The Ultimate Guide to Accounting Under the IFRS 16 Standard

Last Updated on August 30, 2022 by Neil Patel Accel

What is IFRS 16?

IFRS 16 is the International Financial Reporting Standard answer to lessee accounting. It affects any organization with an international lease. In the same way that FASB instituted ASC 842 to gain more visibility into operating leases, the International Accounting Standards Board (IASB) replaced IAS 17 with IFRS 16 accounting.

As quoted by Hans Hoogervorst, IASB chairman “The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows.” Similar to ASC 842, the goal of IFRS 16 is to bring financial visibility into all lease liabilities onto the balance. The key difference being IFRS 16 is the international standard and ASC 842 is the domestic standard.

IFRS 16 is working to bring financial reporting visibility to non-financial assets (such as PP&E) and outlining financial liabilities: 

• Balance sheets – lessees must show their ROU asset as an asset and their obligation to make lease payments as a liability.
• P&L accounts – lessees must  show depreciation as a straight-line basis of the asset in addition to interest on the lease liability.

The IFRS 16 effective date was 1 January 2019 and any annual reporting periods beginning then as well as any subsequent reporting periods after that date must adopt IFRS 16.

How to Account for IFRS 16?

Under IFRS 16, leases are accounted for based on a single-prong model as all leases will be treated as a finance lease. The single lessee accounting model reflects that, at the commencement date, a lessee has a financial obligation to make lease payments for the right to use the underlying asset during the lease term.

In order to recognize the right of use asset and the lease liability under IFRS 16, the lessee will need to recognize at the lease commencement date with subsequent accounting for a finance lease to be calculated similarly to IAS 17. 

Determining whether or not a contract contains a lease 
The first step is to determine what is a lease under IFRS 16. The International Financial Reporting Standard reports that a lease is “a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration.”

Lease Term
Now that you know your contract is and/or contains a lease, the next step is to determine the lease term. Accurately determining the  lease term is a challenge in properly applying IFRS 16 because it requires a significant level of judgement. There are two lease options that are important to take into consideration:

Extension Option and Termination Option
When the lessee has the option to extend a lease, judgements must be made to determine if that option is reasonably certain to be exercised. This judgment impacts the lease term and how/if the lease liabilities will be accurately represented in the lease payments.

When the lessee has the option to terminate the lease, then the lessee has to consider  factors and circumstances that create economic effects.  There are termination costs like negotiation costs, relocation costs, costs of identifying another suitable asset, costs of integrating a new asset into the lessee’s operations, and/ or termination penalties.

Lease Payments and Lease Liability
According to IFRS 16, lease payments are “payments made by a lessee to a lessor relating to the right to use an underlying asset during the lease term,” comprising the following:

• Fixed payments
• Variable lease payments
• The exercise price of a purchase option
• The termination price of a termination option
• Residual Value Guarantee  

The lease liability is measured at the present value of the lease payments. There are certain lease payments that are reassessed over the term of the lease, and the lease liability adjusted accordingly. For example, non-lease components like payment for services, and – variable lease payments that depend on sales or usage of the underlying asset are not included in the lease liability.  So it is important to identify the lease and non-lease components.

Separating lease and non-lease components
For a contract that is, or contains, a lease, an entity shall account for each lease component within the contract separately from non-lease components of the contract, unless applying the practical expedients. For example, separate the right-of-use asset and any provision that includes services like equipment maintenance, janitorial work, repairs of building utilities etc.

Initial and Subsequent Measurement
A lessee may elect to account for lease payments as an expense on a straight-line basis over the lease term. The initial (and subsequent) measurement includes the fixed and variable payments that are measured using the actual index or a rate at the commencement date. To note, a lessee cannot use forward rates or forecasting techniques in measuring variable lease payments. 

Subsequent measurement of the ROU Asset

There are two models that the lessee can apply to the subsequent measurement of the ROU asset. After the commencement date, a lessee shall measure the right-of-use asset applying the depreciation requirements, the cost model is the most common.

The Cost Model
Under the cost model, (the most common model) the right-of-use asset is subsequently measured at cost subtracting the accumulated depreciation and accumulated impairment losses. Depreciation of the right-of-use asset is recognized in a manner consistent with existing standards for PP&E.

If a transfer of ownership of the underlying leased asset will occur by the end of the lease term or if the lessee will exercise the purchase option then the lessee depreciates the ROU asset from the commencement date to the end of the useful life of said asset.

Subsequent measurement of the lease liability

After the commencement date, IFRS 16 requires the lessees to re-measure lease liabilities when there is a lease modification (or a change in the scope of a lease, or the consideration for a lease that was not part of the original t&c of the lease contract) that is not accounted for as a separate contract.

Interest on Lease Liability

Lease liabilities are measured on an amortized cost basis using an effective interest method, similarly to other financial liabilities. Interest on the lease liability in each period during the lease term shall be the amount that produces a constant periodic rate of interest on the remaining balance of the lease liability.