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

5.3 Purchase Options

5.4 Reassessment of Lease Term and Purchase Options

5.1 Commencement Date of a Lease

ASC 842-10 — Glossary

Commencement Date of the Lease (Commencement Date)

The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs 842-10-55-19 through 55-21 for implementation guidance on the commencement date.

ASC 842-10

55-19 In some lease arrangements, the lessor may make the underlying asset available for use by the lessee (for example, the lessee may take possession of or be given control over the use of the underlying asset) before it begins operations or makes lease payments under the terms of the lease. During this period, the lessee has the right to use the underlying asset and does so for the purpose of constructing a lessee asset (for example, leasehold improvements).

55-20 The contract may require the lessee to make lease payments only after construction is completed and the lessee begins operations. Alternatively, some contracts require the lessee to make lease payments when it takes possession of or is given control over the use of the underlying asset. The timing of when lease payments begin under the contract does not affect the commencement date of the lease.

The commencement date of the lease is important under ASC 842 because that date is when (1) lease classification is determined (see Sections 8.3.2 and 9.2 for more information about lessee and lessor classification, respectively) and (2) the lease is initially measured (see Sections 8.4.2 and 9.3.2 for discussion of lessee and lessor initial measurement, respectively). As noted above, the commencement date is the “date on which a lessor makes an underlying asset [i.e., the PP&E subject to the lease] available for use by a lessee.” The commencement date may differ from the date stated in the contract and is not affected by when the lessee (1) must make lease payments (e.g., if the lessor grants the lessee a rent holiday) or (2) expects to use or actually uses the underlying asset. A lease agreement may grant the lessee access to and control over the leased asset before the beginning of the fixed noncancelable term stated in the lease agreement. This is common, for example, when the lessee needs time to construct leasehold improvements or otherwise prepare the leased space for its intended use. It is also common for the lessee not to be required to begin making rental payments until the beginning of the fixed noncancelable lease term.

However, a lease can commence, for accounting purposes, before the beginning of the fixed noncancelable term stated in a lease agreement. ASC 842-10-20 defines the lease commencement date as the “date on which a lessor makes an underlying asset available for use by a lessee.” Further, ASC 842-10-55-19 states that “[i]n some lease arrangements, the lessor may make the underlying asset available for use by the lessee . . . before it begins operations or makes lease payments under the terms of the lease.” In such cases, the lease commences when the lessee has access to and the right to control the use of the leased asset (see Section 3.4 for a detailed discussion of when a customer has the right to control the use of an identified asset), even if that occurs before the beginning of the fixed noncancelable lease term stated in the lease agreement.

Example 5-1

A lease agreement for office space is signed on January 1, 20X9, and the fixed noncancelable term begins on June 1, 20X9, at which time the lessee will begin making rental payments. Under the terms of the lease agreement, the lessee is granted access to the office space to make improvements to the space beginning on January 1, 20X9. In this situation, the lease term commences on January 1, 20X9.

There may also be instances in which a lessee controls an underlying asset before the commencement date of the lease. For example, this may be the case for transactions in which the lessee is involved with a construction project (i.e., the underlying asset that will be subject to the lease is in the process of being constructed). In such cases, the lessee would be required to recognize the asset as the “deemed owner” of the asset before lease commencement and must determine whether derecognition is appropriate as a sale-and-leaseback transaction. (See Chapter 11 for a detailed discussion of when the lessee controls an underlying asset before the commencement date of the lease, and see Chapter 10 for more information about the accounting for sale-and-leaseback transactions.)

Changing Lanes

Inception Date Versus Commencement Date

Unlike ASC 842, ASC 840 required entities to classify leases on the basis of the facts and circumstances present at lease inception (i.e., the date of the lease agreement or commitment, if earlier) instead of at lease commencement, which may lead to different conclusions regarding classification if facts and circumstances change between the dates (see the Changing Lanes discussions in Sections 8.3.2 and 9.2).

In addition, while a lease was initially recognized at lease commencement under ASC 840 as it is under ASC 842, the inputs used to initially measure the lease under ASC 842 are determined at different times than they were under ASC 840. For example, under ASC 840, inputs such as discount rate and fair value, as well as the lease classification itself, were determined at lease inception; however, under ASC 842, the inputs and lease classification are determined at lease commencement. As a result, there could be differences between the initial recognition of a lease under ASC 842 and that under ASC 840.

