Under IFRS 16, lease term equals the non-cancelable period for which the lessee has a right to use the underlying asset together with periods covered by an extension option which the lessee is reasonably certain to exercise and a termination option which the lessee is reasonably certain not to exercise.
Lease term begins on the commencement date, the date on which the lessor makes the underlying asset available for use of the lessee, and it falls anywhere between non-cancelable period and enforceable period. It includes any rent-free periods provided by the lessor to the lessee.
Non-cancelable period and enforceable period
The non-cancelable period of a lease is the minimum period for which (at least) the lessee must continue the lease. It is the period during which the lease contract cannot be terminated without incurring a more than an insignificant penalty.
The enforceable period of a lease is the maximum limit on the lease term. It refers to the longest period for which a lease contract is valid. It is the period during which either the lessee or both the lessee and the lessor have a right to continue the lease. In the context of leases, enforceability is defined with reference to the overall economics and not just the legal provisions. It means that even if the contract allows both lessee and lessor to terminate a lease, but it would not make economic sense for at least one of the parties to do so, the enforceable period is deemed to be longer than the contractual/legal enforcement period.
Extension and termination options
At the commencement date a lessee assesses all the economic factors which create an incentive to extend or not to terminate a lease. It reassesses the likelihood of exercise of such options whenever there is a significant event or change in circumstances that are (a) within the control of the lessee, and (b) affects the likelihood of the lessee exercising or not exercising an option. The lease term is revised whenever an option is exercised or it lapses.
When only the lessor has an option to terminate, it is ignored and the lessee included the period covered by termination option in the lease term. However, if only lessee can terminate, the period covered by termination option must be considered in determining the lease term.
Factors affecting exercise of extension/termination options
Factors that affect assessment of exercise of extension and termination options include:
- Attractiveness of the terms available under the options as compared to the market, such as lease payments during optional period, lease termination penalties and residual value guarantees;
- Significance of the leasehold improvements undertaken or expected to be undertaken by the lessee;
- Costs to be incurred on termination such as negotiation costs, relocation costs, costs of identifying and integrating another underlying asset, or termination penalties and similar costs, including costs to be incurred on returning the underlying asset to specified condition or location;
- Importance of the underlying asset to the company’s operations; and
- Any conditions attached to the exercising the options and the likelihood that those conditions would exist.
In making the assessment, an entity needs to look at its past practice regarding exercise of termination and extension options. Generally, if the non-cancelable period is short, there is greater likelihood that the lessee would have to extend the lease.