IFRS 16 Explained: A Practical Guide to Lease Accounting with Real World Scenarios

There was a time when companies could lease expensive assets such as office buildings, vehicles, machinery, and aircraft without showing most of those obligations on their balance sheets. To someone reading the financial statements, it could appear that the company had very little debt, even though it had committed to paying millions over several years.

That changed with IFRS 16 – Leases.

If you're using someone else's asset for a period of time and you're committed to paying for that right, that commitment should usually appear on your balance sheet.

In simple terms, IFRS 16 ensures that lease commitments are reflected more transparently in financial statements rather than remaining hidden as ordinary rental expenses.

What is IFRS 16?

IFRS 16 is an accounting standard issued by the International Accounting Standards Board (IASB) that explains how organizations should account for lease arrangements.

The standard applies to two parties:

• Lessee: The company or individual using the asset.
• Lessor: The owner of the asset providing the right to use it.

The biggest change introduced by IFRS 16 affects lessees. Most leases now create:

• A Right-of-Use (ROU) Asset
• A Lease Liability

The Basic Principle Behind IFRS 16

Before IFRS 16, many lease payments were treated simply as operating expenses. Companies paid rent and recognized the cost in the income statement.

IFRS 16 changed this approach by recognizing that a lease gives the company an economic benefit — the right to use an asset.

For example, a company leasing an office building for ten years does not own the building, but it controls the right to occupy and use that space during the lease period.

That right has value and is therefore recorded as an asset.

Buying vs Leasing: Understanding the Concept

Buying an Asset

If a company buys a building for GH?8 million, everyone understands that the company owns an asset.

Leasing an Asset

If the company leases the building for ten years, it does not own the building. However, it has obtained the right to use that building for ten years.

IFRS 16 recognizes this right as a Right-of-Use Asset.

What is a Lease Under IFRS 16?

A contract contains a lease when:

• There is an identified asset.
• The customer controls how the asset is used.
• The customer receives substantially all economic benefits from using the asset.

Scenario 1: Office Building Lease

ABC Ltd signs a five-year agreement to occupy a specific floor in a commercial building. Only ABC Ltd has the right to use that space, and the landlord cannot replace it with another location.

This arrangement qualifies as a lease under IFRS 16.

Scenario 2: Cloud Service Arrangement

XYZ Ltd pays a cloud provider monthly for computing services. The provider can move the company's workload between different servers whenever it chooses.

Because XYZ does not control a specific asset, this is generally a service contract rather than a lease.

Right-of-Use Asset Explained

The Right-of-Use Asset represents the value of the company's right to use an underlying asset during the lease period.

The company does not own the building, vehicle, or equipment. Instead, it owns the right to benefit from using that asset.

Lease Liability Explained

The lease liability represents the present value of future lease payments.

In simple terms:

"What are all the future lease payments worth today?"

Future payments are discounted because money today is worth more than money received in the future.

Initial Accounting Entry

When the lease starts, the company records:

How Lease Accounting Works After Recognition

After the lease begins, three main accounting activities occur:

1. Depreciation of the Right-of-Use Asset

The right to use the asset is consumed over the lease term, so the company records depreciation expense.

2. Interest Expense on Lease Liability

The lease liability behaves similarly to a loan. Interest is calculated over time using the effective interest method.

3. Reduction of Lease Liability

Lease payments reduce the outstanding liability after accounting for interest.

Example: Office Lease

Bright Finance Ltd signs a five-year office lease.

• Annual lease payment: GH?200,000
• Present value of lease payments: GH?798,500

At commencement date:

• Right-of-Use Asset = GH?798,500
• Lease Liability = GH?798,500

Lease Term Under IFRS 16

The lease term is not always simply the period stated in the contract.

Companies must consider:

• Renewal options
• Termination options
• Economic incentives
• Business circumstances

Variable Lease Payments

Some leases include payments linked to performance indicators such as sales or production.

Example:

A restaurant pays GH?15,000 monthly plus 5% of monthly sales.

The fixed payment forms part of the lease liability. The sales-based payment is normally recognized as an expense when incurred.

Short-Term Lease Exemption

IFRS 16 provides relief for leases lasting 12 months or less without a purchase option.

Instead of recognizing an asset and liability, the company may recognize lease payments directly as an expense.

Low-Value Asset Exemption

Companies may also elect not to recognize leases for low-value assets such as:

• Laptops
• Printers
• Small office equipment
• Office furniture

Real-World Example: Delivery Company

QuickMove Logistics leases:

• 50 delivery vans
• Two warehouses
• Office premises

Before IFRS 16, these were mainly recorded as rental expenses.

After IFRS 16:

• Right-of-Use Assets appear on the balance sheet.
• Lease liabilities show future payment obligations.

Common IFRS 16 Challenges

• Identifying embedded leases in contracts.
• Determining the correct lease term.
• Selecting the appropriate discount rate.
• Tracking lease modifications.
• Maintaining accurate lease registers.

Why IFRS 16 Matters

IFRS 16 improves transparency by ensuring companies recognize significant lease commitments on their balance sheets.

For investors, it provides a clearer picture of financial obligations.

For lenders, it improves understanding of company leverage.

For management, it provides better visibility over long-term commitments.

Final Thoughts

Although IFRS 16 introduces technical terms such as Right-of-Use Asset, Lease Liability, Present Value, and Discount Rate, the concept is straightforward:

If a company obtains the right to use an asset and commits to future payments, that right and obligation should normally be reflected in the financial statements.

Understanding this principle makes IFRS 16 much easier to apply in practice.