IFRS 16 Leases: Implementation Guide for Auditors

What IFRS 16 changed and why it still causes errors

Your client’s balance sheet just gained €4M in right-of-use assets and a matching lease liability. The managing director is confused. The CFO says it’s “just an accounting change.” But the bank covenant test references total assets and total liabilities, and both moved. IFRS 16 didn’t change the economics of the client’s leases. It changed where they appear. And if the initial measurement was wrong (wrong discount rate, wrong lease term, missing variable payments), every subsequent period carries the error forward through amortisation and interest unwinding.

IAS 17 classified leases as operating or finance. Operating leases stayed off the balance sheet. IFRS 16 removed that distinction for lessees. Every lease above the low-value and short-term thresholds now produces a right-of-use asset and a lease liability on the balance sheet.

The standard has been effective since 1 January 2019. Most entities transitioned years ago. But the errors auditors find today aren’t transition errors. They’re ongoing measurement errors: wrong discount rates carried forward from day one, lease modifications not accounted for, renewal options included or excluded without documented judgment, and variable lease payments misclassified.

IFRS 16.BC5 explains the IASB’s rationale. Under IAS 17, structuring a lease as “operating” kept significant financial commitments off the balance sheet. The IASB estimated over US$2 trillion in off-balance-sheet lease obligations globally at the time of issuing IFRS 16. The single-model approach removed the incentive to structure around the classification boundary. For the auditor, this means every lease contract the client has signed is in scope unless it qualifies for one of the two exemptions.

Identifying a lease under IFRS 16.9

IFRS 16.9 defines a lease as a contract (or part of a contract) that conveys the right to use an identified asset for a period of time in exchange for consideration. The definition has two components, and both must be met.

First, the contract must relate to an identified asset. IFRS 16.B13 clarifies that an asset is identified if it is explicitly specified in the contract or implicitly specified at the time it is made available. A capacity portion of an asset counts as an identified asset only if it is physically distinct (IFRS 16.B14). A contract for 50% of a warehouse’s capacity where the client doesn’t control a physically distinct portion is not a lease.

Second, the customer must have the right to control the use of the identified asset. IFRS 16.B9 defines control as having both the right to obtain substantially all the economic benefits from use and the right to direct the use of the asset. “Directing use” under IFRS 16.B24 means deciding how and for what purpose the asset is used throughout the period of use. If the supplier makes those decisions, it’s a service contract, not a lease.

The areas where identification goes wrong for mid-tier clients are predictable. IT hosting arrangements where the client uses a dedicated server (lease) versus shared infrastructure (service). Fleet management contracts where the supplier can substitute vehicles without the client’s consent (usually a service) versus contracts where specific vehicles are assigned (lease). Equipment rental agreements that look like leases but include substitution rights that are substantive under IFRS 16.B14–B19.

Measuring the lease liability at commencement

IFRS 16.26 requires the lease liability to be measured at the present value of lease payments not yet paid at the commencement date. The payments included in the measurement are defined in IFRS 16.27: fixed payments (less any lease incentives receivable), variable payments that depend on an index or rate, amounts expected to be payable under residual value guarantees, the exercise price of a purchase option if the lessee is reasonably certain to exercise it, and payments of penalties for terminating the lease if the lease term reflects the lessee exercising a termination option.

That list is worth reading carefully because every item is a potential error. Variable payments that don’t depend on an index or rate (e.g., payments based on usage or performance) are excluded from the lease liability and recognised in profit or loss as incurred per IFRS 16.38(b). Clients frequently include them in the liability, overstating both the asset and the liability.

The lease term itself is defined in IFRS 16.18 as the non-cancellable period together with periods covered by an extension option if the lessee is reasonably certain to exercise, and periods covered by a termination option if the lessee is reasonably certain not to exercise. “Reasonably certain” is a high threshold under IFRS 16.BC157. It’s not “more likely than not.” The IASB chose this threshold deliberately to prevent entities from including or excluding renewal periods based on current intentions alone. You need evidence of economic incentive: significant leasehold improvements, the asset’s importance to operations, costs of relocation, and the history of exercising similar options.

Choosing the right discount rate under IFRS 16.26

IFRS 16.26 requires discounting at the interest rate implicit in the lease. If that rate cannot be readily determined (and for most non-Big 4 clients, it can’t), the lessee uses its incremental borrowing rate.

The rate implicit in the lease is defined in IFRS 16.A as the rate that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor. This requires knowing the lessor’s expected residual value and the fair value of the asset. Lessees almost never have this information for property leases, vehicle leases, or equipment leases from third-party lessors.

