Fixed assets are critical for the operations of a business. These can range from high value assets used by manufacturing entities in their production process to lower value assets such as office equipment and furniture required by most entities. Several entities may not have the funding to purchase these outright. To fill this need, there are several leasing companies that purchase fixed assets and lease them out to such entities for use in their business. A lease arrangement is when the leasing company (lessor) being the owner of an asset gives the entity (lessee) the right to use the asset in exchange of periodic lease payments.
This article looks at meaning of and differences between two types of leasing arrangements – finance lease and operating lease.
Definitions and explanations
Finance lease:
A finance lease is a leasing arrangement wherein the lessee makes lease payments to the lessor for the use of the asset, whose related risk and reward is also transferred to the lessee. Typically, before the end of the lease term, the lessee makes payment of residual value of the leased asset to the lessor and gets ownership of the asset.
A leasing arrangement is generally considered as a finance lease if:
- The lessee has the right to purchase the asset at the end of the lease term
- The lease term is at least 75% of the economic life of the asset
- The present value of the lease payments also approximates the current asset value.
Effectively a finance lease is akin to an EMI system wherein the cost of the leased asset (including financing cost) is paid for across the lease term.
Operating lease:
An operating lease is a leasing arrangement wherein the lessee makes periodic lease payments to the lessor as a consideration for use of the asset; however the lessee has no right of ownership of the leased asset during or after the lease term.
Operating lease can be of two types – wet lease and dry lease. Wet lease is when the responsibility of maintenance of the lease asset vests with the lessor. Dry lease is when the lessee bears the cost and responsibility of maintaining the leased asset.
Effectively an operating lease is akin to a normal rent agreement wherein the lessee uses the asset during the lease term.
Difference between finance lease and operating lease:
The difference between finance lease and operating lease has been detailed below:
1. Meaning
- Finance lease is a leasing arrangement in which the risk and reward related to the leased asset is also transferred to the lessee at the time of transfer of the asset in exchange for periodic lease payments.
- Operating lease is a leasing arrangement in which the risk and reward related to leased asset remains with the lessor and the lessee only has the right to use the asset during the lease term.
2. Transfer of ownership of the leased asset
- In finance lease, the lessee has the right to purchase and receive ownership of the leased asset before the end of the lease term.
- In an operating lease, the ownership of the leased asset remains with the lessor and no right of purchase at the end of the lease term is available.
3. Lease term
- The lease term of a finance lease is fairly long and is generally at least 75% of the economic life of the leased asset.
- The lease term of an operating lease is relatively shorter and may be as short as a few months to a few years.
4. Lease payments
- In a finance lease, the lease payments are higher. Generally, the present value of the sum of lease payments is equal to or more than 90% of the leased asset’s current value.
- In an operating lease, the lease payments are lower and need not aggregate to the current value of the leased asset.
5. Maintenance responsibility
- In a finance lease, the responsibility of insuring and maintaining the asset vests with the lessee.
- In an operating lease (other than dry lease), the responsibility of insuring and maintaining the asset vests with the lessor.
6. Accounting treatment by lessor (as per IFRS 16 – Leases)
- In a finance lease, the lessor derecognizes the leased fixed asset in its books. Instead, the lessor recognizes the present value of lease payments and residual value as a receivable in its books. The lessor also recognizes any profit or sale under this arrangement at the commencement of the lease. Subsequently, lease payments are recorded in the profit and loss account and simultaneously reduced from the receivable recorded in the books.
- In an operating lease, the lessor retains the lease asset as a fixed asset in its books. No receivable is created in the books initially, instead receipt of periodic lease payments are recognized as income in the profit and loss account in a manner similar to rent receipts.
7. Accounting treatment by lessee (as per IFRS 16 – Leases)
- In a finance lease (termed as right-of-use lease in IFRS), the lessee recognizes the leased asset as a fixed asset at cost in its books. The cost is determined as a sum of present value of lease payments (lease liability) plus any other direct costs incurred by the lessee. Simultaneously a lease liability is also created in the books. Subsequently, lease payments are recorded in the profit and loss account and reduced from the lease liability.
- In an operating lease (termed as short term lease in IFRS), no asset or liability is created in the books of accounts at the commencement of the lease. Lease payments are recognized in the profit and loss account in subsequent periods.
8. Tax benefit for lessee
- In a finance lease, the lessee can claim depreciation on the asset as well as finance charges of the lease as tax deductible expenses.
- In an operating lease, the lessee can claim the periodic lease payments as a tax deductible expense.
9. Akin to
- A finance lease is akin to a loan agreement and EMI arrangement.
- An operating lease is akin to a rental agreement.
10. Preferred for
- Finance leases are generally opted for in case of leasing of high value fixed assets required for a long duration such as plant and machinery and equipment.
- Operating leases are generally opted for in case of lower value assets which are intended to be used for a few years such as office equipment.
Conclusion – finance lease vs operating lease:
A business owner may utilize both finance lease and operating lease arrangements depending on his needs. When an entity requires high value assets especially for use in its production process but cannot afford to purchase it outright then they can opt for finance lease. On the other hand, if an entity requires to use an asset for a limited time and does not wish to actually own it then it can opt for operating lease.
