Key Points
- The lease liability is measured at commencement using the present value of lease payments, discounted at the rate implicit in the lease or the lessee's incremental borrowing rate (IBR).
- Subsequent measurement splits each payment into an interest charge (profit or loss) and a principal reduction (balance sheet).
- IFRS 16.5 exempts leases of 12 months or less and low-value assets (typically below approximately EUR 5,000) from liability recognition.
- Understating the liability by excluding enforceable extension periods misstates both debt covenants and the related right-of-use (ROU) asset.
What is a lease liability?
On about half the IFRS 16 files we review, the lease liability is the single largest source of audit adjustments. The number itself looks deceptively simple (discount a payment schedule), but the inputs feeding it (discount rate, lease term, payment inclusions, extension assessments) each carry estimation risk that compounds across a portfolio of contracts. Getting comfortable with how the liability works is the difference between signing off on a number and actually understanding what you signed.
IFRS 16.26 requires the lessee to measure the lease liability at commencement as the present value of payments not yet made. Those payments include fixed amounts, in-substance fixed payments, variable payments tied to an index or rate, amounts expected to be paid under residual value guarantees, and the exercise price of a purchase option the lessee is reasonably certain to exercise. Penalties for terminating the lease also factor in if the lease term reflects that termination.
The discount rate is the rate implicit in the lease when it can be readily determined. At firms like ours, most mid-tier audit clients cannot extract the implicit rate from the lessor's pricing, so IFRS 16.26 (b) defaults to the lessee's incremental borrowing rate. After initial recognition, the liability accretes interest and decreases with each payment ( IFRS 16.36 ). The interest charge is calculated on the opening balance each period, producing a front-loaded expense pattern that raises total charges in early years relative to the straight-line operating lease model under the old IAS 17 .
Remeasurement occurs when the lease term or expected payments change. IFRS 16.40 requires the lessee to remeasure the liability using a revised discount rate if the lease term changes or if the assessment of a purchase option changes. ISA 540.13 (a) directs the auditor to evaluate whether the entity's method for measuring the liability is appropriate, covering the discount rate selection and the payment assumptions feeding the calculation.
Worked example: Groupe Lefevre S.A.
Client: Belgian holding company, FY2025, revenue EUR 185M, IFRS reporter. Groupe Lefevre signs a ten-year lease on a 2,200 m² office floor in Brussels, commencing 1 January 2025. Annual lease payments are EUR 480,000, payable at the start of each year (annuity-due). The contract includes a five-year extension option. Groupe Lefevre has fitted out the floor with EUR 1.2M of leasehold improvements, making it reasonably certain the extension will be exercised. No purchase option exists.
Step 1. Determine the lease term
The non-cancellable period is ten years. Because the leasehold improvements create a significant economic incentive to extend, IFRS 16.19 requires inclusion of the five-year extension period. The lease term is fifteen years.
Step 2. Determine the discount rate
The rate implicit in the lease is not available from the lessor. Groupe Lefevre's treasury team obtains a bank quote for a fifteen-year secured facility: 3.8%. This becomes the IBR per IFRS 16.26 (b).
Step 3. Calculate the present value at commencement
Fifteen annual payments of EUR 480,000, payable in advance (annuity-due), discounted at 3.8%. The present value of an annuity-due is calculated by multiplying the ordinary annuity factor by (1 + r). The ordinary annuity factor for 15 periods at 3.8% is 11.1184. Multiply by 1.038 to convert to annuity-due: 11.5409. The lease liability at commencement is EUR 480,000 multiplied by 11.5409, giving EUR 5,539,632.
Step 4. Subsequent measurement at 31 December 2025
The first payment of EUR 480,000 was made on 1 January 2025 (commencement date), reducing the liability to EUR 5,059,632. Interest for the year accrues on this balance: EUR 5,059,632 multiplied by 3.8% gives EUR 192,266. The closing lease liability at 31 December 2025 is EUR 5,059,632 plus EUR 192,266, totalling EUR 5,251,898 (before the second payment on 1 January 2026).
Conclusion: the lease liability of EUR 5,539,632 at commencement reflects a fifteen-year term driven by the extension option assessment. The measurement is defensible because the discount rate and payment timing each trace to documented evidence.
