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What is '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 represents a rental agreement for an asset from a 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 being recorded on their balance sheets. To meet the 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 a credit to the cash account and a 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 the 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.

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