5.1.1 Lease Commencement Date for Master Lease Agreements

ASC 842-10

55-17 Under a master lease agreement, the lessee may gain control over the use of additional underlying assets during the term of the agreement. If the agreement specifies a minimum number of units or dollar value of equipment, the lessee obtaining control over the use of those additional underlying assets is not a lease modification. Rather, the entity (whether a lessee or a lessor) applies the guidance in paragraphs 842-10-15-28 through 15-42 when identifying the separate lease components and allocating the consideration in the contract to those components. Paragraph 842-10-55-22 explains that a master lease agreement may, therefore, result in multiple commencement dates.

55-22 There may be multiple commencement dates resulting from a master lease agreement. That is because a master lease agreement may cover a significant number of underlying assets, each of which are made available for use by the lessee on different dates. Although a master lease agreement may specify that the lessee must take a minimum number of units or dollar value of equipment, there will be multiple commencement dates unless all of the underlying assets subject to that minimum are made available for use by the lessee on the same date.

In a manner consistent with how an entity determines the commencement date for a single lease, an entity must determine the commencement date for each underlying asset that is leased under a master lease agreement on the basis of the date on which the underlying asset is made available for use by a lessee. Therefore, under a master lease agreement, there may be different commencement dates related to when the different underlying assets are made available for the lessee’s use. See Section 13.4 for more information about the accounting for master lease agreements.

5.2 Lease Term

ASC 842-10 — Glossary

Lease Term

The noncancellable period for which a lessee has the right to use an underlying asset, together with all of the following:

Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

ASC 842-10

30-1 An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following:

Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.

55-25 The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.

The lease term is an important input to lease classification and to the initial and subsequent measurement of a lease. The lease term is determined in accordance with ASC 842-10-30-1 (as illustrated below). The next sections further discuss the composition of the lease term and related issues.

5.2.1 Noncancelable Period and Enforceable Period

ASC 842-10

55-23 An entity should determine the noncancellable period of a lease when determining the lease term. When assessing the length of the noncancellable period of a lease, an entity should apply the definition of a contract and determine the period for which the contract is enforceable. A lease is no longer enforceable when both the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty.

A contract is an agreement between two or more parties that creates enforceable rights and obligations. Any noncancelable period within a lease contract would generally be considered enforceable and should be included in the lease term. In addition, cancelable periods should also be evaluated for enforceability in accordance with ASC 842-10-55-23. For a lease to no longer be enforceable under ASC 842-10-55-23, both parties must “have the right to terminate the lease . . . with no more than an insignificant penalty.” Accordingly, a lease is considered enforceable over a cancelable period if either (1) only one party has a termination right or (2) both parties have a termination right but either party would incur a more than insignificant penalty by terminating the lease. After determining the enforceable period, the parties should consider the guidance in ASC 842-10-30-1 (as discussed in Sections 5.2.2 and 5.2.3) to determine the lease term within the enforceable period (i.e., the lease term will either be shorter than or equal to the enforceable period). When either the lessee or lessor has the right to terminate a lease at any time upon giving notice to the other party, the noncancelable period of the lease would include this “notice” period.

Connecting the Dots

Enforceability Is a Broad Concept

As noted above, “noncancelable” and “enforceable” have different meanings under ASC 842, and entities are required to evaluate whether a contract is enforceable over optional periods on the basis of the economic consequences to the parties rather than solely on the basis of contractual or legal enforceability. Periods in which one or both parties have the contractual right, but not the obligation, to extend the agreement are enforceable but not noncancelable periods. Periods in which either party has — but both parties do not have — the right to terminate the agreement are also enforceable but not noncancelable periods. Periods in which both parties have the right to terminate the agreement are not enforceable unless either party would incur a more than insignificant penalty by exercising its right. For example, a lease would be considered enforceable over the period in which the lessee would incur a more than insignificant penalty by terminating the lease, even when the lease is subject to a contractual cancellation right held by the lessor.

