Operating Lease
Definition of an Operating Lease
An operating lease is a short-term lease in which rental payments are made by the lessee and full ownership rights are kept by the lessor. An operating lease generally has an option to purchase or return the equipment at the end of the lease term.
When accounting for an operating lease on your financial statements, just like anything else, there are rules to follow. Those rules are the FASB 13 rules. An operating lease is essentially the polar opposite of a capital lease. In order for your lease to qualify as an operating lease it must meet the following criteria:
- the lease term is less than 75% of the asset’s estimated useful life
- the lease does not contain a bargain purchase option to buy the equipment for less than fair market value.
- ownership of the asset is not automatically transferred to the lessee at the end of the lease term
- the present value of the lease payments is less than 90% of the total original cost of the equipment.
The reason that FASB 13 has such strict criteria is to ensure that the lessee does not have any chance of accounting for the equipment as their own asset, because in doing so they would obtain the tax benefits of equipment ownership. The idea of an operating lease is much like a rental, the main difference is the option to buy the equipment at the end of term. The most common type of end of term option for an operating lease is a fair market value buyout.
Operating Lease Essentials
Benefits of an Operating Lease
- Deduct Monthly Payment as an expense on Income Statement
- Off-balance Sheet Financing
- Flexibility at the End of the Lease Term
The main benefit of an operating lease is that the monthly payments are considered rental payments. This will do two things.
First, the monthly payments will get deducted from your income statement as an expense. Depending on what type of depreciation schedule you are on, this can lower your overall taxable income.
**Remember – Carrying an operating lease means that the lessor (not you) holds the rights to the equipment, including depreciation. You will not be allowed to depreciate the equipment if you choose to carry an operating lease. **
If you are depreciating your equipment heavily in the first couple of years, then choosing an operating lease will likely make you pay more in taxes in the first couple of years. But if you are depreciating on a straight-line basis (the same amount each year) then you could end up saving money in taxes.
The second benefit of an operating lease is that a true operating lease will not show up on your businesses balance sheet as a liability. What does this do for you? For starters, it improves your debt (leverage) ratios.
An operating lease is considered an “off-balance sheet” form of financing. This occurs because the equipment does not technically belong to you, you are renting from the lessor. So rather than that $100,000 piece of equipment being counted as an asset and showing up in your asset and liability sections of the balance sheet, it becomes a footnote in the financial statements.
One other advantage of an operating lease is the flexibility at the end of term. If you specify in the lease documents correctly, you will have the option to either purchase or return the equipment at the end of the lease term. Depending on how much technology progresses for that particular piece of equipment over the period of the lease, you may want to do either. A true operating lease will allow you this option. But beware, most lenders are not in the business of storing and reselling used equipment. For this reason, they are likely to not allow such a clause to return the equipment at the end of the lease.
Disadvantages of an Operating Lease
- Could Have Large and/or Unknown Balloon Payment at the End of Term
- Missed Depreciation Expense
