Why IFRS 16 Exists
Before IFRS 16, companies could keep significant lease obligations off their balance sheets. This made it difficult to compare companies that owned assets outright versus those that leased them.
The Problem IFRS 16 Solves
Consider a company that needs vehicles to operate. They have two options:
- Option A: Buy with a loan - The vehicle appears as an asset, the loan as a liability, with depreciation and interest on the income statement.
- Option B: Lease the vehicle - Under the old standard (IAS 17), only the lease expense appeared on the income statement. Nothing on the balance sheet.
Although operations are identical, the financial statements looked completely different. Companies could hide onerous commitments, and ratios like return on assets were distorted.
IFRS 16 addresses this by requiring lessees to recognise most leases on the balance sheet, bringing previously hidden obligations into view and enabling meaningful comparison between companies.
Key insight: IFRS 16 doesn't change the total expense over a lease's lifetime - it equals total cash payments regardless of accounting treatment. What changes is the timing and presentation of that expense, plus the visibility of lease obligations on the balance sheet.
IFRS 16 Overview
IFRS 16 covers both lessees (those making payments) and lessors (those receiving payments), though the changes primarily affect lessee accounting.
For Lessees
There is no longer any classification of leases. All leases (with limited exemptions) are accounted for similarly to what was previously called a "finance lease":
- Recognise a lease liability - the present value of future lease payments
- Recognise a right-of-use asset - typically equal to the lease liability at commencement
- Recognise depreciation on the asset and interest expense on the liability
For Lessors
Lessor accounting remains largely unchanged from IAS 17. Lessors still classify leases as either:
- Finance leases - when substantially all risks and rewards transfer to the lessee
- Operating leases - when the lessor retains significant risks and rewards
Read more about lessor accounting →
Income Statement Impact Over Time
While total expense equals total payments over the lease term, the pattern differs from straight-line operating lease expense:
| Year | Depreciation | Interest | Total IFRS 16 | Old "Lease Expense" | Difference |
|---|---|---|---|---|---|
| 1 | 82,004 | 28,701 | 110,705 | 100,000 | +10,705 |
| 2 | 82,004 | 23,710 | 105,714 | 100,000 | +5,714 |
| 3 | 82,004 | 18,370 | 100,374 | 100,000 | +374 |
| 4 | 82,004 | 12,656 | 94,660 | 100,000 | -5,340 |
| 5 | 82,004 | 6,542 | 88,546 | 100,000 | -11,454 |
| Total | 410,020 | 89,979 | 499,999 | 500,000 | - |
Example: 5-year lease with 100,000 annual payments at 7% discount rate
Practical note: For companies with rolling lease portfolios (some leases starting, others ending), the front-loaded expense pattern largely averages out across the portfolio.
Lease Identification
Before applying IFRS 16, you must determine whether a contract contains a lease. IFRS 16 defines a lease as:
Definition of a Lease
"A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration."
- IFRS 16.9
In simpler terms: if you pay to use a specific asset for a period, it's likely a lease.
Three Key Questions
To determine if a contract contains a lease, ask:
Is there an identified asset?
The asset must be explicitly or implicitly specified. You need to know which specific asset you'll use.
Do you have the right to control the asset?
Control requires both:
- The right to obtain substantially all economic benefits from using the asset
- The right to direct how and for what purpose the asset is used
Are there substantive substitution rights?
If the supplier can substitute the asset throughout the period of use (and would benefit economically from doing so), you may not have an identified asset.
Common Misconception
A finance loan to purchase an asset is not a lease under IFRS 16. In a lease, the asset remains the lessor's property. With a loan, ownership transfers to the borrower.
For detailed guidance, see IFRS 16.B9-B31 covering identification criteria, or use our lease identification checklist.
Recognition Exemptions
IFRS 16 provides relief for leases that would have minimal impact on financial statements. These may be expensed straight to the income statement without recognising assets and liabilities.
Short-Term Leases
Leases with a term of 12 months or less at commencement (including renewal options you're reasonably certain to exercise).
Elected by class of underlying asset
Low-Value Leases
Leases where the underlying asset has a low value when new (IASB suggests around US$5,000 as a threshold).
Elected lease-by-lease
For exempt leases, recognise payments as an expense on a straight-line basis over the lease term, or another systematic basis if more representative.
