Leasing Text

This is a text only page without interactive elements.

A more readable, interactive page is here.

Rent vs. lease

Both leases and rentals allow one party, the lessee / rentee, to use an asset owned or controlled by another party, the lessor / rentor. The difference, lease agreements cover a long period of time, while rental agreements do not.

For example, a lessor may lease a building from its owner and sub-lease individual units to sub-lessees.

Technically, from a semantic perspective, a renter owns the asset being rented while a rentor does not.

Fortunately, no similar semantic distinction is made for lessors.

As far as the guidance is concerned, no difference between rent and lease exists.

IFRS 16 defines a lease: a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

Similarly, ASC 842 defines a lease: a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

Thus, while not identical in how they define the object of a lease, the standards do agree that a right to use an asset for a period of time, any period of time, whether specified or not, is a lease.

Nevertheless, if the arrangement is for one year or less, lease accounting is not mandatory.

As outlined in IFRS 15 5.a | ASC 842-20-25-2, lease accounting is mandatory only if the term exceed one year.

IFRS 16.5.b includes a second exception for low valued assets.

A discussion of this issue, including how to quantify "low value," can be found in the illustrations that follow.

ASC 842 does not provide a similar exception.

Note: it is also possible for an agreement to specify an indefinite term. However, as this is common mostly with real-estate, illustrations of how to account for this type of agreement are provided in the real-estate section below.

If an entity elects to apply this exception, it should account for the item as a rental rather than a lease.

1/1/X1, ABC "rented" an automobile for one year while XYZ "leased" an identical vehicle for 12 months.

As noted above, there is no difference between a rental and a lease from an IFRS | US GAAP perspective.

It is, however, good practice to refrain from labeling leases not accounted for as leases, "leases."

While IFRS 15 5.a | ASC 842-20-25-2 include an exception short-term leases, as this is an exception, entities may elect account for any arrangement that meets the definition of lease using lease accounting.

IFRS 16 defines a lease: a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

Thus, while not identical in how they define the object of a lease, the standards do agree that a right to use an asset for a period of time, any period of time, whether specified or not, is a lease.

Both agreed to pay the vehicle’s owner 342 at the end of each month.

While arrears payments are relatively uncommon, they provide a better illustration of the accounting.

The accounting for advance payments is shown in the explicit rate example below.

ABC / XYZ

1/31 to 12/31/X1 \| 31.1 to 31.12.X1
Rent expense		342
	Cash		342

While rent expense is not a defined term, recognizing and reporting an item using this label is consistent with the intent of the guidance.

IFRS 16 | ASC 842 does not draw a distinction between a lease and a rent implying that all these arrangements should be recognized and reported as leases.

Nevertheless, since the term rent is commonly used in practice, adding a rent expense account to the COA and rent expense reporting item to the P&L | IS is consistent with the intent the guidance.

Decision usefulness is important to the FASB.

Specifically, in the basis for conclusion to ASU 2016-02.BC4 it states (edited, emphasis added): Given the objective of general purpose financial reporting, the Board also considered the objective of the leases project, which is to increase the decision usefulness and comparability among organizations ... Most users already make adjustments that are often based on incomplete information to a lessee’s reported statement of financial position to capitalize operating leases when operating leases are significant to the lessee.

While the IFRS 16 BC does not mention decision usefulness, the discussion it does provide implies decision usefulness is just as important to it as to the FASB.

In IFRS 16.BC3.a, the IASB notes "many users adjusted a lessees financial statements to capitalise operating leases because, in their view, the financing and assets provided by leases should be reflected on the statement of financial position..." implying it adopted the new guidance for the same reason as the FASB.

Note: while the respective XBRLs do include items such as RentDeferredIncome or PrepaidRent, neither include Rent in the P&L | IS. This implies, if an entity elects to recognize an item as a rental, it will need to add a Rent account in its COA and a Rent extension to its XBRL tagged report.

Also note: while it does not include a IS item, the FASB XBRL does include PaymentsForRent as a SCF item.

Note: this expense would be reported to reflect how the vehicle was used. For example, it was used by management, it would be reported in administrative expenses. If the automobile was also available for the employee’s personal use, a portion of the expense would be reported in employee benefits as a perquisite.

Important

Decision usefulness is a key consideration.

Decision usefulness is important to the FASB.

While the IFRS 16 BC does not discuss decision usefulness, IFRS 16.BC3.a does note: Many users adjusted a lessees financial statements to capitalise operating leases because, in their view, the financing and assets provided by leases should be reflected on the statement of financial position ...

Thus, while the IASB does not specifically mention decision usefulness, the discussion it does provide implies decision usefulness is just as important to it as to the FASB.

As financial statement uses do not consider short-term leases to be leases, capitalizing them, while not prohibited, is not good accounting.

As most users do not consider items leased for a short-term to be assets, capitalizing such items is not good policy.

Thus, the intent of this illustration is not to suggest short-term leases should be capitalized.

Instead, it simply illustrates the difference between rent and lease accounting.

1/1/X1 \| 1.1.X1
PP&E: Vehicles: Automobiles (ROU)		3,947
	Lease liability		3,947

As outlined in IFRS 16.23 | ASC 842-20-25-1, the asset recognized in a lease agreement is a "right-of-use asset."

While the leased asset itself is generally tangible, a right conveyed by an agreement is clearly intangible.

In a subtle difference, IFRS 16 defines a lease (emphasis added): A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

In contrast, ASC 842-20 defines a lease (emphasis added): A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

This implies, while an "underlying asset" could theoretically be intangible, an "identified asset" will always be tangible.

Both IFRS 38 Definitions and ASC 350-30-20 define intangible asset comparably as assets (not including financial assets) that lack physical substance.

Both IAS 38.12.b and ASC 805-20-20 also elaborate that intangible asset arise from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

A lease is an agreement that conveys the right to use an asset. Consequently, the ROU is intangible even if the object of the lease is tangible.

Nevertheless, even though ROUs associated short-term leases could, theoretically, be recognized and reported in PP&E, capitalizing them at all would not be good accounting.

In practice, short-term leases are never capitalized.

Consequently, speculating on how they would be recognized and reported if they were capitalised is similar to speculating how many could dance on the head of a pin, if they could dance.

The key reason IFRS 16 | ASC 842 replaced IAS 17 | ASC 840 was that the latter gave companies considerable latitude in classifying leases as operating rather than finance | capital.

This latitude was used, some say abused, to keep vast amounts of assets and liabilities off the balance sheet and was the personal bugbear of Sir David Tweedy, the first IASB chairman, who vowed to stamp out this abuse and who retired, presumably a happy man, once the mission had been accomplished.

Ironically, while the IASB took the lead on this convergence issue, IFRS is softer than US GAAP even though US GAAP (nominally) held on to operating leases.

