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Lease agreements

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What Are Lease Agreements?

Lease agreements are contractual arrangements that grant one party, the lessee, the right to use an asset owned by another party, the lessor, for a specified period in exchange for periodic payments. These agreements are fundamental to corporate finance and asset management, allowing businesses and individuals to access necessary assets without the upfront financial commitment of ownership. Rather than purchasing an asset outright, a lease agreement provides the benefit of its use, enabling greater flexibility and potentially preserving working capital.

Lease agreements are legally binding documents outlining the terms and conditions, including the lease term, payment schedule, responsibilities for maintenance, insurance, and options for renewal or purchase at the end of the term. The classification and accounting treatment of these agreements have significant implications for a company's financial statements, particularly under modern accounting standards.

History and Origin

The concept of leasing is ancient, with evidence of asset renting dating back to the Bronze Age in ancient Sumeria, around 3000 B.C., where agricultural tools, land, and even livestock were leased. Ancient Babylonian cuneiform tablets also show evidence of lease transactions. In classical antiquity, Romans used leasing for farmland, towns, and personal properties around 200 BC, and in ancient Greece, leasing practices extended to land, tools, and even human labor tied to leased lands.36, 37

Modern financial leasing, as a distinct form of financing35, gained significant traction in the United States after World War II, taking root in England in the 1960s and becoming more prominent in the 1970s. Early modern leasing in the U.S. in the 1870s was notably applied to financing railroad cars and locomotives through equipment trust certificates.33, 34 The introduction of tax benefits in the 1950s and the investment tax credit in the 1960s further spurred the growth of the leasing industry.32

A significant shift in the accounting for lease agreements occurred with the introduction of new standards by international and U.S. regulatory bodies. Historically, many companies structured lease agreements to keep substantial obligations off their balance sheet, a practice known as off-balance sheet financing.31 To address this lack of transparency, the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) globally collaborated to develop new standards.30

The IASB issued IFRS 16 Leases in January 2016, which became effective for annual reporting periods beginning on or after January 1, 2019, replacing the previous standard, IAS 17.29, Similarly, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), in February 2016, codified as ASC 842.28 Publicly traded companies were required to adopt ASC 842 for fiscal years beginning after December 15, 2018 (e.g., January 1, 2019, for calendar year-end companies), while private companies and non-profit organizations generally adopted it for fiscal years beginning after December 15, 2021.27 This change marked one of the most significant overhauls in lease accounting in decades, aiming to increase transparency into lease liabilities.26

Key Takeaways

  • Lease agreements are contracts for the right to use an asset for a period in exchange for payments, without transferring ownership.
  • Modern accounting standards (ASC 842 and IFRS 16) require most lease agreements to be recognized on the balance sheet as a right-of-use asset and a corresponding lease liability.
  • This on-balance sheet recognition provides greater transparency into a company's financial obligations and capital structure.
  • Lease agreements offer flexibility, allowing businesses to access assets and technology without large capital expenditures or the risks of obsolescence.
  • The terms of a lease agreement, including payment structure and lease term, determine its accounting classification and financial impact.

Formula and Calculation

Under ASC 842 and IFRS 16, a lessee generally recognizes a right-of-use asset and a lease liability at the commencement date of the lease. The initial measurement of the lease liability is the present value of the lease payments that are not yet paid.

The formula for the present value of lease payments is:

Lease Liability=t=1nPaymentt(1+r)t\text{Lease Liability} = \sum_{t=1}^{n} \frac{\text{Payment}_t}{(1 + r)^t}

Where:

  • (\text{Payment}_t) = The lease payment due at period (t).
  • (r) = The discount rate, which is typically the rate implicit in the lease. If that rate cannot be readily determined, the lessee uses its incremental borrowing rate.25
  • (n) = The total number of payment periods over the lease term.

The right-of-use asset is initially measured at the amount of the lease liability, adjusted for any lease payments made before or on the commencement date, initial direct costs incurred by the lessee, and any lease incentives received.

Interpreting Lease Agreements

Interpreting lease agreements requires understanding their impact on a company's financial health and operational flexibility. With the adoption of ASC 842 and IFRS 16, most lease agreements, including what were previously classified as operating leases, now result in the recognition of a right-of-use asset and a lease liability on the balance sheet. This change means that financial statements now provide a more complete picture of a company's true obligations.

