Accounting for executory contracts splits along one line: leases go on the balance sheet, and almost nothing else does. Under ASC 842 and IFRS 16, a lessee recognizes a right-of-use asset and a lease liability for virtually every lease longer than twelve months. Every other executory contract — supply agreements, service contracts, purchase commitments — stays off the balance sheet and hits the income statement only as performance occurs, with one significant exception under IFRS for contracts that turn onerous. The rest of the work is in the measurement mechanics, the classification choices, and the disclosures that carry the commitments the balance sheet still doesn’t show.
What Counts as an Executory Contract
An executory contract is an agreement where both sides still owe significant, unperformed obligations to each other. A five-year office lease on day one, a long-term supply agreement before the first shipment, and a multi-year IT services contract before implementation begins all qualify. The defining feature is mutual dependency: your obligation to pay is contingent on the other party’s obligation to deliver, and the reverse.
The historical default was to keep these contracts off the balance sheet entirely. Because both parties still owed roughly equivalent future performance, the rights and obligations were treated as offsetting, so no net asset or liability was recognized. Recognition happened only as goods arrived, services were rendered, or rent came due. That default still governs most executory contracts. Leases are the exception, and the exception is now large enough that it dominates the topic.
Non-Lease Executory Contracts: Recognize on Performance
For an executory contract that isn’t a lease, the accrual basis governs. Revenue and expenses hit the income statement only when the underlying goods are delivered or services are received. Pay a supplier before delivery, and the payment sits as a prepaid asset until the benefit is consumed. Receive the goods before paying, and you record an accrued liability. Signing a long-term contract, on its own, produces no journal entry.
This is where a supply commitment for the next five years, a services retainer, or a take-or-pay arrangement lives before performance begins. The commitment is real, but it doesn’t meet the definition of a liability under the general framework because no past event has yet obligated the reporting entity beyond what the counterparty still owes in return.
When the Contract Becomes Onerous
The picture changes when the contract turns unprofitable, and here IFRS and US GAAP part ways.
Under IAS 37, a contract is onerous when the unavoidable costs of meeting the obligations exceed the economic benefits expected from it. The standard defines unavoidable costs as the least net cost of exiting the contract: the lower of the cost of fulfilling it or any compensation or penalties owed for failure to fulfill it.1IFRS Foundation. International Accounting Standard 37 Provisions, Contingent Liabilities and Contingent Assets The provision equals the excess of those unavoidable costs over expected benefits, and it is recognized immediately, before any goods change hands.
US GAAP has no equivalent general standard. Unless a specific piece of authoritative literature covers the contract type, it is generally considered inappropriate to accrue a loss on a firmly committed executory contract just because it has become unfavorable. Certain contexts do have their own rules — inventory purchase commitments under ASC 330, insurance contracts, and a few others — but a company with an above-market service or supply agreement outside those pockets may have no basis to recognize a loss before performance. The same contract can therefore produce a booked liability under IFRS and remain silent on a US GAAP balance sheet.
Leases: The Rule That Changed the Category
Operating leases used to be the largest bloc of executory contracts kept off balance sheet. A lessee with billions in commitments reported them only in footnotes. ASC 842 and IFRS 16 ended that by requiring lessees to recognize assets and liabilities for essentially every lease longer than twelve months.2IFRS Foundation. IFRS 16 Leases
Both standards share the same core definition: a lease conveys the right to control the use of an identified asset for a period of time in exchange for consideration. When that definition is met, the lessee books a right-of-use (ROU) asset representing the right to use the underlying property, and a lease liability representing the obligation to pay. Companies that once appeared asset-light suddenly reported significantly higher total assets and liabilities.
Short-Term and Low-Value Exemptions
Both standards let lessees skip recognition for leases of twelve months or less. A lease containing a purchase option does not qualify, regardless of term. Elect the exemption and you simply expense lease payments on a straight-line basis.2IFRS Foundation. IFRS 16 Leases
IFRS 16 adds a low-value exemption that ASC 842 does not have. The IASB indicated in its basis for conclusions that it had in mind assets worth roughly $5,000 or less when new — laptops, tablets, individual printers, small office furniture. Cars and most photocopiers were specifically noted as not qualifying. US GAAP reporters must capitalize even inexpensive leases if the term exceeds twelve months.
Measuring the Liability and the ROU Asset
At commencement, the lessee measures the lease liability at the present value of the lease payments not yet paid. The ROU asset is then built from that liability, adjusted for payments already made, incentives received, and initial direct costs.
