IFRS 16 vs ASC 842: How Lessee Accounting Differs, With a Worked Example

The problem both standards solved

Under the older rules (IAS 17 and ASC 840), operating leases stayed off the balance sheet. A company could commit to years of rent payments without showing any related liability. IFRS 16 Leases (effective 2019) and ASC 842 Leases (effective 2019 for public companies, later for private companies) were designed to fix that by putting lease obligations on the balance sheet.

Initial measurement: the same under both

At the commencement date, a lessee measures:

Lease liability: the present value of lease payments not yet paid, discounted at the rate implicit in the lease or, if that cannot be readily determined, the lessee's incremental borrowing rate.
Right-of-use asset: the lease liability plus any initial direct costs, prepaid lease payments and restoration costs, less lease incentives received.

Subsequent measurement: where they split

IFRS 16: one model for every lease

The lease liability is measured at amortised cost, so interest expense is higher in the early years when the balance is larger. The ROU asset is depreciated, usually on a straight-line basis. The total expense is therefore front-loaded.

ASC 842: two models

Finance leases (for example, ownership transfers, or the lease term covers a major part of the asset's economic life) follow essentially the same pattern as IFRS 16: amortisation of the ROU asset plus interest on the liability.
Operating leases recognise a single lease cost on a straight-line basis over the lease term. The ROU asset is reduced by a balancing figure so that the total cost stays level.

Worked example

A company leases equipment for 5 years. Payments are $10,000 per year in arrears, the discount rate is 6%, and there are no initial direct costs or incentives. The lease does not transfer ownership and meets none of the other finance lease criteria, so under ASC 842 it is an operating lease.

Present value of five payments of $10,000 at 6%: $42,124. This is the opening lease liability and ROU asset under both standards.

Expense pattern

Year	Interest (6%)	Depreciation	IFRS 16 total expense	ASC 842 operating lease cost
1	2,527	8,425	10,952	10,000
2	2,079	8,425	10,504	10,000
3	1,604	8,425	10,029	10,000
4	1,100	8,425	9,525	10,000
5	566	8,425	8,991	10,000
Total	7,876	42,124	50,000	50,000

Totals agree at $50,000 (the cash paid), but the timing differs. IFRS 16 shows a higher expense in the early years; ASC 842 operating lease cost is flat.

Year 1 journal entries under IFRS 16

Account	Debit	Credit
Right-of-use asset	42,124
Lease liability		42,124
Commencement
Interest expense	2,527
Lease liability	7,473
Cash		10,000
Payment at year end
Depreciation expense	8,425
Accumulated depreciation: ROU asset		8,425

Effect on financial statements and ratios

Item	IFRS 16	ASC 842 operating lease
Balance sheet	ROU asset and lease liability	ROU asset and lease liability
Income statement	Depreciation (operating) plus interest (finance cost)	Single lease cost within operating expenses
EBITDA	Higher, because no lease cost sits above EBITDA	Lower, because the lease cost is an operating expense
Cash flow statement	Principal in financing; interest per entity policy	Generally all in operating activities

This is why the same lease can make an IFRS reporter look more profitable at the EBITDA level than an otherwise identical US GAAP reporter, while their balance sheets look similar.

Exemptions and practical expedients

Relief	IFRS 16	ASC 842
Short-term leases (12 months or less, no purchase option likely to be exercised)	Optional exemption	Optional exemption
Low-value assets (for example, laptops or office furniture)	Optional exemption, applied lease by lease	No equivalent exemption
Private companies using a risk-free rate	Not available	Available as an election

Practical points

Lease term includes renewal periods the lessee is reasonably certain to exercise, which requires judgement and regular reassessment.
Variable payments linked to sales or usage are generally excluded from the lease liability and expensed as incurred; payments linked to an index or rate are included.
Separating components: both standards allow lessees to elect not to separate non-lease components (such as maintenance) from the lease component, by class of asset.

Application scenarios

Scenario 1: Office lease with a renewal option

Situation. A company signs a 5-year office lease with an option to renew for another 5 years at market rent. It has just spent heavily on leasehold improvements with a 10-year useful life, and relocating would disrupt operations.

Analysis. The lease term includes optional periods the lessee is reasonably certain to exercise. Significant leasehold improvements and high relocation costs are strong economic incentives to renew, so the lease term is likely 10 years. This roughly doubles the lease liability compared with using 5 years. The assessment is revisited if a significant event within the lessee's control changes the incentive.

Scenario 2: Landlord agrees to reduce the rent

Situation. Two years into a 5-year lease, the landlord agrees to cut the annual rent from $10,000 to $8,000 for the remaining 3 years. Nothing else changes.

Analysis. This is a lease modification that is not a separate lease. Under IFRS 16, the lessee remeasures the lease liability using the revised payments and a revised discount rate at the modification date, with a matching adjustment to the right-of-use asset (no gain or loss is recognised, because the scope is unchanged). Under ASC 842, the lessee also remeasures the liability using an updated rate and reassesses lease classification at the modification date.

Scenario 3: Short-term warehouse and office laptops

Situation. A company rents extra warehouse space for 6 months during peak season and leases 40 laptops on a 3-year contract.

Analysis.

Lease	IFRS 16	ASC 842
6-month warehouse	Short-term exemption available: expense payments on a straight-line basis	Short-term exemption available: same treatment
Laptops	Low-value asset exemption can be applied lease by lease	No low-value exemption; recognise on balance sheet unless immaterial under the entity's policy

Summary

IFRS 16 and ASC 842 agree that leases belong on the balance sheet. They disagree on how the cost should flow through the income statement. When comparing companies across frameworks, or converting a set of accounts from one framework to the other, the operating lease line is often one of the largest reconciling items.

This article is for general educational purposes and reflects the author's understanding of the standards at the date shown. Always refer to the authoritative text of the standards and seek professional advice for specific situations.