In 2016, the International Accounting Standards Board (IASB) introduced International Financial Reporting Standard 16 (IFRS 16), which changed lease accounting classifications to increase transparency and comparability as investors and financial institutions evaluate organizations. Public companies in 168 jurisdictions around the world are required or permitted to implement the standard, which went into effect in 2019.
“This Standard sets out the principles for the recognition, measurement, presentation and disclosure of leases. The objective is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information gives a basis for users of financial statements to assess the effect that leases have on the financial position, financial performance and cash flows of an entity.” —IFRS.org
While ASC 842 changed how the “operating lease” classification works to ensure financial liabilities still appear on the balance sheet, IFRS 16 did away with the classification altogether. It was a different solution to the same problem, and the standard now focuses on whether a contract is or contains a lease, rather than on classifying it as an operating lease or finance lease. Nearly all leases are now required to appear on the balance sheet, with some exceptions.
This new process has required companies to collect, organize, and analyze more information about their lease portfolios, putting greater strain on their lease accounting departments and systems—which has also increased the value of quality lease accounting software like Tango Lease. And since it more accurately represents long-term leases as debts, rather than operating expenses, it also fundamentally changes a company’s gearing ratio, EBITDA, cash flow statements, and more.
Even after several years, applying IFRS 16 to your portfolio can be challenging, particularly when it comes to identifying leases and separating lease components and non-lease components within a contract. For example, many contracts contain embedded leases or right of use assets in addition to a service contract, so only part of the contract (the lease) needs to appear on your balance sheet.
In this guide, we’ll walk you through the basics of IFRS 16 and keys to ensuring compliance, including:
- Identifying a lease under IFRS 16
- Separating lease and non-lease components
- Determining lease terms
- Explaining exceptions to IFRS 16
- Simplifying compliance with lease software
Identifying a lease under IFRS 16
A contract doesn’t have to be explicitly called a lease in order to be one—or to contain one. The terms of the contract are what matters. What’s being exchanged, and for how long? Here’s how the standard phrases it:
At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Paragraphs B9–B31 set out guidance on the assessment of whether a contract is, or contains, a lease.
The key details here are the explicit or implicit identification of a specific asset, the right to control it, and a period of time.
Does the contract identify an asset?
The identified asset may be named in the contract, such as “TOYOTA 8FGU32 FORKLIFT #55555,” or the terms of the contract may include requirements that the supplier can only fulfill with a specific asset that meets them. For example, they may only have one CNC machine that meets the customer’s needs and fits the parameters of the contract. In that case, the unnamed CNC machine would be an identified asset.
Does the customer have the right to control the asset’s use?
The right to control an asset is determined by two things:
- Which party has freedom to direct the asset’s use
- Which party primarily obtains the economic benefits from the asset’s use
If the contract defines the conditions in which the asset can be used and prevents the customer from using it for reasonable alternatives, they don’t have the right to control it. For example, if the customer can only use the CNC machine for producing specific products, the supplier has retained control of its use. Or, perhaps the customer is only allowed to use the CNC machine at certain times, either because the supplier needs it or because it’s fulfilling multiple contracts. In this case, the recipient doesn’t “obtain substantially all of the economic benefits from [the asset’s] use.” And they certainly aren’t controlling it.
Does the contract include a set duration?
The final component is that the contract must specify a duration for the agreement. Note, however, that this duration doesn’t necessarily have to be units of time. It just needs to be clear when the agreement will come to an end.
“A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce).”
This can make things challenging when you consider that leases lasting less than 12 months don’t need to appear on the balance sheet. In this case, you’d need to translate production units (or whatever unit is specified in the contract) into months, estimating the length of the contract based on production units per hour, hours of operation, etc.
Once you’ve determined whether a contract is or contains a lease, you only have to reassess whether it belongs on your balance sheet if the terms and conditions change.
Separating lease and non-lease components
Before IFRS 16, many contracts and their components were simply lumped into a company’s operating costs. But since IFRS 16 requires organizations to include embedded leases, lease accountants need to conduct further analysis of contracts to assess which, if any, components need to appear on the balance sheet. In any given contract, some components may meet the criteria of a lease, while others don’t. Each component needs to be evaluated separately on its own merit.
“For a contract that contains a lease component and one or more additional lease or non-lease components, a lessee shall allocate the consideration in the contract to each lease component on the basis of the relative stand-alone price of the lease component and the aggregate stand-alone price of the non-lease components.
The relative stand-alone price of lease and non-lease components shall be determined on the basis of the price the lessor, or a similar supplier, would charge an entity for that component, or a similar component, separately. If an observable stand-alone price is not readily available, the lessee shall estimate the stand-alone price, maximising the use of observable information.”
