Key Points
- The lessee includes an extension option in the lease term only when it is reasonably certain to exercise that option.
- Reassessment is required whenever a significant event or change in circumstances within the lessee's control affects the exercise decision.
- Extension options on property leases in sectors like retail and food production frequently add five to ten years to the recognised lease term.
- Failing to reassess extension options when facts change understates the lease liability and overstates short-term cash flow projections.
What is Extension Option?
IFRS 16.18 defines the lease term as the non-cancellable period plus any periods covered by an extension option the lessee is reasonably certain to exercise (and any periods covered by a termination option the lessee is reasonably certain not to exercise). The "reasonably certain" threshold sits above "more likely than not" but below "virtually certain." IFRS 16.B37–B40 list factors the lessee considers: leasehold improvements with significant remaining value, costs of relocation, the importance of the underlying asset to operations, and past practice with similar leases.
The assessment is not a one-time event. IFRS 16.20 requires the lessee to reassess the lease term whenever a significant event or change in circumstances occurs that is within the lessee's control and affects whether it is reasonably certain to exercise (or not exercise) the option. A reassessment that changes the lease term triggers remeasurement of the lease liability at a revised discount rate under IFRS 16.40. ISA 540.13(b) requires the auditor to evaluate whether the data inputs underlying the lessee's "reasonably certain" conclusion are appropriate for the method used.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production company, FY2025, revenue €67M, IFRS reporter. Rossi leases a 3,400 m² cold-storage warehouse near Milan under a ten-year lease commencing 1 January 2020. The contract includes a single five-year extension option exercisable by 31 December 2028 at an annual rent increase of 3% above the year-ten payment. The non-cancellable annual payment is €310,000 (payable in arrears). The incremental borrowing rate at commencement was 3.2%.
Step 1 — Assess the extension option at commencement
Rossi invested €1.4M in refrigeration fit-out specific to the warehouse. No comparable cold-storage facility exists within 15 km. The controller concludes that Rossi is reasonably certain to exercise the extension option because the fit-out has a 20-year useful life (ten years remaining at the option date) and relocation costs would exceed €600,000.
Step 2 — Determine the lease term
The lease term includes the non-cancellable period (ten years) plus the extension period (five years), totalling fifteen years. Annual payments for years 11 through 15 are €319,300 each (€310,000 plus 3%).
Step 3 — Measure the initial lease liability
Discount ten payments of €310,000 and five payments of €319,300 at 3.2%. The present value of the first ten payments is €2,625,740. The present value of the five extension payments (discounted from year 11 to year 15 back to commencement) is €1,049,610. The total initial lease liability is €3,675,350.
Step 4 — Reassess at FY2025 reporting date
By 31 December 2025, Rossi has spent an additional €280,000 upgrading the refrigeration system (remaining useful life: twelve years, extending well past the extension period). No alternative site has become available. The controller confirms the "reasonably certain" assessment is unchanged. No remeasurement is triggered.
Conclusion: including the extension option produces a lease liability of €3,675,350 at commencement (versus €2,625,740 without the extension), supported by quantified fit-out economics, absence of alternative sites, and relocation cost analysis.
Why it matters in practice
Teams frequently treat the extension option assessment as a boilerplate exercise at commencement and never revisit it. IFRS 16.20 requires reassessment when a significant event or change in circumstances within the lessee's control occurs (a new facility becoming available, a decision to restructure operations, or material changes to leasehold improvements). The FRC's 2022 thematic review of IFRS 16 application found that lessees routinely failed to reassess extension options when triggering events had occurred.
The "reasonably certain" threshold is often conflated with "probable" or "more likely than not." IFRS 16.B37–B40 set a higher bar. Practitioners who document only that exercise is "expected" without referencing the specific economic factors (fit-out value, relocation costs, operational dependency, past practice) leave the conclusion unsupported. ISA 540.18 requires the auditor to evaluate whether underlying assumptions are reasonable, and a bare statement of intent does not meet that standard.
Extension option vs. termination option
| Dimension | Extension option | Termination option |
|---|---|---|
| What it does | Grants the lessee the right to extend the lease beyond the non-cancellable period | Grants the lessee the right to end the lease before the end of the non-cancellable period |
| Effect on lease term | Extends the lease term when the lessee is reasonably certain to exercise | Shortens the lease term when the lessee is reasonably certain not to exercise |
| Assessment threshold | Reasonably certain to exercise (IFRS 16.19) | Reasonably certain not to exercise (IFRS 16.19) |
| Reassessment trigger | Significant event making exercise more or less likely (IFRS 16.20) | Significant event making exercise more or less likely (IFRS 16.20–21) |
| Common audit finding | Extension included at commencement but never reassessed when facts changed | Termination option ignored entirely, leading to an overstated lease term |
Both options follow the same "reasonably certain" threshold under IFRS 16.19. The practical difference is directional: an extension option increases the right-of-use asset and lease liability when included, while a termination option decreases them when excluded. Auditors should test both options on every material lease rather than defaulting to the non-cancellable period.
Related terms
Frequently asked questions
How do I document the "reasonably certain" assessment for an extension option?
Record each factor from IFRS 16.B37–B40 that supports or contradicts exercise: the remaining value of leasehold improvements, relocation costs, the asset's importance to operations, and historical exercise patterns on similar leases. ISA 540.13(b) requires the auditor to evaluate the data inputs, so the working paper must contain quantified evidence rather than a bare conclusion.
Does a rent review clause in the extension period affect the lease liability?
Yes. If the lessee is reasonably certain to exercise the extension option, the payments during the extension period (including any contractual rent increases) form part of the lease payments used to measure the lease liability under IFRS 16.27(a). Estimate the future payments using the terms in the contract and discount them at the rate applicable at commencement (or at the reassessment date if a remeasurement has been triggered).
When does a change in business strategy trigger reassessment of an extension option?
IFRS 16.20 requires reassessment when a significant event or change in circumstances within the lessee's control affects the exercise decision. A board-approved plan to close a facility or relocate operations qualifies. A vague intention to "explore alternatives" does not. The auditor tests whether the event is both significant and within the lessee's control before accepting a change to the lease term.