An operating lease refers to a lease contract where the ownership of the asset does not transfer to the lessee. The lessor keeps the ownership rights throughout the lease contract tenure.
The lessee does not recognize the leased asset or property as an asset on its balance sheet. However, the lessee needs to account for the lease payment, interest expense, and any variable lease expenses during the lease contract period.
Let us evaluate the operating lease accounting under the ASC-842 GAAP rule for the lessee and the lessor separately.
What is an Operating Lease under ASC – 842?
The ASC-842: Leases classifies all leases into two categories; operating and finance leases. Both parties must evaluate the lease contract and determine whether the contract should be classified as an operating or finance lease.
The lease contract evaluation points include:
- The lease term is equal to or greater than 75% of the estimated useful life of an asset.
- The total present value of all lease payments is equal to 90% of the market value of the asset.
- The ownership of the leased equipment or asset will be transferred to the lessee at the end of the lease contract.
- The lease contract offers a bargain purchase option to the lessee at the end of the lease contract.
If the lease contract meets any of the criteria above, it should be termed a finance lease. If the contract does not meet any of the above criteria, it should be recorded as an operating lease.
Accounting for Operating Lease – The Lessee
In determining the type of lease, the first step for the lessee is to determine whether the lease contract fulfills the criteria of an operating lease.
The lessee will not recognize the leased asset on its balance sheet. Since the ownership stakes do not transfer from the lessor to the lessee, the asset would be recognized in the balance sheet of the lessor.
The lessee will record the lease payments as lease expenses. The payments for the lease contract period will be shown on the income statement of the lessee.
The recording of the lease payments should be made on a straight-line basis. It means the total lease amount is divided by the number of lease payments. Each payment will then be recorded as a new entry.
The lessee can take an alternative recording method if it is reasonable or rational behind changing the defined straight-line recognition method.
In some cases, the lease payments increase over time. The lessee shall recognize the increased payment in the relevant lease period with adjusted (increased) payment.
Special Consideration
Some lessors offer an allowance or incentive to the lessee for a lease contract. Such incentives or allowances must be deducted from the lease payments made by the lessee.
Any advance payments for leased asset improvement such as in the real estate leases should be recognized by the lessee. Similarly, any expenses incurred by the lessee on behalf of the lessor for asset improvement should be considered part of the lease payments.
Accounting for Operating Lease – The Lessor
The lessor would recognize the leased asset under or near the fixed asset line of the balance sheet. The leased asset will be depreciated similarly to any other fixed asset owned by the lessor.
The lessor will record initial expenses or allowances offered to the lessee. The incentive or initial expense will be amortized over the lease contract period. The lessor will record it as a reduction of lease payment received from the lessee.
Lease payments received by the lessor will be recorded under the lease/rental revenue section of the income statement. The revenue recognition will be recorded during the period the payment is received or becomes receivable.
Lease payments should be typically recorded on a straight-line basis, similar to the accounting treatment of the lessee.
Any variable lease amounts due to incentives or a change in the lease amount should be recognized by the lessor as well. In some cases, the lease payment will increase due to an increased usage of the asset. For example, additional space is rented out to the lessee before the expiry of the current lease contract.
In such cases, the lessor will record the additional revenue. If the lessor offered an incentive, it will reduce the revenue.
Generally, the lessor will record only the lease revenue arising from the lease contract. There will be no recognition of loss or gain due to a change in the fair value of the leased asset at the end of the lease contract.
Working Example of Operating Lease
Suppose ABC Co. is a leasing company. XYZ is the lessee of the equipment. Both companies enter into the lease contract of equipment leasing for 3 years.
The details of the lease contract are:
- Monthly lease payments of $5,000, or $60,000 yearly.
- ABC provided an incentive allowance of $ 18,000.
The lease payment and the incentive allowance must be recorded using the straight-line methods.
| Item | Year 1 | Year 2 | Year 3 | Total |
|---|---|---|---|---|
| Lease Payment | 60,000 | 60,000 | 60,000 | 180,000 |
| Allowance | 6,000 | 6,000 | 6,000 | 18,000 |
| Net Lease Amount | 54,000 | 54,000 | 54,000 | 162,000 |
The Journal entry for ABC as a lessee will be:
| Item | Debit | Credit |
|---|---|---|
| Annual Lease Expense | 60,000 | |
| Allowance received | 6,000 | |
| Cash | 54,000 |
The Journal entry for XYZ as a lessor will be:
| Item | Debit | Credit |
|---|---|---|
| Annual Lease Income | 60,000 | |
| Allowance Paid | 6,000 | |
| Cash | 54,000 |
The lease amount can change during the existing lease contract. If both parties make a change with mutual consent, then the lease amount change should reflect at the time of change takes effect.
For example, continuing with our example, if the lease contract continues for the years 4 and 5. Both parties may agree to change the lease amount to $6,000 monthly or $72,000 yearly.
The journal entry for the years 4 and 5 will be adjusted as:
For ABC – Lessee
| Item | Debit | Credit |
|---|---|---|
| Annual Lease Expense | 72,000 | |
| Allowance received | 3,300 | |
| Cash | 68,700 |
For XYZ – Lessor
| Item | Debit | Credit |
|---|---|---|
| Annual Lease Income | 72,000 | |
| Allowance received | 3,300 | |
| Cash | 68,700 |
