IFRS 16 lease accounting requires a lessee to recognize almost every lease on the balance sheet as a right-of-use asset and a matching lease liability, then to run depreciation on the asset and interest on the liability through profit or loss over the lease term.1IFRS. IFRS 16 Leases The standard has applied to reporting periods beginning on or after January 1, 2019, and replaced IAS 17’s split between operating and finance leases for lessees. Lessor accounting stayed close to the old model. What follows walks through the mechanics in the order you actually apply them.
Does the Contract Contain a Lease
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. Three tests apply: there must be an identified asset, the customer must obtain substantially all of the economic benefits from using it, and the customer must direct how and for what purpose it is used. If any of the three fails, the arrangement is a service contract and stays off the balance sheet.
Identified Asset
The asset is usually named in the contract. It can also be identified implicitly when the supplier has only one asset available to fulfill the arrangement. It must be physically distinct, or represent substantially all the capacity of a larger asset. A single floor of a building is physically distinct. A capacity slice of a fiber optic cable is not, unless it represents substantially all of the cable’s capacity.2IFRS Foundation. IFRS 16 Leases
A supplier’s right to swap the asset out defeats identification only if that right is substantive. Both conditions must hold: the supplier has the practical ability to substitute alternative assets throughout the period of use, and the supplier benefits economically from doing so.3IFRS Foundation. Definition of a Lease – Substitution Rights (IFRS 16 Leases) A theoretical right without practical means or economic motivation is not substantive.
Economic Benefits and Direction of Use
The customer must have the right to obtain substantially all of the economic benefits from using the asset throughout the period of use. Benefits include primary output, by-products, and other economic benefits such as sublicensing to third parties.2IFRS Foundation. IFRS 16 Leases
The customer must also direct how and for what purpose the asset is used. Where those decisions are predetermined in the contract, the customer still directs use if it operates the asset throughout the period of use, or if it designed the asset in a way that predetermined how it will be used.
Setting the Lease Term
The lease term drives the present value calculation, so it needs to be right. It is the non-cancellable period, plus any extension periods the lessee is reasonably certain to exercise, minus any termination options the lessee is reasonably certain to exercise.2IFRS Foundation. IFRS 16 Leases
“Reasonably certain” is not a vague intention. The lessee weighs every fact that creates an economic incentive to extend or not to terminate: how far below market the renewal rate is, sunk costs in leasehold improvements, the importance of the asset to operations, and penalties or relocation costs tied to leaving. The assessment is revisited when a significant event within the lessee’s control changes the analysis, such as constructing major improvements that make walking away economically irrational.
Splitting Lease and Non-Lease Components
Contracts often bundle a lease with services. A warehouse lease might include maintenance. An equipment lease might include technical support. Lessees split the components and allocate the total consideration between them on relative stand-alone prices. Each lease component follows IFRS 16; non-lease components follow whatever other standard applies.2IFRS Foundation. IFRS 16 Leases
Stand-alone prices are not always easy to pin down, so the standard offers a practical expedient. A lessee may elect, by class of underlying asset, to skip the separation and treat each lease component together with its associated non-lease components as a single lease component. That simplifies the calculation but inflates both the right-of-use asset and the lease liability, because service costs are folded into the capitalized amount. It is worth weighing carefully when service charges make up a large share of total payments.
Leases You Can Keep Off the Balance Sheet
Two optional exemptions let lessees treat certain lease payments as a straight-line expense rather than capitalize them.
- Short-term leases have a maximum possible term of 12 months or less at commencement, including any renewal options. A lease containing a purchase option the lessee is reasonably certain to exercise cannot qualify.
- Low-value asset leases cover assets that are individually low in value when new. Tablets, personal computers, small office furniture, and telephones are the standard examples. The assessment is based on the asset’s value when new, regardless of the age of the specific item leased, and it is made on an absolute basis so different lessees reach the same conclusion about the same type of asset.2IFRS Foundation. IFRS 16 Leases
The standard does not set a specific threshold. The IASB indicated in its Basis for Conclusions that it had in mind assets worth roughly US$5,000 or less when new, and that figure is widely used in practice. Cars never qualify because a new car is not of low value. An asset the lessee subleases, or expects to sublease, is also excluded from the low-value exemption. Entities that elect either exemption still disclose the related expenses in the notes.
