IFRS 16 Leases: Summarised Guide to Lessee and Lessor Accounting

Introduction to IFRS 16

IFRS 16 Leases requires lessees to recognise a lease liability and right-of-use asset for most leases, reflecting the long-term contractual nature of lease arrangements on the balance sheet. The lease liability represents the present value of future lease payments not yet paid, whilst the right-of-use asset represents the lessee's right to use the underlying asset over the lease term.

For lessors, IFRS 16 maintains a dual classification model: finance leases (where substantially all risks and rewards transfer to the lessee) result in derecognition of the underlying asset and recognition of a net investment in the lease, whilst operating leases keep the asset on the lessor's balance sheet with rental income recognised over time.

The standard provides a recognition exemption for short-term leases (12 months or less) and low-value asset leases, allowing only lessees to recognise lease payments as expenses on a straight-line basis rather than capitalising these arrangements.

Scope and Exclusions

IFRS 16 applies to all leases except:

• Leases to explore for or use minerals, oil, natural gas, and similar non-regenerative resources
• Leases of biological assets held by lessees (IAS 41)
• Service concession arrangements (IFRIC 12)
• Licences of intellectual property granted by lessors (IFRS 15)
• Rights held by lessees under licensing agreements for items such as films, patents, and copyrights (IAS 38)

Lessees may elect not to apply IFRS 16 to leases of intangible assets. The standard must be applied to all other leases, including subleases.

Identifying a Lease

A contract 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. Control requires both:

• The right to obtain substantially all economic benefits from use of the asset; and
• The right to direct the use of the asset.

An asset is identified if it is explicitly or implicitly specified in the contract. Substantive substitution rights held by the supplier can prevent a contract from containing a lease, but only if the supplier has both the practical ability to substitute and would benefit economically from doing so.

For detailed guidance on lease identification, including practical examples and assessment frameworks, see our comprehensive article on lease identification under IFRS 16.

Non-Lease Components

Many contracts contain both lease and non-lease components, such as a property lease bundled with maintenance services. Lessees and lessors must separate lease components from non-lease components and allocate consideration based on their relative stand-alone prices.

However, IFRS 16 provides a practical expedient: lessees may elect, by class of underlying asset, not to separate non-lease components and instead account for the combined component as a single lease. This election increases the lease liability and right-of-use asset but simplifies accounting.

Lessors must always separate lease and non-lease components, applying IFRS 16 to lease components and IFRS 15 to non-lease components.

Learn more about separating and accounting for non-lease components under IFRS 16.

General Lease Concepts

Several fundamental concepts apply to both lessee and lessor accounting under IFRS 16.

Lease Payments

Lease payments include:

• Fixed payments (including in-substance fixed payments), less any lease incentives receivable
• Variable lease payments based on an index or rate
• Amounts expected to be payable under residual value guarantees
• The exercise price of purchase options if the lessee is reasonably certain to exercise
• Termination penalty payments if the lease term reflects exercise of a termination option

Variable lease payments that depend on performance or usage (rather than an index or rate) are excluded from initial measurement and recognised as expenses when incurred.

Lease Incentives

Lease incentives are payments made by lessors to lessees (or costs incurred by lessors on behalf of lessees) to enter into lease agreements. Common examples include rent-free periods, up-front cash payments, and lessor-funded leasehold improvements.

Under IFRS 16, lease incentives reduce the lease liability for lessees and the lease receivable for lessors. They are effectively treated as reductions in lease payments rather than separate income or expense items.

For practical examples and detailed treatment, see our article on lease incentives under IFRS 16.

Residual Values

Residual values represent the estimated value of the underlying asset at the end of the lease term:

• Guaranteed residual value (RVG): The portion of residual value guaranteed by the lessee or a third party. This is included in lease payments for lessees and lease receivables for lessors.
• Unguaranteed residual value (URV): The portion not guaranteed by the lessee. This affects lessor accounting only and is included in the lessor's net investment in finance leases.

Residual value estimates require judgment and should reflect market expectations at the lease commencement date. Our detailed guide on residual values under IFRS 16 provides calculation examples and measurement guidance.

Interest Rate Implicit in the Lease

The interest rate implicit in the lease is the discount rate that, at lease commencement, causes the aggregate present value of:

• Lease payments; and
• The unguaranteed residual value

to equal the sum of:

• The fair value of the underlying asset; and
• Any initial direct costs of the lessor.

This rate represents the lessor's return on the lease. Lessees should use the interest rate implicit in the lease if readily determinable; otherwise, they use their incremental borrowing rate.

For calculation methodologies and practical examples, see our comprehensive article on the interest rate implicit in the lease.

Initial Direct Costs

Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained. Examples include commissions, payments to existing tenants to obtain the lease, and legal fees directly attributable to negotiating and arranging the lease.

For lessees, initial direct costs are added to the right-of-use asset. For lessors, they are included in the initial measurement of the net investment for finance leases or deferred and amortised over the lease term for operating leases.

