A lease can be an excellent way for businesses to acquire equipment. No wonder an increasing number of organizations today choose to lease long-term assets rather than buy them.
This decision to lease is primarily based on a range of factors, such as better financial terms, necessity, the lack of available funding, etc.
Finance and operating leases are the two different accounting methods used for such leases and contracts. Both leases are used for varied purposes and lead to differing treatment in accounting.
In this post, we'll learn more about finance vs. operating leases, including their meaning, features, impact, advantages, and more.
What is a Finance Lease?
Also known as a capital lease, a finance lease is an agreement in which the lessor allows the lessee to use a particular asset for a fixed term.
This covers the major part of the asset's economic life, without the transfer of title but with the transfer of risk and rewards.
Finance Lease Features
Below is some of the features of a finance lease:
- The lessor in the finance lease funds all the purchases of all the assets and leases them to the lessee.
- The required assets, such as vehicles, software, equipment, etc., are picked by the lessee.
- The lessee in this lease contract makes use of the asset during the tenure of the lease.
- When the lease expires, the lessee is given the option to acquire ownership of the asset at a bullet payment, which is often a discounted or bargain price.
Impact of Finance Leases
Some of the impacts of a finance lease are as follows:
- Since the finance leased asset is capitalized, it leads to an increase in assets as well as liabilities.
- In the cash flow statement, the finance lease impacts both operating and financial cash flows since the principal part of the lease is recorded under operating cash flow, and the interest part is recorded under financing cash flow.
- In a finance lease, the debt-equity ratio goes up due to an increase in outside liabilities, which leads to additional leverage.
Advantages of a Finance Lease
Some of the key advantages of a finance lease are as follows:
- The asset in a finance lease can be purchased through periodic installments rather than one large upfront investment.
- Finance lease contracts give you the option of flexible repayment structures.
- In the case of a finance lease, the lease rentals are spread out across the lease tenure, and the fixed payments don’t change (in most cases) due to changes in bank interest rates.
What is an Operating Lease?
An operating lease is an agreement in which the lessee is allowed to use an asset with the permission of the lessor for a limited term.
This term is shorter than the economic life of the asset without the transfer of title, risk, and reward.
An operating lease works more like a rental agreement, which is why the rental payments for the use of the asset are charged a rental expense in the profit and loss account in the lessee's books.
Features of an Operating Lease
Below are some of the key features of an operating lease:
- An operating lease refers to a short-term arrangement between the lessee and the lessor for the use of an asset.
- The overall term of the operating lease is always shorter than that of the economic life of that asset.
- In an operating lease, different costs related to that particular asset, such as maintenance costs, various taxes, etc., are paid by the asset owner.
- The rent which is paid in the operating lease by the lessee is lower than the cost of the asset.
- The lessee is free to cancel the operating lease before the end date of the lease.
- The overall terms of an operating lease can vary based on factors such as an agreement between the parties involved.
Impact of Operating Leases
Below are some of the key impacts of operating leases:
- In the case of an operating lease, you record the lease payments as operating expenses.
- The operating lease does not require you to list the equipment on the balance sheet because you do not own it.
- With an operating lease, the leased equipment is returned once the lease tenure is over. This is, therefore, a viable option for equipment you only require temporarily.
Advantages of Operating Leases
Among the key advantages of operating a lease are:
- There is no capital outlay in an operating lease, as you can get the asset you require for your business with zero or minimal outlay. Therefore, any capital that you have can be used for other purposes.
- Here, you can include insurance premiums, accessories, and government fees as part of your lease, so one repayment covers various costs.
- Operating a lease gives you the advantage of effective cash flow, as including a residual value (balloon payment) at the end of an operating lease allows you to reduce your payment and free up more cash.
- In an operating lease, you can opt to include various scheduled servicing and maintenance costs, including registration renewal and repairs in your lease, which can assist you in budgeting costs much more effectively.
Finance Lease vs. Operating Lease: Main Differences
Below is a summary of the key differences between finance/capital leases and operating leases:
Which is Better, a Finance/Capital Lease or an Operating Lease?
Finance and operating leases are gaining popularity among businesses as the company does not have to directly bear the cost of financing the asset. That is a key benefit of a lease agreement since the lessee gets ownership without having to own an asset, whereas the lessor gets to earn a profit on the asset.
However, companies do not prefer all types of leases to be maintained on their lease balance sheet. Many classify their leases as operating leases primarily because they were only recorded on their income statement without impacting the balance sheet.
Hence, operating leases are preferred more as they do not impact a company’s debt-to-equity ratio in a negative way.
This feature of an operating lease not getting recorded on a balance sheet allows the company to look stronger in terms of financials as compared to when the lease was classified as a finance lease. This is what makes an operating lease better than a finance or capital lease.
When it comes to managing finance and operating leases, robust lease management software plays an instrumental role in streamlining and automating the working of your lease contracts.
Managing leases using software with no-code platforms, like LeasO, can offer several advantages. Apart from automating the process, they also help track the status and updates regarding all the active leases at your organization.