What Is an Operating Lease?
An operating lease is a contract that allows for the use of an asset but does not convey ownership rights of the asset. An operating lease represents an off-balance sheet financing. This means that a leased asset and associated liabilities of future rent payments are not included on a company's balance sheet, to keep the ratio of debt to equity low. Operating leases have enabled United States firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets.
[Important: A new ruling—effective for public companies with fiscal periods beginning on Dec. 15, 2018—requires that all leases, unless they are less than 12 months, must be capitalized; that is, recognized on the balance sheet.]
Understanding Operating Leases
Is the arrangement a lease? If so, what kind of lease should it be?
To be classified as an operating lease, the lease must meet certain requirements under U.S. generally accepted accounting principles (GAAP) that exempt it from being recorded as a capital lease. Companies must test for four criteria—“bright line” tests—that determine whether rental contracts must be booked as operating or capital leases. Current GAAP rules require companies to treat leases as capital leases if
If none of these conditions are met, then the lease must be classified as an operating lease. The internal revenue service (IRS) may reclassify an operating lease as a capital lease to deny the lease payments as a deduction, thus raising taxable income and the taxpayer's tax liability.
What types of assets take operating leases?
Typically, assets that are rented under operating leases include real estate, aircraft, and equipment with long useful life spans—such as vehicles, office equipment, and industry-specific machinery.
Differences Between Operating Leases and Capital Leases
United States GAAP accounting treatments for operating and capital leases are different, and can have a significant impact on businesses' taxes.
An operating lease is treated like renting—lease payments are considered as operating expenses. Assets being leased are not recorded on the company's balance sheet; they are expensed on the income statement. So, they affect both the operating and net income.
In contrast, a capital lease is more like a long-term loan, or ownership. The asset is treated as being owned by the lessee, and is recorded on the balance sheet. Capital leases are counted as debt. They depreciate over time and incur interest expense.
- An operating lease is a contract that permits use of an asset but does not convey ownership rights of the asset.
- GAAP rules govern accounting for operating leases.
- A new ruling, beginning in December 2018, requires that all leases—unless they are less than 12 months—must be recognized on the balance sheet.
Operating Leases and Capital Leases—Essential Traits
Below, we cite some of the basic characteristics of operating and capital leases according to the following criteria: ownership, bargain purchase option, present value (PV), accounting, tax, and risks/ benefits.
Operating lease characteristics
- Ownership: Retained by lessor during and after lease term.
- Bargain purchase option: Cannot contain a bargain purchase option.
- Term: Less than 75% of asset’s estimated economic life.
- Present value: PV of lease payments is less than 90% of asset's fair market value.
- Accounting: No ownership risk. Payments considered as operating expenses; shown in profit and loss statement (P&L) on balance sheet.
- Tax: Lessee considered to be renting; thus, lease payment considered rental expense.
- Risks/ benefits: Right to use only. Risks/ benefits remain with lessor. Lessee pays maintenance costs.
Capital lease characteristics
- Ownership: Might transfer to lessee at end of lease term.
- Bargain purchase option: Contains bargain purchase option to buy asset at less than fair market value.
- Term: Equals or exceeds 75% of asset's estimated useful life.
- Present value: PV of lease payments equals or exceeds 90% of asset's original cost.
- Accounting: Lease considered as asset (leased asset) and liability (lease payments). Payments are shown on balance sheet.
- Tax: As owner, lessee claims depreciation expense, and interest expense.
- Risks/ benefits: Transferred to lessee. Lessee pays maintenance, insurance, and taxes.
Example—New Lease Standards, Effective Dec. 15, 2018
Accounting Standards Codification (ASC) 842
In February 2016, the Financial Accounting Standards Board (FASB) revised the rules that govern lease accounting. Most significantly, the standard now requires that all leases—except short-term leases of less than a year—must be capitalized. The new rules become effective for public companies for their fiscal periods beginning on Dec. 15, 2018.
Below, we present a high-level view the top-five most significant changes that come with ASC 842. To see the full new standard, you may consult the FASB.
- Operating leases recognized on the balance sheet: With ASC 842, companies will see huge impacts to their balance sheets. However, the expense recognized in the income statement likely will not be affected. Retailers, drug stores, restaurants, supermarkets, airlines, and telecommunications companies will feel the biggest brunt of this rule.
- Determining whether the arrangement is a lease—bright-line test: Under ASC 842, the only way to get off-balance sheet treatment is if the arrangement does not meet the definition of a lease. Criteria for determining a lease are similar to current U.S. GAAP. The difference lies in whether or not a lessee has the right to control the identified asset.
- Lease payments: What is included? There's a new definition of indirect costs that likely would result in fewer indirect costs being capitalized.
- Sale-leaseback transactions: Now, for a sale to occur, the transfer of the asset must meet certain revenue recognition requirements. If it does not, then the sale does not occur; both the seller-lessee and the buyer-lessor account for any consideration paid for the asset as a financing transaction.
- Increased financial statement disclosures: ASC 842 requires a significant amount of new financial statement disclosures, both quantitative and qualitative, for both lessees and lessors. Before they can implement the new lease standard, companies must ensure that they have the appropriate systems, procedures, and controls in place to provide this new information.