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The leases standard requires lessees to record a right-of-use asset and a lease liability for all leases other than those that, at lease commencement, have a lease term of 12 months or less. A reporting entity can elect an accounting policy by class of underlying asset not to record such short-term leases on the balance sheet. See LG 2.2.1 for information on the short-term lease measurement and recognition exemption.
Similar to accounting policies in other areas of GAAP, reporting entities may be able to establish reasonable capitalization thresholds below which assets and liabilities related to a lease are not recognized. When establishing an appropriate capitalization threshold, a lessee should evaluate all relevant quantitative and qualitative factors impacting both the financial statements and the footnote disclosures, including quantitative information about a lessee's lease costs. This could result in a lower capitalization threshold than would be determined based on the financial statement effects alone.
We do not believe it is appropriate for a lessee to net the right-of-use asset and lease liability when establishing a capitalization threshold. We believe all financial statement line items should be evaluated individually and in the aggregate when establishing an appropriate threshold.
The following sections discuss the initial recognition and measurement of the right-of-use asset and lease liability for finance leases and operating leases.

4.2.1 Measuring the lease liability

On the lease commencement date, a lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments, discounted using the rate implicit in the lease (or if that rate cannot be readily determined, the lessee’s incremental borrowing rate). Lease payments used in measuring the lease liability are amounts due to the lessor excluding any payments that a lessee makes at or before lease commencement. As discussed in LG 3.3.4, there are six items that should be factored into measuring lease payments. Lease arrangements should be thoroughly reviewed to ensure that all applicable payments are being considered.
With some exceptions, the lease payments used to measure the lease liability should be the same as those used to determine lease classification. Two of these exceptions are:
  • To classify a lease, a lessee should use all lease payments (i.e., including payments made at or before the commencement date), whereas only the remaining payments due should be used to measure the lease liability at lease commencement
  • For lease classification purposes, the entire potential payment under a residual value guarantee should be included in the lease payments. The lease liability recorded at lease commencement should only include amounts probable of being owed by the lessee under residual value guarantees
See LG 3.3.4.6 and LG 3.3.4 for information on determining the discount rate and lease payments for lease classification purposes.

4.2.2 Measuring the right-of-use asset

ASC 842-20-30-5 provides guidance on measuring the right-of-use asset at the commencement date.

ASC 842-20-30-5

At the commencement date, the cost of the right-of-use asset shall consist of all of the following:
a. The amount of the initial measurement of the lease liability
b. Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received
c. Any initial direct costs incurred by the lessee (as described in paragraphs 842-10-30-9 through 30-10).

The items added to the lease liability to determine the costs of the right-of-use asset are discussed in the following sections.

4.2.2.1 Payments/incentives occurring at or before commencement

Lease payments made prior to lease commencement (for use of the underlying asset) should be recorded as prepaid rent. This prepaid amount should then be reclassified to the right-of-use asset on the lease commencement date. Thus, the right-of-use asset is increased for any lease payments made by a lessee at or before the lease commencement date. See LG 3.3.4.2 for information on lease incentives.

