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Calculating the lease liability is a fundamental aspect of accounting for leases under the new lease accounting guidance, ASC 842. Not only does it determine the liability on the balance sheet, but it also establishes the starting point for determining the right-of-use asset. The lease liability is recognized at the present value of the future lease payments.
When Do I Recognize the Liability?
Entities should recognize lease liabilities at the date that the lease commences. The lease commencement date is “the date on which a lessor makes an underlying asset available for use by a lessee.” In the year of adoption of ASC 842, entities may elect to recognize the lease liability as of the later of the date of lease commencement and the earliest period presented in the financial statements, or as of the date of adoption of ASC 842.
What Payments Do I Include?
The lease liability should include all payments due under the non-cancelable portion of the lease, plus any payments due under optional periods when the option is controlled by the lessor or when the lessee is reasonably certain to exercise the option. For an in-depth look at determining the lease term, see Implementing the New FASB Lease Accounting Standard: Determining the Lease Term.
Variable lease payments are excluded unless they are associated with an index rate or are in-substance fixed payments. In-substance fixed payments would be any amounts that are unavoidable to be paid or not truly variable. For example, a lease may stipulate that if sales are less than $1,000,000, then a $75,000 lease payment is due, and if sales are over $1,000,000, then a $125,000 lease payment is due. As a minimum payment of $75,000 is unavoidable, it would be considered as a component of the lease payments.
What Discount Rate Do I Utilize?
All lease payments determined to be included above are discounted to determine the present value of the future lease payments. A lessee must utilize the rate implicit in the lease if that rate is readily available. As this information will not commonly be readily available, entities would then utilize either their incremental borrowing rate or the risk-free rate, based upon policy elections made. For further consideration of how to properly determine the discount rate to apply, see Implementing the New FASB Lease Accounting Standard: About the Discount Rate.
Lease Liability Calculation Example
We will walk through a basic lease example to show how the calculations could be performed in Excel. Consider the following fact pattern associated with an office lease:
Lease commencement date of 7/1/2022
Lease term of 2 years
Monthly lease payments of $10,000
Rent fully abated for first 3 months
Rent paid at the beginning of each monthly period
Risk-free rate for a 2-year T-bill is 2.84%
Entity has elected to use risk-free rate
Step 1: Enter Lease Payment Data
The first step is to enter the lease payment data into a spreadsheet. In the table below, the payment data has been entered into the blue column and includes the rent abatement provided for the first three months. The payment dates are consistent with payment being made on the first day of each period, starting with the lease commencement date.
Step 2: Identify the Discount Rate
As mentioned above, there are multiple factors in determining the discount rate. In this example, the lessee has made the policy election to utilize the risk-free rate. The risk-free rate for a similar duration at lease commencement is 2.84%.
Step 3: Calculate the Liability
One way to calculate the liability in Excel is to use the XNPV function. This formula returns the present value for a schedule of cash flows. The function operates as follows: XNPV (Rate, Values, Dates). Each input of the formula can be populated as follows:
Rate: Take the discount rate identified in Step 2 above. Values: This is the schedule of payments due and would be linked to the payment amount in the schedule from Step 1. Dates: This is the date each payment is due and would be linked to the payment date in the schedule from Step 1.
After entering this information into the Excel formula you would arrive at a lease liability, equal to the present value of all future payments, of $203,731. The liability would increase over the next three months as the period with payments becomes closer and the present value discount decreases.
This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.
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