BLM11215 - Lease accounting: lease classification: defining operating leases

This manual is being updated to reflect FRS 102 (2024 amendments). For guidance on the tax treatment of accounts prepared under IFRS 16 or the revised FRS 102, please refer to pages within the BLM50000 chapter.

This section is applicable to entities applying FRS 102 pre 2024 amendments or FRS 105, and for lessors only under IFRS 16 and FRS 102 (2024 amendments). 

See BLM17000 for lessee accounting under the on-balance sheet model under IFRS 16 and FRS 102 (2024 amendments). 

What is an operating lease? 

In contrast to a finance lease, an operating lease does not transfer substantially all of the risks and rewards of ownership to the lessee. That is, an operating lease is a lease where the lease terms do not guarantee that the lessor will get back all, or substantially all, of the cost of the asset plus a commercial rate of interest. In many cases the asset may be leased several times throughout the course of its life, though this is not always the case. 

This means that operating leasing leaves the lessor with a residual value risk. That is, at the end of the term of the lease the lessor will be relying on the value of the leased asset to ensure they make an overall profit. 

In some cases, operating lease rentals can be thought of as reflecting the market rate for hiring the asset concerned. However, this is not always the case and has nothing to do with the definition of an operating lease in accounting. 

Examples of typical operating leases include: 

  • the hire of tools or machinery for a few days to DIY enthusiasts 

  • the hire of a car for a couple of weeks to a holiday maker 

  • the hire ('charter' in nautical or aeronautical language, especially where the hire is for a specific temporal period or trip) of ships or aircraft for an extended period (typically where the asset has a useful life far longer than the hire period) 

  • ordinary leases of real property for many years (again where the asset has a useful life far longer than the hire period). 

Accounting definition of an operating lease 

Under FRS 102 (pre 2024 amendments) and FRS 105, an operating lease is defined as “a lease that does not transfer substantially all the risks and rewards incidental to ownership. A lease that is not an operating lease is a finance lease”. 

The same definition of an operating lease applies for lessors under FRS 102 (2024 amendments) and IFRS 16 (although the definition under the latter also refers to an underlying asset). 

Accountants apply the same criteria whatever the nature of the asset, including land and buildings.  Normally, a single letting of a building is designed to make more than an interest-like return for the landlord (the lessor). This reduces the risk of running at an overall loss from unavoidable overhead costs in times they are unable to find tenants   

Real property leases can also be structured on finance lease terms.The criteria for assessing the risks and rewards incidental to ownership are as set out in BLM11200. 

Further detail on lessee accounting under FRS 102 (2024 amendments) and IFRS 16 is set out in BLM17000 onwards.