Leases

What Are Leases?

A lease is a contractual agreement that grants one party, the lessee, the right to use an asset owned by another party, the lessor, for a specified period in exchange for regular payments. This arrangement falls under the broader category of financial accounting, dictating how companies record and present these transactions on their financial statements. Leases allow businesses to access assets like real estate, equipment, or vehicles without the immediate capital outlay of outright purchase. They establish both obligations and rights, creating a distinct set of liabilities and corresponding right-of-use assets for the lessee.

History and Origin

The concept of leasing assets has existed for centuries, but its modern application in finance and accounting gained significant traction in the mid-20th century, particularly with the rise of equipment finance. For decades, the accounting treatment of leases in the United States was primarily governed by Accounting Standards Codification (ASC) Topic 840, formerly Financial Accounting Standards Board (FASB) Statement No. 13, which was effective as of January 1, 1977. Under ASC 840, many operating leases were considered "off-balance-sheet" financing, meaning the associated assets and liabilities were not fully recognized on a company's balance sheet.

However, the lack of transparency regarding these obligations led to concerns from investors and regulators. This prompted the FASB to embark on a comprehensive overhaul of lease accounting standards. In February 2016, the FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), commonly known as ASC 842. This new standard, which largely converged with the International Financial Reporting Standard (IFRS) 16, aimed to improve visibility into lease obligations. The Equipment Leasing and Finance Association (ELFA), a trade association representing the equipment finance industry, traces its origins to 1961, highlighting the industry's significant growth and evolution over the decades.⁹

Key Takeaways

• Leases are contractual agreements permitting the use of an asset for periodic payments.
• Under ASC 842, most leases (excluding short-term leases) are now recognized on the balance sheet, increasing transparency.
• Lease accounting distinguishes between finance leases (formerly capital leases) and operating leases, impacting how expenses are recognized.
• The lessee records a Right-of-Use (ROU) asset and a corresponding lease liability for most leases.
• Leases offer businesses flexibility and can conserve capital compared to outright asset purchases.

Formula and Calculation

Under ASC 842, the initial measurement of the lease liability for a lessee is the present value of the future lease payments that are not yet paid. The discount rate used is typically the rate implicit in the lease, if readily determinable, or the lessee's incremental borrowing rate. The Right-of-Use (ROU) asset is then measured as the lease liability, adjusted for any initial direct costs, lease incentives received, and prepaid or accrued lease payments.

The present value calculation is crucial for lease accounting:

Where:

• (\text{Payment}_t) = Lease payment in period (t)
• (r) = Discount rate (implicit rate or incremental borrowing rate)
• (n) = Lease term in periods

This calculation ensures that the future obligations are properly valued at the commencement of the lease.

Interpreting Leases

The interpretation of leases, especially under the ASC 842 standard, provides enhanced clarity regarding a company's financial position. Prior to ASC 842, many operating leases were disclosed only in footnotes, making it challenging for users of financial statements to assess a company's full contractual obligations. With the new standard, both operating and finance leases for terms over 12 months require the recognition of a Right-of-Use Asset and a lease liability on the balance sheet.⁷, ⁸

This on-balance-sheet recognition means that a company's total assets and liabilities will generally increase, which can affect financial ratios such as debt-to-equity or debt-to-asset ratios. On the income statement, finance leases typically result in separate interest expense and depreciation expenses, while operating leases show a single, straight-line lease expense. The increased transparency allows investors and creditors to gain a more complete picture of a company's contractual commitments and leverage.

Hypothetical Example

Consider a small manufacturing company, "Widgets Inc.," that decides to lease a new specialized machine for its production line rather than buying it outright. The machine has a useful life of 10 years, and Widgets Inc. enters into a five-year operating lease agreement with the equipment provider.

The lease agreement specifies annual lease payments of $10,000, payable at the beginning of each year. Widgets Inc.'s incremental borrowing rate is 5%.

