The International Accounting Standards Committee defines an Operating Lease as “any lease other than a finance lease”.
An Operating Lease has the following characteristics:
- The lease term is significantly less than the economic life of the equipment.
- The lessee enjoys the right to terminate the lease at short notice without any significant penalty.
- The lessor usually provides the operating know-how, suppliers, the related services and undertakes the responsibility of insuring and maintaining the equipment in which case an operating lease is called a ‘wet lease’. An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment is called a ‘dry lease’.
From the features of an operating lease, it is evident that this form of a lease does not shift the equipment-related business and technological risks from the lessor to the lessee. The lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a reasonable rate of return thereon. Therefore, specializing in operating leases calls for an in-depth knowledge of the equipments per se and the secondary (resale) market for such equipments. Of course the prerequisite is the existence of a resale market. Given the fact that the resale market for most of the used capital equipments in our count~ lacks breadth, operating leases are not in popular use. But then this form of lease ideally suits the requirements of firms operating in sun rise industries which are characterized by a high degree of technological risk.
Following are illustrative situations where a lease will be regarded as an operating lease:
- If the lease has a cancellable period, during which rentals forming more than 10% in present value terms of the fair value of the asset are received;
- If part of the rentals are contingent or conditional, and such rentals form more than 10% in present value terms of the fair value of the asset;
- If the lessor relies upon unguaranteed residual value, and such value forms more than 10% in present value terms of the fair value of the asset;
- If the lessor relies upon guaranteed residual value, but such value is guaranteed by a third party, and such third-party-guaranteed residual value forms more than 10% in present value terms of the fair value of the asset – in this case, the lease will be regarded as a financial lease for the lessor but an operating lease for the lessee;
- If the lessor’s IRR and the lessee’s incremental borrowing rate differ: the lease may be a financial lease for the lessor and an operating lease for the lessee
Differences between Finance and Operating Leases