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Operating Lease Contract with Option to Renew

Hello, My company is starting a new lease agreement for our office building. We recently signed up for a new lease ( 7/15-06/2020) with an option to renew with an additional 5 years. At this moment, the likelyhood to extend the lease is very high. Going through the new lease process, we also incurred our LHI. With an understanding that, LHI items are depreciated at a shorter life of the our company policy ( 10 years) or the remaining of the contract . My question is: 1- When it comes to the useful life of LHI, should we also account for the period that the contract might be extended ( 07/2020-06/2025)? If we do, why ? and if we dont, why? is there any accounting pronouncements outthere that would help me to clarify with this matter? P.S: I did a good amount of research, and i dont seemt to have any luck with this. Thank you so much in advance. Best Regards,

Answers

Nick Sinigaglia
Title: SVP
Company: OnDeck
(SVP, OnDeck) |

The lease term should be the fixed term plus any renewal options that meet specific criteria (mostly bargain renewals or renewal periods where there is a compulsion to renew...i.e. penalties or costs that would compel you to renew - see 840-20-20 - Lease Term). Section 4.3.5.1 of EY's Financial Reporting Developments (FRD) gives good guidance, although non-authoritative.

From your basic facts, I can't tell if the renewal period would be considered in your lease term. If it is a plain vanilla, optional renewal, it is likely not. If there are penalties or compulsions to renew, it may be. Remember, that if the loss of the leasehold improvements at the end of the lease would be significant, that could be considered a "penalty" which might cause you to include the renewal term in the lease term.

Basically, the period over which to amortize the LHI's should be the shorter of the LHI's life or the lease term. The lease term would exclude the 5 year renewal period unless you included that renewal in the lease term as discussed above. I'd also be cautious about a company "policy" that directly conflicts with GAAP. If a 10 year depreciation period for your LHI's is less than both the actual useful life of the LHI as well as the lease, you could run into issues. - -

Ed Pierce
Title: CFO
Company: Coos Bay Partners
(CFO, Coos Bay Partners) |

As it usually does in accounting the response is it depends. The amorphous term leasehold improvements may, depending on materiality, need to be itemized as certain leasehold items may have different individual lives. For example if the leasehold improvements includes built in appliances such as a dishwasher that may or may not have a life of 5 or 10 years. At the end of the day you are estimating the economic life based on the facts and circumstances at the time the asset is placed in service. If at the time your best estimate is that you will renew the lease for additional 5 years then the period of amortization could extend over 10 years. If in year 3 it looks like you will out grow the space and not renew it would seem to me that you would have a change in estimate on the life of leasehold improvements and adjust accordingly.

Anonymous
(Senior Accountant) |

Thank you both for your responds. Truly appreciate it.

Kelvin Smith
Title: Vice President
Company: Financial Computer Systems Inc.
(Vice President, Financial Computer Systems Inc.) |

This issue actually has been addressed authoritatively, but it still ends up being a "facts and circumstances" issue. The SEC Chief Accountant wrote a letter to the AICPA in 2005 (https://www.sec.gov/info/accountants/staffletters/cpcaf020705.htm) clarifying the SEC's position, based on GAAP, that the depreciable life of leasehold improvements should not extend past the life of the related lease, including only renewals whose exercise is "reasonably assured." Under FAS 13 (= ASC 840), the "reasonably assured" threshold is based on economic factors, not typical practice (i.e., "we've always done it that way" doesn't matter). However, the threshold does include, as others mentioned, the question of whether a penalty for termination (or non-renewal) is large enough to impel continuation of the lease. You have to decide whether giving up your LHIs after just 5 years is a large enough loss that failure to renew the lease would be economically nonsensical. Typical practice would base that decision on the LHI value and the normal expected life compared to the initial term of the lease.

eden meng
Title: Senior Accountant
Company: ABC
(Senior Accountant, ABC) |

Your answer helps so much. Thank you

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