Lesson 4 of 7
Leases and what came on balance sheet
ASC 842 put operating leases on the balance sheet. Total assets rose, leverage rose and asset turnover fell, at companies whose operations had not changed.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- ASC 842 moved operating leases onto the balance sheet for fiscal years beginning after 15 December 2018, raising assets, raising liabilities and lowering asset turnover with no change to the business.
- Capitalising a lease yourself for a post-adoption year double counts a liability wherever your debt figure already includes it.
- Under US GAAP, cash rent is unchanged by the standard, so a free cash flow series is comparable across the adoption year while every balance sheet ratio is not.
At a company with material operating leases, the year of adoption moved five things at once: total assets rose, total liabilities rose, debt to equity rose wherever the debt figure includes lease liabilities, asset turnover fell and return on assets fell. The stores were the same stores and the rent was the same rent.
One balance sheet, before and after adopting ASC 842
Before adoption
- Total assets: $1,000m
- Total liabilities: $400m
- Debt to equity: 0.33
- Asset turnover: 1.20x
After adoption
Same company, same year
- Total assets: $1,300m
- Total liabilities: $700m
- Debt to equity: 0.83
- Asset turnover: 0.92x
Nothing in the business changed. The standard changed what the balance sheet shows.
What actually moved
Before ASC 842, an operating lease produced a schedule of future minimum payments in the notes and a rent expense on the income statement. The obligation existed and was disclosed, but it was not on the balance sheet. After ASC 842, the same lease produces a right-of-use asset, the company's right to use the item for the lease term, and a lease liability, the present value of the payments committed to. Both sit on the face of the balance sheet, and both arrive together, so equity barely moves at adoption.
The classification that moved to the income statement
Both lease types are now on the balance sheet, but the operating and finance classification did not disappear; it moved to the income statement. Operating income is therefore higher under a finance lease than an operating lease on identical terms, so operating margin is not comparable between two companies that classified similar leases differently.
Operating lease
- One lease cost, spread evenly across the term.
- Sits entirely in operating expenses.
Finance lease
- Two charges: amortisation of the right-of-use asset, and interest on the liability.
- Amortisation sits in operating expenses; interest sits below the operating line, front-loaded because the liability is larger early on.
Both leases are on the balance sheet now. Where the cost lands on the income statement still depends on the classification.
Whether to add the lease liability to debt
Before adoption, capitalising operating lease commitments from the notes and adding the result to debt was the right adjustment. After adoption, use the recognised liability. Capitalising from the note again double counts it if your debt figure already includes it, and replaces a filed figure with an estimate if it does not. A series that spans the transition needs one deliberate treatment: either estimate the pre-adoption years from the note, or strip the disclosed liability out of the post-adoption years. Taking each balance sheet as filed and calling the change a shift in leverage mostly measures the standard.
Two identical portfolios, two different liabilities
The lease liability discounts remaining payments at the rate implicit in the lease where determinable, and otherwise the lessee's own estimated borrowing rate. Two companies with the same rent schedule can therefore carry different liabilities.
What did not step at all
Cash rent is unchanged. For an operating lease the payments stay in operating activities on the cash flow statement, so a free cash flow series has no step across adoption while every balance sheet ratio does. That asymmetry is the practical takeaway: across the transition, a cash-based measure is more comparable than a balance-sheet-based one, and it is comparable for a reason rather than by luck.
That holds under US GAAP. Under IFRS 16, which a foreign issuer filing a 20-F may use, every lease is treated like a finance lease, so the principal part of the rent moved to financing activities and operating cash flow stepped up at adoption too.
Check yourself
A company's asset turnover fell in the year it adopted ASC 842. What is the most likely explanation?
- Revenue fell that year
- Total assets grew because right-of-use assets were newly recognised, with no change to revenue
- The company sold assets
Show the answer
Answer: B.
ASC 842 adds a right-of-use asset to total assets without changing revenue, so turnover falls mechanically in the adoption year.An analyst capitalises a company's operating leases from the notes and adds the result to its 2024 debt figure. What is wrong with that?
- Nothing; it is the correct adjustment
- The lease liability is already on the 2024 balance sheet, so this double counts it
- Leases cannot be capitalised at all under current rules
Show the answer
Answer: B.
Since ASC 842 took effect, the lease liability already sits on the balance sheet. Adding a self-capitalised figure on top counts the same obligation twice.Which measure is most comparable across a company's adoption of ASC 842?
- Total assets
- Debt to equity
- Cash paid for rent, as reported in operating cash flow
Show the answer
Answer: C.
Cash rent for an operating lease stayed in operating cash flow both before and after adoption. The balance sheet ratios all step at the adoption date; the cash figure does not.Sources
- Financial Accounting Standards Board, ASC 842, Leases, effective for public business entities in fiscal years beginning after 15 December 2018.
- Penman, Financial Statement Analysis and Security Valuation, on accounting rules shifting income between periods rather than into existence.
What this leaves out
- This lesson does not say whether leasing or owning is the better arrangement, and gives no threshold for a lease-adjusted leverage figure.
- Both worked examples use round invented inputs; the discount rates of 5 percent and 8 percent are chosen to make the gap visible and are not any company's disclosed rate.
- Ratios computed across the adoption of ASC 842 are not comparable without restating one side.
- The cash-flow point applies under US GAAP, not IFRS 16.
- Nothing here is advice about any security.