Lease Payments: Accounting and Tax Treatment

A lease is a contractual agreement where one party, the lessor, grants another party, the lessee, the right to use a specific asset for a predetermined period. In exchange for this right, the lessee makes regular, required payments to the lessor. These payments form the basis of the economic relationship and are central to how the transaction is recorded for both accounting and tax purposes.

The structure of these agreements ensures that the lessee can utilize an asset, such as property or equipment, without bearing the full cost of ownership at the outset. The periodic payments are outlined in the lease agreement, specifying the amount and frequency, which are monthly or quarterly. The total obligation over the lease’s life has significant implications for a company’s financial statements and tax liabilities.

Key Components of Lease Payments

The total lease payment used in accounting calculations is often more complex than a simple, flat rental fee. The most common component is fixed payments, which are the consistent, predetermined amounts paid throughout the lease term.

Variable lease payments fluctuate based on external factors. Some variable payments are tied to an index or a rate, such as the Consumer Price Index (CPI). When calculating the initial lease liability, these are included using the index or rate in effect at the lease commencement. Other variable payments might be based on the asset’s usage, like a car lease with a per-mile charge over a certain limit, or a retail store lease with payments based on a percentage of sales; these are expensed as incurred rather than being included in the initial liability measurement.

A residual value guarantee is another potential component, representing a promise by the lessee to the lessor that the asset will be worth a specific amount at the end of the lease. The lessee must include the amount they expect to pay under this guarantee in the calculation of lease payments. If a lease contains an option for the lessee to purchase the asset, and the lessee is reasonably certain to exercise it, the purchase price is included in the lease payments. Penalties for terminating the lease can also be a component if the lease term is determined based on the lessee exercising a termination option.

Lease Classification for Accounting

Before a lease can be recorded on the financial statements, it must be classified. Under the accounting standard ASC 842, leases are categorized by the lessee as either a finance lease or an operating lease. This classification dictates the subsequent accounting treatment and is based on whether the lease effectively transfers control and ownership risks of the asset to the lessee.

The classification process involves evaluating the lease against five specific criteria. If any single one of these criteria is met, the lease is classified as a finance lease; otherwise, it is considered an operating lease. The criteria are:

• The lease transfers legal ownership of the asset to the lessee by the end of the lease term.
• The lease contains a purchase option that the lessee is reasonably certain to exercise.
• The lease term constitutes a major part of the underlying asset’s remaining economic life.
• The present value of the sum of the lease payments and any residual value guarantee equals or exceeds substantially all of the asset’s fair value.
• The asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the term.

Accounting for Lease Payments by the Lessee

For both operating and finance leases with terms longer than 12 months, the process begins with the initial recognition of a Right-of-Use (ROU) asset and a corresponding lease liability on the balance sheet. This brings most leases onto the balance sheet, providing a more complete picture of a company’s financial obligations.

The lease liability is calculated as the present value of all future lease payments expected to be made over the course of the lease. The rate implicit in the lease should be used if it is readily determinable; if not, the lessee should use its incremental borrowing rate. The ROU asset is initially measured at the amount of the lease liability, plus any initial direct costs incurred by the lessee and any lease payments made before the lease commencement, minus any lease incentives received.

For a finance lease, the lessee treats the transaction as if it had financed the purchase of the asset. Each payment is allocated between reducing the lease liability and recording interest expense. The ROU asset is amortized, on a straight-line basis, over the lease term, and this amortization expense is recorded separately on the income statement.

For an operating lease, the accounting is designed to produce a single, straight-line lease expense. This single lease expense includes both the interest component on the liability and the amortization of the ROU asset. While both lease types result in an asset and liability on the balance sheet, the income statement impact differs, with finance leases resulting in higher front-loaded expenses compared to the consistent expense of an operating lease.

Tax Treatment of Lease Payments

The tax treatment of lease payments is governed by the Internal Revenue Service (IRS). For federal income tax purposes, the IRS categorizes a lease as either a “true lease” or a non-tax lease, often considered a financing arrangement. This distinction determines how payments are deducted and who claims ownership benefits like depreciation.

In a true lease, the transaction is viewed as a rental agreement. The lessor retains ownership of the asset, and the lessee is permitted to deduct the full lease payments as a rental expense on their tax return. The lessee does not claim depreciation on the asset, as that tax benefit remains with the lessor.

If the IRS deems the arrangement to be a financing or conditional sale, the tax treatment changes. The transaction is treated as if the lessee purchased the asset from the lessor. The lessee cannot deduct the entire “lease payment” as rent. Instead, the lessee capitalizes the asset and can claim depreciation deductions over the asset’s useful life. The portion of each payment that represents interest is deductible as interest expense. The IRS considers several factors to make this determination, such as whether the lease transfers equity in the property to the lessee.