IFRS 16 Leases – Lease liability

The lease liability will be the present value of the lease payments not paid on the date the contract starts over the lease term. This will be calculated using the interest rate implicit in the lease or, if that is not known, the lessee’s incremental borrowing rate.

Lease payments

The lease payments included in the present value calculation are:

  • any fixed payments less any lease incentives receivable. This includes any payments which are ‘in-substance’ fixed payments – those payments which may be variable, but which are, in reality, unavoidable. One example is a payment which will only made if a particular event occurs when there is no possibility of that event not occurring – this is in-substance a fixed payment,
  • those variable lease payments that depend on an index or a rate – for example the consumer price index or a benchmark interest payment such as LIBOR,
  • 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. Whether the option is reasonably certain should be assessed considering all relevant facts and circumstances which might create an economic incentive for the lessee to exercise, or not to exercise, the option such as the contractual terms, improvements made to the asset and the importance of the asset to the entity’s business,
  • payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

Remaining variable lease payments which are not included in this calculation are expended as incurred.

Lease term

The standard defines the lease term as the:

non-cancellable period for which the lessee has the right to use the underlying asset

and

periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option

and

periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

An entity first performs the assessment of whether it is reasonably certain that an entity will exercise an option at the date when the lessor makes the underlying asset available for use to the lessee (the commencement date of the lease). The assessment of whether an option is reasonably certain to be exercised must be made considering

all of the facts and circumstances  that create an economic incentive to make that decision. These will include contract terms and conditions compared with market rates for the optional periods, any significant leasehold improvements undertaken, any costs associated with termination, the importance of the asset to the entity’s operations and any conditions associated with the option and the likelihood of those conditions existing. As well as the specific terms and conditions of the lease under consideration, the entity’s past practice should be taken into account.

Incremental borrowing rate

The incremental borrowing rate is the amount that the lessee would have had to pay to borrow over a similar term an asset of similar value in a similar economic environment. This rate will therefore be specific to the lease being considered – it is made on a lease by lease basis. As discussed above, experience shows that it is unusual that the rate implicit in the lease is known so this is another area where judgment will need to be applied to all lease arrangements.

Reassessment of the lease liability

It might be necessary to re-assess the lease liability after the commencement date if there is a change to the estimate of the lease payments. Re-assessment will also be required where there a change to the lease term or a change in the assessment in relation to the exercise of options.

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