Rehabilitation Provisions For Leases Explained (With Examples) - IFRS 16

Rehabilitation provisions in lease accounting represent a lessee's obligation to restore, dismantle, or remove a leased asset at the end of the lease term, or to restore the site on which the asset is located.

Under IFRS 16, these decommissioning and restoration obligations are recognised as provisions under IAS 37 Provisions, Contingent Liabilities and Contingent Assets and form part of the initial cost of the right-of-use asset.

Common examples include obligations to:

• Remove tenant improvements and restore office premises to their original condition
• Decommission leased mining or drilling equipment
• Remove leasehold improvements from retail stores
• Restore leased land following excavation or construction activities

The accounting treatment differs fundamentally from lease payments because rehabilitation costs are not included in the lease liability. Instead, they increase the right-of-use asset and create a separate provision liability.

Initial Recognition and Measurement

At the commencement date of a lease with rehabilitation obligations, the lessee applies the following accounting treatment:

Step 1: Estimate the Restoration Costs

The lessee estimates the costs that will be incurred to fulfil the restoration obligation at the end of the lease term. This estimate should reflect:

• The most likely outcome or expected value of the restoration work
• Costs that a third party would charge to perform the work
• Technological advances and cost changes expected by the restoration date
• Risks and uncertainties surrounding the restoration activities

Step 2: Discount to Present Value

The estimated future restoration costs are discounted to present value using a current, pre-tax market-based discount rate as defined in IAS 37. This discount rate should reflect:

• Current market assessments of the time value of money
• Risks specific to the liability (if not already reflected in the cash flow estimates)

This discount rate is determined under IAS 37 and may differ from the incremental borrowing rate used for the lease liability under IFRS 16.

Step 3: Recognise the Provision and Adjust the Right-of-Use Asset

The present value of the restoration obligation is recognised as:

Dr Right-of-use asset (increase by provision amount)  
Cr Provision for rehabilitation (liability)

The right-of-use asset now comprises:

• The initial lease liability amount
• Any lease payments made at or before commencement
• Any initial direct costs
• The present value of estimated restoration costs
• Less any lease incentives received

Step 4: Amortise the Right-of-Use Asset

The right-of-use asset (including the rehabilitation component) is amortised over the shorter of:

• The lease term; or
• The useful life of the underlying asset (if ownership transfers or a purchase option will be exercised)

Step 5: Unwind the Discount on the Provision

Over the lease term, the provision is increased through unwinding of the discount. IFRIC 1 requires this unwinding to be recognised in profit or loss as a finance cost (capitalisation under IAS 23 is not permitted):

Dr Finance costs (unwinding of discount)  
Cr Provision for rehabilitation (increase to reflect passage of time)

Subsequent Measurement and Changes

After initial recognition, the rehabilitation provision is subject to:

• Unwinding of discount (recognised in profit or loss as finance costs)
• Changes in estimates or discount rates (accounted for under IFRIC 1)
• Changes in lease term (may affect the timing and amount of the provision)

The unwinding of discount represents the passage of time and is calculated by applying the discount rate to the provision's carrying amount. This is recognised in profit or loss each period and cannot be capitalised.

Changes in the measurement of the provision due to revised estimates or discount rates are addressed by IFRIC 1, which provides specific guidance on how such changes affect the right-of-use asset.

Changes in Rehabilitation Provisions (IFRIC 1)

IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities applies to changes in the measurement of rehabilitation provisions recognised as part of the cost of a right-of-use asset under IFRS 16.

Events Triggering Remeasurement

IFRIC 1 addresses how to account for changes resulting from:

• Changes in the estimated outflow of resources (for example, revised cost estimates)
• Changes in the estimated timing of the outflow
• Changes in the current market-based discount rate

Accounting Treatment Under the Cost Model

When the right-of-use asset is measured using the cost model (which is the standard approach under IFRS 16), changes in the provision are accounted for as follows:

For increases in the provision:

The increase is added to the cost of the right-of-use asset:

Dr Right-of-use asset
Cr Provision for rehabilitation

The entity must then consider whether this addition indicates that the new carrying amount may not be fully recoverable. If so, the asset must be tested for impairment under IAS 36.

