IFRS 16 Leases
1 Introduction
A lease is a contract that gives one party the right to use an asset owned by another for a period of time, in exchange for payment. The party that owns the asset legally is the lessor; the party that uses it is the lessee. If you rent a flat rather than owning it, your landlord is the lessor and you are the lessee. In business the asset might be a warehouse, a head office, a fleet of sales cars or a single machine.
F1 looks at leases entirely from the lessee’s side. That is where the interesting question sits: the lessee does not own the asset, yet it has the right to use it and gets the benefits from it for years. Should that right appear on the lessee’s statement of financial position?
1.1 The problem IFRS 16 was written to solve
Under the old standard, IAS 17, lessees split their leases into two kinds. A finance lease — one that transferred substantially all the risks and rewards of ownership — went on to the statement of financial position as an asset and a liability. An operating lease did not: the rentals were simply charged to profit or loss as they arose.
The consequence was off balance sheet finance on a very large scale. An airline could operate a fleet of aircraft under operating leases, commit itself to years of unavoidable payments, and show neither the aircraft nor the obligation anywhere on its statement of financial position. Two airlines with identical fleets and identical commitments could look completely different depending on how their contracts had been drafted.
IFRS 16 removed the distinction for lessees. There is now a single lessee accounting model: every lease brings a right-of-use asset and a matching lease liability on to the statement of financial position, with depreciation on the asset and interest on the liability in profit or loss. Only two narrow exemptions survive, and they are covered below.
All six recordings predate IFRS 18 and say nothing about where their amounts land in the 2027 statement of profit or loss — see “Presentation, disclosure and the other statements”.
Notes-only across the set: the identification test, the full right-of-use cost build-up, presentation and disclosure, the IAS 7 treatment of lease cash flows, and the front-loaded expense profile.
Low value and short-life leases: the “applied from 1 January 2019, this is new” framing is dated for a 2027 sitting.
Accounting treatment: dismantling and restoration costs and pre-commencement payments are set aside on video and taught in these notes.
Example 2: the year-4 $237 “give and take with rounding” is explained in these notes — the exact present value is $22,729.75.
2 Identifying a lease
A contract is, or 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 means two things together:
The right to obtain substantially all of the economic benefits from using the asset throughout the period of use.
The right to direct how and for what purpose the asset is used.
If the supplier can substitute a different asset whenever it likes, or keeps the decisions about how the asset is used, the customer has bought a service, not a lease. Buying warehousing capacity “somewhere in the supplier’s network” is a service; leasing a named unit that only you may use, and deciding yourself what goes into it, is a lease.
3 The two recognition exemptions
A lessee may choose not to recognise a right-of-use asset and lease liability in two cases:
Exemption | What qualifies | How the election is made |
Short-term leases | A lease term of 12 months or less at the commencement date, and containing no option to purchase the asset. | By class of underlying asset — all short leases of that class are treated the same way. |
Leases of low-value assets | The underlying asset is of low value when new — laptops, tablets, telephones, small items of office furniture. The test is absolute (the value of the asset itself), not relative to the size of the lessee. | Lease by lease — the lessee may take the exemption on one laptop lease and not another. |
Where the exemption is taken, the payments are recognised as an expense on a straight-line basis over the lease term (unless another systematic basis better reflects the pattern of benefit). Nothing appears in non-current assets and nothing appears in borrowings.
The straight-line trap
“Straight line over the lease term” means the total of the payments divided by the number of years — not the amount paid in each individual year. Rent-free periods and up-front deposits are spread across the whole term, so the expense and the cash rarely match. The difference sits on the statement of financial position as an accrual (cash behind the expense) or a prepayment (cash ahead of it).
Low-value assets
Banana leases a machine to Mango under a four-year lease, and Mango elects to apply the low-value exemption. The annual lease rentals are $2,000, payable in arrears. As an incentive, Banana grants Mango a rent-free period in the first year.
Explain how Mango would account for the lease in its financial statements over the four years.
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If the lease starts part-way through the year, pro-rate the annual expense to the months of the year for which the asset was leased. And read the year the question asks about: examiners like to ask for the statement of financial position figure in year 2 or 3, not year 1.
4 Lessee accounting: initial recognition
For every other lease, at the commencement date — the date the lessor makes the asset available for use — the lessee recognises a right-of-use asset and a lease liability. Start with the liability, because the asset is built from it.
