Operating Lease: How Does It Work?

operating lease

IN THIS ARTICLE

Operating leases can offer businesses a more cost-effective and flexible way to access equipment without the risks and burden of ownership.

In this guide, we explain what operating leases are, how they differ to finance leases – which is important for tax and accounting purposes – and consider the pros and cons of this type of asset finance for businesses.

What is an operating lease?

An operating lease is an agreement that permits the use of an asset without transferring ownership rights. Under an operating lease, a business (the lessee) rents an asset, such as a piece of equipment or a vehicle, from another company (the lessor) for a specified period of time, typically for a period that is shorter than the useful life of the asset.

These leases enable businesses to utilise the asset without incurring the higher costs and risks associated with its purchase.

Operating leases are similar to equipment leases, with the exception that equipment leases are typically for shorter terms and operating leases are typically longer but not for the asset’s entire useful life. As a result, operating leases are frequently the most cost-effective option, as the asset is borrowed for a reduced duration.

Who owns the asset under an operating lease?

Under an operating lease, the lessee does not purchase the asset. Instead, they rent the asset and cannot purchase it at the conclusion of the lease.

The lessor retains ownership of the asset and is responsible for maintenance and repairs. The lessee pays a rental fee for the use of the asset for the duration of the lease, and at the end of the lease period, the lessee returns the asset to the lessor.

Differences between operating leases and finance leases

An operating lease and a finance lease are two different types of lease agreements, with key differences in their accounting treatment, ownership transfer, and risk and reward allocation. Here are the main differences:

  • Accounting treatment: Under an operating lease, the leased asset is not recorded as an asset or liability on the lessee’s balance sheet. Instead, the lease payments are treated as operating expenses on the lessee’s income statement. In contrast, under a finance lease, the leased asset is recorded as an asset and a corresponding liability on the lessee’s balance sheet, reflecting the lessee’s right to use the asset and the obligation to make lease payments.
  • Ownership transfer: In an operating lease, ownership of the leased asset remains with the lessor throughout the lease term and does not transfer to the lessee. At the end of the lease term, the lessee typically has the option to renew the lease, purchase the asset, or return it to the lessor. In a finance lease, on the other hand, the lessee typically assumes ownership of the leased asset at the end of the lease term, either automatically or through a predetermined purchase option.
  • Risk and reward: In an operating lease, the lessor bears most of the risks and rewards associated with the leased asset, such as maintenance, obsolescence, and changes in asset value. In a finance lease, the lessee assumes most of these risks and rewards, as the lease is structured to transfer the risks and rewards of ownership to the lessee.
  • Duration: Operating leases are typically shorter in duration compared to finance leases. Operating leases are usually for a term that is shorter than the useful life of the leased asset, while finance leases are often for a longer term, spanning the estimated economic life of the asset.
  • Purchase option: A finance lease often includes a predetermined purchase option, which allows the lessee to purchase the asset at the end of the lease term for a specified amount. An operating lease may or may not include a purchase option, and if it does, it is usually not predetermined and may be at fair market value.

The 90% rule

The “90% rule” for operating leases refers to a financial accounting test used to determine whether a lease is classified as an operating lease or a finance lease under certain accounting standards, such as the International Financial Reporting Standards (IFRS 16) and the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842.

According to the 90% rule, a lease is classified as a finance lease if it meets any of the following criteria:

  • The present value of lease payments, including any guaranteed residual value, amounts to at least 90% of the fair value of the leased asset at the commencement of the lease.
  • The lease term covers a major part of the economic life of the leased asset, which is generally defined as 75% or more of the economic life of the asset.
  • The leased asset is of such a specialised nature that it is expected to have no alternative use to the lessor at the end of the lease term.

If none of these criteria are met, the lease is classified as an operating lease.

Tax & accounting considerations

The classification of a lease as an operating lease or a finance lease has important implications for financial reporting, as it affects how the lease is accounted for on the lessee’s balance sheet, income statement, and cash flow statement.

Under operating lease accounting, the lease payments are recognized as operating expenses over the lease term, while under finance lease accounting, the leased asset and lease liability are recognized on the lessee’s balance sheet, and the lease payments are allocated between interest expense and amortization of the lease liability in the income statement.

Payments are only reflected for the period during which the asset is utilised, and not for the asset’s total value.

For accounting purposes, an operating lease is treated as a rental expense on the lessee’s income statement, rather than as a long-term debt obligation, which is the case for capital leases.

In the UK, the tax implications of an operating lease depend on whether the lease is classified as a finance lease or an operating lease for accounting purposes.

