# Operating Lease: How It Works and Differs From a Finance Lease

![Operating Lease](https://www.investopedia.com/thmb/ANfUoHh4wMKMsOf_U2awNkC_MnM=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/operating-lease-4191822-1-c4b12434faf241c1ba94b5709525034a.jpg)

*— Investopedia / Joules Garcia*

> **Definition**
>
> An operating lease is a contract that allows for an asset's use but doesn't convey rights of ownership.

## What Is an Operating Lease?

An operating lease allows a business to use an asset without incurring the high expenses involved in purchasing it. It's a contract that allows for an asset's use but doesn't convey ownership rights.

The business that leases the asset is referred to as the lessee and the business that loans it under a lease is the lessor. The responsibilities of each party in the agreement are spelled out in the lease contract and documents but the lessee must generally maintain the asset to ensure that it remains in operational condition less any normal wear and tear.

### Key Takeaways

*   An operating lease is a contract that permits the use of an asset without transferring its ownership rights.
*   A finance lease is a contract that permits the use of an asset and transfers ownership after the lease period is complete and the lessor meets all other contract obligations.
*   GAAP rules govern accounting for operating leases.
*   All leases that are 12 months or longer must be recognized on the balance sheet.
*   Leases shorter than 12 months can be recognized as expenses using the straight-line method.

## How Operating Leases Work

Operating leases have historically enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets. This helps to keep their [debt-to-equity ratios](https://www.investopedia.com/terms/d/debtequityratio.asp) low. This changed in 2016, however, with the release of Accounting Standards Update 2016-02, Leases (Topic 842), and amendments that were made in the following years.

Operating leases are assets rented by a business where ownership of the asset isn't transferred when the rental period is complete. Assets rented under operating leases typically include real estate, aircraft, and equipment with long, useful life spans such as vehicles, office equipment, or industry-specific machinery.

An operating lease is essentially a contract for a company to use an asset and return it in a similar condition to the lessor. This agreement is beneficial for the lessee, particularly when it has expensive equipment or other assets that must be replaced regularly.

## Advantages and Disadvantages of Operating Leases

Advantages

*   No ownership
    
*   Renting may be cheaper
    
*   Short-term
    

Disadvantages

*   No equity
    
*   Financing costs
    
*   Might pay more than market value
    
*   Continuous terms renegotiation
    

### Advantages Explained

*   **No ownership**: Not owning an asset can be beneficial because you won't have to pay for repairs or maintenance.
*   **Renting may be cheaper**: Renting is generally much more affordable than purchasing. This benefits smaller or newer businesses that don't yet have the financial strength to collect expensive assets.
*   **Short terms**: You'll only have to [lease the asset](https://www.investopedia.com/terms/l/leasehold.asp) for as long as you need it, reducing the overall costs of purchasing, maintaining, and selling it if and when you no longer do.

### Disadvantages Explained

*   **No equity**: You don't gain any equity when you lease.
*   **Financing costs**: You might incur financing costs such as interest with a lease.
*   **Might pay more than market value**: The total cost could be more than the market value at the time the lease originated depending on how long an asset is leased.
*   **Continuous terms renegotiation**: Many leases are short-term and the lessor and lessee will renegotiate terms every time the lease expires. This provides the lessor with an opportunity to raise rates or fees.

## Example of an Operating Lease

A restaurant needs power to ensure that it can operate during outages so food won't spoil when refrigeration systems are offline. Power keeps a restaurant from losing business and costly supplies.

A restaurant owner should ensure that they have a generator for this purpose but they might need a much bigger and more expensive one. They'll have to power freezers, refrigerators, ovens, heating lamps, lights, air conditioning, water heaters, and computer systems. Large generators can cost tens of thousands of dollars so the owner might choose to lease one.

> **Important**
>
> The owner would make rental payments to an equipment rental service and account for it as an asset and a liability on their balance sheet because they'll likely need it for more than one year.

## Accounting for an Operating Lease

Operating lease accounting changed in 2016 when the Federal Accounting Standards Board released ASC Topic 842, Leases. The standard provided guidance when accounting for leases. The lease and the corresponding asset value would be required to be reported on the [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp). Leases for less than 12 months can be recognized as an expense using the straight-line basis method, however.

