If you’re preparing for ICAG and still thinking in terms of “finance lease” versus “operating lease” for a lessee, you’re working from a standard that no longer applies. IFRS 16 replaced that entire framework, and scenario questions now expect you to work through a specific recognition-and-measurement mechanism from the ground up. This article walks through exactly how it works, so you can approach any lease scenario with a clear, repeatable method.
The Old World Versus the New World
Previously, lessees classified every lease as either a finance lease — recognised on the statement of financial position — or an operating lease, where rentals were simply expensed as incurred and the asset never appeared on the balance sheet. IFRS 16 abolished this distinction for lessees. The new principle is simple to state and demanding to apply: if you have the right to control the use of an identified asset for a period of time in exchange for consideration, you have a lease, and — with limited exceptions — it belongs on your statement of financial position.
The Two Exceptions
Two practical expedients allow a lessee to skip on-balance-sheet recognition: short-term leases, meaning a lease term of 12 months or less at commencement with no purchase option, and leases of low-value assets, assessed on an absolute basis rather than by reference to the lessee’s size. For these, the lessee may simply expense lease payments on a straight-line basis over the term — much like the old operating lease treatment. Many candidates skip checking for this exemption entirely and default to full recognition even where the scenario facts clearly describe a qualifying short-term or low-value lease.
Recognition: The Right-of-Use Asset and the Lease Liability
For every other lease, at the commencement date the lessee recognises two items: a right-of-use (ROU) asset — the right to use the underlying asset over the lease term — and a lease liability — the obligation to make the remaining lease payments.
Measuring the Lease Liability
The lease liability is initially measured at the present value of the lease payments not yet paid, discounted using the interest rate implicit in the lease where that rate is readily determinable, or otherwise the lessee’s incremental borrowing rate. Payments typically included are fixed payments, variable payments linked to an index or rate, amounts expected under residual value guarantees, and the exercise price of a purchase option the lessee is reasonably certain to exercise.
Measuring the Right-of-Use Asset
The ROU asset is initially measured at cost: the initial lease liability amount, plus lease payments made at or before commencement (less incentives received), plus initial direct costs, plus any estimated dismantling, removal, or restoration costs the lessee is obligated to incur.
Subsequent Measurement
After commencement, the lease liability is measured using the effective interest method — increasing for accrued interest and decreasing for payments made. The ROU asset is generally depreciated on a straight-line basis over the shorter of the lease term and the asset’s useful life, and assessed for impairment under IAS 36 where indicators exist.
Why the P&L Charge Is Front-Loaded
Because the lessee now recognises interest expense on the lease liability plus depreciation on the ROU asset, rather than a single level rental expense, the total profit-or-loss charge is typically higher in the earlier years of the lease and lower in later years — even when cash rentals are perfectly level. Scenario questions frequently test whether candidates understand this mismatch between cash paid and expense recognised.
Exam Tip: Work systematically: first confirm whether the short-term or low-value exemption applies at all — don’t skip this step. Then build the initial measurement of the liability and asset. Then roll both forward separately, showing the interest/capital split on the liability and the depreciation charge on the asset. Marks are awarded for the workings, not just the closing figures — a candidate who shows a clean roll-forward with one arithmetic slip still earns most of the marks available.
Conclusion
IFRS 16 rewards a systematic approach: confirm the exemption question first, measure both the liability and the asset correctly at initial recognition, then roll both forward with full workings. Master that sequence, and lease scenario questions become one of the most predictable areas of the Financial Reporting and Corporate Reporting papers.
Ready to Go Deeper?
This topic — including a fully worked lease liability roll-forward and right-of-use asset depreciation schedule — is covered inside the Profs Accountancy Solutions self-paced course. Enrol in the course at profstudyhub.com and make IFRS 16 one of the most predictable areas of your ICAG paper.
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