IFRS 16 Leases Explained: What is a Lease & How Lease Accounting Works

IFRS 16 Leases is a key accounting standard that changed the way companies recognize leases. It introduces the concept of right-of-use assets and liabilities for lessees. In this article, we’ll break down what a lease is, how lease accounting works under IFRS 16, and the difference between operating and finance leases.

Understanding IFRS 16: Leases in Simple Terms

International Financial Reporting Standard 16 (IFRS 16) is a global accounting standard that changes how companies account for leases. Introduced by the International Accounting Standards Board (IASB), it aims to make financial statements more transparent by ensuring that leases are reported on a company’s balance sheet. This article explains IFRS 16 in simple terms, covering its key concepts with practical examples to help you understand its impact.

What is IFRS 16?

IFRS 16, effective from January 1, 2019, is a standard that governs how companies record leases in their financial statements. A lease is an agreement where one party (the lessee) pays another (the lessor) to use an asset, like property, equipment, or vehicles, for a specific period. Before IFRS 16, many leases were kept off the balance sheet, making it hard to see a company’s true financial obligations. IFRS 16 requires most leases to be recognized on the balance sheet, showing both the asset being used and the liability to pay for it.

Key Objectives of IFRS 16

The main goals of IFRS 16 are:

• Transparency: Show all lease obligations clearly on the balance sheet.
• Comparability: Make it easier to compare companies’ financial positions.
• Accuracy: Reflect the economic reality of lease agreements.

Key Concepts of IFRS 16

Let’s break down the main concepts of IFRS 16, with examples to illustrate each one.

1. Definition of a Lease

A lease under IFRS 16 is a contract where a lessee gets the right to use an identifiable asset for a specific period in exchange for payment. An identifiable asset is something specific, like a particular building or machine, not a general category of items.

Example: Office Space Lease

ABC Ltd. signs a contract to rent a specific office building for five years, paying $10,000 per month. This is a lease because ABC Ltd. has the right to use a specific asset (the office building) for a set period in exchange for payments.

Note: If the contract allows the lessor to substitute the asset (e.g., provide a different building), it may not qualify as a lease under IFRS 16.

2. Right-of-Use (ROU) Asset

Under IFRS 16, when a company leases an asset, it records a “right-of-use” (ROU) asset on its balance sheet. This represents the lessee’s right to use the leased asset during the lease term.

Example: Leasing a Delivery Van

XYZ Corp. leases a delivery van for three years at $1,000 per month. The company calculates the present value of all future lease payments (say, $32,000) and records this as an ROU asset on its balance sheet. This asset shows XYZ Corp.’s right to use the van for three years.

3. Lease Liability

Alongside the ROU asset, the lessee records a lease liability, which is the obligation to make lease payments. This is calculated as the present value of future lease payments, discounted using the interest rate implicit in the lease or the lessee’s incremental borrowing rate.

Example: Calculating Lease Liability

XYZ Corp.’s van lease requires payments of $1,000 per month for 36 months. Using a discount rate of 5%, the present value of these payments is $32,000. XYZ Corp. records a lease liability of $32,000, representing its obligation to pay the lessor over the lease term.

4. Lease Term

The lease term is the period during which the lessee has the right to use the asset, including any optional periods the lessee is reasonably certain to exercise (e.g., an option to extend the lease).

Example: Determining Lease Term

ABC Ltd. leases a warehouse for five years, with an option to extend for another three years. If ABC Ltd. is reasonably certain it will extend (e.g., due to business needs), the lease term is eight years. If not, it’s five years.

5. Short-Term and Low-Value Leases

IFRS 16 allows exemptions for short-term leases (12 months or less with no purchase option) and low-value leases (e.g., small office equipment like laptops or printers, typically worth less than $5,000). These can be treated like rentals, with payments expensed directly to the income statement, not recorded on the balance sheet.

Example: Low-Value Lease

XYZ Corp. leases 10 laptops for its staff, each worth $1,000, for one year. Since the laptops are low-value assets, XYZ Corp. can expense the lease payments monthly without recording an ROU asset or lease liability.

6. Lease Payments

Lease payments include fixed payments, variable payments based on an index or rate (e.g., CPI adjustments), amounts expected to be paid under residual value guarantees, and penalties for terminating the lease early.

Example: Variable Lease Payments

ABC Ltd.’s office lease includes a fixed payment of $10,000 per month plus an adjustment based on the Consumer Price Index (CPI). If the CPI increases by 2%, the payment rises accordingly. Only the fixed and CPI-adjusted payments are included in the lease liability calculation, not variable payments tied to usage (e.g., utility bills).

