Lessee accounting under IFRS 16
The key objective of IFRS 16 is to ensure that lessees recognise assets and liabilities for their major leases.
1. Lessee accounting model
A lessee applies a single lease accounting model under which it recognises all leases on-balance sheet, unless it elects to apply the recognition exemptions (see recognition exemptions for lessees in the link). A lessee recognises a right-of-use asset representing its right to use the underlying asset and a lease liability representing its obligation to make payments. [IFRS 16.22]
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Is IFRS 16 a pre-tax accounting model? |
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Yes. IFRS 16 continues to address lessee (and lessor) accounting on a pre-tax basis, even if tax considerations are often a major factor when a company is assessing whether to lease or buy an asset, and when a lessor is pricing a lease contract. The income tax accounting for lease contracts is in the scope of IAS 12 Income Taxes. The complexities in accounting for income taxes by lessees of on balance sheet leases include, for example, how to apply the initial recognition exemption. |
2. Initial measurement of the lease liability
A lessee initially measures the lease liability at the present value of the future lease payments. [IFRS 16.26]
The key inputs to this calculation are as follows.
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When does a lessee first measure the lease liability? |
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A lessee initially measures the lease liability at the commencement date of the lease. This is the date on which a lessor makes an underlying asset available for use by a lessee. The commencement date should be distinguished from the inception date of a lease, which is the earlier of the date of the lease agreement and the date of commitment by the parties to the principal terms and conditions of the lease. A company assesses whether a contract is, or contains, a lease at the inception date. |
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Are lease liabilities financial liabilities? |
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Yes, lease liabilities are financial liabilities measured in accordance with IFRS 16 – not IFRS 9 Financial Instruments. However, they are subject to the derecognition requirements of IFRS 9. [IFRS 9.2.1(b)] This represents a considerable simplification compared with financial instruments accounting in some cases. For example, common features of lease agreements – e.g. renewal and purchase options – are not accounted for separately, nor do they have the potential to result in the liability being measured at fair value. |
2.1 Lease payments
A lessee includes the following payments relating to the use of the underlying asset in the measurement of the lease liability: [IFRS 16.27]
- fixed payments (including in-substance 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 that the lessee is reasonably certain to exercise; and
- payments for terminating the lease if the lease term reflects early termination.
‘In-substance fixed payments’ are payments that are structured as variable lease payments, but that – in substance – are unavoidable. Examples include: [IFRS 16.B42]
- payments that have to be made only if an event occurs that has no genuine possibility of not occurring;
- there is more than one set of payments that a lessee could make, but only one of those sets of payments is realistic; and
- there are multiple sets of payments that a lessee could realistically make, but it has to make at least one set of payments.
Variable lease payments that depend on an index or rate are initially measured using the index or rate as at the commencement date of the lease. Such payments include payments linked to a consumer price index (CPI), payments linked to a benchmark interest rate (such as IBOR) or payments that vary to reflect changes in market rental rates. [IFRS 16.27–28, IFRS 16.BC166]
Variable lease payments that are highly probable to occur are not in-substance fixed payments if they are based on performance or use of the underlying asset and are therefore avoidable.
A If a lessee provides a residual value guarantee, then it includes in the lease payments the amount that it expects to pay under that guarantee. An unguaranteed residual value is always excluded from the determination of the lease payments by the lessee. [IFRS 16.27(c)]
Lessees determine whether it is reasonably certain that they will exercise a purchase option considering all relevant facts and circumstances that create an economic incentive to do so. This is similar to the approach for assessing whether a lessee expects to exercise a renewal option (see the reasonably certain threshold in the link). [IFRS 16.27, IFRS 16.B37]
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Case – In-substance fixed payments: Minimum lease payment |
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Lessee W leases a production line from Lessor L. The lease payments depend on the number of operating hours of the production line – i.e. W has to pay 1,000 per hour of use. The expected usage per year is 1,500 hours. If the usage is less than 1,000 hours, then W must pay 1,000,000. [IFRS 16.27, IFRS 16.38(b), IFRS 16.B42] This lease contains in-substance fixed payments of 1,000,000 per year, which are included in the initial measurement of the lease liability. The additional 500,000 that W expects to pay per year are variable payments that depend on usage and, therefore, are not included in the initial measurement of the lease liability but are expensed as the ‘over-use’ occurs. |
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Case – Variable payments not depending on an index or rate |
