Operating leases are treated as rental expenses for the lessee, and refer to contracts that permit use, but not ownership, of an asset. Operating leases are accounted for through the recording of periodic payments on the rented asset. Lease payments are defined as an expense on the renter’s income statement. Dissimilar to capital or financial leases, operating leases are not considered assets or liabilities on the lessee’s balance sheet.
An operating lease does not meet the requirements of a capital lease. It is not a formal transfer of ownership of an asset, nor does it contain a bargain purchase option. Operating leases are treated as rental expenses because the lessee does not have ownership, nor risk of ownership, of the underlying asset. By contrast, a capital lease is more similar to a loan, where the asset in question is owned by the lessee and therefore stays on the balance sheet.
An operating lease is a voidable short-term contract formed commonly by equipment manufacturers and land owners. Lease payments are recorded as expenses on the lessee’s income statement, but they do not influence assets or liabilities on the lessee’s balance sheet. As such, operating leases are typically referred to as “off balance-sheet financing.”