If the lease is classified as an operating lease, the lease payments are treated as a deductible expense for the lessee, which reduces the company’s taxable profits. The lessor is subject to income tax on the lease payments received, but is also entitled to claim deductions for expenses related to the lease.

In addition, Value Added Tax (VAT) is charged on the lease payments for operating leases of most assets. The lessee can normally recover any VAT charged on the lease payments, subject to the usual rules for VAT recovery.

It’s important to note that the tax treatment of operating leases can be complex, and depends on a range of factors, including the specific terms of the lease, the asset being leased, and the accounting treatment of the lease. It’s therefore advisable to seek professional advice from a tax specialist to ensure that the tax implications of an operating lease are properly understood and managed.

Is an operating lease right for your business?

Operating leases are generally suitable for businesses seeking short- to medium-term equipment with a high rate of obsolescence or technological change, such as computers or vehicles. They are also used by companies that need to conserve cash or prefer to avoid the risks and financial commitment associated with owning an asset outright.

Pros & cons of operating leases

Using an operating lease can have several advantages for businesses, including:

  • Lower initial costs: Operating leases often require lower upfront costs compared to purchasing an asset outright or obtaining financing for a capital lease. This can help businesses conserve their cash flow and working capital, allowing them to allocate resources to other areas of their operations.
  • Off-balance sheet financing: Since operating leases are not recorded as assets and liabilities on the lessee’s balance sheet, they do not impact key financial ratios such as debt-to-equity ratio, return on assets (ROA), and return on equity (ROE). This can be beneficial for businesses that want to maintain a favourable financial position or comply with certain financial covenants.
  • Flexibility: Operating leases are generally more flexible than other types of leases or outright purchases. They can allow businesses to lease assets for shorter terms, providing greater flexibility to adapt to changing business needs or technological advancements. At the end of the lease term, businesses typically have options to renew the lease, purchase the asset, or return it to the lessor, offering flexibility and agility in managing their asset portfolio.
  • Reduced financial risk: With an operating lease, the lessor typically retains ownership of the asset and is responsible for risks such as maintenance, repairs, and obsolescence. This can reduce the lessee’s exposure to risks associated with asset ownership, providing a level of risk mitigation.
  • Access to new technology: Operating leases can enable businesses to access newer or more technologically advanced assets without the need for a large upfront investment. This can be especially beneficial for businesses that require frequent upgrades or replacements of assets to stay competitive or meet changing customer demands.
  • Tax advantages: Lease payments for operating leases are generally treated as deductible operating expenses for tax purposes, reducing the lessee’s taxable profits and potentially lowering their overall tax liability.

While operating leases can offer benefits, there are also potential drawbacks or cons that businesses should consider when evaluating whether to use an operating lease:

  • Higher overall costs: Over the long term, operating leases can be more expensive compared to purchasing an asset outright or obtaining financing for a capital lease. Lease payments for operating leases may accumulate to a higher total cost compared to the purchase price of the asset, especially for long-term leases, which can impact the business’s bottom line.
  • No ownership or equity: Unlike finance leases or outright purchases, operating leases do not result in ownership or equity buildup for the lessee. At the end of the lease term, the lessee does not automatically own the asset, and may need to enter into a new lease, purchase the asset at fair market value, or return it to the lessor. This means that the lessee does not build equity in the asset over time, which may be a disadvantage for businesses that value long-term ownership and asset appreciation.
  • Obligation to return or renew: At the end of the lease term, the lessee may be obligated to return the asset to the lessor, renew the lease, or purchase the asset at fair market value. This can limit the lessee’s options and flexibility, and may require additional negotiation or financial resources.
  • Potential impact on financial ratios: Although operating leases are not recorded as assets and liabilities on the balance sheet, they may still impact certain financial ratios indirectly, such as the current ratio and the debt service coverage ratio. Lenders, investors, or other stakeholders may consider the off-balance sheet liabilities associated with operating leases when assessing the financial health or creditworthiness of a business.
  • Risk of obsolescence or maintenance: While lessors typically retain responsibility for maintenance and obsolescence in operating leases, the lessee may still bear some risk if the asset becomes obsolete or requires substantial maintenance or repairs during the lease term. This can impact the lessee’s operations or result in additional costs.
  • Limited customisation: Operating leases may have limitations on customisation or modifications to the leased asset, as the asset remains the property of the lessor. This may restrict the lessee’s ability to tailor the asset to their specific needs or requirements.

 

Operating lease FAQs

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Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.

Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.

Before acting on any of the information contained herein, expert professional advice should be sought.

Author

Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.

Gill is a Multiple Business Owner and the Managing Director of Prof Services Limited - a Marketing & Content Agency for the Professional Services Sector.

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