What is an Operating Lease?
Operating lease accounting deals with the treatment of an asset rented by a business under the terms of an operating lease agreement.
An operating lease is an agreement between a lessee (usually a business) to rent an asset from a lessor (usually a finance or equipment leasing company). The lessor owns the asset, and the lessee rents the asset in return for a periodic rental payment. The lessee never owns the asset and at the end of the term returns the asset to the lessor.
Under an operating lease the rights and risks of ownership remain with the lessor. For accounting purposes the rental payments are simply treated as operating expenses in the income statement on a straight line basis.
Operating leases are usually for short term rentals, and the rental period is normally only for a small part of the assets useful life. The lessor would expect the asset to have a residual value at the end of the operating lease agreement. The rental payments do not cover the full cost of the asset and can include other services such as equipment maintenance.
Operating Lease Accounting Example
Suppose a business enters into an operating lease agreement for an asset and agrees to pay a rental of 3,000 for a six month period.
The business recognizes the lease rentals uniformly over the term of the lease. In this example the calculation of the rental expense for each month is as follows.
Rent per month = Total rental expense / Term in months Rent per month = 3,000 / 6 = 500
Operating Lease Accounting Journal Entries
The business completes the operating lease accounting entries by recording the rental payments as an operating expense.
| Account | Debit | Credit |
|---|---|---|
| Rental expense | 500 | |
| Cash | 500 | |
| Total | 500 | 500 |
The operating lease accounting journal shows the reduction in the asset of cash due to the operating lease rental payment.
In summary, accounting for operating leases is simply a matter of recording the rental payments as operating expenses on a straight line basis. This is in contrast to the more complex capital lease accounting process.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.