Short term leases

Short-term leases are a fundamental concept within [Real estate finance] and [Lease accounting], defining agreements for temporary use of an [Asset] without conveying substantial ownership risks or rewards. Unlike longer-term commitments, short-term leases typically have a lease term of 12 months or less and generally do not include an option to purchase the underlying asset. For lessees, this classification often allows for simplified accounting treatment, as these leases may not require the recognition of a [Right-of-use asset] and a corresponding [Lease liability] on the [Balance sheet]. Instead, payments are often recognized as an expense on the [Income statement] as they are incurred.

History and Origin

The concept of distinguishing between different types of leases for financial reporting purposes has evolved significantly over time. Historically, lease agreements were often structured to keep substantial liabilities off a company's balance sheet, particularly through what were known as operating leases. This practice, sometimes referred to as "off-balance sheet financing," could obscure a company's true financial position by not fully reflecting its obligations.³⁰

Recognizing this, accounting standard-setters, notably the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), undertook projects to revise lease accounting. In January 2016, the IASB issued IFRS 16 Leases, which aimed to bring most leases onto the balance sheet for lessees, eliminating the previous classification of leases as either operating leases or finance leases for les lessee accounting.²⁹,²⁸,²⁷,²⁶,²⁵ Similarly, the FASB issued ASC 842, Leases, effective for public companies in 2019 and private companies thereafter, which also requires most leases to be recognized on the balance sheet.²⁴,²³

Both IFRS 16 and ASC 842, however, introduced specific exemptions for short-term leases and leases of low-value assets to reduce the administrative burden for minor agreements. Under IFRS 16, a short-term lease is defined as a lease that, at the commencement date, has a term of 12 months or less and does not contain a purchase option.²²,²¹,²⁰,¹⁹,¹⁸ ASC 842 defines it similarly, as a lease whose term, at commencement, is 12 months or less and does not include a purchase option that the lessee is reasonably certain to exercise.¹⁷,¹⁶ This carve-out for short-term leases reflects a pragmatic approach to lease accounting, acknowledging that the administrative costs of fully capitalizing very short-term agreements often outweigh the benefits of enhanced financial transparency.

Key Takeaways

• Short-term leases are generally defined as agreements for the use of an asset with a term of 12 months or less.
• They often do not require the lessee to recognize a [Right-of-use asset] and a corresponding [Lease liability] on the balance sheet, offering simplified accounting.
• Lease payments for short-term leases are typically expensed on a straight-line basis over the lease term.
• The simplified accounting treatment can enhance flexibility and reduce administrative overhead for businesses.

Interpreting the Short Term Lease

When evaluating a short-term lease, the primary interpretation revolves around its classification and subsequent accounting treatment. For financial reporting under standards like IFRS 16 and ASC 842, the ability to treat a lease as "short-term" provides an election that can significantly impact a company's [Financial reporting] metrics. If a lease qualifies for and an entity elects the short-term lease exemption, the lease payments are typically recognized as an [Expense] on a straight-line basis over the lease term.¹⁵ This contrasts with the treatment of longer-term leases (often categorized as [Finance lease] or regular [Operating lease] under the new standards), which require the recognition of a right-of-use asset and a lease liability, thereby affecting a company's [Asset] and [Liability] totals on the balance sheet.

This simplified approach means that for short-term leases, there is no initial recognition of a lease asset or liability, which can improve certain financial ratios, such as debt-to-equity or return on assets, as less debt and fewer assets are reported. Businesses often prefer this treatment for its reduced complexity in [Lease accounting] and for maintaining a cleaner balance sheet, particularly for recurring, low-value, or temporary needs.

Hypothetical Example

Consider "Tech Solutions Inc.," a software development company. They periodically require additional office space for project teams on a temporary basis. Rather than committing to a multi-year lease, they opt for a short-term lease of a small office suite for 10 months. The monthly rent for this suite is $2,000.

Under the accounting standards, because the lease term is 10 months (less than 12 months) and there is no purchase option, Tech Solutions Inc. can elect to treat this as a short-term lease. Each month, they record the $2,000 payment as a [Rental income] expense on their income statement. They do not need to recognize a right-of-use asset or a lease liability on their balance sheet for this particular agreement. This simplifies their [Financial reporting] process significantly compared to how a longer-term lease for their main headquarters would be accounted for, which would involve capitalization and subsequent [Depreciation] and [Amortization] of the asset and liability.

