Operating Lease

Operating lease is a lease which does not involve transfer of risks and rewards of ownership of the leased asset to the lessee. Operating leases normally have a term which is significantly shorter than the useful life of the leased asset and the present value of lease rentals is significantly less than the fair value of the leased asset.

It is a lease which does not meet the recognition criteria of capital lease (i.e. finance lease).

Compared to Finance Lease

Operating lease and finance lease (i.e. capital lease) are two mutually exclusive basic accounting classifications of leases. IAS 17 Leases defines finance lease in detail and defines operating lease as a lease which is not a finance lease.

Here is a discussion of the differences between a finance lease and an operating lease.

  1. In case of a finance lease the lease term (i.e. the duration of the lease) makes major portion of the useful life of the asset (i.e. in US GAAP, ratio of lease term to useful life is equal to or greater than 75%). If the criterion is not met, the lease is an operating lease.
  2. Another criterion for finance lease (i.e. capital lease) is that the present value of lease rentals make substantively all of the fair value of the leased asset. (US GAAP guidance: present value of minimum lease payments is equal to or greater than 90% of the fair value of the lease). A lease not meeting this criterion is classified as an operating lease.
  3. If the leased asset is a tailor-made asset made for the lessee, it is a finance lease. If the asset is of general nature, i.e. it can be leased out to another party by the lessor, the lease is an operating lease if other criteria are met.
  4. A finance lease may involve transfer of asset to the lessee at the end of the lease term while operating lease does not have any such provision.

Accounting Treatment

Unlike the capital lease, the operating lease does not result in recognition of an asset and liability on the balance sheet of the lessee. Operating lease income/expense is recognized in the books of the lessor/lessee on a uniform basis even if the relevant lease rentals are not uniform.

Example

Fintrax, Inc. obtained some specialized IT equipment from Zoodax, Inc. on a 2-year lease which involve payment of $15,000 at the end of first year and $20,000 at the end of second year. The fair value of the equipment is $40,000 and the present value of minimum lease payments is $30,000. The lessee shall return the equipment to lessor at the end of the lease term and there is no option for the lessee to either purchase the asset at a lower price or extend the lease term. The useful life of the equipment is 4 years.

Solution

The lease should be treated as an operating lease because:

  1. It does not transfer the ownership to lessee at the end of the lease term;
  2. The lease term is only half as long as the total useful life of the asset;
  3. The present value of lease payment is three-fourth of the fair value of the asset (less than the generally accepted threshold of 90%); and
  4. There is no bargain purchase option (i.e. option to buy the asset at lower price at the end of the lease term).

Journal entries

Although Fintrax pays $15000 at the end of first year and $20,000 at the end of second year, it has to recognize the lease rentals expense over the term of the lease using some uniform basis. The same applies to the lessor.

The lessee shall post the following journal entries:

  1. Start of lease: No journal entry
  2. End of Year 1:
    Lease rentals expense ((15,000+20,000)/2)17,500
    Bank15,000
    Accrued lease rentals2,500
  3. End of Year 2:
    Lease rentals expense17,500
    Accrued lease rentals2,500
    Bank20,000

The journal entries posted by lessor shall be the exact opposite:

  1. Start of lease: No journal entry
  2. End of Year 1:
    End of Year 1 Bank15,000
    Lease rentals receivable2,500
    Lease rentals income ((15,000+20,000)/2)17,500
  3. End of Year 2:
    Bank20,000
    Lease rentals receivable2,500
    Lease rentals income17,500

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork