IFRS 16 sets out the principles for the Recognition, Measurement, Presentation and Disclosure of leases.
The Objective is to ensure that ‘Lessees’ and ‘Lessors’ provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial
position, financial performance and cash flows of an entity.
01. What is IFRS 16?
IFRS 16 Leases is an accounting standard issued by the International Accounting Standards Board (IASB) in January 2016. It became mandatory for annual reporting periods beginning on or after 1 January 2019, replacing the previous standard IAS 17 Leases.
The standard’s central objective is to ensure that both lessees and lessors provide relevant information that faithfully represents lease transactions in their financial statements. The most significant change introduced by IFRS 16 is the requirement for lessees to recognise virtually all leases on the balance sheet ending the distinction between operating and finance leases for lessee accounting.
At the commencement date, a lessee must recognise a right-of-use (ROU) asset and a corresponding lease liability for all leases, unless the short-term or low-value asset exemption applies.
Why Did IFRS 16 Replace IAS 17?
Under IAS 17, Operating Leases were treated as off-balance-sheet financing i.e. companies could lease significant assets (aircraft, ships, retail stores) without those obligations appearing on their balance sheets. This obscured the true financial position of companies and made comparability between businesses difficult. Standard setters, investors, and analysts called for reform over many years.
IFRS 16 addressed these concerns by requiring a single, on-balance-sheet accounting model for lessees, resulting in greater transparency, comparability, and a more faithful representation of a company’s financial leverage.
02. Scope & Key Definitions
IFRS 16 applies to all leases, including leases of right-of-use assets in a sublease, with limited exceptions.
Scope Exclusions
IFRS 16 does not apply to:
| Excluded Item | Applicable Standard | Notes |
|---|---|---|
| Exploration or use of minerals, oil, natural gas | IFRS 6 | Non-renewable resources |
| Biological assets (lessee only) | IAS 41 | Living plants and animals |
| Service concession arrangements | IFRIC 12 | Public-to-private arrangements |
| Licences of intellectual property (lessee only) | IFRS 15 | Software, patents, brands |
| Rights to use films, video recordings, plays, manuscripts, etc. | Various | Intangible assets |
Key Definitions
A contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
An asset representing the lessee’s right to use an underlying asset for the duration of the lease term.
The lessee’s obligation to make lease payments, measured at the present value of future lease payments not yet made.
The date on which a lessor makes an underlying asset available for use by a lessee, when initial recognition occurs.
The non-cancellable period of a lease, plus optional extension periods the lessee is reasonably certain to exercise, plus optional termination periods the lessee is reasonably certain not to exercise.
The rate of interest that a lessee would pay to borrow funds necessary to obtain an asset of similar value over a similar term, used when the implicit rate cannot be determined.
03. Identifying a Lease
Not every contract titled a “lease” is a lease under IFRS 16, and not every service contract is free of embedded leases. The standard provides a rigorous framework for identification.
The Three-Part Test
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. Control exists when the customer has both:
Right to Obtain Substantially All Economic Benefits
The customer can obtain substantially all the economic benefits from use of the identified asset throughout the period of use. This includes benefits from the primary output and by-products of the asset.
Right to Direct the Use
The customer has the right to decide how and for what purpose the asset is used throughout the period of use, OR the relevant decisions are predetermined and the customer has the right to operate the asset without the supplier having the right to change those operating instructions.
Identified Asset
An asset is typically identified if it is explicitly specified in a contract. However, even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use, meaning the supplier can practically and economically benefit from substitution.
Many IT outsourcing and transportation contracts contain embedded leases. Entities should review all significant contracts not just those explicitly labelled “lease agreements” to identify whether IFRS 16 applies.
04. Lessee Accounting — Overview
IFRS 16 introduces a single accounting model for lessees, replacing the dual operating/finance lease model under IAS 17. Unless an exemption applies, a lessee must:
Recognise a Right-of-Use Asset
Classify and measure a non-current asset on the balance sheet representing the right to use the underlying leased asset.
Recognise a Lease Liability
Record a corresponding financial liability representing the obligation to make future lease payments, initially measured at the present value of those payments.
