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Lease time

What Is Lease Time?

Lease time, also known as lease term, refers to the non-cancellable period during which a lessee has the right to use an underlying asset in exchange for lease payments to a lessor. This concept is fundamental to financial accounting, particularly under modern accounting standards like IFRS 16 and ASC 842. It is a critical component in determining the recognition, measurement, and disclosure of lease arrangements on a company's balance sheet and income statement. The lease time significantly influences the calculation of the right-of-use asset and corresponding liability that a lessee recognizes for most lease contracts.

History and Origin

Historically, many lease arrangements, particularly those classified as operating leases, were not required to be recognized on a company's balance sheet, leading to concerns about "off-balance-sheet financing." This practice could obscure a company's true financial leverage and obligations. In response to these concerns, accounting standard-setters embarked on a multi-year project to revise lease accounting. The International Accounting Standards Board (IASB) issued IFRS 16, "Leases," in January 2016, which became effective for reporting periods beginning on or after January 1, 2019. Similarly, the Financial Accounting Standards Board (FASB) in the United States issued Accounting Standards Codification (ASC) 842, "Leases," which largely converged with IFRS 16's principle of bringing most leases onto the balance sheet. For public companies, ASC 842 became effective for fiscal years beginning after December 15, 2018, and for private companies, after December 15, 2021.12

These new standards aimed to provide a more transparent and comprehensive view of a company's financial position by requiring lessees to recognize a right-of-use asset and a lease liability for nearly all lease agreements. The core principle behind these changes was that a lease grants a company the right to use an asset for a period, which represents an economic resource and an associated obligation. A lease is a contract where one party, the lessor, allows another party, the lessee, use of their property for a period of time in exchange for consideration.11 The definition of "lease term" was central to implementing these changes, as it dictates the period over which these assets and liabilities are recognized and subsequently amortized or unwound. The shift significantly impacted financial metrics and ratios.10

Key Takeaways

  • Lease time is the non-cancellable period during which a lessee has the right to use an asset.
  • It is a crucial input for recognizing lease assets and liabilities on the balance sheet under IFRS 16 and ASC 842.
  • The lease time includes periods covered by options to extend or terminate if the lessee is reasonably certain to exercise them.
  • Changes in lease time can necessitate a reassessment of the lease liability and right-of-use asset.
  • Short-term leases (typically 12 months or less) may qualify for an exemption, allowing them to remain off-balance sheet.

Formula and Calculation

The lease liability, which is directly influenced by the lease time, is calculated as the present value of the lease payments expected to be made over the lease term.

The formula for the lease liability is generally:

Lease Liability=∑t=1NLPt(1+r)t\text{Lease Liability} = \sum_{t=1}^{N} \frac{\text{LP}_t}{(1 + r)^t}

Where:

  • (\text{LP}_t) = Lease payment in period (t)
  • (r) = The discount rate (typically the interest rate implicit in the lease, or the lessee's incremental borrowing rate if the implicit rate cannot be readily determined)
  • (N) = The total number of periods in the lease time

The right-of-use asset is initially measured as the amount of the initial measurement of the lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee, and an estimate of restoration costs.

Interpreting the Lease Time

Interpreting lease time requires careful consideration of the contract's terms and any options embedded within it. The lease time is not simply the stated fixed period but also includes periods covered by options to extend the lease if the lessee is reasonably certain to exercise those options. Conversely, periods covered by options to terminate the lease are excluded if the lessee is reasonably certain not to exercise them.

This "reasonable certainty" assessment is qualitative and requires significant judgment, taking into account all relevant facts and circumstances that create an economic incentive for the lessee. For instance, if the asset is critical to the lessee's operations and relocating or replacing it would incur significant costs or business disruption, the lessee might be reasonably certain to extend the lease beyond its initial non-cancellable period. The assessment of lease time can directly impact the calculated financial ratios and other performance metrics.

Hypothetical Example

Consider TechSolutions Inc., a software development company that leases office space. The lease agreement states a non-cancellable period of five years. However, it also includes an option for TechSolutions to extend the lease for an additional three years at a slightly increased rent.

TechSolutions performs an assessment and determines that, given the significant costs of moving its operations and the specialized build-out of the current office space, it is reasonably certain it will exercise the three-year extension option. Therefore, for accounting purposes, the lease time is considered to be eight years (5 initial + 3 extension years).

Based on this eight-year lease time and the agreed-upon lease payments, TechSolutions calculates the present value of all expected payments using its incremental borrowing rate. This calculated amount is then recognized as a lease liability and a corresponding right-of-use asset on its balance sheet. The right-of-use asset will be depreciated over the eight-year lease time, and an interest expense on the lease liability will be recognized over the same period.

