Accounting Science

Introducing IFRS 16 Standard: Leases

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mariam elghandour

On February 17, 2025

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The IFRS 16 Standard, “Leases,” represents a qualitative shift in lease accounting, introducing substantial changes to how these contracts are treated in financial statements, especially from the lessee’s perspective. The IFRS 16 Standard provides a new accounting model aimed at improving the transparency, reliability, and comparability of financial information related to leases. In this article, we will present the IFRS 16 Standard, discuss its objectives, scope, and key requirements. We will focus on the new lessee model, how to recognize and measure right-of-use assets and lease liabilities, and highlight the importance of this standard and its impact on financial statements.

What is the IFRS 16 Standard: Leases?

The IFRS 16 Standard is an International Financial Reporting Standard that aims to standardize how leases are accounted for in financial statements. This standard was issued by the International Accounting Standards Board (IASB) to replace IAS 17, “Leases,” and related interpretations.

Objectives of the IFRS 16 Standard:

Improve the Representation of Leases in Financial Statements: The IFRS 16 Standard aims to improve the representation of leases in financial statements, especially from the lessee’s perspective, by recognizing assets and liabilities for most leases on the statement of financial position.
Enhance Transparency and Reliability of Financial Information: The IFRS 16 Standard helps enhance the transparency and reliability of financial information related to leases by providing a more complete picture of an entity’s obligations and rights related to these contracts.
Increase Comparability: The IFRS 16 Standard contributes to improving the comparability of financial statements of entities that use leases, regardless of the lease classification (finance or operating).
Provide Useful Information for Decision-Making: The IFRS 16 Standard provides more useful information to users of financial statements, helping them assess the impact of leases on an entity’s financial position, financial performance, and cash flows.
Eliminate Lessor Accounting Model: IFRS 16 Standard primarily focuses on the lessee accounting, while maintaining the lessor accounting as per the IAS 17.

Scope of the IFRS 16 Standard:

The IFRS 16 Standard applies to all leases, including leases of right-of-use assets in a sublease, except for:

Leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources: These fall within the scope of IFRS 6.
Leases of biological assets held by a lessee (covered by IAS 41).
Service concession arrangements (covered by IFRIC 12).
Licenses of intellectual property granted by a lessor (covered by the IFRS 15 Standard).
Rights held by a lessee under licensing agreements for items such as motion picture films, video recordings, plays, manuscripts, patents, and copyrights (covered by IAS 38).

Definition of a Lease: A contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.

The New Lessee Model:

The IFRS 16 Standard introduces a new accounting model for lessees, where all leases (with some exceptions) are recognized on the statement of financial position. This model eliminates the previous distinction between finance leases and operating leases from the lessee’s perspective.

Under the IFRS 16 Standard, at the commencement of a lease, a lessee must:

Recognize a Right-of-Use Asset: Represents the lessee’s right to use the underlying asset during the lease term.
Recognize a Lease Liability: Represents the lessee’s obligation to make lease payments.

Exemptions from the New Lessee Model:

The IFRS 16 Standard provides two optional exemptions from the requirements to recognize a right-of-use asset and a lease liability:

Short-term Leases: Leases with a lease term of 12 months or less, and that do not contain a purchase option.
Low-value Leases: Leases where the underlying asset is of low value when new (e.g., tablets, personal computers, small items of office furniture).

If a lessee chooses to apply either of these exemptions, lease payments are recognized as an expense on a straight-line basis or another systematic basis over the lease term.

Measurement of the Right-of-Use Asset and Lease Liability:

Lease Liability: Measured at the present value of the lease payments that are not yet paid, discounted using the interest rate implicit in the lease (if readily determinable) or the lessee’s incremental borrowing rate.
Right-of-Use Asset: Measured at the amount of the lease liability, plus any lease payments made at or before the commencement date, less any lease incentives received, plus any initial direct costs incurred by the lessee, plus any costs to restore the underlying asset to its original condition (if any).

