Is a lease liability counted as debt?

In the accounts it is a financial liability, presented separately or within borrowings. For a bank it is debt only if the facility agreement says so. Some agreements count it and measure leverage against EBITDA on the new basis; others exclude it and deduct lease costs from earnings; older ones may freeze the accounting from before the change. Rating agencies generally include lease obligations in their adjusted debt. A lender's own analysis usually reads the leases as fixed obligations whichever way the covenant is written.

How do you calculate a lease liability?

Take the payments the lessee has committed to over the lease term, including periods under options it is reasonably certain to exercise, and discount them to the start date. The rate is the one implicit in the lease if it can be readily determined; otherwise the lessee's incremental borrowing rate, the rate it would pay to borrow a similar amount over a similar term with similar security. Each year, interest is added at that rate and the payments made are deducted.

Why do the right-of-use asset and the lease liability differ after the first year?

Because they run down on different patterns. The asset is usually depreciated in equal amounts over the lease term. The liability falls by the principal part of each payment, which is small at first, when interest takes most of the payment, and larger later. So for most of the lease the liability is above the asset, and the gap closes as the lease nears its end. A lender reading net assets sees that gap as a reduction in equity.

Do small companies have to put leases on the balance sheet?

It depends on the framework. In the UK, companies reporting under FRS 102, including small companies using Section 1A, bring most leases on balance sheet for periods beginning on or after 1 January 2026; micro-entities using FRS 105 do not. In New Zealand and Australia, companies preparing general-purpose accounts apply the lease standard even with reduced disclosures, while businesses that may prepare special-purpose accounts often do not. Short-term and low-value leases can stay off in every case.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Right-of-Use Asset and Lease Liability: a Worked Example

The rent is the same. The accounts now record it as a loan.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-07 · 6 MIN READ

// THE SHORT ANSWER

For a lender, the right-of-use asset and the lease liability are the accountant's answer to a question it used to work out for itself: what would this borrower's leases look like as borrowing? The answer rests on two judgements made by management, how long the lease will run and at what rate to discount the rent, so a lender reads the notes behind the figure as well as the figure. Neither number changes the cash. What changes is where the cost appears, and so EBITDA, operating cash flow and leverage. Whether the liability counts as debt is settled by the facility agreement.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

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PART OF Credit Analysis for Beginners

// 01 — WHAT A LENDER READS IN THE TWO NUMBERS

A lease the business cannot cancel is a promise to pay for years. Under the old split, a lender met an operating lease only in the commitments note and the rent line, and a finance lease on the balance sheet. IFRS 16, adopted as NZ IFRS 16 and AASB 16 for periods beginning on or after 1 January 2019, removed that split for lessees: most leases now produce a liability and an asset. The revised FRS 102 brings a similar model to UK companies for periods beginning on or after 1 January 2026, small companies under Section 1A included. Micro-entities under FRS 105 are outside it, as are New Zealand and Australian businesses whose special-purpose accounts do not follow the standard.

The liability saves the lender work, but it is not the number the lender would have reached alone. Lenders who capitalised leases themselves often applied a multiple to the annual rent. The standard instead discounts the actual contracted payments, over a lease term that management judges, at a rate specific to the lessee.

// 02 — HOW THE TWO ARE MEASURED

Liability at start = present value of the lease payments over the term,

at the rate implicit in the lease or, if that is

not readily determinable, the incremental borrowing rate

Asset at start = liability + payments made at or before the start

− incentives received + initial direct costs

+ estimated restoration costs

Each year: liability + interest − payments made

asset − depreciation, usually over the shorter of term and life

Three judgements set the liability. The lease term includes extension periods the lessee is reasonably certain to exercise, so the same contract can be capitalised over five years or fifteen. The discount rate is usually the lessee's own incremental borrowing rate, because the rate implicit in a property lease is seldom known, and a higher rate gives a smaller liability: a weaker borrower records less lease debt for the same rent. And only fixed or index-linked payments go in, so turnover rent stays an operating cost. Leases of twelve months or less, and leases of low-value assets, may be left off the balance sheet altogether.

// 03 — THE EXAMPLE

An optometry practice group, constructed for this page like every figure in it, signs an eight-year lease on a flagship store at US$250,000 a year, paid at the end of each year, with no incentives or direct costs. Its incremental borrowing rate is 6.5%. The rent and the rate are the example's. In US$000:

Liability at start: 250 × 6.089 (8-year factor at 6.5%) = 1,522

Asset at start = 1,522

Year 1 Old operating lease IFRS 16

Rent in costs 250 —

Change in EBITDA −250 0

Depreciation — 1,522 ÷ 8 = 190

Interest — 1,522 × 6.5% = 99

Charge to profit 250 289

Liability at end of year 1: 1,522 + 99 − 250 = 1,371

Cash paid under both: 250 (151 principal, 99 interest)

Renewal for five more years judged reasonably certain:

Liability at start over 13 years = 2,150

The store costs 289 in the first year's profit against 250 of rent, because interest is charged on a liability that is largest at the start; in the final year the charge is 190 of depreciation and about 15 of interest, below the rent. Over the eight years the total charged equals the 2,000 paid. EBITDA is 250 higher, and operating cash flow is higher by the 151 of principal, which moves to financing, or by the full 250 if the group's policy also puts interest paid there. Nothing about the store changed. The last line shows the weight of one judgement: treating the renewal as reasonably certain adds 628 to the liability, though the group has signed nothing more.

