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Difference Between Finance Lease and Operating Lease

By Tata Capital
29 December 2025
11 mins read
2980

Leasing has become a preferred avenue for companies to acquire assets without major upfront capital outlays. But choosing between a finance lease and an operating lease isn’t always easy. While both options allow using assets without ownership, the implications vary extensively.

Under a finance lease, the risks and rewards of asset ownership are effectively transferred to the lessee, making it similar to acquiring the asset outright through a loan. In contrast, operating leases are viewed as rental agreements, as asset ownership remains with the lessor.

The differences between an operating lease and a finance lease are extensive, encompassing aspects such as asset life coverage, treatment in financial books, payment structures, risk exposure, and tax implications. Choosing the appropriate lease structure according to asset utility intentions can lead to cost savings and flexibility in dynamic business conditions.

This article will delve into the differences between an operating lease and a finance lease.

Prior to discussing the differences between an operating lease and a finance lease, it’s essential to understand the distinction between a lessee and a lessor. A lessee refers to the user of the asset, while the lessor is the owner of the asset.

What is a financial lease?

A finance lease, often referred to as a capital lease, entails a long-term agreement where the lessee essentially assumes the risks and rewards associated with ownership, mirroring the characteristics of a purchase. In simpler terms, it’s a lease that effectively transfers the asset’s ownership rights to the user by the end of the lease term. This type of lease is commonly used for high-value assets like machinery, vehicles, or property.

For instance, Ayush owns a car, and Suresh wants to lease it for 5 years through a finance agreement. Suresh pays Ayush fixed monthly lease amounts and assumes all car costs and risks during the lease – including insurance and damages.

At the end of the 5-year lease, Suresh can make a final balloon payment to Ayush to obtain ownership of the car. This structure allows Suresh to use the car without an outright purchase initially while retaining the option to buy the car by making the final payment when the lease terminates.

Also, read – Equipment Leasing vs Equipment Financing

Pros of financial lease

– Lessors benefit from tax deductions due to asset depreciation, while lessees can deduct lease payments as expenses.

– Lessors receive regular rental payments from lessees, ensuring a consistent revenue stream.

Cons of financial lease

– Finance leases cannot be canceled, so lessees must continue payments even if they don’t use the asset.

– Lessees do not own the leased asset, and lessors have sole discretion over selling it.

What is an operating lease?

In contrast to a finance lease, an operating lease is a shorter-term arrangement wherein the owner retains the asset’s ownership throughout the lease period. Operating leases are used for assets with shorter lifespans or those subject to frequent technological advancements, such as office space, vehicles, or certain types of equipment.

Let’s say Mukesh is opening a new store in Mumbai. He enters a 3-year rental agreement for shop space with a local builder. Mukesh only gains the right to use the retail space by paying rentals. The shop space will never become an asset in Mukesh’s books. He records monthly rental expense on his income statement. All risks remain with the builder.

Before discussing the difference between an operating lease and a finance lease, let’s look at a few of the pros and cons of an operating lease.

Also, read – What Is Lease Rental Discounting

Pros of operating lease

– Since the lessee doesn’t aim to own the asset, the financial burden is reduced, making it suitable for smaller businesses or short-term leases.

– Operating leases offer a way to utilise equipment for a limited period, ideal for businesses concerned about rapid technological advancements.

Cons of operating lease

– Lessees don’t gain equity or decision-making rights with the asset, as they would with ownership.

– Interest expenses are incurred during lease financing despite not gaining equity.

Also, read – What Is Leasehold Property?

Key Differences: Finance Lease vs Operating Lease

The table below represents a comprehensive difference between an operating lease and a finance lease.

Basis of distinction	Financial lease	Operational lease
Tenure	Long term	Short term
Transferability	Ownership rights are transferred to the lessee during the lease, while the lessor retains legal title.	Ownership remains with the lessor throughout the lease term.
Revocation	Once entered, the financial lease agreement usually cannot be canceled.	Contract revocation may be possible under specific conditions, particularly within the initial period.
Tax benefits	Tax benefits include deductions for depreciation, financing charges, and maintenance costs incurred by the lessee.	Tax benefits primarily involve deductions for rental payments made by the lessee.
Risk and reward allocation	Lessees are responsible for maintaining and servicing the leased asset.	Maintenance and servicing responsibilities typically fall on the lessor.
Accounting	Financial lease obligations are recorded on the lessee’s balance sheet as assets and liabilities.	Operational lease expenses are recorded on the lessee’s income statement as operating expenses.

Accounting Treatment: Finance Lease vs Operating Lease under IFRS & GAAP

Understanding the difference between financial lease and operating lease is essential for businesses dealing with leased assets. Under IFRS, a finance lease is recognised on the balance sheet as both an asset and a liability, reflecting the right to use the asset and the obligation to make lease payments. The leased asset is depreciated over its useful life, while interest expense is recorded separately. This approach provides transparency and allows businesses to accurately present their financial position. GAAP follows a similar principle, although the classification criteria can differ, which may impact financial ratios and reporting.

On the other hand, operating leases under IFRS are treated off-balance sheet, with lease payments recognised as an expense over the lease term. This simplifies accounting but provides less insight into a company’s obligations and assets. Under GAAP, operating leases are also expensed over time, although recent updates require some disclosures to improve comparability.

Choosing between a finance lease and an operating lease requires careful evaluation of cash flow, asset control, and compliance with accounting standards. Consulting a reliable lender can help businesses make informed decisions that align with their long-term financial strategy and operational needs, ensuring both efficiency and regulatory compliance.

