At the commencement date, a lessee (a customer) recognises a right-of-use asset and a lease liability (IFRS 16.22). Right-of-use is an asset representing lessee’s right to use the leased asset during the lease term.
Initial measurement of the right-of-use asset
Components of the right-of-use asset
The right-of-use (‘RoU’) asset is measured at cost at the commencement date. The cost of RoU comprises (IFRS 16.24):
- the amount equal to the lease liability at its initial recognition,
- lease payments made at or before the commencement of the lease (less any lease incentives received),
- any initial direct costs incurred by the lessee; and
- an estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories (recognised under IAS 37).
Let’s work through a calculation example on initial measurement of a lease based on the following assumptions:
Commencement date: 20X1-01-01
Discount rate: 5%
Initial direct costs: $20,000
Lease incentives: $5,000
Upfront lease payment for year 20X1: $50,000
I highly recommend to see all the calculations presented in this example in an excel file available for download. You can scroll tables presented below horizontally if they don’t fit your screen.
Future payments for the lease are listed in the table below. For each payment, the discount factor is calculated in order to determine the total present value of the lease liability. Initial measurement of a lease liability amounts to $355,391 and is calculated as follows:
|payment||date of |
The right-of-use (‘RoU’) asset at initial recognition amounts to $420,391:
|355,391||Initial measurement of the lease liability|
|20,000||Initial direct costs|
|50,000||Upfront lease payment for year 20X1|
|420,391||Total: right-of-use asset|
The schedules for accounting in subsequent years for the lease liability and RoU are presented below.
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Lease liability increases every year due to unwinding of discount (charged as finance costs in P&L) and decreases with each payment made:
The carrying amount of the right-of-use asset decreases with depreciation charged each year:
|year||NBV opening |
As we can see, total lease payments amount to $515,000 (this includes initial direct costs, lease incentives and upfront lease payment for year 20X1). Total expense recognised during the lease term amounts to $515,000 as well and is split between depreciation expense ($420,391) and discounting expense ($94,609).
I’ve prepared also a variation of this example that shows how to measure a lease with quarterly payments – see this excel file.
It sometimes happens that a lease starts with a rent-free period. The way that the requirements of IFRS 16 are set out results in depreciation and interest charges being spread throughout the lease period (including rent-free periods) without any manual adjustments to general recognition model. Below is an example for a 2-year lease that starts on 20X1-01-01 with a rent of $30,000 paid quarterly up-front, but where the first two quarters are rent-free. The discount rate in this example is 4%. See the previous example for more detailed explanations on how to account for a lease.
As usual, we start with laying out all lease payments:
|quarter||payment||date of |
In this example, let’s assume that there are no initial direct costs or lease incentives received, therefore the right-of-use asset at initial recognition equals the initial measurement of the lease liability and amounts to $172,272.
The subsequent accounting is the same as for a lease without rent-free periods. The right-of-use asset is depreciated every year and the interest expense is accrued on lease liability. The only difference (when compared to a lease without any rent-free periods) relates to repayments of lease liability, because there are none during the first two quarters. Therefore, the carrying amount of a lease liability increases during these rent-free periods due to accrued interest (discount).
This is how the subsequent accounting for a lease liability looks like:
The carrying amount of the right-of-use asset decreases with depreciation charged each year as usual:
|quarter||NBV opening||depreciation||NBV closing|
See this excel file for calculations.
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Initial direct costs
Initial direct costs are incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained (IFRS 16.Appendix A). The definition of initial direct costs is essentially the same as for incremental costs of obtaining a contract in IFRS 15.
Examples of initial direct costs that are included in the cost of RoU asset are:
- commissions to employees or external agents that arranged a lease, which are payable only if the lease contract is signed,
- legal costs incurred when signing the contract (e.g. stamp duties).
Examples of initial direct costs that can’t be included in the cost of RoU asset are:
- allocation of overheads,
- advisory fees that are incremental, but would have been incurred irrespective of whether a lease contract is eventually concluded or not.
There is also another type of initial direct costs which IFRS 16 is silent about. These are costs directly attributable to bringing a right-of-use asset to the location and condition necessary for it to be capable of operating in the manner intended by management. In other words, we’re talking about ‘asset costs’, not ‘contract costs’. As you can tell, I’m making a direct link to IAS 16 here, which explicitly allows including such costs in the cost of PP&E. This approach can also be adopted for right-of-use assets and paragraph IFRS 16.BC149 implicitly supports this view.
Lease payments made at or before the commencement date
Lease payments made at or before the commencement date are obviously not included in the lease liability, but they are included in the measurement of the right-of-use assets.
