If you wish to learn the differences between operating lease and finance lease, welcome to this post. Let’s learn the advantages, disadvantages, and comparisons of finance and operating lease in this comprehensive post. The key difference between operating lease and finance lease lies in the extent of ownership benefits and risks transferred to the lessee. Operating leases are typically short-term, with less ownership resemblance, while finance leases are long-term and closely resemble asset ownership, often with significant financial and accounting implications for the lessee.
Read this guide to understand the key difference between operating lease and finance lease on the basis of other important aspects.
What is Operating Lease?
The operating lease is the short-term concept where the asset’s ownership isn’t transferred but remains with the lessor. Simply put, in this type of lease contract, using the asset is a right, but there’s no right of ownership of that particular asset.
The lease is beneficial for businesses and individuals, specifically when the company doesn’t need any asset or machine for an extended timeframe. Here, the lessee doesn’t have a choice to buy assets for a price less than the asset's fair market value.
How do Operating Leases Work?
The operating lease is the low-cost method for businesses to procure required items. Unlike the purchase loans, the lessee doesn’t purchase the asset. The lease rents it and they cannot buy the asset at the contract’s end.
In a majority of cases, the agreement includes a residual value based on the lease’s period and the asset’s estimated value at the contract’s end. The asset is sold to a third party at the agreement's end. A finance company refunds the percentage when the asset sells for the residual value. Suppose the asset sells for less than residual value. In that case, one should be liable to make the payment. In short, the operating lease lets businesses to use assets for a low monthly expense than purchasing the asset with the hire purchase.
What is a Finance Lease?
The finance lease is a long-term concept where the asset’s ownership is transferred to the lessee. The finance lease is the commercial lease where the lessee gets the risks and rewards of the fixed asset ownership. In this type of lease, the lessee purchases the asset for a price less than the asset's fair market value.
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How do Finance Leases Work?
The finance lease is the commercial rental agreement, where the lessee first selects the asset for the business. Then, the lessor buys the asset. Both the lessee and lessor enter into a legal contract. After this, the lessee makes payments for using the asset. The lessor then recovers the asset’s cost plus the interest. The lessee can acquire the asset’s ownership at the agreement's end.
The finance lease may significantly impact the firm’s financial statements for accounting purposes. These leases are considered the ownership, so they also influence depreciation costs, interest expenses, liabilities, and assets.
Difference between an Operating Lease and Financial Lease
Here’s a tabulated comparison between operating lease vs finance lease:
||It is a commercial contract where a lessor needs to allow a lessee to use the asset instead of periodic payments for a short timeframe.
||It is a commercial contract where the lessor allows a lessee to use the asset in lieu of periodical payments for a long period.
||Ownership remains with the lessor only
||Ownership transferred to the lessee
|The term of the lease
||A short-term contract
||A long-term contract
|Nature of contract
||A rental contract/agreement
||A loan contract or agreement
||The lessor needs to maintain the asset
||The lessee needs to maintain the asset
|Risk of obsolescence
||Lies on the lessor’s part
||Lies on the lessee’s part
||Cancellation lies on the part of the lessor
||Cancellation lies on the part of the lessee
||The lease rent can be deducted from the tax
||The asset’s expenses like financing and depreciating are allowed for the tax deduction to the lessee
||The lessee does not get any purchasing option in operating the lease
||The lessee gets the option of purchasing the asset taken on lease
Advantages and Disadvantages of an Operating Lease
Here’s presenting the advantages of the operating lease:
- The management may lease the equipment at an amount & use the remaining amount to generate profitable opportunities
- If there’s a risk of equipment becoming outdated in the future, the operating lease might be beneficial.
- If a company goes through times of distress, it may choose the operating lease
- The operating lease payments offer tax benefits
Here’s presenting the disadvantages of operating a lease:
- The lease has the operating lease cost, known as the financing cost. So, there will be a rate of interest included.
- Considering the leasing contract, the company doesn’t own the equipment. If it did, it would have been an asset. But when it comes to the operating lease terms, the liability on financial statements results in a reduced ROI for shareholders.
Advantages and Disadvantages of a Finance Lease
The finance leases provide both advantages & disadvantages considering the liabilities, accounting, and costs.
Here’s presenting the advantages:
- The lessee can use the required asset without buying it.
- Lease financing is less expensive than the other financing types.
- The lessee spreads payments out over various years.
- There’s no burden of the lump-sum cost for the asset.
- The lessee claims the depreciation on a leased asset that reduces the tax liability.
- Even when the asset increases in price, the lessee only pays installments agreed upon.
- The lessee retains the right to buy the asset at the lease period’s end, usually at the bargain rate.
Here’s presenting the disadvantages or limitations of the bargain lease:
- The lessee should maintain/repair asset.
- The lessee should be able to take all risks involved.
- The lessee can never cancel the finance lease.
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Operating Lease vs. Finance Lease: Which One to Choose?
A finance lease is a better choice if you want a long-term contract. But if you need a short-term contract, always opt for an operating lease. The finance lease includes the asset’s ownership transferred to the lessee.
Operating lease vs Finance lease: Real-world Example
Want to learn about the operating lease vs finance lease example? The open-ended vehicle lease is a perfect example of a finance lease. Here, there’s an obligation to buy the vehicle at the lease’s end.
The real-world examples of the operating lease include the following:
- Real estate
- Equipment with long life spans, such as industry equipment, office machines, vehicles, and more.
So, this post has narrated the differences between operating lease vs finance lease, their benefits, drawbacks, and real-life examples. Hero Vired offers integrated programs in financial technologies. Learn more about operating finance and lease finance from the platform. Before that, learn more about Financial Analysis, Valuation, & Risk Management course.