Operating leases: Overview, definition, and example
What is an operating lease?
An operating lease is a type of lease agreement in which the lessee (the renter or user) rents an asset, such as equipment, vehicles, or real estate, for a period shorter than the asset’s useful life. The lease payments typically cover the asset's depreciation and the lessor's profit, but the lessee does not assume ownership or the risks and rewards associated with owning the asset. At the end of the lease term, the asset is returned to the lessor, and the lessee generally has the option to renew the lease, purchase the asset, or lease a different asset.
Operating leases are commonly used for assets that are needed for a limited time or that will be replaced or upgraded frequently, such as office equipment, vehicles, or computers.
Why are operating leases important?
Operating leases are important because they provide businesses and individuals with flexibility and lower upfront costs compared to purchasing assets. Instead of having to invest a large amount of capital in acquiring equipment or property, the lessee can make regular lease payments over a fixed period. This helps improve cash flow, as the lessee does not have to pay the full purchase price upfront.
Additionally, operating leases typically do not require the lessee to account for the asset on their balance sheet as they are considered off-balance-sheet financing. This can make the lessee’s financials look stronger, with fewer liabilities. For businesses, operating leases provide the ability to use high-value assets without taking on the financial responsibility of ownership.
Understanding operating leases through an example
Imagine a business that needs several delivery trucks for a two-year period. Rather than purchasing the trucks outright, the company enters into an operating lease agreement with a leasing company. The lease payments cover the use of the trucks, but the business does not own them and does not have to worry about selling or maintaining them after the lease term expires. At the end of the lease, the business can either return the trucks, lease new ones, or extend the lease term.
In another example, a tech company might enter into an operating lease for office equipment such as computers and printers. The lease allows the company to use the equipment for a set period, after which it can return the equipment and lease upgraded models, without having to worry about obsolescence or resale.
Example of an operating lease clause
Here’s how an operating lease clause might appear in a contract:
“The Lessee agrees to lease the equipment from the Lessor for a period of 36 months, with monthly payments of $500. Upon expiration of the lease term, the Lessee shall return the equipment to the Lessor. The Lessee shall have no option to purchase the equipment at the end of the lease term.”
Conclusion
Operating leases are a practical solution for businesses and individuals who need to use assets without taking on the responsibilities of ownership. By offering flexibility, lower upfront costs, and potential tax benefits, operating leases are a popular option for renting equipment, vehicles, and property. The lessee benefits from using the asset without committing to long-term ownership, while the lessor maintains ownership and can reuse or resell the asset after the lease term ends.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.