In addition to an exception for short term leases, IFRS 16.5.b also exempts low valued assets.

As this exemption does not consider the materially of the exempted items with respect to the entity (IFRS 16.B4), companies can recognize large numbers of low value assets without having to recognize either them, or the associated liabilities, on the balance sheet.

As ASC 842-20-25 does not include a similar "small asset" exception, this is an IFRS only issue.

Although ASC 842-20-25-6 requires some leases to be recognized as operating, the only different between this paragraph and ASC 842-20-25-5 is it allows expenses to be report a straight-line instead of using the effective interest method, which leads to them being front loaded as illustrated below).

It does not exempt lessees from reporting an asset and liability (the way superseded ASC 840 did).

As outlined in IFRS 16.24 | ASC 842-20-30-5, the value of the ROU is derived from the value of the lease liability.

Under previous GAAP, the procedure was reversed. The value of the liability was derived from the value of the asset. Specifically, IAS 17.20 used a fair value or present value whichever was lower approach, while the approach in ASC 840-30-30-3 was present value or fair value whichever was lower.

From a practical perspective, since the asset and liability must equal, it makes little difference which is measured first.

Nevertheless, occasionally, such as if a lease term is not defined or indefinite, keeping in mind that the liability comes first makes applying the guidance easier. An illustration of this is provided in the real estate section below.

XYZ calculated the ROU's value using this table:

Perhaps the simplest way to calculate present value is using the table below.

It can also be determined using Excel's present value function =PV(rate, nper, pmt, [fv], [type]).

Note, the rate must correspond to the periodicity of the payment. In this example, the annual rate needs to be converted to a monthly rate: 0.604¯% = (1 + 7.5%)^1/12 - 1 (simply dividing by 12 will not yield an accurate result).

Present value may also be calculated using this formula (in Excel syntax):

=C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1+1))/((1+D1)^(1/B1)-1))+C1

Where: A1 = number of annual periods, B1 = number of interim periods, C1 = the payment, D1 = the annual rate.

For a payment in arrears the formula is:

=C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1))/((1+D1)^(1/B1)-1))

To prevent rounding errors, it is good to round the result.

=ROUND(C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1+1))/((1+D1)^(1/B1)-1))+C1,2)

=ROUND(C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1))/((1+D1)^(1/B1)-1)),2)

These formulas and others like them can be downloaded on the formulas page.

In contrast to IAS 17 / ASC 840, where the value of the lease liability was derived from the value of the leased asset, under IFRS 16.24.a | ASC 842-20-30-5, the value of ROU is derived from the value of the liability.

As outlined in IFRS 16.26 | ASC 842-20-30-1, the liability is measured at the present value of lease payments.

In this illustration, that value was determined using an (annual) discount rate of 7.5%.

Additional discussion of how to determine an appropriate discount rate is provided in the illustrations that follow.

P	Payment	Discount rate	Present value
A	B	C = (1 + 7.5%)^1/12 - 1	D = B ÷ (1 + C)^A
1	342	0.604%	340
2	342	0.604%	338
-	-	-	-
11	342	0.604%	320
12	342	0.604%	318
			3,947

XYZ converted the annual rate to a monthly rate using this formula: monthly rate = (1 + annual rate)^1/12 - 1.

Simply dividing an annual rate by 12, while simple and occasionally done in practice, will yield an inaccurate result.

1/31/X1 \| 31.1.X1
Depreciation or Amortization		329
	Accumulated depreciation or amortization (ROU)		329
Lease liability		318
Interest expense		24
	Cash		342

Whether a depreciation or amortization expense is recognized depends on if the ROU is recognized in PP&E (depreciation) or outside PP&E (amortization).

Technically, a leased asset should be depreciated in IFRS but amortized in US GAAP.

Specifically, IFRS 16.31 states: A lessee shall apply the depreciation requirements in IAS 16 Property, Plant and Equipment in depreciating the right-of-use asset... while ASC 842-20-35-7 states: A lessee shall amortize the right-of-use asset on a straight-line basis ...

Nevertheless, in practice a leased asset is either depreciated or amortized depending whether it is presented in PP&E or outside of PP&E.

XYZ elected to depreciate / amortize the asset straight-line to a zero residual | salvage value: 3,947 ÷ 12 = 328.92.

Whether an accumulation account is used depends on if the ROU is recognized in PP&E or outside PP&E.

It also depends on if IFRS or US GAAP is applied.

As outlined in IFRS 16.31, an ROU is accounted for according to IAS 16 where IAS 16.6 defines carrying amount as cost less accumulated depreciation and IAS 16.73.d requires accumulated depreciation to be disclosed.

Even if ROU were classified as intangible, IAS 38.74 requires intangible assets to be carried at cost less any accumulated amortisation.

Thus, unlike US GAAP where an accumulation account is optional, in IFRS it should be used.

Unlike IFRS where ROUs are depreciated, both ASC 842-20-35-7 and 842-20-35-8 specify that they are amortized, reinforcing their intangible nature.

Since the guidance for intangible assets (ASC 350-30) does require accumulated amortization to be recognized, using an accumulation account is optional in US GAAP.

Thus, in practice, it is common to amortize intangible assets directly, without this account.

This table illustrates the amortization of the liability using the effect interest method.

However, if this transaction was recognized under US GAAP, it would be an operating lease and a straight-line expense would be recognized. An illustration of the GAAP for operating leases is presented below.

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B _(B+1)= B - F	C	D = B x C	E	F = E - D
1	3,947	0.604%	24	342	318
2	3,629	0.604%	22	342	320
-	-	-	-	-	-
11	678	0.604%	4	342	338
12	340	0.604%	2	342	340
					3,947

12/31/X1 \| 31.12.X1
Depreciation or Amortization		329
	Accumulated depreciation or amortization (ROU)		329
Lease liability		340
Interest expense		2
	Cash		342

If an accumulated depreciation or amortization account had been used, the asset would need to be derecognized.

12/31/X1 \| 31.12.X1
Accumulated depreciation or amortization (ROU)		3,947
	PP&E: Vehicles: Automobiles (ROU)		3,947

If it was depreciation / amortized directly, this step would not be necessary.

Finance lease vs. operating lease

In the past, IFRS (IAS 17) and US GAAP (ASC 840) allowed operating leases to be treated as if they were rentals (above).

Currently, IFRS 16 no longer recognizes operating leases.

It does, however, include an exception for short-term leases and leases of low value assets.

If either exception is applied, the lease is accounted for as if it were a rental (above).

While ASC 842 does, its updated guidance has eliminated practically all the differences.

Under ASC 840, operating leases were accounted for as if they were rentals (above).

Under ASC 842, they are treated like finance leases except for how interest expense is recognized (below).

Note: unlike IFRS 16, ASC 842 does not include an exception for low value assets.

