IFRS 16 — Leases
Lease accounting from the lessee's side
Why the operating lease disappeared from the lessee's books.
9 min read
The idea
Under the previous model a lessee classified a lease as operating or finance, and the operating lease stayed off the statement of financial position, appearing as a straight-line rent expense. The current standard removed that duality for lessees: every lease recognises a right-of-use asset and a lease liability, with two optional exemptions.
The effect is not cosmetic. The balance sheet grows by an asset and a liability that were previously invisible, leverage ratios rise, and a straight-line rent expense becomes constant depreciation plus declining interest, so the charge is front-loaded. A reader who misses this shift will think performance deteriorated.
The treatment
Is it a lease at all?
A contract is a lease if it conveys the right to control the use of an identified asset for a period in exchange for consideration. Control means the right to obtain substantially all the economic benefits from use and the right to direct that use. If the supplier holds a substantive substitution right, the asset is not identified, and the contract is a service rather than a lease.
Initial measurement
The lease liability is measured at the present value of the unpaid lease payments, discounted at the rate implicit in the lease if it can be determined, otherwise at the lessee's incremental borrowing rate. The right-of-use asset is measured at the liability amount, plus payments made at or before commencement, initial direct costs, and dismantling and restoration costs, less lease incentives received.
Subsequent measurement
The right-of-use asset is normally depreciated over the shorter of its useful life and the lease term, unless the lease transfers ownership or contains a purchase option reasonably certain to be exercised, in which case the useful life applies. The liability is measured at amortised cost: increased by interest and reduced by payments, so interest is high early and declines thereafter.
The two optional exemptions
A lessee may elect not to apply the model to short-term leases of twelve months or less that contain no purchase option, and to leases of low-value assets. In those cases payments are expensed on a straight-line basis. The exemption is an accounting policy choice that is disclosed and applied consistently.
Worked example
The entity leases a warehouse for three years with an annual payment of SAR 100,000 at the end of each year. The implicit rate cannot be determined, and the incremental borrowing rate approved for the case scenario is 10% a year. There are no initial direct costs and no incentives.
- Present value of three equal payments at 10%: the annuity factor is 2.4869, so the liability is 100,000 × 2.4869 ≈ SAR 248,690, which is also the right-of-use asset here.
- First-year straight-line depreciation over three years: 248,690 ÷ 3 ≈ SAR 82,897.
- First-year interest: 248,690 × 10% ≈ SAR 24,869, making the first-year total charge about SAR 107,766, above the SAR 100,000 payment — the front-loading that surprises anyone expecting a straight-line expense.
Synthetic teaching amounts with a scenario-approved discount rate; the example does not address any tax treatment.
Commencement — recognise the asset and liability
When the asset is made available for the lessee's use.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Right-of-use asset | 248,690.00 | — |
| Lease liability | — | 248,690.00 |
| Total | 248,690.00 | 248,690.00 |
Year one — depreciation
Allocating the right-of-use asset cost over the lease term.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Depreciation expense | 82,897.00 | — |
| Accumulated depreciation — right-of-use asset | — | 82,897.00 |
| Total | 82,897.00 | 82,897.00 |
Year one — interest and payment
Paying the annual instalment while recognising the period's interest on the liability.
| Account | Debit (SAR) | Credit (SAR) |
|---|---|---|
| Interest expense | 24,869.00 | — |
| Lease liability | 75,131.00 | — |
| Bank | — | 100,000.00 |
| Total | 100,000.00 | 100,000.00 |
Common errors
- Keeping a lease off the statement of financial position because it is 'operating', a classification that no longer exists for lessees.
- Using an unjustified discount rate instead of the implicit rate or a documented incremental borrowing rate.
- Depreciating the right-of-use asset over the asset's useful life when the lease does not transfer ownership.
- Expecting a straight-line rent charge and treating the difference as an error, when it is the natural front-loading of cost.
Interview question
A company leases offices for five years. How do its statements change compared with the old operating-lease treatment?
A right-of-use asset and a lease liability appear where none were shown, raising assets and liabilities and affecting leverage ratios. The straight-line rent expense is replaced by constant depreciation plus declining interest, so the charge is higher in early years and lower later. Part of the cash outflow also moves from operating to financing in the cash flow statement.