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What Is an Operating Lease? Definition & Characteristics Explained

What Is an Operating Lease? Definition & Characteristics Explained

Much of the scientific technology currently available is extremely expensive. Especially for life science companies conducting research without generating profits. Even for those labs with cash flow, it can be financially challenging to buy new equipment using cash, or securing a loan/line of credit. To make matters worse, budgets have shrank or frozen and fundraising and borrowing has become a much more difficult—and often fruitless—undertaking.

With equipment costs being so high, many companies turn to equipment leasing to get what they need. Doing so allows you to continue and accelerate your research, scale operational capabilities, and, ultimately, hit important milestones. It also allows you to preserve working capital and extend cash runway.

There are two primary types of leases: an operating lease and a capital lease, or what is now known as a finance lease.

Most of Excedr’s lease agreements are operating leases, so we have a lot of experience utilizing them and working with the nuances of these agreements for the past decade. In this article, we’ll review:

  • Operating lease definition
  • Criteria and characteristics
  • Accounting for an operating lease under ASC 842
  • The benefits of operating leases

Understanding each lease type will be critical for a few different reasons. The accounting methods used for each will impact your company’s taxes and financial reporting, and knowing the unique characteristics of each lease can make decision-making simpler when it’s time to sign a lease.

Need new or refurbished lab equipment? Excedr leases.

See our equipment list and browse a sample selection of what we can source. Or, if you’re ready, request an estimate.

What Is an Operating Lease?

Lease classification itself is guided using criteria laid out under accounting standards like ASC 842, published by the Financial Accounting Standards Board (FASB), and US Generally Accepted Accounting Principles (GAAP).

An operating lease is a type of lease in which a lessee pays to use an asset for specific period of time, but does not assume ownership of the asset. The lessor, or owner of the asset, retains ownership and is often responsible for maintaining and repairing the asset. It can also be referred to as a fair market value (FMV) lease or rental. They are often contrasted with finance leases, which are more similar to loans and allow the tenant to eventually assume ownership of the asset.

An asset can be defined as “anything of value or a resource of value that can be converted into cash.” Examples include office equipment, industry-specific machinery (such as lab equipment or heavy equipment), various vehicles and aircrafts, and real estate and property.

The term “fair market value lease” can be used to describe an operating lease because, at the end of the lease, the lessee has the option to purchase the equipment at “fair market value.” The term “rental” can also be used because, similar to a rental, an operating lease can be short-term, lasting 12 months or less, and is accounted for similarly on the income statement. However, an operating lease can also be long-term, covering more than 12 months and upwards of 5 or 6 years depending on the company you are leasing through.

Under the guidance of the US GAAP, there are two primary types of lease classifications: operating leases and capital leases.

Each type is classified based on criteria laid out in the lease accounting standard, ASC 842, Leasing, which replaced the previous standard, ASC 840, and was created by the Financial Accounting Standards Board (FASB).

Prior to the update, which became final in 2020, the major difference between a capital lease and operating lease was the accounting treatment of each lease. While there are still some differences, namely the transfer of ownership rights, the new standard has made the treatment of these leases more similar.

A typical operating lease structure can contain different terms, but every contract will include the details regarding your monthly payment amounts owed for the use of the asset, security deposit, and first month’s payment. Furthermore, operating leases will often provide end-of-lease options that give you the choice to:

  • Return the equipment (free of charge)
  • Renew at a discounted rate
  • Or purchase of the equipment for the fair market value (FMV)

We believe in providing these choices to our clients because it gives them more flexibility at the end of the lease term. However, not every operating lease will include end-of-term options (ETO) like these.

Learn about the differences between operating leases and capital leases in our article, "Operating Lease vs. Capital Lease: Differences & Comparisons."

Operating Lease Criteria & Characteristics

The criteria for determining whether a lease is classified as an operating varies depending on the current accounting standards and regulations, which are issued and overseen by the Financial Accounting Standards Board (FASB). The FASB is an independent organization that establishes financial accounting and reporting standards for publicly traded companies and other organizations in the United States.

In 2016, the FASB issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), which established a single lessee accounting model and required lessees to recognize assets and liabilities for leases with terms longer than 12 months. It was first applied to public companies, and then later to private companies, which had to adopt the new standards by January 2022.

According to the latest standard, an operating lease is classified as such so long as none of the following conditions are met:

  • Transference of title/ownership to the lessee: there is a transfer of ownership of the underlying asset to the lessee by the end of the lease term.
  • Bargain purchase option: the lease arrangement grants the lessee an option, which is reasonably certain to be exercised, to purchase the asset at the end of the lease for a price that is well below its FMV.
  • Lease term: the lease term lasts longer than the major part of the asset’s remaining economic life.
  • Present value: the present value of lease payments, plus any applicable residual value guarantee, is greater than or equal to “substantially all” of the FMV of the asset.
  • Asset specialization: the asset is so specialized that it is expected to have no alternative use to the lessor at the end of the lease term.

In other words, if there is:

  • No transfer of ownership.
  • No bargain purchase option.

And:

  • The lease term is less than the major part of the asset’s remaining economic life, or lifetime value.
  • The present value of the lease payments, plus any applicable residual value guarantee (RVG), equals less than the FMV of the asset.
  • The asset is not so specialized it can’t be used after the lease term.

If these criteria are not met, then the lease will, by default, be classified as an operating lease. On the other hand, if one of these conditions is met, such as the transfer of ownership, then the lease will be classified as a capital lease for accounting purposes.

The objective of the latest ASU is to increase transparency and comparability in financial reporting by requiring balance sheet recognition of leases and note disclosure of certain information about lease arrangements.

