Operating lease accounting example (lessee)

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NOTE: Operating lease accounting is planned to be eliminated as part of the FASB's pending revision of FAS 13.

 
Let's take as an example an office lease, for a portion of an office building. It lasts for ten years. The first 5 years, the rent is $5,000 per month; the second five years, the rent increases to $6,000 per month. There is also a clause to pass through any increase in property taxes that may occur.
 
In many cases, the "fair value" of a portion of a building is not easily determinable. If this is true, FAS 13 allows you to skip the present value test [FAS 13, para. 28]. Such leases will, as a rule, never convey ownership, so the only test left to determine whether the lease is capital is whether the lease term is 75% or more of the economic life. A building is typically assigned a life of 20 years or more, so this lease's 10-year term is considerably less than 75%, and the lease is considered operating.
 
If there were no change in the rents, the rental payments would simply be expensed as incurred, making very simple accounting (though the future rent commitment of all leases needs to be disclosed). Since this lease has a scheduled rent increase, which does not reflect a change in the availability of the asset (for example, an increase in the space covered by the lease), FASB Technical Bulletin 85-3 (FTB 85-3) requires the rent to be recognized on a straight-line basis over the life of the lease, with a deferred liability that accounts for the difference between cash rent paid and accrued rent expense. (A lessor also straight-lines the rent, recognizing a deferred asset.)
 
 Monthly journal entry (first 5 years)
 
 Operating rent expense
5500.00
 
     Deferred liability  
500.00
     Cash  
5000.00
 
 Monthly journal entry (second 5 years)
 
 Operating rent expense
5500.00
 
 Deferred liability
500.00
 
     Cash  
6000.00
 
At the end of the life of the lease, the deferred liability will be zero. If a lease is terminated early, you recognize a gain equal to the balance in the deferred liability account (because rent that you have expensed will not actually need to be paid). Any termination penalty is an offsetting loss.
 
In some cases, governmental entities need not level the rent as shown above. Under Governmental Accounting Standard #13 (GAS 13), rents may be expensed as incurred, even when they change during the life of the lease, "when the pattern of the payment requirements, including the increases, is systematic and rational." Increases in the rent due to actual or anticipated inflation are specifically listed as qualifying examples. In such cases, no deferred asset or liability is recognized; each month, operating rent expense is debited and cash is credited for the actual rent payment.
 
You also need to disclose your future rent commitments. At the end of the first year, for example, you have four years of $5000 per month rent remaining, plus five years of $6000 per month. (Future rent commitment disclosure is based on cash, not accrual, rent.) So as of the end of year 1, your disclosure would be:
 
The following is a schedule by years of minimum future rentals on noncancelable operating leases as of December 31, 20X8:
 
 Year ending December 31,
 
   20X9:
60,000
   20X0:
60,000
   20X1:
60,000
   20X2:
60,000
   20X3:
72,000
 Later years:
288,000
 Total minimum future payments required:
600,000
 

To enter this lease in the trial version of EZ13, follow these steps:

Enter a Begin Date (such as January 1, 2010)

Double-click on the Lease Term; in the box that appears, enter 120 (or enter an end date that makes the lease term 120 months exactly, which will be one day earlier in the year than the begin date, such as December 31, 2019)

Leave Classification as "To be classified" and Capital Rate blank, so EZ13 can determine it

Click on the Main data tab, if it is not already present

Enter Gross Rent on the first line of 5000

Enter a Step End date 5 years after the begin date (such as Dec. 31, 2014)

On the second rent line, enter Gross Rent of 6000; the Step End date matching the end of the lease does not need to be changed

Enter Economic Life of 360 (30 years)

Click on the Inception tab

Check the box that reads Fair Value Not Determinable

Click Save. The classification is updated to Operating.

 
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Capital lease accounting is considerably more complex; see an example of that as well.