Operating leases

An operating lease can be useful if your business wants to lease an asset for a short period of time. You can choose to upgrade to the latest model or end the lease contract. You will not receive ownership of the vehicle, but you also won't be tied to a depreciating asset with an uncertain residual value.

What is an operating lease?

An operating lease is like renting. You rent an asset – say a business vehicle or equipment – for a certain amount of time and make regular lease payments. You will have exclusive rights to use the asset during the lease term, but you will not receive ownership of the asset at the end of the term.

This may sound like a finance lease, but they are quite different. The premise is similar: you take out a lease for an asset from a lessor. But unlike an operating lease, a finance lease may come with the option of asset ownership at the end of the lease period. A balloon payment may be required to cover the full cost of the asset. In contrast, with an operating lease, the asset is returned to the lessor at the end of the term. You can choose to lease it again if you wish.

An operating lease can be a good solution for a business that does not want to take on the risk of a depreciating asset. An operating lease may be for you if you want to be able to regularly update or upgrade the asset. Or, if you wish to enjoy the tax benefits of leasing rather than owning the asset.

There are several types of operating leases you can choose depending on what you want out of an operating lease.

Finder survey: How many Australians have taken out a business loan?

What are the features of an operating lease?

• Lower lease payments. Your payments will not be equal to the value of the asset. You also won't have to pay a balloon payment at the end of the term. This makes operating leases generally cheaper than a finance lease.
• Suitable for short-term use of asset. If you want to use the asset only for the short-term, an operating lease can be suitable as you'll be renting or leasing the asset.
• Shorter terms. Loan terms aren't as long. This gives you the option of upgrading the asset regularly and going for a newer model.
• Use of asset, but no ownership. You can use the asset for a set period of time. You won't be tied down to a depreciating asset. On the other hand, you won't own an asset either.
• Lower risk. The lessor maintains the risk of the asset. They take on the risk of the purchase and the resale. Your main obligation is to meet your repayment obligations.
• Tax deductible. Your lease payments are tax deductible.

What are the types of operating leases?

• Fully maintained operating lease. With this, you can roll all operating and maintenance costs into 1 fixed ongoing payment. The lessor will then be responsible for maintaining the asset. Depending on the asset, a fully maintained operating lease usually covers reporting, accident management, roadside assistance, tyre replacement, registration, insurance, ongoing servicing and maintenance, fuel card management and the management and payment of other ongoing considerations. This arrangement is suited for businesses that wish to outsource all aspects of their asset's going management.
• Non-maintained operating lease. With this type of operating lease, the cost of maintaining the asset will not be included in your monthly payments. The lessee (i.e. you) will be responsible for paying for the maintenance of the asset. This way, you'll only have to pay for the costs that have been incurred. This arrangement can cause difficulties with budgeting as you can't foresee the expenses.
• Sale and leaseback. With this arrangement, the lender will agree to purchase vehicles and business assets you've already purchased, and lease them back to you under a normal operating lease arrangement. This can benefit businesses that have already purchased 1 or more assets, but find entering into an operating lease agreement more beneficial than purchasing an asset outright. The asset will be removed from your business's balance sheet once the lender has purchased it from you. You'll have to make ongoing repayments under the new agreement, and these payments would generally be tax deductible.

What are the pros and cons of operating leases?

Pros.

• No residual risk. Residual risk refers to the uncertainty around the residual value of an asset at the end of its lease period. At the end of an operating lease term, the assets are returned to the lessor with no further payments due. Unlike finance leases, you won't have the risk of purchasing an asset where the residual amount payable outweighs the value of the asset.
• All-inclusive fixed payments. Most operating leases involve a fixed ongoing payment that includes a sum for the lease of the asset and its maintenance and operating costs. In the case of a vehicle, this will include all maintenance, servicing, insurance, registration, roadside assistance and regular tyre replacement. The fixed payment can also include a fuel allowance up to a certain kilometre limit, along with an allowance for tolls and other variable fees. As this amount is fixed and pre-negotiated, it's easy to budget for the cost of the asset throughout the lease period. There's no risk of unforeseen expenses as it has all been accounted for.
• Off the balance sheet in limited cases. An operating lease is only kept off a lessee's balance sheet where the lease term is 12 months or less, or the underlying asset is of low value. Under AASB 16 every other lease is recognised as a right-of-use asset and a lease liability, so check with your accountant before relying on this to improve a performance ratio such as return on assets or to protect your overall borrowing capacity.
• Tax deductible repayments. If the assets are used for business purposes, the full amount of the ongoing asset repayment is generally a business tax deduction. GST paid can be claimed as a credit, while the remainder of the repayments are treated as a regular tax deduction. While this is generally the case, it's best to check with your accountant to ensure that the arrangement has the desired taxation benefits for you.

Cons.

• No ownership. You have exclusive rights to use the asset during the term, but you do not own it, nor will you ever own it. At the end of the term, the asset must be returned to the lessor. You won't have an asset to sell or use as a deposit or security for another asset.
• Reduced net income. Whether or not the lease is recognised on your balance sheet, the repayments are typically recorded as an expense. They will appear on your profit and loss statement, increasing your expenses. As a result, your net income will be affected, with a disproportionate amount of expenses being recorded. It's important to seek legal advice to determine which outcome is more advantageous for your business.
• Lack of continuity. There is no guarantee of continuity of the asset following the expiry of the lease agreement. This lack of continuity can make it difficult for some businesses to plan, especially if the asset will be needed on an ongoing basis. Some businesses, however, may only wish to have the asset for a set number of years to perform a specific job.

Is my business eligible for an operating lease?

Each lender will specify what they require, and this may differ from lender to lender. Generally, lenders will look into your:

• Business financials. Lenders will look into your current business financial situation, cash flow, assets and debts. A good credit history can assist with your application. The lender will determine whether you can repay the loan.

• Business history. Most lenders will require your business to be of a certain age. This could be up to 2 years.

• ABN or ACN. They will also require your business ABN or ACN.

Frequently Asked Questions

• What is the main advantage of an operating lease?

  The primary advantage is that the asset does not sit on your balance sheet, which can improve your financial ratios (depending on accounting standards like AASB 16). Additionally, the lease payments are typically fully tax-deductible operating expenses.

• Who is responsible for maintenance in an operating lease?

  Operating leases often include maintenance and servicing in the monthly cost (especially for vehicle fleets). This removes the risk of unexpected repair bills and makes budgeting much easier.

• Do I own the asset at the end of an operating lease?

  No. At the end of the term, you simply hand the asset back to the financier. You do not have an automatic right to purchase it, although some agreements may allow you to make an offer to buy it at fair market value.

• Is an operating lease better for technology equipment?

  Yes, it is ideal for assets that depreciate quickly like computers or servers. Since you return the goods at the end of the lease, you are not stuck with obsolete equipment and can easily upgrade to the latest models.

Written by

Stacey Cole

Author

Add to Preferred Sources

Stacey Cole has degrees in law and science, but happily left the busy world of litigation to be a full-time mother and writer. In her spare time she loves travel, roller coasters, and old-school gaming, even if her daughter can already beat her at most games. See full bio