Implementing the New FASB Lease Accounting Standard: Determining the Lease Term

Once you have identified your leases that require accounting under Accounting Standards Update No. 2016-03, Leases (Topic 842), an important step is to determine the term of the lease. The lease can have several dates, such as:

  • The date the rental agreement is signed or the effective date of the rental agreement
  • The date on which the property is made available to the lessee, possibly for rental improvement work to be carried out before the opening, in the case of a commercial or office lease
  • The start date of lease payments
  • An end date of the lease

The lease may not specify the end date, but may include a term that the lease will cover from a specified start date. Often leases will include additional optional lease terms, after the initial term.

In order to properly account for your leases under Topic 842, the lease start date must be identified and used as the start of the lease term for accounting purposes. Lease payments may not yet be due and/or the asset may not be ready for use for its intended purpose (e.g. retail space being renovated prior to opening) at the time of start date. The start date is defined as the date on which the underlying asset is available for use by the lessee. At the start date, the lease should be valued for classification as a finance or operating lease and the assets and liabilities should be calculated and recorded.

Optional rental periods

Although the lease term generally includes only the non-cancellable term covered by the lease, additional optional periods should be included where the lessee has the option to extend the term and is reasonably certain that he will exercise the option, as well as when the lessor has the option to extend (regardless of whether or not this option is exercised). Tenants should assess the likelihood of exercising their extension options at the start of the lease. When assessing likelihood, all economic factors should be considered, including, but not limited to:

  • Terms of optional periods, including comparison with market rates
  • Costs of investing in an asset expected to have value at the end of the original term and costs of leasing a new asset if the option is not taken
  • Nature of asset and importance to business (e.g. highly specialized or unique location)

If the lease includes a termination option, a similar analysis should be performed to determine the likelihood of that option being taken, including an analysis of the remaining lease payments versus any early termination penalties. Similar to extension options, if the lessor has the ability to terminate, such early termination need not be included.

Options must be reassessed throughout the term of the lease if there is a material change in circumstances or material event that affects the likelihood that the options will be exercised.

Subsequent modification of the duration of the lease

Subsequent changes to the term of a lease will require companies to consider whether the change results in a separate contract or an amendment to the existing contract. If the change is considered a modification of the existing lease, then the rental obligation will be reassessed. When a change to the contract results in both of the following, the change is considered a separate new lease. The original lease would not be affected by the separate new lease.

  • The modification grants the lessee an additional right of use not included in the original lease
  • Lease payments increase in proportion to the standalone price of the additional right of use, adjusted according to the circumstances of the particular contract

If the change does not meet the above two criteria, the change is deemed to be a lease modification. When a lease modification occurs, the classification of the lease must be reassessed and the lease reassessed. The reassessment date is the effective date of the lease modification (the date the modification is approved by both parties to the lease) and is based on the remaining term and payments under the contract, as amended.

If you have questions about the new rental standard or need help implementing it in your organization, please email us.

© Clark Nuber PS, 2022. All rights reserved.

This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax or other advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.

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