Internal costs, general overheads, and costs that would have been incurred regardless of whether the lease was obtained are excluded.

Our detailed article on initial direct costs under IFRS 16 provides identification criteria and accounting treatment examples.

Lease Term

The lease term is the non-cancellable period of a lease, together with:

• Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
• Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

Determining the lease term requires significant judgment about whether extension or termination options will be exercised. Factors to consider include economic incentives, past practice, leasehold improvements, and the importance of the asset to the lessee's operations.

For detailed guidance on assessing lease terms, including reassessment triggers, see our comprehensive article on lease term determination under IFRS 16.

Lessee Accounting

Recognition and Initial Measurement

At the commencement date, lessees recognise:

• A lease liability measured at the present value of lease payments not yet paid; and
• A right-of-use asset initially measured as the lease liability plus initial direct costs, prepaid lease payments, and estimated restoration costs, less any lease incentives received.

The lease liability is calculated by discounting lease payments using the interest rate implicit in the lease (if readily determinable) or the lessee's incremental borrowing rate.

Calculating the Lease Liability (IFRS 16.26-27)

The lease liability comprises the present value of the following lease payments:

• Fixed payments (including in-substance fixed payments), less any lease incentives receivable
• Variable lease payments based on an index or rate, initially 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 reasonably certain to be exercised
• Payments for termination penalties if the lease term reflects exercise of a termination option

Variable lease payments based on performance or usage are excluded from the lease liability and recognised as expenses when incurred.

For step-by-step calculation guidance and practical examples, see our detailed article on calculating the lease liability under IFRS 16.

Calculating the Right-of-Use Asset (IFRS 16.24)

The right-of-use asset is initially measured as:

• The amount of the initial lease liability measurement
• Plus: Any lease payments made at or before commencement, less any lease incentives received
• Plus: Any initial direct costs incurred by the lessee
• Plus: An estimate of costs to be incurred in dismantling, removing, or restoring the underlying asset or site (if the lessee has an obligation)

The right-of-use asset represents the lessee's investment in the right to use the underlying asset over the lease term.

For comprehensive guidance on right-of-use asset measurement and subsequent accounting, see our detailed article on the right-of-use asset under IFRS 16.

Recognition Exemption

IFRS 16 provides an optional recognition exemption for:

• Short-term leases: Leases with a term of 12 months or less at commencement with no purchase option
• Low-value leases: Leases where the underlying asset has a low value when new (IFRS 16 examples suggest approximately £4,000 or less)

Lessees may elect to recognise lease payments for these leases as expenses on a straight-line basis (or another systematic basis if more representative) rather than recognising a lease liability and right-of-use asset.

The election is made by class of underlying asset for short-term leases and can be made on a lease-by-lease basis for low-value leases.

For eligibility criteria and detailed accounting treatment, see our article on straight-line lease accounting under IFRS 16.

Subsequent Measurement

After commencement, lessees measure:

Lease Liability:

• Increase by interest on the lease liability (using the effective interest method)
• Decrease by lease payments made
• Remeasure when there are changes in lease payments, lease term, or purchase option assessment

Right-of-Use Asset:

• Depreciate over the shorter of the lease term or the asset's useful life (if ownership transfers or purchase option is reasonably certain to be exercised, depreciate over useful life)
• Apply impairment testing under IAS 36
• Adjust for remeasurements of the lease liability (except for certain variable lease payment changes)

Interest expense on the lease liability and depreciation of the right-of-use asset are recognised separately in profit or loss.

Lease Modifications

A lease modification is a change in the scope of a lease or the consideration for a lease that was not part of the original terms. Modifications require reassessment and remeasurement.

General Approach

For modifications that do not qualify as separate leases:

1. Remeasure the lease liability using a revised discount rate
2. Adjust the right-of-use asset by the same amount
3. Exception: For partial or full terminations (decreases in scope), reduce the right-of-use asset proportionately and recognise any difference in profit or loss

The revised discount rate is the interest rate implicit in the lease for the remainder of the lease term, if readily determinable, or the lessee's incremental borrowing rate at the modification date.

Separate Lease Treatment

A modification is accounted for as a separate lease if it:

• Increases the scope by adding the right to use one or more underlying assets; and
• The consideration increases by an amount commensurate with the stand-alone price for the increase in scope

This treatment simplifies accounting by treating the modification as an entirely new lease.

For comprehensive guidance on modification accounting, including reassessment triggers and practical examples, see our detailed article on lease modifications under IFRS 16.

Disclosure Requirements

Lessees must disclose information that enables users to assess:

• The effect of leases on financial position, performance, and cash flows
• Significant judgments and estimates made

Key disclosures include:

• Depreciation of right-of-use assets by class
• Interest expense on lease liabilities
• Expense for short-term and low-value leases
• Variable lease payments not included in lease liabilities
• Cash outflows for leases
• Additions to right-of-use assets
• Maturity analysis of lease liabilities
• Information about extension and termination options, residual value guarantees, and leases not yet commenced

Lessor Accounting

Lease Classification

Lessors classify each lease as either a finance lease or an operating lease at lease inception. Classification is based on whether the lease transfers substantially all the risks and rewards incidental to ownership of the underlying asset.