7. Discount Rate

The discount rate is used to calculate the present value of lease payments. It’s either the interest rate implicit in the lease (if known) or the lessee’s incremental borrowing rate (the rate the lessee would pay to borrow funds to buy the asset).

Example: Applying the Discount Rate

For XYZ Corp.’s van lease, the lessor doesn’t provide the implicit interest rate. XYZ Corp. uses its incremental borrowing rate of 5%, which it would pay to borrow $32,000 over three years. This rate discounts the $1,000 monthly payments to a present value of $32,000 for the lease liability.

8. Subsequent Measurement

After initial recognition, the ROU asset is depreciated (like a purchased asset), and the lease liability is adjusted for interest and payments made. The lessee reduces the liability as payments are made and adds interest expense based on the discount rate.

Example: Subsequent Measurement

XYZ Corp.’s $32,000 ROU asset for the van is depreciated over three years ($10,667 per year if straight-line). The $32,000 lease liability accrues interest at 5% annually, and monthly payments of $1,000 reduce the liability. Each month, XYZ Corp. records depreciation and interest expenses in its income statement.

9. Lessor Accounting

IFRS 16 also defines how lessors (those providing the leased asset) account for leases. Leases are classified as either operating leases (where the lessor keeps the asset on its balance sheet and records lease income) or finance leases (where the lessor transfers the asset’s risks and rewards to the lessee).

Example: Operating vs. Finance Lease

A lessor rents a machine to DEF Ltd. If the lease is short-term (e.g., one year), it’s an operating lease, and the lessor keeps the machine on its balance sheet, recording rental income. If the lease is long-term and transfers most risks (e.g., a five-year lease with a purchase option), it’s a finance lease, and the lessor records a receivable for future payments.

10. Presentation and Disclosure

IFRS 16 requires lessees to present ROU assets and lease liabilities separately in the balance sheet or disclose them in the notes. They must also disclose details about lease expenses, cash flows, and maturity of lease liabilities.

Example: Financial Statement Disclosure

ABC Ltd. includes its $500,000 ROU asset and $500,000 lease liability for its office lease in its balance sheet. In its notes, it discloses the depreciation expense ($100,000 per year), interest expense, and a table showing lease payments due over the next five years.

Impact of IFRS 16

IFRS 16 significantly impacts companies with large lease portfolios, such as retailers, airlines, or logistics firms. Key effects include:

• Increased Assets and Liabilities: Companies show higher assets and liabilities due to ROU assets and lease liabilities.
• Changes in Financial Ratios: Debt ratios (e.g., debt-to-equity) increase because of lease liabilities, potentially affecting loan covenants.
• Income Statement Impact: Operating lease expenses are replaced with depreciation and interest, which may affect profit metrics like EBITDA.

Example: Impact on a Retail Chain

A retail chain with 50 store leases previously reported rent as an operating expense. Under IFRS 16, it records $10 million in ROU assets and lease liabilities. Its debt-to-equity ratio rises, and its EBITDA increases because rent is now split into depreciation and interest expenses.

Transition to IFRS 16

Companies transitioning to IFRS 16 can choose between a full retrospective approach (restating past financials) or a modified retrospective approach (applying IFRS 16 from the effective date without restating). Most choose the modified approach to save time and cost.

Example: Transition Approach

XYZ Corp. adopts IFRS 16 in 2019 using the modified retrospective approach. It calculates ROU assets and lease liabilities for all leases as of January 1, 2019, without restating its 2018 financials, making the transition simpler.

Challenges of Implementing IFRS 16

Implementing IFRS 16 can be complex:

• Data Collection: Companies need detailed data on all leases, which can be challenging for those with many contracts.
• Systems and Processes: New accounting software or processes may be needed to track leases and calculate liabilities.
• Stakeholder Communication: Companies must explain changes to investors and lenders, as financial metrics change.

Conclusion

📘 Also Read: IAS 38 – Accounting for Intangible Assets Explained

IFRS 16 revolutionizes lease accounting by bringing transparency to companies’ financial obligations. By recognizing leases on the balance sheet, it provides a clearer picture of a company’s assets and liabilities. While it introduces challenges, especially for companies with many leases, it ensures better comparability and accuracy in financial reporting. Understanding concepts like ROU assets, lease liabilities, and lease terms, as illustrated through examples, helps demystify IFRS 16 and its practical application.