Judgment in Lease Accounting (IFRS 16 / ASC 842)
Leasing is another area where professional judgment significantly influences financial reporting. IFRS 16, which took effect in 2019, represents a principles-based overhaul of lease accounting for lessees, eliminating the bright-line distinction between operating and finance leases. Under IFRS 16, virtually all leases must be recorded on the balance sheet (with limited exceptions for short-term or low-value leases). Meanwhile, US GAAP’s ASC 842 (effective around the same time) also requires balance sheet recognition but retains a dual model for expense recognition (operating vs finance classification for lessees). Both standards aim to reflect the substance of lease obligations, and both require management to make key judgments in applying the guidance to real-world contracts.
Identifying a lease – the first step – itself can need judgment, especially with complex service contracts. A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Sounds straightforward, but consider scenarios like an outsourcing contract for data center capacity or a transportation contract. Is there an “identified asset” (a specific server or railcar) and does the customer control its use? If a manufacturer signs a contract for exclusive use of a specified factory for 5 years (even if the contract is framed as a supply agreement), in substance that might be a lease of the factory. IFRS 16 provides guidance (e.g. if the supplier has substantive substitution rights, maybe it’s not an identified asset), but ultimately management must examine who directs the asset’s use and obtains its benefits. These evaluations involve reading contracts closely and often require consultations between accounting, legal, and operations teams. Missing an embedded lease can mean liabilities and assets are omitted from the balance sheet, a serious error. Conversely, over-identifying leases could lead to capitalizing arrangements that are actually service contracts. Thus, companies have developed decision trees to help consistent analysis: Does the contract specify an asset? Can the supplier swap it? Who decides how and for what purpose the asset is used during the term? These questions guide the judgment. Auditors will typically review a sample of service or outsourcing contracts to ensure the company’s lease identification process is catching what it should. The boundaries of what constitutes a lease can be blurry, and standard-setters (including IFRIC interpretations) have had to clarify issues like whether a capacity portion of a pipeline or fiber optic cable is an identified asset (it can be, if physically distinct and not shared).
Determining the lease term is one of the most consequential and judgmental aspects of IFRS 16 (and ASC 842). The lease term isn’t always just the contractual term – it includes periods covered by extension options or termination options if the lessee is reasonably certain to exercise (or not exercise) those options. “Reasonably certain” is a high threshold (akin to “pretty much sure”), but not a bright-line percentage; management must assess economic and business factors to conclude whether they are reasonably certain to extend or not terminate a lease. This assessment can be very subjective. For instance, a retailer with a 5-year store lease and a 5-year renewal option must judge at commencement whether it is reasonably certain to renew (making it a 10-year lease for accounting) or not (treat as 5 years). They’ll consider location performance, strategic plans, any significant leasehold improvements, and costs of moving. If the store is in a prime mall and integral to operations, they might conclude it’s reasonably certain they’ll stay 10 years (perhaps because leaving would forfeit a profitable spot). Another retailer might be unsure and lean toward not including the extension until more information on year 3 or 4. IFRS 16 explicitly requires judgment in determining the lease term when options are present. And that judgment can heavily impact the balance sheet – a longer term means recognizing a larger lease liability and right-of-use asset (more years of payments). The standard setters expected diversity here because business realities differ. What’s crucial is that the judgment is based on economic incentives, not on a desire to achieve an accounting outcome. Companies must document the factors they considered: e.g. “We included the renewal on our head office lease because we’ve invested in custom improvements that we’d lose if we moved, making us reasonably certain to extend.” Auditors will examine such rationales and also whether they stay consistent over time. If circumstances change (say the retailer initially planned to stay but later decides to relocate), IFRS 16 requires revising the lease term and remeasuring the liability. Judgment is not a set-and-forget element; it should respond to new facts. An IFRS Interpretation Committee agenda decision in 2019 reinforced this: entities need to revisit lease terms (and associated asset depreciation lives) when significant events or changes in circumstances occur that are within the lessee’s control. This dynamic aspect of judgment ensures that financial statements continue to reflect the best estimate of the lease commitment duration.
Estimating the incremental borrowing rate (IBR) is another key judgment under IFRS 16/ASC 842. Since most leases don’t explicitly state a discount rate, lessees must use their IBR – essentially, the interest rate they would incur to borrow, on a similar term and security, the funds to get an asset of similar value. IFRS 16’s definition is principle-based and leaves estimation to management. Determining this rate “involves estimation – it is not an exact science”, and judgment is involved in estimating the rate. Lessees often approach it by starting with a baseline (like a sovereign risk-free rate or reference rate for the lease term) and then adjusting for credit risk, asset-specific factors, collateral, etc. For example, a 10-year real estate lease’s IBR might start with a 10-year fixed mortgage rate (if the property were bought) and adjust for the fact that the lease is secured only by usage rights, perhaps adding a premium for the lessee’s credit rating. If the company has recent borrowing for similar tenor, that could serve as a benchmark. But companies without public debt might rely on bond yield data of peers or banking quotes – again involving judgment. Even small differences in the IBR can materially change the lease liability recorded (lower rate → higher present value). IFRS 16 offers some discussion in its Basis for Conclusions about how to think of IBR, but it deliberately did not prescribe a formula. Thus, two companies might pick slightly different rates for similar leases. The important thing is that each company’s approach is rational and consistently applied. Auditors may involve specialists to assess if the IBRs seem in line with market conditions for that client’s credit standing. IFRS Interpretations Committee guidance also indicated that lessees should consider the lease term and payment profile in determining the IBR – e.g. a bullet payment vs an amortizing payment structure could affect the rate. The takeaway is that estimating discount rates is not mechanical; it requires financial judgment, and particularly so for private companies or emerging markets where credit spreads are harder to determine. This is analogous under US GAAP, though private US companies have an option to use a risk-free rate to simplify (at the cost of potentially overstating liabilities). Public companies under ASC 842, however, also wrestle with IBR judgments just like IFRS reporters.
