS guidelines, please get in touch with us. Contact us now for free consultation or visit our website.

Ervee is a CPA with international experience in Tax and Accounting. He has over 12 years of experience in accounting and bookkeeping and over a year in VAT implementation, registration, and accounting in UAE. He regularly drives out inefficiencies in company operations and loves the challenge of helping clients find additional ways for an easier and improved compliance and verification of transactions.