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Overall

Rent vs. lease

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 sublease 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.

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.

ABC / XYZ

1/31 to 12/31/X1 \| 31.1 to 31.12.X1
Rent expense		342
	Cash		342

While "rent expense" is not a defined term, recognizing and reporting this item aligns with common accounting practice and not inconsistent 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.

Important

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 leased object 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.

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!

1/1/X1 \| 1.1.X1
~~ROU: Automobiles~~		3,947
	~~Lease liability~~		3,947

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 also 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	C = (1 + 7.5%)^1/12 - 1	D = B ÷ (1 + C)^A
1	342	0.604%	340
2	342	0.604%	338
-	-	-	-
11	342	0.604%	320
12	342	0.604%	318
			3,947

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
~~Depreciation or Amortization~~		329
	~~ROU: Accumulated depreciation~~		329
~~Lease liability~~		318
~~Interest expense~~		24
	~~Cash~~		342

Whether a depreciation or amortization expense is recognized depends on the ROU's classification: 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 on whether the leased asset is presented in PP&E or outside 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 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 is 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	Interest expense	Payment	Liability amortization
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
					3,947

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
~~Depreciation or Amortization~~		329
	~~ROU: Accumulated depreciation~~		329
~~Lease liability~~		340
~~Interest expense~~		2
	~~Cash~~		342

If an accumulated depreciation or amortization account had been used, the asset would need to be derecognized.

12/31/X1 \| 31.12.X1
~~ROU: Accumulated depreciation~~		3,947
	~~ROU: Automobiles~~		3,947

If it was amortized directly as possible in US GAAP, 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.

Under ASC 840, operating leases were accounted for as if they were rentals (above).

Under ASC 842, they are treated like finance leases except for how interest expense is recognized (below).

Note: unlike IFRS 16, ASC 842 does not provide an exception for low-value assets.

Lessee

Implicit rate

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.

Dr/Cr

1/1/X1 \| 1.1.X1
PP&E: Machinery and equipment: Machine (ROU)		12,000
	Lease liability		12,000

As outlined in IFRS 16.23 | ASC 842-20-25-1, the asset recognized in a lease agreement is a "right-of-use asset."

While the leased asset itself is generally tangible, a right conveyed by an agreement is clearly intangible.

This implies, while an "underlying asset" could theoretically be intangible, an "identified asset" will always be tangible.

As outlined in IFRS 16.4, leases of intangible assets may, but are not required to, be accounted for as leases (ROUs). However, this does not apply to, as specified in IFRS 16.3.e, leases of licenses (e.g. for motion pictures, videos, plays, manuscripts, patents or copyrights), which cannot be ROUs.

Both IFRS 38 Definitions and ASC 350-30-20 define intangible asset comparably as assets (excluding financial assets) that lack physical substance.

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.

Nevertheless, if the asset is retained, recognizing and reporting it as intangible is frowned upon, as is the mezzanine level.

From an IFRS perspective, the most common justification for not recognizing and reporting ROUs as intangible assets is IFRS 16.31, which requires an ROU to be depreciated as outlined in IAS 16 (rather than amortised as outlined in IAS 38) implying an ROU belongs in PP&E.

From a US GAAP perspective, ASC 842-20-35-7 refers to amortization (not depreciation) and establishes the straight-line method as a default (like ASC 350-30-35-6 does for intangible assets). This suggests an ROU belongs in intangible assets.

However, if the asset is retained, this would require derecognizing an intangible asset and rerecognizing PP&E at the end of the lease term.

Of course, an accounting inconvenience alone does not justify misapplying the guidance.

More importantly, such policy would contradict the FASB's intent.

As stated in ASU 2016-02.BC4: 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 by recognizing lease assets and lease liabilities on the statement of financial position and disclosing key leasing information. For example, users of financial statements are interested in obtaining information about a lessee’s leasing activities, in general, to assess the cash flows, returns, and capital structure of the lessee and to assess the lessee’s ability to meet financial commitments. 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.

Reading between the lines, it becomes clear that financial statement users prefer information in the most digestible form possible.

