Lease Accounting: Right of Use Asset
In the previous couple of articles, we have already seen that sporting franchises prefer to lease out stadiums instead of investing their capital and building them. We also know that these leases need to be accounted for on the balance sheet of the sporting franchise.
We learned about the basics of lease accounting. However, it is important to note that when it comes to lease accounting, it is not only the lease liability that is recorded on the balance sheet.
A leased asset also needs to be recorded. This asset is called the “right of use” asset.
In this article, we will understand what a right of use (ROU) asset is and how it needs to be accounted for.
What is a Right of Use (ROU) Asset?
There are many people who find it strange that the lease needs to be recorded as an asset on the balance sheet of the company. This is because the lease is generally considered to be a liability since it is a schedule of payments that authorizes the franchise to use the asset for a certain amount of time. However, it does not create an ownership interest in the same.
The right of use (ROU) asset is not the actual asset. For instance, in the case of sporting franchises, they are not recording the stadium as an asset on their balance sheet. It would be illegal to do so since they do not own the asset.
Instead, the leased asset involves recording the benefits that the franchise is expected to derive from the rights to use the asset. Hence, a different asset called the right of use (ROU) asset is recorded on the balance sheet.
This right of use (ROU) asset is an intangible asset as opposed to the stadium which would be considered to be a tangible asset. Also, it is important to note that the valuation of the right of use (ROU) asset is done in a completely different manner on the balance sheet.
The original asset i.e. the stadium could be worth a billion dollars. However, the right of use asset may be worth much less considering that it does not give any ownership rights.
Different accounting standards have prescribed different formulas in order to derive the valuation of a right of use (ROU) asset. The component parts which are used in the valuation are mentioned below.
Components of Right of Use Asset
The value of the right-of-use asset is made up of several components. The main components have been explained as follows:
- Firstly, the cost incurred by the franchise in order to obtain the right of use to the stadium needs to be accounted for. This cost is a commitment to a cash flow stream that will be paid in the future.
The present value of these future cash flows is already recorded in the balance sheet as a lease liability. This same lease liability also needs to be included in the valuation of the lease asset. There are other components along with the lease liability that together end up creating the leased asset.
- There might be some initial direct expenses such as legal fees and commissions which the franchise may have incurred while signing the lease. The value of such expenses also needs to be added to the right of use (ROU) assets.
These expenses generally take place before the lease contract is signed. However, still, these expenses should not directly be sent to the profit and loss statement. Instead, they should be capitalized in the balance sheet and then amortized at a later date. It is important to ensure that these costs must be directly related to obtaining the lease.
- It is common for lessors to give some financial incentives to the lessee. These incentives may include the lessor paying the registration costs on behalf of the lessee or such other incentives. However, these benefits are also accruing because of the firm’s decision to take on the lease. It is for this reason that such costs are also considered to be a part of the overall right of use (ROU) asset.
- Lastly, the lease contract may require the lessee to restore the condition to its original state at the end of the contract. Now, this restoration may require some repair expenses. These expenses need to be estimated and the present value of such future outflows should be reduced from the value of the right of use (ROU) asset.
It is important to note that neither the construction costs nor the costs related to designing the stadium are added to the right of use (ROU) asset. It is important to understand that such costs will be added to the original asset by the owner of the asset.
There is a difference between the original asset and a right of use (ROU) asset. If franchises choose to lease their stadiums, they are only accounting for the lease and hence ownership costs as well as the depreciation related to such costs are not relevant for such accounting.
Cash Flow Statement
The treatment of lease-related cash flows on the cash flow statement depends upon the type of lease. If the lease is a financing lease, then the periodic payments being made towards such a lease are considered to be financing costs. Hence, they are reported under financing cashflows in the cash flow statement. On the other hand, if the lease is an operating lease, then the periodic payments are considered to be an operating expense and are recognized under cash flow from operations.
The fact of the matter is that accounting for right-of-use (ROU) assets can be quite complicated. It is important for the accountant to be aware of the difference between an actual asset and a right-of-use asset in order to follow the principles appropriately.
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