Introduction
Target carries two kinds of lease liability on its balance sheet: about $3.8 billion for operating leases and $2.1 billion for finance leases. Both are measured in essentially the same way, as the present value of future lease payments. What separates them is a classification test performed when each lease begins, and the result decides whether the cost appears as a single rent-like expense above earnings before interest, taxes, depreciation and amortization (EBITDA) or as amortization and interest below it, and whether the principal repayments sit in operating or financing cash flow.
Accounting Standards Codification (ASC) 842 kept the distinction between two types of lessee lease that the previous standard drew between operating and capital leases, while bringing both onto the balance sheet. The measurement of the asset and liability is covered in lease accounting under ASC 842; which label applies depends on five tests, applied when the lease begins.
The Five Tests
A lessee classifies a lease as a finance lease if it meets any one of five criteria at commencement. If it meets none, it is an operating lease.
- Finance lease
A lease that, in substance, transfers control of the underlying asset to the lessee, identified under ASC 842 by meeting at least one of five criteria at commencement. The lessee amortizes the right-of-use asset and records interest on the liability separately, much as if it had bought the asset with a loan.
The criteria, set out in ASC 842-10-25-2 and discussed in Deloitte's guide to lease classification, are:
| Test | Question | Common policy threshold |
|---|---|---|
| Transfer of ownership | Does ownership pass to the lessee by the end of the term? | None needed |
| Purchase option | Does the lessee have an option to buy the asset that it is reasonably certain to exercise? | Reasonably certain |
| Lease term | Does the term cover a major part of the asset's remaining economic life? | 75% or more |
| Present value | Does the present value of the payments, plus any residual value guaranteed by the lessee, equal or exceed substantially all of the asset's fair value? | 90% or more |
| Specialized asset | Is the asset so specialized that it has no alternative use to the lessor at the end of the term? | None needed |
ASC 842 does not set bright lines for "major part" and "substantially all," but its implementation guidance describes the 75% and 90% thresholds from the previous standard as one reasonable approach, and many companies apply them as an accounting policy. The first two tests capture leases that are purchases in all but name; the next two capture leases that use up most of the asset's life or value; the last captures assets built for one lessee.
Applying the Tests
Suppose a company leases two machines, each with a fair value of $1,000 and an economic life of eight years. The first lease runs five years with payments whose present value is $700; the second runs seven years with payments whose present value is $920. Neither transfers ownership, includes a purchase option or involves a specialized asset:
| Test | Lease A: five years | Lease B: seven years |
|---|---|---|
| Share of economic life | 62.5%, below 75% | 87.5%, above 75% |
| Present value as share of fair value | 70%, below 90% | 92%, above 90% |
| Classification | Operating lease | Finance lease |
Lease A fails every test and is an operating lease; Lease B meets two tests, either of which alone would make it a finance lease. The same company, leasing similar equipment, will therefore show Lease A's cost as a single operating expense and Lease B's as amortization and interest, with very different effects on EBITDA, as traced in operating and finance leases on the three statements.
Leases That Start Near the End of an Asset's Life
The economic life test is not applied when a lease begins at or near the end of the asset's total economic life, commonly read as the last 25% of it. Leasing a sixteen-year-old aircraft for the last four years of a twenty-year life would otherwise meet the major-part test automatically, because the term covers all of the remaining life, even though the lessee obtains little of the asset's total value. The other four tests still apply.
Property Leases and Land
Most leases of stores, offices and warehouses are operating leases: their terms rarely cover most of a building's economic life, and their payments rarely approach its fair value. Exceptions tend to involve very long ground leases, where the payments can approach the land's fair value, or build-to-suit facilities designed around one tenant. When a lease covers both land and a building, the right to use the land is generally a separate lease component, assessed on its own unless the accounting effect of separating it would be insignificant, because land has an indefinite economic life and a lease of it cannot use up a major part of that life.
Target's Two Lease Books
Target's fiscal 2025 annual report, for the year ended January 31, 2026, shows the two classifications side by side. The company leases retail stores, supply chain facilities, office space, land and equipment, and its finance leases run longer on average than its operating leases:
| Fiscal 2025, $ in millions | Operating leases | Finance leases |
|---|---|---|
| Lease liabilities | 3,834 | 2,113 |
| Weighted average remaining term | 11.8 years | 13.6 years |
| Weighted average discount rate | 4.61% | 4.00% |
| Cost in the income statement | 691 in selling, general and administrative or cost of sales | 152 amortization in depreciation and amortization or cost of sales, 79 interest |
| Cash paid | 529 in operating cash flow | 79 in operating, 142 in financing |
The $691 million of operating lease cost, which includes $143 million of short-term and variable lease cost, sits in operating expenses and reduces EBITDA. The $231 million of finance lease cost does not: amortization is added back as part of depreciation and amortization, and interest falls below operating income. On the cash flow statement, the $142 million of finance lease principal appears in financing activities, so Target's operating cash flow is higher than it would be if those leases had been classified as operating.
Why the Label Matters
Classification decides presentation, not the size of the liability. The differences that follow from it are the ones bankers care about most:
- EBITDA: operating lease cost reduces EBITDA; finance lease cost sits below it, as amortization and interest.
- Operating cash flow: operating lease payments are entirely operating cash outflows; finance lease principal is a financing outflow, so finance lessees report higher operating cash flow.
- Expense pattern: operating leases produce a level cost; finance leases front-load it, because interest is highest in the early years.
- Debt definitions: many credit agreements, especially those written before ASC 842, treat finance leases as debt and operating leases differently, so the label can affect covenant calculations.
Classification is fixed at commencement and is reassessed only if the lease is modified in a way not treated as a separate contract, or if the lease term or the assessment of a purchase option changes. Lessors apply the same five criteria to decide whether a lease is a sales-type lease, removing the asset from their books, and then a further test to separate direct financing leases from operating leases. For lessees, the practical consequence is simple: the same rent can produce two different EBITDA figures, and comparisons across companies, or across a single company's leases, should start from lease-adjusted measures, such as EBITDA before rent and reported debt plus operating lease liabilities (finance lease liabilities, like Target's $2.1 billion, usually already sit inside reported debt and should not be added twice), explained in leverage and coverage ratios.
