Strategic Business Reporting (International) · Leases

IFRS 16 Lessee Accounting: Right-of-Use Asset and Lease Liability

Updated 11 October 2026 · Fact-checked

Under IFRS 16, a lessee recognises a right-of-use asset and a lease liability at commencement. The liability is the present value of unpaid lease payments, discounted at the rate implicit in the lease or the incremental borrowing rate. The asset is the liability plus prepaid payments and initial direct costs, less incentives. Then depreciate the asset and unwind interest.

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

Before IFRS 16, many leases stayed off the statement of financial position. IFRS 16 removes that for lessees. A lessee has a right to use an asset and an obligation to pay. Both go on the statement of financial position at the commencement date, which is the date the lessor makes the asset available for use.

The lease liability is the present value of the lease payments not yet paid at that date. Include fixed payments (less any lease incentives receivable), variable payments that depend on an index or rate (measured using the index or rate at commencement), amounts expected to be paid under residual value guarantees, the price of a purchase option if you are reasonably certain to exercise it, and termination penalties if the lease term assumes you will terminate. Variable payments that depend on usage or sales are not in the liability. Expense them in profit or loss when incurred.

Discount using the rate implicit in the lease if you can readily determine it. If not, use the lessee's incremental borrowing rate (IBR). The IBR is the rate you would pay to borrow, over a similar term and with similar security, the funds needed to obtain an asset of similar value in a similar economic environment. In exams the IBR is usually given.

The right-of-use (ROU) asset starts at the lease liability, plus lease payments made at or before commencement, plus initial direct costs (incremental costs of obtaining the lease, such as legal fees tied to this lease), plus estimated costs of dismantling or restoring the site, less lease incentives received. Initial direct costs go into the asset, not the liability, and they are not discounted.

Afterwards, the liability grows by interest (effective interest method) and falls by payments. The asset is depreciated under IAS 16 principles, normally over the shorter of the lease term and the useful life. If ownership transfers or a purchase option is reasonably certain to be exercised, use the useful life. The P&L charge is depreciation plus interest, which is front-loaded compared with a straight-line rent. Exemptions: you may choose not to apply the recognition model to short-term leases (12 months or less at commencement, with no purchase option) and to leases of low-value assets (assessed on the asset's value when new, regardless of the lessee's size). Then you expense payments, usually straight-line.

Key rules to remember

Lease liability at commencement: Lease liability = Σ [lease payment ÷ (1 + r)^t] for payments not yet paid; r is the rate implicit in the lease if readily determinable, otherwise the IBR. Payments in advance are discounted for zero periods.
Initial ROU asset: ROU asset = lease liability + payments made at or before commencement + initial direct costs + estimated dismantling/restoration costs − lease incentives received; Dismantling costs are also recognised as a provision under IAS 37.
Subsequent measurement of the liability: Closing liability = opening liability + interest (opening liability × r) − payment made; For payments in arrears, interest accrues before the payment. For payments in advance, the payment on the first day reduces the balance before interest accrues.
Depreciation of the ROU asset: Annual depreciation = (ROU cost − residual value) ÷ shorter of lease term and useful life; Use the useful life if ownership transfers or a purchase option is reasonably certain to be exercised.
Current and non-current split: Current liability = liability at year end − liability expected at next year end (before next year's payment is deducted, i.e. the principal repaid in the next 12 months); Equivalent for payments in arrears: next payment − next year's interest.
Exemptions: Short-term: lease term ≤ 12 months and no purchase option. Low-value: asset of low value when new.; Short-term is chosen by class of underlying asset. Low-value is chosen lease by lease. Expense payments straight-line (or another systematic basis).
Variable payments: Index- or rate-linked: include in liability. Usage- or sales-linked: expense as incurred.; Index-linked payments use the index at commencement. Remeasurement later is covered under lease modifications and remeasurement.

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

Use the same order for any lessee question. It keeps the numbers and the narrative marks together.

1Check whether a lease exists and whether an exemption applies. Short-term (12 months or less, no purchase option) or low-value leases may be expensed. If the exemption applies, stop and expense the payments straight-line.
2Fix the commencement date and the lease term. Include periods covered by extension options you are reasonably certain to use. Exclude termination periods you are reasonably certain to use.
3List the lease payments to include: fixed, index-linked, residual value guarantees expected, purchase option if reasonably certain. Exclude usage-based payments. Net off incentives receivable.
4Choose the discount rate: implicit rate if given or readily determinable, otherwise the IBR. Compute the present value to get the opening liability. Watch whether payments fall in advance or in arrears.
5Build the ROU asset: liability + prepaid payments + initial direct costs + restoration costs − incentives.
6Prepare the liability table: opening balance, interest, payment, closing balance. Then calculate depreciation using the correct period.
7Write the journals and extracts: Dr ROU asset, Cr lease liability (and Cr cash for payments and costs paid). Then Dr depreciation and Dr finance cost, with the matching credits. Split the liability into current and non-current.
8Add a sentence or two in words if the question asks for an explanation: why the liability is recognised, or why the exemption applies.

Quickest way: Table-first approach for lease liability questions

When to use it: Use when the question gives payments, term and a rate and asks for year-end balances or the P&L charge. It suits time-pressured Section A or B questions.

Draw a four-column table: opening, interest, payment, closing. Do the present value first and put it in the first row.
Check the table by testing that the last closing balance is zero (allow for rounding).
Calculate the ROU asset in one line from the liability, then divide by the term for depreciation.
Read off the P&L charge as interest plus depreciation. Read the current liability as next year's payment less next year's interest, for payments in arrears.
Write each journal as one line. Give yourself marks for the workings even if a later number goes wrong.

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

Including initial direct costs in the lease liability.
Students treat every cost of the lease as part of the amount owed.
Fix: The liability contains only the present value of lease payments. Initial direct costs, prepaid payments and restoration costs go into the ROU asset only.
Discounting payments in advance as if they were in arrears.
Students apply an annuity factor from a table without checking the timing.
Fix: Discount the first payment for zero periods if it is paid on day one. The liability at commencement is then the present value of the remaining payments, and the day-one payment is added into the ROU asset.
Including variable payments linked to sales or usage in the liability.
Students think all variable payments are lease payments.
Fix: Only payments linked to an index or rate (using the commencement-date level) and fixed-in-substance payments are included. Expense usage-based payments when incurred.
Depreciating over the useful life when there is no transfer of ownership.
Students copy the IAS 16 approach for owned assets.
Fix: Use the shorter of the lease term and useful life, unless ownership transfers or a purchase option is reasonably certain to be exercised.
Ignoring the incentive from the lessor.
Students focus on payments and forget that incentives received reduce the asset.
Fix: Deduct incentives received at or before commencement from the ROU asset. Incentives receivable reduce the lease payments in the liability.
Applying the low-value exemption by reference to the lessee's size or the asset's current value.
Students think a small business can treat any lease as low-value.
Fix: The test is the value of the underlying asset when new, not the entity's size and not the current carrying amount. Typical examples are tablets, small items of furniture and phones. The IASB had in mind assets worth roughly US$5,000 or less when new.

Worked examples

Example 1

On 1 January 20X1, Arden Co leases a machine for 4 years. It pays $100,000 annually in arrears, on 31 December each year. The IBR is 8% (the implicit rate is not readily determinable). The 4-year annuity factor at 8% is 3.3121. Arden pays $10,000 of initial direct costs on 1 January 20X1. The machine has a useful life of 8 years and there is no transfer of ownership. Calculate the amounts for the year ended 31 December 20X1: opening lease liability, ROU asset, depreciation, finance cost, closing liability and its current/non-current split.

Show the solution

Opening liability = $100,000 × 3.3121 = $331,210.
ROU asset = $331,210 + $10,000 initial direct costs = $341,210.
Depreciation: the lease term (4 years) is shorter than the useful life (8 years), so $341,210 ÷ 4 = $85,302.50, which is $85,303 rounded.
Finance cost for 20X1 = $331,210 × 8% = $26,497 (rounded from $26,496.80).
Closing liability = $331,210 + $26,497 − $100,000 = $257,707.
Next year's interest = $257,707 × 8% = $20,617 (rounded). Principal to be repaid in 20X2 = $100,000 − $20,617 = $79,383, so current liability = $79,383.
Non-current liability = $257,707 − $79,383 = $178,324.
Journals at commencement: Dr ROU asset $341,210; Cr lease liability $331,210; Cr cash $10,000. At year end: Dr finance cost $26,497, Cr lease liability $26,497; Dr lease liability $100,000, Cr cash $100,000; Dr depreciation $85,303, Cr accumulated depreciation $85,303.

