What is a lease liability?
A lease liability is the financial obligation for the payments required by a lease, discounted to present value. Under ASC 842, the lease liability is calculated as the present value of the remaining future lease payments.
Which lease payments are included in the lease liability calculation?
Numerous payments varying in amount, timing, or triggering events can be specified within a lease agreement, and it can be hard to determine which of these to include in the lease liability calculation. ASC 842 defines the future lease payments to include in the lease liability calculation as:
- Fixed payments required by the lease agreement, such as base rent
- In-substance fixed payments required by the lease agreement
- Variable lease payments that depend on an index or rate
- Purchase options that are reasonably certain to be exercised
- Penalties for terminating the lease if the lease term reflects the lessee incurring any penalties for termination
- Fees paid by the lessee to the owners of a special purpose entity for structuring the transaction
- Payments probable of being owed by the lessee as the result of a residual value guarantee
Additional information on these various types of lease payments can be found below:
Fixed vs. Variable Payments
Lease payments can be separated into two categories: fixed and variable consideration.
• Fixed consideration is a payment made directly for the right to use the underlying asset and is explicitly stated in the lease contract. These payments will be included in the measurement of the lease liability and ROU asset.
• Variable consideration is a payment incurred for the right to use an asset that varies relative to changes occurring throughout the lease term. These payments are typically not included in the measurement of the lease liability or ROU asset and are simply expensed when incurred. However, variable payments may also include payments related to a stated index or rate, such as CPI. These payments are included in the lease liability calculation, and we discuss specific accounting treatment below.
An example of a fixed payment typically found in a lease agreement is base rent. Base rent is essentially the minimum required payment for a lease. It is the portion of the rent payment explicitly stated in the contract and will be included in the calculation of the asset and liability.
A lease contract may include a payment schedule of the expected annual or monthly payments. Even if the contract includes escalations to the beginning or base payment amount, this type of rent is fixed.
When the periodic payments are structured so they cannot be calculated without the occurrence of an event, such as an amount of sales or units produced, the payments are not considered fixed. Examples of variable payments are monthly rent as a percentage of sales or a per mile rate once a mileage threshold is achieved. Variable lease costs will not be included in the lease liability calculation, but are still required to be disclosed.
Variable lease payments can be presented as what looks like a fixed payment at the beginning of a lease term, e.g. a specified amount for taxes is added to the base rent payment. However, if the payment will be reconciled to actual costs at a future date, and the lessee is required to pay the difference, the cost is considered variable because the final amount is dependent upon actual expenses. To avoid misclassifying variable payments as fixed payments, ask yourself if a reconciliation is required. If the payments are compared to actual expenses or some unknown future amount, they are likely variable.
In-substance Fixed Payments
In-substance fixed payments are the opposite of variable payments presented as fixed payments. These payments can be tricky because they may appear as variable payments, but are in fact, fixed.
An example of in-substance fixed payments would be a lease agreement with payments based on an amount of future sales and a required minimum amount. While the amount based on sales is variable and cannot be calculated until sales are known, the minimum required payment is an in-substance fixed payment. The lessee knows at a minimum they will pay this amount according to the terms of the agreement and can therefore include this amount in their lease liability calculation.
Likewise for the example above of a rate for miles over a certain threshold. The lessee can calculate the lease liability with the base rent amount and any mileage overages are excluded from the initial lease measurement, to be expensed when or if incurred.
Variable Payments Depending on a Rate/Index
As mentioned above, variable payments that depend on sales or an event are not included in the lease liability calculation. However, payments that are variable because of dependence on an index or rate are included in the initial lease liability calculation. The consumer price index (CPI) is an example of an index or rate to which a lease payment schedule may be linked.
A common use of this type of payment in a lease agreement is to specify a base rent amount with annual escalations equal to CPI. Similar to the mileage payment scenario above, the lessee knows the CPI in effect when the lease commences and can, therefore, calculate the
initial lease liability with the index or rate at the lease commencement date. However, escalations based on increases to CPI are variable payments excluded from the lease liability measurement because the increase is an event that can not be predicted.