Also, read – Residual Value: Meaning, Importance, How to Calculate and Examples

Tax Implications and Benefits in India

Navigating the tax aspects of leasing can significantly influence business decisions. Knowing the finance lease and operating lease difference helps in optimising tax benefits while maintaining compliance with Indian regulations.

Depreciation Benefits for Finance Leases: In a finance lease, the lessee recognises the leased asset on the balance sheet. This allows businesses to claim depreciation on the asset, reducing taxable income and providing long-term tax savings.

Expense Recognition for Operating Leases: Payments made under an operating lease are treated as operational expenses. This enables immediate deduction from taxable profits, offering a simpler approach to tax planning compared to finance leases.

Interest Deduction: For finance leases, interest component of the lease payments can be claimed as a business expense. This further reduces taxable income and improves cash flow management.

Impact on Financial Statements: Choosing between finance lease vs operating lease affects how assets and liabilities appear in financial statements, influencing both tax planning and borrowing capacity.

Guidance from Lenders: Consulting a reliable lender ensures businesses take full advantage of tax benefits while complying with statutory requirements. This allows informed decision-making aligned with strategic financial goals.

Also, read – How is supply chain financing bridging the financing gap for MSMEs in India?

When to Choose Finance Lease vs Operating Lease: Decision Factors

Selecting the right lease structure can significantly affect a company’s financial health and operational flexibility. Recognising the finance lease and operating lease difference helps businesses make informed decisions that align with both strategic and financial goals.

Ownership and Asset Control: Opt for a finance lease when the intention is to eventually own the asset. This allows the lessee to record the asset on the balance sheet, enabling depreciation and interest benefits. Operating leases are better suited for temporary asset use without ownership responsibilities.

Impact on Cash Flow: Operating leases require regular lease payments treated as operating expenses, offering predictable short-term cash flow management. Finance leases involve higher initial obligations but provide long-term financial advantages.

Tax and Accounting Considerations: Finance leases allow depreciation and interest expense deductions, reducing taxable income. Operating lease payments are expensed over time, simplifying accounting but limiting balance sheet recognition.

Asset Lifespan and Usage Needs: Choose a finance lease for long-term, high-value assets, and an operating lease for assets that may become obsolete quickly or require frequent upgrades.

Guidance from Lenders: Consulting a reliable lender ensures alignment of lease choices with business objectives, compliance requirements, and optimal financial strategy when considering finance lease vs operating lease.

Finance Lease: Accounting Journal Entries Example

Recording finance lease transactions accurately ensures clear financial reporting. A finance lease recognises both an asset and a liability on the balance sheet, showing the company’s right to use the asset and its obligation to the lender.

Initial Recognition: When the lease begins, the leased asset is debited, and the corresponding lease liability is credited. This reflects the company’s control over the asset and its commitment to the lender.

Lease Payment Allocation: Each payment is split between interest expense and principal repayment. Interest expense is debited to the profit and loss account, while the principal portion reduces the lease liability on the balance sheet.

Depreciation Entry: The leased asset is depreciated over its useful life. Depreciation is debited to the profit and loss account and credited to accumulated depreciation, ensuring accurate representation of asset value.

Impact on Financial Statements: Proper journal entries ensure transparency and compliance with accounting standards, making it easier for stakeholders to understand the financial implications of a finance lease compared to an operating lease.

Also, read – What is Project Financing?

Operating Lease: Accounting Journal Entries Example

Recording operating lease transactions is simple and supports clear financial reporting. Unlike a finance lease, an operating lease does not recognise the asset or liability on the balance sheet, keeping it off-balance sheet.

Lease Payment Entry: Payments under an operating lease are recorded as an expense in the profit and loss account. This reduces taxable income and reflects the cost of using the asset during the lease period.

Payment to Lender: When payments are made, cash or bank is credited, and lease expense is debited. This records the outflow of resources to the lender accurately.

Financial Impact: Entries for operating leases are straightforward, providing transparency in expense reporting. They do not affect asset ownership or depreciation, making them suitable for short-term or flexible asset usage.

Conclusion

Choosing between a finance lease vs operating lease requires careful consideration of the specific needs and objectives of the business. While finance leases offer ownership rights and potential tax benefits, they entail long-term commitments and higher overall costs.

On the other hand, operating leases provide flexibility and minimal maintenance obligations but lack ownership rights and may result in higher expenses over time. Understanding these differences between operating vs finance leases allows lessees and lessors to evaluate and employ the appropriate lease model to meet their business objectives.

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FAQs

Can ownership be transferred in a finance lease?

Yes, in a finance lease vs operating lease comparison, ownership of the asset usually transfers to the lessee at the end of a finance lease, while under an operating lease, it stays with the lessor.

Are operating leases deductible as business expenses in India?

An operating lease is essential for businesses in India, as lease payments are fully deductible as business expenses, providing flexibility in cash flow and tax planning.

What happens to the asset at the end of a finance lease?

At the end of a finance lease, the lessee may gain ownership or purchase the asset, highlighting a key finance lease and operating lease difference for long-term asset control.

Can an operating lease be cancelled early?

To distinguish between financial lease and operating lease, note that operating leases are generally cancellable before term ends, providing businesses with flexibility unlike rigid finance leases.

Which lease type is better for tax savings in India?

For tax efficiency, operating lease provides better deductions as lease payments are fully recognised as business expenses, whereas finance leases emphasise asset ownership, long-term benefits, and less immediate tax flexibility.

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