Operating Lease

Definition

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.

Explanation

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