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.
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:
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.
To determine the value of the asset:
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
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.
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:
For ROU assets subject to a finance lease:
ROU assets under an operating lease are required to:
Here is an example of calculating a right-of-use asset, implementing the calculation mentioned previously. The following are some of the assumptions:
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:
So the final reported values stand at:
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.