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Utility Company C enters into a 20-year contract with Power Company D to purchase electricity produced by a new solar farm. C and D assess that the contract contains a lease. There are no minimum purchase requirements, and no fixed payments that C is required to make to D. However, C is required to purchase all of the electricity produced by the solar plant at a price of 10 per unit. [IFRS 16.27] C notes that it is highly probable that the solar plant will generate at least some electricity each year. However, the whole payment that C makes to D varies with the amount of electricity produced by the solar farm – i.e. the payments are fully variable. Therefore, C concludes that there are no in-substance fixed lease payments in this contract. C recognises the payments to D in profit or loss when they are incurred. |
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Case – Variable payments depending on an index |
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Lessee Y rents an office building. The initial annual rental payment is 2,500,000. Payments are made at the end of each year. The rent will be increased each year by the change in the CPI over the preceding 12 months. [IFRS 16.28] This is an example of a variable lease payment that depends on an index. The initial measurement of the lease liability is based on the value of the CPI on lease commencement – i.e. an annual rental of 2,500,000 for each year of the lease. If during the first year of the lease the CPI increases from 100 to 105 (i.e. the rate of inflation over the preceding 12 months is 5%), then at the end of the first year the lease liability is recalculated assuming future annual rentals of 2,625,000 (i.e. 2,500,000 × 105 / 100). |
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Case – Residual value guarantees |
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Lessee Z has entered into a lease contract with Lessor L to lease a car. The lease term is five years. In addition, Z and L agree on a residual value guarantee – if the fair value of the car at the end of the lease term is below 400, then Z will pay to L an amount equal to the difference between 400 and the fair value of the car. [IFRS 16.27(c)] At commencement of the lease, if Z expects the fair value of the car at the end of the lease term to be 380, then it includes 20 in the lease payments in respect of the residual value guarantee when calculating the lease liability. |
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Which variable lease payments are included in the initial measurement of the lease liability? |
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The initial measurement of the lease liability includes variable lease payments that depend on an index or rate – e.g. the CPI or a market interest rate – and payments that appear to be variable but are in-substance fixed payments. [IFRS 16.BC168–BC169] Variable lease payments that depend on sales or usage of the underlying asset are excluded from the lease liability. Instead, these payments are recognised in profit or loss in the period in which the performance or use occurs. This has a number of important consequences.
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How does the lessee decide whether to include in the lease liability amounts payable on exercise of a renewal, purchase or termination option? |
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The lessee determines whether it is reasonably certain to exercise an option to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease early. This assessment is made by considering all relevant facts and circumstances that create an economic incentive to exercise an option or not to do so (see the reasonably certain threshold in the link). [IFRS 16.18–19, IFRS 16.27(d)–(e), IFRS 16.70(d)–(e), IFRS 16.B37–B40] Each party determines the lease payments in a manner consistent with this assessment as follows.
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What are lease incentives and how are they accounted for by lessees? |
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Lease incentives are payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of the costs of a lessee. Payments made by the lessor to the lessee are not lease incentives when they are associated with other obligations of the lessee to transfer distinct goods or services to the lessor. [IFRS 16.27(a)] Examples of lease incentives provided by lessors include up-front cash payments to the lessee or assumption of costs of the lessee such as leasehold improvements, relocation costs and costs associated with a pre-existing lease commitment. Alternatively, initial periods of the lease term may be agreed to be rent-free or at a reduced rent. Irrespective of its form, a lease incentive is part of the lease payments – i.e. the net consideration for the lease. |
2.3 Discount rate
At the commencement date, a lessee measures the lease liability at the present value of the lease payments using the interest rate implicit in the lease if this can be readily determined. This is the rate that causes the present value of the lease payments and the unguaranteed residual value to equal the sum of the fair value of the underlying asset and any initial direct costs of the lessor. [IFRS 16.26]
If the lessee cannot readily determine the interest rate implicit in the lease, then the lessee uses its incremental borrowing rate. This is the rate that a lessee would have to pay at the commencement date of the lease for a loan of a similar term, and with similar security, to obtain an asset of similar value to the right-of-use asset in a similar economic environment.