Finance lease: implicit rate

1/1/X1, XYZ leased a standard production machine. It agreed to make 5 annual payments of 2,927 (in arrears). At the end of the lease term, title to the machine passed to XYZ.

While arrears payments are relatively uncommon, they provide a better illustration of the accounting.

The accounting for advance payments is shown in the explicit rate example below.

On average, XYZ uses comparable machines it purchases outright for 6 years, after which it sells them for 10% of their acquisition cost. It actually sold the machine for 1,250 on 3/31/X7.

Dr/Cr

1/1/X1 \| 1.1.X1
PP&E: Machinery and equipment: Machine (ROU)		12,000
	Lease liability		12,000

As outlined in IFRS 16.23 | ASC 842-20-25-1, the asset recognized in a lease agreement is a "right-of-use asset."

While the leased asset itself is generally tangible, a right conveyed by an agreement is clearly intangible.

This implies, while an "underlying asset" could theoretically be intangible, an "identified asset" will always be tangible.

Both IFRS 38 Definitions and ASC 350-30-20 define intangible asset comparably as assets (not including financial assets) that lack physical substance.

A lease is an agreement that conveys the right to use an asset. Consequently, the ROU is intangible even if the object of the lease is tangible.

Nevertheless, if the asset is retained, recognizing and reporting it as intangible is frowned upon, as is the mezzanine level.

From an IFRS perspective, the most common justification for not recognizing and reporting ROUs as intangible assets is IFRS 16.31, which requires an ROU to be depreciated as outlined in IAS 16 (rather than amortised as outlined in IAS 38) implying an ROU belongs in PP&E.

From a US GAAP perspective, ASC 842-20-35-7 refers to amortization (not depreciation) and establishes the straight-line method as a default (like ASC 350-30-35-6 does for intangible assets). This suggests an ROU belongs in intangible assets.

However, if the asset is retained, this would require derecognizing an intangible asset and rerecognizing PP&E at the end of the lease term.

Not that a mere accounting inconvenience is sufficient grounds for misapplying the guidance.

More importantly, such policy would contradict the FASB's intent.

As stated in ASU 2016-02.BC4: Given the objective of general purpose financial reporting, the Board also considered the objective of the leases project, which is to increase the decision usefulness and comparability among organizations by recognizing lease assets and lease liabilities on the statement of financial position and disclosing key leasing information. For example, users of financial statements are interested in obtaining information about a lessee’s leasing activities, in general, to assess the cash flows, returns, and capital structure of the lessee and to assess the lessee’s ability to meet financial commitments. Most users already make adjustments that are often based on incomplete information to a lessee’s reported statement of financial position to capitalize operating leases when operating leases are significant to the lessee.

Reading between the lines one realizes that users of financial statements prefer to get their information in the most digestible form possible.

So, if users can compare two companies, one that leases its assets and one that buys them on credit, by simply laying their two balance sheets side by side, they will be more satiated than if they have to chew through gristle hidden in the footnotes.

Thus, from both an IFRS and US GAAP perspective, since this accounting policy increases decision usefulness without violating any explicit guidance, there is no reason a leased asset should not be recognized and reported in PP&E even though it is, technically, an ROU.

In the 2023 revision to its XBRL, the IASB introduced PropertyPlantAndEquipmentIncludingRightofuseAssets and RightofuseAssets.

This implies the IASB is of the opinion that ROU's should be reported as stand-alone items separate from both PP&E and Intangible assets (in the mezzanine).

Similarly, the FASB XBRL also presents FinanceLeaseRightOfUseAsset separately from both PropertyPlantAndEquipmentNet and IntangibleAssetsNetExcludingGoodwill.

Be that as it may, using a mezzanine level implies indecision, which makes some users of financial information antsy.

So, since neither IFRS 16 nor ASC 842 explicitly state ROUs may not be recognized and reported as PP&E, recognizing and reporting them in this way would not contradict the guidance they provide.

IFRS 16.47 merely states: A lessee shall either present in the statement of financial position, or disclose in the notes:

right-of-use assets separately from other assets. If a lessee does not present right-of-use assets separately in the statement of financial position, the lessee shall:
1. include right-of-use assets within the same line item as that within which the corresponding underlying assets would be presented if they were owned; and
2. disclose which line items in the statement of financial position include those right-of-use assets.
lease liabilities separately from other liabilities. If the lessee does not present lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those liabilities.

Also, IFRS 16.53.j states: the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset.

This is often interpreted to mean that an ROU should be recognized and reported together with similar items of PP&E.

This interpretation is further reinforced by IFRS 16.31: "A lessee shall apply the depreciation requirements in IAS 16 Property, Plant and Equipment in depreciating the right-of-use asset, subject to the requirements in paragraph 32" suggesting that an ROU is a type of PP&E and should be treated as such.

ASC 842-20-45-1 merely states: A lessee shall either present in the statement of financial position or disclose in the notes all of the following:

Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets
Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities.

Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position.

ASC 842-20-45-2 states: If a lessee does not present finance lease and operating lease right-of-use assets and lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those right-of-use assets and lease liabilities.

ASC 842-20-45-3 states: In the statement of financial position, a lessee is prohibited from presenting both of the following:

Finance lease right-of-use assets in the same line item as operating lease right-of-use assets
Finance lease liabilities in the same line item as operating lease liabilities.

The guidance merely prohibits mixing financial with operating leases. It does not state they cannot both be recognized and reported in PP&E.

As outlined in IFRS 16.24 | ASC 842-20-30-5, the value of the ROU is derived from the value of the lease liability.

From a practical perspective, since the asset and liability must equal, it makes little difference which is measured first.

IFRS 16.24 | ASC 842-20-30-5 requires the value of the ROU to be derived from the value of the lease liability.

In addition to the liability itself (sub-paragraph a), the cost of the ROU also comprises:

(b) lease payments made at or before the commencement date (less incentives received) and

Note: IFRS 24.d also specifies that disposal costs should be included in the ROU, while ASC 842-20-30-5 does not.

This should not, however, be interpreted to imply that disposal costs are not recognized under US GAAP.

Instead, it reflects that while IFRS approaches disposal from the perspective of the asset, US GAAP approaches it the perspective of the liability.

Consequently, if an entity expects to incur disposal costs, it would recognize them as outlined in ASC 410-20.

Also note: while similar, IFRS | US GAAP guidance on disposal costs | retirement obligations does include some important differences which are and is discussed on Non-current assets page.

However, it also requires this liability to be calculated using the rate implicit in the lease if readily determinable.

Both IFRS 16.26 and ASC 842-20-30-3, require the liability to be measured by discounting the lease payments using the rate implicit in the lease if this rate is readily determinable.

IFRS 16 defines the interest rate implicit in the lease as: the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

ASC 842-20 defines the rate implicit in the lease as: the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

Note: while ASC 842-20 indicates that the implicit rate could be zero, it does not provide any examples of situations where this would be the case.

