Operating Lease Accounting for Lessor: What You Need to Know

What Is an Operating Lease? 

An operating lease enables the use of the asset but not any rights of ownership to the lessee owned by the lessor. The lessee pays the lessor for the usage of the asset for a fixed period of time. The lease agreement specifies rights and obligations of each party. 

Changes in Operating Lease Accounting 

Operating leases need to be accounted for based on the current accounting rules under GAAP or IFRS by both lessors and lessees.

In the past, organizations were not required to declare assets procured through operating leases on their balance sheets, making it difficult to compare performance of organizations purchasing assets with others that used operating leases. In 2016, GAAP and IFRS modified accounting rules to declare operating leases on the balance sheet of lessees. 

Advantages and Disadvantages

Advantages

• No idle assets – procure assets when and where they are needed minimizing idle assets.
• Conserve cash – pay for what you need by minimizing capital investment.
• Minimize maintenance – reduce maintenance of assets by procuring assets fully primed for the term you need it for.
• Obsolescence risk – minimize obsolescence risk by upgrading the assets on operating lease. 

Disadvantages

• Renegotiate terms – if your project overruns due to issues beyond your control, operating lease terms need to be renegotiated.
• Higher costs – purchasing assets is cheaper than procuring asset through operating lease.
• No equity – Organizations are unable to build equity ot claim non cash charges like depreciation.

Examples of Operating Lease

A transportation company is required to open new routes in states they do not currently operate in. To cater to this business requirement they have the of ordering new trucks or procuring them through a lessor from their existing fleet. Ordering new trucks require a large capital outlay and lead time of weeks or months before initiating this business. Procuring these trucks for a fixed period gives the transportation company the benefit of signing up for the new business right away. Although the cost may be higher, it may be more advantageous.

Accounting for Operating Leases

Based on the new accounting rules introduced in 2016, lessors continue to account for these leases as assets on the balance sheet claiming depreciation over the life of the asset. Rental received is accrued straight line over the term of the lease.

However,  the impact is on lessee accounting. If the lease is less than 12 months, the amount payable can be accounted as an expense on straight line over the lease term.  For leases over 12 months, the lessee needs to add the right to use asset and lease liability on their balance sheet.

Conclusion

The lease accounting changes have been implemented for transparency and ease of comparison across different organizations. Operating lease is an important financing option for organizations that do not have the capital or do not desire to use their scarce resources on large capital expenditures.