Key Takeaways
- The lease liability is the present value of future lease payments at commencement date
- Use the rate implicit in the lease if available, otherwise use the incremental borrowing rate (IBR)
- Include fixed payments, index-linked payments, and amounts expected under purchase options or guarantees
- Exclude variable payments that depend on usage or performance
- The discount rate is fixed at commencement unless specific remeasurement events occur
What is a Lease Liability?
The lease liability represents the present value of all lease payments a lessee expects to make over the lease term. It's recognised on the balance sheet at the lease commencement date - the point when the lessor makes the underlying asset available for use.
The lease liability is paired with a corresponding right-of-use asset, which together bring the economic substance of lease arrangements onto the balance sheet.
IFRS 16 Definition
"At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date."
- IFRS 16.26
Calculating the Lease Liability
The lease liability calculation requires two key inputs:
- The lease payments to include in the measurement
- The discount rate to apply to those payments
The present value concept reflects the "time value of money" - the principle that money available today is worth more than the same amount in the future due to its potential earning capacity.
Which Payments to Include
IFRS 16.27 specifies which payments to include in the lease liability measurement:
Include These Payments
Exclude These Payments
- Variable payments that depend on usage or performance (e.g., turnover rent, mileage-based payments) - these are expensed as incurred
- Payments made on or before commencement - these are included in the right-of-use asset instead
- Service components if separated from the lease. Many contracts bundle a lease with services (e.g. a building lease that includes cleaning and maintenance). IFRS 16 requires the lease and non-lease components to be separated, with only the lease component included in the liability. As a practical expedient, lessees can elect (by class of underlying asset) to account for each lease component and its associated non-lease components together as a single lease component
Handling Escalations
- Fixed escalations (e.g. 5% annually). Include every future escalated amount in the calculation
- Index-linked escalations (e.g. CPI). Use the current indexed payment amount for all future periods. When the contractual rent review takes effect and the payment adjusts, remeasure the lease liability using the revised payment. The IASB took this approach because IFRS 16 is complex enough without requiring companies to forecast inflation or other indices
The Discount Rate
IFRS 16 specifies a hierarchy for determining the discount rate:
Rate Implicit in the Lease
Use this rate if it can be readily determined. This is effectively the internal rate of return (IRR) on the lessor's investment: the rate that causes the present value of lease payments plus the unguaranteed residual value to equal the fair value of the underlying asset plus initial direct costs of the lessor.
In practice: This rate is rarely available to lessees because it requires knowing the asset's fair value and the lessor's initial costs.
Incremental Borrowing Rate (IBR)
If the implicit rate cannot be readily determined, use the lessee's incremental borrowing rate - the rate the lessee would have to pay to borrow funds to obtain an asset of similar value in a similar economic environment over a similar term with similar security.
In practice: Most lessees use the IBR. It should reflect the lessee's credit risk, the lease term, and the currency of the lease payments.
Portfolio approach: IFRS 16 permits using a single discount rate for a portfolio of leases with reasonably similar characteristics, provided the result would not differ materially from applying individual rates. Typical groupings include same asset class, similar remaining term, and same currency. This practical expedient can significantly reduce the complexity of determining rates for large lease portfolios.
For detailed guidance on determining the IBR, see our Discount Rates & IBR guide.
Present Value Calculation Methods
There are several ways to calculate the present value of lease payments. All follow the same principle - discounting future cash flows - but differ in flexibility and precision.
| Method | Excel Formula | Best For | Limitations |
|---|---|---|---|
| PV | =PV(rate, nper, pmt) | Simple leases with equal, evenly-spaced payments | Cannot handle escalations or irregular payments |
| NPV | =NPV(rate, values) | Leases with varying payment amounts but regular intervals | Assumes equal periods; requires a payment table |
| XNPV | =XNPV(rate, values, dates) | Any payment structure including irregular timing | Requires a payment table with specific dates |
Which Method is Most Accurate?
The XNPV method provides the most accurate calculation because it accounts for the exact timing of each payment, including:
- Months with different numbers of days
- Leap years
- Irregular payment dates
For simple leases with monthly payments of equal amounts, the PV formula may be sufficient. However, most real-world leases have escalations, rent-free periods, or other complexities that require NPV or XNPV.
