Do You Depreciate Right of Use Assets?
Understand the core accounting principles for depreciating Right-of-Use assets and their impact on your financial reporting.
New accounting regulations have significantly changed how companies report lease agreements on their financial statements. These updated standards require most leases to be recognized on a company’s balance sheet, moving away from previous practices where many lease obligations remained undisclosed. This shift aims to provide a more transparent view of a company’s financial position by bringing these agreements into full financial visibility. The changes introduce a new asset type, known as a Right-of-Use asset, and a corresponding lease liability.
Understanding Right-of-Use Assets
A Right-of-Use (ROU) asset represents a lessee’s contractual right to use an identified asset for a specific period. This asset signifies the lessee’s right to control the use of the leased item and obtain economic benefits from it, rather than representing ownership of the underlying asset itself. For instance, when a business leases an office building, the ROU asset reflects the value of its right to use that building for the lease duration. This concept was introduced by accounting standards like ASC 842 in the United States and IFRS 16 internationally, ensuring nearly all leases appear on the balance sheet.
The recognition of ROU assets on the balance sheet is a direct result of these new lease accounting standards. Historically, many operating leases were treated as off-balance-sheet financing, meaning the associated assets and liabilities were not formally recorded. The current standards now require the capitalization of these leases, presenting both an ROU asset and a corresponding lease liability on the financial statements. This change offers a clearer picture of a company’s total assets and financial obligations to investors and other stakeholders.
The Principle of Depreciating Right-of-Use Assets
Yes, Right-of-Use assets are indeed subject to depreciation. This systematic allocation of the asset’s cost over its useful life is an accounting practice that reflects the consumption of the economic benefits embodied in the asset over time. Just like tangible assets owned by a company, the right to use a leased asset provides benefits that are used up across the lease term, and its cost must be recognized as an expense on the income statement. This aligns with the matching principle, which dictates that expenses should be recognized in the same period as the revenues they help generate.
The depreciation of an ROU asset is a distinct accounting process from the reduction of the corresponding lease liability. While both are recognized on the balance sheet, the ROU asset’s depreciation reflects the expense of utilizing the leased asset, while the lease liability reduction accounts for the repayment of the financial obligation. For finance leases, the ROU asset is depreciated, and interest expense on the lease liability is recognized separately, leading to a front-loaded expense pattern. Conversely, for operating leases under ASC 842, the ROU asset is amortized in a way that typically results in a single, straight-line lease expense recognized on the income statement over the lease term.
Calculating Depreciation for Right-of-Use Assets
The calculation of depreciation for a Right-of-Use asset begins with its initial measurement. This initial value generally equals the lease liability, which is the present value of the future lease payments. This amount is then typically adjusted by adding any lease payments made before or at the commencement date, initial direct costs incurred by the lessee (such as legal fees or commissions directly related to securing the lease), and estimated restoration costs. Any lease incentives received from the lessor are subtracted from this initial measurement.
Determining the useful life over which the ROU asset is depreciated is an important step. Generally, the ROU asset is depreciated over the shorter of the lease term or the useful life of the underlying asset. However, if the lease agreement includes a purchase option that is reasonably certain to be exercised, or if ownership of the underlying asset is expected to transfer to the lessee at the end of the lease term, the ROU asset is then depreciated over the full useful life of the underlying asset. This distinction ensures that the depreciation period accurately reflects the period over which the lessee expects to benefit from the asset.
For simplicity and common practice, straight-line depreciation is widely used for ROU assets, particularly for finance leases. Under this method, the depreciable amount of the ROU asset is spread evenly over its determined useful life. The annual depreciation expense is typically calculated by subtracting any estimated residual value from the ROU asset’s initial value and then dividing that amount by the number of periods in the useful life. For operating leases under ASC 842, while the overall lease expense is straight-lined, the amortization of the ROU asset itself is often a plug figure to achieve that result, meaning the ROU asset’s reduction is not necessarily a constant straight-line amount each period.