The concept of a lease has origin from the business. Most businesses whether start-ups or big companies look for leasing options. The main reason is because of the limiting resources available and less money available for investing. Leasing can be broadly divided into two types – finance lease and operating lease.
Finance Lease vs Operating Lease
The main 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.
In a financial lease, the running and administration costs and expenses are usually higher. The lessor takes the larger residual risk and usually holds a low residual value position which can also be considered negligible. The financial lease provides a tax benefit to the lessee in form of interest and appreciation.
On the other hand, an operating lease has no running or administration expenses. The residual value position held is usually higher. No depreciation or tax benefit can be claimed in an operating lease. The commercial contract of operating lease allows the lessee to use the asset for a typically short period, and only by the lessor.
Comparison Table Between Finance Lease and Operating Lease
| Parameters of Comparison | Finance Lease | Operating Lease |
| Ownership | The ownership of the contract is transferred to the lessee | The ownership of the contract remains with the lessor |
| Time period | 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 |
| Cancellation authority | 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, as well as the return, is transferred to the lessee. Lessee is referred to as the business owner. Lessee often decides the lease assets for business and commercial purposes. The lesser allows the lessee to use the assets for a period that is typically long.
The finance lease does not provide any facility for canceling 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 contract is generally extended.
The concept of financial lease usually 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 usually at the end of the period of 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?
Operating lease refers to the type of lease where all the risk and the return usually stay with the lessor. The commercial contract of operating lease allows the lessee to use the asset for a typically 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 “off the balance sheet lease”. The ownership of the lease is generally under the lessor and not with the lessee.
The other name of operating lease is also known as 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.
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 financial lease is maintained by the lessee while the operating lease is maintained by the lessor.
- 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.
- Financial lease has provision for tax advantage and deduction like depreciation or financing while operating lease only allows the lease rent to be deducted from the tax.
- The option of purchase of financial lease is given to less while there is no provision of purchase in an operating lease.
Conclusion
Correct knowledge about financial leases and operating lease can help the business in particular situations. Each lease type caters to a different type of business. Leases can be easily upgraded to new schemes and technologies. The cash flow within the lease occurs in the form of repayments of the principal amount within the activities of financing.
Both the assets of the leases are owned by the leasing company. However, the provision of cancellation is not offered similarly in both leases. Both the lease provides flexibility to the lessee or the owning company as most of the period of payments can be chosen. The lease provides the freedom of buying all the fixed assets and can play a pivotal role in most businesses.
References
- https://www.tandfonline.com/doi/abs/10.1080/00014788.1998.9728913
- https://www.tandfonline.com/doi/abs/10.1080/0959396032000065373