## Learning Outcomes

After reading this article, you will be able to explain, apply, and evaluate lessee accounting under IFRS 16. You will understand how to identify a lease, calculate the initial and subsequent measurement of the right-of-use asset and lease liability, and handle remeasurement or modifications. You should be able to separate lease and non-lease components, apply exemptions, and address required disclosures for examination purposes.

## ACCA Strategic Business Reporting (SBR) Syllabus

For ACCA Strategic Business Reporting (SBR), you are required to understand and apply the principles behind lessee accounting for leases under IFRS 16. This article supports your preparation by focusing on the following key areas:

- Identification of a lease under IFRS 16
- Initial measurement and recognition of the right-of-use (ROU) asset and lease liability
- Calculation of lease payments, including fixed, variable, and residual value guarantees
- Application of the appropriate discount rate
- Subsequent measurement, including depreciation of the ROU asset and unwinding of the lease liability
- Handling lease modifications and remeasurement of the liability
- Separation of lease and non-lease components in a contract
- Application of short-term and low-value lease exemptions
- Disclosure requirements applicable to lessees

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. Which payments must be included in the measurement of a lessee’s lease liability at lease commencement?
   a) Only fixed lease payments
   b) Fixed payments, variable payments based on an index or rate, and residual value guarantees
   c) Only variable lease payments
   d) Only the first payment due

2. At lease commencement, how is the right-of-use asset initially measured by a lessee?
   a) At fair value
   b) At the present value of lease payments
   c) At the initial measurement of the lease liability, plus direct costs and restoration provisions
   d) As zero, unless the lease term exceeds 12 months

3. True or False? A lessee can avoid recognising a lease liability for a lease of 11 months with a purchase option 'reasonably certain' to be exercised.

4. A three-year lease contract contains both equipment rental and routine maintenance services provided by the lessor. Explain how the lessee should account for this contract under IFRS 16.

## Introduction

IFRS 16 _Leases_ requires almost all lessees to recognise right-of-use (ROU) assets and corresponding lease liabilities for leases, subject to specified recognition exemptions. Understanding the lessee accounting model is key for ACCA SBR. This article explains identification of a lease within a contract, initial recognition and measurement of the ROU asset and lease liability, ongoing measurement, remeasurement triggers, key exemptions, and disclosure requirements.

> **Key Term: lease**
> A contract that conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

### Identifying a Lease

For IFRS 16 to apply, a contract must contain a lease. A contract contains a lease if it gives the customer both:

- The right to obtain substantially all the economic benefits from use of an identified asset
- The right to direct the use of the identified asset throughout the period

Contracts for services that do not grant control over an identified asset are not leases and do not fall within this standard.

> **Key Term: right-of-use asset**
> The lessee’s right to use an identified asset for the lease term.
> **Key Term: lease liability**
> The obligation of the lessee to make lease payments, measured at the present value of future lease payments.

### Initial Recognition and Measurement

At the lease commencement date, lessees must recognise both:

![IFRS 16 lessee initial measurement sequence from lease commencement to lease term, lease payments, discount rate, lease liability, and right-of-use asset.](https://static.pastpaperhero.com/images/acca-sbr-leases-ifrs-16-lessee-accounting-rou-asset-and-lease-liability_00.png)

_Lessee recognition under IFRS 16 proceeds through determining term, included payments and discount rate before measuring the liability and ROU asset._

- A right-of-use asset
- A lease liability

### Lease Liability – Initial Measurement

The lease liability is measured at the present value of lease payments not yet paid at commencement. Payments included:

- Fixed payments (including in-substance fixed)
- Variable payments based on an index or rate, measured using the index/rate at commencement
- Amounts under residual value guarantees
- Exercise price of a purchase option if likely to be exercised
- Termination penalties if the lease term reflects exercising an option to terminate

The lease payments are discounted using:

- The interest rate implicit in the lease, if known
- Otherwise, the lessee’s incremental borrowing rate

### Right-of-Use Asset – Initial Measurement

The ROU asset is initially measured at cost:

- The amount of the initial lease liability
- Plus: any lease payments made at or before commencement
- Plus: initial direct costs incurred
- Plus: provisions for restoration or dismantling
- Less: any lease incentives received

Depreciation of the ROU asset starts when the asset is available for use.

### Subsequent Measurement

### Lease Liability

The lease liability increases by the unwinding of the discount (finance cost) and decreases by lease payments made. The liability is remeasured when lease terms change, or when variable lease payments or guaranteed residual values alter.

### Right-of-Use Asset

The ROU asset is measured at cost less accumulated depreciation and any impairment. Depreciation is usually straight-line over the lease term, or asset useful life if transfer of ownership or purchase option is expected to be exercised.