So, if users can compare two companies, one that leases its assets and one that buys them on credit, by simply laying their two balance sheets side by side, they will be more satiated than if they have to chew through gristle hidden in the footnotes.

Thus, from both an IFRS and US GAAP perspective, since this accounting policy increases decision usefulness without violating any explicit guidance, there is no reason a leased asset should not be recognized and reported in PP&E.

In the 2023 revision to its XBRL, the IASB introduced PropertyPlantAndEquipmentIncludingRightofuseAssets and RightofuseAssets.

Similarly, the FASB XBRL also presents FinanceLeaseRightOfUseAsset separately from both PropertyPlantAndEquipmentNet and IntangibleAssetsNetExcludingGoodwill.

This implies that both boards are of the opinion that ROUs should be reported as stand-alone items separate from both PP&E and Intangible assets (in the mezzanine).

That said, using a mezzanine level implies indecision, which makes some users of financial information antsy.

So, since neither IFRS 16 nor ASC 842 explicitly prohibit recognizing and reporting ROUs as PP&E, doing so would not violate the guidance.

IFRS 16.47 merely states: A lessee shall either present in the statement of financial position, or disclose in the notes:

right-of-use assets separately from other assets. If a lessee does not present right-of-use assets separately in the statement of financial position, the lessee shall:
1. include right-of-use assets within the same line item as that within which the corresponding underlying assets would be presented if they were owned; and
2. disclose which line items in the statement of financial position include those right-of-use assets.
lease liabilities separately from other liabilities. If the lessee does not present lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those liabilities.

Also, IFRS 16.53.j states: the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset.

This is often interpreted as meaning that an ROU should be reported alongside similar PP&E items.

This interpretation is further reinforced by IFRS 16.31: "A lessee shall apply the depreciation requirements in IAS 16 Property, Plant and Equipment in depreciating the right-of-use asset, subject to the requirements in paragraph 32" suggesting that an ROU is a type of PP&E and should be treated as such.

ASC 842-20-45-1 merely states: A lessee shall either present in the statement of financial position or disclose in the notes all of the following:

Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets
Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities.

Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position.

ASC 842-20-45-2 states: If a lessee does not present finance lease and operating lease right-of-use assets and lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those right-of-use assets and lease liabilities.

ASC 842-20-45-3 states: In the statement of financial position, a lessee is prohibited from presenting both of the following:

Finance lease right-of-use assets in the same line item as operating lease right-of-use assets
Finance lease liabilities in the same line item as operating lease liabilities.

The guidance merely prohibits mixing financial with operating leases. It does not state they cannot both be recognized and reported in PP&E.

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.

The reason they are not included in ASC 842 is that US GAAP approaches them from the perspective (as outlined in ASC 410-20) of the liability, not the asset.

From a practical perspective, since the asset and liability must equal, it makes little difference which is measured first.

IFRS 16.24 | ASC 842-20-30-5 requires the value of the ROU to be derived from the value of the lease liability.

In addition to the liability itself (sub-paragraph a), the cost of the ROU also comprises:

(b) lease payments made at or before the commencement date (less incentives received) and

Unlike ASC 842-20-30-5I, IFRS 16.24.d also includes disposal costs in the ROU.

This should not, however, be interpreted to imply that disposal costs would not be recognized under US GAAP.

Instead, it reflects that while IFRS approaches disposal from the perspective of the asset, US GAAP approaches it from the perspective of the liability.

Consequently, if an entity expects to incur disposal costs, it would recognize them as outlined in ASC 410-20.

Note: while similar, IFRS | US GAAP guidance on disposal costs | retirement obligations does include some important differences which are discussed on Non-current assets page.

Unlike IFRS 16.26 which states (edited): At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date..., ASC 842 does not provide any explicit guidance on the "initial measurement of the lease liability".

Instead, it merely defines the lease liability as "a lessee's obligation to make the lease payments arising from a lease, measured on a discounted basis" and then lists those payments in ASC 842-10-30-5.

The result is the same.

However, it also requires this liability to be calculated using the rate implicit in the lease if readily determinable.

