The accounting for an operating lease assumes that the lessor owns the leased asset, and the lessee uses the asset for a fixed period of time. Based on this ownership and usage pattern, we describe the accounting treatment of an operating lease by the lessee and lessor.
Operating Lease Accounting by Lessee
If the lessee is subject to a leasing arrangement that is classified as an operating lease, classify each lease payment as an expense when it becomes payable. If an operating lease includes scheduled rent increases over the term of the lease, there are two ways to account for the altered payments:
- Scheduled increases. Recognize scheduled rent increases on a straight-line basis over the term of the lease, unless some other recognition system better represents the usage of the underlying assets.
- Contingent rentals. If there may be changes in lease payments that are based on such future events as inflation or the amount of property taxes incurred, charge these items to expense as they become accruable.
If an incentive is included in a lease (such as several months of free or reduced rent), the lessee recognizes the lease incentive on a straight-line basis over the term of the lease. Thus, most lease incentives are deferred and recognized over time, rather than being recognized in full as incurred.
If the lessee has agreed to a residual value guarantee, it should measure the guarantee at its fair value at the inception of the lease, even if a deficiency in the residual value is unlikely. If the deficiency becomes probable, the lessee should accrue the expected amount of the deficiency for which it is responsible over the remainder of the lease term, using the straight-line method.
Operating Lease Accounting by Lessor
If the lessor classifies a lease as an operating lease, it should account for the lease in the following manner:
- Depreciate the leased property over its useful life.
- Defer the initial employee-related direct costs of the lease. These are costs that would not have been incurred if there had been no leasing transaction, and which involve evaluating the lessee, negotiating the lease, preparing lease documents, or closing the transaction. These costs should then be recognized over the lease term, in proportion to the amount of rental income recognized.
If the lessor sells property that is being leased under an operating lease, but retains substantial risks of ownership in the property, it should not record the transaction as a sale. Instead, account for it as a collateralized borrowing arrangement.