right of use asset meaning and example

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

For example, Company A, leases a building from entity B.

In this case, company A will be the lessee, and entity B will be the lessor company.

The previous is highly relevant because lease accounting for lessees changed radically from the entry into force of IFRS 16.

In other words, before IFRS 16, lessees were classified as operating and finance.

That is, the lessee was financial if for example, the asset was transferred to the lessee at the end of the contract.

In this case, the lessee recognized a property plant and equipment.

And on the other hand, if the lease was operating, the lessee entity recognized in profit or loss expense for the monthly rental payment of the asset.

From the lessor’s point of view, IFRS 16 is unchanged from the previous standard.

However, there was disagreement with this model because the information presented on operating leases lacked transparency and did not meet the users’ needs for the financial statements.

For this reason, the concept of the operating and financial lease was eliminated by a concept called a right-of-use asset.

Are you looking to stay ahead in the ever-changing business world and enhance your understanding of International Financial Reporting Standards (IFRS)?

Look no further!

Our IFRS course is designed to provide you with the knowledge and skills you need to succeed in today’s global economy.

Our course is led by industry experts who have years of experience in the field, providing you with the most up-to-date and relevant information.

The course is designed to be interactive, with quizzes, case studies, and practical examples to help you retain the information and apply it in the real world.

The course is also flexible, it’s available online, allowing you to learn at your own pace and on your own schedule.

Plus, we offer a money-back guarantee, meaning that if you are not satisfied with the course, we will refund your money.

Don’t miss this opportunity to stay ahead of the game and gain a competitive edge in the business world.

Sign up for our IFRS course today!

Right of use asset meaning

As we said before, an asset of this nature represents the right to use the asset for a certain period.

In other words, it is the benefit associated with using an asset in a lease contract.

Continuing with the analysis, then what is the difference between a right-of-use asset and property plant and equipment?

The difference when exists a property plant and equipment is that an entity controls the asset.

While in a right-of-use asset, an entity has control over the use of an asset for a specified period.

That is, the control over an asset is so different from control over its use of an asset for a period established in a contract.

However, both assets must be recognized in the statement of financial position and recognize their depreciation.

Nevertheless, in the case of property plant and equipment, its depreciation will be over its useful life, while in a right-of-use asset over the useful life of the lease.

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.

Then, this is an example of 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 return 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.

The objective of this exercise is to determine the carrying amount of the right-of-use asset and the lease liability at the beginning of year 4.

The first thing we must do is make the amortization table of the lease liability.

So, the present value at the beginning of the contract is equal to 871,052.

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

On the other hand, the principal payment for year 1, will be the difference between the present value of the lease liability for year 1 and 2.

And in the same way, the principal payment for year 2 will be the difference between the present value of the lease liability for years 2 and 3.

Later we will see the accounting recognition of these calculations.

Year 1: 871,050 – 758,157 = 112,895

Year 2: 758,157 – 633,973 = 124,184

Loan interest

And finally, the interest calculation for year 1, will be made up of the difference between the annual lease payment of 200,000, minus the principal payment.

We do the same for year 2.

Year 1: 200,000 – 112,895 = 87,105

Year 2: 200,000 – 124,184 = 75,816.

In this way, we can proceed to make the amortization table for dismantling costs.

Right of use asset meaning and example-2

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

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

Then , we know that the entity must disburse 30,000 at the end of the lease to leave the asset in the same condition as it was to return at the beginning of the contract.

It is important to say that according to IFRS 16, dismantling costs must be recognized as a higher value of a right of use asset.

But it would be a mistake to recognize the disbursement of 30,000 as part of the right-of-use asset because these resources will be disbursed in the future.

The correct thing is to recognize the value of 30,000 brought to present value,

This results in a decommissioning cost equivalent to 16,934.

Now that we have these calculations, we can know what is the initial value of our right-of-use asset is.

We have that our right-of-use asset will be made up of the present value of the lease liability equivalent to 871,052.

We must also add the disbursements of 50,000 to adapt the asset to the necessary conditions to operate in accordance with the specifications of the entity’s management.

And finally, the dismantling costs of 16,934.

This operation results in a total of 937.986

Right-of-use asset

+Present value of lease payments: 871,052

+Directly attributable costs: 50,000

+Decommissioning Cost: 16,934

Total assets: 937,986

In this way, the accounting recognition would be as follows.

ifrs 16 right of use asset

As we can see, dismantling costs were recognized as a higher value of the right-of-use asset.

The next step will be to calculate the depreciation of the right-of-use asset until the end of year 3.

This gives a value of 468,993.

ifrs 16 right of use asset

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

But this is not all, we must also recognize the lease payment and interest.

In this way, the accounting recognition would be as follows.

As you can see, the entity reversed 3 years of the financial obligation, and on the other hand, the entity recognized interest for 3 years.

In addition, it’s necessary to reverse the decommissioning provision.

In this way, the accounting recognition would be as follows.

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.

And the other hand, we must return the dismantling provision until we reach 30,000.

However, at this point we have a small problem.

It turns out that the entity at this point considers that at the end of the lease the costs for dismantling will no longer be 30,000, but 65,000.

When an event of this nature occurs, an entity should review the 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.

For this we know that the initial balance of the dismantling provision is equal to 16,934.

This value must be adjusted by the interests of years 1, 2 and 3.

Since the balance of the dismantling provision at the end of year 3 is equal to 22,539.

Nevertheless, since there was a change in the estimate of dismantling costs, it is necessary to make a new amortization table.

Right of use asset meaning and example-1

As we can see, the new present value balance is 48,835, and the old balance is 22,539; therefore, it is necessary to adjust the right-of-use asset and the lease liability by 26,296, which is the difference between 48,835 and 22,539.

The accounting recognition of this adjustment will affect both the right-of-use asset and the liability of the contract in the same amount.

Provision opening balance 16,934

Adjustments: 5.605

The final balance for year 3: 22,539

Right of use asset meaning and example 3

Now to calculate the carrying amount of the asset at the end of year 3, we must do the following operation.

We know that the initial balance of this asset is 937,986.

Therefore, the accumulated depreciation at the end of year 3 will be 468,993.

Then, the carrying amount of the right-of-use asset in this example will be 468,993.

This balance must be affected by the change in the estimate of dismantling costs equivalent to 26,296.

In this way, the new carrying amount at the beginning of year 4, is 495,289.

Asset cost: 937,986

Accumulated depreciation: (468,993)

Carrying amount: 468,993

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

New carrying amount asset = 468,993 + 26,296 = 495,289

On the other hand, we see that the liability of the contract at the end of year 3 is equal to 497,370.

This value must also be affected by the change in the estimate of dismantling costs.

Then, the new contract liability at the beginning of year 4, is 523,666.

In conclusion, we show an overview of right of use asset definition.

If you have any questions, leave us a comment.

I hope this post has been useful and see you in the next articles.

News related to right of use asset meaning

Implementing the New FASB Lease Accounting Standard: Lease Classification

If you liked this content please share this post

Facebook