Excel Limitations at Scale
For organisations with large lease portfolios, managing individual payment tables for each lease in Excel becomes unwieldy and error-prone - particularly when handling modifications, remeasurements, and multi-currency leases. This is where dedicated lease accounting software provides significant advantages.
Worked Example
Scenario
A company enters into a 5-year property lease with the following terms:
- Annual rent: £120,000, payable at the end of each year
- 5% annual escalation (fixed)
- No renewal or purchase options
- Incremental borrowing rate: 6%
Step 1: Determine the Lease Payments
| Year | Payment |
|---|---|
| 1 | £120,000 |
| 2 | £126,000 |
| 3 | £132,300 |
| 4 | £138,915 |
| 5 | £145,861 |
| Total | £663,076 |
Step 2: Calculate the Present Value
Discount each payment back to the commencement date using the 6% IBR:
| Year | Payment | Discount Factor | Present Value |
|---|---|---|---|
| 1 | £120,000 | 1 ÷ 1.06¹ = 0.9434 | £113,208 |
| 2 | £126,000 | 1 ÷ 1.06² = 0.8900 | £112,140 |
| 3 | £132,300 | 1 ÷ 1.06³ = 0.8396 | £111,080 |
| 4 | £138,915 | 1 ÷ 1.06⁴ = 0.7921 | £110,033 |
| 5 | £145,861 | 1 ÷ 1.06⁵ = 0.7473 | £108,995 |
| Total | £663,076 | £555,456 |
Step 3: Initial Recognition
The lease liability at commencement is £555,456. (Figures throughout this example are rounded to the nearest pound.)
Subsequent Measurement
After initial recognition, the lease liability is measured using the effective interest method:
- Increase the liability by interest expense each period, calculated using the effective interest method
- Decrease the liability by lease payments made
Amortisation Schedule
Continuing our example:
| Year | Opening Balance | Interest (6%) | Payment | Closing Balance |
|---|---|---|---|---|
| 1 | 555,456 | 33,327 | (120,000) | 468,783 |
| 2 | 468,783 | 28,127 | (126,000) | 370,910 |
| 3 | 370,910 | 22,255 | (132,300) | 260,865 |
| 4 | 260,865 | 15,652 | (138,915) | 137,602 |
| 5 | 137,602 | 8,259 | (145,861) | 0 |
| Total | 107,620 | (663,076) |
Each payment is split between interest and principal. In this example, total interest (£107,620) plus the initial liability (£555,456) equals total payments (£663,076), confirming the schedule unwinds to zero. If the lease is remeasured during the term (e.g. due to an index-linked adjustment), the totals will differ because the liability resets at the remeasurement date.
Periodic Journal Entries
When to Remeasure the Lease Liability
The lease liability must be remeasured when certain events occur. The type of event determines whether to use an updated discount rate or the original rate.
| Event | Discount Rate |
|---|---|
| Change in lease term assessment | Revised rate |
| Change in purchase option assessment | Revised rate |
| Change in amounts expected under residual value guarantees | Original rate |
| Change in payments due to index or non-floating rate | Original rate |
| Change in payments due to floating interest rate | Revised rate |
| Lease modification (not a separate lease) | Revised rate |
For detailed guidance, see our articles on remeasurements and modifications.
Presentation and Disclosure
Balance Sheet
Lease liabilities must be presented separately from other liabilities, or the line items that include them must be disclosed. Where a current/non-current balance sheet is used (as most entities do), they should be split between:
- Current portion - the amount of the liability expected to be settled within 12 months (based on the amortisation schedule, not simply the next payment)
- Non-current portion - the remainder
Cash Flow Statement
- Principal repayments - financing activities
- Interest payments - either financing or operating activities (consistent with other interest)
Required Disclosures
Key disclosures for lease liabilities include:
- Maturity analysis of lease liabilities showing undiscounted cash flows, typically split into time bands (within 1 year, 1-2 years, 2-5 years, and over 5 years), with a reconciliation to the discounted liability on the balance sheet
- Interest expense on lease liabilities
- Total cash outflow for leases
For a complete checklist, see our Disclosure Requirements guide.
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.