Operating Lease
A lease that does not meet any of the criteria of a finance lease is called an operating lease, or true lease.
In contrast to a finance lease, an operating lease leaves the ownership of the leased equipment in the hands of the DPP (lessor) at the end of the contract term. For this reason, the monthly payments tend to be much lower for operating leases than capital leases. The contract cannot allow an automatic transfer of title. While the lessee has an option to purchase the equipment, it is not contractually an expected outcome. Instead, the lessee may decide after the contract expires whether it wishes to buy the equipment, extend the lease, or return the equipment to the lessor. A purchase or lease extension must be negotiated at “fair market value.”
As a result, the risks of ownership remain with the lessor through the course of the contract. These risks are significant, because the lease term covers only a fraction of the asset’s economic life. At the end of the term the equipment will retain a significant residual (or resale) value.
This is important for a couple of reasons. Where monthly rental payments are meant to cover essentially the full cost of the asset in a finance lease, this is not the case with an operating lease. Rather, rental payments are based on the difference between the equipment’s initial cost and its expected residual value at termination. If residual value turns out to be less than expected, the lessor must absorb that loss.
Second, an operating lease is frequently a full-service lease, making the lessor responsible for repairs. While a finance lease is always a “net” lease, meaning that maintenance, insurance, and repairs are the responsibility of the lessee, an operating lease may be either one or the other.
All these characteristics make an operating lease most suitable for short-term leasing (e.g., 12 months), where the asset may be vulnerable to technological change or where a business ma