Lease expense

What Is Lease Expense?

Lease expense is the cost incurred by a lessee (the party that leases an asset) for the use of an asset over a specific period, recorded on its income statement. This cost represents the portion of the total lease payments and related charges recognized in a particular accounting period. It is a fundamental component of financial accounting, reflecting a company's commitment to pay for the temporary use of property, plant, or equipment without outright ownership. Lease expense directly impacts a company's profitability and can significantly influence its reported earnings.

History and Origin

Historically, lease accounting often allowed companies to keep substantial lease obligations off their balance sheet, particularly for what were known as operating leases. This practice, sometimes referred to as "off-balance-sheet financing," meant that a company's true leverage might not be fully transparent to investors and creditors. In response to concerns about comparability and transparency in financial reporting, the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) internationally initiated projects to overhaul lease accounting standards.¹⁶

These efforts culminated in the issuance of Accounting Standards Codification (ASC) 842, Leases, by FASB in 2016, and IFRS 16, Leases, by IASB. For U.S. public companies, ASC 842 became effective for fiscal years beginning after December 15, 2018, while private companies followed later.¹⁴, ¹⁵ The core objective of these new standards was to bring nearly all leases onto the balance sheet, providing a more comprehensive view of a company's financial position and obligations.¹³ This significant shift changed how lease expense is recognized and presented, especially distinguishing between the accounting for operating lease expenses and finance lease expenses.¹² The FASB continues to issue updates to clarify specific aspects of Topic 842, such as those related to variable lease payments or common control arrangements.¹⁰, ¹¹

Key Takeaways

• Lease expense represents the cost a company incurs for using a leased asset during an accounting period.
• Under ASC 842 and IFRS 16, most leases are now recognized on the balance sheet, increasing transparency.
• The recognition of lease expense differs significantly between operating leases and finance leases.
• For finance leases, lease expense comprises amortization of the Right-of-Use (ROU) asset and interest expense on the lease liability.
• For operating leases, a single, generally straight-line, lease expense is recognized over the lease term.

Formula and Calculation

The calculation and presentation of lease expense depend on the classification of the lease under current accounting standards like ASC 842 (for companies following Generally Accepted Accounting Principles (GAAP)) and IFRS 16 (for companies following International Financial Reporting Standards (IFRS)).

For operating leases, the total lease expense is typically recognized on a straight-line basis over the lease term, even if the actual cash payments vary. This means that the total consideration for the lease, including fixed payments, is averaged out over the lease period to arrive at a consistent periodic lease expense.

For finance leases (which replace the concept of capital leases under previous standards), the lease expense has two distinct components recognized on the income statement:

1. Amortization of the Right-of-Use (ROU) Asset: This component is similar to depreciation expense for owned assets and is typically recognized on a straight-line basis over the shorter of the asset's useful life or the lease term.
2. Interest Expense on the Lease Liability: This component is calculated based on the outstanding lease liability and the discount rate implicit in the lease or the lessee's incremental borrowing rate. This results in a declining interest expense over the lease term as the lease liability is reduced.

The sum of these two components represents the total lease expense for a finance lease in a given period.

Interpreting the Lease Expense

Interpreting lease expense requires an understanding of how a company accounts for its leases. Under ASC 842, the distinction between operating and finance leases impacts the financial statements differently, even though both now result in a Right-of-Use (ROU) asset and a lease liability on the balance sheet.

For an operating lease, the single, straight-line lease expense provides a clear, consistent charge to the income statement. This simplicity means that the periodic impact on reported profitability is smooth. Conversely, finance lease expense, comprising separate amortization and interest components, tends to result in higher total expense in the earlier years of the lease and lower expense in later years due to the front-loading of interest expense. When performing financial statement analysis, analysts consider these different expense recognition patterns to ensure accurate comparisons between companies that may have different lease classifications or different proportions of operating versus finance leases. Understanding a company's lease expense helps assess its operational costs and obligations related to asset usage.

Hypothetical Example

Consider a hypothetical company, "Swift Logistics Inc.," which leases a warehouse for a five-year term with annual lease payments of $100,000, payable at the beginning of each year. The implicit rate in the lease cannot be readily determined, so Swift Logistics uses its incremental borrowing rate of 5%.

Under ASC 842:

1. Initial Recognition: At the commencement of the lease, Swift Logistics would recognize a Right-of-Use (ROU) asset and a lease liability on its balance sheet. The lease liability would be the present value of the five annual payments, discounted at 5%.

   $$\text{Lease Liability} = \frac{\$100,000}{(1+0.05)^0} + \frac{\$100,000}{(1+0.05)^1} + \frac{\$100,000}{(1+0.05)^2} + \frac{\$100,000}{(1+0.05)^3} + \frac{\$100,000}{(1+0.05)^4}$$

   This calculation would result in an initial lease liability and ROU asset of approximately $454,595. The first payment of $100,000 is made immediately, reducing the liability.

