For the temporary use of the asset, the Lessor pays hard cash at scheduled rentals to the Lessor. But ownership of the asset still belongs to the lessor, and the lessee has use of it for a specified period of time. For an operating lease, significant risks and rewards of ownership are not transferred to the lessee. Operating leases are often used to lease equipment, vehicles and office supplies, enabling companies to retain flexibility and reduce large up-front costs.
Operating Lease vs Finance Lease
An operating lease and a finance lease are helpful to corporations in entirely different ways. Although both leases allow for the usage of an asset before any immediate ownership, the accounting, financial, and tax treatments thereafter vary remarkably between the two.
Definition and Ownership
Called a contract, an operating lease presents a shorter duration when it is impossible for the lessee to assume full ownership. The lessor retains ownership of the asset and bears the responsibilities of maintenance and disposal. A finance lease transfers most of the risks and rewards of ownership to the lessee, with the latter having the power to put equipment on a hire-purchase basis from the end of the lease term.
Accounting Treatment
Cash leave is on operating cash flow. This leased-and-hired asset is recognised along with the lease liability on the balance sheet as a right-of-use asset, which is the present value of these lease payments. However, the financing lease would have an effect as the lessee is acknowledging the asset and the liability from the start.
Tax Treatment
Payments for an operating lease are 100% deductible as an operating expense. In finance leases, depreciation and interest expenses are deduced separately.
| Feature | Operating Lease | Finance Lease |
| Ownership Transfer | No | Yes |
| Balance Sheet Impact | Asset & Liability | Asset & Liability |
| Expense Recognition | Lease Expense | Depreciation & Interest |
| Maintenance Responsibility | Lessor | Lessee |
| Flexibility | High | Low |
IFRS 16 | Accounting for Operating Leases
In the world of finance, IFRS 16 has impacted the way leases are accounted for. The operative leases were off-balance-sheet operations. This means that all operating lease agreements impact the balance sheet under IFRS 16.
IFRS 16 Operating Lease Accounting Entries
At lease commencement, a company must recognize a right-of-use asset and a lease liability for an operating lease arrangement. To be clear, the lease payment gets split into an interest and a principal portion.
Example of Journal Entries for an Operating Lease
At inception:
Right-of-Use Asset Dr XXXX
Lease Liability Cr XXXX
For lease payment:
Lease Liability Dr XXXX
Interest Expense Dr XXXX
Cash Cr XXXX
For depreciation:
Depreciation Expense Dr XXXX
Accumulated Depreciation Cr XXXX
The effects on the balance sheet will be recognised due to this IFRS 16 for various operating lease terms included in assets and liabilities. This enhances visibility and affects specific financial ratios like debt-to-equity and return on assets.
Advantages and Disadvantages of Operating Lease
Advantages of Operating Lease
An operating lease and a finance lease are helpful to corporations in entirely different ways. The advantages of operating lease are:-
- Lower Initial Capital Investment – Businesses do not require heavy capital investments.
- Flexible – Companies can upgrade or change the equipment when they see fit.
- Tax Write-off – The charge is tax deducted as a business expense.
- No Concern About Asset Disposal – The lessor oversees asset disposal.
Disadvantages of Operating Lease
An operating lease and a finance lease are helpful to corporations in entirely different ways. The disadvantages of operating a lease are:-
- High Payments – Total payments may be larger than the purchase price.
- No Equity – The business is not building any equity in that asset.
- Must Still Pay – The company must fulfil the lease rent even if the asset is outdated.
Operating Lease Tax Treatment
An operating lease is when a firm can simply treated lease payments on tax like any other operating expense, and deduct it from income. This deduction is applied to taxable income, and therefore tax liability. In contrast, both interest and depreciation of the finance lease extremely be deductible separately. Thus, the debit causes the entire operating lease payment to go on direct expense.
Reporting Obligations of Operating Lease
- Enterprises are required to disclose the operating leases in their financial statements Among main disclosures are:
- Particularly for right-of-use assets and lease liabilities
- Duration, payment schedule and interest rates.
