Finance lease and operating lease are the different accounting methods for the lease where in case of Finance lease all the risk and rewards related to the asset under consideration gets transferred to lessee whereas in case of Operating lease all the risk and rewards related to the asset under consideration stays with the lessor.
Differences Between Financial Lease vs. Operating Lease
The lease is an essential concept in business. Start-ups or new small businesses often look for leasing options because their resources are limited, and the owners of these businesses don’t want to invest so much money in acquiring assets to support the business in the beginning. That’s why they lease the assets whenever they require.
This leasing can be of two types – financial lease and operating lease.
A financial lease is a lease where the risk and the return get transferred to the lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. (the business owners) as they decide lease assets for their businesses. Operating lease, on the other hand, is a lease where the risk and the return stay with the lessorLessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period..
So how a business owner would choose between financial lease vs. operating lease? And why will he choose one over another?
In this article, we will find out how and why of a financial lease and operating lease. We will also find out the differences between a financial lease and an operating lease. For example, the main difference between a finance leaseFinance LeaseFinance lease simply refers to a method of providing finance in which the leasing company purchases the asset on behalf of the user and rents it to him for a set period of time. The leasing company is referred to as the lessor, and the user is referred to as the lessee. and an operating lease is financial lease can’t be canceled during the initial period of the contract; operating lease, on the other hand, can be canceled even during the primary period of a contract.
Financial Lease vs. Operating Lease Infographics
There are many differences between a financial lease vs. operating lease. Let’s look at the most significant differences between these two –
Financial Lease and Operating Lease – Key Differences
As you can see that there are several differences between a financial lease vs. operating lease. Let’s look at the critical differences between them –
- A financial lease is a type of lease where the lessor allows the lessee to use the former’s asset instead of a periodical payment for an extended period. Operating lease, on the other hand, is a type of lease where the lessor allows the lessee to use the former’s asset in exchange for a periodical payment for a brief period.
- A financial lease is a lease that needs recording under the accounting system. Operating lease, on the other hand, is the concept that doesn’t need recording under any accounting system; that’s why the operating lease is also called “off the balance sheet lease.”
- Under the financial lease, the ownership transfers to the lessee. Under an operating lease, the ownership doesn’t transfer to the lessee.
- The contract under a financial lease is called a loan agreement/contract. The contract under an operating lease is called a rent agreement/contract.
- Once both the parties sign the agreement, usually, financial lease can’t be canceled. Even after the agreement between two parties, the operating leaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term. can be revoked during the initial period only.
- Financial lease offers a tax deduction for depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. , finance charges. The operating lease provides a tax deduction for rent payments.
- In a financial lease, there is an asset purchase option given at the end of the contractual period. Under an operating lease, there is no such offer.
Financial Lease vs. Operating Lease (Comparison Table)
|Basis for Comparison||Financial Lease||Operating Lease|
|1. Meaning||A commercial contract in which the lessor lets the lessee use an asset instead of periodical payments for the usually long period.||A commercial contract where the lessor allows the lessee to use an asset in place of periodical payments for a small period;|
|2. What it’s all about?||A financial lease is a long-term concept.||Operating lease is a short-term concept.|
|3. Transferability||The ownership is transferred to the lessee.||The ownership remains with the lessor.|
|4. The term of the lease||It is a contract for the long term.||It is a contract for a short term.|
|5. Nature of contract||The contract is called a loan agreement/contract.||The contract is called the rental agreement/contract.|
|6. Maintenance||In the case of a financial lease, the lessee would need to take care and maintain the asset.||In the case of an operating lease, the lessor would need to take care and maintain the asset.|
|7. Risk of obsolescence||It lies on the part of the lessee.||It lies on the part of the lessor.|
|8. Cancellation||Usually, during the primary terms, it can’t be done; but there can be exceptions.||In the case of an operating lease, the cancellation can be made during the primary period.|
|9. Tax advantage||The expenses for the asset such as depreciation, financing are allowed for a tax deduction to a lessee.||Even the lease rent deduction from the tax is allowed.|
|10. Purchasing option||In a financial lease, the lessee gets an option to purchase the asset he has taken on a lease.||In an operating lease, the lessee is not given any such option.|
Understanding financial lease and an operating lease is essential. Understanding these will help you find out which one is more suitable for your business in a particular situation.
If you want to use assets, but don’t want to showcase under accounting record, operating lease is the best option for you. But you need to make sure that the lease shouldn’t follow the four criteria mentioned above.
If you want to use an asset which you can’t afford to buy right now, you should go for financial lease where you can use it for a more extended period, and at the same time, you would also be able to get an option to buy it at the end of the contractual period.
This article has been a guide to top differences between Financial Lease vs. Operating Lease, with practical examples along with infographics and comparative table. You may learn more about financing from the following articles –