How to Determine ‘Reasonably Certain’ Under ASC 842

The lease accounting standard, ASC 842, governs how companies in the United States report leases on their financial statements. A core concept is “reasonably certain,” a judgment-based threshold that dictates the length of a lease term for accounting purposes. This determination directly influences the value of the right-of-use (ROU) asset and lease liability recorded on a company’s balance sheet. An incorrect assessment can materially misstate a company’s financial position.

The “reasonably certain” threshold requires a lessee to evaluate the likelihood of exercising options to extend or terminate a lease. This assessment moves beyond the fixed, noncancelable period of a lease agreement to incorporate future possibilities that have a high probability of occurring, based on an analysis of all relevant economic factors at the lease’s commencement.

Determining the Lease Term Under ASC 842

The foundation of lease accounting under ASC 842 is the accurate determination of the lease term. This term is defined as the noncancelable period of the lease, which is the minimum time both the lessee and the lessor are legally bound to the contract. This initial period forms the baseline for all subsequent calculations and assessments.

The lease term, however, often extends beyond this noncancelable period. The standard requires entities to include periods covered by an option to extend the lease if the lessee is “reasonably certain” to exercise that option. This involves a forward-looking analysis of economic incentives. Conversely, the lease term also incorporates periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise its right to terminate. The standard also accounts for options controlled solely by the lessor, which are automatically included in the lease term.

Key Economic Factors for Assessment

Evaluating whether the exercise of a lease option is “reasonably certain” involves a detailed assessment of various economic factors. These factors are not considered in isolation; their interplay provides the basis for a sound judgment. The guidance in ASC 842 groups these considerations into several categories:

• Contract-based factors: These relate directly to the terms of the lease agreement. This includes analyzing the lease payments in optional periods compared to expected market rates. A renewal option with rental rates significantly below market forecasts would create a strong economic incentive to extend.
• Asset-based factors: These focus on the underlying asset itself and its role in the lessee’s operations. If the asset is highly specialized, customized for the lessee’s use, or situated in a strategic location, the incentive to remain in the lease is heightened.
• Entity-based factors: These pertain to the lessee’s own circumstances and strategic plans. If a lessee has invested in significant leasehold improvements that have a useful life extending beyond the noncancelable lease term, this points toward an intention to renew.
• Market-based factors: This requires the lessee to look outside its own operations to the broader economic environment. This includes assessing the availability of suitable alternative assets in the marketplace. If few comparable assets exist, the lessee has a greater incentive to exercise an existing option.

Applying the Standard to Lease Options

Options to Extend

The application of the “reasonably certain” standard is illustrated when considering options to extend a lease. Imagine a company that leases a retail space for an initial five-year term with an option to renew for another five years. The company invests $500,000 in custom fixtures and leasehold improvements with an estimated useful life of ten years.

A strong economic incentive exists to exercise the renewal option, as failing to renew would mean abandoning the improvements with five years of economic value remaining. At the commencement of the lease, the company would conclude it is reasonably certain to exercise the extension option, and the lease term for accounting purposes would be recorded as ten years.

Options to Terminate

The logic is reversed when assessing an option to terminate a lease. Consider a manufacturing company that leases a warehouse for ten years, with an option to terminate after year seven. The lease agreement stipulates that if the company exercises this termination option, it must pay a penalty equal to one year’s rent.

Furthermore, the warehouse is integrated into the company’s supply chain, and moving would cause significant operational disruption. Given the substantial termination penalty and the high costs associated with operational disruption, it is reasonably certain that the company will not exercise the termination option. As a result, the lease term would be determined to be the full ten years.

Options to Purchase

The “reasonably certain” threshold also applies to options to purchase the leased asset. An entity must assess whether it has a compelling economic incentive to exercise the purchase option. This is most evident with a “bargain purchase option,” where the exercise price is set at an amount significantly below the asset’s expected fair market value.

For example, if a company leases equipment for five years with an option to purchase it for $10,000, and the expected fair market value at the end of the lease is $75,000, a clear economic incentive exists. The lessee is reasonably certain to exercise the purchase option, and the lease term would end on the date the option is exercisable. This lease would likely be classified as a finance lease due to the high probability of ownership transfer.

Reassessment of the Lease Term

The initial determination of the lease term is not necessarily permanent. ASC 842 requires a lessee to reassess its initial judgment if a “triggering event” occurs. A triggering event is defined as a significant event or a significant change in circumstances that is within the control of the lessee.

Examples of such triggering events include a lessee making a business decision that directly impacts the likelihood of exercising an option, such as deciding to sublease the asset. Another trigger would be incurring a significant and unplanned capital expenditure on leasehold improvements, altering the economic incentives.

When a triggering event occurs, the lessee must remeasure the lease liability using a revised discount rate and adjust the right-of-use asset. If the reassessment results in a change to the lease term, the liability is recalculated based on the new term and updated assumptions. This documentation is essential for audit purposes and provides a clear record of the judgments made.