Both IFRS 16.26 and ASC 842-20-30-3 require the liability to be measured by discounting the lease payments using the rate implicit in the lease if this rate is readily determinable.

IFRS 16 defines the interest rate implicit in the lease as: the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

ASC 842-20 defines the rate implicit in the lease as: the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

Note: while ASC 842-20 indicates that the implicit rate could be zero, it does not provide any examples of situations where this would be the case.

However, neither specifies how "readily determinable" should be interpreted.

Which, for some sites, represents a practically insurmountable hurdle, but only if they forget to apply the latest update.

Under ASC 840, to use the rate implicit in the lease, the lessee really did need to know the lessor's profit margin. Since lessors rarely shared this information, this really was a Catch 22.

Previously, ASC 840-10-25-31 stated: A lessee shall compute the present value of the minimum lease payments using the lessee's incremental borrowing rate unless both of the following conditions are met, in which circumstance the lessee shall use the implicit rate:

a. It is practicable for the lessee to learn the implicit rate computed by the lessor.

b. The implicit rate computed by the lessor is less than the lessee's incremental borrowing rate.

However, under ASC 842, this is no longer necessary.

Currently, ASC 842-20-30-3 (edited) states: A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate...

Instead, all the lessee needs to know is the regular sales price of the leased asset on the market. It does not need to know that price before a manufacturer's profit or dealer's markup.

Fortunately, readily determinable fair value is defined in ASC 820.

Unfortunately, this definition only applies to equity securities.

Nevertheless, by analogizing from this guidance, "readily determinable" can be interpreted to mean prices for comparable items which can be easily verified using objective, market data.

In other words, fair value is "readily determinable" if it can be found in price lists, blue books or using similar means (a.k.a. on the internet in less than an hour or so).

If, on the other hand, it requires something more involved, such as soliciting third party offers or calculating multi-period excess earnings, the cost, time and effort involved makes it not "readily determinable."

For its part, while IFRS 13 does not define readily determinable fair value, IFRS 13.B34 does discuss readily available closing prices in exchange markets.

Again, by analogy, it would be reasonable to interpret "readily determinable" the same way as above.

Assuming a plain vanilla transaction excluding, for example, a guaranteed residual amount.

As the rate implicit in the lease is derived from the value of the leased asset, the guidance seems to be circular.

IFRS 16 defines the interest rate implicit in the lease as (emphasis added): the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.

ASC 842-20 defines the rate implicit in the lease as (emphasis added): the rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. However, if the rate determined in accordance with the preceding sentence is less than zero, a rate implicit in the lease of zero shall be used.

Note: while ASC 842-20 indicates that the implicit rate could be zero, it does not provide any examples of situations where this would be the case.

It is not because the leased asset and the ROU (the right to use that asset) are two separate items of which only one, the ROU, is recognized on the balance sheet.

Be that as it may, applying the guidance in practice is actually straightforward.

If the asset can be priced with little effort, the liability equals that market price and an implicit rate is calculated.

If the asset cannot be priced with little effort, the liability equals lease payments discounted using an explicit rate.

IFRS 16.26 | ASC 842-20-30-3 specifies if an implicit rate is not (readily) available, an explicit rate is used instead.

This explicit rate is the lessee's incremental borrowing rate.

The following illustration discusses how to determine this rate.

Since the machine was easy to price, a liability of 12,000 was recognized and a rate of 7% calculated.

As the machine in this illustration was standard and prices of standard machines could be easily confirmed using published price lists, the implicit discount rate was readily determinable. In other words, the ROU and lease liability were measured at the machine's regular sales price and an implicit rate was calculated.

The simplest way to calculate this rate is Excel's rate function: =RATE(nper, pmt, pv, [fv], [type], [guess]):

Where: nper the number of periods, pmt the payment (must be negative), pv (present value) the fair value of the asset, [fv] (future value) should be 0, [type] should be 0 for an advance payment and 1 for an arrears payment, [guess] can be anything or left blank.

In this example, 7.00¯%=RATE(5,-2927,12000,0,0).

