Operating Lease


The financial accounting term operating lease is used to describe one of several lease arrangements that a company can hold.  Operating leases are used to acquire assets on a relatively short-term basis.  The cost of an operating lease appears as an expense on the income statement.


The Financial Accounting Standards Board rules allow companies two methods to account for leases:  capital and operating.  If a lease does not qualify as a capital lease, then it should be classified as an operating lease.

The following tests are used to determine if a lease is to be treated as a capital lease:

  • The term of the lease exceeds 75% of the life of the asset
  • There is a transfer of ownership to the lessee at the end of the lease's term
  • The agreement includes an option to purchase at a "bargain price," which is below fair market value
  • The discounted present value of the lease payments exceed 90% of the asset's fair market value

If none of the above criteria apply, the lease should be treated as an operating lease.

When compared to a capital purchase, or finance lease, an operating lease provides companies with two significant advantages:

  • Balance Sheet Impairment:  operating leases are treated as an expense.  As such, they appear on the income statement and have no effect on the company's balance sheet.
  • Cash Flow: operating leases avoid the large upfront payment that occurs with a capital purchase.

Related Terms

balance sheet, income statement, capital lease, leasehold, off-balance-sheet financing, leveraged lease