IFRS 16 lease liability calculation: a worked example

Step 1: decide which payments count

The liability is built only from the lease payments. They include fixed payments (less lease incentives receivable), variable payments that depend on an index or a rate, measured at the index at commencement, the exercise price of a purchase option the lessee is reasonably certain to use, termination penalties if the lease term assumes termination, and amounts expected under a residual value guarantee.

Left out: variable payments linked to sales or usage, such as turnover rent above a guaranteed minimum, which are expensed as they occur, and non-lease components such as cleaning or security services, unless the lessee elects not to separate them. Forecast inflation is not included either. The liability is remeasured when the index actually changes.

Step 2: choose the discount rate

The rate implicit in the lease is rarely known to a lessee, because it depends on the lessor's residual value and costs. Most lessees therefore use their incremental borrowing rate: what it would cost to borrow a similar amount, over a similar term, with similar security, in a similar economic environment. Here that is 6%. The rate matters a lot: at 5% the same payments would give a liability of about $519,500, at 7% about $492,000.

Step 3: the present value

With equal annual payments at the end of each year, one Excel function does it: =PV(rate, years, −payment), here =PV(E4,E3,-E2) = $505,483.65. By hand it is the sum of payment ÷ (1 + rate)^year over the five years, which is useful when the payments differ from year to year. If the rent is paid in advance, the first payment is made on day 1 and is not part of the liability: =PV(E4,E3,-E2,0,1)-E2 leaves $415,812.67, and the day-1 payment goes into the right-of-use asset instead.

Worked example: lease liability, ROU asset and schedule

Inputs in yellow. Rows 11 to 15 are the liability schedule, rows 17 to 21 the figures for the year-1 balance sheet and income statement. The lease and its numbers are fictional.

Worked example: lease liability, ROU asset and schedule

	A	B	C	D	E
1	Store lease, inputs				Value
2	Annual payment, paid at the end of each year				120,000.00
3	Lease term (years)				5
4	Incremental borrowing rate				6.00%
5	Lease liability at commencement (PV)				505,483.65
6	+ Initial direct costs (broker's commission)				8,000.00
7	− Lease incentive received from the landlord				15,000.00
8	Right-of-use asset at commencement				498,483.65
9
10	Year	Opening	Interest	Payment	Closing
11	1	505,483.65	30,329.02	120,000.00	415,812.67
12	2	415,812.67	24,948.76	120,000.00	320,761.43
13	3	320,761.43	19,245.69	120,000.00	220,007.12
14	4	220,007.12	13,200.43	120,000.00	113,207.55
15	5	113,207.55	6,792.45	120,000.00	0.00
16
17	Current portion at end of year 1 (year 2 principal)				95,051.24
18	Non-current portion at end of year 1				320,761.43
19	Year 1 depreciation of the right-of-use asset				99,696.73
20	Year 1 cost in profit or loss (depreciation + interest)				130,025.75
21	Liability if paid in advance, after the day-1 payment				415,812.67

An educational summary in plain words, not the text of IFRS 16 or ASC 842 and not accounting advice for a specific contract.

Step 4: the right-of-use asset

The right-of-use asset starts at the lease liability, plus payments made at or before commencement, plus initial direct costs (only incremental ones, such as a broker's commission), minus lease incentives received, plus any restoration costs the lease requires. Here: $505,483.65 + $8,000 − $15,000 = $498,483.65. It is depreciated straight-line over the lease term, $99,696.73 a year.

Step 5: the liability schedule and the current portion

Each year, interest = opening balance × rate and closing = opening + interest − payment. Year 1 interest is $30,329.02, so the balance falls to $415,812.67. Interest shrinks as the balance falls, and the closing balance reaches 0 after the fifth payment, which is the check that the schedule is right. It is the same logic as a loan amortization schedule.

On the balance sheet at the end of year 1, the current portion is the principal repaid in year 2: the $120,000 payment minus year 2 interest, $95,051.24. The remaining $320,761.43 is non-current. Showing the whole next payment as current is a common error, because its interest part is not owed yet.

The cost in profit or loss: IFRS 16 vs ASC 842

Under IFRS 16 every lease (apart from the short-term and low-value exemptions) is expensed as depreciation plus interest. In year 1 that is $99,696.73 + $30,329.02 = $130,025.75, more than the $120,000 of rent paid, and the cost falls each year as interest drops. Under US GAAP (ASC 842), the balance sheet is similar, but an operating lease shows one straight-line lease cost, here ($600,000 + $8,000 − $15,000) ÷ 5 = $118,600 a year. Total cost over the five years is the same, only the timing differs.

Common mistakes

• Including turnover rent or service charges. Sales-based variable rent and non-lease services stay out of the liability unless the lessee elects to combine services with the lease.
• Forecasting inflation into CPI-linked rent. Use the index at commencement and remeasure when it changes.
• Discounting payments in advance as if they were in arrears. Use type 1 in PV and take out the day-1 payment, or the liability is too high or too low.
• Showing the whole next payment as current. The current portion is next year's principal: payment minus next year's interest.
• Putting internal costs into the ROU asset. Only incremental initial direct costs qualify. Salaries of your own property team are expensed.
• A schedule that does not end at zero. If the closing balance after the last payment is not 0, the rate, the timing or the number of periods is wrong.