Definition of Operating Lease
An operating lease is a contract where the lessee leases an asset from the lessor for a predefined period without taking on risks and rewards associated with ownership. Typically, the lessor retains ownership, and the lease can often be shorter in duration compared to the asset’s economic life. Operating leases are commonly used for equipment, vehicles, and real estate properties.
Under this arrangement, the lessee may return the asset to the lessor or renew the lease upon completion. The leased asset does not appear on the lessee’s balance sheet as it is not considered a long-term debt obligation.
Examples of Operating Lease
1. Office Space Rental
A small business leases office space in a commercial building on a 5-year lease. The company uses the space for its operations, while the building’s owner, the lessor, remains responsible for major maintenance.
2. Equipment Lease
A manufacturing firm leases machinery for production on a 3-year operating lease. When the lease term ends, the company returns the machinery to the leasing company, opting either to renew the lease or lease newer equipment.
3. Vehicle Lease
A company leases a fleet of vehicles for its sales team for a 4-year term. The vehicles are returned to the leasing company at the end of the lease period, allowing the company to lease newer models.
Frequently Asked Questions (FAQs)
Q1: What is the difference between an operating lease and a finance lease?
A finance lease (or capital lease) transfers most of the risks and rewards of ownership to the lessee and is often longer-term. An operating lease, by contrast, does not transfer such risks, and the leased asset typically remains off the lessee’s balance sheet.
Q2: How are operating lease payments treated in financial statements?
Operating lease payments are typically expensed on the income statement under “rent expense” or a similar category rather than being capitalized on the balance sheet.
Q3: Can an operating lease affect a company’s taxes?
Yes, lease payments under an operating lease can be deductible as business expenses, potentially providing a tax benefit to the lessee.
Q4: What happens when an operating lease term ends?
At the end of an operating lease term, the lessee usually has the option to return the asset to the lessor, extend the lease, or negotiate a new lease for a different asset.
Q5: Are operating leases more beneficial for short-term or long-term needs?
Operating leases are generally more beneficial for short-term needs, allowing companies flexibility and the ability to upgrade equipment or assets without large capital expenditures.
Related Terms with Definitions
1. Finance Lease (Capital Lease)
A type of lease that transfers substantially all risks and rewards of ownership to the lessee. It is capitalized on the lessee’s balance sheet.
2. Sublease
A rental agreement where the lessee (tenant) leases the leased property to a third party, the sublessee, retaining some responsibilities shared with the original lessor.
3. Leaseback
A transaction where one sells an asset and then leases it back from the buyer for long-term use, thus continuing to use the asset without owning it.
4. Lessor
The party in a lease agreement who owns the asset and permits its use by the lessee in exchange for periodic payments.
5. Lessee
The party in a lease agreement who obtains the right to use the asset owned by the lessor for a specified period under agreed terms.
Online Resources
- Lease and Rental Agreements on Investopedia
- Understanding Operating vs. Capital Leases - AccountingTools
- Operating Leases Explained by LeaseQuery
References
- “Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, Terry D. Warfield.
- “Leasing and Asset Finance: The Comprehensive Guide for Practitioners” by Julian Rose
Suggested Books for Further Studies
- “Lease Accounting: A Practitioner’s Guide” by Barry J. Epstein and Ralph Nach
- “IFRS 16 Leases: Practical application” by PwC
- “Leasing and Asset Finance: The Comprehensive Guide for Practitioners” by Julian Rose
