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5.3 Accounting for lease remeasurement – lessee
Publication date: 30 Sep 2021
us Leases guide
A lessee should reallocate the contract consideration among the lease and nonlease components, remeasure its lease liability, and adjust the related right-of-use asset upon the occurrence of certain events. How the lease liability is remeasured and the right-of-use asset adjusted will depend on the reason for the lease remeasurement; in some cases, it will result in an entry to profit or loss. A lessee may also need to do one or more of the following depending on the reason for lease remeasurement:
- Reassess whether a contract is (or contains) a lease
- Reallocate contract consideration
- Reassess the lease classification
- Update the discount rate used to remeasure the lease liability
- Account for initial direct costs, lease incentives, and any other payment made or received in connection with a modification to a lease in the same manner as those items would be accounted for in connection with a new lease (see LG 4.2.2).
Figure LG 5-2 provides an overview of the circumstances that could lead to lease remeasurement.
Figure LG 5-2
Accounting for a lease remeasurement
Accounting for a lease remeasurement
Contract modification: Lease contract is modified in such a way that the combined contract is accounted for as one lease (LG 5.2) |
● |
● |
● |
● |
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Change in lease term: An event occurs that gives the lessee a significant economic incentive to exercise, or not exercise, a renewal option (LG 5.3.1) or an event written in the contract occurs that obligates the lessee to exercise or not exercise an extension or termination option |
● |
● |
● |
● |
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Change in purchase option assessment: An event occurs that gives the lessee a significant economic incentive to exercise, or not exercise, a purchase option (LG 5.3.1) |
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● |
● |
● |
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Contingency resolution: A contingency on which variable payments are based is met such that the variable payments become fixed (LG 5.3.1) |
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● |
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When reassessing lease classification for the events noted in Figure LG 5-2, a lessee should consider the terms and conditions as of that date. In other words, the lessee should reassess lease classification using the fair value and remaining economic life of the underlying asset on the reassessment date.
As discussed in ASC 842-10-15-6, a lessee must reassess whether a contract is (or contains) a lease only if the provisions of the contract are changed.
A lease may be denominated in a currency that is not the same as a lessee’s functional currency. See LG 8.8 for information regarding what exchange rate a lessee should use to remeasure a right-of-use asset into the lessee’s functional currency when a lease is required to be remeasured.
5.3.1 Lease remeasurement — lessee
A lessee should remeasure the lease liability and adjust the right-of-use asset upon the occurrence of any of the events described in ASC 842-10-35-4.
Excerpt from ASC 842-10-35-4
A lessee shall remeasure the lease payments if any of the following occur:
a. . . .
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. However, a change in a reference index or a rate upon which some or all of the variable lease payments in the contract are based does not constitute the resolution of a contingency subject to (b) (see paragraph 842-10-35-5 for guidance on the remeasurement of variable lease payments that depend on an index or a rate).
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.
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.
Question LG 5-1 and Question LG 5-2 discuss how consumer price index provisions may or may not result in a lease remeasurement.
Question LG 5-1
Lessee Corp enters into a five-year lease with payments that increase based on increases in the Consumer Price Index (CPI), but cannot decrease (i.e., the increase creates a new floor for lease payments). As CPI increases, should a lessee remeasure a lease liability to include the impact of the increase to date?
Lessee Corp enters into a five-year lease with payments that increase based on increases in the Consumer Price Index (CPI), but cannot decrease (i.e., the increase creates a new floor for lease payments). As CPI increases, should a lessee remeasure a lease liability to include the impact of the increase to date?
PwC response
No, a lessee should not remeasure a lease liability when payments increase based on a change in CPI. Based on an exception in the leases standard, the change to a reference index upon which some or all of the variable lease payment is based does not constitute the resolution of a contingency. The lease payments continue to be variable as they may increase based on future changes in the CPI. The payments are not fixed and therefore do not meet the definition of lease payments.
Question LG 5-2
Lessee Corp enters into a five-year lease with payments that increase based on increases to the CPI, capped at a cumulative increase of 7%. When CPI reaches the cap, should lease payments be adjusted to include the 7% increase?
Lessee Corp enters into a five-year lease with payments that increase based on increases to the CPI, capped at a cumulative increase of 7%. When CPI reaches the cap, should lease payments be adjusted to include the 7% increase?
PwC response
Yes. The lease payments become fixed because additional increases in CPI will not change the payment amount (because CPI is capped at 7%); therefore, the payments meet the definition of lease payments.
Question LG 5-3 discusses the accounting by a lessee for reimbursing the lessor for capital improvements.
Question LG 5-3
Lessor Corp and Lessee Corp enter into a 5-year operating lease of real estate on January 1, 20X1. The lease permits Lessor Corp to pass on depreciation costs to Lessee Corp for capital improvements made to the building during the lease term. The capital improvements are not an additional performance obligation promised by Lessor Corp to Lessee Corp and therefore are not part of the common area maintenance nonlease component or a separate nonlease component. On January 1, 20X2, Lessor Corp completes a roof replacement project at a total cost of $100,000 with a useful life of 10 years. Under the lease provisions, Lessee Corp will be responsible to pay additional rent of $10,000 per year ($100,000/10 years) during the four- year remaining lease term. How should Lessee Corp account for the obligation to pay the additional rent to Lessor Corp?
