To what extent do lenders or credit analysts care about lease renewal options? In the proposed lease accounting model, lessees will capitalize the longest lease term that is more likely than not to occur. This means that renewal periods that a lessee is not obligated to renew will be measured as part of the lease liability if that renewal period is part of the lease term that is more likely than not to occur. For a lease with renewal options, debt-to-equity ratios will be higher than for a lease of the same asset for the same initial period of use, but without any renewal options.

What strikes me as odd (and gives rise to my first question) is that, generally speaking, a lender would be more willing to lend to an entity with lower debt-to-equity ratios, all else equal. But at the same time, a lender would judge an entity with the option to renew a lease as marginally more credit worthy than an entity without an option to renew a lease, because the latter is more exposed to adverse movements in rental rates.

Said differently, debt-to-equity ratios would favor an entity that leases an asset with no renewal options over an entity that leases the same asset with renewal options. In contrast, the presence of fixed price options to renew a lease make an entity less exposed to adverse rental rate movements than a lease contract without renewal options. So which of the two is more important to lenders and credit analysts when making credit ratings and lending decisions? Under what circumstances would an entity with a fixed-term lease appear more creditworthy than an entity with a lease with optional renewal periods that extend for the same length of time? What are the important economic factors to consider when differentiating between leases with fixed terms and leases with renewal options that cover the same fixed term, and does the proposed leasing model capture and portray these factors in a useful way?

Jeffrey Hales, Shankar Venkataraman, and I are currently pursuing a study that asks these questions, and we’d love to get comments and reactions to these questions as we’re finalizing our experimental task. What are your thoughts?