Lease Liability

Lease liability represents the amount recognized by a lessee on its statement of financial position regarding its leases. It is initially measured at the present value of lease payments and is remeasured whenever there is a change in lease payments or lease modification.

While IAS 17 required lessee to recognize a lease liability on its finance leases only, IFRS 16 and its US GAAP equivalent requires recognition of lease liability on almost all leases. IFRS 16 allows exemption for short-term leases and leases of low-value assets.

Initial measurement of lease liability

At the commencement date, a lessee recognizes a lease liability at the present value of lease payments which are not yet paid determined at the interest rate implicit in the lease if it is readily available, or at the lessee’s incremental borrowing rate.

Let’s say you signed up for a 3-year lease contract for office space on 1 Jan 20X1. The property will be available for possession in three months. You are required to pay $100,000 at the start of each quarter. The lease rentals are to be revised at the end of each year based on the consumer price index. If the interest rate implicit in the lease is not readily available, and your incremental borrowing rate is 10%, you will recognize a lease liability of $1,051,421 on the commencement date of the lease, the date when you will get possession of the property, i.e. on 31 March 20X1.

$$ \text{Lease Liability at 31 March 20X1} \\=\text{\$100,000}\times\frac{\text{1}\ -\ {(\text{1}+\text{2.5%})}^{-\text{3}\times\text{12}}}{\text{2.5%}}\times(\text{1}+\text{2.5%})\\=\text{\$1,051,421} $$

This is recognized by the following journal entry:

Right of use asset $1,051,421
Lease liability $1,051,421

Subsequent measurement of lease liability

Subsequent to initial recognition, lease liability is (a) increased by the amount of finance cost which is calculated by multiplying the opening lease liability by the periodic interest rate, and (b) decreased by the amount of lease rentals paid.

Since the first lease payment is made on 1 April 20X1, opening lease liability is $951,421.

During the Q2 of 20X1, finance cost would be $23,786 (=$951,421× 2.5%). After the payment has been made, the revised lease liability would be $

$$ \text{Lease Liability at 30 June 20X1} \\= \text{\$951,421} + \text{\$23,786} - \text{\$100,000} \\= \text{\$875,206} $$

This involves the following journal entry:

Lease liability $76,214
Finance cost $23,786
Bank $100,000

Lessees typically create a lease amortization schedule which provides the finance cost, reduction in lease liability and closing lease liability as at the end of each period. For example, the following is an extract from lease amortization schedule:

Date Finance Cost Repayment of Lease Liability Closing Lease Liability
31 March 20X1 1,051,421
1 April 201X1 - 100,000 951,421
1 July 20X1 23,786 100,000 875,206
1 September 20X1 21,880 100,000 797,087
1 Jan 20X1 19,927 100,000 717,014
31 March 20X2 17,925 0 734,939

Remeasurement of lease liability

IFRS 16 redefines lease payments to include those variable payments which are linked to some index or rate. In the example discussed above, the lease payments are variable payments linked to the consumer price index. Whenever there is a revision in lease payments due to movement in the underlying index or rate, it results in a remeasurement of the associated lease liability. If there is no lease modification, the revised lease payments are discounted at the original discount rate to work out remeasured lease liability.

If the CPI changes from 121 to 130 by 31 March 20X2, the remeasuared lease payment would be as follows:

$$ \text{Remeasured Lease Payment} = \text{\$100,000}\times\frac{\text{130}}{\text{121}} = \text{\$107,438} $$

Remeasured lease liability would be as follows:

$$ \text{Lease Liability at 31 March 20X2} \\=\text{\$107,438}\times\frac{\text{1}\ -\ {(\text{1}+\text{2.5%})}^{-\text{2}\times\text{12}}}{\text{2.5%}}\times(\text{1}+\text{2.5%})\\= \text{\$789,604} $$

Before the revision in cash flows, lease liability was $734,939. This difference results in an adjustment to the right of use asset:

Right of use asset $54,665
Lease liability $54,665

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2020 XPLAIND.com