At the commencement of the lease, Widgets Inc. would calculate the present value of the five $10,000 payments. This calculated amount would be recognized on its balance sheet as a Right-of-Use (ROU) asset and a corresponding lease liability. Each year, as payments are made, the lease liability would decrease, and a portion of the ROU asset would be amortizationd, with a single lease expense recognized on the income statement for operating leases.

Practical Applications

Leases are ubiquitous across various industries and business operations. They are commonly used for:

• Real Estate: Companies frequently lease office spaces, retail outlets, and warehouses.
• Equipment: From heavy machinery in construction to specialized manufacturing equipment and IT hardware, leasing allows businesses to stay technologically current without large capital expenditures.
• Vehicles: Commercial fleets, company cars, and transportation assets are often acquired through lease agreements.
• Aircraft: The aviation industry heavily relies on aircraft leases, enabling airlines to expand their fleets and manage costs. For instance, in July 2025, Dubai Aerospace Enterprise (DAE) signed a purchase and leaseback agreement with United Airlines for 10 new Boeing 737-9 aircraft, with deliveries scheduled between August 2025 and February 2026.⁶

The widespread use of leases necessitates robust financial reporting standards to ensure transparency for stakeholders. By recognizing lease assets and liabilities, companies provide a clearer view of their obligations, impacting everything from debt covenants to capital budgeting decisions and the overall assessment of a company's cash flow.

Limitations and Criticisms

While ASC 842 significantly enhanced transparency by bringing most leases onto the balance sheet, its implementation has not been without challenges and criticisms. One primary limitation is the complexity involved in identifying, classifying, and accounting for all lease arrangements, particularly for companies with a large volume of contracts. The new rules require entities to distinguish between lease and non-lease components within a contract and to continuously evaluate leases for potential changes that may alter their recognition or measurement.⁴, ⁵

Many public companies, which adopted the standard earlier, reported significant time and expense dedicated to compliance.³ Private companies and not-for-profit organizations have also faced similar challenges, requiring thorough inventory and analysis of all agreements.¹, ² The subjective nature of certain judgments, such as determining the lease term or the discount rate, can also introduce variability in financial statements. While the goal was improved comparability, some critics suggest that the intricacies of the standard can still lead to different accounting outcomes depending on specific interpretations and policy elections.

Leases vs. Debt

The terms "leases" and "debt" are distinct but often confused, especially since the introduction of ASC 842. Prior to the new accounting standards, operating leases were largely considered off-balance-sheet, making them appear less like traditional debt. However, ASC 842 now requires most leases to be recognized on the balance sheet as both a Right-of-Use (ROU) asset and a lease liability, which functions similarly to debt.

The key difference lies in ownership and control. With traditional debt, a company borrows money to purchase an asset, thereby gaining full ownership and control, with the debt representing the obligation to repay the borrowed principal and interest. In a lease, the lessee does not own the asset but obtains the right to use it for a period. While the lease liability recognized on the balance sheet for a lease resembles a debt obligation, it specifically represents the obligation to make lease payments for the right to use the asset, not to repay borrowed funds for its purchase.

FAQs

What is the primary change under the new lease accounting standard (ASC 842)?

The most significant change under ASC 842 is the requirement for lessees to recognize nearly all leases with terms longer than 12 months on their balance sheet as both a Right-of-Use (ROU) asset and a corresponding lease liability. Previously, many operating leases were kept off-balance-sheet.

What are the two main types of leases for lessees under ASC 842?

Under ASC 842, leases for lessees are primarily classified as either an operating lease or a finance lease. The classification determines how the lease expense is recognized on the income statement, though both types result in an ROU asset and lease liability on the balance sheet.

How do leases impact a company's financial ratios?

By bringing lease liabilities onto the balance sheet, ASC 842 can increase a company's reported liabilities and assets. This can potentially impact financial ratios such as the debt-to-equity ratio or the debt-to-asset ratio, which are used by analysts and creditors to assess a company's leverage and financial health.