IFRS 16: Common Pitfalls Businesses Must Avoid

IFRS 16 Leases significantly changed the way organizations account for lease arrangements by requiring most leases to be recognized on the balance sheet. While the standard improves transparency and comparability, it has also introduced complexity, especially for organizations transitioning from previous lease accounting practices.

Many companies continue to face challenges in applying IFRS 16 correctly, even after initial adoption. Misinterpretation, incomplete data, and weak internal processes often lead to errors that impact financial statements, compliance, and decision-making. Understanding the most common pitfalls is essential for maintaining accurate financial reporting and avoiding regulatory scrutiny.

Incorrect Identification of Lease Contracts

One of the most frequent pitfalls under IFRS 16 is failing to correctly identify whether a contract contains a lease. IFRS 16 applies not only to explicit lease agreements but also to contracts that convey the right to control the use of an identified asset.

Businesses often overlook embedded leases within service or outsourcing contracts. For example, IT, logistics, or equipment service agreements may contain lease components that must be accounted for separately. Misidentifying such contracts can result in off-balance-sheet liabilities and inaccurate financial statements.

Overlooking Short-Term and Low-Value Lease Exemptions

IFRS 16 allows exemptions for short-term leases and low-value assets, but these exemptions must be applied consistently and documented properly. Some organizations mistakenly apply exemptions without clear policies or supporting analysis.

Others fail to reassess exemptions when lease terms change or renewal options are exercised. This can lead to inconsistent treatment of similar leases and compliance risks during audits. Clear accounting policies and regular reviews are essential to ensure exemptions are applied correctly.

Errors in Determining the Lease Term

Determining the correct lease term is a judgment-intensive area under IFRS 16 and a common source of error. The lease term includes non-cancellable periods and renewal options that are reasonably certain to be exercised.

Many companies underestimate the lease term by excluding extension options without sufficient justification. Conversely, some include optional periods without proper assessment. Incorrect lease terms affect both the right-of-use asset and lease liability, leading to material misstatements in financial reports.

Incorrect Discount Rate Selection

Selecting the appropriate discount rate is one of the most challenging aspects of IFRS 16. When the interest rate implicit in the lease is not readily determinable, companies must use the incremental borrowing rate.

A common pitfall is using a single discount rate across all leases without considering differences in lease term, currency, asset type, or economic environment. Using an inappropriate rate can significantly distort lease liabilities and interest expense, impacting key financial ratios.

Incomplete or Inaccurate Lease Data

IFRS 16 requires detailed and accurate lease data, including payment schedules, lease terms, renewal options, and variable lease payments. Many organizations struggle due to decentralized lease management and incomplete documentation.

Missing or inaccurate data often results in incorrect calculations, delays in reporting, and audit adjustments. Relying on spreadsheets without proper controls further increases the risk of errors, especially for organizations with large lease portfolios.

Misclassification of Lease and Non-Lease Components

Contracts often include both lease and non-lease components, such as maintenance or service charges. IFRS 16 requires these components to be separated unless a practical expedient is elected.

A common mistake is failing to separate these components or incorrectly allocating consideration between them. This can lead to overstated lease liabilities and right-of-use assets, distorting the financial position of the business.

Improper Treatment of Variable Lease Payments

Variable lease payments can be complex under IFRS 16. Payments that depend on an index or rate must be included in lease liabilities, while those based on usage or performance are expensed as incurred.

Many businesses incorrectly include all variable payments in lease liabilities or exclude index-linked payments entirely. These errors affect both balance sheet recognition and profit or loss, leading to inconsistencies in financial reporting.

Failure to Reassess Leases After Modifications

Lease modifications are another area where errors commonly occur. Changes in lease scope, term, or consideration require reassessment and remeasurement of lease liabilities and right-of-use assets.

Organizations often fail to identify lease modifications or treat them as separate contracts incorrectly. Without proper reassessment, financial statements may not reflect the economic reality of revised lease arrangements.

Inadequate System and Process Controls

Many companies initially implement IFRS 16 using manual processes or basic tools. Over time, this approach becomes unsustainable, especially as lease portfolios grow or contracts change.

Weak internal controls increase the risk of data errors, inconsistent judgments, and delayed reporting. Lack of integration between finance, procurement, and legal teams further complicates compliance and ongoing lease management.

Insufficient Disclosure and Presentation

IFRS 16 includes extensive disclosure requirements designed to provide transparency into leasing activities. Common disclosure-related pitfalls include incomplete maturity analyses, missing qualitative information, or inconsistent presentation across reporting periods.

Inadequate disclosures can raise concerns among auditors, regulators, and stakeholders, even if recognition and measurement are largely correct. Clear, consistent, and well-documented disclosures are essential for full compliance.

Impact on Financial Ratios and Covenants Overlooked

Recognizing lease liabilities and right-of-use assets affects key financial metrics such as EBITDA, leverage ratios, and return on assets. Some businesses fail to assess how IFRS 16 impacts loan covenants, performance metrics, and stakeholder perceptions.

Ignoring these effects can result in unexpected covenant breaches or misinterpretation of financial performance. Proactive communication with lenders and stakeholders is critical to managing these impacts effectively.

Lack of Ongoing Monitoring and Review

IFRS 16 is not a one-time implementation exercise. Lease data, assumptions, and judgments must be reviewed regularly to reflect changes in business operations, market conditions, and contractual terms.

Many organizations treat IFRS 16 as a static process, leading to outdated assumptions and reporting inaccuracies. Continuous monitoring ensures ongoing compliance and improves the reliability of financial information.

Conclusion

While IFRS 16 enhances transparency in lease accounting, it also introduces significant complexity. Common pitfalls such as incorrect lease identification, poor data management, improper discount rates, and weak controls can undermine compliance and financial accuracy.

By understanding these challenges and addressing them through strong policies, reliable systems, and informed professional judgment, businesses can avoid costly errors and ensure accurate financial reporting. A structured and proactive approach to IFRS 16 not only supports compliance but also strengthens financial governance and decision-making.