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4.4 Subsequent recognition and measurement – lessee
Publication date: 30 Jun 2021
us Leases guide
Over the lease term, a lessee must amortize the right-of-use asset and record interest expense on the lease liability created at lease commencement. The income statement recognition and classification are based on how the lease is classified. See LG 3 for information on lease classification.
4.4.1 Finance leases
Finance leases are accounted for in a manner similar to financed purchases. The right-of-use asset is amortized to amortization expense. Interest expense is recorded in connection with the lease liability.
Figure LG 4-2 describes how expenses are recognized for finance leases.
Figure LG 4-2
Lessee finance lease expense recognition
Lessee finance lease expense recognition
Expense classification |
Income statement recognition pattern |
Amortization expense |
Straight-line recognition over the shorter of the useful life of the asset or the lease term |
Interest expense |
Interest method |
Example LG 4-11 illustrates the subsequent measurement of a right-of-use asset and lease liability.
EXAMPLE LG 4-11
Finance lease subsequent measurement and recognition – non-specialized digital imaging equipment lease (lessee)
Finance lease subsequent measurement and 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 |
|
How would Lessee Corp measure the right-of-use asset and lease liability over the lease term?
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).
At commencement, 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 ($4,825).
Lessee Corp would amortize the right-of-use asset on a straight-line basis over the lease term because the remaining economic life is greater than the lease term.
Amortization |
Right-of-use asset |
|
Lease commencement |
$4,825 |
|
Year 1 |
$965 |
3,860 |
Year 2 |
965 |
2,895 |
Year 3 |
965 |
1,930 |
Year 4 |
965 |
965 |
Year 5 |
965 |
0 |
$4,825 |
Interest expense on the lease liability would be calculated using a rate of 7%, the same discount rate used to initially measure the lease liability. The lease liability would change as follows (assuming beginning of year payments):
Payment |
Principal paid |
Interest paid |
Interest expense |
Lease liability (end of year) |
|
Lease commencement |
$3,725 |
||||
Year 1 |
* |
$261 |
3,986 |
||
Year 2 |
1,100 |
839 |
261 |
202 |
3,088 |
Year 3 |
1,100 |
898 |
202 |
139 |
2,127 |
Year 4 |
1,100 |
961 |
139 |
73 |
1,100 |
Year 5 |
1,100 |
1,027 |
73 |
0 |
0 |
$4,400 |
$3,725 |
$675 |
$675 |
*No payment is reflected in Year 1 because the first payment was made at lease commencement and is not included in the lease liability.
Adding the amortization and interest expense from the two charts above, the total expense recorded per period is higher in earlier periods and decreases throughout the lease term (from $1,226 in year 1 to $965 in year 5).
Adding the amortization and interest expense from the two charts above, the total expense recorded per period is higher in earlier periods and decreases throughout the lease term (from $1,226 in year 1 to $965 in year 5).
4.4.1.1 Finance lease with a purchase option
When a lease is classified as a finance lease because it contains a purchase option that the lessee is reasonably certain to exercise, the lessee has an additional payment to make related to the exercise of the purchase option. This additional lease payment should be included in the lease liability as a payment occurring at the date the lessee expects to exercise the purchase option, which is typically at the end of the lease term. Interest expense will be calculated on the full amount of the lease liability, which includes the present value of the purchase option payment. Because it is reasonably certain that the lessee will obtain the asset at the end of the lease term, the right-of-use asset should be amortized over the useful life of the asset, rather than over the lease term.
Example LG 4-12 illustrates the measurement of a finance lease with a purchase option.
EXAMPLE LG 4-12
Finance lease subsequent measurement and recognition – real estate lease with a purchase option (lessee)
Finance lease subsequent measurement and 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 |
|
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 the right-of-use asset and lease liability over the lease term?
Analysis
Based on the facts Lessee Corp could reasonably conclude that the lease is a finance lease because it grants Lessee Corp a fixed price purchase option that Lessee Corp is reasonably certain to exercise (see LG 3.3 for lease classification criteria).
At commencement, 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%; the amount is $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).
Since the purchase option is reasonably certain to be exercised, Lessee Corp would amortize the right-of-use asset over the economic life of the underlying asset (40 years). Annual amortization expense would be $125,000 ($5,000,000/40 years).
Interest expense on the lease liability would be calculated as shown in the following table. This table includes all expected cash flows during the lease term, including the lease incentive paid by Lessor Corp and Lessee Corp’s purchase option. See Example LG 4-3 for a schedule of payments.
Payment |
Interest expense |
Lease liability (end of year) |
|
Lease commencement |
$4,500,000 |
||
Year 1 |
$0* |
$406,840 |
4,906,840 |
Year 2 |
315,000** |
415,143 |
5,006,983 |
Year 3 |
530,450 |
404,718 |
4,881,251 |
Year 4 |
546,364 |
391,912 |
4,726,800 |
Year 5 |
562,754 |
376,466 |
4,540,511 |
Year 6 |
579,637 |
358,098 |
4,318,972 |
Year 7 |
597,026 |
336,497 |
4,058,443 |
Year 8 |
614,937 |
311,323 |
3,754,829 |
Year 9 |
633,385 |
282,206 |
3,403,650 |
Year 10 |
652,387 |
248,737 |
3,000,000 |
Year 10 1 |
3,000,000 |
— |
— |
$8,031,940 |
$3,531,940 |
||
*No payment is reflected in Year 1 because the Year 1 payment was made at lease commencement and is not included in the lease liability.
