Leases: how they are recorded in a small company's accounting

Leases: how they are recorded in a small company's accounting

Signing a three-year lease no longer leaves the same accounting trace it used to. The monthly payment does not change, but the expense stops being linear: at the start the company records more expense than the payment, and at the end less. A long contract splits into three pieces: an asset for the right of use, a liability for the obligation to pay, and a finance cost that follows the liability. Here is the full model, with a warehouse example that closes to the peso.

What changed with the leases standard

Before, an operating lease was recorded as an expense as it was paid, and the contract never appeared on the balance sheet: the company used a warehouse without showing either the asset or the debt. The leases standard changed that. The test is no longer whether a contract is operating or finance; it is whether the contract gives the right to use an identified asset for a period in exchange for consideration. When the answer is yes, the lessee recognizes a right-of-use asset and a lease liability, with very few exceptions.

The practical effect is that the expense is spread differently. The asset is consumed on a straight-line basis and the liability accrues interest on its balance, so early on the expense exceeds the payment and later it falls below it. The total over the contract does not change: only the timing does. And the scope is limited: the standard changes the lessee's accounting, not the lessor's, who still classifies contracts as operating or finance leases under the previous rules.

Which contracts go into the model and which stay as an expense

The test asks three questions: is there an identified asset, does the contract convey the right to obtain substantially all of its economic benefits, and does the customer decide how and for what it is used. If all three are met, there is a lease; if the supplier keeps control and only delivers an output, there is a service.

The standard leaves two exits. Short-term contracts of twelve months or less with no purchase option, and low-value assets, measured when the asset is new and regardless of how important it is to the business. In both cases the payment can still be recorded as an expense month by month, with disclosure of the amount. Judgment shows up in the grey areas: a transport contract with an assigned vehicle and driver may be a service or a lease depending on who directs the operation, and a cloud computing provider is almost never a lease because there is no identified physical asset.

How the three components are calculated

The model has three figures and one logic: the present value of the payments sets the opening size of both the asset and the liability, amortization consumes the asset on a straight line, and interest is calculated each month on the liability balance, which falls by the principal portion of each payment. If one figure is wrong, the other two carry the error to the close.

The example used from here on is a warehouse leased for 36 months, fixed payment of 2,000,000 per month excluding Colombian VAT, payable at the end of each month, with no purchase option and no variable payments. The discount rate is 1% per month, equivalent to 12.68% effective annual: it is an illustrative rate, chosen so the numbers can be replicated by hand; in a real contract the rate is determined as explained below.

How the present value of the payments is calculated

The present value is the sum of the payments brought back to today at the contract rate. With a fixed payment the annuity factor works: 2,000,000 times 30.1075, the factor for 36 months at 1%, gives 60,215,000. That factor is not a figure from the standard or from the market: it comes from discounting each payment and adding them up.

Before discounting, you decide what goes in. In go the fixed payments, variable payments tied to an index using the index value at the commencement date, residual value guarantees expected to be paid, the purchase option price when exercise is reasonably certain, and termination penalties when the term reflects that possibility. Out stay variable payments tied to sales or usage, recoverable VAT, and services that can be separated from the contract.

The rate is the delicate decision. The standard asks for the contract's implicit rate when it can be determined; when it cannot, the lessee's incremental borrowing rate, meaning the rate the company would pay today to borrow with a similar term and similar security. That figure is documented with a bank offer or a current lease contract. An invented rate changes the liability, the interest and the first-year expense, and leaves a table that will not survive review.

The right-of-use asset and its amortization

The asset is not just the present value. It adds initial direct costs, payments made before the commencement date and the estimated cost of dismantling or restoring the property if the contract requires it, and it deducts incentives from the lessor, such as rent-free months or contributions to fit-out works. That is the cost that gets amortized.

Amortization runs on a straight line over the term, or over the useful life if that is shorter. In the warehouse it is 60,215,000 over 36 months: 1,672,639 per month, charged as amortization and not as rent expense.

The asset can also be impaired: if the warehouse stops being used or the contract becomes onerous, the recoverable amount has to be assessed and an impairment loss recognized. It is often forgotten because the asset is not visible in the warehouse: it is visible on the balance sheet.

The liability and its finance cost

The liability uses the effective interest method. Each month interest is calculated on the outstanding balance and subtracted from the payment; what remains reduces principal. In month 1: 60,215,000 times 1% gives 602,150, the payment leaves 1,397,850 of principal and the balance falls to 58,817,150. In month 2 interest is already 588,172, principal rises to 1,411,828 and the balance stands at 57,405,322.

That mechanism explains why the finance cost is high at the start and almost nil at the end. Over the 36 months interest totals 11,784,986. Added to amortization, the total expense of the contract reaches 71,999,986 against 72,000,000 of nominal payments; the fourteen-peso difference is rounding.

