IFRS 16 Training:

Initial Measurement

Introduction

You’ve established that your contract is in scope for IFRS 16 by following the previous guide. You now need to calculate the value to bring on to the balance sheet. This will be in the form of the “Lease Liability” and “Right-of-use asset”. Note that we will specifically look at the transaction from the lessee’s point of view, but the math is very similar if you are the lessor.

So, keep the contract right next to you (or the make-believe contract) because we are finally going to use the amounts and start with the math of it all.

In this guide we will look at the inputs of the calculation and the calculation itself. At the end of this guide, you will be able to download an interactive Excel workbook that shows you exactly how the calculation is performed.

And lastly, we will finish it off with the journals that you have to process.

Lease Liability

The lease liability is simply calculated as the present value of the expected payments you will make after the lease started. If you are unsure what is meant by present value, this is the value of all future payments, discounted to a value today. This is often referred to the “time value of money”. If you use Excel a lot, this is generally calculated using the “PV” or “NPV” formula. If you are still unsure, numerous resources on the internet will be able to help you.

Discount rate
A key input to the present value calculation, is the discount rate or interest rate that you have to use. The standard says to first consider the rate implicit in the lease. In this case, you need to know what the value of the asset is and then you calculate the interest rate that equals that value. In other words, you would need all the inputs to determine the discount rate. Usually lessors don’t disclose this, because it is the “profit’ they are generating from this transaction.

In practice it is very rare for the lessee to know the exact value of the asset, so in the vast majority of cases you’ll use your company’s incremental borrow rate (IBR). That’s just a fancy way to say what rate a bank would charge if you had to take a similar type of loan from them.

Note that your IBR will typically be linked to the local interest rate but adjusted specifically for your entity. Assuming there are no changes to the lease you would never have to update this interest rate during the lease period. You just use the rate at inception and don’t touch it again (unless you need to modify the lease which we’ll discuss in later in the training).

A nice thing to remember is that you are allowed to use a single discount rate to a portfolio of leases if the IBR is used. In other words, you can apply one rate for all your vehicles, because it is in one asset class.

Payments to include
The standard goes into a lot of detail which payments should be included, but in practice it is fairly obvious what to include and what not to include:

  • Any fixed (or as good as fixed) payments gets included
  • Any payments that you are reasonably certain you’ll make, should be included (termination penalties, residual value guarantees, purchase options)
  • Variable payments are excluded (expensed as incurred)
  • Payments made before commencements are excluded, but included in the asset calculation

A question that often arises is what do to with escalating payments and the answer is quite simple:

  • If the escalation is fixed (for instance 5% annually), you include that in the calculation; or
  • If the escalation is linked to an index (such as inflation), you simply pretend it isn’t linked to anything and use the current payment until the end.

The IASB thought IFRS 16 was complex enough and didn’t want people to estimate how inflation and other indexes would affect their lease payments. The obvious question is then, what should you do when the payment actually changes? In short, you recalculate the liability with the updated payments, but this will be discussed in detail later in this training.

Lease Term

A key consideration for the lease liability calculation is the lease term, which is often directly from the contract. This is the period that the asset will be used for. The standard defines this as the “non-cancellable period of a lease”.

There are a lot of factors to consider if the contract has a bit more clauses than standard contracts and in particular renewal clauses. If you are reasonably certain that the contract will be renewed, then you include the expected payments of the extension in the calculation.

Other factors to consider is if you plan to terminate the contract early in which case the termination penalty should be included (if applicable). Your lease liability calculation will start on commencement date (when you start using the asset), so any rent-free periods have to be included in the lease term.

In summary, you use all the payments that you are reasonably certain you’ll make by taking renewal and termination options into account. This requires judgement and will be assessed based on your company’s accounting policies for IFRS 16.

Right-of-use Asset

The liability that you have recognized will result in an asset (the Right-of-use Asset). In most cases, the value of the right-of-use asset will be equal to the lease liability. Only if any payments were made (or received) before the start of the lease, will it be added (or subtracted) to (from) the asset.

In summary, the initial measurement of the Right-of-use asset will equal the following:

  • Start with the Lease liability
  • Plus: Initial payments made before commencement date
  • Plus: Initial direct cost incurred
  • Plus: Provisions for dismantling/Restoration cost (IAS 37)
  • Less: Any lease incentives that were received

Useful life considerations
The useful life of the right-of-use asset will usually equal the lease term. However, you would have to consider if a purchase option will be exercised, because it will impact the useful life. The useful life of the asset will then be determined by how long you will use the asset and not the lease term.

Journals

Once you have the initial liability and asset balances then the hard part is done. You now just need to ensure it goes to the right accounts.

Below are some example journals of the initial recognition for a lease:

The lease take-on journal:
Debit – Right-of-use Asset
Credit – Lease Liability

Payments made before the lease commenced:
Debit – Right-of-use Asset
Credit – Bank

Sometimes a lease contract will have restoration costs/dilapidation provisions:
Debit – Right-of-use Asset
Credit – Provision for Restoration
Restoration Provisions is not part of IFRS 16, but part of IAS 37 and you have to disclose it separately. I.e., don’t include it in your lease liability.

Closing

After the initial measurement is done and you have recognized your lease liability and asset, all you need to do is to amortize it to the end.

With the Rubli lease tool, you have access to a flexible lease model that automatically accounts for any type of lease, even if you have a lease with irregular payments.

In our next guide, we will look at the monthly journals that need to be captured to roll the asset and liability balance down to zero.

Download Excel Example Workbook
Initial Measurement Table of Contents

More guides:

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