IFRS 16 Leases: What Goes on the Balance Sheet and Why

IFRS 16 Leases: What Goes on the Balance Sheet and Why

By Sai Manikanta Pedamallu (ACCA, CMA US, CSCA US, CGMA, ACMA, Dip IFRS, M.Com, MBA, MA)

Lead Instructor, Global Fin X | www.globalfinx.in/manikanta

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Before IFRS 16, a company could lease its entire office portfolio, its manufacturing equipment, and its vehicle fleet, and show none of it on the balance sheet. Operating leases were disclosed in the notes as future commitments, invisible to the asset and liability line items that analysts use to measure leverage, return on assets, and capital efficiency. The balance sheet told an incomplete story.

IFRS 16 ended that. Effective from January 2019, it requires lessees to bring virtually every lease onto the balance sheet as a right-of-use asset and a corresponding lease liability. Globally, the transition brought approximately $3 trillion of lease obligations onto balance sheets. For Indian IT companies that lease millions of square feet of office and development centre space, airlines that lease their entire fleets, and retailers that occupy premises they have never owned, the balance sheet impact was immediate and substantial.

This post covers the definition of a lease under IFRS 16, what goes on the balance sheet and how it is measured, the two recognition exemptions, the income statement treatment, and why the balance sheet changed the way it did.

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Why the Balance Sheet Expanded

Under IAS 17, lease classification drove everything. Finance leases, where substantially all risks and rewards transferred to the lessee, went on the balance sheet. Operating leases did not. The entire accounting depended on which side of an arbitrary classification line a lease fell.

Entities gamed this. Structuring a lease just outside the finance lease criteria kept billions of obligations off the balance sheet. Analysts had to add back estimated operating lease obligations from the notes to get a true picture of leverage. Credit rating agencies already did this for their own analysis. IFRS 16 simply made the financial statements reflect what analysts were already doing manually.

The IASB's logic is straightforward. If you have the right to use an asset for a specified period, that right is an asset. If you are obligated to pay for that right over time, those payments are a liability. The economic substance is no different from borrowing money to buy the asset. The balance sheet should reflect both.

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Is It a Lease? The IFRS 16 Definition

Not every contract involving the use of an asset is a lease under IFRS 16. The standard requires a specific assessment at the inception of every contract that could contain a lease.

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 elements must all be present.

Element 1: An Identified Asset

The asset must be identified, either explicitly (named in the contract) or implicitly (available to the customer at a specified time). Being identified is not sufficient on its own: the supplier must not have a substantive substitution right.

A substitution right is substantive only if the supplier has the practical ability to substitute alternative assets throughout the period of use and would benefit economically from doing so. Both conditions must hold. A data centre operator that can technically move a customer's servers but would incur costs exceeding any benefit from substitution does not have a substantive substitution right. The servers are identified assets.

If the supplier can readily substitute the asset and would economically benefit from doing so, there is no identified asset and the contract is a service, not a lease. A cloud computing contract where the provider can freely migrate workloads across servers without the customer knowing is typically a service: no identified servers, no lease.

Indian context: Infosys leasing a specific floor of a building in Bengaluru, with the floor dimensions and location specified in the agreement, has an identified asset. The building owner cannot substitute a different floor without Infosys's agreement. Identified asset: yes.

An Indian IT company contracting with a cloud provider for compute capacity, where the provider can serve the contract from any available server farm globally, has no identified asset. No lease. Service contract only.

Element 2: The Right to Obtain Substantially All Economic Benefits

The customer must have the right to obtain substantially all the economic benefits from use of the asset during the period of use. If the supplier retains the ability to earn economic benefits from the asset by selling its output to other customers, or by using it for its own purposes, the customer may not have this right.

A company renting a dedicated production line in a contract manufacturer's facility, where no other customer can access that line, obtains substantially all economic benefits. A company paying for a share of a production line, where the manufacturer can use spare capacity for other customers, does not.

Element 3: The Right to Direct the Use

The customer must have the right to direct how and for what purpose the asset is used throughout the period of use, or the relevant decisions must be predetermined.

