Is an Operating Lease Considered Debt?

An operating lease represents an agreement allowing a company to use an asset for a specified period without obtaining ownership. The central question of whether an operating lease constitutes debt has been reevaluated. This reevaluation stems from recent accounting standard updates, specifically ASC 842 in US GAAP and IFRS 16 under International Financial Reporting Standards. These new standards have fundamentally altered how companies report such arrangements on their financial statements.

Operating Leases Prior to Accounting Changes

Before ASC 842 and IFRS 16, operating leases were a form of “off-balance sheet financing.” This meant that leased assets and corresponding lease obligations were not recognized on a company’s balance sheet. Instead, periodic lease payments were treated as operating expenses, impacting the income statement.

This treatment allowed companies to acquire the use of assets, such as real estate, equipment, or vehicles, without increasing their reported debt or assets on the balance sheet. Analysts viewed future commitments from these operating leases as “hidden debt” or debt-like obligations, representing contractual payments a company was obligated to make. These commitments were disclosed in footnotes to financial statements, providing transparency on future payment obligations.

Recognizing Leases Under New Accounting Rules

A shift occurred with ASC 842 and IFRS 16. These standards mandate that all leases, including those previously classified as operating leases, must now be recognized directly on the balance sheet. This change enhances transparency by providing a more complete picture of assets and obligations.

Under these new rules, two components are recognized for every lease. A “Right-of-Use (ROU) Asset” is recorded, representing the lessee’s right to use the asset for the lease term. Concurrently, a “Lease Liability” is recognized, which reflects the present value of future lease payments. This Lease Liability is similar to debt, as it represents a financial obligation to make future payments.

An exception to this on-balance sheet recognition exists for short-term leases. A lease qualifies as short-term if its term is 12 months or less at commencement and it does not include a purchase option that the lessee is certain to exercise. Companies may elect not to recognize ROU assets and lease liabilities for these short-term leases.

Understanding the Lease Liability

The Lease Liability represents a company’s financial obligation to make future payments for its right to use an asset. This liability is calculated as the present value of future lease payments. Calculating this present value requires specific inputs.

The calculation incorporates scheduled lease payments, which include fixed payments and variable payments. The lease term is another input, representing the non-cancellable period of asset use. A discount rate is applied to determine the present value of these future payments.

The preferred discount rate is the rate implicit in the lease, if it can be determined. If the implicit rate is not available, the lessee’s incremental borrowing rate is used; this is the rate the lessee would incur to borrow funds under similar conditions. For private companies, ASC 842 also offers the option to use a risk-free rate.

Financial Statement Implications

Recognizing operating leases on the balance sheet has several consequences for a company’s financial statements. On the balance sheet, both assets and liabilities increase due to the recognition of the Right-of-Use (ROU) asset and the corresponding Lease Liability. This increase in liabilities directly impacts financial ratios, such as the debt-to-equity ratio, which will appear higher, indicating increased financial leverage.

The income statement also reflects changes in expense recognition. For operating leases, a single, straight-line “lease expense” is recognized over the lease term. This differs from finance leases, where separate depreciation of the ROU asset and interest expense on the lease liability are recognized, resulting in higher expenses in the earlier years of the lease term. This distinction can affect profitability metrics.

The cash flow statement is also affected, in how lease payments are classified. For operating leases, cash payments continue to be classified as operating activities. In contrast, for finance leases, the principal portion of lease payments is reclassified from operating activities to financing activities, while the interest portion remains in operating activities. These reclassifications can impact the reported operating cash flow, making a company appear more capable of generating cash from operations.