Long term lease: Meaning, Criticisms & Real-World Uses

What Is Long Term Lease?

A long term lease is a contractual agreement that grants a lessee the right to use an asset for an extended period, typically exceeding one year, in exchange for regular payments to a lessor. This arrangement falls under the broader category of Financial Accounting, specifically dealing with how companies recognize the obligations and rights associated with significant asset usage without outright ownership. Unlike a straightforward purchase that involves a capital expenditure, a long term lease allows a business to acquire the use of essential assets like real estate, machinery, or vehicles without the initial outlay of capital required for purchase. Such leases create both a "right-of-use" asset and a corresponding lease liability on the lessee's balance sheet under modern accounting standards.

History and Origin

The concept of leasing has ancient roots, with evidence suggesting its practice dates back to Sumerian and Roman civilizations, where it involved the use of land, agricultural tools, and even ships. The modern concept of financial leasing, however, gained prominence in the United States after World War II, significantly developing in the 1960s and 1970s. During the 19th and early 20th centuries, leasing became a crucial financing method for industries like railroads, which leased rolling stock to avoid large upfront investments. Key developments in the financial landscape, including the introduction of tax benefits, helped establish leasing as a mainstream financing option. Over time, evolving economic realities and the increasing complexity of business operations necessitated clearer guidelines for how these arrangements impacted a company's financial standing. Major changes to global accounting standards for long term leases began to take shape in the early 21st century. Before these changes, many long term leases were treated as "operating leases" and remained "off-balance sheet," meaning their associated assets and liabilities were not fully reported, which could obscure a company's true financial leverage. The International Accounting Standards Board (IASB) issued IFRS 16 in January 2016, effective for periods beginning January 1, 2019, while the Financial Accounting Standards Board (FASB) in the U.S. issued ASC 842 in February 2016, effective for public companies for fiscal years beginning after December 15, 2018, and for private companies after December 15, 2021⁵. These standards fundamentally altered how long term leases are presented on financial statements.

Key Takeaways

A long term lease provides the right to use an asset for a period typically exceeding 12 months.
Under current accounting standards (IFRS 16 and ASC 842), most long term leases require the recognition of a right-of-use asset and a lease liability on the lessee's balance sheet.
This on-balance sheet recognition aims to improve transparency regarding a company's financial obligations and asset utilization.
The accounting treatment involves calculating the present value of future lease payments.
The classification of a long term lease can significantly impact financial ratios and overall financial reporting.

Formula and Calculation

The initial measurement of a lease liability for a long term lease typically involves calculating the present value of the lease payments. The right-of-use asset is then initially measured at the amount of the lease liability, plus any initial direct costs, prepaid lease payments, and an estimate of costs to dismantle and remove the asset, less any lease incentives received.

The formula for the initial lease liability is:

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

Where:

(\text{LP}_t) = Lease payment in period (t)
(r) = Discount rate (e.g., the rate implicit in the lease or the lessee's incremental borrowing rate)
(t) = Period number
(N) = Total number of periods in the lease term

Subsequent to initial recognition, the lease liability is measured at amortized cost using the effective interest method, while the right-of-use asset is generally depreciated on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset.

Interpreting the Long Term Lease

Interpreting a long term lease involves understanding its impact on a company's financial position and performance. With the adoption of IFRS 16 and ASC 842, virtually all long term leases are now recognized on the balance sheet. This means that a company's assets and liabilities will increase, potentially altering key financial ratios such as the debt-to-equity ratio and return on assets. Investors and analysts can gain a more comprehensive view of a company's true obligations and its utilization of leased assets, which were previously "hidden" off-balance sheet for operating leases. The recognition of an interest expense on the lease liability and depreciation on the right-of-use asset in the income statement also changes how lease costs are presented, replacing a single "rent expense" with two distinct line items.

Hypothetical Example

Consider Tech Innovations Inc., a software development company. It needs new office space for the next five years. Instead of purchasing a building, which would require a significant upfront capital investment, the company decides to enter into a five-year long term lease for 10,000 square feet of office space. The annual lease payments are $120,000, payable at the end of each year. The company's incremental borrowing rate (the rate it would have to pay to borrow funds to purchase a similar asset) is 5%.