Direction includes deciding when and how the asset is operated, what it produces, and where it goes. If the supplier makes all operating decisions without input from the customer, the customer does not direct the use.

A logistics contract where a carrier decides which trucks, which routes, and which drivers are used to deliver a customer's goods does not give the customer the right to direct the use of any identified truck. Service, not a lease, even if the same truck consistently serves the route.

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The Two Recognition Exemptions

Once a contract is identified as a lease, IFRS 16 requires balance sheet recognition, with two optional exemptions.

Short-Term Leases

A lease with a term of 12 months or less at the commencement date is a short-term lease. The lessee may elect, by class of underlying asset, not to recognise a right-of-use asset and lease liability. Lease payments are recognised as an expense on a straight-line basis over the lease term.

A lease containing a purchase option cannot be a short-term lease, regardless of the stated term.

The election is made by class of underlying asset, not lease by lease. If an entity elects the short-term exemption for office equipment, it applies to all short-term office equipment leases.

Low-Value Assets

A lessee may elect not to recognise assets and liabilities for leases of low-value underlying assets. Low value is assessed on an absolute basis, based on the value of the asset when new. The IASB indicated approximately USD 5,000 as the threshold when developing the standard. Tablets, personal computers, small office furniture, and telephone handsets are typical examples.

The low-value assessment is asset-by-asset, not portfolio level. A single printer worth USD 3,000 when new qualifies even if the entity leases 1,000 identical printers.

Both exemptions are lessee-only. Lessors do not have equivalent exemptions.

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Initial Measurement: The Lease Liability

At the commencement date, the lessee recognises a lease liability at the present value of lease payments not yet paid.

What Goes Into the Lease Liability

Lease payments included in the initial measurement:

Fixed payments, less any lease incentives receivable from the lessor. A rent-free period at the start of a lease reduces the fixed payments in the relevant periods but is factored into the measurement.

Variable lease payments that depend on an index or rate, initially measured using the index or rate at the commencement date. Rent linked to the Consumer Price Index is included, measured using the current CPI. Rent linked to revenue or usage is not included (it is genuinely variable and goes to P&L when incurred).

The exercise price of a purchase option if the lessee is reasonably certain to exercise it. Amounts expected under residual value guarantees.

Penalty payments for terminating the lease early, if the lease term reflects the lessee exercising that termination option.

What Does Not Go Into the Lease Liability

Variable payments based on usage or performance (per-kilometre charges, revenue-linked rents). These go to P&L when incurred.

Non-lease components (service charges, maintenance fees) unless the entity uses the practical expedient to combine lease and non-lease components.

The Discount Rate

The lease liability is discounted using the interest rate implicit in the lease if that rate can be readily determined. For most lessee arrangements, the implicit rate is not determinable because it depends on the lessor's residual value assumption, which the lessee does not know.

Where the implicit rate cannot be determined, the lessee uses its incremental borrowing rate: the rate it would pay to borrow funds of a similar amount, over a similar term, with similar security, in the same currency.

For Indian entities, the incremental borrowing rate is typically derived from the entity's actual borrowing rates for similar tenors, adjusted for the specific currency and security characteristics of the lease. Wipro used a weighted average incremental borrowing rate of 5.7% when it first adopted IFRS 16 in FY2019, applied to a portfolio of similar leases.

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Initial Measurement: The Right-of-Use Asset

The right-of-use asset is initially measured at cost, which comprises:

The initial measurement of the lease liability.

Any lease payments made at or before the commencement date, less any lease incentives received.

Any initial direct costs incurred by the lessee: incremental costs of obtaining the lease (legal fees directly attributable to negotiating the lease, not general overhead).

An estimate of costs to dismantle and restore the underlying asset or the site at the end of the lease, if required by the lease terms. This is measured in accordance with IAS 37.

Worked Example: Office Lease in Bengaluru

Infosys (for illustration) signs a five-year office lease for a development centre in Bengaluru:

• Commencement date: 1 April 2025
• Annual lease payments: Rs. 6 crore, payable at the end of each year
• Incremental borrowing rate: 8% per annum
• Initial direct costs: Rs. 0.20 crore (legal fees for lease negotiation)
• No purchase option, no restoration obligation

Step 1: Calculate the lease liability

Present value of five annual payments of Rs. 6 crore at 8%:

Lease liability at commencement: Rs. 23.95 crore.

