Lessee accounting: What is my lease term under ASC 842?
The lease term, as defined in Topic 842, is not necessarily the period between the contractual lease start and end dates. There may be factors within or outside of the lease that could impact an entity’s determination of lease term. Understanding how to determine the term of a lease is foundational to the application of Topic 842. This article provides insight into the determination of a lease term including considerations entities should incorporate into their analyses.
Topic 842 defines lease term as the noncancellable period of the lease, together with all of the following: (i) periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; (ii) periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option; and (iii) periods covered by an option to extend (or not terminate) the lease in which the exercise of the option is controlled by the lessor.
Identifying the commencement date under Topic 842 is integral to determining the lease term. The commencement date is “the date on which a lessor makes an underlying asset available for use by a lessee” (ASC 842-10). However, the commencement date under Topic 842 may not align with the start date in the lease agreement or the inception date of the lease. Further, the commencement date of a lease is not necessarily the date on which the lessee begins making lease payments and could occur prior to the contractual start date. For example, assume a lessee signs a lease on June 15, 2022, for office space and lease payments begin on Jan. 1, 2023. The lessor gives control of the leased office space to the lessee on July 1, 2022, so the lessee can make leasehold improvements to the leased office. In this example, the lease commencement date is July 1, 2022, because that is the date the lessor conveyed the right to control the use of the office space to the lessee. The commencement date is important because that is the date on which the entity determines classification of, and initially measures, the lease.
After determining the lease commencement date, the next step is to determine the noncancellable period of the lease. The noncancellable period is determined by the period of time that the lease agreement is enforceable. A lease is no longer considered enforceable when either party (i.e., lessee or lessor) can terminate the lease without permission from the other party and with no more than an insignificant penalty (ASC 842-10-55-23). If a lease agreement includes an option to terminate with a penalty that is considered significant, then the lease term would encompass the period from the commencement date up through and including the date on which the termination option is exercisable. Also, even though there may be a period of time where the lease is enforceable, it could be considered cancellable and impact the determination of the lease term. For example, a termination option in which one party can terminate the lease with an insignificant penalty would be considered enforceable but cancellable. The key, in that example, is that only one party has the termination right with an insignificant penalty and not both.
When there are termination provisions in the lease agreement, it is important to assess their impact on the lease term. An option where the lessee can terminate the lease during the enforceable period will need to be assessed by the entity at lease commencement to determine if it is reasonably certain it will exercise the termination option. The lease term may extend beyond the date on which the lessee can exercise a termination option if it is reasonably certain that the lessee will not exercise such right to terminate the lease. The entity may consider factors such as provisions in the lease, type, and intended use of the underlying asset, market, past practices, estimates, and a lessee’s intentions in determining whether exercising an option is reasonably certain or not. Other termination provisions might be at the option of the lessor only. With lessor-only termination options, the lessee would assume that the lessor will not exercise a lessor-only termination right when determining the lease term. This is because the lessee does not have control over the lessor, and the lessee would therefore assume that the lessor will not terminate the lease.
A lease may also include a termination option that can be exercised by the lessee that is based on a contingent event. For example, a lessee may enter into a lease for a retail store for a 10-year period that is noncancellable. However, if sales are below a certain threshold for three consecutive years after year two of the lease, then the reporting entity has the option to terminate the lease. In this case, the entity would still assess whether it is reasonably certain to exercise the termination option or not. In this case, the entity would likely consider its forecasted sales levels and the probability of whether the sales will fall below the threshold in order to make that assessment.Options to extend (i.e., renewal options) the lease are assessed in a manner similar to how options to terminate are assessed. If the lessee is reasonably certain to exercise a renewal option, then the period of that renewal is included in the lease term at lease commencement. If the lessor controls the renewal option, the lessee will include that period in its lease term. A reporting entity would use the same type of factors, noted above in assessing termination options, to determine whether it is reasonably certain to exercise a renewal option. ASC 842-10-55-26 provides examples of economic factors to consider including:
a. Contractual terms and conditions for the optional periods compared with current market rates, such as:
1. The amount of lease payments in any optional period
2. The amount of any variable lease payments or other contingent payments, such as payments under termination penalties and residual value guarantees
3. The terms and conditions of any options that are exercisable after initial optional periods (for example, the terms and conditions of a purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates).
b. Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or to purchase the underlying asset becomes exercisable.
c. Costs relating to the termination of the lease and the signing of a new lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee’s operations, or costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location.
d. The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset and the location of the underlying asset.
When a lessee is assessing whether a renewal option is reasonably certain to be exercised or not, it would not look solely to its history of exercising renewal options. Past decisions may have been in response to other factors or market conditions that occurred at that time and may not exist today. For example, if a lessee had previously leased office space with few leasehold improvements and did not exercise the renewal option. History may not be a good indicator if the same lessee has a renewal option on another leased office space that has significant leasehold improvements. Market-based factors should also be considered. For example, assume a lessee had exercised a renewal option on a lease of office space because market rental rates were expected to increase and therefore exceed contractual rent payments during the renewal period. Similar market factors may not exist at the commencement date of a new lease; for example, perhaps market rental rates are expected to go down due to current and expected economic conditions. Alternatively, the renewal option price may not be low enough in relation to estimated future market rents to conclude that exercise of the renewal is reasonably certain. As highlighted with these examples, the decision to renew a lease may be based on a number of factors and, as a result, entities should weigh and assess those factors in aggregate when making their assessment.
Determining the lease term is important because the lease term impacts lease classification and is used in the present value measurements when the lease is initially recorded as well as the ongoing measurements required over the lease term. As discussed in this article, determination of the term of a lease necessitates a holistic approach.