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IFRS 16 Leases – Lessee Accounting: A Simple Explanation

Richard Clarke

IFRS 16 Leases – Lessee Accounting: A Simple Explanation

What is IFRS 16 Lessee Accounting?

IFRS 16 requires lessees to recognise most leases on the balance sheet as a right-of-use (ROU) asset and lease liability, shifting from off-balance-sheet treatment. In the ACCA SBR exam, you’ll calculate these amounts, assess their impact, and apply IFRS principles to financial reporting.

Let’s explore a lease for office space.

Key Components of Lessee Accounting

Under IFRS 16, lessees:

  1. Measure Lease Liability: Present value of future lease payments, discounted at the lease’s implicit rate or incremental borrowing rate.
  2. Recognise ROU Asset: Lease liability plus initial costs, adjusted for prepayments or incentives.
  3. Subsequent Accounting: Depreciate the ROU asset; reduce the liability with payments, adding interest.

Formulae

  • Lease Liability = PV of Lease Payments = Σ [Payment / (1 + Discount Rate)^n]
  • ROU Asset (Initial) = Lease Liability + Initial Direct Costs - Incentives
  • Interest Expense = Lease Liability × Discount Rate

Numeric Example

A company leases an office starting March 02, 2025:

  • Lease Term: 3 years
  • Annual Payment: $20,000 (paid at year-end)
  • Discount Rate: 5% (incremental borrowing rate)
  • Initial Costs: $2,000 (legal fees)
  • Incentive: $1,000 (landlord contribution)

Step 1: Calculate Lease Liability (PV of Payments)

  • Year 1: $20,000 / 1.05 = $19,048
  • Year 2: $20,000 / (1.05)^2 = $20,000 / 1.1025 = $18,141
  • Year 3: $20,000 / (1.05)^3 = $20,000 / 1.157625 = $17,277
  • Total Lease Liability = $19,048 + $18,141 + $17,277 = $54,466

Step 2: Calculate Initial ROU Asset

  • ROU Asset = $54,466 + $2,000 - $1,000 = $55,466

Step 3: Year 1 Subsequent Accounting

  • Interest Expense: $54,466 × 5% = $2,723
  • Payment: $20,000 (reduces liability)
  • Lease Liability (End of Year 1): $54,466 + $2,723 - $20,000 = $37,189
  • Depreciation: $55,466 ÷ 3 = $18,489 (straight-line over 3 years)
  • ROU Asset (End of Year 1): $55,466 - $18,489 = $36,977

What Does This Mean?

  • Balance Sheet: Day 1 shows $55,466 asset and $54,466 liability.
  • Profit or Loss: Year 1 has $18,489 depreciation + $2,723 interest = $21,212 expense (vs. $20,000 under old rules).
  • Impact: Higher assets/liabilities; front-loaded expense pattern.

Management might ask: Can we negotiate lower rates? How does this affect gearing ratios?

Why It Matters for ACCA SBR

IFRS 16 tests your ability to:

  • Apply complex IFRS standards to leases.
  • Calculate PVs and adjust financial statements.
  • Explain impacts to stakeholders (e.g., ratios, covenants).

Practice with multi-year leases or variable payments to excel in SBR!