How to Calculate Lease Liability in IFRS 16 (With Examples)

Introduction

Under IFRS 16, the accurate measurement of lease liabilities is central to financial reporting compliance. While the standard is now well-established, the initial measurement at the commencement date remains critical, and impacts the statement of financial position and statement of profit or loss.

At the commencement date, a lessee measures the lease liability at the present value of the lease payments that are not paid at that date. To derive accurate figures, finance teams must identify specific cash flows and apply the appropriate discount rate.

Everything in the calculation reduces to four inputs: the payments (PMT), the lease term (N), the discount rate (I/Y), and any amount falling due at the end of the term (FV). This article works through each in turn, then brings them together in a worked example.

This article forms part of our full IFRS 16 guide.

1. Defining Lease Payments

Not all cash flows exchanged between a lessee and a lessor constitute "lease payments" under IFRS 16. The standard strictly defines which components are included in the liability measurement and which are expensed as incurred.

Included in Liability Measurement

The lease liability calculation aggregates the following payment types:

• Fixed Payments: Contractual payments made by a lessee to a lessor for the right to use the underlying asset, less any lease incentives receivable.
• In-Substance Fixed Payments: These are payments that may appear variable in form (legal clauses) but are, in reality, unavoidable. If there is no genuine variability, they are treated as fixed.
• Index or Rate-Based Variable Payments: Variable payments dependent on an index or a rate are included. These are initially measured using the index or rate as at the commencement date (e.g., payments linked to CPI, LIBOR/SOFR, or market rental rates).
• Residual Value Guarantees: Amounts expected to be payable by the lessee under residual value guarantees. This is distinct from the maximum amount guaranteed.
• Purchase Options: The exercise price of a purchase option is included if the lessee is reasonably certain to exercise that option.
• Termination Penalties: Payments of penalties for terminating the lease are included if the lease term reflects the lessee exercising an option to terminate.

Excluded from Liability Measurement

Any other amounts, are not lease payments. For example payments based on usage or performance are excluded from the lease liability. These are recognised in profit or loss in the period in which the event or condition that triggers the payment occurs.

The Timing of a Lease Incentive Changes Where It Lands

Lease incentives are commonly netted off "the lease", but the standard splits them by timing, and the two treatments give different balances:

• Incentives receivable after the commencement date reduce the future lease payments, and therefore reduce the lease liability.
• Incentives received on or before the commencement date are not future cash flows at all. They leave the liability untouched and instead reduce the cost of the right-of-use asset.

Both routes reduce the right-of-use asset by the same amount, but only the first reduces the liability, the interest charge, and the maturity analysis.

2. VAT/ Sales-Tax: Which Amount Goes Into PMT

Once the qualifying payments are identified, a lessee still has to decide which version of the number to discount: the VAT-inclusive amount or the VAT-exclusive one. Getting this wrong shifts the liability by roughly 15%, and it is not a matter of policy choice — it follows from how the lessor accounts for output VAT. The deciding factor is whether the VAT is levied per payment or up front, and whether the lessee can claim input VAT thereon.

Normal Rental Agreement — Discount the VAT-Exclusive Payment

In a rental agreement, the lessor levies output VAT on each payment as it falls due, and pays that VAT over to SARS. The VAT portion of every instalment never economically belongs to the lessor; it is collected on behalf of SARS.

Because the lessor is not financing anything in respect of that VAT, it is not part of the amount being financed. The payments discounted into the liability are therefore VAT-exclusive, and the lessee claims input VAT on each payment as it is made:

Dr Lease obligation
Dr VAT control
    Cr Bank

A quoted instalment of R115,000 (VAT inclusive) enters the calculation as R100,000 — that is, R115,000 × 100/115.

Instalment Credit Agreement — the Obligation Includes VAT

An instalment credit agreement (ICA) works differently. Output VAT is levied on the cash value of the asset at commencement, and the lessor must pay it over to SARS immediately, well before it is recovered from the lessee through the instalments.

The lessor is therefore financing the VAT, and recovers it systematically through the payments. The consequence for the lessee is that the lease obligation is VAT-inclusive, and the instalments used as PMT are VAT-inclusive too.

The input VAT is claimed once, up front, and here is the trap: it is claimed on the cash value of the asset, not on the lease obligation. The two are different numbers, because the obligation is the undiscounted financing arrangement while the VAT was levied on the cash price:

Dr Right-of-use asset
Dr VAT control            (15% of the cash value, not of the obligation)
    Cr Lease obligation

If the lessee cannot claim input VAT (a non-vendor, or a denied supply such as a passenger vehicle), there is no VAT control leg. The full VAT-inclusive amount is capitalised to the right-of-use asset, and the lessee instead claims the section 11(a) deduction on the lease payments themselves.

3. Determining the Lease Term

The lease term sets N, and it also decides whether the optional payments from section 1 make it into the calculation at all. It is built up in three parts:

1. The non-cancellable period of the lease — the period during which neither party can cancel. A period still counts as non-cancellable where only the lessor can cancel, or where either party can cancel but only by incurring a penalty significant enough that termination is not a genuine option.
2. Plus periods covered by an option to extend, where the lessee is reasonably certain to exercise it.
3. Plus periods after an optional termination date, where the lessee is reasonably certain not to terminate.

