Right-of-use assets are reduced over time on the balance sheet, but depreciating right-of-use assets works differently depending on how the lease is classified and which standard you follow. Under ASC 842, a finance lease ROU asset is depreciated on a straight-line basis with separate interest expense on the lease liability, while an operating lease ROU asset is amortized using a calculated figure that keeps total lease cost level across the term. IFRS 16 uses a single lessee model, so every on-balance-sheet lease gets depreciation plus interest, the same way ASC 842 treats finance leases.
Two Paths Under ASC 842, One Path Under IFRS 16
Before you pick a method, you need to know what kind of lease you have. ASC 842 keeps the finance-vs-operating distinction for lessees: a lease is a finance lease if it transfers ownership, contains a purchase option the lessee is reasonably certain to exercise, covers the major part of the asset’s remaining economic life, has a present value of payments that equals or exceeds substantially all of the asset’s fair value, or involves a specialized asset with no alternative use to the lessor. Miss all five and it is an operating lease.
IFRS 16 drops the split for lessees. Virtually every on-balance-sheet lease is accounted for like a finance lease under ASC 842, with depreciation of the ROU asset and interest on the lease liability recorded separately. Lessors under IFRS 16 still classify, but that is not the lessee’s problem.
Depreciating a Finance Lease ROU Asset
For a finance lease under ASC 842, the ROU asset is depreciated separately from the interest expense on the lease liability. Depreciation is typically straight-line, running from the commencement date. Interest is calculated using the effective interest method, so interest expense is highest early in the lease and declines as the liability balance drops.
Steady depreciation plus declining interest produces a front-loaded total expense. The first years of the lease carry higher combined charges than the last years. That pattern mirrors the accounting for buying an asset with a loan, which is the economic substance the finance lease classification is trying to capture.
Amortizing an Operating Lease ROU Asset Under ASC 842
Operating leases work differently. ASC 842 requires a single, straight-line lease cost recognized over the lease term. That cost hits the income statement as an operating expense and is not split between operating expense and interest.
The ROU asset still comes down every period. It just does not come down through traditional depreciation. Each period, the ROU asset is reduced by the straight-line lease cost minus the interest accrued on the lease liability that period. Because interest is higher early on, the ROU asset falls slowly at first and faster later. The total expense on the income statement stays level throughout, which is the whole point of the operating-lease model.
IFRS 16 Depreciation Method
Every IFRS 16 lease on the lessee’s books produces depreciation on the ROU asset and interest on the lease liability, calculated separately. Total expense is front-loaded, just like an ASC 842 finance lease.
For the depreciation charge itself, IFRS 16 sends you to IAS 16 (Property, Plant and Equipment). Straight-line is the common choice, but it is not required. If the units-of-production method or another approach better reflects the pattern in which the asset’s economic benefits are consumed, you can use it.1IFRS Foundation. IFRS 16 Leases
How Long Do You Depreciate Over
The depreciation period depends on whether ownership is expected to transfer. If the lease transfers ownership of the underlying asset, or if the lessee is reasonably certain to exercise a purchase option, the ROU asset is depreciated over the full useful life of the underlying asset rather than just the lease term. The reasoning is straightforward: if you end up owning the asset, its economic life to you does not stop when the lease does.
In every other case, the depreciation period is the shorter of the ROU asset’s useful life or the lease term. The lease term usually controls. When you calculate the lease term, include any renewal or extension periods the lessee is reasonably certain to exercise. A five-year base with a three-year extension that is likely to be exercised gives you an eight-year depreciation period.
What Amount Are You Depreciating
The starting value of the ROU asset determines the total pool that gets depreciated. It begins with the initial lease liability, which is the present value of future lease payments at the commencement date. Three adjustments then apply:
- Add any lease payments made to the lessor at or before the commencement date.
- Add initial direct costs such as legal fees or commissions incurred to arrange the lease.
- Subtract any lease incentives received from the lessor, whether a rent-free period or a cash payment.