Examples of low-value assets: laptops, phones, office furniture, small equipment. Note that the assessment is based on the value of the asset when new, regardless of the age of the leased asset.
Initial Measurement
At lease commencement, lessees recognise two items on the balance sheet:
Lease Liability
The lease liability is the present value of future lease payments. This requires two key inputs:
1. Discount Rate
Use one of:
- Rate implicit in the lease - if readily determinable (rarely available to lessees)
- Incremental borrowing rate (IBR) - the rate a lessee would pay to borrow funds to obtain an asset of similar value in a similar economic environment
Once set at commencement, the discount rate remains fixed unless remeasurement requires an update.
Read our detailed guide on discount rates →
2. Lease Payments
Include in the measurement:
- Fixed payments (less any lease incentives receivable)
- Variable payments based on an index or rate (using the index/rate at commencement)
- Amounts expected to be payable under residual value guarantees
- Exercise price of purchase options (if reasonably certain to exercise)
- Termination penalties (if the lease term reflects exercising a termination option)
Handling Escalations
- Fixed escalations (e.g., 5% annually) - include in the calculation
- Index-linked escalations (e.g., CPI) - use the current payment amount; remeasure when the index actually changes
Read our detailed guide on lease liability →
Read about variable lease payments →
Right-of-Use Asset
The right-of-use asset is initially measured at cost, comprising:
Subsequent Measurement
After initial recognition, the lease liability and right-of-use asset are measured each period until the lease ends.
Lease Liability
The liability is measured using the effective interest method:
- Increase by interest expense each period (liability balance × discount rate)
- Decrease by lease payments made
At lease end, the liability should be zero (assuming no modifications).
Right-of-Use Asset
The asset is typically depreciated on a straight-line basis over the shorter of:
- The lease term, or
- The useful life of the underlying asset (if ownership transfers or a purchase option is expected to be exercised)
Other measurement models are available:
- Cost model (IAS 16) - most common approach
- Revaluation model (IAS 16) - if applied to that class of assets
- Fair value model (IAS 40) - for investment property meeting certain criteria
Right-of-use assets are also subject to impairment testing under IAS 36.
Journal Entries
Example: A 5-year office lease with monthly payments of £10,000 and a 5% incremental borrowing rate, giving a lease liability of £530,604 at commencement.
Initial Recognition
Subsequent Measurement (Month 1)
At Lease End
Modifications & Remeasurements
Leases frequently change during their term. IFRS 16 distinguishes between two types of changes:
Remeasurements
Changes in estimates or circumstances that affect future lease payments:
- Change in lease term assessment
- Change in purchase option assessment
- Index/rate-linked payment changes
- Revised residual value guarantee estimates
Modifications
Contractual changes to the scope or consideration:
- Adding or removing right to use assets
- Extending or shortening the lease term
- Changing the amount of consideration
Which Discount Rate to Use?
| Scenario | Discount Rate |
|---|---|
| Lease term change | Updated (current) rate |
| Purchase option assessment change | Updated (current) rate |
| Payment change due to floating interest rates | Updated (current) rate |
| Index-linked payment change | Original rate |
| Residual value guarantee change | Original rate |
| All modifications | Updated (current) rate |
Modification Types
When the scope increases and the additional consideration reflects the stand-alone price for the incremental right-of-use, treat the modification as a separate new lease. The original lease continues unchanged.
Example: Adding an additional floor of office space at market rates.
When scope decreases (partial termination):
- Reduce the right-of-use asset proportionally
- Remeasure the lease liability using a current discount rate
- Recognise any difference in profit or loss
Example: Giving back one floor of a two-floor lease.
For modifications that don't fit the above categories (e.g., term extension without scope change):
- Remeasure the lease liability using a current discount rate
- Adjust the right-of-use asset by the same amount
No profit or loss impact unless the asset adjustment would result in a negative balance.
Lessor Accounting
Lessor accounting under IFRS 16 remains largely unchanged from IAS 17. Lessors must classify each lease as either a finance lease or an operating lease.
Classification Criteria
A lease is classified as a finance lease if it transfers substantially all risks and rewards of ownership. Indicators include:
- Transfer of ownership at end of lease term
- Bargain purchase option
- Lease term is for the major part of the asset's economic life
- Present value of payments equals substantially all of the asset's fair value
- Specialised asset with no alternative use to the lessor
If none of these indicators are met, the lease is an operating lease.
