Updated for the 2026-2027 CFA® Level I curriculum.
Lease accounting determines how a company reports an asset it uses but does not own. Lessees record most leases on the balance sheet as a right-of-use asset and a lease liability. Lessors still classify leases as operating or finance, depending on how much ownership risk transfers to the lessee. CFA Level I tests both sides of this relationship, including the numbers behind the right-of-use asset and the effect of lease accounting on financial ratios.
Quick Answer
Lease accounting requires lessees to record nearly every lease as a right-of-use asset and a matching lease liability, measured at the present value of future lease payments. Lessors still classify leases as operating or finance (sales-type or direct financing), based on whether substantially all risks and rewards of ownership transfer to the lessee. This difference changes how a lease affects the balance sheet, EBITDA, and leverage ratios.
Key Takeaways
Lessees recognize a right-of-use (ROU) asset and a lease liability for nearly all leases, subject to qualifying exemption elections; the general low-value exemption applies under IFRS, not US GAAP.
The lease liability equals the present value of future lease payments, discounted at the rate implicit in the lease or the lessee's incremental borrowing rate.
Lessors classify leases as operating or finance (sales-type or direct financing), based on whether the lease transfers substantially all risks and rewards of ownership.
IFRS and US GAAP finance-style leases increase assets and liabilities and show depreciation or amortization plus interest. US GAAP operating leases also recognize assets and liabilities but generally retain a single lease expense.
A sales-type lease lets the lessor derecognize the underlying asset and record selling profit and a net investment in the lease at commencement.
An operating lease keeps the asset on the lessor's books and recognizes lease income on a straight-line basis.
What You Need to Know for CFA Level I
The LOS asks you to explain lease reporting from both the lessee and lessor side. Expect questions on each side, not just one.
For lessees, know how to build the initial ROU asset and lease liability, and how interest expense and depreciation move through the income statement.
For lessors, know the classification test that separates an operating lease from a finance lease (sales-type or direct financing).
This note stops at lease reporting. Employee compensation plans and share-based payment disclosures belong to a separate note and do not overlap with lease mechanics.
The most common trap is assuming the lessee's short-term/low-value exemption also applies to lessors. It does not. Lessors always apply the classification test.
Why Companies Lease Assets
A company leases an asset instead of buying it for several practical reasons:
Lower upfront cash outlay
Leasing often requires little or no down payment, which frees cash for other uses.
Reduced obsolescence risk
The lessee avoids holding an asset that may lose value quickly, such as technology equipment.
Flexible financing terms
Lease agreements can carry less restrictive covenants than a traditional loan.
Possible tax timing benefits
Lease payments may be deductible in ways that differ from depreciation schedules on owned assets.
Before current lease standards, leasing was also used to keep debt off the balance sheet. That benefit is largely gone for lessees today, since almost all leases now require a recorded liability.
Lease Accounting for Lessees
Right-of-Use Asset and Lease Liability
At the start of a lease, the lessee records a lease liability equal to the present value of future lease payments. The right-of-use asset starts at the same amount, adjusted for any initial direct costs, prepaid lease payments, or lease incentives received.
Under IFRS 16, most recognized leases follow a finance-style subsequent measurement model:
The lease liability accrues interest expense using the effective interest method.
The ROU asset is depreciated, usually on a straight-line basis over the lease term.
Under IFRS, the resulting expense comprises depreciation and interest. The cash payment itself reduces the liability and settles interest.
US GAAP: Finance and Operating Leases
US GAAP retains two lessee classifications under ASC 842. Both generally recognize a ROU asset and lease liability. Finance leases show separate interest and ROU amortization, usually producing higher total expense early in the term. Operating leases generally show a single straight-line lease expense; the ROU asset is reduced by the balancing amount after liability interest.
Recognizing a balance-sheet liability therefore does not by itself imply a higher EBITDA figure. US GAAP operating lease expense generally remains an operating expense, while IFRS and US GAAP finance-style depreciation and interest are excluded from EBITDA. Compare the reporting framework and classification before interpreting margins.
