© 2000 John Petroff
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© 2000 John Petroff |
Operating leases are arranged by an equipment manufacturer or a leasing company (i.e. lessor). Leasing companies are usually not just financial intermediaries but technical service providers specialized in renting specific types of equipment such as cars, trucks, aircraft, ships, copying equipment, computers, construction tools, cranes and so on. The lessor is responsible for maintenance, and must provide a fully operational equipment immediately, should the one used by the lessee fail. The lease is short term, renewable and cancelable. There is no provision for the lessee to acquire the equipment at the termination of any length of use as it is common in capital leases. For the lessee, these leases do not appear on the balance sheet. Lease payments are included in general expenses, and future obligations for operating leases are reported in notes to financial statements.
Operating leases used to hide financially leveraged balance sheets by disguising capital leases as operating leases. Since the tightening of accounting reporting this is no longer the case, in the United States. An operating lease is generally more expensive than an outright purchase or a capital lease for the same equipment, because of the guarantee of service implied in the operating lease, and because of the obsolescence risk assumed by the leasing company. But this need not be always the case because the maintenance cost of a highly specialized equipment rental company can be much less than that of the user firm. Likewise, the leasing company can serve different client markets: those that require the latest technology and those that prefer paying less for a slightly slower equipment. The leasing company can manage the cost of obsolescence much more efficiently than any lessee. This is especially true in high technology equipment such as copying machines and computers. To the lessee, the possibly higher cost of operating leases is justified by the convenience of relying on fully operational equipment and avoidance of obsolescence cost. In addition, because the lease is cancelable financial risk is reduced. Finally, operating leases do reduce the liability of the lessee, allowing it to borrow more than if it used a capital lease or a mortgaged loan. An analyst must assess the consequences of possible excessive borrowing, and the consequences to production and sales, should the firm be forced to cancel its operating lease.
There is a wide variety of operating leases specifically geared for the needs of different industries, with their own particular accounting treatment. For instance, in the air carrier industry, airlines do not show on their balance sheets operating leases even though these leases are non-cancelable.
See review questions Q-12E3.1 through Q-12E3.7.
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