Security deposits paid
Some lessors require a payment of security deposits (collaterals) that will be refunded when the leased asset is returned by the lessee. Such deposits are treated as a separate financial asset at amortised cost under IFRS 9. Those deposits are usually interest-free, therefore their fair value at initial recognition is lower than cash paid at the commencement of the lease. This difference should be treated as initial direct cost and added to the RoU asset (see a similar example with security deposit paid by a contractor).
Lease incentives are payments made by a lessor (supplier) to a lessee (customer) associated with a lease, or the reimbursement by a lessor of costs of a lessee (IFRS 16. Appendix A). Lease incentives are accounted for as a reduction of the right-of-use asset.
Reimbursement of leasehold improvements
In 2020, IASB decided to amend Illustrative Example 13 to IFRS 16 which said that the reimbursements of leasehold improvements are not lease incentives as they relate to an asset recognised under IAS 16. IASB stated that it cannot be automatically assumed that all reimbursements of leasehold improvements are not lease incentives.
If such payments economically represent reimbursement for improvements made to the lessor’s asset, then yes – they are not lease incentives. Factors indicating that leasehold improvements are made to the lessor’s asset include:
- leasehold improvements would be necessary to use the leased asset by most entities (e.g. installing walls in a building),
- assets constructed in the leasehold improvement process do not result from specialised needs of the lessee,
- economic useful life of leasehold improvements exceeds enforceable lease term.
On the other hand, if the leasehold improvements are in fact an asset of the lessee, then any reimbursement made by the lessor should be treated as a lease incentive and accounted for as a reduction of the right-of-use asset recognised under IFRS 16.
Initial measurement of the lease liability
Components of the lease liability
The lease liability should be initially recognised and measured at the present value of the lease payments (IFRS 16.26). Lease payments comprise (IFRS 16.27):
- fixed payments, less any lease incentives receivable,
- variable lease payments that depend on an index or a rate,
- amounts expected to be payable by the lessee under residual value guarantees,
- the exercise price of a purchase option if the lessee is reasonably certain to exercise that option; and
- payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.
You can find the example on initial measurement of the right-of-use asset and lease liability a few sections earlier. See also Example 13 accompanying IFRS 16.
Fixed payments are payments made by a lessee to a lessor for the right to use an underlying asset during the lease term, excluding variable lease payments (IFRS 16. Appendix A).
Variable lease payments
Variable lease payments are the portion of payments made by a lessee to a lessor during the lease term that varies because of changes in facts or circumstances occurring after the commencement date, other than the passage of time (IFRS 16.appendix A). It is important to note that not all variable fixed payments are included in the measurement of lease liability and right-of-use asset. The initial (and subsequent) measurement includes only those variable payments that depend on an index or a rate. Such payments may be linked to predetermined index (e.g. CPI), benchmark rate (e.g. LIBOR) or may vary to reflect changes in market rental rates (IFRS 16.28).
For initial recognition of the lease liability, variable lease payments are measured using the actual value of an index or a rate as at the commencement date (IFRS 16.27(b)). In other words, lessee cannot use forward rates or forecasting techniques in measuring variable lease payments (IFRS 16.BC166).
Variable payments that do not depend on an index or a rate, and those that depend on future activity of a lessee or an underlying asset in particular, are not included in the measurement of lease liability and right-of-use (RoU) asset. They are recognised in P&L (or capitalised in the cost of another asset) in the period in which the event or condition that triggers those payments occurs (IFRS 16.38(b)). Typical examples of such payments recognised in P&L as they occur are:
- payments that depend on performance of the underlying asset (e.g. specified % of revenue, physical output of the leased asset),
- payments for the specified units relating to future usage (e.g. specified mileage of a leased car),
- payments that are linked to taxes or levies imposed on the leased asset (see this post).
See also paragraphs IFRS 16.BC168-BC169 for more discussion and example 14 accompanying IFRS 16.
Note that some variable lease payments may be in fact in-substance fixed lease payments.
In-substance fixed lease payments
Fixed payments include also payments that may, in form, contain variability but that, in substance, are unavoidable. Such payments are called ‘in-substance fixed lease payments’ and are discussed further in paragraph IFRS 16.B42.
Example: In-substance fixed lease payments
Retailer A enters into a 5-year lease of retail space. Fixed monthly lease payments amount to $50 only, but they increase to $1,000 if revenue generated in the point of sales located on the leased space exceeds $3,000 per month. Retailer A is required to keep the point of sales open during at least 8 hours a day. The probability that revenue won’t exceed $3,000 per month is remote.
