CFA Level I Exam · Topics in Long-Term Liabilities and Equity

Lease Accounting: IFRS 16 vs US GAAP for Lessees and Lessors

Updated 7 October 2026 · Fact-checked

A lease gives you the right to use an asset for a period in return for payments. Under IFRS 16 a lessee books a right-of-use asset and a lease liability for almost every lease. Under US GAAP, finance leases and operating leases differ in expense pattern. Lessors classify leases as finance or operating.

Understand Leases: Lessee and Lessor Accounting

A lease is a contract that lets the lessee use an asset owned by the lessor for an agreed period in exchange for payments. Before the current standards, many leases stayed off the balance sheet. Analysts had to adjust for that. Now most leases are on the balance sheet.

At the start of the lease, the lessee records a lease liability, equal to the present value of the remaining lease payments, discounted at the rate implicit in the lease (or the lessee's incremental borrowing rate if the implicit rate cannot be determined). The lessee also records a right-of-use (ROU) asset. It starts at the lease liability plus initial direct costs and prepaid payments, less any lease incentives received.

IFRS 16 has one lessee model. Every lease is treated like a finance lease. The income statement shows depreciation of the ROU asset plus interest on the liability. Expense is front-loaded: higher in early years, lower later. Cash paid for the principal part is financing cash flow. Interest is classified as operating or financing under an IFRS policy choice. CFO is higher than it would be with an operating-lease expense because the principal portion is reported in financing. If the company also classifies interest in financing, interest leaves CFO as well, so CFO is higher still. Short-term leases (12 months or less) and low-value assets may be exempt and expensed straight-line. Payments on these exempt leases are expensed and reported in operating cash flow.

US GAAP (ASC 842) has two lessee classifications. A finance lease is treated like IFRS: depreciation plus interest, front-loaded. The principal portion of the payment is in financing cash flow and the interest is in operating cash flow. An operating lease shows a single straight-line lease expense in the income statement, and the whole payment is in operating cash flow. Both types still put an ROU asset and a lease liability on the balance sheet. A lease is a finance lease if it meets any one of five criteria: ownership transfers; a purchase option the lessee is reasonably certain to exercise; the term covers a major part of the asset's economic life; the present value of payments is substantially all of the asset's fair value; or the asset is so specialized that it has no alternative use to the lessor afterward.

Lessor accounting is largely unchanged in substance from the old standards. Under ASC 842, however, the lessor's sales-type criteria were aligned with the lessee's finance lease criteria. Under IFRS, a lease is a finance lease if it transfers substantially all the risks and rewards of ownership. Otherwise it is an operating lease. Under US GAAP, a lessor classifies as a sales-type lease if any of the five criteria above is met. It is a direct financing lease if the criteria are not met but the PV of payments plus any residual value guaranteed by the lessee or an unrelated third party is substantially all of the asset's fair value and collection is probable. Otherwise it is an operating lease. The lessor in an operating lease keeps the asset and depreciates it, and records rental income.

Key formulas to remember

Lease liability at inception: Lease liability = PV of remaining lease payments, discounted at the rate implicit in the lease or the lessee's incremental borrowing rate; Use annuity due if payments are at the start of each period.
Right-of-use asset at inception: ROU asset = Lease liability + initial direct costs + prepaid lease payments − lease incentives; With no extra costs, ROU asset = lease liability.
Interest expense each period: Interest = Opening lease liability × discount rate; Applies to IFRS lessees and US GAAP finance leases.
Closing lease liability: Closing liability = Opening liability + Interest − Payment; Payment minus interest is the principal repaid.
Depreciation of ROU asset: Depreciation = (ROU asset − residual value) ÷ shorter of lease term and useful life; If ownership transfers or a purchase option is reasonably certain, use useful life.
US GAAP operating lease expense: Single lease cost = total lease payments ÷ lease term (straight-line); Presented as one operating expense; all cash in CFO.
Lessor classification (IFRS): Finance lease if substantially all risks and rewards transfer; otherwise operating; Lessor accounting is largely unchanged from before.

How to solve Leases: Lessee and Lessor Accounting questions

Use this order for any lease question. It tells you the standard, the lease type and the correct statement effects.

1Identify the standard (IFRS or US GAAP) and whether you are the lessee or the lessor.
2If lessee under US GAAP, test the five criteria. Any one makes it a finance lease; none makes it an operating lease. Under IFRS the lessee has one model.
3Compute the lease liability as the PV of payments. Check if payments are in advance (annuity due) or in arrears (ordinary annuity).
4Set the ROU asset equal to the liability, then adjust for initial direct costs, prepayments and incentives.
5Build year 1: interest = opening liability × rate; depreciation = ROU asset ÷ term; or straight-line cost for US GAAP operating leases.
6Find the closing liability: opening + interest − payment.
7Choose the cash flow classification: principal in financing; interest in CFO or CFF at the IFRS policy choice; interest in CFO for US GAAP finance leases; all operating-lease cash in CFO under US GAAP.
8For lessors, classify as finance, sales-type, direct financing or operating, and apply the matching recognition.

Quickest way: Three-option elimination for lease questions

When to use it: Use for conceptual questions on which model applies, expense pattern or statement effects, where you have about 90 seconds.

Ask: IFRS or US GAAP? Under IFRS lessee, think finance-lease pattern always.
Ask: finance or operating (US GAAP)? Finance means depreciation plus interest, front-loaded, financing outflow for principal. Operating means one straight-line expense, all in CFO.
Remember: total expense over the lease life is the same in both patterns. Only timing differs.
Eliminate any option that says operating leases are off balance sheet for lessees. That is no longer true under either standard (apart from short-term and low-value exemptions).
For lessor questions, look for transfer of risks and rewards (IFRS) or the five criteria (US GAAP).

