Making Sense of Lease Accounting Standards: WhatLessors Need to Know About ASC 842 and IFRS 16

Introduction: A New Chapter in Lease Accounting

2019 marked the beginning of a new age of lease accounting. After over a decade of discussion, two major establishments watched those international jurisdictions receive IFRS 16, and U.S. jurisdictions receive ASC 842, replacing (IAS) 17 and (ASC) 840. In those announcements, seen as a way to close the transparency gap in financial reporting, there was a significant increase in the amounts reported on the balance sheet by lessees for their operating leases, bringing these amounts onto their balance sheet, thus increasing the reported asset amounts. Okay, that’s great for lessees, but what about lessors?

While the focus has been on lessees regarding IFRS 16 and ASC 842, lessors, especially lessors leasing vehicles and equipment, are not going to enjoy all of this change without a little bit of their own change.

Lessors will have to understand these changes better to remain compliant, remain competitive, and remain confident in the lessor’s financial reporting products.

The rest of this article will delve deeply into these standards as they relate to lessors by considering:

• The structure of the standards

• The message of what it means to the lessor

• The dissecting of some frequently overlooked sections that are the most relevant parts of the standards to a lessor.

Lease Accounting Standards: A Brief History and Purpose

The main intent of IFRS 16 or ASC 842 is to enhance transparency. With the previous accounting standards, lessees could not report liabilities off their balance sheet by entering into operating leases. These led to incomplete disclosures of the financial situation, which limited investors and regulators from evaluating the company’s real commitments.

IFRS 16 addressed this by removing the distinction between operating and finance leases, making all leases remain on the balance sheet for lessees, except for short term leases or low value leases.

ASC 842 took a slightly different approach from the previous standard, maintaining both finance (previously capital) leases and operating leases, but required both leases to be reported on the balance sheet.

The shape of the standards changed slightly for lessors, with the overall classification structure largely remaining the same. There were notable differences between the categories and how leases were classified and reported.

Lease Classifications: Knowing Where You Stand

Under IFRS 16, lessors still must distinguish between finance and operating leases. However, ASC 842 introduced a sales type lease, and now there are 3 categories. The hope is that these distinctions will be recognized for accounting and financial statement purposes.

There will be differences in income recognition, reporting as an asset, and business perspective in the financial statements depending on the lease. For lessors with portfolios comprising multiple asset types, for example, commercial trucks to industrial equipment, knowing how to classify the lease, including which accounting treatment to apply, is important.

The ASC 842 Classification Tests: What Lessors Need to Watch For

ASC 842 does not entirely change the old tests from ASC 840, but it does move away from the strict “bright line” rules and adds a new test related to the specialization of the asset.

This is what lessors must look at when considering whether they are classifying as finance or operating under ASC 842:

• Ownership Transfer: Will ownership transfer to the lessee on termination of the lease?

• Bargain Purchase Option: Is it reasonably assured that the lessee will purchase the asset at a price lower than fair market value?

• Economic Life: Is the lease term for the greater part of the asset’s remaining economic life?

• Fair Value: Do the present value of the lease payments equal or exceed substantially all of the fair value of the asset?

• Specialized Use: Is the asset specialized such that there will be no alternative use to the lessor at the end of the lease?

If any of these are met, then the lease would be considered a finance lease. If none, then it would be an operating lease.

The fifth criterion, the specialized use test, is new under ASC 842. This can be extremely important for an equipment lessor who is leasing modified machinery and other technology specific vehicles.

Lessor Accounting Treatment: How Each Lease Type Is Handled

Operating Leases

Operating leases follow the easiest model under both IFRS 16 and ASC 842. The lessor keeps the underlying asset on their balance sheet and recognizes income earned over time, typically on a straight line basis.

This model works well here for fleet leasing companies or companies leasing standardized equipment. Consistent income, simple accounting reporting (assuming that the lease terms are fairly standardized and nothing creative has been made).

Finance Leases (ASC 842) and IFRS 16 Finance Leases

For finance leases, the lessor is providing financing. The leased asset is removed from the lessor’s accounts, and a receivable is accounted for the net investment in the lease. Income is recognized in the future on an interest income basis.

