How to Account for Operating Leases

Accounting for operating leases has evolved, presenting new considerations for businesses in how they report these arrangements. This article provides guidance on the steps involved in accounting for operating leases, from identifying the arrangement to its presentation in financial statements.

Identifying Lease Arrangements

Determining whether an arrangement qualifies as a lease is the initial step in the accounting process. A lease exists when a contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. An identified asset can be explicitly specified in the contract or implicitly identified at the time the asset is made available for use. The lessor must not have a substantive right to substitute the asset throughout the period of use for it to be considered identified.

Control over the use of an identified asset means the customer has both the right to obtain substantially all of the economic benefits from the use of the identified asset and the right to direct the use of the identified asset. Directing the use involves having the ability to decide how and for what purpose the asset is used. If the customer can change how the asset is used or the purpose of its use, it generally indicates the customer directs the use.

Gathering Lease Agreement Information

Once an arrangement is identified as a lease, gathering specific information from the lease agreement is important for accurate accounting. The lease term, which includes non-cancelable periods and certain renewal or termination options, is needed to determine the period over which the right-of-use (ROU) asset will be amortized and the lease liability will be settled. This term typically considers periods covered by options to extend or terminate the lease if the lessee is reasonably certain to exercise them.

Lease payments encompass fixed payments, variable payments based on an index or rate, and the exercise price of a purchase option if its exercise is reasonably certain. Amounts probable of being owed under residual value guarantees also factor into lease payments, as do any lease incentives received from the lessor which reduce the overall payment obligation. Initial direct costs, such as commissions or legal fees incurred in securing the lease, are included in the initial measurement of the ROU asset.

The discount rate is a fundamental element for calculating the present value of future lease payments. If the rate implicit in the lease is not readily determinable, the lessee’s incremental borrowing rate should be used. This rate represents the interest rate a lessee would pay to borrow on a collateralized basis over a similar term. Non-lease components, such as maintenance services or utilities, must be separated from the lease component, as they are accounted for as separate contracts.

Initial Recognition of Operating Leases

The next step involves the initial recognition of the right-of-use (ROU) asset and the corresponding lease liability on the balance sheet. The lease liability is calculated as the present value of the future lease payments, utilizing the discount rate over the established lease term.

The right-of-use asset is then measured as the amount of the initial lease liability, adjusted for several factors. These adjustments include adding any initial direct costs incurred by the lessee. Any lease incentives received from the lessor are subtracted from the ROU asset. Prepaid lease payments made by the lessee to the lessor before or at the commencement of the lease term are added to the ROU asset.

Recording these amounts requires a journal entry to reflect the new financial position. A debit to the Right-of-Use Asset account increases the asset balance on the balance sheet. Concurrently, a credit to the Lease Liability account establishes the corresponding obligation. This initial entry formalizes the lease arrangement on the company’s financial records.

Subsequent Measurement of Operating Leases

Operating leases require ongoing measurement and accounting entries throughout the lease term. The right-of-use asset is generally amortized on a straight-line basis over the shorter of the lease term or the useful life of the underlying asset. This amortization expense, combined with the interest on the lease liability, forms a single lease expense that is recognized in the income statement each period.

The lease liability is subsequently reduced as lease payments are made. Each lease payment is allocated between a reduction of the outstanding lease liability and the recognition of interest expense on the liability. The interest component is calculated using the effective interest method, applying the discount rate to the carrying amount of the lease liability at the beginning of the period.

The recurring journal entries typically involve a debit to Lease Expense for the straight-line amount calculated for the period. A credit to Cash or Accounts Payable reflects the actual lease payment made. The difference between the straight-line lease expense and the cash payment often results in an adjustment to the ROU asset or the lease liability, depending on whether the cash payment is greater or less than the recognized expense in a given period.

Financial Statement Presentation and Disclosure

Operating leases impact all primary financial statements. On the balance sheet, the right-of-use (ROU) asset is typically presented as a non-current asset, often grouped with property, plant, and equipment or as a separate line item. The corresponding lease liability is split into current and non-current portions, reflecting the amounts due within one year and beyond one year, respectively.

The income statement reflects a single lease expense for operating leases, which encompasses both the amortization of the ROU asset and the interest on the lease liability. This combined expense is recognized on a straight-line basis over the lease term, providing a consistent charge to earnings.

Cash flows related to operating leases are generally presented within operating activities on the statement of cash flows. This classification reflects the nature of the payments as part of the entity’s core operations. Subsequent lease payments are a direct outflow of cash.

Notes to the financial statements provide additional qualitative and quantitative information about a company’s lease arrangements. These disclosures often include a general description of the leases, such as their nature, purpose, and terms. Key quantitative disclosures include the weighted-average remaining lease term, the weighted-average discount rate used, and a maturity analysis of lease liabilities, which details future lease payments for each of the next five years and thereafter. Significant judgments or assumptions made in applying the lease accounting guidance, such as determining the lease term or the discount rate, are also typically disclosed.