Key Takeaways
- The right-of-use (ROU) asset represents the lessee's right to use an underlying asset over the lease term
- Initial measurement starts with the lease liability, plus initial direct costs, prepayments, and restoration costs
- Depreciation is typically calculated using the straight-line method over the shorter of the lease term or useful life
- Three measurement models are available: cost model (most common), revaluation model, and fair value model
- ROU assets must be tested for impairment under IAS 36 when indicators exist
What is a Right-of-Use Asset?
The right-of-use (ROU) asset represents a lessee's right to use an underlying asset for the lease term. It's recognised on the balance sheet at the lease commencement date alongside the corresponding lease liability.
Under IFRS 16, the ROU asset is essentially a capitalised lease - it reflects the economic benefit of having access to and control over an asset, even though legal ownership remains with the lessor.
IFRS 16 Definition
"At the commencement date, a lessee shall measure the right-of-use asset at cost."
- IFRS 16.23
Initial Measurement
The cost of the ROU asset at commencement comprises several components:
Components of Initial Cost
| Component | Description | Example |
|---|---|---|
| Lease liability | Present value of future lease payments at commencement | £555,456 (from PV calculation) |
| Initial direct costs | Incremental costs directly attributable to obtaining the lease | Legal fees, broker commissions, due diligence costs |
| Prepayments | Lease payments made before or at commencement | Deposit paid on signing, rent paid in advance |
| Less: Lease incentives | Incentives received from the lessor | Rent-free periods, fit-out contributions |
| Restoration costs | Estimate of costs to dismantle/restore at end of lease | Obligation to remove leasehold improvements |
Initial Direct Costs
Initial direct costs are only those that would not have been incurred if the lease had not been obtained. General overheads, costs of negotiating leases that don't proceed, and internal allocation of costs typically don't qualify.
Worked Example: Initial Recognition
Scenario
A company enters into a 5-year office lease with the following terms:
- Lease liability at commencement: £555,456
- Legal and broker fees: £15,000
- Three months' rent paid in advance: £30,000
- Fit-out contribution from landlord: £25,000
- Estimated restoration costs: £20,000
Calculation
| Component | Amount |
|---|---|
| Lease liability | £555,456 |
| Initial direct costs | £15,000 |
| Prepayments | £30,000 |
| Less: Lease incentives | (£25,000) |
| Restoration provision | £20,000 |
| Right-of-Use Asset | £595,456 |
Journal Entry at Commencement
Subsequent Measurement
After initial recognition, the ROU asset must be depreciated and tested for impairment. IFRS 16 provides three measurement models, depending on the class of underlying asset.
Available Measurement Models
Cost Model
The most common approach. The ROU asset is measured at cost less accumulated depreciation and impairment losses, adjusted for remeasurements of the lease liability.
Applies to most leases (vehicles, equipment, most property)
Revaluation Model
Can be used if the lessee applies IAS 16 revaluation model to owned assets of the same class. ROU assets are revalued to fair value periodically.
Requires all assets in class to be revalued
Fair Value Model
Must be used when the ROU asset meets the definition of investment property and the lessee uses the fair value model for its investment properties under IAS 40.
Applies to subleased property or property held to earn rentals
Consistency Requirement
The measurement model must be applied consistently to all ROU assets within the same class of underlying assets. For example, if you use the cost model for one vehicle lease, you must use it for all vehicle leases.
Depreciation
Under the cost model, ROU assets are depreciated in accordance with IAS 16. Straight-line depreciation is most commonly used.
Depreciation Period
The depreciation period depends on whether ownership transfers at the end of the lease:
| Scenario | Depreciation Period |
|---|---|
| Ownership transfers to lessee at end of lease | Useful life of the underlying asset |
| Lessee reasonably certain to exercise purchase option | Useful life of the underlying asset |
| All other leases | Shorter of lease term and useful life |
Annual Depreciation Calculation
For most leases, the residual value is nil because the asset returns to the lessor at the end of the lease term.
Depreciation Example
Using our example with a £595,456 ROU asset and 5-year lease term (no ownership transfer):
| Year | Opening Balance | Depreciation | Closing Balance |
|---|---|---|---|
| 1 | 595,456 | (119,091) | 476,365 |
| 2 | 476,365 | (119,091) | 357,274 |
| 3 | 357,274 | (119,091) | 238,183 |
| 4 | 238,183 | (119,091) | 119,092 |
| 5 | 119,092 | (119,092) | 0 |
| Total | (595,456) |
Depreciation Journal Entry
Lease Termination
At the end of the lease term, the ROU asset should be fully depreciated. However, because depreciation is recorded against accumulated depreciation (not the asset directly), a final journal entry is needed to remove both accounts from the balance sheet.
This journal has no impact on net assets or profit/loss - it simply clears the gross asset and accumulated depreciation from the balance sheet.
Impairment
ROU assets measured under the cost model are subject to impairment testing under IAS 36. An impairment review should be performed when there are indicators that the ROU asset may be impaired.
Common Impairment Indicators
- The leased premises are no longer being used
- Significant decline in the market value of similar assets
- Plans to terminate the lease early
- Subleasing at rates below the head lease cost
- Changes in the economic environment affecting the asset's utility
If impaired, the ROU asset is written down to its recoverable amount, and an impairment loss is recognised in profit or loss.
For detailed guidance, see our Impairment guide.
Adjustments for Remeasurements
When the lease liability is remeasured, the ROU asset is typically adjusted by the same amount. Common remeasurement triggers include:
- Changes in the lease term assessment
- Changes in the assessment of purchase option exercise
- Changes in amounts expected under residual value guarantees
- Changes in future lease payments from index/rate changes
ROU Asset Cannot Go Negative
If a remeasurement would reduce the ROU asset below zero (for example, from a significant reduction in lease term), the excess reduction is recognised in profit or loss rather than as a negative asset balance.
For detailed guidance on when remeasurements occur, see our Remeasurement guide.
Presentation and Disclosure
Balance Sheet
ROU assets can be presented in one of two ways:
- Separately - as a distinct line item
- Within the same category - as if the underlying assets were owned (e.g., within Property, Plant and Equipment), with disclosure of which line items include ROU assets
ROU assets meeting the definition of investment property must be presented within investment property.
Required Disclosures
- Depreciation charge for ROU assets by class of underlying asset
- Additions to ROU assets during the period
- Carrying amount of ROU assets at period end by class
- Details of any impairment losses recognised
For a complete checklist, see our Disclosure Requirements guide.
This article is provided for general informational purposes only and does not constitute accounting, legal or professional advice.