Should Operating Leases Be Included in Debt?

The classification of operating leases on financial statements has been a long-standing point of discussion in accounting. Historically, these agreements allowed companies to utilize assets without formally recognizing the associated obligations on their balance sheets. This led to questions about financial transparency and whether these arrangements, which involve ongoing payments for asset access, should be considered a form of debt. Stakeholders sought a more comprehensive understanding of a company’s true financial commitments.

Understanding Operating Leases and Debt

An operating lease traditionally served as a rental agreement for an asset, such as office space, vehicles, or equipment, where the lessee did not acquire ownership or substantial control over the asset’s economic life. These agreements allowed businesses to access necessary assets without the upfront costs and long-term commitments of ownership. For example, a company might lease a fleet of delivery vans for a few years. Under such an arrangement, the lessor typically retained ownership and was responsible for maintenance, taxes, and insurance.

Debt refers to a financial obligation that requires repayment over time. This encompasses borrowed money, financial obligations, or liabilities. Loans, bonds, notes, and mortgages are common forms of debt, representing amounts that must be repaid, usually with interest. In financial accounting, debt is recorded as a liability on the balance sheet, indicating a present financial obligation.

Historically, a clear distinction existed between operating leases and finance (or capital) leases. Finance leases were recognized on the balance sheet, reflecting the lessee’s substantial ownership-like benefits and risks. Operating leases, however, were treated differently, often remaining “off-balance sheet” and primarily impacting the income statement as rental expenses. This difference in treatment fueled the debate on whether operating lease obligations should be viewed as debt.

Evolution of Lease Accounting Standards

Historically, operating lease payments were expensed on the income statement as rent, not recognized on the balance sheet. This “off-balance sheet” treatment stemmed from viewing operating leases as executory contracts, similar to ongoing service agreements, rather than financial obligations conveying ownership rights.

Concerns grew regarding the transparency and comparability of financial statements when significant lease obligations remained undisclosed. Companies with extensive operating lease portfolios could appear to have fewer liabilities and a stronger financial position than those that purchased assets or used finance leases. This made it challenging for investors and creditors to fully assess a company’s true financial leverage.

This need for greater transparency led the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to develop new accounting standards. These standards, ASC 842 for US GAAP and IFRS 16 for International Financial Reporting Standards, fundamentally changed how leases are recorded. Their core principle is that lessees must now recognize nearly all leases on their balance sheets.

Under ASC 842 and IFRS 16, a “Right-of-Use (ROU) asset” and a corresponding “lease liability” are recorded for most leases. The ROU asset represents the lessee’s right to use the underlying asset for the lease term, and the lease liability reflects the obligation to make lease payments. This liability is calculated as the present value of future lease payments. ASC 842 became effective for public companies after December 15, 2018, and for private companies after December 15, 2021. IFRS 16 became effective for annual reporting periods beginning on or after January 1, 2019.

Impact of New Lease Accounting on Financial Reporting

New lease accounting standards significantly altered how a company’s financial position is presented. On the balance sheet, recognizing ROU assets and lease liabilities increases both total assets and total liabilities. This directly impacts leverage ratios, such as debt-to-equity and debt-to-assets, which generally increase due to added lease liabilities, affecting a company’s perceived financial risk. The current ratio may also decrease if new current lease liabilities grow disproportionately compared to current assets.

The income statement impact varies between the two primary accounting frameworks. For operating leases under ASC 842, a single “lease expense” is recognized on a straight-line basis over the lease term. This expense combines the amortization of the ROU asset and interest on the lease liability, presented as one line item. Under IFRS 16, all leases are treated similarly to finance leases, resulting in separate depreciation expense on the ROU asset and interest expense on the lease liability. This distinction means that under IFRS 16, a single operating lease expense is split, potentially increasing Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) because depreciation and interest are typically excluded from its calculation.

The cash flow statement also reflects these changes. For operating leases, while cash outflow for lease payments remains, a portion representing the principal repayment of the lease liability may now be classified as a financing cash outflow, rather than entirely as an operating cash outflow. The interest component generally remains within operating activities or can optionally be classified as financing activities under IFRS 16. This reclassification impacts reported operating cash flow, potentially making it appear higher than under previous standards.

These changes affect key financial ratios used by investors and creditors. Return on assets (ROA) may decrease due to the expanded asset base from ROU assets, even if net income remains unaffected. Interest coverage ratios can also be impacted as the interest expense component of lease obligations is now more explicitly recognized. Companies are also required to provide more extensive disclosures about their lease commitments in the footnotes to their financial statements, offering greater transparency.