Understanding Right-of-Use Assets Under IFRS 16

The introduction of International Financial Reporting Standard 16 (IFRS 16) marked a significant shift in lease accounting. The standard requires most lease arrangements to be recognised on the balance sheet, replacing the previous operating versus finance lease distinction under IAS 17.

The guiding principle of the standard is simple but powerful that, financial statements should reflect economic reality rather than legal ownership. Where a business controls the use of an asset and derives economic benefit from it, that right represents an asset that must be recognised.

What Is a Right-of-Use (ROU) Asset?

A Right-of-Use asset represents the economic right of an entity to use an identified asset for a specified period in exchange for payment.

In practical business terms, ROU accounting treats long-term leasing arrangements similarly to financing an asset purchase using debt.

Under IFRS 16, lessees recognise:

• A Right-of-Use asset representing the economic benefit of using the asset
• A lease liability representing future payment obligations

This approach improves transparency and makes financial statements more comparable between entities that lease assets and those that purchase them.

Lease Identification and Lease Types

The first step in applying IFRS 16 is determining whether a contract contains a lease.

A contract contains a lease when:

• There is an identified asset that the customer has the right to use, and
• The customer controls how and for what purpose the asset is used while obtaining substantially all economic benefits.

This assessment is important because many modern business arrangements, such as outsourcing, logistics and technology infrastructure agreements may contain embedded lease components.

Under IFRS 16, the focus is no longer on classifying leases as operating or finance leases for lessees. Instead, most leases are recognised on the balance sheet, with only limited practical exemptions applied where appropriate. These exemptions include:

• Short-term leases, generally defined as leases with a lease term of 12 months or less and without purchase options.
• Low-value asset leases, typically applied to assets such as small office equipment, minor IT devices, or other assets considered immaterial on a portfolio basis.

1). Initial Recognition and Measurement

At the commencement date of a lease, companies recognise both a Right-of-Use (ROU) asset and a corresponding lease liability measured at the present value of future lease payments. This treatment ensures that financial statements reflect the economic substance of the lease arrangement rather than only the contractual payment schedule.

Initial Journal Entry

• Debit: Right-of-Use Asset
• Credit: Lease Liability

The lease liability is discounted using:

• The interest rate implicit in the lease where it can be reliably determined, or
• The lessee’s incremental borrowing rate where the implicit rate is not readily available. The rate selected should reflect the economic financing cost applicable to the entity.

Lease payments included in the liability measurement represent genuine economic obligations such as fixed payments, indexed payments, purchase options likely to be exercised, and termination penalties.

The cost of the ROU asset is measured to reflect the economic value of the right to use the asset. It typically includes the lease liability value, direct costs incurred to secure the lease, restoration or dismantling obligations and it is reduced by any lease incentives received.

This treatment ensures the balance sheet reflects the entity’s true economic exposure rather than just contractual payment timing.

2). Subsequent Measurement

After initial recognition, ROU accounting separates lease costs into two main components that reflect both asset usage and financing cost.

a) Depreciation of the Right-of-Use Asset

The Right-of-Use asset is depreciated over the shorter of the lease term or the asset’s useful life where ownership is expected to transfer to the lessee.

Depreciation is generally recognised on a straight-line basis to reflect the systematic consumption of economic benefits over the lease period.

Journal Entry

• Debit: Depreciation Expense
• Credit: Accumulated Depreciation – Right-of-Use Asset

b) Interest Expense on Lease Liability

Lease liabilities are subsequently measured using the effective interest method, similar to other financing obligations.

Each lease payment is allocated between:

• Interest expense representing the cost of financing, and
• Principal repayment reducing the outstanding lease liability.

Journal Entry

• Debit: Interest Expense
• Debit: Lease Liability (Principal portion)
• Credit: Cash/Bank

Since interest is calculated on the outstanding liability balance, interest expense is typically higher in the early periods of the lease and decreases over time as the liability is repaid.

3). Financial Statement Impact

IFRS 16 changes lease accounting by recognising the economic substance of leases on the financial statements rather than treating lease payments as operating expenses. While cash outflows remain the same, expense and cash flow presentation is classified differently.

a). Balance Sheet Impact

Under IFRS 16, lessees recognise both:

• Assets – Right-of-Use (ROU) assets, representing the economic right to use the leased asset over the lease term.
• Liabilities – Lease liabilities, representing the present value of future lease payment obligations.

The recognition of ROU assets and lease liabilities increases total assets and total liabilities. This may affect financial leverage indicators, borrowing capacity, and compliance with debt covenants, providing a more transparent view of an entity’s long-term obligations.

b). Profit and Loss Impact

Instead of recognising lease payments as a single rent expense, IFRS 16 requires lease costs to be separated into:

• Depreciation expense on the Right-of-Use asset, reflecting the consumption of the asset’s economic benefits.
• Finance cost (interest expense) on the lease liability, representing the cost of financing the lease obligation.

This results in a front-loaded expense pattern, where total expenses are higher in the early years of the lease and gradually decrease over time as the outstanding lease liability reduces.

c). Cash Flow Statement Impact

IFRS 16 does not change actual cash payments but changes their classification within the cash flow statement.

• The principal portion of lease payments is presented under financing activities.
• Interest payments are classified depending on accounting policy, either under operating or financing activities.

This separation improves clarity on operating performance versus financing cash flows and enhances transparency in financial reporting.

4). Tax Treatment and Deferred Tax

Tax treatment does not always follow accounting treatment.

In tax computation:

• Actual lease payments are generally deductible because they represent real cash outflows.
• ROU depreciation is a non-cash accounting charge and is usually disallowed.
• Interest expense is added back and disallowed.

These differences between accounting and tax recognition create temporary timing differences requiring deferred tax recognition under IAS 12. Where ROU assets have carrying values for accounting purposes but different tax bases deferred tax liabilities typically arise. This happens because accounting depreciation and interest recognition under IFRS 16 differs from the timing of tax deductions based on actual lease payments.

5). Exemptions Under IFRS 16

Entities may elect practical exemptions for:

• Short-Term Leases – Leases with a term of 12 months or less without purchase options. These are usually expensed directly.
• Low-Value Assets – Includes minor equipment such as small office tools or low-value IT devices. The exemption is applied to reduce administrative complexity where lease portfolios are immaterial.

6). Compliance and Audit Risk Areas

The application of IFRS 16 requires careful judgement, making lease accounting a key area of audit and compliance focus.

1. Lease Identification Risks – Embedded leases may be hidden within service contracts and must be carefully reviewed.
2. Discount Rate Selection – Using inappropriate borrowing rates can materially distort lease liability measurement.
3. Lease Term Judgement – Assessment of extension or termination options must be supported by business and economic evidence.
4. Restoration Obligations – Failure to recognise dismantling or environmental restoration costs is a common audit issue.
5. Remeasurement Requirements – Lease liabilities and ROU assets must be updated when contract terms, payment structures, or options change.

Conclusion

Right-of-Use accounting under IFRS 16 reflects the shift toward financial reporting that prioritises economic substance over legal form, reinforcing that value comes from controlling assets rather than owning them. Today, lease accounting is not just a compliance requirement but a strategic tool for financial planning, risk management, and business decision-making.

Content By:

Ann Wangechi

Tax & Accounting Associate

ann.wangechi@ke.andersen.com