Subsequent measurement for lessees: finance versus operating

• Compute interest and amortization for a finance lease under 842-20-35-1
• Compute the single straight-line cost and plug ROU asset for an operating lease
• Identify events that require remeasurement under 842-10-35-4
• Tie lease balances to the required cash flow and cost disclosures

Finance leases: two expenses

After commencement, a finance lessee measures the liability by adding interest at a constant periodic rate and subtracting payments (842-20-35-1). The ROU asset is carried at cost less accumulated amortization and impairment. The income statement shows amortization of the ROU asset and interest on the liability separately (842-20-25-5).

Interest is computed on a declining liability, so it is highest in the early years. Amortization on a straight-line basis does not offset that, so total expense is front-loaded.

Operating leases: one straight-line cost

An operating lessee recognizes a single lease cost allocated over the remaining lease term on a straight-line basis, unless another systematic and rational basis better reflects the pattern of benefit (842-20-25-6). The liability is still measured at the present value of remaining payments (842-20-35-3). The ROU asset is the plug: the liability adjusted for prepaid or accrued lease payments, the remaining balance of lease incentives, unamortized initial direct costs and any impairment.

So for an operating lease, the ROU asset decreases by the difference between the straight-line cost and the interest accretion on the liability. The interest component is not shown as interest expense.

After an impairment

If an operating ROU asset is impaired under the Topic 360 guidance referenced in 842-20-35-9, the single cost becomes straight-line amortization of the remaining ROU asset plus accretion of the liability (842-20-25-7). Expense becomes front-loaded, like a finance lease. Common triggers are abandoned space and store closures.

Remeasurement of the liability

A lessee remeasures the lease payments under 842-10-35-4 when:

• a modification is not accounted for as a separate contract,
• a contingency on variable payments is resolved so that they become fixed,
• the lease term changes, the purchase option assessment changes, or amounts probable under a residual value guarantee change.

A remeasurement adjusts the ROU asset, with any excess over the asset's carrying amount going to profit or loss (842-20-35-4). The lessee updates the discount rate at the remeasurement date (842-20-35-5), with three exceptions: a change in the lease term or purchase option assessment when the existing rate already reflects that option, a change in amounts probable under a residual value guarantee, and resolution of a contingency on variable payments. Index-based variable payments are remeasured using the index at that date (842-10-35-5). A change in CPI alone is not a trigger.

Presentation and disclosure

Finance and operating ROU assets and liabilities are presented or disclosed separately. Required amounts each period (842-20-50-4) include finance lease cost split between amortization and interest, operating lease cost, short-term lease cost, variable lease cost, sublease income, cash paid for amounts in lease liabilities split between operating and financing cash flows, noncash ROU additions, and weighted-average remaining term and discount rate. A maturity analysis shows undiscounted cash flows reconciled to the liability (842-20-50-6).

Amortization period for finance leases

A finance lessee amortizes the ROU asset from commencement to the earlier of the end of its useful life or the end of the lease term. If the lease transfers ownership or the lessee is reasonably certain to exercise a purchase option, the lessee amortizes to the end of the useful life of the underlying asset (842-20-35-8). A five-year truck lease with a bargain purchase option the lessee will exercise is amortized over the truck's full life, not five years.

Common errors in client schedules

• Recording operating lease cost as interest plus amortization, which overstates early-year expense and misstates EBITDA.
• Forgetting to reduce the ROU asset for lease incentives received after commencement.
• Leaving a remeasured lease at the old discount rate when 842-20-35-5 calls for an updated rate.
• Booking a CPI increase as a liability remeasurement when no trigger occurred.

Audit points

Roll forward each class: opening balance, additions, remeasurements, payments, interest or straight-line cost, closing balance. Agree payments to the cash disbursement records, and recompute a sample. The ROU impairment calculator shows the post-impairment pattern.

Same lease, two classifications at Larchmont Imaging, LLC