The Difference Between Finance Lease and Operating Lease IFRS 16

An operating lease and a finance lease are two common types of leasing arrangements. These leases differ in their treatment under the International Financial Reporting Standards (IFRS) 16, which governs lease accounting.

What is an Operating Lease?

An operating lease is a contract that allows a company to use an asset without transferring ownership rights. Under an operating lease, the lessor retains the risks and rewards associated with the ownership of the asset.

How Operating Leases Work

In an operating lease, the lessee makes regular rental payments to the lessor in exchange for the right to use the asset. The lease term is usually shorter than the useful life of the asset, and the lessee does not bear the risk of obsolescence or fluctuations in the asset's value.

Advantages and Disadvantages of an Operating Lease

Operating leases offer several advantages, including lower upfront costs, flexibility to upgrade equipment, and off-balance sheet treatment. However, they also have disadvantages such as higher overall costs and no ownership rights.

Example of an Operating Lease

An example of an operating lease is when a company leases office space for a fixed period. The company pays rent to the lessor but does not own the office space.

Accounting for an Operating Lease

Under IFRS 16, operating leases are recorded on the lessee's balance sheet as right-of-use assets and lease liabilities. The lease payments are recognized as an expense over the lease term.

Operating Lease vs. Finance Lease

The main difference between an operating lease and a finance lease lies in the transfer of risks and rewards of ownership. In an operating lease, the lessor retains these risks and rewards, while in a finance lease, the lessee assumes them.

What Is the Meaning of Operating Lease?

An operating lease is a leasing arrangement where the lessee has the right to use an asset, but does not assume the risks and rewards of ownership.

What Is the Difference Between an Operating Lease and a Finance Lease?

The key difference between an operating lease and a finance lease is the transfer of risks and rewards. In an operating lease, the lessor retains these risks and rewards, while in a finance lease, the lessee assumes them.

What Are Operating Leases Used for?

Operating leases are commonly used for assets with short useful lives, such as office space, vehicles, or equipment. They provide companies with flexibility and lower upfront costs compared to finance leases.

The Bottom Line

Understanding the difference between finance lease and operating lease under IFRS 16 is crucial for lease accounting. While operating leases offer flexibility and off-balance sheet treatment, finance leases transfer the risks and rewards of ownership to the lessee.