Charge Depreciation on the ROU Asset
Apply IAS 16 depreciation principles (or IAS 38 for intangible assets) to systematically reduce the carrying amount of the ROU asset over the shorter of the lease term and the useful life of the underlying asset.
Recognise Interest on the Lease Liability
Apply the effective interest rate method to “unwind” the discount on the lease liability, recognising interest expense in profit or loss.
Under IFRS 16, the single straight-line operating lease expense under IAS 17 is replaced by two charges: depreciation of the ROU asset (often included in operating expenses) and interest on the lease liability (financing costs). This typically front-loads total expense in the early years of a lease.
05. Initial Measurement
Lease Liability — Initial Measurement
At the commencement date, the lease liability is measured at the present value of lease payments not yet made, discounted using the interest rate implicit in the lease (or the lessee’s incremental borrowing rate if the implicit rate cannot be readily determined).
Lease payments included in the measurement:
- Fixed payments (less any lease incentives receivable)
- Variable lease payments that depend on an index or rate
- Amounts expected to be payable under residual value guarantees
- Exercise price of a purchase option if reasonably certain to exercise
- Payments for penalties for terminating the lease if the lease term reflects exercise of a termination option
Right-of-Use Asset — Initial Measurement
06. Subsequent Measurement
Right-of-Use Asset — After Initial Recognition
The ROU asset is subsequently measured using the cost model (applying IAS 16), unless the lessee applies the revaluation model (for ROU assets relating to a class of assets for which it applies IAS 16 revaluation) or the fair value model (investment property ROU assets under IAS 40).
Under the cost model, the ROU asset is:
- Reduced by accumulated depreciation and impairment losses
- Adjusted for any remeasurement of the lease liability
Depreciation is applied on a straight-line basis over the shorter of:
- The lease term — if the lease does not transfer ownership and there is no purchase option reasonably certain to be exercised
- The useful life of the underlying asset — if the lease transfers ownership to the lessee at the end of the lease term, or the lessee is reasonably certain to exercise a purchase option
Lease Liability — After Initial Recognition
After the commencement date, the lease liability is measured by:
- Increasing the carrying amount to reflect interest (using the effective interest method)
- Reducing the carrying amount to reflect lease payments made
- Remeasuring the carrying amount to reflect reassessments or lease modifications
Remeasurement Triggers
| Trigger | Discount Rate | Adjust ROU? |
|---|---|---|
| Change in lease term assessment | Revised IBR at reassessment date | Yes |
| Change in purchase option assessment | Revised IBR at reassessment date | Yes |
| Change in index/rate (e.g., CPI-linked payment) | Original rate (unchanged) | Yes |
| Change in expected residual value guarantee | Original rate (unchanged) | Yes |
| Lease modification (new lease) | Revised IBR at modification date | Yes |
07. Journal Entries
At Commencement Date
| Account | Dr | Cr |
|---|---|---|
| Right-of-Use Asset | XXX | — |
| Lease Liability | — | XXX |
Each Reporting Period — Interest Accrual
| Account | Dr | Cr |
|---|---|---|
| Interest Expense (P&L) | XXX | — |
| Lease Liability (interest accrual) | — | XXX |
Each Reporting Period — Depreciation
| Account | Dr | Cr |
|---|---|---|
| Depreciation Expense (P&L) | XXX | — |
| Accumulated Depreciation — ROU Asset | — | XXX |
Lease Payment Made
| Account | Dr | Cr |
|---|---|---|
| Lease Liability (principal repayment) | XXX | — |
| Lease Liability (interest — if accrued separately) | XXX | — |
| Cash / Bank | — | XXX |
08. Practical Expedients
IFRS 16 provides two important recognition exemptions that allow lessees to avoid on-balance-sheet treatment for certain leases:
Leases with a lease term of 12 months or less at the commencement date. Payments are recognised on a straight-line basis (or another systematic basis) as an expense in profit or loss. The election is made by class of underlying asset.
Leases where the underlying asset has a low value when new — the IASB indicated approximately USD 5,000 as the threshold. Common examples: laptops, personal computers, small office furniture, telephones. The election is made on a lease-by-lease basis.
The low-value asset exemption is assessed based on the absolute value of the asset when new, regardless of the size of the lessee. A lease of an asset that is low value when new but is material to the lessee does not preclude use of the exemption however, the short-term lease exemption cannot be used if there is a purchase option.
