Operating lease definition
/What is an Operating Lease?
An operating lease is the rental of an asset from a lessor, but not under terms that transfer ownership of the asset to the lessee. During the rental period, the lessee typically has unrestricted use of the asset, but is responsible for the condition of the asset at the end of the lease, when it is returned to the lessor. An operating lease is especially useful in situations where a business needs to replace its assets on a recurring basis, and so has a need to swap out old assets for new ones at regular intervals. For example, the lessee may have decided to replace the office photocopier once every three years, and so enters into a series of operating leases to continually refresh this equipment. Automobiles are also commonly leased under operating lease arrangements.
Advantages of an Operating Lease
There are several advantages to entering into an operating lease. First, this approach may very well be less expensive than a straight asset purchase, which would require a greater initial cash outflow. An underfunded business will enter into an operating lease for this reason, to minimize the amount of cash it is initially spending. Second, an operating lease allows you to switch over to newer assets when the lease expires. This is important when asset capabilities are constantly being upgraded. Third, you may not want to spend money on maintenance, in which case a short-term operating lease is a great way to get rid of moderately old assets before they become a burden. And finally, a shorter-term lease allows you to use an asset only while you need it, and then hand it back to the lessor when you are done with it; this eliminates the cost of selling the asset to someone else.
Related AccountingTools Course
Accounting for an Operating Lease
When a lessee has designated a lease as an operating lease, the lessee should recognize the following over the term of the lease:
A lease cost in each period, where the total cost of the lease is allocated over the lease term on a straight-line basis. This can be altered if there is another systematic and rational basis of allocation that more closely follows the benefit usage pattern to be derived from the underlying asset.
Any variable lease payments that are not included in the lease liability
Any impairment of the right-of-use asset
At any point in the life of an operating lease, the remaining cost of the lease is considered to be the total lease payments, plus all initial direct costs associated with the lease, minus the lease cost already recognized in previous periods.
After the commencement date, the lessee measures the lease liability at the present value of the lease payments that have not yet been made, using the same discount rate that was established at the commencement date. After the commencement date, the lessee measures the right-of-use asset at the amount of the lease liability, adjusted for the following items:
Any impairment of the asset
Prepaid or accrued lease payments
Any remaining balance of lease incentives received
Any unamortized initial direct costs
The lessor records the asset under an operating lease as a fixed asset on its books, and depreciates the asset over its useful life.