If you lease your office, warehouse, photocopier or company van, you have probably noticed your balance sheet looks different to how it used to. Assets and liabilities have grown, even though nothing changed in how you actually run the business. This confuses a lot of SME owners and even some finance teams — and it can spook lenders, investors and directors who are not expecting it. The change comes from an accounting standard called IFRS 16, and understanding it properly means you can explain your numbers with confidence instead of scrambling to justify why your gearing ratio suddenly looks worse.
The problem: leases used to be almost invisible
Before IFRS 16, most leases were treated as ‘operating leases’. That meant the rent you paid simply appeared as an expense in your profit and loss account, spread evenly over the lease term. The lease itself never appeared on the balance sheet. You could commit to five years of office rent worth hundreds of thousands of pounds, and an outsider reading your balance sheet would have no idea that obligation existed. Only a footnote buried deep in the accounts hinted at it.
That created a real problem for anyone trying to compare businesses fairly. A company that owned its building outright looked far more indebted, with a mortgage on its balance sheet, than a company that leased an identical building and kept the commitment off balance sheet entirely — even though both businesses had taken on similarly large long-term financial obligations. IFRS 16 was introduced to close that gap and give a truer picture of what a business actually owes.
What IFRS 16 actually changes
In plain English, IFRS 16 says: if you have the right to use an asset — a building, a vehicle, equipment — for a period of time in exchange for payments, you should recognise that right as an asset on your balance sheet, and the obligation to make those payments as a liability. This applies almost regardless of what you call the arrangement in your paperwork. A five-year office lease, a three-year van contract, or a photocopier agreement can all fall within scope, subject to some practical exemptions for short-term leases (twelve months or less) and low-value assets.
Two new items therefore appear on the balance sheet: a ‘right-of-use asset’, representing your right to use the leased item, and a ‘lease liability’, representing the present value of the payments you have committed to make. Instead of a simple rent expense in the profit and loss account, you now see two separate costs: depreciation of the right-of-use asset, and interest on the lease liability. Over the life of the lease the total cost is the same as before — but it is front-loaded, because interest is higher in the early years when the liability is largest.
Rule of thumb: if you are paying for the right to use a specific, identified asset over time — rather than buying a one-off service — IFRS 16 probably wants it on your balance sheet.
Worked example: a five-year office lease
Suppose your company signs a five-year lease for office space, paying £40,000 per year in arrears. Your borrowing rate — the rate used to discount future payments back to today’s value — is 6 percent. Under the old rules, you would simply post £40,000 a year as rent expense. Under IFRS 16, you first need to work out the present value of those five payments, because that present value becomes both your right-of-use asset and your lease liability on day one.
| Annual lease payment (in arrears) | £40,000 |
| Lease term | 5 years |
| Discount rate (incremental borrowing rate) | 6% |
| Annuity factor for 5 years at 6% | 4.2124 |
| Present value of lease liability (£40,000 × 4.2124, rounded) | £168,500 |
That £168,500 is the figure that goes onto the balance sheet at the start of the lease, both as the right-of-use asset and as the lease liability (assuming no initial direct costs, incentives or restoration obligations, which would adjust the asset side slightly). From here, two things happen every year: the asset is depreciated on a straight-line basis, and the liability accrues interest and is reduced by the cash payments actually made.
| Account | Dr | Cr |
|---|---|---|
| Right-of-use asset — office lease | £168,500 | |
| Lease liability | £168,500 |
Initial recognition of the lease at the commencement date, based on the present value of future payments.
| Account | Dr | Cr |
|---|---|---|
| Interest expense (finance cost) | £10,110 | |
| Lease liability | £10,110 |
Year 1: interest accrues on the opening lease liability at 6% (£168,500 × 6%).
| Account | Dr | Cr |
|---|---|---|
| Lease liability | £40,000 | |
| Bank | £40,000 |
Year 1: cash payment of £40,000 made to the landlord, reducing the lease liability.
| Account | Dr | Cr |
|---|---|---|
| Depreciation expense | £33,700 | |
| Accumulated depreciation — right-of-use asset | £33,700 |
Year 1: straight-line depreciation of the right-of-use asset over the 5-year lease term (£168,500 ÷ 5).
Notice what has happened to the profit and loss account. Instead of one clean £40,000 rent line, you now have £10,110 of interest and £33,700 of depreciation, totalling £43,810 in year one — more than the actual cash paid. That is normal under IFRS 16: costs are front-loaded because interest is highest when the liability is largest. In the final year of the lease, the reverse happens — the interest charge is small and the total charge drops below £40,000. Over the full five years, the total expense recognised is exactly the same as the total cash paid; only the timing and the presentation change.
| Year | Opening lease liability | Interest (6%) | Cash payment | Closing lease liability |
|---|---|---|---|---|
| 1 | £168,500 | £10,110 | £40,000 | £138,610 |
| 2 | £138,610 | £8,317 | £40,000 | £106,927 |
| 3 | £106,927 | £6,416 | £40,000 | £73,343 |
| 4 | £73,343 | £4,401 | £40,000 | £37,744 |
| 5 | £37,744 | £2,265 | £40,000 | £9 (rounding) |
That table is worth sitting with for a moment, because it shows exactly why your balance sheet looks ‘worse’ under IFRS 16 even though nothing about your actual rent has changed. In year one, you are carrying a £138,610 liability that simply did not exist on the balance sheet before. Lenders assessing gearing, current ratio, or covenant headroom will see this — so it is worth flagging to them proactively rather than letting them discover it unannounced.
IFRS 16 can quietly breach loan covenants that were written around old-style ratios. If your loan agreement sets a maximum debt-to-EBITDA or gearing limit based on pre-IFRS 16 figures, adding lease liabilities to the balance sheet could push you over the line — even though your cash position has not changed at all. Talk to your lender before this becomes a surprise at your next covenant test.
What this means for management reporting and decision-making
For internal management accounts, many SMEs still find it useful to show the ‘old-style’ rent expense alongside the IFRS 16 figures, because it makes cost-per-department or cost-per-site comparisons easier to understand for non-finance managers. There is nothing wrong with running a management report that shows rent as a simple monthly cost for budgeting purposes, provided your statutory accounts follow IFRS 16 (or the equivalent under Section 20 of FRS 102, which introduces similar — though not identical — requirements under UK GAAP). The key is knowing which set of numbers you are looking at and why they differ.
It is also worth remembering that EBITDA generally improves under IFRS 16, because rent — previously a single operating expense — is replaced by depreciation and interest, both of which sit below the EBITDA line. If you use EBITDA multiples for valuation or bank covenants, this is a meaningful shift, and it is one reason IFRS 16 attracted so much attention when it was introduced: it changes reported profitability metrics without changing the underlying cash flows of the business at all.
- Check every lease you hold — office space, vehicles, equipment, storage — against the twelve-month and low-value exemptions before assuming IFRS 16 applies; not everything needs to go on the balance sheet.
- Recalculate your right-of-use asset and lease liability using your revised discount rate whenever a lease is renewed, extended or modified, since these events trigger a remeasurement rather than a fresh calculation from scratch.
- Tell your bank and any covenant holders in advance that gearing and EBITDA will move under IFRS 16, so a routine accounting change does not get mistaken for a sign of financial trouble.
- Keep a simple internal schedule (like the table above) for each material lease, showing opening liability, interest, payment and closing liability year by year — it saves hours at year-end and makes audit queries far easier to answer.
Not sure how IFRS 16 affects your leases and covenants?
We help SME owners and finance teams translate accounting standards like IFRS 16 into plain, practical numbers — so you understand exactly what is on your balance sheet and why, before your bank or investors ask.
