Operating lease

An operating lease is the rental of an asset from a lessor, but not under terms that transfer ownership of the asset to the lessee. During the rental period, the lessee typically has unrestricted use of the asset, but is responsible for the condition of the asset at the end of the lease, when it is returned to the lessor. An operating lease is especially useful in situations where a business needs to replace its assets on a recurring basis, and so has a need to swap out old assets for new ones at regular intervals. For example, the lessee may have decided to replace the office photocopier once every three years, and so enters into a series of operating leases to continually refresh this equipment. Automobiles are also commonly leased under operating lease arrangements.

When a lessee has designated a lease as an operating lease, the lessee should recognize the following over the term of the lease:

  • A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis. This can be altered if there is another systematic and rational basis of allocation that more closely follows the benefit usage pattern to be derived from the underlying asset.
  • Any variable lease payments that are not included in the lease liability
  • Any impairment of the right-of-use asset

At any point in the life of an operating lease, the remaining cost of the lease is considered to be the total lease payments, plus all initial direct costs associated with the lease, minus the lease cost already recognized in previous periods.

After the commencement date, the lessee measures the lease liability at the present value of the lease payments that have not yet been made, using the same discount rate that was established at the commencement date. After the commencement date, the lessee measures the right-of-use asset at the amount of the lease liability, adjusted for the following items:

  • Any impairment of the asset
  • Prepaid or accrued lease payments
  • Any remaining balance of lease incentives received
  • Any unamortized initial direct costs

The lessor records the asset under an operating lease as a fixed asset on its books, and depreciates the asset over its useful life.

Related Courses

Accounting for Leases