A right-of-use asset, or ROU asset, represents a lessee’s authority to utilize a leased item, typically property or equipment, over the duration of an agreed-upon lease term. In other words, the lessee is granted the right to obtain the economic benefit from the usage of an asset owned by another entity. Under GASB 87, this asset is referred to as the “lease asset.”
A lease liability, as appropriately named under all three standards (ASC 842, IFRS 16, and GASB 87), is the financial obligation to make the payments arising from a lease, measured on a discounted basis.
ASC 842 differs from the other two lease accounting standards as a result of retaining its dual-model approach to presenting lease assets and lease liabilities on the balance sheet and income statement. That is, ASC 842 continues to distinguish between operating leases and finance leases with each classification requiring a capitalized ROU asset.
However, accounting for finance leases, previously referred to as capital leases, under ASC 842 is largely unchanged compared to ASC 840. Under the old standard, lessees were required to record an asset and liability for capital leases. The same is true under ASC 842.
Under ASC 842, initial operating and finance lease ROU assets are calculated using the exact same method. The steps are as follows:
Start with the initial amount of the lease liability, computed by discounting the remaining lease payments
- + Outstanding balance of prepaid rent or
- – Cumulative remaining deferred rent
- + Initial direct costs
- – Lease incentives paid at or before commencement of the lease
It is important to note that for basic leases, the ROU asset and lease liability will be equal upon lease commencement. For example, if a company has a lease without initial direct costs, prepaid/deferred rent, or a tenant improvement allowance (or some other lease incentive), then the ROU asset and the lease liability will be equal on the lease commencement date.
A classification distinction between operating and finance leases does not exist under IFRS 16. Rather, a single model approach is applied whereby all lessee leases post-adoption are reported as finance leases. These leases are capitalized and presented on the balance sheet as both assets and liabilities, unless subject to any of the exemptions prescribed by the standard. IFRS 16 also refers to the lease asset as a ROU asset.
IFRS 16 directs lessees to calculate the ROU asset as the following:
- The initial amount of the lease liability
- + Payments made at or before the commencement date of the lease
- – Lease incentives
- + Initial direct costs
- + Estimated costs for restoration or removal/disposal per IAS 37 Provisions, Contingent Liabilities, and Contingent Assets
GASB 87 requires a lessee to recognize an intangible right-to-use lease asset, referred to as a lease asset, in conjunction with a lease liability. However, in order to do so, the reporting entity must have the right to control and obtain economic benefit from the present service capacity of the underlying asset.
In addition, the following types of leases are exempt from recognizing a right-to-use asset and lease liability under GASB 87:
- Leases not meeting the definition of an exchange-like transaction
- Leases containing a provision for a title transfer
- Leases with a lease term of 12 months or less, including renewal options
When capturing the activity within the governmental fund, a conversion entry will be necessary at year-end to convert from the modified accrual accounting basis to the required full accrual basis for the government-wide financials.
Similar to IFRS 16, GASB 87 uses a single-model approach and classifies all leases as finance leases. In order to compute the initial leased asset amount a lessee should take the total of:
- The initial lease liability
- + Outstanding prepaid rent amounts
- – Any cumulative remaining deferred rent
- – Unamortized incentive balances received at or before commencement of the lease
- + Initial direct costs incurred to place the asset into service
Under ASC 842 for operating leases, the ROU asset is amortized from the lease commencement date (the date the lessee obtains possession of the underlying asset) to the end of the lease’s term. In some cases, it may be from the commencement date to the end of the useful life of the asset. The same holds true for finance leases under ASC 842, IFRS 16, and GASB 87.
A lease liability is the financial obligation for the payments required by a lease, discounted to present value. Under ASC 842, IFRS 16, and GASB 87, the lease liability is calculated as the present value of the remaining lease payments over the lease term. The preferred discount rate to use is the discount rate implicit in the lease under ASC 842, the implicit interest rate under IFRS 16, or the interest rate implicit in the lease as stated under GASB 87. However, each standard also allows for the use of the lessee’s incremental borrowing rate in defined circumstances when the implicit interest rate can not be determined. Additionally, ASC 842 also offers non-public entities a practical expedient to use a risk free rate.
IFRS 16 also requires lessees to remeasure lease liabilities when future payments change, potentially affecting opening balances when the lease payments are tied to an index. This is not the case, however, under GASB 87 and ASC 842. For more detail on this, read our blog, “IFRS 16 vs. US GAAP Lease Accounting: What Are the Differences?“
ASC 842 offers an additional interest rate option to private companies and nonprofits. Non-public entities have the option to elect a risk-free rate as the discount rate for lease liability calculations. As a result of the FASB’s post-implementation review process, private entities can apply the risk-free rate by class of underlying asset rather than having to apply to the entire lease portfolio.
An operating lease is a contract providing a lessee the right to use an asset without the benefits of ownership. Despite companies’ obligations to make the lease payments associated with their operating leases, ASC 840 and IAS 17 did not require a lease asset or a lease liability to be recorded on the balance sheet, nor did GASB require recording an asset or liability on the statement of net position under GASB 13 or GASB 62. Operating leases did not meet the criteria for capitalization.
ASC 842, IFRS 16, GASB 87, however, now require the capitalization of almost all leases – a major shift in the way lessees account for their operating leases. Aside from the ability to take advantage of a policy election allowing a lessee to account for leases with terms shorter than 12 months similar to an operating lease under the legacy standards, and few other exemptions seen under GASB 87, all leases must be recognized on the balance sheet with a lease liability and ROU asset, calculated at initial recognition as discussed at the beginning of the article.
Note: For more detail on operating lease accounting with treatment and journal entries, read our blog, “Operating Lease Accounting under the New Standard, ASC 842: Full Example and Explanation.”
Operating lease classification has also changed under all three standards, but in different ways. Under IFRS 16 and GASB 87, all leases are classified as finance leases, eliminating the “operating lease” classification. This isn’t the case for ASC 842, though, which makes the following changes to the lease classification criteria:
- A bargain purchase option criteria no longer exists. If the lease contains an option to purchase the underlying asset that the lessee is reasonably certain to exercise, the lease qualifies as a finance lease.
- The 75% of lease term and 90% of FMV rules are no longer definitive. However, the FASB has suggested companies should continue to use these thresholds in their analyses, unless a more appropriate threshold exists, based on the company’s facts and circumstances. The company needs to develop an overall policy with regards to these thresholds to use consistently.
- A new fifth test has been added – you must consider whether or not the asset is specialized in nature and has any future value to the lessor.
This is primarily as a result of the FASB moving away from “rules” based accounting to “principle” based accounting.
Regardless of which new lease accounting standard is being adopted, each standard will result in the recognition of a right-to-use asset and lease liability on the balance sheet upon transition. Reporting entities must have a firm grasp of the financial statement presentation and the methods of computing the ROU asset and corresponding lease liabilities, as each guidance has its own nuanced definition of what is deemed a reportable lease and what variables factor into the calculations.
This comprehensive guide on understanding the ROU asset as it relates to both finance and operating leases should help you in your future calculations. If you’re unsure what type of lease you have, we offer a number of free tools for lease accounting that can help you. To learn more, visit our Features page or schedule a LeaseQuery demo today.