Updated July 14, 2023
Definition of Operating Lease Accounting
An operating lease can be defined as a form of leasing arrangement or an agreement between two parties whereby one agrees to lease, i.e., allows extraction of economic benefits from the use of any particular asset (termed as an underlying asset) for a specified period of time in return for a consideration agreed in the form of periodic lease payments.
Still, risks and rewards related to ownership rights remain with the lessor. The following article provides an outline for Operating Lease Accounting.
Explanation
Operating lease accounting is a methodology that records, reports, and presents a leasing transaction where an underlying asset is lent for use. Its ownership rights remain with the person who grants the asset (lessor). Lease transactions should recognize as operating income in the lessor’s books. Thus, he/ she can claim depreciation on the leased asset and avail of its relevant tax benefits, whereas the person to whom the asset is leased (lessee) will treat lease payments as an expense charged in P&L A/c.
Example of Operating Lease Accounting
Mercedes Inc. has entered into a lease agreement with Audi Inc. for equipment with two years tenure, including a payment of $48,000 annually. The present value of the lease payments is $70,000, and the equipment’s fair value is $2,00,000. At the end of the lease agreement, Mercedes, Inc. has to return the equipment to Audi, Inc. There will be no lease term extension. There is no clause that the lessee could purchase the asset at a discounted price. The equipment has a valuable life of four years. The company allows depreciation on a straight-line basis over a useful life of four years.
Solution:
As per the conditions mentioned in the case study, it is an operating lease Mercedes Inc. will book the lease payments uniformly over the two years.
Annual Lease payment = $48,000
Journal entry in the books of Mercedes Inc.(lessee) will be as follows-
| Date | Particulars | L/f | Debit | Credit |
| Year 1 | Annual Lease Expenses A/c Dr. | 48,000 | ||
| To Bank A/c | 48,000 | |||
| (Being annual lease charges booked) | ||||
| Year 1 | P&L A/c Dr. | 48,000 | ||
| To Annual Lease Expenses A/c | 48,000 | |||
| (Being annual lease charged in P&L A/c) | ||||
| The company will post the same two entries in year 2. |
Now Journal entries in the books of Audi Inc(lessor).
| Date | Particulars | L/f | Debit | Credit |
| Year 1 | Bank A/c Dr. | 48,000 | ||
| Annual Lease Income A/c | 48,000 | |||
| (Being annual lease income recognized in books) | ||||
| Year 1 | Depreciation A/c Dr. | 50,000 | ||
| To Equipment A/c | 50,000 | |||
| (Being annual depreciation charged on equipment) | ||||
| Year 1 | Annual Lease Income A/c Dr. | 48,000 | ||
| To P&L A/c | 48,000 | |||
| (Being annual lease income recognized in books) | ||||
| Year 1 | P&L A/c Dr. | 50,000 | ||
| To Depreciation A/c | 50,000 | |||
| (Being annual depreciation on equipment charged in P&L A/c) | ||||
| The company will post the same two entries in year 2. |
Operating Lease Accounting: Lessee
Suppose the lessee is subject to an agreement classified as an operating lease. In that case, all payments, whether fixed or variable, processed by a lessee to the lessor must be recognized as an expense when the lease amount becomes payable. Lessee is not allowed to record assets in its books of accounts in the case of a finance lease, and therefore operating underlying lease assets are also known as off-balance sheet assets.
If there is any alteration in lease payments, like a scheduled increase over a period of time, then it must be accounted for in either of two ways –
- Schedule Increase: Schedule increases in rent must be recognized straight-line for the lease period until a better way to represent the usage of the underlying asset.
- Contingent Rentals: If the lease agreement mentions increasing the rent due to future events like inflation or incurred property tax, the company must charge these to the expense account based on the accrual.
If the lease agreement includes any incentive, such as free rent or lower rent for several months, the lessee must record incentives straight-line over the lease period. Therefore, the company recognizes most of the lease incentives over a period of time instead of writing them off at the time of occurrence.
Operating Lease Accounting Lessor
If a lease is classified as an operating lease by the lessor, then it must be accounted for as follows-
The lessee usually considers granting assets on an operating lease as a regular business and accounts for it accordingly. Lessor will depreciate the asset over its useful life as normally as any other fixed asset,
Bifurcate the initial cost related to employees and the direct cost of the lease. These costs, like negotiating the lease, documentation, etc., would not have been incurred if the leasing agreement didn’t come into force. Lease terms and lease rental income must record these costs. Also, the company will record and regularly report assets on its balance sheet.
Operating Lease Accounting Under Asc 842
To increase transparency, the FASB issued ASC 842. This new standard states that all leases must be shown on a balance sheet. For an operating lease,
ASC 842 makes the need to recognize a right-of-use asset and all associated liability upon lease inception. Therefore, according to ASC 842, a lease could be identified as an operating lease if it satisfies all the conditions.
- The lessor must retain ownership rights of the asset during and after the lease agreement.
- The agreement does not contain any bargain or residual purchase option for the lessee.
- The agreement does not cover a substantial helpful life of an asset.
- The present value of the periodic lease payments must be less than 90% of the asset’s fair market value.
- An asset must not be specialized so that only the lessee can utilize them without making any significant changes to the asset.
According to ASC 842, there is an exception to capitalizing all lease assets. Thus, a company can select an accounting policy for the treatment of a lease with a term of 12 months from the commencement of the lease agreement. This approach does not require capitalizing the asset or liability on the balance sheet.
Operating Lease Accounting Treatment
Operating lease transactions are recorded and reported by the lessee as follows –
- Balance Sheet – No reporting is required.
- Income Statement – The lease payment is expensed in the income and expense account.
- Cash Flow – The company reports complete lease payments in the operating cash flow statement.
The operating lease is reported by the lessor as follows –
- Balance Sheet – The company must report it as a normal asset on the asset side of the balance sheet.
- Income Statement – The company reports the interest as income while recording the asset’s depreciation as an expense.
- Cash Flow – The company reports complete lease receipts as an inflow on the operating cash flow statement.
Conclusion
An operating lease is a capital asset leasing agreement whereby the lessor agrees to grant the lessee a drawl of economic benefits from using the underlying asset in exchange for periodic lease payments. This approach does not permit capitalization of the underlying asset in the lessee’s books of account. Also, monthly lease payments will be charged as expenses in the entity’s P&L A/c. At the same time, the lessor can capitalize assets in its books of accounts and claim depreciation and related tax benefits. They are simultaneously allowing lessors to recognize lease rentals as their income.
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