Two tests, one store
Updated: 10 hours ago
When a cash-generating unit includes leased property, does the lease liability belong in the impairment test?
Corrib Home Ltd sells homewares from leased stores across the west of Ireland. Its Shop Street store has had a poor year, so it is tested for impairment at 31 December 2026. Before IFRS 16 the test was simple: rent was an operating cost, deducted in the cash flows like wages and electricity. Now the store carries a right-of-use asset, and the lease sits on the balance sheet as a liability.
The right-of-use asset is clearly part of the unit. The liability is less clear. Corrib's finance team tries it both ways. Leaving the liability out shows an impairment of €224,000. Deducting it shows headroom of €428,000. Both methods are used in practice, and both can be defended under IAS 36. They should not give such different answers, and understanding why they do is the point of this post.
What IAS 36 says
Right-of-use assets are tested under IAS 36 (IFRS 16.33), usually as part of the cash-generating unit they serve, because a store lease does not generate cash inflows on its own.
Liabilities are normally left out. The carrying amount of a unit excludes recognised liabilities, unless the recoverable amount cannot be determined without considering them (IAS 36.76(b)).
Financing cash flows are left out of value in use (IAS 36.50). Under IFRS 16, lease payments repay a financing liability: principal and interest.
But a buyer may have to take the liability over. If disposing of the unit would require the buyer to assume a liability, the carrying amount of that liability is deducted in determining both the unit's carrying amount and its value in use, so the comparison is like for like (IAS 36.78). For practical reasons, recoverable amount is sometimes determined after considering recognised liabilities, and the carrying amount is then reduced by those liabilities too (IAS 36.79).
Whatever you do, be consistent. The carrying amount of a unit is determined on a basis consistent with the way its recoverable amount is determined (IAS 36.75).
That gives two approaches. Leave it out: the right-of-use asset is in the unit, the lease liability is not, and lease payments are excluded from the cash flows. Deduct it: the lease liability reduces the carrying amount, and the value in use is reduced by it too, either by deducting the liability's carrying amount or, more often in practice, by keeping the rent in the cash flows.
Corrib Home's Shop Street store
The store's right-of-use asset is carried at €3,500,000 and its fit-out and fixtures at €2,500,000. The lease has ten years to run at €500,000 a year, paid in arrears, and the lease liability, discounted at Corrib's incremental borrowing rate of 5%, is €3,861,000. Before rent, the store is expected to generate €900,000 a year for the ten years. Corrib does not expect to renew the lease, so there is no terminal value. The pre-tax discount rate for the unit is 9%. (All figures in € thousands from here.)
Shop Street store (€'000) | Leave it out | Deduct it: IAS 36.78 | Deduct it: rent in the cash flows |
Right-of-use asset | 3,500 | 3,500 | 3,500 |
Fit-out and fixtures | 2,500 | 2,500 | 2,500 |
Lease liability | – | (3,861) | (3,861) |
Carrying amount | 6,000 | 2,139 | 2,139 |
Cash flows discounted at 9% | 900 a year | 900 a year | 400 a year (900 less rent of 500) |
Value in use | 5,776 | 1,915 (5,776 less 3,861) | 2,567 |
Headroom / (impairment) | (224) | (224) | 428 |
The first two columns agree, as they should. Deducting the liability at its carrying amount from both sides takes the same €3,861 off each, so the answer cannot change. That is what IAS 36.78 describes, and it is why some commentators call the choice neutral.
The third column is where the headroom appears. It deducts the rent in the cash flows, discounted at 9%, rather than the liability at its carrying amount. Ten payments of €500 discounted at 9% are worth €3,209. The liability, discounted at 5%, is €3,861. The difference, €652, is exactly the swing from a €224 impairment to €428 of headroom.
