IFRS 16 Leases: Identifying a Lease, Lease Term, Lease Payments and Exemptions

Many businesses use assets they do not own: delivery vans, generators, office floors, machines. Before 2019 many of these arrangements stayed off the statement of financial position, which hid both the assets a business relied on and the obligations it had taken on to pay for them. International Financial Reporting Standard (IFRS) 16 Leases brought almost all leases onto the lessee’s statement of financial position.

This topic covers why the standard was needed, what counts as a lease, the key terms (inception, commencement, lease term, lease payments, residual values, discount rates) and the two exemptions. The next topic covers lessee accounting.

In the diets reviewed for this page none of the questions read tests leases directly. But the standard is examined at the Skills level and lease figures turn up inside the main accounts question. The definitions here decide every number in the next topic, so learn the lease term and the lease payments carefully. Read non-current assets held for sale and discontinued operations first.

Why the standard changed

The old standard, International Accounting Standard (IAS) 17, split leases into finance leases, which were like buying the asset and appeared on the lessee’s statement of financial position, and operating leases, which stayed off it. But an operating lease also gave the lessee the right to use an asset and an obligation to pay for that right.

Those rights and obligations met the definitions of an asset and a liability in the Conceptual Framework, yet were not recognised. The lessee’s statement of financial position therefore understated both the assets it used and its borrowing. The line between the two types was arbitrary, and comparing entities that leased with entities that bought was hard.

IFRS 16 removed the distinction for lessees: a lessee recognises all leases on its statement of financial position, with two exemptions. Lessor accounting is unchanged: a lessor still classifies each lease as finance or operating and accounts for it as before. This topic and the next one deal only with the lessee, which is what the Skills level examines.

What is a lease

A lease is a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration. The owner is the lessor and the user is the lessee. The lessee obtains the use of a machine or building without buying it and pays a series of rentals.

Identifying a lease

A contract is, or contains, a lease if the customer has the right to control the use of an identified asset for a period in exchange for consideration. That needs three things.

1. There is an identified asset, named in the contract or identified when it is made available. If the supplier has a substantive right to substitute another asset throughout the period, and would benefit from doing so, there is no identified asset.
2. The customer has the right to obtain substantially all the economic benefits from using the asset throughout the period.
3. The customer has the right to direct how and for what purpose the asset is used.

The entity assesses this at inception. A contract may contain a lease and other services, for example a vehicle together with maintenance. The lessee then separates the lease component from the non-lease components, unless it chooses, by class of asset, to account for them together as a single lease component.

The key terms

• Inception date: the earlier of the date of the lease agreement and the date the parties commit to its main terms. The contract is assessed at this date to find out whether it is or contains a lease.
• Commencement date: the date the lessor makes the asset available for use. The lessee’s accounting starts here.
• Lease term: the non-cancellable period for which the lessee has the right to use the asset, together with (a) periods covered by an option to extend if the lessee is reasonably certain to exercise it, and (b) periods covered by an option to terminate if the lessee is reasonably certain not to exercise it.

Two illustrations show how the term is set. A lease has a non-cancellable term of five years at ₦100,000 a year and an option to extend for five more years at ₦1 a year. The lessee is reasonably certain to use the cheap extension, so the lease term is 10 years.

If the extension instead costs ₦200,000 a year, above the market rate, the lessee is unlikely to use it, and the lease term is five years.

Lease payments

Lease payments are the payments the lessee makes to the lessor for the right to use the asset during the lease term. They comprise:

1. fixed payments, including in-substance fixed payments, less any lease incentives;
2. variable lease payments that depend on an index or a rate;
3. the exercise price of a purchase option, if the lessee is reasonably certain to exercise it;
4. payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate; and
5. amounts the lessee expects to pay under residual value guarantees.

Payments for non-lease components are excluded unless the lessee combines them. Variable payments that do not depend on an index or a rate, such as rent of 2% of the lessee’s sales, are not lease payments. They are expensed in profit or loss when incurred.

Residual values and the discount rates

At the end of a lease the asset still has a value, its residual value. A residual value guarantee is a promise by the lessee, or a party unrelated to the lessor, that the asset will be worth at least a stated amount. If it will be worth less, the guarantor pays the shortfall.

An unguaranteed residual value is the part of the residual value the lessor cannot be sure of realising.

Two rates are used to discount lease payments. The interest rate implicit in the lease is the rate that makes the present value of the lease payments plus the unguaranteed residual value equal to the fair value of the asset plus the lessor’s initial direct costs. It is the lessor’s internal rate of return.

If it cannot be readily determined, the lessee uses its incremental borrowing rate: the rate it would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value to the right-of-use asset in a similar economic environment.

