How to account for operating leases?

Also known as a fair market value lease (FMV), an operating lease gives businesses the opportunity to access equipment without the risk of it losing its value or becoming obsolete.
benefits. This is because, instead of appearing as an asset on the balance sheet, rental payments can be offset against profits.
So, what is an operating lease and how do you account for an operating lease?

What is an operating lease?

An operating lease is a contract that allows a business to use an asset, without ownership of the asset being transferred to them. In other words, the company pays to use equipment, but doesn’t own it.

Operating leases are usually short term, and the lessor is responsible for maintaining the equipment throughout the contract.

This type of financing solution allows business to replace or upgrade their equipment, without taking on the risks associated with the assets losing their value or becoming obsolete.

Then, at the end of the lease, the business can either hand the equipment back and upgrade, or extend the lease and continue to use the equipment. 

What are the benefits of an operating lease?

An operating lease offers a number of benefits, including:

  • The total sum of the rentals will typically be less than the original capital cost of the equipment
  • Low payments compared to other financing solutions
  • Offers the flexibility to upgrade to new equipment when needed, or terminate the agreement early
  • At the end of the agreement, the equipment can be handed back, or the term can be extended
  • Fixed monthly payments mean better budgeting and cash flow
  • Doesn’t appear as an asset on the balance sheet.

How do you account for an operating lease?

From an accounts perspective, an operating lease is treated like renting, meaning lease payments are classed as operating expenses. This means the asset doesn’t appear on the company balance sheet, but instead is classified as an expense.

Find out more here.

Is an operating lease an asset?

Operating leases are shown as expenses on the company balance sheet. They are valued as the present value of the lease payments rather than the market value of the asset. The lease liability is also shown on the balance, again as the present value of the lease payments.

Finance vs operating leases

FRS 102 Section 20 determines whether a lease is classed as a finance lease or an operating lease, which impacts how it is accounted for.

If all the risks and rewards associated with the ownership of the asset are transferred from the lessor to the lessee, the lease is classed as a finance lease. This means that the asset will appear on the company’s balance sheet.

If, on the other hand, the risks and rewards associated with the asset remain with the lessor, then the lease is classed as an operating lease and payments are charged to profit or loss.

Find out more here.

Operating leases for companies reporting under the IASB

For businesses reporting to International Accounting Standards Board under IFRS, changes came into force on 1 January 2019, taking a new approach to leasing – IFRS 16.

IFRS 16 takes a new approach to accounting for leases, known as the right-of-use model. This means that, if a company has control over, or the right to use, an asset they are renting, it is classified as a lease for accounting purposes and so must be recognised on the company’s balance sheet.

This means operating leases and other financial liabilities cannot be held off-balance as they had been under the previous rules.

Find out more.

How does a lessor account for an operating lease?

How assets that are subject to operating leases (in other words, the assets that the lessor rents out) are recognised on the lessor’s balance sheet, depends on the nature of the asset. The income arising from the lease is recognised in the lessor’s profit and loss account over the life of the lease, on a straight-line basis.

If, for any reason, there are variable lease payments, they should be recorded in the profit or loss for the relevant reporting period.

See full details of how a lessor accounts for an operating lease here.

Here at CHG-MERIDIAN, we offer a range of finance solutions, including operating leases. If you would like to find out more about our leasing options and services, please don’t hesitate to get in touch.