Why it matters in practice
- Teams frequently measure the lease liability using the non-cancellable period only, ignoring enforceable extension options that the lessee is reasonably certain to exercise. IFRS 16.19 requires inclusion of optional periods when there is a significant economic incentive to extend. Omitting these periods understates both the liability and the paired ROU asset, distorting gearing ratios. We have seen managers simply roll the prior-year lease schedule forward (the SALY approach) without re-examining whether the extension assessment still holds.
- The IBR is often applied as a single entity-wide rate. IFRS 16.26 specifies that the rate must reflect the terms and conditions of the individual lease, including term and currency. ISA 540.13 (b) requires the auditor to evaluate whether the data supporting the rate is appropriate for that specific lease. A blanket rate applied across leases of different jurisdictions and durations fails this test.
- Getting the lease liability right is genuinely frustrating when clients hand you a spreadsheet with 200 contracts and no supporting rate documentation. The file should tell a story, but on too many engagements the lease schedule is the last thing prepared and the first thing that falls apart under review.
Lease liability vs. operating lease expense ( IAS 17 )
| Dimension | Lease liability ( IFRS 16 ) | Operating lease expense (old IAS 17 ) |
|---|---|---|
| Balance sheet recognition | Full present value of payments recognised as a liability from commencement | No liability recognised; payments expensed on a straight-line basis |
| Expense profile | Front-loaded: higher combined interest and depreciation in early years | Flat: equal expense each period over the lease term |
| Debt covenants | Increases reported debt, affecting gearing and interest coverage ratios | No impact on reported debt; off-balance-sheet treatment |
| EBITDA effect | Lease payments no longer deducted above EBITDA; only depreciation and interest appear below | Full lease expense deducted above EBITDA |
| Audit focus | Discount rate, lease term assessment, remeasurement triggers, completeness of population | Straight-line calculation, completeness of operating lease commitments note |
The distinction matters on transition engagements and whenever an entity compares pre-2019 and post-2019 financial metrics. Lenders who set covenants before IFRS 16 took effect may still reference frozen IAS 17 definitions in loan agreements, creating a dual-tracking requirement the auditor needs to verify.
Related terms
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Jurisdiction notes
IFRS 16 lease liability measurement involves significant estimates. In the United Kingdom, the FRC has identified the determination of the incremental borrowing rate and the assessment of lease term extension options as common audit deficiencies for IFRS 16 engagements. In the Netherlands, the AFM expects auditors to evaluate whether all leases have been identified and whether the discount rate applied reflects the entity’s specific credit risk and the lease characteristics. In Australia, ASIC has highlighted lease accounting under AASB 16 as a focus area, particularly the completeness of the lease population and the appropriateness of practical expedients applied.
In the United States, lease accounting follows ASC 842, Leases, which is broadly converged with IFRS 16 for lessee accounting but retains the distinction between finance leases and operating leases on the income statement (unlike IFRS 16 , which treats all leases as finance-type). Auditors apply AU-C 540 (non-public) or PCAOB standards for evaluating lease-related estimates, including the IBR and lease term. PCAOB inspection findings have cited deficiencies in auditors’ evaluation of the completeness of the lease population and the reasonableness of the IBR used to discount lease liabilities. The SEC has also issued comment letters on ASC 842 disclosures, focusing on the qualitative and quantitative information about leasing activities.
Frequently asked questions
How do I audit the lease liability discount rate?
Obtain the entity's rate-setting methodology and compare the selected rate to observable borrowing costs for facilities with a similar term and security profile. ISA 540.18 requires the auditor to evaluate whether management's assumptions are reasonable. If the entity has recent loan agreements, use those rates as a benchmark after adjusting for differences in collateral and tenor.
When does a lease liability need to be remeasured?
IFRS 16.40 requires remeasurement when the lease term changes or when the assessment of a purchase option changes. It also applies when expected payments under residual value guarantees or variable payments linked to an index are revised. The lessee remeasures using a revised discount rate for lease term and purchase option changes, but uses the original rate for index-linked payment updates per IFRS 16.42.
Does a lease liability appear on the cash flow statement?
IAS 7.17 classifies the principal portion of lease payments as a financing activity. The interest portion follows the entity's policy for interest paid (operating or financing). IFRS 16 does not override IAS 7, so the lessee must split each payment between principal and interest in the cash flow statement.