Step 2: Calculate the right-of-use asset

ROU asset = Lease liability + Initial direct costs

ROU asset = Rs. 23.95 crore + Rs. 0.20 crore = Rs. 24.15 crore

Day 1 journal entry:

Dr Right-of-use asset Rs. 24.15 crore

Cr Lease liability Rs. 23.95 crore

Cr Cash (initial direct costs) Rs. 0.20 crore

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Subsequent Measurement: Lease Liability

After initial recognition, the lease liability is carried at amortised cost using the effective interest method.

Each period:

Interest accrues on the opening lease liability at the incremental borrowing rate (8% in the example). This is finance cost in profit or loss.

Lease payments made reduce the liability. Each payment covers the accrued interest first; the remainder reduces the outstanding principal.

Year 1 lease liability movement:

Finance cost in Year 1: Rs. 1.92 crore. Recognised in profit or loss. The closing lease liability of Rs. 19.87 crore is split between current (the portion due within 12 months, broadly the payment less the next year's interest) and non-current.

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Subsequent Measurement: Right-of-Use Asset

The right-of-use asset is subsequently measured using the cost model (unless the underlying asset class uses the revaluation model under IAS 16 or fair value under IAS 40).

Under the cost model, the ROU asset is depreciated over the shorter of the lease term and the useful life of the underlying asset.

If the lease term is 5 years and the useful life of the underlying office space (from the lessee's perspective, measured as the period of control) is 5 years, the depreciation period is 5 years.

Year 1 depreciation:

Rs. 24.15 crore ÷ 5 years = Rs. 4.83 crore per year

This goes to profit or loss as depreciation expense, separate from the finance cost on the lease liability.

Year 1 income statement impact:

Note: total P&L charge in Year 1 (Rs. 6.75 crore) exceeds the actual cash payment (Rs. 6 crore) because interest is front-loaded. In later years, as the lease liability reduces, finance cost falls while depreciation stays constant. Total P&L charges are higher in early years and lower in later years, even though cash payments are level.

This is the opposite of what IAS 17 produced for operating leases, where the straight-line expense matched the cash payment exactly.

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The Income Statement: Two Lines Replace One

Under IAS 17, an operating lease produced one line: operating lease expense, straight-line over the lease term. Simple, predictable.

Under IFRS 16, the same lease produces two lines:

Depreciation of ROU asset: an operating charge, typically sitting within cost of sales or administrative expenses depending on the nature of the leased asset.

Finance cost on lease liability: a financing charge, below operating profit, consistent with how borrowing costs are presented.

This reclassification has a mechanical effect on EBITDA. Because depreciation and finance cost are both below EBIT and EBITDA respectively, the EBITDA of an entity with significant leases improves under IFRS 16 compared to IAS 17. The lease expense that previously reduced EBITDA is replaced by depreciation (which is added back to EBITDA) and finance cost (also below EBITDA). EBITDA goes up. Lease-heavy sectors like retail, aviation, and IT services saw their EBITDA multiples compress on a post-IFRS 16 basis as the denominator increased.

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Lease Term: The Reasonably Certain Test

The lease term is the non-cancellable period of the lease, plus any optional extension periods the lessee is reasonably certain to exercise, minus any optional termination periods the lessee is reasonably certain to exercise.

"Reasonably certain" is a high threshold, close to "virtually certain." It is assessed by considering all relevant economic factors: the significance of leasehold improvements, the importance of the underlying asset to the entity's operations, the cost of moving or replacing the asset, and contractual terms about variable lease payments that depend on whether options are exercised.

For an Indian retailer with a flagship store in a high-street location who has made significant shopfit investment, the extension option on that store's lease is almost certainly going to be exercised. The lease term should include that extension period.

For a temporary project office taken for a 3-year lease with a 2-year extension option, where the entity has no significant investment in the space and could easily relocate, the extension option may not be reasonably certain to exercise.

