The 5 Steps to Complete an Initial Lease Measurement
Last Updated on August 30, 2022 by Neil Patel Accel
What is an Initial Lease Measurement?
An initial lease measurement (or reassessment) is required at the lease commencement date if the lease term has changed or if the lessee is reasonably certain to exercise a purchase of the right of use asset.
When there is a change in lease term or in the conclusion about whether it is reasonably certain that an option to purchase the underlying asset will be exercised, a lessee must:
- Reassess lease classification.
- Measure the lease liability by using revised inputs as of the re-measurement date.
- And, adjust the associated ROU asset.
Once an entity has determined a contract contains a lease, then the lessee will recognize the initial Right-of-use Asset (ROU Asset) and Lease Liability at the Lease Commencement Date utilizing the five steps below:
See our Lease Accounting Glossary of Terms for additional insights.
Step 1: Determine Lease Term
The first step in lease measurement is determining the lease team. The lease term begins at the lease commencement date and includes any rent-free periods provided to the lessee by the lessor. In essence, the lease term is determined by finding the sum of the non-cancellation period and the following:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option.
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
- Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor.
When evaluating periods that contain option periods, “reasonably certain” is considered a high threshold of probability under ASC 842. At the lease commencement date, an entity should assess whether the lessee is reasonably certain to exercise or not to exercise an option by considering all economic factors relevant to that assessment — contract- based, asset-based, market-based, and entity-based factors.
Step 2: Calculate Total Lease Consideration
At the lease commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term:
- Fixed Payments – in substance fixed payments or lease incentives.
- Variable Lease Payments – these depend on an index (such as the consumer price index) or a rate (such as the market interest rate). Variable lease payments are initially measured using the index or rate at the commencement date.
- Exercise Price – This is an option to purchase the underlying asset, only if the lessee is reasonably certain to exercise that option.
- Penalty Payments – These occur when terminating the lease if the lease term reflects a termination penalty when the lessee exercises this option.
- Fees paid by the lessee – Fees are paid to the owners of a special-purpose entity for structuring the transaction.
- (For a lessee only) Amounts probable of being owned by the lessee under residual value guarantees.
It is important to note that only payments allocated to the lease should be considered for purposes of classifying the lease.
Lease Consideration Examples
- Fixed Payments:
- Non-refundable lease payments
- Monthly fixed lease payments
- Lessor reimbursement of moving costs
- Tennant improvement allowance
Non-Lease Consideration Examples
- Refundable lease payments
- Payments based on a change in an index or a rate
- Real estate taxes as they do not provide a separate good or service
- Leasehold improvements paid for by the lessee and not specifically required in the lease contract
- Lease payments tied to sales amounts, regardless of historical and projected performance even if performance seems guaranteed
Lease consideration is an important factor in ensuring your initial lease measurement is accurate.
Step 3: Select a Discount Rate
The discount rate used to calculate the lease liability is only determined once, at the lease inception date using the information available at that lease commencement date. There are two options for the discount rate. The rate implicit in the lease should be selected as the discount rate unless the rate cannot be readily determined. In that case, the lessee is required to select its incremental borrowing rate as the discount rate.
To read more in depth on the discount rate, check out our blog on How to Determine the Discount Rate Under ASC 842.
Rate Implicit in the Lease:
Discount Rate is the rate that yields these to be equal:
Incremental Borrowing Rate:
The Incremental Borrowing Rate is defined as “the rate of interest that 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.” There are four main steps to follow in order to determine the incremental borrowing rate. The lessee should evaluate the collateral considered for the borrowing as follows:
- Start with a rate that is obtained for a general, unsecured, recourse borrowing and should adjust the rate for the effects of the collateral. This should have the effect of reducing the rate.
- The lessee should assume full collateralization and should not assume under- or over-collateralization.
- The collateral considered does not have to be the leased asset. It can be the leased asset, but it may also be any form of collateral that a creditor would be expected to accept to secure a borrowing for a similar term (i.e., collateral that is at least as liquid as the leased asset).
- For leases denominated in a foreign currency, a lessee should calculate its incremental borrowing rate by using assumptions that would be consistent with a rate that it would obtain to borrow, on a collateralized basis and in the same currency in which the lease is denominated.
A determination of the lessee’s incremental borrowing rate at the lease commencement date of a lease may be difficult. If a lessee did not incur borrowing at or near the commencement date of a lease that were for a term similar to the lease term, then the lessee may need to determine its incremental borrowing rate through discussions with bankers, or other lenders, or by reference to obligations of a similar term issued by other with a credit rating similar to that of the lessee. Learn more about The Impact of ASC 842 on Debt Covenants and Bank Capital Requirements in our blog.
Step 4: Perform a Lease Classification Test
The biggest change from the ASC 840 to ASC 842 transition is the classification of leases. Under ASC 842, capital leases are now referred to as finance leases and operating leases are now required to be recognized on the balance sheet. A Lease Classification Test will help you determine whether a lease is a finance lease or operating lease ensuring your initial lease measurement is correct.
If the majority of the assets life is controlled by the lessee, then it should be classified as a finance lease. If not, then it is an operating lease. A lessee shall classify a lease as a finance lease when the lease meets any of the following criteria at the lease commencement date:
- Transfer of Ownership: If the lease transfers ownership of the underlying asset to the lessee by the end of the term.
- Option to Purchase: If the lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
- The Lease Term & Economic Life of Said Asset: If the underlying asset endures a major part of its economic life during the lease term. However, if the lease commence date falls at or near the end of the economic lease of the underlying asset, this criterion shall not be used for purposes of classifying the lease.
- The Present Value Exceeds the Fair Value: If the present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments exceeds 90% or more of the fair value of the underlying asset accounts to substantially all of the fair value of the underlying asset.
- Specialized Asset: If that is the case and it is expected to have no alternative use to the lessor at the end of the lease term.
To learn more about the criteria to determine the lease classification check out our blog: How to Perform a Lease Classification Test.
Step 5: Recognize Lease ROU Asset and Liability
At the lease commencement date, a lessee shall measure both of the following:
- The Lease Liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement
- The Right of Use Asset (ROU)
All leases (finance and operating leases), other than those that qualify for (and for which an entity elected to apply) the short-term recognition exemption, must be recognized as of the lease commencement date on the lessee’s balance sheet. The initial recognition of the lease liability and ROU asset will be the same regardless of lease classification.
The initial recognition of the Lease Liability = Present Value of Remaining Lease Payments @ the selected Discount Rate
The ROU Asset is calculated as follows:
- Initial Lease Liability
- Prepaid Lease Payments
- Any Initial Direct Costs
- Any Lease Incentives Received
Initial lease measurement of your lease liability requires a few steps in order to accurately recognize your lease under the new standards. If you are ready to dive into ASC 842, then check out our Ultimate Guide to Navigating the Lease Accounting Lifecycle Under ASC 842 Compliance.
Accounting Guidance Referenced
- ASC 842-10-20
- ASC 842-10-25-2 (c) through (d)
- ASC 842-10-25-3(b)(1)
- ASC 842-10-30-1
- ASC 842-10-30-3
- ASC 842-20-30-3
- ASC 842-20-30-5
- ASC 842-10-55-25
- ASC 842-10-55-26
- Deloitte A Roadmap to Applying the New Leasing Standard (2020) 220.127.116.11- 18.104.22.168
Check out our Lease Accounting Compliance Hub for all things ASC 842.