It can also be determined using the =IRR or =XIRR function or a present value schedule and trial and error:

P	Payment	Discount rate	Present value
A	B	C	D = B ÷ (1 + C)^A
1	2,927	7%	2,735
2	2,927	7%	2,556
3	2,927	7%	2,389
4	2,927	7%	2,233
5	2,927	7%	2,087
			12,000

12/31/X1 \| 31.12.X1
Interest expense (leasing)		840
Lease liability		2,087
	Cash		2,927
Depreciation or Amortization		1,800
	Accumulated depreciation or amortization (ROU)		1,800

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.

Nevertheless, in practice, an ROU is either depreciated or amortized depending on whether the leased asset is presented in PP&E or outside PP&E, as discussed in more detail above.

This illustration uses a straight-line depreciation method for the sake of simplicity.

While common in practice, IFRS 16.31 does require lessees to depreciate leased assets as outlined in IAS 16.

While it should be clear without saying, IAS 16.32 also specifies that assets to be retained by the lessee are depreciated over their useful lives while assets to be returned to the lessor over their useful lives or the lease term, whichever is shorter.

Similarly, IFRS 16.33 specifies that IAS 36 applies to leased assets, even though there is no reason to think an ROU, like any other asset, could not become impaired.

This implies, if an entity purchases similar assets, it will depreciate the ROU using the same period, method and residual value as those assets.

If the entity does not purchase similar assets, it will depreciate the ROU using the same period, method and residual value it would have used if it had purchased the asset.

For its part, ASC 842-20-35-7 states: A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset's future economic benefits...

This implies, if an entity purchases (could purchase) similar assets, it should depreciate the ROU using the same period, method and salvage value as those assets.

An illustration showing non-linear depreciation is presented below.

Whether an accumulation account is used depends on if IFRS or US GAAP is applied.

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 is used.

Unlike IFRS, where ROUs are depreciated, both ASC 842-20-35-7 and 842-20-35-8 specify they are to be amortized, reinforcing their intangible nature.

This also implies, since the guidance for intangible assets (ASC 350-30) does not require an accumulation account, recognizing accumulation amortization is optional in US GAAP.

Thus, in practice, intangible assets are commonly amortized directly under US GAAP, even though an accumulation account is needed in IFRS.

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B_(B+1)=B-F	C	D=BxC	E	F=E-D
1	12,000	7.00%	840	2,927	2,087
2	9,913	7.00%	694	2,927	2,233
3	7,681	7.00%	538	2,927	2,389
4	5,292	7.00%	370	2,927	2,556
5	2,735	7.00%	191	2,927	2,735
					12,000

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 payments are made at the end of a period, simply recognizing the liability amortization achieves the same result.

31/3/X7 \| 3.31.X7
Accumulated depreciation (ROU)		10,800
Cash		1,250
	Machine (ROU)		12,000
	Asset disposal gain		50

Advance payments

Same facts except payments of 2,735 were paid at the beginning of the year.

1/1/X1 \| 1.1.X1
Machine		12,000
	Cash		2,735
	Lease liability		9,265

Applying the same discount rate to advance payments yields a lower payment.

12/31/X1 \| 31.12.X1
Interest expense		649
Lease liability		2,087
Depreciation expense		1,800
	Accrued lease payment		2,735
	Accumulated depreciation		1,800

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B_(B+1)=B-F	C	D=BxC	E	F=E-D
0	12,000	7.00%	0	2,735	2,735
1	9,265	7.00%	649	2,735	2,087
2	7,178	7.00%	502	2,735	2,233
3	4,945	7.00%	346	2,735	2,389
4	2,556	7.00%	179	2,735	2,556
					12,000

Principal and interest can also be recognized separately:

	Accrued lease payment: Principal		2,087
	Accrued lease payment: Interest		649

1/1/X2 \| 1.1.X2
Accrued lease payment		2,735
	Cash		2,735

Interim entries

Same facts except XYZ made quarterly accruals.

While the effective interest method can be applied with any periodicity, if the payments are annual, common practice is to make interim accruals on a straight-line basis.

