A lease is an agreement between two parties, a lessor and a lessee. In this agreement, the lessor gives the lessee the right to use an asset in exchange for payments. Usually, it consists of leasing property, machinery, vehicles, or other fixed assets. While the lessor stays the owner of the leased asset, the lessee gets to benefit from using it.
What is an Operating Lease?
An operating lease is a lease agreement in which the lessor provides the lessee with the right to use an asset for a short duration. As mentioned above, like other leases, operating leases do not come with ownership of the asset but only with the right to use them. Under the latest accounting standards, companies must classify any asset that they lease for less than 12 months as operating leases.
In contrast, companies that lease assets for more than 12 months must report those assets as capital leases. In the past, there were various requirements for companies to differentiate between operating and capital leases. However, the latest accounting standards have made the classification easier by requiring companies to classify assets based on their time of lease. These are the assets the companies capitalize and show on their Balance Sheets.
Operating leases on Balance Sheet
In the past, because the lessee did not, in substance, own the asset in an operating lease, the leased asset did not appear on the lessee’s Balance Sheet. Instead, the lessee only recorded regular operating lease payments as an expense on their Income Statements. It allowed companies to lease major assets to use in operations and not report them in the Balance Sheet, further allowing them to show better position and performance.
However, under major accounting standards, the treatment of operating leases has changed. Recently, accounting standards started requiring companies and businesses to show operating leases on their Balance Sheet. They also state that companies must record a liability for operating leases with a corresponding asset known as the ‘Right of Use’ assets’ on their Balance Sheets.
Under US GAAP, companies still need to record the operating lease payments as operating lease rent. However, under IFRS, the treatment for recording the lease rent expense has altered. With the introduction of IFRS 16, the accounting standard requires companies following the IFRS to split operating lease rent payments into two components. These are the depreciation and interest components.
The only change these accounting standards have brought is to the presentation of operating leases. As mentioned, companies only need to split the expense, not change it. Therefore, the profits of companies stay unchanged due to the change in the accounting standards. However, these standards have changed the way companies record operating leases in their Balance Sheets.
Recognizing Right of Use Asset
As mentioned above, a right of use asset refers to the amount the companies must recognize on their balance sheet for any assets that they lease under a lease contract. It is the asset that companies must present on the face of their Balance Sheet. When a company obtains a leased asset, it must recognize it as a right of use asset initially at its cost.
The cost of the right of use asset consists of three components. Firstly, it includes the amount of initial recognition of lease liability, which represents the present value of lease payments determined at the rate of interest implicit in the lease. If the interest rate is not available, the company can use its incremental borrowing rate.
Secondly, it consists of the lease payments made before the commencement date after subtracting any lease incentives. It also includes any initial direct costs and the cost of dismantling and restoring the asset, if any. When a company recognizes an asset as the right of use initially, the subsequent accounting treatment is the same as any other acquired asset.
Journal entry
After calculating the cost of the right of use asset, the company can use the following journal entry to recognize it.
| Dr | Right of use asset | x |
| Cr | Lease liability | x |
The company can then depreciate the asset as usual. In case of an operating lease, the company must split the rental payments made into two components, as mentioned above.
Example
A company, ABC Co., leases and asset for five years. The present value of the lease liability of the leased asset, as calculated by the company, equals $100,000. The initial direct cost of the lease is $10,000, which ABC Co. pays in cash. Therefore, ABC Co. can use the following accounting entry to recognize the asset in its Balance Sheet.
| Dr | Right of use asset | $110,000 |
| Cr | Lease liability | $100,000 |
| Cr | Cash | $10,000 |
The right of use asset will appear in ABC Co.’s Balance Sheet at the end of the accounting period, after calculating and subtracting the related depreciation expense from it.
Conclusion
An operating lease is a type of lease agreement in which a lessor provides the right of use of an asset to the lessee. The accounting treatment of operating leases has changed from the past. The new accounting treatment requires companies to recognize an asset called the ‘right of use asset’ in their balance sheet for leases that have a life of more than 12 months. It also requires them to show these assets on their Balance Sheet, unlike in the past when it was omitted.
