To Be or Not to Be...
An Operating Lease

Opposition to Finance Lease Treatment. The Financial Accounting Standards Board (FASB) originally proposed updated lease accounting standards in August 2010 and finalized them in February 2016 (the 2016 Lease Standards). Much of the five-and-a-half-year incubation period can be traced to vocal, organized opposition to the initial proposal by commercial tenants, their trade associations and accountants, and Members of Congress, who complained that the proposal would have imposed what FASB now calls “finance lease” treatment on virtually all leases. Universal finance lease treatment is in fact the approach ultimately adopted by the International Accounting Standards Board (IASB). Opponents’ principal argument was that front-loading of earnings charges under the finance lease approach would significantly and artificially depress earnings—often erratically in years when large leases or many leases were originated or renewed. FASB’s eventual response was to distinguish between finance leases, which continue to employ front-loaded earnings charges, and operating leases, which apply a level annual lease charge composed of interest (that declines over time) and ROU amortization (that increases over time). Under the compromise approach although nearly all leases must be posted to the balance sheet, earnings charges for operating leases are straight-lined to approximate earnings results under the old rules of FAS 13.

Renewal Periods that Count Toward the Lease Term. Lost in the relief many stakeholders expressed with FASB’s two-tier approach is a subtle but consequential change made by the 2016 Lease Standards in how a company measures the term of its lease. In practice lease term is the key metric in applying two of the alternate tests that distinguish an operating lease from a finance lease (under the new rules) or a capital lease (under the old rules). Under the new rules a finance lease is one that meets any of five listed criteria, including where either: (i) the lease term is for the “major part” of the remaining economic life of the asset (allowing what amounts to a safe harbor threshold of 75%); or (ii) the present value of lease payments plus residual value guarantees equals or exceeds substantially all of the fair value of the asset (ASC 842-10-25-2; ASC 842-10-55-2). A longer lease term drives a given lease closer to characterization as a finance lease under both the economic life and present value tests—since a longer term means additional rent. Lease term includes not only the primary term but renewal periods for which the option to renew is “reasonably certain” to be exercised (ASC 842-10-30-1). Under the predecessor standard in FAS 13, a tenant’s optional renewal term could only be tacked onto the primary term in narrowly-defined circumstances involving either a bargain rental rate to renew, a guaranty of the lessor’s debt, certain penalties for non-renewal, or a bargain purchase option. In determining whether a given option was a “bargain”, only price was relevant.

The 2016 Lease Standards on the other hand count the terms of renewal options that are reasonably certain to be exercised because the tenant has an economic incentive to renew, whether arising from contract-based, asset-based, market-based, or entity-based factors. This test encompasses a far broader and more subjective set of potential incentives than a “bargain” option to renew or purchase. See ASC 842-10-30-2; ASC 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 at 95% of market rent at the time of exercise, would likely be treated as a 10 year lease under FAS 13 (and therefore an operating lease) but a 30 year lease under the 2016 Lease Standards (and therefore a finance lease). Listed factors that favor tacking renewal periods onto the initial lease term in this case include operational importance of the asset and its location, specialized nature of the asset, cost of relocating, and significant value to the tenant of leasehold improvements in place when a renewal option becomes exercisable (ASC 842-10-55-26). Moreover, if a tenant actually exercises a renewal option it must then reassess lease characterization in light of the longer term and additional lease payments (ASC 842-10-55-166; 842-10-25-1). If the tenant had initially characterized its lease as an operating lease, exercise of the first renewal option raises an obvious question—why wouldn’t the same FASB-listed factors that prompted its decision to renew also prompt exercise of the tenant’s remaining renewal options?

Problematic Purchase Options. Another avenue to capital lease treatment under FAS 13 was a “bargain purchase option”, the definition of which depended entirely on price. Here too the 2016 Lease Standards cast a wider net. Under the new rules the panoply of potential compulsions discussed above that might lead a tenant to exercise a renewal option must be considered when determining whether the tenant is reasonably certain to exercise its purchase option—a separate conclusion that by itself leads to finance lease treatment (ASC 842-10-30-3). See especially ASC 842-10-55-218, FASB's example that applies finance lease treatment where the specialized nature and operational importance of an asset create a "significant economic incentive" for the lessee to exercise a purchase option priced at FMV.

Conclusion. Some commentators have apparently taken comfort in FASB’s reassurance in the Summary of its 2016 Lease Standards that “reasonably certain” is a threshold consistent with, and intended to be applied in the same way as, the “reasonably assured” threshold of prior guidance. What FASB’s calming language glosses over, however, is that while the quantum of proof required may be no higher than it was under FAS 13, what has changed—to the tenant’s detriment—is the substance of what must be proved.