Leases are an integral part of modern business operations—offering access to property, equipment, or vehicles without upfront ownership costs. For accounting professionals, correctly identifying, classifying, and recording leases is critical to ensure accurate financial reporting and compliance with standards like IFRS 16 and ASC 842.
In this guide, we break down everything you need to know about leases in accounting—from key definitions to financial statement impacts and practical examples.
What is a Lease in Accounting?
A lease is a contract that gives a party (the lessee) the right to use an asset owned by another party (the lessor) for a specified period in exchange for periodic payments.
Key Components of a Lease:
- Identified Asset: A specific, identifiable asset is being leased.
- Lease Term: Period the lessee has the right to use the asset.
- Lease Payments: Payments made by the lessee to the lessor over the lease term.
- Economic Benefits: Control over the use of the asset and benefits from its use.
Types of Leases
Under IFRS 16, all leases are treated similarly (with limited exemptions), while ASC 842 retains a distinction between:
1. Finance Lease (Capital Lease under old standards)
Recognized as an asset and liability on the lessee’s balance sheet.
Indicators:
- Ownership transfer at end of lease
- Bargain purchase option
- Lease term covers major portion of asset life
- Present value of lease payments ≈ asset’s fair value
2. Operating Lease
Previously off-balance sheet; now recorded with a right-of-use (ROU) asset and lease liability, but with straight-line expense recognition.
Accounting for Leases – Lessee Side
Initial Recognition:
- Right-of-Use Asset = Initial lease liability + initial direct costs
- Lease Liability = Present value of lease payments using the discount rate
Subsequent Measurement:
- Finance Lease:
- Depreciate ROU asset
- Interest on lease liability
- Operating Lease:
- Combine lease expense as single operating cost
Accounting for Leases – Lessor Side
Finance Lease (Lessor):
- Derecognize the asset
- Recognize net investment in the lease
- Recognize interest income over lease term
Operating Lease (Lessor):
- Keep asset on balance sheet
- Recognize lease income on straight-line basis
Journal Entry Examples
Lessee – Finance Lease (Initial Entry)
Dr Right-of-Use Asset........XXX
Cr Lease Liability................XXX
Lessee – Operating Lease (Monthly Payment)
Dr Lease Expense..............XXX
Cr Cash/Bank.....................XXX
Lessor – Operating Lease
Dr Cash /Bank..............XXX
Cr Lease Revenue..............XXX
Key Differences: IFRS 16 vs ASC 842
| Feature | IFRS 16 | ASC 842 |
|---|---|---|
| Lessee Classification | Single model (ROU + liability) | Dual model: Finance & Operating |
| Lessor Classification | Finance or Operating | Finance, Operating, or Sales-type |
| Impact on EBITDA | Increases EBITDA | Operating lease still impacts EBITDA |
Exemptions and Practical Expedients
Both standards allow exemptions:
- Short-term leases (<12 months)
- Low-value assets (e.g., office equipment)
These can be expensed directly without ROU accounting.
Impact on Financial Ratios
- Leverage Ratios: Increase due to lease liabilities
- EBITDA: Higher under IFRS 16 due to operating expenses being replaced by depreciation and interest
- Return on Assets (ROA): Decrease due to ROU assets increasing total assets
Technology & Tools
Modern accounting systems like NetSuite, SAP, or LeaseQuery support lease accounting compliance with automation for:
- Lease classification
- Payment schedules
- Amortization tables
- Journal entries
Conclusion
Lease accounting is more complex under the updated standards, but it provides a more transparent view of a company’s financial commitments. Professionals must ensure leases are properly identified, classified, and recorded to maintain compliance and deliver accurate financial insights.