If rentals are paid in advance, the implicit rate is higher than for identical rentals in arrears, because the lessor receives the same cash sooner, though the total finance charge is the same.

Initial direct costs are the incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained, for example commissions and legal fees. The lessee adds its own initial direct costs to the right-of-use asset in the next topic.

The two exemptions

A lessee may choose not to apply the recognition rules to two kinds of lease. It then charges the rentals to profit or loss on a straight-line basis over the lease term, or on another systematic basis if that better reflects the pattern of benefit.

• Short-term leases. The lease term is 12 months or less at the commencement date and the lease has no purchase option. A lease with an extension option the lessee is reasonably certain to use is not short-term, because the term then exceeds 12 months. The election is made by class of asset.
• Leases of low-value assets. The asset is of low value when new, as a guide about 5,000 United States dollars (US$) or less. Value is judged on the asset when new, whatever its age, so a second-hand van that was a high-value asset when new is still not low-value. Items such as laptops, phones and small furniture usually qualify. An asset that depends on, or is highly interrelated with, other assets does not qualify. The election is made lease by lease.

Leases with similar characteristics may be accounted for as a portfolio, provided this is not expected to differ materially from accounting for each lease separately.

The ideas in more depth

What the lessee gains from the change

Statements now show the assets the entity uses and the borrowing that pays for them, so two entities, one that rents a factory and one that owns it, can be compared. The cost is a different profit pattern: instead of one rental expense, a lessee shows depreciation on the right-of-use asset and interest on the liability. Total expense over the lease is similar, but more is charged early.

Why “reasonably certain” matters

Lease term and lease payments both depend on it. If the lessee is reasonably certain to extend, the extra years and rentals become part of the liability. The test looks at economic incentives: a very cheap extension, large costs of moving, or heavy fit-out of the premises all suggest the lessee will stay.

Sources and references

• IFRS 16 Leases: scope and definitions, identifying a lease, lease term, lease payments, discount rates and the recognition exemptions.
• IAS 17 Leases, which IFRS 16 replaced, and the Conceptual Framework definitions of an asset and a liability.

These points are stated as at 5 November 2026.

Worked examples

1. Fixed payments.
   5 × ₦400,000 = ₦2,000,000, less the incentive ₦150,000 = ₦1,850,000.
2. Variable rent. The 2% of sales does not depend on an index or rate, so it is excluded and expensed as incurred.
3. Purchase option. Not reasonably certain, so excluded.
4. Residual value guarantee. The expected payment of ₦60,000 is included.
5. Total.
   ₦1,850,000 + ₦60,000 = ₦1,910,000.

1. (a) The term is eight months, 12 months or less, with no purchase option: short-term. The rentals are expensed.
2. (b) The term is three years, so it is not short-term, but the assets are low-value when new: low-value exemption.
3. (c) The van was a high-value asset when new, and its age does not change that: no exemption. The lessee recognises a right-of-use asset and a liability.
4. (d) The lease term includes the extension, so it is 24 months and not short-term: no short-term exemption. The low-value exemption applies only if the copier itself was of low value when new.

How to answer in the exam

• Define. Give the definition of a lease and say it conveys a right to use an identified asset for a period in exchange for consideration.
• Explain the change. State the old problem (off balance sheet operating leases), then the new rule (all leases on the statement of financial position for lessees) and the two exemptions.
• State the lease term. Non-cancellable period plus reasonably certain extension periods, and termination periods the lessee is reasonably certain not to use.
• Calculate lease payments. List each component and say whether it is included or excluded.
• Apply an exemption. Check the 12-month term and purchase option first, then value when new.

Common mistakes in the exam

• Saying IFRS 16 applies to lessors in the same way. For lessors the finance and operating split remains.
• Calling a lease with a reasonably certain extension a short-term lease.
• Judging low value by the age or current price of the asset instead of its value when new.
• Including variable payments based on sales in the lease payments.
• Forgetting to deduct lease incentives from fixed payments.
• Using the incremental borrowing rate when the implicit rate can be readily determined.

Quick revision

• Lease: right to use an identified asset for a period for consideration. Tests: identified asset, substantially all benefits, right to direct use.
• Lessee: right-of-use asset and lease liability for all leases except short-term and low-value. Lessor unchanged.
• Lease term: non-cancellable period plus reasonably certain extensions, and terminations reasonably certain not to be used.
• Lease payments: fixed less incentives; index or rate variable; reasonably certain purchase option; termination penalties; residual value guarantees expected.
• Rate: implicit if readily determined, otherwise incremental borrowing rate.
• Short-term: 12 months or less, no purchase option. Low-value: low when new, about US$5,000.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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