Loading the player...

What is an 'Operating Lease'

An operating lease is a contract that allows for the use of an asset, but does not convey rights of ownership of the asset. An operating lease represents an off-balance sheet financing of assets, where a leased asset and associated liabilities of future rent payments are not included on the balance sheet of a company.

BREAKING DOWN 'Operating Lease'

To be classified as an operating lease, the lease must meet certain requirements as promulgated by the U.S. generally accepted accounting principles (GAAP).

An operating lease represent a rental agreement for an asset from lessor under the terms that GAAP does not require to record as a capital lease. The typical assets that are rented under operating leases include real estate, aircraft and various equipment with long useful life spans. Operating leases allow U.S. firms to keep billions of assets and liabilities from recording on their balance sheets. To meet operating lease classification, companies must perform tests consisting of four criteria that determine whether rental contracts must be booked as operating or capital leases.

Capital Leases vs. Operating Leases

Current GAAP rules require companies to treat leases as capital leases if they meet certain conditions:

• There is an ownership transfer to the lessee at the end of the lease.

• The lease contains a bargain purchase option.

• The lease life exceeds 75% of the economic life of the asset.

• The present value of the lease payments exceeds 90% of the fair market value of the asset.

If none of these conditions are met, the lease must be classified as an operating lease.

Accounting for Operating Leases

A company that leases an asset under the operating lease arrangement must classify each lease payment as a rental expense by debiting its rental expense account and crediting its lease payable account. Once the periodic lease obligation is paid, the company records credit to the cash account and debit to the lease payable account. The owner of the assets rented under the operating leases must book periodic depreciation by debiting the depreciation expense account and crediting the accumulated depreciation account on his balance sheet.

Change in Lease Accounting

In February 2016, the Financial Accounting Standards Board (FASB) revised rules governing lease accounting by requiring that all leases, except for short-term leases with terms less than a year, must be capitalized. The new rules become effective for public companies for their fiscal periods beginning on Dec. 15, 2018. Capitalizing all types of long-term leases is expected to have a significant effect on balance sheets of retail, airline and hotel operating companies.

RELATED TERMS
  1. Capital Lease

    A lease considered to have the economic characteristics of asset ...
  2. Capitalized Lease Method

    An accounting approach that identifies a company's lease obligation ...
  3. Leasehold

    An accounting term used to classify an asset on a company's balance ...
  4. Closed-End Lease

    A rental agreement that puts no obligation on the lessee (the ...
  5. Lease Utilization

    A financial ratio that measures how much a company uses leasing ...
  6. Bargain Renewal Option

    A clause in a lease agreement that gives the lessee the option ...
Related Articles
  1. Investing

    How Does an Operating Lease Work?

    Operating lease is a term used mostly in accounting to denote a lease that gives the lessee rights to use and operate an asset without ownership.
  2. Managing Wealth

    What is a Capital Lease?

    A lease considered to have the economic characteristics of asset ownership.
  3. Investing

    Uncovering Hidden Debt

    Understand how financing through operating leases, synthetic leases, and securitizations affects companies' image of performance.
  4. Personal Finance

    Is There a Way to Get Out of Your Car Lease Early?

    For those who no longer want their car for whatever reason, transferring the lease to an interested party can be a particularly appealing choice.
  5. Personal Finance

    When Is Buying A Car Better Than Leasing?

    People who lease a car are often more concerned with the short-term picture.
  6. Managing Wealth

    When Is Leasing A Car Your Best Bet?

    Leasing a car isn't right for everyone. But it's attractive for those who want low initial payments and the ability to get a new vehicle every few years.
  7. Retirement

    Retirees: Should You Buy or Lease Your Car?

    To buy or lease – that is the question. For retirees, access to safer cars, comprehensive warranties and tax deductions may drive up leasing's appeal.
  8. Managing Wealth

    Why You Should Buy A Car Instead Of Leasing

    While leasing has certain advantages, buying a car tends to save you money in the long run and offers greater flexibility.
  9. Investing

    New Wheels: Lease Or Buy?

    These two major ways to obtain a car have very different advantages and drawbacks. Find out which is best for you.
  10. Personal Finance

    Auto Leasing Hits Record High in Q4

    Auto Leasing is continuously growing in popularity as a preferred choice of financing.
RELATED FAQS
  1. Why might a bond agreement limit the amount of assets that the firm can lease?

    Bond covenants can limit the amount of leases a company can have because leasing contracts are a form of debt. Taking on ... Read Answer >>
  2. You are currently reviewing the following information for JKL Corp ...

    Free info on financial certification exams including study guides, exam questions, and much more! Read Answer >>
  3. At the beginning of the year, HIJ Corp. began to lease new equipment ...

    The correct answer is: b) Total Lease Payment = Interest expense + Principal repayment Step 1: Interest expense = 8.5% of ... Read Answer >>
  4. At the beginning of the year, ABC Corp. began to lease a major piece of equipment ...

    The correct answer is: A) Under the capitalized lease method, the lessee must treat the asset as if it was purchased with ... Read Answer >>
  5. How have low interest rates affected lease rates in the automotive sector?

    Find out how and why lower interest rates for leasing new automobiles have helped spur more consumers to lease cars instead ... Read Answer >>
  6. What are the differences between single, double and triple-net leases?

    Learn the ins and outs of net lease agreements, including the key differences between single net, double net and triple net ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center