Last Updated on August 10, 2023 by Lauren Covell
ASC 842 and IFRS 16 have drastically changed the face of lease accounting. The ROU, or “Right of Use” asset recording process, has become more complicated for many because of the changes. We’ve created this blog to uncomplicate the matter. Accountants with a firm grasp of right-of-use can provide accurate lease accounting and solid financial advice to company leadership. This blog post will give examples of ROU assets, explain how to account for them under both standards, and help you avoid some of the most common ROU accounting mistakes.
What are ROU assets, and why are they essential for businesses?
Right-of-use (ROU) assets are non-monetary assets that businesses must record when they enter a lease contract. These assets give a company the right to use an asset for a specified period, usually on periodic rent payments. ROU accounting helps businesses to control their liabilities and manage their cash flow. By recognizing the value of the asset upfront rather than over long-term payments, companies can better align their expenses and change their accounting strategy as needed. Even in leases with large advance rents, accounting treatments such as prepaids can be handled by ROU.
Further, ROU accounting ensures businesses are not overstating their liabilities by overvaluing lease terms and underestimating real costs. Proper ROU accounting is essential to provide a realistic picture of an organization’s financial performance and help its investors make informed decisions. Accurate recording of these assets steers companies clear of reputational harm because of failure to disclose information accurately.
Some of the most common ROU assets are:
- Real estate
- Office furniture and equipment, such as printers and copiers
- IT equipment, such as PCs, laptops, and servers
- Medical technology
- Construction equipment and yellow iron
As you can see, ROU assets cover various industries and categories. Let’s dig into how to account for them.
How does ROU accounting work under the IFRS 16 standard?
IFRS 16 is the international standard, rather than GAAP, lease accounting standard.
It is imperative first to understand the components that make up the cost of an ROU asset as we delve into ROU accounting.
According to IFRS 16.24, right of use cost includes the following elements:
- Total lease liability This is calculated by using the present value of all payments due over the length of the lease and discounted at the rate implicit in the agreement.
- Lease payments. These can include:
- Fixed payments: These are set upfront payments that stay the same throughout the contract.
- Variable lease payments: These payments fluctuate based on market indices, such as LIBOR.
- Purchase Options: This is included in the lease liability if the lessee is reasonably likely to exercise the option.
- Residual value guarantees: This is a specified amount that the underlying asset will be worth at the end of the agreement.
- Upfront payments: These are security deposits used as collateral, typically refundable at the end of the agreement.
- Lease incentives: These are payments made by the lessor to, or on behalf of, the lessee to induce the lessee into a contract.
- Direct costs: These are costs incurred due to the lessee entering the contract, such as commissions paid to realtors or fees paid to lenders or attorneys.
- Estimated costs: These are any costs a lessee could incur to make changes to the asset at the end of their lease if they do not intend to keep it.
With all of those elements established, IFRS 16 directs lessees to calculate ROU assets by:
Adding upfront payments less lease incentives to the total lease liability. Then add direct and estimated restorative costs to that sum.
Here is an example case of ROU accounting:
ABC Software enters a three-year space lease with landlord XYZ Real Estate at $2,777.77/month. ABC puts down a security deposit (upfront payment) equal to one month’s rent. The landlord provides a tenant improvement allowance (lease incentive) of $30,000. ABC Software’s legal fees (direct costs) are $1,500. ABC will customize its space to cost around $5,000 to restore it to a condition for the next tenant to use the property.
Calculate the total ROU cost using:
|Total lease liability
Estimated rest/rem/disp costs
How does ROU Asset accounting work under the ASC 842 standard?
First, the lease should be classified as either an operating or a financing lease, as both require different levels of accounting treatment.
ASC 842 has brought all operating leases onto the balance sheet, requiring businesses to closely access all contracts under this new accounting compliance standard. The exception is short-term leases, which ASC 842 defines as:
A lease that, at the lease commencement date, has a lease term of 12 months or fewer and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise.
Operating leases are expensed on a straight-line basis over the lease term. Under ASC 842, both Finance & Operating leases are accounted for on a single lessee accounting model. Requiring lessees to recognise assets based on the initial measurement of the lease liabilities for each and every lease. If a lease modification occurs, then a subsequent measurement must take place, potentially resulting in a separate contract.
