Accounting for Lease Liability Under IFRS 16

If you’ve spent time in the UAE, you’ve likely seen countless signs reading “for lease.” What does that actually mean for the accounting behind it, and how do audit firms in the UAE account for it under IFRS 16? Lease accounting plays a genuinely important role in a financial audit. In December 1997, the IASC adopted the standard of recording leases as a financing activity, later carried forward by the International Accounting Standards Board in April 2001. Under IFRS 16, lease accounting was further modified, with the principles for recognizing the asset, measuring its value, presenting it on the financial statements, and disclosing related information forming the basis of the current reporting requirement. Understanding this calculation properly is essential for any accounting and financial services provider working with lease-holding clients.

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What Is a Lease Liability?

A lease liability is a financial obligation to make payments as required under the lease contract, discounted to its present value. The liability term is measured from the contract’s commencement date. This liability sits alongside the Right-of-Use (RoU) asset recorded in the financial statements, replacing the previous “operating lease” classification under the older standard.

To understand how a lease is presented on the balance sheet, a few core components of the lease liability need to be understood first:

• Lease term. To require liability recognition under IFRS 16, the lease term generally needs to exceed 12 months. Accounting adjustments are made where the term is later renewed or the contract terminated early.
• Lease payments. Payments made toward the asset, including upkeep, renewal, or initial direct costs. Incentives received in connection with the asset reduce the total value used when computing the liability.
• Discount rate. The specific approach to determining the discount rate varies slightly across reporting standards, such as IFRS 16, ASC 842, or GASB 87, but the underlying concept is consistent across all of them: an implicit or incremental borrowing interest rate is used to discount future payments to their present value.

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Worked Example: Calculating the Lease Liability

A company enters a 10-year lease contract with annual payments of $35,000, and an incremental borrowing rate of 8%. The lease liability is calculated as the present value of the future lease payments over the contract term, discounting each future payment back to today’s value using the 8% rate, consistent with the time value of money concept.

This present value figure, $234,852, is calculated by applying the annuity present value formula to the 10 annual payments of $35,000 at an 8% discount rate. This is the amount initially recognized as the lease liability on the balance sheet.

Calculating the Right-of-Use Asset

The lease liability is then used to calculate the Right-of-Use asset. Suppose the same company also incurs an initial direct cost of $5,000 connected to the asset. The RoU asset is then calculated as $234,852 + $5,000 = $239,852. The Right-of-Use asset is debited, while the lease liability and cash accounts are credited accordingly.

What Are the Exemptions in Lease Liability Accounting?

IFRS 16 provides two recognition and measurement exemptions:

Short-Term Lease. Defined as a lease term of 12 months or less. The lessee needs to genuinely control whether the contract term will be extended or terminated, to the extent that a short-term lease isn’t expected to convert into a long-term arrangement in the near future, before it can be treated as exempt from RoU recognition. A lease that includes a purchase option doesn’t qualify as short-term, regardless of its stated duration.

Low-Value Leases. Leases of assets below a relatively low value threshold, commonly illustrated at around $5,000 for a new asset, are generally eligible for this exemption, allowing the lessee to expense payments directly rather than recognizing a Right-of-Use asset and lease liability.

Worked Example: Applying the Low-Value Lease Exemption

A company leases a laptop for office use, valued at $1,200 when new, under a 3-year lease agreement with total payments of $1,500. Because the underlying asset’s value falls well below the low-value threshold, the company can elect the low-value lease exemption rather than calculating a present value lease liability and Right-of-Use asset. Instead, the $1,500 in total lease payments is simply expensed over the lease term as incurred, avoiding the more involved present value calculation that would otherwise apply to a higher-value asset like the 10-year property lease in the earlier example.

Summary

Under IFRS 16, the core objective is to faithfully report and present information about a company’s lease transactions and their effect on cash flow valuation and financial ratios arising from leasing activity. Recognizing both the asset and liability arising from a lease is essential to meeting this objective. A lessee is required to identify the Right-of-Use asset under IFRS 16 wherever the lease term exceeds 12 months, and to recognize the payment obligations arising from operating that lease accordingly.

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