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Is the rate implicit in the lease readily determinable for a lessee? |
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In most circumstances, a lessee is not able to determine the rate implicit in the lease. There is no separate definition of the interest rate implicit in the lease for the lessee. The lack of information available to the lessee (e.g. the lessor’s initial direct costs, the initial fair value of the underlying asset and the lessor’s expectations of the residual value of the asset at the end of the lease) typically makes it difficult for the lessee to determine the interest rate implicit in the lease. Therefore, it is likely to be difficult for lessees to readily determine the interest rate implicit for most leases. As a result, lessees often use their incremental borrowing rate. |
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Should a lessee’s incremental borrowing rate reflect the interest rate in a loan with both a similar maturity to the lease and a similar payment profile to the lease payments? |
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In some cases, a lessee seeking to determine its incremental borrowing rate may have readily observable evidence of the interest rate on a loan with the same term but a different payment profile from the lease. A question arises about whether a lessee’s incremental borrowing rate is required to reflect the interest rate in a loan with both a similar maturity to the lease and a similar payment profile to the lease payments. [IFRS 16.BC162] The IFRS Interpretations Committee discussed this matter and noted that the definition of a lessee’s incremental borrowing rate requires the lessee to determine its incremental borrowing rate for a particular lease considering the terms and conditions of the lease. The Committee observed that it would be consistent with the Board’s objective in developing the definition of incremental borrowing rate for a lessee to refer as a starting point to a readily observable rate for a loan with a similar payment profile to that of the lease, although IFRS 16 does not explicitly require this. |
3. Initial measurement of the right-of-use asset
At the commencement date, a lessee measures the right-of-use asset at a cost that includes the following. [IFRS 16.23–24]
* IAS 37 Provisions, Contingent liabilities and Contingent Assets
A lessee’s ‘initial direct costs’ are the incremental costs of obtaining a lease that would not otherwise have been incurred. This definition is similar to the definition of the incremental costs of obtaining a contract under IFRS 15 Revenue from Contracts with Customers. That is, the focus is on costs that are contingent on actually obtaining the lease. Costs that are directly attributable to seeking to obtain a lease but are incurred irrespective of whether the lease is actually obtained are not initial direct costs.
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Typical initial direct costs of a lessee |
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Include |
Exclude |
* If they are contingent on obtaining the lease |
Costs to obtain offers for potential leases |
4. Subsequent measurement of the lease liability
4.1 Measurement basis
After initial recognition, a lessee measures the lease liability by:
- increasing the carrying amount to reflect interest on the lease liability;
- reducing the carrying amount to reflect the lease payments made; and
- remeasuring the carrying amount to reflect:
- any reassessment (see remeasurement of the lease liability in the link) or lease modifications (see lessee modification accounting in the link); and
- revised in-substance fixed lease payments (see remeasurement of the lease liability in the link). [IFRS 16.36]
Interest on the lease liability in each period during the lease term is the amount that produces a constant periodic rate of interest on the remaining balance of the lease liability. The ‘periodic rate of interest’ is the discount rate used in the initial measurement of the lease liability (see discount rate in the link) or, if appropriate, the revised discount rate (see remeasurement of the lease liability in the link and lessee modification accounting in the link). [IFRS 16.37]
Lessees cannot choose to measure lease liabilities subsequently at fair value. [IFRS 16.BC183]
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Case – Lease liability: Subsequent measurement |
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Lessee X has entered into a contract with Lessor L to lease a building for seven years. The annual lease payments are 450, payable at the end of each year. X estimates that the incremental borrowing rate is 5.04% and uses it to measure the lease liability. The initial recognition of the obligation to make lease payments is 2,600. X performs the following calculations at the end of Year 1.
Notes |
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4.2 Remeasurement of the lease liability
After the commencement date, a lessee remeasures the lease liability to reflect changes in the lease payments. This occurs when the lessee reassesses whether it is reasonably certain to exercise an option to extend the lease or to purchase the underlying asset, or not to exercise an option to terminate the lease early. In addition, the lessee revises the lease term and remeasures the lease liability when there is a change in the non-cancellable period of a lease. [IFRS 16.39] See changes in the lease term for a detailed discussion.
The following table describes which discount rate to use for the remeasurement.
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Lessee remeasures lease liability using revised lease payments and…. |
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an unchanged discount rate when:
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a revised discount rate when:
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Case – Lease liability: Change in variable payments linked to an index |
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Lessee Y enters into a lease for a five-year term with Lessor L for a retail building, commencing on 1 January. Y pays 155 per year, in arrears. Y’s incremental borrowing rate is 5.9%. Additionally, the lease contract states that lease payments for each year will increase on the basis of the increase in the CPI for the preceding year. At the commencement date, the CPI for the previous year is 120 and the lease liability is 655 based on annual payments of 155 discounted at 5.9% to the commencement date. Assume that initial direct costs are zero and there are no lease incentives, prepayments or restoration costs. Y records the following entries for Year 1.
At the end of Year 1, the CPI increases to 125. Y calculates the revised payments for Year 2 and beyond adjusted for the change in CPI as 161 (155 × 125 / 120). Because the lease payments are variable payments that depend on an index, Y adjusts the lease liability to reflect the change. The adjustment is calculated as the difference between the original lease payments (155) and the reassessed payment (161) over the remaining four-year lease term, discounted at the original discount rate of 5.9% (21). Remeasurements of variable lease payments that depend on an index and relate to future periods are reflected in the carrying amount of the right-of-use asset (see Lessor presentation and disclosure in the link). Y records the following entry.
