At a glance
- Standard
- IFRS 16 Leases
- Measurement basis
- Present value of future lease payments
- Discount rate
- Rate implicit in lease, or incremental borrowing rate
- Subsequent measurement
- Effective interest method (liability) + straight-line depreciation (ROU asset)
- Applies to
- UK listed entities and others applying IFRS
- Audit focus
- Completeness, discount rate support, lease term judgement
What the lease liability represents
The IFRS 16 lease liability represents the lessee's obligation to make future lease payments. It is measured as the present value of those future payments, discounted at an appropriate rate to reflect the time value of money.
The lease liability sits on the balance sheet alongside a right-of-use asset, which represents the lessee's right to use the underlying asset for the lease term. Both are recognised at the commencement date of the lease.
Which lease payments are included
The following payments are included in the measurement of the lease liability:
- Fixed payments — the agreed contractual payments over the lease term, less any lease incentives receivable from the lessor
- In-substance fixed payments — payments that appear variable but are in practice unavoidable (for example, where a variable clause always results in the same payment)
- Variable lease payments based on an index or rate — measured using the index or rate at the commencement date (for example, payments linked to the consumer price index)
- Residual value guarantees — amounts the lessee expects to pay under any such guarantee
- Purchase option exercise price — included only where the lessee is reasonably certain to exercise the option
- Penalty payments for termination — included where the lease term reflects the lessee exercising a termination option
Pure variable lease payments — for example, a payment based on usage or sales — are excluded from the lease liability and recognised in profit or loss as incurred.
Discount rate selection
IFRS 16 requires the present value to be calculated using the rate implicit in the lease, where this can be readily determined. This is the rate that causes the present value of the lease payments and unguaranteed residual value to equal the fair value of the underlying asset plus any initial direct costs of the lessor.
In practice, the implicit rate is often not available to the lessee. Where this is the case, the lessee uses its incremental borrowing rate — the rate it would pay to borrow a similar amount over a similar term with similar security.
The choice and support for the discount rate is a significant audit area. Finance teams should document how the rate was determined and retain evidence.
Worked example: five-year property lease
A company enters a five-year property lease on 1 January 2024:
- Annual lease payment: £30,000, payable in arrears on 31 December each year
- No renewal options, no purchase option
- Incremental borrowing rate: 6% per annum
The present value of five annual payments of £30,000 at 6% is calculated as follows:
| Year | Payment (£) | Discount factor at 6% | Present value (£) |
|---|---|---|---|
| 1 | 30,000 | 0.9434 | 28,302 |
| 2 | 30,000 | 0.8900 | 26,700 |
| 3 | 30,000 | 0.8396 | 25,188 |
| 4 | 30,000 | 0.7921 | 23,763 |
| 5 | 30,000 | 0.7473 | 22,419 |
| Total lease liability at 1 January 2024 | £126,372 | ||
The opening journal at commencement is:
Amortisation schedule
After initial recognition, the lease liability is reduced by each payment less the interest component for the period. The interest is calculated using the effective interest method — the opening lease liability multiplied by the periodic discount rate.
| Period | Opening liability (£) | Interest at 6% (£) | Payment (£) | Closing liability (£) |
|---|---|---|---|---|
| Year 1 | 126,372 | 7,582 | 30,000 | 103,954 |
| Year 2 | 103,954 | 6,237 | 30,000 | 80,191 |
| Year 3 | 80,191 | 4,811 | 30,000 | 55,002 |
| Year 4 | 55,002 | 3,300 | 30,000 | 28,302 |
| Year 5 | 28,302 | 1,698* | 30,000 | 0 |
* Adjusted for rounding. The effective interest method ensures the liability closes to zero at the end of the lease term.
Journal entries
For each period, three sets of entries are required:
Interest accrual (Year 1 example):
Lease payment (Year 1):
Depreciation of right-of-use asset (straight-line over 5 years):
£126,372 ÷ 5 years = £25,274 per year
Common errors
- Using a single rate across all leases — the discount rate should reflect the specific lease term, asset type and company credit quality
- Excluding in-substance fixed payments — payments that appear variable but are effectively fixed must be included
- Incorrect lease term — renewal options that are reasonably certain to be exercised must be included in the lease term
- Treating the interest component as a reduction in lease liability — interest is recognised in profit or loss; only the principal component reduces the liability
- Failing to remeasure after a modification — changes in lease terms, payments or options require the lease liability to be remeasured
Frequently asked questions
What is included in the IFRS 16 lease liability?
Fixed payments, in-substance fixed payments, variable payments based on an index or rate, residual value guarantees, and purchase option exercise prices where reasonably certain. Pure variable payments (e.g. usage-based) are excluded.
What discount rate is used for the IFRS 16 lease liability?
IFRS 16 requires the rate implicit in the lease where readily determinable. If not, the lessee uses its incremental borrowing rate — the rate it would pay to borrow a similar amount over a similar term with similar collateral.
How is the lease liability reduced over time?
The lease liability reduces by each lease payment, less the interest component for the period. Interest is calculated using the effective interest method, producing a reducing balance with an increasing principal component over time.
This guide is for general information only. Finance teams should consult a qualified accountant for advice on their specific circumstances.
IFRS 16 calculations without the spreadsheet risk
AuditLease calculates lease liabilities, right-of-use assets and amortisation schedules to IFRS 16 requirements — with journal generation and an audit evidence trail built in.