Lessor Corp and Lessee Corp enter into a 5-year operating lease of real estate on January 1, 20X1. The lease permits Lessor Corp to pass on depreciation costs to Lessee Corp for capital improvements made to the building during the lease term. The capital improvements are not an additional performance obligation promised by Lessor Corp to Lessee Corp and therefore are not part of the common area maintenance nonlease component or a separate nonlease component. On January 1, 20X2, Lessor Corp completes a roof replacement project at a total cost of $100,000 with a useful life of 10 years. Under the lease provisions, Lessee Corp will be responsible to pay additional rent of $10,000 per year ($100,000/10 years) during the four- year remaining lease term. How should Lessee Corp account for the obligation to pay the additional rent to Lessor Corp?
PwC response
The amount of consideration due to Lessor Corp over the remainder of the lease term upon completion of the roof replacement is a variable rent provision that Lessee Corp does not recognize at commencement. Once the amount is determinable upon completion of the roof replacement, we believe Lessee Corp should account for the additional payment as a resolution of a contingency. The lease liability should be remeasured to include the additional fixed payments when they become known (see LG 5.3.3 for more details about remeasurement of lease liability) with a corresponding adjustment to the right-of-use asset (see LG 5.3.4 for more details about right-of-use asset adjustments).
When there is a change in the lease term or probability of exercising an option based on the occurrence of any of the events described in ASC 842-10-35-1, in connection with remeasuring the lease liability and adjusting the right-of-use asset, a lessee should also reassess the lease classification.
A lessee shall reassess the lease term or a lessee option to purchase the underlying asset only if and at the point in time that 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.
Examples of significant events or significant changes in circumstances that a lessee should consider in accordance with paragraph 842-10-35-1 include, but are not limited to, the following:
a. Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable
b. Making significant modifications or customizations to the underlying asset
c. Making a business decision that is directly relevant to the lessee’s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset)
d. Subleasing the underlying asset for a period beyond the exercise date of the option.
A change in market-based factors alone (e.g., increases in market rents such that rents during renewal period would now be considered a bargain or change in the current price to purchase a comparable asset) should not trigger reassessment of the lease term or a lessee option to purchase the underlying asset. A lessee is not required to continually reassess the lease term absent a significant event or change in circumstances.
5.3.2 Change in timing or amount of payment for a lease incentive
Lease incentives for a lessee may be structured in different ways. For example, incentive amounts may be fixed or variable subject to a cap; they may be paid to the lessee upfront or over time. Often, incentives are negotiated to reimburse the lessee for amounts spent by the lessee to furnish or improve the leased property, up to a maximum negotiated amount. The amount and timing of the incentive may depend on the pace at which the lessee furnishes or improves the leased asset. Although the amount and timing of the incentive paid to the lessee could vary after lease commencement, it is generally very unlikely that a lessee would forgo any incentive it negotiated to receive from the lessor. Accordingly, we believe the lessee should treat the incentive in this scenario as an "in substance fixed payment" from the lessor to the lessee. We believe a lessee should estimate the timing of the maximum contractual incentive not yet received and record it as a negative lease payment. This would impact lease classification and the amount recognized for the lease liability and right-of-use asset at lease commencement.
Subsequent to lease commencement, if the actual receipt of the cash from the lessor differs in either timing or amount from the original estimate used to record the lease incentive, we believe the lessee should analogize to the remeasurement guidance for a lessee and remeasure the lease liability (and hence the right-of use asset) using the same discount rate used at the lease commencement date.
See Example LG 5-9 for an illustration.
5.3.3 Remeasurement of lease liability
A lease liability should be remeasured on the effective date of the reassessment event or modification (the date that the modification is approved by both the lessee and lessor) as if the lease were a new lease that commences on that date.
Before remeasuring the lease liability, a lessee must first reallocate the remaining contract consideration between the lease and nonlease components using the relative standalone price of each component on the remeasurement date if the remeasurement is due to one of the following:
- Lease contract is modified in such a way that the combined contract is accounted for as one lease
- An event that is within the control of the lessee occurs that gives the lessee a significant economic incentive to exercise, or not exercise a renewal option or purchase option or an event written in the contract occurs that obligates the lessee to exercise or not exercise an extension or termination option
However, if the remeasurement is due to either (1) a contingency on which variable payments are based is met such that the variable payment become fixed or (2) amounts owed under a residual value guarantee become probable, the reallocation of remaining consideration can be done in two ways. A lessee can make an accounting policy choice to either use:
- the same basis as the initial allocation of the consideration in the contract (or the latest modification not accounted for as a separate contract), or
- the relative standalone price of each component on the remeasurement date.
A lessee should apply its policy consistently for all remeasurements. See LG 2.4.3 for information regarding the allocation of consideration.
ASC 842-20-35-4 and ASC 842-20-35-5 provide guidance on the remeasurement of a lease liability.
After the commencement date, a lessee shall remeasure the lease liability to reflect changes to the lease payments as described in paragraphs 842-10-35-4 through 35-5. A lessee shall recognize the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero, a lessee shall recognize any remaining amount of the remeasurement in profit or loss.
