How to calculate lease liability, step by step (with a worked example)

Every IFRS 16 number flows from one calculation made on day one: the lease liability, defined as the present value of the lease payments not yet paid, discounted at the interest rate implicit in the lease or, when that rate cannot readily be determined — which is almost always the lessee's situation — at the incremental borrowing rate. Get this one number right and everything downstream (the asset, the interest, the amortisation, the disclosures) follows mechanically. This article does the whole thing with a concrete example.

Step 1 — Fix the lease term

The lease term is not just the contract length on page one. It is the non-cancellable period, plus any renewal option periods you are *reasonably certain* to exercise, plus periods covered by a termination option you are reasonably certain *not* to exercise. Reasonably certain is a high bar — it means weighing economic incentives: significant leasehold improvements, relocation costs, the strategic value of the location. A five-year contract with an operator who has poured money into fitting out the premises is often, in substance, a seven-year lease. The term you fix here drives both the payments you include and the discount period.

Step 2 — Collect the lease payments

Into the measurement go fixed payments (including in-substance fixed payments), variable payments that depend on an index or a rate, the amount you expect to pay under a residual value guarantee, the exercise price of a purchase option if you are reasonably certain to buy, and termination penalties where the term reflects early termination. What stays out is just as important: variable payments based on usage or turnover — a percentage-of-sales turnover rent, for instance — are expensed as they occur and never enter the liability.

• In: fixed rent, index-linked rent at the current index, expected residual guarantee payments, purchase option price (if reasonably certain), termination penalties (if in the term).
• Out: turnover-based rent, usage-based charges, maintenance serviced separately, insurance reimbursed at cost.

Step 3 — Choose the discount rate

The rate implicit in the lease is the rate that equates the lessor's investment in the asset with their expected receipts — and as a practical matter, lessees almost never have the information to compute it. So the standard's fallback is the incremental borrowing rate: the rate you would pay to borrow, over a similar term, with similar security, in the same currency, the funds needed to obtain an asset of similar value to the right of use. We cover how to build one defensibly in the next article in this series. For the example, take 10% as given.

Step 4 — Discount each payment to today

The liability is the sum of every payment multiplied by its discount factor. With payments in arrears, the factor for year n is 1 ÷ (1 + r)ⁿ. For the oven lease, five payments of M12,000 at 10%:

Notice the pattern: you will pay M60,000 in cash over five years, but you owe the equivalent of M45,489.44 today, because the later payments cost less in present-value terms. That gap — M14,510.56 — is not a saving; it is the interest that will accrue over the life of the lease as the liability unwinds.

Step 5 — Post the opening entry

At commencement, recognise the right-of-use asset and the liability at the same amount (the asset picks up extra legs — initial direct costs, prepaid rent, restoration obligations — but in this clean example there are none):

That is the entire calculation: fix the term, scope the payments, defend the rate, discount, post. In the next article we put this liability and its twin asset through five years of amortisation and watch the expense pattern that makes IFRS 16 famous.