Operating Lease Accounting

Operating Lease Accounting can be done by considering that the property is owned by the lessor and it is only used by the lessee for a fixed tenure of time due to which the lessee records rental payments as expense in the books of accounts whereas lessor records the property as an asset and depreciates it over its useful life.

What is Operating Lease Accounting?

The term “Operating LeaseOperating Lease An operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term.read more Accounting” refers to the accounting methodology used for leasing agreement where the lessor retains the ownership of the leased asset, while the lessee utilizes the asset for an agreed period of time, which is known as the lease term. When the lease paymentsLease Payments Lease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration.read more become payable, the lessee recognizes each payment as an expense in its income statement.

Financial Statement Impact of Operating Lease

Balance Sheet Impact

There is no impact on the Balance Sheet of Lessee

Effect on Income Statement

Lease payments will be treated as Expense in the Income Statement.

Effect on Cash Flows

Total lease payment reduces cash flow from operationsCash Flow From Operations Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more
Operating leases do not affect the lessee’s liabilities and hence, are referred to as off-balance-sheet financing
Footnote disclosure of lease payment for each of the next five years is required

Examples of Operating Lease Accounting by Lessor

Example #1

Let us take the example of a company that has entered into an operating lease agreement for an asset and has agreed to a rental payment of $12,000 for a period of twelve months. Show the journal entry for the operating lease transaction.

Since it is an operating lease accounting, the company will book the lease rentals uniformly over the next twelve months, which is the lease term. The monthly rental expense will be calculated as follows,

Rental expense per month = Total lease rental / No. of months

= $12,000 / 12

= $1,000

Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month,

Example #2

Let us take the example of a company named ABC Ltd that has recently entered into a lease agreement with a company named XYZ Ltd for some specialized IT equipment for a 2-year lease that involves payment of $20,000 at the end of 1^st year and $24,000 at the end of 2^nd year. The present value of the minimum lease payments is $35,000, while the equipment’s fair value is $50,000. At the end of the lease term, ABC Ltd has to return the equipment to XYZ Ltd, and there is no scope for extension of the leaseExtension Of The Lease A lease Extension is a legal agreement between the lessor & the lessee extending the tenure of the original Lease Contract, including the renegotiated terms in place. Simply put, it refers to an addendum to the actual lease agreement when the latter is about to expire. read more term. Further, as per the lease agreement, the lessee also can’t purchase the asset at a lower price after the expiry of the lease term. The equipment has a useful life of 4 years. Show the journal entry for both ABC Ltd (lessee) and XYZ Ltd (lessor) at the end of 1^st year and 2^nd year.

The above-mentioned lease agreement can be treated as an operating lease because of the following:

The agreement does not allow the transfer of ownership of the equipment from the lessor to the lesseeLessee A Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. read more after the expiry of the lease term
The term of the lease is equal to 2 years, which is less than 75% of the total useful life of the equipment
The present value of the minimum lease payments is $35,000 is 70% of the fair value of the equipment, which is well below the generally accepted threshold of 90%
Since there is no option to purchase the equipment at a lower price after the expiry of the lease term indicates, there is no bargain purchaseBargain Purchase Bargain purchase happens when a company acquires another company at a price less than the fair market value of its assets.read more option.

Since it is an operating lease, ABC Ltd will book the lease rentals uniformly over the next two years. The yearly rental expense will be calculated as follows,

Annual lease rental expense = Average of lease rental for Year 1 and Year 2

= ($20,000 + $24,000) / 2

= $22,000

Now, let us have a look at the journal entry of ABC Ltd,

At the end of the 1^st year