If there is a remeasurement of the lease liability in accordance with paragraph 842-20-35-4, the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following:
a. A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset.
b. A change in amounts probable of being owed by the lessee under a residual value guarantee (see paragraph 842-10-35-4(c)(3)).
c. A change in the lease payments resulting from the resolution of 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 (see paragraph 842-10-35-4(b)).
The discount rate should not be updated if there is a remeasurement due to a change in lease term or purchase option if the discount rate at lease commencement already reflected the options. As discussed in LG 3.3.4.6, the lessee must make a policy election to determine the discount rate either based on the lease term used for accounting purposes or based on the initial lease term plus any extension, termination, and/or purchase options available to the lessee, even when they are not reasonably certain of exercise. For example, if a lessee with a five-year lease with a three-year renewal option used a discount rate at lease commencement that already considered the three-year renewal option, the discount rate should not be adjusted upon remeasurement.
For lease payments that vary based on a rate or index, the lessee should determine the lease payments using the rate or index in effect at the lease remeasurement date. For example, a lessee with lease payments based on LIBOR should determine the future lease payments using the LIBOR spot rate on the lease remeasurement date.
The lease liability should be recorded at the remeasured amount with an adjustment to the right-of-use asset.
5.3.4 Right-of-use asset adjustment
The right-of-use asset will need to be adjusted upon a modification that decreases the lessee’s right of use. This may occur, for example, when the floor space under lease is decreased or a lessee no longer has the right to use a standalone asset. A modification to shorten the lease term is not considered a decrease in the right of use. A decrease in the right of use is treated as either a full or partial termination of the lease. See LG 5.5 for information on the right-of-use asset adjustment in these cases.
For all other changes (e.g., those that give an additional right of use, extend or shorten the lease term, or increase or decrease lease payments), the lessee should adjust the right-of-use asset by an amount equal to the adjustment to the lease liability. Because the original lease is not considered terminated (since the lessee continues to have the right to use the asset identified in the original lease), the lessee generally should not recognize a gain or loss as a result of the modification. However, if the carrying amount of the right-of-use asset is reduced to zero, a lessee should recognize any remaining amount of the remeasurement in net income.
5.3.5 Lease expense subsequent to remeasurement
The determination of lease expense subsequent to remeasurement will depend on the new lease classification and whether that classification has changed.
5.3.5.1 Finance lease upon remeasurement
If a lease is classified as a finance lease upon remeasurement (regardless of the classification before remeasurement), a lessee should calculate interest expense on the lease liability based on the discount rate at the remeasurement date. The right-of-use asset amortization expense should be determined by calculating a new straight-line amortization amount using the revised right-of-use asset value and lease term. When the lease liability is remeasured and the right-of-use asset is adjusted, amortization of the right-of-use asset should be adjusted prospectively from the date of remeasurement.
5.3.5.2 Operating lease upon remeasurement
If there is no change to the classification of an operating lease upon remeasurement, a lessee should calculate the single lease expense after the remeasurement as follows:
If a lease originally classified as a finance lease is remeasured and classified as an operating lease, any difference between the carrying amount of the right-of-use asset after recording the remeasurement adjustment and the carrying amount of the right-of-use asset that would have resulted from initially classifying the lease as an operating lease should be accounted for like a rent prepayment or a lease incentive. See LG 4.2.2.1 for information on accounting for rent prepayments and lease incentives.
5.3.6 Illustrative examples of lease remeasurement
Example LG 5-2, Example LG 5-3, Example LG 5-4, Example LG 5-5, Example LG 5-6, Example LG 5-7, Example LG 5-8 and Example LG 5-9 illustrate how to remeasure a lease for a lease modification or other event.
EXAMPLE LG 5-2
Remeasurement of an operating lease with variable lease payments - no change to lease classification
Remeasurement of an operating lease with variable lease payments - no change to lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease property to be used as a retail store. The following table summarizes information about the lease and the leased property:
Lease commencement date |
January 1, 20X1 |
Initial lease term |
5 years |
Renewal option |
3 years |
Remaining economic life of the leased property |
35 years |
Purchase option |
None |
Annual lease payments for the initial term |
$100,000 |
Annual lease payments for the renewal option |
$114,400 |
Lease increase based on changes in the Consumer Price Index (CPI) |
|
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
At the lease commencement date, Lessee Corp did not have a significant economic incentive to exercise the renewal option. In the first quarter of 20X4, Lessee Corp installed unique tenant improvements into the retail store with an estimated five-year economic life. Lessee Corp determined that it would only recover the cost of the improvements if it exercises the renewal option, creating a significant economic incentive to extend.
The following table summarizes information pertinent to the lease remeasurement.
Remeasured lease term |
5 years; 2 years remaining in the initial term plus 3 years in the renewal period |
Lessee Corp’s incremental borrowing rate on the remeasurement date |
6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased property |
32 years |
Fair value of the leased property at remeasurement date |
$3.8 million |
CPI on the remeasurement date |
125 |
Right-of-use asset immediately before the remeasurement |
$199,238 |
Lease liability immediately before the remeasurement |
$195,238 |
How would Lessee Corp account for the remeasurement?
Analysis
Installing the improvements was a significant event controlled by Lessee Corp, which is now reasonably certain that it will exercise its renewal option based on the significant economic incentive to extend. Lessee Corp would therefore be required to reassess lease classification and remeasure the lease in the first quarter of 20X4.
