What Is an Operating Lease?

What Is an Operating Lease?

Let me tell you directly: an operating lease is a contract that lets you use an asset without gaining any ownership rights. As a business, you can access what you need without the massive upfront costs of buying it outright.

You're the lessee if you're leasing the asset, and the owner is the lessor. The lease agreement spells out everyone's duties, but you, as the lessee, typically handle maintenance to keep the asset running, accounting for normal wear and tear.

Key Takeaways

Remember, an operating lease gives you usage rights without ownership. In contrast, a finance lease hands over ownership at the end once all terms are met. GAAP rules dictate how you account for these, and any lease over 12 months goes on your balance sheet. Shorter ones? Just expense them straight-line.

How Operating Leases Work

Operating leases used to let companies keep huge assets and debts off their books, keeping debt-to-equity ratios looking good. That changed in 2016 with Accounting Standards Update 2016-02 (Topic 842) and later tweaks.

Essentially, you're renting an asset like real estate, planes, or long-life equipment such as vehicles or machinery, and ownership stays with the lessor at the end. You return it in similar condition. This setup works well if you deal with pricey gear that needs frequent replacement.

Advantages and Disadvantages of Operating Leases

On the plus side, no ownership means you skip repair and maintenance bills. Renting often costs less than buying, which helps if you're a small or new business without deep pockets. Plus, short terms mean you only pay for what you need, avoiding long-term ownership hassles.

But there are downsides: you build no equity. You might face financing costs like interest. Over time, you could pay more than the asset's market value. And with short leases, you're constantly renegotiating terms, which might lead to higher rates from the lessor.

Example of an Operating Lease

Consider a restaurant that needs backup power to avoid spoilage during outages—losing business and supplies isn't an option. They might need a large generator for fridges, ovens, lights, and more, costing tens of thousands to buy.

Instead, the owner leases it from an equipment service. Since they'll need it over a year, it shows up as both an asset and liability on their balance sheet.

Accounting for an Operating Lease

Accounting shifted in 2016 with ASC Topic 842 from the FASB, mandating that leases over 12 months appear on the balance sheet as a right-of-use asset and lease liability. Shorter leases? Expense them straight-line.

This change stops balance sheet tricks and gives a truer picture of your rights and obligations. It doesn't cover intangible assets, nonregenerative resources, biological assets, inventory, or assets in construction.

Operating Lease vs. Finance Lease

Both get treated as right-of-use assets and liabilities on the balance sheet, impacting ratios like debt-to-equity or return-on-assets if you rely heavily on leases. But differences matter.

In an operating lease, the lessor keeps ownership, no bargain buy options, terms under 75% of the asset's life, present value below 90% of fair market value, and risks stay with the lessor—you just use it.

A finance lease transfers ownership at the end, includes bargain buys, terms at or over 75% of life, present value at or over 90% of cost, and shifts all risks to you, the lessee.

What Is the Meaning of Operating Lease?

Simply put, it's like renting: lease what you need to run your business instead of buying.

What Is the Difference Between an Operating Lease and a Finance Lease?

A finance lease shifts the asset, risks, and returns to you, eventually transferring ownership. An operating lease keeps everything with the lessor.

What Are Operating Leases Used for?

They let you upgrade equipment easily, dodging obsolescence. No ownership risk, payments are tax-deductible operating expenses, and the lessor handles risks—you just maintain it.

The Bottom Line

Operating leases let you rent assets instead of buying, which is practical and cheaper for many businesses, especially smaller ones. Account for longer leases as assets and liabilities on your balance sheet for a realistic view of your finances.