Operating lease

An operating lease is traditionally a lease arrangement where the lessor (owner) retains the asset and the lessee (renter) pays for temporary use. The lessee has no ownership rights and the asset remains the lessor’s property. Before ASC 842, operating leases were off-balance-sheet: only lease payments were expensed; no asset or liability appeared on the balance sheet. Since 2019, ASC 842 has required most operating leases to be recorded on the balance sheet as right-of-use assets and lease liabilities. This convergence with IFRS 16 brings hidden lease commitments into the open.

Traditional operating lease accounting (pre-ASC 842)

Before ASC 842, an operating lease was simple from an accounting perspective:

• The lessee records rent expense each period.
• No asset or liability appears on the balance sheet.
• The lease is disclosed in footnotes.

Example: A company leases office space for $100,000 per year for five years. It records:

• Annual rent expense: $100,000
• No balance sheet entry

The company’s balance sheet was understated: it had a $500,000 commitment but nothing showed on the sheet.

The ASC 842 revolution

ASC 842 changed this fundamentally. Now, most operating leases must be recorded on the balance sheet:

• Right-of-use (ROU) asset: The lessee’s right to use the leased asset.
• Lease liability: The lessee’s obligation to pay lease payments.

Example (same lease): A company leases office space for $100,000 per year for five years. It records:

• Right-of-use asset: ~$450,000 (present value of future payments, net of interest).
• Lease liability: ~$450,000.
• Annual rent expense is split into depreciation of the asset and interest on the liability.

The balance sheet now reflects the true economic commitment.

Exceptions: short-term leases and low-value assets

ASC 842 allows exceptions for:

• Short-term leases (12 months or less): Can be expensed without a ROU asset.
• Low-value assets (typically <$5,000): Can be expensed without a ROU asset.

Many companies have numerous short-term leases or low-value equipment leases that still qualify for off-balance-sheet treatment.

Finance lease vs. operating lease under ASC 842

ASC 842 preserves the distinction:

• Finance lease: Lessee has substantially all the risks and rewards of ownership. Recorded as if owned (same ROU asset and liability treatment).
• Operating lease: Lessor retains material risks and rewards. Recorded with the new ROU accounting but with different expense patterns.

In both cases, the balance sheet includes a ROU asset and liability. The difference is in the income statement pattern and treatment of purchase options.

Impact on financial ratios

The move to ASC 842 significantly increased reported assets and liabilities for lease-heavy companies (retailers, airlines, real estate). Key effects:

• Debt-to-equity ratio increases (liabilities rise).
• Asset turnover decreases (assets rise).
• Return on assets decreases (assets rise).
• Interest coverage can improve (lease liability interest is now explicit).

Companies that appeared to have low leverage before ASC 842 now show material liabilities. Investors had to recalculate metrics.

Lease payments vs. expense

Under ASC 842, the annual lease payment is split into:

1. Depreciation of the ROU asset: Straight-line over the lease term.
2. Interest on the lease liability: The liability declines as payments are made; interest decreases over time.

This is different from operating lease accounting, where the entire payment was a simple rent expense.

Disclosure requirements

Companies disclose extensive lease information:

• ROU assets and lease liabilities by asset type.
• Lease payments by period.
• Weighted-average lease term and discount rate.
• Future minimum lease payments.
• Commitments not yet recorded (short-term, low-value, or pending leases).

These disclosures help investors understand lease obligations and the company’s facility footprint.

Global adoption: IFRS 16

IFRS 16 (effective 2019 globally) mirrors ASC 842 closely. Most leases must be on the balance sheet with a ROU asset and liability.

This creates some convergence between GAAP and IFRS, though differences in detail remain.

See also