Entrepreneurs can choose a special form of business financing – leasing – in which they can buy almost anything (equipment, machines, office equipment, passenger cars, and even real estate). Leasing is divided into two basic types – financial and operational leasing. They differ from each other in terms of contractual terms. It is very important that every entrepreneur who decides to lease chooses the most advantageous form of leasing. A few years ago, the differences between the two types of leasing were blurred as a result of IFRS 16 (International Financial Performance Standard).
Leasing – the most important differences
The differences between financial and operational leasing concern the duration of the leasing contract, the tax assessment of the leasing, depreciation of the leased asset, and payment of VAT. They may also concern, for example, the purchase of the leased item.
What is operational leasing?
First, let’s explain the terms: a lessor is a financing entity, e.g. a leasing company, a bank, and a lessee is an entrepreneur using the leasing service. Operating (service) leasing is an agreement in which the lessor grants the lessee the right to use a given leased item. In return for such a service, it receives remuneration in the form of leasing installments. However, the desired item is included in the lessor’s assets.
To be more precise – it is the financing institution, and not the entrepreneur, who remains the owner of the given leasing item. The lessor is obliged to prepare depreciation write-offs. The lessee has limited room for maneuver when determining the costs of obtaining income. These include only monthly leasing installments (with VAT added successively) as well as possible initial fees and various expenses related to the use of the leased item (e.g. repairs, replacement of parts).
Operating leasing is not binding – it is treated as a service. The user has the right to terminate the contract and return the leased item at any time.
Advantages and disadvantages of operational leasing
The biggest advantage of operational leasing is the lack of the need to pay the entire VAT when concluding the contract. In this case, VAT (always 23%, regardless of the type of the leased item) is included in each monthly installment. After the end of the operating lease, many entrepreneurs decide to buy the leased item (they pay the final value indicated earlier in the contract). However, this is not mandatory. Other business owners sometimes decide, after the end of the contract, to sign another settlement. This time for another, similar leasing item (e.g. if it is a passenger car, they choose a newer car).
Operating leasing allows you to reduce the tax base. This is a good solution for those entrepreneurs who earn high income while paying high taxes.
Operating leasing has several disadvantages. Unfortunately, you can become the owner of a specific leased item (e.g. a car, machine) only after the leasing contract ends and the item is purchased from the lessor. The redemption value of this item is regulated by the Income Tax Act. The rate also depends on: depreciation rate and contract duration. The financing entity and the beneficiary may therefore agree on the redemption value, but only within strictly defined limits.
An operational leasing agreement cannot be concluded for a period shorter than that indicated in tax regulations – the minimum duration of the settlement cannot be shorter than 40% of the standard depreciation period. For example: passenger cars must be repaid over a minimum of 2 years.
What is financial leasing?
Financial leasing (capital, investment) seems to be similar to operational leasing – the leased asset is transferred to the lessee for use in exchange for the payment of leasing installments. However, here the approach to the issue of recognition in assets or payment of VAT is different. The leased asset is recorded as a fixed asset of the lessee, so it is the lessee – and not the financing entity – who makes depreciation write-offs.
Finance leasing involves significant upfront fees. After concluding the leasing agreement, the entrepreneur must pay the entire VAT (including the first installment) – this is because this source of financing is treated as a supply of goods. There is no entry fee. In financial leasing, the leasing installment is divided into two parts:
- Capital installment – repayment of the initial value of the leased item,,
- Interest installment – the lessee’s cost of obtaining income.
The entrepreneur becomes the full owner of the item immediately after paying the last installment of the financial leasing.
Advantages and disadvantages of financial leasing
Financial leasing – above all – has no restrictions on the duration of the contract. The settlement can be signed for any period (e.g.: in the case of cars, even for less than 2 years). In financial leasing, attention is paid to the VAT rate for a given leased item (the sum of VAT charged on leasing receivables always has the appropriate rate for the fixed asset). This is particularly important when the leased item is taxed at a VAT rate other than 23%. In financial leasing, depreciation is performed by the entrepreneur.
The disadvantage of financial leasing is the necessity – at the beginning of the contract term – to pay the entire VAT tax (calculated on the sum of leasing receivables). What may be a problem for some may be a blessing for others. Smaller companies that are not VAT payers can add the VAT rate at the same rate as the item was charged.
Many lessees complain that they have to keep records of fixed assets and make depreciation write-offs. Such action may be troublesome for those entrepreneurs who have no other assets.
IFRS 16 – how do we now define the differences between leases?
International Financial Reporting Standards IFRS 16 introduced significant changes in the perception of operating and financial leasing. Although both types still exist in law under the Accounting Act, as well as in relation to the lessor, in the light of International Accounting Standards, the lessee does not have to worry about the traditional division.
Under IFRS 16, the lessee – in any case – is obliged to recognize assets and liabilities in the balance sheet (until now, this was not necessary in the case of operational leasing). The new classification does not apply to the leased item itself, but to the right to use it. The type of contract (operating lease, financial lease, lease, tenancy) does not matter. The most important thing is the effect of a given document.
When does IFRS 16 not apply?
There are several situations where IFRS 16 standards do not apply. They concern a specific category of entities’ activities and are separated in the annex to Commission Regulation (EU) 2017/1986 of October 31, 2017.This includes, among others: leasing relating to biological assets, minerals, crude oil, natural gas or licenses for intellectual property (license agreements may result in: films, works of art, manuscripts, patents and copyrights).