Lease Liability

A lease liability is the present value serving as the financial obligation for a business to make payments arising from a lease. This is based on the new lease accounting standard ASC 842, which states that the lessee can derive the lease classification. Earlier, it was based on ASC 840, but now, the operating lease under ASC 840 is taken as an operating lease under ASC 842. Businesses must account for their operating leases as assets and liabilities for any asset that is leased for more than 12 months. Under ASC 842, irrespective of the lease classification, the operating lease liability comes from a balance sheet as there is no classification between operating and capital leases, it has now changed to operating leases and finance leases.

When working with lease liability on the balance sheet, each accounting standard allows an incremental borrowing rate when the implicit interest rate can not be determined. The most important factor is the right-to-use asset (ROU). It assists in painting a more accurate picture of what the company actually owns and owes. The IFRS 16 also makes the lessees regauge lease liabilities when future payments change as it affects the balances when lease payments are linked to an index. This is not the same as the other two accounting standards. Under ASC 842, initial operating lease and finance lease liabilities are derived using the same method. For private companies and nonprofit organizations, the ASC 842 has an additional interest rate option as well.

There are mainly three factors to be needed to record a lease liability on the balance sheet -

• Lease term - the lease term must be determined. It sometimes needs judgment as the lease agreement has renewal and termination options.
• Lease payment - Again, this is derived from judgment only in cases when the payment is linked to the provision of renewal and terminal options.
• Discount rate - The rate is required to discount the lease liability. If the agreement is based on an incremental borrowing rate, the rate must be calculated on reliable factors to ensure accuracy.

To calculate lease liability, one needs the following information:

• Lease term
• Lease payment and
• A discount rate

Once all three of these information are available, the lease liability calculation becomes easy by simply discounting the liability over the lease term using the discount rate. The resulting amount is then mentioned on the balance sheet.

Further, the lease liability can be used to calculate the right-to-use (ROU) asset value.

Below are two distinct examples of lease liabilities; the first is a calculation, whereas the second example comes from real-world news -

Example #1

Suppose a hypothetical example assuming a four-year lease with no renewal options, $45000 as lease payment, paid annually and a discount rate of 9%

Now, as per ASC 842, the lease liability should be recognized as the present value of all four annual lease payments discounted at 9%

For the first year, a 9% discount of 45000 = 40950

For the second year, a 9% discount of 40950 = 37264

For the third year, a 9% discount of 37264 = 33910

And then for the last fourth year, a 9% discount of 33910 = 30858

Sum of all the four annual payments = 40950 + 37264 + 33910 + 30858 = 142982

Therefore the lease liability will come to be 142982.

Example #2

On 27 March 2024, the FRC announced new amendments to the FRS 102, which are applicable in Ireland and the UK. The changes to the UK GAAP will follow the IFRS 16 leases approach, and now, all the operating leases under FRS 102 will be mentioned on the balance sheet. A lease liability will be recognized and unwind as an interest expense; the lease payments will be reduced to liability.

The FRC has also included some optional simplifications, such as the use of an obtainable borrowing rate rather than an incremental borrowing rate, reduced modification triggers to have revised discounted rates and a swift approach to recognize gains and losses for sale and leaseback transactions.