Does a Lease Count as Debt Under Current Accounting Rules?

A lease is an agreement providing the right to use an asset in exchange for payments. Historically, whether a lease was considered debt depended on the agreement’s terms. However, current accounting standards now recognize most lease agreements on a company’s balance sheet. This shift means what was once an off-balance sheet arrangement now directly impacts a business’s reported financial position.

The Evolving View of Leases in Accounting

Accounting for leases has undergone a transformation, moving from a system that kept obligations hidden to demand greater transparency. Previously, under older rules, many operating leases were treated as off-balance sheet items, meaning neither the asset nor the obligation appeared on financial statements. These arrangements were typically disclosed only in the footnotes. This practice, sometimes called “off-balance sheet financing,” raised concerns among investors and analysts who lacked a complete picture of a company’s true financial commitments.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) introduced new standards to address these transparency issues. Known as ASC 842 in the U.S. and IFRS 16, these rules aimed to ensure nearly all leases are reflected on the balance sheet. The objective was to provide a more accurate and comprehensive view of a company’s assets and liabilities, enhancing financial reporting.

How Leases Are Now Recognized on Financial Statements

Under current accounting standards, leases are recognized on financial statements by recognizing a “Right-of-Use” (ROU) asset and a corresponding lease liability. The ROU asset represents a company’s right to use an underlying asset (e.g., property or equipment) for the lease term. This asset is recorded on the balance sheet, reflecting the economic benefit.

A lease liability is simultaneously recognized, representing the present value of future lease payments. This debt-like obligation reflects the company’s commitment to make payments over the lease term. Components of this lease liability typically involve:
Fixed payments
Variable payments that depend on an index or rate
Amounts expected under residual value guarantees
The exercise price of purchase options if their exercise is reasonably certain

The calculation of the present value of these lease payments relies on a discount rate. This rate (often the rate implicit in the lease or the lessee’s incremental borrowing rate) converts future payment streams into their equivalent value today. This recognition applies to most leases with a term exceeding 12 months. The ROU asset and lease liability are typically equal at the lease’s commencement if there are no initial direct costs, prepaid rent, or lease incentives.

Different Lease Classifications and Their Accounting

Under U.S. Generally Accepted Accounting Principles (GAAP), leases are primarily categorized into two classifications: finance leases and operating leases. A lease is considered a finance lease if it meets any of five criteria at the commencement date:
Ownership transfers to the lessee by the end of the lease term.
A purchase option exists that the lessee is reasonably certain to exercise.
The lease term covers a major part of the underlying asset’s economic life.
The present value of lease payments covers substantially all of the underlying asset’s fair value.
The asset is of such a specialized nature that it has no alternative use to the lessor after the lease term.

For finance leases, the accounting treatment involves separate expense recognition on the income statement. Interest expense on the lease liability and ROU asset amortization expense are recorded independently, typically resulting in a front-loaded expense pattern. On the cash flow statement, principal payments on the lease liability are classified as financing activities, while interest payments are usually presented as operating activities.

Operating leases are those that do not meet any of the criteria for a finance lease. While both finance and operating leases require ROU asset and lease liability recognition on the balance sheet, their income statement and cash flow statement impacts differ significantly under U.S. GAAP. For operating leases, a single, straight-line lease expense is recognized on the income statement over the lease term, combining interest and amortization components. All cash payments for operating leases are generally presented as operating activities on the cash flow statement. A limited exception exists for short-term leases (12 months or less), where companies can elect not to recognize ROU assets and lease liabilities on the balance sheet.

The Impact of Lease Accounting on Businesses

New lease accounting standards have implications for a company’s financial metrics and strategic decisions. A key effect is on financial ratios, as recognizing lease liabilities increases reported debt levels. This often increases ratios like debt-to-equity and debt-to-assets, potentially making a company appear more leveraged. Liquidity ratios, such as the current ratio, may also be impacted, since a portion of the lease liability is classified as a current liability.

The changes can affect compliance with loan covenants, agreements with lenders that often rely on specific debt levels or financial ratios. Companies might risk breaching leverage-based covenants due to increased liabilities. Increased on-balance sheet debt could influence how lenders and creditors assess creditworthiness, potentially impacting borrowing costs or terms.

The new accounting standards can influence a company’s strategic decisions regarding whether to lease or purchase assets. Since the balance sheet impact of leasing is now more similar to that of purchasing, the decision-making process may shift to focus more on operational flexibility, cash flow, and long-term cost considerations rather than solely off-balance sheet advantages. These new requirements improve comparability across companies, as most lease obligations are transparently presented on financial statements, providing a clearer view for investors and other stakeholders.