3/31/X1 \| 31.3.X1
Interest expense		162
Lease liability		522
Depreciation expense		450
	Accrued lease payment		684
	Accumulated depreciation		450

Initial direct costs

Same facts except XYZ paid DEF 500 to locate the machine and arrange the lease.

As outlined in ASC 842-10-30-9, initial direct costs are included in the measurement of the ROU. These may include (ASC 842-10-30-9.a) commissions paid to third parties. However, as outlined in ASC 842-10-30-10, they may not include costs that would have incurred regardless of whether the lease was obtained. Thus, if XYZ's purchasing department arranged the lease, XYZ would not have capitalized the associated employee salaries.

IFRS 16 defines initial direct costs comparably and IFRS 16.24.c also guides lessees capitalize these costs. It does not, however, specifically discuss commissions or employee salaries.

1/1/X1 \| 1.1.X1
Machine		12,500
	Lease liability		12,000
	Cash		500

12/31/X1 \| 31.12.X1
Interest expense		840
Lease liability		2,087
	Cash		2,927
Depreciation		1,883
	Accumulated depreciation		1,883

Up-front payment

Same facts except XYZ agreed to pay 4,000 up front and 1,951 at the end of each period.

1/1/X1 \| 1.1.X1
Machine		12,000
	Cash		4,000
	Lease liability		8,000

12/31/X1 \| 31.12.X1
Interest expense		560
Lease liability		1,391
	Cash		1,951
Depreciation		1,800
	Accumulated depreciation		1,800

P	Liability	Discount rate	Interest expense	Payment	Liability amortization
A	B_(B+1)=B-F	C	D=BxC	E	F=E-D
0	12,000	7.00%	0	4,000	4,000
1	8,000	7.00%	560	1,951	1,391
2	6,609	7.00%	463	1,951	1,489
3	5,120	7.00%	358	1,951	1,593
4	3,528	7.00%	247	1,951	1,704
5	1,823	7.00%	128	1,951	1,823
					12,000

Explicit rate

1/1/X1, XYZ leased a made-to-order machine. It agreed to make 36 monthly payments of 342 and had an option to buy the machine for 1,000 at the end of the lease term. XYZ used the machine for 6 years and scrapped it on 31/12/X6.

Dr/Cr

1/1/X1 \| 1.1.X1
PP&E: Machinery and equipment: Machine (ROU)		11,916
	Cash		342
	Lease liability		11,574

As outlined in IFRS 16.23 | ASC 842-20-25-1, the asset recognized in a lease agreement is a "right-of-use asset."

While the leased asset itself is generally tangible, a right conveyed by an agreement is clearly intangible.

This implies, while an "underlying asset" could theoretically be intangible, an "identified asset" will always be tangible.

Both IFRS 38 Definitions and ASC 350-30-20 define intangible asset comparably as assets (not including financial assets) that lack physical substance.

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.

Nevertheless, if the asset is retained, recognizing and reporting it as intangible is frowned upon, as is the mezzanine level.

Under IFRS, the primary justification for classifying ROUs within PP&E rather than as intangible assets stems from IFRS 16.31, which mandates depreciation under IAS 16 rather than amortization under IAS 38.

However, in US GAAP, ASC 842-20-35-7 specifically refers to amortization (not depreciation) and establishes the straight-line method (the default method under ASC 350-30-35-6). As a result, this guidance cannot be used to justify this approach.

Nevertheless, if the leased asset is retained, applying the guidance as written would require derecognizing the intangible asset (the ROU) and rerecognizing PP&E (the machine, equipment, vehicle, etc.) at the end of the lease term.

Too much work.

The problem is, an accounting inconvenience is not sufficient grounds for misapplying guidance. What, on the other hand, could be justifiable is that it may contradict the FASB's intent.

Reading between the lines, it seems clear the FASB is trying to say: financial statement users prefer information in the most digestible form possible.

As a result, under both IFRS and US GAAP, it is common practice to recognize the ROU associated with an asset that will be retained at the end of the lease term the same way the underlying leased asset would be recognized if it were acquired in another fashion: in PP&E.