Issue #35

Operating vs. Finance Leases and What Changed

Desmond Ferraro told his banker he had no debt.

He runs Riverbend Courier, a same-day delivery company in Louisville that moves lab samples, legal filings, and pharmacy orders around Jefferson County. Six vans, a leased warehouse off Mellwood Avenue, eleven drivers. No term loan. No line of credit drawn. Nothing on the balance sheet that looked like borrowing.

His banker pulled up the financial statements his CPA had filed three months earlier and turned the laptop around.

Total liabilities: $837,000.

Desmond had leased everything instead of buying it, and every one of those leases was sitting on his balance sheet as debt.

The rule changed, and most owners missed it

For decades, an operating lease stayed off the balance sheet entirely. A company signed a five-year lease, recorded rent expense every month, and disclosed the commitment in a footnote. Airlines and retailers kept billions of dollars of obligations out of sight this way, which made their leverage ratios look far better than reality.

FASB ended that with ASC 842. Under the current standard, any lease with a term of twelve months or more goes on the balance sheet as a right-of-use asset and a matching lease liability. Both operating and finance leases. No exceptions for the ones you call rent.

Lease liability = Present value of remaining lease payments

ROU asset = Lease liability + prepaid rent + initial direct costs − lease incentives

Leases shorter than twelve months can still be expensed straight-line without hitting the balance sheet. Everything longer shows up.

So what actually separates the two types

The classification no longer decides whether a lease appears on your books. It decides how the expense flows through your income statement, and that difference is bigger than most owners expect.

A lease is a finance lease if it meets any one of five tests. Ownership transfers at the end of the term. There is a purchase option the lessee is reasonably certain to exercise. The lease term covers a major part of the asset's remaining economic life, generally 75% or more. The present value of the payments equals substantially all of the asset's fair value, generally 90% or more. Or the asset is so specialized it has no alternative use to the lessor.

Fail all five, and it is an operating lease.

Notice what the tests are actually asking. Each one is a version of the same question: did you effectively buy this asset and finance it, or did you just rent it? A five-year lease on a machine with a thirty-year life is renting. A five-year lease on a machine that will be worn out in six is a purchase with the payments spread out. The accounting follows the economics.

Classification happens once, at commencement, and it sticks unless the lease is modified.

Desmond's two leases behaved completely differently

The warehouse runs $9,500 a month on a six-year term. The building's economic life is roughly forty years, and the present value of the payments sits nowhere near its fair value, so it fails every test. Operating lease. Riverbend records $114,000 of lease expense every year, flat, for six years.

The van fleet is another story. Six cargo vans at $850 a month each, sixty-month term, with a $1 buyout at the end. That purchase option alone classifies it. Finance lease.

The present value of those payments at a 7% implicit rate comes to about $257,500. That amount lands on the balance sheet as both a ROU asset and a lease liability on day one. The asset then amortizes straight-line over five years at $51,500 a year, while interest accrues on the declining liability.

Cash paid stays at $61,200 every single year. Reported expense starts $7,200 above that and finishes $7,300 below it. Had the same fleet been structured as an operating lease, Desmond would report a flat $61,200 annually, and his first two years of profit would look better.

Why the classification still matters to a lender

Both lease types now inflate total liabilities, so both push up the debt-to-equity ratio. Desmond's $837,000 was almost entirely lease obligations, and it moved his leverage into a band where the bank wanted a personal guarantee.

Finance leases do one thing operating leases do not. Because the expense splits into amortization and interest, only the interest portion sits above the EBITDA line. Amortization is added back. A company carrying finance leases reports higher EBITDA than an identical company carrying operating leases with the same cash payments, which matters enormously if a loan covenant is written on a debt-to-EBITDA multiple.

Lenders know this. Credit analysts recalculate the ratios with leases adjusted, which is why the honest number is worth knowing before the meeting.

There is a real decision buried in all of this. Leasing preserves cash and keeps you flexible on assets that go obsolete, which is why Riverbend leases vans it swaps every five years. Buying builds equity and ends the payments. Since ASC 842 removed the balance sheet advantage that leasing used to carry, the choice now rests on cash flow, useful life, and how long you actually want the asset. Those were always the right reasons.

What to check on your own leases

Pull every agreement with a term over twelve months. Vehicles, equipment, real estate, copiers, and anything with an automatic renewal you are reasonably certain to take. Renewal options that are likely to be exercised get included in the lease term, which is where a lot of understated liabilities hide.

For each one, run the five tests. Then ask your accountant whether the ROU assets and lease liabilities are actually recorded, because plenty of small company balance sheets prepared internally still treat leases the old way.

Desmond did not have less debt than his competitors who bought their vans outright. He had the same obligation with a different label on it, and the label stopped mattering in 2019.