Lease Accounting Under ASC 842: The Lessee Model

Introduction

Before Accounting Standards Codification (ASC) 842, a retailer with thousands of stores could carry billions of dollars of rent commitments and show almost none of them on its balance sheet. The standard, effective for public companies from fiscal years beginning after December 15, 2018, ended that: nearly every lease longer than a year now creates a right-of-use asset and a lease liability. What it did not do is make all leases look alike. US generally accepted accounting principles (US GAAP) kept two lessee models, operating leases and finance leases, and the difference between them still decides whether lease cost lands above or below earnings before interest, taxes, depreciation and amortization (EBITDA).

That split matters more to bankers than the change to the balance sheet itself. Two companies with identical stores, one leasing under operating leases and one under finance leases, report different EBITDA, different earnings before interest and taxes (EBIT) and a different pattern of expense over time, while paying exactly the same cash. Following one lease through both models shows where each number comes from.

Recognizing a lease takes four steps: decide whether a contract contains a lease, set the lease term and the payments it includes, discount those payments, and record the resulting asset and liability. The first two are judgments that decide how large the liability is before any arithmetic starts.

Is It a Lease? Identifying One

A contract contains a lease when it conveys the right to control the use of an identified asset for a period of time in exchange for payment. Control means the customer gets substantially all the economic benefits from using the asset and directs how it is used. The test catches more than property and vehicle leases: a supply agreement that dedicates a specific production line to one customer, or a services contract built around specific dedicated equipment, can contain an embedded lease even though nobody calls it one.

The opposite case matters too. If the supplier can swap the asset for another one at will and benefits from doing so, there is no identified asset, and the contract is a service; capacity in a shared data center or a fleet the provider rotates freely usually falls on that side. Bankers reviewing a target's contracts in diligence, often alongside a quality of earnings review, look for both: embedded leases add liabilities that a quick read of the lease note may miss, and contracts that are not leases keep their cost entirely in operating expenses.

Lease Term and Lease Payments

The lease term is the non-cancellable period plus any renewal periods the lessee is reasonably certain to take and any periods covered by termination options it is reasonably certain not to exercise. A ten-year store lease with two five-year renewals the retailer is reasonably certain to use is a twenty-year lease for accounting purposes: the term doubles on that judgment alone, and at a 6% discount rate the liability rises by more than half.

The payments included are the fixed payments, payments linked to an index or rate (measured using the index at commencement), amounts probable of being owed under residual value guarantees, and the exercise price of purchase options the lessee is reasonably certain to exercise. Payments that depend on usage or sales, such as rent based on a percentage of store revenue, stay out of the liability and are expensed as they occur, which is why heavy users of percentage rent, covered in retail accounting, can report modest lease liabilities relative to their total rent. Two elections also change the size of the liability:

Measuring the Liability and the Asset

At commencement, a lessee measures the lease liability as the present value of the lease payments it has committed to. Deloitte's lessee accounting roadmap summarizes the rate rule: a lessee uses the rate implicit in the lease whenever it is readily determinable, and otherwise its incremental borrowing rate, which in practice is what most lessees use because lessors rarely disclose their pricing.

Incremental borrowing rate

The interest rate a lessee would pay to borrow, on a collateralized basis and over a similar term, an amount equal to the lease payments. Lessees use it to discount lease payments when the rate implicit in the lease cannot be readily determined.

The right-of-use asset starts from the same figure, then adjusts for a few items: lease payments made at or before commencement are added, lease incentives received from the landlord are deducted, and initial direct costs such as broker commissions are added. Leases with a term of 12 months or less, and no purchase option the lessee is reasonably certain to exercise, can stay off the balance sheet under the short-term lease election, with their payments simply expensed.

Take a company that leases delivery equipment for three years, paying $1,331 a year at the end of each year, with an incremental borrowing rate of 10%. Discounted at 10%, the three payments are worth exactly $3,310 today:

Right-of-use asset

The lessee's right to use a leased asset for the lease term, recognized as an asset on the balance sheet. It is initially measured at the lease liability, adjusted for prepaid lease payments, lease incentives and initial direct costs.

