Last Updated on October 6, 2022 by Morgan Beard
Two new accounting standards put in place within the last three years have forever changed the way businesses report their lease agreements. IFRS 16 and ASC 842 were designed to ensure transparency between lessees and their investors. While these new standards may ultimately achieve transparency in investor relations, sweeping changes such as these may also create frustration and confusion in accounting departments. There are some clear differences between IFRS 16 vs. ASC 842 that companies will need to understand.
In this blog, we will demystify the IFRS 16 and ASC 842 standards by explaining what they are and how they apply to your business. Discover which of them applies to your business and how to report and calculate the value of your assets.
What is ASC 842?
ASC 842 is the new lease accounting standard created by the Financial Accounting Standards Board (FASB) and required by all organizations that follow generally accepted accounting principles (GAAP). As GAAP is the U.S. reporting standard, ASC 842 will apply to U.S. based businesses.
Under ASC 842, “a contract is or contains a lease if the contract 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.”
Some of the most common leasable assets are among the most crucial to organizations conducting business. Examples would include:
- Buildings and other real estate
- Computers and other IT equipment
- Fitness equipment
- Medical equipment
ASC 842 makes some changes in terms of what it means to control the use of an identified asset from a reporting standpoint.
What is IFRS 16?
IFRS 16 is the new lease accounting standard put in place by The International Accounting Standards Board (IASB) in January 2019. This accounting standard is used in the European Union, and many South American and Asian companies. International Financial Reporting Standard, IFRS, is not currently accepted in the United States, where GAAP is the preferred standard. However, multinational companies with a U.S. presence use it.
IFRS 16 defines a lease as “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.”
IFRS 16 vs. ASC 842 Similarities
The main similarity between the two standards is intent. If you understand why the FASB and IASB put the new standards in place, then it’s easier to grasp what the standards have in common.
Both standards aim to maintain transparency in reporting from lessees to their investors. This means bringing all leased assets on the balance sheet and reporting them as assets and liabilities. Off-balance sheet operating leases are a thing of the past. Why? While classifying an agreement as an operating lease and writing an asset off as an operational expense is beneficial for a business from a tax standpoint, it can mislead investors as to the company’s financial outlook.
Both standards aim to maintain transparency by bringing all assets on the balance sheet. Under ASC 840, you’d have been within your rights to use off-balance leasing to your advantage. However, as of December 2021, any operating leases would need to be on the balance sheet.
Another commonality between IFRS 16 and ASC 842 is that both have short-term lease exemptions for leases shorter than 12 months. This means that these short-term leases can still be treated as off-balance sheet expenses under both new standards.
Also, both IFRS and ACS 842 delineate exemptions on a variety of other types of leases, including overlap on leases to explore for or use nonregenerative resources such as minerals, oil or natural gas.
IFRS 16 vs. ASC 842 Differences
Comparing IFRS 16 vs. ASC 842 reveals the following main differences between the two standards:
IFRS 16, the international standard, originates from The International Accounting Standards Board, and ASC 842 comes from the Financial Accounting Standards Board. Each board has a unique approach to accounting, which is reflected in the way its new code is written.
Recall that IFRS is the international accounting standard, and ASC is the approach used in the U.S by organizations that use GAAP. IFRS 16 went into effect on January 1st, 2019, and ASC 842 was effective on fiscal years starting on or after, December 15th, 2021.
IFRS 16 Has Removed the Operating Lease
One key difference between IFRS 16 and ASC 842 is the treatment of the operating lease. Under IFRS 16, all leases are now classified as finance leases, with the operating lease being eliminated.
Under ASC 842, the operating lease still exists. The bargain purchase option criteria have been eliminated. Also, 75% of lease terms and 90% of FMV rules are no longer definitive. The FASB recommends that companies use these numbers as thresholds while developing their own policies.
Right of Use Assets’ Calculations
As mentioned above, both IFRS 16 and ASC 842 require lessees to record their agreements on the balance sheet. Lessees are also required to go one step further by recording non-monetary assets as right of use (ROU) assets. So, the right to use the asset is now treated as an intangible asset.