Based on the facts at lease commencement, Lessee Corp could reasonably conclude that the lease was an operating lease since none of the criteria for a finance lease were met (see LG 3.3 for lease classification criteria). At the remeasurement date, Lessee Corp would reassess lease classification and could reasonably conclude that the lease is still an operating lease since none of the criteria for a finance lease are met (see LG 3.3 for lease classification criteria).
Balance sheet impact
To remeasure the lease liability, Lessee Corp would first calculate the present value of the future lease payments for the new lease term (using the updated discount rate of 6%). The following table shows the present value of the future lease payments based on an updated CPI of 125. Since the initial lease payments were based on a CPI of 120, the CPI has increased by 4%. As a result, Lessee Corp would increase the future lease payments by 4% for those payments in the initial lease term (years 4 and 5). As shown in the table, the revised lease liability would be $490,597.
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Total |
|
Lease payment |
$104,000 |
$104,000 |
$114,400 |
$114,400 |
$114,400 |
$551,200 |
Discount |
0 |
5,887 |
12,584 |
18,348 |
23,784 |
60,603 |
Present value |
$104,000 |
$98,113 |
$101,816 |
$96,052 |
$90,616 |
$490,597 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the remeasurement date.
Revised lease liability |
$490,597 |
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Original lease liability |
195,238 |
||||
$295,359 |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Right-of-use asset |
$295,359 |
||
Cr. Lease liability |
$295,359 |
After the adjustment, the right-of-use asset will be equal to $494,597 (original balance of $199,238 + $295,359).
Income statement impact
The single lease expense would be recalculated using the following formula.
The annual single lease expense of $111,040 would be recognized for the remaining term of the lease.
EXAMPLE LG 5-3
Remeasurement of finance lease for a change in expected purchase option exercise - no impact to lease classification
Remeasurement of finance lease for a change in expected purchase option exercise - no impact to lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease manufacturing equipment. The following table summarizes information about the lease and the leased asset:
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years with no renewal option |
Remaining economic life of the equipment |
6 years |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Purchase option |
Lessee Corp can purchase the equipment from Lessor Corp at the end of the lease term for $30,000; this is not considered a bargain purchase option |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
At the lease commencement date, it was not reasonably certain that Lessee Corp would exercise the purchase option because the lease for the manufacturing facility (where the leased equipment is used) was ending in five years. Since Lessee Corp was not certain if it would continue to occupy its current manufacturing location after five years, there was a reasonable possibility that the equipment under lease would no longer be used after that time because the equipment was designed specifically for the current facility.
On January 1, 20X3, Lessee Corp negotiated a modification to the manufacturing facility lease agreement to extend that lease for another ten years. As a result of that modification, Lessee Corp is now reasonably certain that it will exercise the purchase option in the equipment lease (in three years).
The following table summarizes information pertinent to the lease remeasurement.
Remeasurement date |
January 1, 20X3 |
Lessee Corp’s incremental borrowing rate on January 1, 20X3 |
3%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased equipment |
4 years |
Fair value of the leased equipment at remeasurement date |
$300,000 |
Right-of-use asset immediately before the remeasurement |
$272,757 |
Lease liability immediately before the remeasurement |
$285,941 |
How would Lessee Corp account for the remeasurement?
Analysis
Making the modification to the manufacturing facility lease agreement was a significant event controlled by Lessee Corp, which is now reasonably certain that it will exercise its purchase option in the equipment lease. Lessee Corp would therefore be required to reassess lease classification and remeasure the equipment lease on January 1, 20X3 (the beginning of year 3 of the lease).
Based on the facts at lease commencement, Lessee Corp could reasonably conclude that the lease was a finance lease as the lease term was a major part of the remaining economic life of the equipment (see LG 3.3 for lease classification criteria). At the remeasurement date, Lessee Corp would reassess lease classification and based on the facts could reasonably conclude that the lease is still a finance lease as the lease term is a major part of the remaining economic life of the equipment.
Balance sheet impact
To remeasure the lease liability, Lessee Corp would first calculate the present value of the future lease payments for the lease term plus the purchase option using the updated discount rate of 3%, which includes the assumed exercise of the purchase option and a term of 3 years (i.e., the remaining term of the lease). The following table shows the future lease payments including the payment of $30,000 at the end of the original lease term to exercise the purchase option. As shown in the table, the revised lease liability would be $318,801.
Year 3 lease payment |
Year 4 lease payment |
Year 5 lease payment |
Purchase option payment |
Total |
|
Lease payment |
$100,000 |
$100,000 |
$100,000 |
$30,000 |
$330,000 |
Discount |
0 |
2,913 |
5,740 |
2,546 |
11,199 |
Present value |
$100,000 |
$97,087 |
$94,260 |
$27,454 |
$318,801 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the remeasurement date.
Revised lease liability |
$318,801 |
|||
Original lease liability |
285,941 |
|||
$32,860 |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Right-of-use asset |
$32,860 |
||
Cr. Lease liability |
$32,860 |
After the adjustment, the right-of-use asset will be equal to $305,617 (original balance of $272,757 + $32,860).
Income statement impact
Lessee Corp would calculate the interest expense (based on discount rate of 3%) on the lease liability from the remeasurement date as follows.
