Right-of use assets – let’s depreciate or maybe capitalize, or both!

Here’s the background to another issue recently discussed by Canada’s IFRS Discussion Group:

  • Entity A enters into a contract for a ground lease of land and begins construction of a manufacturing facility where it will operate its manufacturing plant. The contract is determined to be a lease under IFRS 16. The lease commenced on September 1, 2019. On that same day, Entity A starts constructing a building on the land. Construction is expected to be completed after October 1, 2020. The lease consists of fixed rent payments with a term of 40 years. The lease contract has no other renewal, termination, or purchase options.

The group discussed when depreciation of the right-of-use asset arising from the ground lease should begin. The most obvious answer would come right out of IFRS 16 – “the lessee shall depreciate the right-of-use asset from the commencement date.” The possible complexity in this case comes from the principle in IAS 16 that depreciation of an asset begins “when it is available for use, i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management.” As the facility won’t be available for use for over a year, and the use of the land is inextricably linked to that of the facility, perhaps depreciation should be deferred until later. Or maybe it’s a matter of policy choice.

The group supported the first view, that depreciation of the right-of-use asset should begin from the commencement date: the right to use the asset starts from that date, and also starts to erode from that date. Some group members threw in that at that date, the land at least is in a condition to be capable of operating in the manner intended by management – that is, to construct a building. They then moved on to consider whether the depreciation on the right-of-use asset should be capitalized as part of the cost of the asset under construction. IAS 16 notes that “the cost of an item of property, plant and equipment may include costs incurred relating to leases of assets that are used to construct, add to, replace part of or service an item of property, plant and equipment, such as depreciation of right-of-use assets.” Although the lease of the underlying land doesn’t fit entirely comfortably into that phrasing, it might not be a big stretch to include it there. For further support, IAS 16 indicates that an asset’s cost includes “any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.” Again, not the closest linguistic fit, but maybe close enough. Or perhaps not, in which case the depreciation should be expensed, to reflect the consumption of the benefits associated with the right-of-use asset.

Most of the group supported capitalizing the depreciation, for the reasons provided. A few preferred the opposite view, maintaining a separation between an asset that represents access to the land over time, and one that directly contributes to constructing a building. One Group member noted that if the land were owned and retained its value, its cost wouldn’t be depreciated, or capitalized into the building. This is true of course, but not really relevant, given the inherent differences between an asset that’s fully owned, and one obtained only under a finite right-of-use arrangement.

The group also considered the application of IAS 23 Borrowing Costs. This one’s more straightforward perhaps, because the standard specifically notes that borrowing costs may include “interest in respect of lease liabilities recognized in accordance with IFRS 16.” Building on this, the group agreed that the entity would capitalize the interest on the lease liability from the lease commencement date to the date the construction of the facility is substantially completed. You may recall that IAS 23 draws a distinction between funds borrowed specifically for the purpose of obtaining a qualifying asset, and those borrowed generally and used for such a purpose – in the latter case, the entity determines a “capitalization rate” based on the weighted average of all borrowing costs and outstanding borrowings during the period. In the fact pattern above, the lease liability represents a general borrowing, in that it’s not specifically incurred to obtaining the qualifying asset as such.

The conclusions all make reasonable sense, although there’s always some arbitrariness attached to such issues. For example, if you regard the right-of-use asset arising from the land lease as being intertwined with the building constructed upon it, it may seem strange that only one year of depreciation is capitalized – that is, the nature of the land’s contribution to the building’s revenue-generating potential remains the same, whether or not the building is still being constructed. Maybe that’s another good argument for why the depreciation would be better expensed from the start…

The opinions expressed are solely those of the author

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