IFRS 16, IAS 16, and IAS 23: Timing of Depreciation of a Right of Use Asset and IAS 23 Capitalization

What is the interaction of IFRS 16, IAS 16, and IAS 23 when a right-of-use asset (RoUA) is used to construct an item of property, plant, and equipment (PPE)?


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 July 1, 2020. On that same day, Entity A starts constructing a building on the land. Construction is expected to be completed after July 1, 2021. The lease consists of fixed rent payments with a term of 30 years. The lease contract has no other renewal, termination, or purchase options.

  1. When does depreciation of the RoUA commence?

Paragraph 32 of IFRS 16 provides specific guidance to require depreciation of a RoUA from the lease commencement date and that this paragraph should be applied instead of IAS 16.

This is due to the fact that the access to the land is granted at the lease commencement date and the land is also in a condition to be capable of operating in the manner intended by management to construct the manufacturing facility.

The right to access the land should be considered separately from the construction of the manufacturing facility.

  1. Should depreciation on the RoUA be capitalized to the asset under construction?

IAS 16 requires that PPE be initially measured at cost.

Both paragraphs 10 and 16(b) of IAS 16 support the capitalization of depreciation of the RoUA into the cost of the manufacturing facility.

The land under lease can be analogized to a leased asset that is used to construct an item of PPE.

Per paragraph 10 of IAS 16 states, “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.

Furthermore, paragraph 16(b) of IAS 16 defines one element of the cost of PPE as “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.” Access and use of the land upon which the facility is to be built is required to bring the facility to the condition necessary for its intended use by management.

Therefore, the depreciation of the RoUA should be included in the cost of the manufacturing facility.

  1. Presuming the asset under construction is a “qualifying asset under IAS 23, should the interest on the lease liability be capitalized as a borrowing cost during the construction period?

Paragraph 8 of IAS 23 requires an entity to capitalize borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset.

The definition of borrowing costs in paragraph 6(d) of IAS 23 include “interest in respect of lease liabilities recognized under IFRS 16.”

This supports the capitalization of interest on the lease liability as a borrowing cost.

Paragraph 17 of IAS 23 further states the commencement date for capitalization of borrowing costs to be the date when the entity first meets all three conditions:

  • It incurs expenditures for the asset;
  • It incurs the borrowing costs; and
  • It undertakes activities that are necessary to prepare the asset for its intended use or sale.

Capitalization is suspended during extended periods when development is interrupted.

Capitalization ceases when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.