Components of Lease Payments:

Fixed Payments: Payments required by the lease that do not depend on an index or a rate.
Variable Payments that Depend on an Index or a Rate: Such as payments linked to the Consumer Price Index. The lease liability is initially measured using the index or rate at the commencement date.
Amounts Expected to be Payable by the Lessee under Residual Value Guarantees: Guarantees provided by the lessee to the lessor that the value of the asset at the end of the lease will not be less than a certain amount.
The Exercise Price of a Purchase Option (if the lessee is reasonably certain to exercise that option).
Payments of Penalties for Terminating the Lease (if the lessee is reasonably certain to terminate the lease).

Subsequent Accounting Treatment:

Right-of-Use Asset: Depreciated over the lease term using the straight-line method, usually, unless another basis is more representative of the pattern in which the future economic benefits embodied in the right-of-use asset are expected to be consumed. The right-of-use asset is tested for impairment in accordance with IAS 36, “Impairment of Assets.”
Lease Liability: The carrying amount of the lease liability is increased to reflect interest on the liability and reduced to reflect lease payments made. Interest expense is calculated using the effective interest method.

Lessor Accounting:

The IFRS 16 Standard retains the lessor accounting model from IAS 17, where leases are still classified by the lessor as either finance leases or operating leases.

Finance Lease: A lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset to the lessee. The lessor recognizes a lease receivable and derecognizes the underlying asset from its books.
Operating Lease: Any lease other than a finance lease. The lessor continues to recognize the underlying asset in its books and recognizes lease income over the lease term.

Disclosure Requirements under the IFRS 16 Standard:

The IFRS 16 Standard imposes comprehensive disclosure requirements for both lessees and lessors, aimed at enabling users of financial statements to understand the impact of leases on an entity’s financial position, financial performance, and cash flows.

Required disclosures from lessees include:

Depreciation expense for Right-Of-Use assets by class of underlying assets.
Interest expense for lease liabilities.
Lease expense related to short term leases that have applied the optional exception.
Lease expense related to low value leases that have applied the optional exception.
Lease expense related to variable payments that were not included in the measurement of lease liabilities.
Income from subleasing right-of-use assets.
Total cash outflow for leases.
Additions of right-of-use assets.
Gains or losses from sales and leaseback transactions.
Carrying amount of right-of-use assets at the end of reporting period, per class of underlying asset.
A maturity analysis of lease liabilities (presenting the contractually undiscounted cash flows on aggregated annual slices for the first five years, and then a combined amount for the years after).
Information about extension and termination options.
Information about leases not yet commenced to which the lessee is committed.
Restrictions or covenants imposed by leases.
Information on sale and leaseback transactions.

Required disclosures from lessors include:

Selling profit or loss (for finance leases).
Finance income on the net investment in finance leases.
Lease income from operating leases.
Income related to variable payments that do not depend on an index or rate.
Information about how the lessor manages the risk associated with its rights in the underlying assets.
A table showing a maturity analysis of lease payments receivable (undiscounted cash flows on aggregated annual slices for the first five years, and then a combined amount for the years after).

Importance of the IFRS 16 Standard for Companies:

The IFRS 16 Standard is an important standard for all companies that use leases, as it helps them to:

Comply with IFRS: The IFRS 16 Standard ensures that companies account for leases consistently with IFRS.
Improve the Quality of Financial Reporting: Applying the IFRS 16 Standard leads to improved quality and transparency of financial information related to leases, especially from the lessee’s perspective.
Enhance Investor Confidence: The IFRS 16 Standard helps build investor confidence by providing more accurate and reliable information about an entity’s obligations.
Better Manage Leases: The IFRS 16 Standard provides a clear accounting framework for leases, helping companies assess and manage these contracts more effectively.
Assess the Financial Impact of Leases: The IFRS 16 Standard helps companies understand the true impact of leases on their financial position, especially with the recognition of lease liabilities on the statement of financial position.

