Full explanation
Overview
You've seen how IFRS 16 puts leases on the balance sheet. Now for the part that actually shows up in exams and in real life: the numbers, and the curveballs. How do you measure a lease? And what happens when the rent rises, the term changes, you walk away early, or the whole thing's in a foreign currency? Let's work through every one.
The control test
First — is it even a lease? IFRS 16 gives a sharp test, absorbing the old IFRIC 4 guidance. You have a lease if you control the use of an identified asset for a period, in exchange for payment.
Control means two things: you get substantially all the economic benefits from using it, and you direct how it's used. A specific floor of a building for five years? Lease. A short stay in any hotel room? Not a lease. That test decides everything.
Money later is worth less than money now
Before we touch a number, one idea we lean on the whole way through: an interest rate. And here's why it matters. Paying ten thousand euros a year for three years is not the same as having thirty thousand today — because money you pay later is worth less than money now.
So we shrink those future payments down to what they're worth today. But at what rate? Ideally, the rate baked into the lease — except landlords rarely reveal it. So a company uses the next best thing: the rate its own bank would charge it to borrow. Think of it like a mortgage rate. Accountants call it the incremental borrowing rate. We'll use five percent.
The liability isn't €30,000
Now the example we'll follow all the way through: a three-year lease, ten thousand euros a year, paid in arrears, at that five percent.
The lease liability isn't the thirty thousand of total payments. It's what those payments are worth today — discounted at five percent.
Discount them, and you get twenty-seven thousand, two hundred and thirty-two euros. That's your lease liability on day one — and your right-of-use asset starts at exactly the same value.
Right-of-use asset & lease liability
Quick pause on those two words. A right-of-use asset just means your right to use the thing — the shop, the machine — for the lease term. You don't own it, but you control it, so you show it as an asset.
And a lease liability is simply the flip side: your promise to make the payments, measured at what they're worth today. Right to use on one side; obligation to pay on the other.
The commencement entry
So the day-one journal is beautifully simple. Debit right-of-use asset, twenty-seven thousand two hundred and thirty-two. Credit lease liability, the same amount.
In one entry, an asset and a liability that were completely invisible under the old rules appear on the balance sheet.
Rent is gone — the cost is front-loaded
Now watch each year — because this is where people get caught out. The old flat rent of ten thousand is gone. It's replaced by two separate costs.
One — the asset depreciates, usually straight-line: twenty-seven thousand over three years, so nine thousand and seventy-seven a year. Two — the liability charges interest: five percent of the opening balance, so one thousand three hundred and sixty-two in year one.
Add them: year-one cost is ten thousand four hundred and thirty-nine — not a flat ten thousand. And because interest is highest early, the cost is front-loaded: higher at the start, lower later. Same total, different shape.
That's the textbook lease. Now — one company, and every curveball real life throws at it.
Meet Nordic Coffee, a UK chain. It signs exactly that lease — a store, three years, ten thousand a year, at five percent. So right now, on Nordic's books: a right-of-use asset and a lease liability, both twenty-seven thousand, two hundred and thirty-two. Let's watch what real life does to them.
Inflation lifts rent — keep the old rate
Year two. The lease is linked to inflation, and a price review lifts the rent from ten to eleven thousand. So — does that extra cost hit this year's profit? No. Nordic re-measures what it owes: the new payments, shrunk to today's value at the original five percent, because an inflation-linked change keeps the old rate. That's twenty thousand, four hundred and fifty-four — up eighteen hundred and sixty. And that increase is simply added to the asset, not expensed. The bigger cost just spreads over the years ahead.
Longer term — use a new rate
Different scenario, same original lease: instead of that inflation bump, imagine business is booming and Nordic extends the deal by two more years. This is a change in the length of the deal — and that flips the rule: now you use a fresh, current rate, say six percent. The payments over the extended term are worth thirty-four thousand, six hundred and fifty-one today — up sixteen thousand fifty-seven. Again added to the asset, now spread over the longer life. Remember the difference: an inflation bump keeps the old rate; changing the length uses a new one.
Exit early — both come off
Not every store works out. One underperforms, so Nordic walks away early — end of year two — paying a one thousand euro penalty to get out. Now both sides come off the books at once: the nine thousand five hundred and twenty-four it still owed, and the nine thousand and seventy-seven of asset left — a difference of four hundred and forty-seven. Take off the one thousand euro penalty, and it's a net five hundred and fifty-three euro loss — and it lands in profit, not tucked into the asset like the others.
Two ropes, one post
Now the one that trips up almost everyone: a lease in a foreign currency. Stay with me — it's simpler than it looks.
Nordic opens a shop in Berlin. The rent's in euros, but Nordic keeps its accounts in pounds — so every year it has to convert. And here's the catch: two things convert differently. What Nordic owes is a fixed pile of euros, so it's re-converted at today's exchange rate every single year. But the asset — its right to use the shop — was locked into pounds on day one and never moves again. Picture two ropes tied to the same post: the debt stretches and shrinks as the exchange rate moves; the asset stays nailed down. Over time they drift apart — and that gap shows up in Nordic's profit as an exchange gain or loss. Nothing about the shop changed; only the exchange rate did.
The right-of-use is more than the rent
Rewind to day one for a moment, because the asset was actually more than just the lease. Nordic also paid initial direct costs to arrange it — legal fees, the agent's commission — and it knows that at the end, it'll have to strip the unit out and hand it back as it found it. Both of those go into the asset too: the upfront cost of setting up the lease, and the future cost to restore the space. The shelving, counters and signage it installed, though, are a separate asset under IAS sixteen — not part of the lease. The right to use is more than the rent alone.
Show the shape of the commitments
At year-end, Nordic can't just show a single number — it has to show the shape of what's coming. The key one is a maturity table: how much of its lease debt falls due within a year, how much in one to five years, and how much beyond. Add the assets by type, plus the depreciation and interest, and a reader can finally see the real commitments. Here's the note they'd actually see.
Sub-let a corner — now you're the landlord
Then Nordic flips to the other side of the table. It sub-lets a quiet corner of the store to a florist — so now Nordic is the landlord. Two things to know. First: is this a big deal or a small one — does it hand over most of the value, or just a slice? And second, the trick: Nordic judges that against its own right to use the store, not the building itself. If the florist takes most of that right, it's treated as a finance sub-lease: Nordic gives up part of its asset and books what it's owed instead.
Onto the books — the easy way
One last question: how did all these leases land on the books in the first place? Before 2019, most were invisible — just rent mentioned in the notes. When IFRS 16 arrived, most companies took the simpler road, called modified retrospective: don't rewrite history, just measure what you owe on day one and move forward. A clean line in the sand.
Every lease, handled
So — the whole toolkit, in one screen. Measure the lease at present value. Inflation rise: keep the old rate, add it to the asset. Extend the term: new rate, add it to the asset. Exit early: derecognise both, gain or loss to profit.
Foreign currency: the debt moves with the exchange rate, the asset doesn't. Plus fit-out and restoration in the asset, a maturity note for disclosure, sub-leases judged against your right-of-use, and modified retrospective on day one.
Master these, and no lease — however messy — can catch you out. That's IFRS 16 in the real world. Next time — IFRS 18, and how financial statements are being redesigned. See you there.