Operating lease accounting
/What is an Operating Lease?
An operating lease is a rental agreement in which the lessee obtains the right to use an asset for a period shorter than its useful life, without assuming ownership risks or benefits. In an operating lease, the lessor retains ownership of the asset and is responsible for major maintenance and insurance costs. These leases are often used for assets like vehicles, office equipment, or short-term property rentals where flexibility is important.
How to Account for an Operating Lease
The accounting for an operating lease assumes that the lessor owns the leased asset, and the lessee has obtained the use of the underlying asset only for a fixed period of time. Based on this ownership and usage pattern, we describe the accounting treatment of an operating lease by the lessee and lessor.
Operating Lease Accounting by Lessee
A lessee accounts for an operating lease by recognizing a right-of-use asset and a corresponding lease liability at the commencement date. The lease liability is measured at the present value of future lease payments, while the right-of-use asset is generally equal to the liability adjusted for prepaid rent, incentives, and initial direct costs. Over the lease term, the lessee recognizes a single lease expense on a straight-line basis, reflecting the total lease cost. The lease liability is reduced as payments are made, while interest accretion increases the liability each period. The right-of-use asset is amortized in a manner that results in a consistent total lease expense over the lease term.
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Operating Lease Accounting by Lessor
For an operating lease, the lessor retains the leased asset on its balance sheet and continues to depreciate it over its useful life. Lease income is recognized on a straight-line basis over the lease term, unless another systematic pattern better reflects the benefit derived from use of the asset. Initial direct costs incurred by the lessor are deferred and amortized over the lease term, typically in proportion to lease income. The underlying asset is periodically assessed for impairment under the applicable asset guidance. At lease end, the lessor accounts for the asset based on its condition and expected future use, which may include re-leasing, sale, or continued operation.
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