In our last blog series, we discussed the lease term, which sounds like a simple concept. However, if you read the blog series, it may have been evident that while figuring out the lease term can be straight-forward, it can also, at times, require some judgment and hence be a little complicated. In this blog, we’ll look at another concept that goes hand-in-hand with the lease term in terms of (pun not intended) figuring out the lease liability.
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 question now is, at which amount do we record the lease liability? A couple of factors will impact the amount of the liability – the lease term and the lease payment. In December’s blog, we discussed coming up with the lease term; in this blog, we’ll dive into the lease payment.
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 and the lease payment. We also need to know the rate that will be used to discount the lease liability. In this blog, the focus will be on the lease payment.
Lease payments include
What do lease payments include?
- Fixed payments
- Payments related to renewal or termination options that the lessee is reasonably certain to exercise
- Variable payments that are based on an index or rate
Let’s go down the list. Fixed payments – this is easy to determine – just look at the contract! Payments related to renewal or termination options that the lessee is reasonably certain to exercise – first determine whether the lessee is reasonably certain to exercise a renewal or termination option and if so, include the amount of the option in the lease payment. So far, so good.
Now let’s discuss the third point – variable payments that are based on an index or rate (for e.g., CPI, LIBOR, etc.). How are these variable payments treated? First, you would use the spot rate at lease commencement. But what happens as the rate changes? Would the amount of the asset or liability be adjusted, based on changes in the rate? The answer is, No. The asset or liability is not adjusted for increases in the variable payment based on an index…the liability is calculated using the spot rate at lease commencement and any increase are treated as variable lease expense.
Let’s look at an example. Assume we have a lease payment of $50,000 a year but it resets each year-end, based on increase in CPI. We calculated our lease liability based on CPI at lease commencement and it amounted to $50,000. However, at the end of year 2, CPI increases, and we owe $55,000 instead of $50,000. We would then just have variable lease expense of $5,000 in year 3. The liability WILL NOT be adjusted, based on this increase in CPI. *
*Note: There are some exceptions to this, one being that if the lease liability is reassessed for other reasons, the rate in effect at the time of reassessment would be applied such that the liability would then be reflective of the payment based on the new rate.
Lease payments do not include
What is excluded from lease payments?
- Amount allocated to nonlease components (lease and nonlease components to be discussed in another blog)
- Variable lease payments that are based on the usage or performance of the underlying asset
Now let’s discuss the second point – variable lease payments that are based on the usage or performance of the underlying asset. These are payments that are not fixed but instead are based on usage or performance. For example, the lease terms can require a payment of $1,000/month plus 5% of revenues. Or, the lease terms can require a payment of $1,000/month plus $0.10 per click. Another scenario may be a payment of $1,000/month plus $100 per use. It is important to note that these amounts are not included in the lease payment! Sometimes, most of the lease payment is based on these variable payments and in these cases, the accounting may seem a little odd. That being said, let’s look at an example.
Assume that a hospital is leasing an MRI machine. The fixed lease payment is $10,000 per year and the variable payment is $100 per use. Assume the hospital accumulated $100,000, based on usage ($100 each time the machine was used). In this case, the lease liability would be $10,000, while the actual variable lease expense would be $100,000! In other words, the lease liability would be insignificant compared to the actual lease expense. But that’s the way it would be recorded.
Determining the amount of the lease liability can require some analysis. Consider the items that are and are not included in the calculation of the lease liability in order to properly allocate the amount between the lease liability and the variable lease expense. Most importantly, keep in mind that sometimes, applying these rules may result in a lease liability that does not reflect the actual lease expense. But if you’re following these rules, no need to question yourself!