Financial Lease vs Operating Lease

Difference Between Financial Lease vs Operating Lease

A lease is an agreement wherein the asset owner gives another party the right to use the asset for a specified period of time in exchange for periodic payments or other assets. Companies often prefer to lease long-term assets instead of purchasing them due to reasons like better financial terms, lack of funds to buy the assets, keeping the assets off the balance sheet, a necessity of the leased asset etc. Two types of leases are prevalent in the business environment viz. capital lease or finance lease and operating lease.

A financial lease is a lease where rewards and risk associated with the leased asset gets transferred to the lessee with a transfer of the asset while in operating risk, risk and return remain with the lessor. Here the lessor refers to the original asset owner while lessee refers to the party using the asset in lieu for lease payments.

For a lease to be classified as a capital lease, any one of the four conditions have to be met:

1. Ownership transfer of asset to the lessee by the end of the lease term
2. An option is given to the lessee to purchase the asset at a discounted rate relative to its fair value at the end of the lease term. This bargain purchase option is usually determined at the beginning of the lease
3. Lease term is greater than 75% of the asset’s useful life
4. The net present value of the lease payments is at least 90% of the leased asset’s fair market value

However, for a lease of Land, only ownership transfer or existence of a bargain purchase option (conditions 1 or 2) would qualify the lease as a capital lease.

An operating lease does not meet any of the above conditions. Thus if you have rented an asset through an operating lease, you have no option to purchase the asset at the end of its life term, you use the asset for less than 75% of its effective life and likewise, the present value of your lease payments will be less than 90% of the asset’s market value. The accounting treatment of your operating lease will be different from that of a capital lease with the leased asset staying off the balance sheet and lease payments getting treated as operating expenses in the Income statement. Effectively its like you have taken a property on rent when you enter into an operating lease, while a capital lease agreement is like buying a property through a loan agreement with payment being made through installments.

Financial Lease vs Operating Lease Infographics

Below is the Top 7 difference between Financial Lease vs Operating Lease

Key Difference Between Financial Lease vs Operating Lease

The primary difference between Financial Lease and Operating Lease are discussed below:

• A financial lease is basically a loan agreement where the lessor transfers the risk and rewards of his asset to the lessee in exchange for periodical payments. Operating lease is basically a rental agreement where the lessor gives the lessee only the right to use the asset without transferring risks and rewards or the ownership of the asset.
• Since financial lease considers a transfer of ownership, the lessee needs to show the asset on the balance sheet and accordingly, depreciation of the asset can be treated as an operating cost. Lease payments are treated as financial interest expense similar to a loan agreement. Operating lease, being similar to a loan agreement, lease payments are shown by the lessee as an operating expense while lessor shows the asset and depreciation in his accounts. Thus lessee, in an operating lease, can keep his balance sheet ‘light’ through the agreement
• In case of a Financial lease, lessee gets the right to use the asset for more than 75% of the assets’ estimated economic life, while in operating lease, the asset is used for much shorter term
• Financial lease offers a tax deduction for depreciation and lease payments as finance charges to the lessee while Operating lease offers a tax deduction for the lease payments only to the lessee
• Under a financial lease, lessee gets the option to purchase the asset at a discounted price at the end of the contractual period, while in operating lease no such option is provided to the lessee
• Financial Lease cannot be cancelled by the lessee during the primary period of the lease while operating lease can be cancelled by the lessee during the primary period

Head To Head Comparison Between Financial Lease vs Operating Lease

Below is the topmost comparison between Financial Lease vs Operating Lease

Financial Lease vs Operating Lease – Final Thoughts

Operating leases provide greater flexibility to companies since they can replace or update the leased equipment more frequently. Further, no transfer of ownership means no risk of obsolescence. Accounting treatments are also simpler in an operating lease while administration and maintenance hassles are much less.

Capital Lease, on the other hand, provides greater tax benefits to the lessee through depreciation and interest expense inclusion in their books. Firms in higher tax bracket are more likely to enter into capital lease agreements rather than operating leases. The disadvantage of a capital lease over an operating lease is the higher administrative and maintenance costs. The resale risk involved in a capital lease is also higher since the lessee has to make sure that the balloon payment for purchasing the asset is available at the end of the lease term. Financial leases are usually more prevalent in case of bigger assets like plant and machinery, buildings and land. Hence, depending on the requirement and tax situation, a company may choose between the Financial Lease vs Operating Lease.

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