how operating leases work
historically operating leases enabled american firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets thereby keeping their debt to equity ratios low however this changed in 2016 with the release of accounting standards update 2016 02 leases topic 842 and amendments in the few years following 1operating leases are assets rented by a business where ownership of the asset is not transferred when the rental period is complete typically assets rented under operating leases include real estate aircraft and equipment with long useful life spans such as vehicles office equipment or industry specific machinery essentially an operating lease is a contract for a company to use an asset and return it in a similar condition to the lessor this agreement is beneficial for the lessee particularly when it has expensive equipment or other assets that need to be replaced regularly advantages and disadvantages of an operating leaseno ownershiprenting may be cheapershort termno equityfinancing costsmight pay more than market valuecontinuous terms renegotiationexample of an operating leasea restaurant needs power to ensure it can operate during outages and not have food spoil when refrigeration systems are offline power keeps a restaurant from losing business and costly supplies a restaurant owner should ensure they have a generator for this reason but they might need a much bigger and more expensive one they ll need to power freezers refrigerators ovens heating lamps lights air conditioning water heaters computer systems and more large generators can cost tens of thousands of dollars so the owner might choose to lease one the owner would make rental payments to an equipment rental service and account for it as an asset and a liability on their balance sheet because they ll likely need it for more than one year accounting for an operating leaseoperating lease accounting changed in 2016 when the federal accounting standards board released asc topic 842 leases the new standard provided guidance when accounting for leases where the lease and the corresponding asset value would be required to be reported on the balance sheet however leases for less than 12 months can be recognized as an expense using the straight line basis method 2