A lease is defined as a contract or part of a contract that conveys the right to use an asset for a period of time in return for a quid-pro-quo. They are considered as off-balance sheet financing items. It means that leased assets and liabilities are not reflected in the balance sheet of a company. Lessor retains the ownership of the leased asset.
As per IFRS 16,
For the lessor, an operating lease is defined as every lease other than the finance lease.
IFRS 16 mandates lease to be termed as a finance lease if all the following conditions are met:
- There is the transfer of ownership to the lessee at the end of the lease period
- The lease contains a purchase option by the lessee
- The period of the lease exceeds 75% of the economic life of the asset
- The present value of lease payments should exceed 90% of the asset’s fair market value.
If none of these conditions is met, the lease would be classified as an operating lease.
Operating lease is used to lease for a short period of time and is similar to renting as the transfer of ownership is not involved. Periodic annual lease payments are treated as operating expenses of the company and are shown in the income statement of the company. The firm doesn’t own the asset hence, the asset is not shown in the balance sheet on the asset’s side. Depreciation is not calculated for assets taken under an operating lease. The lessee has the option either to buy the asset or return the asset to the lessor at the end of the lease period.
For the lessee, the distinction between operating lease and finance lease has been extinguished. All leases will be shown on the balance sheet as liabilities, at the future value of the present lease payments, along with the asset showing the right to use the asset over the lease period.
The advantages of operating lease are given below:
- Greater flexibility: Companies can replace or update the assets more often hence; it provides more flexibility to the lessor.
- There is no risk of obsolescence as there is no transfer in ownership
- Accounting is simpler
- Lease rentals are tax-deductible.
Features of operating lease:
- Lessor retains the right to the ownership of the asset.
- The lease agreement doesn’t contain bargain purchase option.
- PV of lease payments is lease than 90% of the fair market value of the asset.
- Lease rentals are shown as operating expenses and charged to P/L Account.
- Lessee has the right to use only, the risk and benefits lie with the lessor. Lessee pays the costs of maintenance of the asset.
- The term of the lease is less than 75% of economic life of an asset.
Accounting of operating lease:
Lessee records rental payments as expense in the books of accounts and lessor records the property as an asset and depreciate it over its useful life.
Impact of operating lease on financial statements:
The effect of operating lease on the balance sheet is given below:
Effect on the income statement: Lease payments will be expensed in the P/L statement.
Effect on cash flows:
- Lease payments are deducted from cash flow from operations.
- Operating leases do not affect the lessee’s liabilities and hence, are off-balance-sheet items
- Footnote disclosure of lease payment for each of the lease life is required
Example of an operating lease:
Let us take the example of a company that has entered into an operating lease agreement for an asset and has agreed to a rental payment of Rs. 24000 for a period of twelve months. Since it is an operating lease accounting, the company will book the lease rentals uniformly over the next twelve months, which is the lease term. The monthly rental expense will be calculated as follows,
Rental expense per month = Total lease rental / No. of months = Rs.24,000 / 12 = Rs.2,000
Now, let us have a look at the journal entry for recording the operating lease rental transaction for each month. Each month company will record the following entry:
|Rental expenses A/C Dr||2000|
Operating lease accounting by both the parties:
The lessee should recognize the following during the lease period:
- Cost of the lease in each period where the total cost of the lease would be allocated over useful life on the straight-line method
- Any variable lease payments which have not been included in lease obligation
- Any impairment of the right-of-use asset
The lessor should recognize the following;
- Lease payments are charged to P/L Account over the term of the lease on the straight-line method.
- Variable lease payments are recorded in P/L in the same reporting period of the events which caused lease transaction
- Initial direct costs are recognized as expense over the term of the lease.