How to Calculate the Right-of-Use Asset

A Right-of-Use (ROU) asset is a key component of modern lease accounting under ASC 842 and IFRS 16 standards. This asset represents a lessee’s contractual right to utilize an underlying asset, such as property or equipment, for a specified period. These standards mandate the recognition of ROU assets and corresponding lease liabilities, providing a clearer view of an organization’s financial position. Accurate calculation and accounting for ROU assets ensures precise financial reporting.

Key Inputs for Right-of-Use Asset Calculation

Calculating a Right-of-Use asset requires specific information from the lease agreement. The future lease payments form the primary input, encompassing fixed payments, as well as variable payments that depend on an index or rate, such as the Consumer Price Index. Payments related to purchase options are also included if the lessee is reasonably certain to exercise them, along with amounts expected under residual value guarantees, and penalties for early termination if the lease term reflects such an option.

Initial direct costs are incremental expenses directly attributable to obtaining a lease that would not have been incurred if the lease had not been executed. These can include commissions paid to brokers, legal fees for drafting the lease agreement, costs associated with preparing the leased asset for its intended use, or installation expenses. Such costs are added to the ROU asset’s value.

Lease incentives, which are benefits provided by the lessor to the lessee, reduce the value of the ROU asset. These incentives might take various forms, such as cash payments from the lessor to the lessee, reimbursements for tenant improvements, or the lessor assuming the lessee’s existing lease obligations. These reduce the overall cost of the right to use the asset.

Asset retirement obligations (AROs) are also factored into the ROU asset if they are a legal requirement for the lessee. An ARO represents the estimated cost to dismantle or remove the leased asset, or to restore the site to a specified condition, at the end of the lease term. For instance, if a lease requires a lessee to remove specific leasehold improvements at the end of the term, the present value of this obligation is added to the ROU asset.

The discount rate is an important input, used to calculate the present value of future lease payments. The preferred rate is the implicit rate in the lease, which causes the present value of lease payments and any unguaranteed residual value to equal the fair value of the underlying asset plus the lessor’s initial direct costs. This rate is often not readily known or determinable by the lessee.

When the implicit rate is not available, the lessee must use its incremental borrowing rate (IBR). The IBR is the rate of interest the lessee would pay to borrow funds on a collateralized basis, over a similar term, in a comparable economic environment, to obtain an asset of similar value. Determining the IBR may involve considering the lessee’s credit rating, the lease term, and the nature of the collateral.

Initial Measurement of the Right-of-Use Asset

The initial measurement of the Right-of-Use asset at the lease commencement date combines several elements. The process begins with the initial measurement of the lease liability, which represents the present value of the lease payments. This present value calculation discounts all future lease payments using the appropriate discount rate.

Once the initial lease liability is determined, other components are added or subtracted. Lease payments made to the lessor at or before the lease commencement date are added. Initial direct costs incurred by the lessee are also added to the asset’s value.

Conversely, lease incentives received from the lessor at or before the commencement date reduce the ROU asset. If applicable, the present value of any asset retirement obligations is also included in the ROU asset’s initial measurement.

Therefore, the general formula for the initial ROU asset is: Initial Lease Liability + Lease Payments Made at or Before Commencement Date + Initial Direct Costs – Lease Incentives + Present Value of Asset Retirement Obligations. For many basic leases without these additional components, the ROU asset will initially equal the lease liability.

Subsequent Measurement of the Right-of-Use Asset

After initial recognition, the Right-of-Use asset’s value is reduced over the lease term through amortization. The amortization period for the ROU asset is the shorter of the lease term or the useful life of the underlying asset. If the lease transfers ownership or includes a purchase option that is reasonably certain to be exercised, the ROU asset is amortized over the asset’s useful life.

For finance leases, the ROU asset is amortized on a straight-line basis. This amortization expense is presented separately from the interest expense on the lease liability on the income statement.

For operating leases, the ROU asset amortization works with the lease liability to achieve a straight-line total lease expense over the lease term. The periodic ROU asset amortization is calculated as the difference between the straight-line lease expense for the period and the periodic interest accretion on the lease liability.

The ROU asset may also be subject to remeasurement if there are significant changes to the lease agreement or relevant circumstances. Such changes include modifications to the lease term, alterations in future lease payments due to changes in an index or rate, or a reassessment of whether a purchase option will be exercised. These remeasurements require an adjustment to the lease liability, with a corresponding adjustment to the carrying amount of the ROU asset.

Illustrative Calculation Example

Consider a company that enters into a five-year operating lease for office equipment with annual payments of $10,000, payable at the beginning of each year. The company incurs initial direct costs of $500, receives a lease incentive of $200 from the lessor at commencement, and determines its incremental borrowing rate is 5%. There are no asset retirement obligations or purchase options.

The present value of the lease payments must be calculated to establish the lease liability. For five annual payments of $10,000 discounted at 5%, the present value is approximately $45,460. This amount represents the initial lease liability recognized on the balance sheet.

The initial Right-of-Use asset is calculated by adjusting this lease liability. The initial lease liability of $45,460 is increased by the $500 in initial direct costs and reduced by the $200 lease incentive received. Therefore, the initial ROU asset is $45,460 + $500 – $200 = $45,760.

The ROU asset will be amortized over the five-year lease term. For an operating lease, the total lease expense is straight-lined over the lease term. The annual straight-line lease expense is the total cash payments over the lease term ($10,000 x 5 years = $50,000) adjusted for the net initial direct costs and incentives ($50,000 + $500 – $200 = $50,300), divided by the lease term, resulting in an annual expense of $10,060 ($50,300 / 5 years).

In the first year, interest expense on the lease liability is calculated on the outstanding balance. The interest expense for the first year is $2,273 (5% of the average lease liability after the first payment). The ROU asset amortization for the year is the total straight-line lease expense less this interest expense ($10,060 – $2,273 = $7,787). The initial journal entry would debit ROU Asset for $45,760 and credit Lease Liability for $45,460, while also accounting for the initial cash payment and net initial direct costs/incentives. Subsequent periods involve journal entries to recognize the periodic lease expense, reduce the lease liability, and amortize the ROU asset.