Under old lease accounting standards, a lessee would account for a leased asset by recording the asset itself. But this has changed under new lease accounting standards, including ASC 842, GASB 87, and IFRS 16. Now, lessees must account for a leased asset by recording the right to use the asset, rather than the asset itself.

A right of use (ROU) asset represents the value of a leased tangible asset to the lessee over the course of a lease. The longer the lease, the greater the value of the ROU asset.

So, for example, when a business leases an office building, they don’t account for it by recording the whole value of the building, but by recording the value of their right to use the building for the duration they have that right.

This change was introduced to increase transparency in the lease accounting process. However, it has added a few extra steps. In this article, we’ll walk you through what you need to know about accounting for ROU assets.

Tango Lease simplifies your lease accounting process, enabling effortless compliance with current account standards.

How do you calculate the ROU asset?

Use the following formula to calculate the ROU asset:

Initial lease liability + prepaid rend + initial direct costs – lease incentives = ROU asset

Let’s break that down by section to clarify what each part means.

Initial lease liability

The initial lease liability is the total amount of all the lease payments that a lessee will make over the course of the term.

For example, if a lessee is entering into a five-year lease with $5,000 monthly payments, then the initial lease liability would be $5,000 times 60 months equaling an initial lease liability of $300,000.

Prepaid rent

In some cases, a lessee will make payments to the lessor prior to the lease commencement. This is commonly called prepaid rent.

If these prepayments occur, they are part of the value of the ROU asset.

Initial direct costs

For something to qualify as an initial direct cost on a lease, it must be contingent on the lease being signed. This marks a change from previous accounting standards, under which some costs qualified that would occur regardless of whether the lease was actually signed.

Examples of items that qualify as initial direct costs include:

• Costs for preparation of lease documents incurred after lease execution
• Legal fees contingent on successful lease execution
• Commissions paid after lease execution
• Payments to existing tenants to terminate their lease early

By contrast, examples of items that do not qualify as initial direct costs include:

• Fixed employee salaries for time spent preparing lease agreements
• Legal fees that must be paid regardless of successful lease execution
• Costs of negotiating lease terms or conditions
• Occupancy and equipment costs, depreciation, idle time, and other overhead costs

Items that qualify as initial direct costs must be included in the value of the ROU asset.

Lease incentives

A lease incentive is anything a lessor offers to a lessee as an incentive to sign a lease. Lease incentives can come in many forms, including:

• Cash payments
• Leasehold improvements
• Rent-free periods
• A buyout of the lessee’s previous lease

The total value of all lease incentives must be deducted when calculating the value of the ROU asset

How do ROU assets differ between operating and finance leases?

Operating leases follow traditional renting relationships with a limited-term lease of an asset that returns to the lessor at the end of the lease term if not renewed. Finance leases, on the other hand, are more similar to a purchase of the asset. A lease is considered a finance lease if any of the following criteria is true:

• The lessee plans to exercise a purchase option at the end of the lease term.
• Ownership of the asset is transferred to the lessee at the end of the initial lease term.
• The asset has no other use to the lessor at the end of the lease term.
• The lease term is a major component (at least 75 percent) of the asset’s economic life.
• The net present value of lease payments is substantially all (at least 90 percent) of the asset’s fair value.

For the most part, you will account for the ROU asset the same way for either kind of lease. However, you need to take a few specific actions depending on whether it’s an operating or finance lease.

With an operating lease:

• You must record the amortization of the ROU asset to the income statement, but you don’t need to record the interest expense.
• In the cash flows statement, you must classify payments as operating activities.

With a finance lease:

• In addition to recording the amortization of the ROU asset, you must also record the interest expense on the lease liability to the income statement. Record the two separately.
• In the cash flows statement, you must classify variable payments and interest as operating activities, and classify principal repayments as financing activities.

Additional accounting requirements for ROU assets

In addition to the above steps, you must complete the following requirements regardless of whether the ROU asset relates to an operating or finance lease:

• Record the ROU asset on a balance sheet as the present value of lease payments over the course of the lease, adding initial direct costs and subtracting lease incentives.
• Evaluate the ROU asset for impairment in accordance with professional standards.
• Either present the ROU asset separately or combine it with appropriate assets and liabilities.
• Reassess the ROU asset each period for significant changes, and document adjustments to the ROU asset if necessary.

Simplify ROU accounting with Tango Lease

Keeping up with new accounting standards can be a time-consuming chore, but there’s an easier way.

Tango Lease gives you a streamlined process for all your lease accounting management that is fully compliant with current standards, including ASC 842, GASB 87, and IFRS 16. Our software assists with the calculations, creates accounting schedules, auto-generates journal entries, and helps you account for every component of every lease.

And with Tango, you don’t just get software; you get a partner. We’re right there with you throughout the process—providing support, answering questions, and guiding you every step of the way to successful and compliant lease accounting.

Ready to see what Tango Lease can do for your organization? Request a demo today.