Further, in determining the lease term, both the lessee and the lessor should evaluate options to extend or terminate the lease during the enforceable period. Enforceable periods covered by options that provide the lessor with the right to extend or unilaterally terminate the lease are included in the lease term (i.e., it is assumed that the lessor will extend or not terminate the lease). For enforceable periods in which the lessee has the right to extend or terminate the lease, the probability of exercise needs to be assessed. The lease term would include enforceable periods in which it is reasonably certain that the lessee will extend or not terminate the lease (see the next section). Importantly, “reasonably certain” (which is used in the determination of the lease term) differs from “more than insignificant” (which is used in the determination of the enforceable period). For example, when both parties have the right to terminate the lease yet the lessee would incur a more than insignificant penalty to do so, the optional period is enforceable, but this does not mean that the lessee is reasonably certain not to exercise its termination option. However, any economic penalty (or incentive) that would cause a lessee to be reasonably certain not to terminate a lease would also indicate that the lessee would incur a more than insignificant penalty by terminating the lease; the related period would thus be included in both the enforceable period and the lease term.

5.2.2 Periods Covered by Options (Reasonably Certain)

ASC 842-10

30-2 At the commencement date, an entity shall include the periods described in paragraph 842-10-30-1 in the lease term having considered all relevant factors that create an economic incentive for the lessee (that is, contract-based, asset-based, entity-based, and market-based factors). Those factors shall be considered together, and the existence of any one factor does not necessarily signify that a lessee is reasonably certain to exercise or not to exercise an option.

55-26 At the commencement date, an entity assesses whether the lessee is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment — contract-based, asset-based, market-based, and entity-based factors. An entity’s assessment often will require the consideration of a combination of those factors because they are interrelated. Examples of economic factors to consider include, but are not limited to, any of the following:

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).
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.
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.
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.

Entities must assess whether it is reasonably certain that a lease will continue into periods covered by renewal or termination options. When assessing the likelihood of whether a lessee will be economically compelled to (i.e., when assessing whether it is reasonably certain that a lessee will) exercise or not exercise an option to renew or terminate a lease, respectively, the lessee and lessor should consider various economic factors (e.g., contract-based, asset-based, entity-based, and market-based factors). Because the assessment of “reasonably certain” is based on judgments and estimates, lessees and lessors may reach different conclusions about whether it is reasonably certain that a lessee will exercise a renewal or purchase option or not exercise a termination option. Given the subjectivity involved in the evaluation of these economic factors, the longer the period from the commencement date of the lease to the date of exercising the option, the more difficult it would generally be to determine whether a lessee will be reasonably certain to exercise or not exercise an option to renew or terminate a lease (for example, it would be difficult to precisely predict the importance of an underlying asset to the lessee’s operations further into the future). In addition, to apply the short-term lease recognition exemption (discussed in detail in Section 8.2.1), lessees must perform this assessment and determine the lease term.

Connecting the Dots

“Reasonably Certain” and “Reasonably Assured”

Under IAS 17 (the predecessor standard to IFRS 16), an entity used the “reasonably certain” threshold to evaluate the lease term; this threshold is generally interpreted as high. When developing ASC 842, the Board decided to use the term “reasonably certain” to be consistent with IFRS 16 (which supersedes IAS 17). However, paragraph BC195 of ASU 2016-02 indicates that the “reasonably certain” threshold is substantially the same as the “reasonably assured” threshold under ASC 840. Therefore, we do not expect that ASC 842 will change the threshold used to determine the lease term; that is, “reasonably certain” will also be considered a high threshold of probability under ASC 842, as the FASB indicates in paragraph BC71(b) of ASU 2016-02.

ASC 842-10 — Glossary

Penalty

Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following:

Disburse cash
Incur or assume a liability
Perform services
Surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment. Factors to consider in determining whether an economic detriment may be incurred include, but are not limited to, all of the following:
1. The uniqueness of purpose or location of the underlying asset
2. The availability of a comparable replacement asset
3. The relative importance or significance of the underlying asset to the continuation of the lessee’s line of business or service to its customers
4. The existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the underlying asset
5. Adverse tax consequences
6. The ability or willingness of the lessee to bear the cost associated with relocation or replacement of the underlying asset at market rental rates or to tolerate other parties using the underlying asset.

As described in ASC 842-10-20 above, a penalty is any requirement associated with a lease agreement or outside of the lease agreement that could have an adverse financial impact on a lessee (e.g., require disbursement of cash, performance of service, surrendering of an asset). While a penalty may impose a requirement on a lessee to make an additional payment or payments to a lessor, it could also be linked to payments to an independent party or result in a loss of future economic benefits to the lessee as a whole. For example, if a lease termination will result in a loss of a significant amount of income for a lessee, that termination could be viewed as a penalty.

