Have You Ever Faced These Challenges?
- You included extension options in the lease term because management indicated they intended to stay — only for your auditors to question whether the “reasonably certain” threshold was actually met
- A revision to the lease term part-way through a contract required remeasurement of the lease liability, and you were uncertain which discount rate to use
- You are managing a large real estate portfolio with varied option structures and need a consistent framework for assessing which options to include in the lease term
What You Will Learn From This Article
- What “reasonably certain” means in the context of extension and termination options — and why it is a higher bar than “probable”
- The economic factors that support or undermine a conclusion that an option will or will not be exercised
- When and how to remeasure the lease liability when the lease term assessment changes
Who This Article Is For
- Finance professionals managing lease portfolios with extension or termination options
- Those who have had audit challenges on lease term judgements
- Practitioners setting up lease accounting policies for the first time under IFRS 16
The Definition of Lease Term
The lease term under IFRS 16 is the non-cancellable period of the lease, together with (IFRS 16.19):
- Periods covered by an extension option — if the lessee is reasonably certain to exercise the option
- Periods covered by a termination option — if the lessee is reasonably certain not to exercise the option
The lease term begins at the commencement date and ends at the later of the non-cancellable period and any option periods included in the assessment.
The “Reasonably Certain” Threshold
“Reasonably certain” is the most important and most debated concept in IFRS 16 lease term determination. The IASB has positioned this threshold as higher than “probable” — which itself means more likely than not (i.e., greater than 50%).
In practical terms, “reasonably certain” requires that the evidence strongly supports the conclusion that the option will (or will not) be exercised. A view that exercise is “likely” or “expected” is not sufficient. The standard contemplates a situation where there is a high degree of certainty — not merely a balance of probabilities — that the lessee will (or will not) exercise the option.
The consequence of this elevated threshold is significant. Where there is genuine uncertainty about whether an extension option will be exercised — for example, where business conditions are volatile, where the rental market is fluid, or where the entity regularly reviews and renegotiates its property portfolio — the option should generally not be included in the lease term.
Factors That Affect the “Reasonably Certain” Assessment
IFRS 16.B37 identifies the following factors as relevant to the assessment of whether a lessee is reasonably certain to exercise (or not exercise) an option:
Contractual Terms
- Whether the lease payments during the optional period are below market rate (creating an economic incentive to exercise)
- Whether the lease payments during the optional period are above market rate (creating an economic incentive not to exercise)
- The amount of any penalties payable by the lessee if the option is not exercised (or is exercised, in the case of a termination option)
Significant Leasehold Improvements
Where the lessee has made significant improvements to the leased asset — for example, a high-specification fit-out of leased office space, or the installation of bespoke production equipment in a leased facility — there is an economic incentive to remain in the lease long enough to recover the investment. The presence of material leasehold improvements is one of the strongest indicators that an extension option is reasonably certain to be exercised.
Importance of the Underlying Asset
Where the leased asset is important to the lessee’s operations and difficult to replace — a flagship retail location, a key manufacturing site, or a uniquely located logistics hub — the economic disruption of not renewing the lease supports a conclusion that the extension option is reasonably certain to be exercised.
Historical Pattern of Exercise
The lessee’s track record of exercising (or not exercising) similar options on similar assets provides useful, though not determinative, evidence. An entity that has consistently renewed similar leases for the past decade has relevant evidence in support of a reasonably certain conclusion.
Costs of Relocation or Termination
The higher the costs associated with exiting the lease — moving costs, business disruption, the need to find and fit out alternative premises, contractual penalties — the stronger the economic argument for concluding that the extension option is reasonably certain to be exercised.
Industry-Specific Patterns
Real Estate (Offices, Retail, Warehouses)
Real estate leases generate the most lease term debates in practice, because extension options are common and the financial impact of including or excluding them is significant.
Factors supporting “reasonably certain” (include option in lease term):
- Flagship store or headquarters location with no viable alternatives nearby
- Significant fit-out investment that would be written off if the lease were not renewed
- Long-established presence at the location with a strong track record of renewal
- Below-market lease payments during the option period
Factors against “reasonably certain” (exclude option from lease term):
- Standardised unit with multiple comparable alternatives available
- No material leasehold improvements
- Volatile business conditions or active property portfolio review
- Above-market payments during the option period
Manufacturing Equipment and Production Lines
Production equipment that is integrated into a manufacturing process — where substitution would require significant reconfiguration — typically supports a reasonably certain conclusion for extension options. The cost of replacing or relocating the equipment is usually high enough to make non-renewal economically irrational.
Vehicles and Office Equipment
Fleet vehicles and office equipment leases are generally shorter in duration and easier to replace. Extension options are less likely to be assessed as reasonably certain unless the specific asset has unusual characteristics.