However, neither specify how "readily determinable" should be interpreted.

Which, for some sites, represents a practically insurmountable hurdle, but only if they forget to apply the latest update.

Under ASC 840, to use the rate implicit in the lease, the lessee really did need to know the lessor's profit margin. Since lessors rarely shared this information, this really was a Catch 22.

Previously, ASC 840-10-25-31 stated: A lessee shall compute the present value of the minimum lease payments using the lessee's incremental borrowing rate unless both of the following conditions are met, in which circumstance the lessee shall use the implicit rate:

a. It is practicable for the lessee to learn the implicit rate computed by the lessor.

b. The implicit rate computed by the lessor is less than the lessee's incremental borrowing rate.

However, under ASC 842, this is no longer necessary.

Currently, ASC 842-20-30-3 (edited) states: A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate...

Instead, all the lessee needs to know is the regular sales price of the leased asset on the market. It does not need to know that price before a manufacturer's profit or dealer's markup.

Fortunately, readily determinable fair value is defined in ASC 820.

Unfortunates, this definition only applies to equity securities.

Nevertheless, by analogizing from this guidance, "readily determinable" can be interpreted to mean prices for comparable items which can be easily verified using objective, market data.

In other words, fair value is "readily determinable" if it can be found in price lists, blue books or using similar means (a.k.a. on the internet in less than an hour or so).

If, on the other hand, it requires something more involved, such as soliciting third party offers or calculating multi-period excess earnings, the cost, time and effort involved makes it not "readily determinable."

For its part, while IFRS 13 does not define readily determinable fair value. IFRS 13.B34 does discuss readily available closing prices in exchange markets.

Again, by analogizing from this guidance, it would be reasonable to interpret "readily determinable" the same way as above.

Assuming a plain vanilla transaction excluding, for example, a guaranteed residual amount.

As the rate implicit in the lease is derived from the value of the leased asset, the guidance seems to be circular.

IFRS 16 defines the interest rate implicit in the lease as (emphasis added): the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

ASC 842-20 defines the rate implicit in the lease as (emphasis added): the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

Note: while ASC 842-20 indicates that the implicit rate could be zero, it does not provide any examples of situations where this would be the case.

It is not because the leased asset and the ROU (the right to use that asset) are two separate items of which only one, the ROU, is recognized on the balance sheet.

Be that as it may, applying the guidance in practice is actually straight forward.

If the asset can be priced with little effort, the liability equals that market price and an implicit rate is calculated.

If the asset cannot be priced with little effort, the liability equals lease payments discounted using an explicit rate.

IFRS 16.26 | ASC 842-20-30-3 specifies if an implicit rate is not (readily) available, an explicit rate is used instead.

This explicit rate is the lessee's incremental borrowing rate.

The following illustration discusses how to determine this rate.

Since the machine was easy to price, a liability of 12,000 was recognized and a rate of 7% calculated.

As the machine in this illustration was standard and prices of standard machines could be easily confirmed using published price lists, the implicit discount rate was readily determinable. In other words, the ROU and lease liability were measured at the machine's regular sales price and an implicit rate was calculated.

The simplest way to calculate this rate is Excel's rate function: =RATE(nper, pmt, pv, [fv], [type], [guess]):

Where: nper the number of periods, pmt the payment (must be negative), pv (present value) the fair value of the asset, [fv] (future value) should be 0, [type] should be 0 for an advance payment and 1 for an arrears payment, [guess] can be anything or left blank.

In this example, 7.00¯%=RATE(5,-2927,12000,0,0).

It can also be calculated using a present value table and trial and error:

P	Payment	Discount rate	Present value
A	B	C	D = B ÷ (1 + C)^A
1	2.927	7%	2,735
2	2.927	7%	2,556
3	2.927	7%	2,389
4	2.927	7%	2,233
5	2.927	7%	2,087
			12,000

12/31/X1 \| 31.12.X1
Interest expense (leasing)		840
Lease liability		2,087
	Cash		2,927
Depreciation or Amortization		1,800
	Accumulated depreciation or amortization (ROU)		1,800

Whether a depreciation or amortization expense is recognized depends on if the ROU is recognized in PP&E (depreciation) or outside PP&E (amortization).

Technically, a leased asset should be depreciated in IFRS but amortized in US GAAP.

Nevertheless, in practice a leased asset is either depreciated or amortized depending whether it is presented in PP&E or outside of PP&E.

This illustration uses a straight-line depreciation method for the sake of simplicity.

While common in practice, IFRS 16.31 does require lessees to depreciate leased assets as outlined in IAS 16.

While it is implied by this requirement, IAS 16.32 also states that assets to be retained by the lessee are depreciated over their useful lives while assets to be returned to the lessor over their useful lives or the lease term, whichever is shorter. Similarly, IFRS 16.33 specifies that IAS 36 also applies to leased assets, even though this should be obvious.

This implies, if an entity purchases similar assets, it will depreciate the ROU using the same period, method and residual value as those assets.

If the entity does not purchase similar assets, it will depreciated the ROU using the same period, method and residual value it would have used if it had purchased the asset.

For its part, ASC 842-20-35-7 states: A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset's future economic benefits...

This implies, if an entity purchases (could purchase) similar assets, it should depreciate the ROU using the same period, method and salvage value as those assets.

In illustration outlining non-liner depreciation is presented below.

Whether an accumulation account is used depends on if the ROU is recognized in PP&E or outside PP&E.

It also depends on if IFRS or US GAAP is applied.

Even if ROU were classified as intangible, IAS 38.74 requires intangible assets to be carried at cost less any accumulated amortisation.

Thus, unlike US GAAP where an accumulation account is optional, in IFRS it should be used.

Unlike IFRS where ROUs are depreciated, both ASC 842-20-35-7 and 842-20-35-8 specify that they are amortized, reinforcing their intangible nature.

Since the guidance for intangible assets (ASC 350-30) does require accumulated amortization to be recognized, using an accumulation account is optional in US GAAP.

Thus, in practice, it is common to amortize intangible assets directly, without this account.

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B _(B+1)= B - F	C	D = B x C	E	F = E - D
1	12,000	7.00%	840	2,927	2,087
2	9,913	7.00%	694	2,927	2,233
3	7,681	7.00%	538	2,927	2,389
4	5,292	7.00%	370	2,927	2,556
5	2,735	7.00%	191	2,927	2,735
					12,000

31/3/X7 \| 3.31.X7
Accumulated depreciation (ROU)		10,800
Cash		1,250
	Machine (ROU)		12,000
	Asset disposal gain		50

Advance payments

Same facts except payments of 2,735 were paid at the beginning of the year.

1/1/X1 \| 1.1.X1
Machine		12,000
	Cash		2,735
	Lease liability		9,265

Applying the same discount rate to advance payments yields a lower payment.

