Frequently, both franchisees and franchisors encounter the concept of being “reasonably certain to exercise an option.” But what does it mean? If you meet this criteria, how can you tell?
“Reasonably certain” means assessing the likelihood of exercising an option based on current circumstances and foreseeable future events. Intentions are not enough; you have to evaluate feasibility, benefits, and strategic alignment with your long-term goals.
ASC 842 requires organizations to recognize lease assets and liabilities on the balance sheet. This includes guidance on how to account for these leases. How can you be reasonably certain to exercise an option?
Many of our clients have asked this question. I wish I could simply give you a straightforward answer; but… It depends.
I can give you some of the rationale we’ve heard from clients.
The first point, Leasehold improvements, is the biggest and easiest factor to justify. Brick-and-Mortar locations are probably not interested in moving if the location is still viable, because they have made a large investment into the leased location.
That’s why many of our QSR and retail clients decide they’re likely to exercise any options that are within a 25-year window of their lease start date. They explain this decision by saying that spreading the asset’s depreciation over 27.5 years implies they believe the location will remain appealing throughout this period. The FASB outlines this fairly well in 842-10-55-26 Section B. Implementation Guidance and Illustrations (fasb.org) If you don’t typically visit the FASB site you might need to click the link and login, then click the link again, FASB’s site has some nuance…
When considering whether to exercise an option under ASC-842, such as a lease extension or purchase option, entities should assess several key aspects.
Best Practices for Documenting the Decision-Making Process Regarding the Probability of Exercising an Option
- Leasehold Improvements: Leasehold improvements generally serve as key indicators. If the useful life of the improvements is longer than the remaining lease term, including reasonably certain renewal periods.
- Economic Factors: Consider the economic incentives or disincentives related to exercising the option. This includes comparing the costs of exercising the option versus available market alternatives. If the cost of exercising the option is significantly lower than market alternatives, it might indicate a reasonable certainty of exercise.
- Strategic Importance: Evaluate the strategic importance of the leased asset. If the asset is critical to your business operations or provides a strategic advantage, and this may lean towards exercising the option.
- Historical Practices: Your past behavior in similar situations can be an indicator. If historically you have exercised similar options, it might suggest a likelihood of exercising the current option.
- Contractual Terms and Conditions: Examine the specific terms and conditions of the option. Some options might have terms that make exercising them more or less favorable, but not always. It is important to understand the lease and have an accurate lease abstract for reference.
- Market Conditions and Business Forecasts: Analyze current and forecasted market conditions. If future market trends indicate that it would be beneficial to exercise the option, this should be taken into account.
- Asset Specificity: If the leased asset is highly specialized or customized for your business. The specialized or customized nature of the leased asset may increase the likelihood of extending the lease or purchasing the asset.
- Financial Implications: Understand the financial impact of exercising the option, including effects on financial statements, ratios, and covenants.
- Management’s Intent: Finally, the intent of management plays a crucial role. Management’s intention to exercise the option should carry significant weight, even if all other indicators suggest otherwise.
Please note: The information provided here is not legal, financial, or any other form of professional advice. It is based on observations we have made. I advise you to thoroughly document and explain the reasons for your decisions, but don’t forget to document this along with your ASC-842 compliance notes.
