What is IFRS 16?
IFRS 16 is the international accounting standard that governs how leases are recognised, measured, presented and disclosed. It replaced the old standard, IAS 17, and took effect for accounting periods beginning on or after 1 January 2019.
Its headline effect is on lessees (the party using the asset). Under IFRS 16, a lessee recognises — subject to recognition exemptions and scope exclusions — two new items for almost every lease:
- A right-of-use (ROU) asset — your right to use the asset (the office, the vehicle, the machine)
- A lease liability — your obligation to pay for it
Reference: IFRS 16 paragraphs 22— 4.
Why Was IFRS 16 Introduced?
Under the old IAS 17, most leases were classified as "operating leases" and kept off the balance sheet — you simply expensed the rent each year. The problem: a company could commit to billions in future lease payments (think airlines and retailers) and show almost none of it on the balance sheet. Investors could not easily see the real leverage.
IFRS 16 was introduced to bring that hidden financing into plain sight, making balance sheets more comparable and giving investors a truer picture of a company's obligations.
How IFRS 16 Changed Lease Accounting
The single biggest change: the old operating-vs-finance lease split disappeared for lessees. Almost all leases now go on the balance sheet. But there are important exceptions.
Scope exclusions also apply — IFRS 16 does not cover, for example, leases of mineral rights, biological assets, service concession arrangements, or certain intangible licences.
Reference: IFRS 16 paragraphs 3— and Appendix B paragraphs B3— 8.
IFRS 16 Worked Example (Step by Step)
Let's use a clean, realistic example. Imagine your company signs a lease for office space:
| Term | Detail |
|---|---|
| Lease length | 5 years |
| Annual payment | £50,000, paid at the end of each year |
| Discount rate (incremental borrowing rate) | 6% |
| Initial direct costs / restoration obligation | £0 (assumed nil for simplicity) |
Step 1: Calculate the Lease Liability
The lease liability is the present value of all future lease payments. We discount each £50,000 payment back to today using the 6% rate.
| Year | Payment | Discount Factor (6%) | Present Value |
|---|---|---|---|
| 1 | £50,000 | 0.9434 | £47,170 |
| 2 | £50,000 | 0.8900 | £44,500 |
| 3 | £50,000 | 0.8396 | £41,980 |
| 4 | £50,000 | 0.7921 | £39,605 |
| 5 | £50,000 | 0.7473 | £37,365 |
| Total | £210,620 |
So the initial lease liability is £210,620.
Step 2: Calculate the Right-of-Use Asset
The ROU asset is not always equal to the liability. Its full cost is:
Dismantling or restoration obligations (asset retirement obligations — for example, a requirement to return the office to its original state) are added to the ROU asset and recognised as a provision under IAS 37. In our simple example all of these extras are nil, so:
Reference: IFRS 16 paragraph 24.
Journal Entries Under IFRS 16
Day-one entry
At the start of the lease, you record both the asset and the liability:
Cr Lease liability £210,620
Year 1 — a) Depreciate the ROU asset
Straight-line depreciation is assumed here (it is common but not mandatory — you depreciate in line with the pattern in which the asset's benefits are consumed). Over 5 years: £210,620 ÷ 5 = £42,124 per year.
Cr Accumulated depreciation £42,124
Reference: IFRS 16 paragraphs 31— 2.
Year 1 — b) Charge interest on the liability
Interest = opening liability × 6% = £210,620 × 6% = £12,637. The £50,000 payment then reduces the liability:
| Item | Amount |
|---|---|
| Opening liability | £210,620 |
| Add: interest (6%) | +£12,637 |
| Less: payment | −£50,000 |
| Closing liability | £173,257 |
Dr Lease liability £37,363
Cr Cash £50,000
The key insight: front-loaded expense
Under the old operating lease rules, your expense was a flat £50,000 every year. Under IFRS 16, total year-1 expense is:
That is higher than the old £50,000. Because interest is charged on a declining balance, the total expense is front-loaded — higher in early years, lower later. This is one of the most common things auditors check and preparers get wrong.
How is the Discount Rate Determined?
