Lesson 15 - Intermediate Accounting Course 

15. Lease Accounting: Operating vs. Finance Leases (IFRS 16 & ASC 842)

Leasing is a common way for companies to acquire assets without purchasing them outright. However, leases impact financial statements differently based on their classification. The two main types of leases under IFRS 16 and ASC 842 are:

1️⃣ Finance Leases (Capital Leases under old GAAP) – Treated as an asset purchase with a liability.
2️⃣ Operating Leases – Previously considered rental agreements, but now recorded on the balance sheet (under IFRS 16 and ASC 842).

Understanding lease accounting is crucial for companies that lease real estate, equipment, or vehicles, as it affects financial reporting, tax implications, and key financial ratios.

What Changed with IFRS 16 and ASC 842?

🔹 IFRS 16 (Effective 2019) – Eliminated operating leases for lessees; now, all leases must be recorded on the balance sheet.
🔹 ASC 842 (US GAAP, Effective 2019 for public companies, 2022 for private) – Retains both finance and operating leases, but now requires operating leases to be recorded as right-of-use (ROU) assets and lease liabilities.

Before these standards, operating leases were off-balance sheet, meaning they did not impact assets or liabilities directly. Now, both standards increase transparency by requiring companies to recognize lease obligations more clearly.

1️⃣ Finance Leases (Capital Leases under Old GAAP)

A finance lease (under IFRS 16 and ASC 842) is a lease where the lessee effectively gains control of the asset as if they own it.

Criteria for a Finance Lease (ASC 842/IFRS 16) – If any of these apply, the lease is classified as finance:

✔ Ownership transfer – The lessee receives ownership at the end of the lease.
✔ Bargain purchase option – The lessee can buy the asset for less than fair value.
✔ Lease term covers major asset life – Usually 75% or more of the asset’s useful life.
✔ Present value (PV) of lease payments is 90% or more of the asset’s fair value.
✔ Specialized asset – The leased item has no alternative use to the lessor.

Accounting Treatment for Finance Leases

📌 Lessee's Financial Statements:

• Balance Sheet:
  
  

  • Recognize a Right-of-Use (ROU) Asset (the leased item).
    
    

  • Recognize a Lease Liability (future lease payments).
    
    

• Income Statement:
  
  

  • Record Depreciation Expense on the ROU asset.
    
    

  • Record Interest Expense on the lease liability.
    
    

📌 Lessor's Financial Statements:

• Recognizes either a lease receivable (if selling the asset) or continues to carry the asset if they retain ownership.
  
  

Example of Finance Lease Accounting (Lessee):

• A company leases equipment for 5 years at $10,000 per year. The equipment's fair value is $45,000. Since the PV of payments (~$40,000) is close to the fair value, it’s classified as a finance lease.
  
  

Journal Entry to Record the Lease (At Start):

Dr. Right-of-Use Asset    $40,000  

    Cr. Lease Liability         $40,000  

Each Year (Depreciation & Interest):

Dr. Depreciation Expense   $8,000  (if straight-line over 5 years)  

    Cr. Accumulated Depreciation   $8,000  

Dr. Interest Expense        $X  

    Cr. Lease Liability     $X  

2️⃣ Operating Leases

Operating leases are agreements where the lessor retains ownership and the lessee only uses the asset temporarily. Under ASC 842, lessees must now recognize a Right-of-Use Asset and a Lease Liability, similar to a finance lease—but the income statement impact is different.

Accounting Treatment for Operating Leases

📌 Lessee's Financial Statements:

• Balance Sheet:
  
  

  • Recognize a Right-of-Use (ROU) Asset.
    
    

  • Recognize a Lease Liability for future payments.
    
    

• Income Statement:
  
  

  • Record Lease Expense straight-line over the lease term (instead of interest + depreciation separately).
    
    

📌 Lessor's Financial Statements:

• The lessor keeps the asset on its balance sheet and recognizes rental income over time.
  
  

Example of Operating Lease Accounting (Lessee):
A company leases office space for 3 years at $5,000 per year. Since the lease does not transfer ownership or meet finance lease criteria, it’s an operating lease.

Journal Entry to Record the Lease (At Start):

Dr. Right-of-Use Asset    $13,000  (PV of lease payments)  

    Cr. Lease Liability         $13,000  

Each Year (Lease Expense Recognition): 

Dr. Lease Expense      $5,000  

    Cr. Lease Liability     $5,000  

Key Differences Between Finance and Operating Leases 

Why Lease Classification Matters

1️⃣ Impact on Financial Ratios – Finance leases increase liabilities, affecting solvency ratios (debt/equity).
2️⃣ Tax Implications – Finance leases may allow interest deductions, while operating leases remain a rental expense.
3️⃣ Earnings Management – Some companies prefer operating leases to keep expenses predictable and avoid high initial costs.
4️⃣ Compliance with IFRS 16 and ASC 842 – Public companies must correctly classify leases for financial reporting accuracy.

Final Thoughts

The shift in lease accounting standards under IFRS 16 and ASC 842 has led to greater transparency by requiring most leases to be recorded on the balance sheet. Companies must carefully classify leases and understand their financial implications. Proper lease accounting ensures accurate financial statements, aids in decision-making, and prevents hidden liabilities from misleading investors.