12/31/X1 \| 31.12.X1
Interest expense		649
Lease liability		2,087
Depreciation expense		1,800
	Accrued lease payment		2,735
	Accumulated depreciation		1,800

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B _(B+1)= B - F	C	D = B x C	E	F = E - D
0	12,000	7.00%	0	2,735	2,735
1	9,265	7.00%	649	2,735	2,087
2	7,178	7.00%	502	2,735	2,233
3	4,945	7.00%	346	2,735	2,389
4	2,556	7.00%	179	2,735	2,556
					12,000

Principal and interest can also be recognized separately:

	Accrued lease payment: Principal		2,087
	Accrued lease payment: Interest		649

1/1/X2 \| 1.1.X2
Accrued lease payment		2,735
	Cash		2,735

Interim entries

Same facts except XYZ made quarterly accruals.

While the effective interest method can be applied with any periodicity, if the payments are annual, common practice is to make interim accruals on a straight-line basis.

3/31/X1 \| 31.3.X1
Interest expense		162
Lease liability		522
Depreciation expense		450
	Accrued lease payment		684
	Accumulated depreciation		450

Initial direct costs

Same facts except XYZ paid DEF 500 to locate the machine and arrange the lease.

As outlined in ASC 842-10-30-9, initial direct costs are included in the measurement of the ROU. These may include (ASC 842-10-30-9.a) commissions paid to third parties. However, as outlined in ASC 842-10-30-10, they may not include costs that would have incurred regardless of whether the lease was obtained. Thus, if XYZ's purchasing department arranged the lease, XYZ would not have capitalized the associated employee salaries.

IFRS 16 defines initial direct costs comparably and IFRS 16.24.c also guides lessees capitalize these costs. It does not, however, specifically discuss commissions or employee salaries.

1/1/X1 \| 1.1.X1
Machine		12,500
	Lease liability		12,000
	Cash		500

12/31/X1 \| 31.12.X1
Interest expense		840
Lease liability		2,087
	Cash		2,927
Depreciation		1,883
	Accumulated depreciation		1,883

Up-front payment

Same facts except XYZ agreed to pay 4,000 up front and 1,951 at the end of each period.

1/1/X1 \| 1.1.X1
Machine		12,000
	Cash		4,000
	Lease liability		8,000

12/31/X1 \| 31.12.X1
Interest expense		560
Lease liability		1,391
	Cash		1,951
Depreciation		1,800
	Accumulated depreciation		1,800

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B _(B+1)= B - F	C	D = B x C	E	F = E - D
0	12,000	7.00%	0	4,000	4,000
1	8,000	7.00%	560	1,951	1,391
2	6,609	7.00%	463	1,951	1,489
3	5,120	7.00%	358	1,951	1,593
4	3,528	7.00%	247	1,951	1,704
5	1,823	7.00%	128	1,951	1,823
					12,000

Operating lease: US GAAP

1/1/X1, XYZ leased equipment agreeing to make 36 monthly payments of 271 and return it at the end of the lease term.

XYZ estimated the asset's useful life to be 6 years and learned the lessor, likewise the equipment's manufacturer, also sold this equipment for 14,000 on average. It classified the lease accordingly.

ASC 842-10-25-3 states (edited, emphasis added): When none of the criteria in paragraph 842-10-25-2 are met ... a lessee shall classify the lease as an operating lease...

ASC 842-10-25-2 (edited):...

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants [a purchase option] the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset...
The present value of [payments] equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset [was made to order for the lessee].

To evaluate the lease, XYZ considered it would not take ownership of the equipment. The agreement did not include a purchase option. The term was for 50% of the equipment's useful life, which was not a major part. The present value of the lease payments was 62% of the equipment's estimated fair value, which was not substantially equal to that value. Finally, while the equipment was highly specialized, it was not made to order. Thus, it could be leased to a different lessee after its return.

Dr/Cr

1/1/X1
Rented equipment (ROU)		8,797
	Cash		271
	Lease liability		8,526

Even if the criteria for finance lease are not met, the lessee still recognizes an ROU and lease liability.

ASC 842-10-25-2 (edited): A lessee shall classify a lease as a finance lease [if any of the following criteria are met]:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants [a purchase option] the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset...
The present value of [payments] equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset [was made to order for the lessee].

As outlined in ASC 842-20-30-1, the lessee always recognizes a lease liability and right-of-use asset.

This applies to all leases except short term leases (ASC 842-20-25-2) if the lessee has elected to apply that exception.

The only difference, the total expense in an operating lease is linear, while in a financial lease it is front loaded.

As outlined in ASC 842-20-25-6.a [operating lease], the lessee recognizes "a single lease cost, calculated so that the remaining cost of the lease ... is allocated over the remaining lease term on a straight-line basis ..."

In contrast, in ASC 842-20-25-5.a [finance lease], it recognizes: "amortization of the right-of-use asset and interest on the lease liability"...

As this in test is calculated using an effective interest method, the aggregate expense (amortization + interest) is front-loaded.

However, while the asset in an operating lease is also an ROU, this term may be unclear to some financial statements users. Using established terminology, like rent, could thus enhance the decision usefulness of the report, which is something the FASB is concerned about.

In ASU 2016-02.BC4 the FASB states: Given the objective of general-purpose financial reporting, the Board also considered the objective of the leases project, which is to increase the decision usefulness ...

Obviously, since the FASB went to the trouble of drafting an entirely new standard to increase decision usefulness, it would be good accounting policy to apply that standard in a way that optimizes this usefulness.

As outlined in ASC 842-20-25-1, the asset recognized in a lease agreement is a "right-of-use asset."

While the leased asset itself is generally tangible, a right conveyed by an agreement is clearly intangible.

ASC 842-20 defines a lease (emphasis added): A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration.

ASC 350-30-20 defines an intangible asset comparably as assets (not including financial assets) that lack physical substance.

ASC 805-20-20 also elaborates that intangible asset arise from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

A lease is an agreement that conveys the right to use an asset. Consequently, the ROU is intangible even if the object of the lease is tangible.

However, if the leased asset is returned, the ROU should not be recognized and reported in PP&E (above).

Instead, the mezzanine is the better alternative.

The FASB XBRL presents FinanceLeaseRightOfUseAsset separately from both PropertyPlantAndEquipmentNet and IntangibleAssetsNetExcludingGoodwill.

This implies the FASB is of the opinion that ROU's should be reported as stand-alone items separate from PP&E and Intangible assets (in the mezzanine).

Unlike the previous examples, where the mezzanine was criticized, since most users view assets to be returned differently than assets to be retained, in this situation, it enhances the decision usefulness of the information and is recommended.

Reading between the lines one realizes that users of financial statements prefer to get their information in the most digestible form possible.

