Following earlier podcasts with Kristin McLaughlin on how to define a lease, as well as how to differentiate between lease and non-lease components, our latest podcast focuses on lease terms and why they are important under the new FASB ASC 842 lease standard.
Bart Waldeck, Tango’s CMO and SVP of Product Strategy, welcomes back Kristin who is Senior Director, Technical Accounting Consulting (TAC) at RSM US LLP as well as Rick Zelinsky, Vice President of Product Strategy at Tango to discuss how unlike the current standard, ASC 840, ASC 842 makes lease term an integral component of an entity’s calculation to determine its lease liability and right of use asset.
Are you feeling worried about the looming deadline for FASB and IFRS lease accounting compliance? Well, if you are, you’re not alone. Welcome to Tango’s Road to Lease Accounting Podcast Series where we’ll be discussing the steps a company needs to address in order to ensure that your organization is ready. We’ll be covering everything from setting strategy to understanding policy, handling data requirements, picking the best technology, and finally institutionalizing the right processes and controls to ensure that they represent a permanent shift in the way you account for leases.
Hello everyone and welcome back to Tango’s Road to Lease Compliance Podcast Series. My name is Bart Waldeck. I’m Chief Marketing Officer and Senior Vice President of Product Strategy at Tango. Today’s episode focuses on the policy stage of the road to lease compliance and within that stage, the lease term which is important for calculation of lease liability and right of use assets. Joining me today are Rick Zelinsky, Vice President of Product Strategy here at Tango and the main architect behind Tango’s lease solution and, once again, Krist1n McLaughlin, Senior Director of Technical Accounting at RSM USLLP. It’s once again great to have Kristin back to provide insight into some of these key ASC 842 policy decisions that many companies are wrestling with. Welcome, Rick and Kristen and thanks for joining us today.
Okay, let’s shift gears a little bit here and jump into another important element, lease term.
Kristin, under ASC 840, lease term really was not a significant area of focus. Can you explain why, under ASC 842 the importance of lease term?
Sure. The lease term under ASC 842 is an integral component of an entity’s calculation to determine its lease liability and right of use asset. The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor. ASC 842 requires an entity to record a right of use asset and lease liability as of the commencement date of the lease which is defined as the date on which a lessor makes an underlining asset available for use by the lessee. In some cases, the commencement date of the lease may be before the date stipulated in the lease agreement. For example, the date the rent becomes due and payable. This often occurs when the lease space is modified by the lessee prior to commencing operations in the lease space. For example, during the period a lessee uses the lease space to construct its own lease holds improvement.
An entity should determine the non-cancelable period of a lease when determining the lease term. When assessing the length of a non-cancelable lease term, an entity should apply the definition of a contract and determine the period for which the contract is enforceable. An entity shall determine the lease term as the non-cancelable period of the lease together with all of the following: periods covered by an options to extend the lease if the lessee is reasonably certain to exercise that option, period covered by an option to terminate the lease if the lessee if the lessee is reasonably certain not to exercise that option, periods covered by an option to extend or not to terminate the lease in which the exercise of the option is controlled by the lessor. A lease is no longer enforceable when both the lessee and lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty. A penalty could be required payment to the lessor, a payment to a third party, or an amount representing a loss of earnings resulting from terminating the lease.
Kristin, perhaps you can describe some of the key considerations in determining the lease term.
Sure. The lease term is subject to management’s judgements regarding renewal, terminations, or purchase options. The FASB indicated in the basis of conclusions to the standard that the phrase “reasonably certain”, which is also used in IAS standard number 17 and is generally interpreted as a high threshold, has the same meaning as the phrase “reasonably assured” that is used in ASC 840. Therefore the FASB does not anticipate a change in practice. When evaluating whether a lessee is reasonably certain to exercise an option to renew the lease, not terminate the lease or to purchase the underlying asset, lessees and lessors are required to assess all relevant factors to create an economic incentive for the lessee to exercise lease renewal, termination, or purchase options including the existence of a purchase option or lease renewal option and its pricing. Is it a fixed price, is it a discounted rate, is it a bargain? The existence of a termination option, the amount of payments for termination or non-renewal and the pricing of the continuing lease contingent, amounts due under residual value guarantees and other variable lease payments, costs of returning the asset in a contractually specified condition or to a contractually specified location, significant customization, installation costs, or relocation costs. The importance of the lease assets to the lessee’s operation considering the potential business disruptions from not having the leased asset and the availability of a replacement asset should also be considered.
The final consideration is a sublease term that extends beyond the non-cancelable period of a head lease. For example, if you have a head lease that has a non-cancelable term of five years with a two year renewal option and the sublease term is for seven years, you’d likely conclude your head lease term should be seven years.
Well, that wraps today’s Road to Lease Compliance Podcast episode, lease terms. Thanks for joining Rick and special thanks, Kristin, for all your technical accounting guidance as usual. Please join us for future podcasts along the road to lease accounting compliance.