4.2.2.2 Initial direct costs

Initial direct costs should be recorded as an increase in the lessee’s right-of-use asset but should not be recorded as part of the lease liability.
Initial direct costs are incremental costs of a lease that would not have been incurred had the lease not been executed. Costs directly or indirectly attributable to negotiating and arranging the lease (e.g., external legal costs to draft or negotiate a lease or an allocation of internal legal costs) are not considered initial direct costs.
Figure LG 4-1 provides examples of costs included and excluded from initial direct costs.
Figure LG 4-1
Examples of costs included and excluded from initial direct costs
Included
Excluded
  • Certain substantive incentive-based commissions (including payments to employees acting as selling agents)
  • Lease documentation preparation costs incurred after the execution of the lease (e.g., regulatory and other filing fees)
  • Legal fees that are contingent on successful execution of the lease
  • Certain payments to existing tenants to move out
  • Consideration paid for a guarantee of a residual asset by an unrelated third party
  • Employee salaries (including commissions that are in-substance salaries)
  • Internal engineering costs
  • Negotiating lease term and conditions (including the preparation of drafts)
  • Legal fees for services rendered before the execution of the lease
  • Advertising
  • Other origination efforts
  • Depreciation
  • Costs related to an idle asset
Any costs that would have been incurred even if the lessee or the lessor failed to execute the lease are not incremental costs and should be excluded from initial direct costs. Determining whether a payment is an incremental cost may depend on the facts and circumstances. For example, ASC 842-10-55-240 through ASC 842-10-55-242 provides an example in which external legal fees are excluded from initial direct costs because the lessee would be required to pay its attorneys for negotiating the lease even if the lease were not executed. However, when a lessee and lessor execute a legally-binding lease commitment prior to drafting the lease agreement, legal fees for drafting may be incremental costs that can be accounted for as initial direct costs.
Sales tax payments
Some leases of equipment require that the lessee make sales tax payments directly to a taxing authority. The specifics of each arrangement vary greatly by jurisdiction. Certain sales taxes may be considered lessee costs. If this is the case, the sales tax payment is not a lease payment. We believe that a lessee must carefully assess when the legal obligation arises for the sales tax in order to determine if the amount should be recorded as an initial direct cost.
If a legal obligation that requires the lessee to pay sales tax arises at lease commencement, it should be accounted for as a liability and an initial direct cost. For example, if a lessee enters into a 5-year lease with a rent payment of $100 per year and is obligated to pay $8 as sales tax per year to the taxing authority whether or not the lease is cancelled, the lessee should record $40 ($8 per year × 5 years, ignoring present value for example purposes) as a separate liability (i.e., not a lease liability) and initial direct costs at the lease commencement date.
If the legally obligating event to pay sales tax occurs over time, sales tax should be accounted for as incurred. For example, if the rent is billed every month (whether at the beginning or end of the month), sales tax should be expensed in that month, except that sales tax for any rent billed at commencement date should be accounted for as an initial direct cost.
Question LG 4-1 addresses minimum annual guarantee payment arrangements.
Question LG 4-1
Lessee Corp enters into a five-year real estate lease with a minimum annual guarantee (MAG) payment structure in each year of the lease. The MAG amount is contractually set for the first year and is known at lease commencement. For each subsequent year, the MAG amount is reset based on a percentage of sales in the prior year. The reset MAG amount can go up and down compared to the prior year. There is no floor.

How should Lessee Corp account for the MAG payment structure?
PwC response
We believe the first year’s MAG amount is the only in-substance fixed payment in the arrangement. Therefore, at commencement, Lessee Corp should calculate the lease liability and right-of-use asset based on the present value of the first year’s MAG amount. We further believe that Lessee Corp should account for all payments resulting from future MAG resets similar to variable lease payments that do not depend on an index or a rate. Although the MAG is established at the end of the preceding year, it is not incurred until the subsequent year. Therefore, Lessee Corp should recognize future MAG resets in the period in which the obligation for those payments is incurred. Since the only fixed payment is the first year’s MAG at lease commencement, Lessee Corp will not have a lease liability on its books for the remaining lease term after the first year. The right-of-use asset will be amortized over the entire lease term.

4.2.2.3 Examples – lessee initial recognition and measurement

Example LG 4-1, Example LG 4-2, Example LG 4-3, Example LG 4-4, Example LG 4-5, and Example LG 4-6 illustrate the measurement of a right-of-use asset and a lessee's accounting for leases.
EXAMPLE LG 4-1
Measuring the right-of-use asset
Lessee Corp and Lessor Corp execute a 10-year lease of a railcar with the following terms on January 1, 20X9:
  • The lease commencement date is February 1, 20X9.
  • Lessee Corp must pay Lessor Corp the first monthly rental payment of $10,000 upon execution of the lease.
  • Lessor Corp will pay Lessee Corp a $50,000 cash incentive to enter into the lease payable upon lease execution.
Lessee Corp incurred $1,000 of initial direct costs, which are payable on February 1, 20X9.
Lessee Corp calculated the initial lease liability as the present value of the remaining unpaid lease payments discounted using its incremental borrowing rate because the rate implicit in the lease could not be readily determined; the initial lease liability is $900,000.
How would Lessee Corp measure the right-of-use asset and record this lease?
Analysis
Lessee Corp would measure the right-of-use asset as follows:
Initial measurement of lease liability
$900,000
Lease payments made to Lessor Corp before the commencement date (i.e., before the first lease payment)
10,000
Lease incentive received from Lessor Corp at lease execution date
(50,000)
Initial direct costs
1,000
Initial measurement of right-of-use asset
$861,000
On January 1, 20X9 (the lease execution date), Lessee Corp would record the following journal entries:
Dr. Prepaid rent
$10,000
Cr. Cash
$10,000
To record the initial lease payment due at lease inception
View table

