Operating Lease

What Is an Operating Lease?

An operating lease is a legal agreement that allows a company to use an asset without actually owning it. This means they can use the asset without having to pay the full, often very high, upfront cost of buying it outright.

Leases, in general, are like rental agreements. They spell out how long one party can use something, like a property or an item, and in exchange, they make payments, usually in cash or other assets. In accounting, there are two main types of leases: operating leases and finance (or capital) leases.

Leasing assets such as real estate, automobiles, heavy machinery, and aircraft are common examples of operating-type leases. Another term for this is "off-balance sheet financing." This term is used because the companies don't include such assets on the balance sheet as they are directly expensed through the profit and loss account.

IFRS and the US GAAP have separate rules defining lease accounting. While the US GAAP defines leases as operating and finance leases, IFRS has no such classification for the leases. Under IFRS, we define all leases as finance-type (or capital) leases.

Understanding Operating Lease

An operating lease is a legal arrangement that permits the use of an asset but does not grant ownership. By using these leases, firms can use the asset without paying the exorbitant costs associated with buying it outright.

By not owning, i.e., renting such assets, the companies can use them even without showing them on the balance sheet by treating them as operating expenses.

A lease arrangement involves two parties. Lessee is the party to the contract that leases the asset, while the lessor is the party that gives the asset on rent according to particular agreements.

It is particularly desirable to businesses for various reasons. Below is a list of some of them:

1. Helps in acquiring equipment.

Equipment is made available through the lease for a brief time. This lease may be an option for a business with short-term needs for a machine or asset.

2. Can be at par with technological advancements.

Companies may need to change their assets quickly when the industry is in a highly evolving phase. Leasing assets is a good option for companies in such an industry.

3. Use of expensive assets even without any financial assistance.

The company may choose to use this lease if it does not have any financial assistance but wants to continue with its regular business operations.

4. No transfer of ownership.

The ownership of the asset remains with the lessor itself, as compared to financing leases, where the ownership is transferred to the lessee.

5. Reduction of cost for the lessee.

The asset's maintenance part is the lessor's responsibility. This reduces the cost of leasing the asset for the lessee.

How do operating leases work?

These leases are assets rented by a business, where the ownership of the business is not transferred to the company renting the asset. Assets having long useful lives, such as heavy machinery, aircraft, and vehicles, are leased under this agreement.

In the past, such leases allowed American businesses to avoid recording billions of dollars worth of assets and liabilities on their balance sheets, allowing them to maintain low debt-to-equity ratios.

An operating lease essentially entails a corporation using a piece of property and returning it to the lessor in like-new condition. This arrangement is advantageous to the lessee, especially if it owns expensive equipment or other assets that require regular replacement.

The assumption made in the accounting for an operational lease is that the lessor owns the asset being leased, and the lessee has only been granted access to the asset for a specific amount of time. 

Given this proprietorship and utilization design, we depict the bookkeeping treatment of a working lease by the resident and lessor.

An operating lease is a commercial renting agreement involving the following actions:

Step 1: The lessee chooses an asset they need for their firm.

Step 2: The lessor buys the asset, typically a financial institution.

Step 3: The lessor and lessee sign a legal agreement granting the lessee usage of the asset for the duration of the predetermined lease.

Step 4: The lessee pays for the use of the asset through a series of installments.

Step 5: The lessor recovers the asset's cost plus interest. 

Step 6: The lessee has to return the asset to the lessor after the termination of the lease agreement.

In addition to these advantages, operational leases can be designed to enable firms to keep up with the most recent tools and technology. The lessor may be more inclined to enhance the asset over time because they are in charge of its ownership and maintenance. 

In other words, the lessee can access the newest, most effective equipment without paying for its entire purchase and upkeep.

Operating leases vs. Finance leases

The two lease agreements utilized in accounting and finance are operating and financing leases. The ownership of the asset and the length of the lease term is the two parties' primary differences.

The other differences are mentioned in the table below:

Advantages and disadvantages of operating leases

An operating lease is a kind of lease contract in which a business leases an asset from another firm for a predetermined length of time, generally less than the asset's useful life. 

The option to update to newer technology, flexibility, and cheaper beginning costs are just a few benefits that this kind of lease can offer businesses.

The lease also has significant drawbacks, including the possibility of greater long-term expenditures and the lack of ownership rights for the lessee. We will go into more detail about the benefits and drawbacks of these leases below.

The advantages are

1. Ownership of the asset

The lessee has the advantage of using the asset without purchasing it from the lessor.

2. Risk of obsolescence

The lessee does not have to worry about the risk of obsolescence of the asset as such leases are for a very short period.

3. No initial payment

The lessee does not have to pay anything upfront to use the asset. Hence this type of financing can be cheaper, and large capital investment is not required to use the asset.

4. No need to maintain the asset

The lessee is not responsible for maintaining the asset; it lies in the hands of the lessor. Hence, the lessee saves the maintenance costs incurred while using the asset.

5. Frequent change of assets

A major advantage of opting to use operating leases is that the lessee can be at par with the technological advancements in the industry.

On the other hand, the disadvantages are

1. Commitment to payment of rent until the tenure ends.

We cannot pay the rent until the agreement tenure is completed. Here the risk is that if the asset becomes outdated, one must pay the rent until the tenure is over. 

2. No Equity

When you lease an asset, you don't gain any equity in most cases.

3. Financing costs

A company can incur financing costs, such as interest expenses when they opt for this lease. Such costs can increase the expenditure burden on a company.

4. Constant term renegotiation.

Most leases are for a brief period. This implies that each time the lease ends, the lessor and lessee will renegotiate the conditions. The lessor can now increase rates or fees.

5. Possibility of paying more than market value.

Depending on the lease's length, the asset's total cost may exceed its market value when it was first signed.

Example

Often, this type of lease is used for machinery or equipment with a short lifespan that may need to be modified or replaced periodically. Let's look at the example of a business that leases a fleet of cars for its delivery service to understand better how an operational lease operates.

Let's say that ABC Equipment Inc. is the vendor that XYZ Corp. wants to lease a cluster of vehicles for a three-year term. The vehicles have a twelve-year useful life and a fair market value of $90,000. In this circumstance, an operational lease may operate as follows:

The three-year lease period is agreed upon between XYZ Corp and ABC Equipment Inc. The leasing agreement stipulates that XYZ Corp will make a lease payment of $2,500 per month and that the equipment will be returned to ABC Equipment Inc. after the lease period.

The lease payments will be shown as operating costs on the income statement of XYZ Corp. because this is an operational lease. They won't have equipment on their balance sheet as an asset or show the leasing liability as debt.

• Advantages and Risks: Without spending the whole $ 90,000 upfront for buying the vehicles, XYZ Corp benefits from its use for three years. However, they take the risk of any changes in the equipment's fair market value throughout the lease.
• End of Lease Term: XYZ Corp returns the vehicles to ABC Equipment Inc. after the lease period. Customers cannot purchase the equipment from ABC Equipment Inc. at fair market value, extend the lease, or lease a different piece of equipment.

In general, an operational lease enables a business to utilize an asset for a time frame during which you are not required to bear the entire expense and risk of ownership. It may be a convenient and economical method for businesses to get the tools they need to run their operations.

Researched and authored by Naman Jain | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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