Both leases and rentals allow one party, the lessee / rentee, to use an asset owned or controlled by another party, the lessor / rentor. The difference, lease agreements cover a long period of time, while rental agreements do not.
For example, a lessor may lease a building from its owner and sub-lease individual units to sub-lessees.
As far as the guidance is concerned, no difference between rent and lease exists.
IFRS 16 defines a lease: 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.
Similarly, ASC 842 defines a lease: a contract, or part of a contract, that 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.
Thus, while not identical in how they define the object of a lease, the standards do agree that a right to use an asset for a period of time, any period of time, whether specified or not, is a lease.
Nevertheless, if the arrangement is for one year or less, lease accounting is not mandatory.
As outlined in IFRS 15 5.a | ASC 842-20-25-2, lease accounting is mandatory only if the term exceeds one year.
IFRS 16.5.b includes a second exception for low-valued assets.
Further discussion of this issue, including how to quantify "low value," is included in the illustrations that follow.
ASC 842 does not provide a similar exception.
Note: it is also possible for an agreement to specify an indefinite term. However, as this is common mostly with real estate, illustrations of how to account for this type of agreement are provided in the real estate section below.
If an entity elects to apply this exception, it should account for the item as a rental rather than a lease.
1/1/X1, ABC "rented" an automobile for one year while XYZ "leased" an identical vehicle for 12 months.
As noted above, there is no difference between a rental and a lease from an IFRS | US GAAP perspective.
However, it is good practice to refrain from labeling arrangements as "leases" unless they are accounted for as leases.
While IFRS 15 5.a | ASC 842-20-25-2 include an exception for short-term leases, as this is an exception, entities may elect account for any arrangement that meets the definition of lease using lease accounting.
IFRS 16 defines a lease: 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.
Similarly, ASC 842 defines a lease: a contract, or part of a contract, that 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.
Thus, while not identical in how they define the object of a lease, the standards do agree that a right to use an asset for a period of time, any period of time, whether specified or not, is a lease.
Both agreed to pay the vehicle’s owner 342 at the end of each month.
Although arrears payments are uncommon, they offer a clearer illustration of the accounting treatment.
The accounting for advance payments is shown in the explicit rate example below.
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1/31 to 12/31/X1 | 31.1 to 31.12.X1 |
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342 |
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Cash |
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342 |
While rent expense is not a defined term, recognizing and reporting an item using this label is consistent with the intent of the guidance.
IFRS 16 | ASC 842 does not draw a distinction between a lease and a rent implying that all these arrangements should be recognized and reported as leases.
Nevertheless, since "rent" is commonly used in practice, adding a rent expense account to the COA and a rent expense line item to the P&L | IS aligns with the intent of the guidance.
Decision usefulness is important to the FASB.
Specifically, in the basis for conclusion to ASU 2016-02.BC4 it states (edited, emphasis added): Given the objective of general purpose financial reporting, the Board also considered the objective of the leases project, which is to increase the decision usefulness and comparability among organizations ... Most users already make adjustments that are often based on incomplete information to a lessee’s reported statement of financial position to capitalize operating leases when operating leases are significant to the lessee.
While the IFRS 16 BC does not mention decision usefulness, the discussion it does provide implies decision usefulness is just as important to the IASB.
In IFRS 16.BC3.a, the IASB notes "many users adjusted a lessee's financial statements to capitalise operating leases because, in their view, the financing and assets provided by leases should be reflected on the statement of financial position..." implying it adopted the new guidance for the same reason as the FASB.
Note: while the respective XBRLs do include items such as RentDeferredIncome or PrepaidRent, neither include Rent in the P&L | IS. This implies, if an entity elects to recognize an item as a rental, it will need to add a Rent account in its COA and a Rent extension to its XBRL tagged report.
Also note: while it does not include an IS item, the FASB XBRL does include PaymentsForRent as a SCF item.
Note: this expense would be reported to reflect how the vehicle was used. For example, it was used by management, it would be reported in administrative expenses. If the automobile was also available for the employee’s personal use, a portion of the expense would be reported in employee benefits as a perquisite.
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While a short-term ROU could theoretically be recognized, it is not good accounting.
As outlined in IFRS 16.23 | ASC 842-20-25-1, the asset recognized due to a lease arrangement is a "right-of-use asset," commonly abbreviated as ROU (not ROU asset or ROUA). This is because, while the underlying asset is practically always tangible, a right conveyed by an agreement is clearly intangible.
In a subtle difference, IFRS 16 defines a lease (emphasis added): 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.
In contrast, ASC 842-20 defines a lease (emphasis added): A contract, or part of a contract, that 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.
This implies, while an "underlying asset" could be intangible, an "identified asset" will always be tangible.
IFRS 16.4 reinforces this distinction by specifying that intangible assets may be treated as leases (ROUs), except in cases where they function as licenses (e.g., for motion pictures, manuscripts, or copyrights).
Both IFRS 38 Definitions and ASC 350-30-20 define intangible assets comparably as assets, not including financial assets, lacking physical substance.