The incremental borrowing rate under IFRS 16.A is the rate of interest the lessee would have to pay to borrow funds necessary to obtain an asset of similar value to the right-of-use asset, in a similar economic environment, with similar terms and security. This isn’t the client’s average borrowing rate. It’s a lease-specific rate that reflects the lease term, the currency, the economic environment at commencement, and the nature of the asset as collateral.

Most mid-tier clients don’t derive this rate from scratch. They shouldn’t have to.

For mid-tier clients, the practical approach is to start with the client’s observable borrowing rate (the rate on their most recent bank facility) and adjust for term differences, collateral differences, and currency if applicable. IFRS 16.BC161 acknowledges that the incremental borrowing rate requires estimation and permits the use of observable data as a starting point. Document the starting rate, each adjustment made, and the resulting rate applied. If the client used a single rate across all leases of different terms, that is an error unless all leases have substantially similar terms and conditions.

The discount rate has a disproportionate effect on the lease liability. For a 10-year property lease with annual payments of €100,000, the difference between a 3% and a 5% discount rate produces a €68,000 difference in the initial lease liability. Test the rate.

Measuring the right-of-use asset

IFRS 16.23 requires the right-of-use asset at commencement to be measured at cost. That cost comprises the initial measurement of the lease liability (IFRS 16.24(a)), any lease payments made at or before commencement less any incentives received (IFRS 16.24(b)), any initial direct costs incurred by the lessee (IFRS 16.24(c)), and an estimate of costs to dismantle or restore the asset per IFRS 16.24(d).

The fourth component is the one clients miss. If the lease contract requires the lessee to restore the premises to their original condition at the end of the lease, IAS 37 requires a provision for that obligation at commencement. IFRS 16.24(d) adds the corresponding amount to the cost of the right-of-use asset. Clients who recognise the restoration provision forget to capitalise the same amount into the asset. The result: the provision is on the balance sheet, but the asset is understated, and depreciation over the lease term is therefore understated too.

After initial recognition, IFRS 16.29 requires the lessee to apply the cost model (depreciate the right-of-use asset and accrue interest on the lease liability) unless it elects IAS 40 fair value for investment property right-of-use assets, or applies the revaluation model under IAS 16 to a class of right-of-use assets. Most non-Big 4 clients use the cost model. The depreciation period is the shorter of the useful life and the lease term, unless ownership transfers or a purchase option is reasonably certain to be exercised (IFRS 16.32).

How to audit lease modifications

Lease modifications generate more errors than initial recognition because they happen throughout the year and the accounting depends on the nature of the change. IFRS 16.44 defines a modification as a change in the scope or consideration of a lease that was not part of the original terms.

IFRS 16.44 requires the lessee to account for a modification as a separate lease if two conditions are both met: the modification increases the scope by adding the right to use one or more underlying assets, and the consideration increases by an amount commensurate with the standalone price adjusted for the circumstances. If both conditions are met, you have a new lease, and the original lease continues unaffected.

If the modification is not a separate lease, IFRS 16.45 requires remeasurement. The lessee reassesses the lease term, remeasures the lease liability using a revised discount rate, and adjusts the right-of-use asset.

The revised discount rate at the modification date matters here. Clients frequently remeasure the liability using the original commencement date discount rate. IFRS 16.45(c) explicitly requires a revised rate. If interest rates rose between commencement and modification (as they did across most of 2022 and 2023), using the old rate understates the remeasured liability.

Lease modifications that decrease the scope of the lease (e.g., the client gives back a floor of the building) require a partial derecognition under IFRS 16.46(a). The right-of-use asset and the lease liability are reduced proportionally, with any difference recognised in profit or loss. Clients often remeasure the liability without the proportional asset derecognition, inflating both sides.

Worked example: Van der Berg Holding N.V.

Client scenario: Van der Berg Holding N.V. is an Amsterdam-based logistics company with €72M annual revenue. On 1 July 2024, Van der Berg signs a lease for a 2,500 m² distribution warehouse in Utrecht. Lease term: 5 years, no renewal option. Annual rent: €180,000, payable in advance on 1 July each year. Van der Berg paid €12,000 in legal fees to negotiate the lease. The lease requires restoring the warehouse to its original condition at the end of the term (estimated cost: €35,000 in 2029 terms). Van der Berg’s incremental borrowing rate: 4.2% (based on its most recent bank facility of 3.8% for a 3-year term, adjusted upward by 0.4% for the 5-year term difference based on the EUR swap curve at commencement).

