The financial accounting term operating lease is used to describe one of several lease arrangements that a company can hold. Operating leases are used to acquire assets on a relatively short-term basis. The cost of an operating lease appears as an expense on the income statement.
The Financial Accounting Standards Board rules allow companies two methods to account for leases: capital and operating. If a lease does not qualify as a capital lease, then it should be classified as an operating lease.
The following tests are used to determine if a lease is to be treated as a capital lease:
- The term of the lease exceeds 75% of the life of the asset
- There is a transfer of ownership to the lessee at the end of the lease's term
- The agreement includes an option to purchase at a "bargain price," which is below fair market value
- The discounted present value of the lease payments exceed 90% of the asset's fair market value
If none of the above criteria apply, the lease should be treated as an operating lease.
When compared to a capital purchase, or finance lease, an operating lease provides companies with two significant advantages:
- Balance Sheet Impairment: operating leases are treated as an expense. As such, they appear on the income statement and have no effect on the company's balance sheet.
- Cash Flow: operating leases avoid the large upfront payment that occurs with a capital purchase.