Operating Lease vs Finance Lease

What is a Lease?

A lease is a contract between two parties for the right to use an asset. These parties include the lessor and the lessee. Firstly, the lessor is a company or business that owns an asset. In contrast, the lessee is an individual, business or company that uses the asset owned by the lessor. In exchange for the right to use the asset, the lessee makes fixed and regular payments to the lessor.

Lease agreements are prevalent in capital intensive industries. Leases allow companies and businesses to use an asset without having to acquire them. Therefore, companies don’t need to invest heavy amounts in large assets. Instead, they can obtain it from another party that has already paid for it. Although the lease payments are higher than the asset’s cost, the contract allows lessees to spread the cost over several periods.

Lease contracts define several aspects of a lease agreement. These usually include the responsibilities of both parties involved, the payment terms, default penalties and fines, etc. These also include the length of the contract and any other crucial terms. Some lease contracts may also include terms that allow the lessee to obtain the underlying at the end of the contract. Both parties sign the contract, which makes a legal and binding document.

What are the types of Leases?

There are two types of leases that companies and businesses may obtain. These include operating and finance leases. Differentiating between these types of leases is crucial for companies. Before understanding how these are different, it is also critical to understand what finance and operating leases are.

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What is an Operating Lease?

An operating lease represents a lease in which the risks and rewards associated with using the asset remain with the lessor. Usually, operating leases involve the use of an underlying asset for a short period. Similarly, operating leases do not include transferring the underlying asset to the lessee when the contract ends.

For accounting purposes, operating leases include all lease contracts that last less than 12 months. Initially, the lessee recognizes a right-to-use asset in its financial statements. For each period, the lessee must record an expense for any payments against the lease contract. The lessor, on the other hand, recognizes an income for the asset in its income statement.

What is a Finance Lease?

A finance lease is a lease contract that does not qualify as an operating lease. Usually, these include contracts that are long-term. Similarly, in finance leases, the risks and rewards associated with the asset get transferred to the lessee. Sometimes, finance leases also include transferring the underlying asset to the lessee at the end of the contract. However, that is no a requirement.

For accounting purposes, finance leases include any lease contracts that last more than 12 months. For these leases, the lessee must recognize both an asset and a liability in its balance sheet. Similarly, for every period within the lease contract, the lessee must split repayments into interest and principal amounts. The accounting treatment for lessor is similar.

What are the differences between Operating and Finance leases?

There are several differences between operating and finance leases. Some of these include the following.

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Ownership

The ownership of the asset remains with the lessor in both leases. With finance leases, the lessee may get the option to acquire the asset after the end of the lease period.

Risks and rewards

As mentioned above, the risks and rewards associated with the asset remain with the lessor in operating leases. For finance leases, the risks and rewards of the asset get transferred to the lessee.

Accounting treatment

The accounting treatment for both types of leases differ. For operating leases, the lessee records a right-to-use asset. For finance leases, it must recognize an asset and a liability.

Contract length

Operating leases are long-term contracts. As mentioned, these include contracts that last less than 12 months. On the other hand, finance leases are long-term and last more than 12 months.

Tax treatment

For operating leases, lessees pay rent, which is presented and included in the income statement. The lessee can claim this expense as a deduction from income. On the other hand, the lessee can claim tax depreciation for the use of assets under a finance lease.

Asset’s useful life

For operating leases, the lessee only uses a small proportion of the asset’s overall useful life. However, with finance leases, the lessee gets to benefit from a majority of its useful life.

Key Summary of Differences:

Key DifferencesOperating LeaseFinance Lease
OwnershipRemain with the lessorWith lessees
Risk and RewardsRemain with the lessorRisk transferred to the lessees
Accounting TreatmentRecognize as expense in the profit or lossRecognize assets and liability in the Balance Sheet
Contract LengthLess than 12 monthsMore than 12 months
Tax TreatmentClaim rental payment as tax deductible expenseDepending on jurisdiction; can claim depreciation as tax deductible expense
Asset’s useful lifeOnly small proportion of asset’s overall useful lifeBenefit from overall useful life

Conclusion

Leases are a critical finance source for companies. It allows them to use an asset without having to acquire it. There are two types of leases that companies may obtain. These include operating and finance leases. Operating leases are generally short-term lease contracts. In these leases, the risks and rewards of the asset remain with the lessor. For finance leases, the risks and rewards get transferred to the lessee.

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