The following example is extracted from FRS 116 – Illustrative Examples : Example 13
Part 1—Initial measurement of the right-of-use asset and the lease liability
Lessee enters into a 10-year lease of a floor of a building, with an option to extend for five years.
Lease payments are CU50,000 per year during the initial term and CU55,000 per year during the optional period, all payable at the beginning of each year.
To obtain the lease, Lessee incurs initial direct costs of CU20,000, of which CU15,000 relates to a payment to a former tenant occupying that floor of the building and CU5,000 relates to a commission paid to the real estate agent that arranged the lease.
As an incentive to Lessee for entering into the lease, Lessor agrees to reimburse to Lessee the real estate commission of CU5,000 and Lessee’s leasehold improvements of CU7,000.
At the commencement date, Lessee concludes that it is not reasonably certain to exercise the option to extend the lease and, therefore, determines that the lease term is 10 years.
The interest rate implicit in the lease is not readily determinable.
Lessee’s incremental borrowing rate is 5 per cent per annum, which reflects the fixed rate at which Lessee could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a 10-year term, and with similar collateral.
At the commencement date, Lessee makes the lease payment for the first year, incurs initial direct costs, receives lease incentives from Lessor and measures the lease liability at the present value of the remaining nine payments of CU50,000, discounted at the interest rate of 5 per cent per annum, which is CU355,391.
Lessee initially recognises assets and liabilities in relation to the lease as follows.
Right-of-use asset CU405,391
Lease liability CU355,391
Cash (lease payment for the first year) CU50,000
Right-of-use asset CU20,000
Cash (initial direct costs) CU20,000
Cash (lease incentive) CU5,000
Right-of-use asset CU5,000
Lessee accounts for the reimbursement of leasehold improvements from Lessor applying other relevant Standards and not as a lease incentive applying FRS 116. This is because costs incurred on leasehold improvements by Lessee are not included within the cost of the right-of-use asset.
Part 2—Subsequent measurement and accounting for a change in the lease term
In the sixth year of the lease, Lessee acquires Entity A.
Entity A has been leasing a floor in another building.
The lease entered into by Entity A contains a termination option that is exercisable by Entity A.
Following the acquisition of Entity A, Lessee needs two floors in a building suitable for the increased workforce.
To minimise costs, Lessee (a) enters into a separate eight-year lease of another floor in the building leased that will be available for use at the end of Year 7 and (b) terminates early the lease entered into by Entity A with effect from the beginning of Year 8.
Moving Entity A’s staff to the same building occupied by Lessee creates an economic incentive for Lessee to extend its original lease at the end of the non-cancellable period of 10 years.
The acquisition of Entity A and the relocation of Entity A’s staff is a significant event that is within the control of Lessee and affects whether Lessee is reasonably certain to exercise the extension option not previously included in its determination of the lease term.
This is because the original floor has greater utility (and thus provides greater benefits) to Lessee than alternative assets that could be leased for a similar amount to the lease payments for the optional period—Lessee would incur additional costs if it were to lease a similar floor in a different building because the workforce would be located in different buildings.
Consequently, at the end of Year 6, Lessee concludes that it is now reasonably certain to exercise the option to extend its original lease as a result of its acquisition and planned relocation of Entity A.
Lessee’s incremental borrowing rate at the end of Year 6 is 6 per cent per annum, which reflects the fixed rate at which Lessee could borrow an amount similar to the value of the right-of-use asset, in the same currency, for a nine-year term, and with similar collateral.
Lessee expects to consume the right-of-use asset’s future economic benefits evenly over the lease term and, thus, depreciates the right-of-use asset on a straight-line basis.
The right-of-use asset and the lease liability from Year 1 to Year 6 are as follows.
| Lease liability | Right-of-use asset | ||||||
| Beginning balance | Lease payment | interest expense | Ending balance | Beginning balance | Depreciation charge | Ending balance | |
| Yr | CU | CU | CU | CU | CU | CU | CU |
| 1 | 355,391 | – | 17,770 | 373,161 | 420,391 | (42,039) | 378,352 |
| 2 | 373,161 | (50,000) | 16,158 | 339,319 | 378,352 | (42,039) | 336,313 |
| 3 | 339,319 | (50,000) | 14,466 | 303,785 | 336,313 | (42,039) | 294,274 |
| 4 | 303,785 | (50,000) | 12,689 | 266,474 | 294,274 | (42,039) | 252,235 |
| 5 | 266,474 | (50,000) | 10,823 | 227,297 | 252,235 | (42,039) | 210,196 |
| 6 | 227,297 | (50,000) | 8,865 | 186,162 | 210,196 | (42,039) | 168,157 |
At the end of the sixth year, before accounting for the change in the lease term, the lease liability is CU186,162 (the present value of four remaining payments of CU50,000, discounted at the original interest rate of 5 per cent per annum).
Interest expense of CU8,865 is recognised in Year 6.
Lessee’s right-of-use asset is CU168,157.
Lessee remeasures the lease liability at the present value of four payments of CU50,000 followed by five payments of CU55,000, all discounted at the revised discount rate of 6 per cent per annum, which is CU378,174.
Lessee increases the lease liability by CU192,012, which represents the difference between the remeasured liability of CU378,174 and its previous carrying amount of CU186,162.
The corresponding adjustment is made to the right-of-use asset to reflect the cost of the additional right of use, recognised as follows.
Right-of-use asset CU192,012
Lease liability CU192,012
Following the remeasurement, the carrying amount of Lessee’s right-of-use asset is CU360,169 (ie CU168,157 + CU192,012).
From the beginning of Year 7 Lessee calculates the interest expense on the lease liability at the revised discount rate of 6 per cent per annum.
The right-of-use asset and the lease liability from Year 7 to Year 15 are as follows.
| Lease liability | Right-of-use asset | ||||||
| Beginning balance | Lease payment | interest expense | Ending balance | Beginning balance | Depreciation charge | Ending balance | |
| Yr | CU | CU | CU | CU | CU | CU | CU |
| 7 | 378,174 | (50,000) | 19,690 | 347,864 | 360,169 | (40,019) | 320,150 |
| 8 | 347,864 | (50,000) | 17,872 | 315,736 | 320,150 | (40,019) | 280,131 |
| 9 | 315,736 | (50,000) | 15,944 | 281,680 | 280,131 | (40,019) | 240,112 |
| 10 | 281,680 | (50,000) | 13,901 | 245,581 | 240,112 | (40,019) | 200,093 |
| 11 | 245,581 | (55,000) | 11,435 | 202,016 | 200,093 | (40,019) | 160,074 |
| 12 | 202,016 | (55,000) | 8,821 | 155,837 | 160,074 | (40,019) | 120,055 |
| 13 | 155,837 | (55,000) | 6,050 | 106,887 | 120,055 | (40,019) | 80,036 |
| 14 | 106,887 | (55,000) | 3,113 | 55,000 | 80,036 | (40,018) | 40,018 |
| 15 | 55,000 | (55,000) | – | – | 40,018 | (40,018) | – |