Practical Applications

Short-term leases are widely utilized across various sectors due to their flexibility and accounting advantages. In [Real estate investment], short-term agreements allow businesses to adapt quickly to changing space needs, market conditions, or project durations without the long-term commitment of traditional leases. This is particularly prevalent in co-working spaces or temporary retail pop-up shops.

Beyond traditional real estate, the rise of the "sharing economy" has popularized short-term rentals for residential properties. Platforms like Airbnb facilitate millions of such agreements, allowing property owners to lease out spare rooms or entire homes for periods often less than a month. However, the rapid growth of these residential short-term leases has drawn scrutiny from housing advocates and local governments, concerned about their impact on housing affordability and availability. For instance, cities like New York have implemented regulations to limit short-term rentals, often requiring stays to be 30 days or longer unless the host is present, impacting how property is managed and utilized.¹⁴,¹³,¹²,¹¹ Research by the Federal Reserve Bank of San Francisco has also explored the broader implications of short-term rentals on housing markets, including their potential to reduce available long-term housing stock and influence rental costs.¹⁰,⁹,⁸,⁷,⁶

For businesses, short-term leases can be a strategic tool for [Capital expenditure] management, allowing them to conserve capital by expensing rather than capitalizing certain asset uses. They are commonly used for equipment leasing, such as construction machinery, vehicles, or IT equipment, when the need is temporary or uncertain. This approach can positively influence a company's [Cash flow] by spreading costs over time as operating expenses.

Limitations and Criticisms

While offering flexibility, short-term leases come with their own set of limitations and criticisms. From a lessee's perspective, the primary drawback is the potential for higher aggregate costs over time compared to a long-term lease. Lessors often charge a premium for the flexibility offered by short-term agreements to compensate for increased administrative costs, higher turnover, and potential vacancy periods. Businesses seeking long-term stability in their use of an [Asset] may find the lack of guaranteed occupancy or consistent pricing to be a significant disadvantage.

For industries heavily reliant on physical assets, a series of rolling short-term leases could lead to operational instability if renewals are not guaranteed, or if market rates for renewal fluctuate unexpectedly. This can make long-term [Property management] and strategic planning more challenging.

From an accounting standpoint, while the simplified treatment of short-term leases generally reduces complexity, it can also limit the comparability of financial statements between companies that elect the exemption and those that don't, or between entities operating under different accounting standards (e.g., IFRS vs. U.S. GAAP), especially if a company has a substantial volume of such leases. Some critics argue that even with short-term leases, the underlying economic obligation exists, and their exclusion from the balance sheet, even if a practical expedient, might still slightly understate a company's total economic commitments, although this concern is significantly mitigated by the limited term.⁵

Short Term Leases vs. Long-Term Leases

The fundamental distinction between short-term leases and [Long-term leases] lies primarily in their duration and, consequently, their accounting treatment under modern financial reporting standards.

The confusion between the two often arises from the practical election allowed by accounting standards. While most leases now require capitalization, short-term leases provide a notable exception. This distinction significantly affects how a company's financial health, including its [Liability] and asset base, is portrayed to investors and creditors.

FAQs

What qualifies a lease as short-term for accounting purposes?

For accounting purposes, such as under IFRS 16 or ASC 842, a lease generally qualifies as short-term if its lease term is 12 months or less at the commencement date and it does not include a purchase option, or if it does, the lessee is not reasonably certain to exercise it.⁴,³

Why do companies prefer short-term leases?

Companies may prefer short-term leases for their flexibility, enabling them to adapt quickly to changing needs or market conditions. From an accounting perspective, electing the short-term lease exemption can simplify [Financial reporting] by allowing lease payments to be expensed directly, avoiding the recognition of a [Right-of-use asset] and a corresponding [Lease liability] on the balance sheet.

Do short-term leases affect a company's financial ratios?

Yes, by electing the short-term lease exemption, companies avoid adding lease liabilities to their balance sheet. This can result in lower reported [Debt] and higher returns on assets compared to companies that have significant long-term leases capitalized, potentially impacting financial ratios used by analysts and investors.

Are short-term leases common in residential real estate?

Yes, particularly with the rise of platforms facilitating vacation rentals and temporary stays. However, local regulations vary widely, with many municipalities imposing restrictions on the duration and conditions of residential short-term leases due to concerns about housing availability and affordability.²

What are the disclosure requirements for short-term leases?

Even when electing the short-term lease exemption, companies are still required to disclose information about these leases in their financial statements. This typically includes the lease cost recognized for these leases and the classes of underlying assets to which the election applies, ensuring transparency for users of financial statements.¹