Right of Use Asset
A right of use asset refers to the amount recognized by a lessee on its balance sheet that represents its right to use an asset under a lease contract. It is either presented on the face of the balance sheet or as part of fixed assets.
Right of use asset is a new term introduced for leasehold assets by IFRS 16 Leases and ASC 842.
A lessee initially measures a right of use asset at its cost which comprises of the following:
- The amount of initial recognition of lease liability which in turn equals the present value of lease payments determined at the rate of interest implicit in the lease if readily available else at the lessee’s incremental borrowing rate. Lease payments mainly comprise of fixed payments and variable payments linked to some index or rate.
- Lease payments made before commencement date minus any lease incentives.
- Initial direct costs, and
- Cost of dismantling and restoration.
After initial recognition, a right of use asset is accounted for just like an acquired asset. However, it is remeasured whenever there is a remeasurement of lease liability due to change in lease payments.
Nashpa Power has entered into a power purchase agreement with government of a South Asian country. Under the agreement, it will develop a power complex, operate it for 20 years and transfer it for a nominal amount to the government at the end of the 20 year period.
For the purpose of construction of the power complex, the company has obtained land on 20-year lease. At the inception of the lease, i.e. on 1 July 20X8, the company paid an amount of PKR 100 million. From the commencement date of the lease, which is 1 Jan 20X9, the Company is required to pay annual rentals of PKR 10 million plus 1% of its revenue in advance.
The company incurred a cost of PKR 50 million in finalizing the lease half of which represents allocation of the common costs and overheads.
The company is not obligated for any restoration or dismantling costs.
The applicable incremental borrowing rate is 8%.
The cost of a right of use asset can be expressed as follows:
ROU Asset = L + P + I + D
L is the amount at which the associated lease liability is recognized. It equals the present value of lease payments at the commencement date. In this case, lease payments include fixed payments but not the variable payments because those are not linked to an index or rate. You can verify that the present value equals PKR 106 million.
P stands for the payments made before commencement date. In this example, these amount to PKR 100 million.
I represents the initial direct costs. These include only directly attributable costs; hence the allocation of common costs would not qualify for capitalization.
D is the estimated cost of dismantling and restoration. In this case there are no such costs.
Nashpa Power shall recognize a right of use asset at commencement date (i.e. 1 Jan 20X9) of PKR 231 million.
= PKR 106M + PKR 100M + PKR 25M + 0
= PKR 231M
The company can present the asset either on the face of its statement of financial position or in the notes as part of a class of property, plant and equipment in which it would be included had it been acquired.
The right of use asset is depreciated over a period which is shorter of the lease term and its useful life.
by Obaidullah Jan, ACA, CFA and last modified on