Understanding Operating Lease Right of Use Assets: A Comprehensive Guide

Operating lease right of use assets have become a significant topic of discussion in the accounting world since the implementation of new lease accounting standards. In February 2016, the Financial Accounting Standards Board (FASB) issued ASU No. 2016-02, providing updated guidance on lease accounting. This article aims to provide a comprehensive understanding of operating lease right of use assets, including how to record lease liability, calculate the lease liability, and determine the right-of-use asset.

What is an operating lease? An operating lease is a contractual agreement that allows a business to use an asset without transferring ownership rights. These leases are commonly used for equipment, vehicles, and real estate. Unlike finance leases, operating leases do not meet specific criteria for ownership transfer, such as a bargain purchase option or lease term reaching a substantial portion of the asset's economic life.

How to record lease liability? To record lease liability, a lessee must recognize the present value of future lease payments as a liability on the balance sheet. This liability represents the lessee's obligation to make lease payments over the lease term. The initial recognition of the lease liability is typically done at the commencement date of the lease.

How to calculate the lease liability? Calculating the lease liability requires determining the present value of future lease payments. This involves estimating the lease term, lease payments, and discount rate. The lease term includes the non-cancellable period and any optional renewal periods that the lessee is reasonably certain to exercise. Lease payments consist of fixed payments, variable payments based on an index or rate, and any residual value guarantees. The discount rate used is the lessee's incremental borrowing rate, unless the rate implicit in the lease is readily determinable.

What is needed to calculate the right-of-use asset? The right-of-use asset represents the lessee's right to use the underlying leased asset during the lease term. To calculate the right-of-use asset, the lessee must determine the initial measurement of the asset, which is typically the lease liability amount adjusted for any initial direct costs and certain prepayments. Additionally, the right-of-use asset is subject to subsequent measurement, including impairment, lease modifications, and lease terminations.

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