Under IFRS 16 ‘Leases’, determining the correct ‘lease term’ is significant for a number of reasons.
Firstly, the longer the lease term, the larger the lessee’s right-of-use asset and lease liability will be. Secondly, the length of the lease term determines whether a lease qualifies for the short-term lease exemption. Finally, IFRS 16 contains additional application guidance on how to deal with periods covered by options to extend or terminate a lease. While this detailed guidance can be helpful, it also means there is more to consider when determining the lease term.
In our view, ascertaining the correct lease term is one of the most challenging issues in applying IFRS 16 as it is likely to require a significant level of judgement.
'Lease term' is defined as the non-cancellable period for which a lessee has the right to use an underlying asset (including any periods covered by a lessor’s termination option), plus:
- periods covered by a lessee’s extension option if extension is reasonably certain
- periods covered by a lessee’s termination option if the lessee is reasonably certain not to terminate.
While the concept of ‘reasonably certain’ has not changed from IAS 17, the application of this concept in practice requires consideration of all the facts and circumstances that create a significant economic incentive for a lessee to extend the lease (where a lessee has an extension option) or not to terminate a lease (where the lessee has a termination option).
This is ultimately a judgement considering factors specific to the asset, the entity and the wider market. As these factors are wide ranging, we expect this to be a challenging area in practice.
In the IFRS 16 - Lease term [ 109 kb ] we go into more detail on:
Enforceability – We discuss how options to extend or terminate the lease must be enforceable to be considered part of the lease term.
Initial assessment of the lease term – We provide insights into how entities calculate the lease term at the commencement of the lease.
Reassessment of lease term – After the commencement of the lease, the lessee must reassess whether it is reasonably certain to exercise an extension or termination option in certain circumstances, of which we discuss and provide examples on.
We also provide case study examples, as well as the facts and circumstances that may create an economic incentive to exercise or not exercise an option.
We hope you find the information in this article helpful in giving you some detail into aspects of IFRS 16. If you would like to discuss any of the points raised, please speak to our Grant Thornton team.