The existence of a penalty, if large enough, could affect the evaluation of lease term, lease payments, and renewal and purchase options. For example, if a lessee is required to pay the lessor a significant penalty for not renewing a lease, it would be appropriate to conclude at lease commencement that the lease term would include the renewal period because the potential to pay the penalty economically compels the lessee to renew the lease. Similarly, an entity may conclude that it is reasonably certain to exercise a purchase option to the extent that the lease agreement includes a significant penalty payable by the lessee to the lessor for failure to exercise such an option (as discussed in Section 5.3). A penalty is included in lease payments (see Chapter 6) when it is not significant enough to make the exercise of a renewal or purchase option reasonably certain at lease commencement.

5.2.2.1 Contract-Based Factors

Contract-based factors affecting the determination of the likelihood that a lessee will exercise or not exercise an option are linked to the terms of the lease agreement. Examples of contract-based factors include:

The existence of a bargain renewal option.
The existence of contingent or variable payments.
The nature and terms of renewal or termination options.
The costs the lessee would incur to restore the asset before returning it to the lessor.

5.2.2.1.1 Renewal Option

ASC 840 required entities to include in the lease term “[a]ll periods, if any, covered by ordinary renewal options preceding the date as of which a bargain purchase option is exercisable.” In contrast, ASC 842 requires an entity to include in the lease term “[p]eriods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.” ASC 842-10-55-26 expands on the term “reasonably certain,” stating, in part:

At the commencement date, an entity assesses whether the lessee is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment — contract-based, asset-based, market-based, and entity-based factors. An entity’s assessment often will require the consideration of a combination of those factors because they are interrelated. Examples of economic factors to consider include, but are not limited to, any of the following:

Contractual terms and conditions for the optional periods compared with current market rates, such as: . . .

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).

ASC 842 does not explicitly include a requirement to identify a bargain purchase option and to include any ordinary renewal options preceding the exercise date of the bargain purchase option. However, ASC 842-10-55-26(a)(3) requires an entity to consider renewal options preceding a “purchase option that is exercisable at the end of an extension period at . . . below market rates.” Accordingly, while an entity may need to use greater judgment in applying the above guidance from ASC 842, we believe that the accounting outcome achieved under ASC 842 should generally be consistent with that achieved under the more explicit guidance in ASC 840.

We believe that, in evaluating bargain purchase options that are exercisable after a renewal period, an entity should consider all relevant facts and circumstances, including, but not limited to, the utility of the PP&E to the lessee during the renewal period. In addition, we believe that when an ordinary (i.e., nonbargain) renewal option exists, the lease can be considered to have a noncancelable term followed immediately by a purchase option. The exercise price of that purchase option would represent the present value at the end of the noncancelable term of the renewal-period lease payments and the price of the purchase option.

Example 5-2

Consider the following example:

Entity X, the lessee, enters into a lease for equipment with an initial term of five years. The lease includes two lessee-specific options: (1) a five-year renewal option at market rates and (2) an option to purchase the equipment for $100 at the end of the renewal period (i.e., at the end of 10 years). At lease commencement, the equipment is expected to have a fair value significantly greater than $100 when the purchase option is exercisable.
Entity X plans to use the equipment for a specific project that is expected to be completed at the end of the initial five-year lease term. The project is unique and X does not have an alternative use for the equipment outside of the identified project. Therefore, there is no clear utility of the equipment to X over the five-year renewal term.
Entity X concludes that the present value, at the end of the initial term, of the lease payments for the renewal period, plus the purchase option exercise price of $100, does not represent a bargain purchase option when compared with the expected fair value of the equipment at the end of the initial term.

On the basis of the factors (not all-inclusive) outlined above, X is not required to include the renewal period in the lease term because the purchase option at a below market rate does not represent an economic incentive that would cause the lessee to determine that it is reasonably certain to exercise the renewal option. A purchase option at a below market rate will often provide an economic incentive for the lessee to exercise the intervening renewal option. However, in this case, the utility of the equipment during the renewal period is uncertain and therefore significantly reduces the lessee’s incentive to exercise the renewal option. In addition, the present value, at the end of year 5, of the renewal-period lease payments, plus the purchase option price of $100, does not represent a bargain purchase option when compared with the expected fair value of the equipment. Therefore, it is not reasonably certain that X will exercise the renewal option even though the renewal period is followed by a bargain purchase option.

