Leasing assets instead of buying them outright has become a cornerstone of modern business strategy. Among the different types of leases, the operating lease stands out due to its flexibility and off-balance-sheet treatment. In this article, I will break down what an operating lease is, how it differs from other lease types, and why businesses opt for it. I will also explore the accounting treatment under ASC 842, provide real-world examples, and clarify common misconceptions.
Table of Contents
What Is an Operating Lease?
An operating lease is a contract that allows a business to use an asset without transferring ownership. Unlike a capital lease (or finance lease), an operating lease does not require the lessee to record the asset as owned property on their balance sheet. Instead, lease payments are treated as operating expenses.
Key Characteristics of an Operating Lease
- No Ownership Transfer – The lessor retains ownership, and the lessee only has the right to use the asset.
- Short-Term Commitment – Typically, the lease term is shorter than the asset’s useful life.
- Off-Balance-Sheet Financing – Before ASC 842, operating leases were not recorded as liabilities, making them attractive for companies seeking to improve financial ratios.
- Flexibility – Businesses can upgrade or replace assets without the burden of disposal.
Operating Lease vs. Finance Lease
The distinction between an operating lease and a finance lease (previously called a capital lease) is crucial. The Financial Accounting Standards Board (FASB) provides specific criteria under ASC 842 to classify leases:
| Criteria | Operating Lease | Finance Lease |
|---|---|---|
| Ownership transfer | No | Yes |
| Bargain purchase option | No | Yes |
| Lease term vs. useful life | < 75% | ≥ 75% |
| Present value of payments | < 90% of fair value | ≥ 90% of fair value |
If any one of the finance lease conditions is met, the lease is classified as a finance lease. Otherwise, it’s an operating lease.
Example: Comparing Two Lease Scenarios
Suppose Company A leases a machine under two different agreements:
- Operating Lease:
- Lease term: 3 years
- Useful life of machine: 10 years
- No purchase option
- Present value of payments: 80% of fair value
Since none of the finance lease conditions are met, this is an operating lease.
- Finance Lease:
- Lease term: 8 years
- Useful life of machine: 10 years
- Includes a bargain purchase option
- Present value of payments: 95% of fair value
Here, two conditions (lease term ≥ 75% and PV ≥ 90%) are met, making it a finance lease.
Accounting for Operating Leases Under ASC 842
Before ASC 842, operating leases were kept off the balance sheet, leading to concerns about transparency. The new standard requires all leases longer than 12 months to be recorded on the balance sheet.
How Operating Leases Are Recorded
- Initial Recognition
- The lessee records a right-of-use (ROU) asset and a corresponding lease liability at the present value of lease payments.
- Subsequent Measurement
- The lease liability is reduced as payments are made.
- The ROU asset is amortized over the lease term.
Example Calculation
Assume Company B enters a 5-year operating lease for office space with annual payments of $50,000. The discount rate is 5%.
- Calculate Present Value of Lease Payments:
Journal Entry at Lease Commencement:
- Debit ROU Asset: $216,474
- Credit Lease Liability: $216,474
- Annual Amortization:
- The ROU asset is amortized straight-line over 5 years:
Why Businesses Choose Operating Leases
1. Preserving Capital
Leasing avoids large upfront purchases, freeing cash for other investments.
2. Tax Benefits
Lease payments are often fully deductible as operating expenses.
3. Avoiding Obsolescence Risk
Technology and equipment can become outdated quickly. Leasing allows upgrades without residual value risk.
4. Balance Sheet Management
While ASC 842 now requires operating leases on the balance sheet, they still don’t inflate debt-to-equity ratios as much as loans.
Common Misconceptions About Operating Leases
Myth 1: “Operating Leases Are Always Cheaper”
Not necessarily. While they may have lower monthly payments, the total cost over time could be higher than financing or buying.
Myth 2: “Operating Leases Are Just Like Rentals”
Unlike short-term rentals, operating leases are contractual obligations with financial reporting implications.
Myth 3: “ASC 842 Eliminated the Benefits of Operating Leases”
While transparency improved, operating leases still offer flexibility and tax advantages.
Real-World Applications
Case Study: Airlines and Aircraft Leasing
Airlines frequently use operating leases for aircraft to avoid massive capital expenditures. For example, Southwest Airlines leases a significant portion of its fleet, allowing rapid adjustments to market demand.
Retail Industry: Store Leases
Retailers like Walmart use operating leases for store locations, maintaining flexibility to exit underperforming locations without asset disposal hassles.
Conclusion
Operating leases remain a powerful tool for businesses seeking flexibility and efficiency. While ASC 842 has brought them onto balance sheets, their strategic advantages in cash flow management, tax efficiency, and risk mitigation persist. Understanding the nuances helps businesses make informed leasing decisions that align with their financial goals.
