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Operating Lease Vs Finance Lease

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.

Table of Content

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.Operating Lease Vs Finance Lease

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.

Learn More: Financial Market: Meaning, Definition, Types, Functions

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:

Parameters Operating Lease Finance Lease
Meaning 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.
Transferability 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
Maintenance 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 Cancellation lies on the part of the lessor Cancellation lies on the part of the lessee
Tax advantage 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
Purchasing option 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.

Learn More: Financial Accounting vs Management Accounting

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. 
Operating Lease Vs Finance Lease
The real-world examples of the operating lease include the following:

  • Aircraft
  • Real estate
  • Equipment with long life spans, such as industry equipment, office machines, vehicles, and more.

Conclusion

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.

FAQ's

A capital lease, which is now regarded as a finance lease, resembles any financed purchase. The ultimate lease term spans the maximum useful life of the asset. The operating lease resembles the rental agreement where the asset is used for a particular timeframe with the life remaining at the end of the lease.

A lease can be only categorized as a finance lease only when it transfers all rewards and risks incidental to ownership substantially. But a lease can only be called an operating lease when it doesn’t transfer risks and rewards substantially incidental to ownership.

The operating lease is the type of lease that doesn’t transfer ownership or risks & rewards of the lessee’s asset. Note that the lessee pays for using the asset and returns it at the lease term’s end. Operating leases are the expenses on income statements, and they don’t affect a balance sheet. On the other hand, financing leases are treated as the liabilities and assets on a balance sheet as depreciation expenses and interest on an income statement. Thus, financing lease increases the liabilities and assets, thereby reducing the net income and operating cash flow.

It depends on the way you use the asset. Also, your financial scenario is a crucial factor. In case you plan to use your asset until the end of the natural lifespan, you may wish to opt for the capital lease. On the contract, when you need it for a shorter timeframe, the operating lease keeps things simple.

The difference between an operating lease and a finance lease lies in one thing. The operating lease is the contract permitting the use of the asset without transferring the said asset’s ownership rights. On the other hand, the finance lease is the contract that permits using the asset and transferring ownership as soon as the lease period is over. In addition, the lessor also meets the contract obligations.

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