Calculating right-of-use assets is slightly different under each of these new standards.
Under ASC 842
Right-of-use asset: = lease liability + initial direct costs + prepayments – lease incentives
Lease liability means the company’s finance lease obligation at the present date. Initial direct costs are those costs incurred because of the lease being executed, such as documentation fees, commissions, and legal fees. Prepayments are advance payments. Lease incentives would be any payment the lessor gives to the lessee to induce them into entering a contract.
Under IFRS 16
Right-of-use asset = lease liability + prepayments + direct costs – lease incentives + estimated costs for restoration or removal/disposal
The estimated costs for restoration and removal/disposal are different here. IFRS 16 introduces the single lessee accounting model which stipluates that all leases must have their ROU asset and lease liability accounted for.
Low-value Threshold Exemption
While both IFRS 16 and ASC 842 require lessees to record agreements over 12 months, IFRS 16 offers a “low value” exemption. Under IFRS, lessees will not be required to account for agreements under $5,000. This may come as a relief to smaller companies and startups seeking micro-leases.
Indexed Leases Under IFRS 16
Under IFRS 16, variable lease payments linked to a consumer price index must be adjusted each time the index changes. However, companies will not need to make these changes under ASC 842.
The Impact of IFRS 16 vs. ASC 842 on Lessors
The effects of IFRS 16 vs. ASC 842 are primarily on lessees. Bringing leases onto the books that weren’t required to be in previous years. It is going to have a major impact. For lessors, it’s mostly a matter of wording.
ASC 842 for Lessors
Leases will be classified as one of a sales-type lease, a direct financing lease, or an operating lease. Sales type and direct financing leases operate similarly from an accounting perspective. Let’s get a little more granular as we start with sales-type and direct financing and then move to operating leases.
On the balance sheet, the underlying assets will be recognized as net investments and derecognized as assets. On the income statement, selling profit will be recognized at the end of the lease (commencement) for sales-type leases and over the lease term for direct financing. Selling losses will be recognized at commencement for both sales type and direct financing. On the cash flow statement, cash received from leases will be shown as operating cash flows for both agreements.
On the balance sheet, lessors will continue recognizing the underlying asset for operating leases. The income statement will be recorded on a straight-line basis over the lease term. Cash flow is classified as operating cash flows.
IFRS 16 for Lessors
While IFRS has done away with the distinction between the operating and finance lease for lessees. Lessor accounting must classify their agreements as either an operating lease or a finance lease.
Another change that distinguishes IFRS 16 from ASC 842 is subleasing, and this has to do with the new right-to-use asset standards discussed above. The sub-lease rules are:
- If the head lease is accounted for as a short-term lease, the sublease is classified as an operating lease.
- Otherwise, the sublease is classified by reference to the right-of-use asset arising from the head lease rather than by reference to the underlying asset.
The length of the lease determines whether the lease is a finance lease or an operating lease. Also, recall how the right-of-use is an asset under IFRS 16, meaning the sublease is the underlying asset.
The changes for lessors aren’t as significant as they are for lessees, but they should still be noted.
IFRS 16 vs. ASC 842 Takeaways
FASB and IASB have instituted these changes to ensure reporting clarity between organizations and their investors. Understanding the IFRS 16 vs. ASC 842 differences helps ensure that your organization accounts for its leasable assets correctly in the future.
Unless your company is a multinational corporation with a U.S. presence, it is unlikely that you will be using both IFRS 16 and ASC 842. If you are in the U.S. and your organization follows GAAP, then you should use ASC 842. If you are in a foreign country, then IFRS 16 will more than likely apply.
One significant change to both standards that your organization will need to consider is recording the right of use and then calculating the asset up-front correctly. You’ll also need to consider that all leases (minus exemptions) will need to go on the balance sheet and how this will affect your financial statements.
As well as knowing the IFRS 16 vs. ASC 842 differences, it’s crucial that you know which standard you’re working with because there are significant differences between reporting, including how operating leases, exemptions, and variable lease payments are treated.
While IFRS has been in place for three years, ASC 842 is still relatively new. Contact us today if you or your accounting department have questions about either one that we can help with.