Dr. Cash
$50,000
Cr. Lease incentive
$50,000
To record receipt of the lease incentive from the lessor.
View table
On February 1, 20X9 (the lease commencement date), Lessee Corp would record the following journal entries:
Dr. Right-of-use asset
$900,000
Cr. Lease liability
$900,000
To record the right-of-use asset and lease liability
View table

Dr. Lease incentive
$50,000
Cr. Right-of-use asset
$50,000
To reclassify the lease incentive as an offset to the right-of-use asset
View table
Dr. Right-of-use asset
$10,000
Cr. Prepaid rent
$10,000
To reclassify the prepaid rent as an offset to the right-of-use asset
View table

Dr. Right-of-use asset
$1,000
Cr. Accrued expenses
$1,000
To record the initial direct costs
View table
EXAMPLE LG 4-2
Finance lease initial recognition – non-specialized digital imaging equipment lease (lessee)
Lessee Corp enters into a lease of non-specialized digital imaging equipment with Lessor Corp on January 1, 20X9. The following table summarizes information about the lease and the leased assets.
Lease term
5 years, no renewal option
Remaining economic life of the leased equipment
6 years
Purchase option
None
Annual lease payments
$1,100
Payment date
Annually on January 1 (first payment made at lease commencement)
Lessee Corp’s incremental borrowing rate
7%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
Other
  • Title to the asset remains with Lessor Corp upon lease expiration
  • The fair value of the equipment is $5,000 at commencement; Lessee Corp does not guarantee the residual value of the equipment at the end of the lease term
  • Lessee Corp pays for all maintenance of the equipment separate from the lease
  • There are no initial direct costs incurred by Lessee Corp
  • Lessor Corp does not provide any incentives
How would Lessee Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessee Corp could reasonably conclude that the lease is a finance lease as the lease term is a major part of the remaining economic life of the equipment (see LG 3.3 for lease classification criteria).
Lessee Corp would first calculate the lease liability as the present value of the four remaining unpaid annual fixed lease payments of $1,100 discounted at Lessee Corp's incremental borrowing rate of 7%; this amount is $3,725.
The right-of-use asset is equal to the lease liability plus the $1,100 rent paid on the lease commencement date.
Lessee Corp would record the following journal entry on the lease commencement date.
Dr. Right-of-use asset
$4,825
Cr. Lease liability
$3,725
Cr. Cash
$1,100
View table
See Example LG 4-11 for an illustration of the subsequent measurement and recognition for this fact pattern.
EXAMPLE LG 4-3
Finance lease recognition – real estate lease with a purchase option (lessee)
Lessee Corp enters into a property (land and building) lease with Lessor Corp on January 1, 20X9. The following table summarizes information about the lease and the leased asset.
Lease term
10 years
Renewal option
Five 5-year renewal options
If exercised, the annual lease payments are reset to then current market rents
Remaining economic life
40 years
Fair value of the leased property at commencement
$5,000,000
Purchase option
Lessee Corp has an option to purchase the property at the end of the lease term for $3,000,000. Lessee Corp is reasonably certain to exercise this option.
Annual lease payments
The first annual lease payment is $500,000, with increases of 3% per year thereafter (see schedule of lease payments below).
Payment date
Annually on January 1 (first payment made at lease commencement)
Incentive
Lessor Corp gives Lessee Corp a $200,000 incentive for entering into the lease (payable at the beginning of year 2), which is to be used for normal tenant improvements.
Lessee Corp's incremental borrowing rate
9.04%
The rate that Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
Other
  • Title to the property does not automatically transfer to Lessee Corp upon lease expiration
  • Lessee Corp does not guarantee the residual value of the real estate asset
  • Lessee Corp pays for all maintenance, taxes, and insurance on the property separate from the lease
  • There are no initial direct costs incurred by Lessee Corp
