A right-of-use asset is an asset that represents a lessee’s right to use an underlying asset for the lease term (FASB, Accounting Standards Update 2016-02, Master Glossary). The lessee recognizes it at the commencement date alongside a lease liability, and its cost is built up from that liability rather than from the value of the leased item (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-25-1 and 842-20-30-5).
It is the asset half of what Topic 842, Leases, put on a lessee’s balance sheet, and ASC accounting covers what those letters and that number stand for (FASB, Accounting Standards Update 2016-02).
When a Lessee Recognizes One
A lessee recognizes a right-of-use asset and a lease liability at the commencement date (FASB, Accounting Standards Update 2016-02, paragraph 842-20-25-1). That date is the day the lessor makes the underlying asset available for use by the lessee, which is not the day the paperwork was signed (FASB, Accounting Standards Update 2016-02, Master Glossary).
What puts a contract inside the standard is control rather than the word on the cover page. A contract is or contains a lease if it conveys the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration (FASB, Accounting Standards Update 2016-02, paragraph 842-10-15-3).
One exception keeps an asset off the books. A lessee may elect, as an accounting policy by class of underlying asset, not to apply the recognition requirements to short-term leases, and to recognize the lease payments on a straight-line basis over the lease term instead (FASB, Accounting Standards Update 2016-02, paragraph 842-20-25-2). A short-term lease is one that, at the commencement date, has a lease term of 12 months or less and does not include a purchase option the lessee is reasonably certain to exercise (FASB, Accounting Standards Update 2016-02, Master Glossary). Running that election across a client base, year after year, is part of the annual work covered in ASC 842 lease accounting.
What the Cost Includes at Commencement
The cost of the right-of-use asset consists of the amount of the initial measurement of the lease liability, plus any lease payments made to the lessor at or before the commencement date less any lease incentives received, plus any initial direct costs incurred by the lessee (FASB, Accounting Standards Update 2016-02, paragraph 842-20-30-5).
The liability is the starting figure, and it is measured at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (FASB, Accounting Standards Update 2016-02, paragraph 842-20-30-1).
Initial direct costs are incremental costs of a lease that would not have been incurred if the lease had not been obtained (FASB, Accounting Standards Update 2016-02, Master Glossary). A commission qualifies, and so does a payment made to an existing tenant to incentivize that tenant to terminate its lease (FASB, Accounting Standards Update 2016-02, paragraph 842-10-30-9). Costs that would have been incurred whether or not the lease was obtained do not qualify, and the standard names fixed employee salaries, general overheads, and the cost of obtaining tax or legal advice or negotiating lease terms and conditions (FASB, Accounting Standards Update 2016-02, paragraph 842-10-30-10).
That list has three items and no fourth. A dismantling or restoration obligation is not one of them under US GAAP, and it is dealt with as an asset retirement obligation instead.
So the asset and the liability usually start apart. Rent paid up front and a broker commission push the asset above the liability, and a build-out allowance from the landlord pulls it below.
The Build-Up on Stated Numbers
The standard works the arithmetic through on its own facts. A lessee enters into a 10-year lease with payments of $50,000 per year, payable at the beginning of each year, and incurs initial direct costs of $15,000 (FASB, Accounting Standards Update 2016-02, paragraph 842-20-55-22).
The rate implicit in the lease is not readily determinable, so the lessee uses its incremental borrowing rate of 5.87% (FASB, Accounting Standards Update 2016-02, paragraph 842-20-55-24).
The first payment goes out at commencement, so the lease liability is the present value of the remaining 9 payments of $50,000, which is $342,017. The right-of-use asset is $407,017: that liability, plus the $50,000 paid at commencement, plus the $15,000 of initial direct costs (FASB, Accounting Standards Update 2016-02, paragraph 842-20-55-25).
After Commencement the Two Patterns Split
Classification does not change what the asset is. It changes how the cost of the lease reaches the income statement, and with it how fast the asset comes down.
For a finance lease the lessee recognizes amortization of the right-of-use asset and interest on the lease liability as two separate charges, and carries the asset at cost less accumulated amortization and accumulated impairment losses (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-25-5 and 842-20-35-1). The asset is amortized on a straight-line basis unless another systematic basis is more representative of the pattern in which the lessee expects to consume its future economic benefits (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-7). Amortization runs from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term, unless the lease transfers ownership or the lessee is reasonably certain to exercise a purchase option, in which case it runs to the end of the useful life of the underlying asset (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-8).
