Why Are Finance Leases Considered Debt?

Leasing assets is a common practice for businesses, offering flexibility and access to necessary equipment or property without outright purchase. New accounting standards, specifically ASC 842 from the Financial Accounting Standards Board (FASB) in the United States and IFRS 16 from the International Accounting Standards Board (IASB), have significantly changed how leases are reported. These standards require companies to recognize most leases on their balance sheet, treating them in a manner similar to debt obligations. The implementation of ASC 842 and IFRS 16 aims to provide greater transparency into a company’s financial commitments. These new rules effectively bring assets and corresponding liabilities from leases onto the balance sheet, reflecting the economic reality of these arrangements. This change has prompted many to question why certain leases are now considered debt.

Understanding Finance Leases

A finance lease, previously often referred to as a capital lease under older accounting standards, fundamentally transfers substantially all the risks and rewards of owning an asset from the lessor to the lessee. This classification is crucial because it dictates how the lease is recognized on a company’s financial statements. Historically, many leases were structured to remain off the balance sheet, obscuring a company’s full financial commitments. The new standards aim to capture the economic substance of these arrangements.

A lease is classified as a finance lease if it meets any one of five specific criteria at the commencement date. In contrast, an operating lease is any lease that does not meet any of these five criteria:

Ownership of the underlying asset transfers to the lessee by the end of the lease term.
The lease grants the lessee an option to purchase the underlying asset, and it is reasonably certain that the lessee will exercise this option. This “reasonably certain” represents a high threshold, indicating a strong likelihood of exercise.
The lease term covers a major part of the remaining economic life of the underlying asset, often implying 75% or more of the asset’s economic life.
The present value of the sum of the lease payments equals or exceeds substantially all of the fair value of the underlying asset, often interpreted as 90% or more.
The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term, meaning it is custom-built or modified for the lessee’s use.

The Nature of Lease Liabilities

When a lease is classified as a finance lease, the lessee must recognize both a “Right-of-Use” (ROU) asset and a corresponding “lease liability” on their balance sheet. The ROU asset represents the lessee’s right to use the underlying asset for the lease term, while the lease liability signifies the obligation to make lease payments.

This lease liability is measured at the present value of the future lease payments. Present value is a financial concept that discounts future cash flows to their current worth, acknowledging that money available today is more valuable than the same amount in the future. This calculation ensures the lease liability reflects the current economic burden of future payments.

This valuation makes the lease liability functionally similar to a traditional loan or debt obligation, such as a mortgage or a bank loan. The recognition of this liability reflects the economic reality that the lessee has obtained control over the use of an asset, with an unavoidable obligation to make payments for that right. Therefore, the lease liability is treated akin to debt because it represents a future outflow of economic benefits that the entity is contractually obligated to pay.

Financial Statement Presentation

Finance leases significantly impact a company’s financial statements, showcasing their debt-like characteristics. The ROU asset is typically presented as a non-current asset, while the lease liability is split into current and non-current portions, similar to other forms of debt.

The income statement reflects a dual impact from finance leases: depreciation of the ROU asset and interest expense on the lease liability. The ROU asset is depreciated over the shorter of the lease term or the asset’s useful life, unless ownership transfers, in which case it is depreciated over the asset’s useful life.

Interest expense is recognized on the outstanding balance of the lease liability using the effective interest method, meaning the interest portion of each payment decreases over time. This differs from the single, straight-line lease expense recognized for operating leases under the new standards, and contrasts with the simple rent expense under older operating lease accounting.

On the statement of cash flows, finance leases distinguish between principal and interest payments. The principal portion of the lease payments is classified as a financing activity, reflecting the repayment of the debt-like lease liability. The interest portion is typically classified as an operating activity, consistent with how interest on other debt is reported.

Impact on Financial Metrics

The recognition of finance lease liabilities on the balance sheet has substantial implications for various financial metrics, particularly those related to leverage and solvency. A direct consequence is an increase in a company’s total liabilities, which in turn elevates key leverage ratios such as the debt-to-equity ratio and the debt-to-asset ratio. A higher debt-to-equity ratio, for instance, indicates greater reliance on debt financing relative to equity, potentially signaling increased financial risk to investors and creditors. This shift can affect a company’s perceived solvency and its capacity to secure the additional borrowing.

Finance leases also impact Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Both depreciation and interest are typically added back when calculating EBITDA. This means companies with significant finance leases may see an increase in their reported EBITDA compared to previous accounting methods where operating lease payments were expensed as a single operating cost.

Financial analysts and investors now consider these balance sheet and income statement changes when evaluating companies. While a higher EBITDA might appear positive, it is essential to understand the underlying composition of expenses. Lenders and analysts often adjust their calculations or use alternative metrics to maintain comparability across companies and time periods, especially for those with substantial lease portfolios.