What are the common pitfalls and challenges of commercial leasing in your industry?

1 Lease term in accounting definition

Lease term in accounting is the period over which a lease contract is enforceable and the lessee has the right to use the leased asset. It includes any non-cancellable periods, as well as any periods that are likely to be extended or renewed based on the lessee's economic incentives or the lessor's expectations. Lease term in accounting is not necessarily the same as the contractual term, which is the stated duration of the lease agreement.

2 How to determine lease term in accounting

When determining the lease term in accounting, the lessee and lessor need to consider all relevant factors that may affect their decision to continue or terminate the lease. These could include the existence and enforceability of options to extend, renew, or terminate the lease; the economic benefits and costs of exercising or not exercising the options; the historical and expected future behavior of the parties; contractual, legal, regulatory, or market constraints that may limit the options; and the significance of the leased asset to the lessee's operations or lessor's portfolio. It is important to reassess the lease term in accounting whenever there is a change in facts or circumstances that affect the likelihood of exercising or not exercising these options.

3 Lease term in accounting impact

The lease term in accounting has a significant bearing on how the lease is classified and accounted for by the lessee and the lessor. Generally, a longer lease term implies greater control and ownership of the leased asset by the lessee, as well as increased financing and risk exposure by the lessor. This may result in a higher present value of lease payments and a higher lease liability and right-of-use asset for the lessee under new lease accounting standards (ASC 842 or IFRS 16). Additionally, it may cause the lease to be classified as a finance lease (or capital lease) for the lessee and a sales-type lease for the lessor under old standards (ASC 840 or IAS 17). This can also lead to a lower amount of rent expense and a higher amount of interest expense and depreciation expense for the lessee over the lease term, as well as a lower amount of lease income and a higher amount of interest income and gain on sale for the lessor at the inception of the lease.

4 Lease term in accounting challenges

Determining and accounting for the lease term in accounting can prove difficult for commercial tenants and landlords, as it requires estimating the probability and timing of exercising or not exercising the options, as well as applying consistent and reasonable assumptions and judgments across different leases and entities. It is also necessary to communicate and disclose the lease term in accounting and its impact on the financial statements and ratios to stakeholders, such as investors, lenders, auditors, and regulators. Furthermore, complying with the new lease accounting standards may require significant changes in systems, processes, and policies.

5 Lease term in accounting best practices

To overcome the challenges and avoid the pitfalls of lease term in accounting, commercial tenants and landlords should take a proactive and transparent approach to their lease term in accounting. This includes conducting a thorough analysis of the lease contract, developing and documenting a clear and consistent methodology for determining and reassessing the lease term in accounting, using reliable data and evidence to support assumptions and judgments made, engaging with external experts and advisors to obtain guidance and validation, and communicating the lease term in accounting and its impact on financial statements and ratios.