How to Determine Lease Term

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

1. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option
2. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option
3. 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 lease term begins at the lease commencement date and includes any rent-free periods provided to the lessee by the lessor

Reasonably Certain

When evaluating periods that contain option periods, “Reasonably Certain” is considered a high threshold of probability under ASC 842. At the lease 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:

1. 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.
2. 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.
3. 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. 
4. 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.

Termination Rights

If termination rights are symmetrical (both parties have the unilateral right to terminate the arrangement), the lessee and lessor should determine if terminating the lease would result in either party incurring more than an insignificant penalty. If the termination rights are symmetrical with no more than an insignificant penalty, the lease term is limited to the period up to the time those symmetrical rights are exercisable.

When evaluating whether the lessee or lessor would incur more than an insignificant economic penalty, they should consider not only cash payments required to be made upon exercise of the termination options, but also other penalties, such as the cost of abandoning leasehold improvements or the disruption caused by relocating employees.

Accounting Guidance Referenced:

• ASC 842-10-Glossary
• ASC 842-10-20
• ASC 842-10-30-1
• ASC 842-10-55-25
• ASC 842-10-55-26
• PwC Leases October 2020 3-7