Connecting the Dots

Residual Value Guarantee Affecting Lease Term and Lease Payments

Some lease agreements may allow a lessee to early terminate a lease only if the lessee guarantees the residual value of the underlying asset as of the termination date. In these cases, the lessee should evaluate the residual value guarantee when determining whether it is reasonably certain that the option to terminate early will not be exercised. That is, the lessee should evaluate the impact of the residual value guarantee when considering whether it will be economically compelled to terminate the lease before the end of the lease term or whether the residual value guarantee itself would result in the lessee’s continuation of the lease for the full term. This evaluation and the resulting conclusions may affect both the determination of the lease term and the lease payments. See Section 6.7 for additional discussion of residual value guarantees.

5.2.2.2 Asset-Based Factors

Asset-based factors depend on specific characteristics of the underlying asset. Examples of asset-based factors include:

The existence of significant lessee-installed leasehold improvements that would still have economic value when the option becomes exercisable.
The physical location of the asset.
The specialized nature of the asset.
The costs that would be incurred to replace or find an alternative asset (including costs associated with lost production).

5.2.2.2.1 Lease Term

If a lease contains renewal options, the lessee’s investment in leasehold improvements should be considered in the determination of whether renewal periods need to be included in the lease term.

The value of leasehold improvements at the end of the noncancelable lease period could be considered an economic penalty and could provide reasonable certainty that the lessee will renew the lease rather than surrender the value of the leasehold improvements.

When evaluating whether the abandonment or relocation of leasehold improvements constitutes a significant penalty, an entity should consider, among other things, the lessee’s ability or willingness to (1) bear the cost of relocating or replacing the leased property at market rental rates or (2) tolerate other parties using the leased property. Ordinarily, lessees would be expected to be unwilling to abandon leasehold improvements or other assets that are expected to have a significant remaining fair value that would not otherwise be available to the lessee at the end of the lease’s fixed noncancelable term. Similarly, lessees typically would not be expected to be willing to incur significant costs, directly or indirectly, to relocate leasehold improvements.

Therefore, when it is expected that there will be a loss of significant fair value or an incurrence of significant costs, (1) there is usually an economic penalty and (2) the penalty causes the lessee to conclude that exercise of the renewal options is reasonably certain. As a result, the lessee includes the renewal periods in the lease term.

Further, situations in which the lessee is prepared to incur a significant economic penalty rather than extend the lease term beyond its fixed noncancelable term (i.e., lease renewal is not reasonably certain) are expected to be rare. In cases in which the lessee is prepared to abandon the leasehold improvements and incur the economic penalty, the leasehold improvements should be depreciated to a residual value of zero over the fixed noncancelable term of the lease.

5.2.2.3 Entity-Based Factors

The impact of entity-based factors depends on the entity’s historical practice, management’s intent, and common industry practice. Examples of entity-based factors include:

The financial impact on the entity of extending or terminating the lease.
The importance of the leased asset to the entity’s operations.

5.2.2.4 Market-Based Factors

Market-based factors include the market rental or purchase rates for comparable assets and any potential implications of local regulations and statutory requirements.

5.2.3 Periods Within the Control of the Lessor

ASC 842-10-30-1(c) states that “[p]eriods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor” should be included in the lease term. Effectively, under ASC 842, it is assumed that when a lessor has the sole option to continue the lease into optional periods, it will choose to do so. Note, however, that unlike the assessment for options exercisable solely by the lessor, the required assessment for any options to extend or not terminate a lease controlled or effectively controlled by a third party unrelated to the lessor or lessee (e.g., a sublessee), would be the same as that for an option exercisable by the lessee (see Section 5.2.2) in the determination of whether the unrelated third party is reasonably certain to extend or not terminate the lease.

See Section 5.2.4.1 for discussion of how to differentiate between a cancelable lease and a lease with a lessor-controlled option to terminate.

5.2.4 Application of the Lease Term Guidance

The next sections further discuss application of, and issues related to, the lease term guidance.

5.2.4.1 Cancelable Leases

ASC 842-10

55-24 If only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term, as described in paragraph 842-10-30-1(b). If only a lessor has the right to terminate a lease, the lease term includes the period covered by the option to terminate the lease, as described in paragraph 842-10-30-1(c).

A lease contract would not be considered enforceable (i.e., it would be considered cancelable) if the lessee and lessor each have the separate right to terminate the lease without incurring a more than insignificant penalty (see Section 5.2.1 for more information). If the lessee or the lessor individually has the separate right to terminate the lease, those termination options would be assessed as follows:

If a lease contract includes a termination option that gives only the lessee the right to terminate the lease, an entity would evaluate whether it is reasonably certain that the lessee will not exercise that termination option (as discussed in Section 5.2.2).
If a lease contract includes a termination option that gives only the lessor the right to terminate the lease, an entity would not consider that termination option when evaluating the lease term (i.e., it should be assumed that the lessor will not elect to terminate early, as discussed in Section 5.2.3).