4.1 The lease liability
The liability is the present value of the lease payments not yet paid, discounted at the rate implicit in the lease. If that rate cannot be readily determined, the lessee uses its own incremental borrowing rate — the rate it would have to pay to borrow the funds to buy a similar asset. In F1 the rate is always given, and very often the present value itself is given.
Included in the lease payments | Comment |
Fixed payments, less any lease incentives receivable | The core of the calculation. |
Variable payments that depend on an index or rate | Measured using the index or rate at the commencement date. |
Amounts expected to be payable under a residual value guarantee | Only the amount the lessee expects to have to pay. |
The exercise price of a purchase option | Only if the lessee is reasonably certain to exercise it. |
Penalties for terminating the lease | Only if the lease term reflects the lessee exercising the option to terminate. |
Note when the payments fall. Payments in advance are made at the start of each period — the first one on the commencement date itself, so it is paid immediately and never discounted. Payments in arrears are made at the end of each period, so every one of them is discounted. The same headline rental produces a different liability, a different interest charge and a different current/non-current split depending on which it is.
4.2 The right-of-use asset
The asset is measured at cost, which is built up as follows:
Right-of-use asset at cost | $ |
Initial measurement of the lease liability | X |
Add: lease payments made at or before the commencement date | X |
Less: lease incentives received | (X) |
Add: initial direct costs incurred by the lessee | X |
Add: estimated costs of dismantling and restoring the asset or site | X |
Cost of the right-of-use asset | X |
Initial direct costs are the incremental costs of obtaining the lease that would not have been incurred if the lease had not been signed — legal fees on the agreement, commission, delivery and installation. Lease incentives are contributions the lessor makes towards those costs; they reduce the asset.
5 Lessee accounting: subsequent measurement
Right-of-use asset | Lease liability | |
Measured at | Cost less accumulated depreciation and any accumulated impairment losses (the cost model of IAS 16 — Chapter 6). | Amortised cost: the balance is increased by interest at the rate implicit in the lease and reduced by the payments made. |
Charged to profit or loss | Depreciation. | Interest (a finance cost). |
Presented in | Non-current assets — either as a separate line or within the same line as owned assets of the same class, with disclosure of the amount. | Split between current and non-current liabilities. |
5.1 Depreciating the right-of-use asset
Depreciate from the commencement date over the shorter of the lease term and the asset’s useful life. The logic is simple: the benefit stops when the lease ends, so there is nothing to spread the cost over after that.
The exception is where ownership is expected to pass — the lease transfers ownership at the end of the term, or the lessee is reasonably certain to exercise a purchase option. Then the asset will still be there after the lease term, so it is depreciated over its useful life.
There is no “rent expense” for a lease that is on the statement of financial position. Rent is replaced by two separate charges — depreciation, which is level, and interest, which is highest in the first year and falls as the liability is paid down. Total expense is therefore front-loaded compared with the old operating-lease rental. Under IFRS 18 (Chapter 5) the depreciation sits in the operating category and the interest in the financing category, so the two now appear in different parts of the statement of profit or loss.
5.2 The lease liability table
Unwinding the liability is a table, and the layout depends on when the payments fall.
Payments in advance | Payments in arrears |
Balance b/f | Balance b/f |
Less: payment (at the start of the year) | Add: interest at the implicit rate on the b/f balance |
= capital balance outstanding for the year | Less: payment (at the end of the year) |
Add: interest at the implicit rate on that capital balance | = balance c/f |
= balance c/f |
The principle is the same in both: interest is charged for the time the money is actually outstanding. With payments in advance the year’s payment goes out first, so interest is charged on the reduced balance; with payments in arrears the whole opening balance is outstanding all year, so interest is charged on it in full.
Lessee accounting
On 1 January 20X5 Plum entered into a five-year lease of machinery. The machinery has a useful life of six years. The annual lease payments are $5,000, with the first payment made on 1 January 20X5.
To obtain the lease Plum incurred initial direct costs of $1,000, but the lessor agreed to reimburse Plum $500 towards the costs of the lease.
The rate implicit in the lease is 5%. The present value of the lease payments is $22,730. Plum has a 31 December year end.
Demonstrate how the lease will be accounted for in the financial statements over the five-year period.
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Where does the $237 come from? Five per cent of $4,763 is $238.15. The $1 difference arises because the present value has been rounded: the exact present value of five payments of $5,000 in advance at 5% is $22,729.75, and a table built on that figure closes at exactly $5,000. Working from the rounded $22,730, the convention is to take the final year’s interest as the balancing figure so that the liability clears exactly. Never let a rounding difference of a dollar or two send you hunting for an error.
