What Is an Operating Lease?
An operating lease is a contract that gives a business (the lessee) the right to use an asset for a period of time without transferring ownership. The asset remains owned by the lessor, and when the lease ends the lessee typically returns the asset (subject to normal wear and tear) or may renew/replace it per the agreement. Common operating-lease assets include aircraft, commercial real estate, vehicles, and heavy equipment.
Key Takeaways
– Operating leases provide use (not ownership) of an asset in exchange for periodic payments.
– Since ASC 842 (2016/2019), most leases longer than 12 months must be recognized on the lessee’s balance sheet as a right-of-use (ROU) asset and lease liability.
– Operating leases often provide flexibility, lower up-front cost, and off-balance-sheet benefits historically; post-ASC 842 transparency has increased.
– Choose between leasing and buying by comparing total cost of ownership, cash flow timing, tax effects, operational needs, and balance-sheet impacts.
How Operating Leases Work
– Parties: lessor (owner) and lessee (user).
– Contract: specifies lease term, payment schedule, maintenance responsibilities, insurance, end-of-lease options (return, renew, purchase), and penalties for damage or early termination.
– Payments: fixed periodic rentals, sometimes plus variable amounts (e.g., usage, maintenance, taxes).
– Term/Options: the lease term may include renewal options that are included in the lease term if it is “reasonably certain” they’ll be exercised.
– Accounting: under current U.S. GAAP, lessees recognize a ROU asset and a lease liability for most leases >12 months. (See Accounting section below.)
Advantages and Disadvantages of Operating Leases
Advantages (summary)
– Lower initial cash outlay compared with buying.
– Flexibility to replace or upgrade equipment and reduce obsolescence risk.
– Maintenance and residual risk often remain with lessor (depending on contract).
– Payments treated as operating expense (expense profile simplicity historically; still presented as single lease expense under ASC 842 for operating leases).
– Useful when assets are needed for a shorter timeframe or are rapidly depreciating/obsolescing.
Disadvantages (summary)
– No ownership/equity accumulation or asset appreciation.
– Over long terms, lease cost may exceed purchase cost.
– Contractual restrictions (use limits, maintenance, insurance).
– Potential higher total cost of financing vs. outright purchase or other financing.
– Balance-sheet recognition (post-ASC 842) increases reported liabilities and assets, affecting ratios.
Advantages Explained
– Cash preservation: Leasing avoids the up-front capital required to buy expensive assets, conserving working capital for operations or growth.
– Upgrade flexibility: Shorter or renewable leases let firms swap to newer equipment more easily—valuable where technology becomes obsolete.
– Off-risk features: Lessors frequently handle residual value risk and sometimes maintenance or asset remarketing.
– Tax and expense treatment: Lease payments are generally a deductible operating expense; specific tax outcomes depend on jurisdiction and lease structure.
Disadvantages Explained
– Cost over time: Repeated leasing across many years may be costlier than purchase plus financing.
– No equity: Lessee does not accumulate ownership or a saleable asset.
– Contract constraints: Leases can limit permitted use, subleasing, or modifications and can include hefty termination fees.
– Accounting transparency: Since ASC 842, leases typically appear as both an asset (ROU) and a liability on the balance sheet, which can affect leverage and covenant calculations.
Example — Restaurant Generator Lease
Scenario: A restaurant needs a commercial generator costing $30,000 to ensure operations during outages but prefers to conserve cash. It enters a 3-year operating lease with annual payments of $5,000, and a discount rate (incremental borrowing rate) of 5%.
Accounting (high-level):
1. Calculate present value (PV) of lease payments:
PV = 5,000 × [1 – (1+0.05)^-3] / 0.05 ≈ $13,615.
2. Initial recognition: Lessee records a lease liability ≈ $13,615 and a ROU asset ≈ $13,615 (adjusted for any prepayments, incentives, or initial direct costs).
3. Expense recognition: For an operating lease under ASC 842, the lessee records a single lease expense on the income statement, typically straight‑line over the term, while the balance sheet shows the ROU asset and liability.
4. Cash flow: Lease payments generally classified as operating activities (under U.S. GAAP).
Note: If the lease were shorter than 12 months and the lessee elects the short-term exemption, the payments can be expensed as incurred without recognizing ROU asset/liability.
Accounting for an Operating Lease (Practical Steps Under ASC 842)
1. Identify a lease: Determine whether the contract conveys control of the use of an identified asset for a period of time.
2. Determine the lease term: Include non-cancelable periods and options to extend/terminate only if reasonably certain to be exercised.
3. Determine lease payments to include:
– Fixed payments (including in-substance fixed).
– Variable payments tied to an index or rate (e.g., CPI) are included using the index/rate at commencement and subsequently remeasured when the index changes.
