What is a Right-of-Use Asset?
A right-of-use asset represents a lessee's right to use an underlying asset for the right-of-use asset under IFRS 16. The right-of-use asset is a non-financial asset recognised on the lessee's balance sheet, reflecting the economic benefits the lessee expects to derive from controlling the use of the leased asset throughout the lease period.
The right-of-use asset is distinct from the underlying asset itself. The underlying asset remains the property of the lessor, whilst the right-of-use asset represents the lessee's contractual right to use that asset. This distinction is fundamental to the IFRS 16 lease accounting model, which brings most leases onto the lessee's balance sheet.
The recognition of right-of-use assets ensures that a lessee's financial statements provide a faithful representation of its assets and liabilities, eliminating the previous distinction under IAS 17 between finance leases and operating leases for lessees.
This article forms part of our full IFRS 16 guide.
Key Definition
A right-of-use asset is defined in IFRS 16 as "an asset that represents a lessee's right to use an underlying asset for the lease term."
Initial Recognition
A lessee recognises a right-of-use asset at the commencement date of the lease. The commencement date is the date on which the lessor makes the underlying asset available for use by the lessee, not the inception date when the lease contract is signed.
At the commencement date, the lessee recognises both:
- a right-of-use asset; and
- a lease liability.
The recognition requirement applies to all leases, except where the lessee elects to apply the recognition exemption for short-term leases or leases of low-value assets.
The initial accounting entry on the commencement date is:
Debit: Right-of-use asset
Credit: Lease liability
Credit: Cash (for any prepaid lease payments or initial direct costs)
Commencement vs Inception
The commencement date (when the asset is made available for use) differs from the inception date (when the lease is agreed). Recognition occurs at commencement, not inception.
Initial Measurement
A right-of-use asset is initially measured at cost. The cost of the right-of-use asset comprises:
-
The initial measurement of the lease liability – the present value of lease payments not yet paid at the commencement date, discounted using the interest rate implicit in the lease or, if that rate cannot be readily determined, the lessee's incremental borrowing rate.
-
Lease payments made at or before the commencement date – including any prepaid lease payments, less any lease incentives received from the lessor.
-
Initial direct costs incurred by the lessee – incremental costs of obtaining the lease that would not have been incurred if the lease had not been obtained, such as commissions, legal fees, and costs directly attributable to negotiating and arranging the lease.
-
Restoration, removal and dismantling costs – an estimate of costs the lessee will incur to dismantle and remove the underlying asset, restore the site on which it is located, or restore the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories.
The initial measurement can be expressed as:
Right-of-use asset cost = Lease liability + Prepaid lease payments - Lease incentives received + Initial direct costs + Restoration costs
Lease Incentives
Lease incentives received (such as rent-free periods or cash payments from the lessor) reduce the cost of the right-of-use asset, thereby reducing depreciation over the lease term.
Subsequent Measurement
After the commencement date, a lessee measures the right-of-use asset using a cost model, unless it applies one of the exceptions below.
Under the cost model, the right-of-use asset is measured at:
- cost;
- less any accumulated depreciation;
- less any accumulated impairment losses; and
- adjusted for any remeasurement of the lease liability.
Alternative Measurement Models
IFRS 16 permits two alternative measurement models in specific circumstances:
Revaluation Model (IAS 16): If the right-of-use asset relates to a class of property, plant and equipment to which the lessee applies the revaluation model in IAS 16, the lessee may elect to apply that model to all right-of-use assets relating to that class of property, plant and equipment.
Fair Value Model (IAS 40): If right-of-use assets meet the definition of investment property, the lessee may elect to apply the fair value model in IAS 40 to those right-of-use assets. This election can be made on a property-by-property basis.
The cost model remains the default and most commonly applied measurement approach in practice.
Depreciation of Right-of-Use Assets
A lessee depreciates the right-of-use asset from the commencement date. The depreciation period depends on whether ownership of the underlying asset transfers to the lessee:
If Ownership Transfers or Purchase Option Expected to be Exercised
If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term, or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the lessee depreciates the right-of-use asset from the commencement date to the end of the useful life of the underlying asset.
If Ownership Does Not Transfer
If the lease does not transfer ownership and the lessee is not reasonably certain to exercise a purchase option, the lessee depreciates the right-of-use asset from the commencement date to the earlier of:
- the end of the useful life of the right-of-use asset; or
- the end of the lease term.
Depreciation Method
The depreciation method should reflect the pattern in which the lessee expects to consume the right-of-use asset's future economic benefits. Common methods include straight-line, diminishing balance, or units of production. The straight-line method is most commonly applied unless another method better represents the consumption pattern.
The accounting entry for depreciation is:
Debit: Depreciation expense (profit or loss)
Credit: Accumulated depreciation - Right-of-use asset
Depreciation Period
The depreciation period for a right-of-use asset is typically the lease term, unless ownership transfers or the lessee is reasonably certain to exercise a purchase option, in which case depreciation continues over the underlying asset's useful life.
Impairment
A lessee applies IAS 36 Impairment of Assets to determine whether a right-of-use asset is impaired and to account for any impairment loss identified.
The lessee assesses at the end of each reporting period whether there is any indication that a right-of-use asset may be impaired. If such an indication exists, the lessee estimates the recoverable amount of the right-of-use asset.
The recoverable amount is the higher of:
- fair value less costs of disposal; and
- value in use.
If the carrying amount of the right-of-use asset exceeds its recoverable amount, an impairment loss is recognised. The impairment loss is recognised immediately in profit or loss.
