Financial Reporting · Leasing

IFRS 16 Right-of-Use Asset and Lease Liability Initial Measurement

Updated 11 October 2026 · Fact-checked

Under IFRS 16 a lessee recognises a lease liability at the present value of unpaid lease payments, discounted at the rate implicit in the lease or, if not known, the incremental borrowing rate. The right-of-use asset equals that liability plus payments made at or before the start and initial direct costs, less incentives received.

Understand Lessee Accounting: Right-of-Use Asset and Lease Liability

Before IFRS 16, many leases stayed off the statement of financial position. Now a lessee shows almost every lease as a purchase on credit. You get the right to use an asset, and you owe the lessor payments. So you record an asset and a liability.

The lease liability is the present value of lease payments not yet paid at the commencement date. Commencement date is when the lessor makes the asset available for use. You discount the payments, because money paid later is worth less than money paid now.

The discount rate is the interest rate implicit in the lease if it can be readily determined. If not, use the lessee's incremental borrowing rate. In FR the question normally gives you the rate to use.

The right-of-use asset starts at the lease liability. Then you add any lease payments made at or before commencement (such as a first payment in advance), and any initial direct costs (for example legal fees and commission that arose only because you signed this lease). You also add estimated costs of dismantling or restoring the asset where the lease requires it. You deduct lease incentives received from the lessor.

A refundable deposit is not a lease payment. It is a financial asset. Leave it out of both the liability and the asset, unless the question tells you otherwise.

Key rules to remember

Lease liability at commencement: Lease liability = Σ [ lease payment ÷ (1 + r)^t ] for all unpaid payments; r is the implicit rate or incremental borrowing rate. t is the number of periods until each payment. Payments in advance have t = 0 for the first one.
Annuity of equal payments in arrears: PV = payment × [1 − (1 + r)^−n] ÷ r; Use the cumulative discount factor if the question provides one.
Right-of-use asset at commencement: ROU asset = lease liability + payments made at or before commencement + initial direct costs + restoration cost estimate − incentives received; Add all items in this list that apply. Ignore the ones the question does not mention.
Payments included in the liability: Fixed payments (less incentives receivable) + variable payments based on an index or rate + amounts under residual value guarantees + purchase option price if reasonably certain to be exercised + termination penalties if the term assumes termination; Variable payments linked to sales or usage are excluded and expensed when incurred.
Lease term: Lease term = non-cancellable period + optional periods if reasonably certain to be used; Extension options reasonably certain to be exercised extend the term.

How to solve Lessee Accounting: Right-of-Use Asset and Lease Liability questions

Use this order for any initial measurement question. It keeps each figure separate and earns method marks even if one number is wrong.

1Find the commencement date and the lease term, including any option you are reasonably certain to use.
2List the payments that belong in the liability: fixed payments, index-linked amounts, guaranteed residual value and a reasonably certain purchase option. Leave out sales-based variable payments and refundable deposits.
3Note whether payments are in advance or in arrears. This decides the timing t for each payment.
4Choose the discount rate: the implicit rate if given, otherwise the incremental borrowing rate.
5Discount each payment, or apply an annuity factor, and total the present values. This is the lease liability.
6Build the right-of-use asset: start with the liability, add payments made at or before commencement and initial direct costs, deduct incentives received, add restoration costs.
7Show the journal: Dr Right-of-use asset, Cr Lease liability, and Cr Cash for payments made and costs paid. Split the liability into current and non-current only if asked.

Quickest way: Three-line build-up

When to use it: Use in Section A and OT cases where you need one number fast.

Line 1: discount the payments to get the liability. For payments in advance, the first payment is undiscounted, then use an annuity factor for the rest.
Line 2: copy the liability and add cash paid on day one plus direct costs, then subtract incentives.
Line 3: check you excluded deposits and sales-based variable rent. Then select the option that matches.

