Difference Between Operating and Financial Lease

The differences between two basic forms of lease viz. operating lease versus finance lease are mainly related to who owns the leased asset, what accounting and tax treatment are given, who bears the expenses and running costs. Please note that a finance lease and a capital lease are one and the same. We will be using these terms interchangeably.

Not only these, but operating lease versus capital lease also differ in whether a purchase option is present, and the length of the lease term.

Differences Between Financial (Capital) Vs. Operating Lease:

The differences are explained with the help of the following table against various aspects of both operating and financial leases.

Aspects of Difference Operating Lease Financial (Capital) Lease 

Definition

A lease in which all risks and rewards related to asset ownership remain with the lessor for the leased asset is called an operating lease. In this type of lease, the asset is returned by the lessee after using it for the agreed-upon lease term. Read more about Operating Lease for in-depth coverage. In a financial lease (also known as a capital lease), the risks and rewards related to ownership of the asset being leased are transferred to the lessee. Read this article on Finance Lease for more in-depth coverage.

Ownership

The ownership of the asset remains with the lessor for the entire lease period. The ownership transfer option at the end of the lease period is available to the lessee. The title may or may not be transferred eventually.

Accounting Effect

An operating lease is generally treated like renting. That means the lease payments are treated as operating expenses and the asset does not show on the balance sheet. A financial lease is generally treated like loan. Here, asset ownership is considered by the lessee, so the asset appears on the balance sheet.

 

Aspects of Difference

Operating Lease Financial (Capital) Lease 

PURCHASE OPTION

In an operating lease, the lessee does not have an option to buy the asset during the lease period. A financial lease allows the lessee to have a purchase option at less than the fair market value of the asset.

LEASE TERM

The lease term extends to less than 75% of the projected useful life of the leased asset. The lease term is generally the substantial economic life of the asset leased.

EXPENSES BORNE

The lessee pays only the monthly lease payment in an operating lease. In a financial lease, the lessee bears the cost of insurance, maintenance, and taxes.

TAX BENEFIT

Since an operating lease is as good as renting, the lease payment is considered an expense. No depreciation can be claimed. The lessee can claim both interest and depreciation, as a financial lease is treated as a loan.

RUNNING COST

In an operating lease, no running or administration costs are borne by the lessee, including registration, repairs etc., since this lease gives only the right to use the asset. In a financial lease, running costs and administration expenses are higher and are born by the lessee.

EXAMPLE

Projectors, Computers, Laptops, Coffee Dispensers, etc. Plant and Machinery, Land, Office Building, etc.

 

Difference between Operating and Financial Lease

Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

YOU MAY ALSO LIKE READING

OUR LATEST POSTS

15 thoughts on “Difference Between Operating and Financial Lease”

  1. Still don’t get it straight…. a little bit of confusion…
    Does it mean that if I buy a car to lease to someone who needs my services for two years and the year ends I can still own the car and that is operation lease?

    Reply
  2. Hi Nana,
    Thanks for asking the question and sorry for a delayed revert.
    You can lease out a car for 2 years to somebody. If, technically, the risks and rewards associated with the asset lie with you, yes you can call it an operating lease. In operating lease, the ownership is not transferred to the car user but you remain the owner of the car. In your case, the lease term is also less than 75% of the asset life, here also it qualifies to be called as an operating lease. I assume the life of a car is much more than 2 years.
    Thanks.

    Reply
  3. Very good explanations.
    But I have a problem with the accounting effect of operating lease. The “substance over form” concept of accounting requires that we treat transactions according to their economic impact but not their legal form and hence asset leased to a lessee should be recorded in the lessee’s balance sheet as he derives economic benefit from it.
    PLEASE I NEED CLARIFICATION ON THIS.

    Reply
    • Hi.
      Thanks a lot for this information. However I would like to ask something.
      I am not sure, but I have the feeling that after the ASC 842, even for Operatin Leases the lessee has the obligation to show the asset in the Sheet Balance. As I understood, either for Finance and Operating leases, the balance sheet must record a right-of-use asset and a lease liability. Is this correct or am I wrong?
      I would really appreciate if you could clarify this question.
      Thanks.

      Reply
  4. This was explained well and very easy to understand. Can you please describe what the substance of changes which will be brought about by IFRS 16 in 2019

    Reply
  5. I have read this publish and if I may just I desire to suggest you few fascinating issues or tips. Maybe you can write next articles referring to this article. I want to learn more things approximately it!

    Reply

Leave a Comment

Related Posts

Latest Posts