Operating lease

Definitions

Operating lease

For the lessee, an operating lease is one that does not meet any of the below criteria for finance lease classification:

• The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
• The lease grants the lessee an option to purchase the underlying asset, and the lessee is reasonably certain to exercise the option to purchase.
• The lease term is for a major part of the remaining economic life of the asset, unless the commencement date of the lease falls at or near the end of the underlying asset’s economic life.
• The present value of the sum of the lease payments and any residual value guaranteed by the lessee not already reflected in the lease payments is equal to or greater than substantially all of the fair value of the underlying asset.
• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term

US GAAP has a residual definition for operating leases. This means that if a lease contract does not meet any one of the criteria to be classified as a finance lease, then it is classified as an operating lease.

Exam tip: The “major part of economic life” and “substantially all of fair value” tests are judgment calls, not bright-line numbers - US GAAP dropped the old 75%/90% thresholds from prior guidance. A lease with, say, a 10-year term on an asset with a 12-year remaining life is a “major part” of that life and points toward finance lease treatment, while a 3-year term on the same asset points toward operating lease treatment. When a quiz question describes a lease term that consumes most of the asset’s remaining useful life, or payments that recover nearly all of the asset’s fair value, treat it as a finance lease even if no exact percentage is given.

This chapter covers the US GAAP (ASC 842) lessee model. IFRS 16 does not distinguish between finance and operating leases for lessees - it uses a single lessee model where every lease is capitalized like a finance lease. The straight-line uniform lease cost you’ll see below is a US GAAP feature that doesn’t exist under IFRS 16.

Initial recognition

Initial recognition of a lease is the same for finance and operating leases.

In the initial recognition of a lease, you need to determine the value of the lease liability and the ROU asset.

Initial recognition of lease liability

The lease liability is the present value of unpaid lease payments discounted at an appropriate discount rate which can either be the:

• Implicit rate of the lease or
• The incremental borrowing rate.

The process of discounting the lease payments is similar to the concept of a financial instrument at amortized cost discussed in the previous chapter on “investments”.

Initial recognition of ROU asset

The ROU asset is valued at cost which is composed of the following:

• The initial value of the lease liability
• Any lease payments already paid
• Initial direct costs

All above is reduced by any lease incentives received by the lessee

Initial recognition journal entry

The lease liability and ROU asset are connected because they are initially booked in a single journal entry, as follows:

Account	Debit	Credit	Financial statement element
ROU asset	XXX		Asset
Lease liability		XXX	Liability
Cash		XXX	Asset
To record initial recognition of a lease

The credit in cash represents the payments of any initial direct costs, lease payments paid in advance net of any lease incentives received.

Subsequent measurement

The ROU asset and lease liabilities initially recognized above should be subsequently measured differently under the operating lease model. Unlike the finance lease model, there is a single journal entry in operating lease model that records the following:

• Amortization of the ROU asset
• Effective interest expense on the lease liability

The journal entry is as follows:

Account	Debit	Credit	Financial statement element
Lease expense	XXX		Expense
Lease liability		XXX	Liability
ROU asset		XXX	Asset
To record the uniform lease cost

The lease expense above represents the uniform lease cost. The credit in lease liability represents the interest portion of the lease cost while the credit in ROU asset represents the amortization.

Subsequent measurement of ROU asset

Similar to the finance lease accounting, ROU assets under operating lease are also amortized. However, the determination of the periodic amortization is different because it is derived from the uniform lease cost rather than computed directly.

The uniform lease cost represents the total cost of a lease allocated evenly over the lease term. In other words, it is the total lease cost recognized on a straight-line basis across the duration of the lease.

$$\text{Uniform lease cost}=\frac{\text{Total lease cost}}{\text{Lease term}}$$

Where:

$$\text{Total lease cost}=\text{Undiscounted lease payments}+\text{Initial direct costs}-\text{Lease incentives received}$$

For operating leases, the uniform lease cost reflects the entire impact of the lease on the income statement. Although the expense is recognized on a straight-line basis, it is recorded through two components:

• Interest expense on the lease liability
• Amortization of the right-of-use (ROU) asset

Together, these two items equal the uniform lease cost each period. Since the interest portion is computed the same way as for a finance lease (the beginning lease liability balance times the discount rate), the amortization of the ROU asset is found as the remainder, using the following formula:

Uniform lease cost	XX
Less: Effective interest expense (from amortization of lease liability)	(XX)
Amortization of ROU asset for the period	XX

These two items are recorded together through the single journal entry presented earlier.

Example: Uniform lease cost and ROU amortization

Achievable Co. leases equipment under a 3-year operating lease with annual payments of $10,000 paid at the end of each year. There are no initial direct costs or lease incentives. The discount rate is 8 percent.

Step 1: Total lease cost and uniform lease cost

Total lease cost = $10,000 times 3 years = $30,000

Uniform lease cost = $30,000 divided by 3 years = $10,000 per year

Step 2: Initial lease liability (present value of payments)

Discounting the three $10,000 payments at 8 percent gives an initial lease liability of approximately $25,771.

Step 3: Year 1 interest and ROU amortization

Year 1 interest expense = $25,771 times 8 percent = approximately $2,062

Year 1 ROU amortization (the remainder) = $10,000 minus $2,062 = $7,938

Step 4: Year 1 journal entry

Account	Debit	Credit
Lease expense	$10,000
Lease liability		$2,062
ROU asset		$7,938

Answer: The uniform lease cost is $10,000 per year, made up of $2,062 of interest and $7,938 of ROU amortization in year 1. As the lease liability balance declines each year, the interest portion shrinks and the amortization portion grows, but the $10,000 total stays level every year.

Subsequent measurement of lease liability

The subsequent measurement of a lease liability under operating leases has some similarities with finance leases. To avoid duplicating the discussion, you may also refer to the section of subsequent measurement under finance lease.

The slight difference with the finance lease discussion is that the effective interest amortization of the lease liability is already recorded when we booked the journal entry for the uniform lease cost in the previous journal entry.

You will notice that the “interest expense” in the operating lease model is debited to the uniform lease expense instead of a separate “interest expense” unlike the finance lease accounting.

Since the interest portion of the amortization is already recorded, the remaining journal entry to record for the operating lease model pertains to the periodic lease payments:

Account	Debit	Credit	Financial statement element
Lease liability	XXX		Liability
Cash		XXX	Asset
To record the lease payment

Variable lease payments

Any variable lease payments not included in the lease liability is recorded as lease expense in the period when they are incurred.

Account	Debit	Credit	Financial statement element
Lease expense - variable lease	XXX		Expense
Cash or lease payable		XXX	Asset or liability
To record variable lease

Financial statement presentation

Operating lease presentation in the balance sheet

In the balance sheet, the ROU asset is presented as a separate non-current (long-term) right-of-use asset. It is not classified as an intangible asset - it’s a distinct nonfinancial long-lived asset line item.

The lease liability should be split between the current portion and the non-current portion to reflect the timing of the obligations.

Operating lease presentation in the income statement

In the income statement, operating lease accounting results in the recognition of a single lease expense item referred to as the “uniform lease cost”. This item is composed of:

1. Interest expense from the amortization of the lease liability
2. The residual is allocated as the amortization of ROU asset for the period.

Operating lease presentation in the cash flows

In the statement of cash flows, the full amount of periodic lease payment and any variable lease payments are classified as operating cash flows. There is no requirement to split between the interest and the principal component unlike in finance leases.