Lease Term Explained (With Examples) - IFRS 16

Introduction

The lease term is the non-cancellable period of a lease, together with periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option, and periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option - IFRS 16 Appendix A.

This definition requires an entity to look beyond the legal minimum term stated in the contract and assess the economic substance of the arrangement, because optional periods that are reasonably certain to be taken form part of the lease term and must be included in the measurement of the lease liability and right-of-use asset.

This article forms part of our full IFRS 16 guide.

Non-cancellable Period

The non-cancellable period is the time during which neither party can terminate the lease without:

• Permission from the other party, or
• More than an insignificant penalty.

A penalty is not limited to a contractual cash payment. It includes any economic disadvantage, such as:

• Loss of a significant lease incentive,
• Costs of relocating operations,
• Costs of dismantling or restoring assets,
• Loss of customer access or market presence.

If terminating the lease would impose a significant economic burden, the lease is considered non-cancellable for that period.

Options to Extend or Terminate

Many leases contain renewal or break clauses. Under IFRS 16, these options are included in the lease term only if the lessee is reasonably certain to exercise (or not exercise) them.

“Reasonably certain” is a high threshold. It is stronger than “more likely than not” and requires persuasive evidence that management has a firm intention supported by economic factors.

This assessment must be made at commencement and revisited if significant events or changes in circumstances occur.

Reasonably Certain Assessment

At the commencement date, an entity assesses whether the lessee is reasonably certain to:

• exercise an option to extend the lease,
• exercise an option to purchase the underlying asset, or
• not exercise an option to terminate the lease.

The entity considers all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option. This includes any expected changes in facts and circumstances from the commencement date until the date on which the option becomes exercisable.

Key factors to consider

The following factors must be evaluated together. No single factor is determinative.

(a) Contractual terms compared with market conditions

This includes:

• The level of lease payments during any optional period.
• The amount of any variable or contingent payments, including:
  • termination penalties, and
  • residual value guarantees.
• The terms of any options that are exercisable after initial optional periods, for example:
  • a purchase option at the end of an extension period that is priced below current market value.

Favourable pricing relative to the market increases the likelihood that the lessee is reasonably certain to exercise the option.

(b) Leasehold improvements

Significant leasehold improvements that:

• have been undertaken, or
• are expected to be undertaken,

and that are expected to provide substantial economic benefit beyond the non-cancellable period strongly indicate that the lessee is reasonably certain to remain in the lease.

(c) Termination and relocation costs

These include, but are not limited to:

• negotiation and legal costs,
• relocation costs,
• costs of identifying a suitable replacement asset,
• costs of integrating a new asset into operations,
• termination penalties,
• costs of restoring or returning the asset to a contractually specified condition or location.

High termination costs increase the economic incentive to continue the lease.

(d) Importance of the underlying asset

This considers:

• whether the asset is specialised,
• whether its location is strategically important, and
• the availability (or lack) of suitable alternatives.

Assets that are critical to operations or difficult to replace increase the likelihood of extension.

(e) Conditionality of the option

When an option can only be exercised if certain conditions are met, the entity must assess:

• what those conditions are, and
• how likely it is that they will be satisfied.

An option to extend or terminate a lease may be structured together with other contractual features, such as residual value guarantees, in a way that guarantees the lessor a minimum return regardless of whether the option is exercised. In such cases, the entity assumes that the lessee is reasonably certain:

• to exercise an option to extend, or
• not to exercise an option to terminate.

A lessee’s past practice may also provide useful evidence, including:

• the typical period for which similar assets have been used,
• whether renewal options have historically been exercised, and
• the economic rationale behind that behaviour.

This historical behaviour should be considered alongside current contractual and economic factors when assessing reasonable certainty.

Practical Example

Assume a lease has:

• A non-cancellable period of 5 years,
• An option to extend for a further 5 years,
• Significant leasehold improvements economically useful for 10 years,
• No suitable alternative premises nearby,
• Extension rentals that are below market rates.

In this case, the lessee is likely to be reasonably certain to exercise the extension option. The lease term would therefore be 10 years, not 5.

If, however:

• The asset is generic,
• There are many alternatives available,
• The extension rentals are at market rates,
• No major leasehold improvements exist,

then it may be appropriate to include only the initial 5-year period.

Reassessment of the Lease Term

The lease term must be reassessed when there is a significant event or change in circumstances that:

• Is within the control of the lessee, and
• Affects whether the lessee is reasonably certain to exercise (or not exercise) an option.

Examples include:

• A major business acquisition or disposal,
• Significant new leasehold improvements,
• A decision to close or relocate operations,
• Renegotiation of lease terms.

When reassessment occurs, the lease liability is remeasured using an updated lease term and a revised discount rate if required by IFRS 16.

Interaction with Lease Modifications

Lease term determination is closely linked to lease modifications. If contractual terms are formally changed, such as extending the lease period or removing a break option, this is treated as a lease modification and accounted for separately under IFRS 16’s modification guidance.

Judgement about “reasonable certainty” applies even when the contract itself has not been modified.

Conclusion

Lease term determination under IFRS 16 is not a mechanical exercise. It requires a careful evaluation of contractual rights, economic incentives, operational dependencies, and strategic intent. The concept of “reasonable certainty” demands robust judgement supported by objective evidence. Given its direct impact on financial statements, entities must treat lease term assessment as a critical accounting estimate and ensure it is consistently applied, well-documented, and regularly reviewed.

For clarification or feedback on this article, contact us at insight@leash.co.za.