IFRS 16 requires the recognition of a “right of use” (ROU) asset on the balance sheet for ALL leases undertaken by a business. This ROU asset is recorded under the non-current asset section of the balance sheet and represents the fact that the company has the control and rights to make use of a leased item.
The measurement of the ROU asset can come across as a complex calculation at first but in reality it is quite simple and shares many similarities with the regular IAS 16 PPE accounting requirements. Let’s take a look at what items make up the right of use asset and how to calculate the amount that will go on the balance sheet.
Essentially the right of use asset is made up of 3 separate items:
- The present value of future lease payments
- Any payments made on or before the lease commencement date
- Other associated costs (more details below)
The total of these items is then taken and this is the amount of the ROU asset to be recognized on the balance sheet. A detailed explanation of each element can be found below:
1. The present value of future lease payments
This particular calculation is one of the most important aspects to take into account when calculating the IFRS 16 right of use asset. What we mean by the present value of future lease payments is essentially the total amount of the lease liability, over the life of the lease, discounted to present value.
We calculate this by taking into account the interest rate implicit in the lease and number of years in the lease contract and inputting this into a present value formula. We have a guide on how to do this in excel which can be found here.
At first it may seem a bit unusual to use the value of a liability to calculate the value of an asset. However, if you take the same logic and apply this to a regular, non-leased asset, it makes much more sense. Imagine a business buys a van for £10,000 and chooses to pay on credit in 30 days time. The amount we owe for the van is £10,000 (the liability) but we also have an asset, measured at cost per IAS 16, of £10,000 which is the van.
We are essentially saying the same for the ROU Asset:
Yes we have a liability to pay the lease payments on the asset but in return for that, we get to use an asset of that value to generate economic benefits for our business.
In a really simple scenario, where no other costs/payments are involved, the ROU asset would simply be equal to the lease liability upon its initial measurement.
2. Payments made on or before the lease commencement date
Most lease contracts require a deposit to be paid before the leased asset is handed over. As the deposit is paid before the lease term commences, the deposit is not recognised in the initial lease liability and therefore needs to be added to this figure when calculating the right of use asset.
Similarly, lease payments may be made in advance and this would mean that the first month’s/quarter’s/year’s lease payment is made on the first day of the year. Again, this means they are not included in the initial lease liability and therefore need to be added on to the right of use asset.
The reason for this is fairly simple. The deposit/first lease payment makes up part of the cost of the lease and therefore represents the cost you have incurred to obtain the right to use the asset. The amounts are not recorded in the calculation from step 1 as they are not a liability (they have already been paid) and therefore, we must add them back when calculating the ROU asset.
If any incentives are received such as rent free periods or cash incentives these must be taken off the cost of the right of use asset
3. Other associated costs
Much like the treatment of regular property plant and equipment under IAS 16 any other direct costs associated with undertaking the lease must be capitalised as part of the right of use asset. These could be legal fees or costs incurred to negotiate the lease.
Also any costs which are expected to be incurred at the end of the lease such as dismantling the asset or putting the site back to normal must also be capitalised under IFRS 16.
Once these remaining items have been calculated and accounted for, the full value of the right of use asset has been measured. We will now run through an example.
Example – calculating the IFRS 16 right of use asset.
On 01/01/2021, XYZ limited signed a lease agreement relating to the operating lease of a lorry. The present value of future lease payments is calculated as being £15,400. As well as the lease payments due to be made, XYZ limited paid a deposit of £3,000 in order to obtain the lorry and undertook legal advice when signing the lease agreement which cost £500. A cash incentive was granted upon signing the lease to the value of £300
To calculate the ROU asset we will carry out the following calculation:
- Present value of future lease payments £15,400
- Plus: payments made before the lease commencement date £3,000
- Plus: other associated costs £500
- Less cash incentives -£300
- Total right of use asset = £18,600
Summary
Now that we have calculated the ROU asset, it needs to be recorded in the financial statements. Specifically, it needs to be recorded as an asset on the balance sheet and we have created a guide for this which can be found here.
The guidance for the journal entries explain the subsequent income statement charges relating the amortisation of the ROU asset each year.
Please note, the above guidance is based on our interpretation of the latest IFRS 16 accounting standard. Please take the time to read through the official IFRS standard before performing the above calculations.
