Evaluating the Lease Term Under the New Standard
Determining the term of an identified lease has become a key topic of discussion surrounding the implementation of ASC 842. This determination can have material balance sheet implications where leasing is a significant component of a company’s business. Specifically, if a lease qualifies as short-term, companies may make an accounting policy election not to apply certain balance sheet recognition requirements.
What is the impact?
Classifying a lease as short-term simplifies the accounting treatment and eliminates the need to calculate and track the right-of-use assets and lease liabilities associated with long-term leases. Further, if a lease has been deemed a short-term lease, the costs associated with the lease can be excluded from the required short-term disclosures if the noncancelable term of the lease is one month or less.
What is the noncancelable lease term?
After determining a contract meets the definition of a lease, a company must consider the noncancelable lease term when determining if that lease is short-term or long-term.
The noncancelable lease term covers all periods for which a contract is enforceable; a contract is no longer enforceable when both parties have the unilateral ability to terminate the contract without incurring a significant penalty. Under the new standard, any periods representing renewals or extensions at the lessor’s option are assumed to be included in the noncancelable lease term. For renewals that are at the option of the lessee, the assumption of being reasonably certain of exercise hinges on whether a significant penalty exists. More on this below.
Many contracts have no formal renewal option for either party, but include an “evergreen” type clause where the lease may continue for an undefined amount of time at the option of the lessee by either continuing to use and pay for the leased asset or by not exercising a lease termination. In these cases, the evergreen clause constitutes a renewal because the lessee has the option to end the lease or extend for the evergreen period at their sole discretion. Therefore, evergreen clauses should be considered in the assessment of lease term.
Is there a significant penalty?
Determining whether a significant penalty exists when evaluating renewals that are at the option of the lessee is an area of significant judgment. Importantly, these penalties can be economic in nature, as further described below. Determining what is considered significant will vary by company based on internal policies and materiality thresholds.
The following factors should be included in an entity’s evaluation of what would constitute an economic penalty:
- Significant leasehold improvements made to the underlying asset that provide significant economic value to the lessee should they choose to exercise renewal options
- Costs associated with terminating the lease that are not explicitly defined, such as costs to negotiate a new lease, permit/license costs, shipping/handling costs, demobilization or reclamation expenses
- Termination of the lease resulting in disruption to the company’s operation that would be considered significant
- Termination of the lease exposing the company to unfavorable market rate adjustments, forfeited discounts, damage to vendor relationships, or loss of operational efficiencies gained from on-going use of a specific asset
- Short-term lease contracts entered into in response to certain industry fluctuations; similarly, leased assets designed by the vendor in a manner that allows the vendor to be responsive to industry demands in terms of mobility, response time and versatility
In most circumstances, if the lessee’s termination penalty would be significant, the subsequent renewal periods should be included in the calculation of lease term until that termination penalty is no longer deemed to be significant. However, the interpretation of the ‘reasonably certain’ threshold defined under ASC 842 related to exercising stated renewal options should also be considered. In most cases, it would be appropriate to assume that as long as an entity determines that there would be a significant penalty associated with electing not to renew a contract, an entity would be compelled to assess that they are ‘reasonably certain’ to exercise the renewal option to avoid incurring the significant penalty.
Consider a Company that is leasing a generator on a month-to-month evergreen contract. The contract automatically renews each month unless cancelled, and either party can terminate at any time. If the Company chooses to terminate the lease, they must pay a small fee to ship the unit back to the vendor’s yard, but no other monetary termination consideration is defined in the contract. The Company determines that the use of the asset is necessary to sustain the operations of a specific site until permanent infrastructure can be constructed, but does not believe that the lost production associated with a one- or two-day shutdown of that site to swap out the leased asset would result in a material loss of revenue to the Company. The costs associated with swapping out the asset are not material to the Company, and the Company is not reasonably certain that it will continue to use the leased asset at a different site after it is no longer needed at the current site. The Company has no intention of purchasing the leased asset because of the labor and maintenance requirements associated with owning and operating the asset.
Based on these facts, the Company does not believe that a significant termination penalty exists, and therefore they deem the lease to be classified as a short-term lease with a term of one-month or less. None of the penalties associated with terminating the lease were deemed to be significant to the Company (return transportation fee, loss of revenue due to downtime, asset certification cost, uninstallation cost).
Determining what constitutes a non-cancellable lease term involves evaluating the circumstances of each arrangement and the application of significant judgment. The conclusions reached can have material impacts to the balance sheet as well as the disclosures.