IFRS 16 leases: lessee accounting with examples

What IFRS 16 is

IFRS 16 Leases is the IFRS standard that requires a lessee to bring almost every lease onto the balance sheet as a right-of-use asset and a lease liability, then depreciate the asset and charge interest on the liability. It matters because it turns rent into debt: gearing, EBITDA, operating cash flow and covenant ratios all change, even though the cash paid to the landlord does not.

IFRS 16 has applied to annual periods beginning on or after 1 January 2019 and replaced IAS 17, IFRIC 4 and two SIC interpretations. The old split between finance leases (on balance sheet) and operating leases (off balance sheet) disappeared for lessees, who now apply a single model with two optional exemptions. Lessors kept the finance and operating lease classification largely unchanged. The IASB's post-implementation review, opened with a Request for Information in June 2025, concluded in July 2026 that the standard is working as intended overall, with a research project added on reducing lessees' costs of remeasuring lease liabilities and setting discount rates.

Is it a lease? The three-part test

A contract is, or 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. Three conditions must all hold. There must be an identified asset, specified explicitly or implicitly, and the supplier must not have a substantive right to substitute it. The customer must have the right to obtain substantially all of the economic benefits from using it. And the customer must have the right to direct how and for what purpose it is used.

The test often separates similar-looking contracts. A named warehouse unit is an identified asset; a promise of 500 pallet spaces somewhere in the supplier's network, which the supplier can move at will, is not. A truck with a driver whose routes the customer decides can be a lease; a delivery service where the carrier chooses the vehicle and route is not. Most software-as-a-service arrangements are service contracts because the customer does not control the underlying servers. When a contract contains both lease and service elements, such as a vehicle with maintenance, the consideration is split between them, unless the lessee elects, by class of asset, not to separate non-lease components.

Lease term, lease payments and the discount rate

The lease term is the non-cancellable period plus periods covered by an extension option the lessee is reasonably certain to exercise and by a termination option it is reasonably certain not to exercise. Reasonably certain is a high bar, judged on economic incentives such as significant leasehold improvements, relocation costs or below-market renewal rent.

The discount rate is the interest rate implicit in the lease if it can be readily determined, which is rare for property, and otherwise the lessee's incremental borrowing rate: the rate it would pay to borrow, over a similar term and with similar security, the funds needed for an asset of similar value in a similar economic environment. In practice a treasury team builds it from a reference rate for the currency and term, the entity's credit spread and an adjustment for the security the asset provides. Lease payments in the liability are:

• Fixed payments, including in-substance fixed payments, less any lease incentives receivable.
• Variable payments that depend on an index or rate, such as a consumer price index, measured using the index at commencement.
• Amounts expected to be payable under residual value guarantees.
• The exercise price of a purchase option the lessee is reasonably certain to exercise, and penalties for terminating if the term reflects termination.
• Excluded: variable payments linked to sales or usage, such as a turnover rent, which are expensed when incurred, and VAT, which is recovered or expensed under tax rules as invoices arrive.

Initial measurement: the liability and the right-of-use asset

At the commencement date the lease liability is the present value of the lease payments not yet paid, discounted at the rate above. The right-of-use asset is measured at cost: the initial lease liability, plus lease payments made at or before commencement, plus initial direct costs such as agent commissions and legal fees for the lease, plus an estimate of dismantling and restoration costs provided for under IAS 37, minus lease incentives received.

Afterwards the liability is carried at amortised cost: it increases by interest at the discount rate and decreases by payments. The asset is depreciated under IAS 16, usually straight-line, over the shorter of the lease term and the asset's useful life, or over the useful life if ownership transfers or a purchase option is reasonably certain. The asset is also tested for impairment under IAS 36.