Measuring the Lease Liability at Commencement
At the commencement date, the lease liability equals the present value of the lease payments not yet paid. The payments included are:
- Fixed payments, including in-substance fixed payments, less any lease incentives receivable from the lessor.
- Variable payments that depend on an index or a rate, measured initially using the index or rate at the commencement date. Payments linked to a consumer price index or a benchmark interest rate belong here.
- Amounts the lessee expects to owe under residual value guarantees.
- The exercise price of a purchase option, if the lessee is reasonably certain to exercise it.
- Termination penalties, if the lease term reflects the lessee exercising an option to terminate.2IFRS Foundation. IFRS 16 Leases
Variable payments that depend on something other than an index or rate, such as revenue-based rent or usage-based charges, are excluded from the liability. They hit profit or loss in the period the triggering event occurs.
Choosing the Discount Rate
The lessee discounts the payments using the interest rate implicit in the lease. That rate is often impossible to determine in practice because the lessee cannot see the lessor’s residual value assumptions, so most lessees use their incremental borrowing rate instead. This is a lease-specific rate reflecting what the lessee would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value in a similar economic environment.4IFRS Foundation. IFRS 16 Leases – Lessee’s Incremental Borrowing Rate
It is not the entity’s weighted-average cost of capital or a generic corporate borrowing rate. The rate has to reflect the specific lease’s term, collateral, currency, and economic environment. A common approach is to start with an observable rate on a loan with a similar payment profile and adjust for differences in term, security, and jurisdiction. Because judgment is involved, auditors scrutinize this area closely.
Measuring the Right-of-Use Asset at Commencement
The right-of-use asset starts from the lease liability amount and is adjusted for:
- Any lease payments made to the lessor at or before commencement, minus any lease incentives received.
- Initial direct costs the lessee incurs specifically to arrange the lease, such as legal fees or commissions.
- An estimate of the costs to dismantle, remove, or restore the underlying asset at the end of the lease term, where the contract requires it.2IFRS Foundation. IFRS 16 Leases
The result captures the full economic cost of entering the lease, not just the present value of future rent.
Ongoing Measurement
The default for the right-of-use asset is the cost model. The lessee depreciates it on a straight-line basis, or another systematic method reflecting the pattern of consumption, over the shorter of the asset’s useful life or the lease term. If the lease transfers ownership or the lessee is reasonably certain to exercise a purchase option, depreciation runs over the asset’s full useful life.
Two alternative models exist. If the right-of-use asset meets the definition of investment property under IAS 40 and the lessee applies the fair value model to its investment property, the lessee must also apply that fair value model to those right-of-use assets. If the right-of-use asset relates to a class of property, plant, and equipment for which the lessee uses the revaluation model under IAS 16, the lessee may elect to apply that revaluation model to all right-of-use assets in that class.2IFRS Foundation. IFRS 16 Leases
Whichever model applies, the right-of-use asset is tested for impairment under IAS 36. If there is any indication that the carrying amount exceeds the recoverable amount (the higher of fair value less costs of disposal and value in use), an impairment loss is recognized.5IFRS. IAS 36 Impairment of Assets
The lease liability accretes interest each period using the effective interest method at the discount rate set on day one, and reduces as cash payments are made. Profit or loss therefore shows two separate costs: depreciation of the right-of-use asset and interest on the lease liability. Total expense is front-loaded compared with the old straight-line operating lease pattern, because interest charges are higher when the outstanding balance is largest.
Modifications and Remeasurement
Lease terms change. A tenant renegotiates to add another floor. A lessee shortens its commitment by two years. A modification is accounted for as a separate new lease only when both conditions are met: it adds the right to use one or more additional underlying assets, and the payments increase by an amount that reflects the stand-alone price for that additional scope.6IFRS Foundation. IFRS 16 Lease Modifications – Lessee Extending the duration of the same asset is not additional scope, so an extension is never a separate lease.
When the modification is not a separate lease, the lessee remeasures the lease liability by discounting the revised payments at a revised discount rate determined at the effective date of the modification. The adjustment to the right-of-use asset depends on whether scope has decreased:
- Where scope does not decrease, such as an extension or a payment increase, the right-of-use asset is adjusted by the same amount as the change in the lease liability.
