Operating Lease Treatment Harder to Achieve Under 2016 Lease Standards

Authored by Glenn Madere and Louis Battagliese

In August 2010 FASB proposed a new lease accounting standard that it finalized in February 2016. Much of the five-and-a-half-year incubation period can be traced to vocal opposition by commercial tenants and their advisors who objected to what FASB now calls “finance lease” treatment for virtually all leases—the approach ultimately adopted by IASB. Opponents feared that front-loading of earnings charges under the finance lease approach would depress earnings in years when large leases or many leases were originated or renewed. FASB’s response was to distinguish between finance leases and operating leases.  The latter still generate a balance sheet asset and liability but incur level annual earnings charges composed of interest and amortization of a right-of-use asset that collectively approximate earnings charges for operating leases under the prior rules of FAS 13.

Lost in the sigh of relief over FASB’s two-tier approach, however, is a change made to how a company measures the term of its lease. In practice lease term is the key metric under two of the alternate tests that characterize a lease. A finance lease is one that meets any of five listed criteria, including where: (i) the lease term is for the “major part” (e.g., 75%) of the remaining economic life of the asset; or (ii) the present value of lease payments plus residual value guarantees equals or exceeds substantially all (e.g., 90%) of the fair value of the asset (ASC 842-10-25-2; ASC 842-10-55-2). Because a longer term means more rent, it favors characterization as a finance lease under both the remaining economic life and present value tests. Lease term can include renewal periods where the option to renew is “reasonably certain” to be exercised (ASC 842-10-30-1). Under FAS 13, a lessee’s optional renewal term could only be tacked onto its primary lease term in narrowly-defined circumstances involving a bargain renewal rate, bargain purchase option, guaranty of the lessor’s debt, or certain penalties for non-renewal. In determining whether a given option was a “bargain”, only price was relevant.

By contrast, the 2016 lease standards tack on the terms of renewal options reasonably certain to be exercised because the lessee has an economic incentive to renew, whether from contract-based, asset-based, market-based, or entity-based factors. This list describes a far broader and more subjective set of potential incentives than a “bargain” option (see ASC 842-10-30-2 and 842-10-55-26).  For example, a central data center near the company’s headquarters, leased for a ten-year term, with four five-year renewal options, each at 95% of market rent, would likely be treated as 10 year lease under FAS 13 (and therefore an operating lease) but probably a 30 year lease under the 2016 lease standards (and therefore a finance lease). On these facts, listed factors that favor tacking renewal periods onto the primary lease term include the asset’s operational importance, location, and specialized nature, as well as the cost of relocating and the significant value of leasehold improvements in place (ASC 842-10-55-26).  Headquarters buildings, factories, top-grossing stores, distribution centers and other core assets raise the same issue, as do purchase options that the lessee has a significant economic incentive to exercise (ASC 842-10-30-3).

The most telling illustration of this change can be found in FASB’s Example 24 (ASC 842-10-55-218 through -224), which involves a lease of specialized equipment vital to the lessee’s business.  After a 5-year initial lease term, the lessee has an option to purchase the equipment for $90,000, its expected fair value at that time.  Lessor built the equipment specifically to suit the needs of the lessee.  Although scheduled rent payments alone would not violate the remaining economic life test or the present value test, the example finds finance lease treatment based on the lessee’s significant economic incentive to exercise the option due to the specialized nature of the asset and its role in the lessee’s operations–notwithstanding that the purchase option does not constitute a “bargain” under FAS 13.

If a lessee actually exercises a lease renewal option it must then reassess lease characterization in light of the longer term and additional rent (ASC 842-10-55-166; 842-10-25-1).  Exercise of the first renewal option also raises an obvious question—why wouldn’t the same FASB-listed factors that drove the lessee’s decision also prompt exercise of its remaining renewal options?  As these examples illustrate predictability of earnings will often be better served—and volatility minimized—by a realistic initial assessment of the probability that extension options for a core asset will be exercised.

Many practitioners have taken comfort in the Summary of ASC 842, which equates “reasonably certain” option exercise to the “reasonably assured” threshold of FAS 13. What FASB’s calming language glosses over, however, is that while the quantum of proof required may be no greater than it was under prior guidance, the substance of what must be proved has changed—at least for core assets.  Corporate users should consider ownership as an alternative for core assets, especially in structures that employ preferred or hybrid equity financing as a strategy to avoid or minimize grossing up the debt side of the balance sheet.

Glenn Madere and  Lou Battagliese are also principals of Leasehold Equities LLC, www.leaseholdequities.com, which specializes in finance-based cost containment strategies tailored to the new lease accounting and capital market environments.