Have You Ever Faced These Challenges?
- You needed to determine an incremental borrowing rate for a lease portfolio but lacked a clear framework — and the rate you used was challenged by auditors for insufficient supporting evidence
- A mid-lease modification — adding space, changing the term, or adjusting the rental — required remeasurement of the lease liability, and you were uncertain which discount rate applied and how to reflect the change in the right-of-use asset
- You were unsure which costs incurred in connection with entering into a lease qualified as initial direct costs and should be capitalised into the right-of-use asset
What You Will Learn From This Article
- How to construct a defensible incremental borrowing rate — the components, the estimation approaches, and what auditors look for
- What qualifies as an initial direct cost and how to distinguish capitalised costs from period expenses
- How to account for lease modifications — the three treatment categories and when each applies
Who This Article Is For
- Finance professionals responsible for measuring lease liabilities and right-of-use assets under IFRS 16
- Treasury and finance teams responsible for determining incremental borrowing rates
- Those dealing with frequent lease modifications — particularly in real estate, manufacturing, and retail
Initial Measurement of the Lease Liability
The lease liability is measured at the present value of lease payments not yet made at the commencement date, discounted at the rate implicit in the lease or — where that rate cannot be readily determined — the lessee’s incremental borrowing rate (IFRS 16.26).
Lease Payments Included in the Measurement
| Included in the lease liability | Excluded from the lease liability |
|---|---|
| Fixed payments, net of lease incentives receivable | Variable lease payments not linked to an index or rate |
| Payments based on an index or rate (using the index/rate at commencement) | Service components (unless the practical expedient is applied) |
| Amounts expected under residual value guarantees | |
| Exercise price of a purchase option (if reasonably certain to exercise) | |
| Early termination penalties (if the lease term reflects termination) |
In-substance fixed payments: Payments that appear variable in form but are in substance fixed — for example, a minimum guaranteed payment under a “higher of minimum or variable” structure — are treated as fixed payments and included in the lease liability.
The Incremental Borrowing Rate: Construction and Defence
When the IBR Is Used
The rate implicit in the lease is the discount rate that equates the present value of lease payments and the unguaranteed residual value with the fair value of the underlying asset plus the lessor’s initial direct costs. In practice, lessees rarely have access to the information required to calculate this rate — particularly the residual value assumptions embedded in the lessor’s pricing. As a result, the incremental borrowing rate (IBR) is used in the overwhelming majority of cases.
Definition
The IBR is the rate of interest that the lessee would have to pay to borrow over a similar term, with similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment (IFRS 16 Appendix A).
The Four Components of the IBR
Component 1 — Risk-free base rate: The starting point is a government bond yield or swap rate for the relevant currency and maturity that matches the lease term. For a 7-year office lease denominated in Japanese yen, the appropriate base rate would be the yield on 7-year Japanese government bonds or the 7-year JPY swap rate at the commencement date.
Component 2 — Credit spread: The base rate is adjusted upward to reflect the lessee’s credit risk — the additional yield that a market participant would require to lend to this specific borrower. For entities with public credit ratings, observable bond spreads for bonds of similar rating and maturity provide a market-based reference. For unrated entities, comparable data from similar-sized entities in the same industry, or the lessee’s actual borrowing costs on recent comparable facilities, may be used.
Component 3 — Collateral adjustment: The IBR must reflect borrowing secured against an asset similar to the right-of-use asset — because the lease itself is effectively a secured obligation (the lessee uses the asset while making payments, and the lessor retains ownership as a form of security). An unsecured borrowing rate should therefore be adjusted downward to reflect the collateral benefit. The magnitude of this adjustment depends on the nature and value of the underlying asset.
Component 4 — Currency and economic environment: The IBR must reflect the currency in which the lease payments are denominated and the economic environment in which the lessee operates. A JPY-denominated lease uses a JPY-based IBR; a USD-denominated lease uses a USD-based IBR — even if both are entered into by the same entity.
Practical Estimation Approaches
| Approach | Description | When appropriate |
|---|---|---|
| Actual borrowing rate | Use the interest rate on a recent, similar borrowing facility | Where a comparable secured facility exists |
| Market data approach | Construct from observable bond yields or swap rates plus credit spread | For rated entities with access to bond market data |
| Build-up approach | Base rate + credit spread + collateral adjustment | Where market data is limited |
For entities with diverse lease portfolios — varying currencies, asset types, and durations — constructing a separate IBR for every individual lease may be impractical. Portfolio-level IBRs can be applied to groups of leases with similar characteristics (same currency, similar term, similar asset type), provided the entity can demonstrate that the portfolio-level rate approximates what would result from individual calculation.
What Auditors Focus On
In practice, audit challenges on the IBR typically centre on three areas:
- Adequacy of documentation: Is there a clear, reproducible methodology for constructing the IBR?
- Consistency: Is the same methodology applied consistently across similar leases?
- Market data currency: Are the base rates and spreads sourced from the commencement date of each lease, rather than from a single historical date applied across the portfolio?
Initial Measurement of the Right-of-Use Asset
The right-of-use asset is measured at cost at the commencement date (IFRS 16.24):
Right-of-use asset = Lease liability (initial measurement)
+ Prepaid lease payments (payments made before or at commencement)
+ Initial direct costs
+ Estimated restoration costs (recognised per IAS 37)
− Lease incentives receivedInitial Direct Costs
Initial direct costs are incremental costs of obtaining a lease that would not have been incurred but for the lease (IFRS 16 Appendix A). They are capitalised into the right-of-use asset.
