Financing Lease vs Capital Lease: Understanding the Differences

When it comes to leasing transactions, individuals and corporations often encounter two specific types: financing leases and capital leases. Both types offer unique payback options and interest flexibility, making them popular choices for purchasing machinery and equipment. In this comprehensive guide, we will explore the differences between financing leases and capital leases, provide examples, and help you determine which option suits your needs best.

Finance Leases

Finance leases, also known as financing leases, are lease agreements where the lessee assumes most of the risks and rewards of ownership. In a finance lease, the lessee has the option to purchase the asset at the end of the lease term at a predetermined price, which is often significantly lower than the fair market value. This type of lease is commonly used for long-term assets and provides lessees with tax benefits and the ability to claim depreciation expenses.

For example, imagine a construction company leasing heavy machinery for a period of five years. At the end of the lease term, the construction company has the option to purchase the machinery at a predetermined price. If the company decides to exercise this option, they can continue using the machinery for as long as it remains functional, enjoying the benefits of ownership.

Operating Leases

On the other hand, operating leases are lease agreements where the lessee does not assume the risks and rewards of ownership. Operating leases are typically short-term leases used for assets with a shorter useful life. With an operating lease, the lessor retains ownership and responsibility for maintenance and other costs associated with the asset.

For example, consider a technology company leasing office space for a period of one year. At the end of the lease term, the company has the option to renew the lease or move to a different location. Since the technology company does not assume ownership or long-term responsibility for the office space, an operating lease provides flexibility and allows for easy relocation if necessary.

Which is Better: Financing Lease or Capital Lease?

The choice between a financing lease and a capital lease depends on various factors, including the lessee's financial goals, tax considerations, and the nature of the leased asset. Financing leases are often more suitable for long-term assets that the lessee intends to retain and use for an extended period. Capital leases, on the other hand, are better suited for assets that the lessee intends to use for a specific period and then return to the lessor.

It is essential to assess your specific needs and consult with financial professionals to determine which option aligns with your business objectives and financial strategy.

Journal Entry for Operating Lease

When recording an operating lease, the lessee typically makes monthly or periodic lease payments, which are expensed on the income statement. No asset or liability is recorded on the balance sheet. The journal entry for an operating lease reflects the expense incurred:

Debit: Lease Expense

Credit: Cash

Do Operating Leases Go on the Balance Sheet?

Under the new accounting standard ASC 842, operating leases must now be recognized on the lessee's balance sheet as both a right-of-use asset and a lease liability. This change aims to improve transparency and provide a more accurate representation of a company's financial position.

How Software Can Help You With Lease Accounting

Managing lease accounting can be complex, especially with the implementation of ASC 842. Fortunately, there are software solutions available that can streamline the lease accounting process, ensuring compliance with accounting standards and reducing the risk of errors. Lease accounting software helps companies accurately calculate lease liabilities, generate financial reports, and automate lease-related tasks.

Eliminate Lease Accounting Errors

Lease accounting errors can have significant financial implications for businesses. Avoiding these errors is crucial to maintain accurate financial records and comply with accounting regulations. By utilizing lease accounting software and following best practices, companies can minimize the risk of errors and ensure lease-related transactions are accurately recorded.

Conclusion

In summary, financing leases and capital leases are two distinct types of leasing transactions offering different payback options and interest flexibility. Finance leases provide lessees with the option to purchase the asset at the end of the lease term, while operating leases offer flexibility and ease of relocation. The choice between financing leases and capital leases depends on various factors and should be carefully considered based on individual needs and financial goals. Regardless of the chosen lease type, utilizing lease accounting software can help streamline the lease accounting process and ensure compliance with accounting standards.