What is an operating lease?
An operating lease is a contract that allows the use of an asset but does not confer ownership rights over the asset. Operating leases are recorded as off-balance sheet financing, which means that a leased asset and the associated liabilities of future rents are not included in the balance sheet of a business, in order to maintain a low debt / equity ratio. Historically, operating leases have enabled American companies to prevent billions of dollars of assets and liabilities from appearing on their balance sheets.
Under a new rule of the Financial Accounting Standards Board (FASB) in effect on December 15, 2020, public companies must recognize all leases on the balance sheet, unless they are less than 12 months old.
Understanding operating leases
Is the arrangement a lease? If yes, what type of lease should it be?
To be classified as an operating lease, the lease must meet certain requirements under generally accepted accounting principles (GAAP) that exempt it from being accounted for as a capital lease. Businesses need to test four criteria – “clear line” tests – which determine whether leases should be recorded as operating leases or capital leases. Current GAAP rules require companies to treat leases as capital leases if:
- There is a transfer of ownership to the tenant at the end of the lease;
- The lease contains a bargain purchase option;
- The life of the lease exceeds 75% of the economic life of the asset; or,
- The current value (PV) of the rents exceeds 90% of the fair market value of the asset.
If none of these conditions are met, the lease must be classified as operating lease. The Internal Revenue Service (IRS) may reclassify an operating lease as a capital lease in order to reject rental payments as a deduction, thereby increasing the business’s taxable income and tax payable.
What types of assets use operating leases?
Typically, assets leased under operating leases include real estate, aircraft and long-lived equipment, such as industry-specific vehicles, office equipment and machinery.
Differences between operating leases and capital leases
The US GAAP accounting treatments for operating leases and capital leases are different and can have a significant impact on corporate taxes.
An operating lease is treated as a rental – rental payments are considered operating expenses. Leased assets are not recorded on the company’s balance sheet; they are expensed in the income statement. They therefore affect both operating profit and net profit. Other features include:
- Ownership: Maintained by the lessor during and after the term of the lease.
- Reduced purchase option: May not contain option to purchase on favorable terms.
- Term: Less than 75% of the estimated economic life of the asset.
- Current value: The VA of lease payments is less than 90% of the fair market value of the asset.
- Accounting: No property risk. Payments considered as operating expenses; presented in the income statement (P&L) on the balance sheet.
- Tax: The tenant is considered to be a tenant; rental payment treated as rental expense.
- Risks / benefits: Right of use only. The risks / benefits remain with the lessor. The tenant pays the maintenance costs.
In contrast, a capital lease is more like a long-term loan or property. The asset is treated as belonging to the lessee and is entered in the balance sheet. Capital leases are accounted for as debt. They depreciate over time and incur interest charges. Other features include:
- Ownership: Can be transferred to the tenant at the end of the lease term.
- Reduced purchase option: Allows the tenant to buy an asset at a price below fair market value.
- Term: Equals or exceeds 75% of the estimated useful life of the asset.
- Current value: The PV of the lease payments is equal to or greater than 90% of the original cost of the asset.
- Accounting: Lease considered as an asset (leased asset) and a liability (lease payments). Payments are shown on the balance sheet.
- Tax: As the owner, the tenant claims depreciation charges and interest expense.
- Risks / benefits: Transferred to the tenant. The tenant pays maintenance, insurance and taxes.
Key points to remember
- An operating lease is a contract which allows the use of an asset but which does not confer ownership rights on the asset.
- GAAP rules govern the accounting for operating leases.
- A new FASB rule, effective December 15, 2020, requires that all leases, unless they are less than 12 months old, must be recognized in the balance sheet.
What is the effect of the new FASB rule
On December 15, 2020, the FASB revised its rules governing the accounting for leases. Most importantly, the standard now requires that all leases, except short-term leases of less than one year, be capitalized. The other changes are as follows:
- There is a difference in the clear line test which determines whether a lessee has the right to control the identified asset.
- There is a new definition of indirect costs that would likely result in less capitalized indirect costs.
- Under the new rule, in order for a sale or sale-leaseback to take place, the asset transfer must meet certain revenue recognition requirements.
- The new rule requires a significant amount of new information to be provided in the financial statements, both quantitative and qualitative, for both parties.