IFRS 16: Lease calculations

New to this topic?

What it is: IFRS 16 is the standard for leases. A lease is a contract to use an asset, such as an office or a van, in return for payments over time.

Why it matters: A lease is similar to borrowing money to buy the use of an asset. So the company must show it on the balance sheet.

What you do: Record two things. (1) A right-of-use asset: the right to use the item. (2) A lease liability: the present value of the payments still to be made. Depreciate the asset. Add interest to the liability each year.

Example. A van is leased for £5,000 a year for 5 years. At 6% interest, the present value of the payments is about £21,060. The company records a right-of-use asset of £21,060 and a lease liability of £21,060.

Key words

Lessee: The business that rents an asset under a lease and pays for using it.Example: Northwell Fitness rents gym machines, so it is the lessee.
Right-of-use asset: The asset a lessee records for its right to use a leased item. It is depreciated over the lease.Example: A right-of-use asset of £97,405 for leased gym equipment.
Lease liability: The amount a lessee owes for a lease, measured as the present value (today’s value) of the lease payments still to be made.Example: 5 payments of £24,000 discounted at 7% gives a lease liability of £98,405.
Incremental borrowing rate: The interest rate a company would pay to borrow a similar amount, for a similar time, with similar security. It is used to discount lease payments when the lease’s own rate is not known.Example: Northwell would pay 7% to borrow for 5 years, so 7% is used for its 5-year lease.
Low-value asset: A cheap asset, such as a laptop or tablet. A lessee can choose to expense its lease payments instead of putting the lease on the balance sheet.Example: Leasing 4 tablets for reception.

Learn

Under IFRS 16, the company using a leased asset (the lessee) puts almost every lease on its balance sheet. It records a right-of-use asset and a lease liability.

Exemptions

The lessee can choose not to do this for two types of lease: short-term leases (12 months or less, with no option to buy) and low-value assets (such as laptops or phones). For these, the payments are an expense, spread evenly over the lease.

At the start of the lease

Lease liability = Present value of the lease payments not yet paid

Use the interest rate in the lease. If that is not known, use the rate the lessee would pay to borrow the money. For equal payments made at the end of each year: present value = payment × annuity factor. The annuity factor = (1 − (1 + r)⁻ⁿ) ÷ r, where r is the interest rate and n is the number of payments.

Right-of-use asset = Lease liability + Payments made at or before the start + Direct costs of setting up the lease + Cost of removing the asset at the end − Incentives received

After the start

Liability: add interest and take off the payments.
- Payments at the end of the year (in arrears): closing = opening + interest − payment.
- Payments at the start of the year (in advance): take off the payment first, then add interest on what is left.
Right-of-use asset: depreciate it over the lease term or the useful life, whichever is shorter. If the lessee will own the asset at the end, use the useful life.
Profit or loss shows depreciation and interest. It does not show rent.

Example: 3 payments of £10,000 at the end of each year. Rate 5%. Annuity factor = 2.7232. Liability at the start = £10,000 × 2.7232 = £27,232. Year 1: £27,232 + interest £1,362 − £10,000 = £18,594. Year 2: £18,594 + £930 − £10,000 = £9,524.

Current and non-current

The part of the liability paid off in the next 12 months is current. A quick way to find it: this year’s closing balance − next year’s closing balance. Example: £18,594 − £9,524 = £9,070 current. The other £9,524 is non-current.

Watch it explained

Press play to watch the animation, or step through it at your own pace with the arrows.

Videos from YouTube tutors

These videos are made by independent tutors on YouTube, not by Trial Balance. Some use US terms or older exam names (for example F7 for FR), but the principles are the same.

Worked example

A company leases a machine for 5 years. It pays £10,000 a year in arrears. The interest rate implicit in the lease is 6%. It paid £1,000 of legal fees to set up the lease. The machine’s useful life is 7 years.

Working	£
Annuity factor, 5 years at 6%	4.2124
Lease liability (10,000 × 4.2124)	42,124
Add: Initial direct costs	1,000
Right-of-use asset	43,124
Depreciation over the 5-year lease term	8,625 a year

Year	Opening £	Interest at 6% £	Payment £	Closing £
1	42,124	2,527	(10,000)	34,651
2	34,651	2,079	(10,000)	26,730

At the end of year 1: non-current liability £26,730, current liability £34,651 − £26,730 = £7,921.

Account	Dr £	Cr £
Right-of-use asset	43,124
Lease liability		42,124
Cash		1,000
(Recognition of the machine lease at commencement)

Practice questions

Type or choose your answers, then press Check answer. Questions with a New numbers button can be repeated with different figures.