Navigating the New Lease Accounting Standards: ASC 842 and IFRS 16 Explained

Lease accounting has historically been a complex and often opaque area of financial reporting. For decades, many lease obligations—particularly operating leases were kept off the balance sheet, limiting transparency and comparability among companies. This changed with the introduction of two landmark accounting standards: ASC 842 under U.S. Generally Accepted Accounting Principles (GAAP) and IFRS 16 under International Financial Reporting Standards (IFRS). Both standards require lessees to recognise most leases on the balance sheet, fundamentally altering the accounting landscape. This article provides a comprehensive overview of ASC 842 and IFRS 16, their key requirements, differences, implications for financial reporting, and practical considerations for implementation.

Background and Rationale for Change

Prior to ASC 842 and IFRS 16, lease accounting standards allowed lessees to classify leases as either finance (capital) leases or operating leases. Finance leases were capitalised on the balance sheet, but operating leases were typically disclosed only in footnotes, leaving significant liabilities unrecognised on financial statements (FASB, 2016; IASB, 2016). This off-balance-sheet treatment obscured the true extent of lease obligations, complicating financial analysis and credit risk assessment.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) collaborated to develop new standards aimed at increasing transparency and comparability by requiring lessees to recognise right-of-use (ROU) assets and lease liabilities for most leases (FASB, 2016; IASB, 2016). The new standards became effective for public entities in 2019 (ASC 842) and 2019/2020 (IFRS 16), with private companies and smaller entities following later.

Key Requirements of ASC 842 and IFRS 16

Both ASC 842 and IFRS 16 require lessees to recognise a lease liability and a corresponding ROU asset at the lease commencement date. The lease liability represents the present value of future lease payments, while the ROU asset reflects the lessee’s right to use the leased asset during the lease term.

Lease Identification and Classification

Lease Identification: Both standards require entities to assess contracts to determine whether they contain a lease, defined as a contract conveying the right to control the use of an identified asset for a period of time in exchange for consideration (FASB, 2016; IASB, 2016).
Lease Classification:
- Under ASC 842, leases are classified as either finance leases or operating leases, with different income statement presentations (FASB, 2016).
- IFRS 16 eliminates the operating lease classification for lessees; all leases are treated similarly to finance leases, with a single lease expense recognized (IASB, 2016).

Measurement of Lease Liability and ROU Asset

The lease liability is measured as the present value of lease payments over the lease term, discounted using the rate implicit in the lease or the lessee’s incremental borrowing rate if the implicit rate is not readily determinable (FASB, 2016; IASB, 2016).
The ROU asset initially equals the lease liability adjusted for lease incentives, initial direct costs, and any prepaid or accrued lease payments.

Lease Term and Renewal Options

Both standards require careful evaluation of lease terms, including non-cancellable periods and options to extend or terminate the lease if it is reasonably certain that the lessee will exercise or not exercise those options (FASB, 2016; IASB, 2016). This assessment significantly affects the measurement of lease liabilities.

Differences Between ASC 842 and IFRS 16

While both standards share the objective of enhancing transparency, several differences exist:

Lease Classification: ASC 842 retains the dual classification model (finance vs. operating leases), affecting the pattern of expense recognition. Operating leases result in a straight-line lease expense, whereas finance leases produce front-loaded expenses due to interest and amortisation components (FASB, 2016). IFRS 16 requires a single lease expense comprising depreciation and interest, generally resulting in a front-loaded expense pattern (IASB, 2016).
Short-term Lease Exemption: Both standards allow lessees to elect a practical expedient to exclude leases with terms of 12 months or less from balance sheet recognition, recognising lease payments as expense on a straight-line basis (FASB, 2016; IASB, 2016).
Sale and Leaseback Transactions: IFRS 16 provides more detailed guidance on sale and leaseback transactions, often requiring recognition of a right-of-use asset and lease liability even when the transaction qualifies as a sale (IASB, 2016). ASC 842’s guidance is somewhat less prescriptive in this area (FASB, 2016).

Financial Statement Implications

The recognition of lease liabilities and ROU assets on the balance sheet significantly affects key financial metrics:

Balance Sheet: Organisations report higher assets and liabilities, impacting leverage ratios such as debt-to-equity and return on assets (ROA). This can influence debt covenants and borrowing capacity (KPMG, 2019).
Income Statement: Under ASC 842, operating leases continue to produce a straight-line lease expense, whereas finance leases and IFRS 16 leases generally result in higher expenses in earlier periods due to amortisation and interest components (PwC, 2020).
Cash Flow Statement: Lease payments classified as principal repayments reduce financing cash flows, while interest portions affect operating cash flows, altering cash flow presentation and analysis (EY, 2019).

Practical Considerations for Implementation

Implementing ASC 842 and IFRS 16 requires significant effort and cross-departmental collaboration:

Lease Inventory and Data Collection: Organisations must identify all lease contracts, including embedded leases, and gather detailed data such as lease terms, payment schedules, and renewal options (Deloitte, 2019).
Systems and Controls: Many companies invest in lease accounting software to manage complex calculations, disclosures, and ongoing compliance. Internal controls must be enhanced to ensure data accuracy and completeness (KPMG, 2019).
Policy Decisions and Judgments: Entities must establish accounting policies regarding lease term assessments, discount rates, and practical expedients. These judgments require documentation and consistent application (PwC, 2020).
Training and Change Management: Educating accounting personnel, finance teams, and operational managers about the new standards is critical to successful adoption and ongoing compliance (EY, 2019).

Conclusion

The introduction of ASC 842 and IFRS 16 represents a fundamental shift in lease accounting, promoting greater transparency and comparability by requiring lessees to recognise most leases on the balance sheet. While the standards share common objectives, differences in classification and presentation require careful consideration. The financial statement impacts are significant, affecting metrics, ratios, and disclosures. Successful implementation demands comprehensive lease data management, robust systems, and clear accounting policies. As lease accounting continues to evolve, organisations that proactively adapt will enhance the reliability of their financial reporting and meet the expectations of regulators, investors, and other stakeholders.

References

Deloitte. (2019). Lease accounting: A practical guide to implementing ASC 842 and IFRS 16. Deloitte Development LLC.

EY. (2019). Applying IFRS: IFRS 16 Leases. Ernst & Young Global Limited.

FASB. (2016). Accounting Standards Update No. 2016-02: Leases (Topic 842). Financial Accounting Standards Board.

IASB. (2016). IFRS 16 Leases. International Accounting Standards Board.

KPMG. (2019). Lease accounting: Navigating the new standards. KPMG International.

PwC. (2020). Lease accounting: Understanding ASC 842 and IFRS 16. PricewaterhouseCoopers.