Finance leases must include depreciation over the term of the asset or contracted period with no associated interest costs. Prepaid rent or security deposit must be recognized separately from any ROU assets. All ROU assets must also be tested for impairment annually based on their estimated future economic benefits and changes in technological obsolescence. Compared to IFRS 16, ASC 842 does not include a line item for estimated restoration reimbursement or disposal costs.
Let’s evaluate the same lease again using the ASC 842 ROU accounting standard:
ABC Software enters this same three-year space lease with landlord XYZ Real Estate at $2,777.77/month. ABC puts down a security deposit (upfront payment) equal to one month’s rent. The landlord provides a tenant improvement allowance (lease incentive) of $30,000. ABC Software’s legal fees (direct costs) are $1,500.
Recall that under ASC 842, restoration to an asset may not be accounted for as part of the ROU cost:
|Total lease liability
If ABC wanted XYZ to cover the costs of customizing their building, they might negotiate them into the lease incentives. Here, our lease incentives line item would change accordingly.
Properly managing and monitoring these elements makes it possible to produce high-quality financial statements that accurately account for all ROU assets under the ASC 842 standard.
How to calculate ROU Asset amortization
When calculating the ROU asset amortization and lease expense under ASC 842, it’s helpful to break it down into steps.
Determine lease liability
The first step in this process is determining the lease liability, which is equal to the present value of all future minimum lease payments over the lease term. Discount that value using either an implicit rate or an interest rate that reflects a market rate for a similar type of borrowing.
Calculate ROU Asset
Once you have determined the present value of all future minimum lease payments, you can calculate the right-of-use asset by subtracting any upfront costs associated with the lease (such as security deposits) from that total.
The next step in calculating amortization and lease expense under ASC 842 is to determine how much of each period’s payment to classify as an operating expense versus a financing cost. Any portion of a payment towards reducing the principal balance on a loan or paying down a long-term debt obligation should be classified as a financing cost and amortized. Any payment that does not reduce principal or debt obligations should be classified as an operating expense and recognized in full during that period.
Finally, when calculating amortization and lease expense under ASC 842, accountants must also consider certain factors, such as whether impairment losses are associated with leased assets or residual values exist at the end of the term.
For example, suppose an asset has been impaired because of economic obsolescence or other causes during its useful life. In that case, accountants may need to adjust those amounts when calculating their amortization schedule.
Consider residual values
Similarly, suppose there is expected residual value at the end of an asset’s useful life (i.e., estimated proceeds from leasing or selling off that asset). In that case, accountants must also factor this into their calculations when determining their overall amortization schedule, resulting in periodic expenses.
By considering these steps and accurately accounting for upfront costs related to leasing arrangements and periodic payments made throughout each period (both operating expenses and financing costs), accountants can adequately calculate their right-of-use asset amortization and lease expense according to ASC 842 requirements. Doing so will ensure accurate financial reporting for lenders/investors and management.
Lease Amortization Schedule
Calculate your ROU Asset and Lease Liability with our Lease Amortization – Excel Spreadsheet.
Tips on how to avoid common ROU Asset accounting mistakes
Regarding ROU accounting, one of the most critical elements to keep in mind is to take a proactive approach. Many managers make the mistake of waiting until after their organization has acquired an asset before beginning the accounting process. Waiting can lead to errors, such as missing or delayed recognition of those assets in their financial statements. Initial adoption of the new accounting standards updates on your entire lease portfolio and the associated ROU asset and corresponding lease liabilities sooner than later is vital in preparing for the accounting transition.
Companies should stay up-to-date with all accounting trends, regulations, and standards. A good example is staying on top of the changes that have taken place with ASC 842 and IFRS 16.
Finally, organizations should regularly review ROU information on their financial statements and ensure they group their assets correctly. You can avoid mistakes with a proactive and vigilant attitude towards ROU accounting and proper reporting procedures followed. Taking the time to account for ROU assets can lead to significant financial rewards for any organization.
ROU accounting is an essential part of any business, and it’s crucial to understand how to account for your assets under both IFRS 16 and ASC 842 standards. At Occupier, we want to ensure you have all the information you need to make the best decisions for your company. That’s why we offer comprehensive training on lease accounting and support throughout the process. If you’re ready to see how Occupier can streamline your entire lease accounting lifecycle, get in touch with us today and schedule a demo.
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