Last Updated on March 23, 2023 by Morgan Beard
Right-of-use assets are foundational to lease accounting. An ROU asset is represents the lessee’s right to use said leased asset, real estate, equipment or other over the agreed upon lease term.
The adoption of ASC 842 in the United States and IFRS 16 internationally as the new lease accounting standards introduced a new concept: the right-of-use asset. Commonly known as the ROU asset, it’s raised many questions for lease accountants, like what are ROU assets? How are they calculated? And how do ROU assets affect the balance sheets?
You’re in the right place if you’ve ever asked any or all of these questions. Here’s a quick guide to what you need to know about ROU assets.
What is a Right-of-Use Asset?
ASC 842 and IFRS 16 both bring many changes to the lease accounting process. But the most significant difference is that all leases must now be recorded on the balance sheet.
This is where the ROU (right-of-use) asset comes into play. The ROU asset is the lease asset, representing a lessee’s right to use a leased asset over a period of time (the lease term). Under the new rules, the lease liability is the lessee’s financial obligation to make the payments as defined in the lease agreement—on a discount basis.
To keep things simple, think of the ROU asset as how a lease is recorded as an asset on the balance sheet now that new standards require all leases to be recorded as assets and liabilities.
With that knowledge under your belt, here’s a look at how the ROU asset is calculated.
How is the ROU Asset calculated?
At a high level, the ROU asset is calculated as:
- The initial amount of the lease liability
- + any lease payments made to the lessor before the lease commencement date
- + any initial direct costs incurred
- – any lease incentives received
However, there are differences in how the ROU asset is applied in ASC 842 and IFRS 16.
ROU Assets Under ASC 842
The FASB Accounting Standards Update continues to distinguish between operating leases and finance leases, whereas IFRS 16 makes no such distinction. Even though FASB ASC 842 defines two separate lease classifications, the ROU asset is always calculated similarly and will follow the appropriate GAAP guidance.
So, under ASC 842, for both operating leases and finance leases, it starts with the initial amount of the lease liability, computed with the appropriate discount rate on the remaining lease payments. Then add the outstanding balance of prepaid rent or subtract the cumulative remaining deferred rent; add any initial direct costs; and finally, subtract lease incentives paid at or before lease commencement.
Suppose you’re recording a simple lease without any initial direct costs, prepaid or deferred rent, or any lease incentives. In that case, the ROU asset and lease liability will be equal at the time of lease commencement.
That leaves the question of what qualifies as initial direct costs, prepayments, and incentives. If you need clarification, here’s some guidance on what those terms mean in the context of ASC 842.
Initial Direct Costs are a lessee’s incremental costs that occur in the process of obtaining a lease. This includes commissions, legal fees paid toward the origination of the lease, costs related to negotiating lease terms, or costs associated with arranging collateral.
Some things that do not qualify as initial direct costs include internal overhead costs, like sales and marketing expenses; costs related to evaluating a lessee’s financial condition; and costs associated with obtaining offers for potential leases.
Prepayments and Incentives are any rental payments made to the lessor before lease commencement. They often take the form of incentives offered to the lessee to sign a lease agreement. Some examples include payments made to (or on behalf of) the lessee in relation to a lease, or a lessor incurring costs on behalf of the lessee, such as assuming a lessee’s pre-existing third-party lease.
The ROU Asset Under IFRS 16
Since IFRS 16 does not distinguish between operating and finance leases, all leases are reported as finance leases. All leases are capitalized and recognized on the balance sheet as assets and liabilities unless the lease contract qualifies for some of the exemptions allowed under IFRS 16.
IFRS 16’s ROU asset calculation method is also slightly different from the ASC 842 calculation. Under this standard, the ROU asset is calculated as:
- The initial amount of the lease liability
- + the total of payments made at or before the lease commencement date
- – any lease incentives
- + initial direct costs
- + estimated costs for restoration or removal and disposal
The ROU Asset, the Balance Sheet, and Other Financial Statements
The primary goal of the revised lease accounting standards is to increase the transparency of lease accounting and financial reporting. Requiring all leases to be reported as assets and liabilities on the balance sheet significantly impacts all financial statements. This is initially seen in how the ROU asset is amortized.
The amortization schedule for the ROU asset is determined from the lease commencement date to either the end of the lease term or the end of the useful life of the asset, whichever is earlier. In cases where it seems certain that the lessee will exercise an option to purchase the asset, in other words, or the lease transfers ownership, then the amortization period is extended through the end of the asset’s useful life.
Also, the methodology to calculate amortization differs for operating and finance leases. For operating leases, the amortization charge is related to the lease liability. ASC 842 provides two different ways to calculate amortization.
The formula for the first method is:
- Lease liability carrying amount
- + unamortized initial direct costs
- + or – prepaid and/or accrued lease payments
- – the unamortized balance of lease incentives received
This method is practical when a company has a small portfolio of straightforward leases. Lease modifications, remeasurements, impairments, and foreign currency translations will complicate amortization calculation under this method. The second method is a simple formula that will make more sense in these cases:
- ROU asset = Beginning balance – Accumulated amortization
In this formula, amortization is calculated as the difference between the straight-line lease cost for the period, and the periodic accretion of the lease liability.
With ROU calculation and amortization in place, here are some of the differences you can expect on common financial statements.
Profit and Loss Statement
How lease expenses are classified in a profit and loss (P&L) statement differs depending on lease classification.
Lease classification criteria is determined by answering a few questions about the lease:
- Does ownership transfer to the lessee at the end of the lease?
- Does the lessee have a purchase option, and is it reasonably certain they will exercise the option?
- Is the lease term for the major part of the remaining economic life of the lease?
- Is the leased asset specialized (that is, it will not have an alternative use at the end of the term)?
If you answered no to all of the above questions, the lease is an operating lease. If you answered yes to any of the questions, the lease is a finance lease.
With finance leases, interest incurred is classified as interest expense. With an operating lease, it’s classified as a lease expense.
Amortization expense under an operating lease is classified as a lease expense.
Cash Flow Statement
Under the new standards, lessees are required to report the expense associated with an operating lease as an operating liability.
For finance leases, lease payments are reported as financing or operating in the cash flow statement, depending if the amounts in question are related to principal or interest.
The right-of-use assets (ROU assets) and lease liabilities for every finance and operating lease must be disclosed explicitly on the balance sheet. This is the heart and soul of the ASC 842 lease accounting guidelines.
How to Record ROU Impairment
Impairment happens when an asset’s cash flows or other benefits decline. For example, if a natural disaster were to strike and did damage a company’s equipment, that equipment is deemed to have become impaired. With leases now reported as ROU assets, some thought has to be put into how to record the impairment of an ROU asset.
Traditionally, impairment involves a one-time write-off of the difference between the asset’s fair value and its carrying amount. For an ROU asset, the impairment is also to be immediately recorded, which would reduce the asset’s carrying amount. Subsequent measurements after impairment are calculated as the carrying amount immediately after the impairment, minus any accumulated amortization.
What are ROU Assets? Occupier Has the Answers
The ROU asset, and all the changes it brings to lease accounting and financial reporting, is just one aspect of new standards like ASC 842 and IFRS 16. When you consider all the changes, feeling overwhelmed is completely normal. You need a premiere lease accounting system to ensure you’re getting everything right and minimizing the changes to your company’s balance sheet.
Occupier has a sleek and modern solution for your lease accounting needs. The entire process—from calculating the ROU asset all the way through closing the books—is easier than ever with Occupier’s innovative, yet user-friendly, tech stack.
To find out why Occupier is the solution for your lease accounting process, contact us today and schedule a demo.
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