Operating Lease

An Operating Lease is a contractual agreement in which the lessor (owner) grants the lessee (user) the right to use an asset for a specified period without transferring ownership of the asset. It is commonly used for assets such as machinery, vehicles, aircraft, office equipment, and property. Under an operating lease, the lease term is typically shorter than the useful life of the asset, and at the end of the lease period, the asset is usually returned to the lessor.
Operating leases are designed to provide businesses with flexibility in acquiring and using assets without the long-term commitment or financial burden of ownership. They are often classified as off-balance-sheet financing, though accounting standards now require greater transparency regarding leased assets.

Definition and concept

An operating lease is an arrangement where the lessee pays periodic rent to the lessor for the use of an asset, while the risks and rewards of ownership remain with the lessor. Unlike a finance lease (or capital lease), the asset is not capitalised by the lessee, and the payments are treated as operating expenses rather than as repayments of principal and interest.
In simple terms, the lessee uses the asset temporarily without acquiring it, while the lessor retains ownership and may lease it to other parties after the contract ends.

Key characteristics

An operating lease typically exhibits the following features:

• Ownership: The asset remains the property of the lessor throughout the lease term.
• Lease term: Usually shorter than the economic life of the asset.
• Maintenance and insurance: Generally the responsibility of the lessor, depending on contract terms.
• Cancellation: The lease may be cancellable before expiry with prior notice.
• Residual value: At the end of the lease, the asset retains significant residual value, which remains with the lessor.
• Accounting treatment: Lease payments are recorded as an expense in the lessee’s income statement; the asset and liability are not capitalised under older accounting standards.

Example:A company leases photocopy machines for three years from a supplier. The supplier (lessor) maintains ownership and provides servicing. The company (lessee) simply pays a monthly rental fee and returns the machines at the end of the lease.

Parties involved

1. Lessor: The owner of the asset who leases it to another party in exchange for periodic payments.
2. Lessee: The party that uses the asset for an agreed period and pays the rental charges.
3. Asset: The property or equipment leased, which can range from real estate and vehicles to IT hardware or aircraft.

Accounting treatment

Under previous accounting standards (IAS 17 / AS 19):

• Lessees recorded lease payments as expenses in the profit and loss account.
• The leased asset and corresponding liability were not shown on the balance sheet, giving rise to “off-balance-sheet financing.”
• Lessor recorded the asset on its balance sheet and recognised lease income over the lease term.

Under current standards (IFRS 16 / Ind AS 116):

• Lessees must capitalise almost all leases, recognising a “right-of-use asset” and a “lease liability” on their balance sheet.
• Only short-term leases (less than 12 months) or low-value leases qualify as operating leases without capitalisation.
• Lease payments are split into interest expense and amortisation of the right-of-use asset for accounting purposes.

Thus, the distinction between operating and finance leases now lies primarily in the economic substance of the transaction rather than merely its legal form.

Advantages of an operating lease

1. Flexibility: Companies can lease equipment for shorter durations and replace it easily as technology evolves or needs change.
2. No ownership risks: The lessee avoids the risk of obsolescence, maintenance, or asset disposal, which remain with the lessor.
3. Improved liquidity: Leasing avoids heavy capital expenditure, conserving cash flow and allowing funds to be allocated to other strategic uses.
4. Tax benefits: Lease payments are typically treated as deductible operating expenses, reducing taxable income.
5. Off-balance-sheet financing (under older rules): Allowed companies to maintain lower reported debt levels and improve financial ratios such as return on assets (ROA).

Disadvantages of an operating lease

1. Higher total cost: Over time, total payments may exceed the purchase price of the asset.
2. No ownership rights: The lessee cannot build equity in the asset or benefit from its resale value.
3. Limited control: Restrictions may exist on asset usage, modification, or relocation.
4. Accounting changes: With the implementation of IFRS 16 and Ind AS 116, most leases now appear on balance sheets, reducing the earlier financial flexibility advantage.
5. Termination penalties: Early cancellation may attract penalties or forfeiture of deposits.

Operating lease vs. finance lease

Examples of operating leases in practice

• Airline industry: Airlines lease aircraft for limited periods to adjust fleet capacity without long-term ownership costs.
• Automotive sector: Companies lease vehicles for employee use rather than purchasing them outright.
• IT and office equipment: Businesses rent computers, servers, or copiers, returning or upgrading them periodically.
• Retail and property: Shops lease commercial spaces on short- to medium-term operating leases.

Economic significance

Operating leases provide a mechanism for efficient asset utilisation. Lessors can maximise returns by leasing the same asset multiple times, while lessees benefit from operational flexibility and reduced financial risk. The model also supports rapid technological adaptation in industries with short innovation cycles, such as IT or transport.
However, the extensive use of operating leases before the adoption of IFRS 16 raised concerns about transparency and hidden liabilities, prompting accounting reforms to improve disclosure and comparability.

Tax treatment

In most jurisdictions:

• Lease payments are tax-deductible expenses for the lessee.
• The lessor claims depreciation on the leased asset, as ownership remains with them.
• The tax benefits are often reflected in competitive lease pricing structures, allowing cost savings for both parties.

Modern developments

With the global shift to IFRS 16, the boundary between operating and finance leases has narrowed, but operational leasing remains significant in asset-light business models. Companies increasingly use operating leases to manage balance sheets, optimise capital efficiency, and ensure agility in rapidly evolving industries.
Digital platforms and lease management software now facilitate greater transparency, while green leasing initiatives promote environmental sustainability by encouraging the use of energy-efficient leased assets.