The components of the initial ROU asset measurement:
- Lease liability amount: the present value of future lease payments.
- Plus prepaid payments: any amounts paid to the lessor before or at commencement.
- Plus initial direct costs: costs directly attributable to negotiating the lease that would not have been incurred otherwise.
- Less lease incentives: payments made by the lessor to or on behalf of the lessee.
Choosing the Discount Rate
The discount rate has an outsized effect on the reported liability. Both standards follow the same hierarchy: use the interest rate implicit in the lease if you can readily determine it, and if not, use the lessee’s incremental borrowing rate.3IFRS Foundation. Lessee’s Incremental Borrowing Rate (IFRS 16) The implicit rate is rarely determinable because it depends on the lessor’s residual value assumptions, which lessees typically don’t have. Most lessees default to their incremental borrowing rate.
IFRS 16 defines the incremental borrowing rate as the rate the lessee would have to pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value in a similar economic environment. ASC 842 offers one additional option: a non-public business entity may elect to use a risk-free rate (based on US Treasury rates for a comparable period) instead of its incremental borrowing rate. It’s an accounting policy election made by class of underlying asset. A risk-free rate is easier to determine but produces a larger liability, because the lower discount rate yields a higher present value.
Variable Lease Payments
Many commercial leases include payments that move with an index like CPI or a benchmark rate. Under both standards, variable payments tied to an index or rate are included in the initial liability using the index or rate as of the commencement date. Future changes aren’t projected forward; the liability is remeasured when the actual payments change. Variable payments that depend on usage or performance — percentage-of-sales rent in a retail lease, for example — are excluded from the liability and expensed as incurred.
Finance vs. Operating: Where the Income Statement Diverges
Both standards put the lease on the balance sheet the same way. They diverge on how the expense flows through the income statement, and that’s where the finance/operating distinction still matters under US GAAP.
Classification Under ASC 842
A lease is a finance lease if it meets any one of five criteria at commencement:
- Ownership transfers to the lessee by the end of the term.
- The lessee has a purchase option it is reasonably certain to exercise.
- The term covers the major part (typically 75% or more) of the asset’s remaining economic life.
- The present value of lease payments and any lessee-guaranteed residual value equals or exceeds substantially all (typically 90% or more) of the asset’s fair value.
- The asset is so specialized that it will have no alternative use to the lessor at the end of the term.
Miss all five and the lease is operating. The 75% and 90% figures are carried forward as implementation guidance rather than strict thresholds, but they function much the same in practice.
Expense Recognition
A finance lease produces two separate expenses: straight-line amortization of the ROU asset and interest on the lease liability that declines as the balance is paid down. Total expense is front-loaded — higher in year one than in the final year.
An operating lease under ASC 842 produces a single straight-line lease expense over the term, even though the balance sheet still shows a declining liability and a corresponding ROU asset. Behind the scenes, amortization and interest are effectively blended to reach the level expense.
IFRS 16 eliminated the distinction for lessees. Nearly every lease uses what amounts to the finance lease model, with separate depreciation and interest.2IFRS Foundation. IFRS 16 Leases Straight-line operating lease expense is a US GAAP-only feature. An IFRS reporter will show higher total expense in the early years of a lease than a US GAAP reporter with an identical operating lease, though cumulative expense over the full term is the same.
Embedded Leases in Service Contracts
One of the most overlooked pieces of the standard is identifying embedded leases hidden in service contracts. A contract that reads like pure IT hosting, dedicated manufacturing capacity, or a transportation arrangement may contain a lease if it gives the customer the right to control the use of an identified asset for a period of time.
Two conditions must both be met. First, the contract must depend on an identified asset — a specific, physically distinct asset the supplier cannot freely substitute. Second, the customer must have the right to control that asset’s use throughout the period, meaning it obtains substantially all the economic benefits and has the right to direct how and for what purpose the asset is used.
Dedicated server racks where the customer controls which applications run on specific hardware, or a supply contract where the customer takes all output from a named production facility for several years and the facility can’t be swapped, are typical examples. If the supplier retains meaningful decision-making power over how the asset is used, or can freely substitute equivalent assets, there’s usually no embedded lease. IT service agreements, dedicated manufacturing arrangements, and any contract referencing specific equipment or facilities should be reviewed as part of ongoing compliance. Missing an embedded lease understates both assets and liabilities, and auditors know it.
