Lease Term Reassessment Under Ind AS 116 and Its Impact

1. Facts

Navratan Retail Limited, hereinafter referred to as “the lessee”, enters into a lease agreement for a retail shop located in a prime commercial mall. The lease agreement provides for a non-cancellable lease term of five years, together with an option available to the lessee to renew the lease for an additional five years at the same rental terms.

The annual lease rental is Rs. 10,00,000, payable at the end of each year. At the commencement date, the lessee incurs direct cost Rs. 30,00,000, primarily towards interior fit-outs and store customisation. Management expects these improvements to generate economic benefits over a period of ten years. Considering the strategic importance of the location, customer visibility, and the recovery period of the leasehold improvements, the lessee concludes at commencement that it is reasonably certain to exercise the renewal option.

Accordingly, the lease term is determined as ten years, and using an incremental borrowing rate of 8%, the lessee recognises a lease liability and corresponding right-of-use asset based on lease payments over the ten-year period. The present value factor for ten annual payments at 8% is approximately 6.71, resulting in an initial lease liability of approximately Rs. 2,68,40,000 (Rs. 40,00,000 × 6.71).

During the third year of operations, adverse economic conditions significantly affected retail demand, and sales generated from the store declined by nearly 40% compared with initial projections. Although operations continue, management becomes uncertain about the long-term viability of the outlet.

The management of the Navratan Retail Limited is in a dilemma as to whether the lease term should be reassessed immediately due to deteriorating performance, or only when a definitive decision regarding renewal is taken.

2. Relevant Provision

Ind AS 116 – Leases

Para 20 of Ind AS 116

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

Para 24 of Ind AS 116

The cost of the right-of-use asset shall comprise:

……..

(c) any initial direct cost incurred by the lessee

Para B41 of Ind AS 116

Paragraph 20 specifies that, after the commencement date, a lesseereassesses the lease term upon the occurrence of a significant event or a significant change in circumstances that is within the control of the lessee and 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. Examples of significant events or changes in circumstances include:

(a) significant leasehold improvements not anticipated at the commencement date that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable;

(b) a significant modification to, or customisation of, the underlying asset that was not anticipated at the commencement date;

(c) the inception of a sublease of the underlying asset for a period beyond the end of the previously determined lease term; and

(d) a business decision of the lessee that is directly relevant to exercising, or not exercising, an option