Finance Lease or Operating Lease What is the Difference

In business, the lease is quite a critical concept. Be it a new small business or a startup; they generally look out for leasing options as their resources are restricted. Another reason is that owners don’t wish to invest a huge amount in acquiring assets just to support their business in the initial stages. 

Majorly, there are two different types of leasing: financial lease and operating lease. If you are new to this concept, this article is meant to highlight the difference between a finance lease and an operating lease. So, without further ado, let’s get started. 

Defining the Concept of Leasing

The lease is referred to as a finance agreement wherein the owner of the asset (lessor) buys the asset and allows the asset user (lessee) to use it for a specific period against timely payments, known as lease rentals. 

The fundamental terms and conditions of such a lease are written in a document known as the lease deed. Simply put, a lease is an alternative to purchasing an asset with borrowed or owned funds. 

Types of Leasing

There are two prevalent types of leasing:

  • Finance or Capital Lease

This is a type of lease wherein the rewards and risks are transferred to the lessee along with the asset’s transfer. 

  • Operating Lease

Contrary to the finance lease, the rewards and risks are not transferred to the lessee under the operating lease. 

Operating Lease

With an operating lease, you can sign an agreement to finance equipment(s) for less than their usual life. And then, at the end of the period, you can return the equipment(s) without any additional obligations. 

Since this lease type has a shorter term, you can upgrade the asset periodically. You can even do so even when the lease is in force. 

  • The lessee gets access to the equipment for a specific time period in return for regular payments. 
  • The lessee can use the equipment for the entire term of the agreement. The regular rental payments do not equal the equipment’s total value.
  • The lessor has to bear the risk, and the plan is to return the equipment to them at the term’s end.
  • At the agreement’s end, the equipment must maintain a residual value, which is generally predicted at the start of the lease. 
  • Equipment payments could be considered in the regular payments. 

Finance Lease

A finance lease is generally used to purchase equipment(s) for a significant part of their useful lie. Under this type, at the end of the lease term, you get the ownership of the equipment(s) by providing a viable offer to buy the asset. 

Generally, this ‘offer’ is referred to as the balloon amount. With this lease, the lessee will not have to bear a high upfront cost when buying the asset outright. Also:

  • The lessee will be liable for every risk, and the asset will be put on the balance sheet. 
  • The lessor gets to keep the ownership. However, the lessee gets to use the asset exclusively in regard to the agreement. 
  • During the lease period, the lessee pays the rental payments. They can pay a balloon payment at the end of the period (if required).
  • Usually, the agreement’s term is for the useful lifetime of the asset. 

This lease type is non-cancellable in nature. However, it can only be cancelled if:

  • The lessor allows the cancellation
  • There is any contingent event happening
  • The lessee has entered into a lease agreement with the lessor for the similar asset

In case the lessee cancels the agreement o this lease, the lessee will bear any type of losses that the lessor will have to incur. 

Difference Between Finance Lease and Operating Lease

To understand the difference between a finance lease and an operating lease thoroughly, refer to the table mentioned below:

Factors
Finance Lease
Operating Lease
Title
At the end of the lease’s term, the asset’s ownership gets transferred to the lessee.
Asset ownership stays with the lessor throughout the term and even after it.
Residual / Balloon Amount
There is a residual / balloon option that the lessee can take to buy the asset at a certain price.
The lessee doesn’t have an option of residual / balloon amount.
Administration & Running Costs
Administration and running costs are not generally included in this lease type. This means there can be huge price and administration fluctuation for the lessee.
All the running costs, such as insurance, registration, servicing, and more, get included in the agreement within the set term.
Accounting Effect
This is regarded as a loan. Since the lessee has the ownership, the asset gets a place on the balance sheet.
This is regarded as rent. Thus, the lease payments are merely operating expenses; thus, the asset doesn’t get any place on the balance sheet.
Lease Term
The term of the lease is basically the significant economic life of the equipment that has been leased.
The term of the lease can extend to less than 75% of the showcased useful life of the asset.
Cancellation of the Lease
It can be cancelled only on certain events.
It can be done at any time.
Tax Benefits
The lessee gets a chance to claim the depreciation and interest.
The lease payment is regarded as an expenditure; thus, the lessee cannot claim any depreciation.
Example
Office building, land, machinery, plan, and more.
Coffee dispensers, laptops, computers, projectors, and more

Conclusion

And there you have it! The answer depends on your situation if you are considering which option would be the best, operating or finance lease. An operating lease agreement can decrease user administration and let them hand the asset back at the end while paying monthly repayment(s). 

Such an option is generally beneficial for companies running short on funds. On the other hand, a finance lease has more administration requirements. Based on the type of asset, you may have to face resale risk as you will have to ensure that the balloon amount is met at the end of the lease term. 

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *