ROU asset and lease liabilities: Everything you need to know

For businesses that lease property or equipment, a right-of-use (ROU) asset is more than just access to the asset — it’s another data source for accounting teams to manage finances and optimize operations. 

ROU assets allow companies that lease equipment or property to: 

• Control expenses
• Reduce large upfront investments
• Keep their operations flexible
• Stay compliant with ASC 842, GASB 87, and IFRS 16

This article will explore the benefits, the relation to frameworks and legislation, and how to calculate ROU assets. 

Key takeaways:

• ROU assets represent the right to use leased assets, which keeps your balance sheets transparent and your organization compliant with ASC 842, IFRS 16, and GASB 87 accounting standards.
• Calculating ROU involves accurately determining the value of ROU assets, applying discount rates, and adjusting for direct costs, incentives, and prepayments.
• ROU assets are amortized, which spreads the cost of ROU assets over their useful life for a clear view of expense allocation and better cash flow.

What is an ROU asset?

An ROU asset grants the lessee control over the use of a leased asset during the lease term. This includes leased properties such as real estate, vehicles, machinery, and other equipment. 

Accounting teams measure these assets using the present value of lease payments and amortize them over the lease period.

The accounting concept was introduced by the International Financial Reporting Standards (IFRS) and the Financial Accounting Standards Board (FASB), two institutions that set guidelines on how to calculate and present your lease reporting.

What is an ROU asset under ASC 842? 

ASC 842 is a FASB standard that defines an ROU asset as the lessee’s right to use a specified asset for a set term. According to this standard, lessees have to recognize both an ROU asset and a corresponding lease liability on their balance sheets for most leases. 

This approach differentiates between two types of leases:

• Operating leases allow the lessee to use the asset without transferring ownership.
• Finance leases transfer most of the risks and rewards of ownership to the lessee.

What is an ROU asset under IFRS 16? 

IFRS 16 takes a different approach to ASC 842 by using a single model for lease reporting. IFRS 16 considers all leases as finance leases, which means recording both the ROU asset and the corresponding lease liability on the balance sheet, with no distinction between operating and finance leases. 

Leases are capitalized unless they meet specific exemption criteria, such as being short-term or involving low-value assets.

How to calculate ROU assets under IFRS 16

To determine the value of an ROU asset under IFRS 16, you’ll need to follow this formula:

Present value of total lease payments + initial direct costs - lease incentives + prepayments

In practice, this involves summing up all the expected lease payments over the lease term, applying the discount rate given in the lease, adjusting for initial legal and commission costs, and combining incentives and prepayments into the mix. 

What is a lease asset under GASB 87? 

The Governmental Accounting Standards Board (GASB) is specific to public sector entities in the United States, as opposed to international companies. GASB 87, like IFRS 16, uses a single model for lease accounting, classifying all leases as finance leases. 

Under GASB 87, lessees must recognize both a lease liability and an ROU lease asset (also referred to simply as a "lease asset") over the lease term. Lessors, on the other hand, must recognize a lease receivable and a deferred inflow of resources, reflecting the receivable’s value. 

GASB 87 has fewer exemptions than IFRS 16, primarily focusing on lease terms longer than one year, which aligns with the public sector’s aim to promote financial transparency. 

How to calculate lease assets under GASB 87

To calculate the lease asset or ROU asset under GASB 87, apply this formula:

Present value of total lease payments + initial direct costs - lease incentives + prepayments

The calculation steps for GASB 87 are largely similar to IFRS 16. However, there are some differences relating to specific discount rate requirements, disclosure obligations, and the public sector's focus on long-term commitments under GASB 87.  

Benefits of ROU assets

ROU assets offer several advantages for businesses:

• Improved flexibility: ROU assets allow businesses to respond quickly to changing market conditions and operational demands. By leasing assets instead of buying, companies can expand or relocate without long-term commitments or large capital investments.
• Cost savings: Leasing assets can be more cost-effective than purchasing or building them outright. This approach reduces initial capital expenditure and frees up funds for other business operations or investments.
• Improved cash flow management: With ROU assets, companies can spread the cost of asset usage over time through regular lease payments. This method avoids significant upfront costs and keeps your cash flow more consistent.

Examples of ROU assets

ROU assets cover various leased fixed assets — also known as property, plant, and equipment (PP&E) — that are essential for business operations. 

Common ROU asset examples include:

• Real estate properties like office spaces, retail stores, warehouses, or manufacturing facilities where businesses can carry out their operations 
• Vehicles such as cars, trucks, or specialized equipment help with transportation or delivery purposes 
• Equipment assets like leased machinery, heavy equipment, or technology infrastructure support production processes or service delivery while keeping capital expenditures low
• Aircraft and vessels, like airplanes, helicopters, cargo ships, or other maritime vessels help airlines or shipping companies support their transportation operations without the high cost of ownership

What is ROU amortization? 

ROU amortization is the process of spreading the cost of an ROU asset evenly over its lease term. This approach ensures that the asset’s cost is recognized gradually, reflecting how it’s used in day-to-day operations. By amortizing the ROU asset, businesses maintain a clearer view of expenses on their balance sheets, aligning with standards like ASC 842, IFRS 16, or GASB 87.

When a company records an ROU asset, it signals the right to use that asset over time. Just like physical assets — such as equipment or vehicles — an ROU asset’s value decreases as it is used. Amortization helps capture this reduction in value so your financial reports accurately represent the true cost of the asset each period.

