When considering whether a lease is a finance lease or an operating lease, there’s one condition that’s often enough ignored. People mostly focus on either the option to buy the asset with very low value or the actual transfer of ownership at the end of the term which is considered a definite ‘yes’ for considering the lease as a finance lease (that is the asset and the respective liability are recognized on the balance sheet as opposed to just showing the rental charges as period’s expense. Continue reading
Once you’ve determined it really is an operating lease (i.e. the rights and obligations of an ownership are not transferred) and more so, you’ve made the initial payment for the lease, there’s time to start treating the lease on the statements.
I say “statements” since it affects both, balance sheet and income statement. There are two aspects for the operating lease. Continue reading
Effectively there are two ways of “owning” an asset – leasing it or buying it. Yes, leasing refers to renting it and actually buying the asset means you can get a hold of the factual ownership, however, most importantly, with both forms you can use the asset and that’s what we’re on about at the moment. Continue reading
Renting assets is part of everyday business and as it happens, with operating leases there are often enough prepayments required. Question than to the one renting the asset and making the payment should be how this prepayment should be recognized on the accounts. Continue reading
In essence operating lease is something that has minimal risks – you just use the asset, pay for it and only if deemed so, have to also take care of the regular maintenance. The ownership and risks related to this however are never yours (if they were, it’d be a finance lease).
All that you essentially have to worry about is the cash flow needed to pay your monthly dues and that’s about it really. An operating lease does not affect your balance sheet in no other way but the initial payment in the form of prepaid expenses, the cash and profit. No other balance sheet item is affected.
You stepped into an operating lease agreement and as you do that, you also have to pay a considerable amount as the first initial payment (something like 10 to 30% even). This payment is obviously deducted from the total of your payments hence making the monthly payment smaller. As the monthly payment is smaller, there’s one thing to remember with the initial payment though.
The initial payment is never charged as an expense straight away, but recognized as an asset first and the charged into expense over the rental period. It is meant so to spread out the expenses made for an agreement that goes through a longer period.
The accounting entry for recognizing the initial payment is as follows: