Understanding the Difference Between Finance Lease and Operating Lease

When it comes to leasing, two common methods are finance lease and operating lease. Although they may seem similar, there are significant differences between the two. This blog post will explore the distinctions, provide examples, discuss their accounting treatment, and help you determine which lease is best for your business.

Finance Leases

Finance leases are typically used when the lessee intends to own the leased asset at the end of the lease term. In this type of lease, the lessee assumes most of the risks and rewards of ownership.

One example of a finance lease is leasing a printer. Let's say a company needs a high-quality printer for its daily operations but doesn't want to purchase it upfront. By entering into a finance lease agreement, the company can use the printer while making regular lease payments. At the end of the lease term, the company can exercise an option to purchase the printer at a predetermined price.

Operating Leases

On the other hand, operating leases are commonly used when the lessee wants to use an asset for a limited period without the intention of ownership. In this type of lease, the lessor retains most of the risks and rewards of ownership.

An example of an operating lease is leasing an X-ray machine for a medical clinic. The clinic may lease the machine for a few years to provide diagnostic services to its patients. At the end of the lease term, the clinic can either return the machine to the lessor or enter into a new lease agreement.

Key Differences

While both finance lease and operating lease serve different purposes, there are some key differences to consider:

• Ownership: With finance lease, the lessee intends to own the asset at the end of the lease term, whereas with operating lease, the lessee does not have the intention of ownership.
• Accounting Treatment: Finance leases are recognized as assets and liabilities on the lessee's balance sheet, while operating leases are not capitalized.
• Length of Lease: Finance leases are typically long-term leases, while operating leases are usually short-term leases.
• Risk and Rewards: In finance leases, the lessee assumes most of the risks and rewards of ownership. In operating leases, the lessor retains these risks and rewards.

Which Lease is Best for My Business?

Determining the best lease for your business depends on various factors, including your specific needs and financial situation. Finance leases may be more suitable if you want to own the asset at the end of the lease term and are willing to assume the associated risks and rewards. Operating leases, on the other hand, provide more flexibility and are better suited for short-term needs.

Accounting Treatment

Accounting treatment differs for finance leases and operating leases. Finance leases are capitalized, meaning the leased asset is recorded as an asset on the lessee's balance sheet, along with a corresponding liability. Operating leases, however, are not capitalized and are treated as operating expenses.

Conclusion

Understanding the difference between finance lease and operating lease is crucial for making informed decisions about leasing arrangements. Finance leases are suitable when ownership is desired, while operating leases offer flexibility for short-term needs. By considering factors such as ownership goals, accounting treatment, and lease terms, businesses can choose the lease that aligns best with their objectives.