The lessee must account for it as a lease liability and an asset right-of-use on the balance sheet when a lease of more than 12 months is initiated. The intent behind the change is to reduce the ability of organizations to manipulate the balance sheet and create a more faithful representation of a business's rights and obligations.

This standard does not apply to:

*   Intangible asset leasing
*   Exploration for or use of nonregenerative resources
*   Biological assets leases
*   Inventory leases
*   Assets under construction

## Operating Lease vs. Finance Lease

Operating and finance leases are similar for accounting purposes. They're both treated as a right-of-use asset and a lease liability. They're recorded on the company's balance sheet so they can affect a company's financial ratios as a result, such as debt-to-equity, return-on-assets, or solvency if companies use a significant amount of leased assets. There are several differences, however.

Operating lease characteristics include:

*   **Ownership**: It's retained by the lessor during and after the lease term.
*   **Bargain purchase options**: Operating leases cannot contain a bargain purchase option.
*   **Terms**: Terms are less than 75% of the asset’s estimated economic life.
*   **Present value**: The PV of lease payments is less than 90% of the asset's [fair market value](https://www.investopedia.com/terms/f/fairmarketvalue.asp).
*   **Risks/benefits**: The lessee has only the right to use the asset. All risks and benefits remain with the lessor.

Finance lease characteristics include:

*   **Ownership**: Ownership transfers to the lessee at the end of the lease term.
*   **Bargain purchase options**: These options enable the lessee to buy an asset at less than fair market value.
*   **Terms**: The terms equal or exceed 75% of the asset's estimated useful life.
*   **Present value**: PV of lease payments equals or exceeds 90% of the asset's original cost.
*   **Risks/benefits**: All risk is transferred to the lessee.

## What Is the Meaning of Operating Lease?

An operating lease is like renting. A business can lease assets it needs to operate rather than purchase them.

## What Is the Difference Between an Operating Lease and a Finance Lease?

A finance lease transfers the asset and any risk or return to the lessee. Ownership is transferred in a financial lease to the entity that leases the asset. Ownership remains with the lessor, the entity that leased the asset to the lessee, in an operating lease.

## What Are Operating Leases Used for?

Operating leases give companies greater flexibility to upgrade assets like equipment which reduces the risk of obsolescence. There's no ownership risk and payments are considered to be operating expenses so they're tax deductible. The risks and benefits remain with the lessor. The lessee is only liable for the maintenance costs.

## The Bottom Line

Operating leases are agreements that a business might use to rent assets rather than buy them outright. Many small and medium-sized businesses can't afford some of the expensive assets they need to operate so it makes sense for them and it's cheaper to rent them.

Businesses must account for operating leases as assets and liabilities for assets that are leased for more than 12 months. This standard makes their balance sheet a more realistic representation of the company's worth and obligations regarding its leases.

> **Article Sources**
>
> 1.  Financial Accounting Standards Board. "[No. 2016-02 February 2016: Leases (Topic 842)](https://www.fasb.org/Page/ShowPdf?path=ASU+2016-02_Section+A.pdf&title=Update+2016-02%E2%80%94Leases+%28Topic+842%29+Section+A%E2%80%94Leases%3A+Amendments+to+the+FASB+Accounting+Standards+Codification%C2%AE&acceptedDisclaimer=true&Submit=)."
>     
> 2.  Financial Accounting Standards Board. "[No. 2016.02, February 2016: Leases (Topic 842)](https://fasb.org/Page/ShowPdf?path=ASU+2016-02_Section+A.pdf)." Page 3.
>     
> 3.  Financial Accounting Standards Board. "[No. 2016.02, February 2016: Leases (Topic 842)](https://fasb.org/Page/ShowPdf?path=ASU+2016-02_Section+A.pdf)." Pages 2-4.
>     
> 4.  Financial Accounting Standards Board. "[No. 2016.02, February 2016: Leases (Topic 842)](https://fasb.org/Page/ShowPdf?path=ASU+2016-02_Section+A.pdf)." Page 13.
>     
> 5.  The CPA Journal. "[Accounting for Operating Leases | Initial Observations](https://www.cpajournal.com/2022/01/12/accounting-for-operating-leases/)."
>     
> 6.  Oklahoma State University. "[Capital Leases](https://extension.okstate.edu/fact-sheets/capital-leases.html)."