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5 Subsequent measurement of the right-of-use asset
5.1 Measurement basis
Generally, a lessee measures right-of-use assets at cost less accumulated depreciation (see depreciation of the right-of-use asset in the link) and accumulated impairment losses (see impairment of the right-of-use asset below). [IFRS 16.29–30]
The lessee adjusts the carrying amount of the right-of-use asset for the remeasurement of the lease liability – e.g. when there is a change in CPI (see remeasurement of the lease liability in the link). If the carrying amount of the right-of-use asset has already been reduced to zero and there is a further reduction in the measurement of the lease liability, then the lessee recognises any remaining amount of the remeasurement in profit or loss. [IFRS 16.30(b), IFRS 16.38(b), IFRS 16.39]
A lessee applies alternative measurement bases in two circumstances:
- if the right-of-use asset meets the definition of investment property, then the lessee measures the right-of-use asset in accordance with its accounting policy for all of its investment property, which may be at fair value; and
- if a lessee applies the revaluation model to a class of property, plant and equipment, then it may elect to apply the revaluation model to all right-of-use assets that belong to the same class. [IFRS 16.34–35, IAS 40.2]
The following diagram summarises the impact of changes in the carrying amount of the lease liability on the right-of-use asset. [IFRS 16.38–39]
5.2 Depreciation of the right-of-use asset
A lessee depreciates right-of-use assets in accordance with the requirements of IAS 16 Property, Plant and Equipment – i.e. the depreciation method reflects the pattern in which the future economic benefits of the right-of-use asset are consumed. This will usually result in a straight-line depreciation charge. [IFRS 16.31, IAS 16.60]
Depreciation starts at the commencement date of the lease. The period over which the asset is depreciated is determined as follows:
- if ownership of the underlying asset is transferred to the lessee, or the lessee is reasonably certain to exercise a purchase option, then the depreciation period runs to the end of the useful life of the underlying asset; otherwise
- the depreciation period runs to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.[IFRS 16.32]
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Case – Right-of-use asset: Depreciation period |
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Lessee X enters into a non-cancellable, non-renewable five-year lease with Lessor L for a machine that will be used in X’s manufacturing process. The useful life of the underlying machine is 10 years and ownership remains with L. Ownership does not transfer to X; therefore, X depreciates the right-of-use asset from the commencement date over a period of five years (i.e. the end of the lease term). |
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Does IAS 16 component accounting apply to depreciation of leases? |
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Yes. IFRS 16 states that a lessee applies the depreciation requirements in IAS 16 and therefore identifies separate components for the purposes of depreciation. This can be an important practical consideration for lessees that lease big-ticket items under operating leases and adopt a component approach to maintenance accounting – e.g. major maintenance checks in some aircraft leases. [IFRS 16.31, IAS 16.43] |
5.3 Impairment of the right-of-use asset
A lessee applies IAS 36 Impairment of Assets to determine whether a right-of-use asset is impaired and to account for any impairment. After recognition of an impairment loss, the future depreciation charges for the right-of-use asset are adjusted to reflect the revised carrying amount. [IFRS 16.33, IAS 36.63]
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Case – Impairment of the right-of-use asset |
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Lessee Y leases a machine for its manufacturing process over a non-cancellable 10-year period. The initial carrying amount of the right-of-use asset is 1,000, which is subsequently measured at cost and depreciated on a straight-line basis over a period of 10 years – i.e. the depreciation charge per year amounts to 100. At the end of Year 5, the cash-generating unit that includes the right-of-use asset is impaired. An impairment charge of 200 is allocated to the right-of-use asset. Immediately before the impairment, the carrying amount of the right-of-use asset is 500. Following the impairment, the carrying amount is reduced to 300 and the future depreciation charges are reduced to 60 (300 / 5) per year. |
6. Presentation and disclosure
6.1 Lessee presentation
A lessee presents leases in its financial statements as follows. [IFRS 16.47–50]
* Right-of-use assets that meet the definition of investment property are presented within investment property.
6.2 Lessee disclosure
A lessee discloses information that provides a basis for users of financial statements to assess the effect that leases have on financial position, financial performance and cash flows. [IFRS 16.51]
A lessee discloses information about leases for which it is a lessee in a single note or separate section in the financial statements. However, a lessee does not need to duplicate information that is already presented elsewhere in the financial statements, provided that the information is incorporated by cross-reference in the single note or separate section about leases. [IFRS 16.52]
Normally, a lessee discloses at least the following information.
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Quantitative information |
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Relating to the statement of financial position [IFRS 16.47, IFRS 16.53, IFRS 16.58]
Relating to the statement of profit or loss and other comprehensive income (including amounts capitalised as part of the cost of another asset) [IFRS 16.53–54]
Relating to the statement of cash flows [IFRS 16.53]
Other [IFRS 16.55]
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Qualitative disclosures |
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Additional disclosures (if and when applicable) |
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