Part 4 of 5
Hello again everyone. This is now part IV of my five-part series, expanded lease accounting discussion III. In my previous blog, we discussed the journal entries required to create our lease accounting balances. In this blog, I want to introduce some additional lease financial terms and discuss the impacts on our lease. Again, for your reference, here is the complete list for the 5-part series:
- Blog series introduction and new lease accounting terminology
- Basic lease accounting example
- Expanded lease accounting discussion – I
- Expanded lease accounting discussion – II
- Blog series wrap-up & next steps
To begin, let’s look at the numbers for our lease again.
Property Lease: 3 years
Yearly Payments: $150,000, $180,000, $210,000 = Total – $540,000
Borrowing interest rate: 9%
ROU Asset Value – $450,000
Lease Liability – $450,000
Remember the value of the ROU asset & the lease liability are both calculated by determining the present value of the lease payments (PVLP). From here I would like to discuss three lease financial terms: lease incentives, initial direct costs & purchase options. These terms will impact the account balances and will need to be tracked under the new lease accounting standards.
If we introduce lease incentives, which is cash received by the lessee upfront, we would debit cash and credit the ROU asset. This essentially lowers the value of the ROU asset on the balance sheet. Additionally, lease incentives only impact the ROU asset and will not have any impact on the lease liability. To illustrate, if we were to introduce a lease incentive amount of $10,000, then the ROU asset value would now be $440,000 instead of $450,000 from the basic example.
The journal entries pertaining to the ROU asset would be as follows with the net amount for the ROU asset now lowered to $440,000:
Initial Direct Costs
Next when looking at initial direct costs, we have the opposite impact on the ROU asset value. To record initial direct costs, we would debit the ROU asset and credit cash. Thus, initial direct costs will be added to the ROU asset value. For calculating the lease liability, initial direct costs will be ignored since the amounts are paid upfront. To illustrate, if we were to introduce initial direct costs in the amount of $15,000, then the ROU asset value would be $465,000 instead of $450,000 from the basic example.
The journal entries pertaining to the ROU Asset would be as follows with the net amount for the ROU asset now increased to $465,000:
Special note for lease incentives and initial direct costs: regardless if the lease is classified as a finance lease or as an operating lease, the impact on the ROU asset value will the same.
If a purchase option is reasonably certain to be exercised, then the present value of that purchase option needs to be included as part of the PVLP for the ROU asset value and the lease liability calculations. If the purchase option is not reasonably certain then it can be excluded from the PVLP. In this case let’s assume that we have a reasonably certain purchase option for $50,000 which has a present value of $38,609. The result would be that our ROU asset and lease liability would now be $488,609 ($450,000 + $38,609).
Unique to this example, if a purchase option is reasonably certain, then this lease can only be classified as a finance lease since the asset is essentially being purchased. Whereas with lease incentives & initial direct costs, lease classification might not be impacted depending on the dollar amounts involved.
One final subject that gets honorary mention I would like to discuss is asset fair market values. This would include both the fair market value at the beginning of the lease and the fair market value at the end of the lease. Under the current rules you may have been working with these amounts as a process of negotiating your leases and then, to smaller extent, tracking fair market values to determine lease classification. Under the new lease accounting standards, the requirement for tracking asset fair market values will still exist and will still be a factor for classifying a lease as finance or operating.
My main goal of this blog was to provide some additional depth on our lease and to help provide a solid foundation on the new lease accounting standards as you begin implementing the changes. In the next and final blog in this series, I will provide some closing comments and some guidance on next steps.
Thank you for reading and be sure to read our other Lease Administration Blogs.
Steven Brenner, CPA
Senior Principal Consultant