Lease Accounting: Complexities Introduced by New Lease Standards (IFRS 16, ASC 842)

 Leases have always been an essential part of how businesses acquire and use assets. From office buildings and factories to vehicles, aircraft, and IT equipment, leasing allows companies to operate flexibly without tying up huge amounts of capital in ownership. But for decades, lease accounting was criticized for creating “off-balance sheet financing,” where massive obligations were hidden from view.

To address this, standard-setters introduced IFRS 16 (effective January 2019) and ASC 842 (effective for most U.S. companies in 2019, with later extensions for private firms). These standards fundamentally changed lease accounting, requiring most leases to be recognized on the balance sheet. While the goal was transparency and comparability, the shift introduced a host of complexities for accountants, finance teams, and businesses at large.

This article explores the challenges of implementing the new lease standards, their implications for businesses, and strategies to manage the burdens they create.

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The Shift: From Off-Balance Sheet to On-Balance Sheet

Under the old standards (IAS 17 and ASC 840), leases were divided into two categories:

• Finance (capital) leases: Recognized on the balance sheet.

• Operating leases: Treated as rental expenses, kept off the balance sheet.

This allowed companies—especially airlines, retailers, and logistics providers—to keep billions in obligations hidden from investors and lenders. The new rules changed that.

• IFRS 16 requires lessees to recognize nearly all leases as right-of-use (ROU) assets with corresponding lease liabilities.

• ASC 842 takes a similar approach but retains a distinction between operating and finance leases for expense recognition, even though both are now on the balance sheet.

In essence, what was once “hidden debt” is now clearly visible.

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The Core Complexities for Accountants

1. Identifying a Lease

At first glance, this sounds easy—if you’re renting something, it’s a lease. But under the new standards, accountants must assess whether a contract contains a lease. A contract qualifies if it conveys:

• The right to use an identified asset.

• Control over that asset for a period of time.

This creates gray areas, especially in contracts that combine services and assets. For example, does a data center agreement that provides servers along with maintenance staff qualify as a lease, a service, or both? Splitting lease and non-lease components is often judgment-heavy.

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2. Lease Term and Options

Determining the lease term goes beyond just reading the contract dates. Accountants must consider renewal and termination options—specifically, whether the company is reasonably certain to exercise them.

A retail chain, for instance, may have a five-year store lease with an option to renew for another five years. If management is “reasonably certain” to stay, that option must be included in the liability calculation, significantly increasing reported debt. This judgment involves analyzing business strategy, location performance, and industry trends.

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3. Discount Rates

Lease liabilities must be measured at the present value of future lease payments, which requires selecting an appropriate discount rate. IFRS 16 allows either the interest rate implicit in the lease (if determinable) or the lessee’s incremental borrowing rate. ASC 842 offers similar guidance but gives private companies the option to use a risk-free rate.

Choosing and justifying discount rates is complex. Implicit rates are often unavailable, and incremental borrowing rates depend on company-specific factors like credit risk and collateral. Small changes in discount rates can significantly alter reported liabilities.

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4. Variable Lease Payments

Not all lease payments are fixed. Many agreements include variable components tied to usage, sales, inflation indexes, or market rates. For example, an airline might lease aircraft with payments tied to flight hours.

Accounting standards require some variable payments to be included in liabilities, while others are excluded and recognized as expenses when incurred. Distinguishing between these categories is nuanced and requires careful contract review.

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5. Modifications and Remeasurements

Lease terms don’t always stay static. Rent concessions, contract renegotiations, or changes in usage often occur. Each modification may require remeasurement of the ROU asset and liability. During the COVID-19 pandemic, for instance, thousands of companies had to quickly assess the accounting impact of rent deferrals or waivers.

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6. Systems and Data Management

The sheer volume of leases in large organizations presents another challenge. Airlines may have thousands of aircraft and equipment leases. Retailers can have hundreds of store leases across different countries. Tracking terms, renewal options, payments, and modifications in spreadsheets is impractical under the new standards. Many companies had to invest in lease management software, integrate it with ERPs, and establish new processes for data accuracy.

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Business Implications Beyond Accounting

The complexities of IFRS 16 and ASC 842 ripple beyond finance teams into broader business operations:

• Balance sheet impact: Companies report higher assets and liabilities, increasing leverage ratios. This can affect debt covenants, borrowing costs, and credit ratings.

• Earnings volatility: Depreciation of ROU assets and interest on lease liabilities replace straight-line rent expense (under IFRS 16), front-loading costs and reducing earnings in earlier years.

• Performance metrics: EBITDA often increases since rent expense is replaced by depreciation and interest. This can make companies look more profitable, though cash flows remain unchanged.

• Strategic decisions: Some companies reconsider leasing versus buying, contract structures, and lease lengths due to the accounting impact.

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Navigating the Complexities: Strategies and Solutions

1. Robust Lease Inventory
Start with a complete and accurate lease database. Centralizing contracts, capturing key terms, and categorizing components ensures consistency. Many challenges arise simply from incomplete data.

2. Use Technology
Lease accounting software is no longer optional for organizations with significant lease volumes. Automated tools can handle calculations, modifications, and reporting while integrating with ERPs and financial systems.

3. Cross-Functional Collaboration
Lease accounting is not just an accounting function. Legal, procurement, treasury, and operations teams must work closely to ensure contract terms are structured with both business needs and accounting impacts in mind.

4. Policy Development and Training
Companies need clear policies on discount rate selection, lease term judgments, and renewal assessments. Regular training ensures staff apply policies consistently.

5. Engage External Expertise
Complex judgments—like determining lease modifications or handling unusual variable payments—often benefit from input by auditors, valuation experts, or consultants.

6. Scenario Planning
Finance teams should model how different leasing strategies affect financial ratios, debt covenants, and investor perceptions. This helps management make informed business decisions.

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The Future of Lease Accounting

While IFRS 16 and ASC 842 are now established, challenges continue to evolve. As new business models emerge—think subscription-based equipment usage or “as-a-service” models—the line between service and lease may blur further.

In addition, global harmonization remains imperfect. While IFRS 16 treats all leases as finance leases, ASC 842 retains the dual classification. Multinationals must therefore manage both frameworks simultaneously, adding another layer of complexity.

Emerging technologies like blockchain-based smart contracts could one day revolutionize lease administration, automatically updating terms and feeding accounting systems. Until then, companies will continue to navigate the balancing act of compliance, transparency, and efficiency.

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Final Thoughts

The introduction of IFRS 16 and ASC 842 marked a watershed moment in financial reporting. By bringing leases onto the balance sheet, standard-setters achieved greater transparency and comparability—but at the cost of significant complexity for businesses.

For accountants, the challenge lies in interpreting nuanced rules, managing vast amounts of data, and making difficult judgments about lease terms, options, and discount rates. For companies, the impact extends to financial ratios, investor relations, and even strategic decisions about whether to lease or buy.

The path forward requires a mix of robust systems, clear policies, cross-functional collaboration, and technological tools. While the journey is complex, the ultimate reward is a more transparent reflection of financial reality—one that investors, regulators, and businesses alike can trust.