Finance Lease (Lessor)
- Derecognise the underlying asset
- Recognise a lease receivable (net investment in the lease)
- Recognise finance income over the lease term
Operating Lease (Lessor)
- Keep the asset on balance sheet
- Continue depreciating the asset
- Recognise lease income on a straight-line basis
Foreign Currency Leases
When lease payments are denominated in a foreign currency, IFRS 16 interacts with IAS 21 (The Effects of Changes in Foreign Exchange Rates).
Key Concepts
- Denominated currency - the currency in which payments are made
- Functional currency - the currency of the entity's primary economic environment
- Presentation currency - the currency used in financial statements
Translation Rules
| Item | Type | Exchange Rate |
|---|---|---|
| Lease liability | Monetary | Closing rate (creates FX differences) |
| Right-of-use asset | Non-monetary | Historical rate (no FX differences) |
| Interest expense | - | Average rate for the period |
| Depreciation | - | Historical rate (same as asset) |
| Lease payments | - | Spot rate on payment date |
Foreign exchange differences on the lease liability are recognised in profit or loss.
Impairment of Right-of-Use Assets
Right-of-use assets are subject to impairment testing under IAS 36. This is particularly relevant when circumstances suggest the asset's carrying amount may not be recoverable.
Impairment Indicators
Consider impairment testing when:
- Market values have declined significantly
- The asset is no longer being used or is underutilised
- Economic conditions have deteriorated
- The leased property is being vacated or subleased at a loss
- Business performance is worse than expected
Impairment Process
- Identify cash-generating units (CGUs) - determine which CGU includes the right-of-use asset
- Calculate recoverable amount - the higher of fair value less costs of disposal or value in use
- Compare to carrying amount - if carrying amount exceeds recoverable amount, recognise impairment loss
- Allocate the loss - first to goodwill (if any), then to other assets including the ROU asset
Presentation & Disclosure
IFRS 16 requires extensive disclosures to help users understand the impact of leases on the financial position, financial performance, and cash flows.
Balance Sheet Presentation
Lessees must present (or disclose):
- Right-of-use assets separately from other assets (or disclose which line items include them)
- Lease liabilities separately from other liabilities (or disclose which line items include them)
Income Statement Presentation
Present separately:
- Depreciation expense for right-of-use assets
- Interest expense on lease liabilities
- Expenses relating to short-term leases (if not included in above)
- Expenses relating to low-value leases (if not included in above)
- Expenses relating to variable lease payments not included in lease liabilities
Cash Flow Statement
- Principal portion of lease payments - financing activities
- Interest portion - either operating or financing activities (consistent with other interest)
- Short-term and low-value lease payments - operating activities
- Variable lease payments - operating activities
Key Disclosures
Worked Example
Scenario
A company enters a 5-year office lease with the following terms:
- Annual payment: £100,000 (paid at year-end)
- Incremental borrowing rate: 7.93%
- Initial direct costs: £25,000
- No renewal options, purchase options, or restoration obligations
Step 1: Calculate Lease Liability
Present value of 5 annual payments of £100,000 at 7.93%:
PV = £100,000 × [(1 - (1 + 0.0793)⁻⁵) / 0.0793] = £400,000
Step 2: Calculate Right-of-Use Asset
Step 3: Initial Recognition Journal
Step 4: Amortisation Schedule
| Year | Opening Liability | Interest (7.93%) | Payment | Closing Liability | Depreciation |
|---|---|---|---|---|---|
| 1 | 400,000 | 31,720 | (100,000) | 331,720 | 85,000 |
| 2 | 331,720 | 26,305 | (100,000) | 258,025 | 85,000 |
| 3 | 258,025 | 20,461 | (100,000) | 178,486 | 85,000 |
| 4 | 178,486 | 14,154 | (100,000) | 92,640 | 85,000 |
| 5 | 92,640 | 7,360 | (100,000) | 0 | 85,000 |
| Total | 100,000 | (500,000) | 425,000 |
Depreciation = £425,000 ÷ 5 years = £85,000 per year
Try it yourself: Use our IFRS 16 Lease Calculator to calculate lease liability and right-of-use asset values for your own leases.
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.