Lease Accounting Explained Simply: IFRS vs US GAAP

Imagine you rent a car for five years.

Although you do not legally own the car, you are using it almost like an owner. Modern accounting standards recognize this economic reality through lease accounting.

Before understanding the accounting treatment, let’s understand two important terms:

Who is the Lessee and Who is the Lessor?

Lessee: The person or company that rents and uses the asset.
Lessor: The owner of the asset who gives it on rent.

For example, if a company rents office space, the company is the lessee and the building owner is the lessor.

Types of Leases

Leases are broadly classified into:

Finance Lease
Operating Lease

A lease is generally classified as a finance lease when substantially all risks and rewards of ownership are transferred to the lessee.

Common indicators include:

Ownership transfers at the end of the lease.
The lessee has a bargain purchase option.
The lease covers a major portion of the asset’s useful life.
The asset is highly specialized.
The present value of lease payments is substantially equal to the asset’s fair value.

If these conditions are not met, the lease is generally classified as an operating lease.

Lessee Accounting

For CFA candidates, the most important area is lessee accounting.

Finance Lease Accounting

The accounting treatment for a finance lease is largely the same under both IFRS and US GAAP.

Step 1: Calculate Present Value of Lease Payments

The lessee calculates the present value of all future lease payments.

Step 2: Record the Asset and Liability

At the beginning of the lease:

Dr Right-of-Use (ROU) Asset

Cr Lease Liability

The ROU asset represents the right to use the asset, while the lease liability represents the obligation to make future lease payments.

Step 3: Subsequent Accounting

Every year:

The ROU asset is amortized (usually on a straight-line basis).
Interest expense is recognized on the lease liability.
Lease payments reduce the lease liability.

Impact on Financial Statements

Balance Sheet

ROU Asset appears under assets.
Lease Liability appears under liabilities.

Income Statement

Amortization Expense
Interest Expense

Because interest declines over time as the liability reduces, total expense is typically higher in earlier years and lower in later years.

Operating Lease Accounting

This is where IFRS and US GAAP differ.

IFRS Treatment

Under IFRS 16, lessees generally use a single accounting model.

In simple words:

Most operating leases are treated similarly to finance leases.

The lessee records:

ROU Asset
Lease Liability
Amortization Expense
Interest Expense

Therefore, operating leases and finance leases look very similar from the lessee’s perspective under IFRS.

US GAAP Treatment

US GAAP still maintains a separate operating lease model.

The lessee still records:

ROU Asset
Lease Liability

However, the income statement treatment differs.

US GAAP believes that an operating lease is similar to paying rent for the use of an asset. Since the benefit from using the asset is received evenly throughout the lease term, the total lease expense should also be recognized evenly.

Therefore:

Interest expense is calculated internally.
ROU asset amortization is calculated internally.
But the income statement reports only a single lease expense.

The amortization of the ROU asset is adjusted every year so that:

Lease Expense = Interest Expense + ROU Asset Amortization

As a result, the total lease expense remains constant throughout the lease term.

Disclaimer: This article is intended solely for educational and informational purposes. The discussion is based on publicly available information, media reports, company disclosures.