IFRS 16 Leases in the Financial Statements

IFRS 16 removed the old distinction between operating and finance leases for lessees. With limited exceptions, a lessee now recognises almost every lease on the balance sheet: a right-of-use asset and a lease liability. This guide focuses on how that plays out across the statements — position, performance, cash flows and disclosure — from the lessee's perspective.

The single lessee model

At the commencement date, a lessee recognises a lease liability measured at the present value of the lease payments not yet paid, discounted at the interest rate implicit in the lease or, if that cannot be readily determined, the lessee's incremental borrowing rate. It recognises a corresponding right-of-use (ROU) asset, initially the liability plus any payments made at or before commencement, initial direct costs, and an estimate of restoration costs, less any lease incentives received.

There are two recognition exemptions a lessee may elect: short-term leases (a lease term of twelve months or less with no purchase option) and leases of low-value assets. Low value is judged by reference to the value of the asset when new; the IASB had in mind assets of a small absolute value (the Basis for Conclusions refers to an order of magnitude of around USD 5,000), but the standard itself does not set a hard threshold. For leases that qualify and are elected, payments are simply expensed on a straight-line or other systematic basis, with no asset or liability recognised.

Statement of financial position

ROU assets are presented either as a separate line or within the same line as the underlying owned assets would be (with disclosure of which line), and the lease liability is split between its current and non-current portions. Over the lease term the liability unwinds as payments are made and interest accrues; the ROU asset is depreciated, usually over the shorter of the lease term and the asset's useful life (or the useful life if ownership transfers).

Profit or loss — the P&L split

This is the change people notice most. Under the old operating-lease model a single straight-line rental expense hit operating profit. Under IFRS 16 the charge is split in two:

• depreciation of the right-of-use asset (an operating expense); and
• interest on the lease liability (a finance cost).

Because interest is higher in the early years (the liability is larger), the total expense is front-loaded compared with a straight-line rental. Operating profit and EBITDA typically increase relative to the old model, because the depreciation-plus-interest split moves cost below the operating line, while total lease-related cost over the life is unchanged.

Statement of cash flows

Total cash paid does not change, but its classification does. Under IFRS 16 the principal portion of lease payments is presented in financing activities. The interest portion follows the entity's policy for interest paid (financing or operating). Payments for short-term and low-value leases, and variable payments not included in the liability, stay in operating activities. The net effect is that operating cash flow generally improves under IFRS 16, offset by an outflow in financing.

Remeasurement and modifications

Leases are not static. If future payments change because of an index or rate, a reassessment of an extension or termination option, or a change in the amount expected under a residual value guarantee, the lessee remeasures the liability and adjusts the ROU asset. Lease modifications that add a right of use at a stand-alone price are treated as a separate lease; others trigger remeasurement, and a modification that decreases scope is recognised partly in profit or loss.

Variable payments and sale and leaseback

Two features cause more errors than their frequency suggests. Variable lease payments that depend on an index or a rate are included in the liability using the index or rate at the commencement date, and are remeasured only when that index or rate changes; payments that vary with usage or sales are excluded from the liability and expensed as incurred. In a sale and leaseback, the seller-lessee first tests whether the transfer qualifies as a sale under IFRS 15. If it does, the seller-lessee recognises a right-of-use asset for the portion of the asset it retains and recognises only the gain that relates to the rights transferred to the buyer-lessor. If the transfer is not a sale, the asset is not derecognised and the proceeds are accounted for as a financing arrangement.

Disclosures

IFRS 16 requires a lessee to give enough information for users to assess the effect of leases on financial position, performance and cash flows. Typical disclosures include depreciation of ROU assets by class, interest on lease liabilities, the expense for short-term and low-value leases, total cash outflow for leases, additions to ROU assets, and a maturity analysisof lease liabilities (as part of the IFRS 7 liquidity disclosures). Lessors continue to classify leases as finance or operating and disclose accordingly.

How it connects

Leases touch three statements at once, so they interact with IAS 1 presentation and the financing section of the statement of cash flows. The lease-term and discount-rate judgements are exactly the kind that belong in your notes and judgements disclosures.