Worked example: a five-year warehouse lease

Van Dam Distributie BV leases a warehouse from 1 January 2026 for five years at EUR 20,000 a year, paid at each year end. There are no options, the implicit rate is not available and the incremental borrowing rate is 5 percent. The five-year annuity factor at 5 percent is 4.3295, so the lease liability is 20,000 x 4.3295 = 86,590 (rounded to the euro). Legal fees and an agent's commission of 1,410 are initial direct costs, so the right-of-use asset is 86,590 + 1,410 = 88,000, depreciated straight-line at 17,600 a year. VAT is left out.

Commencement entry: Dr Right-of-use asset 88,000 / Cr Lease liability 86,590 / Cr Bank 1,410. Each year end: Dr Interest expense (from the schedule) / Dr Lease liability (the balance of the 20,000) / Cr Bank 20,000, and Dr Depreciation 17,600 / Cr Accumulated depreciation, right-of-use asset 17,600. For year 1 that is Dr Interest expense 4,330 / Dr Lease liability 15,670 / Cr Bank 20,000. The schedule, with interest at 5 percent of the opening balance:

• Year 1: opening 86,590, interest 4,330, payment 20,000, closing 70,920.
• Year 2: opening 70,920, interest 3,546, payment 20,000, closing 54,466.
• Year 3: opening 54,466, interest 2,723, payment 20,000, closing 37,189.
• Year 4: opening 37,189, interest 1,859, payment 20,000, closing 19,048.
• Year 5: opening 19,048, interest 952, payment 20,000, closing 0.
• Check: total interest 13,410 equals total payments 100,000 minus the initial liability 86,590.
• Balance sheet at 31 December 2026: lease liability 70,920, of which 16,454 is current (the year 2 payment of 20,000 less its interest of 3,546) and 54,466 non-current; right-of-use asset 70,400 (88,000 less 17,600).

What the lease does to the statements

The total charge over the lease is 101,410: depreciation of 88,000 plus interest of 13,410, which equals the 100,000 of rent plus the 1,410 of direct costs. The timing is different from rent. The year 1 charge is 21,930 (17,600 + 4,330), the year 5 charge only 18,552 (17,600 + 952). The yearly charges of 21,930, 21,146, 20,323, 19,459 and 18,552 are front-loaded because interest falls as the liability is repaid. A company with many leases of staggered ages sees this effect even out; a young, growing company sees profit reduced in the early years.

EBITDA rises by the full 20,000 because the rent line disappears and is replaced by depreciation and interest, both below EBITDA. Net debt rises by the lease liability, and gearing and interest cover move accordingly, which is why lenders often define covenants on a frozen GAAP or pre-IFRS 16 basis. In the cash flow statement, the principal portion of 15,670 is a financing outflow. The interest portion of 4,330 follows the entity's IAS 7 policy today; once IFRS 18 applies from 2027, IAS 7 as amended requires most companies to classify interest paid as financing. Payments for short-term, low-value and variable leases stay in operating cash flows. Our guide on financial ratio analysis shows how these shifts change the ratios lenders watch.

Remeasurement and modifications

The liability is remeasured when the cash flows or the assumptions change, and the right-of-use asset is adjusted by the same amount (with any excess below zero going to profit or loss). A change in lease term or in the assessment of a purchase option uses a revised discount rate. A change in payments linked to an index or rate, or in amounts expected under a residual value guarantee, uses the original rate, and is made only when the cash flows actually change.

Suppose the warehouse rent is linked to a consumer price index and rises to 21,000 from year 3. At the start of year 3 the remaining three payments are remeasured at the unchanged 5 percent: 21,000 x 2.7232 = 57,188, against a carrying amount of 54,466, an increase of 2,722. Dr Right-of-use asset 2,722 / Cr Lease liability 2,722. The asset's carrying amount rises from 52,800 (88,000 less two years' depreciation of 35,200) to 55,522, and depreciation for the remaining three years becomes about 18,507 a year.

A lease modification that adds the right to use an extra asset at a price commensurate with its standalone price is a separate new lease. Any other modification is remeasured at a revised discount rate at the modification date; a modification that reduces scope, such as giving back one floor, also derecognises part of the asset with a gain or loss.

