If your business would benefit from the use of an asset, like a warehouse or fleet of vehicles, but doesn’t want to purchase those assets outright today, there are two appealing options to choose from: Obtaining a financial lease or an operating lease.
Each lease type comes with its own set of considerations, tax benefits and drawbacks, liability and risk. But when used correctly, both forms of asset usage can work for your company.
In this article, we’ll cover the basic principles of a financial lease vs. an operating lease so you can determine which is the best fit for your business needs.
What is a financial lease?
A financial lease is a common form of financing businesses can use to buy capital assets, like equipment or vehicles. In a typical financial lease agreement, the lessor (the asset’s original owner) provides the lessee (your company) with full use of the asset for a set amount of time, at a set periodic payment rate.
During that time, you can have full access to use the asset however you see fit. At the end of the leasing period, that leasing arrangement will convert into an ownership one — giving you the right of ownership over the asset.
Financial leases are particularly advantageous because they offer businesses more flexibility, lower upfront costs and the ability to quickly obtain the assets they need to grow. And because the company does not take full ownership of the asset until the end of the leasing arrangement, they offer a lower risk than purchasing an asset like a building or vehicle outright.
Financial leases also provide businesses with helpful tax benefits. Depending on the type of financial lease, the business may be able to deduct lease payments as operating expenses on their taxes, reducing their taxable income. Some businesses may even be able to deduct the depreciation of leased assets, a type of noncash expense, further reducing their tax liability.
What is an operating lease?
An operating lease is a type of lease agreement in which the lessee (your company) pays regular rent to the lessor (the landlord or asset owner) for the use of an asset. This arrangement is common for the rental of equipment or property. Operating leases benefit businesses because they offer greater flexibility than other types of leases.
The terms are shorter than with most financial leases, which allows businesses to quickly adjust their office space or vehicle needs as the company grows and changes. And operating leases come with their own tax benefits: Lessees can deduct the cost of rent and maintenance from their tax burden.
Operating leases are often less expensive and more flexible than financial leases, but they do come with drawbacks. The biggest disadvantage is that the lessee is not given the option to purchase the asset at the end of the leasing period.
The money paid over the course of the lease is essentially a sunk cost, as it doesn’t reduce the cost of the asset if the lessee does try to pursue a purchase.
Comparing the key differences of a financial lease vs operating lease
One of the biggest differences between financial leases and operating leases is the risk of obsolescence. Obsolescence refers to when an item has become outdated or no longer useful due to changes in technology, industry trends or consumer preferences. It often occurs with equipment, tools, furniture and software.
The risk of obsolescence is much higher with financial leases, because the lessee is responsible for any residual value at the end of the leasing term. The financial lease is an ownership agreement, meaning the lessee must pay off the purchase at the end of the term, even if the asset has become obsolete and useless to the company.
On the other hand, operating leases carry little risk of obsolescence. The leasing term is shorter, and businesses aren’t required to purchase the asset at the conclusion of the term.
The maintenance requirements of a financial lease vs an operating lease is another significant difference between the two agreements. The maintenance of a financial lease typically falls on the lessee. As you’re moving toward ownership of the asset, you’re responsible for repairs, maintenance, insurance and changes.
But with an operating lease, the lessor is typically responsible for necessary maintenance and repairs. That provides businesses with more flexibility, but less control over the quality and timeliness of repairs and updates.
A financial lease could be more beneficial for your business if you need to purchase equipment or property and want to spread payments out over an extended period of time. But an operating lease could be the better choice if your business needs more flexibility and a shorter leasing term, and doesn’t need to own the asset at the end of the term.
Since the type of lease you choose will have different effects on your key financial statements, as well as determine the tax benefits your company will derive from the lease — you may want to consult with outsourced accounting service to assess its potential impact on your company’s financial status.
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