On the lease commencement date, a lessee is required to measure and record a lease liability equal to the present value of the remaining lease payments. The liability is then discounted using the rate implicit in the lease, if determinable, or the lessee’s incremental borrowing rate.
Standards for Calculating Payments
ASC 842-10-30-5 outlines the standards for calculating lease payments. Lease payments consist of six primary components:
- Fixed payments, including in-substance fixed payments, less any lease incentives paid or payable to the lessee
- Variable lease payments that depend on an index or a rate initially measured using the index or rate at the commencement date
- Exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option
- Payments for termination penalties of the lease if the lease term reflects the lessee exercising an option to terminate the lease
- Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction
- For a lessee only, amounts likely to be owed by the lessee under residual value guarantees
Once the lease payments have been calculated, they’re discounted based on the rate implicit in the lease, if determinable, or the incremental borrowing rate.
The rate implicit in the lease represents the rate of interest that, at a given date, causes the aggregate present value of the lease payments—and the amount a lessor expects to derive from the underlying asset following the end of the lease term—to equal the sum of the fair value of the underlying asset, minus any:
- Related investment tax credit retained and expected to be realized by the lessor
- The lessor’s deferred initial direct costs of the lessor
The incremental borrowing rate is the rate of interest a lessee would have to pay to borrow on a collateralized basis over a similar term—an amount equal to the lease payments in a similar economic environment.
However, ASC 842-20-30-3 provides an alternative for lessees that aren’t public business entities; it allows a lessee to use a risk-free rate for a period comparable to the lease term. The risk-free rate will be inherently lower than an incremental borrowing rate for a specific entity and result in a higher lease liability and ROU asset.
An organization can decide to use a risk-free rate via an accounting policy election. Once it’s elected, it must be used consistently for all leases.
Valuing Right of Use Assets
ASC 842-20-30-5 provides guidance for valuing ROU assets.
ROU assets consist of three components:
- Amount of the lease liability’s initial measurement
- Any lease payments made to the lessor at or before the commencement date minus any lease incentives received
- Any initial direct costs incurred by the lessee
Initial direct costs by the lessee include items such as:
- Legal fees resulting from the execution of the lease
- Lease document preparation costs
Initial direct costs don’t include:
- Employee salaries
- Legal fees for services rendered before the execution of the lease
- Other expenses not directly related to the lease
As stated in ASC 842-20-35-9, a lessee’s ROU asset is subject to impairment guidance in ASC 360, and would be subject to the same testing guidelines as long-lived assets. Long-lived assets, or asset groups, will be tested for recoverability whenever events or changes in circumstances indicate its carrying amount may not be recoverable.
Rate Selection Errors
Errors do occur in rate selection. Selecting a rate that’s too high or low could lead to understating or overstating the lessee’s liability and related ROU.
A potential example would be selecting an unsecured loan rate that was allowed under ASC 840 but isn’t allowed under ASC 842. Typically, an unsecured borrowing rate will be higher than a secured borrowing rate. Using a rate that’s too high will understate the liability and potentially create misleading financial statements. Adversely, selected a rate that’s too low could overstate the lessee’s ROU and increase the chances for future impairments.
Another potential error when valuing ROUs is including costs that aren’t initial direct costs. Each initial direct cost included in the ROU must be analyzed in detail, so the cost directly relates to the ROU and meets the requirements for a direct cost. Otherwise, the lessee increases their risk of overstating their ROUs and creating larger impairments in the future.
We’re Here to Help
If your organization is getting ready to implement ASC 842, please read our Guide—ASC Topic 842: Lease Accounting.