Lease Accounting

What is an Operating Lease?

Overview

An operating lease is an accounting lease classification currently used by both the international and US accounting standards. Leases can also be classified as finance (known as capital under US GAAP). Both international and US standards require different accounting treatment for the two classifications.

Current Lease Accounting Standards

Under current accounting standards, IAS 17 and ASC 840, operating leases do not need to be capitalized on the balance sheet. Instead, they are disclosed in the footnotes of financial statements. They are straight-line expensed on the income statement. Finance leases, on the other hand, are capitalized on the balance sheet and reported as a front-loaded interest expense and depreciation expense on the income statement.

New Lease Accounting Standards

However, in 2016 the International Accounting Standards Board and the Financial Accounting Standards Board released new lease accounting standards. IFRS 16, the international standard, removes the operating lease classification. Instead, companies will account for all leases longer than 12 months and greater than $5000 in value as finance leases. ASC 842, the US standard, keeps the operating lease classification but requires companies to capitalize operating leases on-balance sheet.

Classification Criteria

IAS 17

Under IAS 17, an operating lease cannot meet any of the following criteria:

  • The underlying asset transfers ownership to the lessee at the end of term
  • There is an option to purchase the underlying asset that is likely to be exercised
  • The lease term is for the major part of the remaining economic life of the asset
  • The present value of lease payments is greater than or equal to substantially all of the fair value of the asset
  • The asset is specialized to the extent that it is only useful to the lessee

ASC 840

Under ASC 840, an operating lease cannot meet any of the following criteria:

  • The underlying asset transfers ownership to the lessee at the end of term
  • There is an option to purchase the underlying asset that is likely to be exercised
  • The lease term is for at least 75% of the remaining economic life of the asset
  • The present value of lease payments plus any guaranteed residual value is at least 90% of the fair market value of the asset

Under ASC 842, an operating lease cannot meet any of the following criteria:

  • The underlying asset transfers ownership to the lessee at the end of term
  • There is an option to purchase the underlying asset that is likely to be exercised
  • The lease term is for the major part of the remaining economic life of the asset
  • The present value of lease payments plus any guaranteed residual value is greater than or equal to substantially all of the fair market value of the asset
  • The asset is specialized to the extent that it is only useful to the lessee