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Accounting for leases

Lease
liability
Principal Interest Interest (end of
Payment paid paid expense year)

Year 3 1,100 898 202 139 2,127

Year 4 1,100 961 139 73 1,100

Year 5 1,100 1,027 73 0 0

$4,400 $3,725 $675 $675

*No payment is reflected in Year 1 because the first payment was made at lease commencement and is not
included in the lease liability.

Adding the amortization and interest expense from the two charts above, the total expense recorded
per period is higher in earlier periods and decreases throughout the lease term (from $1,226 in year 1
to $965 in year 5).

4.4.1.1 Finance lease with a purchase option

When a lease is classified as a finance lease because it contains a purchase option that the lessee is
reasonably certain to exercise, the lessee has an additional payment to make related to the exercise of
the purchase option. This additional lease payment should be included in the lease liability as a
payment occurring at the date the lessee expects to exercise the purchase option, which is typically at
the end of the lease term. Interest expense will be calculated on the full amount of the lease liability,
which includes the present value of the purchase option payment. Because it is reasonably certain that
the lessee will obtain the asset at the end of the lease term, the right-of-use asset should be amortized
over the useful life of the asset, rather than over the lease term. Example 4-12 illustrates the
application of this guidance.

EXAMPLE 4-12

Finance lease subsequent measurement and recognition – real estate lease with a purchase option
(lessee)

This example is a continuation of Example 4-3.

The lease is classified as a finance lease because it grants Lessee Corp the option to purchase the asset
underlying the lease and Lessee Corp is reasonably certain to exercise that purchase option. The right-
of-use asset is $5,000,000 and lease liability are $4,500,000.

How would Lessee Corp measure the right-of-use asset and lease liability over the lease term?

Analysis

Since the purchase option is reasonably certain to be exercised, Lessee Corp would amortize the right-
of-use asset over the economic life of the underlying asset (40 years). Annual amortization expense
would be $125,000 ($5,000,000 / 40 years).

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