Why the answers differ
The discount rate. This is the main reason. Cash flows after rent are leveraged: the store has to pay a fixed €500 a year whatever its sales. A cash flow stream with fixed payments ahead of it is riskier, and should be discounted at a higher rate. If rent stays in the cash flows, the rate has to reflect that. For Corrib, the rate that brings the third column back to the first is about 16.3%, not 9%. Using a rate built for unleveraged cash flows on leveraged ones overstates the headroom. The reverse also holds: if rent is left out, the rate should treat lease liabilities as part of the unit's financing, which usually brings it down a little compared with a pre-IFRS 16 rate.
Cash flows beyond the lease term. If the forecast or terminal value assumes the store keeps trading after the current lease ends, the rent for those later years is not part of the recognised liability. It must still be deducted in the cash flows, whichever approach you use. Leaving all rent out of a perpetual terminal value, when only ten years of it are on the balance sheet, is one of the most common errors in these models.
Payments that were never in the liability. Variable rent linked to sales, service charges and payments for short-term or low-value leases are not in the lease liability. They stay in the cash flows as operating outflows under both approaches.
Fair value less costs of disposal. If recoverable amount is fair value less costs of disposal and a buyer would take the lease over, the price reflects the liability. Deduct it, so the value and the carrying amount are measured on the same basis (IAS 36.78).
Recognising Corrib's loss
Corrib leaves the liability out, so it recognises an impairment loss of €224. The store has no goodwill, so the loss is allocated pro rata to the assets in the unit (IAS 36.104): €131 to the right-of-use asset and €93 to the fit-out and fixtures, provided neither falls below its own recoverable amount where that can be measured (IAS 36.105).
The loss reduces assets only. The lease liability is untouched: Corrib still owes the rent, interest continues to accrue, and the right-of-use asset is depreciated on its reduced amount over the rest of the lease. That is also why an impairment can never exceed the assets in the unit, however large the liability.
Which approach to use
Leaving the liability out is the cleaner reading of IAS 36.50 and 36.76, and it keeps the test focused on the assets. Deducting the liability is acceptable, and sometimes necessary when recoverable amount is fair value less costs of disposal, provided it is done consistently. Whichever you choose:
apply it to every unit and every period, and explain it in the note;
make the discount rate consistent with the cash flows: unleveraged with rent excluded, leveraged with rent included;
deduct rent for periods after the current lease term, including in any terminal value;
keep variable and short-term lease payments in the cash flows; and
if the two approaches would give materially different answers, find out why before you sign. The difference is usually a rate problem, not a real one.
Where the choice affects whether an impairment is recognised, it is likely to be a significant judgement to disclose. The Tipping Point helps document it.
The audit angle
Auditors look for consistency first: is the rent inside or outside the cash flows, and does the discount rate match? They recompute the lease liability, check that the forecast deducts rent beyond the lease term, and test whether a reasonably possible change in the rate would remove the headroom (ISA 540). A unit that passes only on the leveraged-cash-flow approach with an unleveraged rate is a red flag.
Our Audit Risk Matrix and Audit Procedure Builder help plan the work on impairment estimates.
In short
The right-of-use asset is part of the unit. The lease liability normally is not (IAS 36.76).
Deducting the liability at its carrying amount from both sides gives the same answer as leaving it out (IAS 36.78).
Deducting rent in the cash flows gives a different answer unless the discount rate reflects the leverage it creates.
Rent beyond the lease term, variable rent and short-term lease payments stay in the cash flows either way.
Impairment losses reduce assets, never the lease liability.
Tools and templates
Our CGU impairment template tests one unit in Excel: carrying amount with right-of-use assets as part of the unit, value in use from a five-year pre-tax forecast with a terminal value, recoverable amount, allocation of the loss with the IAS 36.105 floor, the journal, headroom, a sensitivity grid, the break-even discount rate and a draft note. It follows the leave-it-out approach, with liabilities deducted only in the IAS 36.78 case.
Related on the site:
IFRS 16 Lease Calculator: the lease liability and right-of-use asset at any date, online.
Lease calculator template: the same schedule in Excel.
IAS 36 Impairment of Assets and IFRS 16 Leases: the Learning Hub notes.
Corrib Home Ltd is fictional. Figures are rounded to the nearest €1,000. References are to IAS 36 Impairment of Assets and IFRS 16 Leases.
