IFRS 16 Leases: Summary, Practice Questions & Decision Tree

IFRS 16 applies to almost every contract that conveys the right to use an asset for a period in exchange for consideration. A handful of items are scoped out and handled by other standards — leases of biological assets, service concession arrangements, licences of intellectual property granted by lessors, rights held under licensing agreements for items like films and patents, and leases to explore for minerals and similar resources (IFRS 16.3–4).

For lessees there are two optional escape hatches (IFRS 16.5–8). The first covers short-term leases: a term of 12 months or less at commencement and no purchase option. The second covers leases of low-value assets — think laptops, phones and small office furniture, judged on the asset's value when new, not its age or the lessee's size. Electing either exemption means no right-of-use asset and no lease liability; the lessee simply expenses the payments, normally on a straight-line basis over the term.

• Short-term election: made by class of underlying asset
• Low-value election: made lease by lease
• A 12-month lease containing a purchase option can never be short-term

Before any numbers, IFRS 16 asks a yes/no question: does this contract contain a lease at all? A contract contains a lease when it conveys the right to control the use of an identified asset for a period in exchange for consideration (IFRS 16.9). Control is broken into three tests, and all three must pass.

First, there must be an identified asset — one that is explicitly named in the contract or implicitly specified. If the supplier holds a substantive right to swap the asset for another throughout the period of use, and would benefit economically from doing so, there is no identified asset (IFRS 16.B13–B19).

Second, the customer must have the right to obtain substantially all of the economic benefits from using the asset over the period of use — its output, its capacity, the by-products it generates (IFRS 16.B21–B23).

Third, the customer must have the right to direct how and for what purpose the asset is used during the period of use (IFRS 16.B24–B30). A haulage contract for a specified truck that the customer routes, schedules and loads as it chooses is a lease of that truck. A contract for moving goods where the supplier decides which vehicles from its fleet to use — and can substitute them freely — is a transport service, not a lease.

At the commencement date the lessee recognises two balances that start from the same core number but are not identical. The lease liability is the present value of the lease payments not yet paid, discounted at the interest rate implicit in the lease — or, where that rate cannot be readily determined, the lessee's incremental borrowing rate (IFRS 16.26).

The payments that go into that present value are (IFRS 16.27):

• Fixed payments, less any lease incentives receivable
• In-substance fixed payments (variable in legal form, unavoidable in reality)
• Variable payments that depend on an index or a rate, measured using the index or rate at commencement
• Amounts expected to be payable 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 early termination

The right-of-use asset is measured at cost (IFRS 16.23–24): the initial lease liability, plus any payments made at or before commencement, plus initial direct costs, plus the estimated cost of dismantling or restoring the asset or site, minus any lease incentives already received.

Variable payments that depend on sales or usage — a percentage of store revenue, a charge per machine hour — never enter the liability. They hit profit or loss in the period the sale or usage happens (IFRS 16.38).

After day one the two balances follow separate paths. The lease liability accrues interest at a constant periodic rate on the outstanding balance, and lease payments reduce it (IFRS 16.36–38). Early in the lease the balance is high, so interest is high; it shrinks every year — which is why the total expense under IFRS 16 is front-loaded compared with straight-line rent.

The right-of-use asset is depreciated — normally straight-line — over the shorter of the lease term and the asset's useful life. If ownership transfers by the end of the lease, or the lessee is reasonably certain to exercise a purchase option, depreciation runs over the useful life instead (IFRS 16.31–33). The asset is also subject to impairment testing under IAS 36.

Lessors kept the two-model world. A lease that transfers substantially all the risks and rewards incidental to ownership of the underlying asset is a finance lease; every other lease is an operating lease (IFRS 16.61–63). Indicators pointing to finance classification include ownership transferring by the end of the term, a bargain purchase option, a lease term covering the major part of the asset's economic life, and a present value of payments amounting to substantially all of the asset's fair value.

A lessor in a finance lease derecognises the asset and recognises a net investment in the lease, earning finance income at a constant rate on that investment (IFRS 16.67, 75). A lessor in an operating lease keeps the asset on its own balance sheet, depreciates it, and recognises lease income — usually straight-line — over the term (IFRS 16.81).

Moving leases on balance sheet reshapes the financial statements in three predictable ways. First, EBITDA rises: what used to be rent (an operating expense) becomes depreciation and interest, both of which sit below the EBITDA line. Second, the balance sheet grosses up — total assets and total liabilities both increase, which typically raises gearing ratios. Third, the total lease expense is front-loaded: interest is highest in the early years while depreciation stays flat, so the combined charge starts above straight-line rent and falls below it in later years. Analysts comparing companies across periods that straddle the transition from the old model need to adjust for all three effects.