In our third installment of our lease series, we discuss lease term considerations. Lease Term If we follow the wisdom of Confucius, “Life is really simp...
In our third installment of our lease series, we discuss lease term considerations.
Lease Term
If we follow the wisdom of Confucius, “Life is really simple, but we insist on making it complicated”. As they say though, “the Devil is in the details.” This means, if we don’t pay attention to the little things, we may be in for trouble.
Conversely, I prefer the expression, “God is in the detail”, which means if we pay attention to the small things, events should go well.
So, what details do we need to think about?
Following are some areas to consider:
| Consideration | Response |
| Term of the lease stated in the contract | ASC 842 introduces the concept of legal enforceability for leasing arrangements. Prior to this there was more latitude to consider the economic substance of arrangements. Economic substance relates to the underlying economic or commercial purpose of a business transaction verses its legal form. Legally enforceable terms and conditions are expected to be determined by the terms included in a written contract. This change in concept results in additional complexity regarding verbal contracts and written contracts with the potential for cancelation. |
| Renewal options and termination clauses | ASC 842 requires that entities include renewal or termination clauses that are reasonably certain to be exercised in determination of the lease term. The entity should consider their history of renewing or terminating lease terms. This requires professional judgment. |
| Month-to-month leases | Entities with month-to-month leases with no formal renewal options should report payments for rent and leasehold improvements as expenses when incurred. The phrase “formal renewal option” can be subject to judgment especially when considering related-party leases. Some suggest that a month-to-month lease automatically renews every month, which could indicate that the lease term is longer. This fact when considered with the history of renewal may indicate a longer lease term. To complicate matters further, one could conclude that due to the history of renewal and intentions of related parties, the lease may need to be considered a finance lease (formerly capital lease). In certain cases, professional judgment is required. |
| Unwritten leases | Without a written agreement, it would be difficult to determine legal enforceability. Entities should consider drafting a formal written agreement to support the substance of the transaction. Alternatively, payments for rent should be expensed as incurred. |
| Leasehold improvements | Prior to the adoption of ASC 842, under ASC 840, an operating entity would account for the operating lease by charging the lease payments to rent expense on a straight-line basis over the lease term. Leasehold improvements would have been amortized over the shorter of the useful life of the asset or the lease term including renewal periods that are reasonably assured. In many cases, related-party businesses would amortize the leasehold improvements over a period greater than the lease term concluding that the economic substance supports renewal of the lease because it is in the control of the common owner which is reasonably assured. Under ASC 842, this changes, as the lease is reported based on the legal enforceability of the lease term and the leasehold improvements are amortized over the shorter of this lease term or the economic useful life of the asset. This may result in amortizing leasehold improvements over a shorter period for some entities. |
| Structuring a lease | Entities should structure leases based on the economic substance of the use of the assets to document a clear understanding of the terms, conditions, and expectations of each party. |
These considerations are by no means all inclusive, so take time to consider the details of your contracts.
In our next blog of this series, we cover discount rate considerations used when present valuing future obligations related to leases. In the meantime, let us know if we can be of any help!
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