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: Total lease expense over the lease term generally approximates total lease payments, though additional costs such as initial direct costs, restoration provisions, impairment, or variable payments may cause differences. What changes under IFRS 16 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
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 and control how it is used for a period of time, it is 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) and no purchase option.
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). This is an absolute assessment, not relative to the size of the company, and the asset must be capable of being used on its own.
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.
Common Mistakes with Exemptions
- Forgetting to track exempted leases. Even if you elect the short-term or low-value exemption, you must still disclose the expense recognised for these leases. Maintain a register
- Misapplying the short-term election. The election is by class of underlying asset (e.g. all office equipment, or all vehicles), not lease-by-lease. You cannot cherry-pick which short-term leases to exempt within the same class
- Not reassessing short-term leases. If a lease is initially 12 months but is later modified or extended beyond 12 months, it no longer qualifies. You must recognise a lease liability and ROU asset from the date of the modification
- Using the wrong benchmark for low-value. The assessment is based on the value of the asset when new, not its current value. A five-year-old laptop that cost £1,200 when new is still a low-value asset, even if it is worth £200 today
- Aggregating assets. Each asset must be assessed individually. A fleet of 500 laptops worth £1,000 each qualifies for the low-value exemption even though the total portfolio value is £500,000
Portfolio Approach for Short-Term Leases
While the short-term exemption must be elected by asset class, you can still use a portfolio approach for managing these leases. Group similar short-term leases (e.g. all month-to-month office equipment rentals) and recognise the expense in aggregate. This is a practical simplification, not a change in accounting policy.
Initial Measurement
At lease commencement, lessees recognise two items on the balance sheet: a lease liability (the obligation to make future payments) and a right-of-use asset (the right to use the leased item).
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 a remeasurement requires an update (see the Modifications & Remeasurements section below for when this applies).
Read our detailed guide on discount rates →
2. Lease Payments
Include in the measurement:
- Fixed payments less any incentives from the lessor (e.g. rent-free periods, fit-out contributions)
- Index-linked payments based on a rate or index such as CPI (use the payment amount at commencement)
- Residual value guarantees you expect to pay (e.g. guaranteeing a vehicle's value at lease end)
- Purchase option price if you're reasonably certain to buy the asset (e.g. a bargain purchase option)
- Termination penalties if your lease term assumes you'll exercise an early exit clause
Handling Escalations
- Fixed escalations (e.g. 5% annually). Include every future escalated amount in the calculation
- Index-linked escalations (e.g. CPI). Use the current indexed payment amount for all future periods. When the contractual rent review takes effect and the payment adjusts, remeasure the lease liability using the revised payment. The IASB took this approach because IFRS 16 is complex enough without requiring companies to forecast inflation or other indices
Read our detailed guide on lease liability →
Read about variable lease payments →
Right-of-Use Asset
The right-of-use asset is usually equal to the lease liability, but adjusted for any additional costs or incentives:
- Lease liability: the present value calculated above. This is the starting point for the asset value
- Prepaid lease payments: lease payments made at or before the commencement date (e.g. the first month's rent paid on signing)
- Initial direct costs: incremental costs you would not have incurred if you had not entered the lease (e.g. legal fees for negotiating the contract, broker commissions)
- Restoration costs: an estimate of what it will cost to return the asset to its original condition at lease end (e.g. removing partitions, making good on a property lease). Recognised as a provision under IAS 37
- Lease incentives received upfront: any payments or contributions received from the lessor before commencement (e.g. a cash incentive to sign). These reduce the asset cost
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, calculated using the effective interest method
- Decrease by lease payments made
At the end of the lease term, the liability will be zero. If the lease has been modified or remeasured during its term, the recalculated balance still unwinds to zero by the end.
Right-of-Use Asset
The asset is typically depreciated on a straight-line basis. The depreciation period depends on whether ownership is expected to transfer:
- Ownership transfers or purchase option expected to be exercised: depreciate over the useful life of the underlying asset
- Otherwise: depreciate over the shorter of the lease term and the useful life of the underlying asset
Other measurement models are available, though rarely used in practice:
- 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.
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). This is common for multinational groups leasing offices, vehicles, or equipment in countries with a different currency to the parent entity. The key complication is that the lease liability (a monetary item) must be retranslated at each reporting date, while the right-of-use asset (a non-monetary item) stays at the historical rate, creating foreign exchange differences in profit or loss each period.
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 | - | Transaction-date rate (average rate often used as a practical approximation) |
| 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. This means currency movements can create volatility in the income statement even when the underlying lease terms have not changed.
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
In practice, impairment of right-of-use assets most commonly arises with property leases when a company vacates leased space or subleases it below cost. The impairment loss reduces the carrying amount of the ROU asset and is recognised in profit or loss.
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
Interest expense on the lease liability and depreciation of the right-of-use asset must be presented (or disclosed) separately from each other. They do not need to be standalone P&L line items: interest typically sits within finance costs, depreciation within depreciation and amortisation.
