Key points
- The lease term is not simply the contractual end date. It includes extension and termination option periods where exercise (or non-exercise) is reasonably certain.
- Getting the lease term wrong misstates both the right-of-use (ROU) asset and the lease liability by the same amount.
- Lessees must reassess the lease term when a significant event or change in circumstances occurs that is within their control.
- A five-year warehouse lease with a reasonably certain three-year extension produces an eight-year lease term, nearly doubling the recognised liability.
What is the lease term?
On about half the IFRS 16 files we've reviewed, the lease schedule just rolls the non-cancellable period straight through to the liability calculation with no documented assessment of extension or termination options. It looks tidy. It is also wrong whenever the lessee has a genuine economic reason to stay, and we've seen audit findings flow from exactly that shortcut.
IFRS 16.18 sets the lease term as the non-cancellable period together with periods covered by extension options the lessee is reasonably certain to exercise and periods covered by termination options the lessee is reasonably certain not to exercise. "Reasonably certain" is a high threshold. It sits above "more likely than not" and requires the lessee to consider all relevant economic factors that create an incentive to exercise or not exercise the option.
IFRS 16 .B37 lists the factors: contract-based (penalties for termination, favourable pricing in the option period), asset-based (leasehold improvements with remaining useful life beyond the non-cancellable period), entity-specific (historical exercise patterns, business strategy), and market-based (availability of suitable alternatives). The assessment is made at the commencement date and drives the measurement of both the lease liability and the ROU asset. A longer lease term increases the present value of future payments and raises the depreciation base. A shorter term does the opposite.
IFRS 16.20 requires reassessment only when a significant event or change in circumstances occurs that is within the lessee's control and affects reasonable certainty. Routine annual reviews are not required by the standard, though at firms like ours most teams run them anyway as a matter of policy. ISA 540.13 (b) requires the auditor to evaluate whether the data and significant assumptions underlying the lease term assessment are appropriate, which in practice means testing whether the entity updated its conclusion when triggering events occurred.
Worked example: Henriksen Shipping A/S
Client: Danish maritime logistics company, FY2025, revenue EUR 140M, IFRS reporter. Henriksen leases a 12,000 m² port-side distribution centre in Aarhus. The contract runs for seven years from 1 January 2025, with a five-year extension option exercisable by 30 June 2031. There is no penalty for non-exercise. The incremental borrowing rate is 3.8%.
Step 1: identify the non-cancellable period
The base contract runs from 1 January 2025 to 31 December 2031, giving seven non-cancellable years.
Step 2: assess the extension option
Henriksen has installed EUR 1.9M of refrigerated racking systems with a useful life of ten years. The leasehold improvements will have three years of remaining useful life at the end of the non-cancellable period. Alternative port-side facilities in the Aarhus area are limited (two comparable sites, both currently occupied). Henriksen's board has approved a logistics strategy that depends on this location through 2038. There is no contractual penalty for non-exercise, but four economic factors (leasehold improvements, site scarcity, board strategy, and the absence of viable alternatives) create a strong incentive to extend.
Step 3: determine the lease term
Seven non-cancellable years plus five extension years gives a lease term of twelve years.
Step 4: measure the impact
Annual lease payments are EUR 780,000. The present value of twelve annual payments at 3.8% is EUR 7,295,420. Had the entity concluded the extension was not reasonably certain, the present value of seven payments would be EUR 4,743,690. The difference of EUR 2,551,730 flows through to both the ROU asset and the lease liability.
Conclusion: the twelve-year lease term is defensible because four independent economic factors (leasehold improvements, site scarcity, board strategy, and absence of alternatives) support reasonable certainty, and the EUR 2.55M measurement difference demonstrates why the assessment is material.
Why it matters in practice
- Teams frequently just roll the non-cancellable period forward into the liability calculation without performing a documented assessment of extension and termination options. It becomes a tick box exercise: copy last year's schedule and confirm the end date. IFRS 16.19 requires the entity to consider all relevant facts and circumstances that create an economic incentive to exercise (or not exercise) an option. The FRC's 2022 thematic review of IFRS 16 application found that lease term assessments often lacked sufficient evidence of the factors considered, particularly for real estate leases with renewal clauses.
- Reassessment triggers under IFRS 16.20 -21 are frequently missed. The standard limits reassessment to significant events within the lessee's control (such as exercising an option not previously included, committing significant capital to the leased asset, subletting, or receiving a rent adjustment). Practitioners sometimes reassess at every reporting date (over-applying the requirement) or never reassess after commencement (under-applying it). ISA 540.13 (a) requires the auditor to evaluate whether the entity's method for the estimate is appropriate, which includes confirming the reassessment policy is consistent with the standard.
- This is one of the most frustrating areas to get right on a first-year engagement because the prior auditor's WPs rarely explain why the extension was or was not included. You inherit a number with no reasoning behind it, and rebuilding that reasoning from scratch takes hours of contract reading and management interviews that feel disproportionate to the balance involved.
Lease term vs useful life
| Dimension | Lease term ( IFRS 16.18 ) | Useful life ( IAS 16.6 ) |
|---|---|---|
| What it measures | The period over which the lessee has the right to use the asset, including reasonably certain option periods | The period over which the asset is expected to generate economic benefits for the entity |
| Who determines it | Driven by the lease contract and the lessee's assessment of option exercise | Driven by management's estimate of wear and obsolescence |
| Reassessment trigger | Significant event within lessee's control affecting option exercise ( IFRS 16.20 ) | Reviewed at each reporting date; revised when expectations change ( IAS 16.51 ) |
| Depreciation role | Caps the depreciation period for the ROU asset unless ownership transfers | Sets the depreciation period for owned property, plant, and equipment |
The distinction matters because auditors must verify both figures independently on engagements where the entity holds owned and leased assets in the same asset class. A lease term of eight years and a useful life of fifteen years for an identical building type is internally consistent. A lease term of twelve years and a useful life of nine years for the same asset class raises a question about whether one estimate is wrong.
Related terms
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Frequently asked questions
When do I reassess the lease term under IFRS 16?
Reassess only when a significant event or change in circumstances occurs that is within the lessee's control and affects whether the lessee is reasonably certain to exercise an extension or not exercise a termination option. IFRS 16.20 does not require reassessment at every reporting date. Typical triggers include committing to significant leasehold improvements, deciding to sublet the property, receiving a material rent concession, or exercising an option not previously included in the lease term.
Does the lease term include a rent-free period?
Yes. A rent-free period at the start of a lease falls within the non-cancellable period and is part of the lease term under IFRS 16.18. The rent-free months reduce the total undiscounted lease payments but do not shorten the term. The lease liability calculation under IFRS 16.26 reflects the actual payment profile, including any zero-payment months.
How does the lease term affect depreciation of the ROU asset?
IFRS 16.32 requires the lessee to depreciate the ROU asset over the shorter of the asset's useful life and the lease term, unless ownership transfers or a purchase option is reasonably certain to be exercised. A longer lease term extends the depreciation period and lowers the annual charge per year, while a shorter term concentrates it.