Both IAS 38.12.b and ASC 805-20-20 also elaborate that intangible assets arise from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
A lease is an agreement that conveys the right to use an asset. Consequently, the ROU is intangible even if the object of the lease is tangible.
As outlined in IFRS 16.6 | ASC 842-20-25-2, if a lease is short-term (has a term of 12 months or less) it does not need to be accounted for as a finance lease. As this is an exception, a lessee could decide to account for all leases as leases regardless of duration. However, this practically never, for reasons outlined below, happens in practice.
Decision usefulness is a key consideration.
Decision usefulness is important to the FASB.
Specifically, in the basis for conclusion to ASU 2016-02.BC4 it states (edited, emphasis added): Given the objective of general purpose financial reporting, the Board also considered the objective of the leases project, which is to increase the decision usefulness and comparability among organizations ... Most users already make adjustments that are often based on incomplete information to a lessee’s reported statement of financial position to capitalize operating leases when operating leases are significant to the lessee.
While the IFRS 16 BC does not discuss decision usefulness, IFRS 16.BC3.a does note: Many users adjusted a lessee's financial statements to capitalise operating leases because, in their view, the financing and assets provided by leases should be reflected on the statement of financial position ...
Thus, while the IASB does not specifically mention decision usefulness, the discussion it does provide implies decision usefulness is just as important to it as to the FASB.
As financial statement users do not consider short-term leases to be leases, capitalizing them, while not prohibited, is not good accounting.
As most users do not consider items leased for a short-term to be assets, capitalizing such items is not good policy.
The aim of this illustration is simply to show the difference between the accounting for rentals and leases.
It does not suggest short-term leases should be capitalized.
Don't do it!
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1/1/X1 | 1.1.X1 |
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The key reason IFRS 16 | ASC 842 replaced IAS 17 | ASC 840 was that the latter gave companies considerable latitude in classifying leases as operating rather than finance | capital.
This latitude was used, some say abused, to keep vast amounts of assets and liabilities off the balance sheet and was the personal bugbear of Sir David Tweedie, the first IASB chairman, who vowed to stamp out this abuse and who retired, presumably a happy man, once the mission had been accomplished.
Ironically, while the IASB took the lead on this convergence issue, IFRS is softer than US GAAP, even though US GAAP (nominally) held on to operating leases.
In addition to an exception for short term leases, IFRS 16.5.b also exempts low-valued assets.
As this exemption does not consider the materiality of the exempted items with respect to the entity (IFRS 16.B4), companies can recognize large numbers of low value assets without having to recognize either them, or the associated liabilities, on the balance sheet.
As ASC 842-20-25 does not include a similar "small asset" exception, this is an IFRS only issue.
Although ASC 842-20-25-6 requires some leases to be recognized as operating, the only difference between this paragraph and ASC 842-20-25-5 is it allows expenses to be reported straight-line instead of using the effective interest method, which leads to them being front-loaded as illustrated below.
It does not exempt lessees from reporting an asset and liability (the way superseded ASC 840 did).
As outlined in IFRS 16.24 | ASC 842-20-30-5, the value of the ROU is derived from the value of the lease liability.
As outlined in IFRS 16.24 | ASC 842-20-30-5, the cost of the ROU comprises: (a) the lease liability, (b) any initial lease payments, (c) initial direct costs and (d) disposal costs.
Note: while disposal costs are only specifically mentioned in IFRS 16.24, they would be recognized in US GAAP.
Also note: the reason they are not discussed in ASC 842 is that US GAAP approaches them from the perspective of the liability, while IFRS from the perspective of the asset. While interesting, this difference does not, however, have a palpable effect on accounting practice. The differences that do have an impact are discussed at the end of this page. Differences in IFRS | US GAAP's approach to provisions | contingent liabilities in general is discussed on this page.
Under previous GAAP, the procedure was reversed. The value of the liability was derived from the value of the asset. Specifically, IAS 17.20 used a fair value or present value whichever was lower approach, while the approach in ASC 840-30-30-3 was present value or fair value whichever was lower.
From a practical perspective, since the asset and liability must equal, it makes little difference which is measured first.
Nevertheless, occasionally, such as if a lease term is not defined or indefinite, keeping in mind that the liability comes first makes applying the guidance easier. An illustration of this is provided in the real estate section below.
XYZ calculated the ROU's value using this schedule:
Perhaps the simplest way to calculate present value is using the schedule below.
It can also be determined using Excel's present value function =PV(rate, nper, pmt, [fv], [type]).
Note, the rate must correspond to the periodicity of the payment. In this example, the annual rate needs to be converted to a monthly rate: 0.604¯% = (1 + 7.5%)1/12 - 1 (simply dividing by 12 will not yield an accurate result).
Present value may also be calculated using this formula (in Excel syntax):
=C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1+1))/((1+D1)^(1/B1)-1))+C1
Where: A1 = number of annual periods, B1 = number of interim periods, C1 = the payment, D1 = the annual rate.
For a payment in arrears the formula is:
=C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1))/((1+D1)^(1/B1)-1))
To prevent rounding errors, it is good to round the result.
