Are Lease Liabilities Current or Noncurrent?

Under the guidance of ASC 842, most lease agreements must be recognized on a company’s balance sheet. This standard is based on the principle that a lease creates both an asset—the right to use a property—and a liability—the obligation to make payments. This shift provides a more complete picture of a company’s financial obligations.

The introduction of this standard means many operating leases are now recorded alongside finance leases, significantly impacting financial metrics. This change was made to increase transparency for investors and other stakeholders, giving them a clearer view of a company’s commitments.

Initial Measurement of the Lease Liability

At the beginning of a lease, a company must calculate the total lease liability, representing the financial obligation for the payments required by the lease, discounted to their present value. This calculation requires three primary components: the lease payments, the lease term, and the discount rate. Each of these inputs has specific rules governing its determination, ensuring consistency and comparability.

Lease payments include not just fixed monthly amounts, but also variable payments that depend on an index or a rate. Any reasonably certain payments related to residual value guarantees or purchase options must also be factored in. Payments for non-lease components, such as maintenance services, are excluded unless a company elects a practical expedient to combine them.

The lease term includes the noncancelable period, along with any periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option. The discount rate used is preferably the rate implicit in the lease. If that rate is not readily determinable, the lessee should use its incremental borrowing rate, which is the rate of interest it would have to pay to borrow on a collateralized basis over a similar term for an amount equal to the lease payments.

Defining Current and Noncurrent Classification

Once the total lease liability is calculated, it must be separated into current and noncurrent portions for presentation on a classified balance sheet. A current liability is an obligation that is expected to be settled within one year from the balance sheet date. A noncurrent liability represents the portion of the obligation due after that one-year period.

Applying this principle to a lease liability means identifying the principal portion of payments that will be made over the next 12 months. The remaining balance of the total lease liability is then classified as noncurrent, representing obligations that extend beyond the next year. This separation provides users of financial statements with a clearer understanding of a company’s short-term liquidity and long-term solvency.

Calculating the Current and Noncurrent Portions

The most direct method for separating the lease liability involves creating a lease amortization schedule. This schedule functions much like a loan amortization table, breaking down each payment into its principal and interest components. For each payment period, the interest expense is calculated by multiplying the outstanding liability balance by the periodic discount rate.

To illustrate, consider a company that enters into a five-year lease with annual payments of $50,000 and an incremental borrowing rate of 4%. The initial total lease liability, the present value of these payments, is calculated to be approximately $222,591. At the end of the first year, the company calculates the interest expense, which would be 4% of $222,591, or $8,904.

When the $50,000 payment is made, it is first applied to cover the accrued interest expense of $8,904. The remaining amount, $41,096, is then used to reduce the principal balance of the lease liability. The new outstanding liability balance at the end of the first year would be $181,495 ($222,591 – $41,096).

To determine the current portion of the lease liability at any given balance sheet date, the company looks forward 12 months. The current liability is the sum of the principal reduction portions of all payments scheduled in that upcoming period. The remaining liability balance is classified as noncurrent.

Balance Sheet Presentation

The final step is to present these classified amounts correctly on the balance sheet. Accounting standards require that finance lease liabilities and operating lease liabilities be presented separately from each other and from other liabilities. This can be done either by showing them as separate line items or by disclosing the amounts in the footnotes.

A classified balance sheet would show two distinct line items for lease obligations. Under the “Current Liabilities” section, a line item such as “Current portion of lease liabilities” or “Lease liabilities, current” would appear. Under the “Noncurrent Liabilities” section, a corresponding line item, often titled “Lease liabilities, net of current portion” or simply “Noncurrent lease liabilities,” would be presented.

This distinct presentation allows financial statement users to accurately calculate liquidity ratios, such as the current ratio. Including the current portion of the lease liability in this calculation provides a more accurate assessment of a company’s ability to meet its short-term obligations.