In accounting, a lease liability is a financial obligation to make the payments arising from a lease, measured on a discounted basis. Under both ASC 842 and IFRS 16, the lease liability is calculated using the present value of the lease payments over the lease term and is discounted using the lessee’s incremental borrowing rate or the discount rate implicit in the lease.
IFRS 16 also requires lessees to remeasure lease liabilities in cases where there are changes in future payments, which can affect opening balances in cases where the lease payments are tied to an index. For more detail on this, read out blog, “IFRS 16 vs. US GAAP Lease Accounting: What Are the Differences?“
Under ASC 842, initial operating lease liabilities and finance lease liabilities are calculated using the exact same method. IFRS 16 applies a single-model approach to lease accounting, classifying all leases as finance leases, so the same applies. However, upon transition from IAS 17, there can be differences depending on the transition approach selected by the lessee. For a full explanation of these approaches with two full examples, read our blog, “IFRS 16 Summary and Two Examples of the IAS 17 Transition for Lessees.”
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The right-of-use asset, or ROU asset, is a balance sheet representation of a lessee’s right to use a leased asset over the course of the lease term. ASC 842 and IFRS 16 each require lessees to record the ROU asset for both operating leases and finance leases (capital leases under ASC 840). Likewise, the corresponding lease liability represents the lessee’s obligation to make payments on the lease.
Under ASC 842, the right-of-use asset calculation begins with the initial amount of the lease liability plus any lease payments made before lease commencement. Then, the lessee adds initial direct costs (IDC) and subtracts any lease incentives, such as tenant improvement allowances. This is identical for both operating and finance leases.
This is slightly different from IFRS 16, under which the ROU asset is calculated as the initial amount of the lease liability plus the following:
- Payments made at or before the commencement date of the lease less any lease incentives
- Initial direct costs
- Estimated costs for restoration or removal/disposal per IAS 37, Provisions, Contingent Liabilities and Contingent Assets
Under both ASC 842 and IFRS 16, the ROU asset is amortized (or depreciated for finance leases) from the lease commencement date (the date the lessee begins to make payments) to the end of the lease’s term. In some cases, it may be from the commencement date to the end of the useful life of the asset.
An operating lease is a contract that provides a lessee the right to use an asset without the benefits of ownership. Despite companies’ obligations to make lease payments associated with their operating leases, ASC 840 and IAS 17 did not require a lease asset and an operating lease liability to be recorded on the balance sheet. They didn’t meet the criteria for capitalization.
ASC 842 and IFRS 16, however, change this and require the capitalization of almost all leases – a major shift in the way lessees account for their operating leases. Aside from the ability to take advantage of a policy election that would allow a lessee to account for leases with terms shorter than 12 months similar to an operating lease under the legacy standards, all leases must be recognized on the balance sheet with a lease liability and ROU asset, calculated at initial recognition as discussed at the beginning of the article.
Note: For more detail on operating lease accounting with treatment and journal entries, read our blog, “Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation.”
Operating lease classification has also changed under both standards, but in different ways. Under IFRS 16, all leases are classified as finance leases, eliminating the “operating lease” classification. This isn’t the case for ASC 842, though, which makes the following changes to the lease classification criteria:
- The second test no longer evaluates if a bargain purchase option exists, but if the lease contains an option to purchase the asset that the lessee is reasonably certain to exercise
- The 75% of lease term and 90% of FMV rules are no longer definitive. However, the FASB has suggested that companies should continue to use these thresholds in their analyses, unless there is a more appropriate threshold based on the company’s facts and circumstances. The company needs to develop an overall policy with regards to these thresholds that it uses consistently.
- There is a new fifth test – you must consider whether or not the asset is specialized in nature and has a future value to the lessor.
This is primarily due to the fact that the FASB is moving away from “rules” based accounting to “principle” based accounting.
Accounting for finance leases, previously referred to as capital leases, under ASC 842 is largely unchanged compared to ASC 840. Under the old standard, lessees were required to record a lease asset and liability for capital leases. The same is true under both ASC 842 and IFRS 16.
For basic leases, the ROU asset and lease liability will be equal upon lease commencement. For example, if a company has a lease without initial direct costs, prepaid/deferred rent, and without a tenant improvement allowance (or some other lease incentive), then the ROU asset and the lease liability will be equal on the lease commencement date. The entry will simply be a debit to the ROU asset and a credit to the lease liability for the present value of the lease payments.
We will highlight the differences in subsequent accounting treatment for finance and operating leases.
Finance leases (ASC 842 and IFRS 16)
For finance leases, a portion of each periodic payment represents interest expense and the remainder is a reduction of the lease liability. Subsequent values of the lease liability are determined via accretion using the effective interest method, similar to other financial liabilities. This approach is the same under both ASC 842 and IFRS 16.
Operating leases (ASC 842)
For operating leases, a single lease expense — also known as a rent expense — is recognized each period on a straight-line basis.
Concerning the ROU asset, the difference between finance and operating leases lies in 1) whether or not the amortization of the asset is deemed depreciation expense and 2) the calculation of the periodic entry.
Finance leases (ASC 842 and IFRS 16)
For finance leases, the ROU asset is depreciated on a straight-line basis over the term of the lease. This is recognized as depreciation (or amortization) expense.
Operating leases (ASC 842)
The amortization of the ROU asset for operating leases is not recognized as depreciation expense. For example, in a basic lease (without any incentives, etc), each period, the asset is reduced by the same amount as the liability reduction.
Under ASC 840, operating lease expense was recognized on the income statement using the straight-line method. Under 842, the lease expense will continue to be recognized as a single lease expense, straight-line. This means that the transition to the new lease standard for an operating lease will not affect the income statement. Because the lease liability expense is a single expense, interest expense is not calculated for this type of lease, and as a result EBITDA is not changed. Finally, the lease liability resulting from operating leases is not considered debt, which means debt is also unchanged. The chart below is a simplified diagram summarizing the effect of finance and operating leases on net income, EBITDA, debt and the balance sheet under Topic 842. Keep in mind, however, that this is different from IFRS 16, under which operating leases will be reclassified as finance leases. Interest expense will be calculated for these leases following transition, which will impact these metrics.
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This comprehensive guide on understanding the ROU asset as it relates to both finance and operating leases should help you in your future calculations. If you’re unsure what type of lease you have, we offer a number of free tools for lease accounting that can help you. To learn more, visit our Features page or schedule a LeaseQuery demo today.
These articles provide full examples of the new accounting for leases under ASC 842 and IFRS 16: