Top Issues Audit Firms in Dubai Experience When Implementing IFRS 16 Leases

IFRS 16 has been effective for some time now, yet companies, including audit firms in Dubai, continue to run into recurring questions about its implementation. This guide walks through some of the common issues company audit teams face when applying IFRS 16 to leases.

Identifying Leases

IFRS 16 defines a lease as a contract, or part of a contract, that conveys the right to use an identified asset for a period of time in exchange for consideration, giving the lessee the right to obtain substantially all the economic benefits from using that asset.

Where this gets less straightforward is with non-standard arrangements, contracts where the supplier can substitute the asset for another one, or leases where the rent payable depends partly on turnover, both of which can complicate whether the arrangement genuinely meets the definition.

Some assets identified in an agreement, because they’re uniquely suited to the business’s needs, will fall within the scope of IFRS 16, while other arrangements won’t. Financial audit experts need to confirm that only agreements genuinely giving the business the right to control the use of a specific asset get accounted for under IFRS 16.

Determining the Discount Rate

The starting point for measuring lease liability is discounting the fixed and in-substance fixed payments due over the lease term to their present value. Quantifying the correct discount rate is one of the recurring challenges for Dubai audit services, internal auditors, and external auditors alike.

IFRS 16’s first-choice rate is the “interest rate implicit in the lease.” This is the rate that, when used to discount the lease payments and the unguaranteed residual value, produces a present value equal to the sum of the underlying asset’s fair value and the lessor’s initial direct costs.

In practice, this rate is rarely usable, because determining it requires data lessees typically don’t have access to, the lessor’s projected residual value or initial direct costs are often treated as commercially sensitive and simply aren’t shared.

As a result, financial audit teams discount most leases using the Incremental Borrowing Rate (IBR) instead, the rate a lessee would need to pay to borrow, over a similar term and with similar security, the funds required to obtain an asset of similar value to the right-of-use asset.

Interest Rate Implicit in the Lease vs. Incremental Borrowing Rate

Aspect	Interest Rate Implicit in the Lease	Incremental Borrowing Rate
Preference under IFRS 16	First choice, if readily determinable	Used when the implicit rate can’t be readily determined
Data required	Lessor’s fair value, initial direct costs, and residual value assumptions	Lessee’s own borrowing terms for a similar asset
Practical availability	Rarely available to the lessee	Generally available, since it’s based on the lessee’s own credit standing

Worked Example: Choosing a Discount Rate

A Dubai retail company leases warehouse space for five years. The lessor doesn’t disclose its expected residual value or initial direct costs for the property, which rules out calculating the interest rate implicit in the lease. The company’s finance team instead determines its incremental borrowing rate by referencing the interest rate it would pay on a five-year secured loan of similar value, adjusted for the specific economic environment the lease is in, and uses that rate to discount the lease payments and measure the initial lease liability.

Also check: Statutory Audit Services in Dubai

Non-Lease Components

A lease agreement may require the lessee to purchase other goods or services from the lessor, such as maintenance, utilities, or insurance. Whether these additional items are separated from the lease itself depends on whether they represent a distinct good or service that benefits the lessee independently of the right-of-use asset.

Restoration and Make-Good Provisions

Most lease agreements include provisions addressing restoration of the leased asset. In commercial leases, this often takes the form of a “make-good” clause requiring the lessee to remove its fittings and return the premises to their original condition at the end of the lease. The obligation itself is recognized as a provision under IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

IFRS 16 doesn’t introduce a new recognition requirement for these make-good obligations, that recognition already sits with IAS 37. What IFRS 16 does change is how the resulting cost is treated on initial recognition: the estimated cost of restoring the underlying asset is added to the initial measurement of the right-of-use asset, rather than being accounted for separately.

A provision may also need to be recognized where a lease doesn’t explicitly contain a make-good clause, but IFRS 16 implementation reveals a genuine restoration obligation exists in substance. How these costs and provisions are treated then depends on the transition method applied, and on whether a provision had already been recognized under the previous leasing standard.

Read more: The Impact of IFRS 16 on Financial Statements

Fit-Out Cost Reimbursements: Lease Incentives

Lessors frequently offer incentives as part of a lease agreement. Lease incentives are payments made, or reimbursements provided, by the lessor to the lessee to facilitate the lease. IFRS 16 doesn’t explicitly address one common scenario: where the lessor reimburses the lessee for fit-out costs.

The key question is who ultimately benefits from the resulting asset, the lessor or the lessee:

• Where the fit-out asset remains the lessee’s property and provides no benefit to the lessor, the reimbursement is treated the same as any other cash lease incentive, generally reducing the initial measurement of the right-of-use asset.
• Where the fit-out results in an asset that will ultimately belong to the lessor, this falls outside the scope of IFRS 16 entirely, the lessee isn’t constructing an asset it will own, it’s making upfront payments on the lessor’s behalf that the lessor then reimburses.

Identifying which scenario applies, and applying IFRS 16 correctly as a result, requires a careful read of the specific lease terms rather than a default assumption either way.

Related: External Audit Services in Dubai

Common Mistakes in IFRS 16 Implementation

• Defaulting to IBR without checking if IRIL is determinable. IRIL is the required first choice; IBR is the fallback, not an automatic default.
• Missing implicit restoration obligations. A lease without an explicit make-good clause can still carry a restoration obligation in substance, which still needs to be assessed.
• Treating all lessor reimbursements as lease incentives. Whether the resulting fit-out asset belongs to the lessor or lessee changes the accounting treatment entirely.
• Bundling non-lease components without assessing them. Service elements like maintenance need to be assessed for separation, not lumped into the lease liability by default.

Also check: Financial Statement Audit Services in Dubai

Frequently Asked Questions

What discount rate should be used first under IFRS 16?

The interest rate implicit in the lease, where it can be readily determined. Where it can’t, typically because the lessor’s residual value or cost data isn’t available, the incremental borrowing rate is used instead.

Are make-good provisions a new requirement under IFRS 16?

No. The obligation itself is recognized under IAS 37, as it was before. What changes under IFRS 16 is that the estimated restoration cost is added to the initial measurement of the right-of-use asset.

How are fit-out cost reimbursements from a lessor treated?

It depends on who owns the resulting asset. If it remains the lessee’s, it’s treated as a lease incentive reducing the right-of-use asset. If it becomes the lessor’s, it falls outside the scope of IFRS 16.

Do all goods and services in a lease agreement need to be separated from the lease itself?

Only where they represent a distinct good or service that benefits the lessee independently, this needs to be assessed on the specific facts, not assumed either way.

What happens if a lease doesn’t have an explicit make-good clause?

A restoration provision may still be required if IFRS 16 implementation reveals the obligation exists in substance, even without an explicit clause in the lease.

Getting IFRS 16 Right in Practice

Most IFRS 16 implementation issues come down to the same root cause: not reading the specific lease terms closely enough before defaulting to a standard treatment. Discount rate selection, restoration obligations, and fit-out reimbursements all hinge on facts that are easy to miss on a quick read.

Audit Firms in Dubai can review your lease population against IFRS 16’s requirements and confirm discount rates, restoration provisions, and incentive treatments have been applied correctly before your next audit.