Off-Balance-Sheet Financing, Liabilities and Lease Accounting Under ASC 842
Questions this article answers
- Do operating leases go on the balance sheet under ASC 842?
- What leases stay off the balance sheet under ASC 842?
- How does ASC 842 change debt-to-equity and leverage ratios?
- How does an operating lease affect EBITDA under ASC 842?
- What do you disclose about lease commitments that are not on the balance sheet?
Off-balance-sheet financing, liabilities, and lease accounting once meant one thing: the operating lease. Under ASC 840 a lessee booked rent expense and listed future payments in a footnote. No asset and no liability appeared on the balance sheet. ASC 842-20-25-1 ended that by requiring a right-of-use asset and a lease liability for every lease at commencement, with one exception for leases of 12 months or less.
For private US companies the change applied to fiscal years beginning after December 15, 2021. Calendar-year 2022 was the first year on the new basis. This page covers what the old treatment hid, what still stays off, and what recognition does to leverage ratios, with a worked table on one company.
What did off-balance-sheet financing mean for leases under ASC 840?
ASC 840 split leases into capital leases and operating leases. A capital lease went on the balance sheet as an asset and a debt-like obligation. An operating lease did not. The lessee recorded rent expense, normally straight-line, and the balance sheet showed nothing beyond accrued or deferred rent.
The commitment was disclosed, not recognized. ASC 840-20-50-2 required a lessee to disclose future minimum rental payments under operating leases with initial or remaining noncancelable terms over one year. The disclosure was in total and for each of the next five fiscal years.
A reader who wanted the liability had to build it from that schedule. Lenders and analysts often did, by discounting the schedule or applying a rent multiple.
That is what off-balance-sheet financing meant. A ten-year plant lease committed the company to a decade of payments, yet total liabilities did not move. Two companies with the same operations could report very different leverage, depending on whether they owned or leased. Because the ASC 840 classification tests were bright lines, a lease could be structured to land on the operating side.
The FASB said as much: the previous model "provided opportunities to structure transactions to achieve a particular accounting outcome" (ASU 2016-02, paragraph BC16).
Why does ASC 842 put operating leases on the balance sheet?
The FASB's view was that a lease creates an obligation to pay and a right to use an asset, and both should be visible. ASC 842-20-25-1 states the rule in one sentence: "At the commencement date, a lessee shall recognize a right-of-use asset and a lease liability." The rule does not distinguish operating from finance leases. Classification now affects the pattern of expense, not whether the lease is on the books.
Measurement follows from that. ASC 842-20-30-1 measures the lease liability at the present value of the lease payments not yet paid, discounted at the rate for the lease at commencement. ASC 842-20-30-5 builds the right-of-use asset from that liability, plus payments made at or before commencement, minus lease incentives received, plus initial direct costs. With none of those adjustments, the asset and the liability start equal.
Both amounts are shown apart from other assets and liabilities. ASC 842-20-45-1 requires finance lease and operating lease right-of-use assets to be presented or disclosed separately from each other and from other assets, and the same for the liabilities. In a classified balance sheet, the same paragraph applies the usual current and noncurrent test. Right-of-use assets and lease liabilities "shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent."
The current and non-current classification of lease liabilities is its own exercise, covered on that page.
The income statement changes less than people expect. ASC 842-20-25-6 requires a lessee with an operating lease to recognize a single lease cost, allocated straight-line over the lease term. That is the same shape as ASC 840 rent expense; interest on the liability and amortization of the asset fold into that one line. The wider effects are summarized in the ASC 842 balance sheet impact overview.
What still stays off the balance sheet under ASC 842?
Three categories. Each is disclosed in the lease footnote, and each has a specific paragraph behind it. A controller should be able to point to the paragraph when the auditor asks why a known commitment is not in the liability.
| Item | Why it stays off the balance sheet | ASC paragraph | What is disclosed instead |
|---|---|---|---|
| Short-term leases (lease term of 12 months or less, no purchase option reasonably certain of exercise) | Lessee elects, by class of underlying asset, not to apply the recognition requirements; payments go to expense straight-line | 842-20-25-2 | Short-term lease cost under 842-20-50-4; the amount of short-term commitments if the period's expense does not reasonably reflect them, under 842-20-50-8 |
| Variable payments that do not depend on an index or a rate (percentage rent, usage charges) | Excluded from "lease payments" under 842-10-30-6, so never in the liability; recognized in profit or loss in the period the obligation is incurred under 842-20-25-6(b) | 842-10-30-6; 842-20-25-6(b) | Variable lease cost under 842-20-50-4 |
| Leases signed but not yet commenced | Recognition happens at the commencement date, not at signing | 842-20-25-1 | Information about leases not yet commenced that create significant rights and obligations, under 842-20-50-3(b) |
The short-term election is the one that most resembles the old treatment. ASC 842-20-25-2 lets a lessee, as an accounting policy, choose not to apply the recognition requirements to short-term leases. The payments go to profit or loss straight-line over the lease term. The election is made by class of underlying asset, so a company can elect it for vehicles and not for real estate.
A short-term lease has a term of 12 months or less at commencement and no purchase option reasonably certain of exercise. That threshold is a hard edge. KPMG's Hot Topic puts it plainly: leases whose terms extend beyond one year, "even if only by one day, are not eligible for the short-term lease recognition exemption." Renewal options that are reasonably certain of exercise count toward the term, so a month-to-month lease the company intends to keep may not qualify.
Variable payments are the second category. ASC 842-10-30-6 excludes from lease payments any variable lease payments other than those that depend on an index or a rate. A retail lease at 1% of sales, or an equipment lease billed per hour of use, produces no liability for the variable part. Payments tied to CPI or a market rate are different: they are measured at the commencement-date index and sit in the liability.
The third category is timing. A lease signed in December that commences in March creates no asset or liability in December, because ASC 842-20-25-1 recognizes at commencement. The commitment is real, so ASC 842-20-50-3(b) requires disclosure of leases that have not yet commenced but create significant rights and obligations for the lessee.
How does putting leases on the balance sheet change leverage and coverage ratios?
Total assets and total liabilities both rise by the same amount on day one. Equity does not move unless there was accrued or deferred rent to fold into the asset. So any ratio with total liabilities in the numerator gets worse, and any ratio with total assets in the denominator is diluted. Whether a covenant ratio moves depends on how the loan agreement defines debt, and the example below shows both cases.
A worked before-and-after table for one private company
Harborline Tool & Die is a made-up private manufacturer with a calendar fiscal year. Its first year under ASC 842 begins January 1, 2022. Every input is stated so the arithmetic can be checked.
- Balance sheet at December 31, 2021, under ASC 840: total assets $12,000,000; total liabilities $5,000,000, of which a bank term loan is $3,000,000; equity $7,000,000.
- EBITDA (earnings before interest, taxes, depreciation and amortization) for the year: $2,400,000, after $600,000 of operating lease rent expense.
- Operating leases: one plant lease and two equipment leases with combined fixed rent of $600,000 a year, paid annually in arrears, five years remaining at January 1, 2022. No renewal options are reasonably certain of exercise.
- No prepaid rent, no accrued or deferred rent, no lease incentives, no initial direct costs.
- Incremental borrowing rate: 6%.
These leases were already running under ASC 840, so the day-one amounts are transition measurements. At the application date, ASC 842-10-65-1(l) measures the lease liability at the present value of the remaining minimum rental payments as defined under Topic 840, discounted at a rate established at that date. For Harborline that is five annual payments of $600,000 at 6%.
