Operating Lease: Accounting Treatment, Reporting, and Example

An operating lease is a common form of rental agreement in which the lessee obtains the right to use an asset without assuming ownership. It is typically used for short- to medium-term access to property, equipment, or vehicles, and provides flexibility without the risks of ownership.

With the adoption of ASC 842 (U.S. GAAP) and IFRS 16, the accounting for operating leases has changed significantly — particularly for lessees, who must now recognize most leases on the balance sheet.

This article explains how operating leases work, how they are accounted for under modern standards, and how they differ from finance leases — including a step-by-step example.

1. What Is an Operating Lease?

An operating lease is a contract that allows the lessee to use an asset for a defined period in exchange for periodic payments, without transferring ownership risks or rewards.

✦ The asset is returned to the lessor at the end of the lease

✦ Maintenance and risk of obsolescence typically remain with the lessor

✦ Common for buildings, equipment, vehicles, and IT hardware

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2. Operating Lease Accounting: Lessee Perspective

Under ASC 842 and IFRS 16, lessees must recognize:

✦ A right-of-use (ROU) asset — representing the right to use the leased asset

✦ A lease liability — representing the present value of future lease payments

Initial Recognition:

Lease liability = Present value of lease payments

ROU asset = Lease liability + initial direct costs – lease incentives

Subsequent Measurement:

✦ The lease liability is reduced over time using the effective interest method

✦ The ROU asset is amortized, typically on a straight-line basis

✦ The income statement reflects a single lease expense (combining amortization and interest), presented as an operating expense

This model preserves the appearance of an "operating lease" in the income statement while recognizing the lease on the balance sheet.

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3. Operating Lease Accounting: Lessor Perspective

Lessors continue to classify leases as operating or finance based on ownership risk transfer.

For operating leases, the lessor:

✦ Keeps the asset on the balance sheet

✦ Depreciates the asset over its useful life

✦ Recognizes rental income on a straight-line basis over the lease term

✦ Continues to bear risks such as residual value and maintenance

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4. Operating vs. Finance Lease: Key Differences

Feature	Operating Lease (Lessee)	Finance Lease (Lessee)
Ownership transfer	No	Usually Yes
ROU Asset and Liability	Yes	Yes
Expense Pattern	Single lease expense (straight-line)	Depreciation + Interest (front-loaded)
Balance Sheet Impact	Yes (ROU + Lease liability)	Yes
Asset control at lease end	Reverts to lessor	Often transferred to lessee

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5. Numerical Example: Lessee Accounting for Operating Lease

Scenario:

• A company leases office space for 3 years

• Annual lease payments: $50,000

• Payments made at year-end

• Discount rate: 5%

Step 1: Calculate Present Value of Lease Payments

PV = $50,000 × [1 – (1 + 0.05)^–3] ÷ 0.05 ≈ $136,241

Initial entries:

Debit: Right-of-Use Asset – $136,241

Credit: Lease Liability – $136,241

Step 2: Year 1 Amortization and Interest

Interest = 5% × $136,241 = $6,812

Lease payment = $50,000

Principal portion = $50,000 – $6,812 = $43,188

Amortization of ROU asset (straight-line over 3 years):

$136,241 ÷ 3 = $45,414 per year

Income statement lease expense = $45,414 + $6,812 = $52,226

Debit: Lease Expense – $52,226

Credit: Lease Liability – $43,188

Credit: ROU Asset Amortization – $9,038

Balance Sheet after Year 1:

• Lease liability = $136,241 – $43,188 = $93,053

• ROU asset = $136,241 – $45,414 = $90,827

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6. Disclosure Requirements

Lessee disclosures under ASC 842 and IFRS 16 must include:

✦ Description of lease terms and significant judgments

✦ Maturity analysis of lease liabilities

✦ Total lease expense recognized

✦ Weighted average lease term and discount rate

✦ Cash flow classification of lease payments

Lessor disclosures include:

✦ Income from lease payments

✦ Description of assets leased and risk exposure

✦ Future minimum lease payments

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7. Financial and Analytical Implications

Operating lease accounting affects:

✦ EBITDA: Lease expense remains operating, boosting EBITDA compared to finance leases

✦ Debt ratios: Lease liability increases total liabilities

✦ Asset turnover: ROU assets increase total assets

✦ Comparability: Accounting convergence improves comparability across entities and industries