5.2.4.2 Evergreen Leases

In addition to contracts that specify a period that includes renewal options occurring on an “as exercised” basis, ASC 842 also applies to contracts that automatically renew. For example, leases characterized as “evergreen,” “month to month,” “perpetual,” or “rolling” would meet the definition of a contract and would be subject to ASC 842 if such a contract includes enforceable rights and obligations.

In determining the lease term for such arrangements, an entity would consider the same factors as it would for all other leases. That is, an entity would need to consider contract-based, asset-based, market-based, and entity-based factors to determine the term over which the lessee is reasonably certain to extend the lease.

5.2.4.3 Short-Term Leases

ASC 842-10 — Glossary

Short-Term Lease

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.

A lessee can elect (by asset class) not to record on the balance sheet a lease whose term is 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise (i.e., treat the lease as an operating lease under ASC 840). When determining whether the lease qualifies for this election, the lessee would include renewal options only if they are considered part of the lease term (i.e., those options the lessee is reasonably certain to exercise). If the lease term increases to more than 12 months, or if it is reasonably certain that the lessee will exercise an option to purchase the underlying asset, the lessee would no longer be able to apply the short-term lease exception and would account for the lease as it would other leases. See Section 8.2.1 for more information about a lessee’s accounting for a lease that qualifies for the short-term exemption and Section 15.2.7 for discussion of the disclosure requirements related to the short-term lease recognition exemption.

5.2.4.4 Impact of a Sublease on Lease Term

A lessee that enters into an agreement to sublease the underlying asset needs to assess whether the sublease term will affect the term of the head lease. For example, if the sublease includes renewal options that would, if exercised, extend past the initial term of the head lease, the head lessee would need to evaluate whether it would incur any penalty for not exercising its renewal options in the head lease. The head lessee would consider this factor in addition to other relevant contract-based, asset-based, entity-based, and market-based factors when evaluating whether it is reasonably certain that it will (1) exercise an option to renew, (2) not exercise an option to terminate, or (3) exercise an option to purchase the underlying asset. The existence of a renewal provision in the sublease does not automatically indicate that it is reasonably certain that the head lessee will exercise the renewal options on its head lease. See Section 12.2.1 for further discussion.

5.2.4.5 Lease Term When a Lease Consists of Nonconsecutive Periods of Use

An entity may enter into an arrangement for the right to use an asset during nonconsecutive periods. Such an arrangement may contain a lease as defined in ASC 842-10. Questions have arisen about whether the lease term in such an arrangement should consist of only the nonconsecutive periods of use or the entire period of the arrangement. The lease term is important to the determination of the lease classification and how, and the period over which, to recognize rental expense.

The ASC master glossary defines a lease as a “contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.” Control of the use of the underlying property depends on whether, over the period of use, the lessee has the right to (1) substantially all of the economic benefits from use of the identified asset and (2) direct the use of the identified asset. (The period of use related to identifying a lease is further discussed in Section 3.5.)

Further, ASC 842-10-20 defines the period of use as the “total period of time that an asset is used to fulfill a contract with a customer (including the sum of any nonconsecutive periods of time).” Therefore, in evaluating the lease term, a lessee must determine the period over which it has the right to control the use of the underlying asset, which may comprise only the sum of nonconsecutive periods.

Example 5-3

Retailer A enters into a lease arrangement for the use of mall space for only three consecutive months of the year (the holiday period) for 10 years. Because A only has the right to control the use of the asset for 30 months (i.e., the total of the nonconsecutive periods), A determines that the lease term consists of only the nonconsecutive periods. Therefore, A should use a lease term of 30 months for classification purposes and should recognize rental expense only during these periods, provided that the lease is an operating lease.

Example 5-4

Company B owns a commercial parking garage in a large retail shopping district and charges customers a higher rate to use the garage between the hours of 10 a.m. and 10 p.m. (peak hours). Company B enters into an arrangement with Retailer X that will give X the exclusive right to use the parking garage during peak hours for the next three years. Companies other than X have the right to use the parking garage during off-peak hours.

