The concept of right of use assets has gained significant prominence with the adoption of new lease accounting standards such as ASC 842 (in the United States) and IFRS 16 (internationally). Right of use assets, often referred to as ROU assets, are now a crucial component of lease accounting, representing a lessee’s right to use a leased asset over the lease term. This guide will explore their definition, recognition, measurement, and implications for businesses.

What is a Right of Use Asset?

A right of use asset represents a lessee’s right to use an underlying leased asset for the duration of a lease term. Under current accounting standards, virtually all lease contracts are recognized on the balance sheet as right of use assets and corresponding lease liabilities, fundamentally changing how leases are accounted for compared to previous standards.

Key Characteristics and Definition of Right of Use Assets

Essentially, a right of use asset is:

• An intangible asset that reflects the value of a lessee’s right to use a leased item
• Recognized on the balance sheet alongside a corresponding lease liability
• Initially measured at the present value of future lease payments, plus certain adjustments

Key characteristics of right of use assets include:

• Duration: They exist for the length of the lease term, including any extension periods the lessee is reasonably certain to exercise.
• Control: They represent the lessee’s right to control the use of the identified asset.
• Economic Benefits: They embody the lessee’s right to obtain substantially all economic benefits from the use of the asset.

Common Examples of Right of Use Assets

Understanding right of use assets becomes clearer when we consider real-world examples. Here are some common types of leased assets that typically qualify as ROU assets:

Real Estate:

• Office buildings
• Retail spaces
• Warehouses

Equipment:

• Manufacturing machinery
• Construction equipment
• Medical devices

Vehicles:

• Company cars
• Delivery trucks
• Forklifts

Technology:

• Computer servers
• Telecommunications equipment
• Photocopiers and printers

Specialized Assets:

• Aircraft
• Ships
• Oil rigs

 

Each of these examples represents a situation where a company gains the right to use an asset for a period of time, thus potentially qualifying as a right of use asset under current lease accounting standards.

Recognition and Measurement of ROU Assets

To recognize a lease as a right of use asset:

1. The lease must convey the right to control the use of an identified asset for a period of time in exchange for consideration.
2. Control is assessed based on the ability to direct the use of the asset and obtain its economic benefits.
3. The asset is recognized at the commencement date of the lease.

Lease Term Considerations

The lease term includes the non-cancellable period of the lease and may include options to extend or terminate the lease if the lessee is reasonably certain to exercise those options. Factors influencing this assessment include economic incentives, significant leasehold improvements, and historical practices.

Initial Measurement of ROU Assets

Right of use assets are initially measured at the present value of lease payments over the lease term, adjusted for lease incentives, initial direct costs, and estimated restoration costs, if applicable.

The discount rate used to calculate the present value of lease payments should reflect the rate implicit in the lease (if determinable) or the lessee’s incremental borrowing rate.

Example of ROU Asset Calculation

Let’s consider a simple example to illustrate the initial measurement of a right of use asset:

Company A leases office space for 5 years with annual payments of $100,000, paid at the beginning of each year. The lease has no extension options, and the company’s incremental borrowing rate is 5%.

1. Calculate the present value of lease payments: Present Value = $100,000 + ($100,000 × Present Value Factor for 4 years at 5%) = $100,000 + ($100,000 × 3.5460) = $454,600
2. Assuming no initial direct costs, lease incentives, or restoration costs, the initial ROU asset value would be $454,600.

This example demonstrates how the right of use asset is initially measured based on the present value of future lease payments.

Subsequent Measurement and Adjustments

After initial recognition, right of use assets are generally measured at cost, less accumulated amortization and impairment losses, if any. Amortization is typically recognized on a straight-line basis over the lease term unless another systematic basis is more representative of the pattern of the lessee’s benefit from the use of the ROU asset.

Ongoing Management of ROU Assets

Managing ROU assets involves ongoing considerations throughout the lease term to ensure accurate reporting and compliance:

Lease Modifications

Changes in lease terms, such as modifications or reassessments of lease options, may require adjustments to the carrying amount of right of use assets and lease liabilities.

Impairment Testing

ROU assets are subject to impairment testing when events or changes in circumstances indicate that the carrying amount may not be recoverable. Impairment losses are recognized if the carrying amount exceeds the recoverable amount.

Subsequent Lease Payments

Lease payments made during the lease term are allocated between the reduction of the lease liability and interest expense, reflecting the amortization of the right of use asset.

Disclosure Requirements for ROU Assets

Current leasing standards mandate comprehensive disclosures to provide users of financial statements with a deeper understanding of an entity’s leasing activities:

Quantitative Disclosures

These include:

• The amount of lease liabilities and ROU assets recognized
• The maturity analysis of lease liabilities
• The weighted-average remaining lease term and discount rate

Qualitative Disclosures

These provide additional insights into:

• The nature of the leases
• Significant leasing arrangements
• Any other relevant information to help users understand the financial impact of leasing activities on the entity

Practical Considerations of Right of Use Assets for Businesses

Implementing the new lease accounting standards and managing ROU assets effectively require careful planning and consideration of various practical aspects:

Transition and Implementation

Businesses transitioning to current leasing standards should assess the impact on financial statements, implement necessary changes to accounting systems, and ensure compliance with disclosure requirements.

Internal Controls

Establishing robust internal controls over lease data, lease agreements, and financial reporting processes is essential to mitigate risks and ensure accuracy in lease accounting.

Technology and Software Solutions

Utilizing lease accounting software or integrated enterprise resource planning (ERP) systems can streamline lease management, facilitate lease calculations, and enhance compliance with accounting standards.

Auditing and External Reporting

Working closely with auditors and external advisors can provide additional assurance on lease accounting practices and ensure alignment with regulatory requirements.

Strategic Implications and Benefits of ROU Assets

Beyond compliance, understanding and effectively managing ROU assets can yield strategic benefits for businesses:

Enhanced Financial Visibility

By recognizing lease liabilities and right of use assets on the balance sheet, stakeholders gain a clearer view of an entity’s financial position and leverage.

Improved Decision-Making

Accurate lease data and financial reporting enable informed decision-making regarding lease versus buy decisions, lease renegotiations, and overall capital allocation strategies.

Increased Negotiating Power

Armed with comprehensive lease information and insights, businesses can negotiate favorable lease terms, optimize lease portfolios, and minimize financial risks associated with leasing activities.

Conclusion

In conclusion, understanding Right of Use (ROU) assets is essential for businesses navigating the complexities of modern lease accounting. To reiterate, a right of use asset represents a lessee’s right to use an underlying leased asset for the duration of a lease term. It is an intangible asset recognized on the balance sheet that reflects the value of the lessee’s right to use the leased item, measured based on the present value of future lease payments and other adjustments.

Effective management of ROU assets involves careful measurement, ongoing adjustments, and compliance with disclosure requirements to provide transparency and enhance financial reporting. By embracing the principles outlined in this guide, businesses can leverage ROU assets strategically, optimize lease portfolios, and make informed decisions that contribute to long-term financial success and sustainability.

Understanding and managing right of use assets can be complex, but with the right tools and expertise, businesses can turn this accounting requirement into a strategic advantage.

To learn more about Leasecake’s lease management platform and how we can help you grow your business, manage multiple locations, save money by understanding exactly what’s in your lease agreements, and minimize the risk of overpaying or missing a lease renewal, schedule a demo.

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