What is a Right of Use Asset?

A right of use asset, or ROU, is a lessee’s right to use an asset over the course of a lease. 

More formally, an ROU asset is an identified property or plant of equipment—in other words, an identified asset—that is leased by an entity. The use of this asset by the lessee must be pursuant to the definition of the right of use in the new lease accounting standards: ASC 842 for US GAAP, GASB 87 for US government GAAP, and IFRS 16 for international accounting. 

Most lease assets are now recorded on the Balance Sheet in the form of an ROU Asset and Lease Liability. The right of use asset is considered an intangible asset.

Under this same accounting standard, the amortization period is the length of the lease term, except when ownership is transferred to the lessee at the end of a finance lease. In this case, the lease is amortized over the useful life of the asset.

What Does ROU Mean?

ROU stands for “right of use.” The concept of right of use is now a very important aspect of lease accounting within the parameters of the new lease accounting standards. This asset now encapsulates the details of how a lessee should record the value of the ROU Asset and Lease Liability over the period of a contract.

How is Right of Use Asset Calculated?

The ROU asset is calculated as:

The initial amount of the lease liability

+

Lease payments made to the lessor before the lease commencement date

+ 

Initial direct costs incurred

-

Lease incentives received

= 

ROU asset

Each component of this equation proves important in understanding the value of the ROU asset. The lease liability is important for ROU asset calculations because it is the present value of future lease payments. 

Initial direct costs are also important for the calculation of the ROU asset because they are connected directly to the asset in the lease that the lessee has the right to use over the course of the lease.

What are Other Considerations for ROU Assets?

Most considerations for ROU asset calculation are the same for both finance or operating leases. For both types of leases, an ROU asset has to:

1. Be recorded on a balance sheet as the present value of lease payments over the course of the lease, which adds initial direct costs and prepayments, and subtracts lease incentives.
2. Be presented separately. Operating Lease ROU Assets and Finance Lease ROU Assets should be presented separately from each other and from other assets. 
3. Be evaluated for impairment in accordance with Topic 360, property, plant, and equipment.
4. Be reassessed each period for significant changes.When significant changes are identified, they are generally recorded as adjustments to the ROU asset.

Finance Lease ROU Assets:

1. Record the amortization of the ROU asset and the interest expense on the lease liability on the income statement separately from operating lease expense.

Operating Lease ROU Assets:

1. Record the amortization of the ROU asset to the income statement as an operating lease expense. There is no separate interest expense recorded for an operating lease.

Right of Use Asset Example

An example of the calculation of the right of use asset is as follows:

An asset has a five-year rental period without a renewal option, a $10,000 lease payment at the beginning of each month, and an incremental borrowing rate of 6% with initial direct costs of $2,000.

First, calculate the lease liability, which is the present value of the 60 monthly payments discounted at 6%, for a total of $509,842. When a payment is made at the beginning of the lease term, it is not included in the Lease Liability.

The ROU asset is the lease liability ($509,842) + initial direct costs ($2,000) + prepayments ($10,000) - lease incentives ($0) = $521,842.

What are the Disclosure Requirements for ROU Assets Under ASC 842?

The objective of the disclosure requirements is to enable users of financial statements to have a clear picture of the cash flows arising from leases. Lessees shall include a general description of leases, details on which variable expenses are determined, and a narrative regarding the options to extend or terminate that are recognized or not recognized as part of the ROU Asset and Lease Liability. Residual value guarantees are expected to be paid by the lessee to the lessor.

Lessees should also include finance lease cost, separating both the amortization of the right of use assets and interest on lease liabilities; operating lease cost; variable lease cost; sublease income; net gain or loss recognized from sale and leaseback transactions; and cash paid for amounts included in the measurement of lease liabilities.

How Should Companies Handle the Re-measurement of a Right-of-Use Asset?

When a lease change requires a remeasurement of the Lease Liability and ROU Asset, lessees should re-evaluate the lease payments, allocating consideration to the lease and nonlease components. The lessee should also update the discount rate and reassess the classification of the lease. When the Lease Liability is remeasured, the ROU Asset will also change and if the ROU Asset is reduced to zero, any remaining balance is recorded as a Gain or Loss.   

What are the Tax Implications Associated with Right-of-Use Assets?

ASC 842 does not impact how leases are treated for federal income tax purposes.

Right of Use Assets FAQ’s

Is the Right of Use Asset a Current Asset?

Right of use assets are generally classified as non-current assets on a balance sheet. 

What does right of use mean on a balance sheet?

Right of use refers to the lessee’s right to use an asset over the duration of a lease. 

Is a Right of Use Asset an Operating Lease?

A right of use asset can be either an operating lease or a finance lease.

Where Does the Right of Use Asset Go On a Balance Sheet?

ROU assets are recorded on the balance sheet as noncurrent assets. 

How is the initial measurement of a Right-of-Use (ROU) asset determined?

An ROU asset is measured by taking the initial amount of the lease liability plus any lease payments made to the lessor before the lease commencement date plus initial direct costs incurred less lease incentives received.

How are ROU assets amortized over the lease term?

ROU assets are amortized on a straight-line basis for the life of the lease.

What impact does the discount rate have on the valuation of a Right-of-Use asset?

A higher discount rate causes the ROU asset to be lower, and a lower discount rate causes the ROU Asset value to be higher. 

How do lease modifications affect the Right-of-Use asset?

A lease modification that is not recorded as a separate lease is changed to the existing lease. What type of modification the lease has will dictate how the ROU Asset is affected. Watch our webinar here for more information on what to do if you have lease modifications to record!

Can a Right-of-Use asset be impaired, and how is impairment recognized?

ROU Assets are long-lived nonfinancial assets and fall within the scope of Topic 360: Property, Plant and Equipment. An impairment is usually not within the control of a lessee. When an ROU Asset is impaired, the ROU Asset value is reduced; however, the Lease Liability is not.

What is the difference between a finance lease and an operating lease in the context of ROU Assets?

The calculations for determining the ROU Asset are the same regardless of lease classification. Once the lease classification is determined, the subsequent measurement of the ROU Asset is based on that classification. For Finance Leases, the amortization of the ROU Asset occurs on a straight-line basis and is recorded separately from Interest Expense. For Operating Leases, straight-line expense is recorded as total payments divided by the lease term.   

Still have questions about ROU assets or other lease accounting-related questions? We’re here to answer them. Reach out to us today to learn more about lease accounting (and how software can make your life a lot easier).