// 04 — THE LIABILITY AGAINST THE DEBT A BANK COUNTS

Whether the lease liability is debt for the bank is a question for the facility agreement, not the standard. Agreements signed before a change of standard often froze the old basis through frozen GAAP, so the liability stays out of covenant debt and rent stays in EBITDA. Agreements written since often state the treatment outright: either the liabilities count, beside EBITDA on the new basis, or they are left out and lease costs deducted from earnings, as EBITDAaL does. The liability also differs from the old commitments note, which listed undiscounted payments. And the asset is one a lender seldom gives value as security: a lease can often be assigned only with the landlord's consent, and it is worth little once the tenant has failed.

DEFINED IN ONE PARAGRAPH → · FINANCE LEASE → · FINANCIAL REPORTING, READ BY A LENDER →

// 05 — WHERE IT DECIDES A FILE

In the credit paper, the lender reads the lease notes before the ratio: the maturity analysis of the payments, the discount rate and the term judgements. A clinic or store group on short leases with options carries a liability that depends heavily on management's view of renewals, and a change in that view moves leverage with no change in the rent. A business that refreshes its sites shows the liability stepping up at each renewal even when rent is flat, so the lender separates re-signed space from new space before reading growth into the balance sheet.

In cash flow, the lender restores the lease payments as a deduction before debt service. Under the standard the principal has moved to financing, so a free cash flow built from operating cash flow or from EBITDA would otherwise leave the rent out and overstate what the business can pay the bank.

LENDER'S FREE CASH FLOW → · LEASE-ADJUSTED LEVERAGE →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Australian Accounting Standards Board, AASB 16 Leases (compiled, applicable from 1 January 2024), the Australian text of IFRS 16 — paragraphs 5–6, 18, 24, 26–27, 31, 36 and 50 — Sets the lease term, the measurement of the liability and asset, the discount rate, depreciation, the annual movement of the liability and the cash flow classification of principal and interest — sections 02 and 03.
Financial Reporting Council, FRS 102 Explainer: A summary of the Periodic Review 2024 changes for financial statements users, June 2026 — Section 20 Leases — Confirms the UK lessee model for periods beginning on or after 1 January 2026, the short-term and low-value exemptions, and that the lease liability typically exceeds the right-of-use asset during the lease — section 01 and the FAQ.
Financial Reporting Council, Periodic Review 2024: Key changes, 27 March 2024 — Section 20 Leases — Records that the FRS 102 lease changes have no equivalent in FRS 105, so micro-entities keep the old lease treatment — section 01.

// QUESTIONS PEOPLE ASK

Is a lease liability counted as debt?: In the accounts it is a financial liability, presented separately or within borrowings. For a bank it is debt only if the facility agreement says so. Some agreements count it and measure leverage against EBITDA on the new basis; others exclude it and deduct lease costs from earnings; older ones may freeze the accounting from before the change. Rating agencies generally include lease obligations in their adjusted debt. A lender's own analysis usually reads the leases as fixed obligations whichever way the covenant is written.
How do you calculate a lease liability?: Take the payments the lessee has committed to over the lease term, including periods under options it is reasonably certain to exercise, and discount them to the start date. The rate is the one implicit in the lease if it can be readily determined; otherwise the lessee's incremental borrowing rate, the rate it would pay to borrow a similar amount over a similar term with similar security. Each year, interest is added at that rate and the payments made are deducted.
Why do the right-of-use asset and the lease liability differ after the first year?: Because they run down on different patterns. The asset is usually depreciated in equal amounts over the lease term. The liability falls by the principal part of each payment, which is small at first, when interest takes most of the payment, and larger later. So for most of the lease the liability is above the asset, and the gap closes as the lease nears its end. A lender reading net assets sees that gap as a reduction in equity.
Do small companies have to put leases on the balance sheet?: It depends on the framework. In the UK, companies reporting under FRS 102, including small companies using Section 1A, bring most leases on balance sheet for periods beginning on or after 1 January 2026; micro-entities using FRS 105 do not. In New Zealand and Australia, companies preparing general-purpose accounts apply the lease standard even with reduced disclosures, while businesses that may prepare special-purpose accounts often do not. Short-term and low-value leases can stay off in every case.

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SIGNAL OR NOISE · THE BORROWER · EARNINGS

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THE READING ROOMIN ONE PARAGRAPHRight-of-use asset and lease liability (IFRS 16) What are a right-of-use asset and a lease liability, and do lenders count them as debt?