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 LeaseAn 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. 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 PaymentsLease 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. 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 OperationsCash 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.
- 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
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
Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month,
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 1st year and $24,000 at the end of 2nd 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 LeaseA 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. 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 1st year and 2nd 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 lesseeLesseeA 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. 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 PurchaseBargain purchase happens when a company acquires another company at a price less than the fair market value of its assets. 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
Now, let us have a look at the journal entry of ABC Ltd,
At the end of the 1st year
At the end of the 2nd year
Now, let us have a look at the journal entry of XYZ Ltd, which is exactly the opposite of ABC Ltd,
At the end of the 1st year
At the end of the 2nd year
Operating Lease Accounting Example #3
Let us take the example of a company that has entered into an operating lease agreement for a period of three years with an initial lease payment of $2,000, followed by lease payments of $1,500, $1,000 and $1,000 at the end of first, second and third year respectively. The effective cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders. is 5%. Calculate the interest expenseCalculate The Interest ExpenseThe formula for calculating interest expense is divided into two types: the first is the simple interest method, which involves multiplying the principal outstanding, the rate of interest, and the total number of years (p*t*r). The second approach is the compound interest method, which involves multiplying the principal by one plus the annual rate of interest raised to the number of compound periods less one, and then deducting the resultant value from the total initial sum . component of the lease payment for the current year.
Let us calculate the debt value of the lease payments as follows,
Debt value of lease payments = PV of lease payments in year 1, year 2 and year 3
= $1,500 / (1 + 5%)1 + $1,000 / (1 + 5%)2 + $1,000 / (1 + 5%)3
Depreciation on the leased asset = Debt value of lease payments / No. of years
= $3,199.4 / 3
Therefore, the interest paid on the lease obligation for the current year can be calculated as,
Interest paid on leased asset = Lease payment in the current year – Depreciation on the leased asset
= $2,000 – $1,066.5
Therefore, the interest component of the lease payment in the current year is $933.5.
This has been a guide to what is operating lease accounting and its definition. Here we discuss examples of operating lease accounting by lessor along with journal entries. You can learn more about accounting from the following articles –