Operating Lease

What Is an Operating Lease?

An operating lease is a contract in which the owner of an asset, the lessor, allows another party, the lessee, to use that asset for a defined period in exchange for regular payments. Unlike a purchase or a finance lease, the lessee does not gain ownership at the end of the term. The asset returns to the lessor, who usually keeps the asset on its own books and continues to depreciate it. Common examples include office space, vehicles, aircraft, and computer hardware.

How It Works

The lessee makes periodic payments, often monthly, for the length of the agreement. At the end of the term, the lessee typically returns the asset, may renew the lease, or may have the option to buy it at market value. Because the lessee is simply renting the asset, the lessee's balance sheet has historically shown only the rental expense rather than the full asset and debt. Accounting standards have changed in recent years, and many operating leases now must be recorded on the balance sheet as a right-of-use asset and a lease liability. Even so, the payments are still generally recognized as an operating expense on the income statement over the lease term.

Why It Matters to Investors

Operating leases affect how a company's financial health is read. Lease payments reduce operating income, so a company with heavy lease commitments may show different operating margin figures than a company that owns similar assets. Analysts often review the lease obligations disclosed in company filings when comparing firms, since these commitments represent a real, ongoing cost even when they do not appear as traditional debt.

Advantages and Disadvantages

Operating leases can preserve capital, because the business does not need to spend cash up front to acquire an asset. They also make it easier to upgrade equipment as technology changes. The trade-offs include paying for the use of an asset over time without building equity in it, and the possibility that total payments over the life of the lease exceed the cost of buying outright. Lessees must also honor the contract's terms, which may include restrictions on how the asset is used or maintained.