Accounting for leases: measurement and re-measurement
We have discussed how to identify a lease in a contract and how to classify a lease (as operating or finance type) based on the terms of the lease contract. In this article, we discuss the initial recognition and measurement of leases and how re-measurement is made when changes occur in the contract during the estimated initial period of the lease.
The headline news about the lease standard is the recording of a lease liability and a related right-of-use asset. These are defined, quite simply, in the glossary to ASC 842:
Lease liability
A lessee’s obligation to make the lease payments arising from a lease, measured on a discounted basis.
Right-of-use asset
An asset that represents a lessee’s right to use an underlying asset for the lease term.
Determining the lease liability
In order to determine the lease liability, as with any present value calculation, the lessee requires lease payments information, including:
a. Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs 842-10-55-30 through 55-31).
b. Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date.
c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph 842-10-55-26).
d. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph 842-10-30-1) reflects the lessee exercising an option to terminate the lease.
e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph 842-10-25-2(d).
f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs 842-10-55-34 through 55-36).1
At the lease commencement date (the date on which a lessor makes an underlying asset available for use by a lessee), the lessee shall evaluate the terms of the lease as to what payments are due and what the timing of the payments are. Additional information on variable lease payments is covered in our related lease classification article. The purchase option needs to be evaluated based on the nature of the leased asset, and the likelihood that the lessee will exercise the option due to the underlying economics. Payments expected to be paid for early termination should be included and any probable residual value guarantees should also be part of the expected cash outflow.
The payments are then discounted at the implicit rate in the lease or, if that cannot be determined due to the inability of the lessee to determine the fair value of the leased asset at inception, the lessee shall use its incremental borrowing rate.
Generally, the payments used to determine lease classification will be the same as used for the initial measurement. Except, residual value payments are included for the purpose of lease classification but excluded for the lease liability calculation unless they are probable of being paid.
Determining the right-of-use asset
The asset is recorded as the sum of the following amounts:
- The lease liability
- Any payments made to the lessor prior to commencement date (prepaid rent) less any incentives received from the lessor
- Any initial direct costs associated with the lease
Initial direct costs are those incremental costs that a lessee may incur in connection with entering into a lease. Some examples would be: commissions paid to agents, legal fees related to executing the lease, payments paid to tenants to move out, or consideration paid to a third party to guarantee the residual value.
Generally, internal incremental costs such as salaries, advertising, other origination efforts, etc., may not be considered initial direct costs.
Example: Initial measurement
To illustrate the initial measurement, here is an example derived from ASC-842:
Assume an entity enters into a lease of office space for a period of five years with annual lease payments of $100,000 payable at the beginning of the year. The lease states that the annual payment increases each year based on the increase in the Consumer Price Index (CPI). At inception the CPI is 125. The interest rate implicit in the lease is not readily determinable, so the entity uses its incremental borrowing rate, which is 8 percent, to discount the cash flows.
The entity makes the initial payment of $100,000, and then records a lease liability of $331,213 (which is the present value of four payments of $100,000 discounted at 8 percent). The entity does not make any adjustment for the CPI escalation, as it is indeterminate how much that increase would be.
The entity records a corresponding right-of-use asset of $431,213, which is the present value of the future lease payments plus the initial upfront payment of $100,000.2
Let’s take the above assumptions and add some additional factors.
In order to convince the entity to enter into the lease, the lessor provides an incentive of $35,000 to the entity. In addition, the entity used a broker to locate the property and paid the broker a commission of $10,000. With these facts, the right-of-use asset now would be the sum of the $431,213 above, less $35,000 (lease incentive), plus $10,000 (initial direct costs), or $406,213.
Let’s continue the analysis to reflect the accounting as the property is used. At inception, the opening entry is as follows:
DR
CR
Right-of-use asset
$406,213
Lease liability
$331,213
Cash
$ 75,000
The lease has been categorized as an operating lease, and the entity has determined that its total fixed rent to be $475,000 ($500,000-35,000+10,000) Therefore, on an annual basis, it will recognize $95,000 of fixed rent expense.
After the first year, the CPI has increased by 2 percent. So the lease payment for year two will be $102,000. The entity’s disclosure will reflect variable rents of $2,000 for year two. The lease payments will be reflected as operating cash flows in the entity’s statement of cash flows.
That’s fairly straightforward, and seems familiar, but what happens with the balance sheet accounts? Here is where the accounting gets tricky. Let’s follow the journal entries.
At the end of each, the entity must accrete the interest at 8 percent on the lease liability, record the rent expense, amortize the right-of-use asset, and disburse the cash for year two rent. Note for this example, we will ignore the CPI rent increase.
