Key Takeaways
- The right-of-use asset goes on the balance sheet at the commencement date, not at the date the lease contract is signed.
- Initial measurement includes the lease liability, any payments made before commencement, initial direct costs, and an estimate of dismantling or restoration obligations.
- IFRS 16.5 exempts leases with a term of 12 months or less and leases of low-value assets (typically below approximately €5,000).
- Depreciation of the right-of-use asset and interest on the lease liability replace the old straight-line operating lease charge, front-loading total expense.
What is Right-of-Use Asset?
IFRS 16.22 requires the lessee to recognise a right-of-use asset at the commencement date for every lease that does not qualify for the short-term or low-value exemptions. The initial carrying amount is built from several components: the initial measurement of the lease liability, lease payments made at or before commencement (minus any incentives received), initial direct costs borne by the lessee, and an estimate of costs to dismantle or restore the underlying asset under IFRS 16.24(a)–(d).
After initial recognition, the lessee depreciates the right-of-use asset over the shorter of the asset's useful life and the lease term unless ownership transfers or a purchase option is reasonably certain to be exercised (IFRS 16.32). The depreciation charge and the interest expense on the lease liability together exceed the old straight-line rental charge in the early years of the lease. This front-loading effect hits EBITDA-based covenants less than it hits operating profit, which is why lessees and their auditors need to trace the numbers through both metrics.
The right-of-use asset is also subject to impairment testing under IAS 36. ISA 540.13(a) requires the auditor to evaluate whether the entity's measurement method for the asset is appropriate, including the discount rate applied in the lease liability calculation and the assumptions behind any extension options.
Worked example: Rossi Alimentari S.p.A.
Client: Italian food production company, FY2025, revenue €67M, IFRS reporter. Rossi signs a six-year lease on a 4,500 m² cold-storage warehouse in Milan, commencing 1 January 2025. Annual lease payments are €360,000, payable at the end of each year. The contract includes a four-year extension option that Rossi is not reasonably certain to exercise. There are no lease incentives. Rossi pays €18,000 in legal fees directly attributable to arranging the lease.
Step 1 — Determine the lease term
The non-cancellable period is six years. Rossi has an extension option for four additional years but has no economic incentive to exercise it (no penalty for non-exercise, alternative warehouses are readily available). The lease term is six years.
Step 2 — Measure the lease liability
Rossi cannot readily determine the rate implicit in the lease, so it uses its incremental borrowing rate of 4.2%. The present value of six annual payments of €360,000 discounted at 4.2% is €1,884,946.
Step 3 — Measure the right-of-use asset at commencement
The right-of-use asset equals the lease liability (€1,884,946) plus initial direct costs (€18,000), totalling €1,902,946. No prepayments, no restoration obligations.
Step 4 — Subsequent measurement at 31 December 2025
Depreciation for the year is €1,902,946 divided by six years, giving €317,158 on a straight-line basis. Interest expense on the lease liability for year one is €1,884,946 multiplied by 4.2%, giving €79,168. The combined charge of €396,326 exceeds what a straight-line operating lease expense of €360,000 would have been under the old IAS 17 model by €36,326.
The right-of-use asset of €1,902,946 and corresponding liability produce a front-loaded expense profile, and the measurement is defensible because the discount rate, lease term, and initial cost components are each traceable to external evidence.
Why it matters in practice
Teams frequently set the lease term equal to the non-cancellable period without assessing extension and termination options. IFRS 16.19 requires the lessee to assess whether it is reasonably certain to exercise an extension option (or not exercise a termination option), considering all relevant economic factors. Omitting this assessment understates both the right-of-use asset and the lease liability.
The incremental borrowing rate is often applied as a single entity-wide rate rather than adjusted for the term, currency, security, and economic environment of each lease. IFRS 16.26 specifies that the rate must reflect the terms of the individual lease. ISA 540.13(b) requires the auditor to evaluate whether the data and assumptions are appropriate for the method used. A blanket rate applied to leases of different durations and jurisdictions does not meet this standard.
Right-of-use asset vs. owned property, plant, and equipment
| Dimension | Right-of-use asset (IFRS 16) | Owned PP&E (IAS 16) |
|---|---|---|
| Recognition trigger | Lease commencement date; asset represents the right to use, not ownership | Purchase or construction; asset represents ownership of the physical item |
| Depreciation period | Shorter of useful life and lease term (unless ownership transfers) per IFRS 16.32 | Useful life of the asset per IAS 16.50 |
| Carrying amount components | Lease liability, prepayments, initial direct costs, restoration estimate | Purchase price, directly attributable costs, dismantling estimate per IAS 16.16 |
| Balance sheet presentation | Presented separately or disclosed within the PP&E line per IFRS 16.47 | Within property, plant, and equipment |
| Impairment | IAS 36 applies; recoverable amount compared to carrying amount | Same IAS 36 framework applies |
The distinction matters because right-of-use assets carry a paired liability that owned assets do not. Ratios that rely on total assets or net debt (gearing, return on assets) shift when operating leases come on balance sheet, and auditors need to verify that management has disclosed the effect on covenant calculations.
Related terms
Frequently asked questions
How do I audit the incremental borrowing rate for a right-of-use asset?
Obtain the entity's methodology and compare the rate to observable borrowing costs for facilities with a similar term, currency, and collateral profile. ISA 540.18 requires the auditor to evaluate whether management's assumptions are reasonable. If the entity has recent debt agreements, those rates serve as a useful benchmark after adjusting for differences in security and tenor.
Does a right-of-use asset get tested for impairment?
Yes. IFRS 16.33 subjects right-of-use assets to IAS 36. The lessee must test for impairment when indicators exist (for example, the leased property is partially vacant or sublease market rates have dropped below the head-lease cost). The impairment test compares the carrying amount to the recoverable amount, following the same process as for owned property, plant, and equipment.
What happens when a lease is modified after the commencement date?
IFRS 16.44–46 require the lessee to remeasure the lease liability using a revised discount rate and adjust the right-of-use asset accordingly. If the modification decreases the scope of the lease, the lessee reduces the right-of-use asset proportionally and recognises any gain or loss. If the modification increases scope or consideration without adding a separate lease, the lessee adjusts both the liability and the asset with no gain or loss.