What Is an Operating Lease?
An operating lease is a contract that allows for an asset's use but does not convey ownership rights of the asset. These leases allow businesses to use the asset without incurring the high expenses involved in purchasing it.
The business that leases the asset is called the lessee, and the business that loans it under a lease is called the lessor. The responsibilities of each party in the agreement are spelled out in the lease contract and documents, but generally, the lessee must maintain the asset to ensure it remains in operational condition, less any normal wear and tear.
Key Takeaways
- An operating lease is a contract that permits the use of an asset without transferring the ownership rights of said asset.
- A finance lease is a contract that permits the use of an asset and transfers ownership after the lease period is complete, and the lessor meets all other contract obligations.
- GAAP rules govern accounting for operating leases.
- All leases 12 months and longer must be recognized on the balance sheet.
- Leases shorter than 12 months can be recognized as expenses using the straight-line method.
How Operating Leases Work
Historically, operating leases enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets, thereby keeping their debt-to-equity ratios low. However, this changed in 2016 with the release of Accounting Standards Update 2016-02, Leases (Topic 842), and amendments in the few years following.
Operating leases are assets rented by a business where ownership of the asset is not transferred when the rental period is complete. Typically, assets rented under operating leases include real estate, aircraft, and equipment with long, useful life spans—such as vehicles, office equipment, or industry-specific machinery.
Essentially, an operating lease is a contract for a company to use an asset and return it in a similar condition to the lessor. This agreement is beneficial for the lessee, particularly when it has expensive equipment or other assets that need to be replaced regularly.
Advantages and Disadvantages of an Operating Lease
Advantages
No ownership
Renting may be cheaper
Short-term
Disadvantage
No equity
Financing costs
Might pay more than market value
Continuous terms renegotiation
Advantages Explained
- No ownership: Not owning an asset can be beneficial because you won't have to pay for repairs or maintenance.
- Renting may be cheaper: Renting is generally much more affordable than purchasing, benefitting smaller or newer businesses that don't yet have the financial strength to collect expensive assets.
- Short-term: You'll only need to lease the asset for as long as you need it, reducing the overall costs of purchasing, maintaining, and selling it if you no longer need it.
Disadvantages Explained
- No equity: When you lease, you don't gain any equity
- Financing costs: You might incur financing costs with a lease, such as interest
- Might pay more than market value: Depending on how long an asset is leased, the total cost could be more than the market value at the time the lease originated.
- Continuous terms renegotiation: Many leases are short-term. This means the lessor and lessee will renegotiate terms every time the lease expires. This provides the lessor an opportunity to raise rates or fees.
Example of an Operating Lease
A restaurant needs power to ensure it can operate during outages and not have food spoil when refrigeration systems are offline. Power keeps a restaurant from losing business and costly supplies.
A restaurant owner should ensure they have a generator for this reason, but they might need a much bigger and more expensive one. They'll need to power freezers, refrigerators, ovens, heating lamps, lights, air conditioning, water heaters, computer systems, and more. Large generators can cost tens of thousands of dollars, so the owner might choose to lease one.
The owner would make rental payments to an equipment rental service and account for it as an asset and a liability on their balance sheet because they'll likely need it for more than one year.
Accounting for an Operating Lease
Operating lease accounting changed in 2016 when the Federal Accounting Standards Board released ASC Topic 842, Leases. The new standard provided guidance when accounting for leases, where the lease and the corresponding asset value would be required to be reported on the balance sheet. However, leases for less than 12 months can be recognized as an expense using the straight-line basis method.
When a lease of more than 12 months is initiated, the lessee must account for it as a lease liability and an asset right-of-use on the balance sheet. The intent behind the change is to reduce the ability of organizations to manipulate the balance sheet and create a more faithful representation of a business's rights and obligations.
This new standard does not apply to:
- Intangible asset leasing
- Exploration for or use of nonregenerative resources
- Biological assets leases
- Inventory leases
- Assets under construction
Operating Lease vs. Finance Lease
Operating and finance leases are similar for accounting purposes. They are both treated as a right-of-use asset and a lease liability. They are recorded on the company's balance sheet; as a result, they can affect a company's financial ratios, such as debt-to-equity, return-on-assets, or solvency if companies use a significant amount of leased assets. However, there are several differences.
Operating lease characteristics include:
- Ownership: Retained by the lessor during and after the lease term.
- Bargain purchase options: Operating leases cannot contain a bargain purchase option.
- Terms: Less than 75% of the asset’s estimated economic life.
- Present value: The PV of lease payments is less than 90% of the asset's fair market value.
- Risks/benefits: Right to use only. Risks/benefits remain with the lessor.
Finance lease characteristics include:
- Ownership: Transfers to the lessee at the end of the lease term.
- Bargain purchase options: Enables the lessee to buy an asset at less than fair market value.
- Terms: Equals or exceeds 75% of the asset's estimated useful life.
- Present value: PV of lease payments equals or exceeds 90% of the asset's original cost.
- Risks/benefits: All risk is transferred to the lessee.
What Is the Meaning of Operating Lease?
An operating lease is like renting, a business can lease assets it needs to operate.
What Is the Difference Between an Operating Lease and a Finance Lease?
A finance lease transfers the asset and any risk or return to the lessee. This means that ownership is transferred in a financial lease to the entity that leases the asset. In an operating lease, the ownership remains with the lessor, the entity that leased the asset to the lessee.
What Are Operating Leases Used for?
Operating leases allow companies greater flexibility to upgrade assets, like equipment, which reduces the risk of obsolescence. There is no ownership risk and payments are considered to be operating expenses and tax-deductible. Finally, the risks and benefits remain with the lessor as the lessee is only liable for the maintenance costs.
The Bottom Line
Operating leases are leases a business might use to rent assets rather than buy them outright. Many small and medium-sized businesses cannot afford some of the expensive assets they need to operate, so it makes sense for them—and it's cheaper—to rent them.
Businesses must account for operating leases as assets and liabilities for assets leased for more than 12 months. This standard makes their balance sheet a more realistic representation of the company's worth and obligations regarding leases.
