Imagine two retail companies operating identical businesses in Bangladesh. Both rent large showroom spaces in Dhaka and Chattogram and pay annual rent of BDT 20 million. Before IFRS 16, these lease commitments could largely remain off the balance sheet if classified as operating leases. Investors often saw only the annual rental expense in the income statement and had limited visibility of the long-term obligations hidden in the notes to the financial statements.
The introduction of IFRS 16 Leases changed this situation dramatically. Effective from 2019, IFRS 16 requires most leases to be recognized on the balance sheet. Lessees must record a Right-of-Use (ROU) Asset and a Lease Liability. As a result, many companies suddenly appeared more leveraged, even though their economic obligations had not changed. This is why IFRS 16 is often described as bringing “hidden debt” onto the balance sheet.
The Core Principle of IFRS 16
The fundamental principle is simple: if a company controls the use of an identified asset for a period of time in exchange for consideration, a lease exists. The lessee generally recognizes:
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- A Right-of-Use Asset
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- A Lease Liability
The lease liability is measured at the present value of future lease payments, while the ROU asset is initially measured at approximately the same amount, adjusted for any initial direct costs or prepaid lease payments.
A Practical Example
Assume a company leases office premises for five years.
Annual lease payment: BDT 10,00,000
Discount rate: 8%
Lease term: 5 years
The present value factor of a five-year annuity at 8% is approximately 3.993.
Therefore:
Lease Liability = BDT 10,00,000 × 3.993
= BDT 39,93,000
At commencement, the company records:
Right-of-Use Asset = BDT 39,93,000
Lease Liability = BDT 39,93,000
Instead of recognizing annual rent expense of BDT 10,00,000, the company will subsequently recognize:
Annual depreciation of ROU Asset
= BDT 39,93,000 ÷ 5
= BDT 7,98,600
Interest expense in Year 1
= BDT 39,93,000 × 8%
= BDT 3,19,440
Total expense in Year 1
= BDT 7,98,600 + BDT 3,19,440
= BDT 11,18,040
Notice that the total expense in the early years is higher than the annual lease payment because interest is front-loaded.
Impact on Financial Ratios
One of the most examined areas for ICAEW and ICAB students is ratio analysis. IFRS 16 can significantly alter key performance indicators.
1. Gearing Ratio Increases
Before IFRS 16, lease obligations were often excluded from borrowings. Under IFRS 16, the lease liability becomes part of total debt.
Suppose:
Existing Debt = BDT 50 million
Equity = BDT 100 million
Gearing before IFRS 16
= 50 ÷ 100
= 50%
Adding lease liability of BDT 39.93 million:
New Debt = 89.93 million
New Gearing
= 89.93 ÷ 100
= 89.93%
The company suddenly appears much more leveraged.
2. EBITDA Improves
Under previous accounting rules, lease rentals were treated as operating expenses. Under IFRS 16, rent expense is replaced by depreciation and finance costs.
Since EBITDA excludes depreciation and finance costs, EBITDA rises.
This improvement can make operating performance appear stronger even though cash flows remain unchanged.
3. Return on Assets May Fall
The recognition of the ROU asset increases total assets. As a result, Return on Assets (ROA) often declines because the asset base becomes larger.
Why Financial Managers Must Understand IFRS 16
For financial managers, IFRS 16 is much more than an accounting standard. It affects borrowing capacity, loan covenant compliance, business valuation, performance measurement, and investment decisions. Banks and investors increasingly adjust their analyses for lease obligations when assessing credit risk.
A company planning significant expansion through leased properties may experience a substantial increase in reported liabilities, which can influence financing negotiations and shareholder perceptions. (IFRS 16)
Common Examination Focus Areas
ICAB and ICAEW examiners frequently test:
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- Identification of a lease
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- Initial measurement of lease liability
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- Present value calculations
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- Subsequent accounting entries
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- Impact on financial statements
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- Ratio analysis before and after IFRS 16
Students should therefore be comfortable not only with journal entries but also with explaining how lease capitalization affects business performance and financial risk.
Final Thoughts
The most significant contribution of IFRS 16 is transparency. The standard ensures that companies can no longer hide substantial lease commitments outside the statement of financial position. While the accounting treatment has changed, the underlying economics remain the same. For investors, lenders, and financial managers, IFRS 16 provides a clearer picture of a company’s true financial obligations.
For finance students, mastering IFRS 16 is essential because it sits at the intersection of financial reporting, valuation, ratio analysis, and corporate finance. Understanding how lease liabilities reshape a company’s balance sheet is no longer just an accounting exercise—it is a vital financial management skill.
