IFRS 16

IFRS 16 Leases is the standard in International Financial Reporting Standards that sets out how leases are recognised, measured, presented and disclosed. Its main change was for the lessee: instead of classifying each lease as either a finance lease or an operating lease, a lessee recognises nearly every lease in the statement of financial position, as a right-of-use asset together with a liability for the lease payments.

The standard was issued in January 2016 by the International Accounting Standards Board and has applied since 1 January 2019, replacing IAS 17. Under the old model, operating leases of aircraft, shops, offices and vehicles appeared only in the notes, a form of off-balance-sheet financing that analysts routinely adjusted for. The general subject, including US rules, is covered under lease accounting.

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. The customer has control if it obtains substantially all of the economic benefits from use of the asset and has the right to direct its use. There is no identified asset if the supplier has a substantive right to substitute it. Contracts for services, such as outsourced transport or data capacity, must be assessed to see whether they contain a lease, and lease and non-lease components are generally separated.

At the commencement date the lessee recognises a lease liability, measured at the present value of the lease payments not yet paid. The payments are discounted at the interest rate implicit in the lease or, if that cannot be readily determined, at the lessee's incremental borrowing rate. They include the following.

• Fixed payments, less any lease incentives receivable.
• Variable payments that depend on an index or a rate, such as inflation-linked rent, measured using the index at commencement.
• Amounts expected to be payable under residual value guarantees.
• The exercise price of a purchase option the lessee is reasonably certain to exercise, and penalties for termination if the lease term reflects that choice.

The lease term is the non-cancellable period plus periods covered by extension options the lessee is reasonably certain to exercise. Variable payments linked to sales or usage are excluded from the liability and expensed as incurred.

The right-of-use asset is measured at the amount of the liability, plus payments made at or before commencement, initial direct costs and an estimate of restoration costs, less incentives received. Afterwards the asset is normally depreciated over the shorter of the lease term and its useful life, and tested for impairment. The liability is increased by interest and reduced by payments, and is remeasured when the term, an index or the assessment of an option changes.

A lessee may choose not to apply the model to short-term leases, with a term of twelve months or less and no purchase option, and to leases of low-value assets such as laptops and office furniture. In explaining the exemption, the Board indicated that it had in mind assets worth about 5,000 US dollars or less when new. Payments on exempt leases are expensed, usually on a straight-line basis.

For the lessor, IFRS 16 largely carries forward the earlier rules. A lease that transfers substantially all the risks and rewards of ownership is a finance lease: the lessor derecognises the asset and records a receivable equal to its net investment. Any other lease is an operating lease: the asset stays on the lessor's books and rental income is recognised over the term. An intermediate lessor classifies a sublease by reference to the right-of-use asset and not the underlying asset.

When an entity sells an asset and leases it back, it first applies the revenue standard to decide whether the transfer is a sale. If it is, the seller recognises a right-of-use asset as a proportion of the previous carrying amount and a gain only on the rights transferred to the buyer. If it is not, the transaction is treated as financing. An amendment effective from 2024 clarified how the seller-lessee later measures the liability.

For companies with many operating leases, such as airlines, retailers and shipping firms, the standard increased reported assets and debt, raising measures of gearing. In the income statement, a single rental expense was replaced by depreciation and interest expense. Total expense over the lease is unchanged, but it is higher in the early years, since interest falls as the liability is repaid. Measures of profit before depreciation and interest rise because rent is no longer deducted. In the cash flow statement, repayments of principal are shown as financing, which increases reported operating cash flow. Loan covenants and performance targets had to be reviewed as a result.

The US standard, Topic 842, also brings leases onto the balance sheet but keeps two types for lessees. Finance leases are treated much as under IFRS 16, while operating leases produce a single straight-line expense. US rules have no low-value exemption.

• IFRS Foundation