Financing Lease vs Operating Lease: Understanding the Key Differences

Leasing is a common practice for businesses to obtain access to property and equipment without the need for large upfront investments. Two popular types of leases are financing leases and operating leases. In this guide, we will dive into everything you need to know about financing lease vs operating lease, including examples of each and which option may be better for your business.

Finance Leases

Finance leases, also known as capital leases, are lease agreements that essentially transfer ownership of the leased asset to the lessee by the end of the lease term. These leases are often used for long-term financing of assets such as vehicles, machinery, or buildings.

One key characteristic of finance leases is that they are treated as an asset and liability on the lessee's balance sheet. This means that the lessee recognizes both the leased asset and the corresponding lease liability, which represents the present value of future lease payments.

Finance Lease Example

Let's take a look at a finance lease example to better understand how it works. ABC Corporation, a manufacturing company, decides to lease a new piece of machinery for its production line. The lease agreement specifies a lease term of five years and monthly lease payments of $1,000.

Under a finance lease, ABC Corporation would recognize the leased machinery as an asset on its balance sheet, along with a corresponding lease liability for the present value of future lease payments. The machinery's value would be depreciated over its useful life, and ABC Corporation would expense the monthly lease payments as interest expense and principal reduction.

Operating Leases

Operating leases, on the other hand, are lease agreements that do not transfer ownership of the leased asset to the lessee. These leases are typically used for short-term or non-core assets such as office space, vehicles, or equipment.

Unlike finance leases, operating leases are not recognized as an asset and liability on the lessee's balance sheet. Instead, the lease payments are treated as operating expenses and are recognized in the lessee's income statement.

Operating Lease Example

Let's consider an operating lease example to illustrate how it works. XYZ Corporation, a software development company, decides to lease office space for its new branch. The lease agreement specifies a lease term of three years and monthly lease payments of $2,000.

Under an operating lease, XYZ Corporation would treat the lease payments as operating expenses and recognize them on its income statement. The lease agreement does not impact the company's balance sheet or result in any asset or liability recognition.

Which is Better: Finance or Operating Lease?

The choice between a finance lease and an operating lease depends on various factors, including the nature of the asset, the intended use, and the lessee's financial goals. Here are a few considerations:

• Ownership: If the lessee intends to eventually own the asset, a finance lease may be a better option.
• Financial Reporting: Finance leases impact the lessee's balance sheet, while operating leases do not. This can have implications for financial ratios and capital structure.
• Tax Benefits: Depending on the jurisdiction, tax benefits may differ for finance and operating leases. It's important to consult with a tax professional to understand the tax implications.

Journal Entry for Operating Lease

When recording an operating lease, the lessee typically makes the following journal entry:

Debit: Lease Expense

Credit: Cash (or Accounts Payable, if the payment is to be made later)

Do Operating Leases Go on the Balance Sheet?

Operating leases are not recognized as assets and liabilities on the lessee's balance sheet under the current accounting standards. However, it's important to note that the accounting treatment for leases has recently changed with the introduction of ASC 842 and IFRS 16, which require lessees to recognize most leases on their balance sheets.

How Software Can Help You With Lease Accounting

Lease accounting can be complex, especially with the recent changes in accounting standards. Thankfully, there are software solutions available that can help businesses streamline their lease accounting processes and ensure compliance with the new standards. These software tools automate lease data management, lease classification, and lease calculation, saving time and reducing the risk of errors.

Eliminate Lease Accounting Errors

Lease accounting errors can have significant financial implications for businesses. It's crucial to have robust processes in place to prevent errors and ensure accurate lease accounting. By leveraging software solutions and implementing strong internal controls, businesses can minimize the risk of errors and maintain compliance with accounting standards.

Conclusion

Understanding the key differences between financing leases and operating leases is essential for businesses considering lease options. Finance leases transfer ownership of the asset to the lessee and are recognized as assets and liabilities on the balance sheet, while operating leases do not transfer ownership and are treated as operating expenses. The choice between the two depends on various factors, including the nature of the asset, financial reporting requirements, and tax implications. By leveraging software solutions and implementing strong internal controls, businesses can ensure accurate lease accounting and minimize the risk of errors.