– Exclude purely usage-based variable payments unless in-substance fixed.
– Include purchase options or residual guarantees if exercised/guaranteed are reasonably certain.
4. Select the discount rate: Use the rate implicit in the lease (if known) or the lessee’s incremental borrowing rate.
5. Measure initial lease liability: PV of lease payments not yet paid, discounted.
6. Measure ROU asset: Initial lease liability adjusted for prepaid lease payments, lease incentives received, and initial direct costs.
7. Subsequent measurement:
– Operating lease: Lessee recognizes a single lease expense on the income statement (lease expense spreads over term), and updates liability and ROU for payments and interest/accumulated amortization in accordance with ASC 842.
– Finance lease: Recognize interest on the liability and amortization expense on the ROU (resulting in front-loaded total expense).
8. Disclosures: Provide required qualitative and quantitative disclosures—maturity analysis of lease liabilities, lease expense, and significant judgments (e.g., discount rate, lease term determinations).
9. Short-term leases: Leases with initial term ≤ 12 months may be exempted from balance-sheet recognition if the lessee elects the short-term lease practical expedient; then expense payments as incurred.
Operating Lease vs. Finance Lease (Key Differences)
– Ownership: Finance Lease (similar to capital lease historically) transfers substantially all risks and rewards of ownership to the lessee (often treated like a purchase). Operating Lease does not.
– Balance-sheet/Expense Pattern: Both lease types result in a ROU asset and lease liability on the balance sheet under ASC 842, but income statement treatment differs:
– Finance lease: separate interest and amortization (front-loaded expense profile).
– Operating lease: single lease expense recognized on a straight-line basis (level expense profile).
– Cash flow classification: Finance lease principal is financing activity; interest is operating. Operating-lease cash payments are operating activities (U.S. GAAP).
What Is the Meaning of Operating Lease?
A contract to use an asset for a limited period without transferring legal ownership or substantially all risks/rewards of ownership to the lessee.
What Is the Difference Between an Operating Lease and a Finance Lease?
In short: finance leases transfer most of the economic ownership (risk/benefit) to the lessee and resemble financed purchases; operating leases provide temporary use without economic ownership transfer. Accounting treatment (expense pattern, and cash-flow classification) differs even though both generally appear on the balance sheet today.
What Are Operating Leases Used For?
– Short-to-medium-term access to capital-intensive equipment (e.g., aircraft, construction equipment).
– Businesses that prefer upgrades and avoid technological obsolescence (e.g., IT equipment).
– Situations where preserving cash, preserving borrowing capacity, or offloading residual-value risk is important.
– Temporary capacity expansions or projects with fixed durations.
Important Practical Steps When Considering an Operating Lease
1. Business decision checklist:
– Define operational need and expected useful life vs. lease term.
– Compare total lease cost vs. purchase + financing (include tax, maintenance, resale value).
– Consider technology/obsolescence risk and flexibility needs.
2. Negotiation checklist:
– Negotiate payment schedule, rent escalators, maintenance responsibilities, insurance, early termination rights, and end-of-lease options (purchase price or renewal terms).
– Clarify responsibility for repairs, spare parts, and performance guarantees.
– Define condition standards at return and allowable wear and tear.
3. Accounting & reporting checklist:
– At contract signing, document judgments used (lease term, discount rate, variable payments).
– For leases >12 months, calculate and record ROU asset and liability per ASC 842.
– Track modifications and reassess lease terms & payments when changes occur.
– Ensure systems are in place to capture lease data for disclosures and covenant monitoring.
4. Finance/tax checklist:
– Consult tax advisor—tax treatment of lease payments varies by jurisdiction and lease classification.
– Project covenant impacts because on-balance-sheet liabilities may affect debt ratios.
– Consider residual value guarantees and how they affect reported liabilities.
5. End-of-lease planning:
– Prepare for inspection and return conditions.
– Decide in advance whether to renew, purchase, or replace.
– If buying at end, compare buyout price to market value.
The Bottom Line
Operating leases are a flexible way to access and use assets without immediate ownership. Since ASC 842, most leases longer than 12 months are recorded on the balance sheet, improving transparency but reducing some previous off-balance-sheet benefits. Companies should evaluate leasing vs. buying based on cash flow, cost, operational needs, tax consequences, and accounting impacts, and must follow careful measurement and disclosure procedures under current standards.
Sources and Further Reading
– Investopedia. “Operating Lease.” https://www.investopedia.com/terms/o/operatinglease.asp
– Financial Accounting Standards Board. Accounting Standards Update No. 2016-02, Leases (Topic 842).
– The CPA Journal. “Accounting for Operating Leases | Initial Observations.”
– Oklahoma State University. “Capital Leases.”
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.