IFRS 16.53 requires the following amounts to be disclosed in the notes for the reporting period:
- Depreciation charge for right-of-use assets by class of underlying asset
- Interest expense on lease liabilities
- Expense relating to short-term leases (excluding leases of one month or less)
- Expense relating to leases of low-value assets (excluding short-term low-value leases)
- Expense relating to variable lease payments not included in the measurement of lease liabilities
- Income from subleasing right-of-use assets
- Total cash outflow for leases
- Additions to right-of-use assets
- Gains or losses arising from sale and leaseback transactions
- The carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset
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
Qualitative Disclosures
IFRS 16.59 requires additional qualitative and quantitative information that helps users assess the effect of leases. This typically covers:
- The nature of the lessee's leasing activities
- Future cash outflows the lessee is potentially exposed to that are not reflected in the lease liability, including those arising from variable lease payments, extension and termination options, residual value guarantees, and leases not yet commenced to which the lessee is committed
- Restrictions or covenants imposed by leases
- Sale and leaseback transactions
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: 8%
- Initial direct costs: £25,000
- No renewal options, purchase options, or restoration obligations
Step 1: Calculate Lease Liability
Each payment is discounted back to present value at 8% (verify in our calculator):
| Year | Payment | Discount Factor | Present Value |
|---|---|---|---|
| 1 | £100,000 | 1 / 1.081 | £92,593 |
| 2 | £100,000 | 1 / 1.082 | £85,734 |
| 3 | £100,000 | 1 / 1.083 | £79,383 |
| 4 | £100,000 | 1 / 1.084 | £73,503 |
| 5 | £100,000 | 1 / 1.085 | £68,058 |
| Lease Liability | £399,271 | ||
Step 2: Calculate Right-of-Use Asset
Step 3: Initial Recognition Journals
Step 4: Amortisation Schedule (Years 1-2)
Each year, interest accrues on the opening liability balance and the ROU asset is depreciated on a straight-line basis (£424,271 ÷ 5 = £84,854 per year).
| Year | Opening Liability | Interest (8%) | Payment | Closing Liability | Depreciation |
|---|---|---|---|---|---|
| 1 | 399,271 | 31,942 | (100,000) | 331,213 | 84,854 |
| 2 | 331,213 | 26,497 | (100,000) | 257,710 | 84,854 |
Step 5: Year 1 Journals
Step 6: Lease Modification
Modification Scenario
At the start of Year 3, the company extends the lease by 2 years (5 years remaining) at the same payment of £100,000. The revised incremental borrowing rate is 6%.
This modification is not a separate lease (no additional right-of-use asset is granted), so the existing liability is remeasured using the new rate and remaining term. The difference is adjusted against the ROU asset.
At the point of modification:
- Existing liability: £257,710 (closing balance after Year 2)
- ROU asset carrying amount: £254,563 (424,271 - 2 × 84,854 depreciation)
Remeasure the liability using the new rate and remaining term:
New liability = PV of 5 payments of £100,000 at 6% = £421,236 (verify in our calculator)
The new liability (£421,236) is £163,526 higher than the existing liability (£257,710). Because this is not a separate lease, the increase is added to both the liability and the ROU asset:
The revised ROU asset (£254,563 + £163,526 = £418,089) is now depreciated over the 5 remaining years (£83,618 per year). The revised amortisation schedule:
| Year | Opening Liability | Interest (6%) | Payment | Closing Liability | Depreciation |
|---|---|---|---|---|---|
| 3 | 421,236 | 25,274 | (100,000) | 346,510 | 83,618 |
| 4 | 346,510 | 20,791 | (100,000) | 267,301 | 83,618 |
| 5 | 267,301 | 16,038 | (100,000) | 183,339 | 83,618 |
| 6 | 183,339 | 11,000 | (100,000) | 94,340 | 83,618 |
| 7 | 94,340 | 5,660 | (100,000) | 0 | 83,618 |
Step 7: Derecognition at Lease End
At the end of Year 7, the liability has unwound to zero and the ROU asset is fully depreciated. The final journal clears the asset from the balance sheet:
See more journal entry examples including monthly entries, remeasurements, and terminations →
Putting It All Together
Using the worked example above, the table below shows how IFRS 16 changes the expense pattern compared to the old operating lease treatment. Instead of a flat lease charge each year, the combined depreciation and interest is higher in early years and lower later. Notice how the depreciation changes at Year 3 when the lease is modified.
| Year | Depreciation | Interest | Total IFRS 16 | Old "Lease Expense" | Difference |
|---|---|---|---|---|---|
| 1 | 84,854 | 31,942 | 116,796 | 100,000 | +16,796 |
| 2 | 84,854 | 26,497 | 111,351 | 100,000 | +11,351 |
| Lease modified at start of Year 3: extended by 2 years, rate revised to 6% | |||||
| 3 | 83,618 | 25,274 | 108,892 | 100,000 | +8,892 |
| 4 | 83,618 | 20,791 | 104,409 | 100,000 | +4,409 |
| 5 | 83,618 | 16,038 | 99,656 | 100,000 | -344 |
| 6 | 83,618 | 11,000 | 94,618 | 100,000 | -5,382 |
| 7 | 83,618 | 5,660 | 89,278 | 100,000 | -10,722 |
| Total | 587,798 | 137,202 | 725,000 | 700,000 | +25,000 |
The IFRS 16 total is £25,000 higher than total payments because the initial direct costs are capitalised into the ROU asset and depreciated over the lease term. Under the old standard, these costs would also have been expensed over the lease term, so total expense is the same either way.
Practical note: For companies with rolling lease portfolios (some leases starting, others ending), the front-loaded expense pattern largely averages out across the portfolio.
Frequently Asked Questions
Next Steps
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.