IFRS 16 Leases Explained: Entries, Exemptions and Saudi Adoption

IFRS 16 is the international accounting standard for leases. Its main change is for lessees: almost every lease now goes on the balance sheet as a right-of-use asset and a lease liability, instead of appearing only as rent expense. Leases of 12 months or less and leases of low-value assets can still be expensed if the company chooses. Lessor accounting stays largely the same. In Saudi Arabia, companies reporting under full IFRS apply IFRS 16 as endorsed by the Saudi Organization for Chartered and Professional Accountants (SOCPA).

What IFRS 16 is and when it applies

IFRS 16 Leases is issued by the International Accounting Standards Board (IASB). It replaced the earlier leases standard, under which lessees split leases into finance leases, shown on the balance sheet, and operating leases, which were not. Since most office, shop, warehouse and vehicle rentals were operating leases, large obligations stayed off balance sheets.

The standard applies to any contract that is, or contains, a lease: one that gives the customer the right to control the use of an identified asset for a period of time in exchange for consideration. Control means the customer obtains substantially all the economic benefits from using the asset and directs how and for what purpose it is used. If the supplier has a substantive right to substitute the asset throughout the period of use (it can practically do so and would benefit economically), there is no lease. This is why some service contracts contain a lease and others do not.

On the effective date: the standard has been in force for years, and any company preparing IFRS financial statements today applies it. The exact date and the transition options are set out in the standard itself.

What changed for lessees

On the commencement date, when the asset becomes available for use, the lessee recognizes:

• A lease liability at the present value of the lease payments not yet paid: fixed payments less incentives, variable payments linked to an index or rate, expected amounts under residual value guarantees, a purchase option price the lessee is reasonably certain to exercise, and termination penalties where the lease term assumes termination.
• A right-of-use asset at the amount of the liability, plus payments made at or before commencement less incentives received, initial direct costs and the estimated restoration costs the lease requires.

The asset is then depreciated, usually on a straight-line basis over the shorter of the lease term and its useful life, while the liability accrues interest and falls with each payment. The single rent line is replaced by depreciation and interest, and because interest is higher while the liability is large, total expense is higher early in the lease and lower later, even when rent is flat.

The lease term includes extension periods the lessee is reasonably certain to use and periods after a termination option it is reasonably certain not to use, so renewal judgments drive the numbers. Variable payments not linked to an index or rate, such as rent based on a share of sales, stay out of the liability and are expensed as they occur.

The short-term and low-value exemptions

• Short-term leases: a lease of 12 months or less at commencement, with no purchase option, can be expensed on a straight-line or other systematic basis. The choice is made by class of asset.
• Low-value assets: leases of assets that are of low value when new, such as laptops, mobile phones or small items of office furniture, can also be expensed, lease by lease. The test looks at the asset, not at the size of the company. Cars and real estate do not qualify.

The standard itself sets no amount for low value, so companies set an internal threshold and apply it consistently. Short-term leases renewed again and again deserve a closer look, because the real term may be longer than the contract suggests.

Lessor accounting

Lessors still classify each lease as a finance lease, which transfers substantially all the risks and rewards of ownership, or an operating lease, which does not. Under a finance lease the lessor derecognizes the asset, recognizes a receivable equal to its net investment in the lease and records finance income over the term. Under an operating lease it keeps and depreciates the asset and recognizes lease income, usually on a straight-line basis. Disclosures are more detailed than before, and a sublease is classified by reference to the right-of-use asset, not the underlying asset.

IFRS 16 entries in plain words

Without figures, a lessee’s journal entries follow this pattern:

1. At commencement: debit the right-of-use asset, credit the lease liability. Payments made on that day, initial direct costs and the restoration provision are added to the asset against cash or a provision.
2. Interest, each period: debit interest expense, credit the lease liability, at the discount rate set at commencement.
3. Each payment: debit the lease liability, credit cash or bank.
4. Depreciation, each period: debit depreciation expense, credit accumulated depreciation of the right-of-use asset.
5. On a change in the term, the payments or an index: remeasure the liability and adjust the asset by the same amount; once the asset reaches zero, any further reduction goes to profit or loss.

Exempt short-term and low-value leases are simply debited to rent expense, as before.

The effect on EBITDA and financial ratios

• EBITDA rises, because rent, which sat above it, becomes depreciation and interest, which sit below it.
• Operating profit usually rises a little, since only depreciation stays in operating expenses.
• Liabilities and gearing rise, because the lease liability counts as debt in many ratio definitions, and higher total assets can lower return on assets.
• Operating cash flow rises and financing cash flow falls, because lease principal is shown under financing activities; interest follows the company’s policy for interest paid. The cash leaving the company is unchanged.
• Interest cover can move either way, because both earnings and interest change.

Check your loan covenants: ratios built on debt or EBITDA can move even when the business has not changed, so read how the facility agreement treats leases before discussing results with the bank.

IFRS 16 in Saudi Arabia

Saudi companies reporting under full IFRS, including listed companies, apply IFRS 16 as part of the IFRS endorsed in the Kingdom by SOCPA, a framework usually described as IFRS as endorsed in the Kingdom of Saudi Arabia and other standards and pronouncements endorsed by SOCPA. The endorsement can add requirements or disclosures, so read the endorsed version. Entities allowed to use the IFRS for SMEs as endorsed by SOCPA follow that standard’s own leases section, which differs from IFRS 16, so confirm your framework first.

Local leases often need care: rent paid in advance for a year or more, renewal clauses used as a matter of routine, land leases for industrial or commercial projects, staff housing and vehicle fleets. The zakat and tax treatment of leases follows the rules of the Zakat, Tax and Customs Authority (ZATCA), not IFRS 16, so review it separately.

Practical steps to apply IFRS 16

1. Build a lease register of every office, shop, warehouse, land, vehicle, equipment and housing contract, including service contracts that may contain a lease, with dates, options, payments, escalations, incentives and restoration obligations.
2. Review each contract: confirm it contains a lease, separate non-lease components such as maintenance or elect not to, and assess the lease term.
3. Set discount rates: the rate implicit in the lease if readily determinable, otherwise your incremental borrowing rate for a similar term, security and asset value. Document how you derived it.
4. Write your exemption policy and apply it consistently.
5. Calculate and post with a spreadsheet model or lease software.
6. Monitor changes: renewals, rent reviews, early exits and index changes require remeasurement.
7. Prepare disclosures, including a maturity analysis of lease liabilities and the total cash outflow for leases.

Common mistakes include missing leases hidden in service contracts, ignoring renewal options the company always uses, one discount rate for very different leases, and forgotten restoration obligations.

Frequently asked questions

If you need help building a lease register or checking your first IFRS 16 calculations, Innovant’s accounting team can work through your contracts with you.

Related reading: Debit and Credit in Accounting: The Difference and Journal Entries

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