Under IFRS 16, a lessee recognizes almost every lease on its balance sheet as a right-of-use asset and a lease liability. The liability is the present value of the lease payments; the asset starts from the same figure. Each year the liability accrues interest and is reduced by payments, while the asset is depreciated. Short-term leases and leases of low-value assets can be exempted.
Before 2019, a company could sign a fifteen-year lease on its head office, commit to millions in payments, and show none of it on the balance sheet. The rent simply appeared as an expense each year. IFRS 16, effective from January 1, 2019, replaced IAS 17 and ended that. It changes the numbers, not just the wording, which is why it is tested so often. This guide covers the single lessee model, measurement, a full four-year example and the effect on the financial statements.
The single lessee model
Under IAS 17, lessees split leases in two. A finance lease, one that transferred substantially all the risks and rewards of ownership, went on the balance sheet. An operating lease did not; it was a straight-line rent expense and a note. Predictably, a lot of effort went into structuring leases to land on the operating side.
IFRS 16 removes the choice for lessees. It starts from a different question: does the customer control the use of an identified asset for a period of time in exchange for consideration? If so, there is a lease, and the lessee recognizes:
- a right-of-use asset: the right to use the asset for the lease term; and
- a lease liability: the obligation to make the lease payments.
The logic explains everything that follows. You have not bought the building. You have bought fifteen years of access to it, and that right is an asset you control. The rent you are committed to pay is a liability you cannot avoid. Both belong on the balance sheet.
Measuring the lease liability
At commencement, the lease liability is the present value of the lease payments not yet made. Discounting matters: a promise to pay $100,000 a year for ten years is not a $1,000,000 liability, because most of that money is paid years from now.
IFRS 16 sets the order for choosing the discount rate:
- The interest rate implicit in the lease, if it can be readily determined; otherwise
- the lessee's incremental borrowing rate: what it would pay to borrow, over a similar term and with similar security, the funds to obtain a similar asset.
In practice the implicit rate is rarely available, because it depends on the lessor's assumptions about residual value, which the lessee usually does not know. Most lessees use their incremental borrowing rate. Exam questions almost always give you the rate; the marks are in knowing which one you were given.
Measuring the right-of-use asset
| Component | Effect on the asset |
|---|---|
| Initial lease liability | Starting point |
| Lease payments made at or before commencement | Add |
| Initial direct costs paid by the lessee | Add |
| Estimated costs of dismantling or restoring the asset | Add |
| Lease incentives received | Deduct |
A rent-free period or a landlord's contribution to fit-out costs is an incentive, and it reduces the asset.
Worked example: a four-year equipment lease
A company leases equipment for four years from January 1. It pays $50,000 at the end of each year. Its incremental borrowing rate is 8%. The present value of four payments of $50,000 at 8% is $165,600 (rounded).
At commencement
| Account | Debit | Credit |
|---|---|---|
| Right-of-use asset | 165,600 | |
| Lease liability | 165,600 |
The lease liability over four years
| Year | Opening liability | Interest at 8% | Payment | Closing liability |
|---|---|---|---|---|
| 1 | 165,600 | 13,248 | (50,000) | 128,848 |
| 2 | 128,848 | 10,308 | (50,000) | 89,156 |
| 3 | 89,156 | 7,132 | (50,000) | 46,288 |
| 4 | 46,288 | 3,712* | (50,000) | 0 |
*Includes a small rounding adjustment so the liability finishes at exactly zero.
Two separate things happen each year, and keeping them separate is the whole skill. Interest is charged on the liability (Dr Interest expense, Cr Lease liability) and the payment reduces it (Dr Lease liability, Cr Cash). Separately, the asset is depreciated straight-line over the four-year lease: $165,600 ÷ 4 = $41,400 a year (Dr Depreciation expense, Cr Accumulated depreciation).
