Operating Lease

At commencement the lessee measures the lease liability as the present value of the remaining lease payments, discounted at the rate implicit in the lease when it is readily determinable and otherwise at the lessee's incremental borrowing rate. Payments include fixed amounts, in-substance fixed amounts, purchase or termination amounts the lessee is reasonably certain to pay, and the exercise price of renewal options reasonably certain to be taken; variable payments tied to sales or usage are generally excluded until incurred.

The right-of-use asset starts from that same liability figure and is then adjusted upward for initial direct costs and prepaid rent, and downward for lease incentives received from the lessor. As a result the asset and liability are usually close but rarely identical, and they diverge steadily over the lease term because they unwind on different patterns.

Even though the income statement shows one operating lease cost, the underlying bookkeeping is two-sided. The liability behaves like debt: each period it accretes interest at the discount rate and is reduced by the cash payment made. The right-of-use asset is then amortised by whatever amount is needed for total lease cost to equal the straight-line figure, meaning asset amortisation is the periodic straight-line expense minus the interest accreted on the liability.

Because the liability balance is largest early, the implicit interest component is largest early and asset amortisation is correspondingly smallest. Over time the mix reverses. Total expense over the full term equals total cash paid under either model, and the cash outflows themselves never change; only the timing and the line items in which cost appears differ.

US GAAP keeps a dual lessee model. A lease is classified as a finance lease if ownership transfers, a purchase option is reasonably certain to be exercised, the term covers a major part of the asset's remaining economic life, the present value of payments amounts to substantially all of the asset's fair value, or the asset is so specialised it has no alternative use. Failing all of these, the lease is operating. IFRS 16 abandoned that distinction for lessees: almost every lease produces depreciation plus interest, with narrow exemptions for short-term and low-value leases.

Lessor accounting still uses classification under both frameworks. Under an operating lease the lessor keeps the asset on its balance sheet, continues depreciating it, and recognises lease income on a straight-line basis rather than derecognising the asset and booking a receivable.

Before capitalisation rules tightened, credit analysts approximated lease debt with crude multiples of annual rent and used EBITDAR to compare lease-heavy retailers, airlines and restaurant operators with owners of the same assets. Recognition removed much of that guesswork, but comparability problems persist: a US filer with operating leases reports lease cost inside operating expenses, depressing EBITDA and EBIT relative to an IFRS filer with an economically identical contract, whose depreciation and interest split lifts EBITDA and shifts principal repayment into financing cash flows.

A candidate should be able to discount a payment stream to obtain the liability, build the amortisation schedule, decompose the straight-line cost into interest and amortisation, restate EBITDA, EBIT, interest coverage and debt-to-equity for a change in treatment, and read the maturity analysis, weighted-average discount rate and remaining term disclosed in the lease footnote.