What Is Right-Of-Use Assets (ROU) And How Is It Determined

November 22, 2022
Alok Suman
Lease Management

Why do businesses of all sizes and in all kinds of industries consider leasing assets a lucrative opportunity in the first place?

The reason is simple - leasing offers several benefits to businesses, including boosting their purchasing power, lowering their maintenance expenses (if the lessee is not liable for upkeep), and assisting with improved cash flow management. 

However, due to the severe compliance requirements of the accounting regulations, right-of-use and lease management for assets can become a challenge for various businesses.

So, here is a holistic guide that covers every facet of right-of-use assets to assist companies (both lessee and lessor sides) in comprehending the concept better. Let's get started.

What is a Right of Use Asset?

The term "right of use" (ROU) is considered a critically significant component of lease management within the framework of lease accounting standards and regulations.

This asset now captures specifics of how a lessee gets the authorization to utilize an asset if it's mentioned in a lease during a contract's duration. It does so in a way that makes it easy to understand. 

A lessee will first evaluate an asset representing a right of use based on its cost, which includes the following components:

  • The starting lease liability amount equates to the current value of lease payments calculated using the lease's implicit interest rate, if available, or the lessee's incremental borrowing rate, if not. Primarily, lease payments are composed of fixed and variable payments, which are tied to an index or rate.
  • Leasing payments made in advance of the commencement date, lesser than the value of any leasing incentives.
  • Initial direct costs.
  • Costs associated with dismantling and restoration.

An ROU is accounted similarly to an acquired asset following its initial recognition. On the other hand, the asset gets reevaluated every time there is a remeasurement of lease liabilities owing to a variation in lease payments. It occurs quite frequently.

How is the Value of the Right of Use Asset Determined?

To determine the value of the asset:

  • Begin with the initial lease liability amount.
  • Add any lease payments provided to the lessor before the lease officially commences.
  • Then add any initial direct expenditures incurred and subtract any lease incentives received. 

The ROU calculation formula looks like this:

 

The initial lease liability amount 

Lease payments to the lessor prior to the lease commencement date

Initial direct costs incurred

-

Lease incentives received

ROU asset

And that's how you get the correct value of the ROU asset. The ROU asset cannot be realized accurately without fully appreciating the significance of each factor in this equation.

Since it pertains to the lessee's obligation to complete lease payments based on the current value of the prospective lease payments, the lease liability is a crucial factor to consider when calculating the ROU asset.

Initial direct costs are also very significant for the valuation of the ROU asset. Initial direct costs are expenses directly connected to the asset in the lease that the lessee has the entitlement to utilize during the lease.

What are the Constituents of a Right of Use Asset?

Most elements included in the ROU asset valuation are the same for operating or finance leases. An ROU asset needs to meet the following requirements for both types of leases:

  • Be documented on a balance sheet as the current value of lease payments throughout the duration of the lease. It aggregates initial direct expenses and subtracts lease incentives.
  • Be reported separately or coupled with the proper classification of assets and liabilities, as operating and finance leases cannot be intermixed as this would disregard accounting standards.
  • Get the impairment evaluated in conformity with the guidelines established by professional standards.
  • Each period should include a reevaluation to look for noteworthy changes. In the event that any of these are found, the ROU asset will typically have a modification made to reflect them.

For ROU assets subject to a finance lease:

  • Include the interest expenditure on the lease liability and the amortization of the ROU asset in the income statement.
  • Document the amortization of the ROU asset independently from the amortization of the ROU asset on the income statement, as well as the interest expense on the lease liability.
  • Include the interest and any variable payments under the category of operating activities. On the statement of cash flows, payments made toward the principal repayment are categorized as financing activities.

ROU assets under an operating lease are required to:

  • Report the amortization of the ROU asset on the income statement. When an operating lease is involved, no interest expenditure is taken into account.
  • Categorize payments while preparing the cash flow statement as operating activities.

Understanding the Right of Use Calculation with Examples

Here is an example of calculating a right-of-use asset, implementing the calculation mentioned previously. The following are some of the assumptions:

  • Rental term of six years with no renewal options available
  • After each year, you are obligated to make a lease payment of  ₹40,000
  • The initial direct cost is ₹2,000
  • The rise in the value of the ROU asset (the incremental borrowing rate) is 9%. 

Firstly, the lease liability has to be calculated. The lease liability is equivalent to the current value of the six subsequent payments, which are discounted at a rate of 9%. The total that is arrived at will be ₹179,437.

Now, moving on with the ROU calculation:

  • The initial direct cost, the lease liability, and any prepayments made will be added. Then, any lease incentives offered by the lessor would be subtracted to arrive at the accurate value of the ROU asset.
  • As a result, the ROU asset gets valued at  ₹181,437, which represents the total lease liability of  ₹179,437 plus the lease incentives of ₹2,000. Since there were no leasing incentives or prepayments involved in this scenario, nothing has to be deducted from the total.

So the final reported values stand at:

  • Lease liability:  ₹179,437
  • Cash:  ₹1,000
  • Right of use asset:  ₹181,437

Final Thoughts

Ultimately, the calculations applied in evaluating the right-of-use asset aren't all that complicated; nonetheless, one must deal with the challenging issue of acquiring data for efficient lease management and accounting operations.

As a result, companies have the responsibility to make certain they collect data that can be relied upon in order to verify that the lease payments, lease duration, and discount rates they compute are accurate. 

It is also highly recommended to get access to robust, credible software solutions designed specifically for lease accounting in order to ensure accurate accounting and record entry of right-of-use assets.

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