Other Practical Expedients at Transition
At transition, IFRS 16 offers a package of additional expedients including: applying IFRS 16 only to contracts that were previously identified as leases under IAS 17/IFRIC 4, using a single discount rate for a portfolio of leases with reasonably similar characteristics, and excluding initial direct costs from the measurement of the ROU asset.
09. Lessor Accounting
Unlike lessee accounting, IFRS 16 made relatively few changes for lessors. Lessors continue to classify each lease as either a finance lease or an operating lease based on whether the lease substantially transfers all risks and rewards incidental to ownership of the underlying asset.
- Lessor derecognises the underlying asset
- Recognises a net investment in the lease (receivable)
- Recognises finance income over the lease term using the effective interest method
- Revenue recognised on commencement (if manufacturer/dealer lessor)
- Lessor continues to recognise the underlying asset
- Recognises lease income on a straight-line basis or another systematic basis
- Continues to charge depreciation on the underlying asset
- Initial direct costs deferred and added to the carrying amount
Finance Lease Classification Indicators
A lease is classified as a finance lease when it transfers substantially all risks and rewards. Indicators include:
| # | Indicator | Classification Signal |
|---|---|---|
| 1 | Ownership transfers to lessee by end of lease term | Finance |
| 2 | Bargain purchase option that lessee is reasonably certain to exercise | Finance |
| 3 | Lease term covers major part of economic life of asset | Finance |
| 4 | PV of payments ≈ substantially all of fair value of underlying asset | Finance |
| 5 | Specialised asset only usable by lessee without major modifications | Finance |
| 6 | None of the above substantially met | Operating |
10. Disclosure Requirements
Lessee Disclosures
The objective of IFRS 16 disclosures is to enable users of financial statements to understand the effect that leases have on an entity’s financial position, performance, and cash flows. Required disclosures include:
| Disclosure Area | Required Information |
|---|---|
| Balance Sheet | Carrying amount of ROU assets by class, lease liabilities split into current and non-current portions |
| Income Statement | Depreciation charge, interest expense, short-term lease expense, low-value asset lease expense, variable lease payments not in measurement |
| Cash Flow Statement | Principal element of lease payments (financing), interest paid (financing or operating per IAS 7 policy) |
| Maturity Analysis | Undiscounted lease liability cash flows in bands: ≤1 yr, 1–5 yrs, >5 yrs |
| Qualitative | Nature of leasing activities, significant judgements and assumptions (e.g., lease term, discount rate) |
| Subleases | Income from subleases; finance income on net investment in subleases |
Lessor Disclosures
Lessors must disclose information enabling users to assess the effect of leases on their financial statements, including: a maturity analysis of lease payments receivable (finance leases) and undiscounted lease payments (operating leases), details of significant assumptions and judgements, and qualitative information about risk management relating to residual value exposure.
11. Transition Approaches
Entities had a choice of two approaches when adopting IFRS 16 for the first time:
- Restate all comparative periods presented
- Adjust opening equity of the earliest period presented
- More complex but provides full comparability
- Apply all requirements of IFRS 16 as if standard was always in force
- No restatement of comparative periods
- Cumulative effect recognised in opening equity on 1 Jan 2019
- Less complex; most widely adopted approach in practice
- Offers additional practical expedients at transition
Transition Timeline
IASB publishes IFRS 16, giving entities a three-year preparation period.
Final day of the last annual period before mandatory application for most calendar-year entities.
IFRS 16 mandatory effective date for annual periods beginning on or after this date (early adoption permitted from 2016 alongside IFRS 15).
Annual reassessment of lease terms, discount rates (where triggered), and lease modifications required each reporting period.
