Definition
Operating Lease Accounting is a process within financial accounting where companies account for leases that do not meet the criteria of a capital lease. Unlike a capital lease, an operating lease does not transfer ownership rights and liabilities to the lessee. Instead, the lessor retains ownership and an operating lease is treated as an expense on the company’s income statement.
Key Takeaways
- Operating Lease Accounting refers to the treatment of property, plant, and equipment that a company rents for its usual business operations. The lease payments are considered operational expenses, therefore, no asset or liability is recognized.
- New lease accounting rules issued by the FASB (Financial Accounting Standards Board) and IFRS (International Financial Reporting Standards) now require lessees to record most of the operating leases on their balance sheets, recognizing a lease liability and right-of-use asset.
- The new rules provide more transparency and comparability amongst companies, as previously “off-balance sheet” operating lease commitments are now more visible, enabling investors and other stakeholders to have a more accurate understanding of a company’s financial liabilities.
Importance
Operating lease accounting is important because it provides a more accurate reflection of a company’s financial obligations.
Under previous accounting rules, operating leases were not included on a company’s balance sheet and were considered off-balance-sheet financing.
This could potentially misrepresent a company’s financial health, as it might have significant lease obligations that were not reflected in its financial ratios and debt levels.
However, new standards implemented by the Financial Accounting Standards Board (FASB) now require operating leases to be recorded as both assets and liabilities on the balance sheet.
This change makes companies’ balance sheets more transparent and allows investors, lenders, and other stakeholders to make more informed decisions.
Explanation
Operating Lease Accounting is primarily used for purposes of reflecting the use of assets in the financial statements of a company without necessarily depicting the business as the actual owner of the assets. This kind of lease places the responsibility of the risks and rewards of the owned assets with the lessor.
Essentially, the lessee merely pays for utilizing the asset for a predetermined period, upon expiry of which the asset is returned to the owner. In terms of financial reporting, Operating Lease Accounting enables a company to report lower liabilities, thereby creating a more favorable balance sheet.
The lease payments are considered operating expenses, and are accounted for as such in the profit and loss accounts of a business, spread evenly across the lease term. This can be beneficial for businesses seeking to maintain a strong short-term liquidity position, as it implies lower debt levels.
It also results in consistently predictable expenses, aiding in financial planning and budgeting.
Examples of Operating Lease Accounting
Retail Store Leasing: A common example of operating lease accounting can be found in the retail industry. Big-name retailers like Walmart, Target, and The Gap often lease the buildings where they operate their stores instead of owning them. The lease payments are recorded on their financial statements as an operating expense and do not affect their balance sheets.
Corporate Office Leasing: Many businesses, especially in large cities, lease the office spaces where they operate. For instance, companies in downtown skyscrapers are typically leasing the offices from a real estate company. Even tech companies like Google lease some of their buildings. Again, these lease payments are treated as operating expenses on their income statements.
Company Vehicles Leasing: Corporations often lease operational vehicles such as delivery vans, trucks, or company cars, instead of buying them. For example, FedEx might lease its delivery trucks instead of owning them. These lease payments would be viewed as operating leases, and thus they would be accounted for as regular operating expenses, not liabilities or assets.
FAQs for Operating Lease Accounting
What is an Operating Lease?
An operating lease is a contract that permits the usage of an asset but does not convey ownership rights of the asset. The lessee (user) will make regular payments to the lessor (owner) over the lease term but returns the asset at the end of the contract.
How is an Operating Lease different from a Finance Lease?
A finance lease transfers virtually all of the risks and rewards of ownership, whereas an operating lease does not. Financial leases are treated as a purchase and sale while operating leases are treated as a rental agreement
How is an Operating Lease accounted for?
In an operating lease, lease payments are treated as operating expenses on the lessee’s income statement. The leased asset is not reported on the lessee’s balance sheet. This provides a way to acquire the use of an asset without claiming ownership.
Why do companies use an Operating Lease?
Companies may prefer operating leases because they do not contribute to the company’s leverage. Because operating leases do not appear on the balance sheet as debt, they can make a company’s financial performance appear stronger to an uninformed reader.
What type of assets are commonly leased under an Operating Lease?
Common types of assets leased under an operating lease include commercial and residential real estate, aircraft, trucks and trailers, construction and manufacturing equipment, IT equipment, and office furnishings.
Related Entrepreneurship Terms
- Lease Term: The length of the lease. This is typically the period over which the lessor expects to recover the cost of the leased asset.
- Right-of-Use Asset: An asset that represents a lessee’s right to use an underlying asset for the lease term.
- Lease Liability: An obligation to make lease payments arising from a lease, measured on a discounted basis.
- Lease Payments: Payments made by a lessee to a lessor for the use of an underlying asset.
- Depreciation: The process of allocating the cost of tangible assets over their useful lives.
Sources for More Information
- Financial Accounting Standards Board (FASB): This is a highly reputable source for accounting standards, including those related to operating leases.
- IAS Plus by Deloitte: This site provides a wealth of information about international accounting standards.
- International Financial Reporting Standards (IFRS) Foundation: This site provides information about the globally accepted standards for financial reporting, including lease accounting.
- American Institute of CPAs (AICPA): This professional organization offers resources on a wide range of accounting topics, including leases.
