A Brief Introduction About Operating Lease
For companies, it is very common to end up in situations where it is easier to lease certain assets than to buy them. Some companies may not afford to buy a particular asset, and some may want to benefit from the various benefits of the agreement. It is a legally binding agreement that allows one party known as lessee to lease a particular asset without getting the ownership rights of it, from a lessor.
The agreement contains all the key information regarding this relationship between the lessee and lessor. Lessors make sure that the lessee leases an asset for a period shorter than the economic life of the asset. This agreement is different from a capital lease agreement and considered as off-balance-sheet financing, which means the leases assets and its liabilities won’t be included on a company’s balance sheet. However, it will be included in a company’s income statements.
Assets that can be rented are real estate, equipment, machinery, software, aircraft, etc.
It should be noted that from recently, due to a new Financial Accounting Standards Board (FASB) rule, public companies have to recognize all leases on the balance sheet unless they are shorter than 12 months.
Who Takes the Operating Lease? – People Involved
The debate between Operating Lease Vs Capital Lease is extremely common among companies. Both of these lease agreements can be signed between a lessor and a lessee. A lessor is an individual or a company that allows another company, known as lessee, to use certain assets for a limited period of time, without giving ownership and liability rights. It can be seen as the process of renting an asset. The lessee and lessor decide when and how the regular payment for the asset will be made.
Purpose of the Operating Lease – Why Do You Need It?
What is Operating lease? As discussed above, an Operating Lease Agreement is used when the lessee decides to lease an asset. It can also be used by a company or a lessee when it is in the habit of replacing the old assets. Renting assets become easier than buying the assets, and thus, it is very common for companies to choose lease and especially, Operating Lease that ensures liabilities are not included in the company balance sheet.
Here are some pointwise reasons to choose this agreement –
- It allows one party to lease or rent a useful asset without taking the ownership rights by the end of lease
- To ensure that the lease is not added in the company’s balance sheet
- An agreement contains all the information related to the lease
- It ensures there are no disputes and confusions
- It spells out the conditions and terms of a lease
- It spells out the restrictions of a lease
- It mentions governing laws
- It provides dispute resolution methods
- In comparison to an oral agreement, it is more secure and risk-free
- There is no taxation issue as the lease is considered as renting
Contents of the Operating Lease – Inclusions
Operating lease agreement is used to record assets that one-party rents to another party know as lessee. The process of renting or leasing can also be done orally. However, it is suggested that a written agreement must be signed to keep things in the record and to make the process legally binding. A written agreement reduces a lot of tension and stress as it contains all the information that can be referred in case of any doubt or confusion.
The lease contract must contain the basic details of a lessor and a lessee. Basic details include name, address, phone numbers, etc. of both entities. Further, it must include all the details of the asset. The asset can be a real estate asset, an aircraft, software, equipment, automobile, etc. It is important to add all the information pertaining to the asset. In what condition, the asset is being rented; it should be recorded in the agreement to save the lessee from any false penalty.
Further, the agreement must include the period of the lease. It should also include the details of how the payment will be paid. It will have the details of the term of the lease. Payment can be paid in various ways such as cheques, bank transfers, etc. So, it is important to specify this crucial information with caution.
Dispute resolution methods and governing laws are two other very important inclusions in the agreement. They ensure that both parties are protected from any kind of breach or violation. Termination and late payment fees are two other extremely important inclusions that should be treated with all seriousness. The agreement must also give a solution for an unforeseeable situation such as death, natural calamity, etc. Additional clauses should be added to make the agreement full-proof.
How to Draft the Operating Lease?
Before deciding to sign a Lease Agreement, both parties must understand the Operating Lease vs. Capital Lease. Both of these are different from each other and hold different benefits. It is also important for the lessor to first check the background of a lessee. They almost become part of your business so you must choose a lessee carefully. Both parties are suggested to research on each other. They should also check each other’s credit history, their relationships, their financial standing, etc. Both parties must also understand how much paperwork the leasing requires. It is paramount to understand the paperwork and all its conditions or clauses.
Both parties should maintain a healthy relationship so that they can negotiate on various things, such as late fees and liabilities. It also reduces a lot of pressure. The condition of the asset at the time of renting also plays a huge rule in deciding the whole partnership. Both parties should check the condition together and mention the details in the agreement. They should decide whether the lessee wants to get repairs done on his own or not.
If the lessor wants to take security, then he must mention it to the lessee before drafting the agreement. In some cases, there may be an exemption from security. Insurance, repair, and maintenance are a few things that require in-person discussion between both parties. Once both parties come on the same page, the agreement must be drafted. After drafting the agreement, both parties must give a careful read. You can also take the help of an attorney to understand some hidden clauses and governing laws.
The lessee must negotiate with lessor on security, payment modes, and late payment fee. A healthy relationship between both parties before signing the agreement ensures that there are open discussions for negotiations. The key to good negotiation is in the hands of a lessee. He or she must make sure that they gather points after researching about the lessor and present them in a solid way. As a result of negotiations, some lessors waive off the late payment fees and exempt leases from security.
Benefits & Drawbacks of the Operating Lease
In a Finance Lease or Capital, Lease ownership is transferred to the lessee by the end of the lease period. According to generally accepted accounting principles (GAAP), for a lease to be Capital Lease. it must follow certain rules apart from ownership transfer such as, the lease should contain a bargain purchase option and the lease life should exceed 75% of the asset’s economic life, or the present value of a lease payment should exceed 90% of an asset’s market value. Both the Operating and Capital Lease have their own advantages and disadvantages.
Here are some benefits-
- It specifies the responsibilities of both parties
- It specifies the obligations and liabilities of both parties
- It gives a dispute resolution method
- It makes leasing legally binding
- It spells out all the terms and conditions that both parties can refer to
- It reduces tax liabilities
- It is not added in the company’s balance sheet
Drawbacks of this agreement –
- It involves risk
- It involves security and maintenance
What Happens in Case of Violation?
In case of any violation, both the lessee and lessor are well within their rights to approach the court. However, it is suggested that both parties refer to the agreement and try to mediate before involving the court(1). Depends on the state you live in, the state laws also apply. Both parties should ensure that all obligations and responsibilities are followed as per the agreement to avoid any dispute or breach.
A lease agreement is like a rent agreement that needs a good and healthy off-paper relationship between the entities involved. Both parties must ensure that they follow the agreement’s terms and conditions and maintain a healthy relationship. It is a highly beneficial agreement that helps both parties in their business. So, it must be used with all seriousness. The monthly payments should be made on time by the lessee.
There are many samples/operating lease contract template available online on the contract. However, you must choose the one drafted by an expert. Here is an Operating Lease sample drafted by our expert attorney.