- Where scope decreases, such as giving back a floor or shortening the term, the right-of-use asset and the lease liability are first reduced proportionally to reflect the partial termination, with any difference taken to profit or loss. Any remaining elements of the modification then adjust the right-of-use asset.
Some events force a remeasurement even without a formal amendment. A change in the assessed lease term, or a change in the assessment of a purchase option, both trigger remeasurement at a revised discount rate. Changes in expected payments under a residual value guarantee, and changes in future payments driven by a change in an index or rate, also trigger remeasurement, but the original discount rate is used.
The Lessor Side
Lessor accounting under IFRS 16 carried over largely unchanged from IAS 17. Each lease is classified at inception as either a finance lease or an operating lease, and the classification drives the accounting.
A lease is a finance lease when it transfers substantially all the risks and rewards of ownership to the lessee. Indicators pointing to finance lease treatment include transfer of ownership by the end of the term, a bargain purchase option expected to be exercised, a lease term covering the major part of the asset’s economic life, a present value of payments amounting to substantially all of the asset’s fair value at inception, and an asset so specialized that only the lessee can use it without major modifications.2IFRS Foundation. IFRS 16 Leases For a finance lease, the lessor derecognizes the physical asset, records a lease receivable, and recognizes interest income at a constant periodic rate of return on the net investment. For an operating lease, the lessor keeps the asset on the balance sheet, continues depreciating it, and recognizes income on a straight-line basis or another systematic basis if that better reflects the pattern of benefit.
Subleases carry a wrinkle. An intermediate lessor classifies the sublease by reference to its own right-of-use asset from the head lease, not by reference to the underlying physical asset. Because the right-of-use asset typically has a shorter remaining life than the physical asset, a sublease covering most of the remaining head lease term is more likely to be classified as a finance sublease than the underlying physical asset would suggest.
Sale and Leaseback Transactions
A sale and leaseback happens when an entity sells an asset and immediately leases it back. Whether the transfer qualifies as a sale under IFRS 15 drives the accounting.
When the transfer is a sale, the seller-lessee does not recognize the full gain or loss on disposal. The new right-of-use asset is measured at the proportion of the previous carrying amount that relates to the rights retained through the leaseback, calculated by comparing the present value of the leaseback payments to the fair value of the asset. The recognized gain is limited to the proportion of the total gain that relates to the rights actually transferred to the buyer-lessor. If the transaction is not on market terms, adjustments follow: below-market sale proceeds are treated as a prepayment of lease payments, above-market proceeds as additional financing from the buyer-lessor.
When the transfer fails IFRS 15’s sale criteria, no sale is recognized. The seller-lessee keeps the asset on its balance sheet and records the proceeds as a financial liability under IFRS 9. The buyer-lessor records a financial asset for the same amount under IFRS 9. The arrangement is a financing transaction, which is what it economically is when control never actually passed.
Presentation and Disclosure
A lessee either presents right-of-use assets as a separate line on the balance sheet or discloses which line items include them in the notes. The same applies to lease liabilities. On the income statement, depreciation of the right-of-use asset and interest on the lease liability appear as separate charges, replacing the single operating lease expense line under IAS 17.
In the cash flow statement, principal payments on the lease liability sit in financing activities. Interest payments follow the entity’s IAS 7 policy for interest paid, typically operating or financing. Payments for short-term leases, low-value asset leases, and variable payments excluded from the liability go in operating activities.
Quantitative disclosures are extensive and are presented in tabular format unless another format works better. They include depreciation charges on right-of-use assets by class, interest expense on lease liabilities, expense for short-term and low-value leases, variable payment expense excluded from the liability, sublease income, total cash outflows for leases, additions to right-of-use assets, gains or losses on sale and leaseback transactions, and the carrying amounts of right-of-use assets by class at the reporting date. A maturity analysis of lease liabilities is presented separately from other financial liabilities under IFRS 7. Beyond the table, the lessee gives whatever additional qualitative and quantitative information users need to understand exposure to future cash outflows not captured in the liability, including exposure from variable payments, extension and termination options, and residual value guarantees.