Lease classification (for lessors under IFRS 16 and for lessees under ASC 842) introduces another area of judgment. While IFRS 16 removed the operating vs finance lease classification for lessees (all lessee leases are treated similar to finance leases), it retained classification for lessors, and US GAAP kept it for lessees too. Classification depends on whether substantially all risks and rewards of the asset are transferred. The standards list criteria reminiscent of the old rules: e.g. does ownership transfer by end, is there a bargain purchase option, is the lease term a major part of the asset’s life, is present value of payments substantially all the asset’s fair value, etc. However, IFRS leaves terms like “major part” and “substantially all” judgmental (guideline of 75% or 90% from US GAAP’s old rules can inform but are not hard cut-offs in IFRS). Lessors and US GAAP lessees must sometimes use judgment in borderline cases – e.g. a lease term is 7 years for an asset life of 10 years (70% – is that “major” or not?). If there are any uncertainties (maybe an option to extend not counted in term but likely to be used), that complicates it. The tension between principles and rules is evident here: IFRS leans on judgment (with “substance over form” guiding that if it’s essentially a sale on credit, it’s a finance lease). US GAAP historically had bright percentages, but ASC 842 now acknowledges judgment can be applied around those thresholds. For consistency, many companies still use quantitative thresholds, but they must be careful not to let a desire for off-balance-sheet treatment (for GAAP lessees) bias the assumptions (like choosing an economic life just a bit longer to avoid 75%). With IFRS 16, lessees escaped this particular judgment since all leases are on balance sheet anyway – an example of how removing a rule (classification) actually reduced one kind of judgment needed. Nonetheless, IFRS 16 introduces others (like term and rate as discussed).
Example – Airline industry: Airlines often lease aircraft. Under IFRS 16, an airline brings those leases on balance sheet. Key judgments include the lease term (aircraft leases might have extension options or early termination given market conditions) and the IBR (often large dollar amounts over long terms). Airlines also sometimes have power-by-the-hour arrangements (pay per use) – judging whether those contain a lease (is there a specific plane? Often yes, but payments vary) can be tricky. An example is if Airline A enters a 10-year agreement for the use of 5 specific engines at any given time out of a pool of 8 – if the supplier can swap engines in and out, is there an identified asset? Such nuanced assessments show how facts and circumstances drive the conclusion. A well-known aviation case involved aircraft wet leases (which include crew and maintenance) – are those service contracts or leases of the plane with services? The judgment hinged on who controls the asset’s use; if the airline directs where and when the plane flies, it might be a lease component for the aircraft and a service component for crew. Companies in this sector have had to develop robust frameworks to evaluate these contracts part by part.
Example – Retail industry: A global retail chain implementing IFRS 16 had thousands of store leases. Many store leases include break clauses or renewal options tied to mall terms, etc. The retailer needed to establish a policy for what makes it “reasonably certain” to renew. They might look at store performance: say if a store is profitable and in a strategic location, assume renewal; if marginal, assume no renewal. They also consider corporate strategy (if moving towards online, maybe fewer renewals). On transition to IFRS 16, some retailers took a conservative stance, not including optional periods unless they were very sure, to avoid overcommitting on the balance sheet. Others, emphasizing economic realities, included likely renewals to better reflect that they intended to stay. There was diversity in practice initially. Over time, through disclosures and investor questions, companies refined these judgments. Retailers often disclose their weighted average lease term and some explanation of renewal assumptions – giving insight into their judgment. A notable case: some UK retailers in 2019 were questioned by the Financial Reporting Council (FRC) on why they did or didn’t include certain extension options, as the FRC wanted to ensure consistency with narrative statements (e.g. if an annual report says “we plan to stay in key locations long-term” but the accounting didn’t include renewals, that’s a red flag). The lesson is that judgment in lease accounting must not be made in isolation – it should align with the business’s actual plans and communications.
Overall, lease accounting showcases the interplay between principle and judgment. IFRS 16 gave a clear principle – put leases on the balance sheet at present value of reasonably certain payments – but left the judgment to preparers on what payments and period that entails. It also counts on judgment to determine the discount rate. The result is arguably more faithful representation (no more operating lease off-balance-sheet financing), but initial adoption proved that judgments could significantly sway the numbers. Investors and analysts adapted by scrutinizing disclosures like “lease liabilities” and any sensitivity information provided. Auditors, in turn, often listed lease accounting as a key audit matter, explaining how they evaluated the client’s judgments on term and IBR. The process has improved comparability in some ways (everyone recognizes leases now) but still allows some variability (one company might report a higher lease liability than another mostly due to differing judgments on extension likelihood). As long as those judgments are grounded in economic reality and properly disclosed, the principle-based approach is working as intended. Should judgment be exercised poorly – say a company unreasonably assumes it will not renew any lease to minimize liabilities – it would likely face challenge from auditors and regulators, especially if subsequent actions (like actually renewing many leases) prove the earlier judgment faulty.
In the end, lease accounting under these newer standards exemplifies how professionals develop judgment by combining quantitative analysis (e.g. present value calculations) with qualitative insight (e.g. strategic intentions with leased assets). They often create internal frameworks (like a decision matrix for renewal options based on store profitability) to promote consistency. This is an example of decision-aids we’ll discuss later – effectively internal decision trees or criteria checklists that guide judgment so that it’s systematic rather than ad hoc. But even the best framework cannot eliminate the need for human oversight; as business strategies or market conditions shift, those human judgments must be revisited and updated to keep financial reporting true to the business.