Understanding Lease Liabilities in Accounting

A lease Contract specifying the rental of property. is a contractual agreement between a lessor (asset owner) and a lessee (asset renter or tenant) that grants the lessee the right to use the asset for a period of time in return for cash (rent) payments. Nearly one-fourth of all equipment purchases are financed with leases. The advantages of lease financing include the lack of an immediate large cash payment and the potential to deduct rental payments in computing taxable income. From an accounting perspective, leases can be classified as either operating or capital leases.

Point: Home Depot reports that its rental expenses from operating leases total more than $900 million.

Operating Leases Operating leases Short-term (or cancelable) leases in which the lessor retains risks and rewards of ownership. are short-term (or cancelable) leases in which the lessor retains the risks and rewards of ownership. Examples include most car and apartment rental agreements. The lessee records such lease payments as expenses; the lessor records them as revenue. The lessee does not report the leased item as an asset or a liability (it is the lessor’s asset). To illustrate, if an employee of Amazon leases a car for $300 at an airport while on company business, Amazon (lessee) records this cost as follows:

 


Capital Leases Capital leases Long-term leases in which the lessor transfers substantially all risk and rewards of ownership to the lessee. are long-term (or noncancelable) leases by which the lessor transfers substantially all risks and rewards of ownership to the lessee.³ Examples include most leases of airplanes and department store buildings. The lessee records the leased item as its own asset along with a lease liability at the start of the lease term; the amount recorded equals the present value of all lease payments. To illustrate, assume that K2 Co. enters into a six-year lease of a building in which it will sell sporting equipment. The lease transfers all building ownership risks and rewards to K2 (the present value of its $12,979 annual lease payments is $60,000). K2 records this transaction as follows:

 



Point: Home Depot reports “certain locations … are leased under capital leases.” The net present value of this Lease Liability is about $400 million.

K2 reports the leased asset as a plant asset and the lease liability as a long-term liability. The portion of the lease liability expected to be paid in the next year is reported as a current liability.⁴ At each year-end, K2 records depreciation on the leased asset (assume straight-line depreciation, six-year lease term, and no salvage value) as follows:

 


K2 also accrues interest on the lease liability at each year-end. Interest expense is computed by multiplying the remaining lease liability by the interest rate on the lease. Specifically, K2 records its annual interest expense as part of its annual lease payment ($12,979) as follows (for its first year):