Authored by: Dave Dilworth, Esq.
In the lead up to, and adoption of, the new lease accounting standards, many have looked at short-term leases to manage the impact on corporate balance sheets. However, they may be providing false hope.
Short term leases are defined in both ASC 842 and IFRS 16 as leases that have a likely lease term of 12 months or less and do not include a purchase option that the lessee is likely to exercise. A company can elect to exclude these leases from the balance sheet and treat the rent payments as a periodic expense. If you stop here, you can understand the appeal.
The reality is that these leases will expire. And when the expiration date approaches, companies will need to decide about their need for the leased asset. Under ASC 842 and IFRS 16, leases are reassessed when decisions are made (842-10-25-1 and IFRS 16:20), not when the renewal term starts. So, when a company decides to exercise a renewal option, it will have to include the remaining portion of the initial term with the term of the extension in deciding the new term of that lease. Exercising a 12-month renewal even one day before the expiration of the initial term will result in a lease with a term of more than 12 months, and move that lease to the balance sheet.
Signing 9-month leases with 9-month renewal terms may avoid the above scenario if a company doesn’t have to include a renewal in its likely term. But for most of a leased portfolio, that strategy will fall flat. Real estate, fleet, and other equipment are leased to support a business plan. Signing short-term leases exposes a lessee to tremendous risk in retaining the underlying asset, and to predict the cost of that lease.
Why does this idea persist? I’ve seen two main reasons:
- Too much focus on Day 1. This is not much ado about nothing, the way Y2K is now viewed. This is a change in day-to-day business. As companies adopt, the analyst and investor world is adjusting too, and the initial numbers will not mean as much as seeing trends over time.
- Avoidance as a Strategy. Too much effort has been spent trying to get around the standard, and not enough is spent on understanding it. The IASB and FASB published the discussion paper on this topic in 2009 and debated the rules until codification in late 2016 and early 2017, respectively. There are no quick workarounds. Learn the standard, see how your leases are treated, and – like companies have done for 40 years under FAS 13 – develop your leasing strategy to ensure your preferred treatment.
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