Common mistakes in Leases: Lessee and Lessor Accounting

Saying US GAAP operating leases stay off the balance sheet.
Students remember the old rule from before the new standards.
Fix: Under ASC 842 operating leases create an ROU asset and a lease liability. Only the income statement and cash flow pattern differ.
Using straight-line expense for an IFRS lessee.
Students confuse IFRS 16 with US GAAP operating leases.
Fix: IFRS 16 always uses depreciation plus interest for lessees, so expense is front-loaded.
Discounting at the wrong rate or treating advance payments as arrears.
The question wording on payment timing is easy to skim past.
Fix: Use the implicit rate if known, otherwise the incremental borrowing rate. Set the calculator to BGN for payments at the start of each period.
Forgetting to adjust the ROU asset for initial direct costs, prepayments and incentives.
Students assume ROU asset always equals the lease liability.
Fix: ROU = liability + direct costs + prepayments − incentives.
Putting all lease payments in operating cash flow for finance leases.
Students apply the operating-lease rule to every lease.
Fix: For IFRS lessees and US GAAP finance leases, the principal portion is in financing. Interest is in CFO or CFF at the IFRS policy choice, and in CFO for US GAAP finance leases. The exception is IFRS short-term and low-value leases that are expensed straight-line: those payments are expensed and reported in operating cash flow.
Mixing up sales-type and direct financing leases.
Both are lessor finance-type leases and the names are similar.
Fix: Sales-type: any of the five criteria is met, and the lessor may record a selling profit. Direct financing: criteria not met, but collection is probable and the PV of payments plus any residual value guaranteed by the lessee or an unrelated third party is substantially all of the asset's fair value.

Worked examples

Example 1

A lessee signs a 3-year lease with payments of $10,000 at the end of each year. The rate implicit in the lease is 8%. There are no other costs. Under IFRS 16, what is the closing lease liability at the end of year 1? Options: A) $15,771 B) $17,833 C) $25,771

Show the solution

PV of payments = 10,000 × [1 − 1.08^-3] ÷ 0.08.
1.08^3 = 1.259712, so 1.08^-3 = 0.793832.
Annuity factor = (1 − 0.793832) ÷ 0.08 = 2.577097.
Lease liability at inception = 25,770.97.
Year 1 interest = 25,770.97 × 8% = 2,061.68.
Closing liability = 25,770.97 + 2,061.68 − 10,000 = 17,832.65.
Check: PV of the last two payments = 10,000 × 1.783265 = 17,832.65. Matches.
Calculator (BA II Plus): N=3, I/Y=8, PMT=−10,000, FV=0, CPT PV = 25,770.97.
Distractors: A comes from 25,771 − 10,000 = 15,771, which forgets to add interest. C is the opening liability.

Answer: B) $17,833. Option A ignores interest and option C is the opening liability.

Example 2

Under US GAAP, a lessee has a 5-year lease classified as an operating lease with total payments of $50,000, paid as $10,000 a year. How does the lessee report the lease in year 1? Options: A) One straight-line lease expense of $10,000 in operating expenses, and all cash paid in CFO B) Depreciation and interest expense, with the principal in financing C) No expense in year 1 because the lease is off balance sheet

Show the solution

Identify the standard: US GAAP and the lessee. The lease is classified as operating.
An operating lease gives a single straight-line lease cost = 50,000 ÷ 5 = 10,000 per year.
The whole cash payment goes in operating cash flow.
Option B describes a finance lease. Option C describes the old pre-ASC 842 off-balance-sheet treatment, and also an expense is recorded in any case.

Answer: A) One straight-line expense of $10,000 and all cash in CFO. The ROU asset and lease liability are still on the balance sheet.

Exam tips

Expect conceptual comparison questions: IFRS vs US GAAP, finance vs operating, and effect on EBIT, net income, CFO and leverage ratios.
In the early years of a finance-type lease, expense is higher than straight-line. Net income is lower at first, EBITDA is higher than with an operating expense, and CFO is higher because the principal portion is reported in financing. Interest stays in CFO under US GAAP finance leases and follows the policy choice under IFRS.
Always check whether payments are made in advance. It changes the PV and the first-year interest.
On three-option MCQs, remove any option that treats lessee operating leases as off balance sheet, then compare the two left on expense pattern.
For lessor questions, look for the key words: risks and rewards (IFRS), the five criteria, and the sales-type or direct financing label (US GAAP).

Practice questions from Topics in Long-Term Liabilities and Equity

Leases: Lessee and Lessor Accounting in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Leases: Lessee and Lessor Accounting: frequently asked questions

What is the main difference between IFRS 16 and US GAAP for lessees?

IFRS 16 uses a single model: every lease (apart from short-term and low-value exemptions) gives depreciation plus interest. US GAAP keeps two types. Finance leases look like IFRS, while operating leases show one straight-line expense. Both put an ROU asset and lease liability on the balance sheet.

How do I calculate the lease liability and right-of-use asset?

Discount the remaining lease payments at the implicit rate, or the incremental borrowing rate if the implicit rate is not known. That is the lease liability. The ROU asset starts at the liability plus initial direct costs and prepayments, less incentives.

What is the difference between a finance lease and an operating lease?

Under US GAAP, a lessee classifies a lease as finance if it meets any one of the five criteria, and as operating if it meets none. Under IFRS, only lessors make this split: a lessor's lease is a finance lease if it transfers substantially all the risks and rewards of ownership. The difference shows up in expense pattern and cash flow classification.

What are sales-type and direct financing leases?

They are US GAAP lessor classifications. A sales-type lease meets any of the five criteria, and the lessor can record a selling profit at the start. A direct financing lease does not meet them but still has collection probable and PV of payments plus residual guarantee substantially all of fair value, so the lessor earns only interest income.