Key Takeaways
- An operating lease allows your business to use equipment for a fixed period without taking ownership of the asset.
- Operating leases are commonly used for equipment that becomes outdated quickly or is only needed for a short period.
- Unlike a finance lease, where you have the choice to return, purchase, or upgrade equipment, an operating lease usually requires the equipment to be returned at the end of the lease term.
- Lease payments are generally treated as operating expenses, which means they have the potential to offset tax.
- Businesses in construction, transport, mining, and manufacturing frequently use operating leases.
- An operating lease can reduce the risks associated with equipment depreciation and obsolescence.
- Businesses that regularly upgrade equipment often prefer operating leases over ownership based finance options.
Operating Lease Explained in Plain English
An operating lease is a form of equipment finance that allows a business to rent equipment for a specified period without taking ownership of the asset.
Instead of purchasing machinery, vehicles, technology, or specialised equipment outright, your business makes regular lease payments to use the equipment throughout the agreed term. Once the lease ends, the equipment is typically returned to the finance provider.
An operating lease is commonly used when equipment is only needed temporarily or when the business wants to avoid the risks associated with owning an asset that may lose value quickly.
Many Australian businesses use operating leases to access equipment without tying up capital in assets that may become outdated or unnecessary within a few years.
For example, if your business needs a specialised excavator for a twelve month project, purchasing that machine may not make financial sense. Once the project ends, you could be left with an expensive asset that is no longer generating income.
Under a typical operating lease:
- The finance provider owns the equipment.
- Your business pays regular rental payments.
- The lease term is usually shorter than the useful life of the equipment.
- The equipment is returned at the end of the lease.
- Maintenance packages may be included depending on the agreement.
- There is generally no obligation to purchase the equipment.
Operating leases are one of several equipment finance solutions available to Australian businesses. Other options include chattel mortgages, hire purchase agreements, finance leases, and rent to own arrangements.
How an Operating Lease Differs from a Finance Lease
One of the most common questions business owners ask is whether they should choose an operating lease or a finance lease.
While both options allow you to access equipment without paying the full purchase price upfront, they are designed for different business needs.
Finance Lease
With a finance lease, the lender purchases the equipment and leases it to your business for an agreed term. At the end of the lease, you can typically choose to purchase the equipment, upgrade to newer equipment, or return the asset. Finance leases are often used by businesses that may want to retain the equipment long term.
Operating Lease
An operating lease is generally a shorter term arrangement where your business uses the equipment without intending to own it. Once the lease ends, the equipment is returned to the lender. Operating leases suit businesses that only need equipment for a defined period or prefer to upgrade regularly.
Which Option Is Better?
Neither option is universally better.
A finance lease may suit businesses that:
- May intend to keep equipment long term
- May want eventual ownership
- Expect the equipment to retain value
- Use the equipment heavily throughout its life
An operating lease may suit businesses that:
- Upgrade equipment regularly
- Need equipment temporarily
- Want flexibility
- Prefer lower exposure to asset depreciation
- Have changing equipment requirements
The best choice depends on how long you expect to use the equipment and whether ownership is important to your business.
On Balance Sheet vs Off Balance Sheet Treatment
AASB 16 requires lease transactions to be reported in a way that reflects the assets, liabilities, and cash flow commitments created by the lease.
For an operating lease, this means the lease is generally recognised on the balance sheet.
The asset shown on the balance sheet is not the market value of the equipment. It is usually recorded as the present value of the lease payments.
The lease liability is also shown on the balance sheet and is generally measured as the present value of the remaining lease payments.
The income statement records the cash payment to the lessor as an operating expense.
Unlike some other finance arrangements, there is no separate interest expense or depreciation expense shown in the income statement for the operating lease.
Depending on the asset being leased, such as a car, van, machinery, or other business equipment, the lessee may be able to claim up to 100% of the lease payments as a tax deduction.
Because lease accounting and tax treatment can depend on your business structure, reporting obligations, and the asset being leased, speak with your accountant before entering into an operating lease.
How Are Operating Lease Payments Treated for Tax?
In many situations, operating lease payments are treated as operating expenses and may be deductible as a business expense when incurred.
This can provide a simpler tax treatment compared to purchasing equipment outright and claiming depreciation over time.
Tax outcomes vary between businesses and can change based on legislation and individual circumstances.
You should always seek advice from your accountant before entering into any equipment finance arrangement.
Operating Lease Versus Asset Ownership
When equipment is purchased outright or funded through ownership based finance structures such as a chattel mortgage, businesses may claim depreciation deductions over the asset’s useful life.
Under an operating lease, businesses often claim lease expenses rather than depreciation.
When an Operating Lease Makes Sense for Your Business
An operating lease is not suitable for every business situation. There are several circumstances where it can be effective.
You Only Need Equipment for a Limited Time
A short term equipment lease can be ideal for project based businesses.