12. IFRS 16 vs IAS 17 — Key Differences
| Aspect | IAS 17 (Old) | IFRS 16 (Current) |
|---|---|---|
| Lessee classification | Operating lease or finance lease | Single model — no classification for lessees |
| Balance sheet impact (lessee) | Operating leases off-balance-sheet | All leases on-balance-sheet (except exemptions) |
| Expense recognition (operating leases) | Straight-line operating expense | Depreciation + interest (front-loaded total cost) |
| EBITDA | Reduced by operating lease payments | Improved — depreciation excluded from EBITDA |
| Lessor accounting | Finance lease / operating lease | Finance lease / operating lease (broadly unchanged) |
| Leverage ratios | Lower (off-B/S leases excluded) | Higher (lease liabilities included in debt) |
| Key standard reference | IAS 17 | IFRS 16 |
13. Worked Example
Company A leases office space for 5 years commencing 1 January Year 1. Annual lease payments are $100,000, payable in arrears at year end. The lessee’s incremental borrowing rate is 6% per annum. There are no initial direct costs, prepayments, or restoration obligations.
Step 1: Calculate the Lease Liability (PV of Payments)
Step 2: Initial Recognition (1 Jan Year 1)
| Account | Dr ($) | Cr ($) |
|---|---|---|
| Right-of-Use Asset | 421,236 | — |
| Lease Liability | — | 421,236 |
Step 3: Lease Amortisation Schedule
| Year | Opening Liability | Interest (6%) | Payment | Closing Liability |
|---|---|---|---|---|
| 1 | 421,236 | 25,274 | (100,000) | 346,510 |
| 2 | 346,510 | 20,791 | (100,000) | 267,301 |
| 3 | 267,301 | 16,038 | (100,000) | 183,339 |
| 4 | 183,339 | 11,000 | (100,000) | 94,339 |
| 5 | 94,339 | 5,661 | (100,000) | — |
Step 4: Annual ROU Asset Depreciation
Depreciate ROU asset of $421,236 over 5 years on a straight-line basis:
Income Statement Impact — Year 1
| Item | Amount ($) | Location |
|---|---|---|
| Depreciation of ROU Asset | 84,247 | Operating expenses |
| Interest on Lease Liability | 25,274 | Finance costs |
| Total P&L Charge — Year 1 | 109,521 | |
| vs straight-line under IAS 17 | 100,000 |
Note how the total charge in Year 1 ($109,521) is higher than the $100,000 that would have been recognised under IAS 17’s straight-line operating lease expense — illustrating the front-loading effect of IFRS 16.
14. Frequently Asked Questions
IFRS 16 applies to most leases of tangible assets. It specifically excludes leases of biological assets, mineral rights, licences of intangible assets (for lessees), and service concession arrangements. For intangible assets generally, a lessee may elect to apply IFRS 16 but is not required to do so.
The preferred rate is the interest rate implicit in the lease, which equates the PV of lease payments and the unguaranteed residual value with the fair value of the underlying asset and initial direct costs of the lessor. If this rate cannot be readily determined, the lessee uses its incremental borrowing rate (IBR) the rate it would pay to borrow a similar amount over a similar term to obtain an asset of similar value.
IFRS 16 typically increases total assets and total liabilities (due to ROU asset and lease liability), increases EBITDA (operating lease payments no longer deducted from EBIT), increases debt-to-equity and net debt ratios, increases interest cover calculations that use EBIT, and front-loads profit and loss charges in early lease years. These impacts are significant for sectors with heavy leasing activity such as airlines, retailers, and hospitality companies.
A lease modification is a change to the scope or consideration of a lease not originally part of the terms. If the modification adds the right to use additional assets at a price commensurate with standalone value, it is treated as a separate new lease. Otherwise, whether it increases or decreases scope determines whether remeasurement decreases the ROU asset (decrease in scope) or is recognised in the lease liability at a revised discount rate (all other modifications).
Variable lease payments fall into two categories. Payments that depend on an index or rate (e.g., CPI, LIBOR/SOFR) are included in the lease liability measurement using the index/rate at the commencement date, and remeasured when the index or rate changes. Payments that depend on performance or usage (e.g., a percentage of sales) are not included in the lease liability, they are recognised in profit or loss in the period in which they are incurred.
The principal portion of lease payments is classified as a financing cash outflow. Interest paid on lease liabilities is classified in accordance with the entity’s IAS 7 accounting policy (operating or financing). Short-term and low-value lease payments, and variable lease payments not included in the lease liability, are classified as operating cash outflows. This typically improves operating cash flow metrics compared to IAS 17.
(Qualified) Chartered Accountant – ICAP
Master of Commerce – HEC, Pakistan
Bachelor of Accounting (Honours) – AeU, Malaysia