The short-term and low-value exemptions

A lessee may expense payments on a straight-line basis, instead of recognising an asset and liability, in two cases. A short-term lease has a lease term of 12 months or less at commencement and contains no purchase option; the election is made by class of underlying asset. A lease of a low-value asset qualifies based on the value of the asset when new, regardless of the lessee's size, and the election is made lease by lease. The IASB's basis for conclusions had in mind assets worth in the order of USD 5,000 or less when new, such as laptops, phones and small office furniture. Cars and vans do not qualify, because they are not low-value when new.

Both exemptions need care. A rolling 12-month lease that the lessee always renews may have a longer lease term if renewal is reasonably certain. A low-value asset that is highly dependent on other leased assets does not qualify, and a head lessee cannot use the low-value exemption for an asset it subleases. The total expense for short-term leases and low-value leases must be disclosed.

IFRS 16 compared with ASC 842, ASPE and FRS 102

Cross-border groups, especially Canadian companies with US parents or subsidiaries, meet two or more lease standards at once. The differences that change numbers:

• Classification: US GAAP ASC 842 keeps finance and operating leases for lessees. An operating lease is still on the balance sheet, but its cost is one straight-line lease expense within operating costs, so there is no front-loading and no EBITDA uplift.
• Low-value exemption: ASC 842 has none, although companies often apply a capitalisation threshold; both standards have a short-term exemption of 12 months or less.
• Discount rate: ASC 842 allows entities that are not public business entities to elect a risk-free rate by class of asset; IFRS 16 has no such option.
• Index-linked payments: under ASC 842 a change in an index alone does not trigger remeasurement; under IFRS 16 it does once cash flows change.
• Cash flows: operating lease payments are operating cash flows under US GAAP; under IFRS 16 the principal is always financing.
• Canada: ASPE Section 3065 keeps the older capital and operating lease model, so private enterprises on ASPE still show operating leases off balance sheet.
• United Kingdom: revised FRS 102 Section 20 brings most lessee leases on balance sheet for periods beginning on or after 1 January 2026, with its own simplifications.

Doing this in Skyline Nexus ERP

Calculate the lease schedule in a working paper, then record its results in Skyline Nexus ERP through Fiscal Authority > Journal Entries > New Journal Entry: the commencement entry, then each period's interest and payment. Journals must balance, can carry a cost centre per line so each site's leases are reported with that site, and follow the approval workflow when the amount reaches the configured Approval Threshold. Posting is refused for dates without an open fiscal period, so a closed month cannot be changed quietly.

Set up the lease liability accounts under account types whose Balance Sheet Liquidity and Cash Flow Activity classifications fit: a current and a non-current lease liability account, both classified as Financing, so the Balance Sheet splits them correctly and the Cash Flow report shows the payments as financing. The right-of-use asset can be registered in Asset Management under its own category and depreciated with the Straight Line method on the monthly depreciation run, which posts to the ledger when Auto-post Depreciation Entries is switched on. Record the commencement once only, either through the journal or through the asset register's acquisition posting, and reconcile the register to the ledger at each month end. Our guide on fixed assets and depreciation in Skyline Nexus ERP covers the asset register in detail.

Related guides

Leases touch fixed assets, presentation, ratios and the choice of framework. These guides continue the thread.

• What is IFRS: the framework, who must use it and a map of the standards.
• IFRS vs US GAAP: lease accounting and the other differences cross-border groups meet.
• IFRS vs ASPE in Canada and UK FRS 102 vs IFRS: how private-company frameworks treat leases.
• IFRS 18 presentation and disclosure: where lease interest sits in the new income statement.
• Maintenance and the balance sheet: capitalise versus expense and componentisation under IAS 16.
• Adjusting entries explained: depreciation and accruals at period end.
• Financial ratio analysis: gearing, interest cover and EBITDA after IFRS 16.