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 lessee has the right to control the asset only if it has both of the following rights:
- 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 (e.g., CPI or a market rate such as SOFR). 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 or rate (e.g., payments based on the lessee’s sales or usage).
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. Although this is the preferred rate, computation of the rate implicit in the lease is not covered by the CMA exams.
Incremental borrowing rate
This is the discount rate to use if the rate implicit in the lease is not readily determinable. 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. Under ASC 842, only incremental costs caused solely by obtaining the lease qualify, such as commissions paid once the lease is signed. Costs incurred whether or not the lease is executed - legal fees for negotiating terms, preparing documents, or evaluating the lessor, plus general overhead - are expensed as incurred.
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
Example: Determining the lease term and lease payments
Achievable Co. signs a 5-year non-cancellable warehouse lease with a 3-year renewal option it’s reasonably certain to exercise. Annual rent is a fixed $50,000, plus a CPI-linked escalator (measured using the CPI rate at commencement), plus a variable payment equal to 2% of Achievable’s sales from the warehouse.
- Lease term: years, since the renewal is reasonably certain.
- In the lease liability: the fixed rent and the CPI-based escalator.
- Expensed as incurred: the sales-based payment, since it depends on sales rather than an index or rate.
Answer: lease term = 8 years; lease liability includes the fixed rent and CPI escalator; the sales-based rent is expensed as incurred.
The next chapter, Types of leases, covers how to classify and present finance vs. operating leases.