8.9 Codification Examples

Example 3 — Initial and Subsequent Measurement by a Lessee and Accounting for a Change in the Lease Term

55-22 Lessee enters into a 10-year lease of an asset, with an option to extend for an additional 5 years. Lease payments are $50,000 per year during the initial term and $55,000 per year during the optional period, all payable at the beginning of each year. Lessee incurs initial direct costs of $15,000.

55-23 At the commencement date, Lessee concludes that it is not reasonably certain to exercise the option to extend the lease and, therefore, determines the lease term to be 10 years.

55-24 The rate implicit in the lease is not readily determinable. Lessee’s incremental borrowing rate is 5.87 percent, which reflects the fixed rate at which Lessee could borrow a similar amount in the same currency, for the same term, and with similar collateral as in the lease at the commencement date.

55-25 At the commencement date, Lessee makes the lease payment for the first year, incurs initial direct costs, and measures the lease liability at the present value of the remaining 9 payments of $50,000, discounted at the rate of 5.87 percent, which is $342,017. Lessee also measures a right-of-use asset of $407,017 (the initial measurement of the lease liability plus the initial direct costs and the lease payment for the first year).

55-26 During the first year of the lease, Lessee recognizes lease expense depending on how the lease is classified. Paragraphs 842-20-55-27 through 55-30 illustrate the lease expense depending on whether the lease is classified as a finance lease or as an operating lease.

If the Lease Is Classified as a Finance Lease

55-27 Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset would be amortized on a straight-line basis over the 10-year lease term. The lease liability is increased to reflect the Year 1 interest on the lease liability in accordance with the interest method. As such, in Year 1 of the lease, Lessee recognizes the amortization expense of $40,702 ($407,017 ÷ 10) and the interest expense of $20,076 (5.87% × $342,017).

55-28 At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076), and the carrying amount of the right-of-use asset is $366,315 ($407,017 – $40,702).

If the Lease Is Classified as an Operating Lease

55-29 Lessee determines the cost of the lease to be $515,000 (sum of the lease payments for the lease term and initial direct costs incurred by Lessee). The annual lease expense to be recognized is therefore $51,500 ($515,000 ÷ 10 years).

55-30 At the end of the first year of the lease, the carrying amount of Lessee’s lease liability is $362,093 ($342,017 + $20,076), and the carrying amount of the right-of-use asset is $375,593 (the carrying amount of the lease liability plus the remaining initial direct costs, which equal $13,500).

55-31 At the end of Year 6 of the lease, Lessee makes significant leasehold improvements. Those improvements are expected to have significant economic value for Lessee at the end of the original lease term of 10 years. The improvements result in the underlying asset having greater utility to Lessee than alternative assets that could be leased for a similar amount and that are expected to have significant economic life beyond the original lease term. Consequently, construction of the leasehold improvements is deemed a significant event or significant change in circumstances that directly affects whether Lessee is reasonably certain to exercise the option to extend the lease and triggers a reassessment of the lease term. Upon reassessing the lease term, at the end of Year 6, Lessee concludes that it is reasonably certain to exercise the option to extend the lease for five years. Taking into consideration the extended remaining lease term, Lessee’s incremental borrowing rate at the end of Year 6 is 7.83 percent. As a result of Lessee’s remeasuring the remaining lease term to nine years, Lessee also would remeasure any variable lease payments that depend on an index or a rate; however, in this Example, there are no variable lease payments that depend on an index or a rate. In accordance with paragraph 842-10-25-1, Lessee reassesses the lease classification as a result of the change in the lease term. Assume for purposes of this Example that the reassessment does not change the classification of the lease from that determined at the commencement date.

55-32 At the end of Year 6, before accounting for the change in the lease term, the lease liability is $183,973 (present value of 4 remaining payments of $50,000, discounted at the rate of 5.87 percent). Lessee’s right-of-use asset is $162,807 if the lease is classified as a finance lease or $189,973 if the lease is classified as an operating lease (the balance of the remeasured lease liability at the end of Year 6 plus the remaining initial direct costs of $6,000).

55-33 Lessee remeasures the lease liability, which is now equal to the present value of 4 payments of $50,000 followed by 5 payments of $55,000, all discounted at the rate of 7.83 percent, which is $355,189. Lessee increases the lease liability by $171,216, representing the difference between the remeasured liability and its current carrying amount ($355,189 – $183,973). The corresponding adjustment is made to the right-of-use asset to reflect the cost of the additional rights.

55-34 Following the adjustment, the carrying amount of Lessee’s right-of-use asset is $334,023 if the lease is a finance lease (that is, $162,807 + $171,216) or $361,189 if the lease is an operating lease (that is, $189,973 + $171,216).

55-35 Lessee then makes the $50,000 lease payment for Year 7, reducing the lease liability to $305,189 ($355,189 – $50,000), regardless of how the lease is classified.

55-36 Lessee recognizes lease expense in Year 7 as follows, depending on how the lease had been classified at the commencement date.