Common mistakes in Lessee Accounting: Right-of-Use Asset and Lease Liability

Adding initial direct costs to the lease liability.
Both the liability and the asset are called lease amounts, so students merge them.
Fix: Direct costs are paid to third parties. They increase only the right-of-use asset, with the credit going to cash.
Discounting the first payment when it is made on day one.
Students apply the same factor to every payment automatically.
Fix: A payment at commencement has t = 0, so its present value is the full payment. Discount only later payments.
Including a refundable deposit in the lease liability or the asset.
The deposit is paid to the lessor, so it looks like part of the rent.
Fix: Treat it as a separate financial asset. It is not a payment for the right to use the asset.
Including variable payments based on sales or usage.
Students include every payment mentioned in the scenario.
Fix: Only index- or rate-based variable payments go in. Sales-based rent is charged to profit or loss as it arises.
Ignoring lease incentives received from the lessor.
The incentive is written in a note and gets overlooked.
Fix: Deduct incentives received at or before commencement from the right-of-use asset. Incentives still receivable reduce the payments in the liability.
Using the wrong discount rate or period count.
Students mix the lease term with the asset's useful life.
Fix: Use the lease term for the number of payments. Use the rate given for the lease, not the asset's return.

Worked examples

Example 1

On 1 January 20X1 Ravi Co leases a machine for 3 years. Annual payments of $20,000 are made in arrears on 31 December. The rate implicit in the lease is 10%. Ravi pays legal fees of $1,500 to arrange the lease and receives no incentives. Calculate the lease liability and the right-of-use asset at 1 January 20X1. Discount factors at 10%: year 1 0.909, year 2 0.826, year 3 0.751.

Show the solution

Payments are in arrears, so discount at t = 1, 2 and 3.
Year 1: 20,000 × 0.909 = 18,180.
Year 2: 20,000 × 0.826 = 16,520.
Year 3: 20,000 × 0.751 = 15,020.
Lease liability = 18,180 + 16,520 + 15,020 = 49,720.
Right-of-use asset = 49,720 + 1,500 initial direct costs = 51,220.
Journal: Dr Right-of-use asset 51,220; Cr Lease liability 49,720; Cr Cash 1,500.

Answer: Lease liability $49,720; right-of-use asset $51,220.

Example 2

On 1 April 20X1 Sita Co starts a 4-year lease of equipment. Payments of $10,000 are due annually in advance, starting 1 April 20X1. The lessor gives an incentive of $2,000 cash, received on 1 April 20X1. Sita pays a refundable deposit of $5,000 and direct costs of $800. The incremental borrowing rate is 8%. The 3-year annuity factor at 8% is 2.577. Calculate the lease liability and right-of-use asset at 1 April 20X1.

Show the solution

Four payments in advance: one at t = 0, then three at t = 1, 2, 3.
Payment at commencement: 10,000, not discounted. It is paid on day one, so it is not part of the liability outstanding after payment.
The liability at commencement is the present value of payments not yet paid: 10,000 × 2.577 = 25,770.
Right-of-use asset = liability 25,770 + payment made at commencement 10,000 + direct costs 800 − incentive received 2,000.
25,770 + 10,000 = 35,770; + 800 = 36,570; − 2,000 = 34,570.
The $5,000 deposit is excluded. It is a separate financial asset.

Answer: Lease liability $25,770 (after the first payment is made); right-of-use asset $34,570.

Exam tips

Write the list of included and excluded items first. OT questions often hide a deposit or a sales-based rent to trap you.
Check whether payments are in advance or in arrears before choosing any factor. This is the most common slip in annuity questions.
In constructed response, show each component of the right-of-use asset on its own line. Marks are given for each item.
Use the discount factors the question provides. Do not recalculate them, because small differences can lose accuracy marks.
State the rate you used and why. A short sentence on implicit versus incremental borrowing rate can earn a mark.

Practice questions from Leasing

Lessee Accounting: Right-of-Use Asset and Lease Liability in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Lessee Accounting: Right-of-Use Asset and Lease Liability: frequently asked questions

What is included in the IFRS 16 lease liability?

Fixed payments less incentives receivable, index- or rate-based variable payments, residual value guarantee amounts, a purchase option if reasonably certain, and termination penalties if the term reflects termination. Sales-based variable payments are excluded.

Are initial direct costs part of the lease liability?

No. They are costs such as legal fees or commission that arise only because the lease was signed. You add them to the right-of-use asset, not the liability.

Which discount rate do I use under IFRS 16?

Use the rate implicit in the lease if it can be readily determined. Otherwise use the lessee's incremental borrowing rate. In ACCA FR questions the rate is normally given.

How is a deposit treated in lessee accounting?

A refundable deposit is normally a financial asset under IFRS 9 and is not a lease payment. Keep it out of the liability and the right-of-use asset unless the question says it is a payment for use.