Year |
Remaining cash payments |
Annual lease payment |
Liability balance after annual payment |
Interest expense |
3 |
$330,000 |
$100,000 |
$218,801 |
$6,564 |
4 |
$230,000 |
$100,000 |
$125,365 |
$3,760 |
5 |
$130,000 |
$100,000 |
$29,126 |
$874 |
The revised straight-line amortization of the right-of-use asset should be recalculated as shown in the following table.
Right-of-use asset immediately before the remeasurement |
$272,757 |
||
Adjustment to the right-of-use asset |
32,860 |
||
Adjusted right-of-use asset balance |
$305,617 |
||
Remaining economic life at the remeasurement date* |
4 years |
||
Recalculated annual right-of-use asset amortization |
$76,404 |
*Remaining economic life of the asset is used as opposed to remaining lease term because it is assumed that the purchase option will be exercised.
EXAMPLE LG 5-4
Remeasurement of a finance lease for a change in the probability of payment for a residual value guarantee - lease classification not required to be reassessed
Remeasurement of a finance lease for a change in the probability of payment for a residual value guarantee - lease classification not required to be reassessed
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease manufacturing equipment. The following table summarizes information about the lease and the leased asset:
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years with no renewal option |
Remaining economic life of the equipment |
6 years |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
At the lease commencement date, it was not probable that Lessee Corp would make a payment under the residual value guarantee. On January 1, 20X3, a change in technology made the technology in the leased equipment outdated. As a result, Lessee Corp now expects a decline in the fair value of the equipment and at the end of the lease term, payment of $10,000 is probable under the residual value guarantee.
The following table summarizes information pertinent to the lease remeasurement.
Remeasurement date |
January 1, 20X3 |
Remaining economic life of the leased equipment |
4 years |
Fair value of the leased equipment at remeasurement date |
$200,000 |
Right-of-use asset immediately before the remeasurement |
$272,757 |
Lease liability immediately before the remeasurement |
$285,941 |
How would Lessee Corp account for the remeasurement?
Analysis
Since Lessee Corp now determines that it is probable that it will have to make a payment under the residual value guarantee, Lessee Corp would be required to remeasure the lease on the date of the change (i.e., January 1, 20X3) including the residual value guarantee amount probable of being paid at the end of year 5 (i.e., $10,000).
Based on the facts Lessee Corp could reasonably conclude that the lease was a finance lease at lease commencement as the lease term is a major part of the remaining economic life of the equipment (see LG 3.3 for lease classification criteria). However, Lessee Corp should not reassess the lease classification based on the guidance in ASC 842-10-25-1.
Balance sheet impact
To remeasure the lease liability, Lessee Corp would first calculate the present value of the future lease payments for the lease term (using the discount rate of 5% determined at lease commencement) plus the residual value guarantee. The following table shows the future lease payments, including the payment of $10,000 at the end of year 5 for the residual value guarantee. As shown in the table, the revised lease liability would be $294,579.
Year 3 lease payment |
Year 4 lease payment |
Year 5 lease payment |
Residual value guarantee payment |
Total |
|
Lease payment |
$100,000 |
$100,000 |
$100,000 |
$10,000 |
$310,000 |
Discount |
0 |
4,762 |
9,297 |
1,362 |
15,421 |
Present value |
$100,000 |
$95,238 |
$90,703 |
$8,638 |
$294,579 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the remeasurement date.
Revised lease liability |
$294,579 |
||
Original lease liability |
285,941 |
||
$8,638 |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Right-of-use asset |
$8,638 |
||
Cr. Lease liability |
$8,638 |
After the adjustment, the right-of-use asset will be equal to $281,395 (original balance of $272,757 + $8,638).
Income statement impact
Lessee Corp would calculate the interest expense on the lease liability from the remeasurement date as follows.
Year |
Remaining cash payments |
Annual lease payment |
Liability balance |
Interest expense |
3 |
$310,000 |
$100,000 |
$194,579 |
$9,729 |
4 |
$210,000 |
$100,000 |
$104,308 |
$5,215 |
5 |
$110,000 |
$100,000 |
$9,524 |
$476 |
The revised straight-line amortization of the right-of-use asset should be recalculated as shown in the following table.
Right-of-use asset immediately before the remeasurement |
$272,757 |
|
Adjustment to the right-of-use asset |
8,638 |
|
Adjusted right-of-use asset balance |
$281,395 |
|
Remaining lease term at the remeasurement date |
3 years |
|
Recalculated annual right-of-use asset amortization |
$93,798 |
EXAMPLE LG 5-5
Accounting for a modified operating lease that extends the lease term - no change to lease classification
Accounting for a modified operating lease that extends the lease term - no change to lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease property to be used as a retail store. The following table summarizes information about the lease and the leased property:
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years with no renewal option |
Remaining economic life of the leased property |
35 years |
Purchase option |
None |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
On January 1, 20X4, Lessee Corp and Lessor Corp amend the original lease contract to extend the term of the lease for an additional three years.
The following table summarizes information pertinent to the lease modification.
