What Is Lease Accounting and How Does It Work?

Lease accounting is a specialized area within financial reporting that dictates how companies record and present their leasing arrangements. Its purpose is to ensure financial statements accurately reflect obligations and assets from leased items. A significant shift in accounting standards, notably Accounting Standards Codification (ASC) 842 in the United States and International Financial Reporting Standard (IFRS) 16 internationally, now requires most leases to be recognized directly on a company’s balance sheet, enhancing transparency.

Understanding Key Lease Accounting Terms

The “lessee” refers to the entity that obtains the right to use an asset. Conversely, the “lessor” is the party that provides this right to use the asset.

The “lease term” defines the non-cancelable period during which the lessee has the right to use the underlying asset. This period can also include options to extend or terminate the lease if it is reasonably certain the lessee will exercise those options. A “Right-of-Use (ROU) asset” is the asset recognized by the lessee on its balance sheet, representing its right to control the use of the identified leased asset for the lease term.

Accompanying the ROU asset is the “lease liability,” the corresponding liability recognized by the lessee for its obligation to make lease payments. To determine the present value of these future lease payments, a “discount rate” is applied. This rate is typically the implicit rate in the lease, if readily determinable, or the lessee’s incremental borrowing rate.

Core Principles of Lease Accounting

Under current accounting standards, most leases are recognized on a company’s balance sheet, a significant change from prior off-balance-sheet practices. At the commencement date of a lease, the lessee initially recognizes both a Right-of-Use (ROU) asset and a corresponding lease liability. These amounts are generally measured at the present value of the future lease payments, which discounts the future payments using a specific rate.

Following initial recognition, both the ROU asset and the lease liability undergo subsequent measurement. The ROU asset is typically amortized over the shorter of the lease term or the useful life of the underlying asset, similar to how a purchased asset is depreciated. This amortization is recognized as an expense on the income statement. Concurrently, the lease liability is reduced as lease payments are made, reflecting the repayment of the principal portion of the obligation.

An interest expense is also recognized on the outstanding balance of the lease liability each period, accounting for the time value of money. The combination of ROU asset amortization and interest expense on the lease liability constitutes the total lease expense recognized by the lessee over the lease term.

How Lease Accounting Affects Financial Statements

The application of lease accounting principles directly impacts a company’s primary financial statements, providing a more comprehensive view of its financial position. On the balance sheet, the most noticeable change is the recognition of both the Right-of-Use (ROU) asset and the lease liability. This means that assets and liabilities on the balance sheet generally increase compared to previous accounting treatment. The ROU asset is typically presented with other long-term assets, while the lease liability is split into current and non-current portions.

On the income statement, the impact varies depending on the lease classification (finance lease or operating lease under ASC 842). For finance leases, companies recognize separate expenses for the amortization of the ROU asset and the interest on the lease liability. For operating leases, a single, straight-line lease expense is typically recognized, which combines the amortization and interest components. This systematically accounts for the asset’s usage and the financing cost over time.

The cash flow statement also reflects these changes in how lease payments are classified. Under ASC 842, the principal portion of lease payments for finance leases is classified as a financing activity, similar to debt repayments. The interest portion of finance lease payments and all cash payments for operating leases are generally classified as operating activities. This distinction provides users with a clearer understanding of the cash flows related to a company’s leasing arrangements.

Simplified Approaches and Scope Limitations

While the general principle requires most leases to be recognized on the balance sheet, accounting standards provide specific scenarios where simplified approaches or scope limitations may apply. One such provision is the short-term lease exemption. Under this practical expedient, a lessee may elect not to recognize Right-of-Use assets and lease liabilities for leases with a lease term of 12 months or less at the commencement date and that do not contain a purchase option the lessee is reasonably certain to exercise. Instead, payments for these short-term leases are recognized as an expense on a straight-line basis over the lease term.

Another practical expedient permits companies to elect not to apply the full balance sheet recognition requirements for leases of low-value assets. While ASC 842 does not explicitly define a monetary threshold for “low-value,” common practice suggests assets typically valued at around $5,000 or less when new may qualify. This exemption is applied on a lease-by-lease basis and is intended to reduce the burden of accounting for numerous small-value items like office equipment or small tools.

Companies can also elect a practical expedient to combine lease and non-lease components within a contract. For instance, a lease for office space might include a component for the use of the space (the lease component) and a component for common area maintenance services (a non-lease component). This expedient allows a lessee to account for both components as a single lease component, simplifying the allocation of consideration and subsequent accounting. This choice must be applied consistently to similar classes of underlying assets.