IFRS 16 Leases Explained: Recognition, Measurement, and Journal Entries

IFRS 16 leases are the international accounting requirements that require a lessee to recognise most leases on the balance sheet as a right-of-use asset and a lease liability. In practical terms, IFRS 16 leases ensure that leasing commitments are reflected directly in financial statements rather than disclosed only in notes, improving transparency, comparability, and financial reporting quality.

In this guide, we learn what IFRS 16 leases are, their interpretations, and common mistakes to avoid. Read along to understand key concepts, how to apply them and what training is best

Understanding the Core Model of IFRS 16 Leases

IFRS 16 leases form part of the broader framework of international financial reporting standards. Basically, the foundation of IFRS 16 leases is simple in concept but significant in impact: if a contract conveys control of an identified underlying asset for a period of time in exchange for consideration, it is a lease and must be recognised.

This model eliminates the previous operating-versus-finance classification for lessees. Instead, IFRS 16 leases require:

1. Recognition of a right-of-use asset representing the economic benefit
2. Recognition of a lease liability representing the payment obligation

The purpose is faithful representation. Under IAS 17, operating leases remained off balance sheet, creating inconsistencies between companies that leased assets and those that financed purchases through borrowing.

IFRS 16 leases remove this imbalance by bringing both asset and liability onto the statement of financial position.

Identifying a Lease: Technical Requirements and Practical Judgment

Before applying IFRS 16 leases, entities must determine whether a contract contains a lease.

A contract is within scope when:

1. There is an identified asset
2. The customer obtains all economic benefits substantially
3. The customer directs the use of the asset

An identified asset may be explicitly specified in the contract or implicitly identified. However, if the supplier has substantive substitution rights, the contract may not qualify as a lease.

For example, leasing a specific property for five years usually falls under IFRS 16 leases because the lessee controls the use of that property. By contrast, a data hosting agreement where the supplier can move services between servers typically does not meet the lease definition.

This assessment requires detailed contract review and strong internal controls. Many implementation errors arise from incomplete contract identification across departments.

Initial Recognition and Measurement Under IFRS 16 Leases

At the commencement date, IFRS 16 leases require recognition of two elements:

1. Right-of-use asset
2. Lease liability

1. Measuring the Lease Liability

The lease liability equals the present value of future lease payments over the lease term.

Discount rate selection follows a strict hierarchy:

1. Rate implicit in the lease, if readily determinable
2. Otherwise, the lessee’s incremental borrowing rate

Lease payments included in the calculation typically consist of:

1. Fixed payments
2. In-substance fixed payments
3. Index-based or rate-based payments
4. Residual value guarantees
5. Purchase options when reasonably certain

Variable payments based purely on performance or usage are generally excluded.

This measurement process reflects core IFRS principles of present value and economic substance. It also requires careful documentation, particularly regarding lease term judgments.

1. Measuring the Right-of-Use Asset

The right-of-use asset initially includes:

1. The lease liability
2. Lease payments made at or before commencement
3. Initial direct costs
4. Estimated dismantling or restoration costs

For example, a retailer leasing multiple properties may need to recognise restoration obligations associated with leased properties at the end of the lease term. These estimates are recognised upfront as part of the asset.

The logic is consistent with basic accounting principles:

The asset represents the right to use the underlying asset. Whereas the liability represents the obligation to pay.

Subsequent Measurement and Expense Pattern

After initial recognition, IFRS 16 leases require ongoing measurement of both asset and liability.

1. Lease Liability

Each reporting period:

1. Increase in interest expense
2. Reduce lease payments
3. Remeasure if the lease term or payment assumptions change

If payments are linked to an index, such as inflation, and the index changes, the lease liability must be adjusted.

1. Right-of-Use Asset
2. Depreciated over the lease term or useful life
3. Tested for impairment under IAS 36
4. Adjusted when liability is remeasured

1. Journal Entries in Practice
2. Let’s take an example taught in popular Accounting Training courses in London:
3. Consider a five-year property lease with annual fixed payments of 100,000 and a discount rate of 6%.
4. Present value of payments ≈ 421,236.

1. At Commencement
2. Dr Right-of-use asset 421,236
3. Cr Lease liability 421,236

1. End of Year 1
2. Interest expense: 25,274
3. Dr Interest expense 25,274
4. Dr Lease liability 74,726
5. Cr Cash 100,000
6. Depreciation (straight-line over five years):
7. Dr Depreciation expense 84,247
8. Cr Accumulated depreciation 84,247

Under IFRS 16 leases, this replaces a single rental expense entry. The presentation becomes more structured and economically aligned.

Disclosure and Presentation Requirements

IFRS 16 leases significantly expand disclosure requirements to improve transparency.

Financial statements must disclose:

1. Depreciation by class of underlying asset
2. Interest expense on lease liabilities
3. Expense for short-term leases
4. Expense for low-value leases
5. Total cash outflow
6. Maturity analysis of lease liabilities

Lease assets and lease liabilities must be presented separately or clearly disclosed in the notes. Whereas strong disclosure enhances investor confidence and supports regulatory compliance.

Exemptions and Practical Relief

IFRS 16 leases include two recognition exemptions:

1. Short-term leases (12 months or less)
2. Leases of low-value assets

If elected, payments are expensed as incurred rather than recognised on the balance sheet.

While these exemptions simplify administration, they must be applied consistently and disclosed transparently.

Strategic and Financial Implications of IFRS 16 Leases

IFRS 16 leases affect more than accounting entries. They influence:

1. Reported leverage and net debt
2. EBITDA and operating margins
3. Return on assets
4. Debt covenant compliance
5. Lease-versus-buy decisions
6. Fair value accounting

When a company enters into long-term leasing arrangements, liabilities increase immediately. This can alter capital structure ratios and investor perception.

Boards and finance committees must therefore evaluate leasing strategy alongside financing strategy.

Conclusion

IFRS 16 leases fundamentally transformed lease accounting by bringing right-of-use assets and lease liabilities onto the balance sheet. The model improves transparency, comparability, and alignment with economic substance.

For finance leaders, IFRS 16 leases directly affect financial position, leverage metrics, performance analysis, and governance oversight. Mastery of recognition, measurement, journal entries, and disclosure requirements is essential for compliance and informed strategic decision-making.

Under IFRS 16 leases, leasing decisions are no longer operational details. They are balance-sheet events with measurable financial impact.