Operating leases explained: What are they? How do they work?

Most US businesses need expensive assets to produce the goods and services they sell. These assets are typically cars, vans, plant and machinery. Without them, many businesses simply cannot function. However, buying big-ticket items can create problems with cashflow and for companies with seasonal finances, spending a large sum all at once may be impossible. But not to worry. Say hello to the operating lease – the low-cost way for businesses to secure the major tools they need.

Why spend more to buy when you can pay less to rent? Roll maintenance and repairs into the deal. Reclaim tax and VAT. An operating lease is fast, flexible and affordable. Give your business what it requires without creating a financial crunch.

An operating lease is a low-cost way for businesses to obtain the big-ticket items they need. Unlike purchase loans, the lessee, (you) does not buy the asset, you rent it and you cannot purchase the asset at the end of the contract. 

In most cases (especially with business vehicles), the agreement will include a Residual Value that is based on the period of the lease and the estimated value of the asset at the end of the contract. At the end of the agreement the asset is usually sold to a third party on behalf of the finance company. If the asset sells for more than the Residual Value, the finance company will refund a percentage of the surplus back to you. If the asset sells for less than the Residual Value, you will be liable to make a further payment to the finance company.An operating lease allows businesses to use the asset for a lower monthly cost than buying the asset with hire purchase. Operating leases may come with included maintenance and repairs. In most cases, (except for company cars), businesses may reclaim up to 100% of the VAT element of the monthly cost – including any maintenance or service charges.

Operating leases may be used to secure the use of a wide range of expensive business assets – including vehicles, plant, and machinery.

ASC 842 is a US accounting rule designed to report information that faithfully represents lease transactions and provides a basis for users of financial statements to assess the amount, timing and uncertainty of cash flows arising from leases. To meet that objective, a lessee’s commitment disclosure should recognise assets and liabilities arising from an operating lease as follows:

• Operating leases are shown as an asset on the balance sheet, valued as the present value of the lease payments (not the market value of the asset).
• The lease liability is shown on the balance sheet (similarly, the present value of the lease payments).
• The income statement shows an expense of the cash payment to the lessor within operational expenses.
• No interest expense or depreciation is shown in the income statement.

Depending on the type of asset being leased (car, van, machinery, etc), the lessor may be able to claim up to 100% of the value of the lease payments as a tax deduction.

No. An operating lease is recorded on the balance sheet as an asset and the monthly rental payments are treated as operational expenses, not debt.

ABC Plumbers need a new van for their business. Instead of paying cash or opting for a hire-purchase agreement that comes with higher monthly payments, they secure the van with an operating lease. It works like this:

• The van costs $20,000. 
• The lessor (lender) offers to lease the van to ABC (the lessee) for $350 per month, including service costs, and for 48 months. The Residual Value is set at $4,000. 
• ABC pays one month deposit of $350 and drive their new vehicle away. Over 4 years, they pay a total of $16,800 for use of the van. 
• At the end of the contract, the vehicle is sold for $5,500 – $1,500 more than the agreed Residual Value. The lessor passes 95% of $1,500 back to ABC. They receive $1,425 which they use to lease a new vehicle and put the surplus cash back into their business.

A finance lease is a long-term rental agreement with an option to buy the asset at the end of the contract. An operating lease is also a long-term rental agreement, but there is no option for the lessee to buy the asset. Operating leases typically have lower monthly costs and may require a smaller deposit than a finance lease. They will also usually include maintenance and repairs, and the lessee may be liable to residual payments at the end of the contract.

Read more: our in-depth finance lease vs. operating lease guide