Total expense each year
| Year | Depreciation | Interest | Total expense | Cash paid |
|---|---|---|---|---|
| 1 | 41,400 | 13,248 | 54,648 | 50,000 |
| 2 | 41,400 | 10,308 | 51,708 | 50,000 |
| 3 | 41,400 | 7,132 | 48,532 | 50,000 |
| 4 | 41,400 | 3,712 | 45,112 | 50,000 |
| Total | 165,600 | 34,400 | 200,000 | 200,000 |
Why the expense is front-loaded
Depreciation is the same every year, but interest is charged on a liability that shrinks each year. So total expense starts above the cash rent and ends below it, even though the payments never change. Over the whole lease, expense and cash both total $200,000.
Under the old operating lease treatment, the same lease would have shown a flat $50,000 expense each year. IFRS 16 does not change the total cost; it changes when it appears. A company with many new leases reports lower profit than it would have under IAS 17, and one with mostly mature leases reports higher.
The two exemptions
Both are optional:
- Short-term leases: a lease term of 12 months or less at commencement, with no purchase option. The election is made by class of asset.
- Low-value assets: judged on the value of the asset when new, not on materiality to the lessee. The IASB had figures of around $5,000 in mind. Laptops, office furniture and small IT equipment usually qualify; a car does not, however small it is to a large group. The election is made lease by lease.
Where an exemption is used, the payments are expensed on a straight-line basis, much like the old operating lease treatment.
Lessor accounting did not change
IFRS 16 rewrote lessee accounting but carried lessor accounting forward from IAS 17 almost unchanged. Lessors still classify each lease as a finance lease or an operating lease, based on whether substantially all the risks and rewards of ownership transfer. So the same contract can be a right-of-use asset in the customer's books and an operating lease in the supplier's. The asymmetry is deliberate, and questions like to test whether you noticed it.
The effect on the financial statements
- Balance sheet: assets and liabilities both rise, and gearing ratios get worse, sometimes sharply for retailers and airlines.
- Income statement: rent is replaced by depreciation and interest. Because interest sits below operating profit, EBITDA improves without anything about the business changing.
- Cash flow statement: total cash is the same, but the principal part of each payment moves to financing activities, and interest goes to operating or financing depending on the company's policy. Under IAS 17 the whole payment was operating, so operating cash flow improves too.
Two headline measures improving with no change in the economics is exactly why the standard mattered to analysts, and it is a favorite discussion question. For the difference between profit and cash, see income statement vs cash flow statement.
US GAAP (ASC 842) also puts nearly all leases on the balance sheet, but keeps two types for lessees: finance leases look like IFRS 16, while operating leases show a single straight-line lease cost. See IFRS vs US GAAP differences.
Common lease accounting mistakes
- Recording the liability at the undiscounted total. It is a present value.
- Assuming the asset always equals the liability. They match only when there are no prepayments, direct costs, incentives or restoration costs.
- Depreciating over the asset's useful life by default. Use the shorter of the lease term and useful life, unless ownership transfers or a purchase option is reasonably certain to be exercised.
- Charging interest on the original liability every year. Interest is on the opening balance, which falls each year.
- Applying the low-value exemption by materiality. It is judged on the asset's value when new, in absolute terms.
- Assuming lessors use the single model. They do not.
Practice it
Lease accounting rewards repetition more than reading, because the arithmetic is where errors hide. The liability works like an amortizing loan, close to notes payable, and the asset behaves like any other depreciable asset. Accountely's lease challenges check every line you enter and show exactly which figure went wrong. It's free to start.
Frequently Asked Questions
How is a lease liability calculated under IFRS 16?
As the present value of the lease payments not yet paid at commencement, discounted at the interest rate implicit in the lease or, if that cannot be readily determined, the lessee's incremental borrowing rate.
What is a right-of-use asset?
An asset representing the lessee's right to use the leased item for the lease term. It is measured at the initial lease liability, plus payments made at or before commencement, initial direct costs and restoration costs, less lease incentives received, and is then depreciated.
Which leases are exempt from IFRS 16?
Lessees may choose not to apply the balance sheet model to short-term leases of 12 months or less with no purchase option, and to leases of low-value assets, such as laptops and small office equipment. Payments on those leases are expensed on a straight-line basis.
Why does IFRS 16 increase EBITDA?
Because lease rent, which was an operating expense, is replaced by depreciation and interest, both of which are excluded from EBITDA. The underlying cash payments do not change.