IFRS 16 Lease Liability Measurement: A Technical Guide

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.

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.

2. 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.

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.

3. 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

Conclusion

The initial measurement of lease liabilities under IFRS 16 forms the foundation for lessee lease accounting. We hope this article gave you valuable insights in arriving at this amount.

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