Meridian Ltd: lease term, included payments and the right-of-use asset
On 1 January 20X6 Meridian Ltd entered a lease of a warehouse for a non-cancellable term of five years with an option to extend for a further three years at the same annual rent of $100,000, payable in advance on 1 January. Meridian has fitted the warehouse with conveyor systems costing $700,000 that have no alternative use and would be worthless if the lease ended in 20Y1. Under the lease Meridian must pay the lessor any shortfall against a residual value guarantee capped at $150,000; at commencement Meridian expects to pay $60,000. Meridian paid $20,000 of legal fees and is obliged to restore the site at the end of the term at an estimated cost of $40,000 (present value $25,080). Meridian's incremental borrowing rate is 6%; the rate implicit in the lease cannot be determined. Relevant factors: 8-period annuity-due at 6% = 6.582; 8-year present value factor = 0.627.
1. Determine the lease term and state which payments are included in the lease liability, with reasons for each inclusion or exclusion.
Read the worked answer
Lease term: 8 years. The extension is reasonably certain to be exercised. Meridian has installed conveyors costing $700,000 with no alternative use that would be worthless if the lease ended in 20Y1 – a significant economic penalty for not extending. The rent on extension is the same, giving no incentive to leave. The term is therefore 5 + 3 years, and the option is not treated as a separate decision.
Payments included in the lease liability:
- 8 x $100,000 rent, paid in advance – fixed (in substance) payments for the right to use, discounted as an annuity due.
- Residual value guarantee: $60,000, not $150,000 – the amount expected to be payable under the guarantee is included, discounted from the end of year 8. The $150,000 cap is only a maximum.
Payments excluded from the liability:
- The $20,000 legal fees and the $25,080 restoration obligation are not payments to the lessor for the right to use; they are capitalised in the right-of-use asset instead.
- Any future rent increases not yet fixed and any service charges would be excluded or expensed as incurred.
Because the rate implicit in the lease is not readily determinable, the incremental borrowing rate of 6% is used.
2. Compute the lease liability and the right-of-use asset at commencement and show how each element is measured.
Read the worked answer
Lease liability
- Rent: 100,000 x 6.582 (8-period annuity-due at 6%) = 658,200
- Residual value guarantee: 60,000 x 0.627 = 37,620
- Lease liability = $695,820
Because the first payment is made on 1 January 20X6, the liability is immediately reduced (or, equivalently, the annuity-due factor has already excluded it).
Right-of-use asset
- Lease liability at commencement: 695,820
- Initial direct costs (legal fees): 20,000
- Estimate of restoration costs (discounted): 25,080
- Right-of-use asset = $740,900
The restoration obligation is recognised as a separate provision with the corresponding debit to the right-of-use asset, because the obligation arises from constructing/occupying the leased asset. The provision is accreted as interest expense over eight years while the asset is depreciated. The lease liability is presented separately from the restoration provision and from the current/non-current split of the liability.
Year 1 expense profile
- Depreciation: 740,900 / 8 = 92,613
- Interest: 6% x (695,820 - 100,000) = 35,749
- Total 128,362, versus cash rent of 100,000 – the expense is front-loaded, unlike the old straight-line operating lease charge.
3. Explain how the expense profile changes over the term and what Meridian must do if, during 20X7, it concludes that it will not extend the lease.
Read the worked answer
Profile. Interest is calculated on the outstanding liability and therefore falls each year, while straight-line depreciation of the right-of-use asset is constant. The total charge declines over the eight years, but the average is above the cash rent because of the initial direct costs and restoration accretion.
Change in the lease term. A change in whether the extension is reasonably certain is a reassessment trigger. Meridian must:
- Remeasure the liability using the revised term (five years) and the revised payments, discounted at a revised discount rate determined at the reassessment date (6% if unchanged);
- Adjust the carrying amount of the right-of-use asset by the same amount, with no gain or loss – unless the asset is reduced to zero, in which case any excess goes to profit or loss;
- Recalculate future depreciation over the shortened remaining term.
The reassessment is not a change in accounting estimate applied prospectively through profit or loss at the date of change in the way a provision change would be; the adjustment is absorbed into the asset first, and only flows through profit or loss over the remaining term.