Everything you need to know about leases, from the basics to IFRS 16 balance sheet treatment – explained simply.
Why Understanding Leases Actually Matters
You’ve probably signed a lease at some point, maybe for an apartment, a car, or office equipment. But if you’re running a business or studying accounting, leases go far beyond a monthly payment and a signature. They shape how a company’s finances look on paper, how much debt investors think you’re carrying, and what obligations you’re committing to for years ahead.
Under modern accounting standards like IFRS 16, businesses are now required to bring most leases onto their balance sheets, a rule that has dramatically changed how companies report their financial position. Understanding leases isn’t just an accounting technicality; it’s essential for anyone making financial decisions.
In this guide, we’ll walk through exactly what a lease is, how to identify one, who the parties are, how long a lease lasts, and how they’re treated in the books – with clear, real-world examples along the way.
What Is a Lease?
At its core, a lease is a contract, or a specific part of a contract, that gives one party the right to use an asset (known as the underlying asset) for a specific period of time in exchange for payment, which is called consideration.
Think of it this way: you’re not buying the thing. You’re buying the right to use it.
The Two Main Parties in a Lease
Every lease involves two key players:
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- The Lessee: The person or company that obtains the right to use the asset.
- The Lessor: The person or company that owns the asset and provides the right to use it.
Imagine your business needs a delivery truck. Instead of buying one, you sign a 3-year agreement with a local dealership to use one of their trucks for $500 a month. In this scenario, you are the lessee, the dealership is the lessor, the truck is the underlying asset, and the $500 monthly payment is the consideration.
How Do You Know If a Contract Is Truly a Lease?
Here’s where things get interesting — and where businesses often get it wrong. Not everything that looks like a lease actually is one. Sometimes, what appears to be a lease is really just a service contract. Getting this distinction right has real accounting consequences.
For a contract to officially contain a lease, the lessee must have the right to control the use of an identified asset throughout the period of use. Control is established when the lessee has both of the following rights:
1. The Right to Obtain Substantially All Economic Benefits
This means you get to reap the rewards from using the asset. In our truck example, your business gets to keep all the revenue generated from deliveries made using that truck and the dealership has no claim on the proceeds.
2. The Right to Direct the Use
You get to make the relevant decisions about how and for what purpose the asset is used. In practice, this means you decide the delivery routes, what goods are transported, and when the truck operates.
If the dealership dictated exactly when and where you could drive, the arrangement would likely be classified as a transportation service, not a lease. The distinction sounds subtle, but it completely changes the accounting treatment.
What Is an Identified Asset?
The asset in the contract must be explicitly or implicitly specified. But here’s a critical nuance: if the supplier has a substantive substitution right, it is not considered a lease.
What does that mean? If your contract simply specifies “a truck” and the dealership can freely swap your truck for a different one whenever it’s cheaper or more convenient for them, you don’t truly control a specific asset, and therefore, you don’t have a lease.
A substantive substitution right exists when the supplier can realistically and practically substitute the asset, and benefits from doing so. If they can, there’s no identified asset and no lease.
How Long Does a Lease Last? Understanding the Lease Term
The lease term isn’t always just the base number of years written on page one. Under IFRS 16, the lease term includes:
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- The non-cancellable period of the lease, plus
- Any periods covered by an option to extend, if the lessee is reasonably certain to exercise it, and
- Any periods covered by an option to terminate, if the lessee is reasonably certain not to exercise it.
Why does this matter? Because a longer lease term means a larger liability on your balance sheet. Companies can’t simply write a short lease with long renewal options and pretend the obligations don’t exist. If it’s reasonably certain they’ll renew, the whole expected period must be included.
How Are Leases Handled in Accounting? (IFRS 16 Explained)
Under IFRS 16, businesses must accurately reflect lease agreements on their financial statements so investors and lenders can see their true financial commitments. The treatment differs depending on whether you’re the lessee or the lessor.
For the Lessee (The Business Renting the Asset)
When the lease commences, you don’t simply record a monthly expense and move on. Because you’ve committed to this contract, you must recognise two things on your balance sheet from day one:
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- A Right-of-Use (ROU) Asset: This represents your right to use the asset for the duration of the lease term.
- A Lease Liability: This represents your financial obligation to make the future payments over the lease term.
This was a significant shift from the old rules. Previously, many leases were kept off balance sheet, which meant investors couldn’t easily see how much debt companies had tied up in lease commitments.
Click here to understand the in-depth accounting in the books of lessee.
The Two Exceptions: When You Don’t Need to Recognise on the Balance Sheet
There are two practical shortcuts that allow you to simply recognise lease payments as a straight-line expense instead:
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- Short-term leases: Leases with a term of 12 months or less.
- Low-value assets: Assets that are of low value when new, such as tablet computers, mobile phones, or small items of office furniture.
For the Lessor (The Owner of the Asset)
On the other side of the deal, the lessor must classify the lease into one of two categories based on the economic substance of the arrangement:
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- Finance Lease: This is essentially a sale disguised as a lease. It occurs when the lease transfers substantially all the risks and rewards of owning the asset to the lessee. For example, if you lease a truck for 10 years (its entire useful life) and have an option to buy it for $1 at the end, that’s a finance lease. The lessor has, in effect, sold the asset.
- Operating Lease: If the lessor keeps the majority of the risks and rewards of ownership, it’s an operating lease. Think of renting a car for a weekend, the rental company still owns the risk, will take the car back, and will lease it to someone else. Business as usual.
Conclusion: The Big Picture on Leases
Leases are everywhere in business. From the office you work in, to the equipment your team uses, to the fleet of vehicles that keeps operations running. But they’re not just paperwork. They’re financial commitments that shape how a company looks to the outside world.
Understanding what makes something a lease — control of an identified asset, the right to economic benefits, the right to direct use — helps you identify these arrangements correctly. And understanding how they’re accounted for under IFRS 16 ensures your financial statements tell the true story of your obligations.
Whether you’re a business owner evaluating whether to lease or buy, an accountant working through the classification, or a student studying financial reporting, getting leases right is foundational knowledge. The rules exist not to make life complicated but to make financial statements honest.
The next time you sign a lease or advise someone who is, you’ll know exactly what you’re really committing to.
