The concept of a lease has its origin in the business. Most businesses, whether start-ups or big companies, look for leasing options. The main reason is because of the limited resources available and less money available for investing. Leasing can be broadly divided into two types – finance lease and operating lease.
- Finance leases transfer asset ownership to the lessee at the end of the lease term, while operating leases don’t.
- Lessees account for finance leases as long-term liabilities and capitalize the leased asset, whereas operating leases appear as rental expenses in financial statements.
- Finance lease payments cover the entire asset cost, while operating lease payments provide maintenance and insurance.
Finance Lease vs Operating Lease
The difference between a finance lease and an operating lease is that The ownership of a financial lease is with the lessee at the end of the lease period, while the ownership of the operating lease is with the lessor. So most of the risks and rewards which are related to the assets are of the owner of the particular lease.
The running and administration costs and expenses are higher in a financial lease. The lessor takes the larger residual risk and holds a low residual value position which can also be considered negligible. The financial lease provides a tax benefit to the lessee in the form of interest and appreciation.
On the other hand, an operating lease has no running or administration expenses. The residual value position held is higher. No depreciation or tax benefit can be claimed in an operating lease. The commercial contract of an operating lease allows the lessee to use the asset for a short period and only by the lessor.
|Parameters of Comparison
|The ownership of the contract is transferred to the lessee
|The ownership of the contract remains with the lessor
|It is a commercial contract for the long term
|It is a commercial contract for the short term
|Type of contract
|Finance lease is also known as a loan agreement or contract
|Operating lease is also known as rental agreement or contract
|Provision of cancellation
|Finance lease cannot be cancelled during initial period
|Operating lease can be cancelled during the initial period
|The lease can be cancelled by the lessee
|The lease can be cancelled by the lessor
What is a Finance Lease?
Financial lease refers to the type of lease where the risk and the return are transferred to the lessee. Lessee is referred to as the business owner. Lessee decides the lease assets for business and commercial purposes. The lesser allows the lessee to use the assets for a long period.
The finance lease does not provide any facility for cancelling the lease during the initial period of the contract. The commercial contract allows the lessee to use the asset of the former in lieu of periodical payments. The period of the contract is extended.
The concept of a financial lease lasts for a long term. Financial lease performs recording under the system of accounting and does not allow balance sheets. The other name of the financial lease is also known as a loan agreement or contract.
The financial lease provides an option of asset purchase which is at the end of the period of the contract. The financial lease allows using the acid, which cannot be afforded and lasts for an extended period. The finance company that hires a finance lease is the controller and owner of the financing assets. The risk of obsolescence and even cancellation lies on the part of the lessee in the financial lease.
What is a Operating Lease?
An operating lease refers to the type of lease where all the risk and the return stay with the lessor. The commercial contract of an operating lease allows the lessee to use the asset for a short period and only by the lessor. The operating lease has the provision of cancellation during the primary period of the contract.
The operating lease does not need any recording which is done specifically under the accounting system. The system followed in the operating lease is an “off the balance sheet lease”. The ownership of the lease is under the lessor and not with the lessee.
The other name of an operating lease is also known as a rent agreement or contract. The contract can be revoked, but only during the initial period. The risk of obsolescence and even cancellation lies on the part of the lessor in the operating lease.
An operating lease does not provide much tax deduction. The only deduction offered in the operating lease is in the form of rent payments. Operating leases are best for people who want to use their assets but do not show the same under the accounting record.
Main Difference Between Finance Lease and Operating Lease
- The ownership of the financial lease can be transferred to the lessee, while the ownership of the operating lease can be transferred to the lessor.
- The lessee maintains the financial lease while the lessor maintains the operating lease.
- The risk of obsolescence and even cancellation lies on the part of the lessee in the financial lease while the risk of obsolescence and even cancellation lies on the part of the lessor in the operating lease.
- A financial lease has provisions for tax advantage and deductions like depreciation or financing, while an operating lease only allows the lease rent to be deducted from the tax.
- The option of purchasing the financial lease is given to fewer, while there is no provision of purchase in an operating lease.
Last Updated : 13 July, 2023
I’ve put so much effort writing this blog post to provide value to you. It’ll be very helpful for me, if you consider sharing it on social media or with your friends/family. SHARING IS ♥️
Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.