Leases I: lessee accounting under ASC 842

Northlake needs a larger warehouse for finished stations. Rather than buy a building, it signs a five-year lease. For decades, most such leases never appeared on the lessee's balance sheet: if the lease did not transfer substantially all the risks and rewards of ownership, the lessee simply expensed the rent. Analysts knew this hid enormous obligations; airlines and retailers carried billions of dollars of lease commitments in the notes only. In 2016 both the IASB and the FASB issued new standards, IFRS 16 and ASC 842, that bring almost all leases onto the lessee's balance sheet. The two boards agreed on that principle but not on how the expense should be presented, so lessee accounting is now one of the clearest examples of a remaining IFRS–US GAAP difference.

What is a lease?

A lease is a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Two tests apply. First, there must be an identified asset, specified explicitly or implicitly, and the supplier must not have a substantive right to substitute a different asset throughout the period of use. Second, the customer must have the right to obtain substantially all the economic benefits from use of the asset and the right to direct how and for what purpose it is used. A contract to store goods in any available space in a supplier's warehouse is a service, not a lease; a contract for exclusive use of a specified building is a lease.

Many contracts contain embedded leases. An agreement for a supplier to provide data processing using dedicated servers in the customer's premises, or a transportation contract that uses specified railcars at the customer's direction, may contain a lease even though it is not called one. Contracts often mix lease components, such as the use of equipment, with non-lease components, such as maintenance. The consideration is allocated between them on a relative standalone price basis, although lessees may elect, by class of asset, to treat lease and non-lease components as a single lease component.

Initial measurement for the lessee

At the commencement date, when the lessor makes the asset available, the lessee recognizes a lease liability and a right-of-use asset. The lease liability is the present value of the lease payments not yet paid. Lease payments include fixed payments (less lease incentives receivable), variable payments that depend on an index or rate (measured using the index or rate at commencement), amounts expected under residual value guarantees, the exercise price of a purchase option the lessee is reasonably certain to exercise, and termination penalties if the lease term reflects termination. Variable payments linked to usage or sales, such as a percentage of store revenue, are excluded and expensed as incurred.

The discount rate is the rate implicit in the lease if readily determinable; otherwise the lessee's incremental borrowing rate. Lessees that are not public business entities may elect, by class of underlying asset, to use a risk-free rate for a comparable term instead, which produces a larger liability. The right-of-use asset is measured at the lease liability plus payments made at or before commencement, less incentives received, plus initial direct costs. Asset retirement obligations for leased assets are accounted for separately under ASC 410.

The lease term is the non-cancellable period plus periods covered by options to extend that the lessee is reasonably certain to exercise and periods covered by options to terminate that it is reasonably certain not to exercise. Judging 'reasonably certain' requires looking at economic incentives: significant leasehold improvements, relocation costs, below-market renewal rents and the importance of the asset to the lessee's operations.

Subsequent measurement under ASC 842: finance and operating leases

ASC 842 keeps a dual model for lessees. A lease is a finance lease if any one of five criteria is met at commencement: ownership transfers by the end of the term; the lessee holds a purchase option it is reasonably certain to exercise; the lease term is for the major part of the asset's remaining economic life; the present value of lease payments and any residual value guarantee equals or exceeds substantially all of the asset's fair value; or the asset is so specialized that it has no alternative use to the lessor at the end of the term. Many companies use the bright lines from the old standard, 75 percent for 'major part' and 90 percent for 'substantially all', as policy. Otherwise, the lease is an operating lease. A finance lease is accounted for like the IFRS single model: amortization of the right-of-use asset plus interest on the liability, front-loaded. An operating lease produces a single straight-line lease cost each year in operating expenses. The liability is still measured at the present value of remaining payments, but the right-of-use asset is measured as a balancing figure so that total expense stays straight-line, and all operating lease payments are operating cash outflows.

