How to Calculate a Lease Liability Under IFRS 16

The lease liability is a present value. Getting it right comes down to four questions: which payments, which rate, which period and which timing. We’ll use a three-year café lease at £2,500 a month with the first month free and a 5% effective annual rate.

Step 1: list the payments

Include fixed payments, in-substance fixed payments, variable payments that depend on an index or rate, and amounts under purchase or termination options you are reasonably certain to exercise. Here: 35 monthly payments of £2,500, from month 2 to month 36. The free month is not a payment, but it still affects the timing.

Step 2: choose the discount rate

Use the rate implicit in the lease if you can determine it. Most lessees can’t, so they use their incremental borrowing rate: the rate they would pay to borrow a similar amount, over a similar term, with similar security.

Step 3: match the rate to the payment frequency

Payments are monthly, so the rate must be monthly. A 5% effective annual rate is not 5% / 12.

Step 4: discount each payment from its own date

Each payment is discounted from the month it is paid back to the commencement date. With the first month free, the stream starts one month later.

In Excel: =PV(rate, 35, −2500) / (1 + rate), where the division moves the whole stream back one month.

After day one

The liability grows with interest and falls with each payment. In a rent-free month there is no payment, but interest still accrues, so the liability goes up.