An operating lease is a contract that allows businesses to use an asset without transferring the ownership rights of the asset. This allows businesses to leverage valuable assets without the hefty upfront costs of purchase. The leasing company, known as the lessor, retains ownership, while the business using the asset, defined as the lessee, takes responsibility for its upkeep and operational functionality, excluding normal wear and tear.
Key Takeaways
- An operating lease permits use of an asset without transferring ownership rights.
- Contrast with finance leases which transfer ownership post-lease period subject to contractual obligations met by the lessee.
- Governed by GAAP rules for proper accounting.
- Leases over 12 months are required to be reflected on balance sheets.
- Short-term leases (<12 months) can be expensed straight-line.
How Operating Leases Work
In the past, businesses could obscure significant assets and liabilities from balance sheets using operating leases. This scenario changed post-2016 following the introduction of the Accounting Standards Update 2016-02: Leases (Topic 842). This new regulation mandates including the lease and its associated asset value on the balance sheet, providing a transparent financial outlook.
Typical examples of assets involved in operating leases include real estate, aviation equipment, industrial machinery, vehicles, and various office supplies. Essentially, an operating lease allows a business to utilize an asset while returning it, preferably in good condition, post-lease term—which is advantageous for companies needing regular asset upgrades.
Advantages and Disadvantages of an Operating Lease
Advantages
- No Ownership: Avoid the costs and responsibilities of ownership, such as repairs and maintenance.
- Renting May Be Cheaper: Generally more affordable than purchasing, especially valuable to smaller or newer enterprises.
- Short-Term: Utilize the asset only for as long as it is required, mitigating long-term costs of ownership, maintenance, and disposal.
Disadvantages
- No Equity: Leasing doesn’t build equity, so at the end of the lease, there’s no retained value of the asset.
- Financing Costs: Leases may entail additional financing costs like interest payments.
- Paying More than Market Value: Over the long-term, cumulative lease payments might exceed the asset’s market value at the time of lease initiation.
- Continuous Terms Renegotiation: Frequent renewal of leases may give the lessor an opportunity to revise rates and fees.
Enhanced Example of an Operating Lease
Consider a restaurant aiming for uninterrupted operations during power outages, safeguarding perishables and ensuring continual service. Needing a reliable generator to support functions like refrigeration, cooking, lighting, and heating, the restaurant faces significant upfront costs if they were to purchase a high-capacity generator. Hence, opting to lease a generator represents a cost-efficient solution, ensuring uninterrupted power without the initial capital expenditure. Lease payments to a leasing firm would thus be recorded as both an asset and a liability on the balance sheet since the lease extends beyond a year.
Accounting for an Operating Lease
The 2016 ASC Topic 842, Leases standard reshaped lease accounting rules, necessitating that leases over 12 months appear as liabilities and right-of-use assets on balance sheets, limiting balance sheet manipulation and fostering a more precise financial representation. Exceptions to this rule include leases for intangible assets, exploration resources, biological assets, inventory, and construction assets, maintaining cleaner financial statements and ethical accounting practices.
Operating Lease vs. Finance Lease
Though both lease types similarly impact financial metrics like debt-to-equity ratios, they diverge in several key aspects:
Operating Lease Characteristics
- Ownership: Retained by lessor throughout and after the lease term.
- Bargain Purchase Options: Absent in operating leases.
- Lease Term: Shorter than 75% of the asset’s estimated lifecycle.
- Present Value: Lease payment present value is under 90% of the asset’s fair market value.
- Risks/Benefits: Exclusively the right to use, risks and benefits lie with the lessor.
Finance Lease Characteristics
- Ownership: Transfers to lessee upon lease term completion.
- Bargain Purchase Options: Allows lessee to purchase at below-market rates.
- Lease Term: Matches or exceeds 75% of the asset’s estimated useful life.
- Present Value: Lease payment present value meets or exceeds 90% of the asset’s initial cost.
- Risks/Benefits: Entirely assumed by the lessee.
Understanding Operating Leases
An operating lease allows a business to ‘rent’ necessary assets for operation, maintaining its flexibility and avoiding ownership complexities.
Distinguishing Operating Leases and Finance Leases
A finance lease results in the asset and its financial risks or returns shifting to the lessee, essentially translating to ownership transfer. In contrast, operational leases maintain asset ownership with the lessor throughout and after the agreement term.
Practical Uses of Operating Leases
Operating leases provide vital benefits like flexibility facilitating asset upgradation and reducing obsolescence risks. Payments are treated as operational expenses, blessings in tax considerations, plus maintenance cost liability resting on the lessee shields them from inherent ownership risks.
The Bottom Line
For businesses—especially small to medium ones—working with operational leases rather than managing the substantial upfront costs associated with asset-purchasing stands as a pratical approach. It ensures essential assets are utilized without the fiscal strain of a full purchase, while transparent accounting practices as set by new standards help present a holistic financial stance.
Related Terms: finance lease, leasehold, asset management, lease liability, right-of-use asset.
References
- Financial Accounting Standards Board. “No. 2016-02 February 2016: Leases (Topic 842)”.
- Financial Accounting Standards Board. “No. 2016.02, February 2016: Leases (Topic 842)”. Page 3.
- Financial Accounting Standards Board. “No. 2016.02, February 2016: Leases (Topic 842)”. Pages 2-4.
- Financial Accounting Standards Board. “No. 2016.02, February 2016: Leases (Topic 842)”. Page 13.
- The CPA Journal. “Accounting for Operating Leases | Initial Observations”.
- Oklahoma State University. “Capital Leases”.
