Evergreen leases, often referred to as month-to-month leases, are an essential element for many businesses. These leases automatically renew unless terminated by one of the parties involved, offering a level of convenience that avoids the need for renegotiation. However, this seemingly straightforward structure introduces challenges, particularly in the realm of accounting. So, how can businesses handle these leases effectively while complying with both IFRS 16 and ASC 842?

Evergreen leases bring about a few complexities. Accurate identification of these leases, determining termination rights, managing notice periods, and remeasuring lease values are just some of the hurdles businesses face. Mistakes in handling these aspects can result in non-compliance, operational issues, and unnecessary administrative workload.

In this article, we explore the accounting standards and requirements for evergreen leases under IFRS 16 and ASC 842. We’ll provide you with practical examples and best practices, ensuring that you’re equipped to manage these leases efficiently and in compliance with the regulations.

What Are Evergreen Leases?

An evergreen lease, also known as a month-to-month lease, is a type of lease agreement that automatically renews after its initial term unless either party provides notice of termination. Unlike fixed-term leases, which have a set expiration date, evergreen leases continue indefinitely. These leases provide flexibility and can be set for various periods such as monthly, quarterly, or annually, depending on the agreement between the lessor and lessee.

Key Features of Evergreen Leases

The primary trait of an evergreen lease is its automatic renewal. After the lease’s initial term ends, the lease automatically renews for another period unless a termination notice is issued by either party. This feature ensures continuity without needing to renegotiate or re-sign the lease. Additionally, evergreen leases offer flexibility for both parties. Lessees can continue using the asset without disruption, while lessors benefit from a steady income stream without the need for new contracts.

Termination notices can vary, typically between 30 to 90 days, giving both parties time to adjust to business needs. In certain cases, lease renewals may depend on the usage of the leased asset, such as the number of operating hours or production cycles completed.

Challenges of Managing Evergreen Leases

While evergreen leases offer flexibility, managing them effectively can be challenging. One of the key difficulties is identifying which leases are evergreen, especially in large portfolios. For instance, a retail business must keep track of leases with automatic renewal clauses to prevent unintended renewals. If not properly managed, businesses might face unexpected financial obligations or operational disruptions.

Accurate financial reporting and compliance also become an issue if evergreen leases are not tracked properly. Lease terms, renewal options, and termination notices need to be consistently monitored. If any of these factors are overlooked, it could lead to incorrect financial statements, inefficient cost management, and legal implications.

Accounting for Evergreen Leases under IFRS 16 and ASC 842

Both IFRS 16 and ASC 842 lack explicit guidelines specifically for reporting evergreen leases. As a result, businesses must decide whether the financial impact of these leases justifies detailed reporting. For some companies, especially those with a small proportion of evergreen leases in their portfolio, a simplified compliance approach might suffice.

However, many organizations rely on general guidance, like that offered by the AICPA & CIMA, to determine how to handle evergreen leases. These resources provide valuable insights into reporting practices but also emphasize that each organization must tailor its approach based on specific circumstances. For example, the decision to report an evergreen lease depends largely on whether the lessee, lessor, or both have termination rights, influencing the appropriate accounting treatment.

Practical Scenarios and Accounting Treatment

Let’s break down a few scenarios to understand the accounting implications better.

1. Lessee Has the Right to Terminate
   When the lessee has the right to terminate, the lease liability should be measured based on the present value of the future minimum lease payments (PVMLP) for the period that the lessee is reasonably expected to stay in the lease. The discount rate used for this calculation should be the implicit rate in the lease or, if unavailable, the discount rate at the start of the lease. This calculation can be complex, requiring precise knowledge of the lease term and discount rate.

2. Lessee and Lessor Have the Right to Terminate
   In this case, the lease liability should be remeasured at the end of the non-cancellable period, and the lease will automatically renew unless one party decides to terminate it. The liability will be adjusted to reflect the present value of future payments, and the right-of-use (ROU) asset will be updated accordingly. The depreciation term will also be reassessed based on the revised lease term.

Conclusion

Managing evergreen leases under IFRS 16 and ASC 842 presents unique challenges, from identifying lease terms to accurately measuring liabilities. However, with a deeper understanding of these accounting standards and the complexities involved, businesses can successfully navigate the landscape of evergreen leases. By adhering to best practices and leveraging expert guidance, you can ensure compliance while optimizing lease management strategies.

Through careful planning and continuous monitoring, companies can make the most of their evergreen leases while maintaining financial accuracy and operational efficiency.