WHAT IS OPERATING LEASE (OL)?

An operating lease is a contract that allows for the use of an asset but does not convey ownership rights of the asset.

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KEY TAKEAWAYS

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• An operating lease is a contract that permits the use of an asset without transferring the ownership rights of said asset.

• GAAP rules govern accounting for operating leases.

• A new FASB rule, effective Dec. 15, 2018, requires that all leases 12 months and longer must be recognized on the balance sheet.

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How Operating Leases Work

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Operating leases are considered a form of off-balance-sheet financing. This means a leased asset and associated liabilities (i.e. future rent payments) are not included on a company's balance sheet. Historically, operating leases have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets, thereby keeping their debt-to-equity ratios low.

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To be classified as an operating lease, the lease must meet certain requirements under generally accepted accounting principles (GAAP) that exempt it from being recorded as a capital lease. Companies must test for four criteria—known as the “bright line” test—that determine whether rental contracts must be booked as operating or capital leases. Current GAAP rules require companies to treat leases as capital leases if:

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• There is an ownership transfer to the lessee at the end of the lease;

• The lease contains a bargain purchase option;

• The lease life exceeds 75% of the asset's economic life;

• The present value (PV) of the lease payments exceed 90% of the asset's fair market value.

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If none of these conditions are met, then the lease must be classified as an operating lease. The Internal Revenue Service (IRS) may reclassify an operating lease as a capital lease to reject the lease payments as a deduction, thus increasing the company's taxable income and tax liability.

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Typically, assets that are rented under operating leases include real estate, aircraft, and equipment with long, useful life spans—such as vehicles, office equipment, and industry-specific machinery.

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Operating Lease vs. Capital Lease

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U.S. GAAP accounting treatments for operating and capital leases are different and can have a significant impact on businesses' taxes. An operating lease is treated like renting—lease payments are considered as operating expenses. Assets being leased are not recorded on the company's balance sheet; they are expensed on the income statement. So, they affect both operating and net income. Other characteristics include:

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• Ownership: Retained by the lessor during and after the lease term.

• Bargain purchase option: Cannot contain a bargain purchase option.

• Term: Less than 75% of the asset’s estimated economic life.

• Present value: PV of lease payments is less than 90% of the asset's fair market value.

• Accounting: No ownership risk. Payments are considered as operating expenses; shown in the profit and loss statement (P&L) on the balance sheet.

• Tax: Lessee considered to be renting; lease payment treated as a rental expense.

• Risks/benefits: Right to use only. Risks/benefits remain with the lessor. Lessee pays maintenance costs.

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In contrast, a capital lease is more like a long-term loan, or ownership. The asset is treated as being owned by the lessee and is recorded on the balance sheet. Capital leases are counted as debt. They depreciate over time and incur interest expenses. Other characteristics include:

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• Ownership: Might transfer to the lessee at end of the lease term.

• Bargain purchase option: Enables lessee to buy an asset at less than fair market value.

• Term: Equals or exceeds 75% of the asset's estimated useful life.

• Present value: PV of lease payments equals or exceeds 90% of the asset's original cost.

• Accounting: Lease is considered an asset (leased asset) and liability (lease payments). Payments are shown on the balance sheet.

• Tax: As the owner, lessee claims depreciation expense and interest expense.

• Risks/benefits: Transferred to the lessee. Lessee pays maintenance, insurance, and taxes.

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Special Considerations

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Effective Dec. 15, 2018, the FASB revised its rules governing lease accounting. Most significantly, the standard now requires that all leases—except short-term leases of less than a year—must be capitalized. Other changes include the following:

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• Amends the bright-line test to help determine whether or not a lessee has the right to control the identified asset.

• Installs a new definition of indirect costs that likely would result in fewer indirect costs being capitalized.

• Requires the transfer of the asset to meet certain revenue recognition requirements in order for a sale or leaseback to occur.

• Requires a significant number of new financial statement disclosures, both quantitative and qualitative, for both parties.

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What Are the Key Characteristics that Define an Operating Lease?

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To be classified as an operating lease, the lease must meet certain requirements under generally accepted accounting principles (GAAP). An operating lease is treated like renting—lease payments are considered as operating expenses. Assets being leased are not recorded on the company's balance sheet; they are expensed on the income statement. So, they affect both operating and net income. It is retained by the lessor during and after the lease term and cannot contain a bargain purchase option. The term is less than 75% of the asset’s estimated economic life and the present value (PV) of lease payments is less than 90% of the asset's fair market value.

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How Does GAAP Define a Capital Lease?

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GAAP views a capital lease more like a long-term loan, or ownership. The asset is treated as being owned by the lessee and is recorded on the balance sheet. Capital leases are counted as debt. They depreciate over time and incur interest. The lessor can transfer it to the lessee at the end of the lease term and it may contain a bargain purchase option that enables the lessee to buy it below fair market value. The term equals or exceeds 75% of the asset's estimated useful life. and the present value (PV) of lease payments equals or exceeds 90% of the asset's original cost.

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What Are the Advantages of an Operating Lease?

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Operating leases have certain advantages. Chief amongst them is that they allow companies greater flexibility to upgrade assets, like equipment, which reduces the risk of obsolescence. There is no ownership risk and payments are considered to be operating expenses and tax-deductible. Finally, risks/benefits remain with the lessor as the lessee is only liable for the maintenance costs.

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