Lesson 15 - Advanced Accounting Course

15. IFRS 16: Lease Accounting and Its Impact on Financial Statements

IFRS 16 is the International Financial Reporting Standard that sets out the principles for how leases should be reported in financial statements.

It completely changed the way companies account for leases, especially for those who rent assets like buildings, vehicles, or machinery.

🔍 What is a Lease?

A lease is a contract that allows one party (the lessee) to use an asset owned by another party (the lessor) for a specified period in exchange for payments.

Examples of leases:

• Renting office space
  
  

• Leasing a car for company use
  
  

• Using a piece of equipment in a factory
  
  

🚨 What Changed with IFRS 16?

Before IFRS 16:

• Leases were divided into finance leases and operating leases.
  
  

• Operating leases were not shown on the balance sheet.
  
  

• Many companies had off-balance-sheet obligations, making it hard for investors to understand the full picture of a company’s financial situation.
  
  

After IFRS 16:

• All leases (except short-term and low-value leases) must be shown on the balance sheet.
  
  

• Lessees must now recognize a “right-of-use asset” and a lease liability.
  
  

In simple terms: If you rent something long-term, you now have to treat it as if you own it (financially speaking).

🧠 Why Was IFRS 16 Introduced?

• To increase transparency and comparability.
  
  

• To give investors a true picture of a company’s financial obligations.
  
  

• To prevent companies from hiding large lease commitments "off the books".
  
  

📘 How Lessees Account for Leases Under IFRS 16

🔹 Step 1: Recognize the Right-of-Use Asset

This represents the lessee’s right to use the asset during the lease period.

🔹 Step 2: Recognize the Lease Liability

This is the obligation to make future lease payments, discounted to present value.

📊 Impact on the Financial Statements

1. Balance Sheet

• Assets increase: Because of the new right-of-use asset.
  
  

• Liabilities increase: Due to the lease obligation.
  
  

2. Income Statement

• Instead of rent expense, you now see:
  
  

  • Depreciation on the asset.
    
    

  • Interest expense on the lease liability.
    
    

• This shifts the expense recognition: higher cost at the beginning, lower at the end.
  
  

3. Cash Flow Statement

• Lease payments are split:
  
  

  • Interest goes under operating activities.
    
    

  • Principal goes under financing activities.
    
    

• This improves operating cash flow compared to the old method.
  
  

📝 Exemptions Under IFRS 16

You don’t have to apply the full model if:

1. The lease is short-term (12 months or less).
   
   

2. The asset is of low value (e.g., laptops, phones).
   
   

In these cases, you can still recognize lease payments as expenses, like before.

🧮 Example: Lessee Accounting Under IFRS 16

A company signs a 5-year lease for office space, paying €10,000 per year. The present value of future payments is €43,000.

Initial recognition:

• Right-of-use asset: €43,000
  
  

• Lease liability: €43,000
  
  

Each year:

• Depreciation = €43,000 ÷ 5 = €8,600
  
  

• Interest = e.g., €43,000 × 5% = €2,150 (first year, then less in later years)
  
  

• Total expense (depreciation + interest) is higher in early years.
  
  

🧾 How Lessors (Asset Owners) Account for Leases

Lessor accounting did not change much with IFRS 16.

Lessors still classify leases as:

• Finance leases: If risks and rewards of ownership are transferred.
  
  

• Operating leases: If not.
  
  

So, IFRS 16 mostly impacts lessees, not lessors.

📉 Impact on Companies and Industries

Some companies are heavily affected by IFRS 16, especially those with lots of leases:

This can lead to:

• Higher debt ratios
  
  

• Lower return on assets
  
  

• Changes in EBITDA (since rent expense is replaced with depreciation + interest)
  
  

🔄 Key Adjustments for Analysts and Investors

Analysts now have to:

• Adjust ratios like Debt-to-Equity, EBITDA, ROA, etc.
  
  

• Consider lease liabilities as part of the company’s total obligations.
  
  

• Compare companies more accurately—especially those that lease vs. own.
  
  

📌 Summary Table

✅ Key Takeaways

• IFRS 16 brings all leases onto the balance sheet for lessees.
  
  

• Lessees now recognize both a right-of-use asset and a lease liability.
  
  

• It improves transparency, but affects financial ratios and reported earnings.
  
  

• Certain small or short leases can still be treated as before.
  
  

• Analysts must adjust their models to reflect these changes accurately.