Operating lease

The determination of whether a lease is a finance (also called capital) lease or an operating lease from an accounting point of view is defined in the United States by Statement of Financial Accounting Standards No. 13 (FAS 13). In countries covered by International Financial Reporting Standards, the tests are defined in IAS 17. In July 2006, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) announced the commencement of a joint project to comprehensively reconsider lease accounting. In July 2008, the boards decided to defer any changes to lessor accounting, while continuing with the project for lessee accounting, with the stated intention to recognise an asset and liability for all lessee leases (in essence, eliminating operating lease accounting). This culminated in the issuance of IFRS 16 and FASB Topic 842. Both are effective January 1, 2019. The similarity in the two pronouncements is that leases, which previously qualified as operating leases- and hence resulted in off balance sheet treatment, are now to be capitalized by the lessee.

Unlike a finance lease (differs by geography & whether a small residual value), at the end of the operating lease the title to the asset does not pass to the lessee, but remains with the lessor. Accordingly, at the end of an operating lease, the lessee has several options:

• Return of the equipment
• Renewal of the lease
• Purchase of the equipment (not available in all geographies)

Operating leases, where the lessor takes a residual position, offer a host of benefits to the lessee the type of which finance leases do not. Other benefits of an operating lease vs a finance lease are that working capital is maintained, rentals will be fully tax-deductible if the equipment is used to generate taxable income and there is no resale value risk as the financier will own the asset at the end of the operating lease.