Expected payments under a residual value guarantee are included in the lease liability to the extent it is probable the lessee will owe them, so they flow through into the ROU asset. Restoration costs at the end of the lease are not part of the ROU asset — they are handled separately as asset retirement obligations under ASC 410-20.
The discount rate used to compute the lease liability directly affects the size of the ROU asset. ASC 842 requires the rate implicit in the lease when it can be determined; otherwise the lessee uses its incremental borrowing rate. Private companies that are not public business entities can elect a risk-free rate instead, which is simpler but produces a larger liability and ROU asset because less is discounted away.
Leases That Are Not Depreciated at All
Some leases never produce an ROU asset in the first place, so there is nothing to depreciate.
Short-Term Leases
Under ASC 842, a lessee can elect, as an accounting policy by class of underlying asset, not to recognize an ROU asset and lease liability for leases with a term of 12 months or less, provided the lease has no purchase option. Payments are expensed straight-line over the term. IFRS 16 gives the same exemption on the same conditions.1IFRS Foundation. IFRS 16 Leases
Low-Value Assets Under IFRS 16
IFRS 16 also lets lessees skip recognition for leases of low-value assets. The standard does not fix a threshold, but its basis for conclusions points to assets with a value when new of about $5,000 or less, meaning laptops, small office furniture, and similar items. This is a lease-by-lease election rather than a policy choice by asset class. Payments are expensed straight-line or on another systematic basis that reflects the lessee’s pattern of benefit. ASC 842 does not offer this exemption.
When the Lease Changes
Modifications can change what you depreciate going forward. Under ASC 842, if the modification grants an additional right of use and the price increase is proportionate to the standalone price of that additional right, it is a separate, new lease and the original ROU asset and its depreciation continue unchanged.
If the modification does not qualify as a separate lease, the lessee remeasures the liability using a revised discount rate at the modification date. The change in the liability adjusts the ROU asset. Extending the term increases the ROU asset, and future depreciation is recalculated over the new remaining period. Shortening the term decreases the ROU asset, and if the reduction takes the asset to zero, any excess is recognized as a gain or loss.
IFRS 16 works the same way for most modifications that are not separate leases. The one wrinkle: for a decrease in scope, such as a partial termination, the lessee uses the original discount rate to calculate the gain or loss on the terminated portion.2IFRS Foundation. IFRS 16 Lease Modifications – Lessees
Impairment Is Separate From Depreciation
ROU assets fall under ASC 360’s impairment rules. An impairment charge is not depreciation — it is an event-driven write-down triggered by circumstances like a decline in market value of the underlying asset, a decision to sublease at a loss, or a change in how the asset is used. If the carrying amount of the asset or asset group exceeds the expected undiscounted future cash flows, the impairment loss is measured as carrying amount minus fair value. After that, the new, lower carrying amount becomes the basis for depreciation over the remaining lease term.
Book Depreciation Is Not a Tax Deduction
ROU asset depreciation is a book concept. Federal tax law does not recognize ROU assets, so the depreciation entry on your financial statements does not translate into a tax deduction on its own. For tax purposes, a lessee generally deducts the actual rent or lease payments as a business expense under IRC Section 162(a)(3), which allows deductions for “rentals or other payments required to be made as a condition to the continued use or possession” of business property.3Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses
Because the lessee does not own the leased property, that property generally cannot be depreciated for tax purposes. Capital improvements the lessee makes to the property can be. Leasehold improvements classified as qualified improvement property are depreciated over a 15-year recovery period using the straight-line method for tax purposes.4Internal Revenue Service. Publication 946, How To Depreciate Property
The gap between book treatment (depreciating the ROU asset over the lease term) and tax treatment (deducting cash lease payments as incurred) creates temporary differences that feed into deferred tax accounting. The ROU asset and lease liability have no direct tax counterparts, and the book-tax difference typically reverses over the life of the lease as total expense under both methods converges.