Getting the lease term right matters. Including extension options adds years to the lease, increases the lease liability, increases the ROU asset, and changes the depreciation and interest profile significantly.

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Variable Lease Payments: Two Types

Index-Linked or Rate-Linked Payments

Payments that vary based on an index (Consumer Price Index, Wholesale Price Index) or a rate (MIBOR) are included in the initial lease liability, measured using the current index or rate at commencement.

When the index or rate changes, the lease liability is remeasured and the ROU asset adjusted. The remeasurement uses the revised future payments and the discount rate at the remeasurement date.

An Indian retailer whose lease rent is revised every three years based on the WPI increase will remeasure the lease liability at each rent review date, adjusting the ROU asset for the change in the liability.

Usage-Based or Performance-Based Payments

Payments that depend on usage (kilometres driven, units produced, pages printed) or performance (revenue-linked rent) are excluded from the lease liability. They are recognised in profit or loss when the trigger event occurs.

For a logistics company paying a vehicle hire charge plus Rs. 12 per kilometre driven, only the fixed hire charge enters the lease liability. The per-kilometre element is recognised as and when kilometres are driven.

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Presentation on the Balance Sheet

The right-of-use asset is presented either:

As a separate line item on the face of the balance sheet, labelled "right-of-use assets," or

Included within the same line item as the corresponding asset class (property, plant and equipment, or investment property), with disclosure of the amount included.

The lease liability is presented either:

As a separate line item, or

Combined with other financial liabilities with disclosure of the included amount.

Both the ROU asset and lease liability are split between current (due within 12 months) and non-current on the balance sheet.

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The Indian IT Sector: What IFRS 16 Did to the Balance Sheet

Indian IT companies are among the largest leaseholders in the country. Infosys, TCS, Wipro, HCL Technologies, and Tech Mahindra collectively lease tens of millions of square feet of office and development centre space across India and globally.

Under IAS 17, all of these were operating leases: off balance sheet, straight-line operating expense. The balance sheets of these companies looked asset-light.

Under IFRS 16, the ROU assets for office and development centre space became the largest single non-financial asset on the balance sheets of several of these companies. For Wipro, on adoption of IFRS 16, the company recognised ROU assets and lease liabilities running into thousands of crores of rupees for its global office portfolio, with a weighted average discount rate of 5.7%.

The income statement impact was broadly neutral for earnings (total charges are the same over the full lease term), but the profile changed: higher charges in early lease years, lower in later years. EBITDA increased. Operating profit stayed roughly similar. Finance cost increased.

For analysts valuing Indian IT companies on EV/EBITDA multiples, the post-IFRS 16 EBITDA is not comparable to pre-IFRS 16 EBITDA without adjustment. This created significant comparability challenges in the first two years after adoption.

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Ind AS 116 vs IFRS 16: Key Differences

The alignment between Ind AS 116 and IFRS 16 is very high. There are no material carve-outs. Indian companies applying Ind AS 116 produce lease accounting that is fully consistent with IFRS 16.

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What Big 4 Auditors Focus On

Lease identification in service contracts. The most judgment-intensive area is whether contracts that are not in the form of a lease actually contain a lease. Outsourcing agreements, cloud computing contracts, contract manufacturing arrangements, and dedicated logistics contracts all require assessment against the three-part definition. Auditors review the contract terms, assess whether an identified asset exists, and challenge management's substitution right analysis.

Lease term determination. Auditors test whether extension and termination options have been correctly assessed for reasonable certainty. They review supporting documentation: lease committee decisions, capex in leasehold improvements, strategic plans for specific locations. A retail entity that has made Rs. 5 crore of shopfit investment in a 5-year lease with a 5-year extension option almost certainly intends to exercise that option.

Incremental borrowing rate appropriateness. For Indian entities, auditors test whether the incremental borrowing rate reflects the entity's actual borrowing cost for a similar obligation. Using a single group-wide rate for all leases regardless of currency, jurisdiction, and term is a known simplification that may not be appropriate for all portfolios.

Variable lease payment classification. Auditors verify that index-linked or rate-linked payments have been included in the lease liability at the current index or rate and that genuinely variable performance-linked payments have been excluded.

