IFRS 16 vs. ASC 842: Key Differences in Lease Accounting

The accounting standards for leases, IFRS 16 and ASC 842, were developed to increase transparency for investors. Issued by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) respectively, they addressed the issue of off-balance-sheet lease obligations. Prior to these standards, it was difficult to get a true picture of a company’s financial commitments.

Both IFRS 16, for companies using International Financial Reporting Standards, and ASC 842, for US Generally Accepted Accounting Principles (GAAP), mandate that most leases be recognized on the balance sheet. This involves recording a right-of-use (ROU) asset, representing the right to use the leased item, and a corresponding lease liability for the payment obligation. While the standards were part of a joint project, differences emerged in the final versions.

Core Difference in Lessee Accounting Models

The most significant divergence between IFRS 16 and ASC 842 is their accounting models for lessees. IFRS 16 uses a single-model approach, treating nearly all leases as finance leases. For each lease, the lessee recognizes an ROU asset and a lease liability. On the income statement, the expense is split into interest expense on the lease liability and amortization expense on the ROU asset.

This treatment creates a “front-loaded” expense pattern. In the early years of a lease, the interest expense is higher because the liability is larger. As the liability is paid down, the interest portion of the expense decreases. Combined with straight-line amortization of the ROU asset, the total lease expense is greater at the beginning of the lease term and declines over time.

ASC 842 uses a dual-model approach, requiring lessees to classify each lease as either a ‘finance’ lease or an ‘operating’ lease. While both classifications result in an ROU asset and lease liability on the balance sheet, their income statement impact differs. The accounting for a finance lease under ASC 842 mirrors the IFRS 16 model, with separate interest and amortization expenses.

For leases classified as operating leases, ASC 842 requires the lessee to recognize a single lease expense, calculated on a straight-line basis over the lease term. For example, on a 5-year lease with total payments of $50,000, a company using ASC 842 would recognize a consistent $10,000 lease expense each year. Under IFRS 16, the expense in year one might be $11,500 and in year five might be $8,500, though the total expense over the five years is the same.

Key Distinctions in Scope and Exemptions

While the definition of a lease is largely converged, the standards differ in scope and permitted exemptions. ASC 842 is applied to property, plant, and equipment, while IFRS 16 can also be applied to leases of some intangible assets.

Both standards provide an exemption for short-term leases. Companies may elect not to recognize an ROU asset and liability for leases with a term of 12 months or less. If this election is made, lease payments are recognized as an expense on a straight-line basis. A lease with a purchase option the lessee is reasonably certain to exercise does not qualify for this exemption.

A practical divergence arises with low-value assets. IFRS 16 provides an exemption for leases of assets with a low value when new, such as tablets or small office furniture. The standard suggests a threshold of around $5,000 for the value of the new asset.

This low-value asset exemption does not exist under ASC 842. A U.S. company might establish a capitalization policy based on materiality to achieve a similar outcome, but there is no explicit exemption. This means a company reporting under both standards might have to capitalize a portfolio of small-ticket leases under ASC 842 while expensing them under IFRS 16.

Divergences in Specific Lease Scenarios

The differences between IFRS 16 and ASC 842 extend to transactions like sale and leasebacks and subleases. In a sale and leaseback, an entity sells an asset and immediately leases it back. Both standards require an assessment to determine if the sale qualifies as a true sale under their respective revenue recognition rules.

A distinction emerges in how the ROU asset is measured if the transaction qualifies as a sale. Under IFRS 16, the ROU asset is measured based on the proportion of the asset’s previous carrying amount that relates to the right of use retained. Under ASC 842, the ROU asset is measured based on the present value of the lease payments, which can result in a different gain or loss on the transaction.

The accounting for subleases also differs. An intermediate lessor leases an asset (the head lease) and then subleases that same asset to another party. Under IFRS 16, the intermediate lessor classifies the sublease as a finance or operating lease by referencing the ROU asset from the head lease.

ASC 842 takes a different approach. For a sublease, the classification is determined by referencing the underlying asset itself, not the ROU asset from the head lease. This can lead to different classifications for the same transaction. For instance, a sublease might be classified as a finance lease under IFRS 16 but as an operating lease under ASC 842.

Financial Statement Presentation and Disclosure

The different accounting models lead to variations in financial statement presentation. On the balance sheet, the presentation is similar, with both standards requiring separate presentation of ROU assets and lease liabilities or disclosure in the notes if they are combined with other line items.

The income statement reflects the dual-model approach of ASC 842. Under IFRS 16, all lessee leases result in separate interest expense and amortization expense. Under ASC 842, finance leases are presented similarly, but operating leases result in a single line item for lease expense within operating expenses. This affects financial metrics, as the IFRS 16 approach shows higher operating profit (EBIT) in early years.

This distinction affects the statement of cash flows. Under IFRS 16, principal repayments on the lease liability are classified as financing activities, while interest payments are classified as operating activities. ASC 842 applies a similar split for finance leases. For operating leases under ASC 842, the entire lease payment is classified as an operating activity, which can impact the cash from operations.

Disclosure requirements also differ, with IFRS 16 demanding more extensive information. For instance, IFRS 16 requires a maturity analysis showing the undiscounted lease payments for each of the next five years and a total for the years thereafter. While ASC 842 also has robust disclosure requirements, the specifics can be less prescriptive.