Understanding and Calculating Right-of-Use Assets under ASC 842
Under ASC 842, a Right-of-Use (ROU) Asset represents the lessee’s right to use a leased asset during the lease term. This asset is recorded on the balance sheet along with a lease liability, reflecting the move towards more transparent financial reporting.
How is the ROU Asset Calculated?
The ROU asset is calculated by combining several components at the lease commencement date.
ROU Asset = Initial Lease Liability + Prepaid Lease Payments + Initial Direct Costs − Lease Incentives
Here’s what each component means:
- Initial Lease Liability: The present value of lease payments over the lease term.
- Prepaid Lease Payments: Payments made before the lease start date.
- Initial Direct Costs: Costs directly tied to arranging or negotiating the lease.
- Lease Incentives: Payments or reimbursements provided by the lessor to the lessee.
Example Calculation
Scenario:
- Lease Term: 5 years
- Annual Lease Payment: $10,000 (payable at the end of each year)
- Implicit Interest Rate: 6%
- Prepaid Lease Payments: $2,000
- Initial Direct Costs: $1,000
- Lease Incentives: $500
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To find the present value of the lease payments, use the formula for the present value of an annuity:
Present Value of Lease Payments = Annual Payment × PV Factor
Using the annuity factor for 6% over 5 years (PV Factor = 4.212):Lease Liability = 10,000 × 4.212 = 42,120
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Add up the components:ROU Asset = Lease Liability + Prepaid Payments + Initial Direct Costs − Lease Incentives
Substituting the values:ROU Asset = 42,120 + 2,000 + 1,000 − 500 = 44,620
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Once the ROU asset is recorded, it is amortized over the lease term. For example, if using straight-line amortization:
Annual Amortization = ROU Asset / Lease Term
In this case:
Annual Amortization = 44,620 / 5 = 8,924
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Step 1: Calculate the Lease Liability
Step 2: Calculate the ROU Asset
Amortizing the ROU Asset
Why is the ROU Asset Important?
Recording the ROU asset provides a clearer picture of the lessee’s financial position. It ensures leases are no longer hidden off-balance-sheet, improving transparency and aligning with the principle of substance over form.
By calculating and properly amortizing the ROU asset, companies can maintain compliance with ASC 842 while ensuring accurate financial reporting.
Need Help with Your ASC 842 Lease Accounting?
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