IFRS 16 applies to annual reporting periods beginning on or after 1 January 2019. Getting the accounting right requires both reliable lease data and documented judgements.
How much an error affects the accounts depends on the size and timing of the payments and on the lease term. The number of premises alone does not tell you the amount.
Below we go through five risk areas in IFRS 16 accounting for commercial property leases — and how to catch them.
What IFRS 16 actually requires, in brief
IFRS 16 replaced IAS 17 and applies to annual reporting periods beginning on or after 1 January 2019. The central change was that the lessee’s distinction between operating and finance leases disappeared. In principle, all leases — including leases of offices, shops and warehouses — are now recognised on the balance sheet, with limited exemptions for short-term leases (12 months or less and without a purchase option) and leases of low-value assets.
Two items arise at the commencement date:
- Right-of-use asset. Represents the right to use the premises.
- Lease liability. Represents the obligation to make future lease payments.
The lease liability is measured as the present value of the lease payments not yet paid that fall within the measurement, discounted using the interest rate implicit in the lease if that rate can be readily determined. In practice it is almost never known for property leases, so the lessee’s incremental borrowing rate (IBR) is used instead.
The liability increases with interest and decreases with payments. The right-of-use asset is depreciated under the standard’s rules, for premises often on a straight-line basis over the lease term. With even payments, interest and depreciation together normally give a higher expense at the start than at the end.
That is the basic principle. It gets difficult when you have to apply it to 30 leases with different terms, index clauses, extension options and rent-free periods.
Mistake 1: The wrong discount rate
The discount rate affects the initial amount of the liability and the interest expense. Test the sensitivity against alternative rates and document why the chosen rate fits the lease.
The typical errors:
- WACC is used instead of IBR. The company’s weighted average cost of capital includes the required return on equity and is normally well above the incremental borrowing rate — and it is the wrong rate under the standard whatever its level. This is the kind of error that starts with someone “doing the simplest calculation” and then stays because every lease follows the same principle.
- The same rate is used for every lease regardless of term. The IBR should reflect a similar term, security, value of the asset and economic environment. Different terms need to be assessed, but they do not automatically lead to different rates.
- The rate is not updated on renegotiation or significant changes. When the lease term changes — for example because an extension option is now judged “reasonably certain” to be exercised — a revised discount rate is used in the remeasurement. For pure index adjustments, by contrast, the original rate is used.
The remedy is a rate policy that is documented, dated and covers different terms and currencies. The treasury function is the right owner. Auditors look for exactly this when they assess reasonableness.
Mistake 2: Indexed rents handled incorrectly
For payments that depend on an index, IFRS 16 sets out how initial measurement and later remeasurement are done. A forecast of future inflation must not be built into the initial amount.
The basic rule (IFRS 16.27 b): at the commencement date the lease liability is measured using the rent level that applies at that date. No forecasts of future inflation or index movements are built in. When the index adjustment actually takes effect — typically at the turn of the year — the lease liability is remeasured under IFRS 16.42 b, with the original discount rate unchanged, and the right-of-use asset is adjusted by the same amount.
There are two common errors:
- The remeasurement is made at the wrong time. The index figure is usually published some weeks after the reference month — in Sweden, for example, the October CPI is published in mid-November and the new rent applies from 1 January. Under IFRS 16.42 b the remeasurement is made when the adjustment takes effect on the payments — that is, at the turn of the year, not merely because the index has been published. Assess when the adjustment under the lease takes effect on the cash flows. It is worth aligning this with your auditor and documenting it as a principle.
- The remeasurement is not made at all. In companies with many leases and manual processes, some leases are simply missed. The index supplement is invoiced and paid, but the lease liability is not updated. The liability on the balance sheet then does not reflect the future cash flows. It becomes a qualitative deviation that the auditor will ask about.
Mistake 3: Options assessed inconsistently
Many property leases contain an option to extend for a further period — typically three years at a time — unless the tenant gives notice. The question IFRS 16 asks is: is it “reasonably certain” that the option will be exercised?
Extension periods are included when exercise is judged reasonably certain. Reassessment is required on relevant significant events or changes in circumstances within the lessee’s control, not every time market expectations change.
The typical errors:
- All options are assumed to be exercised. A general assumption that every option will be exercised can overstate the liability. Assess the circumstances of the leases concerned.
- No options are assumed to be exercised. The opposite error. If the company has in fact made significant investments in the premises, or runs a business that depends on that particular location, it is not reasonable to assume that the lease ends at the first opportunity.
- The assessment is made at commencement but never revisited. When circumstances change — for example a fit-out that ties the business to the premises — the assessment is to be revisited. This is often missed.
The lesson: document the basis for the assessment at commencement. The standard requires reassessment when something significant happens that is within your control — a recurring internal review is a good way to catch those events in time.
Mistake 4: Rent-free periods and fit-outs calculated incorrectly
A rent-free period should be visible in the payment schedule. A cash lease incentive received at or before commencement reduces the cost of the right-of-use asset. An incentive to be received later is taken into account in measuring the payments. Contributions to fit-outs need to be assessed according to their substance.
Use the actual timing of the payments. If an initial rent-free period is replaced by the same average rent every month, part of the payments is brought forward. With a positive discount rate, the present value is then higher than with the correct payment schedule.
For fit-outs you have to assess who controls the asset and what a payment relates to. Who pays the invoice does not on its own determine the accounting. A payment may be a lease incentive; the tenant’s own improvement expenditure is assessed separately under IAS 16.
The distinction is not always obvious from the lease wording. It is worth reviewing every new lease with a specific eye on incentives.
Mistake 5: Variable payments mixed up with fixed ones
IFRS 16 distinguishes between different types of lease payment. It is a distinction that does not come naturally:
- Fixed payments are included in the lease liability from the start.
- Variable payments that depend on an index or a rate are included from the start (at the initial level) and adjusted when the index changes.
- Variable payments that depend on anything else — typically turnover in retail premises — are not included in the lease liability at all, but are expensed as they arise.
The error arises when a company has turnover-based rent with a minimum (a typical structure in retail) and treats the whole rent as fixed. The lease liability is then too large, and the income statement does not get the variability that turnover rent actually brings.
The correct treatment: the minimum amount is included in the lease liability as a fixed payment, and the variable part is expensed when turnover triggers it.
In practice: how to catch these errors
If you are responsible for IFRS 16 accounting, these are the three reviews that tend to reveal the most:
- The discount rate. Reconcile it with a current rate policy. If there is none, that is a finding in itself.
- Remeasurement of the lease liability on index changes. Take three randomly selected leases with large rent adjustments in the past two years and check that the liability was actually remeasured at the right time using the right original discount rate.
- The option assessments. Take three leases with options and ask for the documentation of why each option is or is not judged reasonably certain to be exercised. If the documentation is generic or missing, that is often where the errors are.
When Excel is no longer enough
Excel can be used if calculations, changes and reconciliations have adequate controls. Complexity and workflows matter more than a general limit on the number of leases.
IFRS 16 sets no threshold at which Excel must be replaced by a system. Kvarto can support the calculation of the lease liability and the right-of-use asset based on recorded lease data and judgements.
The quality depends on both the lease data and the judgements. Document the rate, the lease term and incentives, and reassess when the standard’s criteria are met. An annual check can be an internal routine, but it does not mean that the rate should change every year.
This article is written for information purposes and does not constitute accounting or legal advice. For questions about specific leases and actual IFRS 16 calculations, we always recommend contacting your auditor.