### Short-term and Low Value Leases

IFRS 16 provides recognition exemptions for:

- Short-term leases (term of 12 months or less, no purchase option)
- Leases of ‘low value’ assets (such as tablets, PCs, small equipment)

If applied, the lessee recognises lease payments as an expense on a straight-line basis, with no liability or ROU asset.

### Worked Example 1.1

A company enters a 4-year lease for office equipment. Annual payments are \$5,000, payable in advance. There is an option to extend for 1 extra year at \$6,000, which management is not likely to exercise. Its incremental borrowing rate is 6%.

**Required:** Calculate the initial measurement of the lease liability and ROU asset at commencement (no initial direct costs, no restoration).

> **Answer:**
> Lease payments = \$5,000 x 4 years = \$20,000 (ignore extension, not reasonably certain).
> Present value of lease payments (annuity due, 4 years, 6%):
>
> - PV = \$5,000 + \$5,000/(1.06) + \$5,000/(1.06^2) + \$5,000/(1.06^3) ≈ \$17,927
>   The ROU asset is also \$17,927 (no adjustments).
>   Initial double entry:
> - Dr ROU Asset \$17,927
> - Cr Lease Liability \$17,927

### Worked Example 1.2

A lessee signs a 3-year property lease with annual payments of \$20,000, due in arrears, and a restoration obligation at lease end costing \$3,000 (future value). The incremental borrowing rate is 5%. No purchase option.

**Required:** Calculate initial ROU asset and lease liability.

> **Answer:**
> Lease liability:
>
> - PV lease payments: \$20,000 × [1/1.05, 1/1.05^2, 1/1.05^3] = \$20,000/1.05 + \$20,000/1.05^2 + \$20,000/1.05^3 ≈ \$54,682
> - PV of restoration: \$3,000/1.05^3 ≈ \$2,593
> - Total initial lease liability: \$54,682 + \$2,593 = \$57,275
>   ROU asset:
> - Lease liability (\$57,275), assuming no other costs, is the initial ROU asset.
>
> **Exam Warning:**
> In the exam, you must explain the choice of discount rate for lease liabilities. If the implicit rate in the lease is not known, you must use the lessee’s incremental borrowing rate.

### Separating Lease and Non-Lease Components

Many contracts include both a lease of an asset and additional services (e.g., maintenance). IFRS 16 requires lessees to allocate the total consideration between lease and non-lease components based on their stand-alone prices, unless a practical expedient is applied.

### Worked Example 1.3

A company leases machinery for \$12,000/year for five years. The contract includes maintenance at \$2,000/year; if contracted separately, the lease would cost \$11,000/year and maintenance \$3,000/year. Lessee elects to separate lease and non-lease components.

> **Answer:**
>
> - Total stand-alone price = \$11,000 + \$3,000 = \$14,000
> - Allocated to lease: (\$11,000/\$14,000) × \$12,000 = \$9,429/year
> - Allocated to maintenance: (\$3,000/\$14,000) × \$12,000 = \$2,571/year
> - Lease liability is based on the present value of \$9,429/year.
>
> **Revision Tip:**
> If time-pressured, focus on your method for allocating payments between lease and non-lease components, as this is often examined.

### Lease Modifications and Remeasurement

A lease liability must be remeasured when:

- The lease term changes
- Lease payments change based on an index/rate
- Lessee reassesses whether they are reasonably certain to exercise options

Changes may result in adjustments to both the liability and the ROU asset.

### Disclosures for Lessees

Annual disclosures must include, at a minimum:

- The carrying amount of ROU assets by asset class
- Additions to ROU assets
- Depreciation and interest charges
- Expense for short-term/low-value leases
- Maturity analysis of lease liabilities

> **Key Term: incremental borrowing rate**
> The rate a lessee would have to pay to borrow over a similar term, with similar security, to buy an asset of similar value in a similar economic environment.

## Summary

Lessee accounting under IFRS 16 requires recognition of lease liabilities and right-of-use assets for most leases. The lease liability is measured at the present value of future lease payments, while the ROU asset incorporates the liability, upfront costs, and restoration obligations. Exemptions exist for short-term or low-value leases, but most lease arrangements must be recognised on the balance sheet. Regular remeasurement and clear separation of components are critical for accurate reporting and exam success.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Identify a lease within a contract under IFRS 16
- Calculate the initial measurement of lease liabilities and right-of-use assets
- Select the appropriate discount rate
- Depreciate ROU assets and unwind the lease liability
- Handle lease modifications and remeasurements
- Separate lease and non-lease components
- Apply recognition exemptions for short-term and low-value leases
- Understand lessee disclosure requirements under IFRS 16

## Key Terms and Concepts

- lease
- right-of-use asset
- lease liability
- incremental borrowing rate


Leases (IFRS 16) - Lessee accounting: ROU asset and lease liability