[Leases – Article 3/5] Measurement of Right-Of-Use Asset and Lease Liability

As discussed in a previous article, under IFRS 16 ‘Leases’, the lessee capitalises lease transactions as a right-of-use asset and a corresponding lease liability, unless the transactions relate to short term leases or low value leases, in which case the lease is expensed.

The next question to answer is: how do we measure the right-of-use asset and the lease liability? This depends largely on the determined lease term, which was discussed in a previous article.

In fact, the starting point for appropriate measurement is to measure the lease liability, which is measured at the commencement date as the present value of future cash flows expected to be paid over the lease term. The discount rate to use, in order to measure the lease liability, is either the interest rate implicit in the lease, or in its absence, the incremental borrowing rate of the lessee.

The right-of-use asset is initially measured at the sum of the following:

• The amount of the initial measurement of the lease liability.
• Lease payments made at or before the commencement date of the lease, less any lease incentives received.
• Any initial direct costs incurred by the lessee.
• An estimate of costs to be incurred when removing the asset.

As a result, a double entry for initial measurement could include the following:

• Debit Right-of-use asset
• Credit Lease liability
• Credit Cash (payments at commencement of lease)
• Credit Prepayments (reversal of any prepaid rent from the past)
• Credit Creditors (suppliers related to initial direct costs)
• Credit Provision (estimate of removal costs)

Subsequent to initial recognition, the lease liability is measured by increasing it with finance cost thereon, and decreasing it by lease payments. This is similar to the effective interest method. However, special attention is required for any reassessments or lease modifications that may happen over time.

The right-of-use asset is typically measured subsequently using the cost model in IAS 16 ‘Property, Plant And Equipment’. This means that the amount of right-of-use asset initially measured is depreciated over the shorter of the lease term and the economic lifetime of the asset.

However, if the right-of-use asset consists of investment property, meaning usually that the underlying asset is being subleased outside the ordinary course of business of the entity, the entity is required to apply IAS 40 ‘Investment Property’. If it applied the fair value model to its investment property, the fair value model must also be applied to the right-of-use asset. IAS 40, para. 40A states that: “when a lessee uses the fair value model to measure an investment property that is held as a right-of-use asset, it shall measure the right-of-use asset, and not the underlying property, at fair value”.

Also, if the right-of-use asset relates to a class of property, plant and equipment to which the lessee applies IAS 16’s revaluation model, the lessee may, but is not obliged to, apply such revaluation model.

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