Operating Lease Treatment by Lessees
In an operating lease, the lessee does not record the leased asset on its balance sheet because the risks and rewards inherent in the ownership of the asset are not transferred to the lessee.
Since no asset is recognized, no liability is created like in a finance lease. Due to this fact, operating lease is considered a form of off-balance sheet financing.
The periodic lease payments are expensed out in a manner consistent with the pattern in which the leased asset is used which in most cases is the straight line method.
On 1 January 2012, OLL Ltd. leased printing equipment to XYZ Ltd. at an annual rent of $10,000. The equipment has a useful life of 5 years and the lease is a period of 1 year. Half of the lease rental is payable at the beginning of the year while the other half is payable at the end of the year. The equipment is expected to generate economic benefits uniformly over the year.
The information provided in the scenario suggests that the lease is an operating lease (because 1 year does not make a major portion of 5 years of useful life). On 1 January 2012, when XYZ Ltd. pays $60,000 being the rental for first 6 months of the year, it will record this as a prepayment.
Each month, it will record an expense of $10,000 by debiting lease rentals expense and crediting prepaid lease (an asset).
From July 2012 onwards, XYZ Ltd will record interest expense of $10,000 per month by debiting lease rentals expense and crediting lease payable (a liability).
The crux of the matter is that under the operating lease, the lessee neither records the leased asset nor the lease liability in its books and it records lease expense in a pattern that matches the actual usage of the asset (irrespective of when payment is made).
Written by Obaidullah Jan, ACA, CFA