Lease term and options

Learning objectives

• Explain what the lease term comprises: the non-cancellable period, periods covered by an extension option that the lessee is reasonably certain to exercise and by a termination option that it is reasonably certain not to exercise.L1, L2
• Assess whether exercise of an option is reasonably certain on the basis of facts and circumstances (significant leasehold improvements, penalties, importance of the asset to the operations, terms of the options compared with market rates).L2, L3, L4
• Determine when the lessee reassesses the lease term (a significant event within its control) and when the lease term is revised (a change in the non-cancellable period).L3

Normative references

• IFRS 16 §18The lease term is the non-cancellable period of the 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 §19In assessing whether a lessee is reasonably certain to exercise an option to extend or not to exercise an option to terminate, the entity considers all relevant facts and circumstances that create an economic incentive, in accordance with paragraphs B37 to B40.
• IFRS 16 §20The lessee reassesses whether it is reasonably certain to exercise (or not to exercise) an option upon the occurrence of a significant event or significant change in circumstances that is within its control and affects that assessment, for an option not previously included, or previously included, in the lease term.
• IFRS 16 §21The entity revises the lease term if there is a change in the non-cancellable period, for example if the lessee exercises an option not previously included, does not exercise an option previously included, or an event occurs that contractually obliges the lessee to exercise an option not previously included or prohibits its exercise.
• IFRS 16 §B34In determining the lease term and the non-cancellable period, the entity determines the period for which the contract is enforceable; a lease is no longer enforceable when the lessee and the lessor each have the right to terminate it without permission from the other party with no more than an insignificant penalty.
• IFRS 16 §B35If only the lessee has the right to terminate, that right is a termination option to be considered in determining the lease term; if only the lessor has the right to terminate, the non-cancellable period includes the period covered by that option.
• IFRS 16 §B36The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.
• IFRS 16 §B37At the commencement date, the entity assesses whether the lessee is reasonably certain to exercise an option to extend or purchase, or not to exercise an option to terminate, considering all relevant facts and circumstances that create an economic incentive, including expected changes up to the exercise date: terms of optional periods compared with market rates, significant leasehold improvements, costs relating to termination, importance of the asset to the lessee's operations, conditions associated with exercising the option.
• IFRS 16 §B38An option to extend or terminate may be combined with other contractual features, for example a residual value guarantee, such that the lessee guarantees the lessor a minimum or fixed return that is substantially the same regardless of whether the option is exercised; the entity then assumes that the lessee is reasonably certain to exercise the option to extend or not to exercise the option to terminate, notwithstanding the guidance on in-substance fixed payments.
• IFRS 16 §B39The shorter the non-cancellable period, the more likely a lessee is to exercise an option to extend or not to exercise an option to terminate, because the costs of obtaining a replacement asset are likely to be proportionately higher.
• IFRS 16 §B40The lessee's past practice regarding the period over which it has typically used particular types of assets (whether leased or owned), and its economic reasons for doing so, may provide information helpful in assessing whether it is reasonably certain to exercise, or not to exercise, an option.
• IFRS 16 §B41Examples of significant events or changes in circumstances within the lessee's control that require the lease term to be reassessed: significant leasehold improvements not anticipated at the commencement date that are expected to give the lessee significant economic benefit when the option becomes exercisable; a significant modification to, or customisation of, the asset not anticipated; the inception of a sublease for a period beyond the end of the previously determined lease term; a business decision directly relevant to exercising, or not exercising, an option.

Original summaries of the paragraphs (reference register), never a quotation of the standard.

24 questions

• Chantiers Orbel leases a site hut for a lease term of {lease_term_months} months from 1 April 20X1, with no purchase option. It applies the short-term lease exemption to this class of assets. The lessor grants a rent-free period for the first {free_months} months; afterwards, Orbel pays {monthly_payment} at the end of each month until the end of the lease. Compute the lease expense for the year ended 31 December 20X1, recognised on a straight-line basis.L1
• The events organiser Festivia leases a marquee structure for {lease_term_months} months from 1 September 20X1, with no purchase option; it applies the short-term lease exemption to this class of assets. The first month is rent-free ({free_months} month), then Festivia pays {monthly_payment} in arrears, at the end of each following month. The reporting period ends on 31 December 20X1. Determine the lease expense for 20X1 and the accrued expense in the statement of financial position at that date.L2
• When a contract contains an early termination option that the lessee is reasonably certain not to exercise, the periods it covers form part of the lease term.L1
• Hortalis leases a warehouse. The contract provides for a non-cancellable period of 4 years, a first extension option of 2 years, which Hortalis is reasonably certain to exercise given the significant leasehold improvements it is making (case datum), then a second extension option of 3 years, whose exercise is not reasonably certain. What is the lease term?L2
• The lease term includes the non-cancellable period as well as the periods covered by an extension option that the lessee is reasonably certain to exercise.L1
• The lessor of Ombrelle grants three rent-free months at the start of an office lease. Those three months are excluded from the lease term, since no lease payment is made during them.L1
• Calvenor leases a hangar for a non-cancellable period of 5 years, with an option to extend for 3 years. The analysis of facts and circumstances concludes that Calvenor is reasonably certain to exercise that option. What lease term should be used?L1
• Fenouillet leases a warehouse for 6 years. The contract allows only the lessor to terminate it at the end of the fourth year; Fenouillet has no termination right. What non-cancellable period should be used?L2
• At each reporting date, the lessee reassesses whether it is reasonably certain to exercise its extension options on the basis of changes in market rents alone, even in the absence of any significant event within its control.L2
• At the commencement date, Pradelle must assess whether it is reasonably certain to exercise the extension option in a lease of a logistics site. Which of the following are facts and circumstances creating an economic incentive that must be considered? (several answers)L2
• Garonnelle leases an archive room for an initial period of 12 months. Thereafter the contract continues month to month, and each party may terminate it at any time without the other's permission, with no penalty or other cost (no improvements, room easily replaceable). Garonnelle plans to occupy the room for 36 months. Over which period is the contract enforceable for determining the lease term?L2
• Lumbres leases a shop for a non-cancellable period of 3 years, with an option to extend for 5 years. At the commencement date, it makes significant leasehold improvements with a useful life of 8 years that cannot be moved elsewhere. The accountant uses a lease term of 3 years on the grounds that the option has not yet been exercised, with no further analysis. What is the error?L2
• At the commencement date, Hautecombe excluded a 4-year extension option from the lease term of its warehouse lease. During the third year, it decides to install in the warehouse a highly customised automated storage system, not anticipated at the outset, from which it will derive significant economic benefit when the option becomes exercisable. The contract itself is not changed. What must Hautecombe do?L3
• At the commencement date, Mirandol used a lease term of 5 years for the lease of a workshop, its 2-year extension option not being reasonably certain. At the end of the fifth year, Mirandol notifies the lessor that it exercises that option, as provided by the contract. How is the lease term treated?L3
• Vaudrey leases an office floor for a lease term of 6 years; its 4-year extension option was not included in the lease term. At the beginning of the second year, Vaudrey enters into a sublease of that floor for 7 years, that is beyond the end of the previously determined lease term. What is the consequence for the head lease?L3
• When an event provided for in the contract contractually obliges the lessee to exercise an option not previously included in the lease term, the entity revises the lease term.L3
• Ternoise leases several industrial sites. Which of the following situations, arising after the commencement date, are significant events within its control that require the lease term of its leases to be reassessed?L3
• Brocéliane, a clothing retailer, leases a city-centre unit for a non-cancellable period of 4 years, with an option to extend for 4 years at a rent fixed at the outset, which management expects to be below expected market rents. Brocéliane spends 900,000 on non-transferable leasehold improvements with a useful life of 10 years. This shop is the most profitable in its network, and the retailer in practice keeps its shops for 8 to 10 years. Write a memo determining the lease term at the commencement date.L4
• Arvelle leases a specific packaging line for a non-cancellable period of 2 years, renewable each year at Arvelle's option for 5 further years, at a rent set at 40% of the initial rent, a case datum considered well below market. The line is integrated into the plant; replacing it would require stopping production for 3 months. Arvelle usually uses this type of equipment for 7 years. Management has made no formal renewal decision. Which analysis is most consistent with IFRS 16?L4
• Quincerot leases forklift trucks for 7 years. Only the lessor can terminate the contract after 3 years, without penalty; Quincerot has no termination right. Quincerot's accountant uses a lease term of 3 years. What is the error?L2
• Saint-Aubrac leases three warehouses. During the year: (1) market rents in the region of the North warehouse rose by 20%, making its unincluded extension option very favourable; (2) Saint-Aubrac completed in the South warehouse significant leasehold improvements not anticipated at the commencement date, from which it will benefit significantly if it extends; (3) Saint-Aubrac formally exercised the extension option of the East warehouse, which was not included in the lease term. Write a memo stating, for each warehouse, whether the lease term must be reassessed, revised or left unchanged.L3
• Pellerin leases a construction machine for a non-cancellable period of 3 years, with an option to extend for 2 years. If Pellerin does not extend, it must pay the lessor, under a residual value guarantee, an amount such that the lessor's return is substantially the same whether or not the option is exercised. What conclusion should be reached on the lease term?L4
• Calvène leases a workshop; the annual payment of {annual_payment} is paid at the end of each year. At 1 January 20X4, {remaining_years} payments remain and the lease liability amounts to {old_liability} (original rate {original_rate}). On that day, Calvène exercises an extension option of {extension_years} years, at the same rent, which was not included in the lease term. The interest rate implicit in the lease cannot be readily determined; Calvène's incremental borrowing rate at that date is {revised_rate}. Compute the remeasured lease liability and the adjustment to the right-of-use asset (rounded to the nearest euro).L3
• The carrier Nordelis leases a logistics platform ({yearly_rent} per year, paid at year end). At the end of 20X5, after significant leasehold improvements decided by Nordelis and not anticipated at the outset, management becomes reasonably certain to exercise the {option_years} years-year extension option at the same rent, previously excluded from the lease term. {payments_left} years non-cancellable payments remain; the lease liability is {liability_before} (initial rate {initial_rate}). The interest rate implicit in the lease cannot be readily determined and the current incremental borrowing rate is {ibr_now}. Determine the remeasured lease liability and the adjustment to the right-of-use asset (rounded to the nearest euro).L4