Lease liability is the present value of a tenant’s contractual obligation to make future lease payments under a lease agreement. It’s recorded on the lessee’s balance sheet as the financial commitment to pay rent (and other contractually required amounts) for the right to use leased real estate.
Legally, the tenant is obligated to pay contractual rent; accounting recognition (lease liability) converts that stream of future payments into a present-value liability and pairs it with a right-of-use asset on the balance sheet.
These terms are related but not identical: “lease liability” is an accounting measure (PV of future payments). “Lease obligation” or “contractual obligation” describes the legal promise to pay. “Rent payable” typically refers to short-term amounts due (current liability) under bookkeeping or accrual accounting.
From the lessee’s view lease liability records the discounted obligation and is matched with a right-of-use asset. From the lessor’s view the lease generates receivables or remains as rental income depending on lease classification; the lessee’s liability is not the lessor’s recognized liability.
Lease liability = present value of all contractually required lease payments during the lease term (including amounts reasonably certain to be paid) discounted at an appropriate rate.
Use the rate implicit in the lease if it’s known and reliably determinable; otherwise lessees use their incremental borrowing rate (the rate they'd pay to borrow similar funds for a similar term and security). For real estate this is commonly the lessee’s incremental borrowing rate.
Include payments for renewal or termination periods only if the lessee is reasonably certain to exercise (or not exercise) the option. “Reasonably certain” is a facts-and-circumstances judgment (business plans, rent economics, penalties).
Both ASC 842 (U.S. GAAP) and IFRS 16 require lessees to recognize a right-of-use (ROU) asset and a lease liability for most leases. IFRS 16 uses a single model (leases accounted similar to finance leases historically). ASC 842 requires a balance-sheet approach but retains two income-statement models: operating and finance (capital) leases.
Lessor accounting under ASC and IFRS still distinguishes operating vs sales-type/finance leases; lessors typically continue recognizing the underlying asset or lease receivable depending on classification. Lessor treatment affects timing of income recognition and can influence tenant negotiation (e.g., residual value guarantees).
Required disclosures include maturity analyses of lease liabilities, weighted-average discount rates, significant assumptions (renewal/termination judgments), and line-item impacts on financial statements—critical for covenant testing and audit evidence.
Typical initial entry on lease commencement:
For a finance/finance-style lease: recognize interest on the lease liability (effective-interest method) and depreciation/amortization on the ROU asset. For an operating lease under ASC 842: lessee recognizes a single lease expense generally straight-lined (but cash payment splits to interest and principal are tracked for disclosure).
Capitalizing leases increases reported assets and liabilities, raising leverage ratios (debt-to-equity, debt-to-assets) and changing balance-sheet composition.
Under ASC 842 a finance lease shows interest and amortization (higher EBITDA), while an operating lease shows a single lease expense (lower EBITDA impact). IFRS 16 typically increases EBITDA for most lessees because the operating lease expense is replaced by depreciation and interest.
Cash payments split between principal and interest: principal portions are typically financing cash flows; interest may be operating or financing depending on accounting policy. Under legacy operating-lease treatment cash rent was operating—changes affect reported operating cash flow.
Higher reported liabilities can breach covenants tied to leverage or fixed-charge coverage; valuations using EV/EBITDA may change because lease liabilities increase enterprise value and EBITDA may also change—underwriting should explicitly model lease liability effects.
The legal party named in the lease (tenant) is contractually liable for rent; guarantors assume additional legal obligations. Individuals may be personally liable if they signed personal guarantees.
In a sublease the original tenant typically remains legally liable to the landlord unless the landlord releases and accepts an assignee; assignment often requires landlord consent and potentially a novation to shift legal liability.
Remedies for default include eviction, claiming unpaid rent, damages for loss of bargain, and seeking accelerated rent for remaining term if contract permits; remedies vary by jurisdiction and lease language.
Buyouts can extinguish future obligations if agreed. Sureties and guarantees provide additional recovery sources for landlords. Security deposits reduce landlord credit risk but are usually limited to recovery of specific defined losses.
