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.
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.
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.
Difference between an operating lease and a finance 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.
Summing up
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.
The best part? You can apply for our business loans from the comfort of your home, right from filling out the application form to uploading the required documents.
So what are you waiting for? Apply for a business loan today and meet all your business financial needs with ease.
11 March 2024
6 mins read
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