Understanding Lease Balance: Definition, Calculation, and Illustrated Example

Lease balance, often referred to as the lease liability or lease obligation, represents the outstanding financial obligation a lessee (the party leasing an asset) owes to the lessor (the owner of the asset) under an operating lease or finance lease. The lease balance is essential for financial reporting and understanding the total amount due over the remaining lease term. Here's a definition, calculation, and an illustrated example:

Definition:Lease Balance is the total remaining payments a lessee is required to make under the terms of a lease agreement. It includes both the principal (the amount financed for the asset) and any accrued interest, if applicable. Lease balance is a key figure in financial statements and reflects the lessee's ongoing financial commitment related to the lease.

Calculation of Lease Balance:The calculation of the lease balance depends on the type of lease:

1. Operating Lease:

   • For operating leases, the lease balance is typically not explicitly stated on the balance sheet. Instead, it's the present value of future lease payments.
   • To calculate the present value of future lease payments, you use the interest rate implicit in the lease (if available) or the lessee's incremental borrowing rate.
   • The formula for calculating the present value of lease payments is:Lease Balance = Σ [Payment / (1 + Discount Rate)^n]where Σ denotes the sum of all future payments, Payment is each lease payment, Discount Rate is the appropriate interest rate, and n represents the number of periods.

2. Finance Lease:

   • For finance leases, the lease balance is the total remaining principal on the lease agreement.
   • To calculate the lease balance for a finance lease, you need to consider the original principal (the cost of the leased asset) and subtract any payments made that reduce the principal.

Illustrated Example:Let's say you have a finance lease for a piece of equipment with the following details:

• Original Principal (Cost of Equipment): $20,000
• Lease Term: 5 years
• Annual Lease Payment: $5,000
• Annual Interest Rate: 6%

Year 1:

• Lease Payment = $5,000
• Interest Payment (6% of $20,000) = $1,200
• Principal Payment = Lease Payment - Interest Payment = $5,000 - $1,200 = $3,800
• Lease Balance after Year 1 = Original Principal - Principal Payment = $20,000 - $3,800 = $16,200

Year 2 (and subsequent years):

• Lease Payment remains $5,000
• Interest Payment in Year 2 = 6% of Lease Balance at the end of Year 1
• Principal Payment in Year 2 = Lease Payment - Interest Payment in Year 2
• Lease Balance after Year 2 = Lease Balance after Year 1 - Principal Payment in Year 2

Repeat these calculations for each year until the lease term ends to determine the lease balance at any given time.

For operating leases, the calculation is more complex and involves discounting all future lease payments to the present value. It's often done using financial software or specialized lease accounting systems due to the need for detailed information on lease payments and discount rates.

Lease balance = Total lease payments - Payments already made