As outlined in ASC 842-20-30-5, the value of the ROU is derived from the value of the lease liability.

As outlined in ASC 842-20-30-5 the cost of the ROU comprises: (a) the lease liability, (b) any initial lease payments and (c) initial direct costs.

From a practical perspective, since the asset and liability must equal, it makes little difference which is measured first.

Under previous GAAP (ASC 840), this expenditure would have been recognized as pre-paid rent.

Under current GAAP (ASC 842-20-30-5.b), it is included in the cost of the ROU.

US GAAP has often been criticized for being rules based while IFRS praised for being principles based.

To address this issue, ASC 842 scraped the rules, replacing them with principles.

In the past, the FASB's standards were not only influenced but often supplemented by the SEC. In the most extreme example, much of the previous guidance on revenue recognition was provided by SAB 104 not ASC 605.

As the SEC has a predilection for precise quantification, older GAAP can include so called "bright lines."

Previous GAAP (ASC 840-10-25-1) stated: A lessee and a lessor shall consider whether a lease meets any of the following four criteria as part of classifying the lease at its inception under the guidance in the Lessees Subsection of this Section (for the lessee) and the Lessors Subsection of this Section (for the lessor):

Transfer of ownership. The lease transfers ownership of the property to the lessee by the end of the lease term. This criterion is met in situations in which the lease agreement provides for the transfer of title at or shortly after the end of the lease term in exchange for the payment of a nominal fee, for example, the minimum required by statutory regulation to transfer title.
Bargain purchase option. The lease contains a bargain purchase option.
Lease term. The lease term is equal to 75 percent or more of the estimated economic life of the leased property. However, if the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.
Minimum lease payments. The present value at the beginning of the lease term of the minimum lease payments, excluding that portion of the payments representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon, equals or exceeds 90 percent of the excess of the fair value of the leased property to the lessor at lease inception over any related investment tax credit retained by the lessor and expected to be realized by the lessor. If the beginning of the lease term falls within the last 25 percent of the total estimated economic life of the leased property, including earlier years of use, this criterion shall not be used for purposes of classifying the lease.

The problem is, this type of guidance provides a roadmap for avoidance. For example, a present value of 90.01% would, in the past, lead to a capital lease while a present value of 89.99% would not .

For this reason, the FASB now tries to avoid bright lines in new and updated standards.

While it tends to make US GAAP somewhat less precise and more subjective, this is the whole point of principles.

They allow practitioners, both accountants and auditors, to take a more holistic view.

For example, if a company had 100 lease agreements with present values ranging 80 to 90%, it is obviously trying to game the system (something a company called Enron was once the past master of), and the entire class would now be recognized as finance lease.

On the other hand if, of those 100 assets, only two or three had fair values in excess of 90% while the rest in the 60% to 70% range, recognized those two or three as a separate class would be pointless.

Note: as ASC 842 eliminated the dramatically different treatment of operating leases, the motivation for applying the guidance creatively has been eliminated.

ASC 842-10-25-2 (edited): A lessee shall classify a lease as a finance lease [if any of the following criteria are met]:

The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
The lease grants [purchase option] the lessee is reasonably certain to exercise.
The lease term is for the major part of the remaining economic life of the underlying asset...
The present value of [payments] equals or exceeds substantially all of the fair value of the underlying asset.
The underlying asset [was made to order for the lessee].

Note: these criteria are identical to those originally outlined IAS 17 and taken, without change, to IFRS 16.

ASC 842 and IFRS 16 are only partially converged.

The last fully converged standards were ASC 606 and IFRS 15, but only when issued.

As the convergence project has ended, the boards no longer issue converged standards. Instead, they merely hold education meetings where they consult one another. Consequently, since they were issued, even ASC 606 and IFRS 15 have drifted apart.

While neither the FASB nor IASB have formally declared that the convergence project is over, the last convergence event (immediately following the SEC's decision to not make a decision on IFRS) listed on the FASB convergence page (link: FASB) was in 2013.

Similarly, in summarizing a recent meeting, the joint session with the FASB was not only just educational, but presented last, as if a footnote (link: IASB).

Reading between the lines, since the SEC lost interest in IFRS, the convergence project is on indefinite, perhaps permanent, hold.

That is not to say IFRS and US GAAP will not continue to be similar. However, expecting them to ever be identical is simply not in the cards as is expecting the SEC to ever adopt IFRS in place of US GAAP.

ASC 842-20-30-5 requires the value of the ROU to be derived from the value of the lease liability.

In addition to the liability itself (sub-paragraph a), the cost of the ROU also comprises:

(b) lease payments made at or before the commencement date (less incentives received) and

Note: IFRS 24.d also specifies that disposal costs should be included in the ROU, while ASC 842-20-30-5 does not.

This should not, however, be interpreted to imply that disposal costs are not recognized under US GAAP.

Instead, it reflects that while IFRS approaches disposal from the perspective of the asset, US GAAP approaches it the perspective of the liability.

Consequently, if an entity expects to incur disposal costs, it would recognize them as outlined in ASC 410-20.

If an implicit rate can be readily determined, the liability is calculated using this rate (above).

ASC 842-20-30-3 requires the liability to be measured by discounting the lease payments using the rate implicit in the lease if this rate is readily determinable.

Note: while ASC 842-20 indicates that the implicit rate could be zero, it does not provide any examples of situations where this would be the case.

However, neither specify how "readily determinable" should be interpreted.

Which, for some sites, represents a practically insurmountable hurdle, but only if they forget to apply the latest update.

Under ASC 840, to use the rate implicit in the lease, the lessee really did need to know the lessor's profit margin. Since lessors rarely shared this information, this really was a Catch 22.

a. It is practicable for the lessee to learn the implicit rate computed by the lessor.

b. The implicit rate computed by the lessor is less than the lessee's incremental borrowing rate.

However, under ASC 842, this is no longer necessary.

Instead, all the lessee needs to know is the regular sales price of the leased asset on the market. It does not need to know that price before a manufacturer's profit or dealer's markup.

Fortunately, readily determinable fair value is defined in ASC 820.

Unfortunates, this definition only applies to equity securities.

Nevertheless, by analogizing from this guidance, "readily determinable" can be interpreted to mean prices for comparable items which can be easily verified using objective, market data.

In other words, fair value is "readily determinable" if it can be found in price lists, blue books or using similar means (a.k.a. on the internet in less than an hour or so).

As XYZ could not readily determine the fair value of the equipment, it used an explicit rate:

While XYZ was able to estimate the manufacturer’s cash selling price, as the equipment was only sold by that one manufacturer, it's fair value was not readily determinable.

Occasionally, companies must acquire assets from a single source.

For example, some chip making equipment is only available from a single manufacturer.

In this situation, the company needs to consider ASC 820-10-35-54I and evaluate if fair value can be determined on the basis of orderly transactions.

