Definitions
A lease is an agreement that conveys to the lessee the right to control the use of an identified asset for a period of time in exchange for consideration.
The agreement should convey the transfer to the lessee of the right to control the asset by:
- obtaining substantially all economic benefits from the use of the asset
- directing its use.
There are two perspectives of accounting for leases, the one for lessor and the one for the lessee.
We note that for CMA exams, the scope only covers accounting by lessees. This is the case when the company is the party using the property subject to the lease. The following concept map includes a summary of the necessary topics to be familiar with in this section:
Basic definitions
The following basic definitions on leases can be helpful in understanding the subsequent discussions. You may skip this section and come back to them while reading the sections that mention them.
Lease payments
These are the payments a lessee includes when measuring the lease liability. They consist of:
- fixed payments over the lease term
- variable payments that depend on an index or rate (measured using the index or rate at lease commencement)
- amounts the lessee is probable of owing under a residual value guarantee
- the exercise price of a purchase option, if the lessee is reasonably certain to exercise it
- termination penalties, if the lease term reflects the lessee exercising an option to terminate the lease.
Variable lease payments
These are lease payments that do not have a fixed amount. These generally have two types:
- included in lease liability: variable lease payments that depend on an index or rate (i.e., LIBOR, CPI etc.). These are measured using the index or rate at the lease commencement date.
- expensed as incurred: variable lease payments that do not depend on an index.
Rate implicit in the lease
The discount rate that makes the present value of the lease payments equal to the fair value of the asset. This is a simplified statement of the definition: more precisely, it’s the rate that equates the present value of the lease payments plus the residual value the lessor expects, to the fair value of the asset plus the lessor’s deferred initial direct costs. Although this is the first preferred rate to be used, computation of the rate implicit in the lease is not covered by the CMA exams.
Incremental borrowing rate
This is the discount rate to be used if the rate implicit in the lease is not available. The incremental borrowing rate is the rate of interest that the lessee would have to pay if they proceed to borrow an amount equal to the lease payments in a collateralized arrangement over a term similar to the lease term. This is essentially the market rate of interest should the lessee just decide to borrow money over the same period to finance the acquisition of a similar asset.
Initial direct costs
These are costs directly related to originating the lease that would not have been incurred if the lease did not exist. Typical costs included are costs in negotiating the lease, preparing the contract, and commissions to real estate brokers.
Lease term
This is the period in which the lessee has the right to use the asset.
This includes:
- the non-cancellable period of the lease agreement
- periods covered by a renewal option that is reasonably certain to be taken by the lessee
- periods covered by a termination option that the lessee is reasonably certain not to exercise
- periods covered by an option to extend or not terminate the lease controlled by the lessor