What it means
The word minimum matters because it excludes payments that are not certain. Fixed rent is included, as is a residual value the tenant has guaranteed and the price of a purchase option the tenant is reasonably certain to exercise, while contingent rent based on sales volume or usage is generally excluded.
The concept became far more visible when lease accounting standards changed. Under current rules most leases sit on the balance sheet as a right-of-use asset and a matching liability, so a company with a large property estate now shows debt-like obligations that previously appeared only in the notes.
The measurement step is discounting. Because a dollar paid in five years is worth less than a dollar today, the future payments are discounted at the rate implicit in the lease, or at the tenant's incremental borrowing rate when that implicit rate is not determinable.
The gap between the total cash payable and the discounted figure is finance cost. Over a five-year lease with meaningful interest rates the present value can be noticeably lower than the sum of the payments, and that difference is recognised as interest expense across the lease term.
The nuance that catches people out is the treatment of options. A ten-year lease with a break after five is normally measured over five years unless the tenant is reasonably certain not to break, while a five-year lease with a cheap five-year renewal the tenant will obviously take is measured over ten.
In practice
Real-world examples.
Example
A retailer signs 40 store leases averaging $95,000 a year for six years. Once discounted, the combined lease liability is large enough to change the group's reported gearing and forces a renegotiation of a bank covenant written on total debt.
Example
An equipment lease includes a $12,000 bargain purchase option at the end of year four that the lessee will clearly exercise. That $12,000 is included in the minimum lease payments because exercise is reasonably certain.
Example
A restaurant lease charges a base rent of $4,000 a month plus 3% of sales above a threshold. Only the $4,000 base rent enters minimum lease payments, because the turnover element is contingent and cannot be measured reliably in advance.
Formula
Calculation
Present value of minimum lease payments = the sum of each payment divided by (1 + discount rate) raised to the power of the period number.
Take a five-year office lease with fixed annual rent of $60,000 payable at the end of each year, no contingent rent, no purchase option, and an incremental borrowing rate of 6%.
Discounting each year's payment gives $56,604 for year one, $53,400 for year two, $50,377 for year three, $47,526 for year four and $44,835 for year five.
Adding those together gives a present value of approximately $252,742. The total cash payable is $60,000 x 5 = $300,000, so the difference of about $47,258 is the finance cost recognised as interest across the five years. The tenant records a lease liability and a right-of-use asset of roughly $252,742 at the start of the lease.Case study
Seen in the real world.
Ashcombe Logistics is an invented company used here as an illustrative example. It leased five distribution units, each at $60,000 a year on five-year terms, and had always described them in the notes as an off balance sheet commitment totalling $1,500,000 of future rent.
When the accounting treatment changed, the fictional company discounted each lease at its 6% incremental borrowing rate, producing a present value of about $252,742 per unit and roughly $1,263,710 in total. That figure appeared as a lease liability alongside a matching right-of-use asset, and reported net debt jumped accordingly.
The finance director's real work was with the lenders. Two covenants were written on a debt to EBITDA ratio, and the new liability pushed the reported ratio from 2.1 times to 3.4 times overnight even though no cash flow had changed. Both lenders agreed to restate the covenants on a frozen basis, and the illustrative company learned to check covenant definitions before signing long leases.
Watch out
Common mistakes.
- Adding up the raw rent payments and calling that the lease liability. The liability is the discounted present value, and using the undiscounted total overstates it substantially on longer leases.
- Including contingent rent based on turnover or usage. Those amounts are excluded from minimum lease payments because they are not fixed obligations, though they still hit the profit and loss account when incurred.
- Ignoring the covenant consequences of capitalising leases. Reported debt and EBITDA both change, and covenants written before the change can be breached without anything real happening to the business.
Questions
People also ask.
What discount rate should be used?
The rate implicit in the lease if it can be determined, and otherwise the lessee's incremental borrowing rate, which is what it would pay to borrow a similar amount over a similar term.
Are renewal options included?
Only when the tenant is reasonably certain to exercise them, which is judged on economics such as a below-market renewal rent or costly leasehold improvements.
Do short leases have to be capitalised?
Most standards allow an exemption for leases of twelve months or less and for low-value items, which can be expensed straight to the profit and loss account instead.
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