Costs that qualify as initial direct costs:
- Broker commissions or finder’s fees paid to secure the lease
- Legal fees paid to external counsel for negotiating and documenting the lease terms
- Costs of evaluating whether a specific asset meets the lessee’s requirements (where directly attributable to the lease)
Costs that do not qualify as initial direct costs:
- Internal legal or finance team costs — these are not incremental (the entity would incur these costs regardless of whether this specific lease were obtained)
- General overhead allocations
- Costs incurred in connection with lease negotiations that did not result in a signed lease
- Costs incurred before the entity begins evaluating the specific lease
The incremental nature of the cost is the key test. If the cost would have been incurred even without this particular lease, it does not qualify.
Restoration Costs
Where the lease agreement imposes an obligation to restore the leased asset to its original condition at the end of the lease — for example, to remove tenant improvements, restore a leased floor to shell condition, or return a vehicle to a defined specification — the estimated cost of that restoration is recognised as a provision under IAS 37 at the commencement date, with a corresponding addition to the right-of-use asset.
The restoration cost estimate should reflect:
- Current market costs for the relevant restoration work
- Inflation over the lease term
- Discounting back to present value using a pre-tax risk-free discount rate (per IAS 37)
Subsequent Measurement
Lease Liability
The lease liability is subsequently measured using the effective interest method:
- Interest accrues at the discount rate applied at commencement (or at the most recent remeasurement date)
- Lease payments reduce the carrying amount of the lease liability
The effective interest method ensures that the interest expense recognised in each period represents a constant periodic rate of interest on the outstanding lease liability.
Right-of-Use Asset
Under the cost model, the right-of-use asset is subsequently depreciated on a straight-line basis (or another systematic basis that reflects the pattern of consumption) over:
- The lease term — where ownership does not transfer at the end of the lease and the lessee is not reasonably certain to exercise a purchase option
- The useful life of the underlying asset — where ownership transfers or a purchase option is reasonably certain to be exercised
IAS 36 impairment testing applies to right-of-use assets in the same way as to other long-lived assets.
Lease Modifications
A lease modification is a change in the scope or consideration of a lease that was not part of the original terms and conditions. IFRS 16 provides three different accounting treatments depending on the nature of the modification.
Treatment 1: Separate New Lease
Where a modification adds the right to use one or more additional underlying assets and the additional consideration is commensurate with the standalone price of the additional right of use, the modification is accounted for as a separate new lease (IFRS 16.44).
Example: A lessee renting 500 square metres of office space adds an adjacent 200 square metres at a market-rate price. The additional space is a new, separately priced right of use — it is accounted for as a new lease.
Accounting: The existing lease continues on its original terms. The additional space is recognised as a new right-of-use asset and new lease liability at commencement of the additional space.
Treatment 2: Decrease in Scope — Partial Termination
Where a modification decreases the scope of the existing lease — reducing the lease term or giving up the right to use part of the underlying asset — the modification is accounted for as a partial termination of the existing lease (IFRS 16.46(a)).
Accounting:
- The right-of-use asset and lease liability are reduced proportionally to reflect the decrease in scope
- Any gain or loss arising from the partial termination is recognised in profit or loss
Treatment 3: Other Modifications — Remeasurement
All other modifications — including increases in scope not at standalone price, changes in the lease term, and changes in the consideration — are accounted for by remeasuring the lease liability at the modification date and adjusting the right-of-use asset accordingly (IFRS 16.46(b)).
Discount rate on remeasurement: For Treatment 3 modifications, the lease liability is remeasured using a revised IBR at the modification date. This is not the original commencement date IBR — it is the rate that reflects market conditions at the date the modification takes effect.
Accounting:
- Remeasure the lease liability at the modification date using the revised IBR
- Adjust the right-of-use asset by the same amount (no profit or loss impact, unless the adjustment reduces the right-of-use asset below zero)
Variable Lease Payments: Subsequent Remeasurement
Variable lease payments based on an index or rate (such as CPI or a property market index) are included in the initial measurement of the lease liability based on the index or rate at the commencement date. When a remeasurement event occurs, the lease liability is updated to reflect the current index or rate.
Variable lease payments that are not based on an index or rate — for example, revenue-based rent — are excluded from the lease liability and recognised as an expense in the period in which they arise.
Comparison with Japanese GAAP
| Area | IFRS 16 | Japanese GAAP |
|---|---|---|
| Incremental borrowing rate | Detailed construction required | Simplified guidance |
| Initial direct costs | Incremental costs only | Similar |
| Restoration costs | Added to right-of-use asset (IAS 37 provision) | Similar treatment under relevant standards |
| Lease modifications | Three treatment categories | Limited specific guidance |
Summary
The key takeaways from lease liability and right-of-use asset measurement are as follows:
- The IBR must reflect the lessee’s credit risk, the lease currency, the asset type as collateral, and the lease term — all four components require documentation
- Initial direct costs are incremental costs only. Internal team costs and overhead allocations do not qualify
- Restoration obligations are recognised as IAS 37 provisions at commencement and added to the right-of-use asset
- Lease modifications require careful classification: additional scope at standalone price is a new lease; scope reduction is a partial termination; all other changes are remeasurements using the revised IBR at modification date
The next article addresses lessor accounting — the classification of leases as finance or operating, and the measurement of the net investment in a finance lease.
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