Capital Leases: Are They Considered Debt?

A business lease is a contractual agreement allowing a business to use an asset for a specified period in exchange for payments. This provides access to resources without the upfront cost of ownership. The accounting treatment of leases has undergone significant changes, impacting how these obligations are presented on financial statements and whether they are considered debt. This article clarifies the evolution of lease accounting standards and how lease obligations are currently viewed.

Understanding Leases Before New Rules

Historically, under previous accounting standards like ASC 840, leases were categorized into capital leases and operating leases. This classification determined their presentation on financial records. For a lease to be a capital lease, it had to meet specific conditions, such as ownership transfer, a bargain purchase option, covering most of the asset’s economic life, or payments equal to most of the asset’s fair value. Capital leases were recorded on the balance sheet as both an asset and a corresponding liability, and this liability was generally considered a form of debt. Operating leases were largely kept off the balance sheet, with payments expensed as rent over the lease term.

Why Accounting Rules Changed

The differing treatment of capital and operating leases under old rules created “off-balance sheet financing.” Operating leases, despite representing substantial financial commitments, did not appear as liabilities on the balance sheet. This obscured a company’s true obligations and leverage, making it difficult for investors and analysts to assess financial health and compare companies. To address this lack of transparency and provide a more complete financial picture, accounting standard-setters overhauled lease accounting. The Financial Accounting Standards Board (FASB) introduced ASC 842, and the International Accounting Standards Board (IASB) issued IFRS 16; these new standards aimed to bring nearly all leases onto the balance sheet, ensuring users of financial statements could see a company’s full lease-related commitments.

Lease Accounting Under Current Standards

Under current accounting standards, ASC 842 (U.S. GAAP) and IFRS 16 (international standards) have fundamentally changed how companies account for leases. Lessees must now recognize a “right-of-use” (ROU) asset and a corresponding “lease liability” on their balance sheets for virtually all leases longer than 12 months. The ROU asset represents the right to use the underlying asset, while the lease liability reflects the obligation for future payments.

Under ASC 842, a distinction remains between finance leases and operating leases. Both classifications result in an ROU asset and a lease liability on the balance sheet. However, expense recognition on the income statement differs: finance leases show separate depreciation and interest expense, while operating leases present a single, generally straight-line, lease expense. IFRS 16 adopts a single model for lessee accounting, treating almost all leases similarly to finance leases under ASC 842, recognizing both depreciation and interest expense.

Are Lease Liabilities Debt?

For finance leases under ASC 842 and all leases under IFRS 16, lease liabilities are considered debt-like obligations. They represent a company’s commitment to make future payments for asset use, similar to how a loan is repaid for an asset purchase. Recognizing these liabilities on the balance sheet provides a more transparent view of a company’s financial commitments, reflecting that leases are a form of financing.

The treatment of operating lease liabilities under U.S. GAAP (ASC 842) presents a nuance. While reported on the balance sheet, they are often referred to as “operating lease liabilities” or “operating obligations” and are typically not classified as traditional debt by many financial analysts or in the context of debt covenants. Despite this distinction, they still represent a significant financial commitment that impacts a company’s overall financial health and must be managed.

Recognizing lease liabilities on the balance sheet for nearly all leases has a notable impact on financial statements and key financial ratios. It generally leads to an increase in both a company’s total assets (due to the ROU asset) and total liabilities (due to the lease liability). This change can affect leverage ratios, such as debt-to-equity or debt-to-assets, potentially making a company appear more leveraged than under previous accounting standards. Therefore, while the classification might vary, these lease obligations represent a financial commitment that influences a company’s perceived risk and financial standing.