“Reasonably Certain” Under ASC 842: How to Determine the Lease Term

ASC 842 uses “reasonably certain” to determine whether an option period belongs in the lease term. The threshold is high, but the standard does not assign it a percentage. Reaching a different conclusion can change the lease liability by more than half.

Black Owl Systems keeps lease records and supporting judgments together throughout the lease term. This guide addresses lessee accounting under ASC 842, with related considerations for lessors.

Teams reporting under IFRS 16 or ASPE 3065 can compare the frameworks below. A centralized lease management record helps retain option assessments and their supporting evidence. Black Owl’s implementation and advisory services can support that workflow.

What does “reasonably certain to renew” mean in ASC 842?

A renewal is reasonably certain when exercising the option is almost a foregone conclusion. Under ASC 842-10-30-1, the lessee includes renewal periods that meet this threshold in the lease term. Periods that do not meet it are excluded.

ASC 840 used the expression “reasonably assured” for the same assessment. When the FASB introduced ASC 842, it deliberately retained that high threshold. The change in terminology did not make the test easier to satisfy.

What does reasonably certain mean?

Reasonably certain demands more than probable. In US GAAP, probable means likely to occur, which practitioners often interpret as a likelihood of approximately 75% to 80%. Reasonably certain sits above that level, closer to virtual certainty.

Those percentages do not define the reasonably certain threshold. The standard specifies no numerical cutoff and does not ask preparers to calculate a probability. It calls for an assessment of the economic incentive to exercise the option.

Using probable as the test admits renewal periods that would not qualify under the higher threshold. Across a portfolio, that approach produces longer lease terms and larger liabilities than the standard requires.

The reverse error is more common: teams take the initial contractual period as the accounting lease term without evaluating the options at all. The resulting liability is understated, an issue auditors specifically investigate. ASC 842 requires the option assessment; it is not a step companies may choose to omit.

What are the requirements for a lease to be considered “reasonably certain”?

There is no checklist whose completion establishes reasonable certainty. ASC 842-10-30-2 identifies factors that create an economic incentive to exercise an option. The conclusion comes from weighing those factors together.

Management’s current intentions provide limited evidence on their own. The stronger evidence concerns what the lessee would be economically compelled to do. Assess the financial and operational consequences of the choice, rather than relying on the current plan.

Leasehold improvements and the comparison between renewal rent and market rent usually carry the greatest weight. Both can be supported with objective evidence, making the conclusion easier to defend.

An option fixed substantially below expected market rent can be nearly decisive by itself. Declining it would mean surrendering economic value without a reason to do so.

A large fit-out creates a similar incentive. Leaving the premises would sacrifice the tenant’s investment, particularly when the improvements have a useful life extending well beyond the initial term.

There is also a circular relationship between the fit-out and its amortization. The investment supports a conclusion that renewal is reasonably certain, extending the lease term. That longer term then extends the amortization period for the improvements that supported the conclusion in the first place. This relationship is common where tenants have invested heavily in their premises.

Applying the threshold to renewal, termination, and purchase options

Reasonable certainty applies to three types of option, although each affects the accounting differently.

A renewal option adds time to the lease term when exercise is reasonably certain. A termination option removes time when its exercise is reasonably certain. Both assessments take place at commencement and draw on the same economic factors.

A purchase option has a different effect. When exercise is reasonably certain, the option points toward finance lease classification, and its exercise price is included in lease payments.

The threshold applies only to options held by the lessee. An option controlled solely by the lessor does not extend the lease term because the lessee cannot decide whether it will be exercised. Where renewal requires both parties to agree, there is no enforceable renewal option.

Enforceability limits the assessment before the economic factors are considered. However compelling the incentive to remain, the lease term cannot extend beyond the enforceable period. Accounting when an option is actually exercised is separate from the conclusion reached at commencement.

Assessing month-to-month and evergreen leases

Month-to-month arrangements are both common and difficult to assess. A contract may run for only one month at a time while the tenant remains in place for years.

Begin with enforceability. Where either party can end a month-to-month arrangement on 30 days’ notice, the enforceable period is one month. Neither party has enforceable rights or obligations beyond that period.

That supports a one-month lease term, which generally qualifies for the short-term exemption. Many companies end their assessment there. For genuinely temporary arrangements, that conclusion holds.

A termination penalty changes the analysis. When ending the arrangement requires a payment that is more than insignificant, the enforceable period extends. The lease term then covers the period during which that penalty applies.

Automatically renewing evergreen leases require the same review. Consider the cancellation notice, any penalty, and whether either party can realistically exercise its cancellation right. A holdover that has continued on unchanged terms for eight years warrants examination.

How the assessment determines the lease term

The contractual period and the accounting lease term need not be the same. A five-year contract with a five-year renewal that is reasonably certain to be exercised has an accounting lease term of ten years.

That ten-year term determines the payments discounted into the liability and the period over which the asset is amortized. The resulting right-of-use asset balance therefore depends directly on the option assessment.

The discount rate must also reflect the term selected. An incremental borrowing rate represents borrowing over a comparable period, so a ten-year lease term requires a ten-year rate. Matching the borrowing rate to the assessed term can change the rate as well as the number of payments, adding to the measurement effect.

When the option assessment must be revisited

Make the initial assessment at commencement. ASC 842 does not require a new assessment at every reporting date; it requires one when specified triggers occur.

A significant event or change in circumstances triggers reassessment when it is within the lessee’s control. Constructing a major extension at a leased site qualifies. A movement in local market rents does not, because the lessee does not control it.

Reassessment is also required when the lessee exercises an option previously assessed as not reasonably certain, or fails to exercise one that had been included in the lease term.

Reassessment and modification are often confused, but they concern different changes. A reassessment revises the judgment about a contract whose terms remain unchanged. A modification changes the contract itself. The events requiring the lease term to be reconsidered determine which accounting process applies.

Why the judgment affects the short-term exemption

The short-term lease exemption is available for a lease whose term at commencement is twelve months or less. The relevant term is the accounting lease term, not merely the period written into the initial contract.

A twelve-month agreement with a renewal option reasonably certain to be exercised runs beyond twelve months for accounting purposes. It does not qualify for the exemption. Applying the election using only the initial contractual period gives the wrong result.

A purchase option reasonably certain to be exercised also prevents use of the exemption. The policy elections available for the lease depend on the same option judgment.

Supporting the conclusion for audit

An unsupported number in a lease system is difficult to defend. Auditors accept judgments supported by reasoning and evidence, applied consistently across the portfolio. The documentation behind the answer matters more than the answer alone.

Prepare a short memo whenever the conclusion is not obvious. Identify the factors considered, the evidence supporting each one, the weight assigned, and the resulting judgment. Around half a page is usually sufficient for a reviewer.

Two additional details make the file considerably stronger. Record who reached the conclusion and when it was made, since auditors will ask for both. Also record when the conclusion should next be revisited, giving trigger events a defined point of reference.

Include the memo reference in the information maintained on the lease record. It belongs with the wider evidence supporting an audit-ready lease file, rather than being stored without a connection to the accounting record.

Applying the factors to three leases

The following three lease examples are illustrative.

The same factors can produce a clear conclusion in either direction or leave room for judgment. The following examples illustrate all three outcomes.

Lease A: suburban office – renewal is not reasonably certain. The initial term is five years, followed by one five-year option at the market rent prevailing on renewal. A standard office fit-out cost $40,000 and will be fully amortized during the initial term. Comparable offices are readily available throughout the submarket. None of the factors supports exercise, and renewal offers no advantage over market rent. The lease term is five years.

Lease B: manufacturing plant – renewal is reasonably certain. A ten-year initial term is followed by a five-year option at fixed rent approximately 30% below the current market. The tenant has installed $4 million of process equipment bolted into the building, making relocation uneconomic. There is no comparable site along the same utility corridor. Three high-weight factors support the same conclusion. The lease term is fifteen years.

Lease C: retail unit – the conclusion is marginal. The contract provides for five years initially and one further five-year period at then-market rent. The tenant has invested $200,000 in a fit-out with twelve years of remaining useful life. Trading is ahead of plan, although several other locations in the catchment would be viable.

For Lease C, the fit-out supports renewal while the market-rate option points against it. The site’s importance to the business is neutral because other locations in the same catchment could work.

Annual rent is $120,000, paid in arrears, and the incremental borrowing rate is 6%. The balance sheet effect of each conclusion is shown below.

The judgment changes the balance sheet by $377,727, or 75%, for this lease alone. On the facts presented, either conclusion can be defended.

An auditor would not usually overturn either answer in this example. A missing memo or inconsistent treatment across comparable leases is more likely to be challenged. Once the term has been established, the difference in the accounting entries follows from the calculation.

Reasonable certainty under IFRS 16 and ASPE 3065

IFRS 16 uses the same expression and the same threshold. IFRS 16.18 includes option periods when exercise is reasonably certain, and the factors in IFRS 16.B37 closely resemble those under ASC 842.

The distinction lies in reassessment rather than in the initial threshold. Like ASC 842, IFRS 16 requires reassessment following a significant event within the lessee’s control. IFRS 16 also accommodates changes in circumstances affecting the assessment more broadly, although practice differs in how widely that provision is interpreted.

ASPE 3065 takes a different approach. Its risks-and-rewards model classifies leases as capital or operating, with renewal options affecting that classification. The Canadian private enterprise standard continues to keep operating leases entirely off the balance sheet.