Short-Term and Low-Value Lease Exception
IFRS offers elections for qualifying short-term leases and leases of low-value underlying assets. US GAAP offers a qualifying short-term lease election but has no general low-value exemption. These leases are expensed straight-line over the term, similar to how operating leases worked under older standards. This exception applies only to lessees.
Effect on the Lessee's Financial Statements
For an IFRS or US GAAP finance-style lease, compared with expensing qualifying rent:
Leverage ratios rise
Adding a lease liability increases total debt, raising debt-to-equity and debt-to-assets ratios.
EBITDA rises
Because lease expense splits into depreciation (excluded from EBITDA) and interest (excluded from EBITDA), operating income and EBITDA are higher than they would be under a single straight-line rent expense.
Expense timing shifts
Interest expense is highest in early years and declines as the liability amortizes, so total lease expense is front-loaded even though cash payments stay level.
Lease Accounting for Lessors
Classification Test: Operating vs Finance Lease
A lessor classifies a lease as finance if any of these conditions apply:
Ownership transfers to the lessee by the end of the lease term.
The lessee has a bargain purchase option it is reasonably certain to exercise.
The lease term covers the major part of the asset's remaining economic life.
The present value of lease payments is substantially all of the asset's fair value.
The asset is so specialized that it has no alternative use to the lessor after the lease ends.
If none of these apply, the lessor treats the lease as an operating lease.
Sales-Type vs Direct Financing Lease
A finance lease from the lessor's side splits into two types:
Feature | Sales-Type Lease | Direct Financing Lease |
|---|---|---|
Who typically uses it | Manufacturer or dealer lessor | Lessor without manufacturer profit |
Selling profit at commencement | Recognized (revenue and cost of goods sold) | Not recognized |
Asset on lessor's books | Derecognized, replaced by net investment in lease | Derecognized, replaced by net investment in lease |
Income recognized over term | Interest income | Interest income |
Lessor Operating Lease Accounting
Under an operating lease, the lessor keeps the underlying asset on its own balance sheet and continues to depreciate it. Lease payments are recognized as rental income, typically straight-line over the lease term.
Right-of-Use Asset and Lease Liability Formulas
Initial lease liability:
where:
: initial lease liability,
: payment in period t,
: discount rate per period, and
: number of payment periods.
Initial right-of-use asset:
where:
: initial right-of-use asset,
: initial lease liability,
: initial direct costs,
: prepaid lease payments, and
: lease incentives received.
Lessor's net investment in a finance lease:
where:
: initial net investment,
: unguaranteed residual value at the end of the term, and
other variables are as defined above.
Working Example
Orion Robotics reports under IFRS and leases a piece of manufacturing equipment for 4 years. The lease requires annual payments of $50,000 at the end of each year. The rate implicit in the lease is 6%. The lease has no purchase option, no residual value guarantee, and does not qualify for the short-term or low-value exception.
Step 1: Calculate the initial lease liability.
Step 2: Set the initial ROU asset.
No initial direct costs, prepayments, or incentives apply, so .
Step 3: Calculate Year 1 interest expense.
Step 4: Calculate Year 1 principal reduction and ending liability.
Step 5: Calculate Year 1 depreciation on the ROU asset.
Total Year 1 income statement expense is $10,395 + $43,314 = $53,709, compared to $50,000 under a straight-line rent expense. Total expense is higher in Year 1 because interest front-loads, but operating income and EBITDA are higher than under the old rent-expense model, since depreciation and interest both sit below the EBITDA line. An analyst comparing Orion to a competitor that leases similar equipment under the short-term exception should adjust for this difference before comparing margins or leverage ratios.
Follow the Lessor's Side of Orion's Lease
Assume an IFRS finance lessor provides Orion's equipment under the same four-year payment schedule. The lessor's net investment at commencement is $173,255, equal to the asset's carrying amount, and there is no residual value or initial direct cost. No selling profit arises under these assumptions.
The lessor replaces the equipment asset with a lease receivable. It does not retain the equipment as depreciable PPE for this finance lease.
