Have expectations around lease renewal, termination or purchase options changed?

Global IFRS Institute | Uncertain times

External events – e.g. geopolitical unrest, natural disasters, climate effects or inflationary pressures – can significantly affect economic activity and sentiment around the world, with the potential to disrupt business operations, supply chains and production lines.

During times of economic uncertainty, companies make business decisions that affect their lease contracts. As a result, lease contracts containing renewal and termination clauses may need to be reassessed to determine whether there is any change to the lease term. Any changes in the lease term could have a significant impact on the carrying amount of lease assets and liabilities.

Further, lease contracts with purchase options may need to be reassessed if the lessee concluded initially that exercise of the purchase option was reasonably certain.

Reassessment of options

IFRS 16 Leases requires a lessee to determine whether it is reasonably certain:

• to exercise an option to extend the term of the lease;
• to exercise an option to purchase the underlying asset at the end of the lease; or
• not to exercise an option to terminate the lease early. [Insights 5.1.100.10]

In doing so, lessees consider all relevant facts and circumstances that create an economic incentive for them to exercise an option or not. [IFRS 16.19]

A lessee remeasures its lease liability when a significant event or a significant change in circumstances within its control changes any of its assessments about what is reasonably certain – i.e. to exercise a renewal or purchase option or not to exercise an option to terminate the lease early. [Insights 5.1.330.10]

A lessee applies judgement when identifying significant events or significant changes in circumstances that trigger reassessment of these options. The lessee then considers the effect of current economic incentives to determine whether it is reasonably certain to exercise, or not to exercise, each option.

For example, a retailer concludes that revised commercial plans developed in response to an uncertain macroeconomic environment triggers a reassessment of renewal options in its store leases. In assessing whether it is reasonably certain to exercise the renewal options, the retailer considers the economic incentives existing at the date of the reassessment.

Accounting for reassessments 

If a lessee changes its assessment of whether it is reasonably certain to exercise a renewal or purchase option, or not to exercise an option to terminate the lease early, then it remeasures its lease liability using a revised discount rate. The lessee adjusts the carrying amount of the right-of-use asset for the remeasurement of the lease liability. If the carrying amount of the right-of-use asset is reduced to zero, then any further reductions are recognised in profit or loss. [IFRS 16.39, 40(a)–(b)]

As a result, reassessment can have a significant impact on the carrying amount of lease assets and liabilities at the date of the reassessment. In turn, this may affect the amount and profile of depreciation and interest expense recognised subsequently.

For example, suppose a company that leases a vehicle initially assessed that it was reasonably certain to exercise an option to purchase the vehicle at the end of the lease term. As a result, it included the exercise price of the purchase option in the initial carrying amount of its right-of-use asset and lease liability, and depreciated the right-of-use asset over the useful life of the vehicle. Subsequently, the company concludes that it is not reasonably certain to exercise the purchase option. It therefore remeasures the right-of-use asset and lease liability, and depreciates the right-of-use asset over the lease term.

What about lessors?

Lessees and lessors use the same guidance for assessing whether they are reasonably certain to exercise options on lease commencement. However, unlike lessees, lessors do not generally reassess their initial assessment of the lease term and purchase options.

Changes in the non-cancellable period of a lease

Decisions that companies make during uncertain times may also affect how the non-cancellable period of a lease is determined. For example, the non-cancellable period of a lease will change if:

• the lessee exercises an option that was not previously included in the measurement of the lease liability;
• the lessee does not exercise an option that was previously included in the measurement of the lease liability;
• an event occurs that requires the lessee to exercise an option that was not previously included in the measurement of the lease liability; or
• an event occurs that contractually prohibits the lessee from exercising an option that was previously included in the measurement of the lease liability. [IFRS 16.21, 40(a)]

IFRS 16 requires a lessee to revise the lease term and remeasure the lease liability using a revised discount rate when there is a change in the non-cancellable period of a lease.

• Consider whether events and circumstances have triggered a requirement to reassess renewal, termination or purchase options.
• Consider the impact of any changes in economic incentives on whether a company is reasonably certain to exercise, or not to exercise, such options.
• Provide clear and meaningful disclosures about judgements and estimates made in reassessing lease options and lease terms.