Analysts and investors evaluating a company with significant leasing activities will consider the size of its lease liabilities relative to its other debts. The recognition of these assets and liabilities impacts key financial ratios such as debt-to-equity and return on assets, potentially making a company appear more leveraged than under previous accounting standards.24,23 Additionally, the accounting treatment for the income statement and cash flow statement also differs between finance (formerly capital) and operating leases under ASC 842, and the single model under IFRS 16 for lessees. Understanding these distinctions is crucial for accurate financial analysis and comparability across different entities.

Hypothetical Example

Consider XYZ Corp., a manufacturing company that decides to lease a new piece of specialized equipment rather than purchasing it. The lease agreement has a non-cancellable term of three years, with annual payments of $10,000 due at the end of each year. XYZ Corp. determines its incremental borrowing rate to be 5%.

To account for this lease agreement, XYZ Corp. must calculate the present value of these future lease payments to determine the initial lease liability and the right-of-use asset:

Initial Lease Liability Calculation:

  • Year 1 Payment PV = $10,000 / (1 + 0.05)(^1) = $9,523.81
  • Year 2 Payment PV = $10,000 / (1 + 0.05)(^2) = $9,070.29
  • Year 3 Payment PV = $10,000 / (1 + 0.05)(^3) = $8,638.38
  • Total Initial Lease Liability = $9,523.81 + $9,070.29 + $8,638.38 = $27,232.48

Upon commencement of the lease, XYZ Corp. would recognize a right-of-use asset of $27,232.48 and a corresponding lease liability of $27,232.48 on its balance sheet.

Over the lease term, XYZ Corp. will:

  1. Reduce the lease liability by the principal portion of each payment.
  2. Recognize interest expense on the outstanding lease liability.
  3. Depreciate the right-of-use asset over the lease term.

For example, in Year 1:

  • Beginning Lease Liability: $27,232.48
  • Interest Expense: $27,232.48 * 0.05 = $1,361.62
  • Cash Payment: $10,000
  • Principal Reduction: $10,000 - $1,361.62 = $8,638.38
  • Ending Lease Liability: $27,232.48 - $8,638.38 = $18,594.10
  • Depreciation (straight-line): $27,232.48 / 3 = $9,077.49

This illustration demonstrates how the lease agreement impacts the company's financial statements beyond simple expense recognition.

Practical Applications

Lease agreements are widely used across various industries, providing flexible financing solutions for both large corporations and small businesses. In 2023, the equipment leasing and finance industry in the United States alone reached a record high of $1.34 trillion, highlighting its significance as a viable option for accessing technology, machinery, and infrastructure without substantial upfront capital expenditures.22,21

  • Equipment Financing: Companies frequently use lease agreements for acquiring machinery, vehicles, office equipment, and technology. This allows them to update assets regularly, manage cash flow, and avoid the risks of obsolescence. The equipment leasing market is projected to continue growing, with businesses increasingly seeking flexible financing options amid changing interest rates.20,19
  • Real Estate: Many businesses lease office spaces, retail outlets, and warehouses rather than purchasing them. This provides flexibility in managing physical footprints and adapting to market changes.
  • Transportation (e.g., Aviation, Shipping): Leasing is a dominant model in the aviation industry, with a significant portion of commercial aircraft being leased rather than purchased by airlines.,18 This enables airlines to expand or adjust their fleets to meet changing demand, avoiding the large capital costs associated with buying aircraft.17 By the end of 2023, approximately 58% of the total global airline fleet was leased.16
  • Government and Public Sector: Public entities often lease vehicles, IT systems, and other necessary equipment to manage budgets and leverage technology without significant direct investment.
  • Consumer Goods: While this article primarily focuses on commercial applications, lease agreements are also common for consumer goods like automobiles, offering individuals access to vehicles with lower monthly payments compared to loan financing.

Lease agreements offer benefits such as preserving liquidity, predictable payments for budgeting, and offloading maintenance responsibilities to the lessor in certain lease types.

Limitations and Criticisms

While lease agreements offer considerable advantages, they also come with limitations and have faced criticisms, particularly concerning their historical accounting treatment and complexity under new standards.