The Financial Impact of the Lease Term Judgement
The lease term judgement directly determines the amount of the right-of-use asset and lease liability recognised on the balance sheet. The difference can be material.
Worked example:
Monthly lease payment: ¥1 million Incremental borrowing rate: 3% per annum Non-cancellable period: 5 years Extension option: 5 years
| Lease term assessment | Lease liability (present value) |
|---|---|
| 5 years (option excluded) | Approx. ¥55.8 million |
| 10 years (option included) | Approx. ¥104.4 million |
The difference — approximately ¥48.6 million — arises solely from the lease term judgement. For entities with large property portfolios, the aggregate impact of these judgements across the portfolio can be substantial, affecting leverage ratios, return on assets, and covenant compliance.
Reassessment of the Lease Term
The lease term is not static. IFRS 16.20 requires the lessee to reassess the lease term upon the occurrence of a significant event or a significant change in circumstances that is within the lessee’s control.
Triggers for Reassessment
- The lessee exercises an option that was previously assessed as not reasonably certain
- The lessee does not exercise an option that was previously assessed as reasonably certain
- A significant leasehold improvement is made or approved — increasing the economic incentive to remain
- A significant change in the lessee’s business — for example, a decision to exit a market or consolidate premises — reducing the economic incentive to extend
Note that reassessment is required by a change in the lessee’s circumstances, not simply by the passage of time. The approach to the end of the non-cancellable period is not, by itself, a trigger for reassessment — though it will inevitably prompt a fresh assessment of whether the extension option should now be assessed as reasonably certain.
Accounting for a Reassessment
Where the lease term is revised, the lessee remeasures the lease liability using a revised discount rate — specifically, the lessee’s incremental borrowing rate at the date of reassessment.
The change in the lease liability is recognised as an adjustment to the right-of-use asset. It is not taken directly to profit or loss (except where the adjustment reduces the right-of-use asset below zero, in which case any excess is recognised in profit or loss).
Worked example — lease term extension:
A lessee originally assessed a 5-year lease term (non-cancellable). At Year 3, a significant fit-out investment is made, and management concludes that the 5-year extension option is now reasonably certain to be exercised.
At Year 3:
- Remaining lease payments under original 5-year term: 2 years
- Additional lease payments under extension: 5 years
- Revised IBR at Year 3: 3.5% per annum
The lessee remeasures the lease liability based on the remaining 7 years of lease payments (2 + 5) discounted at 3.5%. The increase in the lease liability is added to the right-of-use asset and depreciated over the revised remaining useful life.
Lease Register: Documenting the Lease Term Judgement
For entities with large or complex lease portfolios, the lease term judgement must be systematically documented in the lease register to support audit defence and ensure consistency.
At minimum, the lease register entry for each lease should include:
| Field | Content |
|---|---|
| Non-cancellable period | Start date and end date |
| Extension options | Description, option period, exercise deadline |
| Reasonably certain assessment | Conclusion and supporting rationale |
| Reassessment date | Date of last reassessment and next scheduled review |
| Key assumptions | Leasehold improvements, relocation costs, market conditions |
The rationale for the reasonably certain assessment is the most important element. Without documented evidence, the same lease term judgements will be challenged by auditors in every reporting period.
Comparison with Japanese GAAP
| Area | IFRS 16 | Japanese GAAP |
|---|---|---|
| Lease term definition | Non-cancellable period plus options if reasonably certain | Non-cancellable period is the primary basis |
| Extension option treatment | Detailed assessment required | Limited guidance |
| Reassessment requirement | Triggered by significant events within lessee’s control | Limited guidance on reassessment |
| Purchase option treatment | Included if reasonably certain to exercise | Similar |
Summary
The key takeaways from lease term determination are as follows:
- “Reasonably certain” is a high threshold — higher than probable. Genuine uncertainty about whether an option will be exercised means the option should generally be excluded from the lease term
- The factors most strongly supporting a “reasonably certain” conclusion are: significant leasehold improvements, asset importance and irreplaceability, high relocation or termination costs, and below-market option payments
- The lease term judgement has a direct and often material impact on the balance sheet — the difference between including and excluding a five-year extension option can represent tens or hundreds of millions in lease liabilities for a large property portfolio
- Reassessment is triggered by significant events within the lessee’s control — not by the mere passage of time approaching the option date
- On reassessment, the lease liability is remeasured at the revised IBR at the reassessment date, and the corresponding adjustment is made to the right-of-use asset
The next article addresses the measurement of the lease liability and right-of-use asset in detail — covering the incremental borrowing rate, initial direct costs, and lease modifications.
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