Operating Leases

Years ago, a lease in which the lessee received an equipment operator along with the equipment was called an operating lease. Today, an operating lease (or service lease) is difficult to define precisely, but this form of leasing has several important characteristics.

First of all, with an operating lease, the payments received by the lessor are usually not enough to allow the lessor to fully recover the cost of the asset. A primary reason is that operating leases are often relatively short-term. Therefore, the life of the lease may be much shorter than the economic life of the asset. For example, if you lease a car for two years, the car will have a substantial residual value at the end of the lease, and the lease payments you make will pay off only a fraction of the original cost of the car. The lessor in an operating lease expects to either lease the asset again or sell it when the lease terminates.

A second characteristic of an operating lease is that it frequently requires that the lessor maintain the asset. The lessor may also be responsible for any taxes or insurance. Of course, these costs will be passed on, at least in part, to the lessee in the form of higher lease payments.

The third, and perhaps most interesting, feature of an operating lease is the cancellation option. This option can give the lessee the right to cancel the lease before the expiration date. If the option to cancel is exercised, the lessee returns the equipment to the lessor and ceases to make payments. The value of a cancellation clause depends on whether technological and/or economic conditions are likely to make the value of the asset to the lessee less than the present value of the future lease payments under the lease.

To leasing practitioners, these three characteristics define an operating lease. However, as we will see shortly, accountants use the term in a somewhat different way.

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