Operating LeaseEverything You Need to Know

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What is an Operating Lease?

An Operating Lease is a contract that allows the use of an asset without having to transfer the ownership of the said asset.

Payment must be made for the right to use the asset.

How Do Operating Leases Work?

operating lease

Operating Leases have always been left out of recording in the Balance Sheet and keep the debt-to-equity ratio of companies low.

This practice has allowed many American firms to not disclose the billions worth of assets and their corresponding liabilities on the balance sheet. 

The Generally Accepted Accounting Principles (GAAP) established rules on how operating leases are classified, recognized, and recorded in the financial statement and exempt them from being recorded as a Capital Lease.

A “bright line” test is used to determine whether the rental contract passes the four criteria for it to be recognized as either an operating or capital lease. 

The four criteria to consider whether a transaction will be recognized as a Capital Lease are:

  • There is a transfer of ownership at the end of the lease term.
  • A bargain purchase option condition is included in the contract.
  • The lease term has exceeded the asset’s economic life by 75%.
  • The lease payment present value exceeds the asset’s fair market value by 90%.

If the above criteria are not satisfied, the lease contract will be considered an operating lease.

The Internal Revenue Services have the power to reclassify the type of lease the company reports from an operating lease to a capital lease and therefore reject the deductions of lease payments from the income statement.

The tax implication of this reclassification increases the taxable income and tax liabilities. 

These are the following assets that are often being rented out and classified as Operating Income: Real-Estate, Machinery & Equipment (vehicles, production equipment, office equipment), Aircraft, etc.

Operating Lease vs. Capital Lease

operating lease

Operating Lease and Capital Lease have different accounting treatments based on US GAAP, which can mean different impacts on the taxable income.

An operating lease is recognizable as an operating expense of a lessee which is a line item in the Income Statement.

Other characteristics of an Operating Lease are: 

  • Ownership: the ownership remains with the lessor at the end of the lease term.
  • Bargain Purchase Option: the lease agreement does not contain a bargain purchase option condition.
  • Term: should not be more than 75% of the asset’s economic life.
  • Present Value: the Present value must not be more than 90% of the lease payment’s fair market value.
  • Accounting: the payments made are treated as operating expenses and included as part of the Income Statement. There is no ownership risk involved with these transactions.
  • Tax: the payments made by the lessee in the lease transaction are recorded as a rent expense.
  • Risks/benefits: the authority given to the lessee is only the right to use. As such, the risks or benefits related to the physical assets remain to the lessor.

A Capital Lease or Finance Lease, on the other hand, constitutes a long-term agreement or ownership of the asset.

The accounting treatment for this type of lease is a long-term loan or a possible transfer of ownership.

Because it is treated as a debt in the company’s books, the lessee’s responsibility is to pay the interest expense of the related assets.

A capital lease is recorded in the balance sheet and other characteristics of a Capital Lease include the following:

  • Ownership: there is a possibility of transfer of ownership.
  • Bargain Purchase Option: the lessee has the option to buy the rented asset at an amount that is less than its fair market value. 
  • Term: the lease terms exceed the asset’s useful life by 75%.
  • Present Value: the Present value exceeds the asset’s original cost by 90%.
  • Accounting: The treatment of the lease is recorded as a leased asset for assets while the lease payment is part of the liability account. Both account titles are included in the Balance Sheet.
  • Tax: the lessee also records depreciation and interest expense, just like the owner.
  • Risks/benefits: Because there is a transfer of ownership, the ownership risks and benefits are also passed on to the lessee. The lessee will have to pay the necessary maintenance fees, insurance fees, and taxes.

Special Considerations

The FASB revised its rulings about lease contracts that took effect on December 15, 2018.

The standard specifies that long-term leases (one year or more) must be capitalized while short-term leases remain to be part of the lessee’s operating expenses.

Other revisions to the standards are the following:

  • Amended the “bright light” test to include the lessee’s right to control the asset. 
  • An additional definition for indirect cost is provided that could result in fewer capitalization of indirect costs. 
  • A revenue requirement must be met before a successful sale or leaseback transaction should happen.
  • The standard requires both parties’ new financial quantitative and qualitative disclosures in the financial statement.

What Are the Key Characteristics that Define an Operating Lease?

GAAP specifies the requirements that classify a lease contract as an operating lease.

The rented item/property is not recognized as part of the lessee’s assets.

Lease payments are recorded in the Income Statement as an operating expense.

As for the ownership of the asset, it remains to the lessor at the end of the lease term and no bargain purchase option is granted to the lessee.

The term shall not be more than 75% of the asset’s economic life and the present value should not be more than the asset’s fair market value by 90%.

How Does GAAP Define a Capital Lease?

GAAP recognizes the rented item/property as a long-term loan or ownership and requires the same to be included on the Balance Sheet.

Capital leases correspond to interest expenses, while the asset is treated as the lessee’s ownership.

At the end of the term of the lease, the ownership of the asset will be transferred to the lessee.

In the lease agreement, the asset may be obtained by the lessee at an amount that is less than its fair market value called the bargain purchase option.

Before it can be considered a capital lease, the lease term must equal or exceed the asset’s useful life by 75%, and the Present Value of the lease payment must also equate to or exceed the asset’s original cost by 90%.

What Are the Advantages of an Operating Lease?

The various advantages of entering into an Operating Lease are:

  • Since there is no transfer of ownership, the lessee may change the asset or upgrade it according to their needs and avoid the risk of an asset’s obsolescence.
  • Lease payments are recognizable as operating expenses that could be used to decrease tax liability. 
  • Ownership risks will remain with the lessor and the only obligation of the lessee is the maintenance of such an asset. 

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  1. NYU Stern "Operating versus Capital Leases" Page 1 . August 30, 2022

  2. NYU Stern "Dealing with Operating Leases in Valuation" White paper. August 30, 2022