Depreciation periods for right-of-use assets will change if the lessee revisits extension and termination options

Depreciation is often seen as a simple aspect of accounting that doesn’t take much time or require much thought. But as we’ve shown in recent articles, the rules for depreciating leased assets (called right-of-use assets) aren’t always the same as for things a company owns, like property, plant and equipment. Previously, we explained how depreciating right-of-use assets may commence before owned property, plant and equipment and also that the depreciation period for right-of-use assets may be different to owned property, plant and equipment. In this article, we look at how the depreciation period for right-of-use (ROU) leased assets needs to change when a lessee updates its plans about whether it will extend or end a lease early.

What is the depreciation period for a right-of-use asset?

Generally, a lessee will depreciate its ROU assets from the commencement date of the lease (i.e. the date on which the underlying leased asset is made available by the lessor for use by the lessee) to the earlier of the end of the ROU asset’s useful life and the end of the lease term.

Depreciation period for a right-of-use (ROU asset) →

		End of useful life of ROU asset
Commencement date of lease (when lessor makes ROU asset available for use by lessee)	Earlier of: →	OR
		End of lease term

However, if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term, or if the cost of the ROU asset reflects that the lessee will exercise a purchase option, the lessee will depreciate the ROU asset from the commencement date to the end of the useful life of the underlying asset, which may be after the end of the lease term.

What is the useful life of a ROU asset?

Useful life is generally the period over which an entity expects a ROU asset to be available for use by an entity. This is often the same as the lease term if the lessee does not obtain ownership of, or does not exercise an option to purchase, the ROU asset at the end of the lease.

What is the lease term?

The lease term is the non-cancellable period for which a lessee has the right to use the ROU asset, and includes the period covered by:

An extension option if the lessee is reasonably certain to exercise the extension option, and
An option to terminate the lease if the lessee is reasonably certain not to exercise that option.

This lease term will drive the period over which the ROU asset is then depreciated.

Therefore, at the commencement date of the lease, the lessee must assess whether it is reasonably certain to exercise or not exercise these options.

Factors that the lessee would consider include:

Lease terms vs. market rates: Are the future lease payments better or worse than what’s available in the market?
Extra payments: Are there any extra costs, like penalties or guarantees, that could affect the decision?
Significant leasehold improvements made: Has the lessee spent money, or does it intend to spend money, improving the asset in a way that provides significant economic benefits to keep using?
Exit costs: Would it cost a lot to end the lease, move, or find and set up a new asset?
How essential the asset is: Is the asset unique, in a key location, or hard to replace?
Conditions for using the option: Are there any conditions that must be met before the lessee can extend or terminate?

Example 1

Restaurant Chain ABC entered into a five-year lease for a retail store in Shopping Mall XYZ on 1 January 20X1. The lease is non-cancellable and provides Restaurant Chain ABC with the option to extend the lease for a further five years.

Scenario one

Scenario two

Restaurant Chain ABC has operated 25 similar format restaurants in other Australian locations over the past ten years. Typically, it installs a store fit-out intended to last at least ten years. At the commencement date of the lease (1 January 20X1), it assesses that it is reasonably certain to exercise the five-year extension option.

Analysis

In both scenarios in this example, the useful life is assumed to be the same as the lease term. In scenario one, the lease term is only five years because Restaurant Chain ABC concludes it is not reasonably certain to exercise the extension option, as it has no experience running this new type of restaurant. Contrast this with scenario two, where Restaurant Chain ABC has significant experience running these types of restaurants and installs leasehold improvements with a useful life of ten years.

	Scenario one: Don’t exercise extension option	Scenario two: Exercise extension option
Lease term	Five years	Ten years
Depreciation period for ROU asset (retail store)	Five years	Ten years

Changes to lease terms when options are exercised (or not exercised)

As noted earlier, the initial lease term determined on the commencement date includes the lessee’s assessment of the likelihood it will exercise extension options or not exercise termination options (i.e. it must be reasonably certain, a high threshold).

However, the lease term will subsequently change if any of the following occur:

The lessee exercises an option not previously included in the assessment of the lease term
The lessee does not exercise an option previously included in the assessment of the lease term
An event occurs that contractually obliges the lessee to exercise an option not previously included in the assessment of the lease term
An event occurs that prohibits the lessee from exercising an option previously included in the assessment of the lease term.

In all of the above instances, the lease term will change. This will trigger remeasurement of the lease liability using a revised discount rate, with a corresponding adjustment to the ROU asset.

The new lease term will similarly increase or reduce the depreciation period (depending on whether the lease term increases or decreases).

Example 2

Scenario one

Restaurant Chain ABC is setting up a new format restaurant that is not operating in any other locations. At the commencement date of the lease (1 January 20X1), it assesses that it is not reasonably certain to exercise the five-year extension option. Three years into the lease, Restaurant Chain ABC has built up a thriving new restaurant concept and exercises the extension option on 31 December 20X3.

