What is an Operating Lease?

Operating Lease

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Operating Lease

An operating lease is a type of lease where the lessor (or the owner of the asset) retains the ownership of the asset, and the lessee (or the renter) only rents the asset for a period of time that is significantly less than the asset’s useful life.

The lessee is able to use the asset in exchange for regular lease payments, but the asset goes back to the lessor at the end of the lease term. The lessor is responsible for maintenance, taxes, and insurance.

Operating leases are often used for assets like vehicles, office space, and equipment.

One key characteristic of operating leases is that they are not recorded on the lessee’s balance sheet. Instead, the lease payments are considered operating expenses and are recorded on the income statement. This is different from a capital lease (also known as a finance lease), where the lessee treats the leased asset as if it were owned, and the asset and the corresponding lease liability are recorded on the lessee’s balance sheet.

As of a change in accounting standards by the Financial Accounting Standards Board (FASB) in the U.S. (ASC 842) and the International Accounting Standards Board (IASB) internationally (IFRS 16) that came into effect in 2019 and 2021 respectively, both operating leases and finance leases must now be reported on a company’s balance sheet. However, they are still treated differently on the income statement and statement of cash flows. This change is a major shift in how companies account for leases.

Remember to always check the most up-to-date accounting rules and standards when dealing with lease accounting, as regulations and standards can change.

Example of an Operating Lease

Let’s say a company, ABC Corp., needs a fleet of delivery vans for its operations, but it doesn’t want to purchase the vehicles outright. So, ABC Corp. enters into an operating lease agreement with XYZ Leasing, a company that leases vehicles. The terms of the lease are for three years, and ABC Corp. will make monthly payments of $2,000 for the use of the vehicles.

Under the terms of the lease, XYZ Leasing retains ownership of the vehicles. They are responsible for any taxes and insurance related to the vehicles, as well as any maintenance and repairs that the vehicles may need.

ABC Corp. is responsible for making the monthly payments and using the vehicles in accordance with the terms of the lease. At the end of the three-year lease term, ABC Corp. will return the vehicles to XYZ Leasing.

On ABC Corp’s financial statements, the monthly lease payments of $2,000 are recorded as an operating expense on the income statement. Prior to the accounting standard changes in 2019 and 2021, the lease would not appear on the balance sheet, but with the new rules, a right-of-use asset and a corresponding lease liability would now be recognized on the balance sheet.

This is a simplified example, but it illustrates the basic principle of an operating lease.

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