Lease Accounting Under IFRS 16

IFRS 16 Leases (equivalent to SFRS(I) 16 Leases in Singapore) fundamentally changed how lessees account for leases. Under the previous standard, IAS 17 Leases, lessees classified leases as either operating or finance leases. Operating lease payments were expensed on a straight-line basis with no balance sheet recognition. IFRS 16 eliminated this distinction for lessees, requiring nearly all leases to be recognised on the balance sheet.

What Is the Core Model Under IFRS 16?

At lease commencement, a lessee recognises:

• A right-of-use (ROU) asset, representing the right to use the underlying asset for the lease term
• A lease liability, representing the obligation to make future lease payments

The lease liability is measured at the present value of future lease payments, discounted using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee uses its incremental borrowing rate.

The ROU asset is initially measured at the amount of the lease liability, adjusted for:

• Lease payments made at or before the commencement date
• Initial direct costs incurred by the lessee
• An estimate of costs to dismantle or restore the underlying asset

How Are Lease Assets and Liabilities Measured After Initial Recognition?

The following table summarises the key elements of IFRS 16 lease accounting:

Element	Description	Measurement
Right-of-use (ROU) asset	Represents the lessee's right to use the underlying asset	Initially at lease liability amount, adjusted for prepayments, direct costs, and restoration costs; subsequently depreciated
Lease liability	Obligation to make future lease payments	Present value of future payments, discounted at the implicit rate or incremental borrowing rate
Depreciation	Systematic allocation of the ROU asset cost	Over the shorter of the lease term and the asset's useful life
Interest accretion	Finance cost on the lease liability	Applied to opening liability balance each period; front-loaded pattern
Lease payment split	Each payment reduces the liability	Split between interest (profit or loss) and principal (liability reduction)

Depreciation

The ROU asset is depreciated over the shorter of the lease term and the useful life of the underlying asset. If ownership transfers to the lessee at the end of the lease, or a purchase option is reasonably certain to be exercised, the asset is depreciated over its useful life.

Interest Accretion

Interest is recognised on the lease liability each period, calculated by applying the discount rate to the opening balance. This produces a front-loaded interest expense pattern — higher in earlier periods and declining over time.

Lease Payments

Each lease payment reduces the lease liability. The payment is split between the interest component (recognised in profit or loss) and the principal component (reducing the liability).

What Are the Common Challenges in IFRS 16 Lease Accounting?

Inconsistent Payment Schedules

Lease agreements do not always specify uniform monthly payments. Stepped rents, rent-free periods, and annual escalation clauses all affect the present value calculation and the subsequent measurement of both the asset and liability.

Misaligned Lease Periods

Lease commencement dates and payment cycles frequently do not align with the entity's financial year. When a lease starts mid-month, the first and last periods require pro-rata calculations for both depreciation and interest.

Discount Rate Determination

The incremental borrowing rate requires judgement. It should reflect what the lessee would pay to borrow funds of a similar amount, over a similar term, with similar security, in a similar economic environment. Smaller entities without external borrowings often find this assessment difficult.

Lease Modifications

Changes to the lease term, scope, or consideration during the lease require remeasurement of the lease liability and a corresponding adjustment to the ROU asset. The accounting depends on whether the modification is treated as a separate lease or a change to the existing lease.

What Exemptions Does IFRS 16 Provide?

IFRS 16 provides two optional recognition exemptions:

• Short-term leases — leases with a term of 12 months or less at commencement (with no purchase option). The lessee may elect to recognise payments as an expense on a straight-line basis.
• Low-value assets — leases where the underlying asset has a low value when new (the IASB indicated approximately USD 5,000 as a guideline). This exemption applies on a lease-by-lease basis.

These exemptions are practical expedients. Entities that apply them must disclose the expense recognised.

How Does IFRS 16 Affect Financial Statements?

The shift from off-balance-sheet operating leases to on-balance-sheet recognition affects several areas of financial statements:

• Balance sheet: Total assets and total liabilities increase, which may affect debt covenants and financial ratios
• Income statement: The straight-line operating lease expense is replaced by depreciation and interest, resulting in higher total expense in early years and lower expense in later years
• Cash flow statement: Lease payments are split between financing activities (principal) and operating activities (interest), rather than being classified entirely as operating cash flows

For entities with significant lease portfolios, these changes can materially alter the appearance of financial performance and position, even though the underlying economics of the lease have not changed. Entities that also carry prepayments related to leases should ensure these are properly reclassified under the new model. Companies eligible for simplified reporting may wish to consider SFRS SE, which does not require on-balance-sheet lease recognition.