Chapter 5 — Commencement Date, Lease Term, and Purchase Options

5.4 Reassessment of Lease Term and Purchase Options

5.4.1 Lessees

ASC 842-10

35-1 A lessee shall reassess the lease term or a lessee option to purchase the underlying asset only if and at the point in time that any of the following occurs:

There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease.
The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.

35-2 See paragraphs 842-10-55-28 through 55-29 for implementation guidance on reassessing the lease term and lessee options to purchase the underlying asset.

55-28 Examples of significant events or significant changes in circumstances that a lessee should consider in accordance with paragraph 842-10-35-1 include, but are not limited to, the following:

Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable
Making significant modifications or customizations to the underlying asset
Making a business decision that is directly relevant to the lessee’s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset)
Subleasing the underlying asset for a period beyond the exercise date of the option.

55-29 A change in market-based factors (such as market rates to lease or purchase a comparable asset) should not, in isolation, trigger reassessment of the lease term or a lessee option to purchase the underlying asset.

After lease commencement, a lessee must be on the lookout for the occurrence of certain discrete events or changes in circumstances that are within the control of the lessee, as described in ASC 842-10-35-1 and ASC 842-10-55-28. Upon the occurrence of such an event or change in circumstances that is within the control of the lessee, a lessee must reassess the lease term or its conclusion about whether exercise of a purchase option is reasonably certain. A lessee would not reassess the lease term or its conclusion about whether exercise of a purchase option is reasonably certain on the basis of the occurrence of events that are outside its control (e.g., on the basis of only market-driven factors, like changes in fair market rental rates).

When there is a change in lease term or in the conclusion about whether it is reasonably certain that an option to purchase the underlying asset will be exercised, a lessee must (1) reassess lease classification, (2) remeasure the lease liability by using revised inputs as of the reassessment date, and (3) adjust the associated ROU asset. For more information, see Sections 8.3.1 and 8.5.1.

The example below illustrates a scenario in which the lessee would not be required to perform a lease term reassessment.

Example 5-8

On June 15, 20Y1, Company A leases a building to be used as a storage and distribution warehouse for a 10-year term, with two 5-year renewal options. Company A initially determines that, on the lease commencement date, it is not reasonably certain that it will exercise either of the renewal options and therefore concludes that the lease term is 10 years.

On January 15, 20Y5, the city in which the warehouse is located significantly improves its highway system, thereby making the warehouse location more desirable for A’s distribution needs. This by itself would not result in the need for A to reassess whether it will exercise any remaining renewal options, since the significant event or change in circumstances is outside of A’s control.

5.4.1.1 Reassessing the Lease Term and Purchase Options Upon Construction of Leasehold Improvements

In addition to evaluating the impact of leasehold improvements at lease commencement, an entity should consider the effect of leasehold improvements that are made after lease commencement. As discussed in Section 5.4.1, a lessee is required to reassess the lease term or a lessee option to purchase the underlying asset when a significant event or a significant change in circumstances that is within the control of the lessee directly affects whether the lessee is reasonably certain to exercise its related option.

In accordance with ASC 842-10-55-28, a lessee should assess the nature and effect of significant leasehold improvements constructed after the lease commencement date to determine whether the lessee is required, as a result of such improvements, to reassess the lease term and the probability of exercising a purchase option, if applicable.

Example 5-9

On January 15, 20Y5, A installs leasehold improvements with a 10-year estimated useful life. The cost of the improvements is significant, and it is now reasonably certain that A will exercise at least one of its renewal options to avoid losing the value associated with the improvements. In this case, since the change in circumstances is directly attributable to A’s actions, reassessment of the lease term would be required.

5.4.1.2 Impact of ROU Asset Impairment Indicator on Lease Term

As discussed in Section 8.4.4, lessees are required to test ROU assets for impairment in accordance with ASC 360 when events or changes in circumstances indicate that the carrying amount of an asset group containing an ROU asset may not be recoverable (i.e., an impairment indicator). In some cases, a lessee may have concluded at lease commencement that it was reasonably certain to exercise a renewal option (or not exercise a termination option); however, upon the occurrence of an impairment indicator, the lessee may no longer be reasonably certain that it will exercise the renewal option. Therefore, if the lessee were to reassess the lease term upon the occurrence of the impairment indicator, it would no longer include the renewal period in the lease term. If this reassessment was allowed, the ROU asset subject to the ASC 360 impairment test would decrease and the total potential impairment would most likely be reduced.