The link back to the payments is direct, and worth making explicit:

• A purchase option enters PMT/FV only if exercise is reasonably certain — the same threshold that determines the term.
• A termination penalty is included only if the term reflects the lessee terminating. If the term already assumes the lease runs to the end, no penalty is expected, and none is included.
• Extending the term does not just add periods to N; it adds the payments in those periods to the liability.

A five-year lease with a five-year extension option that the lessee is reasonably certain to exercise is a ten-year lease for measurement purposes, roughly doubling the liability. For the full assessment of "reasonably certain", see our article on the lease term under IFRS 16.

4. Selecting the Discount Rate

The lease payments must be discounted to present value. IFRS 16 outlines two possible discount rates:

Primary: Interest Rate Implicit in the Lease (IRIL)

The standard requires the use of the interest rate implicit in the lease if that rate can be readily determined. The IRIL is defined as 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.

The rate is always derived from the lessor's perspective — effectively the lessor's internal rate of return on the lease. This is why it so often cannot be readily determined by a lessee: it requires the fair value of the asset, the lessor's initial direct costs, and the unguaranteed residual value, none of which the lessee necessarily knows.

For a detailed breakdown of this calculation, refer to our technical article: Interest Rate Implicit In The Lease Explained - IFRS 16 & ASC 842

Secondary: Incremental Borrowing Rate (IBR)

If the implicit rate cannot be readily determined, the lessee uses the Incremental Borrowing Rate (IBR).

The IBR represents the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment. Additionally, IFRS 16 allows entities to elect to apply a single discount rate to a portfolio of leases with reasonably similar characteristics as a practical expedient.

The IBR must also be a rate in the currency of the lease payments. Discounting foreign currency rentals at a functional currency borrowing rate applies one currency's interest rate environment to another's cash flows and misstates the liability from day one — see foreign currency leases under IFRS 16.

5. Calculation Methodology: A Practical Example

Once the eligible payments and the discount rate are identified, the calculation follows standard Present Value (PV) principles.

Scenario

• Lease Term (N): 5 Years
• Payment Frequency: Annual (in arrears)
• Fixed Payment (PMT): 100,000 per year
• Purchase Option (FV): 50,000 (Reasonably certain to be exercised at end of Year 5)
• Variable Payment: 1% of revenue (Excluded from calculation)
• Discount Rate (I/Y - IBR): 4.5%

Execution (Excel / Financial Calculator)

To determine the Lease Liability, the inputs for a standard financial calculator or Excel PV function are as follows:

Resulting Lease Liability (PV): 479,120

This is made up of 438,997.67 for the five annual payments and 40,122.55 for the discounted purchase option.

The Same Lease, Paid in Advance

Change one input — payments at the beginning of each period (Type 1, or BGN) — and the answer moves materially:

The whole of the difference sits in the payment leg, which is simply 4.5% higher because each payment is received one period sooner. The purchase option does not move: it is still settled at the end of year 5 either way.

6. From Opening Balance to Balance Sheet

The 479,120 is an opening balance, not a final answer. Two further steps turn it into the figures that appear in the financial statements.

Subsequent Measurement: Amortised Cost

The liability is carried at amortised cost — increased by the interest charge and reduced by payments made. Where the lease is denominated in a foreign currency, a third movement is added: the liability is a monetary item, so it is also retranslated at the closing rate, with the exchange difference recognised in profit or loss.

The year 5 payment includes the 50,000 purchase option, which is what brings the liability to nil. Total interest over the term is 70,880 — the difference between the 550,000 of undiscounted payments and the 479,120 recognised.

Splitting Current and Non-Current

The liability is presented split between current and non-current liabilities. The only definition that always holds is a roll-forward:

Current portion = liability (now) − liability (in 12 months)

At commencement, that is 479,120 − 400,681 = 78,439 current, with 400,681 non-current. Note that the current portion equals the capital portion of the next year's payment (100,000 − 21,560 of interest), not the payment itself.

Where the lease periods and the financial year end do not align, the current portion also picks up interest that has accrued in the current year but is only settled in the next.

When the Liability Has to Be Recalculated

The opening figure is not permanent. A change in the lease term, in the assessment of a purchase option, in the amount expected under a residual value guarantee, or in an index-linked payment all trigger a remeasurement, with the adjustment taken against the right-of-use asset.

Whether the original or a revised discount rate applies depends on what changed, and getting it wrong changes the answer. Our article on lease modifications and remeasurements sets out the full decision rule.

Conclusion

The initial measurement of lease liabilities under IFRS 16 forms the foundation for lessee lease accounting. Get the four inputs right — the qualifying payments on the correct VAT basis, the lease term, the discount rate, and the payment timing — and the schedule, the interest charge, and the balance sheet split all follow mechanically from there.

For additional guidance, please contact insight@leash.co.za.