Under ASC 842, what drives the amount of the lease liability recognized at inception?

• A. The present value of lease payments over the lease term.
• B. The future tax benefits expected from the lease.
• C. The historical cost of the underlying asset.
• D. The fair value of the leased asset.

Answer: (A)

The key idea is that the lease liability at inception is the present value of the payments the lessee is obligated to make over the lease term. You take the fixed lease payments (and other payments the lease requires, such as payments tied to an index or rate at the start, amounts for termination penalties that are reasonably certain to be exercised, and any other required payments under the lease) and discount them back to today using the rate that reflects the cost of borrowing for the lessee. If the rate implicit in the lease is readily determinable, you use that; otherwise you use the lessee’s incremental borrowing rate. This approach captures the time value of money and the lessee’s contractual obligation to make those payments.

Other concepts like future tax benefits, the historical cost of the asset, or the fair value of the asset do not determine the lease liability. They are not the cash-flow-based measure used to establish the liability at inception.