In this article we will tell you the difference between Finance Lease and Operating Lease. Let’s take a look on this topic.
The two basic types of lease are Finance or Capital Lease and Operating Lease. Considering the terms and conditions and the type of assets, a lease can be identified as financial lease or an operating lease. The difference between the finance lease and operating lease are as follows:
Finance Lease is an arrangement commercially made between the lessee and the lessor. The lessee is the borrower who will choose an asset like vehicle, equipment etc. and the lessor who is the finance company will buy it for the lessee. The lessee or the borrower will use the asset but will pay instalments to use it. An operating lease is a short term lease where the finance company or the owner allows its customer to use the asset for a shorter period of time which is less than the life of the asset like if commercial life of a ship is 30 years then it may be provided to the borrower to use for a period of 7 years.
The total economic life of the asset is covered under the financial lease agreement. But the operating lease only covers the short time span for which the asset is leased.
In Financial lease the lessee or the borrower has to bear all the expense like taxes, maintenance, insurance amount etc. related to the asset being borrowed from the finance company. Whereas in case of operating lease the tax, maintenance, insurance and all other expenses are paid by the lessor or owner of that asset.
In financial lease the contract cannot be put to an end by the lessee unless otherwise mentioned in the agreement. The lessee will have to carry on through the whole contract period. But in operating lease the lessee may end the contract before the expiry time of the lease agreement.
The lessee can acquire the asset once all the instalments or the capital amount are paid. The lessor can thus recover the amount as well as the depreciation value as interest from the borrower. The borrower can also bargain and get the asset in lesser amount than the market value. So in financial lease the transfer of ownership of the asset can take place. The operating lease does not allow the transfer of ownership of the asset since the asset is leased for a short period.
The difference between the financial lease and operating lease can also be observed in balance sheets. In financial lease agreement the lease is considered as asset and liability. The lease payments (liability) are shown in the balance sheet. In operating lease, there is no risk of the owner. The payments are considered as the operating or maintenance expenses and are shown as profit and loss.
The above discussed criteria are the key differences between a financial lease and an operating lease. According to the benefits of the lease type and the need of the borrower, one should choose between the financial or operating lease. Both types of lease are beneficial in one way or the other.