Key Takeaways
- A termination option shortens the lease term only if the lessee is reasonably certain to exercise it; otherwise the full contractual period stands.
- "Reasonably certain" is a high threshold that sits above "more likely than not" and requires documented evidence of the economic factors considered.
- Including or excluding a termination option period can shift the lease liability by 30–50% on a typical commercial property lease.
- Failure to reassess the option when triggering events occur is one of the most common IFRS 16 documentation gaps.
What is Termination Option?
IFRS 16.18 defines the lease term as the non-cancellable period plus 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. The termination option assessment is therefore a mirror image of the extension option assessment: if the lessee concludes it is reasonably certain not to terminate early, the full remaining period after the earliest termination date remains in the lease term.
IFRS 16.B37 lists the factors the lessee must weigh. Contractual penalties for early termination, the remaining useful life of leasehold improvements installed in the property, the cost of relocating operations, and the availability of suitable alternative premises all feed the analysis. The assessment is made at commencement and drives the measurement of the right-of-use asset and lease liability. IFRS 16.20 then limits reassessment to significant events or changes in circumstances within the lessee's control that affect reasonable certainty. ISA 540.13(a) requires the auditor to evaluate whether the entity's method for the estimate is appropriate, which means testing the documented rationale behind the termination option conclusion.
Worked example: Fernandez Distribucion S.L.
Client: Spanish wholesale distribution company, FY2025, revenue EUR 34M, IFRS reporter. Fernandez leases a 4,800 m² regional distribution hub outside Valencia under an eight-year lease commencing 1 January 2023. The contract includes a lessee termination option exercisable on 31 December 2026 (the end of year four) with a penalty of EUR 95,000 payable to the lessor. Annual lease payments are EUR 320,000 (payable in arrears). The incremental borrowing rate at commencement is 4.2%.
Step 1 — Identify the termination option
The lease runs from 1 January 2023 to 31 December 2030 (eight years). The lessee may terminate at the end of year four by paying a penalty of EUR 95,000.
Documentation note: record the termination option clause from the signed lease agreement, including the exercise date, the notice period, and the penalty amount per IFRS 16.18.
Step 2 — Assess reasonable certainty at commencement
Fernandez invested EUR 410,000 in conveyor systems and racking specific to this warehouse in Q1 2023. These have a useful life of ten years, leaving six years of economic benefit beyond the earliest termination date. The penalty of EUR 95,000 represents less than four months of rent, which is modest. However, the leasehold improvements dwarf the penalty, and no comparable distribution sites were available in the Valencia region at commencement. Fernandez's board approved a five-year distribution strategy anchored on this location.
Documentation note: document each factor from IFRS 16.B37–B40. Record the leasehold improvement cost (EUR 410,000) and remaining useful life at the termination date, the penalty amount, the alternative-site search results, and the board strategy paper. Conclude that the lessee is reasonably certain not to exercise the termination option.
Step 3 — Determine the lease term
Because the lessee is reasonably certain not to terminate, the full eight-year contractual period is the lease term. The present value of eight annual payments of EUR 320,000 at 4.2% is EUR 2,128,470.
Documentation note: record the lease term conclusion (eight years) with cross-reference to the termination option assessment. Note that had the entity concluded it was reasonably certain to terminate, the lease term would be four years and the liability would be EUR 1,148,960, a difference of EUR 979,510.
Step 4 — Reassessment check at FY2025 reporting date
In September 2025, Fernandez signed a new five-year contract with its largest customer, committing to delivery from the Valencia hub through 2030. No triggering event has occurred that would change the reasonable-certainty conclusion. The original assessment stands.
Documentation note: record that the reassessment trigger test under IFRS 16.20 was performed and that no significant event altered the original conclusion. File the new customer contract as corroborating evidence.
Conclusion: the eight-year lease term is defensible because the leasehold improvements (EUR 410,000 with six years remaining at the option date) and the absence of alternative sites outweigh the modest EUR 95,000 penalty, and the EUR 979,510 measurement difference between the two scenarios confirms the assessment is material.
Why it matters in practice
Teams frequently default to the non-cancellable period (up to the first termination date) without documenting why they excluded the post-termination period. IFRS 16.19 requires the entity to consider all relevant facts and circumstances that create an economic incentive not to exercise the option. An undocumented conclusion is not a defensible conclusion. The FRC's 2022 thematic review of IFRS 16 found that lease term assessments (including termination option analyses) often lacked evidence of the factors considered, particularly for real estate leases.
Reassessment under IFRS 16.20 is frequently either over-applied (reviewing every option at each reporting date when no triggering event has occurred) or under-applied (never revisiting the original assessment despite material changes in the lessee's circumstances). ISA 540.13(b) requires the auditor to evaluate whether the data and assumptions used in the estimate remain appropriate at the reporting date.
Termination option vs. extension option
| Dimension | Termination option | Extension option |
|---|---|---|
| What it does | Gives the lessee the right to end the lease before the contractual expiry date | Gives the lessee the right to continue the lease beyond the non-cancellable period |
| Effect on lease term | Shortens the lease term if the lessee is reasonably certain to exercise | Lengthens the lease term if the lessee is reasonably certain to exercise |
| Reasonable certainty test | Assess whether the lessee is reasonably certain not to exercise (IFRS 16.18) | Assess whether the lessee is reasonably certain to exercise (IFRS 16.18) |
| Typical penalty structure | Lessee pays a termination penalty to exit early | No exercise fee in most contracts, though some include above-market rent in the extension period |
| Common documentation gap | Teams assume the short term without documenting why the post-termination period was excluded | Teams assume the long term without documenting why the extension was included |
Both options feed into the same lease term calculation and are governed by the same factors in IFRS 16.B37–B40. The practical difference is directional: a termination option assessment asks whether there is enough economic incentive to stay, while an extension option assessment asks whether there is enough economic incentive to extend. On a single lease with both options, the entity must assess each one separately and document both conclusions.
Related terms
Frequently asked questions
Does a termination option always shorten the lease term?
No. A termination option shortens the lease term only when the lessee concludes it is reasonably certain to exercise the option. If the lessee is reasonably certain not to terminate (because of leasehold improvements, penalties, or lack of alternatives), the full period beyond the termination date remains in the lease term per IFRS 16.18. The option exists in the contract, but it does not change the accounting unless the exercise threshold is met.
What happens if a lessee exercises a termination option it originally excluded from the lease term?
The exercise itself is a triggering event under IFRS 16.20. The lessee remeasures the lease liability using a revised discount rate at the reassessment date and adjusts the right-of-use asset by the same amount. If the remaining lease term drops to zero, both the liability and the asset are derecognised. Any termination penalty is recognised as an expense when the obligation becomes unavoidable. ISA 540.13(a) requires the auditor to evaluate whether the entity accounted for the reassessment correctly.
How do I document a termination option assessment in the working papers?
Record the option exercise date, the penalty amount, each factor from IFRS 16.B37–B40 (leasehold improvements, alternative premises, contractual terms, entity-specific history), and the conclusion on reasonable certainty. ISA 230.8 requires that documentation be sufficient to enable an experienced auditor with no prior connection to the engagement to understand the judgments made. A bare statement of 'not reasonably certain to terminate' without the supporting analysis fails that test.