Typically, an ROU amortization schedule follows a straight-line approach, meaning the cost is divided evenly across the lease term. This method keeps things simple, offering a clear picture of how the asset’s cost is accounted for each year. For instance, if an ROU asset has an initial value of $120,000 and a six-year lease term, the business would record $20,000 as an expense annually, providing a straightforward snapshot of how the asset’s value declines over time. 

How to calculate the lease liability of an ROU asset 

To calculate the lease liability of an ROU asset, you need to follow these steps: 

1. Calculate future lease payments

Start by reviewing the lease agreement to identify the lease term, payment schedule, and any applicable lease incentives or rent escalations. Include all components of the lease, including fixed payments, variable payments tied to an index, and potential residual value guarantees. Don’t forget purchase options that you can be reasonably certain you’ll use, as they’ll impact the total lease payments.

2. ‍Calculate the lease liability and the discount rate

Calculate the lease liability by discounting the future lease payments to the present value using the right rate. You might find the rate in the lease, which reflects the underlying financial terms. If the implicit rate isn’t available, use the lessee’s incremental borrowing rate, which estimates the rate the lessee would have to pay for a similar borrowing arrangement.

3. Determine the value of the right-of-use asset

The ROU asset’s initial value is based on the calculated lease liability with adjustments for lease incentives, prepayments, and initial direct costs. Subtract any lease incentives from the total liability, as these reduce the overall cost of the asset. Add any prepayments made at or before the lease commencement and include initial direct costs like legal fees, broker commissions, or other transaction-related expenses.

4. Determine the lease liability's unwinding 

Lease liability unwinding is the gradual decrease of the liability over time as the lessee makes payments and recognizes interest expenses. For each reporting period, calculate the interest expense by multiplying the lease liability’s carrying amount by the discount rate. Subtract the lease payment made during that period from the total liability and adjust the carrying amount accordingly.

5. ‍Amortize the ROU asset 

Amortization of the ROU asset spreads its cost evenly over the lease term, reflecting its gradual consumption. To calculate the annual amortization expense, divide the ROU asset's value by the lease life. For example, if the ROU asset is valued at $100,000 and the lease life is 5 years, the annual amortization expense would be $20,000.

Impact of ROU asset and lease liability on the balance sheet

With current accounting standards like ASC 842 and IFRS 16, which require lessees to recognize ROU assets and corresponding lease liabilities on their balance sheets, the impact of ROU assets is more pronounced than ever. 

1. The recognition of ROU assets affects financial ratios, such as leverage and debt-to-equity ratios, as well as key performance indicators (KPIs) like return on assets (ROA) and return on invested capital (ROIC). 
2. The visibility and transparency provided by ROU asset recognition allows stakeholders to assess the organization's lease commitments and better understand its financial position. 
3. The management of ROU assets requires diligent tracking of lease terms, renewal options, and potential impairments, which can have operational and administrative implications. 

Learn more about ROU assets

Here are some of the most common questions about ROU assets and how they impact financial reporting.

What is the difference between ROU asset and lease? 

An ROU asset represents the lessee's right to use a leased asset over the lease term, while a lease generally refers to the contract allowing the use of that asset. In other words, the ROU asset is the accounting recognition of the lessee's control over the asset, whereas the lease encompasses the broader agreement, including terms, conditions, and payment obligations. 

Recognizing the ROU asset and corresponding lease liability on the balance sheet keeps your financial commitments under the lease transparent.

Is an ROU asset depreciated or amortized?

An ROU asset is amortized, not depreciated, which means its cost is spread evenly over the lease term. This approach aligns with how the asset’s value decreases over time as it’s used in operations. Unlike depreciation, which applies to physical assets, amortization suits the intangible nature of ROU assets.

When is an ROU asset recognized?

An ROU asset is recognized on the balance sheet at the start of the lease term. This happens when the lessee gains the right to use the asset, not just when payments begin. Recognizing the asset at this point makes sure your financial reporting is accurate from day one of the lease. 

What are the requirements for ROU assets? 

The requirements for ROU assets can vary depending on the circumstances and agreements between the lessor and the lessee. However, some common requirements for ROU assets include: 

• Lease agreement: There must be a legally binding lease agreement between the lessor (owner of the asset) and the lessee (business or individual leasing the asset). The lease agreement outlines the terms and conditions of the lease, including the duration, rental payments, and other relevant provisions. 
• Funding source: In many cases, businesses may be required to provide a funding source or demonstrate their ability to make lease payments throughout the lease term. Credit reports and bank statements are some of the documents that may be requested to verify the lessee's financial stability. 
• Insurance: The lessee is often required to obtain and maintain appropriate insurance coverage for the ROU asset. This helps protect both the lessor and the lessee from potential damages or liabilities related to the use of the asset.

Streamline your ROU asset and lease liability calculations

Managing ROU assets and lease liabilities can be complex, but NetLease simplifies the process. Our user-friendly lease accounting solutions helps you accurately track, calculate, and report your ROU assets while complying with standards like ASC 842, IFRS 16, and GASB 87. 

Automated tools take the guesswork out of lease liability calculations by generating precise figures based on your chosen method, minimizing manual work and reducing errors. With solutions for NetSuite and any ERP, NetLease offers flexibility and efficiency for your business.

Ready to transform your lease accounting process? Try a self-guided demo to explore how NetLease can enhance your financial reporting.