Tavagapedia

Operating Lease

Key Takeaways

  1. Operating lease is an agreement that gives the right to use assets but does not provide the right of ownership of an asset.
  2. In an operating lease, ownership remains with the lessor, whereas in financial lease lessor is just a financier
  3. After the end of the operating lease, ownership remains with the lessor, but the lessee can return the assets or renew the contract or the lessee may purchase the leased asset.

An operating lease is a lease that allows the borrowing party to keep its leased asset out of its accounting balance sheet, and pay rent on it. The leased asset is not capitalized.
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An operating lease lets the borrowing entity keep its debt-equity ratio low, and hence, favorable in the eyes of investors. Assets, if capitalized even when leased, increases a company’s debt.

Financial lease capitalizes the leased asset and recognizes it as a liability.

What is Operating Lease?

Operating lease is an agreement which gives the right to use assets, but does not give the right of ownership of an asset. Leased assets and liabilities related to leased assets are not included in the company’s balance sheet; therefore, operating lease is considered as off-balance sheet financing. Examples of such assets are aircraft, real estate, vehicles, or any heavy machinery.

Many organizations approach this type of lease for better financial terms, or they don’t have that much financial aid, and in case companies want to replace their assets. In an operating lease, the lessee has unlimited access to the leased asset, but it only has to keep it in better condition. 

After the end of the operating lease, ownership remains with the lessor, but the lessee can return the assets or renew the lease or lessee may purchase the leased asset.

Features of Operating Lease

  1. The operating lease provides equipment for a short duration. When a firm does not need any machines or an asset for long, they may consider this lease.
  2. When companies want to replace their assets, they opt for operating lease, especially when the industry is changing.
  3. When the company does not have any financial aid but intends to continue normal operating activities can opt for this lease.

Accounting of Operating Lease

Accounting and classification of an operating lease are simple and straightforward because there is no transfer of ownership.

In the books of the lessee, lease payments are recognized as an expense item in the Profit and Loss statement. It is an operating cost just like a rental expenses.

However, in the books of the lessor:

  • Lessor must keep the leased asset in the balance sheet under the fixed assets line item
  • Lease income received from the lessee is recognized as an income in the P/L statement
  • Lessor has to bear all the costs of depreciation and check for impairment

Both the lessor and the lessee have to make disclosures in the financial statements with details of the leasing arrangement. The lessor must disclose the accumulated depreciation, impairment, and carrying value in the balance sheet along with expected future lease payments. The lessee also must disclose the future lease payments.

Operating lease vs. Finance Lease

The risk and reward are related to the ownership passed on to the lessee. The lessor is the only legal operator of assets. But in an operating lease, the lessee is only given the right to use an asset that is only for a specific time. So risk and reward, which are incidental to ownership, belongs only to the lessor in case of operating.

The second difference is about obsolescence; in the case of the financial lease, it is the lessee that will bear the risk of obsolescence. And in case of an operating lease, the lessor will take the risk of obsolescence. 

Another difference is related to the cancellation of risk; the financial lease is not cancellable by either party. But in the case of an operating lease, the lessor can release the asset to another lessee, so the lease is kept cancellable by the lessor in an operating lease.

In the financial lease, the lessor will not bear any repair and maintenance cost, he\she only acts as a financier. But in case of an operating lease, the lessor will bear the operating, i.e., maintenance cost. Payout is the cost of the asset plus interest earned. In the financial lease, the lessor will pay full payout, whereas, in an operating lease, the lessor will not pay any payout, because the lessor will release the same asset to other interested candidates.

Some additional characteristics difference are as follows:

  1. Value of lease payments: For an operating lease, the present value of all the future lease payments must be less than 90 percent of the asset’s current fair price
  2. Term of the lease: Asset under an operating lease should not be leased out for more than 75 percent of the asset’s estimated economic life
  3. Accounting: Expenses incurred in the form of leasing costs and accounted for in the P/L statement
  4. Purchase option: Operating leases DO NOT offer a bargain purchase option of the leased asset at the end of the lease. At the end of an operating lease, the lessee can either renew the leasing arrangement or return the asset back to the lessor.

What is an example of an operating lease?

For example, a Horizon company is a printing press. To expand its business, Horizon company needs more printing machines. Let’s assume the market price of a printing machine is Rs.450,000, and a company wants a minimum of two machines for expansion and completes the delivery. The management does not want to invest in the capital now, because of the unpredictable demand in the market, so they decide to lease this machine for Rs.400 per month. So their total expense for both machines would be Rs.800 per month. Therefore, such a tool helps organizations to make calculative decisions in order to achieve success in the business without taking any risk. After experiencing the market, firms may purchase the asset.