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; and
- 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.
