Differences Between Financial And Operating Leases
In the financial and accounting context, a lease is an agreement between two parties, the lessor and the lessee, whereby the lessor allows the lessee to use an asset for a set period of time in exchange for a lump sum of money or payment in instalments if they so choose.
The lessor’s right to use the asset is not subject to any dependencies or service obligations associated with the operation of the asset.
Such leases are classified into two types:
- financial leases;
- operating leases.
Finance lease and operating lease
What is a financial lease?
This is considered an agreement used for the acquisition of goods without the need to apply for loans from financial entities or make large investments since payments are structured over time.
In this way, the asset can be transferred or sold optionally without the contract expressing the final sale. The lessor receives the full cost of the asset upon completion of the payments.
Benefits of this type of lease:
- The value and recurrence of payments are established.
- A minimum cost is established in advance.
- The rent is deducted from corporate taxes.
- Acts as an additional line of financing that does not affect banking arrangements.
- The lease comprises about 70 % of the asset’s useful life.
What is an operating lease?
This type of lease is known as a landlord/tenant lease. It is a contract between two parties, where the owner of an asset transfers the right to use it to any natural or legal person in exchange for a full or periodic payment.
Advantages of operating lease:
- Lease terms are usually short or so-called open-ended contracts.
- No down payment is required to start using the property.
- There is no ongoing maintenance of the asset.
- Allows for the renewal of equipment such as office equipment.
- It is very useful for rapidly depreciating assets.
Differences between finance lease and operating lease
This type of lease has specific aspects that comprise its definition:
- It transfers to the subscriber all the advantages and risks associated with the asset or property.
- When the lease comes to an end, the full transfer of the asset takes place.
- The option to purchase the property at the price established when the contract is made is maintained.
- The value of the periodic payments or lease instalments corresponds to a fair value of the asset established from the beginning.
- The lessee is responsible for the care and maintenance of the leased asset.
- Sometimes a lease of this type is considered as such even if there is no established purchase option. In other words, if the value of the minimum lease payments is equivalent to the reasonable price of the asset and all the advantages of the asset have been transferred, it is referred to as a financial lease.
- Another accounting difference is that this lease must be recorded as if it were the acquisition or purchase of an asset on credit.
This is usually the most common type of lease, and its differences with the previous one are as follows:
- It is established for a determined price and time.
- There is no transfer of the benefits and risks of ownership.
- The lessee contracts additional services such as insurance, maintenance, assistance, especially when it comes to assets that require prompt depreciation, such as electronic goods.
- The care and maintenance of the leased property are provided by the lessor.
- There is no purchase option on the asset being leased.
- Several users can take advantage of the leased asset.
- The value of the minimum lease payments does not correspond to the fair value of the leased asset.
- In accounting matters, this lease is recorded as a rental expense.
Examples of each type of lease
Each of these leases can be evidenced in different circumstances that will depend closely on the needs of the landlord and tenant. Here are some sample cases:
A company dedicated to the manufacture of bicycles has leased to another specific machinery for its production plant. The useful life of this machinery is 5 years and the lease establishes the same period. Similarly, the fair value of the equipment is 20 million euros and the fair value of the total lease payments is just over 15 million euros.
The machinery is specially designed for the leasing company’s operations, and the contract allows it to extend the lease term to lower instalments or to definitively purchase the leased equipment at the end of the agreed 5-year term, this in exchange for an additional 1 million euro.
The contract is established for the acquisition of a car for a specific period of one year. This contract specifies the payment of the same through fixed instalments of 100 euros and with all service expenses covered.
In this case, the car is owned by the person or company that rents it, and the lessor has the right to use it without having to take responsibility for additional maintenance and care costs. Similarly, the lessor is dependent on buying the property at the time the contract ends.
This lease also applies to machinery, computer hardware, office equipment, and more.