Challenges in Applying the IFRS 16 Standard:

Determining Whether a Contract Contains a Lease: In some cases, it may be difficult to determine whether a contract contains a lease according to the definition of the IFRS 16 Standard, especially in complex contracts that include service elements and mixed lease elements.
Determining the Lease Term: It may be difficult to determine the lease term, especially if the contract includes options for extension or termination.
Estimating the Discount Rate: Measuring the lease liability requires using an appropriate discount rate, which may be difficult to determine in some cases, especially if the interest rate implicit in the lease is not readily determinable.
Gathering the Necessary Data: It may be difficult to gather the necessary data to apply the IFRS 16 Standard, especially for companies with a large number of leases.
Changing Systems and Processes: Applying the IFRS 16 Standard may require substantial changes in companies’ accounting systems and processes, which may require additional investments in software and training.
Impact on financial ratios: Applying IFRS 16 Standard may change key financial ratios, such as the debt ratio and interest coverage ratio.

Role of Technology in Applying the IFRS 16 Standard:

Accounting software and Enterprise Resource Planning (ERP) systems help in applying the IFRS 16 Standard more efficiently and accurately through:

Automating the calculation of the right-of-use asset and lease liability.
Tracking lease payments and depreciation schedules.
Managing lease contracts centrally.
Generating the reports necessary to comply with disclosure requirements.
Improving the accuracy and comprehensiveness of financial information related to leases.

Impact of the IFRS 16 Standard on Different Sectors:

The application of the IFRS 16 Standard had a significant impact on many sectors, especially those that rely heavily on operating leases, such as:

Airlines: Airlines had to recognize significant assets and liabilities related to aircraft leases, leading to a substantial increase in their assets and liabilities.
Retail Companies: Retail companies had to recognize significant assets and liabilities related to store and office leases.
Telecommunications Companies: Telecommunications companies had to recognize significant assets and liabilities related to cell tower leases.

Lessons Learned from Applying the IFRS 16 Standard:

Importance of Early Planning: Companies need to plan early for the transition to the IFRS 16 Standard, including assessing the impact of the standard on their systems and accounting processes.
Need for Effective Communication: Companies must communicate effectively with stakeholders, including investors and analysts, to explain the impact of the IFRS 16 Standard on their financial statements.
Need for Training: Accountants and auditors need to receive the necessary training to understand and apply the requirements of the IFRS 16 Standard correctly.
Importance of Technology: Accounting software and ERP systems can help facilitate the application of the IFRS 16 Standard and automate processes related to lease accounting.

Future of Lease Accounting:

The IASB continues to review and improve IFRSs, including the IFRS 16 Standard. The emergence of new business models, such as the sharing economy, may lead to a review of how leases are handled in the future. Technological developments, such as artificial intelligence and blockchain, may also affect how lease data is collected and analyzed, potentially leading to changes in accounting and disclosure requirements.

Questions to Ask When Analyzing Leases under the IFRS 16 Standard:

When analyzing leases under the IFRS 16 Standard, the following questions should be asked:

Does the contract contain a lease according to the definition of the IFRS 16 Standard?
Do any of the optional recognition exemptions apply (short-term lease or low-value lease)?
What is the lease term?
What are the components of the lease payments?
What is the discount rate used to measure the lease liability?
How was the right-of-use asset measured?
How is the right-of-use asset depreciated?
How is interest expense on the lease liability recognized?
What disclosures have been provided about the leases?

Conclusion:

The IFRS 16 Standard represents a significant step towards improving the transparency and reliability of financial information related to leases. Companies that fall within the scope of applying the IFRS 16 Standard must adhere to its requirements to ensure that leases are fairly presented in the financial statements.

Understanding the IFRS 16 Standard is essential for accountants, auditors, investors, and anyone seeking to understand how leases affect an entity’s financial position, financial performance, and cash flows. With the application of this standard, users of financial statements can obtain a more complete picture of an entity’s obligations and rights related to leases, helping them make more informed economic decisions. The IFRS 16 Standard eliminated the distinction between finance and operating leases from the lessee’s perspective, resulting in a fundamental change in how leases are presented on the statement of financial position.