How does financial lease differ from operating lease?
Financial leases and operating leases are two common types of lease agreements that businesses use to acquire assets.
They differ primarily in terms of their accounting treatment, ownership transfer, and the nature of the lease. Here are the key distinctions between financial leases and operating leases:
Ownership and Transfer of Risk and Rewards
- Financial Lease: In a financial lease, the lessee (the party leasing the asset) typically assumes the benefits and risks of ownership similar to an owner. The lessee is responsible for maintenance, insurance, and taxes associated with the asset. At the lease term’s conclusion, the lessee often has the option to purchase the asset at a predetermined price, usually a nominal amount.
- Operating Lease: In an operating lease, the lessor (the entity leasing out the asset) retains ownership of the asset throughout the lease term. The lessee generally lacks the option to buy the asset at the lease term’s end. The lessor is responsible for maintenance and may cover additional costs, such as insurance and taxes.
Financial Lease: Financial leases are typically treated as capital leases for accounting purposes. This means that the lessee reports both the asset and the corresponding liability on their balance sheet. Lease payments comprise interest and principal reduction and are recognized as both an expense and a reduction of the lease liability on the income statement and balance sheet.
- Operating Lease: Operating leases are often treated as operating expenses. The lessee does not record the leased asset or liability on the balance sheet. Lease payments are recognized as operating expenses on the income statement.
Duration and Flexibility of Financial Lease and Operating Lease
Financial Lease: Financial leases are typically long-term leases, frequently used for assets with an extended economic life. These leases offer less flexibility regarding termination or early termination.
- Operating Lease: Operating leases generally have shorter durations and greater flexibility. They are commonly employed for assets with shorter economic lives and can be more readily terminated or renewed.
Financial Lease: Financial leases are often chosen when the lessee intends to use the asset for most or all of its useful life. The lessee essentially assumes ownership responsibilities.
- Operating Lease: Operating leases are more frequently used for assets that the lessee intends to use for a portion of their useful life. The lessor maintains ownership, and the lessee enjoys more flexibility, including the option to return the asset or lease a newer one after the lease term concludes.
In summary, financial leases resemble ownership arrangements, involve different accounting treatments, and typically entail long-term commitments.
In contrast, operating leases resemble rental agreements, result in different accounting treatments, and offer greater flexibility, making them suitable for shorter-term or non-core assets.
The choice between these types of leases depends on factors such as the asset’s nature, the lessee’s accounting and financial goals, and the desired level of control and ownership.
For the further article reading please go through the following subject MANAGEMENT OF FINANCIAL SERVICES.