So far in our blogs, we’ve managed to gather all the necessary ingredients to record the lease liability. We’ve covered the interest rate, the lease term and the lease payments. In this blog, we’ll combine the ingredients to produce the end product – the lease liability. After we record the lease liability, we’ll take it a step further and record the corresponding asset. In order to do that, we’ll first have to familiarize ourselves with a few new concepts, which we’ll do here.
As discussed previously, the major issue with the “old” lease standard was that it did not require all leases to be recorded on the balance sheet, hence creating an opportunity for off-balance sheet financing. With the new lease standard, almost all leases are recorded on the balance sheet. The questions now are:
At which amount do we record the lease liability? At which amount do we record the lease asset?
Several factors will impact the amount of the liability – the lease term, the lease payment and the discount rate. Several factors will also impact the amount of the right-of-use asset – initial direct costs, lease incentives and prepayments. So far in our blogs, we’ve covered determining the discount rate, lease term and lease payment; in this blog, we put it all together so we can record our lease liability on the balance sheet. We’ll also gain a better understanding of what the lease asset and the inputs that go into recording it.
Lease liability – recap
Before we begin, let’s summarize a few concepts. In order to record the lease liability on the balance sheet, we need to determine the lease term. Determining the lease term sometimes requires judgment, particularly when we have renewal and termination options as part of the lease agreement (see December 2019’s blog for additional insight on the lease term).
We also need to determine the lease payment. Determining the lease payment also requires judgment in some cases, for example, when there are payments related to renewal or termination options (see February 2020’s blog for additional insight on the lease payment).
In addition to the lease term and lease payment, we also need to know the rate that will be used to discount the lease liability. If we are using the incremental borrowing rate, we have to make sure the inputs that go into calculating the rate are reliable (see September 2019’s blog for additional insight on the discount rate). We need all three of these inputs to record the lease liability. In this blog, we will figure out how to put it all together.
Lease liability – recording it
The lease liability represents the obligation to make lease payments and is measured at the present value of future lease payments. Once we have gathered our information, i.e., we know the lease term, the lease payment and the discount rate, we simply discount the liability over the lease term, using the discount rate. We then record the lease liability, or the resulting amount, on the balance sheet. Next, we’ll have to record the lease asset. Let’s continue reading to determine what steps we need to take.
To begin, the asset that we are going to be recording is known as a “right-of-use” asset. The right-to-use asset is an intangible asset and if you are familiar with the old lease standard, you’ll notice this as a difference right away. Using the old lease standard, we would record the asset (for example, a truck) directly on the balance sheet; now we are recording the right to use the asset (for example, the right to use a truck) instead of the actual asset itself. The right-of-use asset is an intangible asset.
There are three items that we need to consider before we can arrive at the correct amount for the right-to-use asset:
- Initial direct costs (incurred by the lessee)
- Lease incentives (received by the lessee)
- Lease prepayments (made by the lessee)
Initial direct costs
Initial direct costs are defined as follows:
Incremental costs of a lease that would not have been incurred if the lease had not been obtained
It may help to look at some examples here. Payments made to a lawyer to obtain tax or legal advice would most likely not be an initial direct cost. On the other hand, a payment made to a broker as commission would most likely be an initial direct cost as that payment would only be made if the lease had been obtained. Likewise, a payment made to an existing tenant as an incentive to terminate the lease would likely be an initial direct cost (again, this cost would be incurred only if the lease had been obtained).
Lease incentives and prepayments
A lessor may provide an incentive to a prospective tenant to induce them to sign a lease. This is known as a lease incentive and may be provided in the form of an up-front cash payment, a payment of the lessee’s costs (for example, moving expenses) or the assumption of the lessee’s preexisting lease, to provide a few examples.
Lease prepayments are simply payments made in advance.
Right-of-use asset – recording it
Now that we have all the pieces of the puzzle, let’s calculate our right-of-use asset. We begin with the lease liability. Here is the formula:
= Lease Liability
+ Initial Direct Costs
– Lease Incentives
Putting it all together
Let’s put it all together by looking at an example. Assume the following:
- Six-year lease with no renewal options
- $40,000 lease payment, paid at the end of each year
- Rate is 9% (incremental borrowing rate)
- Initial direct costs equal $1,000
We begin by calculating the lease liability as follows:
- The lease liability will be recorded as the present value of the six payments, discounted at 9%,
- Therefore, the lease liability would equal $179,437
Next, we calculate the right-of-use asset as follows:
- The right of use asset will be recorded as the lease liability plus initial direct costs plus prepayments less any lease incentives
- Therefore, the right-of-use asset would be calculated as $179,437 (lease liability) +1,000 (lease incentives) = $180,437 (Note there are no prepayments or lease incentives in this example)
The journal entry would be:
Right-of-use asset $180,437
. Lease liability $179,437
. Cash $1,000
The trickiest part of recording the lease liability and right-of-use asset is gathering the data. Before we record the lease liability, we should make sure we have the correct figures for the lease term and lease payment and that the discount rate was generated using reliable data. Before we record the right-of-use asset, we should make sure we are making the appropriate adjustments for initial direct costs, prepayments and lease incentives. Once we have all the data, putting it all together should be a cinch!