Do Operating Leases Go on the Balance Sheet?

Leases are common arrangements that allow businesses to use assets like buildings, vehicles, or equipment without outright ownership. How these agreements appear on a company’s financial statements significantly impacts how investors, lenders, and other stakeholders view its financial standing. Understanding the reporting of leases is therefore important for accurately assessing a company’s financial health and obligations.

How Operating Leases Were Accounted For

Before recent changes in accounting standards, operating leases were largely considered a form of “off-balance sheet financing.” This meant that the assets being leased and the corresponding financial obligations were generally not recorded directly on a company’s balance sheet. Instead, only the periodic lease payments were recognized as an expense on the income statement.

Under previous U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), a lease was classified as either a capital lease (known as a finance lease under new standards) or an operating lease. Capital leases, which effectively transferred ownership risks and rewards, were recorded on the balance sheet. Conversely, operating leases, which did not meet these transfer criteria, were kept off the balance sheet.

This off-balance sheet treatment meant that significant financial commitments associated with operating leases were not transparently presented alongside other assets and liabilities. While disclosures in the financial statement footnotes provided some information about future lease payments, the primary financial statements did not fully reflect a company’s total economic resources and obligations arising from these arrangements. This practice could make a company’s debt levels appear lower and its financial ratios seem stronger than they might have been if all lease obligations were fully recognized.

New Rules for Operating Leases

A substantial change in lease accounting has occurred with the introduction of new standards aimed at increasing transparency. These standards, ASC 842 in the U.S. and IFRS 16 internationally, fundamentally altered how companies report leases. The core objective of these updates was to ensure that most leases, including those previously classified as operating leases, are recognized on the balance sheet.

Under both ASC 842 and IFRS 16, a lessee is now required to recognize a “Right-of-Use” (ROU) asset and a corresponding lease liability for nearly all leases with a term longer than 12 months. The ROU asset represents the lessee’s right to use the leased item over the lease term, while the lease liability represents the present value of the future lease payments. This change aims to provide a more complete picture of a company’s financial obligations and the resources it controls.

The effective dates for these new standards varied. For public companies in the U.S., ASC 842 became effective for fiscal years beginning after December 15, 2018. Private companies and non-profit organizations generally adopted later, for fiscal years beginning after December 15, 2021. IFRS 16 became effective for annual reporting periods beginning on or after January 1, 2019.

Understanding Balance Sheet Presentation

The new accounting standards require a more comprehensive presentation of operating leases across a company’s financial statements. On the balance sheet, the primary impact is the recognition of a Right-of-Use (ROU) asset and a corresponding lease liability.

These new assets and liabilities are generally presented as separate line items on the balance sheet, or their details are provided within the accompanying financial statement notes. The lease liability is typically separated into current and noncurrent portions, reflecting payments due within one year versus those due in later periods. This recognition significantly increases a company’s reported total assets and liabilities, affecting various financial ratios such as debt-to-equity.

On the income statement, the expense related to operating leases under ASC 842 is recognized as a single, straight-line lease expense over the lease term. This differs from finance leases, where separate interest and amortization expenses are recognized. For the cash flow statement, all cash payments for operating leases are generally classified as operating activities. This comprehensive reporting provides users of financial statements with greater visibility into a company’s lease obligations.

Information Needed for Lease Accounting

Properly accounting for leases under the new standards requires companies to gather specific and detailed information about each lease agreement. A foundational step involves identifying all contracts that contain a lease component, as the new rules apply broadly. This requires careful review of various agreements, not just those explicitly labeled as leases.

Key data points essential for calculation include the lease term, which is the non-cancellable period for which the lessee has the right to use the asset, including any options to extend if reasonably certain to be exercised. Companies must also identify all fixed lease payments, variable payments dependent on an index or rate, and any residual value guarantees. Initial direct costs, such as commissions or payments to previous tenants that are incremental to obtaining the lease, are also incorporated into the ROU asset.

A crucial input is the discount rate used to calculate the present value of future lease payments. If the rate implicit in the lease is not readily determinable, companies typically use their incremental borrowing rate. This rate reflects what a company would pay to borrow funds over a similar term, in a similar economic environment, with comparable collateral. The careful collection and analysis of these data points are necessary to ensure accurate recognition and measurement of lease assets and liabilities.