Operating Lease

Operating Lease — Overview

An operating lease is a contract that allows a party (the lessee) to use an asset owned by another party (the lessor) without transferring ownership. Commonly used for real estate, aircraft, vehicles, office equipment and industry-specific machinery, operating leases let businesses access required assets without the large upfront cost of purchase.

How operating leases work

• The lessor retains legal ownership of the asset; the lessee has the right to use it for the lease term.
• The lease typically requires the lessee to maintain the asset in working condition, allowing for normal wear and tear.
• Operating leases are flexible and often shorter-term arrangements that can reduce the risk of asset obsolescence and free up capital for other uses.

Key takeaways

• Operating leases permit use of an asset but do not transfer ownership.
• Under current U.S. accounting standards (ASC Topic 842), leases longer than 12 months must be recognized on the balance sheet as a right-of-use (ROU) asset and a lease liability.
• Short-term leases (12 months or less) may be accounted for as an expense using the short-term lease exemption.
• Operating leases differ from finance leases by who bears ownership risks and by typical term and payment thresholds.

Advantages and disadvantages

Advantages
* No ownership: lessee avoids capital outlay and ownership burden.
Potentially lower immediate cost: leasing may be cheaper than buying.
Flexibility: easier to upgrade or return assets when needs change.

Disadvantages
* No equity: lease payments do not build ownership or equity.
Financing cost: lease arrangements can include financing charges.
Potentially higher total cost: long-term leasing may cost more than buying.
* Renegotiation risk: short-term leases may require frequent renewals that can increase costs.

Example

A restaurant may need a large backup generator to keep refrigeration and kitchen systems operating during outages. A large generator can be costly to buy outright, so the owner may lease one instead. Since the generator is likely needed for more than one year, under current rules the lessee would record a right-of-use asset and a lease liability on the balance sheet.

Accounting for operating leases

Accounting for leases changed with ASC Topic 842 (2016). Key points:
* Leases with terms longer than 12 months are recorded on the balance sheet as a right-of-use asset and a corresponding lease liability.
The change aims to provide a more complete and transparent view of a company’s rights and obligations.
Certain lease types are excluded from ASC 842 (for example, leases of intangible assets and some specialized categories).
* Short-term leases (12 months or less) can often be recognized as an operating expense without separate balance-sheet recognition if the lessee elects the short-term exemption.

Operating lease vs. finance lease — main differences

Both lease types result in a ROU asset and lease liability on the balance sheet under modern accounting, but they differ economically and contractually.

Operating lease characteristics
* Ownership stays with the lessor during and after the lease.
No bargain purchase option.
Lease term is typically 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.
Risks and benefits of ownership remain largely with the lessor.

Finance lease characteristics
* Ownership effectively transfers to the lessee by the end of the lease term.
May include a bargain purchase option.
Lease term equals or exceeds about 75% of the asset’s useful life.
PV of lease payments equals or exceeds about 90% of the asset’s original cost.
Most risks and benefits of ownership transfer to the lessee.

Frequently asked questions

What does an operating lease mean in practice?
It means the business rents and uses an asset without taking on ownership; the lessor retains ownership rights.

Why use an operating lease instead of buying?
Operating leases provide flexibility, reduce upfront capital requirements, and let companies avoid ownership risk and obsolescence for rapidly changing assets.

How do operating leases affect financial statements?
Under ASC 842, long-term operating leases appear on the balance sheet as a ROU asset and a lease liability, affecting ratios such as debt-to-equity and return on assets.

Conclusion

Operating leases let businesses access assets they need without purchasing them, offering flexibility and lower short-term costs. Since accounting changes introduced by ASC 842, most leases longer than 12 months must be recognized on the balance sheet, improving transparency of a company’s leased obligations while still preserving the economic distinctions between operating and finance leases.