For decreases in the provision:

The decrease is deducted from the cost of the right-of-use asset, but the deduction cannot exceed the asset's carrying amount:

Dr Provision for rehabilitation  
Cr Right-of-use asset (limited to carrying amount)

If the decrease exceeds the carrying amount of the asset, the excess is recognised immediately in profit or loss:

Dr Provision for rehabilitation  
Cr Right-of-use asset (reduce to zero)  
Cr Profit or loss (excess)

Depreciation of Adjusted Asset

Once the right-of-use asset has been adjusted for the change in the provision, the adjusted depreciable amount is depreciated prospectively over the asset's remaining useful life.

End of Asset's Useful Life

Once the right-of-use asset has reached the end of its useful life (i.e., it is fully amortised), all subsequent changes in the provision are recognised in profit or loss as they occur, as there is no remaining asset cost to adjust.

Unwinding of Discount

IFRIC 1 confirms that the periodic unwinding of the discount must be recognised in profit or loss as a finance cost as it occurs. Capitalisation under IAS 23 is not permitted.

Practical Example: Office Lease with Restoration

Facts:

ABC Ltd enters into a 5-year lease of office space commencing 1 January 2026. The lease contract requires ABC Ltd to remove all leasehold improvements and restore the premises to their original condition at lease end.

• Annual lease payments: £50,000 (paid at year-end)
• Incremental borrowing rate: 6% per annum
• Estimated restoration costs at lease end (31 December 2030): £25,000
• Current market-based discount rate for the provision: 5% per annum
• No initial direct costs or lease incentives

Initial Recognition (1 January 2026):

Lease liability:

Present value of 5 annual payments of £50,000 at 6%: PV = £50,000 × 4.2124 = £210,620

Rehabilitation provision:

Present value of £25,000 due in 5 years at 5%: PV = £25,000 / (1.05)^5 = £25,000 / 1.2763 = £19,588

Right-of-use asset:

Right-of-use asset = Lease liability + Rehabilitation provision = £210,620 + £19,588 = £230,208

Journal entry:

Year 1 (2026) Subsequent Measurement:

Annual depreciation of right-of-use asset: £230,208 / 5 years = £46,042

Unwinding of discount on provision: £19,588 × 5% = £979

Interest on lease liability: £210,620 × 6% = £12,637

Lease payment: £50,000 (reduces lease liability by £50,000 - £12,637 = £37,363)

Journal entries for Year 1:

Carrying amounts at 31 December 2026:

• Right-of-use asset: £230,208 - £46,042 = £184,166
• Lease liability: £210,620 + £12,637 - £50,000 = £173,257
• Provision for rehabilitation: £19,588 + £979 = £20,567

Remeasurement in Year 3 (2028) - IFRIC 1 Application:

On 1 January 2028, ABC Ltd revises its estimate of restoration costs to £30,000 (previously £25,000) due to increased labour costs. The discount rate remains 5%.

Present value of £30,000 due in 3 years at 5%: PV = £30,000 / (1.05)^3 = £30,000 / 1.1576 = £25,918

Carrying amount of provision at 1 January 2028 (before remeasurement): Original provision: £19,588 Unwinding Year 1: £979 Unwinding Year 2: £20,567 × 5% = £1,028 Carrying amount: £21,595

Increase required: £25,918 - £21,595 = £4,323

Journal entry (1 January 2028) per IFRIC 1:

The carrying amount of the right-of-use asset at 1 January 2028 before adjustment: Original cost: £230,208 Accumulated depreciation (2 years): £46,042 × 2 = £92,084 Carrying amount: £138,124

After IFRIC 1 adjustment: New carrying amount: £138,124 + £4,323 = £142,447

The adjusted carrying amount is then amortised over the remaining 3 years: Revised annual depreciation: £142,447 / 3 years = £47,482

Rehabilitation Funds (IFRIC 5)

In some cases, lessees may contribute to decommissioning funds that are established to finance future rehabilitation costs. IFRIC 5 Rights to Interests arising from Decommissioning, Restoration and Environmental Rehabilitation Funds provides guidance on how to account for interests in such funds.

When IFRIC 5 Applies

IFRIC 5 applies when a lessee contributes to a decommissioning fund that has both of the following features:

• The fund's assets are administered separately (either in a separate legal entity or as segregated assets)
• The contributor's right to access the fund's assets is restricted

These funds may be established by a single contributor or multiple contributors, and may be voluntary or required by regulation.

