Once you’ve identified your leases requiring accounting under Accounting Standards Update No. 2016-03, Leases (Topic 842), an important step is to determine the lease term. The lease may include several dates, such as:
- The date the lease agreement is signed or the effective date of the lease agreement
- The date the asset is made available to the lessee, potentially for tenant improvement work to be performed prior to opening, in the case of a lease for retail or office space
- The date rental payments will begin
- A lease end date
The lease may not specify the end date, instead it may include a term the lease will cover from a specified start date. Many times, leases will include additional optional lease terms, subsequent to the initial term.
In order to properly account for your leases under Topic 842, the lease commencement date should be identified and used as the start of the lease term for accounting purposes. Rental payments may not yet be due and/or the asset may not be ready to be used for the intended purpose (e.g., retail rental space being renovated before opening for business) at the time of the commencement date. The commencement date is defined as the date the underlying asset is available for use by the lessee. At the commencement date, the lease should be evaluated for classification as a financing or operating lease and the asset and liability should be calculated and recorded.
Optional Lease Periods
While the lease term typically includes only the noncancelable term covered under the lease, additional optional periods should be included when the lessee has the option to extend the term and is reasonably certain it will exercise the option, as well as when the lessor has the option to extend (regardless of whether such option will be exercised). Lessees should assess the likelihood of exercising their options to extend at the lease commencement. In evaluating the likelihood, all economic factors should be considered, including but not limited to:
- Terms and conditions of the optional periods, including comparing to market rates
- Costs invested into asset expected to have value at the end of the initial term, and costs to lease a new asset if option not taken
- Nature of the asset and importance to the company (e.g., highly specialized or unique location)
If the lease includes an option to terminate, a similar analysis should be performed to determine the likelihood such option will be taken, including an analysis of the remaining lease payments compared to any early termination penalty. Similar to with options to extend, if the lessor has the option to terminate, such early termination should not be included.
Options should be reevaluated throughout the lease term when there is a significant change in circumstances or a significant event that impacts the likelihood of options being exercised.
Subsequent Change to the Lease Term
Subsequent changes to the term of a lease will require companies to consider whether the change results in a separate contract or a modification to the existing contract. If the change is considered a modification to the existing lease, the lease liability will be remeasured at that time. When a change to the contract results in both of the following, the change is considered a separate and new lease. The original lease would not be impacted by the new and separate lease.
- The modification grants the lessee an additional right-of-use not included in the original lease
- The lease payments increase commensurate with the standalone price for the additional right-of-use, adjusted for the circumstances of the particular contract
If the change does not meet both above the above criteria, the change is deemed to be a lease modification. When a lease modification occurs, the lease classification should be reevaluated and the lease remeasured. The date of remeasurement is the effective date of the lease modification (the date the change is approved by both parties to the lease contract) and is based on the remaining term and payments under the contract, as modified.
If you have questions regarding the new lease standard, or you need assistance implementing it for your organization, please send us an email.
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