Under ASC 842, certain “bright lines” have been removed from the test to foster a more principles-based approach to the accounting treatment (more on that later). In addition to removing the bright lines, a new question was added to the test, clarifying whether or not the asset is highly specialized.

Operating Lease Accounting

As mentioned, lease payments under an operating lease are considered operating expenses, and are expensed on the income statement, similar to how rental expenses are accounted for.

ASC 840, the previous accounting standard, did not require these expenses to be recorded on the balance sheet, nor did it require the asset to be listed, leading to eventual criticism of the treatment.

Because ASC 840 did not require the same accounting treatment ASC 842 requires, operating leases were considered a type of off-balance-sheet financing. Simply put, off-balance-sheet financing allows companies to keep financing provided by leases off the balance sheet.

In doing so, companies could keep their debt-to-equity ratios low by treating lease payments as operating expenses, allowing the company to keep the capital it spent on assets, and the assets’ associated liabilities, from being recorded on the balance sheet. This accounting treatment would result in greater flexibility in future financing decisions, potentially cheaper borrowing, and the prevention of breaching loan covenants.

However, users/reviewers of financial statements weren’t able to glean insights from the statements that provided the full picture when it came to a company’s true financial position regarding risk and liabilities.

In some cases, companies’ leases amounted to major obligations for the lessees that were not reported as the debt-type liabilities that they resembled, which made it difficult to compare companies financing their operating assets through rentals versus companies financing through debt.

The previous standard, ASC 840, only required capital leases to be recorded on the balance sheet. This meant operating leases did not need to be recorded, which ultimately led to problems, such as lack of transparency regarding a company’s liabilities.

To reconcile this discrepancy, FASB created ASC 842, which requires companies to report the asset and its associated liability on the balance sheet, providing greater transparency for lease accounting.

FASB requires, under ASC 842, that every lease—except for short-term leases less than 12 months—be included on the balance sheet along with a lease liability and a right-of-use (ROU) asset.

A lease liability represents the lessee’s obligation to make lease payments and is calculated as the present value of all known future lease payments. The ROU asset represents the lessee’s authority to use an asset under the lease agreement, and is measured as the lease liability’s starting amount plus any lease payments made to the lessor before the lease commencement date, plus any initial direct costs incurred, minus any lease incentives received.

The leased asset is represented as a right-of-use (ROA) asset, which signifies the benefits the asset provides over the term of the lease, while the payments are represented as a liability showing the amount owed under the lease agreement.

Now that operating leases realize a liability and asset on the balance sheet, the total assets and liabilities of a company increase. There is little to no impact on debt when transitioning to ASC 842 from previous standards. However, you should consider how the new operating liability can possibly impact financial ratios.

That said, the tax benefits of operating leases remain. What FASB set out to accomplish with ASC 842 was to simply create more transparency to lease accounting.

Learn more about lease accounting in the biotech industry.

What Is the Financial Impact of an Operating Lease?

Operating leases can have a number of positive financial impacts on the lessee. One of the main advantages is that it allows the lessee to preserve cash and working capital by avoiding the need for a large upfront payment to acquire the use of the equipment or asset.

Operating leases can help to minimize the risk of obsolescence and equipment failure as the lessee does not assume ownership of the equipment or asset during the lease term. They can also improve the lessee’s liquidity and flexibility by allowing it to use the equipment without committing to long-term ownership. And because operating leases are recorded as an expense on the income statement, it can improve the lessee’s return on assets (ROA) ratio.

For example, biotech companies may choose to lease equipment instead of buying it for the flexibility. Because these companies often work on cutting-edge research and development projects that require access to the latest technology and equipment, they need to be able to acquire equipment for a specific period of time, and then return it or upgrade to newer models when their leases expire, without being tied to a long-term commitment. This allows biotechs to adapt quickly to changes in the life science industry and stay competitive.

The cost-effectiveness of leasing can also positively impact biotechs. Leasing equipment typically requires a smaller initial investment compared to buying, as leasing only requires paying for the use of the equipment rather than its full purchase price. Additionally, maintenance and repairs are typically the responsibility of the lessor, which can be beneficial for biotech companies as it eliminates the costs associated with maintaining and repairing the equipment.

Finally, leasing can help biotech companies to avoid the risks associated with owning equipment. For example, if a biotech company’s research direction changes, and the equipment is no longer needed, the company will have to bear the cost of disposing of it. Leasing allows biotech companies to avoid these risks by returning the equipment to the lessor at the end of the lease term.

How Excedr’s Operating Leases Can Help Your Lab

You might be asking yourself, “can an operating lease help my laboratory?” And, with the most recent changes to lease standards, “do operating leases still provide the same advantages?” The short and simple answer is : yes, operating leases can indeed help your lab, in a number of ways.

An operating lease can help spread the costs of equipment out over time, helping you avoid large down payments upfront. This effectively preserves your working capital and works to extend your cash runway and maintain a positive cash flow—if you’re currently generating revenue. It still offers the same tax benefits as well, meaning you can still take advantage of 100% tax deductions on your monthly lease payments.

Operating leases can also help you keep your balance sheet clean in case you’re pursuing outside investments. Expenses are normal, and keeping track of them on your balance sheet, in addition to your income statement, will only provide great transparency to anyone interested in your financial statements.

Furthermore, with the new accounting treatment taking effect, it’s possible for your company to depreciate your leased assets and accrue interest expense on tax deductible operating expenses.

Simply put, operating leases help companies access the equipment they need without the burden of ownership and oftentimes with limited maintenance responsibilities, create the potential for tax deductions, and allow for a simple way to manage leased assets.

Contact us today if you’re interested in securing an operating lease for lab equipment.