Answer: Opening liability $331,210; ROU asset $341,210; depreciation $85,303; finance cost $26,497; closing liability $257,707, of which current $79,383 and non-current $178,324. Total P&L charge is $111,800 (depreciation plus finance cost, $85,303 + $26,497).

Example 2

On 1 January 20X1, Brandt Co enters a 3-year lease of equipment. It pays $50,000 annually in advance on 1 January each year, starting 1 January 20X1. The discount rate is 10%. Brandt receives a $6,000 incentive from the lessor on 1 January 20X1 and pays $4,000 of initial direct costs on the same date. Calculate the initial lease liability and ROU asset, and the carrying amounts of both at 31 December 20X1. Assume the useful life is longer than the lease term and there is no transfer of ownership.

Show the solution

Present value of all three payments: $50,000 + $50,000 ÷ 1.10 + $50,000 ÷ 1.21 = $50,000 + $45,455 + $41,322 = $136,777.
The first payment is made on day one, so the initial lease liability is the present value of the two payments not yet paid: $45,455 + $41,322 = $86,777.
ROU asset = liability $86,777 + payment made at commencement $50,000 + initial direct costs $4,000 − incentive received $6,000 = $134,777.
Depreciation for 20X1 = $134,777 ÷ 3 = $44,925.67, which is $44,926 rounded. Carrying amount of ROU asset at 31 December 20X1 = $134,777 − $44,926 = $89,851.
Interest for 20X1 = $86,777 × 10% = $8,678 (rounded from $8,677.70).
Liability at 31 December 20X1 = $86,777 + $8,678 = $95,455. No payment falls within the year after commencement, because the next payment is due on 1 January 20X2.
Check: the remaining payments at 31 December 20X1 are $50,000 due the next day and $50,000 due one year later. Present value = $50,000 + $50,000 ÷ 1.10 = $95,455. This agrees.

Answer: Initial lease liability $86,777; initial ROU asset $134,777. At 31 December 20X1 the ROU asset is $89,851 and the lease liability is $95,455.

Exam tips

Read the payment timing first: in advance or in arrears. It changes both the present value and the opening liability. Underline it in the question.
Show the liability table even if you get the first number wrong. Marks are given for method, and follow-through errors are usually not penalised twice.
If the question mentions a short lease or a cheap asset, test the exemption conditions before you calculate anything. State the condition in a short sentence, such as no purchase option and 12 months or less.
For professional skills marks, explain the effect on gearing, EBITDA and interest cover for a stakeholder. Recognising leases increases assets and liabilities and moves cost from operating expenses to depreciation and finance costs.
Say clearly where each cost goes: initial direct costs and prepaid payments in the asset, interest in finance costs, usage-based payments in profit or loss. Examiners often test this split.

Practice questions from Leases

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 discount rate do I use for IFRS 16 lessee accounting?

Use the rate implicit in the lease if it can be readily determined. If it cannot, use the lessee's incremental borrowing rate. In exam questions, the rate is normally given in the scenario, and you should name which rate it is.

Are initial direct costs part of the lease liability?

No. Initial direct costs are added to the right-of-use asset only. The lease liability is the present value of the lease payments not yet paid. The costs are paid in cash at commencement and are not discounted.

When can I use the short-term or low-value lease exemption?

A short-term lease has a term of 12 months or less at commencement and no purchase option. A low-value lease is a lease of an asset that is of low value when new. If you apply either exemption, you expense the payments, usually on a straight-line basis, and do not recognise an asset or liability.

How is the ROU asset depreciated?

Depreciate over the shorter of the lease term and the useful life of the asset. If ownership transfers to you at the end, or you are reasonably certain to exercise a purchase option, depreciate over the useful life instead. Impairment follows IAS 36.