Examples include:
- Construction contracts
- Infrastructure projects
- Seasonal demand periods
- Temporary capacity increases
If the equipment will only generate income for a specific project, ownership may create unnecessary costs.
Equipment Becomes Outdated Quickly
Some businesses require equipment that can become outdated quickly. An operating lease allows equipment to be refreshed more frequently without dealing with resale challenges.
You Want to Preserve Working Capital
Purchasing expensive equipment can place pressure on cash reserves.
An operating lease spreads costs over time and allows businesses to retain working capital for payroll, utilities, rent, inventory, and other day to day expenses.
You Want Lower Asset Risk
Equipment ownership comes with risks.
Assets can:
- Depreciate rapidly
- Become obsolete
- Require replacement sooner than expected
- Have uncertain resale values
Operating leases transfer much of this risk away from the business.
You Need Equipment Immediately
Equipment finance often allows businesses to access essential assets without waiting to accumulate sufficient cash reserves.
This can help businesses pursue growth opportunities sooner rather than delaying projects while saving for large purchases. Equipment finance remains one of the most common funding solutions used by Australian businesses seeking access to machinery, vehicles, and operational assets.
Industries That Benefit Most from Operating Leases
Operating leases can be used across many sectors. Some industries use them more frequently because of the nature of their equipment requirements.
Construction
Construction companies often require machinery for specific projects.
Examples include:
- Excavators
- Loaders
- Cranes
- Earthmoving equipment
Project timelines frequently align well with short term equipment lease arrangements.
Transport and Logistics
Fleet requirements can change quickly.
Operating leases can help businesses access:
- Trucks
- Vans
- Delivery vehicles
- Specialised transport equipment
without committing to long term ownership.
Mining and Resources
Mining projects often have defined operational periods.
Equipment leasing can help businesses match equipment costs with project revenue while reducing exposure to residual value risk.
Manufacturing
Manufacturers frequently need specialised equipment that may require upgrading as production methods evolve. Operating leases can provide flexibility when production requirements change.
Advantages and Disadvantages of an Operating Lease
Advantages
- Preserves working capital
- Lower upfront costs
- Flexible equipment access
- Reduced depreciation risk
- Easier equipment upgrades
- Suitable for short term requirements
- Potential tax advantages
Disadvantages
- No option for ownership at the end of the term
- Long term leasing may cost more than ownership
- Lease restrictions may apply
- No ability to build equity in assets
Understanding both sides of the equation helps ensure the lease aligns with your business goals.
Frequently Asked Questions
Is an operating lease on or off balance sheet?
Under AASB 16, which governs how Leases are reported by Australian entities AASB 16, operating leases are generally recognised on the balance sheet. Businesses typically record a right of use asset and a lease liability based on the present value of the lease payments. There is no interest expense or depreciation shown in the income statement for an operating lease.
Can I buy the equipment at the end of an operating lease?
In most cases, operating leases are designed around returning the equipment at the end of the lease term. The option to purchase equipment after leasing is present in finance leases, not operating leases.
What industries commonly use operating leases?
Construction, transport, mining, and manufacturing commonly use operating leases because they often require equipment flexibility and regular upgrades. Other industries like healthcare and technology also use this type of equipment financing.
How are operating lease payments treated for tax?
Operating lease payments are generally treated as business expenses and may be deductible when incurred. Tax treatment depends on your individual circumstances, so professional tax advice should always be obtained.
Is an operating lease better than buying equipment?
It depends on your business objectives. If you need equipment for a limited period, want to preserve working capital, or expect regular upgrades, an operating lease may be suitable. If you plan to keep the equipment long term, ownership based finance options may deliver better value.
What is the difference between a short term equipment lease and an operating lease?
A short term equipment lease is often structured as an operating lease. Both arrangements focus on temporary equipment use rather than ownership, making them suitable for project based or seasonal business requirements.
In Conclusion
An operating lease gives businesses access to equipment without the commitment of ownership. It can be a suitable option when you need equipment for a defined period, want to preserve working capital, or expect to upgrade assets regularly. While operating leases generally involve returning the equipment at the end of the term, they offer flexibility and can reduce the risks associated with depreciation and obsolescence. Before choosing an operating lease, consider how long you’ll need the equipment, your cash flow requirements, and whether ownership is important to your long term business plans.
Disclaimer: Loans and their accompanying benefits are available only to those who qualify for them and have been approved. Though we put a lot of care into writing this article, the information presented within is general and doesn’t consider your unique situation. It is not meant to serve as a substitute for professional advice, and you should not rely on it solely for any major financial decisions. You should always consult with a professional when you’re dealing with finance, tax, and accounting matters.
Speak to Dark Horse Financial
Choosing between an operating lease, finance lease, chattel mortgage, or another equipment finance solution depends on how your business uses equipment and what you want to achieve financially.
At Dark Horse Financial, we help Australian businesses compare equipment finance options from a wide range of lenders. We can help you identify the most suitable structure for your circumstances.
