Financial Lease vs Operating Lease

Difference Between Financial Lease vs 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 the lessee refers to the party using the asset in lieu of lease payments. An operating lease does not meet any of the above conditions. while a capital lease agreement is like buying a property through a loan agreement with payment being made through installments is nothing but an Operating lease.

Let us study much more about Financial Lease vs Operating Lease in detail:

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

1. Ownership transfer of an 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. The 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.

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 it is 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.

Head to Head comparison Between 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. An 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 of the ownership of the asset.
• Since a 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 expenses 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 the 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, the lessee gets the right to use the asset for more than 75% of the assets’ estimated economic life, while in an operating lease, the asset is used for a much shorter term.
• Financial lease offers a tax deduction for depreciation and lease payments as finance charges to the lessee, while an Operating lease offers a tax deduction for the lease payments only to the lessee.
• Under a financial lease, the lessee gets the option to purchase the asset at a discounted price at the end of the contractual period, while in an operating lease, no such option is provided to the lessee.
• A financial Lease cannot be canceled by the lessee during the primary period of the lease, while the operating lease can be canceled by the lessee during the primary period.

Financial Lease vs Operating Lease Comparison Table

Below is the topmost comparison between Financial Lease vs Operating Lease

Basis Of Comparison	Operating Lease	Financial Lease
Meaning	Rental agreement/contract in which risks and rewards remain with the lessor	Loan agreement/contract in which risks and rewards are transferred to the lessee
Ownership	Ownership remains with the lessor	Ownership transferred to the lessee
Accounting Treatment	Lessee has to show the lease payment as an operating expense. The leased asset is an off-balance sheet item for the lessee.	A lessee can show depreciation of the asset, while lease payments can be treated as interest. The leased asset is shown on the Balance Sheet.
Lease Term	Contract for short-term	Contract for long-term
Expenses and running cost	Lessee pays only the lease payments.	The lessee bears all expenses, including insurance, maintenance, taxes and other administrative expenses associated with the leased asset.
Risk of obsolescence	Lies with the lessor	Lies with the lessee
Example	Projectors, Computers, Laptops are usually leased through short-term operating lease agreements.	Plant and machinery, land, building are usually leased through longer-term financial lease agreements.

Conclusion

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 the 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 the case of bigger assets like plants 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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