The lease term is the time both parties adhere to the lease agreement. A lease extension option allows the lessee to extend the lease, usually for an amount of time equal to or less than the term of the original lease. Extension options can also provide new lease terms, including a change in the dollar amount of lease payments, among other changes.
If there is no extension or renewal option, there is no obligation to extend or renew the lease. If the extension option is in the lease agreement and the lessee requests an extension, the lessor must agree to the terms of the option.
The lease agreement will cover the required notice that a lessee must give when exercising an extension option, the number of allowed extensions, and the lengths of said extensions.
Extension options are an important part of GASB 87 lease determination. Short-term leases (leases 12 months or less) are excluded from the standard. The lease term is measured as the maximum possible term of the lease. So in this case, even if a lease is only 6 months, if they have a one year renewal option, this lease would still qualify for GASB 87 as the maximum possible lease term is 18 months.
Example:
A municipality has entered into a 10-year lease for a facility. The lease has two five-year lease extension options. That is, the initial lease term is ten years, but the maximum lease term can be 20 years if both five-year lease extension options are exercised.
The lease extension, also known as lease renewal, is important to consider when determining the term of your agreement. These maximum possible lease terms are important when determining whether or not your agreement is considered a short-term lease, or if it will qualify for the GASB 87 standard.