Modification date |
January 1, 20X4 |
Modified annual lease payments |
$110,000 |
Lessee Corp’s incremental borrowing rate on January 1, 20X4 |
6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased property |
32 years |
Fair value of the property at the modification date |
$3.8 million |
Right-of-use asset immediately before the modification |
$199,238 |
Lease liability immediately before the modification |
$195,238 |
Assume that any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessee Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use, Lessee Corp would conclude that that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessee Corp would account for one new modified lease as of January 1, 20X4.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement, Lessee Corp could reasonably conclude that the lease was an operating lease since none of the criteria for a finance lease are met (see LG 3.3 for lease classification criteria). At the modification date, Lessee Corp could reasonably conclude that the lease continues to be an operating lease since none of the criteria for a finance lease are met.
Account for the modified lease
Lessee Corp would remeasure the lease as of the modification date as follows:
Balance sheet impact
The lease liability is remeasured by calculating the present value of the remaining future lease payments for the modified lease term using Lessee Corp’s current discount rate of 6%. The modified lease has five years remaining (two years remaining in the initial term plus three years added with the modification). The modified lease liability would be $491,162 as shown in the table below.
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Year 8 |
Total |
|
Lease payment |
$110,000 |
$110,000 |
$110,000 |
$110,000 |
$110,000 |
$550,000 |
Discount |
0 |
6,226 |
12,100 |
17,642 |
22,870 |
58,838 |
Present value |
$110,000 |
$103,774 |
$97,900 |
$92,358 |
$87,130 |
$491,162 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balance on the modification date.
Revised lease liability |
$491,162 |
|
Original lease liability |
195,238 |
|
$295,924 |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Right-of-use asset |
$295,924 |
||
Cr. Lease liability |
$295,924 |
After the adjustment, the right-of-use asset will be equal to $495,162 (original balance of $199,238 + $295,924).
Income statement impact
Lessee Corp would recalculate the single lease expense using the following formula.
The amounts are as follows:
Lessee Corp would recognize annual single lease expense of $110,800 for the remaining term of the lease.
EXAMPLE LG 5-6
Accounting for a modified operating lease with a decrease in lease term - no change to lease classification
Accounting for a modified operating lease with a decrease in lease term - no change to lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease property to be used as a retail store. The following table summarizes information about the lease and the leased property:
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years with no renewal option |
Remaining economic life of the leased property |
35 years |
Purchase option |
None |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
On January 1, 20X2, Lessee Corp and Lessor Corp amend the original lease contract to decrease the term of the lease to three years and increase the annual lease payments to $110,000.
The following table summarizes information pertinent to the lease modification.
Modification date |
January 1, 20X2 |
Revised remaining lease term |
2 years |
Modified annual lease payments |
$110,000 |
Lessee Corp’s incremental borrowing rate on January 1, 20X2 |
6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased property |
34 years |
Fair value of the property at the modification date |
$4 million |
Right-of-use asset immediately before the modification |
$380,325 |
Lease liability immediately before the modification |
$372,325 |
Assume that any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessee Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use, Lessee Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessee Corp would account for one new modified lease as of January 1, 20X2.
Reassess lease classification based on the terms of the modified lease
Based on the facts at commencement date, Lessee Corp could reasonably conclude that the lease was an operating lease since none of the criteria for a finance lease were met (see LG 3.3 for lease classification criteria). At lease modification date, Lessee Corp could reasonably conclude that the lease continues to be an operating lease since none of the criteria for a finance lease are met.
Account for the modified lease
Lessee Corp would remeasure the lease as of the modification date as follows:
Balance sheet impact
Lessee Corp would remeasure the lease liability on the date of the modification by calculating the present value of the remaining two future lease payments for the modified lease term using Lessee Corp’s current discount rate of 6%. The modified lease liability would be $213,774, as shown in the table below.
Year 2 |
Year 3 |
Total |
|
Lease payment |
$110,000 |
$110,000 |
$220,000 |
Discount |
0 |
6.226 |
6,226 |
Present value |
$110,000 |
$103,774 |
$213,774 |
Although the lease liability has been decreased as a result of the modification, it is not a partial termination of the lease because there was no change to the underlying asset being leased. Therefore, to calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the modification date.
Original lease liability |
$372,325 |
|
Revised lease liability |
213,774 |
|
$158,551 |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Lease liability |
$158,551 |
||
Cr. Right-of-use asset |
$158,551 |
After the adjustment, the right-of-use asset will be equal to $221,774 (original balance of $380,325 - $158,551).
Income statement impact
Lessee Corp would recalculate the single lease expense using the following formula.
The amounts are as follows:
Lessee Corp would recognize annual single lease expense of $114,000 for the remaining term of the lease.
EXAMPLE LG 5-7
Accounting for a change in consideration in an operating lease - no change in lease classification
Accounting for a change in consideration in an operating lease - no change in lease classification
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease property to be used as a retail store. The following table summarizes information about the lease and the leased property:
Lease commencement date |
January 1, 20X1 |
Initial lease term |
5 years (includes a termination option available after year 3 with a termination penalty which is not reasonably certain of exercise at commencement date) |
Remaining economic life of the leased property |
35 years |
Purchase option |
None |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
On January 1, 20X4, Lessee Corp considers terminating the lease and relocating to another location. To entice Lessee Corp to remain in its location, Lessor Corp agrees to amend the original lease contract to reduce the annual lease payments in the last two years to $90,000. The termination penalty in the contract remains the same. Lessee Corp ultimately concludes that it will remain in the lease through the initial lease term.
The following table summarizes information pertinent to the lease modification.