Practical Applications

Lease time is a crucial element in several practical applications across finance and business:

  • Financial Reporting: Under IFRS 16 and ASC 842, virtually all leases with a lease term exceeding 12 months must be recognized on the balance sheet.9,8 The lease time directly dictates the period over which the right-of-use asset is depreciation and the lease liability is reduced.
  • Valuation and Analysis: Analysts use lease time to understand a company's total financial obligations and its asset base more accurately. The on-balance-sheet recognition of leases provides a clearer picture of leverage compared to older accounting standards.
  • Strategic Decision-Making: Companies evaluate lease time when making "lease vs. buy" decisions. A longer lease time might make leasing less attractive if the company anticipates needing flexibility or if owning the asset becomes more economically viable over that extended period.
  • Loan Covenants and Credit Ratings: Changes in lease accounting due to the inclusion of lease liabilities on the balance sheet can impact a company's loan covenants and credit ratings. Lenders often monitor financial ratios, and increased debt (from lease liabilities) can trigger covenant breaches if not managed proactively.7
  • Cash Flow Projections: While the pattern of expense recognition changes (from straight-line operating lease expense to depreciation and interest expense), understanding the lease time helps project future cash flow outflows related to lease payments.

Limitations and Criticisms

Despite the push for greater transparency, the determination of lease time and its impact on financial statements can present challenges and attract criticism. One significant area of judgment lies in assessing "reasonable certainty" regarding lease extension or termination options. This qualitative assessment can introduce subjectivity, potentially leading to different interpretations across companies or even within the same company over time.6

Some critics argue that while the intent of bringing leases onto the balance sheet is sound, the complexity of implementing standards like IFRS 16 requires significant data collection and robust systems, which can be burdensome for companies, particularly smaller ones.5 Furthermore, the accounting treatment might not always perfectly align with the economic substance of every lease arrangement, especially for short-term or low-value leases where exemptions are permitted, but whose application can be complex.4

The changes brought by new lease accounting standards can also impact key performance indicators (KPIs) and financial ratios, such as EBITDA and gearing ratios, which may require companies and investors to adjust how they interpret financial results. This reclassification means that what was once an operating expense now appears as depreciation and interest expense, fundamentally altering reported operating profit.3,2

Lease Time vs. Useful Life

Lease time and useful life are distinct concepts in finance and accounting, though both relate to the duration of an asset's use.

Lease Time refers specifically to the contractual period during which a lessee has the right to use an underlying asset. It includes the non-cancellable period and any optional periods where the lessee is reasonably certain to extend or not terminate the lease. Lease time is primarily relevant for lease accounting, determining the amortization period for a right-of-use asset and the unwinding of a lease liability.

Useful Life, on the other hand, refers to the period over which an asset is expected to be available for use by an entity, or the number of production or similar units expected to be obtained from the asset by an entity. It is an estimation of how long an asset is expected to function productively before it needs replacement or major repairs. Useful life is critical for determining the depreciation of owned assets.

The key distinction is that lease time is a function of the contractual agreement, while useful life is an inherent characteristic of the asset itself. An asset's useful life may be significantly longer or shorter than the lease time. For example, a company might lease a piece of machinery for five years (lease time) but that machinery might have an estimated useful life of 10 years. In certain common control arrangements, leasehold improvements might be amortized over the useful life of the improvements, even if the lease term is shorter.1

FAQs

Why is lease time important in accounting?

Lease time is crucial because it directly dictates the period over which a company must recognize a right-of-use asset and a lease liability on its balance sheet under modern accounting standards. This impacts a company's reported assets, liabilities, and profitability over time.

How do you determine the lease time if there are extension options?

When a lease includes extension options, the lease time includes these optional periods if the lessee is "reasonably certain" to exercise them. This requires a qualitative assessment of all facts and circumstances that create an economic incentive for the lessee to extend the lease.

Are all leases subject to lease time accounting?

No, not all leases are. Short-term leases (typically those with a lease term of 12 months or less) and leases of low-value assets (e.g., small office equipment) may qualify for practical expedients that allow companies to expense the lease payments as incurred, rather than recognizing a right-of-use asset and lease liability on the balance sheet.

What happens if the lease time changes during the lease?

If the lease time changes due to a significant event or a change in circumstances (e.g., exercising an extension option not previously considered reasonably certain), the lease liability and the corresponding right-of-use asset must be reassessed and adjusted to reflect the new lease time. This is considered a lease modification or reassessment.