Difference Between Finance Lease and Operating Lease
Leasing is one of the best or we can say a well-linked method that is obtained by businesses to obtain equipment, automobiles, and other assets without making an outright purchase of them.
There are 2 main categories of leasing- the Finance lease and Operating Lease. Both the solutions have certain benefits and drawbacks, so it is important to consider all the criteria before making a final decision of leasing.
In this article, we will discuss the key differences between finance lease and operating lease, and we will also provide you the difference table through which you will be able to understand the difference in a crisp way.
The asset's ownership is one of the primary distinctions that is noted between finance lease and operating lease. In finance lease, the owner of the lease, i.e, the lessee has the chance to acquire the asset at the end of the term, the end of the term is usually a little sum of money. Through this it is indicated that the lessee, with the option to purchase the asset at the end of the term, is essentially financing the purchase of the item over the lease term.
When it comes to operating lease, the lessor keeps ownership of the item in, and the lessee generally pays just the rental fee for the asset throughout the lease term. Generally, the lessee at the end of the lease term has 3 options: return the asset, renew the agreement, or upgrade to a newer model.
Length of Lease
When the asset is purchased on the agreement of Finance lease, then lessee is bounded with long term commitments as Finance Lease is a long term lease and is usually meant for majority of the asset's useful life. Finance Lease is known as a long term lease as the lessee is basically financing the purchase of the asset, and in the commitment the lease term is structure in such a way that it allows for the repayment of the entire cost of the asset over the term of the lease.
On the other hand, Operating Lease are said to be short term lease and is often measured less than the asset's useful life. Operating lease is known as a short-term lease as the lessor retains the ownership of the asset and the lease term is also structured in a way that allows the lessee to recover a portion of the asset's cost by lease payments.
A financing lease and operating lease are indeed fundamentally different in how the accounting is done. In Finance Lease, the owner of the asset treats the agreement as a purchase agreement and accounts for both the asset and any other related obligations on the lessee balance sheet. Through this, it is indicated that the lessee is paying for the asset's purchase and that the lease payments should be seen as loan payments.
On the other hand, the Operational Lease's lease payments are sought to be treated as rental expenses. Through this, we mean to say that the lessee's balance sheet does not include any assets or obligations. Because of this, the owner of the asset is basically renting the asset for the time period of the lease term or agreement, and the lease payments are considered operational expenses.
Cost of the Lease
Lets have a look at the primary difference between Finance and Operating lease- the Cost of the Lease.
As the finance leases are effectively purchase of the asset due to which the cost of the lease is often higher over the lease compared to an operating lease. This happens so that over the period of time or we can say over the course of the lease, the lessee can finance the total cost of the asset inclusive of the interest and the fees laid upon it.
On the other hand, because the lessor is financing some of the asset's cost, the cost of an operating lease is often lower over the lease term. This is so that the lessor, who still owns the asset, can regroup some of the purchase price by paying the lease payment.
Maintenance and Repairs
Another major distinction between Finance and Operating lease is their maintainance and repair. Under finance lease, the lessee is responsible for doing mainatinance and repair of the asset. It is the responsibility of the lessee as, the lessee ha effectively purchased the assets.
When we have a look at the operational lease, the lessor is indeed in charge of all asset maintainance, upkeep and repirs as well. This happens so that the lessor, who is "authorized" to keep the assets in excellent shape throughout the long lease terms and whosoever retains the ownership of it, may do so.
Finance Lease id generally less flexible than operating lease. It is stated like this because the finance lease is structured as a purchase of the asset, and the terms of the lease are fixed in a bounded agreement which is signed by the owner of the assets.
Operating lease, on the other hand, is more flexible as compared to finance lease. The sole reason behind this is that the lessor retains the ownership of the asset and is able to offer more flexible lease terms that too under a signed contract. By this it is depicted that the lessees are often able to make changes to the lease agreement during the committed lease term. The lessee will be able to upgrade to a newer model or can also adjust the lease term length.
To put it in simple terms, we can say that flexibility is one the vital factors to consider when you are choosing between finance lease and operating lease. Overall, Operating lease is more flexible than finance lease, some finance leases may offer flexibility through lease amendments.
End of Lease Options
The last and one of the most vital difference that we are going to talk about is the End of lease option. In Finance Lease, the lessee gets the option to purchase the asset at the end of term, the other option that the lessee gets is to return the lessor, and the last option the lessee gets is to renew the lease for a new term or to make a new agreement.
On the other hand, in case of operating lease, the lessee has 3 options- to return the asset at the end of the term, to renew the lease for a new term, or to upgrade a new model. This happens as the lessor retains tenure of the asset, and is able to offer more flexible end of lease options.
Overall, Finance lease and operating lease are two different types of lease agreements with visible differences. Finance leases are generally long-term leases that typically allows the user to purchase the asset at the end of the term or tenure, whereas operating leases are usually of sort period of time where the lessor retains the ownership of the asset.
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