To account for this long term lease, Tech Innovations Inc. would calculate the present value of these five annual payments. This present value would represent the initial lease liability and the initial measurement of the right-of-use asset on its balance sheet. Each year, the company would recognize depreciation expense on the right-of-use asset and interest expense on the lease liability, reflecting the cost of using the asset and the financing component of the lease.

Practical Applications

Long term leases are widely used across various industries, providing flexibility and access to assets without requiring immediate full ownership. In commercial real estate, companies frequently lease office buildings, retail spaces, or warehouses for periods often ranging from 5 to 20 years or more. Airlines routinely enter into long term leases for aircraft, enabling them to expand their fleets without the massive capital outlay of purchasing every plane. Similarly, manufacturing firms might lease specialized machinery or equipment for the duration of a production cycle.

From an accounting perspective, the current standards (IFRS 16 and ASC 842) ensure that these significant obligations are transparently presented on the balance sheet. This impacts financial reporting by showing the full extent of a company's liabilities and its asset base, which was not always the case under previous standards⁴. For instance, an EY survey noted that companies in sectors like airlines, retail, and transportation saw their total assets rise significantly due to the capitalization of leases under IFRS 16, leading to increased transparency and comparability for users of financial statements³. The proper accounting for a long term lease is critical for accurate cash flow analysis and a comprehensive understanding of a company's operational commitments.

Limitations and Criticisms

While the modern accounting standards for long term leases aim to enhance transparency, they are not without limitations or criticisms. One primary concern for companies, particularly private entities, has been the complexity and increased administrative burden associated with implementing the new rules. Identifying all leases, valuing the right-of-use asset, and calculating the lease liability require significant data collection and specialized accounting software in many cases.

For some businesses, the on-balance sheet recognition of long term leases can initially make their financial statements appear more leveraged, as both assets and liabilities increase. This might impact existing loan covenants, which are agreements with lenders that require a company to maintain certain financial ratios. While the intent is to provide a truer picture of a company's financial position, the immediate effect can be a perceived worsening of key financial metrics, requiring proactive discussions with lenders and stakeholders². Despite the improved comparability for financial statement users, some information may still lack perfect comparability due to certain intricacies and elections within the standards¹.

Long Term Lease vs. Short-term Lease

The fundamental distinction between a long term lease and a short-term lease lies in their duration and, consequently, their accounting treatment under current standards. A long term lease typically has a non-cancellable term exceeding 12 months. As discussed, these leases generally result in the recognition of a right-of-use asset and a lease liability on the lessee's balance sheet, impacting both assets and liabilities.

In contrast, a short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not contain a purchase option that the lessee is reasonably certain to exercise. Companies can elect a practical expedient for short-term leases, allowing them to expense the lease payments on a straight-line basis over the lease term, similar to how operating leases were accounted for under prior standards. This means that short-term leases do not typically result in the recognition of a right-of-use asset or a lease liability on the balance sheet, providing a less complex accounting treatment. The distinction hinges entirely on the lease term's length.

FAQs

Q1: What is the primary impact of a long term lease on a company's balance sheet?

A1: Under current accounting standards (IFRS 16 and ASC 842), a long term lease requires a company to recognize a "right-of-use" asset and a corresponding lease liability on its balance sheet. This increases both reported assets and liabilities, providing a more transparent view of the company's financial obligations.

Q2: Do all long term leases have the same accounting treatment?

A2: For lessees, most long term leases are accounted for similarly, requiring on-balance sheet recognition. However, there are nuances in how the expense is recognized on the income statement between "finance leases" (formerly capital leases) and "operating leases" under ASC 842. Under IFRS 16, a single lessee accounting model generally applies, with the primary distinction for exemptions related to low-value assets or short-term leases.

Q3: How does a long term lease affect a company's financial ratios?

A3: The recognition of a right-of-use asset and lease liability from a long term lease can impact several financial ratios. For example, the debt-to-equity ratio may increase due to higher liabilities, and return on assets might decrease due to the expanded asset base. These changes reflect the substance of the transaction more accurately but require careful interpretation.