Accounting Treatment of Leases Under IFRS 16 and ASC 842: Balance Sheet Impact and Practical Implications

Lease accounting has undergone a structural shift, bringing most lease commitments onto the balance sheet and changing how companies present assets, liabilities, and performance metrics.

IFRS 16 and ASC 842 were introduced to eliminate off-balance-sheet financing and improve transparency around long-term obligations arising from lease contracts.

This article explains how leases are recognized, measured, and reported in practice, with a focus on balance sheet mechanics, income statement effects, and key differences between IFRS and US GAAP.

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Lease accounting now focuses on control of the right to use an asset.

Both IFRS 16 and ASC 842 are built around the concept of control rather than legal ownership.

A lease exists when a contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

Control requires both the right to obtain substantially all economic benefits from the asset and the right to direct its use.

This definition captures arrangements that previously escaped lease accounting, such as embedded leases in service contracts.

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Initial recognition creates both an asset and a liability.

At commencement date, lessees recognize a right-of-use asset and a corresponding lease liability.

The lease liability represents the present value of future lease payments, discounted using the interest rate implicit in the lease or the lessee’s incremental borrowing rate.

The right-of-use asset initially equals the lease liability, adjusted for prepaid lease payments, initial direct costs, and restoration obligations.

This approach increases total assets and liabilities, affecting leverage ratios and balance sheet structure immediately upon adoption.

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Subsequent measurement affects profit patterns and financial ratios.

After initial recognition, the lease liability is increased by interest expense and reduced by lease payments.

The right-of-use asset is depreciated over the lease term or the useful life of the underlying asset if ownership is expected to transfer.

Under IFRS 16, most leases result in front-loaded expense recognition due to the combination of depreciation and interest.

This pattern contrasts with the straight-line lease expense under previous operating lease models and influences EBITDA, operating profit, and interest coverage ratios.

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IFRS 16 and ASC 842 differ in classification and income statement presentation.

A key divergence between the two standards lies in lease classification for lessees.

IFRS 16 uses a single lessee model, treating almost all leases similarly, with limited exemptions for short-term and low-value leases.

ASC 842 retains a dual model, distinguishing between operating leases and finance leases for income statement purposes.

Although both models recognize assets and liabilities on the balance sheet, expense recognition under US GAAP may remain straight-line for operating leases.

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Practical exemptions reduce complexity but require consistent policy choices.

Both standards allow exemptions for short-term leases, typically those with a term of twelve months or less.

IFRS 16 also provides an exemption for low-value assets, such as small office equipment.

Electing these exemptions avoids balance sheet recognition but requires consistent application across similar contracts.

Inconsistent policy choices can undermine comparability and attract scrutiny from auditors and regulators.

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Lease accounting changes key financial metrics and covenants.

Recognizing lease liabilities increases reported debt, affecting leverage ratios and covenant calculations.

EBITDA typically improves, as former operating lease expenses are replaced by depreciation and interest below EBITDA.

Cash flow presentation also changes, with principal repayments classified as financing cash flows rather than operating.

Companies must reassess debt covenants, performance targets, and stakeholder communication to reflect these structural changes.

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Journal entries illustrate the mechanics of lease accounting.

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Illustrative Journal Entries for Lease Accounting

Transaction	Debit	Credit	Description
Lease commencement	Right-of-use asset	Lease liability	Recognize lease on balance sheet
Periodic interest accrual	Interest expense	Lease liability	Accrue interest on lease obligation
Lease payment	Lease liability / Interest expense	Cash	Settle lease payment
Depreciation of asset	Depreciation expense	Accumulated depreciation	Allocate cost of right-of-use asset

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These entries reflect the economic substance of leasing as a financing decision rather than a simple rental arrangement.

Accurate lease schedules and system support are essential for maintaining ongoing compliance.

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Effective lease management requires coordination beyond accounting.

Lease accounting standards extend their impact beyond financial reporting into procurement, treasury, and operations.

Centralized lease inventories, standardized contract terms, and robust review processes reduce risk and improve data quality.

Organizations that integrate lease considerations into contract negotiation and capital planning gain better control over long-term commitments.

Lease accounting ultimately reinforces the link between operational decisions and financial transparency.

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