Are Operating Lease Liabilities Considered Debt?

Lease agreements allow businesses to access assets like property, vehicles, and equipment without upfront ownership costs. Historically, accounting for these arrangements was complex, especially regarding how lease obligations appeared on financial statements. A central question, particularly with recent accounting standard changes, is whether financial commitments from operating leases should be considered debt. Understanding the evolving landscape of lease accounting is essential for a complete financial picture.

Lease Accounting Before Recent Changes

For many years, U.S. lease accounting, governed by Accounting Standards Codification (ASC) 840, distinguished between “capital leases” and “operating leases.” Only capital leases were recognized on a company’s balance sheet as both an asset and a corresponding liability, treated as financed asset purchases.

Operating leases, in contrast, were largely considered “off-balance sheet” arrangements. Companies would only record a rental expense on their income statement as payments were made. This meant that significant financial obligations associated with long-term operating leases were not visible on the balance sheet, instead being disclosed primarily in the footnotes of financial statements.

The classification between a capital and an operating lease under ASC 840 depended on a set of “bright-line” tests. A lease was deemed a capital lease if it met any of four criteria: if ownership transferred to the lessee by the end of the lease term, if it contained a bargain purchase option, if the lease term was 75% or more of the asset’s economic life, or if the present value of minimum lease payments was 90% or more of the asset’s fair value. If none of these criteria were met, the lease was classified as an operating lease, and its financial obligations remained largely unrecorded on the main financial statements.

The On-Balance Sheet Approach to Operating Leases

The landscape of lease accounting changed significantly with the introduction of new standards: ASC 842 in U.S. Generally Accepted Accounting Principles (GAAP) and IFRS 16 internationally. These standards became effective for public companies in 2019 and later for private companies. A primary objective of these updates was to enhance transparency and comparability in financial reporting by bringing nearly all leases onto the balance sheet.

Under ASC 842 and IFRS 16, companies are now required to recognize a “Right-of-Use” (ROU) asset and a corresponding lease liability on their balance sheet for most leases with a term longer than 12 months. The ROU asset represents the lessee’s right to use the underlying asset for the lease term, while the lease liability reflects the obligation to make lease payments. The lease liability is calculated as the present value of the future lease payments.

To determine this present value, companies typically use the interest rate implicit in the lease; however, if that rate is not readily available, they can use their incremental borrowing rate. The ROU asset is generally measured as the initial lease liability, adjusted for items such as prepaid rent, initial direct costs, or lease incentives. While both operating and finance leases now appear on the balance sheet, their income statement treatment differs under ASC 842. Operating leases continue to show a single, straight-line lease expense, whereas finance leases recognize separate interest expense and amortization of the ROU asset.

Determining if Operating Lease Liabilities Are Debt

With the new accounting standards, operating lease liabilities are explicitly recognized on the balance sheet, prompting a closer look at whether they align with traditional definitions of debt. Debt is generally understood as a financial obligation that must be repaid to a lender, typically with interest. In many ways, the newly recognized operating lease liabilities share characteristics with conventional debt.

These liabilities represent fixed payment obligations, similar to the principal and interest payments on a loan, and require future cash outflows. Their recognition on the balance sheet increases a company’s total liabilities, which in turn impacts leverage ratios such as debt-to-equity and debt-to-assets. This increased leverage can make a company appear to have a higher financial risk. From an economic perspective, the commitment to make a series of payments for the right to use an asset is a financial obligation, regardless of its accounting classification.

Despite these similarities, the Financial Accounting Standards Board (FASB) under U.S. GAAP (ASC 842) distinguishes operating lease liabilities from traditional debt. While they are clearly liabilities, they are not explicitly classified as debt, unlike finance lease liabilities. Unlike some traditional debt, operating lease liabilities are often tied to specific assets and may not be subject to the same direct recourse against the entire company’s assets. Furthermore, they are often not directly subject to the intricate terms of traditional debt covenants, although they can indirectly cause a company to breach such agreements due to their impact on financial ratios.

Different stakeholders view these liabilities through their own lenses. Lenders and banks are well aware of the new standards and adjust their credit assessments, potentially treating these liabilities as debt equivalents when evaluating a company’s borrowing capacity. Credit rating agencies, which often capitalized operating leases as a “debt equivalent” even before the new standards, continue to incorporate these obligations into their analysis to reflect the true financial commitments. For investors, the enhanced transparency is beneficial, but they may need to adjust their financial models to account for the new presentation and to compare companies consistently.

Impact on Financial Metrics and Analysis

The recognition of operating lease liabilities on the balance sheet under ASC 842 has several practical implications for financial metrics and analysis. On the balance sheet, companies will see an increase in both total assets due to the Right-of-Use (ROU) asset and total liabilities from the lease liability. This directly affects leverage ratios: the debt-to-equity ratio and debt-to-assets ratio will generally increase, which might suggest a higher perceived financial risk to external parties. Additionally, the current ratio may decrease as the portion of the lease liability due within one year is classified as a current liability.

For the income statement, operating leases under ASC 842 continue to result in a single, straight-line lease expense. This contrasts with finance leases, which show separate interest expense and ROU asset amortization. The change in accounting treatment for operating leases typically leads to an increase in Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) because the former operating lease expense (rent) is replaced by interest and amortization, which are added back to calculate EBITDA. While this might make EBITDA-based performance metrics appear stronger, lenders often adjust their loan covenant definitions to neutralize this effect. Net income may remain largely unchanged for operating leases, as the total expense recognized over the lease term is generally the same as under previous standards.

On the cash flow statement, the classification of cash outflows can shift. For finance leases, principal payments are now reported under financing activities, potentially improving operating cash flow. A significant consequence of these changes is the impact on loan covenants, as the increased liabilities can cause companies to risk breaching clauses related to leverage, interest coverage, or fixed charges. Companies are encouraged to proactively discuss these changes with their lenders to renegotiate covenants if necessary. Ultimately, while the new standards alter the presentation of financial statements, the underlying economic reality of the lease obligation, as a commitment for future payments, existed even before these accounting changes.