Leases in a Business Combination: IFRS 3 and IFRS 16 (With Journal Entries)

Why Acquired Leases Are Remeasured

When an acquirer obtains control of a business, it does not inherit the acquiree's lease accounting. IFRS 3 Business Combinations requires all identifiable assets acquired and liabilities assumed to be recognised at their acquisition-date values, and leases are no exception.

Every lease in the acquired portfolio has to be measured again from scratch at the acquisition date. A subsidiary with two hundred property and fleet leases will have two hundred liabilities to re-run at a new discount rate, over a reassessed lease term, with an off-market adjustment layered onto each right-of-use asset.

The rules sit in three places:

• IFRS 3.28A and 28B — measurement of leases where the acquiree is the lessee
• IFRS 3.B42 — measurement of assets subject to an operating lease where the acquiree is the lessor
• IFRS 3.17 — the classification carve-out that stops lessor classification being reassessed

This article works through each, then covers the part most guidance stops short of: the consolidation adjustments that persist for the remainder of the lease term.

This article forms part of our complete IFRS 16 guide.

Acquiree as Lessee: Acquisition-Date Measurement

Where the acquiree is the lessee, IFRS 3.28B sets out a two-step measurement that deliberately breaks the usual IFRS 16 symmetry.

Step 1: Measure the lease liability as if it were a new lease

The lease liability is measured at the present value of the remaining lease payments, determined as if the acquired lease were a new lease at the acquisition date.

That phrase does a lot of work. It means the acquirer applies the IFRS 16 measurement requirements afresh, at the acquisition date:

• Lease payments — only those remaining after the acquisition date
• Lease term — reassessed at the acquisition date, including whether extension or termination options are now reasonably certain to be exercised
• Discount rate — determined at the acquisition date, not at the original commencement date. Because the interest rate implicit in the lease is rarely determinable, this is almost always the incremental borrowing rate of the acquired entity at the acquisition date. It reflects the entity's credit standing as part of the acquiring group, which is frequently different from the rate originally used.

Step 2: Measure the right-of-use asset at the same amount, then adjust for off-market terms

The right-of-use asset is measured at the same amount as the lease liability, adjusted to reflect favourable or unfavourable terms of the lease compared with market terms.

• If the acquiree is paying below market rent, the lease is favourable — the right-of-use asset is increased
• If the acquiree is paying above market rent, the lease is unfavourable — the right-of-use asset is decreased

Note what this excludes. Unlike a lease measured at commencement under IFRS 16, the acquisition-date right-of-use asset does not pick up initial direct costs, prepaid or accrued lease payments, lease incentives, or restoration provisions. It is the liability, plus or minus the off-market element, and nothing else.

The Two Recognition Exemptions

IFRS 3 allows the acquirer not to recognise a right-of-use asset and lease liability for:

1. Leases whose lease term ends within 12 months of the acquisition date; and
2. Leases for which the underlying asset is of low value.

Note 'acquisition date'. A 5-year lease may have not qualified for the exemption 4 years ago, but could now qualify under the business combination.

Example: Acquiree as Lessee

Facts

Holdings Ltd acquires 100% of Target Ltd on 1 January 2026. Target Ltd leases office premises:

• Remaining lease term at acquisition: 4 years
• Annual lease payments: 100,000, paid annually in arrears
• Target Ltd's incremental borrowing rate at the acquisition date: 7%
• Current market rent for equivalent premises: 115,000 per annum
• Amounts in Target Ltd's own books at 1 January 2026: right-of-use asset 310,000, lease liability 330,000 (originally discounted at 6%)

Step 1: Lease liability at the acquisition date

Present value of 4 payments of 100,000 at 7%:

100,000 × 3.387211 = 338,721

Step 2: Off-market adjustment

Target Ltd pays 100,000 against a market rent of 115,000, so the lease is favourable by 15,000 per annum:

15,000 × 3.387211 = 50,808

Step 3: Right-of-use asset

338,721 + 50,808 = 389,529

Acquisition-date amounts recognised by the group

At-acquisition consolidation journal

The 70,808 increases the identifiable net assets acquired and therefore reduces goodwill by the same amount (before deferred tax, dealt with below). Where a non-controlling interest is measured at its proportionate share of net assets, it shares in this uplift.

Why There Is No Separate Intangible for Favourable Terms

Under IAS 17, an acquirer that took on an acquiree's favourable operating leases recognised a separate intangible asset for the favourable element, and a separate liability where terms were unfavourable. Many practitioners still reach for that treatment out of habit.

IFRS 16 removed it. Because the off-market element is now folded into the measurement of the right-of-use asset under IFRS 3.28B, recognising a separate intangible would double count it.

Where the acquiree is the lessee, the off-market adjustment is not a separate component. It is part of one right-of-use asset, depreciated as a single amount over the lease term.

As we will see in the lessor example below, the opposite is true where the acquiree is the lessor.

Acquiree as Lessor

Where the acquiree is the lessor, two different rules apply.

Classification is not reassessed

IFRS 3.17 requires the acquirer to classify and designate identifiable assets and liabilities on the basis of conditions existing at the acquisition date — but it explicitly carves out the classification of a lease in which the acquiree is the lessor.

That classification, as an operating lease or a finance lease, is retained on the basis of the contractual terms and other factors at the inception of the contract, unless the contract has since been modified in a way that would change its classification.

So a lease the acquiree classified as an operating lease at inception stays an operating lease in the group accounts, even if the acquisition-date facts would point the other way.

