Case 19 / 183 Analyst
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IFRS 16: Lease Accounting

Accounting & Financial Statements

The prompt

“As an accounting analyst, walk me through how IFRS 16 changes the accounting for an operating lease — specifically, how does the lease get recognized on the balance sheet, and what happens to the company's EBITDA and leverage ratios?”

📋 What you're given

As an accounting analyst, walk me through how IFRS 16 changes the accounting for an operating lease — specifically, how does the lease get recognized on the balance sheet, and what happens to the company's EBITDA and leverage ratios?

1. Task Overview

Task: work through how IFRS 16 recognizes a lease on the balance sheet at inception, and how that recognition flows into Year 1 P&L and leverage metrics.

Step 1: Given Data — Lease Terms

A company signs a 5-year lease for retail space with the following terms.

Line ItemValue
Lease term5 years
Annual lease payment (paid in arrears)$100,000
Incremental borrowing rate (discount rate)5% (0.05)
Pre-IFRS 16 treatmentOperating lease: straight-line rent expense of $100,000/year, no balance sheet recognition
Company's EBITDA excluding this lease$2,000,000
Company's Net Debt excluding this lease$3,000,000

Step 2: Lease Liability at Inception

Under IFRS 16, almost all leases (aside from short-term and low-value exemptions) create a liability equal to the present value of the future lease payments.

Show Lease Liability Formula

Lease Liability = Payment × [1 - (1 + r)^-n] / r

Using this formula, compute the initial lease liability.

Step 3: Right-of-Use (ROU) Asset

Show ROU Asset Formula

ROU Asset = Lease Liability + Initial Direct Costs + Prepaid Lease Payments − Lease Incentives Received

Using this formula, compute the initial ROU asset (assume no initial direct costs, prepayments, or incentives).

Step 4: Year 1 Depreciation and Interest Expense

Show Depreciation and Interest Formula

Depreciation = ROU Asset / Lease Term

Interest Expense = Opening Lease Liability × Discount Rate

Using this formula, compute the Year 1 depreciation and interest expense.

Step 5: EBITDA and Leverage Impact

Show EBITDA and Leverage Formula

New EBITDA = Old EBITDA + Old Rent Expense (moved below the EBITDA line)

Net Debt / EBITDA = Net Debt / EBITDA

Assume:

  • Pre-IFRS 16 EBITDA (excluding this lease) = $2,000,000
  • Pre-IFRS 16 Net Debt (excluding this lease) = $3,000,000

Using these inputs, compute the new reported EBITDA and the Net Debt / EBITDA ratio before and after adopting IFRS 16 for this lease.

💡 Model answer

Try answering out loud first — then reveal the model answer and compare.

⚠️ Common mistakes

  • Assuming IFRS 16 is EBITDA-neutral — the cash paid doesn't change, but EBITDA is structurally higher because rent moves below the line into depreciation and interest
  • Forgetting that interest expense is calculated on the amortizing liability balance, not a flat amount each year — it's front-loaded and declines as the liability is paid down
  • Treating ROU asset depreciation and lease liability amortization as if they move in lockstep — straight-line depreciation and effective-interest liability amortization are different schedules and rarely match year to year
  • Missing the short-term (12 months or less) and low-value asset exemptions, where a lessee can still expense payments straight-line and skip balance sheet recognition entirely
  • Assuming higher EBITDA under IFRS 16 automatically means lower leverage — Net Debt typically rises by the same lease liability, so the ratio can move in either direction

🔁 Follow-up questions

← Previous Case 18: Goodwill: Creation and Impairment Next Case 20: Deferred Taxes →

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