Operating Lease Accounting for Lessors

Introduction

Operating leases have been a vital component of equipment and vehicle leasing. Organizations may require access to specialized assets for specific projects or assignments. Lessees have the option of procuring them on an operating lease. They do not incur capital expenditure or the complexities of procurement. The lessors gain by generating income while the asset is on lease and finding another lessee once it is returned.

Accounting for leases for lessees has undergone substantial changes. This is to ensure their accounting and reporting are streamlined.

What Is an Operating Lease?

The lessor retains ownership of the asset in an operating lease, granting the lessee an option to use the asset for a specified period of time. Operating leases apply when it is difficult to justify asset purchase. This is common when the asset value is high and the time period for which the asset is required is shorter. Assets moved frequently make the asset purchase unviable due to high transportation costs.

The lease specifies roles and responsibilities: Who is responsible for the maintenance, rights, responsibilities, and return conditions?

Changes in Operating Lease Accounting

In 2016, GAAP and IFRS updated their lease accounting standards. Lessees were required to report their lease liabilities on the balance sheet. Before 2016, there was no requirement to report lease liabilities. The format of reporting differed for organizations, making proper comparison difficult.

Lessees now need to report both right-of-use assets and lease liabilities of long-term leases on their balance sheet.

For lessors, there have been no substantial changes; operating leases are reported as assets and depreciated. Operating lease income is straight-lined over the lease life.

Advantages and Disadvantages of Operating Leases

Lessors generate an income stream over the life of long-term assets by leasing them out to multiple lessees. Maintenance is the lessor’s responsibility to keep the assets at optimal performance.

Lessees can execute projects in remote locations. Lessees do not need to make capital investments or maintain assets for the duration.

Lessees may contract for assets with performance conditions in the agreement. Managing obsolescence becomes the responsibility of the lessor. The lessee does not build equity as they would have on purchased assets.

Example of Operating Lease in Practice

A retailer that scales up their operations has a choice: Either they purchase trucks for their new operations or lease them to get a quick start. Leasing may be more expensive than procurement, but it allows them to ramp up quickly. Delays in transportation could impact profitability.

Accounting Treatment for Lessors

The new guidelines do not impact lessors. Lessors still place the liability of the leased asset on their balance sheet and amortize it for its useful life. Rental income is recorded straight-line for the lease period, generating revenue reporting.

The biggest changes are on the side of the lessee. For leases with durations of less than 12 months, the lessee can still record payments as an expense without capitalizing. Leases for more than 12 months require disclosures. The right-to-use asset and related liability provide a more accurate picture of obligations.

Lessors must understand how lessees’ reporting will influence negotiations and pricing models.

Emerging Trends Affecting Lessors

Trends that are impacting operating lease strategies include:

• Asset tracking: IoT and telematics enable real-time asset usage and condition details. This information improves residual value management.

• Flexible structures: Lessees may take assets on shorter leases or payment based on usage. Usage-based payment is common for office equipment.

• Digital transformation: Automate billing, payments, revenue recognition, reporting, and analysis. Allow team members to focus on value-added activities.

Conclusion

Some assets and industries are better suited to operating leases, where the lessee does not have the appetite or desire to take ownership of the asset at the end of the lease.

The accounting treatment may not have changed for lessors, but it is still critical. Lessors need to understand and explain the changes in lessee accounting to become a trusted partner.