The IASB provides the example of a contract that gives a customer the right to use a bulldozer, a truck, and a long-reach excavator for four years for CU600,000 (CU being “currency units”). The 600,000 includes the cost of leasing each of the vehicles and maintenance costs, which will be covered by the lessor.
Since each vehicle can be used on its own or together, and benefitting from one vehicle doesn’t depend on the presence of the others, they each represent a separate lease component. So when separating out the components of this lease, the lessee needs to account for the cost of each individual vehicle and the cost of the non-lease component (the maintenance) based on comparable costs for each individual component.
In some cases, it may be too difficult to estimate the costs associated with some non-lease components, so a lessee may wish to simply combine them with relevant lease components. The standard allows for this through practical expedients:
As a practical expedient, a lessee may elect, by class of underlying asset, not to separate non-lease components from lease components, and instead account for each lease component and any associated non-lease components as a single lease component. A lessee shall not apply this practical expedient to embedded derivatives that meet the criteria in paragraph 4.3.3 of IFRS 9 Financial Instruments.
Determining lease terms under IFRS 16
When determining the length of a lease’s term, IFRS 16 states that you must include optional continuation periods if it’s reasonably certain that you’ll pursue it. That means at a specific moment in time, you need to evaluate “all relevant facts and circumstances that create an economic incentive for the lessee to exercise, or not to exercise, the option, including any expected changes in facts and circumstances from the commencement date until the exercise date of the option.”
This includes considerations like:
- How terms and conditions in the optional period compare to market rates, such as the payment amounts during the optional period, the cost of penalties or value of terms connected to the option (like purchase options that become available after the optional period)
- Leasehold improvements undertaken over the term of the lease that would provide significant benefits to the lessee during the optional period
- Costs associated with terminating the contract (negotiation costs, relocation costs, acquisition costs of an alternative, etc.)
- The importance of the underlying asset to your operations and the availability of alternatives
- Conditions that affect your ability to exercise the continuation option, and the likelihood that those conditions will be met
- The duration of the non-cancellable period of the lease
- The lessee’s past practices (i.e. how long they typically use assets like this and why)
At any time over the course of the lease, the lease term can be adjusted after a significant event or change in circumstance that would affect your likelihood to exercise your right to the optional extension. This includes things like unexpected leasehold improvements or modifications to the underlying asset, a sublease that extends beyond the initial lease period, or business decisions dealing with related assets (such as disposing of or acquiring an alternative asset).
IFRS 16 exceptions and exemptions
While IFRS 16 is broadly applicable and even covers leases and subleases that aren’t explicitly defined as leases, there are a number of exceptions. Here’s a complete list of the types of leases you aren’t required to disclose on your balance sheet:
- Leases shorter than 12 months
- Leases where the underlying asset is of “low value,” even when new
- Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources
- Leases of biological assets within the scope of IAS 41 Agriculture held by a lessee
- Service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements
- Licenses of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from Contracts with Customers
- Rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents, and copyrights
- Leases of intangible assets besides intellectual property
Understanding low-value assets under IFRS 16
Note that IFRS 16 doesn’t attach a fixed dollar amount to what it deems “low value.” Instead, a “low-value asset” has to meet three criteria:
- The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee.
- The underlying asset is not highly dependent on, or highly interrelated with, other assets.
- The underlying asset must be considered low value even when new.
Some examples IASB suggests are “tablet and personal computers, small items of office furniture and telephones.” However, it also specifies that “leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value.”
Simplify IFRS 16 compliance with lease accounting software
IFRS 16 substantially increased the strain lease accounting puts on organizations that are required to follow it. This level of financial transparency requires a far greater time investment. Any given contract could be a lease or contain multiple lease components, and IFRS 16 demands that each contract receive greater scrutiny from lease accounting departments.
On a basic level, that means it’s essential that companies have their contracts and associated documents in a centralized, searchable database where lease accountants and administrators can easily retrieve the information they need and trust that it’s up-to-date. This alone saves enough time to make modern lease accounting solutions like Tango Lease worthwhile investments. But advanced lease accounting software can also streamline key workflows and even automate IFRS 16 calculations like amortization schedules.
AI is also changing what lease accounting software is capable of. Tango’s lease-trained LLM streamlines document intake by automatically organizing uploaded documents and associating them with the correct leases in the system. It even translates lease documents into English from more than 20 languages and performs currency conversions to streamline lease accounting for multi-national operations.
The larger your lease portfolio and the more contracts you have, the more critical it becomes to establish a single source of truth, and the more time and resources you save with a quality lease accounting system.
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