A distinguishing point under ASC 842 is that the lessor must recognize losses on sales at the time of the sale, profits and direct initial costs are deferred until included in the net investment in the lease. This timing will influence when it recognizes profit and will impact quarterly results.

Sales Type Leases (ASC 842 Only)

Sales type leases can only occur if there is a selling profit or loss from the transaction (i.e., when the lessor is selling the asset, like a manufacturer lessor). A sales type lease is a finance lease when it meets all the finance lease tests. Sales type leases are a special type of finance lease, as under ASC 842, control of the asset transfers to the lessee, so revenue begins immediately.

Any cost of goods sold and initial direct costs are recorded on the commencement date of the lease along with the revenue.

Sales type leases are relevant for lessors that manufacture their equipment or sell “new” vehicles with lease packages through their dealerships. Sales type leases allow for the earlier recognition of revenue but still require documentation from a lease and the same accounting precision.

Provisions Worth Knowing: Deep Diving into IFRS 16 and ASC 842

Under IFRS 16, a lessor:

• Classify each lease as either a finance lease or an operating lease.

• Recognizes finance leases as receivable for the net investment.

• Recognizes finance income by applying a constant periodic rate of return over the term.

• Recognizes income from operating leases on a straight line basis, except if there is another systematic and rational method that better reflects the use of the underlying asset.

Under ASC 842, a lessor:

• Classifies leases as sales type, direct finance, or operating.

• Derecognizes the underlying asset if it was a sales type or direct finance lease.

• Recognizes revenue and cost of goods sold (and defers, if applicable) as prescribed by the lease classification depending on the situation.

• Recognizes lease income and expense evenly over the lease term for operating leases.

Although the similarities appear to exist, the accounting treatments are based on how you use the asset, how you structure the revenue, and whether the asset is customized or released/resold, can all be different.

Software and Systems: Staying Compliant and Scalable

While the standards may not have radically changed the way lessors account for leases, they have certainly added a new layer of complexity and scrutiny. For many vehicle and equipment lessors, relying on lease accounting software systems to perform automated classification tests, manage audit trails, and create compliant journal entries has become a standard practice.

For organizations managing hundreds or thousands of leases, relying on manual processes is not only inefficient but also creates risks. The classification tests and treatment rules are applied consistently across each deal. Taking a system driven approach should help reduce the risk of errors, simplify compliance, and help maintain a file path for audit readiness.

Additionally, these platforms also include support for integrations with financial reporting tools, customer management systems, and asset tracking modules.

The Road Ahead: Compliance as a Competitive Advantage

One of the overlooked truths in the leasing industry is that regulatory compliance can be a differentiator. Lessors who demonstrate clarity, consistency, and control over their accounting practices create trust, not just with auditors, but also with investors, partners, and customers.

Proactively keeping up with accounting standard updates, automating classification and reporting, and the related documentation are all components of a larger strategy in which compliance is a business asset instead of a burden.

As standards change and the regulators become more vigilant, the ability to adjust quickly will be even more vital. For those lessors active in fast moving sectors such as mobility, construction equipment, and specialty machinery, speed and flexibility in compliance will increasingly differentiate the leader from the laggard.

Conclusion: Clarity Amid Complexity

IFRS 16 and ASC 842 have undoubtedly changed the dynamics of lease accounting from what they were to what they are now, while lessors may not have experienced the same drastic balance sheet shifts as lessees have, they are now facing more scrutiny, more complexity in classification, and increased expectations for reliability around disclosures.

It is no longer nice to know how each respective standard classifies leases, how to account for each type, and how and where to document your decisions. While focused on compliance with these standards, compliance can extend to optimization in operations, strategy, M&A, and financial forecasts.

For vehicle and equipment lessors, understand the rules and implement the required systems to comply with the respective standards. View lease accounting compliance as part of your overall effort to create a well functioning, transparent, and resilient leasing business.

This new accountability requires an even greater understanding of lease accounting standards, not merely compliance, but also producing the clarity and credibility that will ultimately future-proof the business.