The old lease standard, ASC 840, did not require all kinds of leases to be recorded on the balance sheet, which in turn provided the opportunity for many to use off-balance-sheet financing. This all changed with the release of the new lease standard, ASC 842, requiring all leases to be reflected on the balance sheet.
The change raises different questions such as the amount to be recorded as a lease liability and lease asset. Different factors affect the amount of liability and discount rate. There are also various factors such as prepayment, initial direct costs, and prepayments that impact the right-of-use cash flow statement.
Below are the concepts you need to better understand right-of-use asset rules under ASC 842. (This is especially critical for private companies that are new to ASC 842 and must transition to the standard by their organization’s effective date as of December 15, 2021)
How do you determine lease liability?
Recording the lease liability on a company’s balance sheet requires you to determine the lease term and lease payment. You must also know the rate to be used in discounting the lease liability.
The lease liability pertains to the obligation to make the rental payments using the present value of the future rental payment. Once the company has determined all the information needed such as the lease payment, lease term, and discount rate, then the liability can be discounted over the lease period using the discount rate.
The resulting amount becomes the lease liability and is recorded on the balance sheet. Now, the company has to proceed with recording the leased asset.
What is a right-of-use asset?
The right-of-use asset pertains to the lessee’s right to occupy, operate, or hold a leased asset during the rental period. In the old lease standard, an asset – for example, a cargo truck – would be recorded straight to the balance sheet.
Right-of-use asset under ASC 842
ASC 842 Lease Accounting Standard requires the recording of the actual right-to-use of the asset (such as the cargo truck) rather than the actual asset. This means that the right-of-use asset is an intangible asset.
What is Included in a Right of Use Asset?
A right-of-use asset, also known as an ROU asset, is a key component of lease accounting under accounting standards such as ASC 842 and IFRS 16. It represents the lessee’s right to use a leased asset over the lease term. The right-of-use asset encompasses several components, including:
Lease Liability: The lease liability represents the present value of the lessee’s future lease payments. It is recognized on the balance sheet as a liability associated with the lease agreement.
Initial Direct Costs: Initial direct costs incurred by the lessee in obtaining a lease are included in the right-of-use asset. These costs may include fees for legal services, commissions, and other directly attributable costs incurred to secure the lease.
Lease Payments: The right-of-use asset incorporates the total lease payments over the lease term, including fixed payments, variable payments based on an index or rate, and any residual value guarantees.
Lease Modifications: If there are any modifications to the lease agreement, such as changes in lease terms or lease extensions, the right-of-use asset is adjusted accordingly to reflect the revised lease terms.
Impairment Losses: If there is an indication that the right of use asset is impaired, such as a decline in the asset’s value or changes in the expected lease term, impairment losses may be recognized to adjust the carrying amount of the asset.
How to calculate right-of-use assets under ASC 842
Calculating right-of-use assets under ASC 842 involves several steps. Here’s a general overview of the process:
- Identify Lease Contracts: Determine which lease contracts fall under the scope of ASC 842. Leases with a term of 12 months or less and leases of low-value assets may have specific exemptions.
- Record Lease Liability: Calculate the present value of future lease payments and record the lease liability on the balance sheet. This requires determining the lease term, discount rate, and lease payments (including any variable payments, residual value guarantees, and lease term options).
- Determine the Initial Right-of-Use Asset: The initial right-of-use asset is typically equal to the lease liability, adjusted for any lease payments made before or at the lease commencement date, initial direct costs, and any lease incentives received.
- Account for Lease Payments: Recognize and allocate lease payments between reducing the lease liability and accounting for interest expense. This involves applying the effective interest method to calculate interest expense over the lease term.
- Adjust for Lease Modifications: If there are any modifications to the lease contract during its term, such as lease extensions or changes in lease terms, reassess the lease liability and right-of-use asset based on the updated terms.
- Assess Impairment: Periodically review the right-of-use asset for impairment, considering factors such as changes in the expected lease term, the occurrence of triggering events, or a decline in the asset’s value.
It’s important to note that the specific calculations and considerations may vary depending on the complexity of lease agreements and individual circumstances.
Where Does a Right-of-Use Asset Go on the Balance Sheet?
Calculating the right-of-use amortization requires examining three items closely:
- The incurred initial direct cost by the lessee
- The lease incentives received by the lessee
- The lease payment made by the lessee
What is an initial direct cost?
Initial direct cost is defined as the “incremental costs of a lease that would not have been incurred had the lease not been obtained.”
For example, a broker’s commission paid by the business would be an initial direct cost since this payment was only made because the lease has been obtained. Similarly, a payment made to the current tenant as an incentive to end the present lease contract would likely be classified as an initial direct cost because this cost was incurred since the new lease contract was signed.
On the other hand, payment for a lawyer’s fees for obtaining legal or tax advice may not be considered as an initial direct cost because the services of the lawyer were not the result of having obtained the lease.
What are a lease incentive and a lease prepayment?
A lease incentive is an incentive provided by the lessor to attract the tenant to secure a lease contract. This incentive may be provided in different forms such as payment of the lessee’s costs, an up-front cash payment, or the assumption of the lessee’s current lease.
A lease prepayment, as its name suggests, is a payment given in advance.
Calculating a right-of-use asset: an example
Following the explanation above, here’s a right-of-use asset calculation example. The assumption are as follows:
- Six-year rental period without renewal options
- $40,000 lease payment required at the end of each year
- The right-of-use asset is increased by 9% (the incremental borrowing rate)
- Initial direct cost is at $2,000
To get the lease liability:
- The lease liability is equal to the present value of the six payments that are discounted at 9%.
- The resulting amount will be $179,437.
To get the right-of-use asset:
- The right of use asset will be equal and recorded as the initial direct cost plus lease liability plus prepayments less any lease incentives provided by the lessor.
- Thus, the right-of-use asset is the sum of the lease liability of $179,437 + lease incentives of $2,000, which is $181,437. There were no lease incentives or prepayments in our example, so there’s nothing to subtract.
Therefore, the journal entry would be as follows:
- Right of use asset: $181,437
- Lease liability: $179,437
- Cash: $1,000
The secret to computing the right-of-use asset and liability
In the end, computing for the lease liability and the right-of-use asset isn’t that complicated, but one has to deal with the tricky task of gathering data.
Thus, businesses must ensure that they obtain reliable data to ensure the correct figures of the lease payments, lease term, and discount rate. It also helps to have reliable lease accounting software for proper accounting and record entry of right-of-use assets.