Common indicators of impairment for right-of-use assets include significant changes in the technological, market, economic or legal environment, evidence of obsolescence or physical damage, and significant adverse changes in the extent or manner in which the asset is used or expected to be used.
The accounting entry for impairment is:
Debit: Impairment loss (profit or loss)
Credit: Accumulated impairment losses - Right-of-use asset
Derecognition
A lessee derecognises a right-of-use asset when:
- the lease term ends and the lessee returns the underlying asset to the lessor;
- the lessee exercises a purchase option and acquires ownership of the underlying asset (the right-of-use asset becomes property, plant and equipment);
- the lease is terminated early; or
- a lease modification occurs that decreases the scope of the lease, and the modification is not accounted for as a separate lease.
Upon derecognition, any gain or loss arising from the difference between the carrying amount of the right-of-use asset and any proceeds received (or consideration paid) is recognised in profit or loss.
The accounting entry for derecognition is:
Debit: Accumulated depreciation - Right-of-use asset
Debit: Lease liability (remaining balance)
Debit/Credit: Gain or loss on derecognition (profit or loss)
Credit: Right-of-use asset (original cost)
Presentation and Disclosure
Presentation in the Statement of Financial Position
IFRS 16 does not require right-of-use assets to be presented as a separate line item in the statement of financial position. However, if a lessee does not present right-of-use assets separately, the lessee must:
- include right-of-use assets within the same line item as the corresponding underlying assets would be presented if they were owned; and
- disclose which line items include right-of-use assets.
Many entities present right-of-use assets as a separate line item for transparency and to facilitate analysis by users of financial statements.
Disclosure Requirements
IFRS 16 requires lessees to disclose information about right-of-use assets, including:
- additions to right-of-use assets during the reporting period;
- the carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset;
- depreciation charge for right-of-use assets by class of underlying asset;
- impairment losses and reversals;
- whether the lessee applies the revaluation model or fair value model to any right-of-use assets.
Lessees must also provide a maturity analysis of lease liabilities, expense recognised for short-term and low-value leases, and qualitative and quantitative information about leasing activities.
Practical Examples
Example 1: Initial Recognition and Measurement
On 1 January 2026, Company A enters into a five-year lease of office space. The annual lease payment is £50,000, payable in arrears at the end of each year. Company A's incremental borrowing rate is 6% per annum. Company A incurs £5,000 in legal fees to negotiate the lease and receives a £10,000 lease incentive from the lessor before commencement. Company A estimates it will incur £8,000 at the end of the lease term to restore the premises.
Step 1: Calculate the lease liability
Present value of lease payments = £50,000 × annuity factor for 5 years at 6%
= £50,000 × 4.2124
= £210,620
Note that, due to the wording of paragraph 26, the incentive received before commencement date is not considered in measuring the lease liability, but is still deducted in determining the initial value of the right-of-use asset.
Step 2: Calculate the restoration obligation
Present value of restoration costs = £8,000 / (1.06)^5
= £8,000 / 1.3382
= £5,979
Step 3: Calculate the right-of-use asset
Right-of-use asset = Lease liability + Initial direct costs - Lease incentive + Restoration obligation
= £210,620 + £5,000 - £10,000 + £5,979
= £211,599
Journal entry on 1 January 2026:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Right-of-use asset | 211,599 | |
| Cash | 5,000 | |
| Cash (lease incentive) | 10,000 | |
| Lease liability | 210,620 | |
| Restoration provision | 5,979 |
Example 2: Subsequent Measurement and Depreciation
Continuing Example 1, Company A depreciates the right-of-use asset on a straight-line basis over the five-year lease term.
Annual depreciation = £211,599 / 5 years = £42,320 per annum
Journal entry for depreciation (annually):
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Depreciation expense | 42,320 | |
Accumulated depreciation – Right-of-use asset | 42,320 |
At 31 December 2026, the carrying amount of the right-of-use asset is:
Carrying amount = £211,599 - £42,320 = £169,279
Example 3: Lease with Purchase Option
Company B enters into a four-year lease of manufacturing equipment on 1 January 2026. Annual lease payments are £30,000, payable in arrears. The lessee's incremental borrowing rate is 5%. The lease includes a purchase option at the end of year 4 for £10,000, which Company B is reasonably certain to exercise. The underlying equipment has a useful life of 10 years.
Step 1: Calculate the lease liability
Present value of lease payments = (£30,000 × 3.5460) + (£10,000 / 1.05^4)
= £106,380 + £8,227
= £114,607
Step 2: Determine depreciation period
Since Company B is reasonably certain to exercise the purchase option, the right-of-use asset is depreciated over the 10-year useful life of the underlying equipment, not the four-year lease term.
Annual depreciation = £114,607 / 10 years = £11,461 per annum
This results in lower annual depreciation compared to depreciation over the lease term, reflecting that Company B will continue to use the asset beyond the lease period.
Conclusion
The right-of-use asset is central to the IFRS 16 lease accounting model, ensuring that lessees recognise their rights and obligations arising from lease contracts on the balance sheet. The right-of-use asset is initially measured at cost, comprising the lease liability, initial direct costs, prepaid lease payments, and restoration obligations, and is subsequently measured using a cost model with depreciation over the shorter of the lease term or the useful life of the underlying asset.
Lessees must exercise careful judgement when determining the depreciation period, assessing impairment indicators, and applying the appropriate measurement model to ensure their financial statements faithfully represent the economic substance of their leasing arrangements.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.