As stated in paragraph IFRS 16.B42(a)(ii), in substance fixed payments are also payments that are initially structured as variable lease payments linked to the use of the underlying asset but for which the variability will be resolved at some point after the commencement date so that the payments become fixed for the remainder of the lease term. Those payments become in-substance fixed payments when the variability is resolved and recognised in the lease liability and right-of-use asset.
In the scenario outlined above, Retailer A recognises a lease liability consisting of monthly lease payments of $1,000 as there is no genuine variability in those lease payments.
Retailer B enters into a 4-year lease of retail space with no fixed lease payments. Instead, Retailer B pays the lessor a variable lease fee amounting to 4% of revenue generated in the point of sales located on the leased space.
In this scenario, there is genuine variability in lease payments. Therefore, there are no lease payments to be included in the measurement of lease liability. Instead, variable lease fee is charged directly to P&L every month.
VAT and other non-recoverable taxes
IFRS 16 is silent on the treatment of VAT, sales tax and similar taxes levied on lease payments (all those taxes are referred to as ‘VAT’ in this section). If VAT can be reclaimed (recovered) from tax authorities through some form of tax returns, the accounting is simple: they are recognised as a receivable from, or payable to, tax authorities when the obligation arises. It gets more complicated when such taxes cannot be recovered. As VAT is a levy imposed by the government, it is in the scope of IFRIC 21. This means that VAT payments are not made by lessee to lessor in exchange for the right to use an underlying asset, therefore they are not lease payments and should be excluded from lease liability. Instead, they should be expensed in P&L immediately when they are due. It is possible to include them in the value of the right-of-use asset as initial direct costs, but only if the VAT is payable upfront at the commencement of the lease. Read more in this staff paper and see also this topic.
Residual value guarantees
Residual value guarantee is a guarantee made to a lessor (supplier) that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount. Amounts expected (estimated) to be payable by the lessee under residual value guarantees are included in the initial measurement of a lease liability (IFRS 16.27(c)).
The exercise price of a purchase option is included in the initial measurement of a lease liability if the lessee (customer) is reasonably certain to exercise that option. When considering whether a lessee is reasonably certain to exercise that option, the same criteria as for assessing lease term should be used.
How to determine the discount rate
When measuring lease liability, lease payments are discounted using the interest rate implicit in the lease, if that rate can be readily determined. IFRS 16 does not explain what is meant by ‘readily determined’, a possible approach would be to treat a rate readily determinable if there is no need to make significant estimates or assumptions. It is rare that a rate implicit in the lease can be readily determined by a lessee (customer), because such a rate is affected by factors known only to lessors (e.g. initial direct costs of the lessor or unguaranteed residual value). Moreover, interest rate implicit in the lease is not the same as the rate stated in a lease contract. Therefore, lessees (customers) usually use their incremental borrowing rates, as allowed by paragraph IFRS 16.26.
Interest rate implicit in the lease
Interest rate implicit in the lease is a rate that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor (IFRS 16. Appendix A).
Unguaranteed residual value is that portion of the residual value of the underlying asset, the realisation of which by a lessor is not assured or is guaranteed solely by a party related to the lessor (IFRS 16. Appendix A).
As noted earlier, it is rare that an interest rate implicit in the lease can readily be determined by a lessee and an incremental borrowing rate is used by lessees.
See an example of calculation of an interest rate implicit in the lease in the lessor accounting part of IFRS 16.
Incremental borrowing rate
Lessee’s incremental borrowing rate is the rate of interest that a lessee (customer) would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment (IFRS 16.Appendix A). An observable rate is most often used as a starting point in determining incremental borrowing rate (IFRS 16.BC162). Such an observable rate can be, for example, an actual borrowing rate of an entity, or a property yield for the property leases. Entities may also use their cost of debt.
Such an observable rate must be then adjusted to reflect maturity profile of a lease and type of asset being leased.
When a subsidiary uses financing centralised by a parent, an actual borrowing rate should be adjusted to reflect differences in credit rating of these entities.
For lease payments denominated in a foreign currency, the discount rate for that foreign currency should be used.
Subsequent measurement of the right-of-use asset
The right-of-use asset is measured subsequently at cost, unless the lessee applies the fair value model in IAS 40 or revaluation model in IAS 16 (IFRS 16.29).
Elements of cost
Under the cost model, a right-of-use asset is measured initially at cost (discussed above) less any depreciation and any accumulated impairment losses (IFRS 16.30). Additionally, the cost is subsequently adjusted for any remeasurement of the lease liability resulting from reassessments or lease modifications.
