DP Chapter 6: Leases With Options

Continuing with the review of the FASB & IASB Discussion Paper on revising lease accounting. Today’s installment covers chapter 6.

Summary:

• The lease term should be the “most likely” term, including options to renew, cancel, or purchase.
• Likelihood should be judged including contractual, non-contractual, and business factors, but not lessee-specific factors like intention and past practice.
• Lease term is reassessed at each reporting date, with any change recognized as an adjustment to the carrying amount of the asset and obligation.

Detailed review:

We’re now moving into areas where even existing capital leases are going to be face alterations in the new standard. Under FAS 13 (with IAS 17 being similar), an option to renew is recognized as part of the lease term in most cases only if there is a financial incentive or penalty that causes renewal to be “reasonably assured.” If the renewal was more or less at market rate, in general it was never included in the original lease term, even if the lessee was virtually certain to renew, until actual contractual notice of renewal had been served.

Not under the new standard. While some board members favor keeping this methodology, theirs is a minority view. The majority of both boards has determined that the lessee is to determine the probability of renewal; each possible term would be considered, and the one that management concludes has the greatest probability (even if under 50%) is the term to use.

The boards rejected three other approaches:

• Probability-weighted life: In this approach, if a lessee has a 10-year lease with a 5-year option to renew, and considers that there is an 80% chance of renewal, the lease would be set up with a life of 14 years. This, of course, results in a pro-forma term that can never actually happen.
• Probability threshold: Each option would be considered based on a threshold (virtually certain, reasonably certain, probable, or more likely than not—one of these would have to be chosen). However, the boards feared that this would result in a bright-line, arbitrary rule, when the goal is to switch to principle-based rather than rule-based standards.
• Qualitative assessment: No guidance would be provided; preparers would use their judgment on the basis of “reasonable and supportable” assumptions. But the boards feared that this could be too wide-open, and that constituents would almost inevitably ask for guidance anyway.

It was noted that the most likely lease term doesn’t distinguish between leases with and without options in the middle of the calculated term. This, however, is addressed by requiring reassessment of the lease term at each reporting date on the basis of any new facts or circumstances. If the term changes based on this reassessment, the change in rents due is recognized by adjusting the remaining asset and obligation by the present value of the rents involved. This is another change from the current standard, which alters the lease term only when a contractual exercise of an option is completed.

The boards discussed what could be appropriate factors to consider in determining which options (to extend or terminate) are likely to be exercised. They grouped the factors into four categories:

• Contractual factors (explicit terms of the lease): bargain rents, residual guarantees, penalties, costs for returning the leased asset
• Non-contractual financial factors: existence of valuable leasehold improvements, relocation costs, lost production costs, tax consequences, replacement costs
• Business factors: nature of the asset (core/non-core, specialized, potential competitor’s use), location, industry practice
• Lessee specific factors: lessee intentions, past practice

The boards considered not providing any guidance on these considerations, but concluded they should, and decided the first three categories of factors are appropriate to consider, while lessee specific factors should not be part of the determination of the lease term.

Purchase options are to be considered using the same methodology: most likely outcome, reassessed at each reporting date, any change reflected in the carrying amount of the asset and obligation (including the exercise price of the option in the rent stream if the option is going to be exercised). If the purchase option is included in the lease term, the right to use asset is amortized over the useful life of the underlying asset.