In this example, the lease term is 18 months (i.e., 12 hours a day for 36 months). Company B and Retailer X should therefore use this lease term when determining the lease classification.

Connecting the Dots

Interaction Between Nonconsecutive Periods and the Short-Term Lease Recognition Exemption

As discussed above, the lease term comprises the period of use and the period of use comprises the sum of nonconsecutive periods. Therefore, if the aggregate of the nonconsecutive periods (that comprise the period of use) is 12 months or less, the lease term would also be 12 months or less. Accordingly, the short-term lease recognition exemption (see Section 8.2.1) may be elected.

The examples below illustrate this notion.

Example 5-5

RetailCo enters into a three-year agreement with Landlord under which RetailCo will lease a store in a mall during the months of October, November, and December in each year. Landlord agrees to provide the same store for each of the three years. The aggregate of the nonconsecutive periods (i.e., the period of use) during which the store will be leased by RetailCo is nine months (i.e., three months for each year of the agreement). Accordingly, the lease term is also nine months. RetailCo may elect the short-term lease recognition exemption in this scenario.

Example 5-6

TeamCo enters into a 30-year agreement with City for a lease of a stadium. The terms of the agreement stipulate that TeamCo will have the right to use the stadium for 10 home games a year. The home games are played on various days (i.e., would be nonconsecutive). Because the period of use is 300 days (i.e., 10 days per year for 30 years), the lease term is also 300 days. TeamCo may elect the short-term lease recognition exemption in this scenario.

5.2.4.6 Fiscal Funding Clauses

ASC 842-10 — Glossary

Fiscal Funding Clause

A provision by which the lease is cancelable if the legislature or other funding authority does not appropriate the funds necessary for the governmental unit to fulfill its obligations under the lease agreement.

ASC 842-10

55-27 The existence of a fiscal funding clause in a lease agreement requires an assessment of the likelihood of lease cancellation through exercise of the fiscal funding clause. If it is more than remote that the fiscal funding clause will be exercised, the lease term should include only those periods for which funding is reasonably certain.

A fiscal funding clause in a lease gives a governmental agency the option to cancel the lease if it does not receive funding through the appropriation process to meet its payment obligation under the terms of the lease. Under ASC 842, the lessor must evaluate the likelihood that the fiscal funding clause will be exercised.1

If exercise of the fiscal funding clause is deemed remote, the lease would be considered noncancelable. In contrast, if the exercise of the fiscal funding clause is considered more than remote, the lease term would include only periods for which it is considered reasonably certain that the government agency will obtain the funding.

5.2.4.7 Terminal Rental Adjustment Clauses

A terminal rental adjustment clause (TRAC) is a clause that is generally included in a vehicle lease arrangement. A TRAC stipulates a final rental payment to the lessor of any shortfall, or a receipt by the lessee of any surplus, in the selling price of the vehicle compared with the remaining book value at the end of the lease. The specifics of a TRAC may vary by contract. For example, the amount payable (or receivable) by a lessee under a TRAC would depend on whether the lessee (or lessor) is obligated to pay the entire amount of the shortfall (or surplus) as well as on the depreciation method used to calculate the remaining book value of the vehicle. These terms are generally explicitly stipulated in the contract. If a lease containing a renewal option exercisable by the lessee also contains a TRAC, the terms of the TRAC would need to be considered to ascertain whether it is reasonably possible that the TRAC would result in a significant payment by the lessee to the lessor at the end of the lease term. The existence of a TRAC that is reasonably possible to result in a significant payment by the lessee is an economic factor that would need to be considered in the assessment of whether the lessee is reasonably likely to extend the lease to avoid this payment. (Example 8-1, Scenario B, in Section 8.2.1 illustrates this concept.) However, the existence of a TRAC would not, in isolation, dictate whether a lessee is reasonably certain to exercise an option to extend the lease; the lessee and lessor would also need to consider other economic factors (e.g., contract-based, asset-based, entity-based, and market-based factors). See Section 5.2.2 for further details.

5.2.4.8 Examples Illustrating the Lease Term Guidance

The scenarios in the example below illustrate the application of the guidance on lease term discussed in Section 5.2.

Example 5-7

Scenario 1 — Exercise of the Renewal Option Is Not Reasonably Certain

On January 15, 20Y5, Company A enters into a lease for a machine that includes a noncancelable period of five years, with a three-year renewal option that will require payments based on market rents. The machine has not been customized and the arrangement does not include a termination penalty for not renewing the lease.