End of year one entry
DR
CR
Rent expense
$95,000
Lease liability (accrete interest)
$26,497
Right-of-use asset
$68,503
End of year one balances
Right-of-use asset
$337,710
Lease liability
$357,710
Beginning of year two entry
Lease liability
$100,000
Cash
$100,000
Beginning of year two balances
Right-of-use asset
$337,710
Lease liability
$257,710
End of year two entry
Rent expense
$95,000
Lease liability (accrete interest)
$20,617
Right-of-use asset
$74,383
End of year two balances
Right-of-use asset
$337,710
Lease liability
$257,710
End of year two entry
Rent expense
$95,000
Lease liability (accrete interest)
$20,617
Right-of-use asset
$74,383
End of year two balances
Right-of-use asset
$263,326
Lease liability
$278,326
Beginning of year three entry
Lease liability
$100,000
Cash
$100,000
Beginning of year three balances
Right-of-use asset
$263,326
Lease liability
$178,326
End of year three entry
Rent expense
$95,000
Lease liability (accrete interest)
$14,266
Right-of-use asset
$80,734
End of year three balances
Right-of-use asset
$182,593
Lease liability
$192,593
Beginning of year four entry
Lease liability
$100,000
Cash
$100,000
Beginning of year four balances
Right-of-use asset
$182,593
Lease liability
$92,593
End of year four entry
Rent expense
$95,000
Lease liability (accrete interest)
$7,407
Right-of-use asset
$87,593
End of year four balances
Right-of-use asset
$95,000
Lease liability
$100,000
Beginning of year five entry
Lease liability
$100,000
Cash
$100,000
Beginning of year five balances
Right-of-use asset
$95,000
Lease liability
$0
End of year five entry
Rent expense
$95,000
Lease liability (accrete interest)
$0
Right-of-use asset
$95,000
End of year five balances
Right-of-use asset
$0
Lease liability
$0
As illustrated in the above example, accounting for leases classified as operating can be quite complex as contrasted with the current model. Although the rent expense running through the income statement is the same, the need to account for the balance sheet accounts over the term of the lease requires additional calculations and entries to be made each period.
Accounting for changes subsequent to the commencement date of the lease
ASC 842 addresses various scenarios where the initial lease terms or related assumptions about the lease may change and what the related accounting and re-measurements would be. Generally, there are two situations where an entity may need to re-measure the lease liability. These are:
- lease modifications, and
- other changes to the initial measurement due to changes in the original assumptions.
Lease modifications
The ASC 842 Glossary describes a lease modification as:
Lease modification
A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term).
Modifications can be handled in two ways, either as a new contract or as a modification to the initial contract.
A modification is treated as a new contract when it confers to the lessee an additional right of use.
Example: Modification grants an additional right of use
Lessee entered into a ten-year lease for 10,000 square feet of office space. At the beginning of year six, the entity and the landlord agree to modify the lease for the remaining five years by adding an additional 10,000 square feet of space. The increased rent corresponds to the then market rate of rent. Because the entity acquires an additional right of use, it treats the modification as a separate new lease contract, for 10,000 square feet at the stated rent. It continues to account for the original ten-year lease in the same manner, and measures and records a new lease liability and right-of-use asset related to the modification.3
Example: Modification does not grant an additional right of use
Lessee enters into a ten-year lease for 10,000 square feet of office space with annual rents of $100,000 paid in arrears. The incremental borrowing rate at lease inception is 6 percent. The lease is classified as an operating lease. After five years, the lessee and landlord agree to a lease modification, adding five years to the initial lease term and changing the rent for the remaining ten years to $110,000. At the date of the modification the lessee’s incremental borrowing rate is 7 percent. At the end of the five years, the lease liability and right-of-use asset is $421,236. (Note since the lease payments are made in arrears and the payments are level throughout the lease term, the balances of the lease liability and the right-of-use asset will be equal).
Since the modification does not provide an additional right of use, the modification is not treated as a separate contract, but is accounted for as a modification of the original lease. The lessee must first reassess the classification by assessing the criteria for classification as a finance lease. The extended term and rent do not change the classification and the lessee continues to classify the lease as operating. Therefore, the lessee calculates the present value level rents of $110,000 for ten years at the new incremental borrowing rate of 7 percent; a total of $772,594. The right-of-use asset is increased by the difference, $351,358. There is no gain or loss as a result of the modification.4
Assume the same facts as above, except that instead of office space the right-of-use asset is a piece of equipment, with a remaining economic life of twelve years at the date of modification. Now the additional term of ten years causes the lease to be reclassified to a finance lease, as the remaining term exceeds 75 percent of the remaining economic life. Here, again, the calculation for the additional lease liability and the same adjustment is made to the right-of-use asset. However, going forward the lessee accounts for rent payments in the manner of a finance type lease recognizing interest expense (at 7 percent) and amortization of the right-of-use asset in the income statement. Thus, the income state effect will be to recognize more expense early in the lease and less in the later years, rather than straight line rent expense of $110,000 per year.
Re-measurements as a result of changes in the initial assumptions
ASC 842 requires the lessee to reassess the lease term or lease option to purchase, if any of the following occurs:
a) There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset.
b) There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease.
c) The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so.
d) The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so.5
A lessee shall re-measure the lease payments if any of the following occur:
a. The lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph 842-10-25-8 (note accounting for this was addressed above).
b. A contingency, upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based, is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term.
c. There is a change in any of the following:
1. The lease term, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments on the basis of the revised lease term (note accounting for this event was addressed above).