Choosing the discount rate is one of the most-searched and most-challenged areas of IFRS 16. There are two possible rates:
- Interest rate implicit in the lease — the rate that makes the present value of the lease payments plus the unguaranteed residual value equal to the fair value of the asset plus the lessor's initial direct costs. Use this rate if it can be readily determined.
- Incremental borrowing rate (IBR) — the rate you would pay to borrow, over a similar term and with similar security, the funds needed to obtain a similar asset. Use this when the implicit rate cannot be readily determined.
In practice, lessees rarely have enough information about the lessor's assumptions (residual values, initial direct costs) to calculate the implicit rate, so most companies use the IBR. Because a lower rate produces a larger liability and asset, auditors frequently challenge the IBR — they will ask how it was built up (a reference rate plus adjustments for credit risk, term and security) and whether it is genuinely lease-specific rather than a single group-wide rate applied to everything.
Reference: IFRS 16 paragraph 26.
What Payments Are Included in the Lease Liability?
Getting the payment population right is essential — miss an item and both the liability and the ROU asset are wrong.
✓ Included
- Fixed payments (less any lease incentives receivable)
- In-substance fixed payments
- Variable payments linked to an index or rate (e.g. CPI), measured initially using the index at commencement
- Residual value guarantees (amounts expected to be payable)
- The exercise price of a purchase option (if reasonably certain to exercise)
- Termination penalties (if the term reflects exercising a termination option)
✗ Excluded
- Variable payments based on usage or sales (e.g. turnover rent)
- Service charges and other non-lease components
- Insurance and property taxes recharged by the lessor
- VAT / sales tax
Reference: IFRS 16 paragraphs 26— 7.
When Does the Lease Liability Change?
The liability is not "set and forget". IFRS 16 distinguishes between two situations, and they are accounted for differently:
Reassessment
A remeasurement of the existing lease because of events such as a change in an index or rate (e.g. a CPI-linked rent review), a change in the amounts expected under a residual value guarantee, or a change in your assessment of whether you will exercise an extension, termination or purchase option. You adjust the liability and the corresponding ROU asset.
Lease modification
A change in the scope or consideration of the lease that was not part of the original terms — for example, adding floors to an office lease or renegotiating the rent. Depending on the nature of the change, a modification is accounted for either as a separate new lease or by remeasuring the existing liability. Rent-free periods and rent concessions can fall here too.
Reference: IFRS 16 paragraphs 39— 6.
How Does IFRS 16 Affect the Financial Statements?
Statement of Financial Position
Assets rise (the ROU asset) and liabilities rise (the lease liability). Net assets are broadly unchanged at inception, but the balance sheet is now "grossed up".
Income Statement
The single rental expense is replaced by depreciation (in operating costs) and interest (in finance costs). Total expense is front-loaded over the lease term.
Cash Flow Statement (IAS 7)
This is a very common point of confusion:
- Principal portion of lease payments → financing activities
- Interest portion → operating or financing, depending on the entity's IAS 7 accounting policy choice
- Short-term, low-value and variable lease payments (not in the liability) → operating activities
Note that total cash outflow is unchanged — IFRS 16 only reclassifies where the cash appears, which flatters operating cash flow.
Impact on Financial Ratios
Because IFRS 16 moves lease costs around the financial statements, it changes several headline ratios — something analysts, lenders and finance teams watch closely:
| Metric | Effect under IFRS 16 |
|---|---|
| EBITDA | Increases (rent removed from above the line) |
| Operating profit (EBIT) | Increases slightly (only depreciation above the line) |
| Net debt | Increases (lease liability is debt-like) |
| Gearing | Increases |
| Interest cover | Decreases (new interest expense) |
| ROCE | Usually decreases initially (capital employed rises) |
These shifts can affect debt covenants, bonus targets and valuation multiples, so it is worth modelling them before adoption or before signing a new material lease.
IFRS 16 Disclosure Requirements
Disclosures go well beyond a simple maturity table. IFRS 16 requires a lessee to disclose, among other things:
- Depreciation charge for ROU assets, by class of underlying asset
- Interest expense on lease liabilities
- The expense relating to short-term and low-value lease exemptions
- Additions to ROU assets
- Total cash outflow for leases
- A maturity analysis of lease liabilities
- Qualitative information about leasing activities (nature, restrictions, variable payments, extension/termination options)
Reference: IFRS 16 paragraphs 51— 0.
