What IFRS 16 Changed and Why It Matters
IFRS 16, Leases, replaced IAS 17 and took effect for annual reporting periods beginning on or after 1 January 2019. The change was fundamental. Under IAS 17, a lessee classified each lease as either a finance lease (recognised on the balance sheet) or an operating lease (kept off the balance sheet, with only the rental expense appearing in the income statement). The classification depended on whether the lease transferred substantially all risks and rewards of ownership to the lessee.
IFRS 16 eliminated that distinction for lessees. Under the new standard, virtually all leases are recognised on the balance sheet. A lessee records a right-of-use (ROU) asset representing the right to use the underlying asset, and a corresponding lease liability representing the obligation to make future lease payments. Only two categories of lease are exempt from this on-balance sheet treatment: short-term leases with a term of 12 months or less, and leases of low-value assets below the entity’s materiality threshold.
For UAE businesses with significant property, vehicle, or equipment leases that were previously classified as operating leases and kept off the balance sheet, IFRS 16 produced a material increase in both total assets and total liabilities on transition. The economic reality of the lease arrangements did not change. What changed was the presentation of that reality in the financial statements.
How a Lease Is Identified Under IFRS 16
Before applying IFRS 16, a business must determine whether a contract contains a lease. A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Three conditions must be met simultaneously:
- There is an identified asset, meaning a specific physical asset is the subject of the contract. Where a supplier has the substantive right to substitute a different asset throughout the period of use, no identified asset exists and the contract is treated as a service arrangement rather than a lease
- The lessee has the right to obtain substantially all of the economic benefits from using the asset during the period of use
- The lessee has the right to direct the use of the asset, meaning it decides how and for what purpose the asset is deployed during the contract period
Contracts that do not meet these criteria are service contracts and remain off the balance sheet. This identification step is particularly relevant for UAE businesses with outsourced logistics, IT infrastructure, or cloud computing arrangements, where the distinction between a lease and a service contract requires careful assessment.
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The Balance Sheet Impact
At the commencement of a lease, the lessee recognises:
- A right-of-use asset measured at the initial amount of the lease liability, adjusted for any lease payments made at or before the commencement date, initial direct costs, and estimated costs to restore the asset at the end of the lease
- A lease liability measured at the present value of lease payments not yet made, discounted at the interest rate implicit in the lease or, where that rate cannot be readily determined, at the lessee’s incremental borrowing rate
The ROU asset is subsequently depreciated over the shorter of the asset’s useful life and the lease term. The lease liability is reduced by lease payments made, with each payment split between a finance charge (interest expense) and a repayment of principal.
For a UAE business leasing commercial office space at AED 500,000 per year on a 5-year lease, the approximate initial lease liability at a 5% discount rate would be around AED 2.16 million. Both a new asset and a new liability of that amount appear on the balance sheet from the lease commencement date.
The Income Statement and Cash Flow Impact
Under IAS 17 operating lease treatment, the entire annual lease payment was recognised as a single operating expense in the income statement. Under IFRS 16, the same lease generates two separate charges: depreciation of the ROU asset (an operating charge) and interest on the lease liability (a finance charge).
The total expense over the life of the lease remains broadly the same. The timing and presentation differ in three important ways:
- EBITDA increases because the lease expense previously charged below EBITDA is now replaced by depreciation (which is added back to EBITDA) and interest (which is below EBIT). A business reporting AED 2 million in annual operating lease expenses under IAS 17 will report AED 2 million higher EBITDA under IFRS 16, with depreciation and interest replacing the lease line
- Front-loading of total expense: in the early years of a lease, the interest charge is higher (because the outstanding liability is larger). Total lease-related expense in year 1 exceeds the straight-line rental charge it replaced. This reverses in later years
- Cash flow statement classification changes: lease payments previously shown as operating cash outflows are now split between the principal repayment component (financing activities) and the interest component (financing or operating activities depending on accounting policy). Operating cash flow therefore increases, while financing cash outflow increases by a corresponding amount
How IFRS 16 Affects Key Financial Ratios
| Ratio | Direction of Change Under IFRS 16 | Reason |
|---|---|---|
| EBITDA | Increases | Lease expense moves below EBITDA line |
| EBIT / Operating profit | Broadly unchanged | Depreciation replaces the operating lease expense |
| Net debt | Increases | Lease liabilities added to debt |
| Net debt / EBITDA | Effect depends on lease profile | Both numerator and denominator increase; net impact varies |
| Return on assets | Decreases initially | Asset base increases; profit broadly unchanged |
| Interest cover | Decreases | Finance charge on lease liability added to interest expense |
For UAE businesses in sectors with significant lease portfolios , retail, logistics, hospitality, aviation, and real estate occupiers , these ratio changes can be material. Banks and lenders often adjust their covenant calculations to account for IFRS 16 lease liabilities, but this needs to be confirmed and documented in each lending relationship.
The Corporate Tax Connection
Under UAE Corporate Tax (Federal Decree-Law No. 47 of 2022), taxable income is derived from accounting net profit prepared under the applicable accounting standards. IFRS 16 changes the character of the lease-related deduction from a single operating expense to depreciation plus interest. Both depreciation on ROU assets and interest on lease liabilities are generally deductible expenses for Corporate Tax purposes, but the timing and amount of the deduction in each period differ from the pre-IFRS 16 position. This needs to be tracked in the Corporate Tax computation, particularly in the early years of long leases where the interest component is highest.
Frequently Asked Questions (FAQs)
What did IFRS 16 replace?
IFRS 16 replaced IAS 17, Leases. It took effect for annual periods beginning on or after 1 January 2019. The key change was eliminating the operating lease / finance lease distinction for lessees, requiring almost all leases to be recognised on the balance sheet as a right-of-use asset and lease liability.
Which leases are exempt from IFRS 16 on-balance sheet treatment?
2 categories are exempt: short-term leases with a lease term of 12 months or less at commencement, and leases of low-value assets. For both exemptions, the lessee can elect to recognise the payments as an operating expense on a straight-line basis over the lease term instead of applying the full IFRS 16 model.
Why does EBITDA increase under IFRS 16?
Under IAS 17, operating lease payments were recognised as operating expenses within EBITDA. Under IFRS 16, those payments are replaced by depreciation of the ROU asset (which is added back to reach EBITDA) and interest on the lease liability (which sits below EBIT). The lease expense effectively moves below the EBITDA line, increasing the reported EBITDA figure without any change in the underlying economics of the business.
Does IFRS 16 affect the equity value of a business?
Not fundamentally. IFRS 16 changes the presentation of lease obligations and assets in the financial statements, but does not change the underlying cash flows generated by the business. Enterprise value and equity value calculations need to be adjusted to account for the new presentation, but the economic value of the business remains the same.
How does IFRS 16 interact with UAE Corporate Tax?
Under Federal Decree-Law No. 47 of 2022, taxable income is based on accounting net profit under IFRS. IFRS 16 changes the deduction from a single operating lease expense to depreciation plus interest. Both are generally deductible, but the timing differs across the lease term. The Corporate Tax computation should track this difference, particularly in the early years of long leases.
Need Expert Advice?
Contact the team at Farahat & Co. for professional support and expert insights for businesses operating in the UAE.
How Farahat & Co. Can Help
Farahat & Co. assists UAE businesses with IFRS 16 implementation, ROU asset and lease liability calculations, lease identification assessments, and the preparation of IFRS-compliant financial statements that correctly reflect current lease portfolios under the standard.
Contact Farahat & Co. today to discuss your IFRS 16 accounting and financial statement requirements.