- Expenses on short-term and variable leases.
- Cash outflows for lease payments.
[quillforms id=”488″ width=”100%” ]
Relevance to ACCA Syllabus
Important concepts covered in ACCA syllabus: Operating leases The new lease accounting standards introduced are bringing significant recognition of leases in the balance sheets IFRS 16. Candidates are required to apply their understanding of the implications of dealing with operating leases under IFRS in terms of financials, cash flows & key financial ratios in ACCA exams. This subject explains how the consolidated financial accounts can be prepared, which is a prominent area of study in ACCA, similar to economic analysis.
Operating Lease ACCA Questions
Q1: Under IF221IF6, does an operating lease have to be recognised on lessees’ financial statements?
A) Only in the income statement as an expense
B) As an asset, and as a liability on the balance sheet
C) On the liability side alone, with no asset recognition
As a footnote with a contingent liability in the financial statements.
Ans: B) P&l impact for the period.
Q2 Before IFRS 16 what were operating leases?
A) They were responded to as an asset and liability
B)They only were reported in net income as a rental expense
C) They were classified as financing leases
D) They were treated as off-balance-sheet liabilities
Ans: B) They considered only as a rent expense at income statement
Q3: What is the difference that IFRS 16 makes to a company’s financial ratios during the transition from operating leases under IAS 17?
A) It reduces debt-equity ratio
B) It has no impact on any of the finance ratios
C) It increases liabilities and reduces return on assets
D) It reduces the amount of total assets and total liabilities
Ans: C) It heightens liabilities and increases return on assets
Q4: What is a major exception of the IFRS 16, recognizing leases?
A) All leases of more than 1 year term
B) Leases of low-value assets
C) Rentals of prime business real estate
D) Leases with unlimited renewals
Ans: B) Leases of low-value assets
Q5: What is the progression of the lease liability on an entity’s balance sheet in accordance with IFRS 16?
A) Fixed — It stays the same throughout the lease term
B) It decreases when you make lease payments and record interest expense
C) It increases due to new lease payments
D) It is removed from the balance sheet once payments begin
Ans: B) It decreases as the lease payments are made and interest expense is recognised
Relevance to US CMA Syllabus
Lease accounting constitutes a key segment in the US CMA syllabus on performance, planning, and reporting. The impact of leases on the balance sheet due to the transition in the treatment of leases from operating (off balance sheet) to finance (on balance sheet) and the presentation of the operating lease expense on the income statement are relevant to managing costs, assessing financial performance, and business planning.
Operating lease US CMA Questions
Q1: What will lessees need to do under ASC 842 in the financial statements with regard to operating leases?
A) As a rental expense only
B) Lease liability and right-of-use asset
C) because it is not being considered as a liability task
D) A current liability
Ans: B) Right-of-use asset and lease liability
Q2: What is the key distinction between an operating lease and a finance lease (previously referred to as capital lease) under US GAAP?
A) Finance leases must capitalise the asset and not operating leases.
B) Ownership transfers at the end of a finance lease but not at the end of an operating lease
C) Operating lease interest costs less than finance lease interest costs
D) A finance lease may only be on corporeal property
Ans: B) Finance lease at the end of the lease transfer ownership, Operating lease does not
Q3: What Are the Accounting Implications of Capitalising an Operating Lease Under ASC 842?
A) Affect assets and liabilities
B) Revenues up, profits down
C) Saves plenty in operating costs
D) Store financial metric on balance sheet
Ans: A) both Assets and liabilities Increase.
Q4: An operating lease is best described by which of the following? Options
A): An operating lease do not pass the risk and rewards of ownership
B) A finance lease always transfers ownership
C) Operating lease is similar to a lease purchase instalment
D) Operating lease PV
Ans: A) Operating lease transfers none of the risks and rights of ownership
Q5: Which statement is correct regarding operating leases under ASC 842?
