Table of Contents
If your startup needs access to expensive pieces of kit like machinery or vehicles, you should consider entering a lease agreement. There are different types of leases, depending on the assets you want to lease. This article will explain the different kinds of leasing, namely operating and financing leases.
What Are Leases?
Even in the business world, a lease operates like a car lease. You pay a fee to borrow a piece of equipment in exchange for its use. However, lease agreements in a business context usually last for at least a year and as long as fifteen years or more.
Lessors commonly lease the following assets to lessees:
- airplanes and helicopters;
- ships, yachts and other watercraft;
- fleets of cars, vans, and lorries; and
- complex machinery like aircraft engines and high-value manufacturing equipment.
Operating vs Financing Leases
Broadly speaking, you can divide leases into either operating or financing leases. Let us explore each of these in further detail.
Operating Leases
Operating leases refer to shorter-term leases. Most operating leases are for two to five years. The primary purpose of an operating lease is for the lessee (your startup) to obtain the benefit of using the asset in question for a period shorter than the asset’s economic life.
For an aircraft, its economic life might be 30 or more years. In contrast, certain other machinery might have a far shorter economic life.
Under an operating lease, the lessor retains ownership of the asset and is responsible for the maintenance and repairs (though there are exceptions to this for aircraft and shipping leases).
Financing Leases
Financing leases usually last for the economic life of an asset. The purpose of a finance lease is usually to provide the lessee with the use of the asset over its economic life. The lessee will make regular payments to the lessor over this period. The effect is that by the end of the period, the lessee will have paid for the asset’s market value at the point the lease arrangement began. An additional premium amount will be factored in over the course of the lease agreement, similar in principle to interest for a loan.
Importantly, ownership of the asset remains with the lessor for the life of the lease. However, repairing and maintaining the asset is the lessee’s responsibility. Likewise, you will also need to insure the asset.
Continue reading this article below the formCall 0808 196 8584 for urgent assistance.
Otherwise, complete this form and we will contact you within one business day.
Accounting Considerations
Operating Leases
Historically, accounting policies and regulations treated operating leases exclusively as business expenses. That meant that they did not affect the startup’s balance sheet. For these reasons, you may still hear operating leases referred to as “off-balance sheet” forms of leasing.
However, accounting standard reforms now mean that your business must record certain operating leases on your balance sheet. Exceptions typically apply to leases of 12 months or less or for low-value assets. At the start of the lease agreement, you record the benefit of using the equipment on the asset side of your balance sheet and the corresponding obligation to pay for the lease over the lifetime of the agreement as a liability.
Finance Lease
Finance leases have typically always been recorded on the balance sheet. This means finance leases are functionally similar to debt financing from an accounting perspective.
Legal and Financial Considerations
Finance leases are long-term contracts. Operating leases are shorter-term. In this sense, you have more inherent flexibility under an operating lease because you do not have to renew or reenter into another lease at the end of the operating lease. However, financing leases do not permit you to end the lease early — at least not without significant cost.
From a financial perspective, your startup must be able to generate sufficient cash to make the lease payments under both leases. Failure to make payments under the lease agreement usually entitles the lessor to take immediate possession of the asset. You may also pay a penalty fee.
Tax Considerations
Payments made under an operating lease are treated as expenses, which are tax deductible.
Payments under financial leases are partly tax deductible. Specifically, the interest portion of the lease agreement is tax deductible. The remaining portion is treated similarly to how your startup’s capital assets are treated. That is, you accrue a portion of the asset value as you pay for the leased asset on the asset side of your balance sheet. You can then deduct, as an expense, a fair depreciation charge. This amount is tax deductible.
However, the specifics of this are quite complex and depend on the circumstances surrounding the lease agreement.
This cheat sheet outlines what you should be aware of in your lease agreement.
Other Forms of Leasing
Shipping and Aerospace
In the context of leasing ships or aircraft, various leases and other arrangements let you benefit from using the vessel without entering into a lease. For instance, in shipping, most contracts for the use of a ship are called charters, some of which are technically leases.
Similar customs apply to the terminology of aircraft. For instance, a wet lease describes an operational lease where the lessor provides you with a crew, plane and maintains the aircraft. In contrast, a dry lease is where you must crew, insure and maintain the plane yourself. Note that a dry lease can be either an operating lease or a financial lease, depending on the terms of the agreement and the parties’ objectives.
Sale and Leaseback
Sale and leasebacks are similar to finance leases, except the lessee sells the asset to the lessor (usually a bank) and then pays the lessor leasing fees for the asset’s economic life.
There are various cash flow and tax advantages to sale and leasebacks compared to finance leases, but their purpose is broadly the same.
Hire-Purchase Agreements
These describe lease agreements related to the supply of motor vehicles and computer equipment. Most hire-purchase agreements are between businesses and consumers rather than business-to-business.
Key Takeaways
Leasing is one way for startups to benefit from using costly assets like machinery or vehicles. The two main types of leases are operating and financing leases. Operating leases are shorter-term agreements where the lessor maintains maintenance and insurance responsibilities. Financing leases last for the asset’s economic life, during which you, as the lessee, make regular payments to the lessor. Various legal, financial, and accounting differences exist between operating and financing leasing.
If you need help with your startup, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
We appreciate your feedback – your submission has been successfully received.
