Under IFRS 16, a lessee recognises almost every lease on the balance sheet as a right-of-use asset and a corresponding lease liability. The mechanics are well defined, but getting the inputs right — discount rate, payment stream, term — is where most errors happen in practice.
Step 1: Establish the lease term
Start with the non-cancellable period, then add any renewal option the lessee is reasonably certain to exercise, and any termination option it is reasonably certain not to exercise. "Reasonably certain" is a high threshold — it requires evidence (economic incentive, significant leasehold improvements, contractual penalties for non-renewal), not just an assumption that renewal is likely.
Step 2: Identify the payments to include
The lease liability is measured at the present value of:
- Fixed payments, less any lease incentives receivable
- Variable payments that depend on an index or rate (e.g. CPI-linked rent), measured using the index or rate at the commencement date
- Amounts expected under residual value guarantees
- The exercise price of a purchase option, if reasonably certain to be exercised
- Termination penalties, if the lease term reflects exercising a termination option
Purely usage-based variable payments (for example, a percentage of retail sales) are excluded from the liability and expensed as incurred.
Step 3: Choose the discount rate
Use the rate implicit in the lease if it can be readily determined. In practice, for most lessees, it can't — the lessor's residual value assumptions and the fair value of the asset usually aren't disclosed. In that case, use the lessee's incremental borrowing rate: the rate the lessee would have to pay to borrow, over a similar term and with similar security, the funds necessary to obtain an asset of similar value in a similar economic environment.
Step 4: Discount the payments
Discount each payment to present value at the commencement date, using the rate from Step 3. A five-year lease with a single annual payment in arrears and a 6% incremental borrowing rate isn't discounted by a flat "5 years at 6%" — each individual payment is discounted for the exact number of periods until it's due, and the results summed.
Step 5: Recognise the right-of-use asset
Initially, the right-of-use asset equals the lease liability, plus any lease payments made at or before commencement (less incentives received), plus initial direct costs, plus an estimate of dismantling or restoration costs where applicable.
Step 6: Account for subsequent measurement
Each period, the lease liability accretes interest (unwinding the discount) and reduces for cash payments made — the two rarely net to a level "rent expense" the way an operating lease under the old IAS 17 model did. The right-of-use asset is generally depreciated on a straight-line basis over the shorter of the lease term and the asset's useful life.
Where this typically goes wrong
- Using the lessee's general cost of borrowing instead of a rate matched to the specific term, currency and security of the actual lease
- Missing an embedded lease inside a larger services contract (e.g. a dedicated server, or a specific piece of equipment named in a supply agreement)
- Forgetting to reassess the liability when a renewal becomes reasonably certain partway through the original term, or when an index-linked payment resets
- Treating short-term leases (12 months or less) or low-value asset leases as requiring full IFRS 16 treatment when they qualify for the recognition exemption
None of this is exotic — it's the standard as written. What tends to break down is doing it consistently across a portfolio of leases with different terms, currencies and renewal clauses, and being able to show the calculation, not just the result, when an auditor asks.