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Lease classification

Question 3-5

How should a lessee consider its past practices in assessing whether it is reasonably certain to exercise
an option to renew a lease or to purchase an underlying asset?

PwC response
A lessee should not rely solely on past practice, but should consider the economics underlying its
negotiated arrangement. The FASB acknowledged that optional terms may not meet the conceptual
definition of a liability, and therefore, the measurement of a lease liability should include options only
when the lessee has economically little choice but to exercise the option. However, a lessee’s past
practices (e.g., its history of retaining assets for a particular length of time before replacing them) may
be in response to factors that would commercially compel the lessee to renew the lease or to exercise a
purchase option.

To determine whether a renewal option is reasonably certain of exercise, a lessee and lessor should
compare the renewal rents with the expected fair market rents for equivalent property under similar
terms and conditions. In general, a renewal option with renewal rents that are equal to or greater than
the rents in the initial lease term is not considered to be reasonably certain of exercise; however, this
presumption could be overcome if the economic penalties the lessee would suffer by not exercising the
renewal option are significant. Any step-down in rents in a renewal period should give rise to a
presumption (which can be overcome) that the renewal option is reasonably certain of exercise by the
lessee. See LG 3.4 for factors to consider when determining whether renewal, termination, or purchase
options are reasonably certain of exercise.

We believe that a lease that is cancellable only upon the occurrence of a remote contingency should be
considered noncancellable for lease classification purposes.

If significant enough, a penalty for cancellation may result in a conclusion that continuation of the
lease appears, at lease commencement, to be reasonably certain. If so, it should be considered
noncancellable for any periods in which the penalty exists.

Question 3-6

How should a lessee and lessor determine the lease term in an arrangement that has no explicit end
date?

PwC response
A lessee and lessor should evaluate the enforceable rights and obligations in the contract. Any period
that may not be cancelled by the lessee should be included. Additionally, any provisions that allow the
lessee to extend the lease (i.e., renewal options) should be evaluated to determine whether the lessee is
reasonably certain to exercise them. For example, a lease agreement may provide a lessee with the
right to use an underlying asset on a daily basis (no stated end date) that the lessee may return at any
point subsequent to the first day of use. The noncancellable period of this type of lease would be a
single day and each subsequent day would be considered a daily renewal option that should be
included in the lease term if determined to be reasonably certain of exercise by the lessee after
considering all relevant contract-, asset-, entity-, and market-based factors.

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