An operating lease allows a business to use an asset, such as a vehicle or piece of equipment, for a set period without taking ownership of it. The lessor retains the risks and rewards of ownership, while the lessee simply pays to use the asset for the agreed term. This type of lease is often used for short-term arrangements where the asset’s useful life extends beyond the lease period. Understanding how to record these leases correctly is important, especially with new accounting rules coming into effect from 1 January 2026.
What is an operating lease?
An operating lease is where the risks and rewards of ownership are not transferred to you from the lessor, and where the lease covers a period less than the useful economic life of the asset.
A common example is a motor vehicle lease for 24 months. The car would be expected to have a useful life of over 24 months, and the lease requires that the car is returned to the lessor at the end of the term. These leases are often described as contract hire agreements by lease companies.
What is the current accounting treatment for operating leases?
The accounting treatment for operating leases is due to change for accounting periods starting on or after 1January 2026, in line with finance leases.
For accounting periods starting before this date, lease payments are recognised as an expense to the Profit and Loss Account on a straight line basis over the term of the lease.
How to account for an initial lease payment?
Contract hire or operating lease agreements often require an initial lease payment, commonly amounting to 3 months’ worth of lease costs.
For example, a 24 month lease starting February 2025, requires an initial rental cost of £990, followed by 23 subsequent rentals of £330. This payment schedule will be detailed out on the lease agreement.
As the lease costs need to be recognised on a straight-line basis over the term of the lease, this initial lease payment needs to be split between the cost for February 2025 (month 1), in this example £330, and the remaining cost to be spread across the full term of the lease (in this example £660 to be recognised over 24 months from February 2025). £660 spread over 24 months equates to a cost of £27.50 per month.
A prepayment journal is therefore posted for the initial rental cost at 28-02-2025:
Dr prepayments £990
Cr motor vehicle lease costs £990
A journal is then posted to release the cost for the first month from prepayments at 28-02-2025:
Dr motor vehicle lease costs £330
Cr Prepayments £330
This leaves a remaining cost of £660 to spread across the full term of the lease.
A repeating journal is then set up in Xero, starting 28-02-2025 and ending 31-01-2027 to release the remaining cost over each of the 24 months of the lease:
Dr motor vehicle lease costs £27.50
Cr prepayments £27.50
Read our full guide on accounting for value added tax (VAT) to learn more.
If you need help with this, or with other advice, then please get in touch with our accounting team.