IFRS 16 – When is a lease not a lease?

Companies using IFRS accounting standards, which include all listed companies, are now in the process of ensuring that they comply with the new regulation, IFRS 16, which stipulates that the value of leased assets and all associated payments due are shown on company balance sheets.

The new rules applied from 1 January 2019 and the biggest change for companies affected is that leases previously defined as operating leases will be shown ‘on balance sheet,’ often for the first time. Some such companies will experience a significant change in some of their key accounting ratios, such as gearing. The most affected industries are retail, airlines and leisure where a high percentage of leased assets are operating leases that have previously been ‘off balance sheet’.


For IFRS purposes a lease is defined as a contract that conveys to a lessee the right to control the use of an identified asset for a period of time in return for consideration. A lease will have the following characteristics:

– An identified asset to which the user has a right of use
– The user obtains substantially all the economic benefits of the asset
– The user has the right to direct the use of the asset

If one or more of the above does not apply, the agreement concerned is not a lease and is therefore not subject to IFRS 16. One factor which will help determine whether a lease has each of the three characteristics shown above, and in particular if an asset is identifiable, is whether a supplier has the right to substitute an asset and the degree to which that right is substantive.

To be substantive a supplier would have the right (and demonstrated ability) to substitute alternative assets throughout the life of an agreement and to benefit economically from such substitutions. A user should have no control over the substitution process and not benefit economically from such substitution. Substitution is not substantive if the supplier has an obligation to substitute an asset on a specified date or in response to the occurrence of a particular event. The terms of asset substitution should be stated within a contract to confirm the degree to which substitution rights are substantive.

To repeat, an agreement that allows for substantive substitution might not qualify as a lease and therefore would fall outside of IFRS 16 rules.

Where a finance agreement is defined as a lease there are two circumstances where IFRS 16 suggest that the agreement need not be shown on a balance sheet:

1. A short-term lease
The lease accounting exemption for short-term leases is included in IFRS 16 and is an accounting policy choice which a lessee may elect to apply, but they can only have that option if the lease meets certain criteria.

In short, a lease agreement can be exempted from inclusion on balance sheet (should a lessee choose to do so) if it:

– Does not extend beyond 12 months in duration
– Does not contain any purchase options
– All leases of the same underlying assets receive the same treatment (in regards to exemption)

The lessee will have to compare the lease contract against the new standard, paying particular attention to any lease extension options or break clauses. Where such an option or clause applies, the lessee will have to apply the ‘reasonably certain’ assessment criteria to judge whether the respective option to extend or terminate the lease will be taken up. Therefore a lessee could not treat a lease as exempt simply because it had a break clause option inside 12 months if the expectation is that the lease will extend beyond twelve months.

2. Low value assets
A lessee can elect not to show certain low value assets on a balance sheet and in those circumstances exemptions can be applied on a lease by lease basis. IFRS 16 does not clearly define what constitutes a low value asset but for guidance purposes an asset costing less than £5,000 when new, such as a laptop, is suggested as equipment that might qualify for exemption. Importantly, IFRS 16 does not permit a lessee to break an asset down into many underlying assets of low-value unless each asset can be used entirely independently. Similarly, if an underlying asset is highly dependent or interrelated with other assets then it is unlikely to qualify for exemption.

Source: BNP Paribas