Leases, explained

A lease is a contract that lets you use someone else's asset, such as an office, a vehicle or dedicated servers, for a set period in exchange for payments. ASC 842 is the US GAAP standard for recording one.

The thinking behind it is that a three-year lease commits you to three years of payments much as a loan would. So from the day the lease starts, the balance sheet shows that obligation and the right to use the space you got in return.

At the start of the lease you record a lease liability equal to the present value of the payments. Present value means future payments discounted back to today's dollars with an interest rate, so $3,000 due in two years counts for less than $3,000 today. Opposite it you record a right-of-use asset, usually the same amount, adjusted for prepaid rent, incentives or upfront costs.

Most startup leases are operating leases. For those, the P&L shows one level lease expense each month. Behind it, each payment reduces the liability and the asset is written down at a pace that keeps the total expense straight-line.

Acme signs a 36-month office lease at $3,000 a month, $108,000 in total. Discounted at its borrowing rate, the payments are worth about $100,000 today, so Acme books a $100,000 right-of-use asset and a $100,000 lease liability on day one.

Each month Acme pays $3,000 and records $3,000 of lease expense. The liability includes an interest element, so it runs down a little slower than the payments, and both balances reach zero at month 36. Over the full lease the P&L carries $108,000, the same as the cash paid.

A right-of-use asset sits near fixed assets on the balance sheet, but you don't own the office. Leases of twelve months or less can stay off the balance sheet under the short-term exemption. Auditors look for leases hiding inside other contracts, so keep a list of anything that gives you exclusive use of an asset.

A lease is a finance lease instead if it transfers ownership, includes a purchase option you're reasonably certain to exercise, runs for a major part of the asset's life, has payments worth substantially all of its fair value, or covers an asset so specialized it has no other use to the lessor. A finance lease puts interest and amortization on the P&L instead of one level lease expense.