If the Lease Is Classified as a Finance Lease at the Commencement Date

55-37 Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset will be amortized on a straight-line basis over the lease term. The lease liability will be reduced in accordance with the interest method. As such, in Year 7 (the first year following the remeasurement), Lessee recognizes amortization expense of $37,114 ($334,023 ÷ 9) and interest expense of $23,896 (7.83% × $305,189).

If the Lease Is Classified as an Operating Lease at the Commencement Date

55-38 Lessee determines the remaining cost of the lease as the sum of the following:

1. The total lease payments, as adjusted for the remeasurement, which is the sum of $500,000 (10 payments of $50,000 during the initial lease term) and $275,000 (5 payments of $55,000 during the term of the lease extension); plus
2. The total initial direct costs attributable to the lease of $15,000; minus
3. The periodic lease cost recognized in prior periods of $309,000.

55-39 The amount of the remaining cost of the lease is therefore $481,000 ($775,000 + $15,000 – $309,000). Consequently, Lessee determines that the annual expense to be recognized throughout the remainder of the lease term is $53,444 ($481,000 ÷ the remaining lease term of 9 years).

Example 4 — Recognition and Initial and Subsequent Measurement by a Lessee in an Operating Lease

55-41 Lessee enters into a 10-year lease for 5,000 square feet of office space. The annual lease payment is $10,000, paid in arrears, and increases 5 percent each year during the lease term. Lessee’s incremental borrowing rate at lease commencement is 6 percent. Lessee classifies the lease as an operating lease in accordance with paragraphs 842-10-25-2 through 25-3. Lessee incurs initial direct costs of $5,000.

55-42 At the commencement date, Lessee receives a $10,000 cash payment from Lessor that Lessee accounts for as a lease incentive. Lessee measures the lease liability at the present value of the 10 remaining lease payments ($10,000 in Year 1, increasing by 5 percent each year thereafter), discounted at the rate of 6 percent, which is $90,434. Lessee also measures a right-of-use asset of $85,434 (the initial measurement of the lease liability + the initial direct costs of $5,000 – the lease incentive of $10,000).

55-43 During the first year of the lease, Lessee determines the remaining cost of the lease as the sum of the following:

1. The total lease payments of $115,779 (the sum of the 10 escalating payments to Lessor during the lease term of $125,779 − the lease incentive paid to Lessee at the commencement date of $10,000)
2. The total initial direct costs attributable to the lease of $5,000.

The amount of the remaining lease cost is therefore $120,779 ($115,779 + $5,000). Consequently, Lessee determines that the single lease cost to be recognized every year throughout the lease term is $12,078 ($120,779 ÷ 10 years). This assumes that there are no remeasurements of the lease liability or modifications to the lease throughout the lease term.

55-44 At the end of Year 1, the carrying amount of the lease liability is $85,860 (9 remaining lease payments, discounted at the rate of 6 percent), and the carrying amount of the right-of-use asset is the amount of the liability, adjusted for the following:

1. Accrued lease payments of $2,578 (the amount of payments to Lessor to be recognized as part of the single lease cost each year during the lease of $12,578 [total payments to Lessor of $125,779 ÷ 10 years] − the first year’s lease payment of $10,000)
2. Unamortized initial direct costs of $4,500 (gross initial direct costs of $5,000 – amounts recognized previously as part of the single lease cost of $500 [total initial direct costs of $5,000 ÷ 10 years])
3. The remaining balance of the lease incentive of $9,000 (gross lease incentive of $10,000 – amounts recognized previously as part of the single lease cost of $1,000 [total lease incentives of $10,000 ÷ 10 years]).

Therefore, at the end of Year 1, Lessee measures the right-of-use asset at the amount of $78,782 ($85,860 – $2,578 + $4,500 – $9,000).

55-45 At the beginning of Year 2, Lessee determines the remaining cost of the lease to be $108,701 (the total lease payments of $115,779 + the total initial direct costs of $5,000 – the single lease cost recognized in Year 1 of $12,078). The single lease cost to be recognized in Year 2 is still $12,078 ($108,701 ÷ 9 years). For the purposes of the Example, only the first two years’ determination of the single lease cost are shown. However, the single lease cost will be determined in the same way as in Years 1 and 2 for the remainder of the lease and, in this Example, will continue to equal $12,078 every period for the remainder of the lease term assuming that there are no remeasurements of the lease liability or modifications to the lease.

55-46 At the end of Year 2, the carrying amount of the lease liability is $80,511, and the carrying amount of the right-of-use asset is $71,855 (the carrying amount of the lease liability of $80,511 – the accrued lease payments of $4,656 + the unamortized initial direct costs of $4,000 – the remaining balance of the lease incentive received of $8,000). For the purposes of the Example, the subsequent measurement of the lease liability and the subsequent measurement of the right-of-use asset are shown only for the first two years. However, Lessee will continue to measure the lease liability and the right-of-use asset for this lease in the same manner throughout the remainder of the lease term.

Example 23 — Lessee Purchase Option

55-211 Lessee enters into a 5-year lease of equipment with annual lease payments of $59,000, payable at the end of each year. There are no initial direct costs incurred by Lessee or lease incentives. At the end of Year 5, Lessee has an option to purchase the equipment for $5,000. The expected residual value of the equipment at the end of the lease is $75,000. Because the exercise price of the purchase option is significantly discounted from the expected fair value of the equipment at the time the purchase option becomes exercisable, Lessee concludes that it is reasonably certain to exercise the purchase option. The fair value of the equipment at the commencement date is $250,000, and its economic life is 7 years. The discount rate for the lease, which is Lessee’s incremental borrowing rate because the rate implicit in the lease is not available, is 6.5 percent.

55-212 Because the lease grants Lessee an option to purchase the underlying asset that it is reasonably certain to exercise, Lessee classifies the lease as a finance lease.

55-213 Lessee recognizes the lease liability at the commencement date at $248,834 (the present value of 5 payments of $59,000 + the present value of the $5,000 payment for the purchase option, discounted at 6.5%). Because there are no initial direct costs, lease incentives, or other payments made to Lessor at or before the commencement date, Lessee recognizes the right-of-use asset at the same amount as the lease liability.

55-214 Lessee amortizes the right-of-use asset over the seven-year expected useful life of the equipment, rather than over the lease term of five years, because Lessee is reasonably certain to exercise the option to purchase the equipment. Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset is amortized on a straight-line basis.

55-215 During the first year of the lease, Lessee recognizes interest expense on the lease liability of $16,174 (6.5% × $248,834) and amortization of the right-of-use asset of $35,548 ($248,834 ÷ 7).

55-216 At the end of Year 1, the right-of-use asset is $213,286 ($248,834 – $35,548), and the lease liability is $206,008 ($248,834 + $16,174 – $59,000).

55-217 At the end of Year 5, the carrying amount of the right-of-use asset is $71,094 ($248,834 – [$35,548 × 5]), and the remaining lease liability is $5,000, which is the exercise price of the purchase option. Lessee exercises the purchase option and settles the remaining lease liability. If the right-of-use asset was not previously presented together with property, plant, and equipment, Lessee reclassifies the right-of-use asset to property, plant, and equipment and applies Topic 360 to the asset beginning on the date the purchase option is exercised.

Example 24 — Lessee Purchase Option

55-218 Lessee enters into a 5-year lease of specialized equipment with annual lease payments of $65,000, payable in arrears. There are no initial direct costs or lease incentives. At the end of Year 5, Lessee has an option to purchase the equipment for $90,000, which is the expected fair value of the equipment at that date. Lessor constructed the equipment specifically for the needs of Lessee. Furthermore, the specialized equipment is vital to Lessee’s business; without this asset, Lessee would be required to halt operations while a new asset was built or customized. As such, Lessee concludes that it is reasonably certain to exercise the purchase option because the specialized nature, specifications of the asset, and its role in Lessee’s operations create a significant economic incentive for Lessee to do so. The fair value of the equipment at the commencement date is $440,000, and its economic life is 10 years. Lessee’s incremental borrowing rate is 6.5 percent, which reflects the fixed rate at which Lessee could borrow an amount similar to that of the lease payments ([$65,000 × 5 lease payments] + the $90,000 purchase option exercise price = $415,000) in the same currency, for the same term, and with similar collateral as in the lease at the commencement date.

55-219 The lease grants Lessee an option to purchase the underlying asset that it is reasonably certain to exercise. In addition, the underlying asset is of such a specialized nature that it is expected to have no alternative use to Lessor at the end of the lease term. As such, Lessee classifies the lease as a finance lease.

55-220 Lessee recognizes the lease liability at the commencement date at $335,808 (the present value of 5 payments of $65,000 + the present value of the $90,000 payment for the purchase option to be made at the end of Year 5, discounted at 6.5%). Because there are no initial direct costs, lease incentives, or other payments made to Lessor at or before the commencement date, Lessee recognizes the right-of-use asset at the same amount as the lease liability.

55-221 Lessee amortizes the right-of-use asset over the 10-year expected useful life of the equipment rather than over the lease term of 5 years, because Lessee is reasonably certain to exercise the option to purchase the equipment. Lessee depreciates its owned assets on a straight-line basis. Therefore, the right-of-use asset is amortized on a straight-line basis.

55-222 During the first year of the lease, Lessee recognizes interest expense on the lease liability of $21,828 (6.5% × $335,808) and amortization of the right-of-use asset of $33,581 ($335,808 ÷ 10).

55-223 At the end of Year 1, the right-of-use asset is $302,227 ($335,808 – $33,581), and the lease liability is $292,636 ($335,808 + $21,828 – $65,000).

55-224 At the end of Year 5, the carrying amount of the right-of-use asset is $167,903 ($335,808 – $33,581 × 5), and the remaining lease liability is $90,000, which is the amount of the purchase option. Lessee exercises the option to purchase the equipment and settles the remaining lease liability. If the right-of-use asset was not previously presented together with property, plant, and equipment, Lessee reclassifies the right-of-use asset to property, plant, and equipment and will apply Topic 360 to the equipment beginning on the date the purchase option is exercised.