Key Points
- Lease incentives reduce the right-of-use asset at commencement, not the lease liability.
- Common forms include rent-free periods, upfront cash payments, contributions toward fit-out costs, and assumption of the lessee's obligations under a pre-existing lease.
- A rent-free period on a ten-year office lease worth EUR 600,000 per year reduces the right-of-use asset by the present value of the forgone payments rather than being spread on a straight-line basis.
- Misclassifying an incentive as a separate capital contribution overstates the asset and distorts depreciation over the lease term.
What is Lease Incentive?
IFRS 16 Appendix A defines a lease incentive as a payment made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by the lessor of costs of the lessee. IFRS 16.24(b) requires the lessee to deduct any incentive received from the initial carrying amount of the right-of-use asset. The incentive does not reduce the lease liability, which is measured solely by reference to future lease payments under IFRS 16.26.
In practice, incentives take several forms. Landlords offer upfront cash contributions toward fit-out costs, reimburse removal costs from a previous premises, grant rent-free months at the start of the term, or assume obligations under the lessee's old lease. When a rent-free period exists, the lessee still recognises the full lease liability based on the contractual payment schedule (which shows zero payments during the rent-free months), so the incentive is already captured in the liability measurement. The IFRS 16.24(b) deduction from the right-of-use asset applies only to cash incentives or reimbursements not already reflected in the payment stream.
ISA 540.13(a) requires the auditor to evaluate whether the entity's measurement method for the right-of-use asset is appropriate. That evaluation covers verifying that any lessor contribution has been correctly identified as a lease incentive rather than treated as a separate capital grant.
Worked example: Schafer Elektrotechnik AG
Client: German electronics company, FY2025, revenue EUR 310M, IFRS reporter. On 1 January 2025, Schafer signs a ten-year lease on a 3,800 m² office floor in Frankfurt. Annual lease payments are EUR 420,000, payable at the end of each year. The lessor offers two incentives: a cash fit-out contribution of EUR 250,000 paid to Schafer on the commencement date, and two months of rent-free occupancy that are already reflected in the payment schedule (the first payment is due on 31 December 2025, not earlier). No extension options exist.
Step 1 — Determine the lease term
The non-cancellable period is ten years. There are no extension or termination options. The lease term is ten years.
Step 2 — Measure the lease liability
Schafer cannot determine the rate implicit in the lease. The incremental borrowing rate is 3.6%, based on a secured ten-year facility quoted by Deutsche Bank in December 2024. The present value of ten annual payments of EUR 420,000 discounted at 3.6% is EUR 3,444,719.
Step 3 — Identify the lease incentive
The rent-free months are already reflected in the payment schedule (the first EUR 420,000 payment falls on 31 December 2025, ten months into the lease). No separate deduction is needed for those months because the liability calculation already captures the payment timing. The EUR 250,000 cash fit-out contribution is a lease incentive under IFRS 16 Appendix A and must be deducted from the right-of-use asset under IFRS 16.24(b).
Step 4 — Measure the right-of-use asset at commencement
The right-of-use asset equals the lease liability (EUR 3,444,719) minus the lease incentive received (EUR 250,000), giving EUR 3,194,719. No prepayments or restoration obligations apply.
Conclusion: the right-of-use asset of EUR 3,194,719 is lower than the lease liability by the EUR 250,000 cash incentive, and the measurement is defensible because each component traces to a contractual document or external rate source.
Why it matters in practice
- Teams frequently record a cash incentive from the lessor as deferred income rather than deducting it from the right-of-use asset. IFRS 16.24(b) is explicit: lease incentives received reduce the asset, not the liability. The deferred-income treatment overstates the right-of-use asset and creates a fictitious liability that unwinds on a basis the standard does not support.
- Rent-free periods cause double-counting errors when the lessee deducts the forgone rent from the right-of-use asset while also measuring the lease liability based on the actual (reduced) payment stream. The rent-free months are already captured in the liability because the payment schedule includes the zero-payment periods. A separate deduction from the asset double-counts the incentive. ISA 315.25 requires the auditor to understand the entity's lease process well enough to catch this at the risk assessment stage.
Lease incentive vs. initial direct cost
| Dimension | Lease incentive | Initial direct cost |
|---|---|---|
| Direction of payment | Lessor pays the lessee (or bears a cost on the lessee's behalf) | Lessee pays a third party or the lessor for costs that would not have been incurred without the lease |
| Effect on right-of-use asset | Reduces the initial carrying amount under IFRS 16.24(b) | Increases the initial carrying amount under IFRS 16.24(c) |
| Typical examples | Fit-out contributions, rent-free periods, moving cost reimbursements, assumption of old lease obligations | Legal fees, brokerage commissions, stamp duty, permit fees |
| Audit focus | Verifying the payment qualifies as a lease incentive rather than a separate transaction or capital grant | Verifying the cost is incremental (would not have been incurred if the lease had not been signed) per IFRS 16 Appendix A |
| P&L effect over the lease | Lower depreciation charge because the asset starts at a smaller amount | Higher depreciation charge because the asset starts at a larger amount |
The distinction matters because misclassifying an initial direct cost as a lease incentive (or the reverse) shifts the right-of-use asset in the wrong direction at commencement and distorts depreciation over the full lease term.
Related terms
Frequently asked questions
How do I account for a rent-free period under IFRS 16?
The rent-free months feed directly into the payment schedule used to measure the lease liability under IFRS 16.26. Because the zero-payment months are already reflected in the discounted cash flows, no separate deduction from the right-of-use asset is needed. Depreciation on the right-of-use asset then spreads the cost over the full lease term.
Does a lease incentive affect the lease liability?
No. IFRS 16.26 measures the lease liability based on future lease payments only. The incentive reduces the right-of-use asset under IFRS 16.24(b), not the liability. If the incentive takes the form of reduced payments (such as rent-free months), those lower payments are already reflected in the liability measurement. Cash incentives received separately reduce only the asset.
When should the auditor challenge the classification of a lessor payment?
When the payment could be either a lease incentive or a separate transaction (for example, compensation for early termination of a previous lease with a different landlord). ISA 540.13(a) requires the auditor to evaluate whether the entity's method is appropriate. If the payment is contingent on entering the new lease, it is a lease incentive under IFRS 16 Appendix A regardless of how the contract labels it.