One of the trickier parts of IFRS 16 is that the lease term is not always a fixed, simple number. Many leases include renewal options, termination options, or both, and businesses need to make a judgment call about whether these options will actually be exercised. That judgment does not stay static either. It can change over the life of the lease, which means the lease term itself sometimes needs to be reassessed.
If your finance team has ever had to explain to an auditor why a lease term assumption changed mid contract, you already know this is an area worth understanding thoroughly. Here is a clear breakdown of how lease term reassessment works.
What Determines the Initial Lease Term
At the start of a lease, IFRS 16 requires the lease term to include the non-cancellable period of the lease, plus any periods covered by a renewal option if the lessee is reasonably certain to exercise it, and any periods covered by a termination option if the lessee is reasonably certain not to exercise it.
This means the initial lease term is not always just what is written as the base contract length. If a business is highly likely to renew a lease based on its history or strategic plans, that renewal period should be factored into the initial calculation.
Why “Reasonably Certain” Requires Real Judgment
The phrase “reasonably certain” is doing a lot of work in this standard, and it is not a simple checkbox. Businesses need to consider factors such as contractual terms of optional periods compared to current market rates, the significance of any leasehold improvements, costs relating to termination such as relocation costs, and the importance of the underlying asset to the business operations.
For example, if a company has invested heavily in customizing a leased office space, it is more likely to exercise a renewal option rather than absorb the cost of relocating and losing that investment. This kind of reasoning needs to be documented, not just assumed.
When Reassessment Is Required
Unlike the discount rate, which is generally fixed at lease commencement, the lease term is not locked in permanently. IFRS 16 requires reassessment of the lease term when there is a significant event or change in circumstances within the lessee’s control that affects whether they are reasonably certain to exercise an option.
This could include a business decision to expand operations at a leased location, a change in strategy that makes relocation more likely, or significant leasehold improvements made partway through the lease that increase the likelihood of renewal.
What Happens When the Lease Term Changes
When a reassessment results in a change to the lease term, the lease liability needs to be remeasured using a revised discount rate, and the right of use asset is adjusted accordingly. This is different from a lease modification, which involves a change to the contractual terms of the lease itself, such as a rent reduction negotiated with the landlord.
Reassessment is about a change in judgment regarding options that were already part of the original lease agreement, not a change to the agreement itself.
Common Triggers Businesses Should Watch For
Some of the most common events that should prompt a business to revisit its lease term assumptions include expansion or downsizing decisions that affect whether a location will still be needed, market rent changes that make a renewal option significantly more or less attractive, and major capital investment in the leased space that was not anticipated at lease commencement.
Finance teams should not wait for year end reporting to think about these triggers. Building a habit of checking in with operational teams throughout the year helps catch reassessment triggers as they happen, rather than discovering them retroactively.
Termination Options Deserve Equal Attention
While renewal options tend to get more attention, termination options matter just as much. If a lease includes an early termination option and the business becomes reasonably certain it will exercise that option, perhaps due to downsizing or relocating operations, the lease term should be shortened accordingly, and the liability remeasured.
Ignoring termination options, or failing to reassess them when circumstances change, can result in an overstated lease liability that does not reflect the business’s actual expected obligations.
Building a Process That Holds Up to Scrutiny
The best defense against reassessment errors is a consistent, documented process. This means keeping a record of the reasoning behind each lease term assumption at inception, flagging leases with significant renewal or termination options for periodic review, and involving relevant business units, such as real estate or operations teams, in providing updated information that could affect lease term judgments.
Final Thoughts
Lease term reassessment is one of those areas of IFRS 16 that rewards businesses who stay proactive rather than reactive. Judgments about renewal and termination options are rarely permanent, and circumstances change. By building a habit of monitoring these triggers and documenting the reasoning behind lease term decisions, finance teams can stay ahead of reassessment requirements instead of being caught off guard during reporting season.