2. The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph 842-10-35-1. A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option.
3. Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees.6
The following examples illustrate some of the above concepts.
Example: Change in assumptions related to renewal option
Assume an entity enters into a property lease with an initial term of five years with an option to extend the term for an additional three years. The annual rents are $50,000 for the initial term and $55,000 for the extended term. At the inception of the lease the entity was not certain about the success of this expansion to the new space and determined it was probable that it would not take up the option to extend the lease. As such, it accounted for the lease using lease payments of $50,000 for five years, using its incremental borrowing rate of 7 percent. The present value was calculated as $205,010 and recorded as the lease liability with the corresponding right-of-use asset.
During the third year of the lease, the operations at the new location were exceeding all expectations and as a result the lessee made a significant investment in leasehold improvements to enhance the customers’ experience. As a result, the lessee now has a significant economic incentive to exercise the renewal option, in order to realize the full benefit of its investment in the improvements. As a result, the lessee must reassess its initial measurements.
At the time of the re-measurement (at the end of year 3) the lease liability is now $90,401, which is also the balance of the right-of-use asset (the balances are the same as the rent payments are made in arrears). On the re-measurement date the lessee’s incremental borrowing rate is now 7.5 percent. The lessee determines that the lease with the renewal still qualifies as an operating lease. The lessee calculates the net present value of the now 5 remaining lease payments, totaling $265,000 at a 7.5 percent discount rate to yield a new lease liability of $213,546. It records the following entry to adjust the balance sheet:
DR
CR
Right-of-use asset
$123,145
Lease liability
$123,145
The income statement effect would be calculated as the:
Annual rent expense
Undiscounted cash flows $265,000+ (the right-of-use asset-lease liability) = $265,000/5=$53,000.
In this example, since the balance sheet accounts are equal, the annual rent is just the average for the five years. In other situations, such as when the rents are paid in advance or there are incentives or direct leasing costs, the annual rent is more complex to calculate. But the above formula will work.
Example: Change in assumption related to purchase option exercise
Assume an entity enters into a contract to lease some construction machinery. The terms of the lease are annual payments of $50,000 per year for five years, with a purchase option of $15,000 (which is not considered a bargain purchase option). The economic life of the asset is 6 years. At the inception of the lease it was not reasonably certain that the lessee would exercise the purchase option as it was not a bargain.
The lessee determined that the lease at inception was a finance lease due the fact that the lease term exceeded 75 percent of the economic life of the asset. Its incremental borrowing rate at inception was 5 percent and it used that rate to calculate the lease liability as $216,474. This amount is recorded also as the right-of-use asset.
After three years, the entity realizes that the scope of the road building project for which the machine was rented has changed significantly and is likely to extend for an additional two years. As a result it determines that it would be more economical for it to exercise the purchase option at the end of the five years rather than lease a new machine for an additional two years.
The lessee now must re-measure its lease liability to reflect this change in assumptions. At the time of the re-measurement the lessee’s incremental borrowing rate is now 4 percent. The balance sheet accounts are: Lease liability (at end of three years) $92,971; right-of-use asset (after 3 years of straight line amortization) $86,589.
The entity calculates a new lease liability as the net present value of the remaining lease payment: $50,000 for two years, plus the $15,000 purchase option paid at the end of the fifth year, discounted at 4 percent. The new lease liability is $122,041. The increase in the lease liability is $29,070. The entity records the following journal entry:
DR
CR
Right-of-use asset
$29,070
Lease liability
$29,070
The income statement effect would be as follows:
Right-of-use asset after adjustment $115,659
Three years remaining useful life 3
Annual amortization through year six $38,553
Annual interest expense related to new lease liability would be:
Year four $4,882
Year five $3,077
Those are just some basic examples of the reassessment and re-measurement concepts. In each situation, the entity must consider lease classification, changes in expected lease payments, changes in expected lease term, changes in exercise of purchase options and other features. In situations where there were index increases, adjustment to the original lease payment stream may be more complex.
Conclusion
As noted above, although accounting for finance leases will be familiar to entities used to capital lease accounting, the accounting for operating leases is quite complex and will require compound journal entries to properly accrete interest to the lease liability, reduce the right-of-use asset and properly recognize rent expense. In order to do so, many entities may need to use off system spreadsheets, as the legacy enterprise resource planning (ERP) systems may not be able to handle such entries automatically. This will, of course, require attention to internal control over financial reporting (ICFR). Moreover, when encountering the need for re-measurements, entities will need to document all of the assumptions and calculations to support the accounting after modifications.
For more information on this topic, or to learn how Baker Tilly can help with the transition to the new leasing standard, please contact our team.
1ASC 842-10-55-(226-231)
2ASC 842-10-55-(226-231)
3Adapted from ASC 842-10-55-(160-161)
4Adapted from ASC 842-10-55-(162-165)
5ASC-842-10-35-1
6 ASC-842-10-35-4