Modification date |
January 1, 20X4 |
Modified annual lease payments |
$90,000 |
Lessee Corp’s incremental borrowing rate on January 1, 20X4 |
4%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased property |
32 years |
Fair value of the leased property at the modification date |
$3.7 million |
Right-of-use asset immediately before the modification |
$199,238 |
Lease liability immediately before the modification |
$195,238 |
Assume that any additional right of use, the original contract and the modified contract meet the definition of a lease.
How would Lessee Corp account for the lease modification?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use, Lessee Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessee Corp would account for one new modified lease as of January 1, 20X4.
Reassess lease classification based on the terms of the modified lease
At lease commencement, since Lessee Corp is reasonably certain to not exercise the termination option, a lease term of five years was used. Based on the facts Lessee Corp could reasonably conclude that the lease was an operating lease at lease commencement since none of the criteria for a finance lease are met (see LG 3.3 for lease classification criteria). At the lease modification date, Lessee Corp could reasonably conclude that the lease continues to be an operating lease since none of the criteria for a finance lease are met.
Account for the modified lease
Lessee Corp would remeasure the lease as of the modification date as follows:
Balance sheet impact
Lessee Corp would remeasure the lease liability on the date of the modification by calculating the present value of the remaining future lease payments for the modified lease term using Lessee Corp’s current discount rate of 4%. The modified lease liability would be $176,538, as shown in the table below.
Year 4 |
Year 5 |
Total |
|
Lease payment |
$90,000 |
$90,000 |
$180,000 |
Discount |
0 |
3,462 |
3,462 |
Present value |
$90,000 |
$86,538 |
$176,538 |
To calculate the adjustment to the lease liability Lessee Corp would compare the recalculated and original lease liability balances on the modification date.
Revised lease liability |
$176,538 |
|
Original lease liability |
195,238 |
|
($18,700) |
Lessee Corp should record the following journal entry to adjust the lease liability.
Dr. Lease liability |
$18,700 |
||
Cr. Right-of-use asset |
$18,700 |
After the adjustment, the right-of-use asset will be equal to $180,538 (original balance of $199,238 - $18,700).
Income statement impact
Lessee Corp would recalculate the single lease expense using the following formula.
The amounts are as follows:
Lessee Corp would recognize annual single lease expense of $92,000 for the remaining term of the lease.
EXAMPLE LG 5-8
Accounting for a modified finance lease – lease classification changes to an operating lease
Accounting for a modified finance lease – lease classification changes to an operating lease
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease manufacturing equipment. The following table summarizes information about the lease and the leased equipment:
Lease commencement date |
January 1, 20X1 |
Lease term |
10 years with no renewal option |
Remaining economic life of the leased equipment |
12 years |
Purchase option |
None |
Annual lease payments |
$100,000 |
Payment date |
Annually on January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Other |
|
On January 1, 20x4, Lessee Corp and Lessor Corp amend the original lease contract to decrease the remaining term of the lease to four years and increase the annual lease payments to $110,000
The following table summarizes information pertinent to the lease remeasurement required upon the change from a finance to an operating lease.
Modification date |
January 1, 20x4 |
Remeasured remaining lease term |
4 years |
Modified annual lease payments |
$110,000 |
Lessee Corp’s incremental borrowing rate on the remeasurement date |
6%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Remaining economic life of the leased equipment |
9 years |
Fair value of the leased equipment at the modification date |
$900,000 |
Right-of-use asset immediately before the remeasurement |
$574,548 |
Lease liability immediately before the remeasurement |
$607,569 |
Assume that any additional right of use, the original contract, and the modified contract meet the definition of a lease.
How would Lessee Corp account for the remeasurement?
Analysis
Determine if the lease modification is a separate new contract
As the modification does not grant an additional right of use, Lessee Corp would determine that the modification is not a separate new contract. Since the modified contract meets the definition of a lease, Lessee Corp would account for one new modified lease as of January 1, 20X4.
Reassess lease classification based on the terms of the modified lease
Based on the facts at lease commencement date, Lessee Corp could reasonably conclude that the lease was a finance lease as the lease term was a major part of the remaining economic life of the equipment (see LG 3.3 for lease classification criteria). At the lease modification date, Lessee Corp could reasonably conclude that the lease is an operating lease since none of the criteria for a finance lease are met.
Account for the modified lease
Lessee Corp would remeasure the lease as of the modification date as follows:
Balance sheet impact
To remeasure the lease liability, Lessee Corp would first calculate the present value of the future lease payments for the new lease term (using the updated discount rate of 6%). As shown in the table, the revised lease liability would be $404,031.
Year 4 |
Year 5 |
Year 6 |
Year 7 |
Total |
|
Lease payment |
$110,000 |
$110,000 |
$110,000 |
$110,000 |
$440,000 |
Discount |
0 |
6,226 |
12,100 |
17,462 |
35,969 |
Present value |
$110,000 |
$103,774 |
$97,900 |
$92,358 |
$404,031 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the remeasurement date.
Revised lease liability |
$404,031 |
|
Original lease liability |
607,569 |
|
($203,538) |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Lease liability |
$203,538 |
||
Cr. Right-of-use asset |
$203,538 |
After the adjustment, the right-of-use asset will be equal to $371,010 (original balance of $574,548 - $203,538).