A) Leases cost are only recorded as operating expense
B) Operating leases must be recorded on the balance sheet
C) Under the standard, companies treat all leases as on-balance-sheet items
D) Disposal of assets is required at the end of an operating lease
Ans: B) Operating leases must be recorded on the balance sheet
Relevance to US CPA Syllabus
Because US GAAP controls on lease accounting, it is going to prepare you for the US CPA test in which the fabric considerably base on ASC 842. The new leasing standard conceptually impacts a wide range of financial statements and disclosures. Also, candidates for CPA exam should be equipped to define the accounting treatments for operating leases and the impact on business decisions and reporting practices and financial ratios.
Operating Lease US CPA- Questions
Q1: What is the reporting requirement for lessees of operating lease assets and liabilities under ASC 842?
A) Off-balance-sheet items
B) Operating income
C) To be reflected on the balance sheet as right of use assets and lease liabilities
D) Only in the footnotes
Ans: C) Balance sheet as right-of-use assets and lease liabilities
Q2) Lease payments made under an operating lease are__________.
The amortisation expenses they are charged with
B) They affect interest expense and depreciation
C) They will be considered as straight-line expense on income statement
D) They have an immediate accounting impact as they reduce liabilities on the balance sheet
Ans: C) Charge as straight line expense in income statement
Q3: What is the impact of the new lease accounting on EBITDA for companies with operating leases?
A) It has a material impact on EBITDA
B) It increases EBITDA as you split lease expense into interest and depreciation
C) It has no impact on EBITDA
D) It reduces EBITDA and total revenue
Ans: B) Lease expense is split to interest & depreciationline through P&L, which sounds increases to EBITDA
Q5: Which financial ratio is most directly affected by changes in a company’s total assets?
A) Return on assets (ROA)
B) Gross profit margin
C) Dividend yield
D) Earnings per share (EPS)
Ans: A) Return on assets(ROA)
Q5: Who establishes US lease accounting standards?
A) FASB (Financial Accounting Standards Board)
B) Iternational Accounting Standards Board (IASB)
C.) SEC (Securities and Exchange Commission)
D) PCAOB (Public Company Accounting Oversight Board)
Ans: A) Financial Accounting Standards Board (FASB).
Relevance to CFA Syllabus
The lease accounting IFRS is part of financial statement analysis in the CFA exam. Comprehension of how operating leases affect financial ratios, profitability, and valuation is equally important for candidates. Since IFRS and US GAAP reflect in different ways the lease accounting, CFA candidates will need to evaluate and differentiate their influece on investing decisions.
Operating Lease CFA Questions
Q1: Assessment of how operating leases impact company’s return of equity (ROE)
A) Increase ROE by shortening liabilities
B) More provisions of lower correlated output will decrease ROE
C) No effect on ROE
D) Higher ROE through lower costs
Ans: B) As Higher reported debt will leads to decrease in ROE
Q2: Why is the debt/ equity ratio distorted if operating leases are capitalised?
A) Increase in debt-to-equity ratio
B) Reduces financial leverage
C) is neutral to balance sheet
D) Removes lease liabilities
Ans:A) Increase in debt-to-equity ratio
Q3: What is considered an expense for an operating lease (IFRS)?
A) Depreciation expense
B) Straight-line rent expense
C) Interest Expense And Amortization
D) Interest expense only
Ans: B) Straightline basis lease expense
Q4: How are operating leases treated as off-balance-sheet financing in the context of CFA financial analysis?
A) They reduce transparency
B) Do not affect leverage ratios
C) Lower cash outflows
D) They reduce net income
Ans: A) Lack of transparency
Question 4: In a financial analyst’s role, how do we adjust the financial statements for operating leases?
A) Add operating leases to debt equivalents
B) Gross analysis without lease liabilities
C) Ignore lease payments
D) Treat them as unfunded liabilities
Ans: A) Treat operating leases like debt
