Accounting For Leases in The United States - Lessee Accounting

Lessee Accounting

Under an operating lease, the lessee records rent expense (debit) over the lease term, and a credit to either cash or rent payable. If an operating lease has scheduled changes in rent, normally the rent must be expensed on a straight-line basis over its life, with a deferred liability or asset reported on the balance sheet for the difference between expense and cash outlay.

Under a capital lease, the lessee does not record rent as an expense. Instead, the rent is reclassified as interest and obligation payments, similarly to a mortgage (with the interest calculated each rental period on the outstanding obligation balance). At the same time, the asset is depreciated. If the lease has an ownership transfer or bargain purchase option, the depreciable life is the asset's economic life; otherwise, the depreciable life is the lease term. Over the life of the lease, the interest and depreciation combined will be equal to the rent payments.

For both capital and operating leases, a separate footnote to the financial statements discloses the future minimum rental commitments, by year for the next five years, then all remaining years as a group.

Other lessee financial accounting issues:

• Leasehold Improvements: Improvements made by the lessee. These are permanently affixed to the property, and revert back to the lessor at the termination of the lease. The value of the leasehold improvements should be capitalized and depreciated over the lesser of the lease life or the leasehold improvements life. If the life of the leasehold improvement extends past the life of the initial term of the lease and into an option period, normally that option period must be considered part of the life of the lease.
• Lease Bonus: Prepayment for future expenses. Classified as an asset; amortized using the straight-line method over the life of the lease.
• Rent Kicker, or Percentage Rent: Common in retail store leases. This is a premium rent payment that the lessor requires and is treated as a period expense. For example, it may be stated in the contract that if sales are over $1,000,000, any excess over this amount will have 2% taken out as a rent kicker. This is not reported as part of the future minimum rental commitments disclosure, nor in the 7(d) test to determine whether the lease is capital or operating.