The entire $50,000 receipt is not income. Part is the return earned on financing, and the rest recovers the outstanding investment.
For a separate lease that qualifies as operating, suppose the lessor owns equipment costing $100,000, with a five-year life and no residual value, and earns level annual rent of $25,000. With no other adjustments, it retains PPE, records $20,000 annual depreciation, and recognizes $25,000 rental income. Its annual pretax contribution is $5,000 before other costs.
The classification determines whether the lessor reports an investment earning finance income or an underlying asset generating rent and depreciation. Classify from the lease terms rather than choosing whichever treatment produces a preferred result.
Common Exam Traps
Applying the lessee exemption to a lessor
The short-term and low-value lease exception belongs only to lessees. A lessor always applies the full classification test, regardless of lease length or asset value.
Assuming capitalizing a lease lowers EBITDA
For an IFRS or US GAAP finance-style lease, the expense comprises depreciation or amortization and interest, both excluded from EBITDA. EBITDA goes up, not down, compared to full rent expense treatment.
Confusing sales-type and direct financing leases
Both leases replace the asset with a net investment in the lease, but only a sales-type lease recognizes selling profit (revenue and cost of goods sold) at commencement.
Using the wrong discount rate
The lease liability uses the rate implicit in the lease when the lessee can determine it. If not, the lessee uses its own incremental borrowing rate, not the lessor's.
Treating the lessor's operating lease asset as derecognized
Under an operating lease, the lessor keeps the asset on its own balance sheet and keeps depreciating it. Only finance leases trigger derecognition by the lessor.
Practice Question
An analyst compares two IFRS reporters with qualifying 12-month leases for identical equipment under identical terms. Company A elects recognition; Company B elects the short-term exemption. Company A reports the lease as a right-of-use asset and lease liability. Company B expenses the lease as a single rent expense under the short-term lease exception. In the first month after commencement, before either lease expires, which statement most accurately describes the difference between the two companies?
Company A reports lower EBITDA and lower total liabilities than Company B.
Company A reports higher EBITDA and higher total liabilities than Company B.
Company A reports the same EBITDA as Company B, but higher total liabilities.
Correct Answer: B
Explanation: Company A's lease liability increases total liabilities compared to Company B, which reports no lease liability. Company A's lease expense splits into depreciation and interest, both excluded from EBITDA, while Company B's rent expense reduces operating income and EBITDA directly. Company A therefore reports both higher EBITDA and higher total liabilities.
Option A: Reverses the direction of both effects. Capitalizing a lease raises liabilities and raises EBITDA, not lowers them.
Option C: Correctly identifies the liability effect but incorrectly assumes EBITDA is unaffected. It ignores that rent expense and the depreciation/interest split sit in different places on the income statement.
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FAQs About Lease Accounting for Lessees and Lessors
What is the difference between an operating lease and a finance lease for a lessee?
IFRS generally uses a single finance-style lessee model, subject to qualifying exemptions. US GAAP recognizes most leases on the balance sheet but distinguishes finance leases from operating leases. US GAAP operating leases generally retain a single straight-line lease expense.
How is the right-of-use asset calculated?
The right-of-use asset starts at the same amount as the initial lease liability (the present value of future lease payments), adjusted for initial direct costs, prepaid lease payments, and any lease incentives received.
Do lessors use the same accounting model as lessees?
No. Lessors still classify each lease as operating or finance (sales-type or direct financing) based on whether substantially all risks and rewards of ownership transfer to the lessee. This dual model differs from the lessee's largely single capitalization model.
Why do companies lease assets instead of buying them?
Common reasons include lower upfront cash outlay, reduced exposure to asset obsolescence, more flexible financing terms than traditional debt, and potential tax timing benefits from lease payment deductions.
How does lease accounting affect financial ratios?
IFRS and US GAAP finance-style lease accounting generally increases recognized assets and liabilities relative to expensing an exempt lease. Depreciation and interest are excluded from EBITDA. US GAAP operating leases also recognize a ROU asset and liability but generally retain a single operating lease expense.