2. Lease Classification: Let's assume this lease is classified as an operating lease under ASC 842.

3. Lease Expense Recognition (Operating Lease): Swift Logistics would recognize a single, straight-line lease expense on its income statement each year. The total payments over five years are $500,000 ($100,000 x 5).

   $$\text{Annual Lease Expense} = \frac{\text{Total Lease Payments}}{\text{Lease Term}} = \frac{\$500,000}{5 \text{ years}} = \$100,000$$

   Each year, $100,000 would be reported as lease expense, providing a consistent view of the cost of using the warehouse. The difference between the cash paid and the recognized expense in early years, and vice-versa in later years, would adjust the lease liability.

If this were a finance lease, the annual lease expense would be composed of decreasing interest expense on the liability and straight-line amortization of the ROU asset, leading to a front-loaded total expense.

Practical Applications

Lease expense is a critical figure in various aspects of business and financial analysis:

• Financial Statement Analysis: Investors and analysts examine lease expense to understand a company's recurring operational costs and its reliance on leased assets versus owned assets (which typically result in depreciation and interest expense from debt). The adoption of ASC 842 has brought significant lease obligations onto the balance sheet, affecting key metrics such as the debt-to-equity ratio.⁹
• Budgeting and Forecasting: Businesses use historical lease expense figures to project future costs, especially when considering new leases or renewing existing ones. This aids in accurate financial planning and resource allocation.
• Credit Analysis: Lenders and credit rating agencies analyze lease expense and the underlying lease liabilities to assess a company's overall leverage and ability to meet its financial obligations. The new standards provide greater transparency into a company's long-term commitments.⁸
• Operational Decisions: Management evaluates lease expense in conjunction with other operational costs to make informed decisions about whether to lease or buy assets, and to negotiate more favorable lease terms. This is particularly relevant for significant assets that would otherwise require substantial capital expenditures.
• Tax Implications: The deductibility of lease expense for tax purposes can vary depending on jurisdiction and lease classification, making it an important consideration for tax planning.

Limitations and Criticisms

While the new lease accounting standards (ASC 842 and IFRS 16) aim to enhance transparency, their implementation has not been without challenges and criticisms. One significant point of contention has been the complexity and cost associated with transitioning to the new rules, particularly for companies with numerous leases. Identifying and abstracting all lease contracts, including embedded leases, and then collecting and validating the necessary data, has proven to be a substantial undertaking.⁶, ⁷ Many companies have reportedly underestimated the time and resources required for full compliance.⁴, ⁵

Furthermore, although the standards aimed for convergence, there remain notable differences between ASC 842 and IFRS 16, particularly in how lessees classify and account for leases after initial recognition. For example, ASC 842 retains the distinction between operating and finance leases for lessees, leading to different income statement expense patterns, whereas IFRS 16 applies a single model, often resembling a finance lease for most lease types.², ³ This can still lead to comparability challenges for global investors analyzing companies reporting under different frameworks. Some critics also suggest that while more lease liabilities are now on the balance sheet, the complexities introduced might obscure rather than simplify the underlying economics for some users.¹

Lease Expense vs. Lease Liability

Lease expense and lease liability are distinct but related concepts in accounting, both arising from a leasing arrangement. The primary confusion often stems from their different locations and purposes within a company's financial statements.

Lease expense appears on the income statement and represents the periodic cost of using a leased asset. It is an expense recognized over time, reflecting the consumption of the asset's economic benefits during a specific reporting period. For operating leases under ASC 842, this is a single, often straight-line, amount. For finance leases, it comprises amortization of the Right-of-Use (ROU) asset and interest expense on the lease liability.

Lease liability, conversely, is a balance sheet item. It represents the present value of a company's future lease payments at a specific point in time. It is a financial obligation that a lessee has to a lessor for the right to use an underlying asset. Under ASC 842, both operating and finance leases result in the recognition of a lease liability on the balance sheet, significantly increasing the transparency of a company's long-term obligations that were previously off-balance-sheet for many operating leases.

In essence, lease liability quantifies the total obligation for future lease payments at a given date, while lease expense represents the portion of that obligation (or the cost of asset usage) recognized as a cost in a particular reporting period.

FAQs

What is the primary purpose of recognizing lease expense?

The primary purpose of recognizing lease expense is to reflect the cost incurred by a company for using leased assets over a specific accounting period on its income statement. This provides a measure of the operational cost associated with accessing and utilizing assets without owning them.

How do new accounting standards (like ASC 842) affect lease expense?

New accounting standards like ASC 842 (U.S. GAAP) and IFRS 16 (international) significantly altered lease accounting by requiring nearly all leases to be recognized on the balance sheet as a Right-of-Use (ROU) asset and a lease liability. While operating leases generally still result in a straight-line lease expense, finance leases now show distinct amortization of the ROU asset and interest expense on the lease liability, which is typically higher in earlier periods.

Is lease expense always the same as the cash paid for a lease?

No, lease expense is not always the same as the cash paid for a lease in a given period. For operating leases, especially, the lease expense recognized on the income statement is often a straight-line amount, even if cash payments are not. For finance leases, the lease expense is composed of amortization and interest, neither of which directly aligns with the cash payment in any given period, though the total expense over the lease term should reconcile with the economic cost of the lease. The actual cash paid for leases is typically reported in the operating activities section of the cash flow statement.