# Warehouse lease: IFRS 16 (single model) vs ASC 842 operating lease, 5 years at 6%
payment, rate, years = 200_000, 0.06, 5
liability = sum(payment / (1 + rate) ** t for t in range(1, years + 1))
rou0 = liability
dep = rou0 / years
print(f"Initial liability and ROU asset: {liability:,.0f}")
print(f"{'Year':>4} {'Interest':>9} {'Dep':>9} {'IFRS 16 total':>14} {'ASC 842 op cost':>16} {'Liability end':>14} {'Op-lease ROU end':>17}")
ifrs_total = us_total = 0
for y in range(1, years + 1):
    interest = liability * rate
    liability = liability + interest - payment
    ifrs = interest + dep
    us = payment                          # straight-line single lease cost
    rou_us = liability                    # with no prepaid/accrued rent, ROU equals the liability
    ifrs_total += ifrs; us_total += us
    print(f"{y:>4} {interest:>9,.0f} {dep:>9,.0f} {ifrs:>14,.0f} {us:>16,.0f} {liability:>14,.0f} {rou_us:>17,.0f}")
print(f"Totals: IFRS 16 {ifrs_total:,.0f}; ASC 842 operating {us_total:,.0f}")

Initial liability and ROU asset: 842,473
Year  Interest       Dep  IFRS 16 total  ASC 842 op cost  Liability end  Op-lease ROU end
   1    50,548   168,495        219,043          200,000        693,021           693,021
   2    41,581   168,495        210,076          200,000        534,602           534,602
   3    32,076   168,495        200,571          200,000        366,679           366,679
   4    22,001   168,495        190,495          200,000        188,679           188,679
   5    11,321   168,495        179,815          200,000             -0                -0
Totals: IFRS 16 1,000,000; ASC 842 operating 1,000,000

The program shows the difference. Under IFRS 16, lease expense in year 1 is $219,043 (interest of $50,548 plus depreciation of $168,495), falling to $179,815 in year 5. Under an ASC 842 operating lease, the expense is $200,000 every year. Both total $1,000,000 over the lease, and the liability is identical at every year end; only the pattern and presentation of expense differ. Because the operating-lease right-of-use asset is a plug, it equals the liability in each year in this simple case, while the IFRS right-of-use asset is depreciated faster than the liability is repaid in the early years.

Practical expedients and exemptions

ASC 842 allows lessees to elect, by class of underlying asset, not to recognize short-term leases, those with a term of twelve months or less and no purchase option the lessee is reasonably certain to exercise; payments are expensed straight-line. There is no low-value exemption like IFRS 16's, but companies may apply a capitalization threshold for immaterial leases as an accounting policy, consistent with materiality. Private companies may also elect to use a risk-free discount rate and, under ASU 2023-01, to use the written terms and conditions of arrangements between entities under common control.

How IFRS and ASPE compare

Outside the United States, IFRS 16 applies a single model: every recognized lease is accounted for like a US finance lease, with depreciation and interest presented separately. A Canadian or European competitor with the same warehouse lease would therefore report higher operating profit and EBITDA than a US company reporting an operating lease, and classify the principal portion of payments as a financing cash flow. Canadian private enterprises using ASPE still apply the older capital/operating model, keeping operating leases off the balance sheet entirely. Analysts comparing companies across frameworks need to adjust for these differences.

Effects on financial statement analysis

Bringing leases onto the balance sheet increased reported debt and assets for lease-heavy companies, raising debt-to-equity and lowering return on assets. Under IFRS 16 it also raised EBITDA, because rent was replaced by depreciation and interest, both excluded from EBITDA. Loan covenants written in terms of EBITDA or debt often had to be renegotiated or defined on a 'frozen GAAP' basis. Analysts comparing a retailer reporting under IFRS with one reporting operating leases under US GAAP must adjust: the US company's EBITDA includes lease cost, while the IFRS company's does not. Lease disclosures, including maturity analyses of lease liabilities, weighted-average remaining lease terms and discount rates, help with these adjustments.