The annuity factor is (1 − 1.06−5) ÷ 0.06 = 4.212364, so the liability is $600,000 × 4.212364 = $2,527,418. ASC 842-10-65-1(m) then measures the right-of-use asset at the initial measurement of the lease liability, adjusted for prepaid or accrued rent and unamortized initial direct costs. There are none here, so the asset is the same $2,527,418. The undiscounted payments total $3,000,000, so imputed interest over the term is $472,582.
| Line | ASC 840 presentation | ASC 842 presentation | Change |
|---|---|---|---|
| Operating lease right-of-use asset | $0 | $2,527,418 | +$2,527,418 |
| Total assets | $12,000,000 | $14,527,418 | +21.1% |
| Operating lease liability | $0 | $2,527,418 | +$2,527,418 |
| Total liabilities | $5,000,000 | $7,527,418 | +50.5% |
| Equity | $7,000,000 | $7,000,000 | none |
| Total liabilities to equity | 0.71 | 1.08 | +0.36 |
| Funded debt to equity (bank loan only) | 0.43 | 0.43 | none |
| Funded debt plus lease liabilities to equity | 0.43 | 0.79 | +0.36 |
| EBITDA | $2,400,000 | $2,400,000 | none |
| Funded debt to EBITDA | 1.25 | 1.25 | none |
| Funded debt plus lease liabilities to EBITDA | 1.25 | 2.30 | +1.05 |
Read the table by pairs. Total liabilities to equity jumps from 0.71 to 1.08 because the operating lease liability now sits in total liabilities. Funded debt to equity does not move, because the bank loan is $3,000,000 either way. The whole covenant question sits in that distinction; the effect of ASC 842 on debt-to-equity ratios is covered in more depth on that page.
Does an operating lease change EBITDA under ASC 842?
No. ASC 842-20-25-6 gives the operating lease a single straight-line lease cost of $600,000 a year, and ASC 842-20-45-4 includes it in income from continuing operations. Deloitte's Roadmap adds the step that matters for EBITDA: the single lease expense is classified as "cost of sales; selling, general, and administrative expenses; or another operating expense line item."
That is above the EBITDA line, where rent expense sat under ASC 840. Year-one interest accretion of $2,527,418 × 6% = $151,645 is not presented as interest; it is inside the single lease cost.
A finance lease is the case that moves EBITDA. Its charge is amortization of the right-of-use asset plus interest on the liability, and both sit below EBITDA. Had Harborline's leases been finance leases, EBITDA would have risen by roughly the $600,000 of lease cost. Whether a lender accepts that uplift is a matter of the agreement, worked through on the EBITDA-based loan covenants under ASC 842 page.
What happens to loan covenants written before ASC 842?
A covenant is measured the way the credit agreement says. The FASB considered this directly. In the basis for conclusions to ASU 2016-02 the Board noted that "Topic 842 characterizes operating lease liabilities as operating liabilities, rather than debt" (paragraph BC14). The Board added that those amounts "may not affect certain financial ratios that often are used in debt covenants."
The same paragraph notes that "a significant portion of loan agreements contain 'frozen GAAP' or 'semifrozen GAAP' clauses," so a ratio change caused solely by an accounting change is not a default. Other agreements define debt by reference to the balance sheet, so the new liability is picked up automatically.
At the first ASC 842 year-end the controller computes the covenant both ways and documents which definition applies. For Harborline, funded debt to EBITDA stays at 1.25 under a definition that excludes lease liabilities and becomes 2.30 under one that includes them. A covenant set at 2.00 passes on the first reading and fails on the second, with no change in the business. The ASC 842 impact on financial ratios and covenants page covers the other ratios.
What does a controller disclose about commitments that are not recognized?
The footnote still carries what recognition leaves out. ASC 842-20-50-4 requires disclosure of operating lease cost, short-term lease cost excluding leases of one month or less, variable lease cost, and cash paid for amounts included in lease liabilities. It also requires the weighted-average remaining lease term and discount rate. Short-term and variable cost show the reader what the balance sheet does not; the full list is on the lessee disclosures under ASC 842 page.
Two paragraphs deal with commitments directly. ASC 842-20-50-8 applies when short-term lease expense does not reasonably reflect the lessee's short-term commitments; the lessee then discloses that fact and the amount of the commitments. ASC 842-20-50-3(b) requires information about leases not yet commenced that create significant rights and obligations. For Harborline, a ten-year warehouse lease signed in December 2022 at $300,000 a year, commencing March 2023, appears here and not on the December 31, 2022 balance sheet.
The recognized liability gets its own schedule. ASC 842-20-50-6 requires a maturity analysis of lease liabilities. It shows undiscounted cash flows for each of at least the next five years, a total for the years after, and a reconciliation to the balance sheet. For Harborline at January 1, 2022, that is five lines of $600,000, a total of $3,000,000, less imputed interest of $472,582, equal to the $2,527,418 liability.
Put together, the balance sheet shows the $2,527,418 liability, the maturity analysis explains it, and the other disclosures cover what the liability leaves out. That combination is what replaced off-balance-sheet financing. The obligation is no longer hidden in a five-year schedule; it is recognized, and the footnote explains the edges.
Frequently asked questions
Are operating leases still off the balance sheet under ASC 842?
No. ASC 842-20-25-1 requires a lessee to recognize a right-of-use asset and a lease liability at the commencement date of every lease, operating or finance. The only commenced leases that can stay off the balance sheet are short-term leases with a term of 12 months or less. That requires the lessee to make the policy election in ASC 842-20-25-2.
A lease that has been signed but has not yet commenced is also unrecognized, because ASC 842-20-25-1 recognizes at the commencement date.
Does ASC 842 change EBITDA for an operating lease?
No. Under ASC 842-20-25-6 an operating lease produces a single straight-line lease cost, which is included in income from continuing operations under ASC 842-20-45-4. That cost sits above the EBITDA line just as rent expense did under ASC 840, so EBITDA for an operating lease is unchanged. Only a finance lease moves the charge into amortization and interest.
What leases and payments stay off the balance sheet under ASC 842?
Three things: short-term leases, when the lessee elects the policy in ASC 842-20-25-2. Variable lease payments that do not depend on an index or a rate, which ASC 842-10-30-6 excludes from lease payments. And leases that have been signed but have not yet commenced, because recognition happens at the commencement date. Each is still disclosed in the lease footnote.
Sources and further reading
- ASC 842-20-25-1, 842-20-25-2 and 842-20-25-6 (lessee recognition, the short-term lease election, and operating lease cost), and ASC 842-20-30-1 and 842-20-30-5 (initial measurement of the lease liability and right-of-use asset), as reproduced in Deloitte's Roadmap: 8.2 Policy Decisions That Affect Lessee Accounting and 8.4 Recognition and Measurement.
- ASC 842-10-30-6 (amounts excluded from lease payments), as reproduced in Deloitte's Roadmap: 6.9 Amounts Not Considered a Lease Payment.
- ASC 842-20-50-3(b), 842-20-50-4, 842-20-50-6 and 842-20-50-8 (lessee disclosures), as reproduced in Deloitte's Roadmap: 15.2 Lessee Disclosure Requirements.
- ASC 842-20-45-1 and 842-20-45-4 (balance sheet and income statement presentation), as reproduced in PwC's Financial statement presentation guide: 14.2 Lessees.
- The private-company effective date, ASC 842-10-65-1(b) as amended by ASU 2020-05, on PwC Viewpoint: ASU 2020-05, Effective Dates for Certain Entities.
- KPMG, Hot Topic: ASC 842, Understanding the short-term lease exemption (updated May 19, 2021), quoted above on the 12-month threshold.
- ASC 840-20-50-2 (lessee disclosure of future minimum rental payments under operating leases), as reproduced in Deloitte's Heads Up: At "Lease" There Are Answers to Transition Questions.
- ASC 842-10-65-1(l) and (m) — transition measurement of the lease liability and right-of-use asset for leases previously classified as operating under ASC 840; ASC 842-20-25-6(b) — variable lease cost.
- ASU 2016-02, Background Information and Basis for Conclusions, paragraphs BC14 and BC16, as reproduced on PwC Viewpoint.
- Deloitte Roadmap: Leases, section 14.2, Lessee presentation, including 14.2.2.2 on classifying the single lease expense.
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