Operating leases

Definition

Operating leases are rental agreements in which the lessee pays for the right to use an asset without taking on the risks and rewards of ownership. Unlike finance leases, operating leases do not require the asset to be recorded on the lessee's balance sheet, which can be beneficial for companies looking to keep their liabilities low and maintain a strong financial position.

5 Must Know Facts For Your Next Test

1. Operating leases are typically shorter in duration compared to finance leases and can provide flexibility for lessees who may need access to assets without long-term commitments.
2. Under operating leases, lease payments are considered operating expenses, which can affect a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA).
3. Since operating leases are not capitalized, they allow companies to avoid increasing their reported debt levels, making their financial statements appear more favorable.
4. The new lease accounting standards (ASC 842 and IFRS 16) have changed how operating leases are reported, requiring lessees to recognize lease liabilities and right-of-use assets on their balance sheets, thus reducing off-balance sheet financing benefits.
5. Operating leases are commonly used for assets like office space, equipment, and vehicles, making them a popular choice for businesses that prefer flexibility over ownership.

Review Questions

• How do operating leases differ from finance leases in terms of accounting treatment and financial reporting?
  • Operating leases differ from finance leases primarily in how they are treated on financial statements. Operating leases allow the lessee to avoid recording the leased asset and liability on their balance sheet, making them appear less leveraged. In contrast, finance leases require both the asset and liability to be recognized on the balance sheet, impacting key financial ratios. This distinction is crucial for understanding how businesses manage their balance sheets and maintain desired financial positions.
• What are the implications of the new lease accounting standards on operating leases for financial reporting?
  • The new lease accounting standards, ASC 842 and IFRS 16, significantly impact how operating leases are reported. Companies must now recognize lease liabilities and right-of-use assets on their balance sheets, which reduces the ability to leverage off-balance sheet financing. This change enhances transparency but may lead to higher reported debt levels and alter financial ratios such as leverage and return on assets. Companies must adapt their strategies to accommodate these new requirements.
• Evaluate the strategic advantages and disadvantages of using operating leases as a financing option for businesses.
  • Operating leases offer several strategic advantages for businesses, including improved cash flow management, flexibility in asset usage without long-term commitments, and maintaining lower reported debt levels. However, disadvantages include potentially higher overall costs compared to ownership over time and less control over the leased assets. Additionally, with changes in accounting standards requiring recognition of lease liabilities, companies must carefully assess how operating leases fit into their overall financing strategies while balancing these pros and cons.

Related terms

Finance leases: Leases that transfer substantially all the risks and rewards of ownership of an asset to the lessee, leading to the asset being recorded on the balance sheet.

Capital lease: A type of lease that is treated as a purchase of an asset for accounting purposes, which typically involves a transfer of ownership at the end of the lease term.

Off-balance sheet financing: A financial strategy where liabilities and assets are not recorded on the balance sheet, often used to improve financial ratios and limit risk exposure.