6 Splitting the liability: current and non-current
The liability on the statement of financial position must be split between the amount falling due within twelve months of the reporting date (current) and the rest (non-current). You do not need a second calculation — the answer is already in the liability table.
The rule
Look at next year’s row and take the figure that stands immediately after next year’s payment: that is the non-current liability. The current liability is the total liability at the reporting date less that figure.
Payments in advance – the figure after the payment is next year’s capital outstanding column (brought forward less payment).
Payments in arrears – the payment is the last thing to happen in the year, so the figure after it is next year’s closing balance.
The rule works because the current portion is the principal that will be repaid over the coming twelve months. With payments in advance the whole of next year’s payment is principal: it is made on the first day of the year, before any further interest has accrued. With payments in arrears a full year’s interest accrues first, so only the balance of the payment reduces the principal.
Applying it to Plum at 31 December 20X5 (the end of year 1), where the total liability is $18,617 and the year 2 payment of $5,000 falls on 1 January 20X6:
Lease liability at 31 December 20X5 | $ |
Non-current (year 2 capital outstanding after the payment) | 13,617 |
Current (18,617 − 13,617) | 5,000 |
Total | 18,617 |
Do not simply take the closing balance twelve months later ($14,298 for Plum) as the non-current figure when the payments are in advance. That balance includes the $681 of interest that accrues during 20X6 — a cost of next year, not part of what is owed at the reporting date. For payments in arrears the closing balance is the right figure, because there the payment comes after the interest. Take the figure that follows next year’s payment and you are right either way.
7 Payments in arrears
When the payments fall at the end of each period, every payment is discounted and the table charges interest on the full opening balance before deducting the payment.
A four-year lease of a delivery van requires $9,000 to be paid annually in arrears. The rate implicit in the lease is 7%, and the present value of the payments is $30,485.
Year | B/f $ | Interest at 7% $ | Payment $ | C/f $ |
1 | 30,485 | 2,134 | (9,000) | 23,619 |
2 | 23,619 | 1,653 | (9,000) | 16,272 |
3 | 16,272 | 1,139 | (9,000) | 8,411 |
4 | 8,411 | 589 | (9,000) | – |
At the end of year 1 the liability of $23,619 is split: non-current $16,272 (the year 2 closing balance) and current $7,347. Compare this with a lease in advance — here interest is charged on the whole $30,485 in year 1, so the first-year finance cost is much larger.
8 Presentation, disclosure and the other statements
Statement | What appears |
Financial position | Right-of-use assets within non-current assets, presented separately or within the same line as the equivalent owned assets (with disclosure of which line they sit in). Lease liabilities split between current and non-current, presented separately from other liabilities or disclosed in the notes. |
Profit or loss | Depreciation of right-of-use assets, and interest on lease liabilities as a finance cost. Under IFRS 18 these fall in different categories — depreciation is operating, interest is financing (Chapter 5). |
Cash flows | The cash payments are financing outflows — both the principal element and, under IAS 7 as amended by IFRS 18, the interest element (Chapter 12). Payments on short-term and low-value leases stay in operating activities. |
IFRS 16 also requires disclosure of the total cash outflow for leases, additions to right-of-use assets, the carrying amount of right-of-use assets by class, the expense relating to short-term and low-value leases, and a maturity analysis of the lease liabilities.
Lessor accounting is outside the F1 syllabus. For completeness: IFRS 16 left the lessor model broadly as it was under IAS 17, so lessors still classify leases as finance or operating leases. The asymmetry is deliberate — the off balance sheet problem was a lessee problem.
Every lease goes on the lessee’s statement of financial position unless it is short-term (12 months or less, no purchase option, elected by class) or low value (elected lease by lease), in which case the payments are simply expensed straight line over the term. Otherwise: the lease liability is the present value of the remaining lease payments at the rate implicit in the lease; the right-of-use asset is that liability plus payments made at or before commencement, plus initial direct costs and dismantling costs, less incentives received. Depreciate the asset over the shorter of the lease term and the useful life — the useful life if ownership is expected to pass. Unwind the liability in a table: with payments in advance, deduct the payment then charge interest; with payments in arrears, charge interest then deduct the payment. Next year’s closing balance is the non-current liability, and the rest is current.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
IFRS 16 Leases
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