Although ASC 820-10-35-54I.b specifically addresses a seller that markets an asset to a single buyer, by analogy the guidance also applies to a buyer that can only source an asset from a single seller.

XYZ also considered, in estimating the average selling price, it only evaluated a few transactions of which it had knowledge not a representative sample of all transactions.

Thus, it concluded it had insufficient information to determine an implicit rate, and used an explicit rate instead.

Consequently, XYZ measured the ROU at present value using its own, incremental borrowing rate.

To determine its incremental borrowing rate, It used an offer from its bank of 7.5%.

As outlined in ASC 842-20-30-3, the explicit rate to be used is the lessee's incremental borrowing rate.

While they do not use identical wording, ASC 842 defines an incremental borrowing rate as the interest a lessee would pay if it borrowed the funds to purchase the asset instead of leasing it.

The simplest way to determine this rate is based on current credit ratings.

ASC 842-20-55-19 presents an example where it considers the rate a lessee with a BBB rating would pay to borrow funds on the market.

However, for a lessee without a rating, an offer from a third party, i.e. a bank, is generally easier than trying to estimate what rating it would be entitled to if it did have a rating.

A rate can be estimated using a model such as: (H(k(t),B(t))) = (α1 ÷ (α2 + N(t) ÷ k(t))μ x θB(t).

Creditworthiness and Thresholds in a Credit Market Model with Multiple Equilibria (link: springer, mirror), Lars Grune, Willi Semmler and Malte Sieveking (2003).

P	Payment	Discount rate	Present value
A	B	C = (1 + 7.5%)^1/12 - 1	D = B ÷ (1 + C)^A
0	271	0.604%	271
1	271	0.604%	269
-	-	-	-
34	271	0.604%	221
35	271	0.604%	219
			8,797
	8,797 - 271 = 8,526

XYZ converted the annual rate to a monthly rate using this formula: monthly rate = (1 + annual rate)^1/12 - 1.

Simply dividing an annual rate by 12, while simple and occasionally done in practice, will yield an inaccurate result.

XYZ converted the annual rate to a monthly rate using this formula: monthly rate = (1 + annual rate)^1/12 - 1.

Simply dividing an annual rate by 12, while simple and occasionally done in practice, will yield an inaccurate result.

Alternatively, it could have also calculated this value manually:

8,797 = (1 + 0.604%) x 271 x (1 - (1 + 0.604%)^-36) ÷ 0.604%

A collection of easy-to-use Excel formulas and functions can be downloaded on our formulas page.

1/31/X1 For simplicity, the payment was made the last day of the period. If it had been made 2/1, an accrued rent expense would have been recognized in January.
Rent expense		271
Lease liability		219
	Cash		271
	Rented equipment (ROU)		219

In contrast to a finance lease (above) where both an amortization and interest expense are reported, in an operating lease only a single expense item is presented.

ASC 842-20-25-6 (edited): After the commencement date, a lessee shall recognize ... a single lease cost, calculated so that the remaining cost of the lease ... is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset ...

To emphasize the difference, this item should be labeled as a Rent or Rental expense.

While ASC 842-20-25-6.a specifies that a lessee will report a single lease cost, it does not specify how this cost should be labeled when recognized and reported.

However, since the FASB's intent was to enhance the decision usefulness of the reported information, using terminology that emphasizes the difference between finance and operating leases, such as referring the latter as rentals, would consistent with its objective.

The reason is, financial statement users do view finance and operating leases differently and would certainly welcome terminology that makes the difference obvious over terminology that disguises it forcing them to dig through the footnotes to find the information.

P	Liability	Discount rate	Adjustment	Rent exp.	Liability amort.
A	B_(B+1)=B-F	C=(1+7.5%)^(1/12)-1	D=BxC	E	F=E-D
0	8,796	0.604%	0	271	271
1	8,526	0.604%	52	271	219
-	-	-	-	-	-
35	269	0.604%	2	271	269
				9,756	8,797

As the lease was classified as operating, an interest expense was not recognized.

Nevertheless, since it still needs to be calculated so the liability can be amortized, XYZ classified it as an adjustment.

As the lease was classified as operating, XYZ recognized the payments as rent expenses.

Specifically, as stated in ASC 842-20-55-29, Example 3 (edited): Lessee determines the cost of the lease to be [9,756] (sum of the lease payments for the lease term and initial direct costs incurred by Lessee). The annual lease expense to be recognized is therefore [271 = 9,756 ÷ 36 = 271].

Note: as XYZ did not incur any initial direct costs, it did not need to adjust for them.

P	Liability	Discount rate	Adjustment	Rent expense	Liability amort.
A	B_(B+1)=B-F	C=(1+7.5%)^(1/12)-1	D=BxC	E	F=E-D
0	8,796	0.604%	0	271	271
1	8,526	0.604%	52	271	219
-	-	-	-	-	-
35	269	0.604%	2	271	269
					8,797

As the lease was classified as operating, an interest expense was not recognized.

Nevertheless, since it still needs to be calculated so the liability can be amortized, XYZ classified it as an adjustment.

As XYZ did not incur any initial direct costs nor receive any lease incentive, and the lease payments were fixed throughout the lease term, it recognized the amortization of the ROU and lease liability at the same amounts.

While both ASC 842-20-55-29 to 30 (Example 3) and ASC 842-20-55-38 to 46 (Example 4) suggest the amortization of the ROU and lease liability should equal, ASC 842-20-35 does not provide explcit guidance on this issue.

However, ASC 842-20-35-7 (Finance Leases) does state (edited, emphasis added): A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset's future economic benefits...

Also, ASC 842-20-25-6 states (edited, emphasis added): After the commencement date, a lessee shall recognize ... a single lease cost, calculated so that the remaining cost of the lease ... is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset ...

This implies an entity could elect to amortize the ROU and liability differntly, for example stragiht line:

1/1/X1
Rented equipment (ROU)		8,797
	Cash		271
	Lease liability		8,526

1/31/X1
Rent expense		271
Lease liability		219
Accrued lease (plug)		25
	Cash		271
	Rented equipment(ROU)		244

10/31/X3
Rent expense		271
Lease liability		268
	Cash		271
	Accrued lease (plug)		23
	Rented equipment (ROU)		244

11/31/X3
Rent expense		271
Lease liability		269
	Cash		271
	Accrued lease (plug)		25
	Rented equipment (ROU)		244

12/31/X3
Rent expense		271
Lease liability		269
	Accrued lease (plug)		26
	Rented equipment (ROU)		514

While arguably more systematic, as it requires a plug account, it is unlikely any company would elect this approach.

Note: for the sake or readability, this illustration does not discuss initial direct costs, lease incentives or step rents. Please see ASC 842-20-55-29 to 30 (Example 3) and ASC 842-20-55-38 to 46 (example 4) for illustrations that mix all these issues together.

