How to Calculate ROU Asset Balance for an Operating Lease under ASC 842

The impact of ASC 842 on ROU calculation 

The release of ASC 842 impacted both the balance sheets and income statements for companies regarding their leases. Under the old standard, companies could configure agreements so that leases were presented in a favorable way, even if the underlying economics of the transaction might have told a different story.  

One of the balance-sheet items that must be recorded is the right-of-use (ROU) asset. The ROU asset represents a lessee’s right to use an asset over the life of the lease. 

Why did this change come about? Under ASC 840, some companies structured agreements so that all payments would be expensed in the period paid, and no liability would be presented on the balance sheet. Regulators took note of companies that took advantage of this loophole and investigated further. These agreements smelled a lot more like liabilities that should be presented on the balance sheet, and, thus, ASC 842 was born. 

Under ASC 842, a contract is a lease “…if the contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration…” If a contract meets this definition, two balance-sheet impacts will be made: an asset and a liability. Depending on the terms of the lease, the lease may be classified as an operating lease or a financing lease. These two classifications have some accounting differences, so the classification is important. The remainder of this article will discuss the asset piece and how it is calculated for operating-type leases. 

How to calculate the ROU asset 

When calculating the ROU asset amount to be booked to the balance sheet, there are several inputs. The overall idea here is that we’re taking the net present value of the payments and booking the ROU asset based on that amount. The incremental borrowing rate of the company is broadly used and is accepted as the discount rate in the Net Present Value (NPV) calculation. There are a few inputs that should also be considered when performing this calculation. These include prepayments, initial direct costs and lease incentives. 

Let’s go through a simple example of a lease and the calculation of the ROU asset. We will assume the following terms of the lease and that payment is made in arrears: 

  1. 60-month term 
  2. $1,000 payment made monthly 
  3. 4.5% incremental borrowing rate 

Below, you can see the first 3 months of the schedule based on these inputs. The NPV equation used is as follows with “r” as the monthly incremental borrowing rate: 

NPV = (1st Payment / r ^ Period #) + (2nd Payment / r ^ Period #) + … + (Last Payment / r ^ Period #) 

PERIOD NUMBER  

PAYMENT 

ALLOCATED TO PRINCIPAL 

INTEREST ACCRETION 

RIGHT-OF-USE ASSET BALANCE 

LEASE-LIABILITY BALANCE 

0 

 $                          -    

 $                                             -    

 $                                           -    

 $                                         54,435.25  

 $                             54,435.25  

1 

 $             1,000.00  

 $                                   795.87  

 $                                 204.13  

 $                                         53,622.71  

$ 

53,639.38  

2 

 $             1,000.00  

 $                                   798.85  

 $                                 201.15  

 $                                         52,807.19  

 $                             52,840.53  

 

Once this ROU asset has been booked, it will be amortized over the term of the lease. There will be the corresponding lease liability as well, and these impacts can be major for companies moving to ASC 842. 

Automate amortizations instead 

When considering how to handle this transition, a lot of companies have built a spreadsheet for each lease to track the amortization schedule. With all these inputs—not to mention modifications of leases—using a separate schedule for each lease quickly becomes burdensome and error-prone. That’s when using a tool such as NetLease can save a lot of time and energy and bring immediate compliance. 

Bottom line: 

The calculation of these balance-sheet amounts is at the heart of the lease-accounting standard. Getting this right is critical to being compliant. Unfortunately, this has added some complexity. Use the information above to nail it! 

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