However, an ROU asset impairment indicator alone should not trigger a reassessment of the lease term. ASC 842-10-35-1 states that a lessee should only reassess the lease term when one of the following conditions is met:

There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease.
The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.

Under ASC 842-10-35-1(a), for a significant event or change in circumstances to trigger a lease term reassessment, the event or change in circumstances must be within the lessee’s control. ASC 842-10-55-28 and 55-29 provide implementation guidance on the types of events that would or would not meet this requirement:

55-28 Examples of significant events or significant changes in circumstances that a lessee should consider in accordance with paragraph 842-10-35-1 include, but are not limited to, the following:

Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable
Making significant modifications or customizations to the underlying asset
Making a business decision that is directly relevant to the lessee’s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset)
Subleasing the underlying asset for a period beyond the exercise date of the option.

Therefore, a lessee should not reassess the lease term solely because of external events or changes in circumstances that are outside the lessee’s control.

On the other hand, ASC 360-10-35-21 gives the following examples of impairment indicators:

A significant decrease in the market price of a long-lived asset (asset group)
A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition
A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator
An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group)
A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group)
A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50 percent.

Accordingly, a significant event or change in circumstances driven solely by market-based factors (e.g., a significant decrease in market price) may constitute an impairment indicator under ASC 360 but would not qualify, in isolation, as a lease term reassessment event.

Furthermore, in many situations involving asset group impairments, management may have made an internal decision not to exercise the renewal option and may have communicated this decision publicly or to the board of directors. However, we do not believe that such an internal decision alone constitutes a lease term reassessment event, because no significant event or change in circumstances within the lessee’s control has yet taken place.

Therefore, upon the occurrence of an impairment indicator, entities should separately consider whether one of the conditions in ASC 842-10-35-1 related to reassessing the lease term has also been met. If none of those conditions are met, a lessee would not be permitted to change the lease term, even though the lessee may no longer be reasonably certain to exercise a renewal option previously included in the lease term.

Example 5-10

Scenario 1

On July 1, 20X2, Retailer L enters into a 10-year operating lease of a building with a 10-year renewal option. At lease commencement, L is reasonably certain that it will exercise the renewal option because of its installation of significant leasehold improvements; therefore, L determines that the initial lease term is 20 years. However, as a result of a significant decrease in market demand for L’s products, L concludes that an impairment indicator exists on June 30, 20X7, at which point L is no longer reasonably certain that it will exercise the renewal option; accordingly, L’s management communicates to L’s board of directors that it no longer intends to exercise the option.

The change in L’s conclusion regarding the exercise of the renewal option is solely a result of the decrease in market demand. No significant event or change in circumstances has occurred that is within L’s control and directly affects whether L will exercise the renewal option. Therefore, L would not reassess the 15-year remaining lease term on June 30, 20X7, and would test the asset group containing the full ROU asset for impairment in accordance with ASC 360.

Scenario 2

Assume that in addition to experiencing a significant decrease in market demand for its products (as addressed in Scenario 1 above), L disposes of its significant leasehold improvements on June 30, 20X7. In this scenario, L concludes that the disposal constitutes a significant change in circumstances that is within its control and directly affects whether it will exercise the renewal option. Therefore, L would reassess the lease term on June 30, 20X7, and since it is no longer reasonably certain that it will exercise the renewal option, L would reduce the remaining lease term from 15 years to 5 years and would remeasure the lease, resulting in a decrease in the lease liability and the corresponding ROU asset. Then, L would test the asset group containing this lower ROU asset for impairment in accordance with ASC 360.

5.4.2 Lessors

ASC 842-10

35-3 A lessor shall not reassess the lease term or a lessee option to purchase the underlying asset unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8. When a lessee exercises an option to extend the lease or purchase the underlying asset that the lessor previously determined the lessee was not reasonably certain to exercise or exercises an option to terminate the lease that the lessor previously determined the lessee was reasonably certain not to exercise, the lessor shall account for the exercise of that option in the same manner as a lease modification.

A lessor does not reassess the lease term or a lessee purchase option unless the lease is modified and the modification is not accounted for as a separate contract. A lessee’s exercise of an option to extend or terminate the lease or purchase the underlying asset would be accounted for by the lessor in a manner similar to a lease modification unless the initial lease term determination includes the effects of those options. If a lessor includes in its lease term an optional renewal period because it is reasonably certain that the lessee would exercise that option, the lessor would not account for the lessee’s exercise of the renewal option as a lease modification. See Section 9.3.4 for detailed discussion of the contract modification guidance for lessors.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.