Where Does a Right-of-Use Asset Go on the Balance Sheet?

Companies frequently lease assets like office buildings, vehicles, and equipment instead of purchasing them. Historically, many lease agreements were not fully reflected on a company’s balance sheet, obscuring financial commitments. A Right-of-Use (ROU) asset fundamentally changes this by recognizing a lessee’s right to use an underlying asset for a period. This provides a clearer picture of a company’s financial position. This article clarifies where ROU assets are reported on a balance sheet and explains the significance of this accounting treatment for financial transparency.

Defining Right-of-Use Assets

A Right-of-Use (ROU) asset represents a lessee’s contractual privilege to use an identified asset for a specified lease term in exchange for consideration. This concept emerged with modern lease accounting standards, such as ASC 842 in the United States and IFRS 16 internationally. These standards require the recognition of most leases on the balance sheet, a significant shift from previous practices where many operating leases remained off-balance sheet, enhancing transparency.

The “right of use” signifies the lessee’s ability to control a specific asset and obtain economic benefits from its use during the lease period. This control distinguishes a lease from a service contract. A lease arrangement involves two main components: the ROU asset and a corresponding lease liability, representing the obligation to make lease payments.

Common examples of ROU assets include office space, manufacturing machinery, vehicles, and other equipment. The current framework ensures these contractual rights and obligations are transparently presented in financial statements, providing a comprehensive view of a company’s financial health.

Initial Valuation of Right-of-Use Assets

When a lease commences, a Right-of-Use (ROU) asset is initially measured and recognized on the balance sheet. Its initial value is typically derived from the initial lease liability. This lease liability is calculated as the present value of future lease payments expected over the lease term.

To determine the present value, key inputs include the lease payments, the lease term length, and an appropriate discount rate. The discount rate used is generally the rate implicit in the lease. If this rate cannot be readily determined, the lessee’s incremental borrowing rate is used. For non-public entities, a risk-free rate may be elected as a practical expedient.

Beyond the present value of lease payments, the initial ROU asset measurement also includes certain other costs. These can encompass initial direct costs incurred by the lessee to secure the lease, such as commissions. Additionally, any lease payments made to the lessor before or at lease commencement, and costs to dismantle or restore the asset at the end of the lease term, are added. Conversely, lease incentives received from the lessor reduce the ROU asset’s initial value.

Ongoing Accounting for Right-of-Use Assets

After initial recognition, Right-of-Use (ROU) assets undergo ongoing accounting adjustments throughout the lease term. ROU assets are amortized, similar to the depreciation of other long-lived assets. This amortization expense is recognized on the income statement, systematically reducing the asset’s carrying value over time.

The amortization period for an ROU asset is typically the shorter of the lease term or the useful life of the underlying asset. As lease payments are made, the corresponding lease liability is reduced. Each payment is typically split between a reduction of the principal liability and an interest expense recognized on the income statement.

ROU assets are also subject to re-measurement events, which can alter their carrying value and the associated lease liability. These events include lease modifications, changes in the lease term, or revisions to the discount rate. ROU assets are also subject to impairment testing, similar to other long-lived assets, if indicators suggest the asset’s carrying amount may not be recoverable.

Displaying Right-of-Use Assets on the Balance Sheet

Right-of-Use (ROU) assets are classified as non-current assets on a company’s balance sheet, reflecting their long-term nature. Companies have flexibility in presentation. Most commonly, ROU assets are presented as a separate line item, such as “Right-of-Use Assets,” to highlight their presence and value.

Alternatively, a company may include ROU assets within the broader Property, Plant, and Equipment (PP&E) line item. If this approach is taken, separate disclosure in the notes to the financial statements is required, detailing the ROU assets included within PP&E.

The corresponding lease liability, representing the present value of future lease payments, is presented on the liabilities side of the balance sheet. This liability is split into current and non-current portions, reflecting payments due within one year versus those due in future years. The balance sheet presentation of both the ROU asset and lease liability provides a comprehensive view of a company’s leasing activities.

Extensive disclosures in the notes to the financial statements are mandatory for ROU assets and lease liabilities. These disclosures provide qualitative and quantitative information, including a general description of the leases, the weighted-average remaining lease term, and the weighted-average discount rate used. Companies must also disclose information about lease costs, variable lease payments, and significant judgments made in applying the lease accounting standards.

The inclusion of ROU assets and lease liabilities on the balance sheet directly impacts financial analysis. It increases a company’s reported assets and liabilities, which can affect financial ratios such as the debt-to-equity ratio and asset turnover. This provides investors and other stakeholders with a more complete understanding of a company’s financial obligations and overall leverage.