At lease commencement, A determines that the lease term is limited to the noncancelable period of five years. This determination is made on the basis that A is not economically compelled to exercise the three-year renewal option because (1) the lease payments during the renewal period are at market, (2) there is no termination penalty if it does not renew the lease, and (3) the machine has not been customized.

Scenario 2 — Exercise of the Renewal Option Is Reasonably Certain

On May 15, 20Y5, Company B enters into an equipment lease that includes a noncancelable period of five years, with a three-year renewal option that includes payments based on market rents. Company B modifies and configures the underlying asset at a significant cost. In addition, the equipment is a vital asset in B’s manufacturing process (i.e., B’s production output would be significantly affected if this asset were not in place).

At lease commencement, the lease term would be eight years. After considering the asset-based factors, B concludes that it would suffer a significant penalty if it were to exit the lease at the end of the noncancelable period because it would abandon the costs associated with modifying and configuring the equipment. Further, since this asset is vital to B’s manufacturing process, nonrenewal of the lease may adversely affect the company’s operations. On the basis of these factors, B concludes that it is reasonably certain that it will exercise the renewal option. As a result, the lease term is eight years.

Scenario 3 — Lessee and Lessor Both Have Right to Terminate

On April 9, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B with no renewal or purchase options. Under the terms of the lease, A and B have the unilateral right to terminate the lease at the end of the lease’s second year without cause or penalty.

In this scenario (in the absence of other contract-, market-, or entity-based factors), the noncancelable period, as well as the lease term, would be two years. According to the terms of the arrangement, B has the right to terminate the lease at the end of year two, thereby limiting A’s ability to extend the lease past this period. In addition, because A can terminate the lease at the end of year two, it does not have an obligation to make lease payments past that period.

Scenario 4 — Lessor Has the Right to Terminate

On June 1, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B in which B has the right to terminate the lease at the end of year two without cause or penalty.

In this scenario, the noncancelable period and the lease term are four years. The lease term would always include optional periods that are controlled by the lessor.

Scenario 5 — Lessee Has the Right to Terminate

On June 1, 20Y6, Lessee A enters into a four-year equipment lease with Lessor B in which A has the right to terminate the lease at the end of year 2.

In this scenario, both parties must assess whether it is reasonably certain that A will not terminate the lease after year 2 (in considering the factors described in ASC 842-10-55-26). The lease term would be two years unless the parties conclude that it is reasonably certain that A will not terminate the lease.

ASC 842-10

30-4 See paragraphs 842-10-55-19 through 55-21 for implementation guidance on commencement date and paragraphs 842-10-55-23 through 55-27 for implementation guidance on lease term and purchase options. See Examples 23 through 24 (paragraphs 842-10-55-210 through 55-224) for illustrations of the requirements on purchase options.

Illustration of Lessee Accounting for Purchase Options

55-210 Examples 23 through 24 illustrate the evaluation of whether a lessee is reasonably certain to exercise an option to purchase the underlying asset.

The Codification examples referenced in ASC 842-10-30-4 and ASC 842-10-55-210 are reproduced as follows:

Example 23 in ASC 842-10-55-211 through 55-217 is reproduced in Section 8.9.2.1.
Example 24 in ASC 842-10-55-218 through 55-224 is reproduced in Section 8.9.2.2.

Footnotes

We would generally expect the governmental agency, as lessee, to apply GASB accounting standards and not ASC 842.

5.3 Purchase Options

ASC 842-10

30-3 At the commencement date, an entity shall assess an option to purchase the underlying asset on the same basis as an option to extend or not to terminate a lease, as described in paragraph 842-10-30-2.

When evaluating the lease term, an entity would consider a purchase option in the same manner as it would an option to extend or not terminate a lease. If it is reasonably certain that a lessee will exercise the option to purchase the underlying asset at the end of the lease term, the lessee will (1) classify the lease as a finance lease (see Section 8.3.3.4) and (2) amortize the ROU asset over the underlying asset’s remaining useful life and not over the lease term (see Section 8.4.3.1). Similarly, a lessor that concludes that the lessee is reasonably certain to exercise the purchase option will (1) classify the lease as a sales-type lease and (2) include the option purchase price as a lease payment that is used in the measurement of the net investment in the lease (see Section 9.2.1.2). Section 6.4 discusses the effect on lease payments of determining that the exercise of a purchase option is reasonably certain.

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.