Need to check a real lease against IFRS 16?
Use our free GAAP Compare tool to research IFRS 16 vs your local GAAP, or bring your specific lease to the Meeting Room and talk it through with an expert AI panel — all free.
Try GAAP Compare Free →Common IFRS 16 Mistakes to Avoid
- Using the wrong discount rate. Use the implicit rate if readily determinable; otherwise a properly built-up, lease-specific IBR — not a single blanket group rate.
- Including the wrong payments. Service charges, usage-based variable rent and VAT should be excluded from the liability.
- Confusing reassessment with modification. They have different accounting treatments.
- Straight-lining the total expense. Depreciation is straight-line, but interest declines — so total expense is front-loaded.
- Forgetting restoration obligations. Dismantling/restoration costs form part of the ROU asset and a provision under IAS 37.
- Thin disclosures. The notes require far more than a maturity analysis.
Frequently Asked Questions
What is a right-of-use asset?
It represents your right to use a leased asset over the lease term. It is initially measured at the lease liability, plus payments made at/before commencement, initial direct costs and estimated restoration costs, less lease incentives received.
How do you calculate a lease liability under IFRS 16?
It is the present value of the unpaid future lease payments at commencement, discounted at the interest rate implicit in the lease or, if that cannot be readily determined, your incremental borrowing rate.
What discount rate should be used under IFRS 16?
The implicit rate if readily determinable; otherwise the incremental borrowing rate. Most lessees use the IBR because they lack the lessor's information to compute the implicit rate.
Are all leases recognised on the balance sheet?
No. Short-term leases (12 months or less, no purchase option) and low-value asset leases are exempt, and certain contracts are outside IFRS 16's scope.
What leases are exempt from IFRS 16?
Short-term leases and leases of low-value assets (a qualitative test — e.g. laptops, phones, small office furniture). Scope exclusions also apply, such as mineral rights and biological assets.
How does IFRS 16 affect EBITDA?
It increases EBITDA, because rental expense is replaced by depreciation and interest, both of which sit below EBITDA. Net debt and gearing rise as a trade-off.
How are lease payments shown in the cash flow statement?
Principal within financing activities; interest within operating or financing (IAS 7 policy choice); short-term, low-value and variable payments within operating activities.
What happens if a lease is modified?
Depending on the change, it is either a separate new lease or a remeasurement of the existing liability and ROU asset. This differs from a reassessment (e.g. a CPI revision or options reassessment).
What are the journal entries for IFRS 16?
On day one: Dr ROU asset / Cr lease liability. Each year: Dr depreciation / Cr accumulated depreciation, and Dr interest & Dr lease liability / Cr cash for the payment.
This example is simplified for educational purposes and does not constitute professional accounting or audit advice. Actual lease accounting may require consideration of variable lease payments, lease incentives, restoration obligations, non-lease components and lease modifications. The article reflects IFRS Accounting Standards effective as of July 2026. Always apply the specific facts of your lease and consult the full text of IFRS 16 and your own advisors before finalising treatment.
Real-Life Case Study: A 5-Year Office Lease, Start to Finish
Scenario. A consultancy signs a 5-year office lease: £50,000 payable annually in arrears, incremental borrowing rate 6%, no purchase option.
Initial measurement. Lease liability = present value of five £50k payments at 6% = £210,618. The right-of-use asset is recognised at the same amount (plus any initial direct costs).
- Depreciation: straight-line £42,124 per year.
- Year-1 interest: £210,618 × 6% = £12,637; liability reduces by £37,363.
- Year-1 total P&L charge: £54,761, higher than the £50k cash rent (front-loading).
Takeaway. Over the full term total expense still equals total cash paid (£250k), but the profile is front-loaded. Model the whole schedule before signing so the early-year profit hit is no surprise.
Illustrative composite scenario for educational purposes. Figures are indicative and do not represent any specific company.