Remeasurement completeness. When lease terms, payment amounts, or certainty of exercising options changes, the lease liability and ROU asset must be remeasured. Auditors test whether all qualifying remeasurement events during the year have been identified and processed.

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Dip IFRS Exam Angle

IFRS 16 is one of the most heavily examined topics in Dip IFRS. Calculation questions, journal entries, and conceptual identification questions all appear regularly.

Most tested areas:

Lease definition assessment: given a contract description, determine whether it is a lease under IFRS 16. Apply the three elements: identified asset, substantially all economic benefits, right to direct use.

Initial measurement: calculate the lease liability as the present value of future lease payments and the ROU asset as the lease liability plus initial direct costs and any payments made before commencement.

Subsequent measurement: build the lease liability amortisation table (opening balance, interest at IBR, payment, closing balance) and calculate annual depreciation of the ROU asset.

Income statement presentation: know that depreciation and finance cost replace the single operating lease expense. Know that early years produce higher total charges than later years.

Short-term and low-value exemptions: know the conditions and that the election for short-term leases is by class of asset, while low-value is asset by asset.

Common traps:

Using the coupon rate or stated interest in the lease as the discount rate. If the implicit rate is unknown, use the incremental borrowing rate.

Depreciating the ROU asset over the asset's useful life rather than the shorter of the lease term and useful life. An office lease for 5 years in a building with a 50-year life is depreciated over 5 years.

Including variable usage-based payments in the lease liability. Only fixed payments and index-linked or rate-linked variable payments are included.

Forgetting that the lease liability amortisation is EIR-based, not straight-line. Each period's interest charge decreases as the liability reduces.

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FAQ

Does IFRS 16 apply to leases of intangible assets?

IFRS 16 may be applied to leases of intangible assets other than those excluded (items like film rights, patents, and copyrights under licensing agreements). The application to intangible asset leases is an accounting policy choice; the exemption is narrow.

What happens if a lease is modified?

A modification that increases the scope of the lease and increases the consideration commensurately is treated as a separate new lease. Other modifications are treated as remeasurements of the existing lease, adjusting the lease liability and ROU asset from the modification date.

Can a lessee revalue its right-of-use asset?

If the underlying asset class is measured under the revaluation model in IAS 16, the lessee may apply the same revaluation model to the corresponding ROU asset. If the underlying asset would be classified as investment property measured at fair value under IAS 40, the lessee applies the fair value model to the ROU asset.

Is a security deposit paid to the lessor part of the lease liability?

No. A refundable security deposit is a financial asset under IFRS 9. It is not a lease payment and does not form part of the lease liability. If the deposit is interest-free, it is measured at fair value at initial recognition, and the difference from cash paid is treated as a prepaid lease payment added to the ROU asset.

Does IFRS 16 affect the statement of cash flows?

Yes. Principal repayments of lease liabilities are classified as financing activities. Interest payments (if presented separately) are also financing or operating activities depending on the entity's policy. Short-term and low-value lease payments remain in operating activities. This means operating cash flows improve for entities with significant leases: the portion of lease payments representing principal repayment moves from operating to financing.

What is a sublease and how is it classified?

A sublease arises when a lessee leases the underlying asset to a third party. The sublease is classified as a finance or operating lease based on the ROU asset, not the underlying physical asset. This means a short remaining lease term on the head lease will usually make the sublease a finance lease, because the ROU asset has a short remaining life.

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Enroll with Global Fin X

IFRS 16 produces some of the most calculation-intensive exam questions in the Dip IFRS syllabus. Lease liability amortisation tables, ROU asset depreciation schedules, remeasurement mechanics, and sale and leaseback accounting all require practice with numbers, not just conceptual understanding. Our programme covers IFRS 16 across four dedicated posts with in-depth lectures, worked examples, exam-style MCQs, and a dedicated LMS for working professionals.

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Faculty profile: www.globalfinx.in/manikanta

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This is Post 27 of the Global Fin X IFRS Series. Previous: IFRS 13: Fair Value Hierarchy. Next: Post 28: IFRS 16 Lessee Accounting: Full Worked Example with Numbers.