The right-of-use (‘RoU’) asset is depreciated in accordance with IAS 16 requirements (IFRS 16.31). The depreciation period of RoU should not exceed the lease term, unless the lease contract transfers ownership of the underlying asset to the customer (lessee) by the end of the lease term or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option (IFRS 16.32).
Right-of-use assets are subject to impairment under IAS 36. Most often, RoU assets are a part of a CGU and therefore are not tested for impairment individually. For more details, see this great publication by EY.
Fair value and revaluation model
If a lessee applies fair value model to its investment properties, the same accounting should be applied to right-of-use assets that meet the definition of investment property in IAS 40 (IFRS 16.34).
If a lessee applies a revaluation model to PP&E under IAS 16, it may elect to apply this model to all of the RoU assets that relate to the same class of PP&E (IFRS 16.35).
Subsequent measurement of the lease liability
What impacts subsequent measurement of the lease liability
After the initial recognition, the measurement of a lease liability is affected by (IFRS 16.36):
- accruing interest on the lease liability;
- lease payments made; and
- remeasurements reflecting any reassessment or lease modifications.
Accruing interest on the lease liability
Lease liabilities are measured on an amortised cost basis using an effective interest method, similarly to other financial liabilities (IFRS 16.37). See an example.
Interest is recognised in P&L unless it can be capitalised under IAS 23.
Lease payments reduce the carrying amount of the lease liability.
Variable lease payments not included in the measurement of the lease liability are recognised in P&L in the period in which the event or condition that triggers those payments occurs (see more discussion on variable lease payments).
Remeasurements of the lease liability
When and how a lease liability is remeasured
Remeasurements of the lease liability are treated as adjustments to the right-of-use asset. If the carrying amount is reduced to zero, any further reduction is recognised immediately in P&L (IFRS 16.39).
The lease liability is remeasured when (IFRS 16.40,42):
- there is a change in the assessment of a lease term, or
- there is a change in the assessment of an option to purchase the underlying asset, or
- there is a change in the amounts expected to be payable under a residual value guarantee, or
- there is a change in future lease payments resulting from a change in an index or a rate used to determine those payments
The remeasurements made under (a) and (b) should be made using a revised discount rate, and under (c) and (d) using an unchanged discount rate. However, remeasurements made under (d) should be made using a revised discount rate if they are caused by a change in floating interest rates (IFRS 16.41,43).
See also remeasurements resulting from lease modifications.
Starting data for this example is identical as in the example on initial recognition. It will not be reproduced here, so make sure to see this example beforehand. All calculations presented below are also available for download in an excel file. Let’s now assume that the lease term is reassessed at the end of year 20X6 and extended to 31 December 20Y5 (instead of 31 December 20Y0 as originally planned). The payments for years 20Y1-20Y5 will be $55,000. The discount rate is also revised upwards from 5% to 6%.
At the reassessment date, the entity calculates the present value of lease liability as follows. You can scroll tables presented below horizontally if they don’t fit your screen.
Before the reassessment, the lease liability amounted to $186,162 (value at the end of year 20X6, see the example on initial recognition). Entity needs to recognise the increase in lease liability as follows:
As a result of the entries above, the value of right of use asset increases to $360,168 (was $168,156 at the end of year 20X6) After the reassessment, the schedules for accounting in subsequent years for the lease liability and right-of-use asset are presented below.
|year||NBV opening |
Changes in an index or a rate
Variable lease payments linked to an index or a rate are reassessed when there is a change in future lease payments. In other words, the adjustment is recognised only when the adjustment to lease payments takes effect (IFRS 16.BC188-BC190).
Foreign currency exchange
IFRS 16 does not have specific provisions on the impact of foreign currency exchange differences arising on lease liabilities. Therefore, general IAS 21 provisions apply. In particular, it means that the value of right-of-use asset cannot be adjusted by the foreign currency exchange differences arising on lease liabilities (IFRS 16.BC196-BC199).
Consolidation procedures for intragroup leases
Accounting for leases is significantly different for lessees and lessors which is a pain for those preparing consolidated financial statements for groups with intragroup leases. Unfortunately, there is no easy solution to this problem. One of the solutions is that the lessee, in consolidation journal only, accounts for a lease contract as an ‘old school’ operating lease which will facilitate automatic intra-group eliminations. Alternatively, consolidation team can just manually reverse all the balances pertaining to the intra-group leases and eliminate lease income against depreciation of right-of-use asset and finance costs. Obviously, they won’t be identical so the difference has to be tracked and accounted for in retained earnings until the lease period ends.
See also this summary by KPMG.
More about IFRS 16
See other pages relating to IFRS 16: