IFRS 16

IFRS 16 replaced IAS 17 and eliminated the classification of leases as operating or finance leases for lessees. Under the new model, lessees recognize a right-of-use asset and a corresponding lease liability for virtually all leases, with limited exceptions for short-term leases (12 months or less) and leases of low-value assets.

Before: if you rented an office, it was just an expense each month - nothing on your balance sheet. After: that same office lease now shows up as an asset (your right to use the office) and a debt (the total rent you owe over the lease term). The income statement also changes - instead of one 'rent expense' line, you now have depreciation of the asset and interest on the liability.

Imagine you borrow your friend's bicycle for a year and promise to pay $5 every month. Before IFRS 16, you just wrote down '$5 spent' each month. Now, you have to write down: 'I have a bicycle worth $60' (the asset) AND 'I owe $60 total' (the debt). As you pay each month, the debt goes down and the bicycle gets a little more worn out.

RetailCo signs a 5-year lease for a store at $120,000/year. Discount rate: 5%. Lease liability = present value of 5 payments of $120,000 = $519,162. Right-of-use asset = $519,162 (equal to liability at inception, plus any prepayments or initial direct costs). Each year: depreciation expense of ~$103,832 (straight-line) plus interest expense starting at $25,958 (5% of $519,162, declining each year).

Under the old rules, two companies could have identical economic obligations but report completely different balance sheets depending on how they structured their leases. An airline that bought planes showed billions in assets and debt; an airline that leased identical planes showed neither. IFRS 16 ensures economic substance is reflected regardless of legal form.

Thinking IFRS 16 makes all leases 'finance leases.' It does not. The old classification is gone for lessees - there is just one model. However, the income statement pattern (front-loaded expense due to interest) resembles the old finance lease treatment, which surprises companies expecting a straight-line expense.

At commencement, the right-of-use asset is measured at cost, comprising: the initial measurement of the lease liability, any lease payments made at or before commencement less incentives received, initial direct costs incurred by the lessee, and an estimate of costs to dismantle/restore the underlying asset. Subsequently, it is depreciated over the shorter of the useful life and the lease term.

The right-of-use asset is basically the value of your right to use something for the lease period. You start with the total obligation (lease liability), add anything you paid upfront, subtract any landlord incentives, and add costs you will incur to restore the property at the end. Then you depreciate it - write it down gradually over the lease term.

You rent a treehouse for 3 years. The 'right-of-use asset' is like writing in your notebook: 'I have the right to play in this treehouse for 3 years, and that right is worth $36 (12 months x 3 years x $1/month).' Each year, you cross out $12 because one year of playing is used up.

Forgetting to include restoration costs in the initial measurement. If your lease requires you to remove improvements or restore the property at the end, those estimated costs must be added to the right-of-use asset (and a provision recognized).

The lease liability is initially measured at the present value of lease payments not yet paid, discounted using the interest rate implicit in the lease (if readily determinable) or the lessee's incremental borrowing rate. Lease payments include fixed payments, variable payments based on an index/rate, amounts expected under residual value guarantees, purchase option exercise prices (if reasonably certain), and termination penalties (if the term reflects exercise).

The lease liability is how much you owe in today's money for all the future rent payments. You take all the payments you will make over the lease and discount them back to today using an interest rate. Each period, you pay down the liability (like a loan) - part of your payment is interest, and the rest reduces what you owe.

If you promise to pay $10 every month for 12 months, you owe $120 total. But $120 in the future is not worth exactly $120 today (because money today can earn interest). So the lease liability starts at a slightly lower number - maybe $115. Each month you pay $10, but a tiny bit of that is 'interest' on what you still owe, and the rest reduces your debt.

EquipCo leases machinery for 4 years at $50,000/year, paid at year-end. Incremental borrowing rate: 6%. Lease liability = PV of annuity = $50,000 x [(1 - (1.06)^-4) / 0.06] = $173,255. Year 1 interest: $173,255 x 6% = $10,395. Year 1 principal reduction: $50,000 - $10,395 = $39,605. Closing liability: $133,650.

Using the wrong discount rate. The rate implicit in the lease is preferred but often not available. The incremental borrowing rate must reflect what the lessee would pay to borrow a similar amount, for a similar term, with similar security, in a similar economic environment. Using a generic corporate rate is incorrect.

Does IFRS 16 affect the income statement?

Yes. Instead of a single operating lease expense (rent), lessees now recognize depreciation of the right-of-use asset and interest expense on the lease liability. Total expense over the lease term is the same, but it is front-loaded (higher in early years due to interest) rather than straight-line.

What are the exemptions under IFRS 16?

Lessees may elect not to apply the recognition requirements to: (1) short-term leases with a term of 12 months or less (no purchase option), and (2) leases where the underlying asset is of low value (guidance suggests approximately $5,000 or less when new). These are expensed as incurred.

How does IFRS 16 differ from ASC 842?

The biggest difference: ASC 842 retains a dual classification model for lessees (operating vs finance leases), while IFRS 16 uses a single model. Under ASC 842, operating leases still produce straight-line expense. Under IFRS 16, all leases produce front-loaded expense (depreciation + interest).