Finance Lease Indicators:

• Ownership transfers to the lessee by the end of the lease term
• The lessee has a purchase option that is reasonably certain to be exercised
• The lease term is for the major part of the asset's economic life
• The present value of lease payments amounts to substantially all of the asset's fair value
• The underlying asset is so specialised that only the lessee can use it without major modifications

If any of these indicators are present, the lease is likely a finance lease. However, classification requires judgment based on the substance of the transaction.

For detailed guidance on lease classification, including practical examples and indicator analysis, see our comprehensive article on finance lease vs operating lease under IFRS 16.

Finance Lease Accounting

Initial Recognition

At the commencement date, lessors recognise:

• Derecognition of the underlying asset
• Recognition of a net investment in the lease measured at the gross investment discounted at the interest rate implicit in the lease

The gross investment in the lease comprises:

• Lease payments receivable; and
• Any unguaranteed residual value accruing to the lessor

The net investment in the lease is the gross investment discounted at the interest rate implicit in the lease. The difference between gross and net investment represents unearned finance income.

Interest Rate Implicit in the Lease

For lessors, the interest rate implicit in the lease is calculated such that the net investment (present value of lease payments plus unguaranteed residual value) equals the fair value of the underlying asset plus any initial direct costs of the lessor.

This rate represents the lessor's return on the lease investment and is used to allocate finance income over the lease term using the effective interest method.

Subsequent Measurement

Lessors:

• Recognise finance income over the lease term based on a pattern reflecting a constant periodic rate of return on the net investment
• Reduce the net investment by lease payments received
• Reassess estimated unguaranteed residual values regularly and adjust future income recognition if necessary (reductions in estimated residual values are recognised immediately)

Manufacturer or Dealer Lessors

When manufacturers or dealers offer finance leases as a sales tool, they recognise:

• Revenue at the fair value of the underlying asset (or lower if discounted)
• Cost of sales at the cost (or carrying amount) of the underlying asset, less the present value of the unguaranteed residual value
• Selling profit or loss in the period (applying IFRS 15 principles)

Manufacturer or dealer lessors do not capitalise initial direct costs; instead, they recognise them as expenses at commencement because they primarily relate to earning the selling profit.

For detailed guidance and practical examples, see our article on manufacturer or dealer lessor accounting under IFRS 16.

Operating Lease Accounting

Initial Recognition

For operating leases, lessors:

• Continue to recognise the underlying asset on their balance sheet
• Depreciate the asset in accordance with the lessor's normal depreciation policy
• Capitalise initial direct costs and add them to the carrying amount of the underlying asset

Subsequent Measurement

Lessors:

• Recognise lease income on a straight-line basis over the lease term (or another systematic basis if more representative)
• Depreciate the underlying asset in accordance with IAS 16 or IAS 38
• Amortise capitalised initial direct costs over the lease term on the same basis as lease income
• Apply impairment testing under IAS 36

Variable lease payments not dependent on an index or rate are recognised as income when earned.

Lease Modifications

Finance Lease Modifications

Finance lease modifications are generally accounted for under IFRS 9 Financial Instruments. The lessor treats the modification as a modification of the financial asset (net investment in the lease).

If the modification would have resulted in a different lease classification had it been in effect at inception, the lessor accounts for it as a new lease from the modification date.

Operating Lease Modifications

Operating lease modifications are accounted for as new leases from the modification effective date. Any prepaid or accrued lease payments relating to the original lease are treated as part of the lease payments for the new lease.

Disclosure Requirements

Lessors must disclose information that enables users to assess:

• The nature of leasing activities
• How lessors manage risk associated with rights retained in underlying assets

Finance Lease Disclosures:

• Selling profit or loss (for manufacturer or dealer lessors)
• Finance income on the net investment
• Income from variable lease payments not in the measurement
• Maturity analysis of lease payments receivable
• Qualitative and quantitative explanation of significant changes in carrying amount

Operating Lease Disclosures:

• Lease income, separately disclosing variable lease payments
• Maturity analysis of lease payments receivable
• For each class of underlying asset, information required by IAS 16 and IAS 38

Conclusion

IFRS 16 Leases fundamentally changed lease accounting by requiring most leases to be recognised on lessees' balance sheets, providing greater transparency about lease obligations and asset rights. The standard maintains a dual model for lessors, distinguishing between finance leases (which transfer substantially all risks and rewards) and operating leases (which do not).

Successful IFRS 16 implementation requires careful judgment in identifying leases, determining lease terms, selecting appropriate discount rates, and accounting for modifications. Both lessees and lessors must understand the detailed requirements for initial recognition, subsequent measurement, and comprehensive disclosure.

This hub page provides an overview of IFRS 16's key principles, but the linked articles offer the detailed guidance, practical examples, and calculation methodologies needed to apply the standard correctly in complex situations.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.