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. Operating leases are counted as off-balance sheet financing—meaning 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. Historically, operating leases have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets.
Under a new Financial Accounting Standards Board (FASB) rule effective Dec. 15, 2018, public companies must recognize all leases on the balance sheet unless they are shorter than 12 months.
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 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:
- 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 asset's economic life; or,
- The present value (PV) of the lease payments exceed 90% of the asset's fair market value.
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 reject the lease payments as a deduction, thus increasing the company's taxable income and tax liability.
What types of assets use 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
U.S. 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 operating and net income. Other characteristics include:
- Ownership: Retained by lessor during and after lease term.
- Bargain purchase option: Cannot contain a bargain purchase option.
- Term: Less than 75% of the asset’s estimated economic life.
- Present value: PV of lease payments is less than 90% of the 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; lease payment treated as a rental expense.
- Risks/benefits: Right to use only. Risks/benefits remain with the lessor. Lessee pays maintenance costs.
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. Other characteristics include:
- Ownership: Might transfer to the lessee at end of lease term.
- Bargain purchase option: Enables lessee to buy an asset at less than fair market value.
- Term: Equals or exceeds 75% of the asset's estimated useful life.
- Present value: PV of lease payments equals or exceeds 90% of the asset's original cost.
- Accounting: Lease considered as an asset (leased asset) and liability (lease payments). Payments are shown on the balance sheet.
- Tax: As owner, lessee claims depreciation expense, and interest expense.
- Risks/benefits: Transferred to the lessee. Lessee pays maintenance, insurance, and taxes.
- An operating lease is a contract that permits the use of an asset but does not convey ownership rights of the asset.
- GAAP rules govern accounting for operating leases.
- A new FASB rule, effective Dec. 15, 2018, requires that all leases—unless they are shorter than 12 months—must be recognized on the balance sheet.
What's the Effect of New FASB Rule
Effective Dec. 15, 2018, FASB revised its rules governing lease accounting. Most significantly, the standard now requires that all leases—except short-term leases of less than a year—must be capitalized. Other changes include the following:
- There is a difference in the bright-line test that helps to determine whether or not a lessee has the right to control the identified asset.
- There's a new definition of indirect costs that likely would result in fewer indirect costs being capitalized.
- Under the new rule, for a sale or leaseback to occur, the transfer of the asset must meet certain revenue recognition requirements.
- The new rule requires a significant number of new financial statement disclosures, both quantitative and qualitative, for both parties.