ifrs 16 right of use asset

Right of use asset in IFRS 16 is an asset that represents a right for a lessee to use an underlying asset during the term of the lease.

As we can see in the previous paragraph, we only refer to the term “lessee” for the following reason:

IFRS 16 was issued in January 2016 as a replacement for IAS 17, which was first issued in April 2001.

Before IFRS 16, both lessees and lessors referred to lease arrangements in financial and operating terms.

With the previous standard, NIC 17, an entity recognized an asset in the balance sheet if the agreement fulfilled the financial lease definition.

However, if the transaction was an operating lease, a company would have to recognize an expense in profit or loss.

Then, with the IFRS 16 incorporation, the operating and financial term was replaced with the right of use asset concept.

And from then on, all agreements that contain a lease must be recognized within the statements of financial position.

It is important to say that this change occurred from the lessee’s perspective, since the operating and financial concept is still used from the lessor’s point of view.

Characteristics of right of use asset

Next, we will show a series of this type of asset characteristics to better understand this concept.

When an entity enters into a lease agreement with a third party, the entity has the right to use an asset for a specified period of time.

In other words, the entity does not have control of the asset, but control of the use of the asset.

It is essential to understand that there is a big difference between controlling an asset and controlling its use.

For example, an entity agrees with a third party to lease a warehouse for 40 years with an annual payment of 200,000.

Under IFRS 16, the entity must recognize a right-of-use asset corresponding to the present value of the lease payments to present value.

With the previous standard (IAS 17), this agreement meet the characteristics to be classified as a financial lease.

In that case, with the previous standard, the lessee would have recognized a property, plant, and equipment because it had control of the asset.

However, in IFRS 16, an asset’s control concept does not exist.

In change, this standard refers to the concept of “right of use”

This change is fundamental because from now, the entity management must not evaluate whether an agreement is operational or financial but must assess whether the deal contains a lease and proceed to recognize a right-of-use asset.

Initial recognition right of use asset

According to paragraph 24 of IFRS 16, the initial cost of a right-of-use asset will be made up of the following elements.

  • The amount of the initial measurement of the lease liability, as

    described in paragraph 26.

  • Any lease payments made at or before the commencement date, less

    any lease incentives received.

  • Any initial direct costs incurred by the lessee.

  • An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories.

Example of a right-of-use asset.

An entity leases a warehouse for six years.​

An annual payment of 200,000 is established for the right to use the asset.

The company will use the warehouse to store medicines.

Due to medicine’s characteristics, it will be necessary to make modifications to the asset to meet the requirements to store this type of inventory.

For this, it was necessary to incur disbursements of 50,000.

According to the warehouse owner, once six years have passed, the entity will deliver the asset under the same conditions as those established at the beginning of the agreement.

For this reason, the company’s management considers it will have to incur 30,000 to restore the asset once the rental contract ends.

The entity uses a 10% rate to determine the present value effect of lease payments and show the effect of decommissioning costs.

At the beginning of year 4, the entity considers the disbursements to restore the asset should go from 30,000 to 65,000.

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To solve this exercise, we are going to follow the following steps.

1 Step: Make the amortization table of the lease liability.

2 Step: Make the Dismantling costs amortization table.

3 Step: Carry out the accounting recognition of the right-of-use asset and the contract liability

Step 4: Recognize the accumulated depreciation of the right-of-use asset until the end of year 3.

Step 5: Recognize the interest, the principal payment and lease payment of until the end of year 3, in addition to the increase in the liability for the provision for dismantling.

6 Step: Adjust the change in the value of the dismantling provision   according to IFRIC 1.

Step 7: Determine the new carrying amount of the right-of-use asset and the lease liability.

1 Step: Make the amortization table of the lease liability.

ifrs 16 right of use asset

Let’s remember that the IFRS 16 paragraph 26 establishes that an entity will measure at the beginning of the agreement the lease liability for the equivalent of the present value of the payments established in the contract.

To calculate the present value is necessary to use must use a formula in Excel called PV

Year 1: Present Value = PV (10%; 6; -200,000) = 871,052

Year 2: Present Value = PV (10%; 5; -200,000) = 758,157

Principal’s payment

Year 1: 871,050 – 758,157 = 112,895

Year 2: 758,157 – 633,973 = 124,184

Loan interest

Year 1: 200,000 – 112,895 = 87,105

Year 2: 200,000 – 124,184 = 75,816.

2 Step: Make the Dismantling costs amortization table.

ifrs 16 right of use asset

Present value year 1: = ((1 + 10%) ^ – 6) * 30,000 = 16,934

Present value year 2: = ((1 + 10%) ^ – 5) * 30,000 = 18,628

3 Step: Carry out the accounting recognition of the right-of-use asset and the contract liability

Right-of-use asset

+Present value of lease payments: 871,052

+Directly attributable costs: 50,000

+Decommissioning Cost: 16,934

Total assets: 937,446

ifrs 16 right of use asset

Step 4: Recognize the accumulated depreciation of the right-of-use asset until the end of year 3.

ifrs 16 right of use asset

Accumulated depreciation = (937,986 / 6) x 3) = 468,993

Step 5: Recognize the interest, the principal payment and lease payment of until the end of year 3, in addition to the increase in the liability for the provision for dismantling.

ifrs 16 right of use asset

The payment of the lease liability is made up of the principal payment for years 1, 2, 3, equivalent to 112,895 + 124,184 and 136,603.

6 Step: Adjust the change in the value of the dismantling provision   according to IFRIC 1.

Paragraph 5 of IFRIC 1, changes in existing liabilities for decommissioning, restoration, and similar, establishes changes in the decommissioning liability will be added or deducted from the asset and in the same way with the arrangement liability.

However, before making this accounting adjustment, we must determine the carrying amount of the decommissioning liability at the end of year 3.

Provision opening balance 16,934

Adjustments: 5.605

The final balance for year 3: 22,539

Now it is necessary to calculate the new depreciation cost amortization table, only for three years, based on the new information.

ifrs 16 right of use asset

As we can see, the new balance of the present value is 53,719, and the previous balance is 22,539; therefore, it is necessary to adjust the asset for the right of use and the liability of the lease in 31,180, which is the difference between 53,719 and 22,539.

ifrs 16 right of use asset

Step 7: Determine the new carrying amount of the right-of-use asset and the lease liability.

To determine the carrying amount of asset and liabilitie, it is necessary to calculate this value at the end of year 3.

Asset cost: 937,986

Accumulated depreciation: (468,993)

Carrying amount: 468,993

Initial liability balance: 871,052

Adjustments: (373,862)

New liability balance: 497,370

New carrying amount asset = carrying amount asset at year 3 + adjustment due to change in decommissioning costs.

New carrying amount asset = 468,993 + 31,180 = 500,173

New liability carrying amount = Year 3 carrying amount + adjustment due to change in decommissioning costs.

 New liability carrying amount = 497,370 + 31,180 = 528,550.

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