Exercising options with lease terms

Definitions, factors to consider when exercising an option, lease exemptions, and more.

Jump to:

The incremental borrowing rate (IBR) is the rate most companies will use to discount the lease liability. In this blog, we are going to look at another component that will go into the calculation of the lease liability – the lease term. 

At first glance “lease term” may sound like a simple concept. However, once you encounter leases with “optional” periods, it may be a bit more complicated than expected to figure out what the lease term is.  

At lease inception, a lease liability is booked; the liability will be discounted using the selected rate (for example, the incremental borrowing rate) and over the term of the lease. Just as the rate used will impact the amount of the liability, the lease term will have an impact as well. 

What is a lease term?

Lease term is the noncancelable period in which the lessee has the right to use an underlying asset together with optional periods for which it is reasonably certain that the lessee will exercise the renewal option or not exercise the termination option or in which the exercise of those options is controlled by the lessor. 

So, our main objective is to determine whether it is reasonably certain that the lessee will exercise the renewal option or not exercise the termination option. 

Based on the definition of lease term above, the questions that will arise are: 

1. Which factors should be considered when assessing to exercise a renewal option?
2. What does “reasonably certain to exercise an option” mean?

Let’s explore the implications of these two questions. 

Which factors should be considered when assessing to exercise a renewal option?

At the beginning of the lease term, we may not be sure whether we are going to exercise an option. So, we’ll have to make an assessment. Here are some factors to think through and the related considerations: 

• Entity-specific factors 

Contract-based factors

If the contract requires the lessee to incur substantial costs to restore the asset before returning it to the lessor, it may be an indication the lessee will exercise the option to renew. 

Asset-based factors

If the lessee has installed significant leasehold improvements that would still have economic value when the option becomes exercisable or the facility is in a geographically desirable location with no other viable locations, it may be an indication the lessee will exercise the renewal option. 

Entity-specific factors

If management is working on a project that is expected to extend beyond the time the contract end date, it may be an indication the lessee will exercise the renewal option. 

Market-based factors

If comparable rentals in the area are increasing in price or there aren’t any other feasible options, it may be an indication the lessee will exercise the renewal option. 

What does “reasonably certain to exercise an option” mean?

“Reasonably certain” means that the likelihood of exercising an option based on the above factors in this case means almost certain. So, in other words, if one of the factors above exists, we can conclude that based on the factor, we are almost certain we would exercise an option. 

Remember, the objective is to figure out at what amount the liability should be booked – ultimately, it’s about recognizing a liability so optional terms should only be included in the measurement of the lease liability when the lessee has almost no choice (economically) but to exercise the option. 

In other words, it is reasonably certain that a liability exists when any of the above factors indicate that the lessee would be compelled to renew the lease or to exercise a purchase option.  

One other thing worth noting here is that there is a short-term lease exemption. 

What is a short-term lease exemption?

According to the leases standard 842, a short-term lease is a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. 

If we have a lease that meets this definition, 

• Lessee has option to apply simplified guidance, similar to current operating leases (no asset or liability recognized) 

• Recognize lease payments on a straight-line basis over the lease term 

• No asset or liability on the balance sheet 

• Policy election on asset-class basis 

So, now we must consider the following: At the commencement date, is the lease term 12 months or less?

Examples of short-term lease exemptions

Here are two separate examples that will display how two identical arrangements can result in two separate ways of accounting for the leases, based on the assessment of whether it is reasonably certain the lessee will exercise a renewal option. 

In the first scenario, 

• ABC Company (lessee) enters into a contract to lease a piece of construction equipment for a six-month period, with the option to extend the term for up to twelve additional months (in three-month increments). 

• Considering the nature of the project, ABC determines that it expects to use the equipment for only nine months and so is reasonably certain that it will exercise only one of the four renewal options. 

• Since the lease term is not more than 12 months (it’s only 9 months), ABC would be able to elect the short-term lease exemption. 

In the second scenario, 

• ABC Company (lessee) enters into a contract to lease a piece of construction equipment for a six-month period, with the option to extend the term for up to twelve additional months (in three-month increments). 

• The equipment is to be used in a project expected to take 18 months. 

• ABC expects to use the equipment for 18 months and so is reasonably certain to exercise all four renewal options. 

• The expected lease term is greater than 12 months so ABC would not be able to elect the short-term lease exemption. 

So, even though the facts are the same in both scenarios, the first scenario results in no lease asset or liability being booked while the second scenario results in a lease asset and liability being booked. Pay close attention to how clients are making these assessments. 

Assessing lease terms

Determining the lease term may often involve assessing whether an option, that may result in a different term than the fixed term, will be exercised. When making this assessment, consider contract-based, asset-based, entity-based and market-based factors.  

To include the optional period in the lease term, it must be “reasonably certain” that the lessee will exercise the option. It is important to understand how to make these assessments (or how our clients are making these assessments) to ensure that the lease asset and lease liability are properly booked. 

Webinar Preparing for the New Leases Standard (ASC 842) Watch our free on-demand webcast for an overview of the ASC 842 lease standard. Emphasis includes areas such as lease definition, lease classification, balance sheet presentation, transition, lease term, lease payment, lessee accounting, implementation considerations and disclosure requirements.

Related blogs:

Research tool Checkpoint Catalyst US GAAP A next generation online research tool that provides valuable insight on business combinations, consolidation, financial instruments, income taxes, leases, and revenue recognition.

Story originally seen here