Small-business and lessees may elect the short-term lease exemption (leases with term ≤12 months and no purchase option reasonably certain to be exercised) to avoid balance-sheet recognition. Practical expedients (e.g., not separating lease/non-lease components) are available under ASC 842 for lessors/lessees meeting criteria.
Structuring arrangements as service contracts (when appropriate), using short-term leases, or planning subleasing strategies can reduce balance-sheet recognition or mitigate covenant exposure.
Security deposits, letters of credit, parent guarantees, or landlord concessions can be used to improve credit metrics or provide lender comfort even if the lease liability remains on the balance sheet.
Inputs: annual rent = $120,000, term = 5 years, discount rate = 5% (annual), payments at year-end. PV of ordinary annuity = 120,000 * [(1−(1+0.05)^−5)/0.05] = 120,000 * 4.32948 ≈ $519,538. That is the initial lease liability (before adjusting for prepaid rent, incentives, or initial direct costs).
At commencement:
First-year entries (assuming year-end payment and effective‑interest):
Use Excel’s PV function for quick calculation: =PV(rate,nper,pmt,[fv],[type]). Search for “lease accounting spreadsheet ASC 842 template” to find templates; maintain a schedule showing undiscounted payments, discount rate, PV factor, and reconciliation to cash flows.
Not legally identical—lease liability is an accounting liability, not always debt under legal documents—but lenders commonly treat significant lease liabilities like debt for covenant and credit analyses.
Yes. Under ASC 842 operating leases produce a single lease expense (so EBITDA impact may differ), while finance leases show interest and depreciation, typically increasing EBITDA relative to former operating-lease treatment. IFRS 16 generally increases EBITDA since operating lease expense is replaced by depreciation and interest.
Include fixed lease payments, amounts reasonably certain under extension/termination options, certain CPI/indexed amounts, and payments for leased services/taxes contractually required. Exclude purely variable, usage-based payments unless in-substance fixed.
If an extension (or cancellation avoidance) is reasonably certain, include the additional payments in the lease term and liability; if not, exclude them. Document the business rationale for the judgment.
Only for short-term leases (≤12 months) if you elect the short-term exemption or when a contract is a service rather than a lease; otherwise ASC 842 and IFRS 16 require capitalization for most leases.
Scenario: 7-year lease, annual rent $100,000, 6 months free (first year), lessee incremental borrowing rate 6%, startup expects to stay full term and will sublease as needed. Steps: (1) build payment schedule (years 1–7 with first-year half rent), (2) convert to annual payments and discount at 6%, (3) compute PV = sum of discounted payments → lease liability, (4) record ROU asset equal to liability plus adjustments for prepaid or incentives. Balance sheet: increases assets and liabilities by similar amounts; income statement: records depreciation and interest (finance-style) or single lease expense (ASC operating model) depending on classification.
Consult an accountant when leases include complex variable payments, embedded derivatives, multiple lease components, or when capitalization meaningfully affects covenants, investor reporting, or tax compliance.
Consult a lawyer for guarantee language, assignment/sublease approval, enforcement remedies, interpretation of termination clauses, or disputes over default and remedies.
Provide the executed lease and amendments, payment/escrow schedules, correspondence about concessions, invoices/bank statements for lease payments, and any guarantees or security agreements.
Refer to the authoritative standards: ASC 842 (U.S. GAAP) and IFRS 16 (International). For internal glossary references see ASC 842 and IFRS 16. For ROU concepts see right-of-use asset.
Create a schedule with undiscounted payments, discount factors, PV by period, interest schedule, and ROU amortization columns; use Excel/Google Sheets PV, NPV and amortization templates.
Look for practical guides titled “ASC 842 implementation checklist,” “IFRS 16 small entity guide,” and lease PV calculators; use the Excel PV function and build a one-page lease schedule for each material lease.
Lease liability converts future lease promises into a present-value balance-sheet liability, significantly affecting reported leverage, income-statement presentation, and cash-flow classification. Proper measurement requires careful collection of lease terms, reasonable judgments about options and variable payments, and selection of an appropriate discount rate. Early planning, clear documentation, and professional advice help manage covenant impact and negotiation strategy for both tenants and landlords.