Measurement follows the classification

• Operating lease — under IFRS 3.B42, the acquirer recognises the underlying asset and measures it at fair value, taking into account the terms of the lease. No separate asset or liability is recognised for the off-market element, because the value of those terms is already embedded in the asset's fair value.
• Finance lease — there is no underlying asset to recognise. The acquirer recognises the net investment in the lease, measured at fair value at the acquisition date.

The componentisation point

For an operating lease, IFRS 3.B42 gives one asset at one fair value. But that single amount contains two economically distinct elements with different lives:

1. The underlying asset itself, which will generate returns over its remaining useful life
2. The favourable or unfavourable contract element, which is consumed over the remaining lease term

Example: Acquiree as Lessor

Facts

Holdings Ltd also acquires Property Ltd on 1 January 2026. Property Ltd owns a building that it leases to an external tenant under a lease classified at inception as an operating lease.

• Fair value of the building, disregarding the lease: 2,000,000
• Remaining useful life of the building: 25 years
• Remaining lease term: 5 years
• Contractual rental: 220,000 per annum
• Market rental for equivalent premises: 200,000 per annum
• Appropriate discount rate: 8%

Off-market element

The tenant pays 20,000 per annum above market, so the lease is favourable to Property Ltd as lessor:

20,000 × 3.992710 = 79,854

Acquisition-date fair value of the asset (IFRS 3.B42)

2,000,000 + 79,854 = 2,079,854

Subsequent depreciation — two components, two periods

After five years the favourable element is fully amortised, the rental reverts to market, and the building continues to depreciate at 80,000 per annum over its remaining twenty years. Had the full 2,079,854 been depreciated over 25 years, the asset would have remained overstated for the whole of that remaining period.

A note on investment property

If the building meets the definition of investment property under IAS 40 and the group applies the fair value model, this componentisation question falls away entirely — the asset is remeasured to fair value at each reporting date and no depreciation is recognised. The componentisation issue only arises under the cost model.

Restoration Provisions Assumed on Acquisition

Where the acquiree has an obligation to dismantle, remove or restore the leased premises, that obligation is a liability assumed in the business combination. It is recognised separately and measured at its acquisition-date fair value.

The point to watch is that it does not increase the acquisition-date right-of-use asset. IFRS 3.28B defines the right-of-use asset as the lease liability adjusted only for off-market terms — restoration costs are not part of that formula.

This is a real difference from a lease measured at commencement under IFRS 16, where the present value of restoration costs forms part of the initial cost of the right-of-use asset. See our article on rehabilitation provisions under IFRS 16 for that treatment.

After the acquisition date, the provision unwinds through finance costs and is remeasured under IFRIC 1 in the normal way — with subsequent IFRIC 1 remeasurements once again adjusting the right-of-use asset.

Deferred Tax and the Effect on Goodwill

Deferred tax is recognised on the temporary differences between the acquisition-date carrying amounts of the right-of-use asset and lease liability and their respective tax bases.

Two points matter here:

• The initial recognition exemption in IAS 12 does not apply to assets and liabilities recognised in a business combination. Deferred tax is recognised in full.
• The resulting deferred tax balance forms part of the identifiable net assets acquired, and therefore feeds back into the goodwill calculation.

Because the acquisition-date lease amounts differ from the amounts in the acquiree's own books, the group's deferred tax on the lease will differ from the subsidiary's — producing a further consolidation adjustment in each subsequent period.

South African readers should also work through the interaction with section 23C and the tax base of the lease obligation, covered in our article on the tax treatment of leases in South Africa.

Subsequent Consolidation Adjustments

The acquired subsidiary carries on accounting for the lease in its own separate financial statements using its original commencement-date amounts and its original discount rate. Nothing in IFRS 3 changes the subsidiary's books. The group, however, carries the remeasured acquisition-date amounts.

The two sets of numbers therefore diverge every period, and pro-forma consolidation journals are required for the remainder of the lease term — exactly as they would be for any other revaluation of identifiable net assets at acquisition.

Continuing the lessee example — year ended 31 December 2026

Pro-forma consolidation journal for the year

Note that the lease payment of 100,000 is identical in both sets of records and requires no adjustment — only the split between interest and capital differs.

The adjustments unwind to nil over the remaining lease term, but they must be repeated and rolled forward every period until they do. Deferred tax on each of these adjustments follows.

Pre-Existing Lease Relationships

A special case arises where the acquirer was already leasing to, or from, the acquiree before the business combination.

This is a pre-existing relationship under IFRS 3.51 to 53. The business combination effectively settles it, and any gain or loss on that settlement is recognised in profit or loss separately from the acquisition accounting — it is not part of the consideration transferred and does not affect goodwill.

Where the contract is favourable or unfavourable relative to market, the settlement gain or loss is measured by reference to that off-market element, capped by any settlement provisions available to the counterparty.

From the acquisition date onwards, the lease becomes an intragroup transaction and is eliminated in full on consolidation. Our guide to intercompany leases sets out those elimination journals in detail.

Conclusion

Acquired leases are one of the few areas where IFRS 3 and IFRS 16 interact directly. The acquiree's carrying amounts are not carried forward: the liability is measured afresh at the acquisition date, the right-of-use asset takes its measurement from that liability plus an off-market adjustment, and no separate intangible is recognised for favourable terms.

Where the acquiree is the lessor, classification is frozen at inception, the underlying asset comes in at a fair value that already reflects the lease terms, and the off-market element is componentised so that it amortises over the lease term rather than the life of the asset.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.