On the balance sheet the liability splits into current and non-current according to the principal payable in the next twelve months. It is not a memorandum account: it is debt, and banks read it as debt when they assess a credit line.

How to build the month-by-month table

Six steps and two checks. List the payments with their dates, calculate the present value at the documented rate, fix amortization by dividing the asset by the number of months, calculate interest on the opening liability balance, subtract it from the payment so the remainder reduces principal, and repeat month by month. The checks: the sum of principal repayments must equal the opening liability, and total expense must equal the sum of payments. If either fails, the error is in the rate, the number of periods or the date of the first payment.

The totals come from adding rows rounded to the peso. In the final month 14 pesos are adjusted in the payment and 4 in amortization so that the liability balance and the asset close at exactly zero; the effect is a matter of cents and changes no conclusion. What matters is the crossover: from month 20 the monthly expense falls below 2,000,000. Before that point the model records more expense than the previous treatment; after it, less.

Where VAT, services and variable payments fit

The present value is calculated excluding VAT. If the warehouse is leased for 2,000,000 plus VAT, the liability is measured on 2,000,000 and the tax follows its own path, recoverable if the activity allows it or part of cost if it does not. Putting the tax inside the liability inflates the asset and the finance cost, and it is one of the errors a reviewer spots fastest.

Services on the same invoice are separated. Administration, security, insurance and maintenance are non-lease components and go to expense as they accrue, unless the company elects not to separate them and treats the package as a lease; that decision is made by class of asset, documented, and does not flip from one month to the next.

Variable payments tied to sales or usage stay out of the liability: they are expensed in the period incurred. A retail space with a fixed rent plus a percentage of sales carries two treatments on the same invoice, and if the system receives that invoice as a single line someone has to split it; otherwise the expense gets mixed and comparison with the previous year stops being useful.

What happens with modifications and renewals

A contract rarely ends the way it started: the area grows, the term is extended, the payment is renegotiated or the lessor waives months. Each event forces the table to be revisited, not patched at year end.

The general rule: if the scope or the consideration changes and the change was not part of the original terms, the liability is recalculated by discounting the revised payments at a rate updated to that date, and the difference adjusts the right-of-use asset. If the change reduces scope, the asset is reduced first and any excess goes to profit or loss. On early termination, asset and liability are derecognized and the difference goes to the result of the period.

Renewal has its own calendar. The term includes extension periods when exercise is reasonably certain, and that is assessed at commencement, not when the date arrives; if certainty changes later, the liability is recalculated. That judgment is the one that generates the most discussion in audit: the answer is not in the contract but in the evidence of intent, such as investments made in the premises or the practical difficulty of moving.

Effect on ratios and on income tax

The first effect is EBITDA. Before, the full payment reduced operating profit; now amortization is added back and interest sits below the operating line. A company with large leases shows better EBITDA without having improved its operation, and that has to be explained when comparing against prior years.

The second is leverage: the liability enters financial debt and the asset enters total assets. The debt-to-equity ratio worsens, especially in the first year, when the liability is still high and profit for the year is lower. If there are covenants, review the loan agreements before signing the lease, not after.

The third is income tax. In Colombia the deductibility of a lease follows tax law rather than accounting standards: the lessee keeps deducting the rent accrued, and amortization of the right-of-use asset and the interest are not deductible for that reason alone. A temporary difference therefore appears. In year 1 accounting expense is 26,343,433 while the rent deduction is 24,000,000; the 2,343,433 difference reverses in later years and must appear in the tax reconciliation. If the contract is a finance lease, the tax mapping is different and has to be reviewed with the accountant before posting.

What to disclose in the notes and what to keep on file

Disclosure must let a third party rebuild the table: amortization of the right-of-use asset by class of asset, interest on the liability, short-term and low-value lease expense, variable payments outside the liability, and total cash outflow for the period. Also the maturity analysis by year and future outflows not included in the liability, such as residual value guarantees and extensions not recognized.

The working file matters as much as the note. For each contract, keep the signed document, the present value calculation with the rate and its support, the month-by-month table, the evidence behind the term judgment, and every modification with its date. That package saves redoing the work at audit.

Common mistakes

Lease mistakes are rarely conceptual: they are operational.

An honest closing before you decide

This model does not replace the accountant or a reading of the contract. With a single small lease, the table and the disclosure can cost more than the precision they add; with ten contracts that change every year, skipping them costs more in review and in credit decisions. The useful question is not whether the standard applies, but how many contracts there are and what supports the rate.

Before starting, check three things: the contract inventory with dates, the rate with its supporting document, and a written exemption policy. With those, the table is built once and maintained; without them, it is rebuilt every December. Accounting software that records the right-of-use asset, the liability and the amortization table in the same ledger where invoices are posted avoids that rework; Kardex Tauro does it inside its accounting module, with inventory and invoicing in the same system.

Keep reading

• Expense, cost and asset: how to classify each purchase
• Fixed asset inventory: how to maintain and update it