**In Year 2, a payment of $515,000 was made but the lease incentive of $200,000 was also received.
1Exercise of purchase option at the end of term
Although the lease was for 10 years, the asset had an economic life of 40 years. When Lessee Corp exercises its purchase option at the end of the 10-year lease, it would have fully extinguished its lease liability but continue depreciating the asset over the remaining useful life.
4.4.2 Operating leases — lessee
Operating lease expense is recorded in a single financial statement line item on a straight-line basis over the lease term. This differs from finance lease expense recognition which is typically higher in the earlier years of a lease and declines over time.
The lessee could compute the periodic straight-line expense at the lease commencement date based on the sum of the following, divided by the lease term:
- The total lease payments under the lease plus
- Any initial direct costs incurred by the lessee, less
- Any lease incentives received from the lessor
In Example LG 4-13, the amortization of the right-of-use asset is described as the difference between the straight-line lease expense, as computed above, and the accretion of interest on the lease liability each period. In order to calculate the amortization of the right-of-use asset, "interest" must be calculated each period on the lease liability. However, there is no amount recorded as interest expense. The "interest" amount is used to accrete the lease liability and to amortize the right-of-use asset.
Rather than calculate the periodic amortization of the right-of-use asset, the guidance in ASC 842 describes how to measure the right-of-use asset at each reporting date. ASC 842-20-35-3 describes the measurement of the right-of-use asset at any point in time after the lease commencement date, as follows:
- The balance of the lease liability, adjusted for
- Any prepaid or accrued lease payments,
- Any unamortized initial direct costs, and
- The remaining balance of any lease incentives received.
Both of these approaches result in the same balance for a right-of-use asset.
Example LG 4-13 illustrates a lessee’s subsequent measurement and recognition of an operating lease.
EXAMPLE LG 4-13
Lessee operating lease subsequent measurement and recognition – automobile lease
Lessee operating lease subsequent measurement and 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 |
|
How would Lessee Corp measure the right-of-use asset and lease liability over the lease term?
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).
At commencement, 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 is required to pay $500 per month for three years, so the total lease payments are $18,000 ($500 × 36 months). Lessee Corp would then calculate the straight-line lease expense to be recorded each period by dividing the total lease payments by the total number of periods. The monthly straight-line expense would be $500 ($18,000 ÷ 36 months). The rental payment and the straight-line expense are equal as the lease does not contain any escalation provisions or other required or optional payments.
Lessee Corp would calculate the amortization of the lease liability as shown in the following table. This table is shown on an annual basis for simplicity; the schedule would be calculated on a monthly basis to reflect the frequency of the lease payments.
Payment |
"Interest" on the lease liability* |
Lease liability |
|
Lease commencement |
$16,018 |
||
Year 1 |
$5,500** |
$820 |
11,338 |
Year 2 |
6,000 |
500 |
5,838 |
Year 3 |
6,000 |
162 |
— |
$17,500 |
$1,482 |
*Although these amounts are labelled as "interest," there is no interest expense recorded in the income statement. These amounts are calculated on the lease liability on a monthly basis in order to determine the ending balance of the lease liability; however, there is only one straight-line lease expense recorded in the income statement. See LG 4.4.2 for additional information.
**This amount excludes the first month's payment since it was made at lease commencement and is not included in the lease liability.
The amortization of the right-of-use asset is calculated as the difference between the straight-line lease expense ($500 per month) and the interest calculated on the lease liability. The following table shows this calculation. This table is shown on an annual basis for simplicity; the schedule would be calculated on a monthly basis to reflect the frequency of the lease payments.
Straight-line expense (A) |
Interest on lease liability (B) |
Amortization (A – B) |
Right-of-use asset |
|
Commencement |
$16,518 |
|||
Year 1 |
$6,000 |
$820 |
$5,180 |
11,338 |
Year 2 |
6,000 |
500 |
5,500 |
5,838 |
Year 3 |
6,000 |
162 |
5,838 |
— |
$18,000 |
$1,482 |
$16,518 |
Example LG 4-14 discusses timing of lease cost recognition in contract manufacturing arrangements.
EXAMPLE LG 4-14
Contract manufacturing arrangements
Contract manufacturing arrangements
Customer Corp enters into a 5-year contract manufacturing agreement with Supplier Corp. Other facts of the arrangement are:
- Customer Corp has exclusive use of Supplier Corp’s manufacturing facility for five years
- Customer Corp will issue non-cancellable purchase orders to Supplier Corp periodically throughout the five-year period
- Customer Corp is not required to order a minimum volume of products over the five-year period although Customer Corp expects to use substantially all of the manufacturing capacity during the term of the arrangement
- Price per unit of the manufactured product is specified in the agreement
- Supplier Corp ships the products free on board destination to Customer Corp’s facility and Customer Corp is contractually obligated to pay Supplier Corp upon delivery of products Example LG 4-1 discusses timing of lease cost recognition in contract manufacturing arrangements. Customer Corp’s facility
- Customer Corp has identified a lease component (i.e., the right to use Supplier Corp’s manufacturing facility) and non-lease components in the arrangement
Assume that Customer Corp has appropriately determined that the contract manufacturing arrangement contains a lease under ASC 842.
When should Customer Corp recognize the lease cost associated with the lease component?
Analysis
We believe payments by Customer Corp to Supplier Corp allocated to the lease component are variable lease payments and should be recognized in the period when the manufactured product is delivered. In other words, it would not be appropriate to recognize a lease cost in a period when there is no delivery of the manufactured product. Note that this issue arises only when it is concluded that Customer Corp directs the use of Supplier Corp’s manufacturing facility. See LG 2.3.2.2 for a discussion of dispatch rights.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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