Definition
An operating lease is a contract that allows for the use of an asset but does not convey rights of ownership of the asset. It is considered a rental agreement where the lessee pays the lessor regular payments for the use of the property or equipment. The lessor retains the responsibility for maintenance and repairs of the leased asset.
Key Takeaways
- An operating lease is a contract that allows the use of a particular asset but without ownership transfer. The lessee pays the lessor periodic payments for a predetermined period of time.
- Operating leases are most often used for leasing items of property or equipment like buildings, airplanes, or copiers, and they are not recorded on the lessee’s balance sheet. Instead, they are considered as a kind of operational expense.
- In contrast to a capital lease, an operating lease provides the lessee much more flexibility and can deliver tax advantages by potentially lowering taxable income, since the lease payments are typically considered a business expense.
Importance
The finance term “Operating Lease” is important because it represents a significant financing option for businesses, especially those that require expensive equipment or assets but may not have, or prefer not to use, large amounts of capital upfront.
Operating leases are agreements that allow a company to use an asset without owning it, typically in exchange for regular payments.
This lease is crucial as it provides the benefits of using the asset without the risks associated with ownership, such as depreciation.
Further, it keeps the company’s balance sheet cleaner as the lease liability and the asset itself are not recorded.
This flexibility can improve financial ratios and also offer potential tax advantages, contributing beneficially to a company’s financial management strategy.
Explanation
The primary purpose of an operating lease is to permit a company to use an asset without burdening their balance sheet with the full cost of the asset. Operating leases are used by businesses that need to use equipment or property which may get outdated quickly such as computers, airplanes or vehicles.
With operating leases, companies have the benefit of using the asset but the asset is not listed on the company’s balance sheet, which allows them to maintain lower liabilities. This type of financial arrangement is appealing to businesses as it provides them access to high-priced assets without the upfront investment, leaving them better poised to allocate funds elsewhere in their organization.
Furthermore, operating leases also offer businesses the flexibility to upgrade their equipment. Because operating leases typically have shorter lease terms than capital leases, businesses have the option to upgrade to new or more advanced equipment at the end of the lease term.
This advantage can be significant for businesses operating in rapidly evolving industries where technological advancements can quickly render equipment obsolete.
Examples of Operating Lease
Commercial Office Space: A prominent real-world example of an operating lease, many businesses prefer this type of lease for renting office space. They do it to avoid the liabilities of owning a property. The lessee (business firm) pays the lessor (property owner) periodic payments for using the space. Maintenance, taxes, insurance, and other related expenses often fall under the lessor’s responsibility.
Fleet Leasing: Many companies that require vehicles for their operations use operating leases to avoid hefty upfront costs. For example, a package delivery company might opt for an operating lease on a fleet of delivery trucks or vans. The leasing company maintains ownership of the vehicle and handles servicing, maintenance, while the courier company pays a regular lease payment and uses the vehicles for its operations.
Aircraft Leasing: Airlines often lease aircraft through operating leases to conserve their capital and maintain flexibility. It allows companies to use current, state-of-the-art planes without the financial burden of buying them outright. This way, they can keep their fleet up-to-date and efficient, paying regular lease payments for usage of the planes to the leasing companies. The leasing company retains ownership of the aircraft and handles major maintenance and repairs.
Operating Lease FAQ
What is an Operating Lease?
An Operating Lease refers to a lease agreement that allows the use of an asset but does not confer ownership rights of the asset. Key characterstics are: risks and ownership belong to the lessor, shorter-term than the asset’s life, and they are typically not fully amortisable.
How is an Operating Lease different from a Finance Lease?
While both are lease agreements, the key difference lies in the ownership of the asset. In an Operating Lease, the lessor retains ownership of the asset, whereas in a Finance Lease, all the risks and rewards associated with owning the asset are transferred to the lessee, essentially making it a purchased asset for the lessee.
What are the benefits of an Operating Lease for a business?
An Operating Lease allows a business to use an asset without the financial responsibility of owning the asset, such as depreciation and maintenance costs. It also keeps the liability off the balance sheet, freeing up capital resources and improving the company’s financial ratios.
How is rent expense calculated for an Operating Lease?
Rent expense in an Operating Lease is typically straightforward. The lease payments are recognized as an expense on a straight-line basis over the lease term unless another systematic basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished.
What happens at the end of an Operating Lease term?
At the end of an Operating Lease term, the lessee typically has a few options: renew the lease, return the asset, or sometimes purchase the asset, depending on the specifics of the lease agreement.
Related Entrepreneurship Terms
- Lease Agreement
- Lease Term
- Lease Payments
- Residual Value
- Off-Balance Sheet Financing
Sources for More Information
- Investopedia: An extensive educational resource dedicated to investment and finance.
- Accounting Tools: A resource designed to provide comprehensive information on accounting principles and practices.
- Corporate Finance Institute: An excellent resource providing online finance courses and certifications.
- Financial Accounting Standards Board (FASB): The designated organization in the private sector for establishing standards of financial accounting.
