ROU (Right of Use) assets are associated with the adoption of the new accounting standard called ASC 842, which requires companies to recognize lease liabilities and corresponding ROU assets on their balance sheets for most leases. ROU assets represent the lessee's right to use a specified asset for the lease term.
Here's how ROU assets are typically calculated and recognized
Initial Recognition:
When a company enters into a finance lease agreement (capital lease), it recognizes a liability for the lease payments and an asset for the right to use the underlying asset (ROU asset).The ROU asset is measured at the present value of the lease payments over the lease term usually 90% or more of the FMV of the asset. Lease Term: usually 75% or more of the assets useful life. Payments are split between interest expense and reduction of the lease liability. The agreement typically includes a bargain purchase option. The lessee has the option to purchase the asset at the end of the lease term for a price significantly lower than the assets FMV. Finance leases are commonly used for acquiring high-value assets like machinery, equipment, and vehicles, technology and IT infrastructure, medical equipment, aircraft, office equipment, renewable energy projects. Finance leases provide businesses with the flexibility to acquire essential assets, manage cash flow, and maintain up-to-date equipment, ultimately supporting their growth and operational efficiency.
Lessee's Perspective: The lessee recognizes both a right-of-use asset and a lease liability on the balance sheet. The lease payments are allocated between interest expense and reduction of the lease liability.
Lessor's Perspective: The lessor records the lease as a financing arrangement and recognizes interest income over the lease term.
When a company enters into an operating lease agreement, the lessor does not transfer ownership of the asset to the lessee and the lease is treated as a rental agreement.
Both are required to be reported on the balance sheet if they have a term longer than 12 months.
Lessee's Perspective: The lessee recognizes both a right-of-use asset and a lease liability on the balance sheet. The lease expense is recorded on a straight-line basis over the lease term.
Lessor's Perspective: The lessor retains ownership of the asset and records lease income over the lease term.
Subsequent Measurement:
The ROU asset is generally amortized over the lease term, and the lease liability is reduced as payments are made. The amortization expense is typically recognized on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which the lessee consumes the ROU asset's economic benefits.
Impairment Testing:
Companies need to assess whether events or changes in circumstances indicate that the carrying amount of the ROU asset may not be recoverable.
If there are indicators of impairment, an impairment test should be performed, and the asset adjusted accordingly.
Lease Modifications:
If there are modifications to the lease terms, the ROU asset and lease liability may need to be adjusted to reflect the changes in future cash flows.
Disclosure Requirements:
Companies are required to disclose information about their leasing activities, including a maturity analysis of future lease payments and a reconciliation of the beginning and ending balances of the ROU asset.
It's important to note that the accounting treatment of ROU assets can vary depending on the specific details of the lease agreement and the applicable accounting standards in a given jurisdiction. Companies should adhere to the relevant accounting standards (such as ASC 842 for U.S. GAAP) and seek guidance from accounting professionals to ensure accurate and compliant financial reporting.
See also: Lease Classification
See also: Topic 842 update March 2023
https://asc.fasb.org/imageRoot/39/117422939.pdf
