Operating Lease

An 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 do not result in recognition of lease receivable by lessors.

Under the previous accounting standards on leasing, IAS 17 and its US GAAP equivalent, both the lessee and the lessor were required to classify their leases between finance lease and operating lease. The new lease accounting standard, IFRS 16, require the lessor but not the lessee to classify its leases between finance lease and operating lease.

Operating lease can also be defined as a lease which does not meet the recognition criteria of capital/finance lease.

Differences with finance lease

The difference between a finance lease and an operating lease lies in whether the risks and rewards incidental to ownership of the leased asset are transferred from the lessor to the lessee. Risks and rewards are considered not to be transferred if:

1. The lease term is not major portion of the useful life of the asset;
2. The present value of lease payments does not make substantively all the fair value of the leased asset;
3. The leased asset is not tailor-made for the lessee but is of general nature such that it can be leased out to another party by the lessor; and
4. The ownership of the leased asset does not transfer to the lessee at the end of the lease term.

Accounting treatment

Unlike the finance/capital lease, an operating lease does not result in recognition of net lease receivable and derecognition of the underlying asset. The lessor continues to hold the asset on its balance sheet and depreciate it.

Operating lease income is recognized in the books of the lessor 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 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.

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 the total useful life of the asset;
3. The present value of lease payments 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

The lessee shall recognize a right of use asset and a lease liability arising from the lease on its balance sheet at the commencement date of the lease.

Although Fintrax pays $15000 at the end of first year and $20,000 at the end of second year, Zoodax has to recognize the lease rentals income over the term of the lease using some uniform basis.

The lessor shall not pass any journal entry at the inception/commencement. However, at the end of Year 1, it shall pass the following journal entry:

The journal entry at the end of Year 2 would be as follows:

by Obaidullah Jan, ACA, CFA and last modified on May 8, 2020