The schedule of lease payments (excluding the purchase option) is shown below.
Date
Amount
Year 1 (paid at commencement)
$500,000
Year 2 ($515,000 – $200,000 lease incentive)
315,000
Year 3
530,450
Year 4
546,364
Year 5
562,754
Year 6
579,637
Year 7
597,026
Year 8
614,937
Year 9
633,385
Year 10
652,387
Total
$5,531,940
How would Lessee Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessee Corp could reasonably conclude that the lease is a finance lease because the fixed price purchase option is reasonably certain to be exercised (see LG 3.3 for lease classification criteria).
Lessee Corp would first calculate the lease liability as the present value of the remaining unpaid annual lease payments, less the lease incentive paid in year 2, plus the exercise price of the purchase option using a discount rate of 9.04%.
PV of annual lease payments, less lease incentive
$3,237,510
PV of purchase option at end of lease term
1,262,490
Total lease liability
$4,500,000
The right-of-use asset is equal to the lease liability plus the $500,000 rent paid on the lease commencement date ($5,000,000).
Lessee Corp would record the following journal entry on the lease commencement date.
Dr. Right-of-use asset
$5,000,000
Cr. Lease liability
$4,500,000
Cr. Cash
$500,000
View table
See Example LG 4-12 for an illustration of the subsequent measurement and recognition for this fact pattern.
EXAMPLE LG 4-4
Lessee operating lease recognition – automobile lease
Lessee Corp leases an automobile from Lessor Corp on January 1, 20X9. The following table summarizes information about the lease and the leased asset.
Lease term
3 years, no renewal option
Remaining economic life of the automobile
6 years
Purchase option
Lessee Corp has the option to purchase the automobile at fair market value upon expiration of the lease.
Monthly lease payments
$500 (first payment made at lease commencement)
Payment date
Beginning of the month
Lessee Corp’s incremental borrowing rate
6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
Other
  • Title to the automobile remains with Lessor Corp upon lease expiration
  • The fair value of the automobile is $30,000 at commencement; Lessee Corp does not guarantee the residual value of the automobile at the end of the lease term
  • Lessee Corp pays for all maintenance of the automobile separate from the lease
  • There are no initial direct costs incurred by Lessee Corp
  • Lessor Corp does not provide any incentives
How would Lessee Corp measure and record this lease at commencement?
Analysis
Based on the facts Lessee Corp could reasonably conclude that this lease is an operating lease as none of the criteria for finance lease classification are met (see LG 3.3 for lease classification criteria).
Lessee Corp would first calculate the lease liability as the present value of the remaining unpaid monthly fixed lease payments discounted at Lessee Corp's incremental borrowing rate of 6%; this amount is $16,018.
The right-of-use asset is equal to the lease liability plus the $500 rent paid on the lease commencement date ($16,518). Lessee Corp would record the following journal entry on the lease commencement date.
Dr. Right-of-use asset
$16,518
Cr. Cash
$500
Cr. Lease liability
$16,018
View table
See Example LG 4-13 for an illustration of the subsequent measurement and recognition for this fact pattern.
EXAMPLE LG 4-5
Lessee operating lease recognition
Lessee Corp leases a copier from Lessor Corp on January 1, 20X9. The following table summarizes information about the lease and the leased asset.
Lease term
3 years, no renewal option
Remaining economic life of the copier
5 years
Purchase option
None
Annual lease payments
$500, which includes Lessor Corp maintenance for the term of the lease
Lessor Corp normally leases the same copier for $475 per year and offers a maintenance contract for $75 per year.
Payment date
Annually on January 1 (first payment made at lease commencement)
Lessee Corp’s incremental borrowing rate
5.5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
Other
  • Title to the copier remains with Lessor Corp upon lease expiration
  • The fair value of the copier is $2,000 at commencement; Lessee Corp does not guarantee the residual value of the copier at the end of the lease term
