Revolutionising Financial Reporting: The Impact of ASC 842 and IFRS 16 on Lease Accounting
- Arthur Hong
- Feb 23
- 3 min read
Introduction:
Lease accounting is an unwanted factor in the financial reporting of a business or firm, the reason is the impact on the balance sheet, income statement, and cash flows. But what is lease accounting? It represents the recording and managing of lease agreements in financial statements. Lesses are the entities that lease or rent assets from another party for a specified period, lessors own the assets being leased and lesses earn revenue by renting these assets.
Before 2016, there was not a need to report the lease account to the balance sheet but shortly after the introduction of ASC 842 and IFRS 16 which strongly affected the companies who follow the U.S Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards.
Conditions:
Under previous standards, operating leases were often excluded from balance sheets, this empowered a major issue - there were fewer liabilities for all firms. Due to the ASC 842 and IFRS 16, all leases are now required to be recorded on the balance sheet in 2019 under these circumstances:
1. Contractual Agreement - In which there must be a legally binding contract between the lessee and lessor
2. Identifiable Asset - the lease must involve an identifiable, tangible asset such as equipment or property
3. Control Over Use - The lessee must have the right to control the use of the asset during the time
4. Lease Term - The lease term must exceed 12 months or be considered material to the financial statement
If these criteria are met, the lessee must recognise the right-of-use asset and lease liability on the balance sheet, therefore a lease liability.This approach aims for a more accurate picture of a company’s financial obligations by including nearly all lease commitments whether for properties, equipments, or vehicles to improve transparency for investors and stakeholders.
Challenges for firms:
Through the introduction of those new policies, it created immense challenges for firms:
1. Increased liabilities - Lease liabilities count as debt; this impacts leverage ratios such as the increase in WACC and potentially increase perceived financial risk. With discount rates increasing, it causes a decrease in the present value of future cash flows, affecting valuations and financial metrics like NPV and IRR.
2. Reduced Financial Flexibility - Greater liabilities, affects the borrowing capacity and limit the funds available
3. Impact on Profitability Ratios - New interest expenses and amortisation can affect net income, altering profitability metrics
4. Strained Covenants - Additional liabilities may breach loan covenants tied to leverage or debt levels, this requires renegotiation
Ultimately negatively influences investors' perceptions and a company’s creditworthiness.
Benefits:
However, it can increase the EBITDA figure of the businesses, under the new lease accounting standards, lease payments are no longer classified as simple operating expenses, as they are divided into two components (Interest expense and amortisation). Since EBITDA does not include depreciation, interest, or amortisation, the removal of lease payments from the operating expenses can lead to a higher EBITDA figure.
The clear benefit of the imposition of those new regulations is better visibility into the company’s financial obligations. Allowing investors and regulators to assess a company’s financial health more accurately, leading to an improvement in comparability across businesses.
Real life examples:
One of the companies that was majorly affected by the accounting standards is General Electric: GE’s balance sheet included a substantial increase in lease liabilities, which raised concerns for its financial leverage and overall risk profile. Due to the nature of leasing in the airline industry, although it helps Delta Air Lines to operate without the large upfront costs of purchasing aircrafts, freeing up capital for other investment, it experienced a debt push leading an increase in its debt-to-equity ratios as well as the other financial metrics.
Conclusion:
Lease accounting under ASC 842 and IFRS 16 has redecorated how leases appear in financial statements, emphasising transparency and consistency. Although such implementations can appear to be challenging for firms, these standards at last will benefit the stakeholders by the provision of a clearer view of the company’s financial obligations and assets.
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