The Disadvantages of an Operating Lease

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Businesses often use heavy equipment, vehicles or buildings in their business. Heavy equipment allows the business to service its customers. Vehicles allow the employees to visit customer facilities. Buildings provide a location for business to occur. Many companies choose to lease these assets rather than purchase them. Companies with no intention of purchasing the asset often pursue an operating lease for the asset. Several disadvantages exist for companies who enter into operating leases.

Definition

An operating lease occurs when no transfer of ownership is intended. The lessor, or the owner of the asset, retains ownership of the asset throughout the duration of the lease and receives the asset back at the end of the lease. The lessee, or the company using the asset, records only the expenses associated with the lease. The lessee never records an asset in its accounting records.

Increased Expenses

One disadvantage of entering an operating lease involves the higher level of expenses reported. Businesses who enter operating leases record a lease expense for each period throughout the duration of the lease. These expenses appear on the company’s income statement. The income statement reports the revenues earned for the period, the expenses incurred and the net income for the period. Financial statement users like to see companies report a positive net income. Expenses, including the operating lease expense, reduce the company’s net income.

Lack Of Ownership

Asset ownership increases the level of equity owned by a company and the decision-making responsibility regarding the asset. A disadvantage of entering an operating lease is that the leased asset appears nowhere as an asset on the company’s accounting records. The company holds no ability to sell or modify the asset without the lessor’s permission. Lack of ownership benefits represents another disadvantage to an operating lease.

Lack Of Continuity

Operating leases represent temporary arrangements between the lessor and the company. When the lease expires, the terms of that lease become void. The lessor and the company spend time renegotiating the terms or ending the relationship. The company needs to reconsider the lease and evaluate its options on a regular basis. This lack of continuity makes it difficult for the company to plan, another disadvantage.

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