  • Lessee Corp pays $100 in legal fees related to filing the executed lease with the regulatory authorities, which are treated as initial direct costs
  • Lessor Corp does not provide any incentives
Lessee Corp has not made an accounting policy election to not separate the lease and nonlease components for this class of asset.
How would Lessee Corp measure and record this lease at commencement?
Analysis
The arrangement contains a copier lease (lease component) and maintenance (nonlease component). An allocation of the annual $500 fixed payment between the copier lease and maintenance would be made as follows:
Standalone price (A)
Relative % (A/$550)
= (B)
Annual fixed
payment (C)
Allocated annual
payment (B × C)
Annual copier lease payment
$475
86.4%
$500
$432
Annual maintenance contract fee
75
13.6%
$500
68
Total
$550
100%
$500
Based on the facts Lessee Corp could reasonably conclude that the lease is an operating lease as none of the criteria for finance lease classification are met (see LG 3.3 for classification criteria).
Lessee Corp would first calculate the lease liability as the present value of the remaining unpaid annual allocated lease payment amount of $432 discounted at Lessee Corp's incremental borrowing rate of 5.5%; this amount is $798.
The right-of-use asset is the sum of the lease liability, plus the $432 lease payment made on the lease commencement date and the initial direct costs paid by Lessee Corp ($100); this amount is $1,330 ($798 + $432+ $100).
Lessee Corp would record the following journal entry on the lease commencement date.
Dr. Right-of-use asset
$1,330
Cr. Lease liability
$798
Cr. Cash
$532
View table
EXAMPLE LG 4-6
Lessee operating lease recognition – lease payments tied to an index
Lessee Corp enters into a lease of equipment with Lessor Corp on January 1, 20X9. The following table summarizes information about the lease and the leased assets.
Lease term
4 years, no renewal option
Remaining economic life of the leased equipment
7 years
Purchase option
None
Annual lease payments
The first annual payment is $1,500
The annual payment increases each year by the prime rate on January 1st. For example, if the prime rate is 3% on January 1, 201X, then the lease payment for year two would be $1,545 ($1,500 + ($1,500 × 3%)).
Payment date
Annually on January 1 (first payment made at lease commencement)
Lessee Corp’s incremental borrowing rate
8%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp.
Other
  • Title to the asset remains with Lessor Corp upon lease expiration
  • The fair value of the equipment is $10,000 at commencement; Lessee Corp does not guarantee the residual value of the equipment at the end of the lease term
  • Lessee Corp pays for all maintenance of the equipment separate from the lease
  • There are no initial direct costs incurred by Lessee Corp
  • Lessor Corp does not provide any incentives
Prime rate at the lease commencement date is 3%. The lease payments based on the prime rate at commencement are:
Date
Amount
Lease commencement
$1,500
Year 2
1,545
Year 3
1,591
Year 4
1,639
Total
$6,275
View table
How would Lessee Corp measure and record this lease at commencement?
Analysis
Based on the facts, Lessee Corp could reasonably conclude that the lease is an operating lease as none of the criteria for finance lease classification are met (see LG 3.3 for classification criteria).
Lessee Corp would first calculate the lease liability as the present value of the remaining unpaid fixed lease payments plus the variable lease payment (based on the Prime rate at the lease commencement date) discounted at Lessee Corp's incremental borrowing rate of 8%; this amount is $4,096. Even if the Prime rate is expected to increase each year, the lease payments must be calculated using the rate at lease commencement and the rate will only be updated upon certain lease remeasurement events (see LG 5).
The right-of-use asset is equal to the lease liability plus the first lease payment made at lease commencement ($5,596).
Lessee Corp would record the following journal entry on the lease commencement date.
Dr. Right-of-use asset
$5,596
Cr. Lease liability
$4,096
Cr. Cash
$1,500
View table
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