What is the proper lease term to use under the new lease guidance?

August 1, 2018

Your lease terms can affect how you will calculate operating lease liabilities and assets on your balance sheet under the new lease accounting standard. In particular, the length of your lease will have a significant impact.

With the upcoming implementation of the new lease accounting standard, companies will be required to calculate and record to their balance sheet a lease liability along with a corresponding right-of-use (ROU) asset for operating leases. Previously, these lease commitments only had to be disclosed in the financial statement footnotes. It is important to understand the variables that will impact the initial calculation used to determine these new balance sheet accounts.

You will need to gather several key pieces of information to properly calculate the initial ROU asset and lease liability. These include initial direct costs, lease payments, applicable discount rate, and the term of the lease.

Determining the proper lease term

That new guidance, ASC 842 – Leases, defines the lease term as:

The noncancellable period for which a lessee has the right to use the 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 the option
  • Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise the 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

The noncancellable portion is straightforward and usually clearly defined in the lease contract. The periods covered under options controlled by the lessee have a threshold of “reasonably certain to exercise” which is a high threshold similar to being “reasonably assured” under the previous guidance. This is a subjective determination, but one that should be discussed and considered to make sure the lease liability is being properly captured and no user of the financial statements is being misled. Options that are not held by the lessee, but rather the lessor, are assumed to extend the lease term automatically, which would lead to higher initial lease liability and ROU asset balances.

Consider the lease term when entering into new lease agreements. Generally speaking, leases with longer lease terms, including those that may have multiple options to extend, will lead to higher initial balances for the lease liability and ROU asset, resulting in a greater impact on your balance sheet when implementing this standard.

Short-term lease option

There is an option to make an accounting policy election that would allow you to not record lease liability or ROU assets for short-term leases—those defined as having a term of 12 months or less. However, when calculating the term you must consider the extension options as noted above. While this may be seem like a good option to avoid the additional work associated with calculating and recording the new balance sheet items, short-term leases generally contain a premium in higher lease payments as the lessor is taking on a higher risk due to the short-term nature of the contract. The cost-benefit of entering into short-term leases may not be worth it in the long-run when compared to the cost of calculating and recording the new balance sheet items.

Be prepared for implementation

The most important thing you can do to be ready for the implementation of the new lease standard is to take a full inventory of all current leases and those you plan on undertaking in the future. You need to have a thorough understanding of all your lease agreements and the underlying terms to determine the impact of this new standard.

For additional background information, read our recent article “Operating leases hitting the balance sheet.

Schenck will continue to follow updates on this standard and provide additional implementation guidance. If you have questions, please contact a Schenck professional at 800-236-2246.

Tags: Accounting