Accounting Treatment

Under IFRIC 5, the lessee must recognise both:

• The full decommissioning obligation as a liability (as part of the right-of-use asset under IFRS 16)
• A separate reimbursement right representing its interest in the fund

The key principle is that contributing to a fund does not eliminate the lessee's obligation to pay decommissioning costs.

Measuring the Reimbursement Right

If the lessee does not have control, joint control, or significant influence over the fund, the reimbursement right is measured at the lower of:

• The amount of the decommissioning obligation recognised; and
• The contributor's share of the fair value of the fund's net assets

This means the reimbursement asset cannot exceed the decommissioning liability.

Recognition in Profit or Loss

Changes in the carrying value of the reimbursement right (other than contributions to and payments from the fund) are recognised in profit or loss in the period in which they occur.

Example: Fund Contribution

Continuing the ABC Ltd example, assume ABC Ltd is required to contribute £18,000 to a restoration fund at lease commencement. At 1 January 2026:

The reimbursement right is initially measured at the amount paid. Subsequently, if the fund's fair value increases to £20,000 but the decommissioning obligation is only £19,588, the reimbursement right is capped at £19,588 (the lower amount).

Additional Contributions

If the lessee has an obligation to make potential additional contributions (for example, if the fund's assets are insufficient or another contributor becomes bankrupt), this is a contingent liability under IAS 37. A liability is recognised only if it is probable that additional contributions will be made.

Disclosure Requirements Under IFRIC 5

Lessees must disclose:

• The nature of their interest in the fund
• Any restrictions on access to the fund's assets
• Contingent liability disclosures if there is an unrecognised obligation to make additional contributions

Disclosure Requirements

Lessees must provide disclosures for rehabilitation provisions under IFRS 16, IAS 37, IFRIC 1, and IFRIC 5 (if applicable).

IFRS 16 Disclosures

Under IFRS 16, lessees disclose:

• The carrying amount of right-of-use assets by class of underlying asset (which includes any rehabilitation provision adjustments)
• Additions to right-of-use assets during the period (including new rehabilitation provisions)
• The maturity analysis of lease liabilities (separate from provisions)

IAS 37 Disclosures

Under IAS 37, lessees disclose for each class of provision:

• A reconciliation showing:
  • The carrying amount at the beginning and end of the period
  • Additional provisions made (including new leases)
  • Amounts used during the period (actual restoration costs incurred)
  • Unused amounts reversed
  • Increase from unwinding of discount
  • Changes from remeasurement (IFRIC 1 adjustments)
• A brief description of the nature of the obligation and expected timing
• Uncertainties about the amount or timing of outflows
• The discount rate(s) used

IFRIC 1 Disclosure Considerations

While IFRIC 1 does not mandate specific disclosures, entities should ensure that changes in rehabilitation provisions and their impact on right-of-use assets are clearly presented in the IAS 37 provision reconciliation.

IFRIC 5 Disclosures

When IFRIC 5 applies, lessees must additionally disclose:

• The nature of their interest in decommissioning funds
• Any restrictions on access to fund assets
• Contingent liability disclosures for unrecognised obligations to make additional contributions

Presentation

In the statement of financial position:

• Right-of-use assets are presented separately or disclosed in the notes
• Provisions are presented as current or non-current based on expected settlement timing
• Lease liabilities are presented separately from provisions
• Reimbursement rights (IFRIC 5) are presented as separate assets

In the statement of profit or loss:

• Depreciation of right-of-use assets is included in operating expenses
• Unwinding of discount on provisions is presented as finance costs (cannot be capitalised)
• Interest on lease liabilities is presented as finance costs
• Changes in reimbursement rights (IFRIC 5) are presented in profit or loss

Conclusion

Accounting for leases with rehabilitation provisions under IFRS 16 requires careful application of multiple standards. Lessees must recognise decommissioning obligations as additions to the right-of-use asset at lease commencement, apply IFRIC 1 when remeasuring these provisions to adjust the asset rather than profit or loss, and ensure that the periodic unwinding of discount is expensed as finance costs.

When decommissioning funds are involved, IFRIC 5 requires recognition of both the full obligation and the reimbursement right, with the reimbursement asset capped at the lower of the obligation and the fund's attributable fair value.

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