What are lease liability and ROU asset under IFRS 16?

Understanding IFRS 16 and its importance

IFRS 16, effective from 1 January 2019, is a key accounting standard by the International Accounting Standards Board (IASB). It changes how leases are recognized in financial statements, enhancing transparency and comparability. Companies must now include most leases on the balance sheet, removing the distinction between operating and finance leases for lessees.

This standard significantly impacts companies with large lease portfolios, affecting metrics like EBITDA, asset turnover, and leverage ratios. By recognizing lease liabilities and Right of Use (ROU) assets, IFRS 16 ensures financial statements more accurately reflect lease transactions.

Compliance with IFRS 16 is mandatory for companies in the European Union reporting under IFRS standards. Understanding lease liability and ROU asset concepts is essential for accurate financial reporting and effective lease management.

Defining lease liability under IFRS 16

Lease liability under IFRS 16 is the present value of lease payments a lessee must make over the lease term. This includes fixed payments, variable payments based on an index or rate, amounts under residual value guarantees, and the price of a purchase option if likely to be exercised.

The lease liability is initially measured at the lease’s start and adjusted for interest and payments. Interest expense on the lease liability is recorded in profit or loss, representing the financing cost of the leased asset.

Recognizing lease liabilities provides a comprehensive view of future lease obligations, benefiting stakeholders like investors and creditors who rely on accurate financial information.

Explaining the Right-of-Use (ROU) asset

The Right-of-Use (ROU) asset represents a lessee’s right to use an asset during the lease term. Initially measured at cost, it includes the lease liability amount, any payments made before the lease starts, and any initial direct costs.

The ROU asset is depreciated over the lease term or the asset’s useful life, whichever is shorter. Depreciation expense is recognized in profit or loss, reflecting the asset’s economic benefit consumption.

The ROU asset is shown separately on the balance sheet, clarifying the assets controlled through leases and enhancing financial statement transparency.

How to measure and recognize lease liability and ROU asset

To measure and recognize lease liability and ROU asset under IFRS 16, companies follow a systematic approach. At the lease start, the lease liability is the present value of lease payments, discounted using the lease’s implicit interest rate or the lessee’s incremental borrowing rate.

The ROU asset is measured at cost, including the lease liability amount, any pre-lease payments, initial direct costs, and estimated dismantling or restoration costs.

After initial recognition, the lease liability is adjusted for interest and payments, while the ROU asset is depreciated over the lease term. Any lease liability remeasurements, such as changes in payments due to modifications, are reflected in the ROU asset.

Practical examples of accounting for leases under IFRS 16

Consider a company leasing office space for five years with annual payments of 100,000€. At the lease start, the present value of payments, discounted at a 5% borrowing rate, is 432,950€. This amount is recognized as both the lease liability and the ROU asset.

During the lease term, the company records interest expense on the lease liability and depreciation on the ROU asset. In the first year, the interest expense is 21,648€ (5% of 432,950€), and the depreciation expense is 86,590€ (432,950€ divided by 5 years).

For equipment leases with variable payments based on usage, the lease liability is initially measured based on the index at the lease start and adjusted for index changes, with corresponding adjustments in the ROU asset.

These examples show IFRS 16’s practical application, emphasizing accurate measurement and recognition of lease liabilities and ROU assets. Adhering to these principles ensures compliance and transparent financial information for stakeholders.

For more information on how to achieve IFRS 16 compliance with help of Fatman Frame IFRS 16, see the introduction and book your demo with us.