Lease Term Under IFRS 16 for Cancellable Property Rental Contracts

A business opens a second office in a building and signs a rental contract with the landlord. The contract runs for 5 years, but either party can end it at any time by giving 60 days’ notice, with no penalty for doing so. How does this affect the lease term recognized under IFRS 16, and how should the accounting team record it?

IFRS 16 was issued in 2016 and required implementation from 1 January 2019, fundamentally changing how lessees account for lease contracts. Under the previous standard, IAS 17, lessees could simply record rental costs as an expense in profit or loss for the duration the lease operated. Under IFRS 16, that treatment no longer applies, lessees instead recognize a right-of-use asset and a corresponding lease liability on the statement of financial position for most leases, with rental payments split between reducing the lease liability and finance cost, alongside amortization of the right-of-use asset.

This guide explains how to determine the lease term where a contract includes cancellation clauses, walks through two worked examples showing how mutual versus one-sided termination rights change the outcome, and covers the short-term lease exemption.

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Determining the Lease Term Under IFRS 16

Under IFRS 16, the lease term is the non-cancellable period of the lease, the period during which the agreement is genuinely enforceable. If either party can end the lease unilaterally, with no penalty for doing so, the agreement isn’t enforceable beyond the point that termination right becomes exercisable, regardless of what the contract’s stated overall duration says.

Worked Example 1: Mutual Termination Right

In the opening scenario, the contract states a 5-year duration, but either party, lessor or lessee, can terminate with 60 days’ notice and no penalty. Because both parties hold this right, and there’s no financial or practical barrier stopping either side from exercising it, the lease isn’t genuinely non-cancellable beyond that 60-day window. The lease term for accounting purposes is therefore treated as short, generally the 60-day notice period, not the stated 5-year duration, since the business could genuinely be required to vacate, or could choose to leave, well before the 5 years are up.

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Worked Example 2: One-Sided Termination Right (Lessor Only)

Now consider a different scenario: a 10-year lease where only the lessor holds the right to terminate, on 2 months’ notice, and the lessee has no equivalent right to end the lease early. From the lessee’s perspective, this is a meaningfully different situation. The lessee can’t unilaterally walk away, so the lessee’s own obligation runs for the full stated term. The lessor’s right to terminate doesn’t shorten the lease term for the lessee’s accounting purposes, it simply represents a risk that the lessor might exercise that right at some point, not a right the lessee itself controls.

This is why a lessor’s unilateral termination right is often overlooked when determining lease term, and it should be, from the lessee’s side, the full 10-year period remains the relevant non-cancellable period for recognizing the right-of-use asset and lease liability, even though the lessor could theoretically end the arrangement early.

The Short-Term Lease Exemption

There are situations where a lessee doesn’t need to recognize a right-of-use asset at all. This applies where the lease term is 12 months or less (a genuine short-term lease with no purchase option), or where the underlying asset is low-value when new, such as furniture or standard office computers.

Once a business determines a lease qualifies as short-term, it has two options: apply the exemption, or book the rental payments as an expense in profit or loss for the lease’s duration. The exemption must be applied consistently across an entire class of underlying assets, not selectively to individual leases within that class. A bank regularly renting branch offices under similar terms, for example, needs to apply the exemption to all its branches uniformly, not to some branches and not others.

Where a lease isn’t exempt, it must be accounted for like any other lease, recognizing a right-of-use asset and corresponding lease liability, even where doing so is administratively more involved than the short-term treatment would have been.

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How Farahat & Co. Can Help

Farahat & Co., a leading Audit & Accounting Firm, helps businesses correctly determine lease terms under IFRS 16, apply the short-term lease exemption consistently, and account for right-of-use assets and lease liabilities in compliance with the standard.

Contact Farahat & Co. today to discuss your IFRS 16 lease accounting requirements.