Analysis – Scenario one

The initial lease term at the commencement date is only five years because Restaurant Chain ABC concludes it is not reasonably certain to exercise the extension option, as it has no experience running this new type of restaurant. However, at the end of the third year, Restaurant Chain ABC exercised its extension option. The remaining lease term is therefore seven years, not two.

The lease liability will be remeasured on 31 December 20X3 using a revised discount rate, with a corresponding increase to the ROU asset. The remaining depreciation period for the ROU asset will also increase from two to seven years.

Scenario two

Restaurant Chain ABC has operated 25 similar format restaurants in other Australian locations over the past ten years. Typically, it installs store fit-outs intended to last at least ten years. At the commencement date of the lease (1 January 20X1), it assesses that it is reasonably certain to exercise the five-year extension option.

Restaurant Chain ABC does not run profitably and four years into the lease (on 31 December 20X4), it gives notice to the lessor that it will not exercise its option to extend the lease for another five years. This is despite having installed a store fit-out with a useful life of ten years.

Analysis – Scenario two

The initial lease term at the commencement date is ten years. Restaurant Chain ABC concludes it is reasonably certain to exercise the extension option as it has significant experience running these types of restaurants and has installed leasehold improvements with a useful life of ten years.

However, at the end of the fourth year, Restaurant Chain ABC notified the lessor of its intention not to exercise its extension option. Therefore, the remaining lease term is for only one year, not six.

The lease liability will be remeasured on 31 December 20X4 using a revised discount rate, with a corresponding decrease to the ROU asset. The remaining depreciation period for the ROU asset and the leasehold improvements (store fit-out) will also decrease from six years to one year. That is, depreciation on the carrying amount of the ROU asset will be accelerated.

Changes to lease terms when reassessing ‘reasonably certain’ criteria

Other than when the outcome of options not previously considered ‘reasonably certain’ is finally determined, lessees must also reassess the length of the lease term where a significant event has occurred or there has been a significant change in circumstances that:

Is within the lessee’s control, and
Affects whether the lessee is reasonably certain to exercise an extension option not previously included in the lease term, or not exercise a termination option previously included in the lease term.

This will change the lease term, noted above, used to calculate the ROU asset and also the depreciation period.

Here are some examples of major changes that might require a company to reassess the lease term of a ROU asset:

Unexpected upgrades: The lessee makes significant leasehold improvements to the leased asset that weren’t planned at the start, and will benefit them if they stay longer or buy the asset.
Big changes to the asset: The lessee customises or modifies the asset in a significant way that wasn’t expected when the lease began.
New sublease: The lessee starts renting out the asset to someone else for longer than the original lease term.
Business decisions: The lessee makes a choice that affects whether they’ll stay or leave—like renewing a related lease, selling off an alternative asset, or shutting down the part of the business that uses the leased asset.

Example 3

Three years into the lease, Restaurant Chain ABC has built up a thriving new restaurant concept and decides to revamp its store fit-out to accommodate a bigger seating area. It incurs a significant amount of capital expenditure (CAPEX) for this purpose. It has not yet formally exercised its extension option, but the improvements are expected to have a useful life of at least seven years.

Analysis

However, at the end of the third year, Restaurant Chain ABC must reassess the lease term because a significant event (the expanded store fit out) has occurred that is within the lessee’s control, and affects whether the lessee is reasonably certain to exercise an extension option not previously included in the lease term.

Restaurant Chain ABC is now reasonably certain to exercise the extension option because of its significant spend on store fit-out, which has an expected useful life of at least seven years.

The lease liability will be remeasured on 31 December 20X3 using a revised discount rate, with a corresponding increase to the ROU asset. The remaining depreciation period for the ROU asset will also increase from two to seven years.

It should be noted that lessees are not required to reassess the length of the lease term at each reporting date because the International Accounting Standards Board considered that such an approach would be too costly for entities with many leases to implement. Therefore, IFRS 16 does not provide a mechanism to permit entities to reassess the length of the lease term in circumstances other than if:

A significant event has occurred or there has been a significant change in circumstances that affects whether the lessee is reasonably certain to exercise an extension option not previously included in the lease term, or not exercise a termination option previously included in the lease term, and
The significant event or significant change in circumstances is within the entity’s control.

More information

Our publication contains in-depth discussion and examples to help you apply IFRS 16 to your organisation.

Need help?

BDO offers comprehensive support for your lease accounting needs. Our cloud-based system, BDO Lead, simplifies the complexities of implementing IFRS 16. We also provide outsourced leased management services, handling your lease accounting using BDO Lead.

For assistance, please contact BDO’s IFRS & Corporate Reporting team.