Income statement impact
The single lease expense would be recalculated using the following formula.
The annual single lease expense of $101,745 would be recognized for the remaining term of the lease.
EXAMPLE LG 5-9
Remeasurement due to change in timing of leasehold incentive receivable
Remeasurement due to change in timing of leasehold incentive receivable
On January 1, 20X1, Lessee Corp enters into a contract with Lessor Corp to lease a building. The following table summarizes information about the lease and the leased property:
Lease commencement date |
January 1, 20X1 |
Lease term |
5 years with no renewal option |
Remaining economic life of the leased property |
30 years |
Purchase option |
None |
Annual lease payments |
$1,000,000 |
Payment date |
January 1 |
Lessee Corp’s incremental borrowing rate |
5%
The rate Lessor Corp charges Lessee Corp in the lease is not readily determinable by Lessee Corp
|
Lease incentive |
Lessor Corp agrees to reimburse Lessee Corp up to $300,000 for leasehold improvements completed within the first two years of the lease |
Other |
|
It is unlikely Lessee Corp would forgo any lease incentive it negotiated to receive from Lessor Corp. Lessee Corp expects that it will complete the improvements two years after lease commencement.
Lessee Corp finishes the leasehold improvements in one year (as opposed to the original estimate of two years) and utilizes the entire lease incentive of $300,000. The payment for the lease incentive was received on 12/31/X1. The following table summarizes information pertinent to leasehold improvements completion date.
Remaining lease term |
4 years |
Right-of-use asset immediately before leasehold improvements completion date |
$3,497,534 |
Lease liability immediately before leasehold improvements completion date |
$3,437,534 |
How should Lessee Corp account for the difference in timing from the original estimate?
Analysis
Since it is unlikely Lessee Corp would forgo any lease incentive it negotiated to receive from Lessor Corp, Lessee Corp would account for the incentive as an in-substance fixed payment to be received from Lessor Corp. Lessee Corp would consider the lease incentive as a negative lease payment two years after lease commencement since Lessee Corp expects that is when it will complete the improvements.
Based on the facts, Lessee Corp could reasonably conclude that the lease is an operating lease at lease commencement since none of the criteria for a finance lease are met (see LG 3.3 for lease classification criteria).
When measuring the lease liability at lease commencement, Lessee Corp would include the lease incentive as a negative lease payment based on the expected timing of completion of leasehold improvements (i.e., two years after commencement date). The lease liability at commencement would be $4,273,842 calculated as follows:
1/1/X1 |
1/1/X2 |
12/31/X2 |
1/1/X3 |
1/1/X4 |
1/1/X5 |
Total |
|
Lease payment |
$1,000,000 |
$1,000,000 |
(300,000) |
$1,000,000 |
$1,000,000 |
$1,000,000 |
$4,700,000 |
Discount |
0 |
(47,619) |
27,891 |
(92,971) |
(136,162) |
(177,298) |
(426,158) |
Present value |
$1,000,000 |
$952,381 |
(272,109) |
$907,029 |
$863,838 |
$822,702 |
$4,273,842 |
When the timing of the receipt of the lease incentive changes from the original estimate at commencement, the lease liability must be remeasured using the discount rate at lease commencement. In this example, the lease liability is remeasured at 12/31/x1 (concurrent with the receipt of the incentive payment).
To remeasure the lease liability, Lessee Corp would first calculate the present value of the future lease payments for the remaining lease term (using the original discount rate of 5%). As shown in the following table, the revised lease liability would be $3,723,248.
1/1/X2 |
1/1/X3 |
1/1/X4 |
1/1/X5 |
Total |
|
Lease payment |
$1,000,000 |
$1,000,000 |
$1,000,000 |
$1,000,000 |
$4,000,000 |
Discount |
0 |
47,619 |
92,971 |
136,162 |
276,752 |
Present value |
$1,000,000 |
$952,381 |
$907,029 |
$863,838 |
$3,723,248 |
To calculate the adjustment to the lease liability, Lessee Corp would compare the recalculated and original lease liability balances on the remeasurement date.
Revised lease liability |
$3,723,248 |
|
Original lease liability |
3,437,534 |
|
($285,714) |
Lessee Corp would record the following journal entry to adjust the lease liability.
Dr. Cash (for lease incentive received) |
$300,000 |
||
Cr. Right-of-use asset |
$14,286 |
||
Cr. Lease liability |
$285,714 |
The single lease expense would be recalculated using the following formula.
Question LG 5-4 discusses amortization of a right-of-use asset that has been impaired and subsequently modified or remeasured.
Question LG 5-4
If a lessee impairs a right-of-use asset in an operating lease and then either modifies the lease such that the modification is not considered a new lease or a remeasurement event occurs, should the lessee continue to amortize the ROU asset on a straight-line basis?
If a lessee impairs a right-of-use asset in an operating lease and then either modifies the lease such that the modification is not considered a new lease or a remeasurement event occurs, should the lessee continue to amortize the ROU asset on a straight-line basis?
PwC response
Yes. We believe the lessee should continue to amortize the right-of-use asset on a straight-line basis if an impairment of a right-of-use asset in an operating lease is subsequently followed by a lease modification that is not considered a new lease or a remeasurement event occurs. See LG 4.6.2 for more details about right-of-use asset amortization upon an impairment.
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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