What it means
The two sides of a lease are the lessor, who owns the asset and grants the right to use it, and the lessee, who pays for that right. The contract sets the term, the payment amount and schedule, and what happens at the end, including any option to extend, buy or hand the asset back.
Anything that restricts how the asset is used or who bears repair costs also sits in the lease and affects its real economics. Businesses lease rather than buy for cash reasons and for flexibility.
Leasing avoids a large upfront payment, keeps the asset current in fast-moving categories such as vehicles and IT, and often bundles maintenance into a single predictable payment. The trade-off is that the total cost over the full term is usually higher than outright purchase, because the lessor prices in financing and residual risk.
The accounting has changed significantly in recent years. Under IFRS 16 and the equivalent US standard, a lessee records a right-of-use asset and a lease liability for almost every lease longer than 12 months, rather than treating rent as an ordinary expense.
The effect is that reported assets, debt and EBITDA all move, even though nothing about the underlying deal has changed. That matters for anyone reading a set of accounts or negotiating a loan covenant.
A retailer with 80 shop leases can add tens of millions to reported liabilities on adoption, which changes gearing ratios and can breach borrowing limits written before the rules moved. Comparing companies across years therefore requires checking which basis each set of figures uses.
There are practical exemptions worth knowing. Short leases of 12 months or less and leases of low-value items such as laptops and printers can usually stay off the balance sheet and be expensed straight to the profit and loss account.
Judgement about renewal options also matters: if extending is reasonably certain, the extra years go into the measurement from the start.
In practice
Real-world examples.
Example
A dental practice leases three treatment chairs over five years rather than paying $180,000 upfront. The monthly payment includes servicing, so the practice avoids both the capital outlay and unpredictable repair bills while it builds up its patient list.
Example
A logistics operator signs ten-year leases on two distribution centres. Because the term is long, the right-of-use assets and lease liabilities are large enough to move the company's reported gearing ratio, and the finance team renegotiates a covenant with its bank before signing.
Example
A film production company leases specialist camera equipment for a six-week shoot. The term is under 12 months, so it uses the short-lease exemption and simply expenses the rental cost as the production runs.
Formula
Calculation
The lease liability at commencement is the present value of the payments:
Liability = annual payment x [(1 - (1 + r) ^ -n) / r], where r is the discount rate and n is the number of periods.
A design agency leases a floor of office space for 3 years at $50,000 per year, payable at the end of each year, and its incremental borrowing rate is 5%.
Annuity factor = (1 - 1.05 ^ -3) / 0.05 = (1 - 0.863838) / 0.05 = 0.136162 / 0.05 = 2.72325.
Lease liability = $50,000 x 2.72325 = $136,162 (rounded to the nearest dollar).
The right-of-use asset is recorded at the same $136,162, assuming no upfront costs or incentives. Total cash paid across the lease is 3 x $50,000 = $150,000, so the difference of $150,000 - $136,162 = $13,838 is interest recognised over the three years. In year one, the interest charge is 5% x $136,162 = $6,808, and the asset is amortised by $136,162 / 3 = $45,387, giving a total first-year charge of $52,195 against a cash payment of $50,000.Case study
Seen in the real world.
This illustrative case involves Harbour Lane Books, a fictional chain of eleven independent-style bookshops. All eleven premises were leased on terms of between five and nine years, and under the old accounting rules the rent appeared as a single operating expense of about $2.4 million a year.
When the group adopted the current lease standard, it recognised right-of-use assets and lease liabilities of roughly $9.6 million. Reported EBITDA improved, because rent was replaced by depreciation and interest below that line, but reported net debt rose sharply and the leverage covenant in its revolving credit facility was suddenly close to its limit.
Nothing about the fictional business had changed: same shops, same rent, same cash. The finance director renegotiated the covenant definition with the bank, and thereafter the board reviewed every new lease for its balance sheet effect as well as its rent. The illustrative point is that a lease is a financing decision dressed as an operating one.
Watch out
Common mistakes.
- Assuming rent is always a simple monthly expense, when most leases over 12 months now sit on the balance sheet as an asset and a liability.
- Ignoring renewal options during measurement. If extension is reasonably certain, those years belong in the liability from day one.
- Comparing a leasing quote with a purchase price on headline monthly cost alone, without discounting the payments to a present value.
Questions
People also ask.
Does a lease count as debt?
For most analysts and lenders, yes: a lease liability is a contractual obligation to pay, so it is usually treated alongside borrowings when assessing gearing.
What discount rate should a lessee use?
The rate implicit in the lease if it can be determined, and otherwise the lessee's incremental borrowing rate for a similar term and security.
Are all leases capitalised now?
No: leases of 12 months or less and leases of low-value assets can generally be expensed as incurred if the entity applies those exemptions consistently.
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