What is Operating Lease?
An operating lease is a contract that allows for an asset’s use but does not convey ownership rights of the asset. These leases allow businesses to use the asset without incurring the high expenses involved in purchasing it.
The business that leases the asset is called the lessee, and the business that loans it under a lease is called the lessor. The responsibilities of each party in the agreement are spelled out in the lease contract and documents, but generally, the lessee must maintain the asset to ensure it remains in operational condition, less any normal wear and tear.
Operating leases are assets rented by a business where ownership of the asset is not transferred when the rental period is complete. Typically, assets rented under operating leases include real estate, aircraft, and equipment with long, useful life spans—such as vehicles, office equipment, or industry-specific machinery.
Essentially, an operating lease is a contract for a company to use an asset and return it in a similar condition to the lessor. This agreement is beneficial for the lessee, particularly when it has expensive equipment or other assets that need to be replaced regularly.
Operating leases are often treated as off-balance sheet items. This means that the leased asset and the associated lease liability may not be recorded on the lessee’s balance sheet, and the lease expenses are typically recognized on the income statement over the lease term.
What is Finance Lease?
A finance lease is a commercial lease in which the legal owner of an item is a finance business, and the user leases the asset for an agreed-upon amount of time. Finance leases (also known as capital leases) transfer most of the risks and rewards of asset ownership to the lessee. It is frequently used to purchase leased assets for most of its economic life.
In other words, a financial lease is a contractual arrangement where a lessee obtains the use of an asset for most of its economic life, resembling ownership. This type of lease comes with a purchase option, enabling the lessee to buy the asset at the lease term’s end. It offers advantages like cost distribution and tax benefits. But also comes with commitments and potentially higher total costs. It’s a way to use an asset without a big upfront cost, like a long-term rental with a chance to buy.
Finance leases are generally long-term leases, and the lease term usually cover the majority of the asset’s useful life. The lessee records the leased asset as well as the associated liability on its balance sheet. This makes the lease appear as a form of financing and impacts the lessee’s financial ratios. Generally, firms in a higher tax bracket would like to classify leases as finance.
The lessee is responsible for maintenance, insurance, and other operating costs associated with the leased asset. At the end of the lease, after the final payment has been made, the asset may be transferred to the lessee for a nominal amount.
Finance Lease vs Operating Lease: Key Differences
|Basis of Comparison
|Typically transfers to the lessee at the end of the lease term.
|Ownership remains with the lessor.
|Term of Lease
|Generally long-term, covering a significant portion of the asset’s useful life.
|Usually short-term, typically less than the asset’s economic life.
|Often includes a bargain purchase option or a predetermined residual value.
|Typically does not include a bargain purchase option; may have a fair market value purchase option.
|Lessee usually claims depreciation on the asset.
|No depreciation claimed by the lessee.
|Lessee is responsible for maintenance and other costs.
|Lessor retains maintenance responsibility in many cases.
|Risk and Rewards
|Lessee bears most of the risks and rewards of ownership.
|Lessor retains most of the risks and rewards of ownership.
|Recorded as an asset and liability on the lessee’s balance sheet.
|Generally not recorded on the lessee’s balance sheet; expenses are recognized on the income statement.
|Lessee may enjoy tax benefits, such as interest and depreciation deductions.
|Lessor receives tax benefits, and the lessee may benefit from lower lease payments.
|Typically less flexible; the lessee commits to a longer-term arrangement.
|Offers more flexibility, allowing the lessee to upgrade or switch to new assets more easily.
|Fewer restrictions on the usage of the leased asset.
|May have more restrictions on usage to protect the lessor’s interests.