12/31/X3
Rent expense		271
Lease liability		269
	Rented equipment (ROU)		540

In the final period, XYZ reduced the value of the ROU by both the liability amortization and final lease payment, which matched up with the first payment that was included in the cost of the ROU (as outlined in ASC 842-20-30-5.b) instead of being expensed.

Indefinite term

XYZ rented office space for an indefinite term at 1,174 per month.

Dr/Cr

Important

Neither IFRS 16 nor ASC 842 specifically address leases with an indefinite term.

The only place the word indefinite appears in IFRS 16 is paragraph B55, but only to remind lessors "an important consideration is that land normally has an indefinite economic life."

In ASC 842, it does not appear at all.

Nevertheless, these terms are common in some jurisdictions so the guidance they do provide must be interpreted.

While XYZ intended to occupy the premises indefinitely, it could terminate at any time with 6 months' notice.

In most agreements, the termination conditions are symmetrical.

If they are not, the party with the longer commitment (IFRS 16.B34 | ASC 842-10-55-23) dictates the term.

For example, if XYZ could terminate with 6 months’ notice but the lessor with 12, the term would be 12 months.

Beyond the 6-month termination period, the agreement did not specify how long rent would remain fixed, only that it could be renegotiated by either party if market conditions changed.

1/1/X1 \| 1.1.X1
Pre-paid rent		1,174
Leasehold (ROU)		7,044
	Cash		1,174
	Lease liability		7,044

As discussed in the explicit rate illustration above, the ROU is derived from the value of the lease liability.

As an indefinite term is not one year or less, XYZ recognized both a lease liability and an ROU.

As outlined in IFRS 16.5.a | ASC 842-20-25-1, lease accounting need not be applied to leases of 12 months or less.

However, this exception can only be applied if the lease agreement specifies the lease term.

If it does not, as in this illustration, the term is indefinite and an indefinite term is not 12 months or less.

However, since the lease did not include any non-renewal penalty and it was not reasonably certain XYZ would remain in the lease for any particular period of time, it measured the liability at 6 x 1,174.

As outlined in IFRS 16.B34 to B41 | ASC 842-10-55-23 to 27, the lease term comprises the non-cancelable period plus any period(s) covered by an option.

The non-cancelable period is determined by evaluating the penalty associated with the lease.

The following illustrations discusses the penalty in more detail.

As outlined in IFRS 16.B34 to B41 | ASC 842-10-55-23 to 27, the lease term comprises the non-cancelable period plus any period(s) covered by an option.

The option period(s) is determined by evaluating if the lessee is reasonably certain to exercise the option.

The following illustrations discusses reasonably certain in more detail.

As it could give notice at any time, XYZ concluded it was only ever obliged to make six payments.

While it did consider the guidance on discounting, XYZ concluded the difference between the sum of 6 payments and their present value was immaterial and recognizing it unnecessary.

While they say it in different ways, both IFRS 16.26 and ASC 842-20-30-1 require the lease liability to be discounted. ASC 842 even mentions discounting in the definition of Lease Liability (IFRS 16 does not include Lease liability in its defined terms).

ASC 835-30-55-2 (edited, emphasis added) states: Generally accepted accounting principles (GAAP) require use of the interest method. There is no basis for using an alternative to the interest method except if the results of alternative methods do not differ materially from those obtained by using the interest method...

While IFRS does not provide similar, specific guidance, IAS 8.8 does state: IFRSs set out accounting policies that the IASB has concluded result in financial statements containing relevant and reliable information about the transactions, other events and conditions to which they apply. Those policies need not be applied when the effect of applying them is immaterial. However, it is inappropriate to make, or leave uncorrected, immaterial departures from IFRSs to achieve a particular presentation of an entity’s financial position, financial performance or cash flows.

Assuming XYZ’s aim was not to achieve a particular presentation of an entity’s financial position, considering materiality in forming its policy was acceptable under IFRS as well.

In normal practice, short-term obligations are rarely discounted.

While neither IFRS nor US GAAP specifically state discounting short-term items is never necessary; they do suggest as much.

For example, ASC 835-30-15-3.a specifically exempts short-term payables, while IAS 37.45 only requires discounting where the effect of the time value of money is material (and ASC 450 does not generally require discounting at all).

Similarly, on the other side of the balance sheet, IFRS 15.63 | ASC 606-10-32-18 excepts short-term receivables (as does ASC 835-30-15-3.h).

1/31/X1 \| 31.1.X1
Rent		1,174
	Pre-paid rent		1,174

2/1/X1 \| 1.2.X1
Pre-paid rent		1,174
Interest expense		N/A
Lease liability		N/A
	Cash		1,174

As the liability was not measured at present value, no interest was recognized.

While it did consider the guidance on discounting, XYZ concluded the difference between the sum of 6 payments and their present value was immaterial and recognizing it unnecessary.

Assuming XYZ’s aim was not to achieve a particular presentation of an entity’s financial position, considering materiality in forming its policy was acceptable under IFRS as well.

In normal practice, short-term obligations are rarely discounted.

While neither IFRS nor US GAAP specifically state discounting short-term items is never necessary; they do suggest as much.

Similarly, on the other side of the balance sheet, IFRS 15.63 | ASC 606-10-32-18 excepts short-term receivables (as does ASC 835-30-15-3.h).

As the liability was not measured at present value, no amortization was recognized.

While it did consider the guidance on discounting, XYZ concluded the difference between the sum of 6 payments and their present value was immaterial and recognizing it unnecessary.

Assuming XYZ’s aim was not to achieve a particular presentation of an entity’s financial position, considering materiality in forming its policy was acceptable under IFRS as well.

In normal practice, short-term obligations are rarely discounted.

While neither IFRS nor US GAAP specifically state discounting short-term items is never necessary; they do suggest as much.

Similarly, on the other side of the balance sheet, IFRS 15.63 | ASC 606-10-32-18 excepts short-term receivables (as does ASC 835-30-15-3.h).

Security deposit

Same facts except XYZ also paid a 3-month security deposit.

1/1/X1 \| 1.1.X1
Pre-paid rent		1,174
Security deposit		3,522
Leasehold (ROU)		7,044
	Cash		4,696
	Lease liability

While the lease liability was not discounted for the reasons outlined above, the security deposit was not discounted because ASC 835-30-15-3 specifically exempts both returnable (such as security deposits) and non-returnable (such as pre-paid expenses) deposits.

Unfortunately, IFRS does not provide a similar, blanket exemption, which leads some to conclude that security deposits ought to be discounted under IFRS.

Nevertheless, since security deposits are exempted in IFRS 15.62.c, even though this guidance specifically addresses security deposits associated with revenue, it could, by analogy, be applied to other security deposits as well.

Insignificant leasehold improvements

Please register to view the remainder of this illustration.

Search form