Finance Leases and Operating Leases
Many companies acquire significant amounts of their long-term assets on lease. In a lease arrangement, a lessor agrees to allow a lessee to use an asset that the lessor owns. The lessee can take on the asset in either a finance lease or an operating lease arrangement.
Finance Leases, also known as Capital Leases, are long term rental contracts where ownership of the asset remains with the lessor but aspects of the ownership are transferred to the lessee. These are for a longer term of the asset's life, and the lessee typically assumes maintenance and insurance costs, and other risks and rewards associated with the asset. These leases often include an option to purchase the asset at the end of the term for a fixed amount.
Operating Leases usually have a shorter term when compared to Finance Leases, and lessees typically do not front maintenance or insurance costs, or have an option to purchase the asset at the end of the lease.
How are these leases shown on a company's financial statements?
Prior to 2019, all finance leases were shown on a lessee's balance sheet as both a long-term asset and as debt. Operating leases, in contrast, were left completely off of the balance sheet, and only recorded as rental payments on the income statement and in accompanying notes to the financial statements.
With the adoption of IFRS 16 (IFRS) and ASC 842 (US GAAP) on January 1st of 2019, companies became required to recognize the assets and liabilities for all leases with terms greater than 12 months. These led to the following changes:
Operating Leases, formerly left off the balance sheet, were now required to be included in a firm's long term assets as a "Right-Of-Use Asset" and in liabilities as a "Lease Liability"
Finance Leases also became recognized as long-term "Right-Of-Use Assets" and as a "Lease Liability"
Expenses on the income statement transferred to "right-of-use amortization" from lease rental expenses
Any interest expense for operating leases is recorded in interest expense
As of 2025, most companies disclose their operating and finance leases separately, rather than lumping them into a single "lease liability".
How does RapidRatings classify assets, liabilities and expenses associated with leases?
Assets: All leased assets are recorded in long term assets under the name "Right-Of-Use Assets". We classify ROU assets as part of a company's PP&E.
Liabilities: Finance leases are taken into our debt calculation, while operating leases are classified to "other liabilities". If the distinction is not made between finance leases and operating leases on a company's balance sheet, and instead there is a single line item saying "Lease Liabilities", we take the whole item as debt, keeping in line with our conservative rating methodology.
Expenses: We allocate all Right-Of-Use Amortization to depreciation, and any associated interest expense into our interest expense figure.