1. Lease identification (IFRS 16.9)

The contract specifies a particular warehouse at a specific address. Van der Berg has exclusive use. The lessor has no substantive substitution rights. This is a lease under IFRS 16.9.

2. Lease liability at commencement (IFRS 16.26)

Lease payments: 5 annual payments of €180,000, payable in advance.

• First payment (1 July 2024): paid at commencement, not included in the liability.
• Remaining 4 payments: €180,000 each on 1 July 2025, 2026, 2027, 2028.

Present value of remaining payments at 4.2%:

3. Right-of-use asset at commencement (IFRS 16.23–24)

Restoration provision calculation: €35,000 / (1.042)⁵ = €28,540.

4. Subsequent measurement (year 1)

Depreciation of ROU asset: €870,862 / 5 years = €174,172 per annum.

Interest on lease liability (year 1): €650,322 × 4.2% = €27,314.

Lease liability at 30 June 2025 (before second payment): €650,322 + €27,314 = €677,636.

Lease liability after second payment (1 July 2025): €677,636 − €180,000 = €497,636.

Practical checklist for your next engagement

1. Obtain the client’s complete lease register and reconcile it to the right-of-use asset and lease liability balances in the trial balance. If the client doesn’t maintain a lease register, that is a deficiency in the internal control environment you should document under ISA 265.
2. For each material lease, inspect the contract and verify the lease term, payment amounts, payment timing (advance or arrears), and any renewal or termination options. Compare against the assumptions in the client’s IFRS 16 model.
3. Test the discount rate. Obtain the client’s incremental borrowing rate documentation. Verify the starting rate against observable evidence (bank facility letter, loan agreement). If adjustments were made for term or collateral, verify the basis. Flag any lease where the client applied a rate that differs by more than 50 basis points from what the evidence supports.
4. Check for lease modifications during the period. Review board minutes, management accounts, and enquire with the CFO. For each modification identified, verify whether it was accounted for as a separate lease (IFRS 16.44) or as a remeasurement (IFRS 16.45), and confirm the revised discount rate was used.
5. Verify that the right-of-use asset includes all four components of IFRS 16.24. Restoration provisions under IFRS 16.24(d) are the most commonly omitted. If the lease requires the client to restore premises, check that both the IAS 37 provision and the corresponding IFRS 16.24(d) addition to the ROU asset exist.
6. Reconcile the IFRS 16 model to the general ledger. Lease calculations are frequently maintained in a standalone spreadsheet that doesn’t tie to the GL. Test the journal entries for at least two quarters: depreciation of the ROU asset, interest on the lease liability, and lease payments reducing the liability.

Common mistakes

• Using the commencement-date discount rate when remeasuring for a lease modification. IFRS 16.45(c) requires a revised rate at the modification date. The ESMA 2023 European Common Enforcement Priorities report flagged discount rate errors in lease modifications as a recurring issue across European filings.
• Excluding restoration obligations from the right-of-use asset. IFRS 16.24(d) requires the estimated cost of dismantling or restoring the asset to be included in the ROU asset cost. The IFRS Interpretations Committee’s June 2020 agenda decision confirmed that the initial estimate of restoration costs is part of the asset, not a separate expense. Omitting it understates both the asset and depreciation.
• Including all renewal options in the lease term without assessing “reasonably certain.” IFRS 16.BC157 sets a high threshold. The FRC’s 2022 thematic review on IFRS 16 noted that some firms accepted client assertions about renewal intentions without evaluating the economic factors required by IFRS 16.19.

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Further reading and source references

• IFRS 16, Leases: effective 1 January 2019. The core lessee model is in paragraphs 22–46, with the discount rate hierarchy in paragraph 26 and Appendix A.
• IFRS 16.BC5: the IASB’s basis for conclusions on the single-model approach, including the US$2 trillion off-balance-sheet estimate.
• ESMA 2023 European Common Enforcement Priorities: enforcement findings on discount rate errors in lease modifications.
• FRC 2022 thematic review on IFRS 16: findings on “reasonably certain” lease term assessments and renewal option judgments.
• IFRS Interpretations Committee, June 2020: agenda decision confirming that restoration costs form part of the right-of-use asset under IFRS 16.24(d).
• Lease liability: Ciferi glossary entry covering the IFRS 16 measurement requirements, the discount rate hierarchy, and remeasurement triggers.