IFRS 16 in plain words: how a lessee accounts for a lease

Under IFRS 16 a lessee shows almost every lease in the statement of financial position. Payments that used to be expensed as operating leases now create an asset and a liability.

The core idea

At the start of a lease the lessee recognises:

• A lease liability: the present value of the future lease payments.
• A right-of-use asset: the liability plus any payments made in advance, initial direct costs and dismantling costs.

After that, the liability grows with interest and falls with payments, and the asset is depreciated.

Worked example

A 3-year lease has payments of 10,000 at the end of each year and a rate of 8%. The 3-year discount factor at 8% is 2.577.

• Initial liability: 10,000 × 2.577 = 25,770. The asset is also 25,770.
• Year 1 interest: 25,770 × 8% = 2,062 (finance cost).
• Liability at the end of year 1: 25,770 + 2,062 − 10,000 = 17,832.
• Depreciation: 25,770 ÷ 3 = 8,590 a year.

In year 1, profit or loss bears 2,062 + 8,590 = 10,652, more than the 10,000 payment. Interest is highest early on, so the expense is front-loaded.

Two exemptions

A lessee may skip the asset and liability and expense payments on a straight-line basis for:

• short-term leases: 12 months or less with no purchase option;
• leases of low-value assets: such as a laptop or a phone.

Effect on ratios

• Gearing rises: the lease liability is added to debt.
• Asset turnover and ROCE may fall: assets increase.
• Operating profit may improve: depreciation replaces the lease expense and interest moves to finance costs.

IFRS 16 appears in both calculation and interpretation questions in ACCA FR. Practise it in the FR question bank in learning mode, then test yourself in an FR mock exam.