The new FASB changes that will go into effect in 2019 for public companies and 2020 for private companies will require that all future lease obligations are recorded on the corporate balance sheets.  This measure is meant to provide transparency given that leases are contracts with future liabilities.  However, the FASB measure goes further in that options to extend the lease will also need to be noted on balance sheets in most cases.  The leases your company has in place today and any new leases are going to fall under the new rules.

The following from FASB defines the lease term:

Lease Term: The non-cancellable period for which a lessee has the right to use an underlying asset, together with all of the following:

• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
• Periods covered by an option to terminate the lease 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 exercise of the option is controlled by the lessor.

The following are the guidelines for determining whether a lessee is “reasonably certain” to exercise an option to extend the lease:

Reasonably Certain Test:  At the commencement date, an entity assesses whether the lessee is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment—contract-based, asset-based, market-based, and entity-based factors. An entity’s assessment often will require the consideration of a combination of those factors because they are interrelated. Examples of economic factors to consider include, but are not limited to, any of the following:

A. Contractual terms and conditions for the optional periods compared with current market rates, such as:

• The amount of lease payments in any optional period.
• The amount of any variable lease payments or other contingent payments, such as payments under termination penalties and residual value guarantees.
• The terms and conditions of any options that are exercisable after initial optional periods (for example, the terms and conditions of a purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates).

B.  Significant leasehold improvements that are expected to have significant economic value for the lessee when the option to extend or terminate the lease or to purchase the underlying asset becomes exercisable.

C.  Costs relating to the termination of the lease and the signing of a new lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee’s operations, or costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location.

D.  The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialized asset and the location of the underlying asset.

Impacts to Your Company

Based on the above, it is likely that most companies will be recording lease option periods on their balance sheet.  While it may be possible to avoid one or two of these tests through creative structuring of the lease agreement, it will be difficult to avoid all four of the criteria above.  A few examples are noted below that pertain to the “reasonably certain” tests:

• For companies with an option to renew at a rental rate that is stated as a discount to market rate, the option years will certainly need to be recorded on the balance sheet.
• For companies that have a high cost of relocation due to specialized improvements, the option years will certainly need to be recorded on the balance sheet.
• For companies with recent space improvements with a remaining usable life and value, the option years will need to be recorded on the balance sheet.
• For companies that have a lease clause whereby they need to restore the premises to a shell condition or condition as specified by the Landlord in the lease that existing prior to tenant’s improvements, the lease option years will need to be recorded on the balance sheet.

Historically, tenants have preferred to have options to extend the lease because it provides a measure to control the space and also was a negotiating chip to some extent.  Now, these options to extend the lease will have some consequences.  Moving forward, at minimum, space users will need to consider the value of having an option to extend the lease versus how that option impacts the balance sheet.  For companies that use the International Financial Reporting Standards (IFRS), these lease options to extend will also have a negative effect on the profit and loss statement that will result in a lower net income, so even more to consider.

ITRA Global is an organization of real estate professionals specializing in representing commercial tenants and buyers in the leasing, acquisition and disposition of office, industrial and retail facilities. With coverage in major markets around the world, ITRA Global is one of the largest organizations dedicated to representing tenants and occupiers of commercial real estate. Clients benefit by having an experienced professional as their trusted advisor, providing conflict-free representation with total objectivity. To learn more about conflict-free representation and ITRA Global locations, please visit the ITRA Global web site.

Article submitted by Wayne Teig of ITRA Global / Minneapolis – St. Paul, Minnesota, USA.