Financial Lease vs Operating LeaseWhat are the differences?

When you need certain properties but don’t have the cash needed to acquire them, there is always the option of leasing.

For example, if you want an office space to house your business’s administrative function, you can just rent it instead of purchasing one.

Of if you want a building to house your production process, you can rent it instead of purchasing one.

Furthermore if you need service vehicles for your sales personnel, you can lease that as well!

Leasing allows a business to use the leased properties without having to own them.

It gives businesses another option to continue their operations.

Plus, leasing allows businesses to use certain properties without having to commit to their full useful life.

It’s pretty convenient for both parties (the lessee and lessor).

The lessee won’t have to worry about having immediate cash to purchase the property.

The lessor will have a reliable monthly inflow of cash without having to sell the property.

Additionally, depending on the length of the lease, the lessor may be able to lease the property to different lessees.

In accounting, lease contracts can be categorized depending on the terms of the contract.

These two types of lease contracts are finance lease and operating lease.

As they’re both types of leasing contracts, they have one thing in common.

That is, there are at least two parties: the lessor who provides the property to be leased, and the lessee who acquires the right to use the leased property.

In this article, we will be discussing what these two types of leases are.

We will also discuss the differences between the two types of leases.

By the end of the article, you should be able to distinguish between the two types of leases.

What is a lease?

According to IFRS 16 – Leases:

“A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.”

A lease is a type of contract wherein there are two parties – the lessor and the lessee.

It is a legal and binding contract, and as such, there are consequences if either party fails to uphold the terms of the lease contract.

The lessor is the party responsible for providing the property to be leased/rented.

In exchange, the lessor receives payment depending on the terms of the contract.

On the other hand, the lessee is the party that acquires the right to use the leased property.

In exchange, the lessee is responsible for making payments to the lessor according to the terms of the contract.

What differentiates a lease from a common rent contract is the length/term of the contract.

A common rent arrangement usually has a short term (e.g. 30 days, 60 days, etc.).

On the other hand, a lease contract can span for a year or more.

When IFRS 16 was issued, there was a considerable shift in accounting for leases.

Before the issuance of IFRS 16, only capital leases (now referred to as financial leases) are required to be presented on the business’s balance sheet.

Post issuance of IFRS, all leases that have a term of more than 12 months are required to be presented on the business’s balance sheet.

This is regardless of whether the lease is an operating or finance lease. The asset and liability accounts to be reported will depend on the type of lease.

What is a finance lease?

A finance lease (also referred to as capital lease) is a type of lease contract in which the lessee carries the risk and rewards associated with the ownership of the property.

Legally, the lessor still owns the property.

But in accounting, the lessee has economic ownership over the asset.

So in substance, the lessee is the owner of the leased property.

Under the US GAAP, for a lease to be recognized as a finance lease, one of the following conditions must be met:

• The lease term covers a major part (more than 75%) of the property’s useful life. For example, a property has a useful life of 4 years. If the lease has a duration of more than 3 years, then it is considered a finance lease
• The present value of all cash flows related to the lease (lease payments and any residual value) is equal to or greater than the fair market value of the leased property
• The lessee is granted an option to purchase the leased property at a price that is lower than its fair value; also known as the “bargain purchase option”
• At the end of the lease, the legal ownership of the leased property is transferred from the lessor to the lessee

Aside from the conditions above, a lease may also be considered a finance lease if it meets this condition:

• The leased property is specialized for the use of the lessee. The lessor does not have any alternative use for it when the lease term ends

A finance lease is an alternative to buying properties that the business will surely use for a major part of its useful life.

With it, the business is given an option to make regular payments while enjoying the economic benefits of the property.

What is an operating lease?

An operating lease is a type of lease contract wherein the lessee acquires the right to use the leased property.

The lessor is responsible for providing the leased property.

An operating lease typically has a term that is shorter than the useful life of the leased property.

Additionally, the lessor retains ownership of the leased property even after the end of the lease.

An operating lease is ideal for properties that have a residual value (e.g. vehicles, machinery, plant).

At the end of the lease term, the lessor can lease out the property again.

Or the lessor can sell it for its residual value.

On the lessee’s part, it allows the use of a property for business operations without having to purchase it.

Additionally, the lessee does not have to fully commit to the full useful life of the leased property.

The lessee is allowed to pursue another property at the end of the lease term if s/he wants to.

On the lessor’s part, an operating lease allows earning from the leased property without having to transfer its ownership.

This means that the lessor still has the legal right to the leased property.

And since the leased property has a residual value after the lease term, s/he has the choice to lease it out again or sell it.

Prior to the issuance of IFRS 16, all operating leases were not required to be recognized in a business’s balance sheet.

This allowed businesses to accumulate properties without having to record them in their books.

However, with the FASB’s issuance of IFRS 16, operating leases that have a term of more than 12 months are required to be shown on a business’s balance sheet.

The new standard may pave the way to more accurate financial statements.

Finance Lease vs Operating Lease

Essentially, any lease that isn’t a finance lease is an operating lease.

But before we can get to that conclusion, we must elaborate on the difference between the two types of leases.

Ownership over the leased property

During the duration of both types of lease, the legal ownership over the leased property remains with the lessor.

However, under a finance lease agreement, the lessee carries the economic risks and rewards that come with the leased property.

So in substance, the lessee is the owner of the leased property, just not on paper.

On the other hand, an operating lease agreement only provides the lessee the right to use the leased property.

The ownership over the leased property is not transferred to the lessee unless the lessor transfers it by way of sale or donation.

At the end of the term, the lessee in a finance lease agreement can exercise his/her option to purchase the property at a much lower price than the residual value.

In most finance lease agreements, this bargain purchase option is reasonably expected to be exercised.

Thus, most finance lease agreements end with a transfer of ownership to the lessee.

In contrast, operating leases don’t have such purchase options.

Transfer of ownership over the leased property will remain with the lessor unless s/he decides to sell or donate it.

Terms of the lease

A finance lease will typically have a term that is more than 75% of the leased property’s useful life.

As such, it is almost guaranteed to be long-term (i.e. more than 12 months).

For example, a leased property has a useful life of 10 years.

If the lease has a term of more than 7.5 years, then it is considered a finance lease.

In contrast, an operating lease can either be short-term or long-term.

Since an operating lease typically has a term that is shorter than the useful life of the leased property, it can be short-term (12 months or less) or long-term (more than 12 months).

Provided that the lease term does not exceed 75% of the leased property’s useful life.

For example, a leased property has a useful life of 10 years.

The lease term could be as short as 30 days or as long as 7.5 years, and it’d still be considered an operating lease.

But if the lease term exceeds 7.5 years, then it’d be considered a finance lease.

Maintenance of the leased property

Maintenance of the leased property is the responsibility of the owner.

As such, in a finance lease agreement, maintenance of the leased property lies on the part of the lessee.

Unless it’s explicitly stated in the lease contract that responsibility lies with the lessor.

On the other hand, under an operating lease, maintenance of the leased property lies on the part of the lessor.

This is because the lessor retains ownership of the leased property in substance and form.

Of course, this may be contested if the lease contract explicitly mentions that it is the lessee’s responsibility.

But otherwise, the responsibility lies with the lessor.

Risk of obsolescence

Same with the responsibility for the maintenance of the leased property, the risk of obsolescence is carried by the owner.

As such, under a finance lease agreement, the lessee carries the risk of obsolescence.

Even if the leased property becomes obsolete, the lessee will have to abide by the lease contract.

If the lessee chooses to terminate the lease contract due to obsolescence of the property, s/he will have to make up for the amount of loss incurred by the lessor.

Under an operating lease agreement, the lessor carries the risk of obsolescence.

If the leased property becomes obsolete, the lessee is not responsible for the losses.

Additionally, the lessee can choose to not extend the loan agreement once it ends.

Accounting for the lease

(This section follows IFRS 16 – Leases)

On the lessee’s part, accounting for leases will depend on the term of the lease.

If the lease term is 12 months or less, the lessee can opt to record the lease as an outright expense.

If the lease term is more than 12 months, then the lessee would have to record an asset and a liability account.

On the lessor’s part, accounting for leases will depend on whether the lease is a finance or operating lease.

If the lease is a finance lease, the lessor will have to record a receivable equal to the amount of the net investment in the lease.

If the lease is an operating lease, the payments received are recorded as rent income.

Conclusion

Understanding whether the lease agreement you’re about to go into is a finance or operating lease is essential.

It will help you in choosing the best lease agreement for your business or the property that you are about to lease.

For example, if you want to rent a property with the intention to purchase it, then a finance lease agreement would be ideal for you.

However, if you just want to rent a property for a short-term period and renew it only when necessary, then an operating lease agreement would be best for you.

Knowing which type of lease is the most suited for your situation will help in managing your finances.