=ROUND(C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1+1))/((1+D1)^(1/B1)-1))+C1,2)
=ROUND(C1*((1-(1+((1+D1)^(1/B1)-1))^(-A1*B1))/((1+D1)^(1/B1)-1)),2)
These formulas and others like them can be downloaded on the formulas page.
Under IFRS 16.24.a | ASC 842-20-30-5, unlike IAS 17 / ASC 840, the value of the ROU is derived from the liability rather than the leased asset.
As outlined in IFRS 16.26 | ASC 842-20-30-1, the liability is measured at the present value of lease payments.
In this illustration, that value was determined using an (annual) discount rate of 7.5%.
Further discussion on how to determine an appropriate discount rate is included in the illustrations that follow.
P |
Payment |
Discount rate |
Present value |
A |
B |
D = B ÷ (1 + C)A |
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1 |
342 |
0.604% |
340 |
2 |
342 |
0.604% |
338 |
- |
- |
- |
- |
11 |
342 |
0.604% |
320 |
12 |
342 |
0.604% |
318 |
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3,947 |
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XYZ converted the annual rate to a monthly rate using this formula: monthly rate = (1 + annual rate)1/12 - 1.
Simply dividing an annual rate by 12, while simple and occasionally done in practice, will yield an inaccurate result.
1/31/X1 | 31.1.X1 |
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329 |
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24 |
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342 |
Whether a depreciation or amortization expense is recognized depends on if the ROU is recognized in PP&E (depreciation) or outside PP&E (amortization).
Technically, a leased asset should be depreciated in IFRS but amortized in US GAAP.
Specifically, IFRS 16.31 states: A lessee shall apply the depreciation requirements in IAS 16 Property, Plant and Equipment in depreciating the right-of-use asset... while ASC 842-20-35-7 states: A lessee shall amortize the right-of-use asset on a straight-line basis ...
Nevertheless, in practice an ROU is either depreciated or amortized depending whether the leased asset is presented in PP&E or outside of PP&E as discussed in more detail above.
XYZ elected to depreciate / amortize the asset straight-line to a zero residual | salvage value: 3,947 ÷ 12 = 328.92.
Whether an accumulation account is used depends on if the ROU is recognized in PP&E or outside PP&E.
It also depends on if IFRS or US GAAP is applied.
As outlined in IFRS 16.31, an ROU is accounted for according to IAS 16 where IAS 16.6 defines carrying amount as cost less accumulated depreciation and IAS 16.73.d requires accumulated depreciation to be disclosed.
Even if ROU were classified as intangible, IAS 38.74 requires intangible assets to be carried at cost less any accumulated amortisation.
Thus, unlike US GAAP where an accumulation account is optional, in IFRS it should be used.
Unlike IFRS, where ROUs are depreciated, both ASC 842-20-35-7 and 842-20-35-8 specify they are amortized, reinforcing their intangible nature.
Since the guidance for intangible assets (ASC 350-30) does not require accumulated amortization to be recognized, using an accumulation account is optional under US GAAP but not under IFRS.
This schedule illustrates the amortization of the liability using the effective interest method.
However, if this transaction were recognized under US GAAP, it would be classified as an operating lease, and a straight-line expense would be recorded. An illustration of the GAAP for operating leases is presented below.
P |
Liability |
Discount rate |
Payment |
Liability amortization |
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A |
B(B+1)=B-F |
C |
D=BxC |
E |
F=E-D |
1 |
3,947 |
0.604% |
24 |
342 |
318 |
2 |
3,629 |
0.604% |
22 |
342 |
320 |
- |
- |
- |
- |
- |
- |
11 |
678 |
0.604% |
4 |
342 |
338 |
12 |
340 |
0.604% |
2 |
342 |
340 |
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3,947 |
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As outlined in IFRS 16.36 | ASC 842-20-35-1, the lessee should increase the liability to reflect interest and decrease it to reflect the payment. If payment is made at the end of the period, as in this example, recognizing a liability amortization achieves the same result.
12/31/X1 | 31.12.X1 |
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329 |
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329 |
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340 |
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2 |
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342 |
If an accumulated depreciation or amortization account had been used, the asset would need to be derecognized.
12/31/X1 | 31.12.X1 |
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3,947 |
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3,947 |
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If it was depreciation / amortized directly, this step would not be necessary.
Finance lease vs. operating lease
In the past, IFRS (IAS 17) and US GAAP (ASC 840) allowed operating leases to be treated as if they were rentals (above).
Currently, IFRS 16 no longer recognizes operating leases.
It does, however, include an exception for short-term leases and leases of low value assets.
If either exception is applied, the lease is accounted for as if it were a rental (above).
While ASC 842 does, its updated guidance has eliminated practically all the differences.
Lessee
1/1/X1, XYZ leased a standard production machine. It agreed to make 5 annual payments of 2,927 (in arrears). At the end of the lease term, title to the machine passed to XYZ. On average, XYZ uses comparable machines it purchases outright for 6 years, after which it sells them for 10% of their acquisition cost. It actually sold the machine for 1,250 on 3/31/X7.
Although arrears payments are relatively uncommon, they better illustrate the accounting treatment.
The accounting for advance payments is shown in the explicit rate example below.
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