What is a Lease Liability? Measurement Under Ind AS 116

Recognising a right-of-use asset requires recognising something on the other side of the balance sheet. That something is the lease liability — and getting its measurement right depends on two decisions that carry more judgement than most people expect: which payments to include, and what rate to discount them at.

What is a Lease Liability?

A lease liability is the lessee’s obligation to make lease payments, measured at the present value of the lease payments not yet paid at the commencement date.

It is recognised alongside the corresponding right-of-use asset. The two arise from the same contract and are recognised at the same moment.

Which Payments Are Included

Two of these deserve elaboration because they drive most of the measurement difficulty.

Variable payments — the index distinction

A rent that increases annually by a fixed 5% is effectively fixed and is included. A rent that rises with an inflation index is included, measured using the index at commencement. But a rent calculated as a percentage of store sales is excluded from the liability entirely and expensed as incurred.

This creates a genuine difference between retailers on fixed rents and those on turnover-linked rents — the latter report smaller lease liabilities for economically similar arrangements.

Extension and termination options

Where a lease has a five-year term with a five-year extension option, the liability covers five years or ten depending on whether extension is reasonably certain.

That assessment considers economic incentive — significant leasehold improvements, the cost of relocating, whether the location is strategically important, and whether the rent in the option period is below market. It is a judgement, and it can double or halve the reported liability.

The Discount Rate

Ind AS 116 sets a clear hierarchy:

1. The interest rate implicit in the lease, if readily determinable
2. Otherwise, the lessee’s incremental borrowing rate

The implicit rate is the rate that makes the present value of lease payments plus unguaranteed residual value equal the fair value of the underlying asset plus the lessor’s initial direct costs.

In practice it is rarely determinable, because a lessee does not know the lessor’s assumptions about residual value. So most lessees use the incremental borrowing rate — the rate they would pay to borrow, over a similar term with similar security, the funds needed to obtain an asset of similar value in a similar economic environment.

The rate matters enormously. Discounting the same payment stream at 8% rather than 11% produces a materially larger liability, particularly for long leases.

Worked Example

A five-year office lease at ₹20 lakh per year, paid annually in arrears, discounted at 9%:

Total payments are ₹1 crore; the liability is roughly ₹77.8 lakh. The ₹22.2 lakh difference is the interest that will be recognised over the lease term.

How the Liability Unwinds

Subsequently the liability is measured using the effective interest method:

Closing liability = Opening liability + Interest accrued − Payment made

Interest falls each year as the balance reduces — ₹7.00 lakh in year 1 down to ₹1.65 lakh in year 5. Meanwhile ROU asset depreciation stays level at ₹15.56 lakh a year.

This is the front-loading effect in numbers. Total across five years is ₹1 crore either way — but the profile differs, and for a rapidly expanding company with many new leases, the early-year excess is not offset by mature leases.

Remeasurement

The liability is remeasured when certain events occur, with a corresponding adjustment to the ROU asset:

Where the adjustment exceeds the carrying amount of the ROU asset, the excess goes to profit or loss.

Presentation

Lease liabilities are shown separately from other liabilities, split between current and non-current. In the cash flow statement, principal repayments sit in financing activities, while interest follows the entity’s Ind AS 7 policy for interest paid.

Key Takeaways

• A lease liability is the present value of unpaid lease payments at commencement
• Fixed and index-linked payments are included; sales-linked variable payments are not
• Extension options are included only where exercise is reasonably certain — a significant judgement
• Discount at the implicit rate if determinable, otherwise the incremental borrowing rate
• Most lessees use the incremental borrowing rate because the implicit rate is rarely known
• The liability unwinds using the effective interest method — interest is highest in year one
• Combined with straight-line depreciation, this produces a front-loaded expense
• Remeasurement adjusts the ROU asset, with excess going to profit or loss

Frequently Asked Questions (FAQ)

Q: What is a lease liability under Ind AS 116?

It is the lessee’s obligation to make lease payments, measured at the present value of payments not yet made at the commencement date. It is recognised together with a corresponding right-of-use asset.

Q: Which payments go into the lease liability?

Fixed payments less incentives receivable, variable payments linked to an index or rate, amounts expected under residual value guarantees, purchase option price where exercise is reasonably certain, and termination penalties where relevant. Payments linked to sales or usage are excluded and expensed as incurred.

Q: What discount rate is used for a lease liability?

The interest rate implicit in the lease if readily determinable, otherwise the lessee’s incremental borrowing rate. Since lessees rarely know the lessor’s residual value assumptions, the implicit rate is usually not determinable and the incremental borrowing rate is used.

Q: Are lease extension options included in the liability?

Only where exercise is reasonably certain at commencement. The assessment considers economic incentives such as leasehold improvements, relocation costs and whether option-period rent is below market. This judgement can substantially change the reported liability.

Q: Why is the lease expense higher in early years?

Because the ROU asset depreciates evenly while interest on the liability is highest when the balance is largest. Combined depreciation and interest therefore exceed the old straight-line rent in early years and fall below it later, though total cost over the lease is identical.

Q: When is a lease liability remeasured?

On a change in lease term or purchase option assessment, using a revised discount rate; and on changes in expected residual value guarantee amounts or in an index or rate affecting payments, using the unchanged rate. The adjustment goes against the ROU asset.

Q: Where does lease liability repayment appear in the cash flow statement?

Principal repayments are classified within financing activities. Interest follows the entity’s accounting policy for interest paid under Ind AS 7. This is why adopting Ind AS 116 increased reported operating cash flow for many companies.

Related Reading:

• What is a Right-of-Use Asset?
• What is the Incremental Borrowing Rate?
• Ind AS 116 Impact on Financial Ratios
• What is Debt-to-Equity Ratio?