IFRS 16 Leases represents a significant shift in accounting for lease arrangements, aiming to strengthen transparency and comparability across financial statements. Effective from January 2019, IFRS 16 replaced the previous lease accounting standard IAS 17, introducing a single lessee accounting model that brings most leases onto the balance sheet. This article explores the key elements of IFRS 16, its implications for lessees and lessors, and the practical steps for compliance.

What is a Lease under IFRS 16? 

Under IFRS 16, a contract is classified as a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. This definition hinges on two main criteria: the presence of an identified asset and the right to control its use.

Identified Asset 

An asset is considered identified if it is explicitly specified in the contract or implicitly specified at the time it is made available for use by the customer. Key considerations include:

  • Explicit Identification: The asset's make and model are clearly detailed in the contract.
  • Implicit Identification: The asset is uniquely designed for a specific customer or market, making it clear which asset is being referred to without explicit listing.
  • Substantive Substitution Rights: If the supplier has the practical ability and economic benefit to substitute the asset, it is not considered identified under IFRS 16.

Right to control

For a lessee to control the use of an identified asset, they must obtain substantially all of the economic benefits from its use and direct how and for what purpose the asset is used throughout the lease term. This control is demonstrated through the ability to make significant decisions about the asset’s use.

Accounting for Leases under IFRS 16

Lessee Accounting 

At the commencement date of a lease, lessees must recognise a right-of-use (ROU) asset and a corresponding lease liability. The rental expense in the profit and loss statement is replaced by depreciation on the ROU asset and interest on the lease liability. To determine the lease liability, lessees need to:

  1. Determine the Lease Term: Assess whether the lessee is reasonably certain to exercise extension or termination options based on factors such as lease payments relative to market rates, significant improvements made to the asset, and costs associated with relocating or finding a new asset.
  2. Calculate Lease Payments: Include fixed payments, variable lease payments based on an index or rate, and amounts expected to be paid under residual value guarantees.
  3. Establish the Discount Rate: Use the rate implicit in the lease if readily determinable, or the lessee’s incremental borrowing rate (IBR). 

The ROU asset is then measured by adjusting the initial lease liability for any lease payments made at or before the commencement date, minus any lease incentives received.

Subsequent Measurement

  • Depreciation: The ROU asset is depreciated in accordance with IAS 16 Property, Plant, and Equipment, using the shorter of the lease term or the asset’s useful life.
  • Amortisation: The lease liability is amortised using the effective interest method, with interest expenses recognised in the profit and loss statement. 

Lessor Accounting 

For lessors, IFRS 16 retains the classification of leases as either operating or finance leases, similar to IAS 17:

  • Finance Leases: Lessors recognise a finance lease receivable equal to the net investment in the lease at commencement. Income is recognised over the lease term, reflecting a constant periodic rate of return.
  • Operating Leases: Lease income is recognised on a straight-line basis over the lease term.

Conclusion 

IFRS 16 Leases marked a pivotal change in how leases are accounted for, bringing greater transparency to financial reporting. By requiring the recognition of lease assets and liabilities on the balance sheet, IFRS 16 eliminates off-balance-sheet financing, providing stakeholders with a clearer view of a company’s financial obligations. For businesses navigating the complexities of IFRS 16, RSM Malta offers expert guidance to ensure compliance and optimise lease accounting practices. 

Written by Rachel Mamo, Manager - Outsourcing