One major criticism historically was the potential for off-balance sheet financing under previous accounting standards like ASC 840 and IAS 17. Operating leases were not required to be recognized as assets or liabilities on the balance sheet, which could obscure a company's true financial leverage and obligations from investors and analysts.15,14 This lack of transparency was a primary driver for the development of current standards.13

Despite the intent of ASC 842 and IFRS 16 to enhance transparency by requiring most leases on the balance sheet, implementation has presented new challenges:

  • Complexity: Complying with the new standards requires significant effort in identifying all lease agreements, including embedded leases within service contracts, and gathering detailed data for accurate calculation and reporting.12,11
  • Impact on Financial Ratios: The recognition of substantial lease liability and right-of-use asset on the balance sheet can alter key financial metrics. Companies may see an increase in debt-to-equity ratios, which could impact their credit ratings or ability to obtain further financing.10,9,8
  • Comparability Issues: While the new standards aim to improve comparability, some financial statement users have found that comparability can still be challenging due to differing interpretations or elective practical expedients in applying the rules.7,6 For instance, IFRS 16 eliminated the distinction between operating and finance leases for lessees, while ASC 842 retained it, leading to different income statement impacts for similar transactions under different reporting frameworks.,5
  • Transition Costs: The transition to the new lease accounting standards can involve significant costs for companies, including system upgrades, process redesign, and employee training.4

The accounting for lease agreements continues to evolve, with ongoing discussions and amendments by standard-setting bodies to address practical implementation issues.

Lease Agreements vs. Finance Lease

The term "lease agreements" is broad, encompassing all contractual arrangements for the use of an asset, while a "finance lease" (also known as a capital lease under previous U.S. GAAP) is a specific classification of a lease agreement under accounting standards. The distinction between different types of lease agreements, particularly operating leases and finance leases, has historically been crucial for accounting treatment and still holds relevance under U.S. GAAP.

Prior to the new accounting standards (ASC 842 in the U.S. and IFRS 16 internationally), operating leases were treated as off-balance sheet financing and typically expensed on a straight-line basis on the income statement. In contrast, capital (finance) leases were recognized on the balance sheet with a corresponding asset and liability, treated more like an asset purchase financed by debt.

Under ASC 842, the distinction between operating and finance leases for the lessee is retained, but both types now result in the recognition of a right-of-use asset and a lease liability on the balance sheet for leases with terms over 12 months.3,2 The primary difference in accounting for lessees under ASC 842 lies in the subsequent measurement and presentation on the income statement and cash flow statement:

  • Finance Lease: Similar to asset purchases, with separate recognition of interest expense on the lease liability and depreciation of the right-of-use asset. Payments are split between financing (principal and interest) and investing (depreciation) activities on the cash flow statement.
  • Operating Lease: Results in a single, generally straight-line, lease expense on the income statement, encompassing both the interest and depreciation components. Lease payments are typically classified as operating activities on the cash flow statement.

IFRS 16, conversely, largely eliminated this distinction for lessees, adopting a single lease accounting model where all leases (with minor exceptions for short-term or low-value assets) are accounted for similarly to a finance lease, requiring recognition of a right-of-use asset and lease liability.1,

In essence, a finance lease is a specific accounting classification within the broader category of lease agreements, characterized by criteria that suggest the lessee effectively obtains control over the underlying asset, akin to ownership.

FAQs

What is the primary purpose of a lease agreement?

The primary purpose of a lease agreement is to allow a lessee to use an asset for a defined period without purchasing it outright, in exchange for regular payments to the lessor. This arrangement provides flexibility and can help preserve a company's capital.

How do new accounting standards impact lease agreements?

New accounting standards, specifically ASC 842 and IFRS 16, significantly impact lease agreements by generally requiring lessees to recognize both a right-of-use asset and a lease liability on their balance sheet. This aims to increase transparency regarding a company's financial obligations that were previously off-balance sheet financing.

What is a "right-of-use asset"?

A right-of-use asset is an asset recognized on a lessee's balance sheet under current lease accounting standards (ASC 842 and IFRS 16). It represents the lessee's right to use an underlying asset for the lease term. Its value is generally determined by the initial measurement of the lease liability.

Are all lease agreements recorded on the balance sheet now?

Under ASC 842 and IFRS 16, most lease agreements with a term longer than 12 months are recorded on the balance sheet. Short-term leases (12 months or less) and leases for low-value assets may qualify for an elective exemption from this requirement.

How does a lease agreement differ from buying an asset?

A lease agreement grants the right to use an asset without transferring ownership, typically involving periodic payments over a defined term. Buying an asset, conversely, transfers ownership to the purchaser, usually involving a lump sum payment or financing through a loan, and results in the asset being fully recognized on the buyer's balance sheet from the outset.