IFRS 16 Leases: how leases are reflected in the financial statements

What problem the standard solves

Before the standard, a large share of lease obligations never appeared on the balance sheet: payments were simply charged to expenses of the period. Companies with large leased portfolios looked considerably less indebted than they really were.

Users of financial statements — banks, investors, analysts — had to reconstruct the full picture from the notes themselves. The standard closed this gap by moving leases from the notes into the primary statements.

The logic of the change: the lessee obtains a controlled resource — the right to use an asset — and at the same time an obligation to pay. Both meet the definitions of an asset and a liability.

What changes for the lessee

The key change is a single accounting model: the lessee recognises a right-of-use asset and a lease liability. For lessees, the former split between operating and finance leases has essentially lost its relevance.

The expense profile changes as well. Instead of an even lease payment, the statement of profit or loss shows depreciation of the right-of-use asset and interest expense on the liability. The total over the whole term remains comparable, but the allocation across periods shifts towards the beginning.

The statement of cash flows is restructured too: payments are reallocated between sections, which affects familiar operating cash flow indicators.

• recognition of a right-of-use asset
• recognition of a liability for lease payments
• depreciation of the right-of-use asset instead of lease expense
• interest expense on the lease liability
• reclassification of lease payments in the statement of cash flows
• expanded lease disclosures

What is a lease and what is not

Not every contract with the word «lease» in it is a lease for the purposes of the standard, and conversely, some service contracts in substance contain a lease. The key test: is there an identified asset, and does the customer obtain the right to control its use throughout the term?

Control means the ability to obtain substantially all of the economic benefits from using the asset and to direct how and for what purpose it is used. If the supplier can substitute the asset at any time at its own discretion, the indicators of a lease weaken.

This is the stage where disagreements arise most often. Contracts for transport, warehouses, equipment and sites require substantive analysis rather than a formal reading of the title.

Difficult areas in practice

First, determining the lease term. Contracts often contain options to extend or terminate early, and assessing how likely they are to be exercised requires management judgement rather than a mechanical count.

Second, the discount rate. The liability is measured at the present value of payments, and the choice of rate has a significant effect on the resulting amounts. It has to be supported by documentation.

Third, variable payments and contracts where a lease is mixed with services. Separating components affects both the size of the liability and the expense profile.

Fourth, modifications: extensions, changes in floor area, renegotiated payments. Each such event requires remeasurement, and without an established process this quickly becomes a source of errors.

Impact on ratios and on relationships with banks

Bringing lease liabilities onto the balance sheet changes leverage and capital structure ratios. For companies with covenants in loan agreements this may have direct consequences if the terms are defined through balance sheet metrics.

At the same time, earnings before interest, depreciation and amortisation increase: lease expense moves out of operating line items. Comparing «before» and «after» periods without explanation becomes misleading.

We recommend discussing the effect with lenders in advance. A conversation before the financial statements are issued goes far more smoothly than explanations afterwards.

How to prepare for application

Start with an inventory of contracts. In practice this is the most labour-intensive stage: some contracts are kept in business units, some were extended verbally, some are documented as services.

Next comes analysing each contract for lease indicators, determining the term and payments, and choosing and supporting the rate. The outcome should be recorded in the accounting policy and an internal procedure so that new contracts are processed consistently.

Think about the tool separately. While there are few contracts, calculations are kept in spreadsheets, but as the portfolio grows, manual remeasurement at every modification becomes a source of errors.

Leader Audit supports companies in Uzbekistan at every stage: from the contract inventory to preparing disclosures and reviewing calculations. The specific requirements of the standard and how they are applied should be checked against the current edition of the international standards.

• collect and organise all lease contracts
• review service contracts for embedded lease components
• determine the lease term taking options into account
• support the discount rate
• set up accounting for contract modifications
• prepare disclosures in the notes