The liability then behaves like a loan, measured the way debt is carried at amortized cost. Each year it accretes interest at 10% and is reduced by the payment, and the schedule is identical under both lease models:

Interest falls each year because the balance it is charged on keeps shrinking. That simple fact drives the whole difference between the two models.

For an operating lease, ASC 842 keeps the income statement looking the way it did before the standard: a single lease cost, recognized on a straight-line basis over the term and reported inside operating expenses. With even payments and no incentives, the straight-line cost is simply the annual payment, $1,331 in each of the three years.

The balance sheet still has to move, and here the accounting works backward. The liability follows the schedule above, so the right-of-use asset is reduced by whatever amount keeps the total expense at $1,331: the payment less the year's interest accretion. In year one that is $1,000, in year two $1,100 and in year three $1,210, which takes the asset to zero at the end of the lease, in step with the liability. The result is a lease that sits on the balance sheet like debt but reads on the income statement like rent:

When the Right-of-Use Asset Is Impaired

The straight-line pattern breaks when a right-of-use asset is impaired. A retailer that closes underperforming stores but remains bound by their leases tests the related right-of-use assets for impairment under the same model used for property and equipment, and writes them down when the expected cash flows no longer support their carrying value. The write-down is a one-time charge, often reported within restructuring costs, and afterward the lease cost on those stores is no longer straight-line: the smaller asset is amortized while the liability keeps accreting interest, so the remaining expense falls and is front-loaded. Store-closure programs at chains with large lease portfolios are a common source of these charges, and of the adjustments bankers make when normalizing earnings around them.

A lease becomes a finance lease when it looks more like a purchase financed with debt. ASC 842-10-25-2 sets out five classification criteria, and meeting any one of them is enough:

The codification describes 75% of economic life and 90% of fair value as one reasonable way to read "major part" and "substantially all", though companies are not required to use those thresholds; the judgments are covered in operating vs finance lease classification.

Once classified as a finance lease, the same equipment produces two separate charges. The right-of-use asset is amortized, usually straight-line over the shorter of the lease term and the asset's useful life (or over the useful life when ownership transfers or a purchase option is reasonably certain), here the three years at about $1,103.3 a year, and the liability's interest is recorded as interest expense, following the schedule: $331 in year one. The first year side by side:

Under the finance lease, EBITDA is unaffected, EBIT is hit less, and pre-tax income is hit more in year one. Over the life of the lease the pattern reverses, because the interest charge shrinks as the liability is repaid:

Total expense over the three years is the same under both models, equal to the $3,993 of payments (the finance lease figures differ by a rounding decimal); only the timing differs. A finance lease front-loads expense, while an operating lease spreads it evenly.

The balance sheet shows the same front-loading. At the end of year one, the liability is identical under both models, but the finance lease asset has been amortized faster:

Under the operating lease, asset and liability move in lockstep, so the lease has no net effect on equity beyond the rent already expensed. Under the finance lease, equity is temporarily lower by the extra expense recognized early, a gap that closes as the interest charge falls in later years.

The two models also split the same cash payment differently, which changes reported operating cash flow and free cash flow even though the cash leaving the company is identical:

A company with finance leases therefore reports higher operating cash flow than an otherwise identical company with operating leases, because most of its lease payments are classified as debt repayment. Free cash flow measured as operating cash flow less capex inherits the same distortion, which is one reason analysts subtract finance lease principal payments when they compare free cash flow across companies. Signing a new lease never appears in the cash flow statement at all: the right-of-use asset and the liability arrive together with no cash changing hands, so companies disclose them as a non-cash item, assets obtained in exchange for new lease liabilities, in the lease note.

Taxes and Deferred Taxes on Leases

Tax rules do not follow ASC 842. For tax purposes, a typical operating lease is simply rent, deductible as it is paid, so the right-of-use asset and lease liability have no tax basis. The book asset and liability therefore create deferred taxes: a deferred tax liability on the right-of-use asset and a deferred tax asset on the lease liability, which largely offset when the two balances move together, as they do for a plain operating lease. They diverge when incentives, prepaid rent or impairments separate the asset from the liability. The full statement effects of a lease, including taxes, are traced in leases on the three statements.

The lease footnote is where the numbers behind a company's lease liability are disclosed, and three items in it repay attention. The maturity table lists undiscounted future payments by year, which is larger than the liability on the balance sheet because the liability is a present value. Starbucks, a heavy lessee of stores, reported about $11.9 billion of operating lease obligations in its fiscal 2024 annual report, measured as undiscounted contractual payments, a figure that sits alongside a smaller discounted liability on its balance sheet.

The note also discloses the weighted average remaining lease term and the weighted average discount rate. Together they show how long the commitments run and how much the liability depends on the rate chosen: the longer the leases and the higher the incremental borrowing rate, the further the liability sits below the undiscounted payments. The worked lease makes the point: discounted at 6% instead of 10%, the same three payments of $1,331 are worth about $3,558 rather than $3,310, so a lessee with stronger credit records a liability about 7.5% larger for an identical lease. Finally, the note reports variable lease costs, such as rent tied to sales or usage, which are expensed as incurred and never enter the liability at all, and leases signed but not yet commenced, which will add to the liability once they start.

The two-model structure creates comparability problems that bankers have to solve before benchmarking anything. EBITDA is the first: a company leasing mostly under operating leases carries its full lease cost inside EBITDA, while a company that owns its assets, or leases them under finance leases, does not. Comparing EBITDA margins or EBITDA multiples across the two without adjusting mixes different things.

Industries that lease heavily have developed their own fix. Retailers, restaurant groups and airlines are often analyzed on EBITDAR, earnings before interest, taxes, depreciation, amortization and rent, alongside lease-adjusted leverage, so that the leasing decision drops out of the comparison.

EBITDAR

Earnings before interest, taxes, depreciation, amortization and rent. It adds lease or rent costs back to EBITDA so that companies that lease their assets can be compared with companies that own them.

Enterprise value (EV) raises the matching question. If operating lease costs stay in EBITDA, the operating lease liability should stay out of net debt, and if the lease is treated as debt, its cost should come out of EBITDA; the treatment in valuation is covered in operating leases as debt-like obligations. Leverage follows the same logic: credit agreements and rating agencies each define whether lease liabilities count as debt, so lease-adjusted and reported leverage can differ meaningfully for heavy lessees, a point to check whenever leverage and coverage ratios are compared.

Leasing is also a financing decision in its own right. In a sale-leaseback, a company sells real estate it owns and leases it back, raising cash while keeping the use of the property; if the transaction qualifies as a sale, the asset leaves the balance sheet and a lease liability takes its place. The conditions for sale treatment and the effect on EBITDA and leverage are covered in sale-leaseback accounting.

Comparisons Across the 2019 Line and in Restructuring

Historical comparisons need care. Under the previous standard, ASC 840, operating leases stayed off the balance sheet entirely and appeared only as commitments in the notes, while capital leases, the predecessor of finance leases, were recorded much as finance leases are today. Balance sheets and leverage ratios from before adoption are therefore not comparable with later ones for heavy lessees, even though the income statement treatment of operating leases barely changed.

Leases also behave differently when a company is in distress. In a Chapter 11 case, a debtor can reject unprofitable leases and turn the remaining obligation into a capped unsecured claim, one of the main tools retailers use to shed stores, as covered in executory contracts and leases under Section 365. Lease accounting gives the liability a precise value on the balance sheet; restructuring law decides how much of it the company ultimately pays.

A Checklist for Heavy Lessees

The practical checklist for any company with material leases is short:

Applied consistently, those four steps make a heavy lessee comparable with an owner of the same assets, which is the whole point of the exercise. The difference between the two lease types in everyday terms is also laid out in the explainer on operating vs finance leases.