When an entity (the lessee/ the borrower) enters into a lease, IFRS 16 requires them to bring almost all leases onto their balance sheet. This is a shift from older accounting rules where many leases were just treated as simple monthly expenses.
To account for a lease, the lessee must recognise two things at the commencement date:
a Right-of-Use (ROU) asset and
a lease liability.
Here is the step-by-step breakdown of exactly how this is handled, measured, and reported.
Step 1: Initial Measurement (Day 1)
1. The Lease Liability
At the very beginning, the lessee measures the lease liability at the present value of all the lease payments that have not yet been paid. Because a dollar today is worth more than a dollar tomorrow, you must discount these future payments using the interest rate implicit in the lease, or, if that is hard to determine, your company’s incremental borrowing rate.
The lease payments you must include in this calculation are:
- Fixed payments (minus any lease incentives you receive).
- Variable payments that depend on an index or a rate (like payments tied to inflation).
- Amounts you expect to pay under a residual value guarantee.
- The exercise price of a purchase option, but only if you are reasonably certain you will buy the asset at the end.
- Termination penalties, if your lease term assumes you will cancel early.
2. The Right-of-Use (ROU) Asset
The ROU asset represents your right to use the leased item. It is initially measured at cost. This cost is simply a formula:
- The initial amount of your lease liability (calculated above).
- Plus any lease payments you made at or before the commencement date (minus any incentives received).
- Plus any initial direct costs you incurred to get the lease (like broker fees).
- Plus an estimate of the costs you will eventually incur to dismantle, remove, or restore the asset at the end of the lease.
Example: Imagine you lease a heavy piece of machinery for 3 years. You agree to pay $10,000 at the end of each year. Your borrowing rate is 5%.
- The present value of those three $10,000 payments is roughly $27,232. This is your initial lease liability.
- You also paid $1,000 upfront to have the machine transported to your factory.
- Your ROU asset is recorded at $28,232 (the $27,232 liability + the $1,000 transportation cost).
Step 2: Subsequent Measurement (Day 2 Onward)
Once the lease is running, you must account for how both the liability and the asset change over time.
1. The Lease Liability (Amortisation)
You treat the lease liability like a standard bank loan. Over time, you increase the carrying amount to reflect interest accumulating on the liability, and you decrease it to reflect the lease payments you are making. The interest is calculated at a constant periodic rate.
2. The Right-of-Use Asset (Depreciation)
You generally apply the cost model to the ROU asset, which means you depreciate it over time. You will depreciate the asset from the commencement date to the earlier of the end of the asset’s useful life or the end of the lease term. (Note: If the lease transfers ownership of the asset to you at the end, you depreciate it over its entire useful life).
Exceptions to the cost model: If the leased asset is treated as an investment property, you can apply the fair value model. Alternatively, if it belongs to a class of property, plant, and equipment where you use the revaluation model, you can revalue the ROU asset as well.
Step 3: Financial Statement Presentation
Because of this accounting method, your financial statements will look distinct:
- Income Statement: You will not see a single ‘rent expense’ line. Instead, the cost is split into two parts: interest expense on the lease liability and depreciation charge for the ROU asset.
- Balance Sheet: You must present right-of-use assets separately from other assets (or disclose which line items include them), and lease liabilities separately from other liabilities.
- Cash Flow Statement: The cash payments you make are split. The portion that pays down the principal of the lease liability is classified as a financing activity, while the interest portion follows your standard policy for interest paid.
The Exceptions: The Easy Way Out
The standard offers two highly convenient practical expedients where you do not have to calculate ROU assets and lease liabilities. You can simply record the lease payments as a regular straight-line expense over the lease term.
These exceptions apply to:
- Short-term leases: Any lease with a total term of 12 months or less.
- Low-value assets: Leases where the underlying asset is of low value when it is new (e.g., tablets, personal computers, telephones, and small office furniture).
