Financial Lease vs Operating Lease: Understanding the Key Differences

Leasing is a common practice in the business world, allowing companies to access assets without the need for upfront purchase. Two common types of leases are financial leases and operating leases. While they may sound similar, there are key differences between the two that every business owner and accountant should understand.

What is a Financial Lease?

A financial lease, also known as a capital lease, is a long-term lease agreement where the lessee (the business) essentially buys the asset from the lessor (the owner) over time. The lessee assumes most of the risks and rewards associated with ownership, and the lease is typically non-cancelable.

Under a financial lease, the lessee records the leased asset as an asset on their balance sheet, along with the corresponding liability for the lease payments. This means that the leased asset and the lease liability are reported on the company's financial statements.

What is an Operating Lease?

An operating lease, on the other hand, is a short-term lease agreement where the lessee (the business) rents the asset from the lessor (the owner) for a specific period of time. The lessor retains the risks and rewards of ownership, and the lease is typically cancelable.

Unlike a financial lease, an operating lease does not require the lessee to record the leased asset or the lease liability on their balance sheet. Instead, the lease payments are treated as operating expenses and are recorded on the income statement.

Key Differences

Now that we understand the basic definitions of financial leases and operating leases, let's dive into the key differences between the two:

1. Ownership: In a financial lease, the lessee assumes most of the risks and rewards of ownership, while the lessor retains ownership in an operating lease.
2. Lease Term: Financial leases are typically long-term agreements, often covering the majority of the asset's useful life. Operating leases, on the other hand, are usually short-term agreements.
3. Accounting Treatment: Under a financial lease, the lessee records the leased asset and the lease liability on their balance sheet. In an operating lease, the lease payments are treated as operating expenses and are recorded on the income statement.
4. Cancellation: Financial leases are generally non-cancelable, meaning the lessee is obligated to make all lease payments. Operating leases, on the other hand, are usually cancelable, allowing the lessee to terminate the lease early.

Which is Better: Financial Lease or Operating Lease?

The choice between a financial lease and an operating lease depends on various factors, including the company's financial goals, the nature of the asset, and the company's accounting practices. Here are some considerations:

• Ownership Goals: If the company intends to own the asset at the end of the lease term, a financial lease may be more suitable.
• Short-Term Needs: If the company only requires the asset for a short period of time, an operating lease provides more flexibility.
• Accounting Impact: Companies looking to keep their balance sheet clean and avoid additional liabilities may prefer operating leases.
• Tax Implications: It's important to consult with a tax professional to understand the tax implications of both types of leases.

Journal Entry for Operating Lease

The journal entry for an operating lease includes recording the lease payments as an operating expense on the income statement. Here's an example:

Debit: Lease Expense
Credit: Cash

Do Operating Leases Go on the Balance Sheet?

Unlike financial leases, operating leases do not go on the balance sheet. Instead, the lease payments are treated as operating expenses on the income statement.

Conclusion

Financial leases and operating leases serve different purposes and have distinct accounting treatments. Understanding the differences between the two can help businesses make informed decisions when it comes to leasing assets. Whether you opt for a financial lease or an operating lease, it's crucial to consult with accounting professionals and consider your company's specific needs and goals.