For an operating lease the lessee recognizes a single lease cost, calculated so that the remaining cost of the lease is allocated over the remaining lease term on a straight-line basis (FASB, Accounting Standards Update 2016-02, paragraph 842-20-25-6). The asset is then measured at the amount of the lease liability, adjusted for prepaid or accrued lease payments, the remaining balance of any lease incentives received, unamortized initial direct costs, and impairment (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-3).
That second rule has a consequence worth stating plainly. Nothing amortizes an operating-lease right-of-use asset on a schedule of its own. It is re-derived from the liability every period, so it falls slowly while the liability is still large and quickly near the end, even though the expense stays flat.
The same lease shows both patterns. Classified as a finance lease, year one produces amortization expense of $40,702 and interest expense of $20,076, and the asset ends the year at $366,315 (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-55-27 and 842-20-55-28).
Classified as an operating lease, year one produces one figure instead, annual lease expense of $51,500, being the $515,000 total cost of the lease spread over 10 years, and the asset ends the year at $375,593, which is the lease liability of $362,093 plus the remaining initial direct costs of $13,500 (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-55-29 and 842-20-55-30).
Where the Asset Sits on the Balance Sheet
A lessee either presents in the statement of financial position, or discloses in the notes, finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets (FASB, Accounting Standards Update 2016-02, paragraph 842-20-45-1). Where they are not presented separately on the face of the statement, the lessee discloses which line items include them (FASB, Accounting Standards Update 2016-02, paragraph 842-20-45-2), and presenting finance lease right-of-use assets in the same line item as operating lease right-of-use assets is prohibited outright (FASB, Accounting Standards Update 2016-02, paragraph 842-20-45-3).
Right-of-use assets carry the same current and noncurrent considerations as other nonfinancial assets in a classified statement of financial position (FASB, Accounting Standards Update 2016-02, paragraph 842-20-45-1), and classified balance sheet sets that split out.
Booking both halves grows total assets and total liabilities at the same time, so a renewed office lease moves leverage ratios without anyone borrowing, and debt to asset ratio analysis works that effect through.
The asset can also be written down. A lessee determines whether a right-of-use asset is impaired, and recognizes any impairment loss, under Section 360-10-35 on impairment or disposal of long-lived assets (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-9), the test impairment losses covers.
What a Right-of-Use Asset Is Not
The Underlying Asset
An underlying asset is the asset that is the subject of a lease, for which a right to use that asset has been conveyed to a lessee (FASB, Accounting Standards Update 2016-02, Master Glossary). The lessee never books the building or the forklift. It books a right, for a stated term, which is why amortization stops at the end of the lease term rather than the end of the item’s own life unless ownership passes to the lessee (FASB, Accounting Standards Update 2016-02, paragraph 842-20-35-8).
The Lease Liability
The lease liability is the lessee’s obligation to make the lease payments arising from a lease, measured on a discounted basis (FASB, Accounting Standards Update 2016-02, Master Glossary). It is the same lease seen from the other side of the balance sheet, and the two open at the same number only where the lessee prepaid nothing, received no incentive, and incurred no initial direct costs (FASB, Accounting Standards Update 2016-02, paragraph 842-20-30-5).
Common Questions
No. A fixed asset is owned property held for use in operations, and a right-of-use asset is a right held for a term. The confusion is fair, because Topic 842 gives the right the same current and noncurrent considerations as other nonfinancial assets and sends its impairment to the long-lived asset section (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-45-1 and 842-20-35-9). What it may not do is disappear into property, plant and equipment on the face of the statement.
Under US GAAP, amortized, and only where the lease is a finance lease. An operating lease produces a single lease cost with no amortization line behind it (FASB, Accounting Standards Update 2016-02, paragraphs 842-20-25-6 and 842-20-35-7).
The word changes under IFRS Accounting Standards, and so does the model behind it. A lessee applies the depreciation requirements in IAS 16 Property, Plant and Equipment in depreciating the right-of-use asset, and presents interest expense on the lease liability separately from that depreciation charge (IFRS Foundation, IFRS 16, paragraphs 31 and 49). That treatment applies to every lease a lessee recognizes, so the straight-line single lease cost of a US operating lease has no counterpart there. The wider split between the two frameworks is in GAAP vs IFRS.
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