Impact of Operating Leases on Financial Statements

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  • 0:04 Operating Lease
  • 1:31 Start of the Lease
  • 2:27 Accounting For Your Lease
  • 3:27 Lesson Summary
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Lesson Transcript
Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you'll learn how to record the journal entries for an operating lease. You'll also learn what impact an operating lease has on the balance sheet, income statement, and cash flow statement.

Operating Lease

Question: What does a car lease and an apartment lease have in common?

Answer: They are both examples of operating leases.

These leases are formed when individuals or companies want to use an asset, but either don't have the money to buy the asset or do not want to include in the asset in their balance sheet. These are operating leases. You can think of it as periodic rent payments, where the lessor (the one who owns the asset) gives you (the lessee) use of the asset for a specific period of time, so long as you make rent payments.

Let's imagine you've leased your own car - a BMW. The terms of lease are a bit unusual. Instead of monthly payments, you have 5 annual payments of $5,000 beginning January 1, 2016, on the date of the lease's inception, and continuing every January 1 until the last payment on January 1, 2020. After the last lease payment, you have to return the car to BMW. You are simply renting the car from BMW for the next 4 years. They retain the rights and responsibilities of ownership, and, as the lessee, you are contractually obligated to make your annual lease payments. There is no sale at inception; instead, the payments are considered rental payments - rent revenue for the lessor (BMW) and rent expense for the lessee (you). Because of this arrangement, you do not put the value of the car on your personal balance sheet. Instead, the car remains an asset of BMW.

Start of the Lease

So, you've started the lease. At each of the five payment dates, you pay for the upcoming year. They credit cash of $5,000 and debit pre-paid lease. In plain English, you pay $5,000 for the upcoming year's lease. We create an asset account, pre-paid lease, because the lessee has not received the benefits of the lease for that year. They haven't used the car. Accrual accounting stipulates that expenses are recognized as they are accrued. The journal entry will look like this:

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