Modifications and Impairment After Commencement
Lease terms change often, and the accounting has to keep up.
A modification is treated as a separate new contract only when two conditions are both met: it grants an additional right of use not in the original lease, and the payments increase by an amount that reflects the standalone price for that additional right. Adding a floor to an existing office lease at the building’s market rate typically qualifies; the new floor gets its own ROU asset and liability, and the original lease is untouched.
When a modification doesn’t qualify as a separate contract — a term extension, a rent reduction, a partial surrender of space — the lessee reassesses classification, remeasures the lease liability using a revised discount rate, and adjusts the ROU asset. The revised rate is the incremental borrowing rate as of the modification date, not the original rate. In a rising rate environment, remeasurement can increase the liability even when the economic terms of the modification are favorable.
Recognizing an ROU asset also means testing it for impairment like any other long-lived asset. Under US GAAP, ASC 360 governs. The recoverability test compares the asset group’s carrying amount to undiscounted future cash flows from its use and eventual disposition. If carrying amount exceeds those cash flows, the asset is impaired, and the loss is measured as the excess of carrying amount over fair value. Under IFRS, IAS 36 uses a single step: when indicators exist, compare carrying amount to recoverable amount, defined as the higher of fair value less costs to sell and value in use.
The scenario that surfaces impairment most often is vacated or underused space. Sign a ten-year office lease, abandon two floors in year three, and the ROU asset for those floors will likely fail recoverability. The impairment charge hits earnings immediately, the reduced ROU asset continues to depreciate over the remaining term, and the lease liability does not change because the payments are still owed. An earnings hit with no reduction in reported debt is a hard combination for financial ratios.
What Still Gets Footnote Treatment
Plenty of executory commitments remain off balance sheet even after ASC 842 and IFRS 16. Non-cancelable purchase obligations are the largest category — enforceable commitments to buy minimum quantities of goods or services over a specified period. They produce real cash outflows but no recognized asset or liability until performance begins.
SEC Disclosure Rules for Public Companies
SEC registrants disclose contractual obligations under Regulation S-K, Item 303. The current rule requires discussion in MD&A of material cash requirements from known contractual and other obligations, including the type of obligation and the relevant time period.4eCFR. 17 CFR 229.303 (Item 303) Management’s Discussion and Analysis The earlier version of this rule prescribed a specific tabular format breaking obligations into categories — long-term debt, lease obligations, purchase obligations — across defined time periods.5U.S. Securities and Exchange Commission. Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Many companies still present a similar tabular schedule voluntarily because analysts expect it, even though the current rule is more principles-based.
Lease-Specific Disclosures
ASC 842 requires extensive quantitative and qualitative disclosures to help users assess the amount, timing, and uncertainty of lease cash flows: finance lease cost, operating lease cost, short-term lease cost, and information about the significant judgments management applied in measuring lease assets and liabilities.
Companies that elect the short-term lease exemption must disclose the election, identify the classes of assets it applies to, and report lease costs for short-term leases with terms longer than thirty days. If undiscounted short-term lease obligations differ significantly from reported short-term lease cost for the most recent annual period, that difference must also be disclosed.
IFRS 16 requires similar disclosures and adds total cash outflow for leases, a maturity analysis of lease liabilities, and information about sale-and-leaseback transactions.
Impact on Ratios and Debt Covenants
Capitalizing operating leases isn’t just an accounting exercise. It changes the ratios lenders use to monitor covenants. A company that reported its lease commitments only in footnotes now shows substantially higher total liabilities, pushing debt-to-equity and debt-to-tangible-net-worth ratios into less favorable territory. The ROU asset offsets on the asset side, but equity doesn’t change at transition beyond modest retained earnings adjustments, so leverage ratios almost always deteriorate.
Income statement effects vary by framework. Under IFRS 16, EBITDA improves because lease expense is reclassified into depreciation and interest, both excluded from EBITDA. Under ASC 842, operating leases still produce a single operating expense line, so EBITDA is unaffected for those leases; ASC 842 finance leases produce the same EBITDA benefit as IFRS 16.
Ongoing lease activity keeps affecting covenant math. Every new lease adds to total liabilities, every modification triggers remeasurement, and every impairment charge reduces equity. Lenders that haven’t updated covenant definitions to either exclude lease liabilities or use frozen-GAAP provisions may find borrowers technically in default because of the accounting change rather than any change in the underlying business.