The initial lease liability is calculated with the index or rate in effect at the lease commencement date applied for the lease term. Over the term of the lease, as payments are made with the actual index or rate applied, any variance is recognized as expense. Additionally, a change
in the index or rate the payments depend on does not trigger a remeasurement of the lease liability on its own. Rather, if another event occurs to cause a remeasurement, the index or rate is updated to the index or rate in effect at the remeasurement date.
Additional Payments
Some payment types, such as base rent, will be the main drivers in the calculation of the lease liability, but other items could also have an impact on the liability balance. These items include:
- The price of a purchase option, if the lessee is reasonably certain to exercise that option,
- Penalties for terminating the lease, if the lease term used for the lease liability calculation reflects the lessee exercising an
- option which invokes penalties,
- Fees paid by the lessee to the owners of a special purpose entity for structuring the transaction, and
- Payments for a residual value guarantee, if the payments are probable of being owed by the lessee.
Although this is not an exhaustive list, these are the types of payments to look for within a lease agreement when calculating the lease liability.
Lease vs. Nonlease Components
Lease components are sections of the contract which directly transfer the right to use the underlying asset to the lessee in exchange for consideration. A nonlease component is a section of the contract which transfers a good or service to the lessee that is separate from the
use of the underlying asset in exchange for consideration. Lastly, non-components are payments that do not contribute directly to the right to use the underlying asset and do not transfer any value to the lessee, such as property taxes or insurance.
The nature of the payment, fixed or variable, does not dictate the determination of whether it is a lease component. Frequent examples of nonlease components include the cost of common area maintenance (CAM) provided by the landlord for a real estate lease, or charges for
maintenance, landscaping, janitorial, or other services related to the lease.
Some types of payments may be either a lease or nonlease component, depending on circumstances, such as a security deposit. When determining if a security deposit should be included in your lease payments, confirm if the deposit is refundable or non-refundable. In
in short, refundable deposits are not included as lease payments but any non-refundable deposits are, and if paid before commencement, will increase the value of the ROU asset.
It is also normal to see lease agreements structured with one payment stream consisting of both lease and nonlease components. If this is the case, ASC 842 requires the lessee to allocate the total contract consideration, or that of the combined components, to each of the individual lease and nonlease components on a relative standalone price basis. To complete the allocation lessees must use observable standalone prices for each component or estimate the standalone prices using the available market information if they are not readily available. However, a practical expedient exists which allows lessees and lessors to elect by underlying asset class to account for each lease and nonlease component as a single lease component, saving the resources required to separate these costs.
Present Value
Present value, commonly referred to as PV, is the calculation of what a future sum of money or stream of cash flows is worth today given a specified rate of return over a specified period of time.
Under the new lease accounting standards, lessees are required to calculate the present value of any future lease payments to determine the obligations to be recorded on the balance sheet for both operating and finance leases. The calculation is performed using the term and
payments specified in the lease and a rate of return that is specific to either the lease or the organization. The present value of the lease payments is used to establish both the lease liability and the related ROU asset.
Borrowing Rate/Discount Rate
To calculate the present value of the future remaining payments, use the rate implicit in the lease or one of the borrowing rate practical expedients. More information on borrowing rates can be found here.
How to calculate lease liability
A common question usually asked is, "How does LeaseGuru calculate Lease Liability?" The following is a breakdown on the process using goal seek in excel. Lucky for you, LeaseGuru will perform these calculations for you and saves you from doing this for your entire lease portfolio!
In this article, we will walk through the steps to calculate Lease Liability.
To calculate Lease Liability in excel you will need to complete the following steps:
- Firstly, you will need to calculate the daily rate. This can be done by taking the annual rate and divide it by 365.
- Calculation: Annual rate / Days in a year = Daily rate
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To find the line by line expense, you will take the liability times the number of days times the daily rate.
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Calculation: Expense = Previous Total Liability * Number of Days * Daily Rate
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The next step will be to find the Liability Reduction. This will be equal to your cash payments less your expense.
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Calculation: Liability Reduction = Cash - Interest Expense
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The total liability will equal the prior liability less the reduction.
- Calculation: Previous line's Liability Balance - Liability Reduction=Current Line's Liability Balance
- Now that we have all of the liabilities lined up we have the proper calculation to derive at these, we need to know what is the opening liability. This will be done using What If Analysis - Goal Seek.
- Set cell (last period's liability balance cell) To value (0) By changing cell (First period for liability balance in table)