Lease Accounting: Classification and Financial Statement Impact
- Graziano Stefanelli
- Jun 17
- 3 min read
Lease accounting is a central component of financial reporting for companies that use or provide assets under lease agreements. Recent changes in both US GAAP (ASC 842) and IFRS (IFRS 16) have significantly increased the visibility of leases on balance sheets, eliminating most off-balance sheet accounting and requiring transparent disclosure of leasing activities. The classification of leases determines how assets, liabilities, expenses, and cash flows are reported and can materially impact key financial metrics.
1. Types of Leases
a) Finance Leases (US GAAP/IFRS) / Capital Leases (Legacy US GAAP)
These leases effectively transfer substantially all risks and rewards of ownership to the lessee. The lessee recognizes a right-of-use (ROU) asset and a lease liability on the balance sheet.
b) Operating Leases
These leases do not transfer ownership risks and rewards. Under the new standards, lessees must still recognize an ROU asset and a lease liability, but expense recognition differs from finance leases.
c) Short-Term and Low-Value Leases
Leases with a term of 12 months or less (short-term) or for low-value assets (such as laptops) may be exempt from balance sheet recognition and are instead expensed as incurred.
2. Lease Classification Criteria
Under US GAAP (ASC 842) and IFRS 16, a lease is classified as a finance lease if any of the following apply:
Ownership transfers to lessee by end of lease term.
Lease includes a purchase option likely to be exercised.
Lease term covers the major part of asset’s economic life.
Present value of lease payments amounts to substantially all of the asset’s fair value.
The asset is specialized and only usable by the lessee.
If none of these criteria are met, the lease is classified as an operating lease.
3. Initial Recognition and Measurement
At Commencement Date:
ROU Asset: Measured at the amount of the lease liability, plus initial direct costs, prepaid lease payments, and restoration costs.
Lease Liability: Present value of unpaid lease payments, discounted at the lease’s implicit rate or the lessee’s incremental borrowing rate.
Journal Entry (at inception):
Dr. Right-of-Use Asset
Cr. Lease Liability
4. Subsequent Measurement
a) Finance Leases
Depreciate the ROU asset over the lease term.
Interest expense is recognized on the lease liability.
Total expense is front-loaded.
Typical Annual Entries:
Dr. Depreciation Expense
Dr. Interest Expense
Cr. Accumulated Depreciation
Cr. Lease Liability (for payment portion)
b) Operating Leases
Single lease expense recognized on a straight-line basis over the lease term.
ROU asset and lease liability are reduced over time.
5. Lessor Accounting
Lessors classify leases as:
Sales-Type Lease: Transfers ownership-like risks and rewards; derecognize the asset and recognize a receivable.
Direct Financing Lease: Similar, but without sales profit.
Operating Lease: Asset remains on lessor’s balance sheet; recognize lease income on straight-line basis.
6. Financial Statement Impact
a) Balance Sheet
Lessees must recognize both ROU assets and lease liabilities (except for short-term/low-value leases).
Operating and finance leases appear similarly on the balance sheet.
b) Income Statement
Finance leases: Amortization of ROU asset and interest expense presented separately.
Operating leases: Single lease expense.
c) Cash Flow Statement
Principal repayments on lease liability classified as financing outflows.
Interest portion may be operating or financing, depending on policy.
Lease payments for short-term/low-value leases classified as operating outflows.
7. Example: Lessee Lease Accounting
Scenario:
Company signs a 5-year equipment lease with annual payments of $20,000. Present value of payments is $90,000.
At inception:
Dr. Right-of-Use Asset $90,000
Cr. Lease Liability $90,000
First year payment (portion):
Dr. Interest Expense
Dr. Lease Liability
Cr. Cash
Depreciation (straight-line):
Dr. Depreciation Expense $18,000
Cr. Accumulated Depreciation $18,000
8. Disclosure Requirements
Both US GAAP and IFRS require detailed disclosures, including:
Nature and terms of leasing arrangements
Maturity analysis of lease liabilities
Expense related to short-term, low-value, and variable leases
Reconciliation of opening and closing ROU assets and lease liabilities
9. Common Issues and Best Practices
Identifying all lease components: Separate non-lease components (maintenance, etc.).
Discount rate selection: Document how the rate is determined.
Reassessment triggers: Significant changes in terms or assumptions require remeasurement.
Disclosure completeness: Include all required qualitative and quantitative data.
10. References
US GAAP: ASC 842 “Leases”
IFRS: IFRS 16 “Leases”
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